Fairfax has cashed in some of its CDS gains

Fairfax Financial Holdings Ltd., which has just cashed in on a huge bet against the U.S. bond market, has laid down a wager that the credit crunch will hit Europe with a similar force. The insurance firm yesterday revealed a 2007 profit of $1.1-billion (U.S.), more than quadruple the previous year's results, thanks to its investment in credit default swaps (CDS), which rise in value when market conditions deteriorate. Fourth-quarter profit more than tripled to $564-million. But Fairfax chairman and chief executive officer Prem Watsa is also setting his sights across the Atlantic. Fairfax has invested about $60-million in European CDS in the belief that the lending problems that have struck UBS AG, Credit Suisse Group and other financial institutions may grow more serious."[The losses] are slowly starting to hit the marketplace," Mr. Watsa said.
Fairfax's 2007 results were driven by $705-million in investment gains in the fourth quarter from CDS, including those tied to distressed monoline insurers. CDS are similar to an insurance policy against a default on bonds or loans. A buyer such as Fairfax pays a small premium and stands to gain if the borrower defaults, or if the perceived risk of a default grows higher.Before last summer, credit default swaps were inexpensive. In the case of monoline insurance companies, which have run into trouble for backing collateralized debt obligations with too many risky loans in them, an investor could buy swaps for between 1 and 2 per cent - in other words, paying $1-million to $2-million for $100-million worth of credit protection. Today, that same insurance can cost $25-million or more, as the market worries that companies like Ambac Financial Group Inc. and MBIA Inc. will not be able to handle their massive debts.Mr. Watsa said credit risk in the monolines is now "much closer to being fairly priced," so Fairfax sold virtually all of those swaps in January and early February. As of Feb. 15, it still owned credit default swaps worth nearly $1.3-billion.But he said many other assets - including stocks - are still too expensive, particularly if the U.S. has a deep recession.
Fairfax's results were also boosted by a strong year in insurance underwriting. The company paid just 94 cents in claims and expenses for every dollar in premiums it received. Analyst Jeff Fenwick of Cormark Securities Inc. said Fairfax's operating fundamentals in the insurance business are strong, even without the CDS gains.
The fact that Fairfax has cashed in some of its CDS gains - leaving it at year-end with almost $1-billion of cash - means the company is in a strong financial position for 2008, he said.
The shift into European CDS also looks like a good bet, Mr. Fenwick said, because "we've seen the contagion from what's gone on in the U.S. markets spreading around the world."Fairfax stock has moved up sharply recently, rising from about $200 six months ago to more than $300.