Readers might first need a quick tutorial: A credit default swap(CDS) is an agreement between two parties that deals with the credit risk on a third-party bond. One party buy protection by offering an up-front fee to the seller. In return, the buyer's principal is protected by the seller in case of default or some other adverse event. When such event happens, the seller usually pays face value on the bond to the buyer, and he assumes the defaulted bond withe the hopes of recovering at least some of his losses.
Now it is important to note two things about this transaction. First, the counter-party you deal with is very important (for the buyer of protection). If the bond you bought protection for defaults but the other party in your trade can not afford to pay you, then you still lose money. So, this counter-party risk must also be managed for.
Second, you do not need a default to occur to start making money on a purchased CDS. If the perception of risk in a bond starts to increase, then the cost of insurance will rise and your purchased protection would be worth more in the market.
Now, the funny thing about Fairfax's CDS investment is that they did not own the underlying bonds they bought protection for. So Fairfax's intent was clear- they thought the companies they bought protection against would default in the near future. And so far, their prediction seems to be coming to fruition. For example, Fairfax held swaps against all the major bond insurers- MBIA, Ambac, PMI Group, and MGIC. Their share prices have plummeted as their survival has come under doubt. (see chart)
Fairfax also bought swaps against other major sub-prime players like Countrywide, Washington Mutual, and Societe Generale. The last one has been all over the news recently as the company reported a major loss:
AN OLD line of Hank Paulson's has been dusted off since news broke of a €4.9 billion ($7.2 billion) trading loss at Société Générale, France's second-largest bank. “We will never eliminate people doing bad things,” the former head of Goldman Sachs, now America's treasury secretary, once said. “In a town of 20,000 people, there's a jail.” The question now being asked of SocGen is: shouldn't there also be a police force?Fairfax picked their targets correctly, but they were also careful about which counter-parties they dealt with- Deutsche Bank, Barclays, and Citigroup. As an example, Calculated Risk reports:
The future of the bank itself is also in doubt. Its shares have slumped since the start of the year (see chart) and its credibility has been shredded, not just by the trading loss but also by write-downs of subprime-related investments.
Deutsche Bank ... reported no write-downs related to structured products and less than EUR50 million net write-downs in leveraged finance. ... The bank also reiterated its EUR8.4 billion pretax profit goal for 2008, even though it said it expects "conditions to remain challenging in 2008."All this leaves me excited about Fairfax's 4th Quarter earnings report on February 22. Around that time they should also be making their annual filings with regulators, which will mean I can find updated information on Fairfax's swaps and investment portfolio.