Fairfax Financial - Victim or Profiteer

Around the world, heads are shaking as to what caused this financial crisis and surprisingly a Canadian company, Fairfax Financial Holdings Ltd. (FFH), just might have the answers.  However, don’t expect Fairfax’s publicity shy CEO, Prem Watsa, who also happens to be The Globe and Mail’s 2008 CEO of the Year, to offer many details on what went wrong.  Watsa’s company has an incredible multi-billion dollar lawsuit pending against some of the biggest hedge funds on Wall Street and its $2 billion windfall from placing side bets against the financial system was legal but imho highly unethical.  In trying to break down the causes of the financial crisis, allow me to present the:

The 7 Reasons Fairfax Financial Holdings Ltd. Knows What Caused The Financial Crisis:

1.  Fairfax is a victim of Wall Street greed, corruption and organized crime.

2.  Fairfax is a victim of naked short selling and the lack of government regulation

3.  Fairfax is a profiteer of credit default swaps and the lack of government regulation

4.  Fairfax is a profiteer of the U.S. government bailout of the financial system

5.  Fairfax is a victim of leverage

6.  Fairfax has benefited from leverage

7.  Fairfax is a profiteer from the corruption and/or ineptitude of the credit rating agencies, the SEC, and the monoline insurers.

Taking a closer look at each:

1.  Fairfax is a victim of Wall Street greed, corruption and organized crime. Fairfax’s lawsuit alleges illegal stock market manipulation and collusion between hedge funds, analysts and journalists.  Recently revealed discovery in the $5 billion lawsuit shines a light on what might turn out to be widespread, ugly, organized crime on Wall Street.  A long list of dirty tricks, and criminal actions were used to try and destroy Fairfax’s share price and thereby benefit a group of sleazy, short selling hedge funds.  If these powerful hedge funds are shown to have broken the RICO (Racketeer Influenced Corrupt Organization Act), then how many others may be guilty?  Bernie Madoff ($50 billion hedge fund rip-off) may have had links to the Russian mob, Jim Chanos (Kynikos Associates) hangs around with the same hooker that brought down NY Governor Spitzer.  Who are these guys?  Just how corrupt is Wall Street?  Patrick Byrne (CEO of Overstock.com) has tried to expose the high level of corruption on his Deep Capture website, and the 2008 Weblog winner for Best Business Blog has been on a crusade against naked short selling.  Which brings us to the point #2.

2.  Fairfax is a victim of naked short selling and the lack of government regulation:  Defendants in Fairfax’s lawsuit likely engaged in illegal naked short selling.  Legal short selling is not at issue here, except that it should be monitored by the SEC for illegal trading.  Naked short selling is.  The practice is widespread, especially by large hedge funds, and it undoubtedly contributed to the financial crisis.  The SEC has failed to reign in naked short selling and has been immorally negligent in its supervision of hedge fund shorting practices.  While long positions in hedge funds are reported on periodic 13F Filings to the SEC, short positions are not.  The SEC’s temporary ban on shorting hundreds of financial stocks in the fall of 2008, is evidence enough that short positions should have been monitored and the laws against naked short selling enforced.

3.  Fairfax Financial is a profiteer of credit default swaps and the lack of government regulation: Profiteers basically take unethical advantage of situations and that is what Fairfax has done.  Credit Default Swaps have been a gravy train for financial institutions since the Commodity Futures Modernization Act of 2000.  The size of the cds market is difficult to fathom but take it from SEC Chairman Chris Cox last October,  it has played a large role in the financial crisis.

The roughly $60 trillion market for credit default swaps lacks transparency, is unregulated and creates an environment for market manipulation, Securities and Exchange Commission Chairman Christopher Cox said. The market’s size exceeds the gross domestic product of every country in the world combined, he noted.“It’s so important for Congress to act now,” Cox said at an SEC conference on disclosure for investors. “There is no longer any excuse for failing to act”.

That’s just great!  The “world’s greatest casino game” goes completely unregulated for years and now as banks, insurance companies and investment banks are collapsing all around us, the government wants to take action.  The facts speak for themselves; financial institutions took in billions of dollars in premiums, made guarantees to counterparties they would never be able to honor because they ignored reasonable reserve requirements, paid out millions in bonuses to themselves, and then when “shit hit the fan”, ran to the government to bail them out.  Fairfax was, of course, long cds’, betting on big problems for a host of sub-prime lenders and insurance companies.  They would argue their involvement in the cds market was for insurance purposes but this does not pass the giggle test.  Fairfax knows the difference between insurance (with its reserve requirements) and unregulated speculation.  Fairfax also knew that many of the companies selling cds guarantees were not going to be able to make good on them.  Which leads to the next point….

4.  Fairfax is a profiteer of the U.S. government bailout of the financial system: Fairfax played the “too big to fail” card when it came to choosing who it was going to buy its cds’ from.   By choosing the largest of financial institutions (too big to fail) and then limiting their counterparty risk by contractually obligating these institutions to continually deposit government securities in collateral accounts that would cover the current market value of Fairfax’s cds, Fairfax ensured itself of being payed off.  For a public company collecting over $2 billion dollars from its cds portfolio, there is precious little information provided by the company as to its counterparties.  However Citigroup (through Citibank Canada) is likely a primary counterparty, and some information about which companies Fairfax bet against can be gleaned from their subsidiary filings.  Why, in God’s name, are taxpayers bailing out Citigroup to the tune of $45 billion already, when much of it is going to payoff counterparties like Fairfax.   In 2008 Citigroup’s exposure to credit derivatives was in the hundreds of billions.  Companies that played the free and easy cds game should suffer the consequences when their counterparties don’t have the cash to pay up.  Our economic system demands that the Citigroup’s of the world fail.  Hedge fund tycoons are cashing in on their cds positions and real wealth is being concentrated in fewer and fewer hands - a sure recipe for long term economic disaster.  Trace the cash coming out of the “too big to fail” institutions like Citigroup, Bank of America, and Goldman Sachs and you’ll see profiteers like John Paulson (Paulson and Co.), reaping in billions of dollars personally.  While there’s nothing wrong with traders reaping in $billions from taking aggressive, high risk positions, there’s plenty wrong with them taking advantage of what amounts to a regulatory loop hole, and a knowledge that their positions would be backstopped by government.

5.  Fairfax is a victim of leverage: Hedge funds such as SAC Capital (the main defendant in Fairfax’s lawsuit) increase the power of their trading by borrowing against the base amount of their investor’s money.  In 1998 when Long Term Capital Management (another “too big to fail” entity) was saved by the Federal Reserve, its leverage was 30 to 1.  SAC routinely accounts for 3% of the NYSE trading volume and 1% of NASDAQ’s.  When the hedge funds described in Fairfax’s lawsuit, took to shorting Fairfax’s stock, it is easy to see they used leverage to bring down Fairfax’s share value.

6.  Fairfax has benefited from leverage: Fairfax was able to grow by some 30%/year from 1985 - 1999 by using leverage to aggressively acquire assets. Like many companies, Fairfax took advantage of a low interest rate environment to expand their business.  This low interest rate environment was created by globalization (cheaper manufacturing kept prices and inflation low), productivity (technology improved output), and a Federal Reserve (under Greenspan) that kept interest rates too low.  Greenspan created a systemic imbalance where the desire for riskier investments overwhelmed safer investments.  Leverage works great in an expanding financial atmosphere, but it similarly exacerbates problems when contraction occurs.  This is what we are now seeing around the world.

7.  Fairfax is a profiteer from the corruption and/or ineptitude of the credit rating agencies, the SEC, and the monoline insurers. For years, Fairfax knew that the credit ratings of many of the monoline insurers were unrealistic and likely “fixed”.  The game went like this.  Lenders were able to remove themselves from the actual risk of the loans they made by securitizing the loans.  An entity such as an investment bank (are there any left?)  would issue layers of bonds or equity (a hierarchy of risk and payout structures) and the proceeds would be used to buy up these loans and pay the original lender a fee.  Because the originator of the loan would have no lasting liability for the loan’s performance, loan quality was sacrificed for loan volume.  Homes were built, sold to unqualified buyers, and everything was fine as long as house prices kept going up and homeowners squeaked out their monthly payments.  The investment bank would now have a collateralized debt obligation (CDO) that was entitled to the cash flow from the portfolio of credits.  When sold to investors, the same portfolio of assets could offer different investors different risks and returns.  The investment bank would earn a fee for initiating the instrument and a management fee over the life of the CDO.  The credit rating of the instrument would, of course,  be vital in determining how much interest would have to be paid out to investors.  For a fee, a monoline insurers could be paid to wrap their AAA credit ratings around the CDO’s and guarantee their performance.  In the same way that municipalities paid premiums to monoline insurers to raise the credit standing of their bonds, and thereby lower their overall interest outlay, so could CDO’s.  The integrity of the whole system, however, depended upon the integrity of the credit rating agencies and their oversight by the SEC.  Both failed miserably.

In a January 3rd, 2009 New York Times Op-Ed piece, Michael Lewis (Liar’s Poker) and David Einhorn (President of Greenlight Capital) made the case against the credit rating agencies and the SEC.  In 1990 MBIA (one of the larger monoline insurers) was primarily an insurer of municipal bonds with equity of $931 million, debt of $200 million and a justifiable AAA credit rating.  By 2006, as a result of an explosion in CDO’s, MBIA had grown to have equity of $7.2 billion against a staggering debt of$26.2 billion, but somehow still preserved its AAA rating.  A downgrading of MBIA would simultaneously downgrade tens of thousands of credits that were guaranteed by MBIA.  In turn, this would significantly effect the revenues the credit agencies could expect from MBIA in the future.  There was little incentive for the credit agencies to do their job.  Similarly SEC investigators could be expected to “take it easy” on Wall Street, because a lucrative Wall Street career stood waiting in the wings.  The credit rating agencies were beholden to the insurers, the SEC investigators were beholden to Wall Street and the fictitious credit ratings of the monoline insurers created a great opportunity for a profiteer.

Given Fairfax’s cds portfolio, it is difficult to imagine a scenario where Fairfax did not understand and try to profit from the corruption in the system.  By taking cds positions against MBIA, Ambac, Radian, AIG, etc., Fairfax knew that eventually the evidence against the bond insurers would be so overwhelming that the credit agencies would have to make the downgrades and in turn trigger Fairfax’s windfall.  The real exposure in the system was not reflected in the institutions that were suppose to protect investors.  Fairfax didn’t so much make a strategic trade that paid off when their vision of the future became reality, as they made a trade against the corruption in the system that paid off when the obsfucation could no longer be tolerated.  Smart business or profiting from the corruption of others?

Conclusion:

I have no axe to grind with Fairfax Financial Holdings Ltd..  As far as I know, the company has not broken any laws and it’s only of interest to me because its operations touch on so many aspects of the financial crisis.  The company can be seen as a microcosm of our sad world today.   We cry foul when injustices are perpetrated against us, but cannot live our own lives devoid of unethical behavior.  Even though Fairfax had been damaged by the greed and corruption in the financial system, it could not resist the temptation to take advantage of this same systemic weakness and corruption.  Prem Watsa espoused the “value investing” of Benjamin Graham and then turned to a speculative opportunity (cds positions) that presented itself from a damaged system.

Fairfax might yet turn out to be a force for good.  If its lawsuit against the hedge funds can expose the prevalence of corruption on Wall Street, then the court findings might lead to improved SEC regulations and enforcement.  However, what is really needed is a paradigm shift that demands government take on a larger role in our lives.  From finance to energy, the environment, climate change, and the Millienium Development Goals, our challenges have to be met by forward thinking governments and people willing to sacrifice profits for ethics.