Fairfax Financial Bets on Deflation Thesis

Prem Watsa

Prem Watsa, Chairman and CEO of Fairfax Financial, has made a bold bet on falling prices over the next decade according to an article in The Wall Street Journal.  Fairfax Financial is an insurance company based in Canada which many have compared to Warren Buffett’s Berkshire Hathaway due to Mr. Watsa’s impressive long term track record.  Fairfax posted very strong results in 2007 and 2008 due to large gains in equity hedges and credit default swap positions that were taken based on Mr. Watsa’s correct reading of the economy ahead of the Great Recession.

While the case for deflation has been more popular over the past couple of months as economic news worsens and government bond yields have dropped to levels not seen since the depths of the financial crisis, Mr. Watsa has been worried about deflation for some time.  In December, we noted that Mr. Watsa’s views on deflation seemed to be very different from Warren Buffett’s warnings regarding a potential “onslaught of inflation” in the coming years.

Here is an excerpt from The Wall Street Journal regarding the Fairfax Financial deflation bet:

Fairfax paid $174 million in upfront fees to protect $22 billion of its investment portfolio against the possibility of deflation over the next decade. In exchange, Fairfax will receive a payment amounting to the drop in CPI below 2%—the level of inflation when Fairfax bought its contracts—multiplied by the $22 billion.

If deflation averages 2% annually over the next 10 years, Fairfax’s contracts would rise in value the equivalent of 4% of $22 billion, or $880 million, each year over the next decade, according to traders familiar with Fairfax’s trades. In that scenario, if Fairfax holds on to its investments during the 10-year period, it would reap nearly $9 billion from its $174 million investment. The company wouldn’t get anything for its bet if inflation turns out to be higher than 2% over the next 10 years.

Currently, the market seems to agree with Mr. Watsa’s assessment and is unconvinced by Mr. Buffett’s long term warnings regarding “greenback emissions” that seem like the path of least resistance for governments grappling with record levels of debt.  Essentially, the current market sentiment is assuming that the United States and other major rich economies will experience a Japan-style malaise for at least the next five to ten years.  How else can one justify purchasing a ten year treasury note at a paltry 2.5 percent yield, particularly at a time when many well established blue chip companies trade at modest valuations and offer higher dividend yields?

Time will tell whether the inflation or deflation thesis is proven correct.  With heavyweight investors with stellar track records on opposite sides of the debate, intelligent investors should keep an open mind regarding the risks of deflation even if skeptical regarding the willingness of governments to resist the easy lure of inflation to cure debt woes.

Disclosure:  The author of this article owns shares of Berkshire Hathaway.  No position in Fairfax Financial.

Goldman’s Problems Continue with Threat of FCIC Derivatives Audit

Despite paying the largest penalty ever assessed against a financial firm by the Securities and Exchange Commission, Goldman Sachs is still an attractive target for government panels investigating the financial crisis. Goldman agreed to pay a $550 million settlement on July 15 in connection with the Abacus case in which the SEC alleged that Goldman failed to disclose key information regarding the portfolio selection process.  Today, the Financial Times reported that Goldman is facing a separate inquiry by the Financial Crisis Inquiry Commission (FCIC) regarding the company’s use of derivatives.

FCIC Chairman Phil Angelides believes that Goldman Sachs is not being honest regarding the manner in which the company tracks revenues generated from derivatives trading.  At a recent hearing, two Goldman executives told the FCIC panel that the bank does not break out trading revenue generated strictly from derivatives:

They maintained that such information would give little insight into the bank’s trading risks as many trades involving a derivative contract also include an offsetting cash security. For instance, Goldman might buy a credit default swap to hedge against the possible default of a company where the bank also has a position in its debt. Tracking the revenue of one slice of a trade would ignore whatever gains or losses were booked on the other side, the bank said.

This seems entirely reasonable given the manner in which derivatives are used by large financial institutions.  The FCIC is threatening to send auditors to examine the raw data at Goldman and it is possible that programmers could extract only derivatives trades from the vast databases that the firm keeps to track trading activity.  However, without looking at such trades in the overall context of what they were intended to accomplish, the exercise would appear to be more likely to confuse the issue than to provide any insight for investigators.

It is unclear whether the FCIC understands how financial institutions use derivatives in modern markets:

Mr Angelides said he remained skeptical that Goldman did not have the derivatives information, given the bank’s reputation for risk management and its discipline in marking the value of every position daily. “It’s not credible that that’s a black hole,” Mr Angelides said. “It defies logic that these institutions have no clue of how much money they are making or losing from these derivatives.”

Goldman Sachs is known for risk management and it would in fact “defy logic” if the bank had no mechanisms in place to measure risk.  However, looking at a part of a transaction made up of a derivatives position while failing to examine offsetting transactions does not constitute “risk management”.  Rather, it seems to be a political exercise meant to vilify a financial instrument rather than a credible attempt to examine the overall risks being taken by financial institutions in a more holistic manner.

It is unclear whether government officials understand the nature of how derivatives are actually used and what risks emanate from such use, or if they do understand the issues but are attempting to make some political point by falsely isolating the impact of derivatives books from broader transactions.  In either case, loud announcements threatening audits will not help reassure markets regarding the stability of the financial system.

Disclosure:  The author has no direct position in Goldman Sachs but owns shares of Berkshire Hathaway, a large investor in Goldman Sachs securities.

Bill Clinton on Goldman Sachs, Financial Regulatory Reform

In the CSPAN video shown below, former President Bill Clinton comments on the SEC charges against Goldman Sachs and provides a brief account of his views regarding the problems with the financial system.  Mr. Clinton specifically cites John Bogle’s views regarding financial intermediation consuming a greater share of economic output.  He also provides some good examples regarding the difference between hedging transactions in derivatives and speculation.

Few investors would normally look to Mr. Clinton as an authority on financial matters.  However, it is worth noting that he was able to get to the heart of the issue in under five minutes while Senators of both parties struggled for hours yesterday during the Goldman Sachs hearings to even grasp the nature of a synthetic CDO.

For RSS Feed Subscribers, please click on this link for the video.