This week, the Liberal Party of Canada announced that they would reverse the Conservative Party's plan to tax income trusts. Clearly, our nation’s largest political parties don’t see eye to eye on this issue. So what ever happened to income trusts following the Conservative’s initial announcement to tax income trusts in the first place?
On October 31, 2006, Jim Flaherty proclaimed to Canadians that the government would be implementing new taxes on income trusts in 2011. In essence, the income tax structure benefits which allowed trusts to distribute a very high percentage of their cash flow – in some cases, nearly 100% – would end. The following day, income trusts in Canada lost roughly one-fifth of their market capitalization – a huge loss for a company in one or two years, let alone one day. As the clock starting ticking, the management and directors of income trusts had to start contemplating what move was best for the funds. Should they cut distributions when they ran out of cash? Should they restructure? Should they refinance? Should they convert into an entirely new entity? Should they sell off some or all of the trust?
Two of these options become the most widely feasible for most income trusts: either cut distributions to the extent of the proposed tax increases, or convert into a corporate structure.
The logic for converting to a corporation (from a trust) is generally “short-term pain for long-term gain.” A conversion would:
a) Reduce the distribution expectations – many corporations have no dividend or one below 3%; and
b) Allow management to re-allocate funds to invest in growth opportunities.
The immediate reaction to the distribution cut would be for existing unitholders – aka “yield pigs” (investors who are looking for trusts distributing cash for a 10% or higher yield) – to sell off their units in large blocks (short-term pain). Many Canadian income trusts followed this route: Aeroplan Income Fund, TransForce Income Fund, Fairborne Energy Trust, High Arctic Energy Services, Trinidad Energy Service Income Trust, and Keystone North America. 90-days following the announcement that they would convert, these trusts traded on average down 17%.
The second option available in income trusts is to cut distributions to unitholders. Two Canadian trusts have taken this route: Primary Energy Recycling Corporation and Boralex Power Income Fund, which cut distributions by 31% and 22%, respectively. 90-days following the announcements they would cut distributions, they traded on average down 24%.
What can we learn from this? Firstly, the fundamental reason why people invest in any income trust is for its stability: predictable cash flows, tangible assets with easy-to-understand valuation procedures, tax benefits, and steady distributions. Income trusts also have significantly higher yields than bonds, bank dividends, preferred shares, and almost all other securities that one could name. Thus, when income trusts announce distribution cuts – especially when the market does not expect them – the unit price is at risk.
And yet, it would seem that management is stuck between a rock and a hard place: converting to a corporation results in a negative outcome for shareholders, as evidenced from their double-digit decline since conversion. Moreover, one’s entire shareholder base will be replaced with more aggressive, growth-focused investors which could take a more active role in their growth-development phase.
The conventional wisdom suggests that there are two certainties in life: death and taxes. But, if it’s up to Liberal leader Stephane Dion, perhaps income trusts will get a tax break after all. How unconventional.
Tuesday, September 23, 2008
Wednesday, September 17, 2008
Into the Abyss
No one knows where this market is heading or what it is currently doing. CFOs are perplexed at the relentless downward pressure on their share prices, even though their balance sheets may be in relatively good shape (I emphasize relatively). One of the main problems right now is market liquidity and borrowing costs. It simply costs a lot more money to borrow now than it did a week ago, a month ago, or a year ago. This is due to a complete lack of confidence in what banks are holding on their balance sheets, and how those assets are valued, in addition to a growing perception that perhaps the broker-dealer business model of Goldman, Morgan, and three of the casualties of the crunch - Bear, Lehman and Merrill.
Banks simply don't want to lend to each other because they have no idea of who might be next to fail. This has easily been one of the craziest two weeks ever. That's a pretty powerful statement. Consider this fact, one that I found truly outrageous and unbelievable when I first read it today on the WSJ website. For a brief period, investors actually bid more than par for 1 month T-bills. Think about that for a second. That's like me saying to you, "Hey, here is $101. In one month, can you give me back $100?". Investors, as the Journal noted, were thus saying to themselves, well, I'm going to go right ahead and take a loss on this, but at least the loss will be small and I'll know what it is. This is mindblowing. It has never happened before ever.
The game has completely changed for investors and traders. A year ago, heck, even a few months ago, there were people calling bottoms in the financials. Often, this was accompanied by an adage that basically said, "hey, these companies are big, safe, and they'll be around in 10 years, 20 years... so they are a solid long-run investment". You can't say that with any certainty anymore. Will Morgan Stanley be around in its current form in 1, 2, 5 or 10 years? Who knows. The company has a much stronger balance sheet than those that have failed. They have liquidity, but you never know what can happen once traders pummel the stock and capital providers lose confidence.
When will this all end? No one knows. It's going to be a long and painful process. Banks have to delever. Companies around the world bought complicated assets largely linked to the U.S. housing market for years. They did this by borrowing money. This borrowed money was for a period of time "cheap". Now the value of these assets are falling faster than a fan of the Ottawa Senators hopes during April. These assets need to be written down to appropriate levels - something many CEOs have been extremely reluctant to do due to the huge, huge losses that would be sustained. Once companies clean up their balance sheets, they need to repair them by rebuilding their capital base. The capital cushions have been diluted and eroded due to the aforementioned losses. Many banks were levered near 30 times. This has simply proven to be too much. Getting rid of all this debt will be long and painful, and will cost a lot of money. Consumers will be hit. Borrowing costs will rise. Hedge funds will be smoked. They rely heavily on leverage to amplify returns. Now debt is much more expensive, the returns won't be as rosy. The ripple effects will soon reach Main Street.
The philosopher George Santayana once opined that those who cannot remember the past are condemned to repeat it. The market must learn the hard way that too much leverage and risk that is hard to measure and quantify can engender great danger and many losses. One thing remains certain however, this is a tremendous learning experience for the market, and for observers of it.
Banks simply don't want to lend to each other because they have no idea of who might be next to fail. This has easily been one of the craziest two weeks ever. That's a pretty powerful statement. Consider this fact, one that I found truly outrageous and unbelievable when I first read it today on the WSJ website. For a brief period, investors actually bid more than par for 1 month T-bills. Think about that for a second. That's like me saying to you, "Hey, here is $101. In one month, can you give me back $100?". Investors, as the Journal noted, were thus saying to themselves, well, I'm going to go right ahead and take a loss on this, but at least the loss will be small and I'll know what it is. This is mindblowing. It has never happened before ever.
The game has completely changed for investors and traders. A year ago, heck, even a few months ago, there were people calling bottoms in the financials. Often, this was accompanied by an adage that basically said, "hey, these companies are big, safe, and they'll be around in 10 years, 20 years... so they are a solid long-run investment". You can't say that with any certainty anymore. Will Morgan Stanley be around in its current form in 1, 2, 5 or 10 years? Who knows. The company has a much stronger balance sheet than those that have failed. They have liquidity, but you never know what can happen once traders pummel the stock and capital providers lose confidence.
When will this all end? No one knows. It's going to be a long and painful process. Banks have to delever. Companies around the world bought complicated assets largely linked to the U.S. housing market for years. They did this by borrowing money. This borrowed money was for a period of time "cheap". Now the value of these assets are falling faster than a fan of the Ottawa Senators hopes during April. These assets need to be written down to appropriate levels - something many CEOs have been extremely reluctant to do due to the huge, huge losses that would be sustained. Once companies clean up their balance sheets, they need to repair them by rebuilding their capital base. The capital cushions have been diluted and eroded due to the aforementioned losses. Many banks were levered near 30 times. This has simply proven to be too much. Getting rid of all this debt will be long and painful, and will cost a lot of money. Consumers will be hit. Borrowing costs will rise. Hedge funds will be smoked. They rely heavily on leverage to amplify returns. Now debt is much more expensive, the returns won't be as rosy. The ripple effects will soon reach Main Street.
The philosopher George Santayana once opined that those who cannot remember the past are condemned to repeat it. The market must learn the hard way that too much leverage and risk that is hard to measure and quantify can engender great danger and many losses. One thing remains certain however, this is a tremendous learning experience for the market, and for observers of it.
Sunday, September 14, 2008
Another One Bites The Dust
I promise I won't break out in song, but am I the only one that hears Queen's song playing constantly in their heads? Let's be honest folks, it's a killing field out there. As I write this, Lehman Brothers appears as if it won't make it past the next few days, let alone the next few hours. Barclay's just pulled out of the bidding for the distressed bank. It was basically the last bidder available for Lehman. The Journal reported that Barclay's walked away from the bidding for a variety of reasons which will be determined in the coming hours and days. One can assume that no agreement could be reached on what would be done with the billions of dollars of toxic assets that Lehman holds. It is an end similar to that of Bear Stearns, save for the fact that it wasn't directly a liquidity issue that caused Lehman to fail, but rather a lack of confidence in the bank's ability to continue its operations. Lehman didn't face the cash crunch that Bear did, as Lehman was and is able to borrow from the Fed's emergency discount window, unlike Bear. It's more a question of what the value of Lehman's $50-odd billion of illiquid assets is worth. In the summer, Merrill unloaded about $31 billion of notional debt at 22 cents on the dollar. At some price, there is a buyer for the illiquid Lehman debt. The thing is, at that price, Lehman is probably bankrupt anyway.
One of the main reasons that Barclay's likely walked away was the fact that the government lead by Treasury Secretary Hank Paulson was completely unwilling to bail out Lehman as it did with Bear, Fannie and Freddie. They refused to provide a backstop for the risky mortgages that a potential buyer would have had to assume. The moral hazard is simply too great. The coming failure of Lehman sends a powerful message to those who seek and take excessive risks. The government isn't (and shouldn't) be there to wipe up the mess that private companies take. Although the government did largely bail out Bear and Fannie and Freddie, in those cases, the shareholders were almost completely wiped out. Nevertheless, the government did enter into a catch-22 situation, in that they almost created an expectation with their previous bailouts that they would continue to bail out firms. Lehman however, seems to have been the final straw.
So what's next for Lehman? Well, it appears as if (barring some new development) the firm will file for Chapter 7 bankruptcy, and will likely be liquidated. There was an emergency trading session called today in order to unwind the credit default swaps that Lehman had entered into. It's extremely complex and will take quite a while to sort out. With respect to Lehman directly, it will probably be broken up and its assets auctioned to the highest bidder. Distressed-debt funds, private equity funds, sovereign wealth funds - these will be the types of buyers of Lehman's assets. It won't be pretty for the markets. Tomorrow will be a manic Monday for sure.
In other news, Merrill - a firm that could be potentially be next on the credit-crunch casualty list - is apparently in advanced talks to merge with Bank of America, one of the suitors rumoured to have been interested in Lehman. According to the Journal, the price for Merrill has been pegged at around $25 to $29 per share. Over the past week, Merrill's share price has fallen by 36%. This will, in my opinion, at least help stabilize the storm that is about to descend this week in the wake of Lehman's likely collapse.
One of the main reasons that Barclay's likely walked away was the fact that the government lead by Treasury Secretary Hank Paulson was completely unwilling to bail out Lehman as it did with Bear, Fannie and Freddie. They refused to provide a backstop for the risky mortgages that a potential buyer would have had to assume. The moral hazard is simply too great. The coming failure of Lehman sends a powerful message to those who seek and take excessive risks. The government isn't (and shouldn't) be there to wipe up the mess that private companies take. Although the government did largely bail out Bear and Fannie and Freddie, in those cases, the shareholders were almost completely wiped out. Nevertheless, the government did enter into a catch-22 situation, in that they almost created an expectation with their previous bailouts that they would continue to bail out firms. Lehman however, seems to have been the final straw.
So what's next for Lehman? Well, it appears as if (barring some new development) the firm will file for Chapter 7 bankruptcy, and will likely be liquidated. There was an emergency trading session called today in order to unwind the credit default swaps that Lehman had entered into. It's extremely complex and will take quite a while to sort out. With respect to Lehman directly, it will probably be broken up and its assets auctioned to the highest bidder. Distressed-debt funds, private equity funds, sovereign wealth funds - these will be the types of buyers of Lehman's assets. It won't be pretty for the markets. Tomorrow will be a manic Monday for sure.
In other news, Merrill - a firm that could be potentially be next on the credit-crunch casualty list - is apparently in advanced talks to merge with Bank of America, one of the suitors rumoured to have been interested in Lehman. According to the Journal, the price for Merrill has been pegged at around $25 to $29 per share. Over the past week, Merrill's share price has fallen by 36%. This will, in my opinion, at least help stabilize the storm that is about to descend this week in the wake of Lehman's likely collapse.
Tuesday, September 9, 2008
UAL rides the rollercoaster
Dearest traders,
Hope you (all five of you that read this) took my Sunday night advice with the mid-day put options. Probably could have made an easy 50 percent there. For all of you who did not listen to my prophetic words, maybe you will learn for next time I dare predict the future.
Enough of the self-praise for today. An interesting anecdote for you that reveals a lot about the psychology (re: fear) of the markets right now. Early yesterday into the trading day, Bloomberg terminals flashed with the headline that United Airlines had filed for bankruptcy protection. No one dared to do any real fact check, just the word “bankrupt” was enough to send the shares plunging to $3.00 from a $12.16 open -destroying about a billion dollars of market value in the process. The internet allowed for all of this to happen within 13 minutes of the story being accessible. Lucky for UAL, management sorted things out; by the end of the day shares had rebounded, and were off only 11 percent.
One of the reasons I found this situation so amusing was how it was juxtaposed with a recent job description I was looking at. It was for a trading floor position (i.e. the guys who believed that UAL was worthless yesterday). Attention to detail and ability to verify/process information were listed as numbers one and two in attributes required for the position. It surely would seem that way. At the information session for this position, I asked one of the traders how could this kind of mistake could ever happen on a trading floor –supposedly where the best and the brightest go to work. He said that sometimes things are flying so fast out there, mixed with the recent scares from the banking sector, it might be safer to pull the trigger and ask questions later than to get caught in the bloodbath.
The point here is that the markets are still a little jittery. Today, the entire potash industry seems to be taking a beating. I dare say that this is a good time to get in, but this is more a long-term play, as opposed to the one-day like play I recommended Sunday. Soon to follow, a post on why I am bullish on potash.
Hope you (all five of you that read this) took my Sunday night advice with the mid-day put options. Probably could have made an easy 50 percent there. For all of you who did not listen to my prophetic words, maybe you will learn for next time I dare predict the future.
Enough of the self-praise for today. An interesting anecdote for you that reveals a lot about the psychology (re: fear) of the markets right now. Early yesterday into the trading day, Bloomberg terminals flashed with the headline that United Airlines had filed for bankruptcy protection. No one dared to do any real fact check, just the word “bankrupt” was enough to send the shares plunging to $3.00 from a $12.16 open -destroying about a billion dollars of market value in the process. The internet allowed for all of this to happen within 13 minutes of the story being accessible. Lucky for UAL, management sorted things out; by the end of the day shares had rebounded, and were off only 11 percent.
One of the reasons I found this situation so amusing was how it was juxtaposed with a recent job description I was looking at. It was for a trading floor position (i.e. the guys who believed that UAL was worthless yesterday). Attention to detail and ability to verify/process information were listed as numbers one and two in attributes required for the position. It surely would seem that way. At the information session for this position, I asked one of the traders how could this kind of mistake could ever happen on a trading floor –supposedly where the best and the brightest go to work. He said that sometimes things are flying so fast out there, mixed with the recent scares from the banking sector, it might be safer to pull the trigger and ask questions later than to get caught in the bloodbath.
The point here is that the markets are still a little jittery. Today, the entire potash industry seems to be taking a beating. I dare say that this is a good time to get in, but this is more a long-term play, as opposed to the one-day like play I recommended Sunday. Soon to follow, a post on why I am bullish on potash.
Sunday, September 7, 2008
Fannie/Freddie and their Chilean Parallel
My response to a comment made by Mr. Ballard under the “Fannie and Freddie” post: well, they should begin to stabilize or they "should" begin to cost taxpayers some serious cash.
I had the opportunity to do a course on Latin American banking systems while on exchange in Buenos Aires. There are many interesting parallels between the Chilean banking situation in the late 1970s early 1980s and what is happening right now in the US. In the 70s as a response to a major banking crisis, the Chilean government gave what amounted to a full guarantee to a major Chilean mortgage bank. This created an unlimited liability for the Chilean taxpayer. Chilean banks, incentivized to take on significant risk given that they were guaranteed in the case of default, exploited this opportunity and developed mortgage portfolios that were exceedingly risky. Eventually, due to an outside shock, the system collapsed and the Chilean economy was sent into a two-year depression, accompanied by all the social costs that this entailed.
Anyone who analyses the situation recognises the central failure here: regulation. If a government is to accept an unlimited liability of this kind, prudential regulation must accompany it to keep banks’ portfolio risk in check. The US government needs to follow up this move with a proper policy for prudential regulation on the mortgage front, or risk a fate similar to that of the Chilean banking system in the 1980s.
I commend the US government’s initiative to scale back the size of Freddie and Fannie, opening up the door for competition in this market. When it comes to banks, larger institutions are less likely to fail –but the old adage “the bigger they are, the harder they fall” is quite poignant here.
How do we as traders profit off this? It certainly scares away the bears who thought there might be some kind of eminent disaster in the wings due to the failure of either Freddie or Fannie. The US government eliminated the uncertainty associated with the worst-case scenario in this action. Treasury bills are down, now that the government has an exposure to these risky mortgage assets. This all has bad implications for the value of the dollar. Of course, all this will already be priced in by the time we normal people get to the markets tomorrow.
I am going to bet holders of bank stocks are breathing a sigh of relief right now. All I can say is that I wish I had listened to Scott Taylor last week and made that bank play... What I am going to do: play volatilities at mid-day with a few put options on bank stocks, after the excitement has subsided. I'm still pessimistic about this whole situation.
I had the opportunity to do a course on Latin American banking systems while on exchange in Buenos Aires. There are many interesting parallels between the Chilean banking situation in the late 1970s early 1980s and what is happening right now in the US. In the 70s as a response to a major banking crisis, the Chilean government gave what amounted to a full guarantee to a major Chilean mortgage bank. This created an unlimited liability for the Chilean taxpayer. Chilean banks, incentivized to take on significant risk given that they were guaranteed in the case of default, exploited this opportunity and developed mortgage portfolios that were exceedingly risky. Eventually, due to an outside shock, the system collapsed and the Chilean economy was sent into a two-year depression, accompanied by all the social costs that this entailed.
Anyone who analyses the situation recognises the central failure here: regulation. If a government is to accept an unlimited liability of this kind, prudential regulation must accompany it to keep banks’ portfolio risk in check. The US government needs to follow up this move with a proper policy for prudential regulation on the mortgage front, or risk a fate similar to that of the Chilean banking system in the 1980s.
I commend the US government’s initiative to scale back the size of Freddie and Fannie, opening up the door for competition in this market. When it comes to banks, larger institutions are less likely to fail –but the old adage “the bigger they are, the harder they fall” is quite poignant here.
How do we as traders profit off this? It certainly scares away the bears who thought there might be some kind of eminent disaster in the wings due to the failure of either Freddie or Fannie. The US government eliminated the uncertainty associated with the worst-case scenario in this action. Treasury bills are down, now that the government has an exposure to these risky mortgage assets. This all has bad implications for the value of the dollar. Of course, all this will already be priced in by the time we normal people get to the markets tomorrow.
I am going to bet holders of bank stocks are breathing a sigh of relief right now. All I can say is that I wish I had listened to Scott Taylor last week and made that bank play... What I am going to do: play volatilities at mid-day with a few put options on bank stocks, after the excitement has subsided. I'm still pessimistic about this whole situation.
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