In the early days of 2007,

Fairfax Financial Holdings Ltd.
 

chief executive

Prem Watsa

huddled with Brian Bradstreet, the investment team’s resident bond whiz, and the company’s small investment committee. The basic approach was always the same, so Watsa looked around the room and asked the usual question: “What’s the best idea we’ve got?”

Bradstreet bit his tongue. He still loved the big trade Fairfax had going. The investment was born of caution, to defend against a hit to Fairfax’s capital. But if it paid off, it would also lead to a massive windfall. Call it a huge insurance policy with potential dividends. So far, they were taking an enormous bath on it, to the tune of almost a quarter billion dollars. “At any other place, I would have been kicked out on the street,” he says. But the best investors are often early — and Fairfax was usually early.

These are the scenarios that repeat in the history of Fairfax. It pulled out early from bubbly Japanese stocks in the ’80s, leaving a lot of money on the table as the market made its predicted final manic surge to the peak. It lost a lot of money preparing for the 2000 tech wreck, until it finally cashed in huge. So, here it was again with a big, expensive contrarian call that had yet to pay off.

With hindsight, it looks easy from the outside. Smart investors see a serious problem, make a trade, sit back, and then hit the jackpot. But sitting in these kinds of trades carries a cost — to your nerves and likely to your short-term profits. As the quarters and years roll by and the losses mount, you have to keep asking yourself if you are actually right. Will it pay off? Is it time to take a loss? Or do we double down one more time?

Even legendary investors have found themselves unable to hold on to a winning hand when the waiting is so expensive. Famed investor Julian Robertson closed his Tiger Management hedge fund in March 2000 at the peak of the bubble. He had seen the risks but ran out of patience — and money — shorting runaway tech stocks for two years. He quit his marathon a few feet short of the finish line. So did Laurence Tisch, CEO of the Loews Corporation holding company. Tisch spent four years shorting stocks in the same period and gave up by 2000 after booking US$2.5 billion in losses, just months before the peak.

Doubling down

The big trade Fairfax had going was a short on financial companies with exposure to the growing bubble in mortgage securities. Their crystal ball could not say when. Bradstreet still had his teeth locked firmly on his tongue. The others were looking sideways, waiting. So it was the soft-spoken colleague Francis Chou who piped up: “Buy more credit default insurance,” he told the room.

“We swallowed hard and purchased some more,” recalls Watsa. With US$341 million already invested, paper losses (they would only record an actual loss if they sold the securities) had reached US$211 million by 2007. The value of the position kept going the wrong way into June 2007. That summer, however, all hell broke loose, as predicted, and Fairfax was surfing in cash.

Sorting through the devastation, Watsa took sober stock with shareholders: “All of the investment risks that we worried about and have written to you about for at least the past five years simultaneously reared their ugly head, as the 1-in-50 or 1-in-100 year storm in the financial markets landed in the fall of 2008. There were very few places to hide, let alone prosper.” Of course, he was speaking for other investors — Fairfax did find a place to hide and prospered very nicely.

This was Fairfax’s version of The Big Short. The book and movie made a legend of investors like Michael Burry, a smart contrarian investor who figured out a way to profit handsomely from the Great Financial Crash — reportedly US$100 million for him, plus another roughly US$750 million for his clients.

Fairfax made close to US$4.2 billion on its (even) Big(ger) Short, but no one made a movie about it. If they did, the perfect guy to do the champagne-bubble-bath-explainer scene on credit default swaps (CDS) would be Bradstreet. He was the trade’s chief architect. Unlike Margot Robbie in the Big Short movie, he sports a white beard that would blend into the bubbles, making the eyes of his poker face stand out.

First, a quick refresh for historical context. In the lead-up to the Global Financial Crisis, banks, mortgage insurers, debt raters and the real estate industry had all helped to profitably push consumers into a lot of unsound mortgages, which were in turn packaged into mortgage-backed securities alongside traditional healthy mortgages. It was like a virulent infection in the financial system that weakened it from within.

In movies and in TV interviews, strategists commonly try to position themselves as the ones who called a big crash. Most of that is bluster. It’s easy to say after the fact, and if you did call it, did you act on it? Wade Burton, president today of Fairfax’s investing arm but working with Cundill Investment during the early run-up to the crash, says seeing the problem was actually dead easy: “Everyone knew there was a monster problem, but only a handful acted on their convictions — and none more so than Prem. You could see the CDS spreads showing where it was going to go.”

Watch out for the reinsurers

In the world of Benjamin Graham, the father of value investing, rule number one is always to not lose money. That time was now. Fairfax could see the mortgage market dislocation happening, and the challenge was how to gauge its potential impacts on other parts of the financial system —before Fairfax got sideswiped. He and the team determined the link to reinsurance was the overriding threat to Fairfax.

So, what’s reinsurance, really? Insurance is simple enough. The insurer sells premiums to individuals or companies to cover risks. The insurer can then offload some of that risk by buying reinsurance from another insurer. You cover the client, and you pay someone to cover you. The recoverable (i.e., the money owed to pay out a claim) is the loss on your business that you can offset with coverage from a reinsurer. Fairfax is one of the major insurers that operates in both insurance and reinsurance.

“In the old days, we bought a lot of insurers with long-tail liabilities, where you just don’t know what you might be exposed to,” says Bradstreet. “There was a lot of reinsurance attached to those assets. The value of the recoverables sitting on our balance sheet was about US$6 billion or so, which was a multiple of our common equity. So, if anything went wrong with our reinsurers, that recoverable would not be recoverable. We would have to come up with new money to pay those claims.”

Fairfax had never had to worry about a scenario where the reinsurers themselves went bankrupt and were unable to pay Fairfax. As they explored the looming disaster, the scenario quickly went from “What if?” to “When?” The clock was ticking, and Fairfax did not have a US$6-billion cushion on hand for a rainy day.

There were all kinds of signs the storm was coming, recalls Bradstreet: “We ourselves on the fixed-income side were being offered Ponzi-type stuff to invest in that came with an AA or AAA rating. So I began to fear that the reinsurance companies we were relying on to pay us might buy this junk and get into trouble, and we would not get paid. That would blow us right out of the water. I was losing a lot of sleep, trying to think about how to minimize the risk, especially since both the stock and housing markets were already overheating.”

So that’s where it started: How does Fairfax hedge its exposure to reinsurers — in particular AIG, Munich Re, and Swiss Re? “I started studying the financial statements of these companies,” says Bradstreet, “and sure enough they all held these asset-backed, mortgage-backed, high-yield bonds that were pure risk. AIG was the one that scared me most. I thought they were doing crazy balance sheet stuff.”

Fear is a good motivator, and Fairfax learned it had to step back and look at its exposure more broadly. “We were able to buy a lot of CDS on AIG, Swiss and Munich,” Bradstreet explains. “But a lot of the firms we had exposure to did not exist anymore. They were assets held in trust accounts, so you couldn’t buy CDS on them. So we had to get creative, which is something we are good at. You have to be good at seeing problems before others do, and you have to be able to find ways to protect yourself against loss.”

Wait, who is insuring the reinsurers?

What those first CDS trades failed to do was target where the ultimate threat was coming from, beyond AIG and the other reinsurers. “We had to ask ourselves what we were explicitly afraid of. That big fear was the exposure these reinsurers had to the mortgage market. We were able to buy some protection on Fannie Mae and Freddie Mac. We bought big protection on all the mortgage insurers and mortgage lenders.”

Fannie (Federal National Mortgage Association) and Freddie (Federal Home Loan Mortgage Corporation) are federally backed U.S. agencies that guarantee home mortgages, and both collapsed in the Global Financial Crisis in September 2008. When Fairfax was investing against Fannie Mae, that lender already had $80 of exposure to toxic loans for every $1 of common equity. A single match could burn this house down, and a giant firestorm was headed straight for it.

Before the big payoff finally arrived, Fairfax had been in the hot seat. “It can get very lonely being value investors,” offers Watsa. You can tell other investors you are building an ark to survive the next storm, but they are just going to point up at the clear blue sky and call you nuts with all your crazy CDS doomsday bets. So you wait.

 

“We thought it would happen in 2005, 2006, 2007…” says Watsa. “Some of you wondered — sometimes loudly — why we bother with these hedges and credit default swaps,” he told shareholders in his 2006 letter. “Besides our comfort in having this protection, we continue to think that this insurance policy may pay dividends — perhaps sooner than you think.” In hindsight, he was early as usual. And dead right.

It ended up being transformational, burying any lingering financial-strength concerns related to the recent public war with Wall Street hedge funds over allegations of financial distress. “When others were awash in red ink, we made a ton of dough. No other insurance or reinsurance company came close. Our reputation was not only restored, but it rose higher than ever.”

The astounding combined total windfall from swaps and shorting the stock market was more than US$4.6 billion, but Watsa reminded investors, “We had to endure years of pain before harvesting the gains.” The next big problem, compounded by additional gains as Fairfax scooped up bargains from the ensuing bear market, was a much more welcome one — what to do with all the money.

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Abridged and adapted by the author, from The Fairfax Way, Published 2025 by Viking, an imprint of Penguin Canada.