Canada – Page 17

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.

Indexing Illusions

Article: This $100 Billion Fund Manager Says Canadian Stocks Are About to Bounce.

The argument is that because the TSX has underperformed the S&P 500, there will be a regression to the mean that will have the TSX align to the S&P 500 (or vice versa).

This article implies that over-weighting the TSX and under-weighting the S&P 500 would outperform an even-weighting of both indicies.

I’m not predicting the future of each index, but the relevant variable to consider is that the top two sectors of the TSX currently are roughly 35% financials (think the big banks, insurance, etc.) and 20% energy, while the top two sectors of the S&P 500 are roughly 24% IT (think about the FAANGs – Facebook, Amazon, Apple, Netflix, Google, etc.) and 15% financials.

Very roughly speaking, if you think financials and energy will do better, invest in the TSX. If you believe in the FAANGs and want a flatter distribution of sectors, invest in the S&P 500. (Intuitively, it would appear to me that if you bought the S&P 500 and shorted the high P/E components such as Facebook, Amazon, Netflix, Google, and others such as Tesla, you’d probably have a comparable value index – I’m sure some quants out there have already done this simple work years ago).

An index always consists of components that can be individually analyzed. Conventional financial literature suggests that an index somehow is better than investing in components, but the only inherent benefit of this is the risk-reduction power of diversification rather than any basis in valuation.

Implications of Canada-USA trade disruption

All of this talk about Donald Trump liking Justin Trudeau in the media was a fantasy perpetuated by the current government to try to paint a picture of how we can “get along”.

Of course, the undercurrents were anything but – not only were there significant trade disputes ongoing (softwood lumber to name one), but the rumblings of NAFTA being pulled and other Canada-US relationship issues are significantly material issues that were not being given sufficient attention.

So now the USA is firing another salvo in the attempt to negotiate a better deal – steel and aluminum tariffs. This is part of a broader negotiation strategy relating to NAFTA and will continue to hurt Canada’s (and Mexico’s) economies because of capital investment uncertainty.

Already with the election of Donald Trump it is perfectly evident that relatively fewer want to invest in Canada when the relative risk/reward ratio is being seriously skewed by corporate hostility in both federal and provincial governments in Canada, coupled with a very business-friendly climate in the USA. This pressure will likely continue with the current presidency.

The gross incompetence of our existing federal government at getting anything done (other than throwing money down a black hole) will be costing Canadians dearly in terms of continuing to decrease our standard of living.

The math on trade disputes is pretty simple.

The United States represents the vast majority of the Canadian export economy (about 75%).

Canada represents about 15% of the United States’ trade exports.

As a result, the USA can inflict much more economic pain to Canada than the other way around. As a result, when the USA decides to tighten the screws (like they are with this speculated tariff on steel and aluminum), it is one more step to negotiating a more beneficial trade deal.

What does this mean for the markets?

Likely in Canada, a lower interest rate as the economy will slow further. This would also decrease the value of the CAD/USD pair.

Canada Budget 2018: Speculation

I speculated this earlier in my 2016 annual report, but these options for the Canadian government are most certainly still in play:

1. Flow-through share deductions will be eliminated.
2. Employee stock option deduction will have a full, instead of half inclusion rate, OR the amount will be capped to some nominal amount (e.g. CAD$50k allowed or something).
3. Taxation of capital gains on principal residences is going to have some restrictions (time, or value) placed.
4. Partial inclusion of capital gains will rise (right now a Canadian taking a capital gain will include 50% of the gain as income; I speculate this will increase to 2/3rds or even 3/4).
5. I do NOT believe the non-tax exemption for private and public health plans will be scrapped. This would be a political nightmare for the government compared to the rather esoteric notions on the items, but this was floated around last year.
6. The GST will rise (probably to 7%).
7. Corporate income taxes, on large corporations, will rise.

The Canadian government is going to be more and more desperate for money – with rising debt and rising interest rates, the interest bite will expand once again (the debt is roughly $650 billion, so a 1% rise is a $6.5 billion interest hike on a $300 billion budget). It is also very unlikely the existing government will focus on cost reduction, hence, they will be looking at every corner to pick away revenues. The items above seem to be the lowest lying fruit, although they each will come with their own political costs. The botched implementation of a corporate tax reform on passive income was met with a significant amount of opposition. The politically easier route would be to simply rack up the deficits and not offend anybody, especially since there will be an election within 20 months.