Fairfax bets on low inflation

Fairfax Holdings spent about $175 million this year, betting that prices won’t rise much over the next decade, and has already made $100 million on the deal. WSJ has details (sub. req.):

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.

The whole story sounds like the company is betting on deflation – prices actually falling. Even the excerpt above contradicts itself. And betting that prices will actually fall across an entire decade is pretty risky. Even Japan only had six years in the last 19 where inflation fell below 0%.

But a bet on low inflation at the start of this year makes a lot more sense, as 10-year Treasury yields were rising and the consensus held that government overspending would force prices to take off. Fairfax was playing the contrarian.

Now the 10-year is around 2.5%, and more investors are concerned about deflation. So Fairfax’s position has already netted it $100 million in capital gains.

The move is portrayed as protection on Fairfax’s investment portfolio, but I have trouble seeing that. Much of Fairfax’s investments is tied up in property-casualty reserves, which are a natural hedge against deflation. The method of P&C reserving <wonk> loss triangles </wonk> have long-term inflation built into them. So deflation between now and the date claims are paid would reduce your ultimate loss from what you thought it would be. Anybody smart enough to short the CPI would know that.

What this really sounds like is a clever play on Fairfax’s $1 billion asbestos and environmental exposure. (See pages 147 and 49 of the 2009 annual report.) That money won’t be paid out for years and years and years. Asbestos cases take forever to settle. It’s like Bleak House in slo-mo. Just this week, Travelers won a $262 million judgment on a case that’s 17 years old. And the loser is appealing. Who knows when that cash will change hands?

Putting 20% of your A&E reserves into a contrarian derivative would be odd and daring, but, so far, profitable.

Update: Hard to tell what kind of derivative Fairfax bought, but it behaves somewhat like an inflation swap.

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