Bank of Canada getting nervous about debt levels

The Governor of the Bank of Canada in a recent speech is saying that while the economy appears to be recovering, that household debt levels are of a concern. Most consumer debt expense is through a mortgage.

In particular, the following paragraph is worthy of mention:

The simulation generates a scenario indicating that, by the middle of 2012, almost one in ten (9.6 per cent) Canadian households would have a debt-service ratio greater than 40 per cent, the threshold above which households are considered financially vulnerable (Table 2). Moreover, the percentage of debt owed by these vulnerable households would almost double. Both of these metrics are well above their recent peaks.

It is worthy to note that “Scenario 1” and “Scenario 2” of the Bank of Canada have short term interest rates at 1.5% at the end of 2010, and 3.1% at the end of 2011 (in Scenario 1) and 4.00% at the end of 2011 (in Scenario 2). These are hypothetical scenarios, but it does not appear that the Bank of Canada will be keeping rates at 0.25% past their June 2010 declaration.

A debt service ratio is generally considered to be debt interest expense divided by pre-tax income. Depending on what type of statistics one prefers to look at, household income in Canada averages roughly $86,000 for a married couple, or roughly $36,000 for an “unattached individual”. In the case of an individual, a debt coverage ratio of 40% is paying approximately $14,400 a year in interest payments, or about 1,200 a month.

Right this second, the best market rate you can get on a variable rate mortgage is prime minus 0.25%. Prime currently is 2.25%. So if you have your average unattached individual buy a condominium for $300,000, they will be paying about $6,000/year in interest payments. However, if the bank rate goes up 2.85% as it will in “Scenario 1”, suddenly that $6,000 interest payment will be going to $15,300 a year. On a $36,000 pre-tax income (or about $29,300 take-home given BC 2010 tax rates), this is a huge amount of debt service, just over half. If you use a $50,000 pre-tax income, your net take-home goes to $38,900 and interest represents 39% of after-tax income.

Harvest Energy Trust takeover by KNOC approved

The takeover of Harvest Energy Trust, for $10/unit and acquisition of debt by the Korean National Oil Company (KNOC), has been approved by Harvest Energy unitholders. The vote was 90.2% in favour. They required 66.7% for approval.

One particular note of amusement is the Harvest Energy Yahoo message board that was dominated by trolls were screaming about voting against the merger. If you believed that the message board was a representative sample of the unitholders, you would have received the impression that the takeover vote would have failed 90% against, instead of in favour! Message boards for most companies are worse than useless – the information that travels through them should be regarded with the same credibility of that of supermarket tabloids.

Retail investors generally do not matter in terms of corporate governance – it is the institutional investors, primarily mutual, pension and hedge fund owners that control most of the votes in publicly held corporations. The market had priced in Harvest units as if the takeover vote was a done deal, and indeed, the market was correct on this projection.

Once the takeover is finally cleared, with an expected date of December 22, 2009, Harvest will be delisted. My guess why they do this at the end of the year, opposed to the beginning of January is because so many people have accrued losses on Harvest Units that management decided it was worth crystallizing the capital losses for the 2009 tax filing, rather than deferring capital gains for 2010.

Within 30 days of the takeover, KNOC is obligated to make an offer to the debenture holders for the cash repurchase of debt at 101% of par value; I will be tendering my debt (or selling it on the open market above 101%, whatever the case may be) simply because of uncertainty of being able to be paid out. While I have glossed over KNOC’s financials, and believe them to be a very solvent and viable corporate entity, the information I have on them is not timely, they do not report to SEC or SEDAR, and I don’t want to have to deal with a Dubai-like situation where Harvest Energy defaults on its debentures, and KNOC will not guarantee the debt.

I am quite happy to tender the debt in 2010 as this way I can defer capital gains until I file my taxes in April 2011.

TFSA account transfers

If you are considering changing where your TFSA account is, it is probably easier to liquidate around this time of year (mid December) and withdrawal all the funds from your account and deposit the cash to a new account early in January of the next year. Assuming you have $5,100 in a TFSA account on December 15, 2009, if you withdraw it before the end of the year, your TFSA contribution room on January 1, 2010 will be $10,100 ($5,100 plus $5,000) and you can open up an account wherever you want and deposit it. In fact, you can open up an account and just fund it exactly at the beginning of the year.

If you withdraw the $5,100 on January 1, 2010, you will have to wait until January 1, 2011 in order to be able to bring the $5,100 of capital into the TFSA tax shield.

The true value of the TFSA won’t be felt until years later when everybody will have contribution rooms sufficiently high that you will be able to shield considerable amounts of savings – assuming interest rates ever rise to respectable levels again (e.g. 5%), in 10 years, you will be able to shield $50,000 at 5% interest, or about $2,500 of tax-free income a year. This essentially will create a risk-free situation for most ordinary people to shield interest income from the government.

The TFSA is truly a financial instrument of lower-income Canadians, while the RRSP is the preferred vehicle for higher-class Canadians. Unlike the USA Roth IRA, the Canadian TFSA is a heck of a lot more flexible – you do not have to wait until you are 59.5 years old to withdraw funds without tax penalty.

Dubai gets bailed out… sort of

Abi Dhabi decided to bail out Dubai, by providing a $10 billion equity injection. This was presumably after the insiders bought back a ton of Dubai debt (which was trading below 50 cents on the dollar and post-announcement is around 70 cents). About $4.1 billion of the equity injection is earmarked for repayment of maturing Islamic debt, while the other $5.9 billion is going toward paying contractors and other working capital needs.

My quick guess is that the Islamic debt gets paid off first to avoid any judicial inquiry on what happens to investors in such debt – i.e. whether they will get a stake in a reorganized company. The conventional debtholders (where there is an active secondary market) are going to be at the mercy of the Dubai courts; I doubt they will be getting any favourable treatment. Maintaining the perception of confidence in the Dubai debt system is crucial for Dubai if they are to retain any foreign institutional investors, and inevitably whatever settlement coming out of the Dubai debt default will be precedent-setting.

I decided to look up what Islamic Debt was, and the Wikipedia entry on Sukuk was rather enlightening – it seems that it has characteristics of zero-coupon debt. That said, I have no idea who would ever want to invest in such financial instruments – at least when investing in Canadian or US debt instruments, you would likely have a better chance in bankruptcy court than you will in Dubai (General Motors notwithstanding!).

(Update: Apparently this is not an equity injection, it is debt.)

FairPoint – the only bankrupt company I ever had money in

FairPoint Communications was spun off of Verizon a year and a half ago. It mainly consisted of Verizon’s rural landline businesses. They carved out the company and distributed shares to Verizon shareholders. Since at the time I had money in the Telecom HOLDR, I received a distribution of one share of FairPoint.

There was no point in selling the share – it would have cost me nearly as much in commissions as the share price. My only hope was that management would be smart and do a tender offer for small lot owners (e.g. 10 shares or less) which would relieve me of the burden of receiving useless amounts of paper concerning voting for the board of directors, etc.

The company had way too much debt when it was spun out of Verizon, and a year and a half later, it has filed for Chapter 11. I look forward to my 4.5 cent piece of paper reorganizing and vanishing out of my account.

So far to date, this is the only company that I have held shares in that went bankrupt. All other companies I sold well before their Chapter 11 filings.

FairPoint is a viable operation; it just needs to reduce its debt by some 70-80% in order to be financially sustainable. Considering that most of its debt was inherited from Verizon (Verizon decided to take a $1.2 billion dividend out of it before spinning it out), one would think that they would have known that leveraging the company before giving it away would have killed the equity holders.

China will be sucking the world’s crude supply dry

The title is a one-line summary of what I will be describing in this post. Essentially with the global economic downturn slated to moderate due to the injection of fiscal stimulus, the countries that will continue to face true organic growth will have a need to consume more energy.

There is no economy on this planet growing faster than China, and not surprisingly, one can see from this article that their actual crude consumption has increased, and will continue to increase in the future. Note that Japanese consumption continues to decline, which is lock-step with their economy.

The only two questions that need to be answered is whether North American consumption will decrease and where will the supply come from?

I will borrow a slide from R-Squared (who incidentally knows much more than what he discusses on his blog, and knows much more than your typical politician on the issue of alternative fuel sources) and just say that the supply side looks to be capped in the future:

Slide04

Since world oil production has probably peaked, or is close to peaking, any supply-side shocks will have a disproportionate amount of impact in price. It is likely that an absolute floor for crude is $35 as seen in late 2008, in the middle of the economic crisis. It is also more likely in ‘regular’ times that the floor for crude prices is higher, likely around $60 per barrel.

Marginal costs for alternative energy sources are still much higher than the price for crude extraction and processing; most of the inputs for alternative energy sources (e.g. corn ethanol) rely heavily on other energy inputs (crude and natural gas).

The only thing that will make alternative energy more viable is higher crude prices. And higher is where crude will go in the medium term. As crude’s price continues to go higher, more and more supply sources start to become economically viable. There won’t be a shoot-up to $1000 a barrel (barring some sort of global conflict) but a climb in prices is inevitable given the demand-supply dynamics.

The only salvation against higher crude prices are energy breakthroughs in other fields, such as the development of sustainable fusion, or less capital expense intense solar energy, or the development of high capacity low-loss energy storage.

What ever happened to Menu Foods?

Menu Foods was a company that ran into a huge amount of trouble for distributing pet food that contained Melamine, which caused kidney problems in pets, sometimes leading to death. The first precautionary recall was in March 2007 and then it took another month for them to isolate what exactly was causing the problem. It was through a supplier, ChemNutra Inc., who used wheat gluten that was imported from Xuzhou Anying Biologic Technology Development Co. in Wangdien, China. The whole history of the case is documented on the company’s website here.

These series of events took the company’s units from seven dollars a share to about one dollar less than a year after the news broke. Financially, the company is not on solid ground – although it was somewhat profitable before this incident (making about $24 million in distributable cash in calendar 2006), its balance sheet was quite leveraged, with a net debt of about $100 million.

Fast forward a few years, it still has the debt – some $105 million. The only difference is that $75 million matures in October 2010. The company breached its covenants in 2007 (primarily due to the aforementioned recall) and as a result had to cut its distributions to zero and pay its creditors a rate of LIBOR plus 5.8%.

Lately, however, the company seems to have recovered from its near-death experience: they have settled the lawsuit, and they are now generating cash again – about $11.1 million in free cash in the first 9 months of 2009. Their units, in response, have gone up from about 80 cents at the beginning of the year to $2.50 currently; at 29.3 million units outstanding, that is approximately a market value of $73 million.

The primary hurdle for Menu Foods at this point seems to be the renegotiation of their $75 million debt. If they can achieve this, then unitholders will be sitting pretty and perhaps distributions could continue after they have continued to deleverage their balance sheet. It is interesting to note that a company that was originally on its deathbed is now positioned to survive, in no part due to investors’ risk preferences being expanded in the zero interest rate environment.

A quick look at the top 10 Nasdaq stocks

The following is a very superficial look at the top 10 capitalized companies trading on the Nasdaq (not the NYSE), their market capitalization, and the P/E based on the next fiscal year’s analyst consensus estimates. Also added in are some very quick notes on the respective companies. In order for the index to rise, the top 10 usually must rise as well. I typically do not invest in large capitalization companies because you implicitly are giving up an advantage as a small investor that most large investors do not – the ability to be nimble and build substantial positions in small companies.

Amazon – $58B – P/E 53, pricing in INSANELY high growth, both top line and margins
Amgen – $57B – P/E 11, patent expiration on Epogen coming soon
Apple – $170B – P/E 20, lock on the digital music market, perhaps not the hardware side though, probably under-valued amazingly enough.
Cisco – $139B – P/E 15, essentially a ‘commodity’ network hardware company now
Comcast – $49B – P/E 14, boring cable company
Google – $186B – P/E 22, profiting on any mouse clicks on the internet, decimated traditional media, probably has reached upper end of scale.
Intel – $112B – P/E 14, commodity CPU maker
Microsoft – $264B – P/E 14, commodity OS maker, eroding margins from open source software
Oracle – $113B – P/E 13, commodity DB maker, same thing as Microsoft (they really should merge)
Qualcomm – $75B – P/E 17, basically half the cell calls on the planet (CDMA) make a profit for this company

Canadian Interest Rate Projections

The following are the projected 3-month interest rates, determined by the 3-month Bankers’ Acceptance Futures… note that these are quoted in 100 minus the percentage rate expected, so 97 would be equal to 3%. My gut instinct would suggest that the March and June contracts are slightly undervalued, but well within a margin of error. Essentially this is a bet on whether the Bank of Canada will stick by its conditional June 2010 deadline before it will consider raising interest rates:

Month / Strike Bid Price Ask Price Settl. Price Net Change Vol.
+ 09 DE 99.560 99.565 99.565 0.000 5301
+ 10 JA 0.000 0.000 99.545 0.000 0
+ 10 FE 0.000 0.000 99.525 0.000 0
+ 10 MR 99.510 99.520 99.510 0.010 3909
+ 10 JN 99.330 99.340 99.330 0.000 13737
+ 10 SE 98.910 98.920 98.910 0.000 5674
+ 10 DE 98.450 98.490 98.470 0.050 2102
+ 11 MR 98.120 98.130 98.130 0.040 945
+ 11 JN 97.720 97.820 97.810 0.030 429
+ 11 SE 97.410 97.500 97.500 -0.010 150
+ 11 DE 97.090 97.190 97.260 -0.040 75
+ 12 MR 96.870 96.950 96.960 0.010 7
+ 12 JN 96.670 96.770 96.790 -0.020 46
+ 12 SE 96.550 96.650 96.690 -0.050 32

What makes Vancouver Real estate so expensive?

What makes Vancouver real estate so special? It is very difficult to isolate to a single variable, but geography, immigration, culture, historical performance, and interest rates are all contributing to a very high degree of real estate price inflation, much higher than conventional rational analysis would suggest. I will address these elements separately.

A rational framework for real estate pricing: A rational price would be a discounted cash flow model of rental revenues, subtracting carrying costs (property taxes, insurance, maintenance, cost of capital) and adding in an amount for the ‘ownership premium’. Just browsing through MLS, I came up with the following example:

Richmond-House

Working out the math, we have $15,600/year in rent collection, subtracting roughly $2,500 in property taxes, $800 insurance, $1,200 in maintenance, factoring in zero for cost of capital, assuming a 4% “return on investment”, and adding in a very generous 50% “ownership premium” leaves us with a “rational” valuation of $416,250. Asking price: $838,000, so our model was off by about half. The rational real estate valuation model is clearly broken and should be thrown out – it fails to adequately model what we see presently in Vancouver.

Just like the stock market, real estate in Vancouver is governed (at least for now) by a different model other than discounted cash flows. Let’s look at the variables I outlined in the first paragraph.

Geography: The Greater Vancouver area is surrounded by mountains to the north, water to the west, the United States to the south; all three directions cannot be expanded upon. The only direction available for further land development is east, which is constrained primarily to Surrey and western Langley due to the commute times to where the job centres are located. In addition, another constraint to the land supply is the Agricultural Land Reserve (ALR), which protects a substantial amount of land south of the Fraser River. I will attach a map below showing the extend of the ALR’s boundaries:

GVRD-with-ALR

We see that most of the potential new residential development within an hour’s drive of Vancouver and Burnaby can only be located in Surrey, west Langley Township and west Maple Ridge. Otherwise residential development has to concentrate on density, which has definitely been the case in Richmond, Vancouver, Burnaby and New Westminster. We also see, strictly as a function of geography, that northwest Surrey has a good chance long-term of being the economic centre of the Lower Mainland area.

Finally, there is an interesting study to be made to comparing the prices of real estate in Blaine, WA, versus that of neighbouring White Rock, BC or South Surrey; $250,000 purchases you a pretty nice home in Blaine, while that amount gets you into a 35-year old 2-bedroom apartment in White Rock. It is clear that geographical constraint is one major variable in explaining large real estate prices in the Lower Mainland area, and is the primary supply-side consideration.

Immigration: There are two categories of immigration of concern – net intraprovincial migration (mainly people moving from Ontario to British Columbia), and international migration (people moving from overseas to BC, from mainly Asia). The vast majority of people coming into BC are moving into the Greater Vancouver area, and is neatly summarized by reports from BC Statistics. The BC Stats Q2-2009 Population Report is worth reading. Of note is that the net migrants from the rest of Canada tend to be older people, presumably escaping to BC for the better winter climate. These people will likely be more asset-rich than average migrants (they can afford to move into a more expensive area), thus adding more demand to the local condominium or townhouse markets.

The formula is pretty simple – increasing population means an increased need for housing supply. Due to the subsequent demand from more people via migration, the net result is an increased price for housing.

Culture: It is drilled into the fabric of society that owning is better than renting especially with housing. The ‘ownership premium’ is an economically relevant variable – it essentially says that if the costs of renting or ownership are equivalent, a rational individual would choose to own. This, in itself, would explain a higher amount of demand and thus higher prices, especially when compared to relative costs of renting.

In addition, a significant minority of international migrants that have come into the Vancouver area over the past 20 years are Chinese, and in Chinese culture, the importance of owning your own strip of real estate is even more powerful than it is in western culture. As a result of increased net international migration and this cultural mindset, demand for ownership is increased, increasing prices.

Contrasting this is the European mindset, where property prices are generally so high that the thought of owning them (unless if you are part of society’s elite) is a foreign concept.

Fortunately in North America, everybody can be elite enough to own their own piece of real estate – and jump on the opportunity, whatever the cost may be. The urgency to do this (typically seen with the lines such as “you will be priced out forever if you don’t get into the market now”) seems to be awfully attractive to those that don’t know how to generate returns elsewhere.

Historical Performance: The Vancouver real estate market has endured quite well over the past 10 years (a non-logarithmic chart is here), and as mentioned previously, survived two stock market crashes with great resiliency. Since the mentality of Joe Public is to extrapolate the financial trajectory of asset classes out to infinity, it would give the impression that real estate is a stable investment, and will continue producing gains at historical rates (which if you randomly ask people on the street, should be anywhere between 5 to 20 percent annualized over the next 10 years). The confidence in future capital gains increases demand for real estate for two reasons – one is because it makes sense to borrow money for less and buy into an asset class that will return more, and secondly because of the sense that real estate will not depreciate.

Putting a different spin on this, if everybody “knew” that real estate prices would go down 2 percent a year, a significant amount of demand we see presently would evaporate, and we would see increased supply as people would try to unload their depreciating properties.

A significant number of people got burned in the stock market crashes in 2000-2002 and lately in 2008, with both crashes seeing the stock market indexes down from their local peaks about 45% and 55%, respectively. The same people, investing in mutual funds, will have seen similar performance, whether they have invested in active funds (taking a 2.0-2.5% reduction each year in management expenses) or passive index funds (typically taking 0.2% to 0.6% for most exchange-traded funds). Either way, people would have taken a huge haircut in 2008, similar to how most Canadians fared when they invested in Nortel shares at $100 a pop back in the tech boom.

So Joe Public, based on past performance, is unlikely to invest in stocks, simply because they are seen as a money-losing financial instrument. Risk-free money also earns nearly nothing in the present low-rate environment. Historically (over the past 10 years), the only three sectors that Joe Public has been able to obtain a significant return on investment has been one of the following:

1. Gold, or related precious metal commodities that are typically seen as a store of value when confidence in paper currency erodes; five years ago, gold was roughly US$430 and is now US$1160.
2. Long-dated government bonds. As short term rates continue to drop, long-term risk-free debt with higher coupons trade at premiums; depending on when you timed this, you would have realized roughly a 7% compounded return.
3. For the Vancouver area only (although there may be other regions of Canada that this analysis will apply to), real estate. Note that most of the US real estate market has been decimated with the sub-prime mortgage crash (caused by excessive foreclosures).

I would argue that capital allocation is a major part of real estate demand locally in Vancouver, simply by the virtue that the real estate market has not crashed.

These four variables alone contribute to a significant amount of demand in the market, which likely explains the performance of the market for the past five years. However, there is another factor that has increased demand even further, and that is interest rates.

Interest Rates: With short-term interest rates at an all-time low (the Bank of Canada’s overnight target rate is 0.25%, which is as low as it can practically get, and Prime is 2.25%), this has the effect of skewing people’s dollars from savings accounts (which earns roughly 1% in a short-term savings account) into more riskier assets. For “Joe Public”, where does most of this risk capital go toward? Real estate. In addition to other variables which tend to favour real estate, I would content that low rates cause an already expensive market to be fuelled by further incremental demand.

The simple example is that a variable rate mortgage these days will result in a 2.05% interest rate, as long as rates continue to remain dirt cheap. The result is an interest payment of about $1,400 a month on a $800,000 mortgage loan, which is comparable to rental rates (seeing the Richmond house example above).

Conclusions: If we were to use some marginal analysis, it would suggest that whenever interest rates rise, it will have a disproportionally negative effect on real estate demand, as mortgages would become quite expensive. The second analysis point is that one would have to look at net immigration into BC to see whether demand will increase or not. Finally, likely the real reason why real estate in Vancouver continues to remain high is because… prices have remained high. It is the perception of stability and high prices that keep demand high in Vancouver.

Will the real estate market see pricing decreases in the future? I don’t know. The market is quite reflexive in terms of its price as a determinant of future pricing. Any commodity market (and this does include real estate) faces periodic 40% downturns (Vancouver’s last 40% downturn was in 1981-1982), but timing this event, if it indeed does happen, requires luck – pundits have been calling for the downfall of Vancouver’s real estate valuations for the last five years. The strongest argument for a downturn is valuation, but just like in stock markets, valuation is rarely a just cause for short selling a stock – there needs to be psychological circumstances that changes the nature of the investing climate in order for prices to permanently decline. My guess is that such a psychological change would be perpetuated by… lower prices.