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A Canadian insurer is turning to a seldom-used strategy to make a big wager on falling prices over the next decade. As more investors worry about the possibility of deflation— or a sustained period of falling prices that could cripple stocks— Fairfax Financial Holdings Ltd. has spent nearly $200 million to buy derivative contracts wagering on a decline in the consumer-price index, an inflation indicator. The trade could lead to huge profits if deflation occurs.
Fairfax purchased some of the derivative investments in the first three months of the year, when few fretted about deflation and the cost of the contracts was cheap. It added more in the second quarter. The derivatives now are catching the attention of some on Wall Street. They have gained more than 50% in value since Fairfax made its original purchases from a number of banks, generating paper profits of more than $100 million.
The Fairfax bet, which aims to protect $22 billion of Fairfax's investment portfolio, comes as investors grapple with a particularly challenging environment, with the economy fragile and stock indexes struggling. Few investors are willing to make big wagers on deflation, despite its potential, with many skeptical any deflationary period would last long. The U.S. hasn't experienced an extended bout of deflation since the Great Depression.
Still, Fairfax isn't selling its deflation protection, despite its recent run-up in value. It thinks bigger gains could be ahead if the U.S. experiences a painful bout of deflation. "We are extremely concerned about a double dip in the economy and about a deflationary environment," says Paul Rivett, chief operating officer for Fairfax's investing department.
Derivative bets on inflation aren't new. Some companies and investors pay small premiums to buy inflation "caps" or "floors" that pay off if inflation rises above or falls below a certain level. Others buy derivatives betting on moves in economic indicators like the CPI, the inflation indicator that is now running at an annual rate of about 1%. But interest is growing among some larger investors for deflation derivatives like those Fairfax bought. Today it would cost about $330 million to protect the same $22 billion, dealers say.
Traders can sell these contracts to others in the "interdealer market," where banks trade with each other, something that was rare for such contracts six months ago. About $4.5 billion worth of these contracts have been trading each month in the interdealer market, up from $2.5 billion a month last year, according to traders. Fairfax was founded in 1985 by Prem Watsa, who has made a series of acquisitions; its name derives from the phrase "fair, friendly acquisitions". Mr. Watsa's investments for Fairfax have led some to dub him Canada's 'Warren Buffett'.
But in the U.S., Fairfax also has drawn attention for heated battles with short sellers; it has claimed these bearish investors helped drive down the insurer's shares several years ago before they turned higher in 2006. Fairfax shares have soared to more than 400 Canadian dollars (US$377) a share from about C$100 four years ago. The insurer has a solid track record anticipating bad economic times.
In 2003, Fairfax bought credit derivatives wagering on weakness among lenders including Countrywide Financial, scoring several billion dollars of profits when the housing market cracked in 2007. Lately, the company has been studying bouts of deflation suffered in the U.S. and, more recently, in Japan, and it is getting worried. "People say they understand deflation, but they don't understand how corrosive it is," Mr. Rivett says.
The Fairfax team believes U.S. households have only begun reducing borrowing and increasing savings, a trend it expects will lead to less spending, higher unemployment and deflation. 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.
Fairfax wouldn't comment on potential returns or how the trades were structured. Some banks selling these derivatives say they are skeptical of deflation. Prices for the derivative insurance suggest a 20% chance of deflation over the next 10 years, traders say. The banks say they have hedged their exposure, or reduced their risk, by finding other investors skeptical of deflation to take the other side of the trades or by purchasing their own insurance.
But traders say there are no perfect hedges when selling these derivatives. Some counterparties could be heavily on the hook in the event of steep deflation. (Warren Buffet has famously called such derivatives, "Weapons of Financial Destruction"— but nevertheless has a huge derivative bet that the stock market will be higher in about 10 years [Call option].)
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