Clearwater Seafoods buys 3 months of time

I wrote earlier about Clearwater Seafoods Income Fund and their solvency issues. They had two maturities due – a small one in late September, and a much larger one on December 2010.

I have been an interested spectator to see how this resolves. I am not interested in purchasing either their equity or debt.

The first announcement in this refinancing game was on September 28, 2010, when Clearwater came to an arrangement with the September debt holders.

Of the CAD$11.9M debt that was due, three of the debtholders consisting of a majority ($8.8M or 74%) of the amount agreed to extend the debt to December 15, 2010, with the penalty of raising the coupon from 6.7% to 10.5% and the accumulated interest to date.

The rest of the minority holders (26% or $3.1 million) will be paid off the interest and debt principal.

So the company managed to pay off $3.1 million of debt, and deferred $8.8 million for less than three months.

The big maturity coming up (December 31, 2010) is a $45 million issue, which trades as CLR.DB on the TSX, with the last quoted value of 88 cents on the dollar. The relatively large price suggests the market anticipates that there will be a refinancing at relatively attractive terms for the underlying company. If Clearwater manages to get around this debt hurdle, there are successive hurdles to be cleared in 2012, 2013 and 2014.

Lack of fixed income candidates

I’ve been scanning the entire list of exchange-traded debt and asset-backed securities, and the number of securities that are trading at a substantial discount to par you can count with the fingers of one hand.

On the US side, you have subsidiaries of Ambac, AIG, and SLM Corp.

On the Canadian side, you have Clearwater Seafoods, First Uranium, Holloway Lodging REIT, Lanesbourough REIT, Newport Partners, Priszm, Royal Host and Sterling Shoes.

All of these companies have significant issues, so an investment in the debt of any of these issuers involve a substantial amount of risk, including their ability to refinance. Right now is the most debt-friendly time to finance, so one wonders what would happen in the event of a slowdown in the debt issuance market.

Questrade offering bonds

I notice that Questrade is offering bonds to their clients. More interestingly, they have a comprehensive list of securities available with tentative pricing. This method of offering is a good step, although they probably will need to automate the transactions.

They claim to be offering it “commission-free”, but the commission is embedded in the bid-ask spread. For example, a Government of Canada bond maturing on December 1, 2011 (a year and a couple months away) is quoted at bid 1.28%, ask 1.26%. This is not bad when you consider that 1-year T-Bills have a yield of 1.23%.

One of the big differences between retail investing and institutional investing is that if you have $100 million lying around, you just can’t dump it all into Ally or some retail savings bank and get your 2%; with large quantities of cash, you have to pile them into government securities in order to get a risk-free return – in this case, locking away $100 million you can get about 1.23%, at least using end-of-September quotations. If you want 2% or higher, you have to go all the way out to December 2015 for Government of Canada debt (2.04% on the ask); if you are willing to settle for a province, Quebec has June 2014 issues for 2.06%.

A retail investor does have the option of putting money risk-free into retail facilities, and thus this makes investing in government bonds quite useless since typically GIC rates (of up to 5 years of maturity) will be higher than prevailing government bond rates.

Corporate debt is another story – you can find higher yields there, but will have to take the appropriate amount of risk, and/or be willing to take debt with very long terms to achieve the desired yield. Most of the interesting issues are also exchange-traded, which alleviates the hassle of dealing with somebody over the telephone.

Finally, Interactive Brokers has a system that enables automated transactions on bonds, but it strongly depends on the corporate issue whether you will have any liquidity available.

Cracking the real estate agent market

(Link to news story: MLS real estate deal ‘may force out agents’)

About thirty years ago, the stock trading business was cracked open when brokers could charge whatever commissions they wanted – the eventual result of this was automated stock trading and dirt-cheap commissions. A trade in the old days could cost $100 (and that was in 1970’s dollars), while today you can get them done for a dollar.

Essentially, the full-service broker was supposed to provide “value” in their advice to buy or sell securities, but there was an embedded conflict of interest – the broker made money by performing transactions, as opposed to giving good advice. Discount brokerages alleviate this problem by allowing individuals to make their own trading decisions.

The same trend toward discounting will happen to real estate transactions. Currently a typical commission scheme is 8% for the first $100,000 and 2% thereafter; so a transaction on a $500,000 place could be around $16,000 or 3.2% of total transaction price. Suffice to say, this is a huge liquidity penalty (not even including the property transfer tax in BC).

What value does a real estate agent provide? It is one of being a liquidity provider – trying to find somebody to purchase your property. They also provide some supplementary paperwork (mainly copied from templates), but you still have to engage in a lawyer and/or notary to get some other paperwork done to close the transaction.

It is debatable how much “marketing value” is provided by an agent, but what is clear is that real estate transactions are likely to become cheaper as service components become separated. Also, people that can actively shop their property around will likely be able to save significant amounts of money.

Reducing property transaction costs will strongly help to increase liquidity in the real estate marketplace, which would also increase the accuracy of valuation.

One of the primary reasons why I do not dabble in real estate is simply due to the lack of liquidity and the transaction costs. I’d much rather prefer to invest in companies that specialize in real estate since they are likely to have better skills in property management than I ever would.

Real Estate asset bubbles

David Merkel writes the following about financial asset bubbles:

If they want to get a little more complex, I would tell them this: when a boom begins, typically the assets in question are fairly valued, and are reasonably financed. There is also positive cash flow from buying the asset and financing it ordinarily. But as the boom progresses, it becomes harder to get positive cash flow from buying the asset and financing it, because the asset price has risen. At this point, a compromise is made. The buyer of the asset will use more debt and less equity, and/or, he will shorten the terms of the lending, buying a long-term asset, but financing it short-term.

Near the end of the boom, there is no positive short-term cash flow to be found, and the continuing rise in asset prices has momentum. Some economic players become willing to buy the asset in question at prices so high that they suffer negative cash flow. They must feed the asset in order to hold it.

It is at that point that bubbles typically pop, because the resources necessary to finance the bubble exceed the cash flows that the assets can generate. And so I would say to the new office studying systemic risk that they should look for situations where people are relying on capital gains in order to make money. Anytime an arbitrage goes negative, it is a red flag.

I couldn’t help but read this and think to myself: This can apply to Vancouver real estate.

When the boom begins, the assets are fairly valued – you could say the same thing about the Vancouver Real Estate market around year 2000 – your average detached home was around $375,000; townhouse $250,000; condo $190,000. Some properties you could purchase and rent out and still have a cash flow positive proposition.

And then… “Near the end of the boom, there is no positive short-term cash flow to be found, and the continuing rise in asset prices has momentum. Some economic players become willing to buy the asset in question at prices so high that they suffer negative cash flow. They must feed the asset in order to hold it.

This is exactly what is happening to real estate in Vancouver today – people buying properties are purchasing them not for cash generation purposes, but for an implicit increase in asset value, hoping to dump it off to the next sucker for a higher price. The carrying costs of property are higher than the cash flows you can derive from them.

It is just a matter of time before asset prices adjust to a value defined by financial return. Timing when this may occur is very difficult. For myself, I have under-estimated the resiliency of the marketplace – there were many times that I thought things had “peaked”. Fortunately I am not a short seller, but I do strongly believe that those that are leveraged up on Vancouver residential real estate should strongly look at their holdings and ask themselves whether they could financially handle a 20-25% decline in valuation over a two year period. Even after such a correction, property values would still be at the higher end of a rational price range.

A lot of people use real estate as a “store of value” – i.e. owning the title to land is a better proposition than holding cash, which could potentially depreciate through inflation. While you can claim diversification, I do not believe it is hedging risk of depreciation of the asset value. Contrast this with an investment in a large natural resource company that has plenty of reserves, or a low-cost leader in consumer staples, and you will likely find better stores of value there than the existing Vancouver real estate market.