Wanna see what Warren Buffett's worst nightmare looks like? Then take a glance at Fairfax Financial ( FFH), the troubled Canadian investment company that owns a raft of American insurance firms.

Toronto-based Fairfax used to be known as the Berkshire Hathaway ( BRK.A) of the North because of its Buffett-aping CEO and its enviable record of earning strong returns by buying cheap companies. After a recent series of stumbles, though, it's clear that chief exec Prem Watsa has fallen well short of the Sage of Omaha.

Now, has Fairfax fallen into a deep hole it can't climb out of? That is the question hanging over the publicity-shy, Indian-born Watsa as he leads the company into what is shaping up as its toughest year yet.

Tough Times

Fairfax, recently listed on the New York Stock Exchange, has been hit by credit downgrades and deep reserve deficiencies in its U.S. insurance companies, including TIG Insurance, which is highly exposed to the disastrous workers compensation product.

True, Watsa, in Fairfax's faux-frank Berkshire-style annual reports, has readily confessed that times are tough and that big acquisitions have failed to hit targets. But investors want more than selective repentance. Indeed, to understand the true health of Fairfax, details are needed on a number of key, but complex, areas.

First, there are reinsurance deals. Reinsurance at its simplest -- and rarely is it simple -- is the insurance that insurance companies themselves purchase to adjust their exposure, free up capital and manage earnings. Reinsurance can take many forms, however, and some deals can be structured so that the reinsurer is, for all intents and purposes, lending money to the company ceding the risk.

With Fairfax, some investors wonder whether a large and critical reinsurance deal struck with Swiss Re is really a form of debt, which, if treated as such, would increase the company's leverage. In addition, the Swiss Re premiums are being paid by the Fairfax holding company, not the insurance subs, where cost trends are closely watched.

Next, Fairfax must explain the role of obscure offshore subsidiaries. The fear among some investors is that the subs are being used to move cash from regulated U.S. companies to the Fairfax parent, where liquidity is getting tighter. Recall that Conseco, which recently filed for bankruptcy protection, consistently struggled to raise money from its insurance and finance units to meet parent company expenses and pay off its burdensome obligations.

At the root of Fairfax's problems, however, are the reserves for losses at its U.S. property and casualty subs, including TIG and Crum & Forster. These entities look deeply underserved, which could prompt regulatory action and thus deprive the parent company of cash it needs from its subs.

Bottom line? If things go badly for Watsa, Fairfax could face the mother of all liquidity crunches over the next 18 months.

Farifax declined to comment on a list of questions, saying: "We believe our annual report is the best forum to answer shareholder questions."

Fairfax stock rose $1.65 Wednesday to $78, leaving it 40% off its 52-week high. That steep drop has drawn in bargain hunters, who lick their lips at the fact that Fairfax's market worth of $1.1 billion is under half its book value of $2.3 billion at the end of the third quarter. (Dollar amounts are expressed here in U.S. currency, converted at the current exchange rate from Canadian dollars.)

Hanging in the Balance

The value investor's book value approach fails to hold up if Fairfax's assets are lower than the balance sheet indicates and liabilities are in fact higher. On the asset side, one item looks particularly doubtful: a deferred tax asset, which represents tax deductions Fairfax might be able to take on future profits. Notably, to utilize these deductions, Fairfax subs will actually have to show strong profits, which they didn't in the first nine months of 2002. For example, Fairfax's third-quarter numbers show the U.S. subs making an operating profit of just $5 million.

Companies must write down deferred tax assets if it becomes clear that a company can't produce the profits to make use of the assets. And while U.S. operations may have eked out a small operating profit up until the third quarter, it's likely that their performance is still deteriorating badly, given the fact that Fairfax announced a drastic restructuring of TIG in December. As part of the cleanup, it strengthened TIG's reserves by $200 million, suggesting that a third-quarter improvement in TIG's profitability numbers was a mirage. Fairfax has $1 billion of deferred taxes. Write that down by half and book value is cut by 20%.

The liability side of the balance sheet is more complex still. The basic question to be asked here is whether liabilities are somehow understated. In particular, how likely is it that the reinsurance written by Swiss Re is tantamount to a debt financing? It is impossible to tell without extra details from the company. But reinsurance can be structured to behave like debt.

Fairfax took out the Swiss Re reinsurance to cover itself against insufficient loss reserves at the distressed U.S. insurers that it bought at what looked like bargain-basement prices. It is known that Fairfax bought $1 billion of cover from Swiss Re, and has paid back a certain amount in premium. But beyond that it's close to impossible to gauge the true nature of the contract.

However, even if the Swiss Re policy is not debt, investors need to be aware that the cost of it is borne by the parent, not the insurance subs, which would appear to give an artificial boost to margins at the subs. Of course, the sniping on the Swiss Re deal may turn out to be groundless, but investors still need to focus hard on Fairfax's habit of using its own offshore entities to reinsure its onshore business.

Reassuring Reinsurance?

The suspicion here is that offshore reinsurers are being used to get liquidity out of regulated entities and transfer it to the parent. A Dublin-based entity called ORC Re, which had only seven employees at the end of 2001, appears to play a large role. For example, TIG's 2001 statutory accounts show ORC Re agreeing to indemnify TIG for up to $340 million of losses -- at a cost of $115 million. When a company reinsures, it is able to free up capital and boost the capital and surplus measures that regulators keep a close eye on.

But why didn't TIG carry out that reinsurance with a non-Fairfax entity? Without disclosure from ORC Re, investors have been left to make guesses.

One viewpoint is that Fairfax, perhaps due to regulatory pressure, doesn't get to extract dividends from a stressed entity like TIG. So, instead, TIG pays out reinsurance premium to ORC Re, which then pays dividends to the Fairfax parent. Indeed, Fairfax's insurance subs are paying a lot less to the parent, forking out only $36 million to the parent in 2001, compared with $210 million in 2000. What's more, the subs' maximum dividend capacity shrunk in 2002 to $150 million from $223 million in 2001, due to poor operating results. It is believed that the Fairfax parent gets around 75% of its dividends from offshore subs, not U.S. and Canadian entities.

The seemingly central role of ORC Re, and perhaps others, seems questionable enough, but there is another twist: The Fairfax parent also uses its bank lines to place letters of credit at its regulated and offshore subs to shore up their capital. Letters of credit are commitments from a bank to pay out a certain amount of money, and are often used to boost capital at insurance companies. Indeed, Fairfax clearly states in its 2001 annual report that its letters of credit had been "pledged as security for subsidiaries' reinsurance balances, principally relating to intercompany reinsurance between subsidiaries."

Squared Circle

All this has led some investors to surmise that liquidity is simply swirling in a circle.

Dry Wells?
Dividends paid to Fairfax holding company by subsidiares (U.S. dollars)
Sources: Fairfax, Detox

The theory goes: Dividends mainly from the offshore subs are being paid to keep enough liquidity at the parent to reassure the banks so that Fairfax will have letters of credit to place with the subs so they can pay dividends to the parent. If this is so, and the basic business continues to deteriorate, the banks and the insurance regulators are likely to call a stop to it soon. Indeed, the banks don't seem to be renewing the credit lines on which the letters of credit are issued. In February 2002, Fairfax had $595 million of unsecured committed bank lines, compared with $821 million in 2001.

So, what might be Watsa's next move? There is still $365 million of cash at the holding company and some unrealized gains on some spectacularly clever derivative bets on the S&P 500 and U.S. Treasuries. And, of course, some bank lines are still available. This is not much of a margin of safety. Just next month, a $140 million issue of debtlike securities comes due. No surprise that Fairfax is trying to extend it.

Watsa may try and buy more reinsurance coverage for TIG so that regulators agree to allow the entity to sell assets, such as Odyssey Re ( ORH). But such a deal could be punitively expensive. As part of the December TIG restructuring, Fairfax had to put $800 million of TIG assets in a trust "principally pending TIG's satisfaction of certain financial tests at the end of 2003." Watsa could forego an early reinsurance deal and wait till then, but presumably it's not certain TIG will be able to pass those tests.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to peter.eavis@thestreet.com.