Insurance: Non-Life Business Now Enters Growth Phase

http://economictimes.indiatimes.com/personal-finance/insurance/insurance-news/Insurance-Non-life-business-now-enters-growth-phase/articleshow/6745302.cms

MUMBAI: After playing second fiddle to the life insurance industry for several years, the non-life business has roared back into growth mode. In the first six months of the current fiscal, the industry has recorded 23% growth and there are signs that profitability has improved as well.

“In a stable price environment, the non-life industry should grow by 2-2 .5 times the rate of GDP growth. What we are now seeing is some stability in pricing coupled with opening up of hitherto untapped sectors because of government schemes like the Rashtriya Swastha Bima Yojana,” said ICICI managing director Bhargav Dasgupta .
The growth rate in the first half is almost twice the 13% growth recorded in the whole of 2009-10 .

....

For the first half of the current fiscal, private insurers have recorded total premium of . 9,204 crore against . 7,312 crore in FY10 — recording a growth of 25.9%. Stateowned insurers have collected total premium of . 14,500 crore in the first half of FY11 against . 11,184 crore in the previous year — resulting in a 21% growth.

....

Among companies, HDFC Ergo continues to be one of the most aggressive growing by 49%. ICICI Lombard General Insurance — leader among private companies — has grown 32%. Tata AIG General has also managed a 33% growth despite its foreign parent’s troubles internationally.

Watching The Greats

Berkshire Hathaway and Fairfax Financial are perhaps the two of the greatest asset allocating machines out there today. They both released their 13-F filing yesterday, listing their common stock holdings at the end of the December period. Paying particular attention to Fairfax, we see a lot of major positions:

(Value, in $)

102 mil Alcoa
99 mil Burlington Northern
271 mil Dell
162 mil Frontier Communications
195 mil GE
234 mil Intel
459 mil Johnson and Johnson
98 mil King Pharma
294 mil Kraft Foods
96 mil Level 3 Comm.
159 mil Magna Intl
318 mil Pfizer
104 mil Wells Fargo

*Note: Positions in bold are new.

Not surprisingly, there is a lot of overlap with Buffett, who holds major positions himself in Burlington Northern, Kraft, Wells Fargo, and Johnson and Johnson.

According to Nasdaq, the total value of U.S.-listed common stock holdings at Fairfax is now up to *$4.7 billion (this excludes any foriegn holdings). Just over two years ago, the total common stock portfolio was at about $1.8 billion, and that was significantly hedged with market short positions. Prem and co. are at last putting major money into work with stocks, indicating that they see significant returns ahead. If they're right, great things lie in store for shareholders of Fairfax.

Source:
http://holdings.nasdaq.com/asp/OwnerPortfolio.asp?FormType=OwnerPortfolio&CIK=0000915191&HolderName=FAIRFAX+FINANCIAL+HOLDINGS+LTD%2F+CAN

*Correction, 2/19/09: included in the Nasdaq portfolio was $2.2 billion in value of Odyssey Re shares which were not included under equities in their 2006 balance sheet. Because Fairfax reported earnings today however, we know that total common stocks is at $3.8 billion, with $2.3 billion added to investments in the quarter. So although not as large as the originally stated notional amount, there has been a considerable increase in their common stock exposure.


Disclosure: The author owns shares in Fairfax Financial, Odyysey Reinsurance, and Burlington Northern.

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:

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.

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

AIG Discloses Weakness in Derivative Accounting

Another company which Fairfax has bought credit protection against has visited the confessional:

American International Group Inc., the world's largest insurer by assets, said auditors found a ``material weakness'' in how the company values its credit- default swap portfolio. The stock fell the most in 20 years.

The contracts declined by about $4.88 billion in October and November, according to data in a regulatory filing today. The drop was confirmed by company spokesman Chris Winans. AIG had said in December that the value of the ``super senior credit derivatives'' fell by about $1.1 billion in those two months. The stock retreated 11 percent to $45.16 as of 10:19 a.m. in New York Stock Exchange composite trading...

And from another article:

Credit-default swaps tied to AIG's bonds soared 37 basis points to a record 207 basis points, according to CMA Datavision.

For those unfamiliar with Fairfax's CDS portfolio, see the previous post.

A Small Update on Fairfax's CDS Portfolio

As I was glancing back at the list of companies Fairfax held Credit Default Swaps on, I had to note how amazing this investment has turned out to be.

Readers might first need a quick tutorial: A credit default swap(CDS) is an agreement between two parties that deals with the credit risk on a third-party bond. One party buy protection by offering an up-front fee to the seller. In return, the buyer's principal is protected by the seller in case of default or some other adverse event. When such event happens, the seller usually pays face value on the bond to the buyer, and he assumes the defaulted bond withe the hopes of recovering at least some of his losses.

Now it is important to note two things about this transaction. First, the counter-party you deal with is very important (for the buyer of protection). If the bond you bought protection for defaults but the other party in your trade can not afford to pay you, then you still lose money. So, this counter-party risk must also be managed for.

Second, you do not need a default to occur to start making money on a purchased CDS. If the perception of risk in a bond starts to increase, then the cost of insurance will rise and your purchased protection would be worth more in the market.

Now, the funny thing about Fairfax's CDS investment is that they did not own the underlying bonds they bought protection for. So Fairfax's intent was clear- they thought the companies they bought protection against would default in the near future. And so far, their prediction seems to be coming to fruition. For example, Fairfax held swaps against all the major bond insurers- MBIA, Ambac, PMI Group, and MGIC. Their share prices have plummeted as their survival has come under doubt. (see chart)


Fairfax also bought swaps against other major sub-prime players like Countrywide, Washington Mutual, and Societe Generale. The last one has been all over the news recently as the company reported a major loss:

AN OLD line of Hank Paulson's has been dusted off since news broke of a €4.9 billion ($7.2 billion) trading loss at Société Générale, France's second-largest bank. “We will never eliminate people doing bad things,” the former head of Goldman Sachs, now America's treasury secretary, once said. “In a town of 20,000 people, there's a jail.” The question now being asked of SocGen is: shouldn't there also be a police force?
...
The future of the bank itself is also in doubt. Its shares have slumped since the start of the year (see chart) and its credibility has been shredded, not just by the trading loss but also by write-downs of subprime-related investments.

Fairfax picked their targets correctly, but they were also careful about which counter-parties they dealt with- Deutsche Bank, Barclays, and Citigroup. As an example, Calculated Risk reports:

Deutsche Bank ... reported no write-downs related to structured products and less than EUR50 million net write-downs in leveraged finance. ... The bank also reiterated its EUR8.4 billion pretax profit goal for 2008, even though it said it expects "conditions to remain challenging in 2008."

All this leaves me excited about Fairfax's 4th Quarter earnings report on February 22. Around that time they should also be making their annual filings with regulators, which will mean I can find updated information on Fairfax's swaps and investment portfolio.

Prem Watsa: He Has Never Been More Bearish

In a rare interview, the chairman of Fairfax Financial Holdings Ltd. said he thinks it's possible the United States is on the cusp of a prolonged market slide, similar to the one endured by Japan between 1990 and 2003, when the Nikkei index plunged 80 per cent.

...
Mr. Watsa suggested the decision to put 75 to 80 per cent of Fairfax's portfolio .into government debt - "for the first time, I think, ever" - reflects his view that credit markets will take a long time to digest the problems in the U.S. real estate and mortgage business.

"We don't know how bad the recession's going to be, so credit is going to be tough," he said. "You're going to have these big losses, the banks are going to have big losses. So we are worried."

Mr. Watsa took particular aim - not for the first time - at the structured-products industry on Wall Street and Bay Street. Many of those securities got high ratings from the credit agencies, but have cracked under the strain of rising U.S. mortgage defaults.

The Fairfax chairman said the products were always flawed because they shifted the risk away from the person making the lending decision - which encouraged auto finance or mortgage companies to give loans to almost anyone, since they would not have to bear the losses on defaults.

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Earnings Roundtable

Four of my companies released earnings today. Unfortunately I have not yet listened to the conference calls for any of these companies, so I will hopefully be able to expand on this commentary shortly. For now...

SFK Pulp Fund
First, the bad. SFK's earnings have and continued to get hit by the relentless rise in the Canadian dollar (see chart). This has the effect of lowering their revenues, which are based in terms of US dollars, while their costs remain the same. The thesis has basically been that 90% of NBSK pulp capacity is in Canada or Europe, so the entire industry is getting squeezed by the recent rise. And SFK represents a very low-cost competitor on the production curve, and worldwide demand should continue to grow into the future. So the timing has so far been off, but Pope and Talbot recently filed for creditor bankruptcy. Either the prices they charge will have to increase or their going to have to disband operations, because their EBITDA (Earnings before interest, taxes, depreciation and amortization) was negative 5 months ago before the Canadian dollar run-up. On that note, they did announce a $20 increase for this month as well. As for where the Canadian dollar is going from here, that is something I feel like looking into.

Harvest Natural Resources
There is not much to talk about in this one, especially without listening to the conference call. Since Chavez signed the contract after the third quarter ended, the company will not record the benefit and the results of the operations on their financials until the next quarter.

Exchange Bank of Santa Rosa
This report probably went by unnoticed because it is still not published on their site, but it is available on the FDIC Call Thrift Data. Overall, I continue to be impressed. Earnings per share for the quarter came out to $3.14, and $9.73 for the last 9 months. But more importantly, the loan underwriting and reserves continue to be phenomenal.

30 day + delinquencies / gross loans = .78%
90 day + delinquencies / gross loans = .67%
Allowance for losses / gross loans = 1.78%

I'm going to have to make a post comparing this reserving with some of the companies Fairfax owns credit default swaps against. The allowance for loan losses doesn't even cover the 90+ day delinquencies for many of these companies, even after some very large loan loss provisions recently.


Fairfax Financial
Fairfax reported exceptional earnings today. The insurance operations had an underwriting profit of $62 million for the quarter, the holding company now has $836 million in cash, and debt continues to fall. Simply put, the team at Fairfax has done a remarkable job to get Fairfax where it is today.

With respect to the credit default swaps, the portfolio had a fair value of 546 million at the end of September. If we compare the last two numbers of the table in this post, we can see that since quarter end these spreads have widened significantly more. The question on current value will almost certainly be brought up on the conference call tomorrow, but I'm not so certain they will answer that. Last quarter they mentioned the updated fair value of the CDS portfolio in their earnings release. It would seem uncharacteristic of them to release this number on a conference call, where some people will certainly hear it before others. The management at Fairfax will probably avoid giving any updates in order to avoid speculation in their own shares.

Fairfax CDS Gains Demystified

Over the past few days, I have been posting about my expectations for huge gains in Fairfax's Credit Default Swap portfolio based on the terrible news the underlying companies have been reporting and the sharp drops in their stock prices. But the actual gains was still up for speculation because I could not find information on the actual credit default spreads for these companies. Well today, I received just that.
(Note: Current day refers to Oct. 26)

Spaced out by Oct'06- June'07- July'07- Sept'07- Current Day

Ambac 11- 47-152- 180-478

AIG 10- 13- 53- 32- 53

Countrywide 36- 67-136- 260-410

Freddie Mac 5- 9- 27- 17- 25

MBIA 22- 65-160- 132-302

MGIC 30- 70-206- 163-381

PMI 30- 45-106- 132-318

Radian 32- 72-216- 379-784

Washington Mutual 22- 41-82- 91- 154

The scale for the table and the chart use the last day of the month, and Fairfax's last CDS update was on July 31st. So if you compare the July '07 numbers with the current day numbers, you can get a sense for just how much some of these positions have appreciated.

Recent News Concerning Holdings

SFK Pulp Fund
Pope and Talbot announced $20 Increase in NBSK pulp effective immediately.

Harvest Natural Resources
Chavez has signed the new conversion agreement for Harvest, eliminating some of the political uncertainty over the stock.
Crude Oil rises to a record $92.40, adding more margin of safety to the Net Present Value calculations.

Fairfax Financial
Since my last update on Fairfax's CDS portfolio 10 days ago, some more bad news has popped up.

Countrywide Loses 1.2 Billion, Expects Turnaround. I'm not so optimistic.
MBIA posts a 3Q Loss.
MGIC slashes dividend 90% after 3rd quarter loss.
AIG may take a 9.8 billion dollar sub-prime mortgage hit. I was not sure when I saw AIG in their CDS portfolio if this position was meant as a hedge for recievables or as an investment. This seems to point to the latter.

Update on Fairfax's CDS Portfolio

Fairfax Financial owns a large portfolio of Credit Default Swaps (CDS) on several mortgage and financial companies. These contracts protect the principal value of the debt of these financial companies in case they default. But Fairfax does not own the debt of any of these companies, so it is not being used as a hedge. Rather, the CDS portfolio is a large (18 billion notional amount) bet that these companies will face credit difficulties. Back in August, I gave a list of the companies in their portfolio. Below is an update on what has been happening to some of the companies since then.

1. Countrywide Financial
Stock Since August (1st): -39%
Countrywide to Book Restructuring Charge

Struggling mortgage lender Countrywide Financial Corp. expects to book a pretax charge ranging from $125 million to $150 million related to its plan to slash thousands of jobs amid rising defaults and foreclosures.
...

Last week, Countrywide disclosed its mortgage fundings for September fell 44 percent from the same period a year ago.

Countrywide also reported a higher percentage of delinquencies between August and September in its loan servicing portfolio, which accounts for nearly 14 percent of all mortgage debt in the U.S., along with a higher number of loans in foreclosure.

Note that this charge doesn't even deal with provisions or loan write-downs. This is just for severance expenses. I'm looking forward to the 3rd Quarter report on October 26th.


2. PMI Group
Stock Since August: -32%
PMI Group to Swing to Loss in 3Q

Mortgage insurer PMI Group Inc. said Thursday it expects to report a net loss of $1.05 per share for the third quarter due its weakening mortgage insurance business and writedowns on derivatives.

3. Washington Mutual
Stock Since August: -19%
WaMu profit sinks 72%, sees more housing slump
From Calculated Risk:

"This is perhaps the most challenging cycle for housing that we've seen in many decades," WaMu Chief Executive Kerry Killinger said in an interview. He and other WaMu executives said they don't see any improvement in the near term.

"I have never seen housing credit conditions change so significantly over such a short period of time, nor can I remember a period when there was less clarity about near-term housing and credit trends," [Chief Financial Officer Tom] Casey said

4. MGIC Investment
Stock Since August: -30%
MGIC Investment Swings to 3Q Loss

Without a decline in loss severity or improved cure rate in the coming months and because of expected paid losses, MGIC projects it will not post net income in the fourth quarter or for the full year in 2008.

5. Ambac Financial
Stock Since August: -7%
Ambac Expects 3Q Loss

Ambac Financial Group Inc., an insurer of corporate and public bonds, said Wednesday it expects to post a third-quarter loss of up to $3.50 per share, as a result of a "mark-to-market" adjustment for its credit derivative portfolio.

A Few Tangents on Fairfax

Last night I went looking into a few things that I thought might affect Fairfax's value. The results are below.

1. Effect of a strengthening Canadian dollar
From the standpoint of a US investor, the overall strengthening of the Canadian dollar is a positive for US investors, in that it increases the value of Northbridge, their Canadian subsidiary. This is partially offset by an increase in corporate costs from the Toronto headquarters. Overall, the effect is pretty insignificant. Judging based on the market value of Northbridge, a 5% rise would add 88 million in value. If looking at earnings, a 5% rise would add approximately 9 million in operating income. (before tax) These are based off the table on pg. 53 which breaks down the overall business in terms of region.

2. Very Long-Tail Float from Run-off?
Under "Contractual Obligations", insurers include their loss reserves as well as a time-span for when they expect those to be paid out. I was hoping that perhaps Fairfax possessed a lot of super long-tail business from run-off which are reserved for today, but will not have to be paid until much, much later.

At the end of 2006, Fairfax had:
3-5 years 1.686 billion
5++ years 2.162 billion
Total reserves 10.658 billion

3 year++ reserves/ total reserves : 36.1%
5 years ++ reserves/ total reserves: 20%

Now in comparison, Allstate's property and casualty business had:
3 year++ reserves/ total reserves: 25.78%
5 years++ reserves/ total reserves: 14.23%

Which seems encouraging, but then I looked at Berkshire Hathaway, which only provides 3 years ++ numbers, and they were at 36.3%. So overall, I'd have to say that perhaps they have a slight edge in this respect, but not by much.

Also, some people have asked whether Fairfax's long term bond portfolio perhaps was a way to match assets with expected liabilities. Fairfax had over 6.7 billion in treasuries with a maturity greater than 5 years, far more in excess of the 2.1 billion they have reserved for. So the answer to that appears to be "No".

Prem Watsa Presentation at Scotia Capital- Notes

Fairfax Today
- At end of march 2007, 700 million US gross premiums for ICICI Lombard, 5,000 people.
- Consolidated, about 4.8 billion premiums written, 60% orh and 60% northbridge
- Mostly, commercial line company
- 5 Yr Growth in book value adjusted for dividends
Northbridge (?)
Odyssey 18.7%
Crum forster 17.9%

- Fairfax level had Run-off problems, “we think now that is history”
- 25% net debt to capital, soonest payment is 245 million due in 2012.
- We think property and casualty industry is on a downswing.
- Prices have come down in first half, we think it will continue to come down.
- Investment Side of business; 22% cash reserves, 55% in bonds, small corporate bond position. Went from 50% to 80% of equity portfolio hedged, plus 18 billion notional CDS portfolio.
- Conservatively structured for potential risks we see, not what we’ve seen over the last 6 months but worse, so we’re keeping our portfolio structure.

Why we’re concerned about the US: Can Japanese experience be repeated in the US?

- The 13 or 14 years from Nikkei peak in 1890, it went down. 40,000 to 7,500.
- even though interest rates fell from 8.00% to .50%, the stock market still fell down significantly.
- we like treasuries, 10 yr and above- if you look at it from a very long perspective, it is still a very high rate, 4.60%.
- High yield spread has been much higher, went down, going up again now.
- CDS for countrywide was about 150 basis when we bought, went to 50 basis points , now significantly higher.

Q & A

- Q: whether you would sell CDS'? (Question doesn’t come up on call, my guess based on the answer given below)
Our view is it’s our judgment, and if we get sufficient spread we will take it. Some we think have a higher chance of having credit problems, but fair to say given an appropriate price we would sell it.

- Q: Counter-party risk of CDS Portfolio?
Counter-parties are Citibank, Duetsche bank, and Barclays, so major institutions, along with pledged collateral. People think Fed Reserve will drop rates and we will be back in business, we think that might not be the case, so we’re keeping treasuries and CDS portfolio.

-Q Plans on ICICI Lombard?
Long, long term holding. Right now 6 billion premiums of India, we have 700 million. They’re projecting it will be 12 billion in 5 years, that’s still very small for 1 billion people. Fairfax is more in the investment management of the funds of the business. No intention of monetizing it.

-Q: Comment on Earnings?
We focus on increasing book value by 15%, earnings may be volatile depending on when they realize capital gains, and we don’t give guidance. $1.50 book value in 1985 to $165 today.

-Q: Some time ago you gave general guidance on runoff of break even, anything new?
No, still the case, we’re looking at approximately break even.

-Q: Long-tail claims of Runoff still stable?
There could be bumps, but we’re happy with reserves we have set.

We have 16 billion of investments, 3 billion in equity, and 4.5 billion of premiums written. 500 million interest from portfolio, but majority from capital gains. We made a ton of money in India- market went from 3000 in 2003 to 15000 today; we have little in India today.

I'll post Archive Link and Slides here as soon as available.

WaMu Chief Sees Perfect Storm

Washington Mutual today, after setting aside 500 million more for loan losses, said that they are amid what he called "a near perfect storm" in US housing. I wonder if he got the term from Prem Watsa, who has used the term often and is predicting a 1 in 50 or 1 in 100 year catastrophic event. Either way, it is good to know that the Fairfax team does hold CDS against Washington Mutual, among the many other mortgage names.

To see the list of other holdings in the Fairfax CDS portfolio, see this.

Fairfax Mentioned in Value Investor Insight

Fairfax Financial has a write-up in the August issue of VII by Whitney Tilson, with a price target of $365 (albeit, using some faulty numbers). Anyways, their thesis repeats what I've been saying here: Large CDS gain potential, and a hidden value in ICICI, combined with an overall very undervalued market price. I'd also add bond gains. Sorry, no direct link, as its subscription only.

Flight to Safety

Dazel from the Berkshire Hathaway Shareholders board pointed out something that hasn't recieved much press- the recent dramatic fall in treasury yields, especially short-term. See this link.

Meanwhile in the world of computer-model trading,

"Wednesday is the type of day people will remember in quant-land for a very long time," said Mr. Rothman, a University of Chicago Ph.D. who ran a quantitative fund before joining Lehman Brothers. "Events that models only predicted would happen once in 10,000 years happened every day for three days."

More "black swans"!

ICICI Lombard

ICICI Lombard recently came out with its annual report for the 06-07 year. The numbers show a company that continues to be a great growth story- here are some of the numbers:

Financial Year	2006-07	2005-06
Figures in nos.
No. of policies sold	3,136,393	1,461,039
No. of claims handled	642,777	243,951
No. of employees	4,770	2,283
No. of offices	220	154

Financial Year	2004-05	2003-04	2002-03	2001-02
Figures in nos.
No. of policies sold	607,926	249,531	98,293	9,148
No. of claims handled	84,970	23,487	8,022	420
No. of employees	1,249	561	284	116
No. of offices	96	63	35	11

Fairfax currently has a 24% stake in the company and has it recorded on the balance sheet at a conservative valuation. I see the largest private insurer in a fast growing industry, and the chance to take a lot of business from inefficient government competition. This could be a much more significant part of Fairfax in the future.