Watsa's Massive Bet

All this talk of deflate-gate got me thinking about another kind of deflation.  No, Prem Watsa (Chairman and CEO of Fairfax Financial Holdings (FRFHF)) doesn't have a put option on air pressures of footballs, but he does have a massive bet on global deflation.  It's scary how big the bet has become.

Check this out, from the 2013 letter to shareholders: 

When Watsa first put on this trade, he had $34.2 billion in notional amount on.  As of the end of 2013, there was $82.9 billion.  Now, the initial reference point was that the ten-year cumulative deflation both during the depression in the 1930's in the U.S. and recently in Japan was around 14%.  This means that the possible gain if we see similar deflation around the world can be $11.6 billion!

FRFHF's common equity was $7.2 billion as of the end of 2013, just to give you an idea how big this trade is.  

This is the breakdown by region:

And this is the cumulative loss-to-date from the deflation trade:

Hold on to your chair and look at this table from the 3Q 2014 report:

The notional amount outstanding has increased from $82.9 billion to $108 billion.   That is just staggering.

So let's see how this increase since 2010 compares to FRFHF's common equity:

                                     2010                           3Q2014
Common equity            $7.8 billion                   $8.6 billion
Notional amount         $34.2 billion               $108.0 billion
Potential gain                $4.8 billion                 $15.1 billion
   % of equity                 62%                          175%
Potential loss               $302 million               $639 million
   % of equity                 3.9%                          7.4%

The notional amount looks huge at almost 13x common equity, but since these are basically put options, only the premium paid up front is at risk.

I calculated the potential gain using 14%, which might be aggressive.   The true risk here is that deflation doesn't happen and the puts expire worthless.  In that worst case scenario, FRFHF would lose 7.4% of their common equity; not a disaster.

Remember, too, that these options have an initial period of ten years. As of the end of 2013, the remaining term on the contracts was 7.5 years, so the potential loss actually amounts to something like 1% of common equity per year.   Not a big gamble at all.

How Do Banks Hedge This Thing? 
The corollary to how interesting this trade is to FRFHF is how much of a pain it must be for the banks on the other side.  If we get into a deflationary spiral, banks can end up owing a lot of money to FRFHF.  How do they go about hedging this thing?  I know that CPI futures were planned for listing on the Chicago Mercantile Exchange (CME), but that didn't happen.  Treasury TIPs can be used to hedge, I suppose.

Big banks would also seek out counterparties to take the other side.  There must be plenty of entities wishing to hedge against inflation.   Being short puts won't help against high inflation, though, as they don't make any more than the premium initially received.

Deflation Coming?
In any case, this is very interesting and I've always seen deflation as the higher risk than inflation (again, because of my observation of Japan over the years).

For deflationists, the recent ECB decision to start massive quantitative easing may have been the final hurdle to get over.  If this doesn't stop the deflationary (or at least disinflationary) pressure, then things can get pretty interesting.  

In any case, this is an interesting situation.  This can be the trade of the century if we dip into deflation; the ultimate limited risk (don't lose much if wrong)/ high return (huge gains if right) trade.