30SEP08:
31DEC08 INDICES:
FTSE100:3550
DOW30:7550
# HEDGE FUNDS:4425 30JUN08: Oil to be USD200 by 30OCT08 USA Inflation to be 7.5% by 30OCT08
...oops 23APR08:
Next Rights Issue:
HBOS...yes
All & Lec ...
...1 Nil. 17APR08: Oil to be USD127 by 30SEP08
...16MAY08 losing my touch 27FEB08:
2 Banks go bust by 30JUN08
BS down, Lehman (a bit late I know) 20NOV07: Northern Crock to be sold for 15p
Nationalized 01NOV07: Oil to be USD103 EOM
...peaked too soon 08OCT07:
SEC to fine Goldman for pricing issues
...still waiting 15JUN07: ML to buy-out BS
JPM got there first 06JUN07: The Big Crash: 17OCT07
...well it's here
Today the news is dramatic and mostly about blaming others:
Index arbitrage programme trades are blamed for the market correction.
Ernst & Young predicts that Hedge Funds will be the saviours of the market as Pirate Equity are blamed for corporate debt-fest collapses [Editor: It doesn't quite say that]
Insurance Company Fairfax blames SAC and other Hedge Funds for giving it a hard time.
CTA Futures Hedge Funds blame no one for their dips in performance.
ABN AMRO blames itself for being a useless company.
UK MP's are to raid Pirate Equity ships and blames them for just being Pirates.
Morningstar blames the SEC for its failure to sign up Hedge Funds to its database.
A string of corporate collapses is likely next year as debt-laden private equity deals begin to unravel, a leading firm of accountants said yesterday.
The complexity of the deals and the timing of debt repayments will undermine companies that under previous ownership structures might have survived, said insolvency experts from Ernst & Young.
The firm's analysis of corporate buyouts and potential losses for investors is likely to increase pressure on private equity firms under fire from unions over job cuts.
The government has called on the industry to be more transparent. The purchase of Madame Tussauds by US private equity firm Blackstone this week follows high-profile deals including Permira's buyout of breakdown recovery firm AA from Centrica and Birds Eye from Unilever
The Treasury select committee yesterday launched an inquiry into the private equity industry to review its impact on the economy and various stakeholders. The committee was responding to intense criticism by unions and senior Labour politicians following allegations of profiteering and anti-labour practices.
A report by the Financial Services Authority also prompted the review, the powerful all-party committee said.
Last week the industry said a working group chaired by former Bank of England director and Morgan Stanley banker, Sir David Walker, would examine the need for more disclosure by private equity firms and debt funds set up to buy companies.
The British Private Equity and Venture Capital Association (BVCA), which will publish the results of Sir David's inquiry, welcomed the intervention of the Treasury committee yesterday and said it would be pleased to make representations to MPs.
Private equity deals often involve buying companies with billions of pounds of bank loans and other funding through the international debt markets. Private equity firms often target stock market listed companies that they hope to revamp and re-sell in three to six years.
Unions say they are only able to manage dramatic increases in profits in a short time because they are largely based offshore and avoid corporation tax, avoid tax on much of their debt interest and use anti-labour tactics to drive down wages and other costs. Unions feared that a possible takeover of supermarket chain J Sainsbury by private equity firms would result in cuts to staff terms and conditions.
Fees paid to private equity firms have also attracted criticism. Partners in private equity firms have enjoyed bonuses that in some cases have dwarfed the sums offered by London investment banks, unions said.
Keith McGregor, an insolvency partner at Ernst & Young, said the complex nature of many private equity deals was likely to make them more prone to collapse if they suffered a downturn in sales or increase in costs.
"The quality of the debt has dropped off in the last few years. Debt with a CCC rating has a one in three chance of going bust within two years. But it is the fastest growing element of debt in private equity structures," he said.
He said the situation would worsen next year when a significant increase in costs would begin to hurt companies when they needed to fund the second tranche of their debt repayments. The first level of debt, known as senior debt, is paid back in instalments and lenders have the first call on the company's assets if it should go bust. The second and third tier of debt is typically paid back after four and six years respectively.
"Around 90% of the debt issued in the world is less than three years old. That means tranche two and three are still one and three years away from being repaid. There is no reason why the default rate will go up this year. I don't think it will hit until 2008," Mr McGregor said.
The big deals
Ten years ago a private company would only need to think about its overdraft and bank loans. Depending on the size of the company, the loan might be held by one bank or several. As Ernst & Young partner Alan Hudson describes it, one bank would act as sheriff if there was any problem making repayments. Those uncomplicated days have gone. A company subject to a takeover by a private equity firm will find itself with a layer of debtors, all with different rights and expectations. They might be hedge funds or pension funds. If the company gets into trouble it might find itself negotiating with a gang of distressed debt buyers looking for a quick profit.
In a typical deal, the owners of the first level of debt are paid first.
When a company fires its first distress signal these creditors may be in line to get 90% of their money back and care little if the whole enterprise goes under.
Other creditors, further down the hierarchy, may want the company to keep trading to give them a chance of recouping losses. Mr Hudson says firms like his have already seen creditors fighting so hard the company is paralysed and eventually broken up.
Fintag says Haven't I been telling you this for the past 6 months? So good to be proved right - again.
STOP LOSS - COMPUTER SAYS NO
Programme traders blamed for US market plunge (financialnews-us) The head of a specialist US research company has blamed programme traders, who use computers to profit from discrepancies between the prices of stock market indices, for the sharp fall in the Dow Jones Industrial Average last week.
Hank Camp, who runs HL Camp & Company, an investment adviser that specialises in programme trading research, believes about 250 points of the 400 point fall in the Dow Jones Industrial Average last Tuesday was down to programme traders selling stock through index arbitrage strategies.
The New York Stock Exchange defines a programme trade as one that involves the purchase or sale of 15 or more stocks with a value of $1m (€763,000) or more.
On an average day, programme traders account for about 50% of all US equity trading volumes but that can spike to between 70% and 80% on some days.
The biggest programme trader by volume is UBS. Morgan Stanley, Goldman Sachs, Credit Suisse and Lehman Brothers are also highly active.
HL Camp & Company data shows that no programme traders bought stock last Tuesday, which it notes is extremely rare. Among the stocks that were sold the most during sell programmes last Tuesday were investment banks Goldman Sachs and Morgan Stanley, technology companies Cisco, Google and Microsoft, and consumer staples such as Walmart and Black & Decker.
Camp said: "Most programme traders know that after Washington's birthday [February 19] in years that end in seven, you do not want to be long securities, you want to be short. So we, along with most of our clients, were short on February 22 and February 23, and before that for this pattern that ends in seven: that's how programme trading works. When you know what the markets usually do, you can programme your computers to sell securities short, and look for an event like Tuesday."
Meanwhile, algorithmic trading, which is a sub-set of programme trading, caused European exchanges problems last week with the volume of buy and sell messages these models were sending. Brokers estimated that algorithmic trading volumes trebled last week.
US stock markets fell again yesterday with the Dow Jones closing down 0.53%. Asian stock markets finished up overnight and European markets were trading up on the open this morning.
The Vix index, which is a measure of the volatility of the S&P500 index, hit a nine-month high of 20.4% yesterday before closing at 19.6%. The index has rebounded from historical lows of about 9% in mid-February.
Fintag says Unfortunately hard coded stop loss triggers have no emotional override. Whereas a trader can surmise that the blip is temporary, the computer just says no.
CRYSTAL BALLS UP
Man's AHL fund fell 8% in share rout (ft) The flagship fund of Man Group, the world's biggest listed hedge fund manager, had its second worst week on record during the recent stock market rout.
AHL, the $17bn (£8.8bn) managed futures fund, fell 8.23 per cent in the week, Man said yesterday. Its worst performance was in March 2003 when it plunged almost 10 per cent in a week after the Iraq invasion.
The market turbulence has also hit the float of the first hedge fund to join the main market in London, it emerged yesterday.
Brevan Howard, the London hedge fund manager, expects to raise less than the €1bn (£680m) it was aiming for, although still "comfortably" above its €500m minimum level when it lists this week, people close to the fund said.
The performance of AHL was widely expected to have been poor because the fund profits from trends in the markets and loses out when trends end - as they did dramatically last week. Rival funds, such as London's Aspect Capital and Winton Capital, use similar models and are also thought to have done badly.
The poor performance is unlikely to hit Man's profit unless it continues for some time as most of the new money the group raises for AHL comes through structured products with guarantees or protection built in. Man declined to comment.
However, last year Man suffered after AHL peaked in May and had several months of sustained poor performance, hurting its ability to raise new money.
The group's shares have already been hit far more than the FTSE 100 - of which it is a member. Last Tuesday, when the markets had theirbiggest fall, Man was down 5.3 per cent and the shares carried on down until yesterday, when the markets began to recover. Yesterday, the shares were up 0.75p at 529½p.
Several funds of hedge funds have already said they regard the dip in the managed futures sector as a buying opportunity.
The funds are inherently far more volatile than most hedge funds. AHL's top weekly return slightly exceeds its biggest loss, at just under 10 per cent in October 1998.
Fintag says CTA is always more volatile than most other strategies. That is why it is such a fun strategy to be in. We were down 6% but then we have a high sharpe and sortino ratio. So what.
The Treasury Select Committee announced yesterday it would hold an inquiry into the industry in the wake of the furore of the past few weeks.
It said the decision was taken in the light of the Financial Services Authority's discussion paper into the regulatory risk of private equity and the decision by the industry to organise a working group under Sir David Walker into better disclosure.
John McFall, chairman of the committee, told The Times that the Walker initiative was “an attempt at self-regulation. Parliament is taking the opportunity to scrutinise that.”
Details on the terms of reference and timing of the inquiry would be included in a call for written evidence in due course. Once written submissions are in, the committee will summon witnesses and the inquiry could put the spotlight on some of the most media-shy financiers.
Trade unions have conducted a lively campaign to bring the industry under closer scrutiny and to reform the tax regime under which private equity thrives.
The GMB attacked the industry after the AA, the private equity-owned roadside rescue company, admitted that its cost-cutting had gone too far.
Pressure has also intensified from the Transport & General and from the shopworkers union Usdaw since private equity bidders confirmed they were interested in taking over J Sainsbury.
GMB general secretary Paul Kenny welcomed the inquiry: “We have been calling on MPs to look at practices in the private equity industry, particularly the tax regimes that apply.”
The British Venture Capital Association also welcomed the move and said it would be happy to give oral evidence if invited so to do.
The committee also announced plans to examine competition in banking and the future of free banking. Mr McFall said that the banks had just reported profits collectively of £40 billion and it was time to reexamine competition seven years after the Cruickshank review.
Fintag says Another FiNTAG rant that seems to be having the desired effect. Less heat on Hedge Funds and more on the true market crooks. We want efficient markets, liquidity and a bit of volatility. The Pirates want to destroy lives, communities and corporations in a way that makes Gordon Gecko look like an amateur.
ABN AMRO IS TOLD IT'S USELESS
Tosca joins attack on ABN (ft) A second British hedge fund will today join the attack on ABN Amro when the $4.5bn Toscafund warns the Dutch bank not to launch big acquisitions, and calls for a merger with a better-run rival.
Tosca owns more than 1 per cent of ABN, which is under attack from The Children's Investment fund (TCI), another big London hedge fund which wants ABN to break itself up.
The move comes amid controversy over the role of hedge funds at ABN and arguments about aggressive activism from other funds attacking Dutch companies including Stork, the industrial conglomerate, and Ahold, the food retailer.
Tosca's intervention is particularly significant because its holding company is chaired by Sir George Mathewson, former chairman of Royal Bank of Scotland, Britain's second- biggest bank. Fred Watt, former RBS finance director, is a non-executive and adviser.
But some other ABN shareholders have already backed the view of hedge funds that the bank's management has been underperforming. In the past week, PGGM, one of the largest Dutch pension funds, said it shared TCI's concerns over ABN strategy, while SNS Asset Management, which has a 0.3 per cent stake, said it supported a break-up.
VEB, the Dutch shareholder association, has also echoed several of the concerns raised by TCI.
"It is evident that over the past five years the management of ABN Amro has failed to deliver acceptable returns," Tosca said.
"Accordingly, we do not believe that ABN Amro should make any major acquisitions. We also believe that all the stakeholders would benefit by way of a merger with another large group which has a proven track record in adding value."
However, Tosca will make clear it is not working with TCI and describes its investment as "passive". It has already told management it is unhappy, but will say it is hoping for a "positive, constructive" response from the bank on how to improve shareholder returns.
Tosca is run by Martin Hughes, one of the "Tiger cubs" who used to work for hedge fund legend Julian Robertson's Tiger Management.
Fintag says If ABN AMRO's management was more effective (looking at their accounts, the board of directors look like they are the living dead) it wouldn't have to waste its considerable resources on fending off aggrieved Hedge Funds.
NOBODY SAID IT WOULD BE EASY
Morningstar Big-Hedge Fund Sign-Up Hasn't Been Stellar (dailyii) Morningstar is discovering that its big plans for the hedge fund industry have not been a ride in the country. Last year, CEO Joe Mansueto detailed that his company was going to double HF coverage and headed in that direction by buying rival Altvest.
So far, however, Morningstar's success in signing up the biggest hedge funds has been less than stellar. According to Crain's Chicago Business, to date only six of the top 20 hedge funds have submitted even partial information - and that participating doesn't include hometown HF giant Citadel Investment Group. There are various theories for the lackluster performance. "The best hedge funds are close to new investors," Mark Hutchins of Citigroup Global Markets, told Crain's, "and if I'm a closed hedge fund, why am I reporting to a database?" Oddly enough, some Citadel information has been made public as a result of its $500 million bond issue in 2006. But for now, the Morningstar HF database appears to be the domain of smaller firms, though Mansueto hopes that will change. "There are hedge funds that are more progressive that see this as a the future of making the industry transparent so the government doesn't come in with heavy-handed regulation," says Mansueto. Among them is Loyola Capital. The Lake Forest, Ill.-based hedge fund submits to the Morningstar database as well as several others, because, founder Robert Reynolds said in an interview with Crain's, since by law hedge funds are not allowed to advertise, this is "the only way we can get our number out to the public."
Fintag says It all comes down to incentive. FiNTAG has put some of his better funds onto Morningstar but lets face it an investor isn't going to make an investment decision on whether it is in Morningstar or not. The chips are against you. If they grade you badly, your Hedge Fund goes out of business.
It is better to stay quiet and let your performance and the quality of your other investors help sway new investors.
And as FiNTAG has said many times before, Hedge Fund databases are about as useful as an old jigsaw. They are incomplete, inaccurate and a waste of time.
SINGAPORE CITI
Citi opens prime brokerage office in Singapore (asianbanker) Citi has opened a Prime Brokerage office in Singapore. The office will cater to the growing requirements of Citi's clients in the country, offering them full access to the bank's global Prime Brokerage platform. This new initiative underlines the bank's commitment to Singapore and the growing importance and growth in the Singapore hedge fund industry.
"We need to be on the ground in S ingapore, serving our growing client base and providing local clients with the benefits of Citi's global Prime Brokerage platform," said Hannah Goodwin, Citi's head of Prime Brokerage for Asia Pacific. "This is a major growth area for the bank's Prime Brokerage operations in the region and underlines Singapore's emergence as a major Prime Brokerage centre in Asia."
Alexis Fosler will run Prime Brokerage sales in Singapore and other ASEAN countries and will also cover India Prime Brokerage sales. She has been working in the offshore banking industry in the British Virgin Islands and previously worked in Hong Kong in equity sales/research for SBC, UBS and Credit Suisse. Also joining the Singapore office will be Paul Weir, who has been appointed Citi's c lient service manager for the Singapore Prime Brokerage office. Prior to joining Citi, Paul worked for Bear Stearns for five years and was most recently in charge of the bank's European Fixed Income Prime Brokerage operations. Further additions to this team are expected over the coming year.
"Singapore has done an excellent job in helping to attract hedge fund managers and asset managers to the country via various incentives. Singapore has a lot to offer, from the lifestyle and the people to the efficient tax and regulatory environment. This has helped boost the industry in Singapore with many new funds coming to Singapore. Citi is actively looking to add more people to the team in the coming year given this continued growth in the business," said Hannah Goodwin.
The Prime Brokerage business operations will complement Citi's recently established hedge fund administration department, that is headed by Eric Tan. Citi also has a Singapore based hedge fund sales team.
With offices in New York, London, Tokyo, Hong Kong, Sydney and San Francisco, Citi is one of the world's leading providers of Prime Brokerage services, leveraging of Citi's global distribution network and worldwide relationships to offer Prime Brokerage clients innovative solutions.
Present in Singapore for 105 years since 1902, Citi is a leader in the banking and finance sector providing world class products and services to clients globally. Prime Brokerage is just one of several new capital markets activities from Singapore to be added as we build and grow with our clients. Singapore is also a strategic hub for Citi's regional management, marketing, operations and technology expertise, and hosts Citi's state of the art processing and computer centres serving the transactional needs of Citi branches in over 50 countries.
In 2006, Citi was voted best bank in Singapore by the Asset Magazine and best foreign bank in Singapore by Financeasia. The bank also topped AsiaRisk's 2006 end user poll for interest rate options, currency options and currency forwards in Singapore. Citi was also awarded best debt house in Singapore by IFR Asia and best equity house in Singapore by Euromoney last year.
Fintag says Good move. As the honkers crowd are driven out by the yellow smog, they will be rushing to Singapore. We like Singapore.
FAIRFAX
The inside story of a Wall Street battle royal (fortune) No, it's not a crime novel but the tale of insurance giant Fairfax and its CEO's crusade against some very powerful hedge funds. Is it a quest for justice or an attempt to silence critics?
July 26, 2006: Canadian insurer Fairfax Financial Holdings sues a group of hedge funds and research analysts for $5 billion in New Jersey state court, alleging a stock market manipulation scheme in which the funds sold Fairfax's shares short, got analysts to write negative research reports that pushed the stock down, and made fortunes. The list of some 20 defendants ranges from market wizard Steven Cohen, the ultraprivate multibillionaire who runs the $12 billion hedge fund SAC Capital, to the previously obscure Spyro Contogouris, who, according to the lawsuit, is an "operative for short-selling hedge funds that pay him to drive down the price of stocks."
Nov. 14, 2006: The U.S. Attorney for the Southern District of New York announces the arrest of Spyro Contogouris. An affidavit filed by FBI agent B.J. Kang accuses Contogouris of "systematically defrauding" a Greek businessman of at least $5 million from 1997 to 2002. The charges are unrelated to Fairfax, but the company's stock soars 10 percent on the news, and its lawyer, Marc Kasowitz, says the charges "don't surprise us, given Fairfax's own claims against Mr. Contogouris and others for being engaged in a racketeering conspiracy." kasowitz.03.jpg Kasowitz: He says Fairfax filed suit days before "a massive attack."
Tug of war over a controversial stock Fairfax has sued a group of hedge funds and others alleging that they sought to drive down the company's share price. While the stock has been volatile, it climbed well above its lows when Fairfax filed its suit, and it has soared since then, inflicting losses on short-sellers. January 2003 Morgan Keegan initiates coverage with an underperform rating, citing a multibillion-dollar loss-reserve deficiency. March Fairfax stock hits low. August 2004 Fitch places Fairfax on negative ratings watch, citing "increasing liquidity pressures" and "decline in transparency of the management's public disclosures." Early 2005 Spyro Contogouris begins writing reports critical of Fairfax. September Fairfax announces receipt of an SEC subpoena regarding its nontraditional and reinsurance transactions. June 2006 Spyro Contogouris attempts to question former Fairfax CFO Trevor Ambridge. July Fairfax files suit on the 26th. The next day it announces a financial restatement that will reduce shareholder's equity. November Spyro Contogouris is arrested in New York on charges of defrauding his former employer.
Dec. 12, 2006: Carlos Mendez, a former Naval officer who is now a senior partner at Institutional Credit Partners, which manages a multibillion-dollar fixed-income portfolio, had complained to an FBI agent he knew that someone was following ICP's employees. He gets a call from the agent asking him to come in. When he arrives, an agent he's never met, B.J. Kang, greets him with some abrupt questions. "What hedge funds do you work with?" he asks. And then: "Why is Marc Kasowitz interested in ICP's employees?"
The story of Fairfax, which had $6.8 billion in revenues last year, has more twists and turns than "The Departed." It reaches from the trading floors of some of the world's most powerful hedge funds to the offices of the FBI to havens of corporate secrecy like Bermuda, Luxembourg and Hungary. It involves financial machinations so complex that obfuscation seemed to be a business strategy, and the question isn't only whether the machinations are legal but whether anyone can even figure them out.
This isn't just another squabble between short-sellers and their targets. If Fairfax and its CEO, Prem Watsa, are right - and some people believe they are - then greedy hedge funds are trying to bring down an innocent company, ripping off small investors.
Fairfax (Charts) alleges that the defendants "engaged in an organized effort to destroy Fairfax" and have "reaped immense, ill-gotten profits." The allegations tap into fears about the secrecy and power of hedge funds and how they may use analysts and, yes, journalists to manipulate the market. Watsa insists that his lawsuit is not a referendum on short-selling - "I short stocks," he says - but rather about stopping a "smear campaign."
Fairfax's suit claims that short-selling schemes have "targeted many dozens, if not hundreds, of other publicly traded companies." Last spring Kasowitz testified at a Senate Judiciary Committee hearing on the relationship between hedge funds and analysts, describing a "pervasive pattern of market manipulation" on the part of "certain extremely powerful hedge funds." Reinsurance: Risky business
But there is also the distinct possibility that Watsa and his company are not, in fact, victims - in which case the story is perhaps even more disturbing. After the last round of corporate scandals, regulators and the public cried out for more hardheaded analysis. Where were the skeptics, they asked? Now, just a few years later, there are skeptics aplenty about Fairfax, and they have taken their suspicions to regulators, rating agencies and others.
But it appears they have been muzzled by a blunt instrument-litigation. "This is clearly an improper effort to silence perceived critics of the company," says David Zensky, a lawyer at Akin Gump who is representing defendant Exis Capital Management. "It's bad for the market, and it's a bad precedent." (All the parties Fairfax is suing either denied wrongdoing or declined to comment.)
Nor is Fairfax the first to use this new tool. Overstock.com (Charts) and Biovail (Charts) (also represented by Kasowitz) have brought similar suits. The suits are in their early stages, but a California court recently allowed the Overstock.com case to proceed. That ruling was troubling to those who believe critical analysis is vital to the markets.
Of course, it's also possible that the truth resides in an uncomfortable place somewhere in the middle. Fairfax's lawsuit is stuffed with unsavory allegations that Contogouris and others "engaged in a long-term campaign of personal harassment" of Watsa, his family members and others connected to the company.
But even such misconduct wouldn't mean that questions the skeptics raise aren't valid. Questions of financial impropriety are especially troubling at an insurer, where they can harm not only investors but also the policyholders who are counting on the insurer in case of disaster. And now, if an investor or policyholder were to seek help answering those questions, he or she would find only silence. Or rather, mostly silence. The Warren Buffett of Canada
Today there's a Rashomon-like quality to the Fairfax story, but that wasn't always the case. Watsa began creating the sprawling company now known as Fairfax Financial Holdings in 1985. Fairfax - the name stands for "fair, friendly acquisitions" - was a phenomenal success, with a stock that soared from about $3 in 1985 to a high of over $600 in 1999 (all the figures in this paragraph are in Canadian dollars).
Watsa was called the "Warren Buffett of Canada." But unlike Buffett, Watsa built his empire via progressively larger acquisitions of troubled property and casualty insurers. It was risky, because if you buy insurers that have done a bad job of underwriting, losses can snowball for years. That's what happened at Fairfax.
In the late 1990s the Toronto-based company bought companies like Sphere Drake, which had operations in London and Bermuda and had exposure to asbestos claims, and the U.S.-based TIG, which had big workers' compensation claims. Watsa had to increase Fairfax's reserves repeatedly and put some of the European businesses and, eventually, a large part of TIG into "runoff," meaning they stopped writing new business and merely paid claims on existing policies.
In 2001 - partly because of claims from the destruction of the World Trade Center - Fairfax lost more than $300 million. By late 2002 its stock had fallen to $115, and the rating agencies had downgraded its debt to junk, a rating it carries today. By March 2003, Fairfax had just $210 million of cash on its balance sheet, far less than rating agencies want to see at a company of its size. (At the end of 2002 Fairfax began trading on the New York Stock Exchange; at the end of 2003 it began reporting its results in U.S. dollars.)
Watsa had another problem: short-sellers - investors who borrow shares and sell them, hoping to buy them back at lower prices in the future, betting the company's stock price will fall. To the shorts Fairfax looked as if it were headed for serious trouble, if not bankruptcy. By early 2003 more than two million Fairfax shares were sold short.
In conference calls and annual meetings, Watsa assured investors that he was taking steps to fix Fairfax's problems. He remained upbeat, describing results most quarters as "excellent" or saying that he was "very pleased." In general, even a troubled insurer can avoid collapse for a long time if it can sustain the confidence of the market and keep cash coming in the door.
But the company continued to struggle. What money Fairfax made came from investing activities. As any student of Buffett knows, insurance companies get most of their profits by investing policyholder premiums. And Watsa seems to be a superb investor. Over the seven years through 2005, Fairfax booked $2 billion in investment gains, and another $3 billion in interest and dividends.
But Fairfax has also been hit with huge claims from events like the Gulf Coast hurricanes, and the losses from operations that Watsa put into runoff have continued - in 2005 they totaled more than $600 million (before taxes). On a conference call in early 2006, Watsa conceded that "over the past seven years, on a cumulative basis, we have barely been profitable."
Short-sellers and other skeptics argued the situation was even worse. Fairfax's reserves still weren't adequate, they claimed, and the company's heavy use of a controversial product known as finite reinsurance (the same product whose abuse would result in the indictments of former executives of both AIG (Charts) and General Re in the fall of 2006) was artificially boosting Fairfax's earnings while camouflaging the amount of its leverage. And they complained about indecipherable transactions among offshore affiliates. The critics said Fairfax was so weak that it would not be able to pay all its claims.
In a visit to Fortune's offices last fall, Watsa, a soft-spoken, gentlemanly figure, was accompanied by Fairfax vice president Paul Rivett, Kasowitz and Mike Sitrick, a public relations consultant with a reputation for aggressive tactics. (His Web site features press clippings saying things like Sitrick is "the PR guy you want in your corner if you want to play hardball with the media.") Watsa said he was surprised to find himself with both a lawyer and a PR man. For years he avoided the press, never gave guidance on earnings, and catered only to long-term investors. He cites "honesty and integrity" as Fairfax's core values and said that he had always believed, "Put your head down and the results will out."
The way the Fairfax executives told the story, Fairfax's poor performance was not what attracted the short-sellers. Rather, "They saw us as an easy target," Rivett said. "We don't talk to the media, our stock is thinly traded [meaning a relatively small number of shares change hands each day, making it easier to manipulate the price] and this is a reputational business."
Rivett said short-sellers started the "Fairfax Project" on Jan. 16, 2003, when John Gwynn, a research analyst at regional broker Morgan Keegan, released a report estimating that Fairfax's loss reserves were $5 billion smaller than they should be. Fairfax promptly issued a press release calling the report "totally wrong."
Even so, over the next few trading days Fairfax stock fell some 20 percent. A few weeks later Gwynn corrected his math, saying that the number was actually $3 billion. In the view of the Fairfax camp, Gwynn hadn't simply made a big mistake - rather, his report was an "intentional attempt to cause a massive stock price drop." (Gwynn and his firm are defendants in the lawsuit.) Fairfax says the $3 billion figure was also wrong, but between 2003 and 2005, Fairfax increased its reserves by $1.4 billion.
Because the hedge funds knew the contents of the report before its public release, Rivett said, they were able to make a killing - but they weren't done. The hedge funds kept "substantial" short positions and then, Rivett says, they couldn't get out. He is alluding to a market phenomenon known as a short squeeze. Because fewer than 16 million of Fairfax's shares trade, if a short-seller were to purchase shares to cover his position, that demand for the stock could quickly push the price higher. If shorts all began buying at the same time, the stock could soar. Thus, said Rivett, the only way the conspirators could get out of their positions was by sending Fairfax's stock to zero using an "ambitious campaign of disinformation and dirty tricks." Insurance companies take on global warming
The hedge funds that Watsa says victimized Fairfax are a Who's Who of the industry, and many have connections to one another. There's SAC and Exis Capital, run by Adam Sender, who used to work at SAC. Third Point and its colorful CEO, Daniel Loeb, are defendants, as is a Third Point analyst, Jeff Perry, who used to work at SAC. But of all the people Fairfax sued, it reserved particular vitriol for Spyro Contogouris, conspicuously not a member of the Wall Street elite.
Contogouris, 45, splits his time between New York City and New Orleans, and his background is not in high finance but real estate - he managed properties for a Greek family with whom he eventually became embroiled in a lawsuit.
After New York attorney general Eliot Spitzer eviscerated Wall Street research, Contogouris went into business as an independent research analyst. He proved himself by writing critical reports on what officials have now alleged was a Ponzi scheme involving stamp collecting and eventually acquired about a half-dozen clients for his firm, which he called MI4 Reconnaissance.
When the insurance industry came under scrutiny in late 2004 thanks to Spitzer's investigation of industry giant AIG, Contogouris began to search for other companies that might have run afoul of the complex insurance accounting rules. He quickly zeroed in on Fairfax. In notes to clients Contogouris raised questions about Fairfax's use of finite reinsurance, as others had.
On Sept. 7, 2005, Fairfax announced that it had received a subpoena from the Securities and Exchange Commission regarding its use of "nontraditional insurance and reinsurance." Later that month Fairfax disclosed another SEC subpoena and said that the U.S. Attorney for the Southern District of New York was also participating in the review. Watsa reassured investors, telling them that "we have had a full review by us and by our independent auditors" and that all that turned up were several small contracts at its partly owned, publicly traded subsidiary, Odyssey Re.
But in March 2006, Fairfax announced that both the company and Watsa had received additional subpoenas regarding his reassuring comments, and that its auditor - PricewaterhouseCoopers - had also been subpoenaed. Fairfax's financial statements warned that "the ultimate effect on its business & could be material and adverse." On conference calls Watsa puts the subpoenas in the context of the industrywide investigation into finite reinsurance but otherwise declines to comment. Credit-rating agency Moody's says it is "comfortable" that "any adverse regulatory developments will be manageable." Foreign intrigue
Contogouris and an associate, Max Bernstein, traveled around the world unearthing Fairfax financial documents. These papers provided tantalizing information on transactions that sent preferred shares - that were supposedly worth hundreds of millions of dollars - back and forth among a dense web of Fairfax subsidiaries in places like Ireland, Bermuda, Gibraltar and Hungary, where the disclosure requirements are limited.
Here's an example of the type of activity Contogouris and Bernstein highlighted for their clients. Start with a Fairfax subsidiary called nSpire Re, which is based in Ireland. Fairfax's documents say it reinsures the U.S. operations, is responsible for the claims of the European runoff and provided much of the financing for the acquisition of Fairfax's U.S. operations. Financial statements show that in 2004 and 2005, a company called Fairfax Liquidity Management Hungary sent nSpire Re more than $1.6 billion of dividends in the form of preferred shares in two other companies - Fairfax (Gibraltar) and FFHL (Bermuda).
In a presentation to Fortune, Fairfax executives explained that Fairfax used transactions like the one above as part of a strategy that was originally designed to reduce taxes. They explained that in essence, Fairfax's Hungarian subsidiary lent money to Fairfax Inc., the U.S. operation, to finance acquisitions.
As a result, the U.S. operations paid interest to Hungary, which had a lower tax rate. Over time the structure morphed; at one point Hungary owned 62.5 percent of the equity in the U.S. operation and was owed repayment of a $500 million loan. Fairfax will not disclose how much this arrangement increased its already large tax credits. Nor was Fortune allowed to keep a copy of the presentation.
Fairfax supporters aren't troubled by the company's complexity. "They [Watsa and his team] are incredibly smart people who think this is a good way to structure a company," says Joyce Sharaf, an analyst at credit rating agency A.M. Best. Robert Dye, a portfolio manager at Regis Management who bought shares in Fairfax in the spring of 2006, says, "I made the decision to believe Watsa and [Fairfax CFO] Greg Taylor."
Dye calls Fairfax's practices "creative" but says that the short-sellers have "tried to exploit" this. Fairfax's Rivett says this structure is "not unusual," that rating agencies, shareholders and other journalists have not found it "any more complicated" than that used by any other multinational company, and that it "had no impact on Fairfax's consolidated financial statements apart from the net tax savings realized."
Yet these internal dealings still raise questions. Insurance companies like to keep their subsidiaries separate so that trouble in one does not affect the whole. Both policyholders and bondholders are entitled to specific pots of money. Fairfax's financial statements say it does not engage in the "cross-collateralization by one group company of another group company's obligations." But Fairfax's subsidiaries are intertwined via loans and the stake that nSpire Re holds in the U.S. business. For example, the U.S. operation has sent well over $500 million to nSpire Re, at least some of which was used to pay claims in the European business.
In addition, the stake in the U.S. operation has been pledged to support Fairfax lines of credit. For instance, Hungary swapped its stake in the U.S. operation for preferred shares in Fairfax Gibraltar. In 2003, Gibraltar was pledged as collateral for a Fairfax line of credit, which, Fairfax says, the parent company used to back letters of credit. Rivett says that the letters of credit were not off-balance-sheet financing because Fairfax's financials disclose that letters of credit were issued to back internal reinsurance obligations. "I cannot say strongly enough that there has not been, and there will not be, any off-balance-sheet financing" in this structure or otherwise, says Rivett. Buying into crisis: Investing in insurance
The biggest question, though, surrounds the cash. According to the presentation given to Fortune, the U.S. operations have paid roughly $1 billion in interest and loan repayment to the foreign subsidiaries. It's not clear where the U.S. operations got all this cash. (Fairfax says it came from interest income, dividends and the proceeds of a bond offering by one of its U.S. companies, but will not provide more detail.)
And Fairfax's explanations still don't account for all the cash that it says moved through the overseas subsidiaries. Its lawsuit also says that nSpire Re paid Fairfax a $500 million dividend. That fact was not in the presentation given to Fortune. When asked about this transaction, Rivett would only say that "further information & will be provided as the lawsuit progresses."
Contogouris, who found the documents that shed some light on this, had his own theory. He thought that Fairfax had found a way to circumvent insurance regulations and inappropriately use policyholder cash from the U.S. to pay losses elsewhere. Fairfax then replaced that cash with what he called "fake" preferred shares "to trick policyholders, insurance regulators and investors."
He conceded that he couldn't connect all the dots. As he wrote in one note, "We do work based on speculation, and last I checked, it wasn't illegal." But he didn't leave much doubt about what he thought. "Fairfax," he wrote in one note, is the "greatest known insurance fraud of the 21st century."
Fairfax says that Contogouris's theories are "groundless and defamatory." Rivett and Kasowitz argue that Contogouris's past discredits him - and the hedge funds he worked for. "No jury will believe these highly sophisticated hedge funds were paying this individual for his investment advice," says Rivett.
Fairfax also alleges that Contogouris misrepresented himself, stalked its executives, and sent threatening e-mails to Watsa and his secretary from anonymous accounts. Contogouris's lawyer, Joe Tacopina, calls these accusations "totally false."
One episode that Fairfax cites as evidence of Contogouris's misconduct occurred last summer, when Contogouris contacted a former Fairfax CFO, Trevor Ambridge, asking him in an e-mail about the "seemingly incomprehensible inter-company asset movements." He also told Ambridge he could introduce him to someone who would "act as a liaison to current regulators."
Truth be told, Contogouris is something of a mystery. In September the New York Post reported that he was working for the FBI when he contacted Ambridge - and that an FBI spokeswoman confirmed the FBI connection. The FBI says it asked the Post to retract the statement that an FBI spokeswoman had confirmed Contogouris's role but will not comment on whether it had a relationship with Contogouris.
On July 26, 2006, Fairfax filed its lawsuit alleging stock manipulation. But if there was a "Fairfax Project" to sink the stock, it hadn't been very successful. At the time the lawsuit was filed, Fairfax's stock was at about $115, more than double its lows from the spring of 2003 and well above its price at the time Fairfax says the campaign began.
One reason is that Fairfax never lost the support of its big investors. From 2003 through today, Fairfax has raised more than $1.5 billion by selling debt and equity in itself and its subsidiaries. A chunk of the buying has come from a group of longtime Watsa supporters, including Mason Hawkins, the widely respected head of Southeastern Asset Management, and firms controlled by Canada's Power Corp. Southeastern and Power now own more than 50 percent of Fairfax's stock. (Southeastern declined to comment; Power Corp. did not return calls.)
Ironically, if not for the short-sellers, Fairfax's stock might be much lower. A thinly traded, heavily shorted stock like Fairfax's can skyrocket if, for instance, investors who have lent their shares to short-sellers recall them, forcing the short-sellers to find another source of shares to borrow or buy stock to cover their positions.
While Fairfax charges that the defendants have reaped "immense, ill-gotten profits," at least some defendants claim the opposite is true. Exis Capital Management's lawyer David Zensky says that his clients never realized any gains on their short position in Fairfax and in fact have booked substantial losses. Others who have been short Fairfax's stock since the beginning of this decade have lost small fortunes.
The timing of the suit was curious. Kasowitz says that Fairfax filed suit to prevent a "massive attack. We were a day or two away from something very bad happening to the company."
But there may be another explanation. On July 27, just one day after it sued, Fairfax announced that it was working on an extensive restatement of its financials from 2001 to the present. Watsa said that Fairfax would have to reduce shareholders' equity by $225 million to $240 million (or about 7 to 8 percent) as of March 2006 because of accounting errors. Watsa called it a "very embarrassing" moment. But all the headlines were dominated by the lawsuit, and Fairfax's stock only dipped slightly.
In August, when Fairfax did restate its results, the new filings included warnings from both Fairfax's management and its auditors that they had found a number of "control deficiencies" that "could result in misstatements of any of the company's financial statement accounts." (Fairfax says it is "continuing to remediate the material weaknesses.")
A few months later there was another odd coincidence. On Nov. 7, Contogouris filed his own lawsuit against several Fairfax subsidiaries, PricewaterhouseCoopers and Sitrick, laying out his case against Fairfax. Then, on the evening of Nov. 13, Contogouris was arrested. In essence, the criminal complaint tells one side of the civil case between Contogouris and the Greek family for whom he worked, which dates back to 2002.
The next day Fairfax stock rose 10 percent. There's no connection between the criminal charges against Contogouris and Fairfax - but they had an effect. "I think people didn't believe what was in the [Fairfax] lawsuit until Spyro got arrested," says A.M. Best's Sharaf. "Then everyone said, 'Wow. This is true.'"
Fairfax's stock continued to soar, hitting over $200 in late 2006. Kasowitz says this is proof that Fairfax disrupted a conspiracy. The lawsuit "caused these people to restrain themselves," says Kasowitz. That, at least, is true. Contogouris has taken his lawsuit off his Web site and put out a note saying that at the behest of his lawyers, he would no longer analyze stocks. Gwynn also stopped covering Fairfax, citing a "litigation strategy designed by Fairfax to silence negative research."
That might have been the end of the story but for Institutional Credit Partners - the firm for which Carlos Mendez works. ICP does not invest in equities, but it has bought credit default swaps on one of Fairfax's publicly traded subsidiaries, Odyssey Re, which means that it will profit if Odyssey Re fails to make payments on any of its debt.
ICP established its position before being contacted by Fortune and has not traded in any Fairfax or Odyssey Re securities since November. ICP executives provided Fortune with access to unedited research because they are deeply disturbed by the possibility that legitimate research may be being suppressed.
ICP portfolio manager William Gahan began to examine Fairfax in spring 2006. After months of research using only publicly available information, he called Brandon Sweitzer, a senior fellow at the U.S. Chamber of Commerce who is also a Fairfax director, and asked to discuss what he called "accounting peculiarities." Sweitzer, Gahan says, was surprisingly defensive. (Sweitzer did not return a call seeking comment.)
A few days later, on Oct. 12, Gahan got a letter from Kasowitz: "We understand that you have informed a director of the company that you have evidence of financial fraud at Fairfax." The letter went on to demand that Gahan forward any information and analysis he had done to Kasowitz, who also sent ICP a copy of Fairfax's lawsuit.
ICP viewed Kasowitz's letter as an attempt to intimidate Gahan and didn't respond. Shortly after that, Gahan and other ICP employees noticed cars lurking outside their building and following them home. ICP forwarded the license plate numbers to an FBI contact - which explains why the FBI called Mendez. ICP says the FBI confirmed that the pursuers were from Kasowitz's firm. Kasowitz denies having Gahan followed but says his firm has put ICP "under investigation."
Like others before them, the ICP folks ran into dead ends at Fairfax. But there was one deal that they felt showcased how far Fairfax was willing to go in its quest for cash. In March 2003, Fairfax announced that it would buy 4.3 million shares of its subsidiary, Odyssey Re, which would bring its ownership of the unit to just over 80 percent - enough to consolidate its results for tax purposes. That would allow Fairfax to use its big tax losses to offset Odyssey's taxes.
But Fairfax didn't simply pay the $78 million it would have cost to buy the Odyssey Re shares. Instead, Bank of America set up an offshore subsidiary that borrowed the shares - just as a short-seller would do - and sold them to Fairfax in exchange for a $78 million note. The note was convertible back into shares of Odyssey Re at specified times. Fairfax told investors it was buying the shares for "investment purposes" as well as "tax-sharing payments." But it isn't clear what the investment purpose was, because Fairfax would not benefit from an increase in Odyssey Re's stock price - and the IRS frowns on deals that are done only for tax reasons.
ICP spent countless hours dissecting SEC filings and hired tax lawyers and forensic accountants to provide independent validation of its work. "This is not an open and shut case, but there are significant question about whether there was a legitimate nontax business purpose to this transaction," says Bryan Skarlatos, a partner at tax attorneys Kostelanetz & Fink. "We have questions about the economic substance of the transaction," says Philip Kruse, a managing director at Alvarez & Marsal, a consulting firm.
In the summer of 2006, after the New York Post raised questions about this transaction, one analyst asked on a Fairfax conference call, "What risk is there that the IRS looks at the usage of this asset and challenges it?" Watsa reassured listeners that "we had an IRS ruling before we did this." Today Fairfax says it "never sought an IRS ruling on the 2003 transaction because none was needed," and "independent opinions were obtained from respected legal, tax and accounting firms that the transaction fell within IRS guidelines."
Fairfax and Bank of America have since unwound this transaction, and indeed, Fairfax did not benefit from the increase in Odyssey Re's stock price. In addition, Bank of America had to purchase shares to return the shares it borrowed and sold to Fairfax. It is not clear how many shares the bank purchased, but the buying helped Odyssey Re's stock increase more than 20 percent from August to December. And in December, Fairfax sold nine million Odyssey Re shares to investors, collecting $338 million.
All Bank of America will say is that "we do not comment on client matters." Kasowitz's firm says that ICP attempted to "derail" this offering and links ICP to "highly abnormal short trading" in Odyssey Re's shares. But ICP does not trade stocks, long or short.
In late February, Fairfax announced 2006 results. Thanks to the sale of Odyssey Re stock, it now has more than $700 million of cash on its balance sheet. Oddly, the lawsuit itself could be Fairfax's biggest risk. For if it proceeds to the discovery phase and the defendants have to turn over documents, they will surely request Fairfax's internal documents in return. What kind of tale will they tell?
Fintag says And I thought War & Peace was a tad too long.
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Haven't I been telling you this for the past 6 months? So good to be proved right - again.