Garth Turner on Variable/Fixed mortgages – bad advice

On Garth Turner’s “Bingo” post on March 29, 2010, he states:

But the big question I was asked today: what should you do about your mortgage?

The bankers will be on the phone to you soon ‘suggesting’ you lock in, ‘for your own protection.’ Have none of it, if you are in a cheap VRM. We know why the lenders are saying that, since they count on scores of people now rushing in to voluntarily increase their payments. Once again, they play the emotional card, consistently suggesting actions counter to the best interests of Canadians.

A prime-minus VRM is a gift. Keep it. The Bank of Canada rate would have to soar by more than 200 basis points (2%) by Christmas for you even to consider locking in. And even then you would be saving money staying variable. In fact, the typical prime minus one half borrower would be better off staying put until the prime mushroomed almost 4% above current levels. You’d still be paying less a month.

And a prime rate of 6.25% is not going to happen for two, three or perhaps four years. Any sooner and you could mop up the economy with a Swiffer.

Right now, a 5-year variable rate mortgage is prime minus 0.5%, and if you shop around, the 5-year fixed rate is 3.79%.

Prime is currently 2.25%, and should rise to 3.50% by the end of the year. Markets currently suggest the prime rate will be 4.75-5.00% at the end of 2011.

Thus, a variable rate mortgage, locked at prime minus 0.5%, should have a higher rate than a fixed rate mortgage sometime in the second half of 2011.

If prime stayed at 4.25% for the rest of the 5-year term, then a variable rate mortgage is still a cheaper option. However, the differential between the two is close enough that for most everyday people, I would still suggest a 5-year fixed rate if you can get 3.79% for it. It is highly likely over the 5-year period you will outperform the variable option, especially if the yield curve starts to invert (which will happen if the economic recovery runs out of steam).

The crystal ball becomes considerably more fuzzy if you use a 4.39% 5-year fixed rate (which is currently what is ING Direct’s posted rate). If rate increases in 2012-2014 moderate, then taking the variable rate option will be a winner. However, this is exceedingly difficult to predict.

Either way, the lack of ultra-cheap credit will have the effect of slowing down demand in the housing market. Whether that will translate into lower prices remains to be seen. Personally, I have long since thought the housing market was irrational beyond belief, but have come to accept it could be that way for longer than my lifespan.

Ultimately, the only time that housing will become “cheap” in Vancouver is likely when people don’t want to buy houses when mortgages are so expensive that GICs start to become an attractive investment option. Just imagine living back in 1982 when you had a choice of buying some Vancouver special for $150,000 on an 18% 5-year fixed-rate mortgage or renting and putting your would-be down payment in a GIC earning 15% and not having to worry about making those $27k/year interest payments… in situations like that, the cost of capital becomes so high that renting becomes a much more viable alternative.

If we ever see those days again, where buying a house is very difficult because you have such more financially attractive (and accessible) options elsewhere, I would suspect valuations are ripe for buying. We are a long way away from this, even if mortgage credit is given out at 5%.

Athabasca Oil Sands IPO valuation – summary

I am reading plenty of news how Athabasca Oil Sands is planning a very large public offering. According to their final prospectus, they will raise $1.35 billion @ $18/share of gross proceeds and about $1.26 billion net.

Since this got on the media’s radar, it should be a foregone conclusion that the option to purchase more of the offering will be exercised, so the final offering should be around $1.55 billion gross, and $1.45 billion net. The following analysis assumes the latter will be the case.

Note this is just a summary analysis. It only scratches the surface, but it covers what I figure are the salient details.

After the offering, they will have about 400 million shares outstanding, and assuming an $18 purchase price, this is a market capitalization of about $7.2 billion.

What exactly would an IPO subscriber be purchasing? This is why looking at the prospectus (all 288 pages in its full glory) is a valuable exercise. The company is a development stage company that has interests in a few tar sands near the Fort McMurray area of Alberta. They are currently not performing, but they are expected to come online in a few years, per the following schedule (page 8):

It would be reasonable for an investor to think this company will be producing net losses until around 2014-2015 when their oil sands projects come online.

After the offering, the company will have about $2 billion in the bank and about $400 million in long term debt. Thus, it will mostly be capitalized with equity and should have sufficient room to finish most of what they need to by 2014 – they will have to raise a little more money between now and then.

Page 78-84 of the prospectus contains some significant assumptions and analysis of the company’s estimated reserves. The first chart is based on a discounted net present value given the best estimates:

What this says is that if you have a 10% cost of capital and bought this company’s resources at the various sites for $11.2 billion, it would be a neutral decision. Of course, assumptions such as whether the company will be able to realize the “best estimate” or something better or worse is something for an investor to determine. Also, the following assumptions on future oil prices are made:

Roughly, it is assumed that (the media-quoted oil price source – there are different prices for different classes of oil) oil in 2010 will be US$80 in 2010; that the CDN/USD exchange will be 0.95, and that oil will increase $3/barrel until 2014, and then up 2% from there.

If projected oil prices are lower than this, you “lose” as an investor. If projected oil prices are higher, you “win”.

My quick take is that there are other companies out there using steam-assisted gravity drainage technologies to extract oil from tarsands. It takes a little (and I literally mean this; a little) research to figure out who those players are (beyond Suncor) and looking at their economic profiles. I can safely say that if I were offered shares of Athabasca Oil Sands at the IPO price, I would pass from a valuation perspective. From a market perspective, however, it would be worth considering strictly to sell it off at a post-IPO price. It kind of reminds me of the internet stocks in the late 90’s.

Once this company does go public it would not surprise me that they would get a valuation bump, and other similar companies that already are trading should receive bumps as a result. I have seen this already occur, probably in anticipation of the IPO.

If you had to invest into Athabasca Oil Sands and not anywhere else, I would find it extremely likely there will be a better opportunity to pick up shares post-IPO between now and 2014.

Posted bank mortgage rates irrelevant

I noticed there was a headline yesterday that a few of Canada’s major banks were raising posted rates on 5-year fixed rate mortgages from 5.25% to 5.85%.

This is completely irrelevant news. The reason is because posted rates are about as valid as the MSRP sticker price you see when you try and buy a new car – they will certainly sell it to you for that price and be very happy to make a bloated margin, but with some simple negotiation you can bat down the price to a more acceptable level.

I do not know why banks even bother with “posted” rates anymore – there must be a reason why they don’t post their most competitive rates. I am guessing it is because they don’t want to appear to be in direct price competition with each other.

Going to a mortgage broker or even looking at ING Direct’s site gives you a better reflection of what market reality is – it has not budged from 3.69% and 3.89% for a 5-year fixed term, respectively.

In reality, what happens is that the market establishes mortgage rates on a fixed spread over the 5-year government note rate:

The 5-year rate has hovered around 2.4% to 2.9% over the past 10 months; the 5-year fixed rate mortgage (at ING Direct) has hovered between 3.79% and 4.49% in the same timeframe.

Analysis of RESPs

The Registered Education Savings Plan (RESP) is a tax sheltered vehicle that is designated for parents to save up for the education of somebody – usually this is the children of the people contributing to the RESP, but in theory you can define anybody as a beneficiary of the plan. Eventually when such people take higher education, you can designate proceeds to the beneficiary in question, and the beneficiary will take the income contributions as taxable income. Presumably because they are young and have less income, they will pay little to no tax on the proceeds.

For the rest of this post, I will define the beneficiary as just “children”.

Benefits and disadvantages

The benefits can be summed up in three points:
1. Transferring income while avoiding attribution;
2. Income tax deferral;
3. Canada Education Savings Grants.

The disadvantages can be summed up as follows:
1. Risk that your children will not seek higher education.
2. Requires financial skill to self-manage.
3. Fees.

The competing choice is funding money outside the confines of an RESP and giving it to the children when they go to school, or to give some portion of money to children and having them invest it in their own names.

Analysis

To put the conclusion first, my general analysis suggests that RESPs are only useful if you intend to fund part or all of your childrens’ educations and you are very convinced they will be going to an eligible higher education institution. In other words, I would not contribute to an RESP until they are, at the latest, 15 years of age when you can detect whether they have enough ‘scholarly’ potential to warrant it and you have sufficient after-tax funds that won’t put a hole into your own personal finances.

If you discover your child does not want to attend upper education, you can move the RESP proceeds into an RRSP, but there are non-trivial conditions attached with this transferability. Otherwise accumulated income taken out the RESP is taxed at your marginal rate plus 20%.

From a financial perspective, the RESP enables you to avoid attribution by indirectly “giving income” to your children, and also shelters growth of funds from taxes (which will eventually be taken as taxable income by the children). Contributions are not tax deductible and principal withdrawals are not taxed. The excess of principal payments is taxed.

The Government of Canada will chip in some money via the Canada Education Savings Grant, which will contribute 20% of the first $5,000/year contributed, to a lifetime maximum of $36,000 contributed. So in theory if you contributed $4,500/year ($36,000 total) for the first 8 years of your child’s life, the CESG would result in an extra $7,200 in the account. If your family income is less than $77,769/year, the CESG grant will be 30% of the contribution amount. If your family income is less than $38,832/year, the CESG grant will be 40% of the contribution amount.

The CESG is a material benefit when investing in an RESP, functionally acting as an instant 20% return on investment. Using the “contribute until the last moment” strategy, the CRA helpfully points out the criteria that must exist in order the RESP to receive the CESG:

However, since the CESG has been designed to encourage long term savings for post-secondary education, there are specific contributions requirements for beneficiaries who attain 16 or 17 years of age. RESPs for beneficiaries 16 and 17 years of age can only receive CESG if at least one of the following two conditions is met:

* a minimum of $2,000 of contributions has been made to, and not withdrawn from, RESPs in respect of the beneficiary before the year in which the beneficiary attains 16 years of age; or
* a minimum of $100 of annual contributions has been made to, and not withdrawn from, RESPs in respect of the beneficiary in at least any four years before the year in which the beneficiary attains 16 years of age.

This means that you must start to save in RESPs for your child before the end of the calendar year in which the beneficiary attains 15 years of age in order to be eligible for the CESG. The CESG and accumulated earnings will be part of the educational assistance payment paid out of the RESP to the beneficiary.

Assuming your child enters into upper education when they turn 17, the safest strategy appears to be determining how much money you intent on contributing and dividing them into $5,000 amounts. If you have $5,000 to contribute, then put that into the RESP the year your child turns 15, and put it in a 2-year GIC which matures when they are ready to enter higher education. If you have $10,000 to contribute, put $5,000 into the RESP when they turn 15 (into a 2-year GIC), and another $5,000 the following year into a 1-year GIC. This way, you will realize a 20% gain plus whatever the return on the GIC is.

This strategy requires no financial sophistication other than the effort to find a fee-free RESP provider that gives good fixed income rates and taking out the appropriate GIC with the specified maturity date.

The RESP gives the contributor full liquidity capability – they can withdraw principal at any time, but they would have to refund the CESG in the process. Still, the availability of liquidity is a crucial factor in an investment decision, and having the ability to get back your principal (e.g. let’s say you lost your job when your child was 6 years old and the RESP is hardly going to be a high priority at this time compared to an education that may or may not happen in 11+ years) is very important.

I cannot find good justification for employing other investment strategies concerning RESPs – for example, if immediately after the birth of a child the parents open up an RESP for the child. In this scenario, the primary risk is that the parents will need the money at a future date and a more pressing reason than the far-off goal of purchasing educational credits for children. The other risk, of course, is not knowing whether the newborn will be attending such an institution. Also, because of the long timeline, such investments are likely to be more risky in nature, requiring a level of financial sophistication to invest in the proper stocks and bonds. Finally, the benefit of avoiding income attribution could be entirely avoided by transferring the funds to the child’s name and investing the proceeds in securities that will yield capital gains (as capital gains will be attributed to the child, while income will be attributed to the parent).

Thus, the “get the CESG as late as possible” strategy is likely the only real viable strategy for the RESP.

A final note on scholarship trusts

It is my opinion that most education scholarship trusts are terrible, terrible, terrible investment vehicles compared to the strategy presented above. In addition to paying fees that are ridiculously expensive, you are surrendering liquidity, and also surrendering the flexibility to get your money whenever you want if your child goes to school. For example, if your child decides to enroll into a two-year trades program, you will receive significantly less money than if he/she enrolled in a four year program. In particular, I will single out the largest of the scholarship trust companies, Canadian Scholarship Trust, as being financially counter-productive to any parents’ wish to actually pay for their children’s educations via an RESP. It is my opinion that companies like those are what give other educational scholarship companies an incredibly bad name.

It is true if you jump the hoops just perfectly (i.e. making your monthly payments from an early date, never missing payments and having your child continue with a 4-year education) that enrolling in such a plan would be a net plus, but the risk taken is phenomenally higher than the simple strategy presented above. The performance of the Canadian Scholarship Trust has also not been that much higher than a GIC – the 5-year performance from October 2003 to 2008 has been 4.5%. You can read this and the rest of the gory details on their prospectus document – a document that I suspect most of their subscribers don’t read, mainly because if they did so they would quickly realize what a bad deal they are receiving.