The conference call recently held by executives of Fairfax Financial Holdings Ltd. to discuss second-quarter earnings with analysts revealed in a nutshell the current risks to the global credit markets. It also revealed how shrewdly the company handles itself.

The Toronto-based holding company, which owns a number of insurance, reinsurance and investment companies in Canada, the United States and Asia, revealed that its second-quarter profits had dropped 27% year over year, mostly because of a drop in investment gains. But that was just the side show. On the main stage were details showing that Fairfax had made moves more than a year ago to deal with the vulnerability of the credit markets.

In the midst of the earnings report, Prem Watsa, chairman and CEO, said Fairfax had accumulated $340 million of credit default swaps, an investment that looked as if it might pay off handsomely.

“It was very good investing and foresight,” says Stephen Bowland, an analyst at CIBC World Markets Inc. in Toronto who covers the sector. “A CDS is used in a variety of ways, but for Fairfax to short the U.S. market with what is occurring now was great analysis.”

At the heart of the conference call was the security of billions of dollars of loans spread across global markets in various debt products. A few days later, Fairfax’s investment in CDSes began to come good as the quality of asset-backed credit paper came under scrutiny.

A CDS is a derivative instrument based on bonds; in this case, corporate bonds. The buyer of a CDS pays a premium to the seller to assume the risk that the issuer of the underlying bond will default on the coupon or interest payment. CDSes let investors insure their bond holdings against the risk of default.

“One party is selling insurance and the counterparty is buying insurance against the default of the third party’s debt,” writes Francis Chou, owner of Chou Associates Management Inc. in Toronto, in his latest annual report. Chou is a former Fairfax vice president and a long-time friend of Watsa.

Insurance companies often use CDSes to hedge their reinsurance recoverables, adds Bowland. The products ensure that the insurer will be able to pay out in the event of a catastrophe.

Not surprising, several subsidiaries of the Fairfax holding company, including New Jersey-based P&C insurer Crum & Forster Holdings Inc. and Connecticut-based reinsurer OdysseyRe Holdings Corp., hold CDSes as part of their regular business. It was obvious to analysts such as Bowland, however, that Fairfax is using the CDSes for other purposes.

“The other portion was used for speculative gain, which is uncommon,” says Bowland. “The speculative portion was essentially shorting the subprime mortgage in the U.S.”

Since the beginning of 2006, Watsa said in the conference call, Fairfax bought CDSes to cover the notional value of $18 billion in bonds. The company bought the latest batch in December 2006 and, on average, they matured over a period of a little more than four years.

Watsa shrugs off a suggestion that he was somewhat overprotected against market risk. After all, 77% of the company’s portfolio is invested in government bonds, with minimal corporate bonds.

“We look at it as a comprehensive hedge against everything we do,” says Watsa. “We think we are going into a very difficult environment. We’ve been thinking this for some time, so I’d take this with some salt, but we do think we’re going through some tough times.”

He also says the company had taken CDSes on a handful of companies in the financial services sector, but he wouldn’t reveal any names.

“The swaps are on mortgage guarantors; they’re with brokers, they’re on the banks, they’re on insurance companies,” he says. “[They’re] on financial services companies because that’s where the risk is, that’s where the expansion has taken place, so we’ve protected ourselves. Being a financial institution, we’ve protected ourselves against the negative possibilities.”

CDSes are also traded for investment purposes. Their price is related to the probability of a default, and the spread on the instruments was widening in the days before Fairfax’s earnings call. The total cost of the CDSes was about $340 million and, on June 30, just days before the market troubles began, their potential value had swelled to $537 million.

@page_break@“As the spreads continue to widen, Fairfax stands to gain considerably on this position,” says analyst Tom MacKinnon, director of equity research, insurance, Scotia Capital Inc. in Toronto.

An example of the gains can be seen with CDSes on $10 million of a bond issued by New-York based Bear Stearns Cos. , the second-largest underwriter of mortgage bonds. In late July, the CDSes were quoted as high as US$145,000, up from US$30,000 at the beginning of June, according to a Bloomberg LP report.

Watsa said Fairfax would be watching the process closely, but added that CDS prices are volatile, and there was no certainty the company would realize gains by selling them. “We don’t know when the problems will happen,” Watsa said. “These collateralized bonds, these CDOs [collateralized debt obligations], the asset-backed bonds, are all over, and so I think we need to protect ourselves.”

The fiasco with asset-backed commercial paper flared up, and it showed what a good call Fairfax made, says MacKinnon. “They never bet the farm on anything. It could just be like shorting a stock or buying a cheaply valued stock.”

No other insurers were doing this, MacKinnon adds, but big players such as Warren Buffett had been warning about the U.S. mortgage situation as long as two years ago.

Unfortunately, Watsa is notoriously tight-lipped and Fairfax turned down the chance for any of its executives to speak about their reasons for investing in CDSes.

Chou agrees in an e-mail that Fairfax’s call on the CDSes was prescient. In fact, Chou, who was named fund manager of the decade at the 2005 Canadian Mutual Fund Awards, took the unusual step of asking his unitholders to approve of his interest in buying CDSes in his 2006 annual report, around the same time Fairfax would have been considering them. “The Chou funds would be interested in buying this type of insurance,” the report states. The fund company could begin buying the CDS in March 2007, it adds.

The Chou report also delivers an assessment of heavy risk-taking by financial services companies

“We may be witnessing a ‘tragedy of the commons,’ where the search for quick individual profits is causing a system-wide increase in risk and reckless behaviour,” Chou writes.

He names the subprime mortgage lenders, for whom “credit standards were so lax and liberal that homeowners didn’t even need to produce verification of income to be able to borrow up to 100% or more of the appraised value of their houses …

“Some optimists believe the worst is over,” Chou adds in the March report. “However, they may be in for a surprise. Instead of it being the darkest hour before the dawn, it could be the darkest hour before pitch black. It will take a while for the excesses to wring themselves out of the system.” IE