Mental Models From Guns, Germs, And Steel

I was flipping through Guns, Germs, and Steel by Jared Diamond today. As luck would have it, the first page I flipped to reminded me of not one, but two mental models from other subjects. Maybe these just happened to stand out because I have been reading so much on Charlie Munger lately. Regardless, I kept reading and kept making more and more connections from a variety of disciplines. Here was what I came up with it.

1.

All other things being equal, people seek to maximize their return of calories, protein, or other specific food categories by foraging in a way that yields the most return with the greatest certainty in the least time for the least effort. Simultaneously, they seek to minimize their risk of starving: moderate but reliable returns are preferable to a fluctuating lifestyle with a high time-averaged rate of return but a substantial likelihood of starving to death. One suggested function of the first gardens nearly 11,000 years ago was to provide a reliable reserve larder as insurance in case wild food supplies failed.

The first part of this involves the opportunity cost concept from economics. Here, it is being used in a narrowed sense to describe the satisfaction of hunger. Even more interesting is the idea that people prefer "moderate but reliable returns" of food compared to higher risk and higher returns. You often hear Warren Buffett and Prem Watsa take the opposite statement on investing- that they prefer lumpy but out-sized returns over reliability. On closer analysis, this difference makes sense. In investing, we have a much longer time horizon and so a short-term slump can be handled without severe consequences. But with food, the consequence of a slump is starvation and death- a much less manageable risk.

2.

As we already noted, the first farmers on each continent could not have chosen farming consciously, because there were no other nearby farmers for them to observe. However, once food production had arisen in one part of a continent, neighboring hunter-gatherers could see the result and make conscious decisions. In some cases the hunter-gatherers adpoted the neighboring system of food production virtually as a complete package; in others they chose only certain elements of it; and in still others they rejected food production entirely and remained hunter-gatherers.

This reminded me of my philosophy class on Descartes. He argued that all of our ideas came from a combination of other ideas we have experienced in the past, and no idea could exist in us unless it had some truth in the outside world. The same concept is being used here regarding agriculture. Its mass implementation occurred only after someone stumbled upon farming's great benefits and other people witnessed it.

3.

A fourth factor was the two-way link between the rise in human population density and the rise in food production. In all parts of the world where adequate evidence is available, archaeologists find evidence of rising densities associated with the appearance of food production. Which was the cause and which the result? This is a long-debated chicken-or-egg problem: did a rise in human population density force people to turn to food production, or did food production permit a rise in human population density?

The old Chicken-or-egg dilemma. Just because you have found a correlation between two variables doesn't mean you've also answered which one has caused the other. These are usually two different problems.

4.

That is, the adoption of food production exemplifies what is termed an autocatalytic process- one that catalyzes itself in a positive feedback cycle, going faster and faster once it has started.

We saw another example of an autocatalytic process with the housing bubble. As lenders began to loosen their standards, less people defaulted because they had more access to refinancing. This made the lender's business look great, and caused them to loosen their standards even more.


5.

Instead of being enclosed in a poppable pod, wild wheat and barley seeds grow at the top of a stalk that spontaneously shatters, dropping the seeds to the ground where they can germinate. A single-gene mutation prevents the stalks from shattering. In the wild that mutation would be lethal to the plant, since the seeds would remain suspended in the air, unable to germinate and take root. But those mutant seeds would have been the ones waiting conveniently on the stalk to be harvested and brought home by humans. When humans then planted those harvested mutant seeds, any mutant seeds among the progeny again became available to the farmers to harvest and sow, while normal seeds among the progeny fell to the ground and became unavailable. Thus, human farmers reversed the direction of natural selection by 180 degrees: the formerly successful gene suddenly became lethal, and the lethal mutant became successful.

This is just to remind us of the inherent randomness of the world. Sometimes, you can have every conceivable thing in your favor, and then one black-swan type event comes in and completely changes everything. Long Term Capital Management thought they had a sure thing, and then one "six sigma event" came along and completely wiped them out, endangering the entire financial system in the process.


6.

The second type of change was even less visible to ancient hikers. For annual plants growing in an area with a very unpredictable climate, it could be lethal if all the seeds sprouted quickly and simultaneously. Were that to happen, the seedlings might all be killed by a single drought or frost, leaving no seeds to propagate the species. Hence, many annual plants have evolved to hedge their bets by means of germination inhibitors, which make seeds initially dormant and spread out their germination over several years. In that way, even if most seedlings are killed by a bout of bad weather, some seeds will be left to germinate later.

Instead of seedlings being all killed by a single frost, think of an entire investment portfolio getting wiped out by the loss of a single holding. So what do you do? You hedge your bets. The plants spread out their germination over several years so some seeds will still be left. Similarly, people diversify their portfolio so no single event can wipe them completely out.

I came across all of this within 13 pages, and I've learned two things. One, these big concepts can be applied in a lot of instances if you really look for it. Two, Jared Diamond has a brilliant multi-disciplined mind and I need to really finish his book.

P.S. Many of you might also find this post comparing Bruce Lee's philosophy with Warren Buffett interesting.

Commercial Honor, Equitable Principles, Fair Dealings

John Bogle, chairman of Vangaurd, recently gave a speech to the Financial Industry Regulatory Authority about the declining ethics in the mutual fund industry.

This morning, I’ll focus on investor protection in the mutual fund industry, discussing what can be done to assure that fund investors get a fair shake, or, as I wrote in my senior thesis at Princeton University almost 57 years ago, that “mutual funds must be operated in the most efficient, economical, and honest way possible.” It was that thesis that opened the door to my first job in this industry, and I’ve been with the same firm ever since, although it has changed greatly.¹ That was a pretty good characterization of how the industry worked in 1951. But it is with regret that I report to you that the ethos of today’s mutual fund industry—with some, but not nearly enough, exceptions—has moved away from those principles. I am a tough critic of today’s fund industry, but acknowledge that my views are not widely shared by my industry colleagues. Indeed, one veteran industry leader has stated that “Mr. Bogle’s view of ethics may be somewhat outside the mainstream.” He was, of course, quite right.

To set the stage for my remarks, I’ve chosen as my title the three central standards of the NASD Rules of Fair Practice: “a member, in the conduct of its business, shall observe high standards of commercial honor and just and equitable principles of trade,” and shall engage in “fair dealing with investors.” With these principles in mind, let me discuss how they relate to the mutual fund industry, which has changed in so many fundamental ways.

• A new mission. We’ve moved our central mission from stewardship to salesmanship, and our core value from managing assets to gathering assets. We have become far less of a management industry and far more of a marketing industry, engaging in a furious orgy of “product proliferation” that has ill-served our investors. Once an industry that “sold what we made,” our new motto has become “if we can sell it, we will make it.” For example, right at the peak of the late, great bull market, we created 494 new “aggressive growth” funds, investing largely in technology and telecommunication stocks. The consequences for our investors were devastating.
• Our funds, once broadly diversified, became largely specialized. In 1951, almost 80 percent of all stock funds (60 of 75) were broadly diversified among investment-grade “blue-chip” stocks, pretty much tracking the movements of the stock market itself, and lagging its returns only by the amount of their then-modest operating costs. Today, our total of 512 “large-cap blend funds” account for only 11 percent of all stock funds. These “market beta” funds are now vastly outnumbered by 4200 more specialized funds—3,100 U.S. equity funds diversified in other styles; 400 funds narrowly-diversified in various market sectors; and 700 funds investing in international equities, some broadly diversified, some investing in specific countries. The challenge in picking funds, dare I say, has become roughly akin to the challenge in picking individual stocks. I don’t regard that change as progress
• The wisdom of long-term investing has given way to the folly of short-term speculation. In 1951, a mutual fund held the average stock in its portfolio for about six years—investing. Today, the average holding period for a stock in an equity fund portfolio is just over one year—speculation. Neither is that change progress.
• We’ve discouraged long-term investors. With the substantial differences in short-term returns that inevitably occur among these different fund styles, investors have come to chase past performance. In 1951, most fund investors just picked funds and held them—on average, for about 16 years. Today, investors trade their funds, now holding the typical fund in their portfolios for a period of only about four years. A negative reversal with unfortunate consequences for our clients.
• The ethos of fund managers has changed. Once dominated entirely by small, privately-owned firms and operated by professional investors, the industry is now dominated by giant, publicly-owned firms, largely operated by businessmen bereft of investment experience. Today, 41 of the 50 largest fund managers are publicly-held, including 35 owned by giant U.S. and international financial conglomerates. Small wonder that these firms are all too eager to focus on maximizing the return on their own capital invested in the fund management companies they own, rather than focusing on maximizing the return on the capital they are investing for fund shareholders. Another compelling negative for our clients.

….

Together, this disgraceful conduct represents a sorry chapter in this industry history. But I know of no easy way to regulate or legislate a return to our industry’s traditional values. Competition, in fact, is driving us in quite the opposite direction. As long as our industry participants—our fund managers and marketers, our brokerage firm account executives, and our financial advisers—have more information at hand than their clients possibly could—the economists call this information asymmetry—a largely unaware investment public will be inadequately informed. Regulations calling for more complete disclosure would be a huge help in protecting investors from their own naiveté and lack of information.

Also interesting:

One of the great unexplained curiosities of the mutual fund industry is its unwillingness to call attention to the vital role of investment income in shaping the returns on equities. Theory tells us, and experience confirms, that dividend yields play a crucial role in shaping stock market returns. In fact, the dividend yield on stocks has accounted for almost one-half of their total long-term return. Of the 9.6 percent nominal total return earned by stocks over the past century, fully 9½ percent has been contributed by investment return—4 ½ percent by dividend yields and 5 percent from earnings growth. (The remaining 0.1 percent resulted from an 80 percent increase in the price-earnings ratio, from 10 at the start of the century to 18 at the end, amortized over the long period. I describe changes in the P-E ratio as speculative return.)

Prescriptions for Sure Misery

I'm on spring break now, which means I have some extra time for my leisure reading. So, I finished the first book on my list, which was Poor Charlie's Almanack. It was a terrific book which offers you ages of experience and knowledge. For this Easter holiday, I wanted to share with you the message from one of my favorite speeches, which discusses the prescriptions for sure misery. This idea originated from Johnny Carson, who offered the first three rules:

1. Ingesting chemicals in an effort to alter mood or perception,
2. Envy
3. Resentment

To these, Charlie adds:

4. Be unreliable,
5. Learn only from your own experience
6. Go down and stay down
7. Minimize objectivity

As many of you may know, Charlie is always very big on the process of inversion. So instead of telling you how to be very successful in life, he discusses the surefire ways to be miserable. And if you can just manage to avoid these terrible pitfalls in life, you should turn out fairly happy and successful.

Happy Easter

A discussion about the economy with Paul Volcker

Charlie Rose interviews Paul Volcker, Chairman of the Fed from 1979 to 1987, about the state of the economy today.

Characteristics of Equity and Debt

I thought that in the wake of the current financial mess, it would be a good time to go over an important difference between equity and debt investing.

Every company faces the choice to finance their business/ expansion plans with equity capital or debt capital. First, let us start with equity investing. There is a clear and pretty well accepted definition for the value of issued shares to investors- it is the discounted future cash flow of your share in the business. It is much more difficult in practice, and most people's guesses are as good as anybodies. For the company however, all that matters is that initial issuance price. Regardless of what the true value of their issued shares are, the amount of money the company raises is equal to the initial share price multiplied by the number of shares issued. These shares can never be "put back" to the company.

Afterwards, investors deal only amongst themselves. If I, as an investor, am able to perfectly calculate the value of a company's share and purchase it for less than that price, I would be value investing. In the short term, their value is reliant on what "Mr. Market" is willing to offer me on that day. But the good thing about stock investing is that I have no deadline on which I am forced to sell my shares. So if I had no time restraints, I could just hold on to those shares and watch as the company generates the cash flow (which I had perfectly predicted). At some point, the market will either recognize this or investors will demand the company dividend this money to them, allowing me to recognize fair value for my shares.

But when dealing with debt investing, the situation is usually very different. The reason is because debt matures and principal must be paid back. Let us say that once again, I can perfectly predict the future cash flow of a certain business. This time though, the business is financed with debt which initially matures in five years. For the first five years, everything goes as planned. The company pays its interest, and even uses its excess cash flow to start repaying its debt. Still, at the end of five years, the company has a large portion of its principal remaining unpaid.

The company now has no choice- it needs to refinance to pay back its existing debtholders, and its ability to do so relies completely on the market's risk perception at the time. With stocks, this wasn't the case: an investor could just hold on to his shares into the future, and the share price would eventually represent its fair value. But as a holder of debt, an investor is now exposed to the danger that the market might not want to refinance the company's debt at a fair cost, if at all. And although I know the company's future cash flow justifies refinancing, I, in all likelihood, can not afford to refinance all the debt myself. The business can now be forced into bankruptcy, and a perfectly viable business can be forced into liquidation. The only way a debt investor can completely avoid this risk exposure is to make sure that the business' income can cover both its interest and its principal payments as they come due, but this type of conservatism is rarely seen.

To make matters worse, the great business rarely even bothers with debt. The Coca Cola's of the world have the most predictable and stable businesses, and the lenders feel the most comfortable lending to them. Yet, these companies also never need to leverage themselves because they have strong competitive advantages and are already earning great returns on their investment. It is usually the bad businesses which resort to debt in order to boost their profitability. And the worst businesses need to leverage themselves to the moon just to earn a decent return. The current financial crisis is fraught with just those types of situations. What happened to Carlye Capital, which collapsed earlier this month? (link)

In a short news release issued early Friday, the fund, which is managed by a unit of Washington, D.C., private-equity firm Carlyle Group, said it received "substantial additional margin calls and additional default notices from its lenders" and that "these additional margin calls and increased collateral requirements could quickly deplete its liquidity and impair its capital."
...
Carlyle Capital managed only $670 million in client money, but used borrowing to boost its portfolio of bonds to $21.7 billion, meaning it was about 32 times leveraged.

What Carlyle did was borrow at X% and invest in securities making (X+.50)%. The only way to make the returns on investment in that semi-attractive was, well... 32 times leverage. And what happened? The market got nervous and they decided not to refinance. The same thing is causing problems for SIV's, hedge funds, and financial institutions in general. Some of these companies may have done all of their work correctly (unlikely), but making the market confident of that is not so easy. After all, if a company like Carlyle was only 3% off, its entire equity would be wiped out and losses would start accruing to its debtholders. These financial firms are starting to realize that when dealing with debt, it is not just what you think that counts. And a 3%, 5%, or even 10% margin of safety is not very reassuring to investors after the housing bubble we have just witnessed.

Hypothetical Question

If you were put in charge with the goal of making a better society, would you want the cost of purchasing a house to go up or down?

I'm not saying we should be happy that home prices are now falling. But as we were celebrating our increased home wealth over the last several years, not many people stopped to think how these illusionary gains were really making us any better off.

Updated Info on Fairfax's CDS Portfolio

At the end of 2007, Fairfax's CDS portfolio held the following names:

Munich Re
Ace Ina Holdings
Allianz Finance
Societe Generale
Aegon NV
Zurich Financial
Deutsche Bank
Swiss Re America
Ambac Inc
AIG
Bank of America
Barclays
Capital One Bank/Financial
Citigroup
Countrywide
Freddie Mac
Fannie Mae
Genworth Financial
Goldman Sachs
Hanover Re
JP Morgan
MBIA
MGIC
PMI Group
Radian Group
Washington Mutual
XL Capital

Of these, the ones in bold were initiated/added to during the year.

Last year, I wondered why so many property and casualty insurers were included in their CDS portfolio. The reason appears more clear now, as insurer investment losses are set to overtake those of Hurricane Katrina. These has caused the credit protection costs of many of these insurers to soar:

Canwest Global

After running through the numbers and business for Canwest, an investment in their stock definetely looks interesting. Canwest has an Enterprise Value of 2.8 billion (2.1 billion debt + 100 million cash + 800 million market capitalization).

Of that, their publicly-traded 56% stake in Network 10 is worth 1.2 billion. This is before any capital gains taxes, but effectively you are paying 1.6 billion for the rest of their business.

For that 1.6 billion, you get 28% of the Canadian newspaper publication, 11.3% of total TV audience, and a 250 million equity stake in CW Media(more on this later). In 2007, the publishing business had revenues of 1.3 billion and pre-tax profit of 260 million. The Television business had 670 million in revenues and 70 million in pre-tax profits.

Why is it so cheap? One reason is because of balance sheet confusion, which makes Canwest look more indebted than it really is. If you subtract Network 10's debt (because it is a seperate publicly traded co.) and CW Media's debt (non-recourse), the debt level is much more manageable.

A more likely reason though is because the terms of the CW Media deal is very confusing. Currently, Canwest owns 35% of the subsidiary, yet it is consolidated because it has majority voting power. The deal was levered up with almost 800 million in debt, and in three years the company will merge with Canwest's Canadian Television business. Their ultimate stake will depend on how profitable the business is at that time, making this entire mess difficult to value.

Still, it is difficult not to assign some at least some positive value for the Canadian TV segment. And you can likely justify the price you are paying for Canwest off the newspaper alone; It currently trades at 1.23x sales, while most of its American peers are trading at around 1.3x sales. Throw in the fact that this is business has minimal capital expenditures and the cash flow is really "free", and it seems like a great deal.

Notes From A Conversation with Munger

Tonight I got to see A Conversation with Charlie Munger at Caltech in Pasadena. I took some notes on the discussion below. C refers to Charlie Munger speaking, while T stands for Tom Tombrello, the interviewer. These are not their exact words.


C: I love Occum's Razor (Wikipedia). Einstein once said make everything as simple as possible, but not simpler. In the field of messy social sciences, use a variety of disciplines and look for a confluence of factors when dealing with "lollapaloozas". (significant and strange events, black swans)

For example, I was fascinated about what made people join Moonies, a cult-like group. It didn't make sense until I ran into Pavlov, who experimented on dogs by pushing them to nervous breakdowns (He did this by locking them in cages and then raising the water level up to mouth height, making them think they were about to drown) . Afterwards, they would act in the complete opposite fashion. This was very similar to one of the Moonies conversion methods: "causing the target to snap".

I always like when I ask economics students how you can raise prices while also increasing demand. One in fifty will say in luxury good situations, where raising the prices gives the appearance of quality. But no one ever comes up with the most successful method- raising the price and then using the extra money to bribe the sales agents. We see this all the time in title insurance, mutual funds, and some defense contracts.

I liken my own education to a gold miner with a pan in the gold rush days. I sift through and pick up the big nuggets of information. I let other people deal with the placer mining.

Derivatives have intensified the common-mode failure. (Concentrating too much similar risk in one party) Wall Street has created things so complicated and complex, and you had no choice but to rely on a ratings agency. This was not a modest problem. Professionals and Academia has failed us by not questioning what was going on.

T: It is interesting that in physics and the natural sciences, there is linearity. Cause and effect are intertwined. In the social sciences, that is not the case. If Munger was to say tonight that the economy is going to free fall, it could very likely cause the economy to free fall tomorrow morning.

It is funny, I was talking with a friend who was working at a place called Division X, which was working on nuclear weapons. And he just kept going on about the competition and how they had to get these more powerful weapons out or else they would lose out to competition. Finally I get to thinking, there is no way we are talking about the Soviet Union. And he says no, I'm talking about our competitors, Livermore. No one stopped to think hey, our country is escalating the arms race in competition with itself.

Q&A:
Thoughts on Global Warming?
C: I think its a problem, but not as big as Al Gore makes it out to be. What I think is real silly is turning corn to fuel. There is a case where the environmentalists did not first stop to ask the ecologists about what goes into the dirt needed to grow corn. (I think?) I think we should want to preserve petrochemicals because they may have more valuable uses than driving our cars and heating our homes. Once we're out, we're out.

Thoughts on how this current credit crisis plays out?
C: The lessons to this are unbelievably important. There were some people making unbelievable gains with no social contribution.

Best piece of advice for new investors?
C: Go at it with a capitalistic perspective. Competitions will always be coming at you if you are earning great returns, so have some barrier. And invest with a margin of safety- If you were an engineer and you know you were going to have 10,000 ton trucks driving over your bridge, you would build a bridge that can stand 15,000 tonnes. Similarly, buy a stock for much less than you think it is really worth.

Fairfax's 2007 Shareholder Letter

To Our Shareholders:
2007 was the best year in our history. For the first time in 22 years, we earned in excess of $1 billion* after tax ($1.096 billion to be exact) or $58.38 per diluted share. Mark-to-market book value grew by 48.7% to $230.01 per share and we ended the year with almost $1 billion in cash and marketable securities in our holding company. We like lumpy but this was as lumpy as we have ever had!

Book value per share has compounded at 26% over the past 22 years and our common stock price has followed at 23% per year. While we are excited about these results, we have some way to go to make up for the biblical seven lean years that you have suffered.
...

In last year’s Annual Report, we discussed the change in our financial objectives going forward from a return on shareholders’ equity objective to a 15% compounding over time of our mark-to market book value. I mentioned the favourable impact on our rate of compounding of holding some common stock positions for the very long term. I am pleased to say we have identified one position that we feel very comfortable holding for a very long time because of its excellent track record, wonderful culture and decentralized structure of operations.

Johnson & Johnson has perhaps the best long term track record we have come across. They have compounded sales and earnings for the last 100 years in excess of 10%per year. The growth prospects for their products on a worldwide basis are unlimited.We own 5.9 million shares at a cost of $62.29 per share with amarket value of $370 million.We think in the next few years, Mr.Market may give us many more opportunities like Johnson & Johnson that we can purchase at attractive prices for the long term. Ifwe choose properly, you may be pleased with our rate of compounding of book value in the future.

...

2007 was another very good year for Hamblin Watsa’s investment results, even excluding our CDS position which is not included in the results shown above. These results are due to Hamblin Watsa’s outstanding investment team, led by Roger Lace, Brian Bradstreet, Chandran Ratnaswami and Sam Mitchell.

The very significant risks that we identified for you in the past few years have now materialized with a vengeance. In the past year, we have seen a major decline in housing prices and its collateral impact on asset backed bonds, CDOs and other instruments. As the U.S. economy heads into a recession, risk is now being identified and repriced in structured investments based upon automobile loans, commercial real estate loans, credit card receivables, leveraged buyout debt and bank loans.

Hyman Minsky, the father of the Financial Instability Hypothesis, said that history shows that “stability causes instability”. Prolonged periods of prosperity lead to leveraged financial structures that cause instability. We are witnessing the aftereffects of the longest economic recovery (more than 20 years) in the U.S. with the shortest recession (2001). Regression to the mean has begun – but only just begun!

We have witnessed credit spreads widen dramatically for mortgage insurers, bond insurers and junk bonds, reflecting mainly the problems of the housing market. We remain vigilant for the spreading of these risks into all credit markets, because the same loose lending standards and asset backed structures have been applied to these markets. Also, as we have mentioned in the past, we remain concerned about the potential decline in record after-tax profit margins in the U.S. and its impact on stock prices. Of course, the potential impact of the U.S. economy and stock prices on the rest of the world’s economies and stock prices, particularly given that most of the
world’s stock markets are trading at close to record highs, is why we continue to protect our portfolios from a 1 in 50 to 1 in 100 year financial storm.

Recently, we came across an interesting observation by the man who provided the intellectual underpinnings of “long term value investing” and to whom we are ever indebted. BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932. If you didn’t see the risks in 1925 (very hard to do), it was very unlikely that you survived the crash! We think Ben’s observation may be relevant to what we have experienced in the past five years. We reminded you in our 2005 Annual Report that “Jeremy Grantham of Grantham Mayo said that of the 28 bubbles that they have studied in all asset categories (including gold, silver, Japanese equities and 1929), this recent bubble in the U.S. stock market is the only one that has not completely reversed itself (just as it was about to in 2003, it turned and rebounded).” Caveat emptor!!

In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record low interest rates and record high fiscal deficits, Japan went through years of mild deflation. The feelings at the time in Japan were that they were different and would not allow stock prices and land prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!

The assumption in the marketplace that “structure” would eliminate or significantly reduce all risks collapsed as thousands of mortgage structures were downgraded, some from AAA to CCC in a single day. After five years where the average downgrades were less than 1%, in 2007 S&P downgraded nearly 16% of the 36,000+ residential mortgage backed securities it rated. In the marketplace, the prices of many of these asset backed bonds declined significantly in the second half of 2007 and have continued to decline since then. Currently, some AAA subprime mortgage
backed bonds are trading at 60¢ on the dollar and some similar AA issues are trading at 25¢ on the dollar. Please remember that there are approximately $3.8 trillion in asset backed and non-Agency mortgage backed securities where the same structuring techniques and “good times” assumptions have been employed to create “highly rated” securities. Only time will tell, but our expectation is that few of these securities will remain unscathed.

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Fairfax's Next Move?

Although Fairfax has still not published its 2007 Annual Report, we know that Odyssey Re substantial increased its holdings of foreign government bonds during 2007, from $441 million to $1,126 million. These were almost entirely composed of German and French government bonds, and the intent was most likely to capitalize on a strengthening euro.




It is likely that Fairfax made this bet across the entire holding company.So far the bet has been successful, as the dollar has continuously plummeted over the last year.

Investing 101 From Buffett

Buffett gets better at explaining investing every year. This is a comprehensive description from this year's Berkshire shareholder letter.

Businesses – The Great, the Good and the Gruesome
Let’s take a look at what kind of businesses turn us on. And while we’re at it, let’s also discuss what we wish to avoid.

Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag. We like to buy the whole business or, if management is our partner, at least 80%. When control-type purchases of quality aren’t available, though, we are also happy to simply buy small portions of great businesses by way of stockmarket purchases. It’s better to have a part interest in the Hope Diamond than to own all of a rhinestone.

A truly great business must have an enduring “moat” that protects excellent returns on invested capital. The dynamics of capitalism guarantee that competitors will repeatedly assault any business “castle” that is earning high returns. Therefore a formidable barrier such as a company’s being the lowcost producer (GEICO, Costco) or possessing a powerful world-wide brand (Coca-Cola, Gillette, American Express) is essential for sustained success. Business history is filled with “Roman Candles,” companies whose moats proved illusory and were soon crossed.

Our criterion of “enduring” causes us to rule out companies in industries prone to rapid and continuous change. Though capitalism’s “creative destruction” is highly beneficial for society, it precludes investment certainty. A moat that must be continuously rebuilt will eventually be no moat at all.

Additionally, this criterion eliminates the business whose success depends on having a great manager. Of course, a terrific CEO is a huge asset for any enterprise, and at Berkshire we have an abundance of these managers. Their abilities have created billions of dollars of value that would never have materialized if typical CEOs had been running their businesses.

But if a business requires a superstar to produce great results, the business itself cannot be deemed great. A medical partnership led by your area’s premier brain surgeon may enjoy outsized and growing earnings, but that tells little about its future. The partnership’s moat will go when the surgeon goes. You can count, though, on the moat of the Mayo Clinic to endure, even though you can’t name its CEO.

Long-term competitive advantage in a stable industry is what we seek in a business. If that comes with rapid organic growth, great. But even without organic growth, such a business is rewarding. We will simply take the lush earnings of the business and use them to buy similar businesses elsewhere. There’s no rule that you have to invest money where you’ve earned it. Indeed, it’s often a mistake to do so: Truly great businesses, earning huge returns on tangible assets, can’t for any extended period reinvest a large portion of their earnings internally at high rates of return.

Let’s look at the prototype of a dream business, our own See’s Candy. The boxed-chocolates industry in which it operates is unexciting: Per-capita consumption in the U.S. is extremely low and doesn’t grow. Many once-important brands have disappeared, and only three companies have earned more than token profits over the last forty years. Indeed, I believe that See’s, though it obtains the bulk of its revenues from only a few states, accounts for nearly half of the entire industry’s earnings.

At See’s, annual sales were 16 million pounds of candy when Blue Chip Stamps purchased the company in 1972. (Charlie and I controlled Blue Chip at the time and later merged it into Berkshire.) Last year See’s sold 31 million pounds, a growth rate of only 2% annually. Yet its durable competitive advantage, built by the See’s family over a 50-year period, and strengthened subsequently by Chuck Huggins and Brad Kinstler, has produced extraordinary results for Berkshire.

We bought See’s for $25 million when its sales were $30 million and pre-tax earnings were less than $5 million. The capital then required to conduct the business was $8 million. (Modest seasonal debt was also needed for a few months each year.) Consequently, the company was earning 60% pre-tax on invested capital. Two factors helped to minimize the funds required for operations. First, the product was sold for cash, and that eliminated accounts receivable. Second, the production and distribution cycle was short, which minimized inventories.

Last year See’s sales were $383 million, and pre-tax profits were $82 million. The capital now required to run the business is $40 million. This means we have had to reinvest only $32 million since 1972 to handle the modest physical growth – and somewhat immodest financial growth – of the business. In the meantime pre-tax earnings have totaled $1.35 billion. All of that, except for the $32 million, has been sent to Berkshire (or, in the early years, to Blue Chip). After paying corporate taxes on the profits, we have used the rest to buy other attractive businesses. Just as Adam and Eve kick-started an activity that led to six billion humans, See’s has given birth to multiple new streams of cash for us. (The biblical command to “be fruitful and multiply” is one we take seriously at Berkshire.)

There aren’t many See’s in Corporate America. Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.

A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements. Ask Microsoft or Google.

One example of good, but far from sensational, business economics is our own FlightSafety. This company delivers benefits to its customers that are the equal of those delivered by any business that I know of. It also possesses a durable competitive advantage: Going to any other flight-training provider than the best is like taking the low bid on a surgical procedure.

Nevertheless, this business requires a significant reinvestment of earnings if it is to grow. When we purchased FlightSafety in 1996, its pre-tax operating earnings were $111 million, and its net investment in fixed assets was $570 million. Since our purchase, depreciation charges have totaled $923 million. But capital expenditures have totaled $1.635 billion, most of that for simulators to match the new airplane models that are constantly being introduced. (A simulator can cost us more than $12 million, and we have 273 of them.) Our fixed assets, after depreciation, now amount to $1.079 billion. Pre-tax operating earnings in 2007 were $270 million, a gain of $159 million since 1996. That gain gave us a good, but far from See’s-like, return on our incremental investment of $509 million.

Consequently, if measured only by economic returns, FlightSafety is an excellent but not extraordinary business. Its put-up-more-to-earn-more experience is that faced by most corporations. For example, our large investment in regulated utilities falls squarely in this category. We will earn considerably more money in this business ten years from now, but we will invest many billions to make it.

Now let’s move to the gruesome. The worst sort of business is one that grows rapidly, requires significant capital to engender the growth, and then earns little or no money. Think airlines. Here a durable competitive advantage has proven elusive ever since the days of the Wright Brothers. Indeed, if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down.

The airline industry’s demand for capital ever since that first flight has been insatiable. Investors have poured money into a bottomless pit, attracted by growth when they should have been repelled by it. And I, to my shame, participated in this foolishness when I had Berkshire buy U.S. Air preferred stock in 1989. As the ink was drying on our check, the company went into a tailspin, and before long our preferred dividend was no longer being paid. But we then got very lucky. In one of the recurrent, but always misguided, bursts of optimism for airlines, we were actually able to sell our shares in 1998 for a hefty gain. In the decade following our sale, the company went bankrupt. Twice.

To sum up, think of three types of “savings accounts.” The great one pays an extraordinarily high interest rate that will rise as the years pass. The good one pays an attractive rate of interest that will be earned also on deposits that are added. Finally, the gruesome account both pays an inadequate interest rate and requires you to keep adding money at those disappointing returns.

Buffett Quotables

CNBC's Michelle Caruso-Cabrera takes a look at the wit and wisdom of billionaire investor Warren Buffett.

http://www.cnbc.com/id/15840232?video=668860686

Roubini's Testimony to House of Rep.

This letter is a little bit technical, but it does a terrific job outlining the possibility of a vicious cycle/serious recession.

...
Start first with the recession that is now enveloping the US economy. Let us assume – as likely - that this recession – that already started in December 2007 - will be worse than the mild ones – that lasted 8 months – that occurred in 1990-91 and 2001. The recession of 2008 will be more severe for several reasons: first, we have the biggest housing bust in US history with home prices likely to eventually fall 20 to 30%; second, because of a credit bubble that went beyond mortgages and because of reckless financial innovation and securitization the ongoing credit bust will lead to a severe credit crunch; third, US households – whose consumption is over 70% of GDP - have spent well beyond their means for years now piling up a massive amount of debt, both mortgage and otherwise; now that home prices are falling and a severe credit crunch is emerging the retrenchment of private consumption will be serious and protracted. So let us suppose that the recession of 2008 will last at least four quarters and, possibly, up to six quarters. What will be the consequences of it?

Here are the twelve steps or stages of a scenario of systemic financial meltdown associated with this severe economic recession.

First, this is the worst housing recession in US history and there is no sign it will bottom out any time soon. At this point it is clear that US home prices will fall between 20% and 30% from their bubbly peak; that would wipe out between $4 trillion and $6 trillion of household wealth. While the subprime meltdown is likely to cause about 2.2 million foreclosures, a 30% fall in home values would imply that over 10 million households would have negative equity in their homes and would have a big incentive to use “jingle mail” (i.e. default, put the home keys in an envelope and send it to their mortgage bank). Moreover, soon enough a few very large home builders will go bankrupt and join the dozens of other small ones that have already gone bankrupt thus leading to another free fall in home builders’ stock prices that have irrationally rallied in the last few weeks in spite of a worsening housing recession.

Second, losses for the financial system from the subprime disaster are now estimated to be as high as $250 to $300 billion. But the financial losses will not be only in subprime mortgages and the related RMBS and CDOs. They are now spreading to near prime and prime mortgages as the same reckless lending practices in subprime (no down-payment, no verification of income, jobs and assets (i.e. NINJA or LIAR loans), interest rate only, negative amortization, teaser rates, etc.) were occurring across the entire spectrum of mortgages; about 60% of all mortgage origination since 2005 through 2007 had these reckless and toxic features. So this is a generalized mortgage crisis and meltdown, not just a subprime one. And losses among all sorts of mortgages will sharply increase as home prices fall sharply and the economy spins into a serious recession. Goldman Sachs now estimates total mortgage credit losses of about $400 billion; but the eventual figures could be much larger if home prices fall more than 20%. Also, the RMBS and CDO markets for securitization of mortgages – already dead for subprime and frozen for other mortgages - remain in a severe credit crunch, thus reducing further the ability of banks to originate mortgages. The mortgage credit crunch will become even more severe.

Also add to the woes and losses of the financial institutions the meltdown of hundreds of billions of off balance SIVs and conduits; this meltdown and the roll-off of the ABCP market has forced banks to bring back on balance sheet these toxic off balance sheet vehicles adding to the capital and liquidity crunch of the financial institutions and adding to their on balance sheet losses. And because of securitization the securitized toxic waste has been spread from banks to capital markets and their investors in the US and abroad, thus increasing – rather than reducing systemic risk – and making the credit crunch global.

Third, the recession will lead – as it is already doing – to a sharp increase in defaults on other forms of unsecured consumer debt: credit cards, auto loans, student loans. There are dozens of millions of subprime credit cards and subprime auto loans in the US. And again defaults in these consumer debt categories will not be limited to subprime borrowers. So add these losses to the financial losses of banks and of other financial institutions (as also these debts were securitized in ABS products), thus leading to a more severe credit crunch. As the Fed loan officers survey suggest the credit crunch is spreading throughout the mortgage market and from mortgages to consumer credit, and from large banks to smaller banks.

Fourth, while there is serious uncertainty about the losses that monolines will undertake on their insurance of RMBS, CDO and other toxic ABS products, it is now clear that such losses are much higher than the $10-15 billion rescue package that regulators are trying to patch up. Some monolines are actually borderline insolvent and none of them deserves at this point a AAA rating regardless of how much realistic recapitalization is provided. Any business that required an AAA rating to stay in business is a business that does not deserve such a rating in the first place. The monolines should be downgraded as no private rescue package – short of an unlikely public bailout – is realistic or feasible given the deep losses of the monolines on their insurance of toxic ABS products.

Next, the downgrade of the monolines will lead to another $150 of writedowns on ABS portfolios for financial institutions that have already massive losses. It will also lead to additional losses on their portfolio of muni bonds. The downgrade of the monolines will also lead to large losses – and potential runs – on the money market funds that invested in some of these toxic products. The money market funds that are backed by banks or that bought liquidity protection from banks against the risk of a fall in the NAV may avoid a run but such a rescue will exacerbate the capital and liquidity problems of their underwriters. The monolines’ downgrade will then also lead to another sharp drop in US equity markets that are already shaken by the risk of a severe recession and large losses in the financial system.

Fifth, the commercial real estate loan market will soon enter into a meltdown similar to the subprime one. Lending practices in commercial real estate were as reckless as those in residential real estate. The housing crisis will lead – with a short lag – to a bust in non-residential construction as no one will want to build offices, stores, shopping malls/centers in ghost towns. The CMBX index is already pricing a massive increase in credit spreads for non-residential mortgages/loans. And new origination of commercial real estate mortgages is already semi-frozen today; the commercial real estate mortgage market is already seizing up today.

Sixth, it is possible that some large regional or even national bank that is very exposed to mortgages, residential and commercial, will go bankrupt. Thus some big banks may join the 200 plus subprime lenders that have gone bankrupt. This, like in the case of Northern Rock, will lead to depositors’ panic and concerns about deposit insurance. The Fed will have to reaffirm the implicit doctrine that some banks are too big to be allowed to fail. But these bank bankruptcies will lead to severe fiscal losses of bank bailout and effective nationalization of the affected institutions. Already Countrywide – an institution that was more likely insolvent than illiquid – has been bailed out with public money via a $55 billion loan from the FHLB system, a semi-public system of funding of mortgage lenders. Banks’ bankruptcies will add to an already severe credit crunch.

Seventh, the banks losses on their portfolio of leveraged loans are already large and growing. The ability of financial institutions to syndicate and securitize their leveraged loans – a good chunk of which were issued to finance very risky and reckless LBOs – is now at serious risk. And hundreds of billions of dollars of leveraged loans are now stuck on the balance sheet of financial institutions at values well below par (currently about 90 cents on the dollar but soon much lower). Add to this that many reckless LBOs (as senseless LBOs with debt to earnings ratio of seven or eight had become the norm during the go-go days of the credit bubble) have now been postponed, restructured or cancelled. And add to this problem the fact that some actual large LBOs will end up into bankruptcy as some of these corporations taken private are effectively bankrupt in a recession and given the repricing of risk; convenant-lite and PIK toggles may only postpone – not avoid – such bankruptcies and make them uglier when they do eventually occur. The leveraged loans mess is already leading to a freezing up of the CLO market and to growing losses for financial institutions.

Eighth, once a severe recession is underway a massive wave of corporate defaults will take place. In a typical year US corporate default rates are about 3.8% (average for 1971-2007); in 2006 and 2007 this figure was a puny 0.6%. And in a typical US recession such default rates surge above 10%. Also during such distressed periods the RGD – or recovery given default – rates are much lower, thus adding to the total losses from a default. Default rates were very low in the last two years because of a slosh of liquidity, easy credit conditions and very low spreads (with junk bond yields being only 260bps above Treasuries until mid June 2007). But now the repricing of risk has been massive: junk bond spreads close to 700bps, iTraxx and CDX indices pricing massive corporate default rates and the junk bond yield issuance market is now semi-frozen. While on average the US and European corporations are in better shape – in terms of profitability and debt burden – than in 2001 there is a large fat tail of corporations with very low profitability and that have piled up a mass of junk bond debt that will soon come to refinancing at much higher spreads. Corporate default rates will surge during the 2008 recession and peak well above 10% based on recent studies. And once defaults are higher and credit spreads higher massive losses will occur among the credit default swaps (CDS) that provided protection against corporate defaults. Estimates of the losses on a notional value of $50 trillion CDS against a bond base of $5 trillion are varied (from $20 billion to $250 billion with a number closer to the latter figure more likely). Losses on CDS do not represent only a transfer of wealth from those who sold protection to those who bought it. If losses are large some of the counterparties who sold protection – possibly large institutions such as monolines, some hedge funds or a large broker dealer – may go bankrupt leading to even greater systemic risk as those who bought protection may face counterparties who cannot pay.

Ninth, the “shadow banking system” (as defined by the PIMCO folks) or more precisely the “shadow financial system” (as it is composed by non-bank financial institutions) will soon get into serious trouble. This shadow financial system is composed of financial institutions that – like banks – borrow short and in liquid forms and lend or invest long in more illiquid assets. This system includes: SIVs, conduits, money market funds, monolines, investment banks, hedge funds and other non-bank financial institutions. All these institutions are subject to market risk, credit risk (given their risky investments) and especially liquidity/rollover risk as their short term liquid liabilities can be rolled off easily while their assets are more long term and illiquid. Unlike banks these non-bank financial institutions don’t have direct or indirect access to the central bank’s lender of last resort support as they are not depository institutions. Thus, in the case of financial distress and/or illiquidity they may go bankrupt because of both insolvency and/or lack of liquidity and inability to roll over or refinance their short term liabilities. Deepening problems in the economy and in the financial markets and poor risk managements will lead some of these institutions to go belly up: a few large hedge funds, a few money market funds, the entire SIV system and, possibly, one or two large and systemically important broker dealers. Dealing with the distress of this shadow financial system will be very problematic as this system – stressed by credit and liquidity problems - cannot be directly rescued by the central banks in the way that banks can.

Tenth, stock markets in the US and abroad will start pricing a severe US recession – rather than a mild recession – and a sharp global economic slowdown. The fall in stock markets – after the late January 2008 rally fizzles out – will resume as investors will soon realize that the economic downturn is more severe, that the monolines will not be rescued, that financial losses will mount, and that earnings will sharply drop in a recession not just among financial firms but also non financial ones. A few long equity hedge funds will go belly up in 2008 after the massive losses of many hedge funds in August, November and, again, January 2008. Large margin calls will be triggered for long equity investors and another round of massive equity shorting will take place. Long covering and margin calls will lead to a cascading fall in equity markets in the US and a transmission to global equity markets. US and global equity markets will enter into a persistent bear market as in a typical US recession the S&P500 falls by about 28%.

Eleventh, the worsening credit crunch that is affecting most credit markets and credit derivative markets will lead to a dry-up of liquidity in a variety of financial markets, including otherwise very liquid derivatives markets. Another round of credit crunch in interbank markets will ensue triggered by counterparty risk, lack of trust, liquidity premia and credit risk. A variety of interbank rates – TED spreads, BOR-OIS spreads, BOT – Tbill spreads, interbank-policy rate spreads, swap spreads, VIX and other gauges of investors’ risk aversion – will massively widen again. Even the easing of the liquidity crunch after massive central banks’ actions in December and January will reverse as credit concerns keep interbank spread wide in spite of further injections of liquidity by central banks.

Twelfth, a vicious circle of losses, capital reduction, credit contraction, forced liquidation and fire sales of assets at below fundamental prices will ensue leading to a cascading and mounting cycle of losses and further credit contraction. In illiquid market actual market prices are now even lower than the lower fundamental value that they now have given the credit problems in the economy. Market prices include a large illiquidity discount on top of the discount due to the credit and fundamental problems of the underlying assets that are backing the distressed financial assets. Capital losses will lead to margin calls and further reduction of risk taking by a variety of financial institutions that are now forced to mark to market their positions. Such a forced fire sale of assets in illiquid markets will lead to further losses that will further contract credit and trigger further margin calls and disintermediation of credit. The triggering event for the next round of this cascade is the downgrade of the monolines and the ensuing sharp drop in equity markets; both will trigger margin calls and further credit disintermediation.

Sears Holdings Letter to Shareholders

Eddie Lampert, Chairman of Sears Holding, published his annual letter to shareholders today describing the results and the future for the company. In the letter, he publishes a chart showing market capitalization, sales and capital expenditures for retail companies worth more than 5 billion. (excerpt of the chart reproduced below) The chart shows the often neglected fact that Sears is a giant in the retail world, ranked 8th in terms of sales. Second, the company's stock is trading at less than 30% of annual sales, which is much lower than its peers. The reason for the discrepancy is in part due to negative bias, but mostly it is because Sears is much less profitable than its competitors. Eddie Lampert's goal going forward is to use the company's scale , size, and unique assets to increase efficiency and squeeze out extra value for Sears shareholders. It seems like a very plausible outcome and at its current price, the stock is worth keeping an eye on.

Correction: Fairfax's ICP Lawsuit

After a lengthy discussion regarding the last post, as well as more research, I have to issue a correction. And unfortunately, things have become much more confusing. I'm assuming in this that people have already read the last post.

First, the initial mistake. I had assumed that the convertible option on the debt would result in newly issued shares. But since it is Fairfax's holding company level which is holding the debt, this is actually not the case. The exchange option into Odyssey Re("ORH") shares must come from Fairfax itself, meaning it would be equivalent to giving back a portion of the shares it had purchased.

At first, I thought that would have still been fine. Based on what Fairfax announced, the first transaction involved the purchase of 4.3 million ORH shares for 78 million in debt and the option to convert into 2.15 million shares. In such transaction, ORH's stock would have had to rise 75% for the convertible feature to even be worthwhile, meaning that it was a legitimate transaction (the reasons for which were spelled out in the previous post).

However, I then ran across conflicting reports. On the one hand, I had the Fairfax press release, which stated that:

Fairfax Financial Holdings Limited, through a subsidiary, has purchased 4,300,000 outstanding common shares of Odyssey Re Holdings Corp. in a private transaction. As a result of this purchase, Fairfax beneficially owns 52,364,400 (80.6%) of the 65,003,963 outstanding common shares of Odyssey Re. As consideration, the subsidiary issued US$78,045,000 principal amount of 3.15% Exchangeable Notes due February 28, 2010 which are exchangeable into 2,150,000 Odyssey Re common shares for two week periods commencing on each of November 19, 2004 and February 16, 2005.

But then I found the SEC documents relating to this transaction, which can be found here and here. They state:

Amendment No. 1 to the Schedule 13D related to the purchase by Fairfax, through a subsidiary, pursuant to a master note purchase agreement, dated as of March 3, 2003, of 4,300,000 outstanding Shares (the "2003 Purchased Shares") in a private transaction. As consideration for the Purchased Shares, a subsidiary of Fairfax issued $78,045,000 aggregate principal amount of 3.15% Exchangeable Notes due February 28, 2010 (the "Old Exchangeable Notes"), exchangeable into 4,300,000 Shares.

In addition, two other passages which stuck out:

WHEREAS, the Issuer and the Guarantor intend that the transactions contemplated hereby result in the Guarantor being able to treat members of the consolidated group (within the meaning of U.S. Treasury Regulations section 1.1502-1(h)), of which Fairfax, Inc., a wholly-owned subsidiary of the Guarantor, is the common parent, as owning at least 80 percent of the outstanding Shares (as defined below) and therefore treat Odyssey (as defined below) as a member of such group for U.S. federal income tax purposes;
(Note: this is one of the first lines in the master purchase agreement)

And also:

it is acting for its own account, and has made its own independent decision to enter into this Agreement and each other Transaction Document and as to whether this Agreement and the other Transaction Documents are appropriate or proper for it based upon its own judgment and upon advice of such advisors as it deems necessary; each of the Issuer and the Guarantor acknowledges and agrees that it is not relying, and has not relied, upon any communication (written or oral) of the Purchaser or any affiliate of the Purchaser with respect to the or any other Transaction Document and that it has conducted its own analyses of the legal, accounting, tax and other implications hereof and thereof (it being understood that information and explanations related to the terms and conditions of this Agreement or any other Transaction Document shall not be considered investment advice or a recommendation to enter into this Agreement or any such Transaction Document); it further acknowledges and confirms that it has taken independent tax advice with respect to this Agreement and each other Transaction Document;legal, accounting, tax or other implications of this Agreement.

The combination of all of this leaves me scratching my head. I want to go with my trust in Prem, but as someone in the comments said: In this instance, Prem may have been "a bit too clever." So, the lawsuit remains a risk and I will have to settle for a "wait and see" approach. That is unfortunate too, because Odyssey Re is trading at a very discounted price on concerns over this lawsuit.

Fairfax: Any Merit in the ICP Counter-Suit?

As many of you are probably well aware, Fairfax reported its 4th Quarter earnings the other day. Since the CDS gains were expected and well covered earlier on this site, I do not think there is much more I can add over their own release on that matter. But what I wanted to talk about was the ICP press release released right before earnings, entitled:

Fairfax Financial is Asked to Answer Disclosure Questions on Conference Call

Essentially, ICP is counter-suing Fairfax, alleging that the transaction Fairfax entered into with Bank of America in 2003 was improper. In the transaction, Fairfax purchased 4.3 million shares of its subsidiary Odyssey Re's stock("ORH") in exchange for 78 million in debt that was also exchangeable into Odyssey shares. ICP is challenging two things with regards to this transaction. The first is that Bank of America did not really borrow the 4.3 million shares it sold short to Odyssey. The second is that the transaction's structure had no business purpose, but was executed for the sole reason of saving money on taxes. (Something which is not allowed)

Again, remember that I am no legal expert- I am just using common sense. But in this situation I think that is enough. I can throw out the first argument about the borrowed shares right away. There are several major banks who have been involved in naked short selling, so Bank of America was not doing something unheard of. And I can not see how Fairfax can be faulted because Bank of America did not uphold its responsibility to borrow the shares.

What about the merits to the second argument- that the transaction had no business purpose, and was commenced just to save money on taxes? Fairfax definitely did save on taxes from this transaction, because the purchase of the shares allowed it to consolidate Odyssey, and so use the holding company's past losses to offset Odyssey's profits. Well first, we have got to break the transaction down into two parts, because Fairfax first made the transaction in March of 2003, and then refinanced it in November of 2004 with different terms.

1. March 2003: Fairfax purchased 4.3 million ORH shares for $78 million in debt at 3.15% interest and exchangeable into 2.15 million ORH shares.

2. November 2004: Fairfax refinances the debt for 101 million in debt at 3.15% interest and exchangeable to 4.3 million ORH shares.

So let's begin with the first transaction. Hypothetically, if Fairfax was taking out a loan and buying ORH shares, there would be no problem whatsoever to that. And, if Fairfax wanted to save interest costs by adding a convertible feature, that would also be fine. Since the exchange feature involves only 2.15 million shares, there does not appear to be any doubt- Fairfax has ownership of these shares, profiting from any gain in price and suffering from any losses.

But when Fairfax refinanced the debt in November of 2004, the transaction appears to have some questionable features. If Fairfax bought 4.3 million ORH shares in exchange for debt that is also exchangeable to 4.3 million shares, has a proper transaction actually commenced? Will Fairfax really gain if the price goes up, or is it just paying a small interest fee so they can temporarily claim "rights" to the shares and save on its taxes?

My understanding is that it is a proper transaction. Let's look at a few hypothetical examples to see. First, if the stock price went down to $10, Fairfax does face a loss. This is because the value of it's 4.3 million shares are now much lower, but it still owes the 101 million in debt, which Bank of America would have no reason to convert. So, the transaction satisfies the risk of loss requirement.

Now, if the share price increased to $40 per share, would Fairfax profit? The 4.3 million ORH shares are worth 172 million. The Bank of America debt of 101 million would also be converted, meaning Bank of America also ends up with 172 million worth of stock- and Fairfax no longer owes 101 million in debt. Now, this is where ICP says that the two of these cancel out and none of them are better off. But that is not really correct. Fairfax's shares are now worth 172 million and they do not owe the debt, so they did receive the profits. In return they had to issue 4.3 million shares, giving up a piece of their ownership. The company's financial and capital position is clearly different than it would have been if the transaction did not occur.

Economically, Fairfax is also still better off. Before the transaction, Odyssey Re had 65.142 million shares outstanding, which Fairfax owned 73.6% of. When the transaction first completed, Fairfax's stake increased to 80.4%, satisfying the 80% ownership level for tax purposes. At the end of our $40 example when Bank of America converts, Odyssey would have 69.442 shares outstanding, and Fairfax would own 75.3%. So Fairfax can clearly say it benefited by doing this transaction because it ended up with a larger ownership of Odyssey Re without needing to lay out any capital up-front.

So overall, this leads me to believe that there is little risk to Fairfax from this ICP lawsuit. Of course I was never really worried because I trust Prem and there was this excerpt below from the conference call, but I felt it would be right to understand the transaction myself.

Q: Bill began, from ICP capital. I have submitted some very detailed and comprehensive questions related to your 2003 tax consolidation. First question is do you plan on responding to those in written form?

A: Yes, good morning, William. You put a press release out, so let me put this into perspective in relation ship to your press release. The press release was issued late yesterday afternoon by a company. This is for our shareholders just so that they know a little bit about the perspective on it called institutional credit partners or ICP and by William Gayen [ph] ICP employee accusing Fairfax from profiting from an improper tax transaction. ICP and Gayen [ph] had dependents in a lawsuit brought by Fairfax in which Fairfax alleges that they and others engaged in a racketeering conspiracy to harm Fairfax by disseminating information about Fairfax so that short sellers could profit. I just wanted to make two points. First we took great care and obtained expert advice before entering into the transactions raised in the release. We have reviewed the accusations in the press release and we are confident they are baseless and misleading. Second, when Fairfax first learned in October 2006 that GAyen was alleging fraud by Fairfax, our counsel requested that Gayen [ph] to provide any information he had about this alleged fraud and to meet to discuss this information. But he never responded to that request. Because these accusations have also been raised by ICP and Mr. Gayen [pn] in their response to the racketeering lawsuit brought by Fairfax, it would be improper to address these accusations now in any further details. So thank you for asking that, and Jane next question

Wheat Prices Skyrocketing

Here is a multi-year chart of wheat prices:



That can not be good for inflation...

Pulp News

Three pulp producers reported earnings today- Mercer, Catalyst Paper and Tembec. Here are some excerpts from each regarding pulp fundamentals:

Mercer

Pulp markets continued to strengthen in the final quarter
of 2007, ending a year of continual price increases resulting
from both strong demand and a weakening U.S. dollar. Based
upon the current demand levels we are seeing in the market
and historically low inventory levels, we believe that there
will be continued upward pressure on pricing into the first
part of 2008.

Catalyst

Pulp markets were strong throughout 2007 with global pulp
shipments up 3% year-over-year and low world producer and
consumer inventories during the year.

...
Demand for NBSK pulp is expected to remain steady during
the first half of 2008, with the expectation that benchmark
prices will increase modestly in early 2008 followed by
potentially softer pulp prices in the second half of the year.
Higher consumption by China is expected to be offset by
weaker demand from markets in the U.S. and Europe, which
is expected to limit overall growth in demand in 2008.

Tembec

Looking ahead, pulp markets should remain strong and price increases have already been announced for the March quarter.

The March price increase is another good sign. I am hoping to do an updated write-up on SFK Pulp Fund as soon as I can get a few questions answered.

Berkshire's Letter to MBIA

(hat tip to David)

February 6, 2008

Mr. Gary Parr
Deputy Chairman
Lazard

Dear Gary:

As you know, many constituencies in the financial markets have been increasingly focused on the emerging issues in the financial guaranty industry for several weeks now. In fact, we ourselves have had several meetings with the New York Insurance Department to explore whether there is something we can do under the current circumstances that would be helpful in addressing the growing concerns in the financial marketplace. Unfortunately, the structured finance "side" of the business, with its many moving pieces and interdependent variables, has proven to be beyond our ability to adequately analyze. Nonetheless, we are ready and willing to lend our reinsurance support to the municipal side of the house, and in fact had set out in a letter to the New York Superintendent of Insurance a concept that we believe would address the needs and concerns of main street America's municipalities. The Superintendent has no objection to our approaching you with this proposal. We would like to meet with you and your client, MBIA, to discuss whether MBIA would have any interest in the proposal .

The key elements of the proposal we described to the Superintendent were: (1) we would raise the capital level in our monoline insurer, Berkshire Hathaway Assurance Corporation (BHAC), to $5 billion; (2) we would assume by reinsurance the muni bond portfolio of several of the monoline companies for a premium of 150% of the existing unearned premium reserves of the companies (with respect to two of the leading companies this would result in a combined unearned premium reserve of $6 billion, plus $3 billion for a total premium of $9 billion which, with the increased capital contribution to BHAC would result in approximately $14 billion of assets available to meet the combined $600 billion or so of total principal value of municipal bonds insured by these two companies); (3) we would undertake not to reduce BHAC's assets by dividends, fees, etc., for a minimum period of ten years; and (4) we had furthermore proposed that, if the companies found a preferable solution during the first 30 days of our cover, they could have a no-questions-asked walk-away option in consideration of a break-up fee that would be paid to us.

The gist of our proposal to you is that we would reinsure MBIA's current municipal bond insurance portfolio in consideration of a premium payment to us of an amount equal to 150% of the existing unearned premium reserves. Like many potential reinsurance buyers, I recognize that your first reaction may be that this is an excessive premium, and I want to offer you upfront the thought processes that led me to conclude that this is in fact a fair proposal that achieves important objectives for both parties.

We priced this proposed reinsurance cover to reflect the significant opportunity cost from our perspective in providing this type of bulk reinsurance cover. In the current market environment, we are able to command premium levels double (or higher) your client's prior rates to insure the risks that in addition have the benefit of your client's AAA insurance cover. Given our conservative use of capital (for example, the capital ratios in our monoline insurer would be higher than other insurers and would not be subject to reduction by dividends, fees, etc. for a minimum of ten years under the concept we presented to the Department), by offering this cover we forgo these direct opportunities to wrap already wrapped bonds. Despite this, there is an obvious appeal to a bulk transaction like this given the low overhead costs which would be involved.

Taking all these factors into account, we came down in favor of making the proposal and are prepared to pursue it with you directly. It is efficient as both a bulk transaction and a transaction that we believe will help stabilize the currently unstable marketplace conditions for the municipal business. In that sense, this approach also has the appeal of serving the greater public good, not an unimportant consideration for us, both as a matter of principle and as a company with a vested interest in national economic conditions.

From your perspective, I would respectfully suggest that this proposal would allow MBIA to release substantial capital from the municipal bond side of the house that can be deployed to support other obligations. I would submit that our proposal at the pricing levels we require is actually a cheap way for MBIA to raise capital as compared to other alternatives and is therefore of great benefit to MBIA's owners and their municipal bond policyholders.

Should this proposal prove to be of interest to you, and I sincerely hope that it is, we would ask for the courtesy of a reply as soon as possible. We would be prepared to complete this transaction within the next five days.

Sincerely,

Ajit Jain,
President

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