Saturday, 22 December 2007

TSX-listed income trusts with credit rating of A and A+, as of October 2007

In my previous post, I published the list of TSX-listed companies with recent A and A+ credit ratings. In this post, I am presenting a list of Canadian income trusts, which have the highest credit ratings given by the top international credit-rating agencies. The spreadsheet with these income trusts is posted here.

Of course, just the fact of being on this list does NOT guarantee that an income trust will have bright performance in the future or that its unit price will soar to new highs any time soon. Of course not. However, being a part of this list means that a trust's financials satisfy a set of pretty tough financial-performance criteria, in particular those that relate to liquidity and leverage issues. Therefore, the list of these top-rated income trusts can be a good starting point to proceed with further screening and selection of possible candidates for a long-term investment portolio.

Please note that the list was compiled at the end of October 2007, so some things might have changed during the last 1.5 months. Also, a word of general caution should be given with respect to the published credit ratings - the credit agencies can screw up big time in the their assessment of credit risks and risk exposure, as the recent financial crisis demonstrates very well.

Attachment (Google spreadsheet): A rated Canadian income trusts.

Friday, 21 December 2007

TSX-listed companies with A and A+ credit ratings

As I was going through my my records, I thought it would be helpful if I posted one of my lists (its short version). It includes all TSX listed companies (almost all of them are Canadian), which had A or A+ credit rating as of the end of October 2007.

For value investors it is important to pick up companies with good financials. A top-quality credit rating assigned to a company by Moody's or Standard & Poor's credit agency is an indocator of such quality. Although the recent crisis in the finanical-services sector revealed that these ratings are not that reliable, they are still useful when pre-screening for high-quality companies with good long-term prospects.

When browsing through the list, note that it is 1.5 months old now, so some changes surely occurred during this period. A few of the companies on the list were acquired, and a few of them received credit-rating downgrades due to the issues related to the continuing financial turmoil and asset-backed financial instruments.

Anyway, here is the list of TSX-listed companies with A and A+ credit rating, as of October 2007.

In a future post, I will publish a list of A-rated Canadian income trusts.

Wednesday, 19 December 2007

Business tax reductions by the Ontario government

In its 2007 Economic Outlook and Fiscal Review released on December 13, 2007, the government of Ontario proposed $1.1 billion in corporate tax reductions over the next three years. The reductions are intended to support manufacturers and other sectors and include the following measures:
  1. Elimination of the Capital Tax on January 1, 2008, for corporations primarily engaged in manufacturing and resource activities;
  2. A 21% Capital Tax rate cut for all businesses retroactive to January 1, 2007, on the way to its elimination in 2010; and
  3. Increase in the small business deduction threshold from $400,000 to $500,000, retroactive to January 1, 2007.
Looks like some positive news in here for the Ontario economy, which lately suffers from the strong loonie and lower U.S. demand for Ontario products. Although the selective-incentive approach is still used here, I think that these measures are much better than largely populist and spending-oriented PST reductions and sector-oriented subsidies. How about also doing something on the individual consumer/saver side and cutting the provincial PIT rate by a percentage point or more, at least for the lowest tax bracket? That would be nice.

Customer review: Questrade discount brokerage

It took me at least several months of web research, reading, and website visits before I finally decided on my choice of a discount brokerage for my equity RRSP account. As a starting point of reference for you to get a better picture of what companies serve Canadian customers in this market, you can look at the latest, summer 2007, market comparison of Canadian brokerages by Surviscor. In my own search for the overall good brokerage firm, I considered the following several factors:
  1. Availability of no-fee, low-cost RRSP and stock-trading account services;
  2. A broker’s membership in the Investment Dealers Association of Canada (IDA) and insurance of customer funds and accounts by the Canadian Investment Protection Fund (CIPF);
  3. Lowest transaction fees;
  4. No/low limits on minimum account balances;
  5. Trading in Canadian and US securities;
  6. Easiness of web access to an online trading platform for fast, secure, and dependable equity trading;
  7. Availability of technical support and customer service over the phone, chat, and e-mail.
It looks like a long list, but at least it captures some of the key parameters that I wanted to take into account. My initial plan was to open an RRSP account since I had accumulated a large unused RRSP limit and was planning to use the RRSP tax-deduction benefit to reduce my and my wife’s growing personal income taxes. As the next second step, in a couple of years, I was also planning to open a regular stock trading account. Given my very frugal nature, the key decision parameter for me was obviously zero fees associated with opening and maintaining these accounts. The second very important related concern was to get an account with the lowest per-transaction costs.

At the end, my final choice was Questrade where I opened my RRSP account. I have been currently initiating small stock positions on this account, and we will see if the size of my deposits (and hence the account balance) will increase over time.

What is my opinion about Questrade so far? Well, here is a brief review:

One of the pluses for me was that the company is located in Toronto, very close to where I live. I think it is always better to have a broker who is located nearby rather than using a company which is located abroad or far away.

Their stock trading fee of $4.95 on up to 495 shares is currently unbeatable in Canada (the fees increase by $0.01 per share on excess of 495 shares per trade). There is also an alternative plan with a fixed fee of $9.95 with an unlimited number of traded shares per transaction – this plan may especially appeal to those traders/investors who are into penny stocks. Because my trades are very small at this point, I do not need the $9.95 plan and therefore use a very affordable $4.95 plan.

The nice feature of both price plans is that there is no fee differentiation depending on the balance of your accounts. Most other brokerages set a minimum limit of anything from $25,000-100,000 in account assets as a prerequisite to take advantage of low transaction fees. Questrade has a very low C$1,000 minimum funding requirement; that is, you can start using the account after you deposit C$1,000 or more. I think this is a fairly small limit, especially if you compare it with the minimum funding limits set by the other Canadian brokerages. In addition to low account balance requirements, there are no maintenance fees or account inactivity fees, which certainly appeals to amateur investors who do not trade frequently or regularly.

It is relatively easy and straightforward to open a Questrade trading or RRSP account. I filled out an online application, which can be saved in progress and completed over time. Then I printed out the forms and mailed them, along with making an EFT deposit to fund my account. In a week or so, the account was fully operational.

There are three different online accounts that a customer uses at Questrade: (1) MyQuestrade administrative account with access to general information, account options, and features; (2) an online trading platform of a customer’s choice from several alternatives offered by Questrade; and (3) a pension plan account administered and maintained by the third-party organization. Some people complained about having to use three different accounts and having to remember three different sets of login IDs and passwords. I personally do not have any issues with that and even agree with Questrade that this account separation, if anything, enhances a customer’s security by reducing a chance of online fraud.

There are several different choices of trading platforms, starting with the free Webtrader and QuestraderWeb. These two platforms are very basic, plain trading platforms, which work quite OK for me since I do not trade in real time anyway. The more advanced trading platforms, which are offered by Questrade, are free only if you are an active trader generating a certain monthly minimum of trades. If you do your research in advance and use mostly limit orders, then you will be just fine with the Webtrader platform. I am not sure about the beta version of the second free platform, QuestraderWeb, since I am a bit concerned about its current encryption and web security features; that’s why I use the Webtrader. This platform is easy to navigate, and all of its functions are pretty straightforward. My impression is that execution of trades was very fast with market orders. Limit orders worked just fine as well.

Some people complained about poor customer service at Questrade. So far, I cannot say anything negative about it and hopefully will not have anything like that in the future. A couple of times I was in touch with Questrade’s customer reps over the phone and in chat, I received a pretty good and prompt service. Around busy times (mornings and evenings), phone waiting delays can be substantial but I can perfectly live with that by setting my phone on the speaker while performing my regular activities and waiting for the response at the same time.

One thing that I view as a minus with Questrade is a pretty long processing delay after an EFT deposit transfer. It takes roughly four business days for your online bank deposit to get reflected on your trading account. I think this is unacceptably too long since it is just a direct wire transfer which technically takes seconds to go through the electronic banking system.

Some people who do a lot of trading with U.S. stock complained about the fact that Questrade does not offer wash trades and charges a fairly large 10 bp spread on FX conversions. Because at this point I am more interested in Canadian stocks and do not actively trade U.S. stocks, this issue is not really important for me.

A bottom line: I think Questrade currently delivers the highest value-to-price service ratio in Canada for small investors and traders who have small asset balances and who trade irregularly and infrequently. It is probably true that wealthy investors with large asset holdings may prefer the safety, extra services, and extended customer support of large national or international brokerages rather than keep their portfolios with the budget-oriented Questrade. At this point, I am definitely better off with Questrade, and the future will tell if I stay and continue growing my portfolio balance with them.

In the case you are thinking about opening a low-cost trading or RRSP account, Questrade currently offers a very neat promotion: if you are referred by its customer, you get a $50 credit which is applied towards your cumulative trading fees in three months after you activate your account. This is equivalent to 10 free trades under the $4.95 plan. It sounds pretty good to me. If you are planning to open an account with Questrade, you can use this reference link, with me as a referrer. The Questrade system will automatically recognize you as a referred person and you will get your credit in three months after you activate your account. Just in case, my referrer ID is BEIT.

Also, Questrade currently runs a referral-based associate program where you can become Questrade’s associate and earn commissions from all people who become associates as a result of your reference (you need not be a customer to become a Questrade associate). If you want to register as a Questrade associate and sign up other associates through your blog or website, you can fill out the form on this page. On the application form, do not forget to put my Parent Affiliate ID, BEIT, in order to register as a referred associate.

If you have some questions about my personal experience with the Questrade account, I will be happy to answer them.

Questrade: Open a Questrade Account Online  Start Trading & Investing

Sunday, 16 December 2007

One source of wealth you may not be fully aware about: daily 1.4K deposits on your life account

Once in a while each of us occasionally stumbles upon a very powerful idea or thought that has a very strong influence on our lives. It may come to you from another person, from a book, or even from a web post. One of such wisdoms is about one great asset that everybody has access to, but not everybody uses well, pretty much like everything else in Life.

It seems that every person in this world is born unequal to the others. We have different parents, different racial and cultural origins, and different bodies. Some of us are born in safe economically developed countries, have rich parents, eat well, and are healthy. The others are born in poorest countries, do not have one or both parents, starve every day, and struggle with various disabilities.

Some of us complain about this unfairness of Life, the others take it as given. Some are unhappy about their personal lives and their surroundings, while the others seem to enjoy Life’s event most insignificant events. One of the traditionally biggest sources of “unfairness” complaints has been money, or the lack of it. Many people say: “If I were rich, then I would do….” or “if I had a million dollars, then I could …”

Well, guess what? It looks like that in at least one very important aspect your life is very fair in comparison with lives of all other people. Every single day, each person receives a deposit of a precious asset. It is the same for everybody, every living human being. It is equal to 1,440 deposit units. Every single day during his or her life (including weekends and holidays!), each person gets this deposit. Its value is objective, and it does not appreciate or depreciate over time (it can do so only in a person’s own subjective perception). Every month, it sums up on average to 43,200 units, and every year it is a whopping 525,600 units.

These units can be traded, exchanged, donated to other people, consumed, invested, or let expired worthless. The downside thing is that they expire immediately unless we put them in any use right away. We can make these funds start working for us early in our lives and generate huge future returns. It is true that some people are better in managing these funds than others, but the beautiful thing about them is that everybody can learn how to use and invest them properly. One can make mistakes and misallocate some of these deposits, but there is so much of them and they are paid with such regularity that even relatively large losses can be compensated later.

What are these magic deposits and what is the asset? The answer is simple – the deposit units are minutes, and the precious asset is time. Can you say that anyone is treated unfairly in this allocation? I admit that the person may be stripped of these deposits early in his/her life, before reaching a certain level of consciousness. It is like with everything. But once you can walk, talk, eat, and sleep on your own, you are fully entitled to your deposits of magic everyday minutes.

How you spend every single one of them during each day of your life determines what you get later in your life. You may invest them wisely in your physical and mental health, personal and professional development, and education, which will deliver huge benefits later in your life. You may share them with the other people you know or do not know and may donate them to help others. Alternatively, you may waste them on destructive or meaningless activities, which are either useless at best or harmful to you and the other living creatures around you.

The great thing that I love about our Life is that the same general principles apply to very different aspects of our individual lives. Time is one of our most valuable assets with a huge potential, and we can certainly say that the key rules applied to asset management and money investing apply to time management as well. Like with money, the following several steps do magic with your generous time endowment and can generate great returns for you:

(1) Write down a list of well-defined long-term and short-term objectives;
(2) Develop a set of clear and specific strategies to achieve these objectives;
(3) Regularly invest your time to activities that are a part of these strategies;
(4) As time progresses, adjust your goals and strategies if necessary.

How to master the wise use of our daily time deposits? There are different effective time-management techniques, and I would like to share them in my future posts. For now, I will mention just one of them: the principle of taking slow baby steps that do not stop.

The old saying that I heard somewhere can be rephrased as follows: “You need to slow down to go faster. Go as slow as possible, but never stop, and you will arrive at your destination point in the shortest time.” One of the most important tricks to achieve the long-term success in anything is to break up the long-term project/plan into tiny everyday pieces, as tiny as 5-10 minute intervals a day. The most difficult task is to find enough stamina to do these five-minute particles every single day over years. The key to success is everyday discipline and determination to achieve and to progress.

This is the powerful approach, which definitely has proven to work for me before and which I am still trying to master in my time management and other aspects of my life. I currently apply my slow non-stopping baby steps towards my debt reduction and equity investing. And, of course, every day I try to remember about my generous 1,440 daily deposit and try to productively allocate it among several things that are a part of my long-term goals.

Friday, 14 December 2007

Seven reasons why I am not buying ETFs and index funds

I have been observing a very common and powerful trend lately – everybody seems to be into ETFs and indexes. It is not just a trend. It is the latest fad among investors and traders, which is strongly promoted in the media. These funds have been hugely popular among different breeds of investors and traders. Experienced investors use them to diversify their portfolios and increase their exposure to different markets and sectors. Beginner investors buy them because it is an easy and affordable way to invest into the whole market or just one of its segments. Traders use them to relatively safely ride on strong market trends. Non-investors who just want to save a bit for their retirement buy them because they are told to buy them. Here is the media pressure at work here.

I have to admit that there are quite a few positive things about ETFs and index funds. They can and probably should be used in certain situations. However, overall I remain pretty skeptical about them and personally prefer individual stocks. Why am I so cautious about ETFs and indexes (let’s also throw in mutual funds into the list)? Well, there at least several reasons for that, and I will try to summarize them below:

1. Careful selection beats bundling: For experienced investors and traders with a well-defined strategy, a group of carefully selected individual stocks will deliver better performance (in terms of return on investment and/or dividend yield) that an index. In many cases, the underlying portfolio of a sectoral and topical index is dominated by large holdings of a very few companies. Why buy a bunch of companies with different concurrent performance levels if you can pick just one or two leaders from the list and these leading stocks will easily beat the index, which can be dragging behind thanks to its underperforming members?

2. A proxy will always be a proxy: An ETF or index is just a very crude proxy of an imitated broad index – it cannot reproduce a market index well enough and quickly enough because the portfolio manager can’t continuously and promptly rebalance the fund’s portfolio. If this is the case, then why the fund price should mimic the momentum movements in the market? It is just another asset with a limited level of capitalization and liquidity, which abides the law of supply and demand. If there is not enough liquidity in trading the fund, then even prompt rebalancing of the fund portfolio cannot make it reproduce all moves of the underlying market index/portfolio. What if an ETF represents a declining sector and suddenly a large investor decides to buy a large lot of the fund’s stock? Would not the fund’s price go up as a result of that? But then what about closely tracking the market’s moves?

3. A fund manager’s black box at work: Unless you work for the fund, you do not know how the fund’s management handles its portfolio, i.e., how often the fund assets are rebalanced, what stocks or other assets are picked up and in what quantities, where the assets are stored, and whether they are used for some equity lending/borrowing activities that the fund’s shareholders are not aware of. That reminds me of the fairly recent scandal with Morgan Stanley, which collected money from investors to purchase and store physical silver bullions on behalf of its clients. As it turns out this silver was phantom and investors’ money was spent on something else. Those folks surely thought they were proud owners of silver safely kept from them by the reputable Wall Street brokerage.

When I read about such cases, should I trust brokerages and funds, even if the top ones occasionally try to screw their clients? I am not so sure because the same things likely happen elsewhere too. People buy shares of numerous gold, silver and platinum funds thinking that they buy precious metals. I strongly doubt that there are physical metal holdings somewhere in these funds and even if there are some, then fund investors/ shareholders will never be able to see and touch these so attractive and expensive pieces of metal. In reality, it is most likely just paper, paper derivatives, and people are therefore trading paper, which surely is a bit too pricey for its real intrinsic value.

Of course, my stock shares are also paper, but at least they are legally linked to individual real-life companies and are collateralized by physical assets of these companies, which have decades of market reputation and which have performed real-life delivery of goods and services for years. What real things have those fund guys delivered to you and the rest of the world so far other than a receipt for your money? Have you seen the assets they claim they hold and/or store on your behalf? Are you sure that these funds will stay in place when the things get tough?

4. Always read a small-font disclaimer in the fund’s description: The previous paragraph raises another important issue with buying ETFs and index funds – the issue of reputation and investor protection. Before you invest in those funds, do you read tiny-font disclaimers under descriptions of many of them? For example, read this tiny disclaimer on CIBC investment funds:

“CIBC Mutual Funds and CIBC Family of Managed Portfolios are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer, nor are they guaranteed by CIBC. There can be no assurance that money market funds will be able to maintain their net asset value per unit at a constant amount or that the full amount of your investment in a fund will be returned to you.”

Sounds good: they collect your money, but do not promise your anything in return. In some other cases, the legal entity behind a family of funds is a limited-liability company registered in some distant offshore. If the things go sour, good luck claiming your money – some fund manager guy laying on a sunny beach of an offshore tropical paradise and sipping a Breezer will just chuckle envisioning you and other investors trying in vain to claim your money back.

5. Danger - derivatives: Many funds actively use derivatives to boost their performance or save cash intended to purchase portfolio assets. Indeed, why bother buying an asset if you can open a leveraged position at a fraction of the asset cost? For example, read this pretty note to Vanguard funds on their website:

“The fund may invest, to a limited extent, in stock futures and options contracts, warrants, convertible securities, and swap agreements, which are types of derivatives. Reasons for using these investments include: keeping cash on hand to meet redemptions or other needs while simulating full investment in stocks and reducing transaction costs or adding value when these instruments are favorably priced. Losses (or gains) involving futures and options contracts can be substantial—in part because a relatively small price movement in a contract may result in an immediate and substantial loss (or gain) for a fund. Similar risks exist for warrants, convertible securities, and swap agreements.”

I do not want to invest my money in derivatives and, even less so, I want somebody else doing it for me, without asking my permission.

6. Fees, fees, fees: Last but not least, one of the most important downturns of actively or passively managed funds is fees. Even you do not trade the fund shares, you still pay an annual management fee. MERs (management expense ratios) range from a fraction of a percent for most liquid actively traded funds to a whopping 2-3+% for the other less liquid or more "upscale" funds. Think about it: even if you annual fund management fee is pretty low at 0.5%, it means that on your $10,000 position you pay $50 a year on top of the trading fee to open the position. For $50, I can do up to 10 trades at Questrade, buying excellent individual stocks. When you invest into a fund, you regularly pay your fees to some guy you are not familiar with, no matter how well or badly the fund perfoms – it is definitely not the best way to spend your hard-earned money.

7. Exchange rate swings can boost or kill the performance of your ETFs: Unfortunately, many investors forget that buying shares of an ETF or a mutual fund may involve significant foreign-exchange risks if the fund's portfolio includes foreign assets or if fund shares are denominated in a foreign currency. For example, most Canadian investors buy USD-denominated funds because the most liquid, popular ETFs are listed in the United States and are denominated in U.S. dollars. Unfortunately, even those USD-denominated funds, which generated a positive return over the last year or less, deliver either weak or ugly performance to a Canadian investor once the latest USD-CAD exchange rate trend is taken into account. The choice of CAD-denominated and FX-hedged ETFs currently available to Canadian investors is fairly limited and includes no more than 20+ index, sectoral, and topical ETFs provided largely by iShares and Vanguard (correct me if I am wrong). Since I live, save, and spend in Canada and am planning to retire in Canada, I prefer my portfolio holdings to be hedged against the FX risk exposure. Currently, most ETFs and mutual funds come without this feature.

At the end of the day, each investor or trader decides for her/himself whether to invest in ETFs and index funds. I prefer staying away from them for the seven main reasons I stated above.

Tuesday, 4 December 2007

On housing prices in the Greater Toronto Area

As my mortgage payments were slowly but steadily growing along with interest-rate hikes during the last 2.5 years (see my previous post), the market value of our residential property in a quiet suburb north of Toronto was persistently climbing as well. Of course, it is personally very comforting to see a value of your house to go up by 30% over a couple of years. Periodically, a couple of real estate agents are calling to deliver us the exciting news about new records set by prices on similar houses in our neighborhood. I feel happy and express my sincere excitement every time I talk to them, but politely decline an offer to put our house on sale and find something bigger, better, and (of course) "just a bit" pricier ("A bit" is "only" S50-100K). No thanks no. I will pay off this one first and then we will see. Moreover, I see some clouds on the horizon of the Canadian housing market, which are about to bring a refreshing rain of falling housing prices (speaking metaphorically, the thunderstorm is already raging across the border).

Do I want housing prices to go down? Yes. Am I nuts telling such things? I do not think so. It looks like we are about to see the long-term cycle taking its long overdue turn towards the sizable price correction, and I think that this correction is absolutely necessary because, as an economist, I dislike pricing bubbles.

Market bubbles arise mostly due to speculative and often artificially infused demand; are almost always created thorugh the excessive use of leverage; contribute to the overall inflation rate; distort and limit consumption and savings choices of many households; increase personal debt burden in the economy and thus eventually hurt the overall economic growth; and stand behind many cases of personal bankruptcies. Honestly, don't you think that prices of houses in Toronto and its suburbs look a bit too high lately? I definitely do not think that these prices are justified by fundamentals. I bet that those who are still shopping around for a house can really tell that.

I was recently taking part in a project, which analyzed and compared price elasticities of local taxes on residential and commercial property across 25 GTA municipalities. The charts below plot some of the GTA and Toronto data related to our project. They show time series of equalized residential assessment per capita (which basically is used as a measure of the average property value) and the corresponding tax rates on residential property (the upper and lower tier rates only, the education portion not included).

I read somewhere that historically a full long-term cycle of residential property prices in Canada lasts approximately 18 years. By looking at the GTA residential property data, we can see that the new cycle, which took off in 1989-1990 (I arbitrarily count from the year during which the prices peaked and reversed), is about to begin in 2008-2009 if the long-term patterns are to be respected. In fact, we are kinda a bit late already in Canada with a start of a pricing correction. The U.S. housing market has already taken a dive, and I do not see any compelling reason why we in Canada should enjoy our own housing bubble however.

By looking at the assessment trend line, we can observe how the market accelerated in 1986-1989 before sharply reversing in 1990. The slump continued for some time, before the market picked up in 1997 and again has shown strong double-digit growth in most GTA municipalities since 2003.

Also, looking at the charts, we can see a strong, statistically significant negative relationship between property values and property tax rates. One of the measures that governments use in order to determine what property tax rates to set is price elasticity, which measures the response in property values to a marginal increase in the tax rate (dB/dt*T/B, where B is the tax base and t is the tax rate). The government is not interested in or sincerely cares about changes in property values per se; rather, their concern is how their total property tax revenue (tax base*effective tax rate, or B(t)*t) will be affected by changes in the tax rate. A Laffer curve, or a revenue hills curve, which can be contructed using price elasticity estimates, is used to show the relationship between tax revenues and corresponding tax rates, including a revenue-maximizing tax rate.

Speaking in terms of price elasticities of property values, we can define the revenue-maximizing tax rate as the one under which the price elasticity is equal to -1 (1 in absolute terms). If it is below -1 (that is, we have low elasticity), then the tax revenue can be increased by a further tax hike. If it is above -1 (that is, we have high elasticity), further tax increases will drive down property values too much and as a result the overall government property-tax revenues will fall. For obvious reasons, governments prefer finding themselves on a low-elasticity portion of the Laffer curve where they can still increase a tax rate a bit more to squeeze extra revenue dollars from tax payers.

Our analysis on the GTA residential property data has indicated that the price elasticity estimates among GTA municipalities and regions are currently way below -1 for pretty much every municipality in the Greater Toronto Area and have been staying low at least over the last ten years. From the elasticity formula above, we can figure out that elasticity estimates can be low when residential tax rates are too low and when tax-base values are overinflated by a price bubble. Indeed, we can observe from the charts that most GTA municipalities were decreasing their effective tax rates or at least kept them flat during the last several years when the speculative growth in housing prices accelerated noticeably and when the buy-buy-buy-a-house chant was all over the place. Without a doubt, such tax policy further contributed to the excessive growth in housing prices.

Am I advocating for higher property taxes? No (as a home owner). Should the local governments decrease taxes when the real estate market is already overheated? Defintely no since they fuel the speculative demand and contribute to a bubble's development. Should the residential real-estate prices be periodically corrected by the market? Yes, absolutely. Is there a role for local governments in control of property prices? Maybe yes in theory, but I doubt that it can be justified in reality for a variety of objective reasons.

Is there any other way to keep housing prices in check? The minimum-leverage and minimum-credit-rating requirements in mortgage financing can be one of the effective natural controls. The U.S. government are learning these simple things the hard way right now, or are they? Looks like they do not care that much. The Canadian government should if they do not want to be on the same page with the socially indifferent U.S. "civil" servants.

Saturday, 1 December 2007

A note on sub-prime debt and derivatives

As time goes by, you will notice that I will talk quite a bit about Canadian, U.S., and foreign economy and markets. I can't help it because I am an economist by education and (some say) mentality.

Also, another feature of this blog will be reviews of and references to some of the other financial blogs that I regularly or occasionally read and/or am subscribed to. Some posts in these fellow blogs are very interesting and make me think about fresh aspects of a situation or issue that are non-standard and are not captured by the attention of general public.

A lot of media attention recently is on the sub-prime crisis that is the key factor why the financial sector in the U.S. and Canada has gone down over the last several months in 2007. The primary focus right now is on the sub-prime debt issues and trading in so-called CMOs (collaterlized mortgage obligations), MBSs (mortgage-backed securities), SIVs (structured investment vehicles), and other asset-backed-security schemes with sophisticated names, but frequently a shaky substance behind them. What has not grasped people's attention yet is a possible problem with other derivatives, in particular a family of credit derivatives.

The markets for unfunded and funded credit derivatives (including various types and variations of CDSs (credit default swaps), CDOs (collateralized debt obligations), and credit spread options) and other credit securities (such as loan guarantes) have grown tremendously during the last several years. However, they have not been put to the real test yet as the global economy has not experienced any severe recessions and financial crises during the last decade (the 1997-1998 Asian financial meltdown and the 2000-2002 equity market correction, although pretty significant, do not really count here).

Certinaly, one can think of credit derivatives as credit insurance on underlying loans, bonds, other securities/assets/liabilities. However, the problem with them is that they are also in essence highly leveraged securities with a great degree of risk exposure both to their sellers and buyers. In rapidly deteriorating market credit conditions, the probability of credit events (e.g., default on interest payments, decrease in an entity's credit rating, failure to repay a credit facility, etc.), which triggers insurance payments on credit insurance instruments, increases significantly.

The potential issue that we are facing right now can be described in plain terms by using an analogy from insurance markets (and we DO in fact discuss credit insurance here). On the one hand, we basically have credit insurers (mostly financial institutions) who wrote a lot of insurance contracts with above-average risk exposure, without creating and maintaining a proper capital base to honor possible insurance claims if most of them come due in the case of a major claim-triggering event. Another related problem here is incorrect pricing of credit premiums due to the biased information from credit agencies or due to the use of mediocre premium-pricing models. It means that credit-insurance premiums do not properly cover the underlying credit-default risks (most likely understating them).

On the other hand, we have buyers of this credit insurance who happily think that they are well protected against their risk exposure on the underlying insured contracts. Buyers include financial insututions and non-financial corporates.

We also have the third group here, which is associated with assets or liabilities covered by the underlying credit-insurance contracts. These companies or other types of organizations have earlier sold their assets (which may well be represented by asset-backed securities) to or borrowed from credit-insurance buyers. When the situation get tough, they may default on their payments or other obligations, which effectively triggers a credit event. Keep in mind that a credit event can happen even without default on the associated asset/liability. Credit event can be represented by deterioration in a company's credit rating, by a change in a company's financial ratio(s), by a decrease in a market or sector index, or by a company's default on its other obligations not covered by the credit-insurance contract. You name it. The credit markets have been very inventive in creating credit instruments of all shapes and colors.

Add speculators in credit derivatives to the overall mix, and you now have the picture of who is involved in the credit-insurance system.

To finish the story, when a credit occurs, a credit-insurance buyer calls a credit-insurance seller and asks for the insurance payment. The problem is that when credit events all of a sudden happen in large quantities and at once, such wave of claims may paralize the whole credit-insurance system, given its weakness in terms of capital coverage and potentially large underpricing of underlying risks. Since most of credit derivatives are associated with corporate debt markets (both long-term and short-term), you can figure out what consequences may be there for the real sector of the economy.

Anyway, what initially started as defaults on subprime mortgages amid the softening economic situation in the U.S., has now been spreading onto the other parts/sectors of the financial system both in the States and abroad. This contagion effect, partly due to the chain reaction through borrowing/lending/financing channels and partly due to the increasing panic in financial markets, may as well spread into the credit derviatives markets. If it happens, then the financial-services sectors and the economy, both in the States and other countries, may be in some extra serious trouble.

Most investors probably know what Warren Buffet, the icon of all serious value investors, said when asked about derviatives. "Time bombs" and "financial weapons of mass destruction" are some of the terms that he used. Here is the link to the old related article.

You can also read another interesting recent post on this issue here. I will use this link as an opportunity to mention Jesse's Café Américain blog and market analysis. I found it very recently and liked it. Very good market charts, analysis, and comments. As I said in the beginning of this post, I will comment on the other blogs that I more or less regularly read or look at

A humorous look on the sub-prime crisis

I think it was a very funny way to talk about the not-so-funny situation in the financial markets related to the subprime crisis:

Here is another one, with the same gentlemen performing:

These British folks are so funny sometimes.