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Talking Interest Rates, Mortgage Backed Securities and Banks with Taylor Cottam, CFA

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Biography: Taylor Cottam, has managed financial risk and traded fixed income products inside both GMAC bank and other financial institutions in Europe, North America and Canada. He has written about business and economic issues for prominent trade magazines and is the owner and principal contributor to He has published the 2010 Best to Invest Series at which focuses on Economic Efficiency, long-term growth rates and incremental economic activity (yet to be published).  He is a CFA Charterholder, a Certified Financial Risk Manager (FRM) and holds an MBA from INSEAD.

Q: Mr. Cottam, what is your outlook on financial institutions going forward (in Canada, the U.S. and Europe)? Are there any specific areas in this sector (such as the financial institutions in particular countries or particular segments of the market for eg. life insurance companies etc.) that stand out in either good or bad ways?

A: Looking primarily at banks, if I had to compare Europe, Canada and US, I would be most concerned about Europe. European Commercial and Residential real estate has not experienced the magnitudes of asset price declines as they have in the US, but also because their economic recovery will likely not be as strong as it is in the US or Canada. Although sentiment is improving, European commercial real estate investment is a fraction of what it once was and is vulnerable to an anemic recovery. The residential sector will likely suffer in Spain as the residential price levels will buckle under depression level unemployment. Of course, the European regulatory environment is piecemeal. Higher leverage in Germany and UK banks give them little wiggle room for deteriorating assets. The Spanish Banks could more readily survive another black swan event, where the German and UK banks would not.

For the US, I am cautiously optimistic. Although housing prices will likely continue dropping, their ascent will be tied to increases in the long-term interest rates. The banks have asset moderate price declines factored into their stock price. I am more concerned about the Payment Option Arms (POA) resets in California and Florida, credit card receivables and another wave of foreclosures. There is the real possibility that the asset price declines could be worse than the 10-20% that is baked in. However, much of the pain has been felt in the US, and many of the less healthy players have been shaken from the system or given life support, leaving some very strong banks, JP Morgan the best example, with a few zombies like Citigroup and GMAC.

Canadian Banks are in the best shape. There is little to fear with asset quality in Canada. The residential mortgages by and large are all guaranteed by the Canadian government which has kept the secondary market alive if not altogether healthy during the crisis. The magnitude of the pullback in residential and commercial properties was not as severe as what we saw in the US. Profitability is strong and increasing.

During normal times I would focus on imminent bank profits, as the differential between the 2 and 10 year spot rates are as high as they have ever been, however, asset quality is the key for price discovery for these banks and will ultimately determine where the price rests. There is no profit wad that can plug a 20%+ decline in commercial real estate prices.

Q: With the short end of the yield close to zero and the huge rally in bonds this year, what if any, trends of dislocations are you seeing in the fixed income markets?

A: All Banks should profit handsomely off the yield curve for the next year or so. They will need it as their asset quality will decline. Interestingly enough, strong earnings and asset write-offs, should lead to a big bump in Return On Asset (ROA) numbers. Ignore this for the most part. I would look for Canadian banks to take advantage of US weakness and their strengthening bundle of cash and buy US presence. TD Bank Financial Group and Royal Bank of Canada have both been aggressive in strengthening their presence in the US.

The Crisis has forced the Mortgage Backed Securities market in the US to be almost 100% guaranteed by the US government (Fannie and Freddie are now government entities). Canada is not far behind with CMHC guaranteeing the lion’s share of all mortgages with a smaller presence of Genworth insured paper. Both markets continue to function well, although the asset quality of US FHA mortgages, concerns me; the leverage they have taken on dwarfs anything allowed in a private company.

Q: Mr. Cottam, what is your outlook on interest rates? Also, do you foresee inflation or deflation going forward?

A: Inflation as an increase in the Money supply M2 can be different from the CPI/PPI numbers. The Fed’s extraordinary efforts to increase the money supply have just compensated for the deflation from housing. The question is how much longer will the Federal Reserve keep the spigot open. If the Fed keeps the rates at zero much later than June, which I deem likely, inflation should show up in the CPI numbers. I think right now the danger of inflation is much greater than deflation, and the balance that the Fed is undertaking is delicate.

Q: How are you (or would you) adjust your portfolio to offset the risk of inflation and rising rates on the one hand and deflation on the other?

A: In spite of the concerns, the yield curve is steep and the possibility of recovery real. There is no sector that I would short. For the wise bottom up analyst, there could be a possibility to short European Banks vulnerable to asset deterioration, but in general I would not fight the yield curve, which for both Europe and North America is at historic spreads. 2006 brought us a slew of analysts which discounted the invert. I don’t think it wise to believe those who forecast pessimism given the current interest rate environment.

Commodities are particularly poised to benefit from an economic recovery as increased economic activity will put pressure on supplies. Gold and Silver, but also Platinum and Palladium should also benefit from inflation. They also are a likely haven for security if economic growth disappoints.

Q: Lastly, Mr. Cottam, can you please highlight 1-2 stock/trade idea that you think offers best value moving forward and your reasons for liking it?

A: Over the course of the next five years, the holder of the shortest term investments, i.e. commodities should benefit from increased economic activity. I would look at Silver as the most undervalued from historic norms.

Silver and other precious metals like platinum and palladium are not income producing assets like oil and other commodities that are used in other parts of the economy.  Apart from jewelery, the only purpose these metals serve are as a hedge for inflation, which is a concern that many investors, including myself have expressed.  Gold is attractive, but less so than Silver because Gold is very close to its all time highs.  Silver is still 20% off its historic highs.

Canadian banks, TD Bank Financial Group (TD: TSX) in particular, should benefit from the steep yield curve and are poised to capture increased economic activity taking place in Canada and the US. They are more expensive, but in this case, the minimal risk of asset price declines makes them a bargain.

TD in particular, is poised for growth in the US market.  Many do not realize that close to half of their banking revenue comes from the US, while only a third of their banking Net Income (see q4 income statement). TD is focusing on growing their core banking business in the United States.  I was in Boston recently and it seemed like their was a TD on every corner.  The insolvency of much of the US banking industry has left real esate and other US assets cheap.  As they grow, if they can increase profit margins to what they are in Canada,  that could add another 500MM per annum to the bottom line.  I don’t see that kind of opportunity at Royal Bank of Canada or ScotiaBank who haven’t focused on Wealth Management and International Banking respectively.  TD is becoming a big player in the US market without the legacy of bad assets that the other big banks suffer from.  Additionally, earnings and assets are also cheaper.  So not only do I believe that TD will grow faster than the other Canadian Banks, but they are also cheaper.
Thank you Mr. Cottam!

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