Canada and Big Bailouts

The Bank of Canada (BoC) lowered its target overnight rate by 25 basis points to 2.25 percent Tuesday morning, citing severe strains on financial markets, a coming global recession triggered by an ongoing US recession and a sharp decline in commodity prices as its primary concerns going forward. The BoC is the first central bank to follow up the Oct. 8 coordinated rate cuts by global monetary authorities with another cut.

“Some further monetary stimulus will likely be required to achieve the 2 percent inflation target over the medium term,” the BoC said in its official statement announcing the cut.

Falling commodity prices and the continuing global financial crisis are hurting the Canadian economy, but the slowdown and falling energy prices have helped put a lid on inflation; core inflation is now projected to remain below 2 percent through until the end of 2010. Total inflation is expected to have peaked in the third quarter and is forecast to fall below 1 percent in the middle of next year before returning to the 2 percent target by the end of 2010.

The BoC forecast full-year growth of 0.6 percent for 2008 and 2009 and recovery to 3.4 percent growth in 2010.

Canada’s banks hesitated in passing onto consumers and business the BoC’s half-percent Oct. 8 reduction, which limited Canadians’ ability to access credit. Most did, however, trim rates after the federal government announced it would provide CAD25 billion to buy mortgages from the banks.

Governments in the US and Europe have helped their banks by increasing guarantees on deposits, injecting capital and buying shares, moves that could put Canadian banks, which haven’t received such treatment, at a disadvantage. Lenders in the interbank markets have to decide whether they’re going to lend to a sovereign credit or a bank that hasn’t been guaranteed by the government.

But Finance Minister Jim Flaherty and Prime Minister Stephen Harper have broadly hinted of a plan to level the field for Canadian banks. Canada’s banks, while relatively strong, are hurt by the “unintended consequences” of massive government bailouts in Europe and the US.

Flaherty, according to the Toronto Globe and Mail, is considering a plan under which the government would guarantee loans by Canadian banks to other financial institutions to avoid leaving the banks at a competitive disadvantage.

The government has taken steps to ease banks’ concerns. On Tuesday, the government announced it will buy up to CAD7 billion of insured mortgages from financial institutions on Thursday, the second expenditure in a CAD25 billion plan to help banks free up cash for lending and overcome credit market constraints.

The federal Canada Mortgage and Housing Corp will buy mortgage-backed securities maturing in 2013 in an auction, setting a minimum yield for the transaction to ensure a return on its investment. Finance Minister Jim Flaherty announced the plan Oct. 10 to help cushion banks from the global financial crisis and address a scarcity of private-sector lending.

The government bought CAD5 billion worth of mortgages last week, getting an average yield of 4.241 percent, above the minimum target set, suggesting a healthy interest in the auction. The number and names of participating institutions wasn’t made public.

The Financial Post’s Diane Francis reported last week that Brendan Caldwell, President and CEO of Caldwell Investment Management, said in a briefing to clients that, “if commercial banks with government backing can borrow at, effectively, government or sovereign rates and ours must borrow at commercial banking rates, then Canadian banks are at a disadvantage.” A nationalized bank can borrow at 1 percent, while the commercial bank rate borrowing cost could be 4 percent. Leveling the field requires no “capital infusion,” only a guarantee of their loans to match the “sovereign” rating.

Canadian banks don’t need a sovereign guarantee; any further moves to bolster banks would be about preserving competitiveness with other government-backed global institutions with lower costs of capital. This is an opportunity for Canada to capitalize on its discipline, prudence and the strong balance sheets those things lead to.

The good news is the credit market is improving.

The three-month London Interbank Offered Rate (LIBOR) was marked at 3.83 percent Tuesday, down from 4.06 percent Monday. The TED spread, the difference between the three-month LIBOR and the three-month US Treasury, narrowed to 257 basis points from 297 late Monday. The TED spread had been as high as 465 basis points earlier in October.

The improvement in bank lending over the last week is critical and analysts say it must continue to improve in the months ahead. Frozen credit markets have further punished an already weakening economy, and there’s still a lot of thawing that must happen before we’re out of trouble.

The bad news is investor attention is turning to third quarter earnings. Twenty-one percent of S&P 500 companies have reported results, and we’re careening toward a 10 percent overall decline from year ago levels, according to date compiled by Thomson Reuters.

New York Times financial writer Floyd Norris suggests that, when the National Bureau of Economic Research gets around to declaring it, we may be in for some surprising news about the start of the current US recession. Norris points out that just as Federal Reserve Chairman began his testimony before the House Budget Committee yesterday:

[T]he Conference Board released its index of coincident indicators. That index not only confirmed that a recession is under way, but it provided powerful evidence that it began in 2007, or in January 2008 at the latest.

Here’s why:

The overall index of coincident indicators is down 1.2 percent from its record high, set in October 2007. Since 1960, every time the index has fallen by at least 1 percent, the bureau later concluded the economy was in recession.

The argument now is when the recession began. Those who scorned the idea that there was a downturn earlier this year now say it began in the third quarter of this year. They pointed to growth in gross domestic product in the second quarter as proof there was no recession, but that argument is unpersuasive.

The G.D.P. figure is likely to be revised down before we are through, but even if it is not, G.D.P. growth is only one indicator the bureau uses. The others are real income, employment, industrial production and wholesale-retail sales. Those are the four items that make up the index of coincident indicators.

In the seven recessions since 1960 — the only ones during which the index of coincident indicators was calculated — the bureau later concluded that the recession began within two months of the beginning of the decline in the coincident indicators. This time the index began to decline in November 2007. So the possible range is from September to January.

In all likelihood, this recession either has reached its first birthday or will soon do so.

The upshot is we’re likely nearly 12 months in, and there’s little sign we’re close to emerging from it. This could be the longest downturn since the 43 months from August 1929 to March 1933 that define what we commonly refer to as the Great Depression.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Elliott Gue for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011362 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with me and my colleagues Gregg Early, Neil George and Elliott Gue.

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Algonquin Power Income Fund (TSX: APF.UN, OTC: AGQNF) announced the conclusion of its strategic review and a corresponding 74 percent cut in its distribution from CAD0.92 on an annual basis to CAD0.24 per unit. Management said the distribution cut will “better position the fund for future growth” and will “maximize unitholder value in the current business climate.” The good news is there’s been no material change in fundamental operations. The question now is how Algonquin proceeds with plans to grow the business. Algonquin seems to have accomplished a de facto conversion, but it won’t have to go to unitholders for approval. The fund will take advantage of its tax structure right now but will pay out as if it were a corporation. Sell Algonquin Power Income Fund.

First Quantum Minerals (TSX: FM, OTC: FQVLF) announced a new company record for copper production, 82,200 tons for the third quarter of 2008. The new record exceeds the production levels of the third quarter of 2007 and the second quarter of 2008 by more than 22,600 tons and 1,200 tons, respectively. Stockpiles of copper concentrate at the end of the third quarter totaled approximately 19,900 tons. First Quantum Minerals is a buy up to USD40.

CI Financial Income Fund (TSX: CIX.UN, OTC: CIXUF) announced its intention to convert to a corporation. Unitholders will vote on the conversion at a meeting in December. “The environment that supported CI’s decision to convert to a trust in 2006 no longer exists,” CEO Bill Holland said in a statement detailing the decision. CI, under a corporate structure, is well placed to expand its footprint in any industry consolidation. The converted CI will pay a quarterly dividend of CAD0.12 per share; it will pay an additional CAD0.04 per share for the quarter ended March 31. Hold CI Financial Income Fund.

A&W Revenue Royalties Income Fund (TSX: AW.UN, OTC: AWRRF) reported same-store sales growth for the third quarter of 6.5 percent, down from a year-to-date figure of 7.4 percent but sufficient to fuel an 11.1 percent quarterly increase in distributable cash to CAD5.1 million. Royalty income was up 10.4 percent to CAD5.3 million. A&W reported sales increased 10.4 percent to CAD175.3 million during the third quarter. Distributable cash unit increased to CAD0.367, up from CAD0.34 a year ago. Trustees of the fund approved a special distribution of CAD0.10 per unit, payable on Nov. 30 to unitholders of record as at Nov. 15. A&W Revenue Royalties Income Fund is a buy up to USD14.

Priszm Income Fund (TSX: QSR.UN, OTC: PSZMF) reported a 1.9 percent decline in sales in the third quarter to CAD95.9 million. Same store sales growth for quarter was down 2.4 percent from year-ago levels. Income from restaurant operations decreased CAD0.9 million to CAD11.7 million from CAD12.6 million. Third quarter earnings before interest, taxes, depreciation and amortization was CAD11.2 million, down from CAD12.1 million in the third quarter of 2007. Distributable cash was CAD8.5 million, down from CAD11.1 million a year ago. Priszm Income Fund is a hold.

New Flyer Industries (TSX: NFI.UN, OTC: NFYIF) received orders over the last three months for up to 845 buses, for a combined value of USD484 million. Of these, 584 buses are new orders, and 261 were exercised options. Total orders during 2008 are up to 3,332, good for USD1.78 billion in sales. New Flyer Industries is a buy up to USD13.