Blessed by the Potato

Rather than talk about myself this fortnightly update I figured I’d turn it over to my RL friends who are starting new blogs for the spring. First up is Ben, who’s launching a new business venture in southern Ontario in the form of an organic farm. Here’s Ben with the details:

Fresh Start Farm is a project Lisa and I have put together in order to test the waters when it comes to market gardening and earning a sustainable living farming. We are both huge foodies and we’ve been growing all kinds of things for our own consumption on a small scale over the years. At the same time we have both yearned for more space where we could expand our gardening into full-on farming. We both agree that the farming lifestyle is one that we would love to embrace.

After attending the Guelph Organic Conference last year, we both agreed that it was going to be our goal, over the next 5 years, to transition our current careers from what they are now, to full time farming.

We have rented a piece of land, roughly ¼ acre, in Pelham, a short drive from our house in Welland, while we continue the search for a suitable homestead to purchase.

We have invested a decent amount in seeds, soil amendments, tools and things, although the biggest investment will come in the form of our time throughout the growing season this year. In order to sell the produce we produce, we have rented a booth at the Welland Farmers’ Market, which is a fairly large and well attended market very close to our home and farm.

We have created the website in order to blog about our experience as well as get the word out as to what’s going on, what our problems and successes are, and most importantly, what we will have for sale at the market, once that time of year rolls around!

I’m sure most of your readers are in Toronto, so they would probably never attend the Welland Market, but in the future we may start offering a CSA delivery to the GTA. I still have a strong connection to North York, and I would love to get a booth at that market, if possible. In the interim, I encourage everyone to follow us as we go about doing what we do, offer comments and questions, and see that it is possible to be awesome if you want to be!

And also Lenny has launched a blog where he talks about whatever he feels like (so far, making his own pizza dough and encryption).

As for me, I’ve got my first job interview coming up later in the week. This is for a position I applied for in December, so I guess they’re not in a terrible rush to hire someone (and does give me hope for all the other applications I haven’t heard back on yet — there could yet be good news!). I’d say I’m pretty nervous to face the interview, but Wayfare’s way worse. To be fair, she knows how terrible I am at interviewing and the awful turns interviews can take, whereas I am consumed by the notion that I am generally awesome in all things, so it’ll be fine. ;)

Flag football is coming to an end, and much to my surprise attendance never got better. Who are these people that shell out over $100 to join a football league and only show up for one game? After much discussion and debate I decided not to join any leagues for the spring: as good as team sports are for motivating me to actually get out and exercise, there’s just too much uncertainty with a new job (any. day. now.) and baby on the way (same). Plus many of the spring leagues are on weeknights, and I have zero desire — nay, a full-on hatred of the very thought — of commuting around Toronto rush-hour at 6pm to try to make a game half-way across the city. Others may whine, but I’ll take a 10pm Sunday game every time.

I leave London alone for two months, and it all goes to hell…

Another article at the Globe warning about the housing market. I like the way Tom Bradley phrased this: “When I pull together the economic fundamentals, valuation and sentiment, real estate, as an investment, doesn’t look very attractive. The distribution of potential outcomes looks asymmetrical to me – limited upside and plenty of possible downside. But what really screams out at me is how many important factors are at extremes … bad extremes. One or two off-trend numbers can be explained away, but too many are jumping off the charts – price increases, mortgage rates, loan growth, consumer debt and home ownership levels.”

James Randi on scientists and trust and skepticism.

Nelson tries to find a way to short the Canadian real estate market.

Teacher Man, writing for CFB, says the Canadian real estate bubble can’t be denied any longer.

Reader Rhea, from Seattle writes in:

We have a rental property in what was supposed to be an up-and-coming neighborhood near Downtown Seattle. We lived there for 2 years and loved it. It is on the top floor of what was a new condo (now 7 years old), and has amazing views of the water, mountains, and downtown. We paid $275,000 7 years ago. Then we moved and bought a house and rented it out for 4 years for $1500/mo. That tenant left and we tried to find another renter, but had a hard time at that price point, eventually renting it out for $1300. We pay about $2100/mo including HOD’s. We got into a bad mortgage deal, as was typical at the time. Zero down/Interest Only.

All condo sales in the building have been short sales, and estimation of condo [market value] is around 200k. Question is, do we re-finance, which would cost us 125k to get mortgage down an amount which renters would cover. Or short sell it?

Hi Rhea, thanks for the question.

I’ll start with a question of my own: why did you hold on to the condo after you bought a house? Is it because you planned on moving back in later, or because you loved the idea of becoming landlords, or was it purely an investment motivation?

The fact is, as an investment, the condo turned out to be a poor one. You’ve lost money on it, and the thing to realize is that the money is gone and you can’t get it back. You can realize the loss bit by bit as the rent falls short of the monthly costs, or you can face the loss all at once by paying down the mortgage deficiency now or doing a short sale, but no matter how you slice it, it’s not coming back.

With that realization, the most important thing to consider for your decision of what to do in the future is your motivation for holding on to this condo. If you just love being a landlord and would do it even if you had to pay for the privilege, just so you could speak with tenants and help put roofs over their heads, or if you plan on moving back in to this specific unit in the next few years, then one of the options for continuing to hold on to it would best suit you. If you don’t love being a landlord, and were just looking for an investment, then you might want to think about just taking your losses and selling it.

At a current value of $200,000 and current rent of $1300/mo, your price-to-rent is 154X, which is in the roughly break-even range. Continuing to hold it shouldn’t hurt you further (at least not much), but it’s still not a very good investment. If you can get the rent back up to $1500/mo (while still maintaining good tenant quality and low vacancy) then it might be worth holding on to, with a price-to-rent of 133X, but it’s still not a stellar investment, especially if you find being a landlord to be a time-sucking chore (and the time commitment will only get worse as your unit approaches 10 years of age and starts to need more maintenance and appliance replacements).

So ask yourself whether you have a good non-investment reason for holding on to the condo, and if you don’t, then speak to a real estate broker about selling it. If you do still want to hold on to it even if it isn’t a good investment, and if you have the cash available to pay down the mortgage and refinance, then speak to a mortgage broker or your bank about your refinancing options.

For my Canadian readers (which I thought was all of you — no idea where Rhea came from!) this is an example of “speculative holding.” Rhea didn’t buy her condo with the intention of being a real estate speculator, nor the house that followed… but instead of selling the condo to buy the house, she held on to rent it out. Thankfully no one I know in person has become a speculative holder, but I’ve seen them around the various personal finance fora, choosing to borrow against the starter home to buy the second and then rent it out, rather than sell to move up… becoming real estate speculators in the process. This is a kind of phantom speculative demand: you don’t see them lining up in the cold, clamouring to buy pre-construction, and they’re not at any point applying for an investment mortgage, but the speculative holding has the same effect on the market… and on the speculators themselves.

Not to pick on Rhea, but in this particular case it was egregious speculation: with an interest-only mortgage if it’s cash flow negative you should know immediately something is going wrong. With an amortized mortgage if you’re not very good at math, it’s easy to fool yourself that you’re at least “building equity” while being “a little” cash-flow negative.

I read the The Hunger Games books not that long ago, in part because of the hype for the upcoming movie. I enjoyed it, plowing right on into the 2nd and 3rd books in the series. The action seemed well-suited to a movie adaptation, so I had high hopes going into the theatre today.

Unfortunately I can’t recommend the movie. The biggest drawback is the terrible camera work. It’s shaky cam, like the Blair Witch Project or Cloverfield, except worse: instead of just being one shaky camera, it’s rapid cuts between many shaky cameras. And not just for the action scenes (which are likely deliberately motion blurred to nothingness to get a PG rating): even just sitting down to eat dinner seems to require rapid cuts to different shaking viewpoints.

So here is what I propose: director Gary Ross and Michael Bay should be put into an arena where they will fight to the death. The winner will get a tripod, the loser, well… But a much-needed tripod! So worth it!

Other than that, it was okay: they seemed to do a decent job of streamlining the plot to fit the time and format. The acting was pretty decent, which is a tough feat with so many child actors. The movie had some behind-the-scenes looks at the arena and the gamemakers, which I think were good additions. There were a few points though where I had to question if people who hadn’t read the book would be able to follow along.

Spoilers!

For instance, Katniss and Rue decide to blow up the food & supplies cache of the careers, but don’t explain why in the movie, so it seems really random. Watching the movie, you wonder why Katniss doesn’t just put an arrow into a few of them from her cover in the bushes, and what blowing up their stuff serves to accomplish — in the book it’s explained that they’re dependent on the supplies from the cornucopia, so if she can take those away they’d be on a more even footing, or even an advantage to Katniss with her superior survival skills. Plus the story does a pretty good job of not having Katniss run around terminating other kids with her superior archery skills, even though that’s what it looks like the book is building towards at first.

Then, after Rue dies, it’s kind of strange to see Katniss get so worked up, since Rue had all of like 3 minutes of screentime before that. I think their relationship was built up much better in the book, and I didn’t catch any hint of “you remind me of my kid sister who I loved so much I volunteered for this freak show to save her” in the on-screen relationship.

Well, it looks like the group deal fad may finally be getting to its final phase. About two years ago new group deal sites were popping up like crazy, offering steep discounts on everything from restaurants to meat to rock climbing.

I quickly soured on the concept after finding a few deals hard to redeem (one $10 offer ended up expiring before I could use it, and it ended up being a real last-minute rush to finally use my rock climbing pass the week before it expired). Some people got burned bad by the various butcher offers. Plus after the first few months there didn’t seem to be any decent deals, and far too many individual deal sites to track. I ended up signing up for Red Flag Deals’ roundup, which monitored most of the deals and just sent you one email… and really, there’s been nothing to get me excited. Many recent deals have you paying for coupons, which is confusing and stupid.

Then recently I noticed large discounts starting to come back, such as today’s wireless iphone keyboard for 60% off ($50 normally $120!!). Except… that’s not the regular price, or at least it shouldn’t be. Futureshop has it at $90, and Amazon (US) as cheap as $19. Plus the small print in the email says you have to pay for shipping as well, making that a paltry 30% off the futureshop price. There are plenty of other examples, so be sure to check if the huge percentage off advertised by the group deal is actually what you’ll be saving: it may not be worth the hassle if the so-called discount isn’t remotely realistic.

I’ve been scratching my head about the BMO special since the first iteration in January.

It’s puzzling because it seems so unprecedented: I can’t recall the banks openly competing on price this much before. I can think of a few reasons for it, but those don’t give me much comfort in the motives:

1. BMO is willing to trade margin for marketshare. This could work long-term for them, since many of these customers will renew in 5 years with BMO at higher spreads, but aggressive banks aren’t comforting. There’s a reason we like to comfort ourselves with the image of the conservative Canadian bank. There are news reports that BMO has been losing market share, which could explain this push to take it back, but desperation is no better a trait than aggression in a bank.

2. It’s about funnelling people into fixed rates. The 2.99% special is a lower rate than their (posted) variable-rate mortgage, and only a few basis points above a discounted variable. Maybe they saw something they didn’t like about Canadians’ abilities to handle future rate increases on variables, and BMO is trying to stabilize the portfolio at the expense of margins and shaking up the market. On the one hand, that could be seen as being relatively comforting: distressing that they got worried, but comforting that they’re taking steps to mitigate risk to rate changes. On the other hand, the fixed rate funnel also means that they have now lowered the qualifying rate from ~5.5% to ~3%, and if they needed to take that step to get people to qualify, I quake in fear. OTOH, the 25-year amortization suggests they’re not trying to scrape the bottom of the barrel.

3. It’s about the lack of features. Combined with #1 (adding business down the road), the lack of prepayment means people won’t take as much advantage of the low rates to pay down principal, so upon renewal they’ll get a larger mortgage (or more certainty of that larger mortgage) at the new rate.

On a systematic level, I don’t know what to make of this policy. It could help stabilize the housing market, or contribute to the last hurrah of getting marginal buyers in. For BMO, it could be a shrewd long-term move, or an act of discounting desperation. It’s a puzzler.

We’re clearly doing this all wrong. While we’re getting prepared and things are starting to feel very real now with all the baby stuff, we’re not spending nearly enough time enjoying our last kid-free days. I think that delightful mixture of anticipation and terror is giving way to thoughts of “what have we done” and brief panic attacks. But we’ve done our first aid and baby care and birthing classes; the furniture is assembled and the adorable baby clothes ready to be puked and pooped on. I don’t know if anyone is ever fully ready for this, but we’re as close as we’re going to get.

And most importantly, the nest is feathered:

[And no, the stuff in the crib won’t still be in there when it’s time for baby to go in, we’ve been warned about suffocation hazards. But for now it’s adorable.]

I still can’t believe how busy I am in unemployment. I figured if nothing else, having no steady income would be a chance to take some time to catch up on all the video games I didn’t play over the xmas break. Instead, I think I’ve been almost as busy as when I was working. The move didn’t help with that, so once I finish the last bit of unpacking (this week?) that might give me a bit of time back (and none too soon — Mass Effect 3 just came out!).

What I’ve found really shocking though is the complete silence on the job front. Not a single interview, even for the jobs I was perfect for. Ah, well, hopefully something will come up soon… On with the links!

An old speech of Charlie Munger’s is reposted, and it’s still good reading.

Rick Mercer epitomizes the condo insanity with the Condo Gun.

More and more housing bubble stories in the media, including the cover at Maclean’s. VREAA says this:

“Show of hands.. Anybody who hasn’t heard that Housing in Canada is in a ‘Bubble’?
Nobody?
Okay… so we’ve all heard.
Pumps are primed.
Now class… How are we going to respond to initial price drops?
Anybody?”

Larry MacDonald puts up another blog post attempting to counter the housing bear sentiment. I will admit: I simply do not understand his position. He doesn’t seem to refute the severe overvaluation — indeed, he confirms it — yet for some reason it doesn’t seem to bother him. Instead he talks about the lack of catalysts: “I agree with him that there is over-valuation—but I also believe there are other factors to consider. […]the catalyst for an end to the U.S. housing mania—a major tightening in monetary policy. I don’t see it in Canada yet;[…]” [emphasis mine]. To put it in terms of a bad analogy, it’d be like being at a party and finding a gas leak. “I smell gas. This is dangerous, I’m getting out of here” I’d say. “I smell it too,” Larry might say, “but nobody’s smoking in here. It’s fine. we can just open the windows and it’ll slowly air out.” “Well, either it blows up, or we’ll feel a chill with the windows open. Either way, this party is going to suck. Later!”

After saying he was leaving blogging and posting less frequently, TMW returns with this little post on valuing real estate. What I find hilarious is that just a week or two ago the BoC released a report saying that this was exactly the algorithm people used when valuing real estate, and that it was faulty because all it did was check to see if a particular property was over/under-priced relative to recent market moves, but implicitly assumed that both the starting price and the growth rate were rationally determined by an efficient market. If those two conditions weren’t true — and believe me, they’re not — then bubbles easily form because very few market participants are doing absolute pricing analysis. So this is a great method to use if you want to try to price a property for sale (to meet current market conditions), and a good one to use if you don’t care about overall valuation and just want to avoid being the one sucker who buys the most over-priced condo in the building… but you need an additional check as to the overall market sanity (i.e.: a rent vs buy analysis for your situation).

John Hempton at Bronte Capital explains why, despite Bronte’s small size, he isn’t chasing small caps. In short, he doesn’t think they’re as over-looked as many who chase small-caps think.

Boomer & Echo compare index funds to the big bank’s equity mutual funds. It goes about as well as you’d expect.

Michael James wonders if Berkshire Hathaway may be an index alternative and suitable for a passive investor. I figure why not: it’s diversified, the fees are low, and the long-term track record is good.

An article in the New York Times describes research that shows people with high IQs may get better investment returns. Though it doesn’t look like the returns come from digging up under-valued stocks, simply from following common sense investing principles that don’t require a high IQ to understand. “[Economists…] argued in a paper published in 2008 that many households avoid investing directly in stocks out of vague fears that they might be deliberately misled or cheated.” I know I’ve seen that kind of misplaced distrust many times when discussing investing. Somehow, over-valued under-diversified real estate is safe, and stocks are a rigged game.

Teller talks about magic and human perception. A fun little read! [HT: Barry Ritholtz]

One meme out there regarding the housing bubble is that today’s price doesn’t matter because immigrants are going to create so much demand that they’ll support the market. “Toronto has X thousand immigrants. Every year.” To paraphrase & combine a few examples. Thing is, you can’t look at immigration in a vacuum. Ben Rabidoux must be seeing the same chatter, since he also just had a post on population growth.

Consider my shower. Let’s say I just bought the AwesomeSauce™ 8-head shower system, capable of spraying out an amazing 23 litres of skin-scorching hot water a minute. I clamber on in there, intent on scrubbing away the shame of being a renter.

How long before I flood my house?

You can’t answer because that’s just one part of the problem, on the other side is my drain, taking away the influx.

So for immigration, part of that is just offsetting the natural population decline in the country. The net national growth rate is just a touch over 1%. It’s higher in Toronto and Vancouver, but still just about 2%. For comparison, the US growth rate is about 0.8%, and was running neck-and-neck with Canada over the last decade. Ben has some charts showing how much higher it was in some states that boomed and busted.

Ok, 2% growth per year every year is a fair bit of growth: enough to over-power infrastructure and public transit and the like over time. Toronto is full and getting even more crowded. But is that demand driving housing prices, and will it continue to drive housing prices? How can we consider other metrics in the face of the unstoppable immigration tidal wave?

Another important factor to consider is the ownership rate: in 10 years we went from something like a 65% ownership rate to 70% nationally. That seems like a trivial change: half a percent a year. Let’s try to put that ownership rate change in perspective with population growth to get an idea of some of the trends driving housing:

In the GTA, with all that immigration, we went from 5 million people to 6 million in 10 years. That’s something like 650k-700k new owners created by immigration/population growth (households would be lower by some factor like 2.4X, and about 300k of the newcomers would be renters). We also created 250-300k new owners by increasing the ownership rate. And that’s if you are conservative and assume that the increase in the ownership rate in a boom town is the same as it is nationally.

To get to my point: there’s a limit to how much that ownership rate can be increased. There’s a hard limit of 100%, but even below that, there will be some portion of the population that just isn’t going to buy. Even if we don’t reverse course and bring it back down to 65% — just stay here at 70% — that has consequences. Over the last 10 years, demand has been 40% higher than it “should” have been because of the expanding ownership proportion. We had ~1M (or likely more) new owners in the GTA rather than ~700k expected from population growth alone. If the next 10 years features a reversal of that trend — owners becoming renters again, or the average age of owning pushing back a few years — then demand could swing from 1M/decade to 400k/decade, or a 60% drop. Even just stopping the process of borrowing future demand and hitting a plateau represents a 30% decline in demand from the current run rate.

What will that do to prices? To be fair to my point above about looking at both sides, you have to know what the supply situation will be like. But everything suggests supply will stay robust.

Unfortunately like many other pieces of the puzzle, there’s no timing information with this one: though the US topped out at 70% homeownership, that’s not to say that Canada can’t keep going for 75% in the next decade, or 80% in the one after that. But the seemingly small change in this number represents a very meaningful slice of demand, so it’s important to understand — doubly so because it’s a factor that has changed over time, whereas population growth and immigration have been steady for much more than just the last 10 years.

A rolling loan gathers no loss.

I’ve long said that the mortgage default rate has no predictive value in spotting housing market trouble: it’s a lagging indicator. The reason is very common-sense: as prices increase rapidly, even someone with no equity to start with can refinance after a year or two, or sell and be able to cover the transaction costs. There is no reason to default in a rising market unless you’re particularly bad at arranging your finances and can’t even make it a few months to be rescued by the rising tide.

Then I was reading something about the junk bond fiasco of the 80’s and came across another interesting feature of credit bubbles. As you lend to less and less creditworthy people/businesses, your eventual loss rate will increase — those chickens eventually come home to roost. But firstly, rolling loans gather no losses: with loose credit, and increasing valuations on the underlying collateral, it’s very easy to just borrow your way out of trouble for the short term. Even then, the defaults don’t occur immediately except in the most egregious of cases (which did happen at the end of both the junk bond craze and the US subprime debacle). Another feature is that you increase the size of the lending pool as the credit bubble inflates. So if you look at the default rate, it may be flat even though the number of defaults is steadily increasing — just not quite as fast as the denominator (total credit) is also increasing. That makes the default rate look better than it really is, and doubly so when combined with the lag time before a loan defaults. Seth Klarman says that you could have spotted the junk bond crisis before the bust by looking at the default rate and adjusting for the increase in the denominator.

To give a quick example of how that would work, say your default rate is steady at 1% — this is a level you are happy with and for decades in your industry has been a level that indicates there’s no trouble. Then you rapidly increase the size of your loan portfolio, doubling it within say 6 months. You should have zero defaults on the new loans since they haven’t had time to default, so your default rate should be halved now. If it’s still 1%, you have a problem, and may not realize it.

So I went to look up some Canadian mortgage data. As expected, the default rate is low. It was rock-bottom when the 90’s first started, as prices were at their peak there. Then as Toronto’s bubble crashed out and the economy worsened, the default rate increased, topped out at about 0.7%, and then improved. Around the economic crisis and recession in 2008/2009 (also when Alberta prices started their “soft landing”) the rate increased modestly, but is still generally fairly low. That’s the blue line, and is a chart you’ve probably seen many times before.

But in that dataset is also the total number of mortgages, and that has increased much faster than the population growth rate: if you assume that the year 2002 is a “normal” period to start from, and increase the mortgage size with our population growth rate (1.1-1.2% according to Google), then in 2012 we should have just about 3.7M mortgages. Instead, that number is higher by about 16%. If you then take the number of defaults, and compare them to that denominator, you get an adjusted default rate in red — and that is, by the conservative historical standards of our country, fairly high. And this is still a lagging indicator. But on an absolute basis, it’s still pretty low: while the growth in the mortgage pool has been tremendous by mortgage standards, the dilution of the denominator isn’t as dramatic as it was with junk bonds.

To cut it up a different way, consider the situation as separate pools of mortgages. You’ve got say 3.7M mortgages that represents the normal, conservative Canadian lending market that everyone likes to talk about. These are the people that would own their houses no matter what the real estate boards were projecting, many have been in real estate for decades and have significant equity. With times being reasonably good and house prices being at record highs, we might expect the default rate on this pool to be near its lows of 0.1-0.2%. Let’s be generous and say it’s even higher than that — 0.25% — so this pool of mortgages represents about 9300 of our defaults today.

Then we have the 560k new mortgages that represents all the insanity of the past 12 years: demand pulled forward, low downpayments, long amortizations, teaser rates, fuzzy thinking — whatever it was that drew these people into the market that maybe shouldn’t have been there in the first place. Of that pool, 140k were issued just in the last year alone. Since we don’t expect defaults to occur immediately unless there is a huge problem in underwriting, we wouldn’t think of defaults as coming from those. That leaves 420,000 mortgages issued in the last 10 years that would be responsible for 7000 of the defaults, a rate of 1.7%. The default rate separated out for this pool is put in pink on the graph. As an aside, it goes off-scale in 2009 — in part because the fixed 0.25% default rate assumption simply wasn’t true for the regular mortgage pool (times weren’t great), and in part because that’s when house prices stopped going up and actually went down (briefly).

Now, this is all back-of-the-envelope and full of room for error. This is not the one peg I’d hang my housing bear hat on (that would be price-to-rent). But it is another way of looking at things that I hadn’t come across before.