Blessed by the Potato

Larry McDonald is giving people a sneak peek at Professor Milevsky’s upcoming book. One neat concept is the idea of a “holistic porfolio” — that you decide on your investments not just based on your risk tolerance and time horizon, but also on your human capital and career. I think I’ll add it to my summer reading list (as soon as I find my summer reading list in the move) as it sounds like a neat idea that I could get behind. Jonathan Chevreaux mentioned a similar concept in Findependence Day. So, as he says, if you’re an investment banker, maybe you should have a portfolio that is largely bonds, since your human capital is very stock-like: your job security and salary are probably closely linked with the equities market. Vice-versa, teachers are very bond-like with a stable job that is not sensitive to economic conditions, and a healthy pension to boot. So what money they invest should be largely in equities.

So, what about homeowners? On the one hand, a mortgage is like being short bonds – a negative bond, since you’re borrowing money rather than lending it. To compensate for that, Prof. Milevsky suggests homeowners should own bonds (and avoid REITs to prevent over-exposing themselves to real estate). Buying a house may also be like buying stocks because of the long-run returns, and sensitivity to economic conditions.

However, I questioned that, since I don’t think a person could expect positive after-tax returns in bonds when borrowing with a mortgage (maybe in corporates, but not by much) — you’d probably be better off paying down the mortgage. It’s important to be diversified, but does it make sense to do so without an expected return? Also, while the mortgage may be like a negative bond, to me the house itself is bond-like since it’s interest-rate sensitive and a slow, steady grower. Obviously there I’m disagreeing about houses being stock-like, and I might have to wait for the book for the full explanation of why I might be wrong. Though real estate may be best considered as its own asset class and perhaps we shouldn’t try to shoe-horn it into the bond-like/stock-like paradigm.

It promises to be an interesting discussion, so please feel free to jump over to the Canadian Business Online blog and join in with your thoughts!

There is a great deal of systematic risk associated with allowing people to buy homes with 0 or 5% down. It’s a part of the system that I really think needs to be changed, and that I hope does get changed soon if our government ever gets back to work (especially with the deficit, I hope they’re refunding their salaries for all this time off!).

The risk comes from a number of fronts. One is that it allows young, stupid people to buy homes. People who don’t have a track record of sticking to a budget, or of weathering a bad year, or even of being able to save very much at all are allowed to take on massive amounts of debt, which is in a way kind of crazy. Especially since the ability to buy with a small downpayment means that it often ends up that the downpayment is all the homebuyers have at first: no emergency fund in case something unexpected happens, and no equity in their home to borrow against. They start off stretched to the limits. Multiply it out across all the young recent homebuyers in our population, and a slight recession (where they are caught with their shorts down and need to sell due to job loss) can turn into a massive housing bust. I have to admit that I was actually surprised that the emergency interest rates were able to overcome this last year — I had given the Canadian housing market up for dead when it ground to a halt in the fall of ’08.

Add it all up: people with no proven history of being able to stick to a budget for a long period of time, no home equity to speak of, and no safety net, and it may not surprise you to hear that having no equity in your home is almost as strong a predictor of defaulting on your mortgage as having poor credit. Now, that’s for the post-crash US market, so it’s having no equity to begin with and then being upside-down that I’m talking about, but with only 5% and closing costs of ~10%, even a flat market can leave you upside-down if you’re forced to sell. Of course, “layered” risk factors are exponentially more risky: someone with poor credit (i.e.: someone who has been late or defaulted on a payment in the past) but managed to save up a 20% down payment and has it invested in the house has let’s say a ~1% chance to default in a bad housing market, and someone with good credit but no equity has a ~0.8% chance of defaulting, but someone with poor credit and no downpayment is way more likely to default, at say ~7%. This is where a lot of the attention goes in the discussions of the shoddy US lending practices and how Canada is “different”… but we’re writing a tonne more low-downpayment mortgages (though to people with decent credit), which is really only a difference of degrees vs subprime in terms of risks to the system. It’s not throwing gas on the fire in terms of adding accelerants, but it still burns.

And speaking of acting as an accelerant, have you ever heard someone complain in the last few years that “the market goes up faster than we can save!”? And what happens when someone complains that the housing market is going up faster than they can save? They stop saving and dive in with whatever they’ve got, even if they have to borrow the downpayment from mom and dad. It’s how speculative bubbles are made: prices start to rise, and people, being afraid they won’t be able to buy higher, buy in a panic. Which drives prices higher… When you have to have skin in the game, it can slow things down. If you have to save up 20%, it can mean that no matter how fast the market goes up, you still have to keep saving. You can’t bring demand forward from younger and younger people afraid of being priced out but who don’t have savings yet. And if you do get priced out then that helps act as a natural brake, because the demand is both removed when prices over-shoot (and people trying to save harder may spend less and put a damper on the local economy which may also help slow the market), and because it limits speculative frenzy. You don’t see a whole lot of people running down to pick up a half dozen condos on the first day of pre-sales when they have to put down 20%.

Of course, the most bizzarre proof that I have that low down-payment mortgages are dangerous is the existence of the CMHC itself. Banks are not allowed by law to hold a mortgage with less than 20% down — if they could, they might write many such mortgages. But doing so would put our whole banking system at risk if there’s a housing crash because there’s a good chance that even with a minor housing crash, with many homes having several years of mortgage payments under them, that the banks could not expect to recover more than 80% of the home’s original value. And banks failing due to aggressive mortgage writing could bring down commercial lending, and lead to panic and runs for deposits, and all the doomsday scenario stuff that we just went through in the US. So our banks aren’t allowed to hold those sorts of mortgages without insurance.

However, in a strange twist, a low-downpayment mortgage insured by CMHC is less risky to the bank than a conventional mortgage would be, since CMHC doesn’t just cover the difference between the actual downpayment and the insurance-free 20%, but rather the whole cost of the mortgage. The risky mortgage is basically off the bank’s balance sheet and put into a CMHC mortgage-backed security. Ah, yes, “securitization”. You’ve heard that word in the news a lot: a way of taking the risk away from the people making the decisions about writing a mortgage. Yes, that risk factor is alive and well up here in Canada, despite the recent lessons from the south.

As a new year rolls around, I’ve noticed a lot of questions out there about what to do about contributions to the TFSA: how much room there is, whether to contribute, what to hold, etc. I’ll try to break it down, and don’t mind going into more detail in the comments if anyone has detailed questions, but to put it very simply:

You have $5000 of new contribution room for 2010. Contribute $5000. Invest in something (TD e-series mutual funds if you don’t need the money for a decade or so, or a high interest savings account if you might need the money soon). If you procrastinated all the way since last January, then you also have your $5000 of room from 2009, for a total of $10,000 of contribution room that you should use.

That’s it, see you next year.

Seriously, it’s not that complicated — it’s certainly far simpler than the RRSPs people have been dealing with for years. There’s no need to check your notice of assessment for your contribution room, no need to figure out tax brackets and deductions, and no deadline. Everyone out there, if you have $5000 to invest, should be sheltering it in a TFSA.

There is some sidebar discussion about whether a TFSA or an RRSP is a better way to save for the long term if you only have enough money to fill one or the other. My answer, at the risk of over-simplifying, is simple: go with the TFSA. Why? Because if you screw up and need the money back, you can withdraw penalty-free* and get the contribution room back in under a year. People all too often get paralysed when faced with too many complicated decisions, so don’t sell yourself short. If you’re going to procrastinate until the end of the year over which vehicle is better for you and end up in neither, then just trust me and pick the TFSA. Perfect is the enemy of good enough.

*(though your bank may charge a transaction fee, sometimes hefty)

Note that TD does not give me a kick-back for all the referrals I throw their way but I wouldn’t mind if they did <nudge , nudge>. While it’s a bit more paperwork to set up, a self-directed TD Waterhouse brokerage account may be easier than an e-series mutual fund account since the reps actually know what it is, and it can be done in person. Both can hold the low-cost e-series index funds.

The other bloggers got to play a stock-picking game for 2010, so I suppose I will too! Note that this is a game with a set end-date so looking for value is not necessarily the way to go — often a shoot-the-moon approach works well in these kind of games. So bear that in mind, and don’t consider any of these as recommendations for you to actually buy!

First off, I’ve got to agree with Mike from Four Pillars and say that I’m bearish on gold. As suggested in the comments, I’ll short the bull ETF rather than long the bear one. As an aside, I very nearly bought some HBD in real life at the beginning of December, I was fairly certain that gold’s shine had reached the end. Unfortunately these commodity ETFs are highly dangerous financial instruments — even if you’re right in the end, you can be destroyed by volatility in the meantime. After giving it a long, hard think through, I doubt I’ll ever be sure enough to buy in for real.

Pick 1: Short TSE:HBU. ($22.22)

Next, I’ve read through analysis of the US mortgage insurers, Fannie and Freddie. I have a real hard time deciphering their books. More importantly, I can’t get my head around the political risk — is the government purposefully trying to drive these two entities into the ground? The terms of F&F’s bailout were much stricter than any of the banks, and in the last reporting period, Fannie had buttloads of cash on hand, which is costing them 10% to hold on to! I can’t fathom why the government is making them carry that load, rather than making the bailout a demand loan, other than to kill them. However, if the US government isn’t going to kill them off entirely, then there looks to be a good chance that the (now junior) preferred shares will have some value. I don’t know if that value will be realized by year-end, but since they’re trading for pennies on the dollar, I’ll make that my next pick.

Pick 2: Long NYSE:FRE.W (I’m not sure which series exactly to pick — I figure depth below par value is probably more meaningful than the coupon that’s not being paid. The W closed 2009 at $0.95 US)

IMRIS is a small Canadian biotech company that makes an MRI system hung from rails so it can be moved in and out during surgery (vs moving the patient in and out of the fixed MRI). They have a pretty decent order backlog as it is, and a partnership with Siemens. In addition, they’ve had some new applications recently approved. I think now that the economy is recovering (which affects hospitals and universities too), that their business will pick up and they’ll resume the parabolic growth curve for a few years, although they’re still at the money-losing stage of their development. Also, hopefully the market’s attention will return to small, speculative plays like this.

Pick 3: Long TSE:IM ($5.30)

Finally, I still like the energy sector. I’m tempted to pick XEG (an ETF of Canadian oil companies, not a commodity ETF), but I own it in real life; while I like it as an investment, I don’t think it’s going to shoot the lights out in a competition like this. So instead I’ll pick A123, a maker of batteries for electric cars, on the theory that a return to high gas prices will goose the hybrid/nascent PHEV market. Personally, I think A123 is already overhyped and I probably wouldn’t invest in it in real life at this point. Lithium ion batteries have a lot of potential, but NiMH batteries are almost as good (ok, heavier and bulkier, but cheaper too), and have decades of demonstrated real-world reliability in EVs and hybrids. For the next year or two, A123 may do well (especially if GM ever actually builds the Volt and it doesn’t suck), but I have to wonder what will happen when the Cobasys patent runs out in 2014 — will LIon become an expensive niche?

Pick 4: Long NASDAQ:AONE ($22.44 US)

I’ve long been opposed to the privatization of Canada’s Crown corporations. To my mind, most of them exist for very good reasons: to ensure service delivery in what might otherwise be an underserved market, to foster competition in a marketplace prone to monopolies/oligopolies, or to provide a service that private corporations can not be trusted to handle. In many cases to operate without profit as the prime motive. Plus privatization hasn’t served us terribly well in the past: look at Ontario’s 407 or Drive Test centres, for example.

However, with the recession putting a dent into the government budgets, there is a lot of talk about privatization again. I’m even more opposed to it now because in addition to the other factors, the timing isn’t particularly good. Interest rates are low, and there is demand for safe government bonds (or an aversion to risky investments). The government should have no problem issuing all the debt they need to cover the deficit in this environment, so a sale isn’t a necessity. More importantly, the private sector is going through some of the same pains of the recession — and with the flight to safety, have to pay a premium to raise money — so they’re not going to be able to put attractive valuations on the Crown corporations for buyouts. We’ll get more buck for our bang by waiting until conditions to improve to sell (at which point interest rates may be higher and the 5-year bonds may be maturing and all set to be paid off).

Call me a Keynesian, heck, call me a socialist, but to my mind the economy runs in cycles. The job of the government is to work against the boom-bust cycle: the government is supposed to run massive deficits during recessions to prop up the economy (and to weather the decreased revenue), and is supposed to pay that debt down during the good times with surpluses. However, everyone always seems shocked and appalled whenever a recession brings about the double-whammy of increased spending and decreased tax revenue, and the government starts racking up debt (though caution with debt is always warranted). When things turn around and a surplus is generated, people are again put off by the fact that the government is “over-taxing” them, and demand tax cuts and pork-barrelling, when the boom times are when taxes should be raised and the debt retired. If the government had to take over some failing industries in the downturn, such as say a railroad or two, the boom times might be a good time to spin that off in an IPO; not trying to sell of what good assets they have in a downturn.