RESP Time

Attention young families! You've just added a new member to your clan and now it's time to figure out how you're going to save for THEIR future, let alone your own.

In Canada, we have the Registered Education Savings Plan (RESP). This plan is a tax-free way of saving for education in the future. I will answer a few questions about RESPs so you can decide if one is right for you or someone close to you.

Why do I need one? - If you want to help your child/grandchild save for their education, the RESP is the best way to do it.

Week 23 - Quantitative Easing

Here is another post that I just realized I hadn't actually 'posted'...

I wanted to discuss something you may have read about in the news over the past few years; the US housing market. Many economists consider the health of the housing market the most important factor to the overall health of the economy. Recently, the US Federal Reserve has taken steps to keep mortgage rates very low, by buy long-term government bonds. The process is called quantitative easing. I will do my best to first explain why the U.S. would do this and how it is supposed to help the economy recover.

Mortgage Lending

To start, we need to take a look at the process of bank lending for mortgages. When you go to the bank to get a mortgage for your house, the bank will lend you that money at a certain rate. This rate isn't an arbitrary number that they pull out of the air, however. It is based on the rate that the bank can borrow the funds from the central bank (the federal reserve in the US) in order to lend to you. The bank makes its profit by making the rate they charge you higher than the one they have to pay the central bank.

For example, let's say you bought a house and need to borrow $200,000. You want some security on your interest rate, so you decide to get a 5-year fixed rate mortgage at 4% interest. That means that the bank will lend you the money for 5 years and guarantee you will pay a rate of 4% to the bank. So, the bank now needs to come up with $200,000. They go to the Central Bank and ask for a 5-year loan. The central bank posts their lending rates and in this case, they are lending for, say, 1.5% for 5-year paper. So the difference is 4% - 1.5% = 2.5% which is the profit for the bank. 2.5% per year x $200,000 x 5 years = about $25,000 (excluding compounding)... nice to be a bank...

House Prices

As you can imagine, the easier it is to get a mortage, the easier it would be to buy a house. If rates were 0%, in theory we could keep borrowing money and buying property, as long as our credit was good enough. That's why in times of very low interest rates, house prices tend to rise. More people can afford the lower mortgage payments that go along with low interest rates.

That's what happened in the US about 8 years ago. In an effort to stimulate the economy, the Federal Reserve decided to cut interest rates to near-record lows, which made it easier to borrow money. Everyone borrowed money. Some people even borrowed enough money to buy multiple houses. Why not? It was a self-fulfilling prophecy; the cheaper the money, the more the value of your house increased. If your house increased in value, you could re-finance your mortgage and borrow more to buy another house. This demand for houses then fuelled the continued increase in house prices.

As the economy improved, inflation crept back into the system. Unemployment was nice and low. This usually spells time for the government to increase interest rates again, to make sure inflation doesn't continue to rise. When this started to happen in 2006, people would then go to refinance their mortgages and realize that they would not be able to afford the payments. Instead of getting that 5-year fixed rate mortgage at 4%, it was now costing them 7% or more. They realized they would have to sell their house. This lead to a large decline in house prices, as many people began downsizing into houses they could afford. This had a domino effect. It meant that there was less demand for new homes being built, which lead to more workers getting laid off, which lead to higher unemployment. Never mind that the banks nearly overrode the entire financial system in 2008. That's fodder for another post.

The Role of the Fed

When this happened, the US Federal Reserve cut rates literally to 0%. But banks were still being very cautious about lending money. So the next step is quantitative easing. This is when the Fed literally turns on the printing press and starts printing new money for the system. They use this money to buy US long-term bonds, which has the effect of lowering the yield on the bonds. So when banks lend mortgage money and need to borrow government money, the interest they pay will be even lower. That means the interest we pay to get a mortgage will be lower as well, which in theory should create demand for housing again.

It has taken a while but this process seems to be finally working. House prices south of our border are slowly creeping higher, as more people are realizing they can afford a new mortgage. Hopefully this continues, as it will mean more jobs in the housing sector, which should mean more jobs elsewhere.

The Risks

The main risk of quantitative easing is that by continuously printing money, you are lowering the value of the money in the system, which could lead to hard goods costing more - this is inflation. The hope is that as the economy improves, the Fed will be able to reverse the process. They can sell the bonds they've bought, which will slowly cause long-term yields to rise again... which SHOULD put a slow-down on inflation. We shall see how this chess match plays out.

That is all. Hopefully you have somewhat of an understanding of quantitative easing (QE) now. Thanks for reading my post.

What week is this?

Well, it has been about 14 months since my last post.

In financial markets, one could say that not much has changed. Europe is still mired in debt, with seemingly a new country every month entering the headlines. The latest is Spain, who this past weekend announced that they would be receiving up to 100 billion Euros to bail out their banks. It is ugly.

Back in Canada, things look somewhat better. As the expression goes, if the US sneezes, then we get a cold. Well, it seems like the endless sneezing fits of the US are finally subsiding. Their housing market has actually improved lately for the first time in years. This is a positive because it means people will be less reluctant to walk away on a mortgage if their house has real value. Unemployment has also been on the decline. It seems that they are even seeing some manufacturing jobs return home after spending a long time overseas.

The one area of the investment world that continues to skyrocket upwards is the fixed income universe. The yield on the 10-year Canada bond is now well below 2% (remember, since the coupons on bonds are a fixed dollar amount, the yield will go down as the price of bonds goes up). It seems people have been burned so consistently by their stocks that they just want the safety of something that won't go down. Even though to buy it today means only getting 2% return on your money. But if you factor in inflation (i.e. the purchasing power of $1), the real return on your money is probably going to be close to 0% per year.

So if you are looking toward your investments for income, where do you turn? I believe the answer lies in owning a diversified portfolio of dividend-paying common stock. It is still possible to buy high-quality Canadian companies that will pay you over 4% in dividends each year. Yes, you will be subject to the ups and downs of the daily market but at the end of the day, you will get paid. Even as we speak, 4 of the 5 large Canadian banks have dividends that are at least 4% of their share price (the only exception being TD, at 3.7%). Compare that to bonds and you are getting almost a 100% raise in income... not to mention paying about 1/2 as much tax! It is a no-brainer.

If you do decide to stick with bonds in your portfolio, then keep them short-term. You don't want to be holding bonds that mature in 20 years and have interest rates start to rise. Why would anyone want to buy your bond that pays 2% when new ones are coming out that pay 4%? And guess what that will do to the price of your bond... not good. This is called interest rate risk and it is something that we haven't had to consider in Canada for almost 30 years. But it is real and it does cause bond prices to fall (sometimes dramatically) in value.

Anyway, it is good to be back blogging. I'll try to make my next update sooner than 14 months from now.

Thanks for reading.