The consequences of political stupidity

“Papandreou’s move also exposes the fatal flaw of grand plans for a political or fiscal union to support the euro: the “people,” not governments, remain the real sovereign. Governments may sign treaties and make solemn commitments to subordinate their fiscal policy to the wishes of the EU as a whole (or to be more precise, to the wishes of Germany and the European Central Bank); but, in the end, the people may reject any adjustment program that “Brussels” (meaning Berlin and Frankfurt) might want to impose.” (An except from “The Revolt of the Debtors” by Daniel Gros, Director of the Center for European Policy Studies, in an op-ed on Project Syndicate, November 3, 2011)

We are about to witness a major credit crisis unfold yet again. This time, the culprit isn’t inflated housing values or sub-prime mortgages. No, this crisis is a lot more political than it is financial.

At the center of the crisis we find Greece, a small peripheral nation that has long lived beyond its means. As Greece is a member of the European Monetary Union (otherwise known as the Eurozone), a community of nations who share the same currency, it finds itself in a rather remarkable predicament of having to rely on other Eurozone members to bail it out so that it won’t default on its obligations to bond holders — many of which are Europe’s biggest banks.

The governments of Germany and France, who are major contributors to a stability fund — the EFSF — that provides the bailout payment stream to Greece and other peripheral nations, are demanding that in exchange for a bailout, the Greek government must institute a series of deep austerity cuts that have so far proven to be quite useless in solving Greece’s economic woes. Until now, the austerity measures demanded by France and Germany have been passed by the Greek parliament despite huge public opposition. It appears, however, that you can’t keep the electorate quiet for long.

Following last week’s summit where European leaders have agreed tentatively to expand the existing 400 billion Euros European Financial Stability Facility by an additional 1 trillion Euros, Greek prime minister George Papandreou surprised officials this past Monday by announcing he would hold a public referendum on the additional austerity cuts demanded by France and Germany in exchange for an 8 billion Euros payment so that Greece could pay its bondholders in December. According to Papandreou, the referendum is necessary so that the Greek electorate can decide if they would like to remain in the Eurozone. European leaders were blindsided by the decision. In an emergency summit that took place yesterday in Cannes, the leaders of France and Germany gave Greece an ultimatum: pass the austerity cuts that we demand without a referendum or go bankrupt.

“The EU remains a collection of sovereign states, and it therefore cannot send an army or a police force to enforce its pacts or collect debt. Any country can leave the EU – and, of course, the eurozone – when the burden of its obligations becomes too onerous.”

European officials are being quite cavalier with their attitude towards Greece. While no one is denying that Greece has serious financial issues that must be addressed, the quick solutions that European leaders are seeking to alleviate the markets are non-existent. The austerity cuts that have been demanded by France and Germany are not necessarily designed to help Greece but rather please the electorate back home. Both the French and German public believe, and understandably so, that they should not foot the bill to bail out a small country that has been reckless with its finances for years. Germany’s Chancellor Angela Merkel and France’s President Sarkozy understand very well that if they don’t take a tough line with Greece, they would pay a heavy political price when they run for elections.

“As long as member states remain fully sovereign, investors cannot be assured that if the eurozone breaks up, some states will not simply refuse to pay – or will not refuse to pay for the others.“

The ramifications of a Greek default would be felt across the Eurozone. Whether European officials admit it or not, Greece is the one in the driver’s seat. Greece could very well refuse the bailout, default on its obligations to bond holders, and bring back the Dragma. If anything, many economists have argued that defaulting on its debt would actually be helpful to Greece in getting back on track. However, the consequences of a Greek default for the Eurozone as a whole would be enormously challenging. The exposure that French and Italian banks have to Greek bonds means that these banks would have to be recapitalized quickly to offset the losses.

Another by-product of a Greek default is that bond yields of troubled European economies such as Spain and Italy would surge, making it almost impossible for these nations to borrow money through the bond markets. The cracks are already starting to appear; the yield on 10-year Italian bonds reached a Euro-era high of 6.40% earlier today. Once the yield approaches 7%, it is generally recognized that borrowing costs at such high levels are unsustainable.

In the worst case scenario, the EFSF would now be tasked with bailing out Spain and possibly Italy. Greece found itself in exactly the same predicament early in the crisis, as did Portugal and Ireland. And what’s even more troubling is that while the European Central Bank has been buying Italian bonds in an effort to lower the yield, the yield has actually continued to rise as investors lose confidence in the ability of European officials to resolve the crisis. Today’s .25% rate cut by the ECB effectively signals that Europe is about to enter into major crisis mode.

The approach taken by European officials is quite baffling. Three years ago at the peak of the sub-prime crisis, U.S. Treasury Secretary Hank Paulson effectively gave a blank cheque to the banks and successfully prevented a collapse of the banking system. While we can argue about the merits of giving the banks so much capital, in the end it stabilized the financial system. While the monetary system of the Eurozone is very different from the U.S., what we need are bold thinkers at a time where the world’s banking system is once again at risk.  The questions were asked later because U.S. officials understood that if they didn’t act quickly, a collapse of the banking system would lead to the collapse of not only the U.S. economy but the world’s economy as the credit markets dry up and consumers empty out their bank accounts.

One has to wonder why European officials aren’t thinking along the same lines given the calamity that’s ahead of them. Instead of providing Greece with the money it needs and signaling to the markets that Europe has the financial resources and political willpower to take care of its own problems, leaders have opted to engage in a game of chicken. This is a strategy that’s going to fail and drag everyone else along for the ride.

Tax-deductible mortgages: is now the best time to invest?

“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”

A popular quote by Warren Buffett, CEO of Berkshire Hathaway and legendary value investor.

Over the past few months I have noticed more people calling me up about tax-deductible mortgages, the so-called Smith Maneuver. Investors, particularly those with a long-term horizon, are looking for a cheap source of capital as stock valuations, especially high quality value stocks, are hitting very attractive multiples as a result of all the volatility we have seen in the markets over the past few months. We’re at a point where borrowing to invest in the financial markets can be a very lucrative proposition for the right individual. The reasons behind this logic are:

• Interest rates are poised to remain low for at least another year and possibly longer as the world’s largest economies shift into slower growth
• Inflation so far remains well-anchored which means that central banks are unlikely to proceed with dramatic rate increases
• Housing prices in large metropolitan areas such as Vancouver and Toronto remain on solid footing
• Stock valuations of large blue chip companies, both in Canada and abroad, have reached very attractive valuation levels

With a tax-deductible mortgage, the client essentially taps into a home equity line of credit (HELOC) to borrow funds which are then used for investment purposes. The interest costs paid by the client to borrow the funds are tax-deductible as long as the funds are used to purchase qualified investments as defined by the Canada Revenue Agency (CRA). Note: interest on borrowed money to make an RRSP contribution is not tax-deductible.

The main attraction of this strategy, aside from the fact that the interest is tax-deductible, is that a HELOC provides a cheap source of capital. Unsecured loans from the bank or credit union are priced at about 8% to 10%. Personal lines of credit are priced at the institution’s prime rate (currently 3%) + 5% to 7%, effectively the same rate as a typical loan. At such high rates, there’s no logic in borrowing the money to invest unless you’re very confident that your investment can yield a much higher return than the cost of borrowing (highly unlikely at these rates). In contrast, our lowest HELOC rate at the moment is prime + .25% or 3.25%. That’s twice less than the price of an unsecured loan or line of credit. Moreover, a HELOC can be set up with numerous positions to offset interest rate risk. For example, a portion of the balance can be set up as a floating (variable) rate while the other portion can be set up as a fixed rate. There are many HELOC options available so it’s important to pick one that:

• Provides you with the maximum amount of flexibility in terms of access to capital
• Be structured in a way that reflects your level of risk aversion

That’s the borrowing component.

Next, you will need to set up a portfolio or investment strategy on how to use the funds. For this strategy, I highly recommend the services of a fee-only adviser. I recommend their services for two reasons:

1) They set up a personalized financial plan that revolves around your objectives and risk tolerance

2) Fee-based planners are generally not compensated through commissions from mutual fund companies. As such, they can structure a portfolio using low-cost investment vehicles such ETFs and individual stocks

Most fee-only planners have at least a Certified Financial Planner designation (CFP) and some carry additional designations such as Certified Investment Manager (CIM) through the Canadian Securities Institute and in some cases even a Chartered Financial Analyst (CFA) awarded by the CFA Institute. Simply put, fee-only planners are highly accredited individuals with a wealth of experience. The typical client includes executives, business owners, high-net-worth individuals, and charitable foundations. While some fee-based planners require that clients have a sizable portfolio to become a client, there are fee-based planners who are willing to accept clients with smaller portfolios.

In terms of choosing the right investment approach, it is important to talk with your financial planner about your objectives and risk tolerances. It would be helpful to perform a stress test so that you can become aware of your personal level of risk aversion. You’d be surprised how often investors have no clue about the true meaning of risk. While some financial planners may only ask a few generalized questions, I personally recommend taking the investor questionnaire provided by the Vanguard Group who pioneered low-cost index funds and passive ETFs. It is one of the better stress tests available out there for individual investors. In order to maximize the efficiency of a tax-deductible mortgage, it is important to choose investments that are tax efficient. Mutual funds that have high turnover ratios, for example, can trigger a series of taxable events that can erode your returns and offset the tax deduction.

Once your investment plan is implemented, it is important to keep in touch with your adviser (or rather your adviser should be keeping in touch with you) on a regular basis. If any life-changing events have taken place (new baby, marital breakdown, loss of income, etc.), make sure your adviser becomes aware of it so that appropriate adjustments can be made if necessary.

There are risks associated with borrowing to invest

First, the projected rate of return may change negatively and the value of your investments can drop. Even if the value of your portfolio drops, you are still liable for the HELOC payments. Second, by tapping into a HELOC, you are leveraging the equity you have built up in your home. Should the value of your home decrease for any reason, you may find yourself underwater with your mortgage. Third, if you decide to float the rate on the revolving position, the rate may change at any time. Remember, lenders control line of credit rate by adding an increment on their prime rate. Unlike a variable rate mortgage where the spread is locked, HELOC spreads are not locked and can be increased by the lender with minimal notice. Fourth, the lender may also collapse the HELOC facility altogether (highly unlikely but the risk is there) and you will be liable for any amount owing on the HELOC. Fifth, in some cases it may actually be more worthwhile to prepay the mortgage and build wealth through equity instead of borrowing to invest in a highly volatile market environment.

Putting the amount of risk involved in perspective, it’s crucial for clients and their financial planner to run a series of “what if” scenarios to determine whether the client is suitable for this strategy. As I have said previously, for the right individual with a very long-term investment horizon this can represent a good opportunity to diversify their nest egg and buy into the markets when valuations of many high quality equities are quite low. Other individuals, however, would be better paying off debt.

To summarize the steps of putting together a tax-deductible mortgage:

1) Pick the right HELOC product

2) Pick the right financial planner

3) Define your objectives clearly using multiple time horizons (short, medium, and long-term goals) and understand your personal level of risk

If you would like to consult with us about a tax-deductible mortgage, feel free to send me an email. We work with independent fee-only planners who specialize in low-cost investing and we have preferential pricing from lenders for individuals who are interested in implementing this strategy. We work together with financial planners to find the most suitable product and ensure that the mortgage plan remains in sync with your financial plan.

Final note: this post is not meant to be construed as blanket advice. Always consult with a qualified investment adviser before making any investment decisions. Investing in the markets always carries a risk including total loss of principal.