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.