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Only a handful of financial companies worldwide are in better shape now than before this crisis started. Fairfax Financial is one of them. CEO Prem Watsa managed to make $2 billion and thumb his nose at his opponents at the same time

He is a little bit greyer than he was before the beginning of his biblical seven lean years, and a little bit balder, and slightly more wrinkled, but wiser, too. He has learned. He has discarded one of his own personal commandments, a rule he rarely breached in 20 years: Thou Shalt Not Give Interviews to the Press. He has opened his mind and his mouth to journalists, analysts, skeptics and enemies. He has a PR agent now. He does conference calls and takes questions. He has done all this because he had to--because his life's work was attacked, and because it became clear to him that the world had changed, and it wasn't good enough any longer to stay cloistered in his comfortable circle of friends and admirers and confidants and fellow travellers.

But that doesn't mean he likes it. And it doesn't mean he wants the attention any more than he did a decade ago, before all the trouble started, when he was still labelled a "recluse" and Bay Street loved him and his peculiar creation, insurance and investment company Fairfax Financial Holdings Ltd. Over the decades, The Globe and Mail has named dozens of CEOs of the Year. Prem Watsa is the first, as far as anyone can recall, who tried to reject the honour. Vehemently.

It's Fairfax policy to reject all awards to individuals. In 1999, Watsa even turned down a business leader award from his alma mater, the Richard Ivey School of Business; other Fairfax executives have rejected similar nominations. Watsa would not pose for photographs or grant an interview for this story (though he has given several interviews to The Globe this year, most recently in early October, when he spoke at length about the financial crisis and predicted a long, deep and painful recession). Through the company's chief legal officer, Paul Rivett, Watsa asked us to rename the title "Company of the Year" and grant it to Fairfax instead of him. He even offered to try to find us a more willing candidate. These efforts were not an act of false modesty. In Rivett's Toronto office, there is a limestone plaque that reads: "There's no limit to what a man can do or where he can go if he doesn't mind who gets the credit" --a quotation often attributed to Ronald Reagan. Watsa gave one to all senior Fairfax executives.

Well, tough luck, fella. Sometimes you have to suck it up and accept the credit. And this year--the most extraordinary year in financial markets since the Depression--is unquestionably Prem Watsa's time. His critics, the so-called cadre of hedge funds and their hired hatchet men whom Watsa alleges tried to destroy Fairfax in 2005 and 2006, are in retreat. The very practice of short-selling, while hardly discredited, is under scrutiny now, as are the practices of the brokers and traders who serve short-sellers. An analyst who helped touch off panic selling in Fairfax shares--by writing a report that essentially claimed the company was on the road to bankruptcy because it had failed to set aside a necessary $5 billion (all currency in U.S. dollars) for insurance claims--has been fired for leaking that document to some clients before its release. Fairfax seems financially healthy for the first time since Monica Lewinsky was on everyone's lips. In the summer, Moody's Investors Service raised Fairfax's credit rating, which it hadn't done since 1998; DBRS Ltd. moved the company's bonds to investment grade, where they hadn't been since 2002.

But these are mere details. The real reason Watsa is the (reluctant) recipient of the title is that, in three words, he called it. He didn't know that the greatest financial disaster in decades would unfold in the autumn of 2008, of course, and he didn't predict that it would sink such leviathans as Lehman Brothers and American International Group, his biggest rival in insurance. But he did spot the source of the trouble long before most everyone else. And he has $2 billion to prove it.

April 14, 2003. The scene: Room 105 of the Metro Toronto Convention Centre in Toronto. It's a friendly crowd, made up of hundreds of Fairfax shareholders, the company's managers and the curious who've wandered in from their day jobs on Bay Street.

Prem Watsa has some comedy in mind to open the 9:30 a.m. meeting. Days earlier, U.S. troops had captured Baghdad and, in the chaos that followed, helped pull down a statue of Saddam Hussein. The photograph of the statue in mid-fall became instantly famous. Watsa has superimposed his own face on the dictator's head. He projects it onto a large screen with a caption: "The Shorts."

Laughs all around. But Watsa had no idea how vicious his battle with the short-sellers was about to become. In the three years that followed, Fairfax claims in a lawsuit, they attempted to paint Watsa as a white-collar crook, and Fairfax as an Enron-style accounting fraud. (The case is now in the discovery phase in a New Jersey court.) And the shorts had no clue what a huge payoff Fairfax would ultimately reap from the investment moves that Watsa and Brian Bradstreet, one of the founding partners of Hamblin Watsa Investment Counsel, Fairfax's money-management division, began making that same year. No one did.

The war with the hedge funds, which has been well-documented in this publication and elsewhere, is a strange tale. It is, and was, deeply personal. One of the most fantastic allegations is that a man named Max Bernstein, in collaboration with Spyro Contogouris, a mysterious figure who supposedly conducted research for hedge funds, sent a letter in 2005 to Rev. Barry Parker at St. Paul's Anglican Church in Toronto. Watsa sits on the church's investment committee. The letter compared Watsa to Marty Frankel, a financier who bilked insurance companies of $200 million and, in 2004, was sentenced to nearly 17 years in prison, and concluded: "Be aware, Father, be skeptical and ask Mr. Watsa to make confession. God Bless, P. Fate."

"He was plenty mad about it," says John Clark, a long-time friend of Watsa's who runs JCClark Ltd., a Toronto investment manager.

Most everyone agrees that some of Watsa's decisions--his reluctance to speak publicly, the complexity of Fairfax's structure and the move to list on the New York Stock Exchange in late 2002--made him easier prey for a short-selling assault. "I'd say he was a little naive in the ways of Wall Street, as opposed to Bay Street," says another long-time associate. In July, 2006, Fairfax filed suit in the Superior Court of New Jersey, claiming that Contogouris was just one player in a massive and illegal conspiracy by a group of hedge fund managers--including one of the biggest, Steve Cohen of SAC Capital Management, and Jim Chanos, a famous short-seller who called the Enron collapse in 2001--to drive it into bankruptcy by spreading negative news and rumours.

None of the allegations has been proven; two years on, the sides are still haggling over who should be included among the defendants and what evidence can be shielded from the public eye. But the notion that a financial company could be brought down by the Wall Street gossip factory is no longer so far-fetched. The stunning death spiral of Bear Stearns in March was, many suspect, partly fuelled by rumours about the investment bank's balance-sheet problems. In banking and insurance, people either have confidence in you, or you're out of business.

It's fair to say that by the time Watsa started to grab the attention of the shorts, investors' confidence in him and Fairfax had already been shaken. Two acquisitions in the late 1990s--U.S. insurers TIG Holdings and Crum & Forster--went badly. Those mistakes were compounded by bad luck. And it's also true that it wasn't just hedge funds with allegedly nefarious motives that said Watsa was in deep trouble. Around this time, a high-profile manager at one of Canada's largest fund companies examined Fairfax's financial statements and concluded that it was "a house of cards."

The 9/11 terrorist attacks, which dragged the company to a $406-million loss in 2001, weakened an already tottering balance sheet. To raise money, Watsa had to sell off 38% of Fairfax's crown jewel, its Canadian insurance operation, Northbridge Financial. He turned to Fairfax's largest and most loyal shareholders for more equity in 2004 and again in '05, raising a total of $600 million. The latter year was Fairfax's worst ever, because of insurance claims caused by Hurricanes Katrina, Rita and Wilma. The company posted a loss of $447 million. "I think his investment record has never faltered. It's the insurance record that has been patchy," says Rob Grundleger, the co-founder of Groundlayer Capital in Toronto, who has known Watsa since Fairfax's early days.

Watsa, who worships Warren Buffett, quotes from value-investing guru Benjamin Graham and has a bust of Sir John Templeton in a boardroom at Fairfax, was chastened, but not depressed. "He's the same person when he's up as when he's not up," says Clark. Like his hero from Omaha, Watsa measures the progress of his company by the growth in its net worth, or book value, per share. By the end of 2005, that figure was $137.50--lower than it was in 1999--and the business was staggering under the weight of too much debt. And things kept getting worse. No sooner had Fairfax filed its New Jersey suit than it announced an accounting problem that would wipe more than $200 million in past profits off the books.

That was the low point for the stock, which languished around $120 (Canadian) but soon after began to rise, and for Fairfax's public image. "For us, it was just a question of continuing to work hard, and the results will out, eventually," Watsa recalled this past February.

But even he could not have imagined the speed of the turnaround. The causes of it, sure. The insurance business improved--there were no Katrinas in 2007. But the key was an investment opportunity Bradstreet had identified more than five years earlier. He'd noticed the mushrooming growth of credit default swaps.

The best way to understand a CDS is to think of it as an insurance policy against an unpaid debt. Suppose you are a commercial banker at RBC who has given a $100-million loan to a manufacturing company. The borrower makes auto parts for SUVs, and its biggest customer is General Motors. Seeing that (a) fuel-sucking vehicles are out of style, and (b) GM is itself a fine candidate for Chapter 11, you begin to worry about that loan. Using a credit default swap, you pay an investor (or another bank) a premium of $2 million to assume the risk (called "buying protection" ).

A year later, the parts company goes broke and, in liquidation, is able to pay back only $75 million of its loan. RBC has just saved itself a bundle: It receives $25 million from whomever sold it the protection (assuming, of course, that the seller has the money to pay up). This is one of the mechanisms by which trillions of dollars in loans, bonds and other forms of credit risk are cut up, sold off and transferred around the world. Some estimates have put the size of the CDS market at more than $60 trillion.

But there's also a way to make money--rather than simply to avoid losing it--through credit swaps. As with all forms of insurance, the cost of a CDS fluctuates depending on the perceived risk. An investment firm with a negative view on the auto industry's prospects might buy that same credit protection for $2 million; as the parts company flounders, the investor might be able to sell the CDS for, say, $6 million to another bank that has suddenly wakened up to the risk. For enterprising investors, it's a way to risk a small amount of money for the potential of a much larger payment--if you bet the right way.

And that's how Watsa and Fairfax made a $2-billion score. From 2003 through early 2007, they bought protection against banks and other entities that were exposed to the lending and mortgage boom, when the risks were believed to be low and the swaps were cheap. Then they sold as Wall Street was seized by its most serious crisis since the 1930s. But how did he know?

Watsa's genius--his single most important investment insight of the past five years--was to recognize that the new gnomes of finance had got it all wrong. Their fancy securitization schemes, which packaged up mortgages and consumer debt into bonds, weren't reducing risk; they were increasing it.

Buffett has received a lot of credit lately for calling derivatives "financial weapons of mass destruction" way back in 2003. But Watsa was every bit as prescient in seeing the weaknesses of what Wall Street euphemistically calls "structured finance." "Take the case of an automobile dealer," Watsa wrote to shareholders in early 2004. "Prior to securitization, the dealer would be very concerned about who was given credit to buy an automobile. With securitization, the dealer (almost) does not care, as these loans can be laid off through securitization." And the triple-A credit ratings given to thousands of these asset-backed bonds? A mirage, Watsa suggested. The default rates on them "will likely be very different in the future--particularly if we experience difficult economic times." About the only thing missing from his treatise was the word "subprime."

But it took years for the scenario to unfold. As the low interest rates of the early part of the decade evolved into one big easy-money lending orgy, investors' perceptions of risk went down, not up. Fairfax's CDS bets were down 74% by the end of 2006. "But we still held it," Watsa said, "and we took a deep breath and bought some more."

Then, in the summer of 2007, Watsa gathered key Fairfax executives at a retreat in Niagara-on-the-Lake, Ontario. One of the speakers was James Grant, the editor of Grant's Interest Rate Observer, a highly respected investment newsletter. He mentioned that two credit-oriented hedge funds at Bear Stearns had just blown up. The reckoning had begun.

Watsa, Bradstreet and the rest of the investment group at Fairfax's in-house money manager chose their targets well. Using CDSs, they bet against the financial health of so-called monoline insurers such as MBIA Corp. that had recklessly backstopped hundreds of billions of dollars in mortgage bonds. Watsa felt they had taken on massive, unrecognized risk and didn't deserve their triple-A credit ratings. "All you had to do was take a prospectus or you take their 10-K and you open it up and you say, 'Let me look at the risk factors,'" he said in February. "And you just read it. It's all there. And what's amazing is that when you read it, you can't believe that these guys did what they did. They never worried about risk...and the only way that could happen is if we have a long period of stability--a long period where there wasn't any accidents. You'd never take that risk otherwise."

Most of these investments turned into huge winners. During the credit boom, credit swaps could be bought against the monolines for 1% or 2% (that is, a payment of $1 million or $2 million would pay $100 million if the company defaulted and the bonds were worth zero). By early this year, that same in-surance cost 25%, or $25 million. Fairfax bet against U.S. and European banks too, also using swaps.

By the end of the Week from Hell--Sept. 15 to 19, when Lehman failed, AIG disintegrated and even mighty Goldman Sachs seemed in peril--Watsa and Bradstreet had cashed in much of their $433-million credit bet. And what a bet it was: Through Oct. 24, Fairfax had earned six times its original investment. It had sold more than $2.05 billion in swaps and still held some $600 million worth.

It was a gold strike, one that has made up for a lot of Fairfax's mistakes during the lean years, and which has made it much harder for short-sellers to spook the market about its solvency. At the end of 2005, the holding company had $559 million in cash and investments, but more than twice as much long-term debt--about $1.4 billion. The numbers are now reversed: There's more cash and investments ($1.2 billion) than debt ($1.05 billion). The share price, which for so long traded far below book value, hit a nine-year high in October. As of Nov. 5, it was up 22% on the year, the eighth-best performance among the 280 financial services companies in the Bloomberg world U.S. financial index.

So the roles have reversed. They--the wizards of Wall Street, the overcompensated bankers, the lazy and uncreative money managers--are now the ones who must pass around the begging bowl to get more equity, as Watsa did a few years ago. They are the ones too weakened by their own errors to capitalize on the post-crash prices for financial assets.

Watsa, meanwhile, keeps finding new ways to spend his war chest. Officially, he is bearish on the stock market. In October, he told The Globe that despite the collapse in equities, it could still get a lot worse before a new bull market takes hold. "History shows you've got to have months of redemptions [from mutual funds]. That's an indication that people are losing their confidence and want to be out of the market. Stock markets are not down 50% in Canada or the United States from their highs. They've got a long ways to go down before that happens."

But he has rarely been more able to find the sort of unloved, beaten-up and toxic stocks that only a deep-value investor like Prem Watsa could love. In early November, he increased his stake in CanWest Global Communications, the troubled media company; Fairfax is by far the largest shareholder outside the Asper family. The company also owns nearly 20% of the subordinate shares of Torstar Corp. It holds 19.73% of International Forest Products Ltd.

This is one way in which Watsa really is like his hero, Warren Buffett: Both men are stepping in as cash-rich saviours of the troubled and desperate, and exacting a hefty price in return for their capital. In Buffett's case, it's preferred shares paying 10% interest in General Electric and Goldman Sachs. In Watsa's, it's the convertible debt of troubled Canadian firms like AbitibiBowater and Mega Brands, the Montreal toymaker.

Only someone of Watsa's patience could stand it. "He is a real cool-hand Luke when it comes to controversial investments," says a friend who has known Watsa since his early days as an investor, when Watsa managed money for Confederation Life. John Clark adds that Watsa is a unique investor who is now in a unique position in a world that's suddenly starved for capital. "They're the only guys standing that can put in the type of money that is required for some of these investments they're looking at, and have a time horizon of 10, 15 years," says Clark. "I've been telling people things are going well, but watch out" --they're about to get better.

Does that mean more accolades? Say it isn't so. Prem Watsa just doesn't want to hear it.

© 2007 The Globe and Mail. All rights reserved.

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