First are tax cuts.  The basic personal amount has gone up to $10320 and the thresholds for the 15% and and 22% tax brackets are now $40,726 and $81,452.  Note that the basic personal amount was already scheduled to have gone up to $10,100 this year (from $9,600 in 2008).  Whatever, it’s still less taxes that I have pay this year, right?  Yup.  By my calculation someone earning $81,452 or more will save $391.  According to data from StatsCan http://www40.statcan.ca/l01/cst01/media01-eng.htm the average person earns 41839.2 (the median is probably lower as the income of Canadians does not follow a normal distribution) so the average Gordon will save about $284.  Yay.  Can you hear the excitement in my voice?  Well, at least taxes didn’t go up.

Payroll taxes – I mean “EI premiums” – are going to be frozen this year.  Usually they go up every year, so this year I won’t have to pay more towards Employment Insurance.

“Action to Stimulate Housing” – haven’t we just exited the longest and most pronounced housing boom in decades?  In any case the big news here is a temporary Home Renovation Tax Credit.  This credit is only good for 2009, for projects between $1000 and $10,000.  Remember that credits are for the lowest bracket, or 15%.  So this means a savings of up to $1350.  And it means that I bought my new windows a few months too soon.   There are a few catches to consider:
* the credit is for costs above the $1000 threshold.  So if you install carpet for $1001 your credit is (1001 – 1000) x 15% = 15 cents.
* this credit is only for improvements that are deemed to be “enduring in nature” i.e., not appliances nor maintenance.

There are many other initiatives that are aimed at helping Canadians as whole, like infrastructure, etc.  But these appear to me to be the only things that individuals can take advantage of.

Expected value is statistical tool that economists may use to determine what outcome to expect.  It is sum of the probabilities multiplied by the outcomes – note that this is not the same thing as the probable outcome.  This concept can best be described with the use of an example.

Suppose that you and nine friends get together for a game of chance.  Each person bets one dollar and puts their name into a hat.  You draw one name out of the hat and the winner gets to keep all the proceeds.

10 people betting $1 apiece, only one winner. Your odds of winning 1 in 10 or 10% (conversely, your chance of losing is 90%).

Therefore, the probable outcome is that you will not win the draw and thus lose one dollar.

Your expected value is -$1*90% + 10*10% = $0.10 (90% chance of losing your $1 bet, 10% chance of winning $10).

This means that if you kept playing all night you could expect that, on average, you would earn ten cents for every dollar bet.  If you played ten times in a row, statistically speaking, every person should come out even.

When playing at the casino the house generally has the games set up so that the expected outcome results in proceeds to themselves.  For example, according to wikipedia, the game of roulette is set up so that the odds of winning is 1 in 38 and the payout is 35 to 1.

Expected Outcome = (-1$*37/38) + ($35*1/38) = -$0.0526.  Therefore, if I play once then the probability is that I will lose.  If I play all night then I can expect to lose, on average, five cents on every bet.  Thus the house earns five cents on every dollar bet.

Which is a better ‘investment’?  With the draw you expect to earn something every bet whereas with roulette you lose with every bet.

Modern Portfolio Theory uses this same idea to identify the expected value for the return your portfolio will see.

All of the jobs numbers from around the world are showing the same things, people are losing jobs.  Since Alberta was really driving Canada’s economy seeing that people are losing jobs and taking pay cuts there is the confirmation that we’ve been expecting.  None of this really comes as a surprise of course with oil worth less than a third of what it was a year or two ago.  My point is simply that the good times are over.  Canada’s manufacturing sector was lagging for a long time and the US housing market started to collapse a few years ago already.  But now that Alberta has finally succumbed the peak in the Canadian economy is over as well.

The other side of this is related to real estate.  Calgary real estate peaked about a year about already.  The absorption rate (the time is would take, statistically, to sell a house) is around 10 months, but prices have not fallen very much.  The key was that there were still low unemployment and many high-paying jobs.  In fact, one reason for the dramatic rise in real estate prices was the high income earners were looking to jump aboard the express train of high yielding real estate.  When prices stopping rocketing to the sky it didn’t matter because speculators were able to hold multiple properties, either by renting out the excess or being comfortable allowing their high wages to carry them through the rough patch.  Now that people are losing jobs it will be the time to really pay attention to house prices.

Things have been cooling off in the last 18 months, or so, so I decided to take a look at the Calgary Real Estate Board’s December 2008 statistics package.  Side note: I have to hand it to CREB for keeping and publishing great stats, the best in Canada, in my opinion.

• Over the last year median sale price has dropped from 368,500 to 340,000, or 7.7%.
• They’ve had huge volume compared to sales for a long time now and the absorption rate is currently sitting at 10 months.  That means if you have a house to sell, you can expect it to take 10 months before it gets sold.

What isn’t in this report is the state of the local economy.  I have heard from friends that the job market is starting to look bleak.  People are starting to lose jobs.  Apparently, if you apply for a job and don’t list a Calgary address then the application ends in the garbage.  What this means is that inventory may increase and/ or prices will start to drop as people are forced to sell.

By and large, however, the insurance industry works as it should.

• The premiums are based on risk and coverage.  An 18 year old male insuring a Ferrari is going to cost.. alot.  Short driving exprerience and statistical likelihood of an accident, and the value of the asset being insured.
• Deductables are there, IMHO, to prevent us from making frivolous claims.  Consider that a smashed windshield might cost 100$ to replace, but in total might cost $150 insurer once they pay administrative costs.
• The coverage can be somewhat sneaky, e.g., they may pay for floods but not sewer backups, and we never realize it until it is too late.  However, you do get the coverage that you pay for.

So whatever our feelings on insurance, it works as intended.  Usually.

Insurance works best when only a few of the many insured make claims.  When widespread catastrophe strikes it becomes very difficult for the insurer to cover all payments.  It’s not like an insurance company puts our premiums under their mattresses, they invest the money. They invest your premiums in the same market that has seen your savings and retirement plans lose 50% of their value in a few short months.

I’m not doomsaying, I’m not predicting that you won’t be able to get your car fixed after your recent fender bender.  I am merely pointing out that insurance is not a guarantee.  For more of a gloomy perspective check out this from Bankruptcy Law Network

Where I am going with this is how this relates to the Credit Default Swap (CDS) market and our current ‘credit crisis.’

CDS’s are similar to insurance, except that they insure against loan defaults.  Your bank will pay a premium for insurance against people not paying back their loans.  The good folks at places like Bear stearns will gladly accept premium payments at the risk of having to pay out the full amount in case of default.  Unfortunately, if a large number of these loans do default then the insurer may not be able to meet the payments.  Your bank paid their premiums for insurance but did not receive the benefit.

Consider this hypothetical example.

Balgonian International Group (BIG) commences a leveraged buyout of Louisiana Trust Insurance (LTI) for $2B.  It’s leveraged because they need a loan, which they get from Bull Steers Investment Bankers (BSC).  BSC implements a Credit Default Swap to remove the risk from their books, Frehman Sisters (FEH) accepts the swap.  FEH gladly accepts the premiums and invests them wisely in an up and coming insurance company called Louisiana Trust, whose shares have seen a dramatic increase lately (since the announcement of a buyout).

Unfortunately a bad hurricane season, and the fact that LTI only services Louisiana, has bankrupted LTI.
BIG has also been hit hard and they can not make the payments on their loan, they default.
BSC attempts to recoup their losses on the loan by asking their swap counterparty (FEH) to pay up.
FEH invested the premiums so they sell their stake in LTI.  Unfortunately, due to the bankruptcy of LTI, their stock has dropped 99%.
Everyone loses.

To be fair cheap credit can be a great thing.  It is the ease with which we get it and how we use it that determines whether or not it is a good thing.  Easily obtained credit and cheap credit are two different things.

Financing a house at 4% is definately cheaper than financing it at 4%.  Being pre-approved for twelve different credit cards at the same time while purchasing that dream home is ease of credit. Combining the two can be deadly.

Here are a two tips to help avoid the credit trap.

1. Pay cash for everything!  You can only spend what you have.  An alternative for the more disciplined is use free reward credit cards to pay for everything (and get the cash back, or free groceries) – but only buy as much as you can back with cash.  This takes much more discipline and you need to be extra cautious for the trap.
2. Buy only what you can afford.  It is reasonable to assume that you will need to take out a mortgage to buy a house but buy one that makes sense given your income – not what you can afford based on the monthly payments!

That is it, two tips to sum it up.  Buy what you can afford and pay cash (or equivalent).

Paying the maximum payment you can afford every month for a house is not a house that you can afford.  What happens if/when the payments go up?

If you want a big screen TV, plan for it in your budget.  It may takes months to get enough cash but you will know that you will have enough to pay for it.

Thinking of a car loan?  What happens if you finance that shiny new Escalade for $50,000 and a few months later get into an accident that destroys it?  By that time the car has depreciated, as car do, to below what you owe on it.  E.g., insurance offers you $40,000 but you still owe $45,000.

Joe lives near a lake, he loves water skiing so he decides to buy a boat (and truck to haul it around, of course).  The price tag for the new toys comes to $50,000.  He doesn’t have the money but, luckily, his bank offers him a Home Equity Line of Credit (HELOC) on the equity that now exists in his home.  The HELOC rate is a low 5%.  The great part is that he doesn’t need a re-payment schedule, he can pay interest only  but decides to pay it off over 25 years.  Payment = $290/m.

Joe pays for everything with credit and tries to pay off the full amount every month.  Unfortunately, there always seems to be a good deal on something that he needs.
Month one: 50″ plasma & home theatre combo sale.  Price = $6000
Month two: a much deserved vacation away from work.  Destination, Cabo.  Price $3000
Month twelve: etc.  By this point Joe has somehow seen his credit card debt maxes out at $25000.  At 18% financing, his monthly interest payments are sitting at $375/m.

Total income: $3000/m

debt service liabilities: $2243/m
Other liabilities (food, property tax, utilities): $500/m

Net income: $257/m  Joe is still keeping his head above water (although he’s not really paying down his debt and he still has no emergency savings.

Unfortunately, interest rates have risen.  His house now costs $1800/m (at 5.5%) and his HELOC is up to 7%, so the payments are $350/m.  Property taxes have also gone up to help pay for the infrastructure in the new subdivisions.

Total income: $3000/m

debt service liabilities: $2525/m
Other liabilities (food, property tax, utilities): $550/m

Net income: -75/m  Yikes!  To cover the shortfall, Joe gets another credit card.

Joes truck needs a new transmission, $2000
His house needs a new water heater, $275
Economic downturn means that Joe gets ‘downsized,’ he’s a smart guy and gets a job quickly but has to settle for $45,000/yr, or $2800/m

Monthly payments keep increasing, he sees the power of compounding… in reverse!

Joe has fallen victim to the Jaws of the Credit Trap!

It is important to remember that the moon, the seasons, and the economy are all cyclical.  Unlike the seasons we cannot predict with any degree of certainty how long the economic cycle will last.  Bear markets tend to start quickly and bull markets tend to recover slowly.  We’ve definitely seen the stock market tank very rapidly over the past months.  However, the indices appear to be stabilizing, despite the bad news that surrounds us, despite the tax loss selling, and despite the Madoff Affair.  We are likely in for a long road to recovery, hangovers are never fun.  But things will turn around, and hopefully, we have nowhere to go but up.

Image courtesy of Yahoo Finance

This is not the time to mourn, but to dance.
Merry Hibernal Solstice everyone.

Arbitrage is taking advantage of a price difference in multiple markets.  In the futures market an arbitrage opportunity presents itself when the basis between the spot and futures prices deviates from the normal cost of carry.

There are times when a futures price is more expensive than it should be, i.e. costs more than the spot + the cost of carrying the asset.  During these times an arbitrager could sell futures contract and buy the asset.  This is know as Cash and Carry Arbitrage.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.
A 3 month gold futures contract, for some reason, currently costs $1060
The arbitrager performs a Cash & Carry by purchasing some gold and selling a futures contract to deliver gold in three months.

cost of gold = $1000
cost of carry = $10/month x 3 months
Income from futures sale = $1060

Net = $30.  Mr Arbitrager made an easy $30.

There are other times when a futures price is cheaper than it should be, i.e., costs less than the spot + the cost of carry.  During these times an arbitrager could buy futures contract and sell the asset.  This is know as Reverse Cash and Carry Arbitrage.

hmm, this may not work quite as slick.  I cannot sell the asset today if I don’t own it!  Don’t worry, you may be able to borrow it from someone else and then sell it:)  Yeah, I know, they may not like you selling their gold, but you will get the gold back because you bought a futures contract.

e.g.,
Gold currently costs $1000 / oz, and has an associated cost of carrying (storing, insuring, etc) of $10 / month.  A 3 month gold futures contract, for some reason, currently costs $940.  The arbitrager performs a Reverse Cash & Carry by:

• borrowing the gold from his girlfriend
• giving her his prized stamp collection as collateral
• paying her rent
• selling the gold
• purchasing a futures contract to receive delivery of gold in three months.

Mr Arbitrager made $100 by selling the gold and buying a cheap futures contract.  However, he will still need to pay rent on the borrowed gold and he loses the enjoyment of his stamps until the gold is delivered.

The difference between the spot and futures price is called the basis.  In a normal market there are adequate supplies of the underlying asset for every futures contract (i.e., every delivery month) and the basis reflects a premium on the futures contract (for the cost to carry).  For a better explanation, see yesterday’s post

Occasionally the futures price will drop below the spot price which is said to be an inverted market.  Of course, such a simple term would not be fun, so I present to you… (drum roll please), “backwardation.”

Normal market = contango
Inverted market = backwardation

Backwardation may occur for a number of reasons:

• Seasonal fluctuations of asset.  In the winter, the demand for heating oil increases but by the spring the demand will have waned so the futures price will not increase.
• A sudden lack of the asset.  When a refinery breaks down the supply of gas starts to drop and the price goes up, but generally the refinery will be operational again in three months so the futures price doesn’t need to increase.
• Asset does not store well.  Gold keeps well in my basement, oranges don’t.  If the oranges are ripe now then it would be better to own the physical asset.
• Asset is difficult to short sell.  Assets that are hard to short are generally those that meet the above conditions as well.

In an inverted market people prefer to own the physical asset.  If I need oil to heat my house then I would place a high value on owning the asset during a blustery Canadian winter.  The value placed on the commodity is known as a convenience yield.  Isn’t it convenient that I actually own oil now so that I can use it to heat my home and I won’t freeze.