Fairfax Financial Hedges Amid Concern About The Financial Market

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Prem Watsa is not very bullish on the economy; The Warren Buffett of Canada has been hedging against a large decline for quite some time. Watsa’s Fairfax just released its Q3 results and it seems that Watsa is still concerned. Below are excerpts from the press release and the quarterly filing. We will have more information on this topic tomorrow when Watsa speaks on the conference call (expect some BBRY questions).

Mr. Watsa, Chairman and Chief Executive Officer of Fairfax Financial Holdings Ltd (TSE:FFH), commented, “Our insurance companies are doing very well with a combined ratio of 93.4% in the third quarter and 93.9% in the first nine months of 2013 and we continue to be soundly financed, with quarter-end cash and marketable securities at the holding company of $1.1 billion.

Fairfax Financial’s market loss from bonds

However, we were affected in the quarter with mark to market losses from bonds (because of rising interest rates in the quarter) and a mismatch in our equity portfolios between our common stocks and our hedges. The Russell 2000 (INDEXRUSSELL:RUT) used for much of our hedging was up about 10% while the S&P 500 INDEX (INDEXCBOE:SPX) was up about 5%. Our common stock portfolios were up in the 6% range, not dissimilar to the S&P 500 but significantly less than the Russell 2000. Our long term performance has been in excess of most indices. We continue to believe that the mark to market losses will reverse in the future. We are maintaining our defensive equity hedges due to our concern about the financial markets and the economic outlook.”

Fairfax Financial Hedges

Fairfax Financial Holdings Ltd (TSE:FFH) has purchased derivative contracts referenced to consumer price indices (“CPI”) in the geographic regions in which it operates which serve as an economic hedge against the potential adverse financial impact on the company of decreasing price levels. ACDS

At September 30, 2013 the company’s remaining credit default swaps have a weighted average life of less than one year (less than one year at December 31, 2012) and a notional amount and fair value of $895.7 and $0.8 respectively ($1,898.7 and $1.7 respectively at December 31, 2012).

At September 30, 2013 the company’s remaining credit default swaps have a weighted average life of less than one year (less than one year at December 31, 2012) and a notional amount and fair value of $895.7 and $0.8 respectively ($1,898.7 and $1.7 respectively at December 31, 2012).

Fairfax Financial Holdings Ltd (TSE:FFH) has economically hedged its equity and equity-related holdings (comprised of common stocks, convertible preferred stocks, convertible bonds, certain investments in associates and equity-related derivatives) against a potential decline in equity markets by way of short positions effected through equity and equity index total return swaps, including short positions in certain equity indexes and individual equities as set out in the table below. The company’s equity hedges are structured to provide a return which is inverse to changes in the fair values of the equity indexes and certain individual equities.

At September 30, 2013 equity hedges with a net notional amount of $7,813.4 ($7,668.5 at December 31, 2012) represented 100.1% (100.6% at December 31, 2012) of the company’s equity and equity-related holdings of $7,808.7 ($7,626.5 at December 31, 2012). Net losses related to the company’s equity and equity-related holdings after equity hedges in the third quarter and first nine months of 2013 of $477.8 and $301.7 respectively were inclusive of net realized gains of $256.0 and $578.4 respectively recognized on sales of equity and equity-related holdings with original costs of $699.3 and $1,492.5 respectively.

Concurrent with these sales, Fairfax Financial Holdings Ltd (TSE:FFH) closed out a portion of its hedges to match the amount of equity and equity-related holdings sold and to rebalance its equity hedge ratio to approximately 100%. In the third quarter of 2013, the company closed  S&P 500 INDEX (INDEXCBOE:SPX) and Russell 2000 short equity index total return swaps with original notional amounts of $644.9 and $350.6 respectively ($710.4 and $350.6 in the first nine months of 2013 respectively) and in doing so realized losses of $577.0 ($611.5 in the first nine months of 2013). During the third quarter of 2013, the company initiated short positions in individual equity total return swaps with an original notional amount of nil ($389.8 in the first nine months of 2013) net of positions closed.

Fairfax Financial credit contracts

At September 30, 2013 the company’s remaining credit default swaps have a weighted average life of less than one year (less than one year at December 31, 2012) and a notional amount and fair value of $895.7 and $0.8 respectively ($1,898.7 and $1.7 respectively at December 31, 2012).

CPI-linked derivative contracts

Fairfax Financial Holdings Ltd (TSE:FFH) has purchased derivative contracts referenced to consumer price indices (“CPI”) in the geographic regions in which it operates which serve as an economic hedge against the potential adverse financial impact on the company of decreasing price levels. At September 30, 2013 these contracts have a remaining weighted average life of 7.7 years (7.7 years at December 31, 2012) and a notional amount and fair value as shown in the table above. In the event of a sale, expiration or early settlement of any of these contracts, the company would receive the fair value of that contract on the date of the transaction. The company’s maximum potential loss on any contract is limited to the original cost of that contract.

Foreign exchange forward contracts

Long and short foreign exchange forward contracts primarily denominated in the euro, the British pound sterling and the Canadian dollar are used to manage certain foreign currency exposures arising from foreign currency denominated transactions. The contracts have an average term to maturity of less than one year and may be renewed at market rates.

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