The Rational Walk
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Fairfax Financial Bets on Deflation Thesis August 26, 2010

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.

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Goldman’s Problems Continue with Threat of FCIC Derivatives Audit July 26, 2010

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.

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Bill Clinton on Goldman Sachs, Financial Regulatory Reform April 28, 2010

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.

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Berkshire Lobbies Congress on Derivatives Collateral Requirements April 26, 2010

The Essays of Warren Buffett

In a warning that was largely ignored at the time but proven correct in subsequent years, Warren Buffett referred to derivatives as “financial weapons of mass destruction” in his 2002 letter to Berkshire Hathaway shareholders.  Critics of Berkshire’s recent involvement in derivatives often like to point out the superficial inconsistency between Mr. Buffett’s earlier warnings and his willingness to enter into derivatives contracts in recent years.  Today’s Wall Street Journal article regarding Berkshire Hathaway’s lobbying efforts related to the financial regulatory reform bill are already raising charges of hypocrisy. Let’s take a brief look at the facts and how the legislation may impact Berkshire Hathaway.

Background

While Warren Buffett has emphasized the dangers of derivatives on many occasions, he entered into a number of derivatives contracts in recent years to take advantage of what he believed were mispriced terms at the inception of each contract.  The derivatives generally fall into two categories:  Equity puts and credit default swaps on individual companies.  The equity puts are long term contracts that require minimal collateral and are not exercisable until contract expiration.  In a previous article, we provided more details regarding the nature of these contracts in an attempt to clear up persistent misunderstandings regarding the issue.  Mr. Buffett’s latest letter to shareholders provides updated information based on developments in 2009

In addition to the derivatives portfolio managed personally by Mr. Buffett, certain Berkshire subsidiaries such as MidAmerican enter into derivatives contracts for hedging purposes.

Derivatives “Float” and Collateral Requirements

At the end of 2009, Berkshire Hathaway held approximately $6.3 billion of “derivatives float” which represents funds received from counterparties that Berkshire can use for investment purposes.  Berkshire’s counterparties are required to make payments at the inception of contracts. According to Note 12 in Berkshire’s 2009 annual report, very minimal collateral requirements exist and even additional credit downgrades would only require a relatively modest increase in collateral:

With limited exceptions, our equity index put option and credit default contracts contain no collateral posting requirements with respect to changes in either the fair value or intrinsic value of the contracts and/or a downgrade of Berkshire’s credit ratings. Under certain conditions, a few contracts require that we post collateral. As of December 31, 2009, our collateral posting requirement under such contracts was $35 million compared to about $550 million at December 31, 2008. As of December 31, 2009, had Berkshire’s credit ratings (currently AA+ from Standard & Poor’s and Aa2 from Moody’s) been downgraded below either A- by Standard & Poor’s or A3 by Moody’s an additional $1.1 billion would have been required to be posted as collateral.

One additional point that is often missed is that Berkshire continues to own the securities posted as collateral and benefits from any returns earned by the collateral.

It is obvious that Berkshire was able to secure very favorable terms from counterparties regarding collateral requirements precisely because the financial strength of Berkshire has never been seriously questioned.

Berkshire Objects to Retroactive Changes to Collateral Requirements

According to the Wall Street Journal article, Berkshire Hathaway is only objecting to efforts in Congress to retroactively apply new collateral requirements to existing contracts:

The provision, sought by Berkshire and pushed by Nebraska Sen. Ben Nelson in the Senate Agriculture Committee, would largely exempt existing derivatives contracts from the proposed rules. Previously, the legislation could have allowed regulators to require that companies such as Nebraska-based Berkshire put aside large sums to cover potential losses. The change thus would aid Berkshire, which has a $63 billion derivatives portfolio, according to Barclays Capital.

Mr. Buffett’s push is especially notable because he has warned of the potential dangers of derivatives, famously branding them “financial weapons of mass destruction.”

The White House has been trying to kill the Berkshire provision on the grounds that it would weaken the government’s ability to regulate the enormous market for derivatives. Berkshire Hathaway argued that it shouldn’t be made to redo existing contracts and that it is already healthy enough to cover its obligations. The battle over the provision shows how lobbying by businesses and lawmakers to insert just a few words into a complex bill can have a major impact on the country’s biggest companies.

The proposed changes to collateral requirements would have widespread impacts and are not targeted specifically to Berkshire.  The current reports regarding Berkshire’s lobbying indicate that the company is seeking a broad based “fix” to prevent the government from forcing retroactive changes to existing contracts rather than a special exemption only for Berkshire.

Bottom Line Impact

While it is impossible to know exactly what the bottom line impact of the proposed legislation would be for Berkshire Hathaway, it is important to note that any additional collateral that Berkshire is forced to post would continue to be owned by Berkshire and would earn income for the company while it is held.  The ultimate gain or loss from the derivatives position would be unchanged with the main difference being that additional collateral would have to be posted for the duration of the contracts, most of which will remain outstanding for many years.

The more significant impact going forward may be to discourage Berkshire from entering into new derivatives contracts if collateral requirements for new contracts become even more onerous.  A reduction in this type of activity may be inevitable in any case because many Berkshire shareholders may only trust Warren Buffett to personally manage these types of risks.  Whether shareholders would be comfortable with a proprietary derivatives strategy run by Mr. Buffett’s successor is far from clear.

From a valuation perspective, it seems most conservative to consider the $6.2 billion proprietary derivatives float to be in “run off” rather than a permanent source of value.  The derivatives positions will likely produce significant profits for Berkshire over the next several years but renewal of such opportunities seems too uncertain to rely on the proprietary derivatives strategy as a source of ongoing value.  In contrast, Berkshire’s much larger $62 billion of insurance float remains a long standing and enduring source of intrinsic value for the company.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides more information regarding the company including a brief section regarding the derivatives portfolio.

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Derivatives: Implications for Investors June 27, 2009

Carol Loomis has written a “must read” article on derivatives which appears in the July 6 issue of Fortune Magazine as well as online at Fortune.com.  At a time when regulation of derivatives is a major focus in Washington, it is useful to step back and take a deeper look at the events of the past several years to understand the depth of the problem and the complexities awaiting those who would try to reduce the overall level of systemic risk inherent in these complex instruments.  Here are a few excepts and comments from the article along with my views on how investors can manage risks associated with derivatives.

The Case For Regulation

While many have claimed that the cause of derivatives problems at companies such as AIG was management error rather than any systemic problem related to the derivatives instruments, the article presents a different view:

A basic reason for favoring regulation is that derivatives create a kind of mirage. They don’t extinguish risk, they simply transfer it to a different party — a counterparty, as the term goes. The ultimate outcome is millions of contracts and an endless, virtually unmapped, web of connections among financial institutions. That maze exists today, and so does the systemic threat it raises: that some major counterparty will go bust and drag down other institutions to which it is linked.

We came perilously close to such a chain reaction in the past 18 months, as both the economy and the financial system buckled in distress. Derivatives cannot be called the central villain in this drama. That dishonor belongs to some combination of bad management and a real estate world gone crazy. But derivatives elevated the stakes, as they seem constantly to do. Today, as the financial system goes about digging itself out of the muck of trouble, no one imagines that the risks of derivatives have diminished. That’s what the regulatory clamor is all about.

The article goes on to describe how many red flags have been visible for at least fifteen years dating to a 1994 Fortune article also written by Carol Loomis.  The current article describes many of the problems that faced Bear Sterns, Fannie Mae and Freddie Mac, and Lehman Brothers.

Profits for Everyone!

I found the portion of the article dealing with the perverse accounting problems related to derivates particularly important and insightful.  Due to the often opaque characteristics of complex derivative contracts, it was normal and common for each side of such a transaction to book a profit.  This pleasant result has created many problems unwinding the derivatives exposure of major financial institutions because the valuation of a contract is apparently subjective under many circumstances.  The article goes into some detail regarding a peculiar situation involving Lehman, Bank of America, and J.P. Morgan that would be amusing if it did not point to such a serious malfunction of the system.

Move now to the accounting problem. While sometimes the fair value of a derivative can be precisely determined, at other times it must be derived from murky markets and models that leave considerable room for interpretation. That gives the holders of derivatives a lot of bookkeeping discretion, which is troubling because changes in fair value flow through earnings — every day, every quarter, every year — and alter the carrying amounts of receivables and payables on the balance sheet.

The subjectivity involved in derivatives accounting also means that the counterparties in a contract may come up with very different values for it. Indeed, you will be forgiven if you immediately suspect that each party to a derivatives contract could simultaneously claim a gain on it — which should be a mathematical impossibility.

Berkshire Hathaway and Derivatives

Here is an interesting excerpt related to Berkshire Hathaway and the apparent (but incorrect) inconsistency between Warren Buffett’s characterization of derivatives as “weapons of financial mass destruction” and Berkshire’s own position in mispriced derivatives:

…. it is a celebrated fact in the financial world that the man who sparked 1,370,000 Google citations for “financial weapons of mass destruction” has bought a good many of them for Berkshire Hathaway (BRKA, Fortune 500). Explaining, Buffett points out that as far back as 1998 he had told shareholders about derivatives Berkshire owned, and that he never said he wouldn’t again exploit a mispricing when he saw one in a derivative. (It is the opinion of this writer, a friend of both Buffett’s and Munger’s, that Buffett is incapable of ignoring mispricings, wherever in the financial markets they may exist.)

Reform Proposals

The article goes on to discuss some of the initiatives under discussion which would attempt to reduce the systemic risk related to derivatives.  This includes the clearinghouse concept in which derivatives with “standard” features would be cleared on an exchange in an attempt to reduce counter-party risk  as well as discussions underway in Washington to create a regulator with broader authority to deal with systemic risks to the system.  A quote from the article calls into question whether the nature of regulatory agencies can keep up with the ever changing nature of financial innovation on Wall Street:

“It doesn’t matter what they do in Washington,” said a New York derivatives trader recently, showing Wall Street’s all too common contempt for policymakers. “The smart guys who come out of business school don’t take regulatory jobs there. The smart guys go to places where there are chances to do well. And if there are new rules, the smart guys will just deal with them and move ahead.”

Implications for Investors

What’s an investor to do in a system where derivatives could cause new meltdowns at unpredictable times?  There is probably not much that can be done to fully protect against a systemic meltdown.  However, on a micro level, companies should be scrutinized in great detail when it comes to derivatives exposure particularly when it comes to the methodology used to mark derivatives to market.

In my opinion, the opaque characteristics of the mark to market process and the degree to which derivatives can imperil a company that mismanages exposure places most companies with significant derivatives exposure in the “too hard” pile when it comes to evaluating candidates for investment.  I would rather miss some good opportunities than take unquantifiable risks with my capital.  The title of this article may imply that some ideas for managing exposure to companies exposed to derivatives will be proposed, but instead my solution is to simply “punt”.  I think that this is an intelligent solution.  While others may have the ability to deal with this risk, it is outside my circle of competence and I suspect the same is true for the vast majority of investors.

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