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Liquidity concerns a hardy perennial at Fairfax

Analysts have again drawn sharply opposing conclusions about the liquidity of Canadian financial services holding company Fairfax Holdings after it published its Q2 2004 results.

The company, which models itself on Warren Buffett's Berkshire Hathaway, has stakes in US (re)insurer Odyssey Re, property and casualty insurer Northbridge Financial, New Jersey based commercial property and casualty insurer Crum & Forster and Lloyd's insurer Advent as well as other insurers and reinsurers.

In its 29 July trading statement Fairfax reported a 74 percent fall in Q2 profits against the same period in 2003 when it recorded big investment gains from the sale of bonds. It said net income came to $46.0mn against $173.7mn in Q2 2003, with revenue down to $1.44bn against $1.63bn for Q2 2003.

Despite this Fairfax said the headline results masked "excellent underwriting performance" at its subsidiaries, including a 7.1 percent increase in net premiums at continuing insurance and reinsurance operations.

But for Morgan Keegan analyst John D Gwynn, Fairfax's optimism concealed a darker story of a company desperately shuffling assets in a bid to stay afloat.

On 9 August, the analyst, who in a telephone interview told The Insurance Insider that Fairfax was "skating on thin ice", published research in which he said liquidity remained a "major challenge".

He wrote: "The strain of financial leverage, coupled with the volatility of runoff cash requirements could significantly stress corporate cash flows over the remainder of the year."

Where Fairfax published a Q2 2004 combined ratio of 94.9 percent for the quarter, Gwynn quoted a far higher "consolidated combined ratio" of 106.8 percent - a figure that, unlike Fairfax's own calculations, included run-off operations.

Gwynn's negative stance on Fairfax comes from his view that persistent reserving issues at its subsidiaries, high leverage at holding company level and the "aggressive utilisation of off-balance sheet funding mechanisms" - including finite reinsurance transactions and inter-company letters of credit facilities - are all degrading Fairfax's financial flexibility.

In his latest commentary he published extracts from 15 public filings, which showed financial guarantees made by Fairfax to its subsidiaries. Among them was an as-yet-unexercised agreement by Fairfax to allow Crum & Forster an interest free, $40mn loan to settle "corporate obligations" repayable in June 2018. Another was an agreement whereby Fairfax financed its Lindsey Morden subsidiary on a $22mn shortfall in its funds. This, the filing said, was because Lindsey Morden was "unable to generate sufficient funds internally in the first quarter 2004 to meet its liabilities and obligations". Under the terms of the agreement, Fairfax has offered to finance Lindsey Morden until January 2005.

A third disclosure, in an Odyssey Re's filing, revealed that in Q2 2004 the company pledged £110mn of US treasury notes and placed them on deposit at Lloyd's "on behalf of" insurer Advent, which is 6.8 percent owned by Fairfax. Commented Gwynn: "Based on the Odyssey disclosure, it therefore appears that Odyssey Re has been caused, for whatever reason, to step into a Fairfax obligation."

Gwynn noted the "large number" of disclosed inter-company financial guarantees "only aggravate the liquidity situation at Fairfax", adding that there may be other guarantees which are not yet in the public domain. He concluded: "The net effect of these transactions was to overstate Fairfax holding company cash balances by $199.5mn at 30 June 2004."

For a more positive take on Fairfax, it was left to analysts at Ferris Baker Watts, who said the company's latest results were broadly in line with expectations.

In a research note sub-headed "Quiet quarter, good results" published on 30 July, analyst Mark A Dwelle said Fairfax had witnessed continued operating improvements in ongoing businesses. Although he said a discount on the stock was warranted because of the company's "difficult" financial structure and risks associated with its large run-off operation, he added: "We see no near-term liquidity issues."

For more bullish analysts such as Dwelle, understanding Fairfax is about taking into account the company's structure and its effect on the way income and outgoings are booked. As Dwelle explained in his 30 July note, holding company obligations tend to be loaded towards the beginning of the year while subsidiaries' dividends are generally taken at the end of the year - and failure to take this into account may be behind investors' liquidity concerns.

Dwelle pointed an increase in the cash position from $296mn at the end of Q1 2004 to $305mn for Q2 2004. He concluded: "We continue to note that liquidity in the underlying operating subsidiaries is not an issue. Each unit, based on recent statutory filings, seems to have more than ample liquidity to meet its normal expected obligations. Liquidity concerns, such as they are, rest solely with the holding company and arise because substantially all of the company's debt is held at the holding company level."

The question for investors and commentators is whether Dwelle's explanation holds water. Barring any immediate liquidity crisis, it remains to be seen whether the bulls or the bears are closest to unravelling the mysteries of Fairfax.

Still buoyant? Projected cash flows at Fairfax Holdings

Cash at 31/3/04 ex. CFI balances (US$mn)


Swiss Re payment


Note Exchange offer


Holding Co. interest costs


Holding Co. costs


Preferred share dividends


Northbridge share sale


Bank borrowings 125


CFI dividends


Tax sharing payments


Cash expected at 6/30/04


Reported cash at 6/30/04 ex.CFI balances (mn)


(Source: CIBC World Markets Inc and company reports)


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