Prem Watsa -" Regression to the mean has begun - but only just begun!"

This quote is from Prem Watsa's annual letter to shareholders for 2007 released today. The performance for Canadian insurer Fairfax Financial(FFH) for 2007 was excellent and I have discussed this in earlier posts. I think there are only a handful of companies in the world that can boast of a 26% compounded return in book value over 22 years.

But I want to focus on Prem Watsa's outlook as he discusses in his annual letter.

"We have witnessed credit spreads widen dramatically for mortgage insurers, bond insurers and junk bonds, reflecting mainly the problems of the housing market. We remain vigilant for the spreading of these risks into all credit markets, because the same loose lending standards and asset backed structures have been applied to these markets"(Prem Watsa 2007 annual report)

This concern has certainly been reflected in the credit default swap index that has widened out to over 180 basis points as of yesterday according to Bloomberg up from 29 basis points a year earlier.

Prem Watsa is clearly concerned that defaults will spread to credit cards, auto loans & so on.

"BenGraham made the point that only 1 in 100 of the investors who were invested in the stockmarket in 1925 survived the crash of 1929 – 1932" (Prem Watsa annual report 2007)

Imagine going to a financial advisor to put some money into a mutual fund and him or her advising you that equities can be risky investments and ,by the way, only 1 out of 100 investors survived the 1929 - 1932 crash. This was a fascinating piece of historical perspective.

"In our 2005 Annual Report, we also discussed the Japanese experience from 1989 to 2004 when the Nikkei Dow dropped from 39,000 to 7,600 while yields on 10 year Japanese government bonds collapsed from 8.2% to 0.5%. With the Federal Reserve dropping the Fed Funds rate down to 3% from 5.25%, we might be witnessing a repeat in the U.S. of the Japanese experience. In spite of record lowinterest rates and record high fiscal deficits, Japanwent through years ofmild deflation. The feelings at the time in Japan were that they were different andwould not allow stock prices andland prices to fall – not dissimilar to the sentiment currently prevailing in the U.S.!!" (Prem Watsa 2007 annual report)

Could the US face the Japanese experience all over again. Deflation is definitely under way with falling asset values and rising commodity prices. Its a scary thought and would have global stockmarket implications.

"We continue to protect our shareholders froma 1 in 50 or 1 in 100 year financial storm by hedging over 80% of our equity exposure against the S&P 500 (mainly), by holding approximately 80% of our investment portfolio in treasury bills and government bonds, and by our $18 billion notional CDS position." (Prem Watsa 2007 annual report)

Prem Watsa has built the defences for Fairfax Financial to protect the company if we are in fact going into a 1 in 100 year storm. Even though the insurance industry and Fairfax are facing lower premiums from a softer insurance cycle , I still like the way Fairfax Financial is positioned and if credit markets continue to deteriorate Fairfax could end up making considerable investment gains on their credit default portfolio that will more than compensate for an inevitably softer underwriting performance.

Disclosure: I own shares of Fairfax Financial (FFH)