The Biggest “If,” Ever

US Federal Reserve Chairman Ben Bernanke, in remarks prepared for an address to the Council on Foreign Relations in Washington, reiterated his view that the recession could end in 2009 if the financial system stabilizes.

“Governments around the world must continue to take forceful and, when appropriate, coordinated actions to restore financial market functioning and the flow of credit,” Bernanke said today. “Until we stabilize the financial system, a sustainable economic recovery will remain out of reach.”

The trouble is that, although there’s broad agreement that stabilizing the financial system is the sine qua non for economic recovery, there’s no consensus on how to actually do it.

Last fall, we highlighted on several occasions a broad indicator of the health of the financial system, the TED Spread. The TED Spread is an expression of the difference between the three-month London Interbank Offered Rate (LIBOR) and the three-month US Treasury. It measures the reluctance of banks to lend to one another, represented by a rising three-month LIBOR, as well as an ongoing flight to quality, or demand for the safety of US Treasuries.

Following Lehman Brothers’ mid-September meltdown, the TED Spread spiked to ludicrous levels from ridiculous levels–the broad measure of confidence among banks was elevated even before the government allowed Lehman to fail. Nevertheless, Lehman was a flashpoint, and the impact of its demise on the entire global financial framework is now the template for what economists, politicians and investors describe as “systemic risk.”

Source: Bloomberg

Coordinated interest rate cuts by central banks and an alphabet soup of government programs to prop up commercial lending squeezed the spread back to pre-September 2008 levels, although by no stretch did we reach normalcy. But now, coincident with a new round of indiscriminate equity selling, we’re seeing a new phase of widening. In short, confidence is again on the wane.

The Fed chief today offered further assurance that the central bank, the US Treasury and other regulators “will take any necessary and appropriate steps” to ensure banks have capital to “function well in even a severe economic downturn.” That means, essentially, “no more Lehmans.”

How to achieve normal functioning of the credit market? Team Obama has yet to spell out important details of how its proposed public-private partnership scheme will remove toxic assets, primarily mortgage securities, from the balance sheets of banks, a critical step in ensuring their long-run capital positions.

Sheila Bair, chairman of the Federal Deposit Insurance Corporation (FDIC), told The Washington Post that “buying troubled assets would create a clear strategy for ending the government’s intervention in the banking system, something investors are eager to see.” At the heart of the program is an “aggregator bank,” a variation on the “good bank/bad bank” model proposed by many observers.

According to Bair, the government will establish, with private investors, partnerships to buy toxic assets. A key aspect will be the provision of low-interest loans to these public-private partnerships. Discussions about the appropriate mix of public and private funds, which combined would serve as essentially a down-payments for loan secured through the Federal Reserve. A bigger government piece would allow buyers to pay higher prices because their risk exposure would be reduced. But that means taxpayers would be exposed to greater risk.

The public-private partnership contributions would be leveraged up–the government and the investor could kick in USD1 million each, then borrow USD8 million, for example–so the fund could by toxic assets. The private investor would determine how much to pay and how to manage the acquired assets. Ideally, the public-private partnerships will buy assets at discounts that make upside potential realistic, but not at such deep discounts that selling institutions have to absorb fatal losses.

In most cases, the thinking goes, you’ll end up with two healthy institutions–the public-private partnership with a realistic opportunity to see gains from its toxic assets and the now-detoxified bank, ready to lend again based on its healthy balance sheet. Other banks, with exposure that outweighs the value of remaining assets, could be forced to raise money from the government. And it’s possible some banks will take losses so large that they won’t survive.

Lehman’s failure, in and of itself, didn’t cause the dramatic fall 2008 selloff in equities and general flight from risk. It was, clearly, a crucial moment that tells us a lot about how we should deal with weakened financial institutions today. Letting Citigroup (NYSE: C) or Bank of America (NYSE: BAC) implode on their own may be a reasonable outcome in terms of an academic discussion about the free market. But the reality, as indicated in the chart above, is that confidence would be destroyed.

“Caution, Measured Optimism, Common Sense”

Among the many gifts from Canada–a template for sound banking, enormous natural resources, Strange Brew–is the healthy skeptic Diane Francis. This morning, Diane declares “Buffett is still wrong,” but pivots into a useful summary of her several recent interview with Prem Watsa, the to decision-maker at Fairfax Financial Holdings (TSX: FFH, NYSE: FFH).

Mr. Watsa led his company to record profits in 2008, and Fairfax investors have enjoyed significant outperformance amid this market maelstrom. His approach? Focus on “long-term valuable, big companies with good, tested management.”

While it’s impossible to predict when the market and the economy will turn around, you can position yourself for long-term gains by sticking to solid businesses. We provide a good starting point, with an emphasis on fourth quarter and full year 2008 earnings, in the March Canadian Edge.

Speaking Engagements

There are few better places to combine work and play than Sin City: Join Canadian Edge, Editor Roger Conrad and The Energy Strategist Editor Elliott Gue for The Money Show Las Vegas, May 11-14, 2009, at The Mandalay Bay Resort & Casino.

With Elliott’s and Roger’s sage advice, this is one trip to Vegas that won’t make a wreck out of you.

To attend as Roger’s guest, click here or call 800-970-4355 and refer to promotion code 012649.

And make plans to join Roger, Elliott, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23, to Saturday, April 25.

Roger, a steady hand through many market events such as the one we’re dealing with now, will talk about Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street, the in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. These guys love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Maple Leaf Memo discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.

The Roundup

Conservative Holdings

CML Health Care Income Fund’s (TSX: CLC-U, OTC: CMHIF) 2008 acquisitions and organic growth at its existing medical imaging and diagnostics facilities drove a fourth-quarter profit of CAD26.9 million (CAD0.30 per unit), up from CAD24.3 million (CAD0.28 per unit) a year ago. CML also benefited from increases in lab funding from provincial governments.

Operating, general and administrative expenses for the fourth quarter increased to CAD95.6 million from CAD52.1 million a year ago due to increases in salaries, rents and fees resulting from acquisitions and growth in tests and procedures performed.

CML paid out CAD24 million to unitholders from distributable cash flow of CAD24.8 million, a 96.6 percent payout ratio. Revenue for the quarter was CAD133.4 million, up from CAD82.3 million in the fourth quarter of 2007.

Earnings for 2008 edged up to CAD101.5 million (CAD1.14 per unit) from CAD100.2 million (CAD1.16 per unit) in 2007. Revenue for 2008 increased 47.9 percent to CAD462.5 million. CML Health Care Income Fund is a buy up to USD13.

Pembina Pipeline Income Fund’s (TSX: PIF-U, OTC: PMBIF) 2008 success was driven in large part by its completion in July of the CAD400 million Horizon Pipeline. Prudent management and solid execution has positioned it to similarly benefit over the long term from the Nipisi and Mitsue projects, both of which should come on line by mid-2011.

Horizon is operated under a 25-year contract to service Canadian Natural Resources’ (TSX: CNQ, NYSE: CNQ) oil sands assets near Fort McMurray, Alberta. In August, Pembina executed similar agreements with Canadian Natural Resources and EnCana (TSX: ECA, NYSE: ECA) for the Nipisi and Mitsue pipelines.

Cash flow from operations totaled CAD219.9 million during 2008 (CAD1.64 per unit), a 16 percent increase over 2007. Pembina generated CAD453.9 million in annual revenue, a 16 percent increase from CAD389.7 million in 2007. Net operating income for the year was CAD303 million, up from CAD260.1 million. Net earnings were up 14 percent to CAD161.8 million. Operating expenses rose to CAD150.9 million from CAD129.6 million in 2007, while administrative expenses increased to CAD38.6 million from CAD30.6 million.

Distributable cash for the year was CAD207.2 million, up from CAD188.9 million in 2007. The fund registered a payout ratio based on distributable cash of 96 percent.

Pembina’s balance sheet remains relatively healthy, with a total aggregate debt-to-enterprise value of 32.1 percent at the end of 2008. The best way to play Canada’s oil sands because its revenue is based on locked-in, long-term contracts, Pembina Pipeline Income Fund is a buy up to USD18.

Conservative Holdings’ Reporting Dates

• Artis REIT (TSX: AX-U, OTC: ARESF) Mar. 18, 2009 (Confirmed)
• Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) Mar. 30, 2009 (Confirmed)
• Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) Mar. 16, 2009 (Estimated)
• Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF) Mar. 11, 2009 (Estimated)
• TransForce (TSX: TFI, OTC: TFIFF) Mar. 12, 2009 (Confirmed)

Aggressive Holdings

Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) replaced 175 percent of its 2008 production while recording proved-plus-probable finding, development and acquisitions (FD&A) costs of CAD15.33 per barrel of oil equivalent; those efforts boosted its Reserve Life Index to 8.8 years.

Daylight recorded 2008 production of 21,045 barrels of oil equivalent per day (boe/d), an increase of 3 percent from 2007. Funds from operations (FFO) was CAD264.4 million for the year, and the trust paid out 44 percent of distributable cash. Fourth quarter FFO was down 36 percent on a quarter-over-quarter basis, reflecting the dramatic decline in commodity prices last fall. FFO for the year was up 59 percent over 2007.

Daylight realized operating netbacks of CAD38.48 per boe in 2008, an increase of 41 percent over the CAD27.37 per boe in 2007. Operating netback was CAD28.98 per boe for the fourth quarter, a decrease of 29 percent from the third quarter.

As at Dec. 31, 2008, Daylight’s outstanding bank debt had been reduced to CAD219.9 million from CAD257.3 million at the end of 2007; the trust increased its bank credit facility to CAD350 million at year’s end from CAD300 million at the end of 2007.

Daylight has more than CAD130 million available to pursue strategic opportunities. Daylight’s credit lines were reviewed and approved by its banks in November 2008. Its next regularly scheduled review is May 2009. Buy Daylight Resources Trust up to USD11.

Newalta (TSX: NAL, OTC: NWLTF) reported net income for the fourth quarter declined to CAD9.1 million (CAD0.21 per unit) from CAD23.6 million (CAD0.53 per unit) a year ago. The fourth quarter of 2007 number was inflated by higher future income tax recoveries. Fourth quarter FFO declined 15 percent to CAD17.5 million (CAD0.41 per share) from CAD20.5 million (CAD0.50 per share) a year ago.

Revenue for the period actually climbed 6 percent to CAD145.3 million from CAD137.1 million, while earnings before interest, taxes, depreciation and amortization rose 4 percent. Western segment revenue declined 13 percent on a steep slowdown in drilling activity, although waste processing volumes increased year-over-year as a result of growth in its heavy oil business. The Eastern segment generated a 43 percent increase in revenue on acquisitions completed in Quebec and Atlantic Canada in 2007 and solid performance at its Stoney Creek Landfill.
For 2008 Newalta’s net earnings dropped 4 percent to CAD58.9 million from CAD61.2 million a year ago. FFO grew 20 percent to CAD95.9 million from CAD79.9 million last year. Revenue for the year increased 19 percent to CAD597 million from CAD499.9 million. Waste volumes were higher overall in 2008, and drill site equipment utilization improved to 45 percent in 2008 from 28 percent in 2007.

In a statement accompanying the earnings release, Newalta said “it anticipates a reduction in waste volumes in all business units and a steep decline in the value of the products that it recovers from waste” in the first quarter. The company plans to hold down capital investment during the first half of 2009 and will reevaluate in the second quarter based on business conditions. Newalta is a buy up to USD5.

Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) reported fourth quarter net income of CAD50.7 million (CAD0.48 per unit), down from CAD73.3 million (CAD0.69 per unit) a year ago. FFO for the three months ended Dec. 31, 2008 was CAD67.4 million (CAD0.64 per unit), down 2 percent from CAD69 million (CAD0.65 per unit). Revenue for the period was down 10 percent to CAD89.4 million.

Looking at full year 2008 results, Peyto cut interest expense by 15 percent from 2007 levels, despite a roughly 8 percent increase in total debt. Proved reserves were increased 16.9 percent, while net present value for proved reserves rose 10 percent per share.

Management has also been successful hedging its output, moderating the impact on earnings of fluctuations in natural gas prices. That’s a major factor in holding down the payout ratio, despite conservative production levels. And the nature of the trust’s properties is such it can ramp up production dramatically later in 2009 if prices should recover.

Even the relatively high debt level of 1.8 times annualized cash flow isn’t really a cause for concern, given the trust’s large cushion with regard to its lender covenants, the nature of its low-cost assets and the general strength of its lender banks. The yield of 22 percent is priced for great risk this trust just doesn’t have. Peyto Energy Trust is a buy up to USD10.

Aggressive Holdings’ Reporting Dates

• Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV) Mar. 18, 2009 (Confirmed)
• Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF) Mar. 13, 2009 (Confirmed)
• Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) Mar. 11, 2009 (Estimated)
• Provident Energy Trust (TSX: PVE-U, NYSE: PVX) Mar. 12, 2009 (Confirmed)