The year 2008 will go down as one of history's worst, but it was the best year in the history of Canada's Fairfax Financial Holdings Limited. Its Chair and CEO, Prem Watsa, and his team, were among the few money managers who forecasted, and profited, from the economic catastrophe.
As a result, Fairfax has become one of North America's 10 largest property and casualty companies. Here are the highlights of its 2008 financial results, followed by an exclusive interview with Prem Watsa today talking about the future, what stocks has begun to invest in and other opportunities.
Highlights are:
1. Fairfax's 2008 earnings were C$1.4-billion for 2008, making it Canada's most profitable corporation.
2. Fairfax posted record investment gains of C$2.72-billion in 2008.
3. Book value increased by 21% in 2008.
4. The year ended with $1.56-billion in cash or cash equivalents in Fairfax's treasury.
5. Common shareholders' equity increased from C$4.1-billion to C$4.9-billion.
The net investment gains were the result of shorting stock indices, hedging existing common stock positions, buying credit default swaps (a form of insurance against bond decreases) and profits from sales of U.S. T-bills.
What's most interesting, however, about Fairfax's huge success is its avoidance of any counter-party risk in terms of its credit default swaps. In other words, Fairfax bought these swaps from the world's three pre-eminent banks and required full collaterization. Others, by contrast, have found that the party who insured the bond prices went under and the profits with it."
Q. How did you avoid the counter-party risk with these swaps?
A. "We worried about the collateral that these people would have and the possible bankruptcy of banks and our counterparties. So we did these with Citibank, Deutschebank and Barclays Bank. We also, unlike anybody else, were concerned about this and the banks thought we were crazy. We wanted them to collateralize their obligation to us so they put treasuries into an account in our name, held in trust, in order to backstop their obligations to us. At one point the collateral was US$1 billion. We had very little counter party risk because we dealt with Citibank, which the U.S. government would not let go under, with Barclays which the U.K. would not let go under and Deutschebank which Germany would not let go under. But even if Citibank went bankrupt we had the collateral. We also bought tradeable contracts so that we could sell them through the bank into the marketplace."
"We sold $12.6-billion of these swaps, the cost was $271.5-million and were shocked at how much we got which was $2.2-billion. The remaining $8.87-billion, cost $161-million, and have a value of $415-million."
"We think the major gains in the CDS contracts are over."
Q. Does that mean you believe the markets are at the bottom?
A. "Bottom? Stock prices are down 50%, credit spreads are very wide in the U.S. and Obama has come with a very significant stimulus plan. The Treasury Secretary has a very thoughtful way of handling the banks and yet no one believes it's the bottom."
"Today we've some of the biggest actions by the U.S. government in terms of stimulus, interest rates at zero and nobody believes it'll have any impact."
Q. What has to change to get out of this?
A. "We still have to worry about deflation because remember while Obama and the US government are spending this money, the rest of the economy -- businesses and individuals -- are deleveraging. We are saving, not expand capacity, we're scared. It's also important to note that the U.S. federal government is only 20% of the economy. It's spending but 80% of the economy is deleveraging."
"Demand is the issue and what we have to worry about. Also remember that in the last five years, half of the increase in consumer spending in the US was home equity loans borrowed against appreciation of homes. And that's all gone."
"The ultimate test is will the 80% start spending and we will not know that for some time."
Q. So does that mean it won't and that you are not investing again yet?
A. "We have been negative on common stocks for 4 or 5 years, and hedged our positions. But we stopped hedging in December and have bought long-term valuable, big companies with good, tested management such as Johnson & Johnson, Dell Computers, Kraft Foods, Wells Fargo, Intel and others. We believe these will pay off five years from now. We also like corporate and muni [tax free municipal bonds] bonds."
"U.S. municipal bonds always sold at a lower yield than US treasuries because one is tax free and the other is taxable. In the fourth quarter, we were able to sell Treasuries, yielding pre-tax 3 to 3.5%, and have been buying munis yielding an average of 5.75% after tax. This is unheard of. We bought minis guaranteed by Berkshire Hathaway [Warren Buffett's company]."
Q. Will inflation come roaring back with all the spending by governments?
A. "It's a potential problem in the future but right now the problem is demand, excess capacity all over the place. It will be a worry a few year from now but not currently."
Q. How long will it take for fear to disappear?
A. "The U.S. reacts quickly, as opposed to Japan. But it's a question of pessimism which means it's not a bad time to buy for the long term. We could have four or five years of difficult times. We really don't know."
Q. Some call this the end of capitalism what do you think?
A. "No I don't see that. Obama believes in private markets. But we had 20 years without a recession, because of monetary policy, which is why this one is so severe. Recessions take out the excesses in the system by slowing things down, lowering stock market and housing values so interest rates come down and the correction occurs. But for 20 years we didn't have that."
From my blog
Don't tell me the story of a gambler who won big at the Casino to prove gambling is profitable.
Peter Schiff also called the financial crisis, but his odd obsession with global decoupling and avoiding short positions caused his firm to significantly underperform the stock indexes in 2008. Instead of shorting equities, he went long foreign equities and got crushed. He also forecasted bear markets in Treasury bonds and dollars, and those turned out to be the two lonely bull markets. How could somebody be so right about the problem and yet so wrong about the consequences?
Volkswagon notwithstanding, 2008 was a great year for the shorts. I think that now would be a good time to get out short positions in the financial sector, though, because the government's new convertible stock injection policy could conceivably cause a viciously sharp rally if the asset-backed debt securities start changing hands again.
Myself, I've been almost exclusively in CD ladders since 2006, because I don't believe that individuals should engage in uninsured private investment, and I'm very happy with that decision. I'll let my credit union's fund managers decide how they're going to pay my guaranteed returns.
So, they did their due dilligence, and ended up making a bundle. What a great example of why you should stick to fiscal basics and not just "trust the new paradigm."