Canada – Page 17

Canadian Dollar, Genworth MI and Residential REITs

This will be a rambling post in no particular order.

1. The Canadian dollar has tumbled with Donald Trump beating the war drums on the trade portfolio:

This will keep going lower and lower until the Government of Canada realizes that a lower currency doesn’t mean you’re more competitive when you’ve basically killed your own industry. Normally there is correlation between oil prices and the Canadian dollar but this linkage has now been considerably more muted because of WTIC to Alberta oil differentials. Investment has been flowing away from Alberta/SK oil and everything is on maintenance mode.

This will clear the way, however, for the Bank of Canada to raise interest rates another quarter point.

Domestically, this is going to be a disaster for general Canadian standards of living. It seems to be that our largest urban export is continuing to be real estate.

2. Speaking of real estate, bearish market participants in Genworth MI are going to face a short squeeze:

I’m not sure why anybody would want to use Genworth MI as a proxy for Canadian housing when there are so many more other investment vehicles to express this sentiment, ones that are trading well above book value and are making nowhere close to as much money as Genworth MI is on their insurance portfolio.

I’ll send a “hat tip” to Tyler, who writes infrequently at Canadian Value Stocks, for the brief mention of my continuing analysis of Genworth MI. The best analogy I can give is “picking up hundred dollar bills in front of a steamroller” instead of the usual cliche of “picking up nickels”. Genworth MI is claimed to be poised to have a giant collapse, but the variables required to make that happen seem distant at this point in time. Hint: Pay attention to China.

3. Speaking of real estate, the most hyped investment seems to be mortgage REITs and also residential REITs. The cap rates received by purchasers are incredibly low. Example press release linked here, key quotation in the first paragraph:

Northview Apartment Real Estate Investment Trust (“Northview”) (TSX:NVU.UN) today announced that it has agreed to acquire a 623 unit portfolio of six apartment properties (the “Acquisition Properties” or the “Acquisition”) from affiliates of Starlight Group Property Holdings Inc. (“Starlight”). The aggregate purchase price of the Acquisition Properties is $151.8 million (excluding closing costs), representing a weighted average capitalization rate of 4.5%.

A 4.5% cap rate? Do I even need to open a spreadsheet to know that the purchasing side of the transaction is wholly reliant on capital appreciation of the underlying properties for this to make financial sense?

The big favourite in this market is Canadian Apartment Properties (TSX: CAR.UN) and they probably can’t even believe how much their equity has traded up over the past year. They did a secondary at $35.15/unit and probably feel like idiots since just three months later they’re trading at $43/unit.

We drill down into their financials and see that from the last quarter, extended to 12 months, their normalized funds flow through operations (recall that accounting rules will add gross amounts of volatility in REITs due to mark-to-market rules when properties are re-appraised and this difference will be added or subtracted from income, making standard income statement comparisons incomprehensible without going through mental gymnastics) results in a net yield of about 4.3%.

An investment in CAR, therefore will expect to receive 4.3% plus the variable components of changes of rental amounts, property values, financing and operating expenses, and vacancy rates. Will these variable components be enough to give a rational equity investor a higher rate of return as surely nobody would want to take equity risk for a measly 4.3% gain?

The Canada-USA trade war is not going to end well

The US administration is using a tariff on steel and aluminum imported from Canada, Mexico and the EU. They had threatened to do that before in March, but exempted Canada and Mexico during that round (notably Prime Minister Justin Trudeau took “credit” for this). Now the tariffs are in place, effective yesterday.

Presumably this is part of a negotiation concerning NAFTA which hasn’t gotten the results the US administration wants.

Canada’s response is here, which they claim to consist of CAD$16.6 billion that the USA will levy against Canadians.

Included is not only steel and aluminum, but other household products. This includes yogurt, roasted coffee (although not decaffeinated!), strawberry jam, non-frozen orange juice… in other words, my breakfast is going to get 10% more expensive!

Here’s the big problem with the “tit-for-tat” strategy that Canada is employing: The USA has a lot more money than Canada does. If the USA decides to raise the stakes and put on another $50 billion in tariffs, what US imports are Canada going to go after next?

It’s pretty clear where this end-game is going to go – the purchasing power of the Canadian dollar will drop.

My other comment is that Ontario is the most sensitive province to steel and aluminum import tariffs. They are also undergoing a provincial election at the moment which has a strong possibility of a minority government (which means paralysis). Finally, Ontario is 40% of Canada’s GDP, so the US tariffs hit the correct part if the USA wanted to make some political impact. They clearly know what they’re doing.

Short-term Canadian Interest Rates

The Bank of Canada’s next interest rate decision will be on May 30th.

Pundits are saying the bank will stand pat, citing various economic statistics, trade uncertainty with NAFTA, lunar cycles, etc.

There is one other statistic that matters much more than others, and it is the following chart (10-year government bond yield):

As long as the spread between short-term rates and the 10-year yield remains greater than a percentage point, this gives them clearance to raise rates, especially when lock-step with the Federal Reserve.

My prediction, if it wasn’t obvious by the tone of the previous writing is, that barring some major change or news over the next week, the Bank of Canada will raise the short-term target rate to 1.5% (up 0.25%) on May 30th of this year.

Right now the 3-month Bankers’ Acceptance is at 1.69% which translates into 98.31 on the futures contract. Currently the June 2018 BAX Futures are trading at 1.81% (98.19), which also factors in some interest rate probability concerning the July 11, 2018 decision.

(Update, May 29, 2018: Given that 2, 5 and 10 year rates have dropped significantly in the past week, I’m withdrawing my prediction. Next cycle will depend on the rate spread between short-term and 10-year yields.)

The case to short Genworth MI

I very much like reading the short sale cases of anything I hold. It forces you to check your own analysis and compare conclusions. I remember dissecting a post back in October 2016 that was posted on Seeking Alpha (David Desjardins said he bought January 2018 put options at a strike price of 18 – if held to maturity they would have expired out of the money).

The newest case I’ve read is from Tim Bergin, who wrote extensively about it on his website and even won the runner-up status in an investment idea contest (something to be fairly proud about considering the quality of presentations that go into these sorts of things – there is a large amount of raw financial brainpower that want to be noticed by hedge fund managers).

I agree with some of Tim Bergin’s analysis of Genworth MI (TSX: MIC), but there are some missing elements of the analysis. This post may appear to be a bit critical and if Tim – you’re reading this – please note I appreciate your work much more than what this post is letting on!

Items I agree with

* I generally agree that the maximum upside (as a short-seller this would be downside), in the short-term time horizon, is about 20-30%.

* I also agree that if the facts in his thesis materialize (specifically: 5-15% mortgage default rates, 20-40% housing price declines) that the price of Genworth MI will drop 60-100%. I believe that his projections are actually conservative if this occurs (i.e. the numbers he presented will be worse).

* B-20 will impact housing prices. What this will typically result in, however, is that would-be buyers would shop for lower valued properties that can fit the financing parameters.

* The correlated risks in the investment portfolio (e.g. debt/preferred share investments in financials that would presumably be linked to real estate credit markets).

* Using LTV and amortization is not a sound way of pricing an insurance product, but this is due to consumer simplicity and also just matching whatever CMHC charges – in any event, if the market was actually competitive, based on loss ratios, mortgage insurance premiums would be much lower.

Items I disagree with

* The analysis seems heavy on severity and not frequency. The trigger point for frequency is not debt ratios, but rather employment (something not discussed in the presentation).

* The most fatal flaw in the presentation: The “soft-landing” scenario (slide 26). Reading the slides, I don’t get the impression the author is differentiating between revenue recognition and premiums written. Cash intake (premiums written) in FY2017 was $663 million. Even if the company only recognized revenues on a 10-year basis (this modelling is also flawed), in a “soft landing” scenario, the revenue recognition would normalize to the rate that premiums were being written. There is no explanation for why premiums written would drop by 60%.

* The conversion to “actual loan-to-value (LTV)” (slide 19) is a very creative way to bloat the ratio and implies the liability book is larger than it may seem, but ultimately it doesn’t mean anything – the fact that it takes money to dispose of delinquent properties is known and banks also incur the same risks, or in any industry where there is collateral backing loans.

* The 10-year revenue recognition suggestion doesn’t make sense. Looking at FY2017 year end, the average transactional mortgage insurance LTV is 62% – each and every year after the mortgage loan is amortized even further, reducing risk. So even in the event that housing prices drop 25% universally, the LTV still is 83% – defaults that occur will not be severe, unless if the defaults are part of a (my terminology) “cascade selling” where selling of defaulted properties causes further price drops. What would the accounting basis be for delaying recognition of revenues that has an incredibly high probability of never incurring further cost? It’s pretty self-evident that the further the LTV drops (whether it is due to appreciation of property or amortization of debt) the less risky the insurance written is. Of course in a declining housing price environment, LTVs may go above 90% and then it becomes reliant on the mortgage holder to continue paying down the mortgage and amortizing debt instead of having the safety valve of just selling the property (which would explain how Home Capital Group and others got away with sloppy underwriting).

* In relation to US mortgages (strategic defaults), recourse in Canada is quite powerful.

* That MIC’s insurance portfolio is weaker because of the reduced (90%) government backstopping. Performance data between CMHC and MIC (loss ratios) would suggest otherwise. I agree I don’t know why this is the case, but it would suggest that MIC does have better screening techniques.

Items that should be in the analysis but isn’t mentioned

* That as long as CMHC profits from mortgage insurance that Genworth MI will as well and any “crash” scenario will also greatly affect the government (with even more political consequences than financial ones), thus the federal government has a high incentive to preventing a crash scenario from occurring.

* If mortgage insurance was such a crappy deal for MIC (and by extension CMHC), would they not have a justification to raise insurance rates even further, just like how they did when the OSFI raised mortgage insurance capital requirements?

* MIC’s data from the 2008-2009 economic crisis seemed to suggest that even in a sour economy that they can still make money.

* Genworth Financial’s 57% ownership in MIC is a big question mark considering the China Oceanwide merger process (that has been going on for over a year).

* What if MIC just said the following tomorrow: “We’ve stopped writing mortgage insurance. We will be letting our existing insurance book run to expiry and distribute the remaining free equity to shareholders.” – what is the terminal value of MIC in this case?

Closing Thoughts

I’ll be happy to let Tim Bergin borrow my shares of MIC if he wishes to short it. The market currently asks 2.4% for a borrow, plus 4.7% carrying costs for quarterly dividends.

What if Alberta shut down the Trans-Mountain Pipeline?

There are media rumblings that Alberta will be shutting off the flow of oil to British Columbia on the Trans-Mountain Pipeline (TSX: KML) with the enactment of Bill 12. Right now the Bill is sitting on the notice paper of the Alberta legislature so we do not know precisely what the content of the Bill says.

Enactment of Bill 12 (or at least one that would cut off the pipeline) would not happen for a variety of reasons – one is that Kinder Morgan is contractually bound to deliver oil, and an act of the legislature stopping this would mean that Kinder Morgan could make a civil claim for damages. At the very least the Government of Alberta would be civilly liable for such an action. It would also likely be deemed to be against the Canadian Charter.

But let’s run a thought experiment and pretend that for whatever reason it actually happened. The media report states that one of the consequences would be that the price of gasoline would rise above $2/litre.

I would claim that gas prices would go much higher than this – my paper napkin estimate would be a free market price closer to $5 per litre after a month of pipeline shutdown. It is at this price range that there would be a material amount of price elasticity in terms of decreasing gasoline consumption. In addition, it is quite likely that YVR airport would have to significantly curtail a material amount of flight activity as there would be an insufficient supply of aviation fuel. I would view it as probable that a prolonged period that Trans-Mountain was inactive would cause a severe logistical constraint on the cost of transportation and the subsequent cost structure would result in significantly increased costs for transportation services (e.g. bus and cargo logistics).

The rationale for this: The Vancouver, BC area used to have 4 oil refineries but three of them have shut down in the mid 90’s. The sole remaining refinery is the Chevron Burnaby refinery (now owned by Parkland Fuel (TSX: PKI) but will refer to them as Chevron for the remainder of this post), which processes about 55,000 barrels of oil a day. A barrel of crude oil (roughly 159 litres) can be refined into ordinary unleaded gasoline, diesel, kerosene (aviation fuel), paraffins, etc. Very roughly for dilbit (and this depends on what comes in), you can get around 40% to gasoline, 30% goes to diesel/jet fuel, 10% liquid gas, 10% fuel oils, and 10% other.

The Chevon refinery receives most of its crude oil (feedstock) via three routes: tanker (barge), rail, pipeline. By curtailing the pipeline, there would have to be increased traffic on other transportation modes. Chevon has a 3 day supply of feedstock.

Metro Vancouver (Greater Vancouver Regional District – extending from Bowen Island, Lion’s Bay and West Vancouver eastwards to Maple Ridge and Langley) pays 17 cents per litre of gas taxes to Translink on regular gasoline and clear diesel. Translink is on track to earn about $380 million this year from gasoline taxes, which works out to roughly 38,000 barrels of gasoline a day for the region. This does not include gasoline sold in Abbotsford and Chilliwack, which is fed from Metro Vancouver and would contribute another 10% of gasoline consumption (assuming a proportionate consumption to population).

This also does not assume that any “border leakage” of taxation occurs. It is second nature to a lot of people that live close to the border to go down to Blaine, WA or Bellingham, WA to save on gasoline – prices are CAD$0.35-$0.50/litre cheaper. We will assume that this does not occur in a material manner (one estimate is 1-2% of consumption).

Putting aside this assumption, this means roughly 42,000 barrels/day of Chevon capacity is used for gasoline consumption, which would infer that the refining capacity at Chevon is just about at its maximum limit. There is another Chevron terminal which deals strictly with refined product (65% motor fuel and 35% diesel) that imports another 8 million barrels/year of product (22,000 barrels/day). It is not entirely clear to me how much of this is “external” and how much of this is from the Chevron refinery.

We have not included the consumption effects of the YVR airport. The airport consumes approximately 5 million litres of jet fuel each day, which is another 31,000 barrels per day. Its primary source for this fuel is from a Kinder Morgan Pipeline (despite all the attention that Trans-Mountain gets, this Kinder Morgan pipeline extends underneath most of the residential area of Vancouver within incident) – but due to insufficient capacity on this pipeline, YVR has to import approximately 20% of its refined jet fuel product from Cherry Point, WA.

The residual jet fuel from Cherry Point to YVR is carried by tanker truck, approximately 30 each day. This is the most expensive and inefficient form of transportation (in relation to pipeline, tankers and rail).

In Washington State, there are two major crude refining facilities which receive their crude oil feedstock via tankers from Alaska (another irony of Canada’s “tanker-free” Pacific policy) – the closest refineries are at Cherry Point and Ferndale. Cherry Point has a refining capacity of 225,000 barrels/day and the Ferndale refinery is about 100,000 barrels/day.

If the BC Chevon refinery was starved from its crude oil feedstock from pipeline, there would be an immediate shortfall of refined fuel product at current levels of consumption. Needless to say, it would not matter at this point how many tanker trucks you tried to bring over the border or how much you tried to feed the Chevron terminal, it would not come close to the amount of domestic consumption – there would not be enough tanker trucks available, and Cherry Point would not be able to economically supply that amount of refined product on short notice as has other customer commitments in-state.

There is a pipeline that connects Cherry Point to Sumas, but the logistics of converting this into a refined product pipeline is not clear to me. Either way, this would not be easy to pull in on short demand.

At this point there would likely be severe rationing of fuel stocks and I would suspect that in a short period of time (within about a week of being starved from crude from Trans-Mountain) pricing would go much, much higher than the $2/litre estimated by the media report. In addition, YVR airport operations would likely be impacted. Needless to say, the economic disruption would be massive and at this point it should be completely self-evident how important the pipeline and the domestic refinery is for the Metro Vancouver economy.

OPINION: The Metro Vancouver public consciousness of the importance of the crude oil pipeline would likely be extremely amplified by a shutdown of the Trans-Mountain Pipeline. It is probably one reason why the NDP government in Alberta is considering this action, even though they would know it would come with huge future consequences in the form of an adverse court verdict – one that they are happy to deal with after their next election.