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FFH equity hedges --- trying to understand


el_chieh
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I'm having a hell of a (very bad!) time understanding how FFHs short equity index and short equity swaps are reflected on its financials.

 

Please help me connect dots in the financials:

 

From 2009 to 2Q13 FFH generated net investment losses from equity hedges of $2,220.8BN (mostly "unrealized") and "paid net cash in connection with the reset provisions of its short equity and equity index total return swaps" of $2,269.7BN.

 

As of 2Q13 FFH had $1,022.7BN in "assets pledged for short sale and derivative obligations" as part of its investment portfolio (including holdco cash).

 

As of 2Q13, FFH has $94.4MM in "short sale and derivative obligations" related to its short swaps out of a total of $132.1MM.

 

As of 2Q13, the short swaps are carried on the books at $61.4MM (Assets: $155.8MM, Liabilities: $94.4MM).

 

I really can't tie all the above together:

 

+ If FFH closes the short swaps, what happens to the $1,022.7MM collateral?

 

+ Has FFH already paid out >$2BN to counterparties?  Does FFH investment portfolio (including holdco cash) still hold the $2BN?

 

+ Is $1,022.7MM in collateral in addition to the >$2BN paid out above?  Or, do we still owe counterparties ~$1BN after the collateral?

 

+ What is "short sale and derivative obligation" of $132.1MM (of which $94.4MM is related to short swaps)? 

 

Thanks!

 

 

 

 

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My understanding:

These are OTC swaps. To enter into the swaps, Fairfax was required to post "initial margin" of $1b. This is collateral to cover P&L between reset dates of the swaps in the case that Fairfax defaults and can't pay.

 

The swaps reset/settle on some periodic basis. Meaning, periodically (a) Fairfax sends the P&L to the bank, and (b) the bank sends LIBOR plus some spread on a notional amount to Fairfax. After this settlement, the contract has 0 balance sheet value. It's similar to an exchange traded futures contract that settles daily after which a "new" contract is effectively created at 0 value. Except the settlement is less frequent.

 

Fairfax has since lost $2b. So assuming this $2b is net (including interest accrual to Fairfax), yes Fairfax would have sent the $2b to the counterparty (+/- a relatively small amount of additional collateral to cover P&L since the last reset).

 

If they unwind the contracts in a somewhat orderly fashion they should get most of that $1b back. Some would probably go to cover the P&L since the last reset.

 

I believe the $132mm is what they have lost since the last reset date on certain contracts (emphasis on certain because other contracts are in asset positions). They have not paid this amount to counterparties yet, but appear to have posted a small amount of additional collateral.

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Thanks, helpful.

 

So to confirm:

 

~$2BN has been paid out to counterparties (our P&L losses)...this cash has left FFH, unlike our investments which contain the collateral.

 

~$1BN on our books is deposited as collateral in favor of counterparties, to support our swaps.

 

~$94MM (out of $132MM which includes other derivatives) still owed to counterparties (in between resets).

 

~$156MM in short swap value (as quoted by broker-dealers).

 

 

 

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Yes I think that is pretty much right. Though I'm not sure what you mean by "our investments which contain the collateral."

 

The $156mm is the gross value of the contracts in an asset position, not the net value of the swaps. I'm not sure if these are broker quotes or if there is a counterparty credit risk adjustment on top of the trivial part of marking the P&L.

 

Minor point, but I guess I would note also that the $1b in collateral is mostly, but not soley attributable to the equity swaps.

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I agree with wknecht. I work with equity swap derivatives every day and have added some clarity below:

My understanding:

These are OTC swaps. To enter into the swaps, Fairfax was required to post "initial margin" of $1b. This is collateral to cover P&L between reset dates of the swaps in the case that Fairfax defaults and can't pay.

This is mostly correctly. Also probably includes variation margin to some extent for the P/L that has moved against Fairfax/Counterparty since the last cash settlement.

 

The swaps reset/settle on some periodic basis. Meaning, periodically (a) Fairfax sends the P&L to the bank, and (b) the bank sends LIBOR plus some spread on a notional amount to Fairfax. After this settlement, the contract has 0 balance sheet value. It's similar to an exchange traded futures contract that settles daily after which a "new" contract is effectively created at 0 value. Except the settlement is less frequent.

 

Fairfax has since lost $2b. So assuming this $2b is net (including interest accrual to Fairfax), yes Fairfax would have sent the $2b to the counterparty (+/- a relatively small amount of additional collateral to cover P&L since the last reset).

 

Also correct. It could also be LIBOR minus a spread depending on swap rates. From the looks of it, Fairfax lost 2,220B on the index portion of the swap, but paid a total amount of 2,269B total. This means they're probably losing money on the interest leg too if the subtracting of the spread resulted in a negative figure for a period of time (totally possible, have seen it before).

 

Since these typically settle monthly, or quarterly, it's possible Fairfax was losing money on both sides of the trade for 3 or more months.

 

 

If they unwind the contracts in a somewhat orderly fashion they should get most of that $1b back. Some would probably go to cover the P&L since the last reset.

 

I believe the $132mm is what they have lost since the last reset date on certain contracts (emphasis on certain because other contracts are in asset positions). They have not paid this amount to counterparties yet, but appear to have posted a small amount of additional collateral.

 

Chances are they'd receive the whole $1B back and settle the P/L with a separate payment. You don't pay your settlements cash with your collateral unless if you go bankrupt. But for all intents and purposes of the total cash changing hands, this is correct. Also, I agree, the 132M is likely the accrued liability that they had in current losses on the swaps for this reset period.

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