Fact checking on charities

In Canada, charities that are registered with the federal government enjoy certain benefits that other non-profit organizations do not. In exchange for being compliant with multiple government regulations, they have the ability of issuing tax receipts which equates to a refund of income taxes of 20.06% for the first $200 donated, and 43.7% for anything above that, using BC rates.

One of the items that a registered charity has to comply with is reporting to the Canada Revenue Agency so there is a degree of transparency where people can see where money is raised and spent within a charity. You can access this on the CRA Charities Listings site.

It is very important to know when an executive of a registered charity says that “We do not receive any government funding” that you check lines 4540 to 4560 on the return; if you see revenues there, the management is lying to the public. In addition, they are implicitly receiving government funding due to the value of the tax refund from charitable contributions. For example, if you were to donate $1,000 to a charity, your after-tax cost is actually $610.28. The federal and provincial government are essentially donating the other $389.72 in the form of an income tax refund.

Also there is the well-known issue of having a high percentage of money wasted on administration expenses. If line 5010 (Management and Administration component of total expenditures) and 5020 (Money spent to raise more money) are high compared to total expenditures in a charity, I would look at it as probable that they are not being efficiently run.

My advice would be to donate only to registered charities that you know at least one of the directors of, and your opinion of the director is positive. At least if they incompetently squander your money, you’ll be able to grill them in person and keep them accountable.

Present cost of portfolio insurance

I am noticing that the implied volatility of the S&P 100 is below 20% right now, which is the lowest it has been since when the financial crisis really picked up steam (September 2008). At the peak of the economic crisis this was around 80%.

The concept of portfolio insurance is simple – buying put options represents a form of insurance. You can play with these options and come up with some concepts that can be translated into English for less financially sophisticated people.

Let’s pretend you owned $100 of the S&P 500. If you wanted to insure your portfolio against any further downside for the rest of 2010 (i.e. you wanted to guarantee that you could sell your $100 of S&P 500 for $100 at the end of 2010), how much would it cost you? The answer is about $9.89 given closing option prices on December 24, 2009. This sort of insurance is good if you anticipate a possibility of the market declining, but you still want some “skin in the game” in the event the S&P 500 goes up between now and the end of the year.

We can repeat the same thought experiment, except asking ourselves if we wanted the right to sell your $100 of S&P500 for $90 by the end of 2010, a 10% loss. This insurance will cost you $6.14 to purchase.

The difference between these two values are $3.75.

What this practically means is you can bet the following ways (again, note I am indexing the value of the S&P 500 right now to 100 for the purposes of this post):

1. You can bet that the S&P 500 will not drop at the end of 2010. Reward for getting this right: $9.89 for $100 notional risk. Punishment for getting it wrong: $9.89 minus $1 for every $1 that the S&P goes below $100 at the end of 2010.

2. You can bet that the S&P 500 will not drop more than 10% at the end of 2010. Reward for getting this right: $6.14 for $100 notional risk. Punishment for getting it wrong: $1 for every $1 that the S&P goes below $90 at the end of 2010.

The “bets” to describe the results of predicting an S&P 500 level of 90 to 100 are a little more complicated to explain, but they can be done with portfolio insurance as well. Essentially you can feed any probability distribution into a model and have it crank out the optimal purchases/sales of options to correspond with your crystal ball forecasting.

Since I can’t forecast indexes, I’ll leave this to the gamblers. That’s what most option markets end up being. Right now, the option markets are saying that they expect volatility to be low, which keeps option prices low. This generally favours people that have strong beliefs that the markets will go rapidly in one direction or another.

Canadian government firing a warning shot on real estate

Finance Minister Jim Flaherty made a statement on December 18, 2009 regarding maximum amortization periods and down payment rates. While I don’t have a copy of the statement or speech made, the National Post has a fairly good summary.

The salient detail is that the finance ministry might change the guidelines and decrease the maximum amortization period of a mortgage (currently 35 years), and increase the minimum downpayment (currently 5%). It would be likely that 30 year mortgages with 10% down payments will be the new rule.

The federal government is probably realizing that the CMHC has guaranteed a ton of debt and in the event of a Canadian real estate meltdown that it would have to pay a very heavy bill as people begin to default on underwater mortgages – this would occur when incomes do not rise to match rising interest rates. Most of the Canadian banks would get away with the financial damage, while CMHC would be paying the bill.

CMHC does collect a one-time insurance premium, according to this schedule:

Loan-to-Value Premium on Total Loan Premium on Increase to Loan Amount for Portability and Refinance
Standard Premium Self-Employed without third Party Income Validation Standard Premium Self-Employed without third Party Income Validation
Up to and including 65% 0.50% 0.80% 0.50% 1.50%
Up to and including 75% 0.65% 1.00% 2.25% 2.60%
Up to and including 80% 1.00% 1.64% 2.75% 3.85%
Up to and including 85% 1.75% 2.90% 3.50% 5.50%
Up to and including 90% 2.00% 4.75% 4.25% 7.00%
Up to and including 95% 2.75% 6.00% 4.25%* *
90.01% to 95% —
Non-Traditional Down Payment		 2.90% N/A * N/A
Extended Amortization Surcharges
Greater than 25 years, up to and including 30 years: 0.20%
Greater than 30 years, up to and including 35 years: 0.40%

So let’s pretend you buy some Yaletown condominium for $400,000 and decide to pay 5% down and a 35-year amortization.  Your insurance premium, with a verifiable income, is 3.15%, or about $12,000 for the right to have your bank protected in the event of you defaulting on the $380,000 mortgage.

If the rules change to 10% down and 30-year amortization, the CMHC premium goes down to 2.2%, or about $7,900 on a $360,000 mortgage.  Strictly looking at the premiums, it would suggest that changing to a 10%/30-year system would reduce defaults by 30%.

The problem deals with correlation – if one mortgage defaults, it is more likely that others will in a cascading line (mainly because CMHC will have to sell the property in order to recover as much of the defaulted loan as possible, depressing the market, and likely causing other strategic defaults).  It doesn’t matter what caused the default, but my prime hypothesis is when people go and get their 2% floating rate mortgages, when the Bank of Canada starts to raise rates in the middle of 2010, people will be facing double interest payments when they haven’t properly budgeted for it.

There is also the batch of people that got low 5-year fixed rate mortgages facing renewal – right now 5-year fixed rates are still at relatively low rates (3.8%) but the party will end.

The finance ministry is just trying to make sure the party ends slowly (by people paying off their high-leverage loans over a long period of time), instead of the cops coming in and storming the house (if people can’t pay the interest on their high-leverage loans and cause a cascading default).  Jim Flaherty probably knows this is a financial time bomb that can potentially go off if the wrong circumstances hits the economy, and is taking preventative medicine to do so.

CMHC mortgage bonds currently trade like fixed income government securities.  You can see a chart of mortgage bonds outstanding on this chart.

Should you take CPP at age 60?

Canadians that have been employed and contributed to the Canada Pension Plan currently have an option whether to take their pension at age 60, or wait until later before they start drawing benefits.

The general rule is that if you worked 35 of 42 years of your working career (i.e. from age 18 to 60 minus 7 low income years) at a full level of CPP contributions (in 2009 this implied a $46,200 salary) you will receive approximately $11,210 per year at age 65 as your CPP pension.

If you decide to take CPP when you hit the age of 60, you will be penalized 0.5% per month, or a 30% total sum; this will reduce your annual take-home to $7,847 per year. The advantage is that you get to collect $7,847 a year for five years, while in the scenario of taking CPP at age 65, you would receive nothing until reaching that age.

If you wait until you reach age 61, your penalty goes from 30% to 24% and this is not a 6% increase in benefits; it is actually (0.3-0.24/0.7) or a 8.57% difference.

Most commentators on this issue do a “breakeven age” analysis of CPP. While this is mathematically correct, even if your life expectancy is expected to be longer than 76.7 years (which is the breakeven age between taking CPP at age 60 vs. 65), there are two very relevant factors to take into consideration:

1. The guaranteed income supplement (GIS). If you have no other expected income at the age of 65, you will effectively be taxed on CPP income at the rate of 50% because for every dollar of CPP you earn, you will have your GIS reduced by 50 cents.

2. If you take CPP, if you ever work again, you no longer have to pay CPP, which is a 4.95% savings on your paycheque.

3. A dollar earned at age 60 is more useful than a dollar earned at age 65 simply because of the probability of dying goes higher and because money is easier to spend while (relatively) younger. This “quality of life” factor is almost never discussed.

The only reason one would want to delay taking CPP beyond the age of 60 is because they are expecting to make enough other supplemental income where the GIS clawback no longer becomes a factor and also that they have enough bottled income stashed away (i.e. through RRSPs) that they are in no need of money at the present moment. In this case, the expected lifespan of the individual becomes the primary determinant of when to take CPP.

All of this discussion does not discuss the rule changes that will be taking place for people taking CPP in 2012 and beyond. I have analyzed this previously. The rule changes will discourage people from taking CPP early.

Harvest Energy debenture liquidation

I noticed in my accounts today that the “D” series of Harvest Energy (6.4% coupon, maturity October 31, 2012) has been sold at 1.015 on the dollar. I set the order about a month after the takeover announcement.

At this price, the debentures have a current yield of 6.31% and an implied capital gain of -0.51%.

There is a floor price of 1.01 on the dollar because of the obligation of KNOC to purchase all debentures at this price; my sense of risk suggests that I should be liquidating them on the open market higher than the 1.01 repurchase price. I don’t want to wait two and three-quarters years to collect my money since I can probably reinvest the proceeds at a rate better than 5.8%.

The “E” series of trust units is a little trickier; its coupon is 7.25%, maturity on September 30, 2013. Right now it is at 1.0175 which is implying a current yield of 7.13% and a capital gain of -0.46%. It is priced relatively lower than the D series. If you assume the same yield valuation on the E series, you get a price of 1.045 on the debentures (current yield 6.94%, capital gain -1.15%) but the debentures will never trade that high. My liquidation point for the E series is between 1.015 and 1.045 and we will see if it gets there.

Harvest “G” is the longest duration and highest coupon (7.5%, maturity May 31, 2015) and it is trading at 1.026 currently. This is an implied current yield of 7.31% and a capital gain of -0.67%.

I will be happy to receive a premium over the 1.01 floor price and be rid myself of the debentures, preferably in the new tax year. I don’t like liquidating gains at the end of a tax year, but the price offered was too attractive. Fortunately, this liquidation also included my TFSA, which is now sitting at $13,000 for the end of this year.

I am also relatively pleased I can liquidate these things for a premium on the open market, mainly because if I had to submit instructions to my broker (in this case, Questrade), I have a sinking feeling that they would screw up the tendering or otherwise cause me to lose liquidity.