2006 FFH Options Bet

[Mephistopheles]

I keep hearing about how people made a killing in 2006 betting on Fairfax options. Would anyone like to share the story of what happened, and what was the situation with Fairfax and it's stock at that time?

[Parsad]

I'm sure both Ericopoly and Uccmal can enlighten you on that period.  One retired and one could have retired.  Cheers!

[ERICOPOLY]

The Nobel Prize winners claim that stock prices reflect the data available to the market.  In this case, the data was fraudulent and the market price reflected the lies being spread through the media. 

 

For example, in June 2006 the stock dropped 10% in one day on rumors that Prem was leaving the country with shareholders' money in hand.

 

So basically if you thought Prem was honest then you had an edge.  The 2008 $140 strike calls were priced at $2 a share on June 23rd, 2006.  That was roughly book value per share at the time.  So that gave you about a 70x leverage on book value.

 

Oh, then there was the hurricane thing... in 2005 they lost a lot of money and it was blamed on KRW, but really they lost a bit more from the runoff division that year than they did from the hurricanes. OdysseyRe reduced their wind exposure by 25% after the hurricanes.  The March 2006 annual letter to shareholders claimed that they believed runoff would approach breakeven in 2006.

 

So if you trusted Prem, it was a good bet.  The hurricane season is typically over by then end of October, which still gives you 15 months before options expiry.  And on June 23rd you could pay just $2 per share for the Jan 2008 $140 strike calls, and $140 strike being roughly book value at the time, a very good chance that you'll at least be able to recover your $2 per share even if there were a repeat of KRW.  The stock was just so depressed already, it was almost as if the repeat of KRW had already happened.

 

Plus the short interest was huge -- something like 25% or so.  They would cover it stands to reason. 

[Kraven]

Very interesting.  Thanks for sharing.  The math on that is unbelievable.

[Uccmal]

I cant recall who first bought the idea.  I know Mungerville (the original) had discussed FFH Leaps as early as 2004.  Maybe Eric, maybe Numquam Perdo (he paid for an expensive house in TO with cash from his proceeds).  He may have ressurrected the idea in 2006.  Dengyu the Nugget, and Aberhound also did very well.  My friend Ajay from Ca did very well, as did Sleepless Twindaddy.

 

My records show me buying the common earlier in the year at just above 100 per share, then 2008, and 2009 leaps in June 2006.  The stock languished for a month after my options purchases, then FFh announced the lawsuit on July 26th, and the stock immediately took off.  Sanjeev was at lunch. 

 

One might call this overnight success, except I had held FFh since 1997/98 in small amounts, had read the AR every year to the best of my ability, and have been to every AGM since 1998, except this year. 

 

I kept buying more Leaps all the way into the subprime crisis, up to Jan 2011s.  When FFh delisted the gravy train stopped. 

 

These kinds of deals pop up from time to time.  Spring 2009 was another period.  Right now, I believe that a similar opportunity exists with BAC (Hat tip Francis Chou) and AIG (thanks Plan Maestro). 

 

Right now I hold around 70000 Leaps/warrants and common on BAC, and 20000 leaps/warrants/common on Aig.  Low risk - huge potential returns.

 

 

 

 

 

 

[twacowfca]

FFH had massive adverse development of reserves resulting from buying insurance companies with increasingly toxic long tail liabilities plus big losses from hurricanes the year before.  Plus an investigation by the SEC as part of a wider probe involving BRK and AIG. This led to the coordinated short attack much discussed on this board.

 

What we did was look through all this negativity to the future. Here were the facts that contradicted the short thesis.

 

1) they were starting to see the light at the end of the tunnel with less adverse development on legacy reserves, and the current business they were writing was becoming profitable.

 

2) the current hurricane season was shaping up to be a zero in August Sept when we started buying the FFH calls. This indicated large profits in the near future instead of the large losses they experienced the year before.

 

3) the SEC investigation appeared to be an aftrethought of the BRK AIG fraud where the government felt obliged to check out the rumors planted by the short sellers of FFH.  Nothing had come of it after more than a year, and nothing substantial appeared likely to impact their reputation.

 

4) Their Far East business was doing great.

 

5) Short interest was large.  We had been getting 12% per annum for more than a year to lend our FHH shares.  In a sense, we were getting a huge dividend on FFH shares that didn't come out of FFH's capital!

 

6) Most importantly, Prem's history and reputation until the lies put out by the short sellers had been exemplary.  He and FFH were supported by ethical, respected value managers like Steven Markel,  Peter Cundill and Mason Hawkins who demonstrated their faith in FFH by injecting new capital on fair terms when badly needed.

 

I had had the opportunity to converse informally with Prem early one morning for two hours in 2003 as I pitched in with him and a few others from his office to unpack FFH annual reports and set up for a meeting.  There was no doubt in my mind after that talk that Prem is a straight shooter without pretense.

 

In short, the clouds were parting in the late summer of 2006, and the future looked bright.  :)

[ERICOPOLY]

Maybe Eric, maybe Numquam Perdo (he paid for an expensive house in TO with cash from his proceeds).  He may have ressurrected the idea in 2006.  Dengyu the Nugget, and Aberhound also did very well.  My friend Ajay from Ca did very well, as did Sleepless Twindaddy.

 

This was my first ever options purchase.  DengyuTheNugget worked at Microsoft as did I, and I pointed him in the direction of this board and started telling him about FFH.  He then quickly talked me into buying the options instead of the common.  I had to go and figure out how to enable options trading in my account.  What a good time to learn about options!

 

[stahleyp]

Maybe Eric, maybe Numquam Perdo (he paid for an expensive house in TO with cash from his proceeds).  He may have ressurrected the idea in 2006.  Dengyu the Nugget, and Aberhound also did very well.  My friend Ajay from Ca did very well, as did Sleepless Twindaddy.

 

This was my first ever options purchase.  DengyuTheNugget worked at Microsoft as did I, and I pointed him in the direction of this board and started telling him about FFH.  He then quickly talked me into buying the options instead of the common.  I had to go and figure out how to enable options trading in my account.  What a good time to learn about options!

 

Now that's gangsta! haha  ;)

 

Yes, I know I just said that on an investment forum.  ???

[Liberty]

Thanks for the history, guys. Wish I had been around back then  :)

[onyx1]

Thanks for the history, guys. Wish I had been around back then  :)

 

 

+1

[watsa_is_a_randian_hero]

during 2007 and 2008, the pricing of FFH would also follow its peers (other insurers) and trade down during time periods when the firm was actually making money (its CDS bets were paying off).  For those of us that dug into NAIC filings and found ORH's disclosures of which CDS it owned, it was possible to estimate real-time what its gains were. 

 

There were times in 2007-2008 that I had over 100% of my net worth in FFH, if the options were looked at on a notional basis.  In absolute terms, over half of all of the money I've made throughout my life on investments was made either on FFH or ORH.

 

I currently don't think its that great of a value, but I still hold what would be thought of by traditional asset managers as an oversized position.  Since earlier this year, I've actually owned a larger position in the long-term bonds paying 7.75% than the stock. 

 

 

[Guest hellsten]

Thanks for sharing :D

 

"We think this is a zero" veteran New York short seller Jim Chanos

 

http://financialsector.blogspot.com/2006/01/prem-watsa-fairfax-financial.html

[Parsad]

Thanks for sharing :D

 

"We think this is a zero" veteran New York short seller Jim Chanos

 

http://financialsector.blogspot.com/2006/01/prem-watsa-fairfax-financial.html

 

There are two quotes in the article that are very interesting when viewed over 6 years later!

 

The first:

 

In its rebuttal volley, Fairfax charged that short sellers were trying to manipulate its stock. Short sellers attempt to profit from share price declines by "borrowing" stock. The lender may be a brokerage or a shareholder, and typically takes a commission. The short sells the stock, hoping a wave of selling will drive down the price so he can purchase shares later at lower prices. The short returns the shares to the lender once he's taken a profit. Naturally, the shorts try hard to talk the stock price down. Morgan Keegan analyst John Gwynn, one of the authors of the damning report, responded angrily to Fairfax's accusation. "We're not in cahoots with the shorts," he said.

 

We subsequently now know that Gwynn released his report ahead of time to a number of hedge funds...Kynikos was one of them.

 

Spoken as only a diehard conservative investor can. For a sunny forecast from Watsa, one has to turn the subject to the only sort of event that will bring the long war with the shorts to an end.

 

"Once we perform, once we make a lot of dough, believe me, the stock's going up."

 

Say no more!  Cheers!

[Mephistopheles]

The Nobel Prize winners claim that stock prices reflect the data available to the market.  In this case, the data was fraudulent and the market price reflected the lies being spread through the media. 

 

For example, in June 2006 the stock dropped 10% in one day on rumors that Prem was leaving the country with shareholders' money in hand.

 

So basically if you thought Prem was honest then you had an edge.  The 2008 $140 strike calls were priced at $2 a share on June 23rd, 2006.  That was roughly book value per share at the time.  So that gave you about a 70x leverage on book value.

 

Oh, then there was the hurricane thing... in 2005 they lost a lot of money and it was blamed on KRW, but really they lost a bit more from the runoff division that year than they did from the hurricanes. OdysseyRe reduced their wind exposure by 25% after the hurricanes.  The March 2006 annual letter to shareholders claimed that they believed runoff would approach breakeven in 2006.

 

So if you trusted Prem, it was a good bet.  The hurricane season is typically over by then end of October, which still gives you 15 months before options expiry.  And on June 23rd you could pay just $2 per share for the Jan 2008 $140 strike calls, and $140 strike being roughly book value at the time, a very good chance that you'll at least be able to recover your $2 per share even if there were a repeat of KRW.  The stock was just so depressed already, it was almost as if the repeat of KRW had already happened.

 

Plus the short interest was huge -- something like 25% or so.  They would cover it stands to reason. 

 

Interesting stuff. So how much of your portfolio did you put into these options? A very large % I assume, since it was enough to help you retire. At what price did you end up selling the option?

 

This is interesting because I was just looking at AIG 2014 $50 calls, which are selling for about $1.50. I'm wondering what you think of them? 17 months till expiration, and the strike is $10 below current per share book value. If BVPS is $80 by then, as some people predict, and the stock sells for 1.0x, then these options would make out very well. But this is all coming from a beginner, so I'd be curious to know what you think of it.

[ERICOPOLY]

The Nobel Prize winners claim that stock prices reflect the data available to the market.  In this case, the data was fraudulent and the market price reflected the lies being spread through the media. 

 

For example, in June 2006 the stock dropped 10% in one day on rumors that Prem was leaving the country with shareholders' money in hand.

 

So basically if you thought Prem was honest then you had an edge.  The 2008 $140 strike calls were priced at $2 a share on June 23rd, 2006.  That was roughly book value per share at the time.  So that gave you about a 70x leverage on book value.

 

Oh, then there was the hurricane thing... in 2005 they lost a lot of money and it was blamed on KRW, but really they lost a bit more from the runoff division that year than they did from the hurricanes. OdysseyRe reduced their wind exposure by 25% after the hurricanes.  The March 2006 annual letter to shareholders claimed that they believed runoff would approach breakeven in 2006.

 

So if you trusted Prem, it was a good bet.  The hurricane season is typically over by then end of October, which still gives you 15 months before options expiry.  And on June 23rd you could pay just $2 per share for the Jan 2008 $140 strike calls, and $140 strike being roughly book value at the time, a very good chance that you'll at least be able to recover your $2 per share even if there were a repeat of KRW.  The stock was just so depressed already, it was almost as if the repeat of KRW had already happened.

 

Plus the short interest was huge -- something like 25% or so.  They would cover it stands to reason. 

 

Interesting stuff. So how much of your portfolio did you put into these options? A very large % I assume, since it was enough to help you retire. At what price did you end up selling the option?

 

This is interesting because I was just looking at AIG 2014 $50 calls, which are selling for about $1.50. I'm wondering what you think of them? 17 months till expiration, and the strike is $10 below current per share book value. If BVPS is $80 by then, as some people predict, and the stock sells for 1.0x, then these options would make out very well. But this is all coming from a beginner, so I'd be curious to know what you think of it.

 

I had varying strikes.  I kept adding to the $140s as they dropped in price, but I had some $70 strike 2009 calls too, just so that my break-even point wasn't so high if we got all the way to expiration.

 

I had every dollar I could find invested in them.  I was not allowed to allocate my 401k to them because it was in an employer plan.  But essentially it was 100% of my taxable account and IRAs, and that amounted to about 50% of my total net worth at the time (including estimated real estate estate equity).  My 401k was about 20% of my net worth, with real estate equity making up the other 30%.

 

I don't have any comment on the AIG options idea.  I'm not using very much notional leverage anymore -- I think you need to reach a certain escape velocity to leave the atmosphere, but then at a certain point it doesn't take much fuel to remain in orbit.

 

Forgot to answer your question:  I started selling as FFH approached $160, to cut down on the leverage.  It's hard to suddenly come into that much money and remain calm, I wish I had held on longer.

[Cardboard]

I did quite well with FFH options in 2006, but did not buy far out of the money LEAP options. Instead, closer to the money and with shorter duration. Not sure if it was a much safer bet.

 

The situation at the time was really a bet on the hurricane season and 2006 turned out to be one of the weakest on record. It was preceeded by KRW in 2005, but also don't forget the 4 hurricanes that hit Florida in 2004. At the time, there was a constant barrage in the media about the oceans becoming warmer due to global warming and that these two terrible years would keep on repeating forever.

 

While I say that, the flaw in the shorts logic is that even if 2006 had turned out to be bad for hurricanes, the company would not likely have gone under. There was already too much improvements in place at Fairfax from the weakest point or late 2002. It was a point of the time where you would scratch your head and wonder why there was such weakness in the stock price or what info your were missing. Kind of like BAC or AIG today.

 

However, if 2006 had been bad for hurricanes, I believe that the notion of permanently more hurricanes would have taken hold and kept pressure on reinsurers valuations and the like. It would have likely made Fairfax show a break-even or loss for 2006 and it is possible that Ericopoly's bet would not have paid out near as much with more pressure on the share price for a much longer period.

 

So IMO, similar risk and reward exists with AIG today or with these $50 calls Jan 2014 that you pointed out Mephistopheles. If there was $60 calls or at book value, they would likely trade around $0.60 now or a leverage of 100 times book as per Ericopoly's calculation. So it is higher than the 70 times of Fairfax, because the price to book value is 0.57 time instead of 0.64 time with Fairfax or price to strike. 

 

The question really is, would you put a significant portion of your net worth into $60 or even $50 AIG Jan 2014 call options? Ericopoly did hedge his bet with in the money options. There is always the risk of another recession or of Europe imploding between now and then. Valuations are also quite different than they were in 2006, but is it possible that big caps bargains like AIG will disappear within 2 years? It is another scratch your head type of discount in part due to the government who is selling tons of shares at any price (like FFH shorts) and the Street holding on to buying. If you look at the share price lately, they can't seem to resist anymore.

 

It was not easier at the time to pull the trigger on these FFH options. So the "bet" makes sense, but you have to look at what happens to your situation and accept the consequences if these options expire worthless because your timing was simply off. You will not get the same leverage with the warrants converting at $45 and expiring in 2021, but you can be sure that your "premium" will remain more or less intact for a long time even if the stock prices languishes until 2014.

 

Cardboard 

[bmichaud]

You guys had some serious effing 'nads putting that much unto a leveraged bet, let alone one that could potentially expire worthless due to bad timing. As intriguing and fun as it is to learn about those situations, it is extremely dangerous to extrapolate for most here. Just reading about the situation here led me to look at the BAC 2014's (I typically do not use options)....I would vomit if I put 50% of anything in the $10 calls selling for $.87 or the $15 calls for $.21. It would be a phenomenal return just to get back to break-even over that time let alone generate the return necessary to justify that risk.

 

With FFH you had a relatively defined catalyst holding the stock down - i.e. a coordinated short attack - whereas BAC is simply depressed due to a horrendous operating environment. Perhaps Parsad's theory of TBV by FYE 2012 due to litigation risk retrenchment is a form of catalyst, and he's probably right, but still who knows...

 

I remember reading Berkowitz's BAC thesis in mid-2010 about $2 of core earning power and his expectation for a veritable investor's wet dream with a virtually 100% payout ratio consisting primarily of buybacks driving the EPS figure ever higher in a virtuous cycle....fortunately I didn't buy in for whatever reason, but my point is that one could have made a highly credible case for a FFH-type scenario back then and 50% of one's net worth would have gone up in smoke by now, two years later.

 

Sorry to keep rambling, but the Freddie PFD's are another example of something fun to think about, but a highly improbable favorable outcome - that one dude's thesis was phenomenal, and the position was his LARGEST!!!! I guess my overall point is to caution those considering making a sizable bet on something that can go POOF, as tempting as it is upon hearing stories such as Eric's.

[ERICOPOLY]

With FFH you had a relatively defined catalyst holding the stock down - i.e. a coordinated short attack

 

Not just that, but a very well defined window in time so that your time decay was not a big deal for the duration of the thesis window. 

 

See, the 2014 BAC calls right now are not a case of "either they work out by this November or they don't".

[Parsad]

With FFH you had a relatively defined catalyst holding the stock down - i.e. a coordinated short attack - whereas BAC is simply depressed due to a horrendous operating environment. Perhaps Parsad's theory of TBV by FYE 2012 due to litigation risk retrenchment is a form of catalyst, and he's probably right, but still who knows...

 

We own no BAC LEAPS...just common and the A warrants.  Even though I believe that BAC should trade at tangible book, you have to be absolutely right on the timing buying LEAPS.  We're far more comfortable with a six-year time horizon, $13 strike and adjustable strike price than buying two year, no-benefit LEAPS. 

 

It certainly took alot of balls for those guys to buy FFH LEAPS back then, but at the same time, they were using their own money.  It would have been painful to lose that capital, but it would be harder to explain it to partners in a fund.  We had no fund back in 2003, and I did buy quite a few LEAPS as well in my personal portfolio...not as many as Ericopoly, Uccmal or Indirect...but quite a bit.  We only put a small amount of the portfolio in SNS LEAPS...about 6%...we made a killing in them.  Anyone who bought OSTK LEAPS a couple of months ago would have done quite nicely too.  But getting the timing right has a bit of luck involved, so you should be careful.  Cheers!

[rohitc99]

this reminds of the book - the big short :)  ...except that this was a big long !

 

now only if we can get michael lewis to write a new book  on this !

[Mephistopheles]

 

I don't have any comment on the AIG options idea.  I'm not using very much notional leverage anymore -- I think you need to reach a certain escape velocity to leave the atmosphere, but then at a certain point it doesn't take much fuel to remain in orbit.

 

 

I agree completely. I'm currently a student, so if I were to bet the farm on something like this, it would be a very tiny portion of my lifetime earnings.

 

 

[wescobrk]

 

We own no BAC LEAPS...just common and the A warrants.  Even though I believe that BAC should trade at tangible book, you have to be absolutely right on the timing buying LEAPS.  We're far more comfortable with a six-year time horizon, $13 strike and adjustable strike price than buying two year, no-benefit LEAPS. 

 

It certainly took alot of balls for those guys to buy FFH LEAPS back then, but at the same time, they were using their own money.  It would have been painful to lose that capital, but it would be harder to explain it to partners in a fund.  We had no fund back in 2003, and I did buy quite a few LEAPS as well in my personal portfolio...not as many as Ericopoly, Uccmal or Indirect...but quite a bit.  We only put a small amount of the portfolio in SNS LEAPS...about 6%...we made a killing in them.  Anyone who bought OSTK LEAPS a couple of months ago would have done quite nicely too.  But getting the timing right has a bit of luck involved, so you should be careful.  Cheers!"

 

Hi Sanjeev,

 

I agree the timing has some luck involved but once the 2015 leaps come out in a couple of months, the only risk I see is the transactional cost of continuing to roll into longer leaps.

 

If BAC isn't above 10 dollars a share in 2015 then the thesis was false in all likelihood for BAC, it seems to me.

 

[Uccmal]

I bought leaps that were barely out of the money.  My largest common stock position at the time was NB, as I viewed it as much safer than Fairfax.  NB being public, well funded, growing, well managed, and firewalled from FFh made it safe imo. 

 

As Eric alludes to the difficulty for most of us and myself which was holding these positions. I would sell them out, take the gains and roll over to the next Leap cycle in the fall each year, until FFH delisted. 

 

I do the same now.  I have stopped buying BAC and AIG Leaps until the 2015s come out.  If they have moved nowhere I will sell them, losing the time duration portion of the investment.  If they drop precipitously I will hold them, and buy the 2015s if the thesis is still intact.  The warrants are very handy in this environment, especially for AIG.  BAC common is so cheap it is sort of a toss on warrants versus common. 

 

BAC leaps I hold right now : largest number is 2014 - $10' others are, 7$, 12$, and a few 15$.  As I sell them I sell from the top strike down.  That is after I unload the remaining 2013 - 7.50s which are few. 

 

AIG: some 27$, 30$, 35, 40, and 45s.  Wont buy anymore 2014s this late in the cycle.  Building the warrant and common position now on pull backs, should they happen.

 

JPM- have a small 2014 position I built after the London Whale.

 

A certain portion of all of this is intended to be kept as common to provide future dividend income, for when I quit the day job. 

 

FFH is still my largest position, followed by RBS preferreds, and SSW.

[Guest Dazel]

 

 

Anyone that took the time to read and count could see what Fairfax portfolio was doing...the stock did not follow because the investment community gave up on Prem and Fairfax..except for LonfLeaf, Cundill and Markel. It was shooting fish in a barrel!

 

Bank of America is a different animal...hope you guys are right but very very different.

 

Dazel.

[Parsad]

 

 

Anyone that took the time to read and count could see what Fairfax portfolio was doing...the stock did not follow because the investment community gave up on Prem and Fairfax..except for LonfLeaf, Cundill and Markel. It was shooting fish in a barrel!

 

Bank of America is a different animal...hope you guys are right but very very different.

 

Dazel.

 

I think Fairfax was actually much harder to analyze than Bank of America...smaller company, fewer analysts, lesser known company, complicated subsidiary structure, huge runoff business and recoverables relative to book...it was very difficult.  The only reason that many people held the stock was because of their trust in Prem and our message board.  I think alot of people that ultimately held the stock, would have sold without both.  When you have a leader with trust, and a community to vent and talk to, it helps alot.  Fairfax's decision to listen to shareholders and decide what information they needed was also crucial. 

 

With Fairfax, you were truly relying on their numbers being correct and that the reported exposures were accurate.  With Bank of America, and many other large financial institutions, there has been so much scrutiny, on so many levels, that you have some more trust in the reported numbers.  There is no industry in the United States, that receives as much regulatory guidance or provides as much detail, as the financial industry presently...other than perhaps the Department of National Security.  And when things do show up like at JPM, every level of government jumps on them to explain and make changes. 

 

Remember, at the worst point in Fairfax's 7 years, they had leverage of about 11-1...for an insurance company!  Today that leverage is less than 5-1.  BAC today has leverage of about 9-1, down from about 12-1, and I expect that to creep down to about 8-1.  In a business that is a heck of alot more transparent and simple when examining long-tail risk.  In fact, I dare say that both businesses look very similar in the way their CEO's went about repairing the company and reducing leverage, while opening up the books to their shareholders to give them more comfort.  I can't say with certainty what will happen, but my bet is obviously that this is another significant case of mispriced valuation due to an overabundance of fear relative to the actual underlying risk.  Cheers!