Stress testing my dividend play

I am making an arbitrage play on Canadian dividends by taking out loans at 3% and buying dividend paying banks that pays 10%. The interests of both are taxed to my favour. The only downside is that banks are going to get decimated as we see the unraveling of Citigroup. Once the world’s largest bank.

Here are the two sides of the coin

Positives

1. Capital ratio of 10% i.e. leveraged only 10 times
2. Ranked #1 financial system in the world (after the collapse)
3. Stable deposit base
4. Overly heavily regulated by government
5. Low derivative involvement
6. Stable income that has not reported losses yet

Negatives

1. Resource based economy (~50% of GDP)
2. Reliant on US economy
3. Mark to market rule that can be worked around

The reasoning is very simple, if the too conservative Canadian banks fall, so will the banks everywhere in the world. Once that happens, money will not matter. Here’s the big but. Will they continue to be able to pay dividend? The answer lies in whether or not they can continue to make a proft. So far, all of them are able to do so except one Canadian Imperial Bank of Commerce who reported a quarter of loss.

Last quarter was relatively stable, but the coming quarter will see just how stable they can really be when the record layoff in January causes a huge consumer default in credit cards. That’s the kind of things that’s not predictable.

So what am I to do? Imagine the worst case scenario of course and test to see if I can survive in each of them for the following 5 years.

A few test case

Scenario 1

1. High inflation
2. Rising interest rate
3. Dividend cut

This is the most likely to happen scenario. Low interest rate and the huge amount of money injected will lead to hyper inflation and will in turn push the interest rate up alongside it as governments try to push down inflation.

In this case, the inflation itself will drive the stock’s valuation up since inflation is the definition of an increase in equity price. The interest which I have to pay to maintain this loan will rise exponentially however. Which means that at one point, I will have to sell the stock in order to avoid paying the interest that are adjusted up along with inflation. The timing of this will be based purely on the interest payment as a percentage of my income.

Scenario 2

1. High inflation
2. Low interest rate
3. Dividend cut

This could happen as an interim state or it could become permanent based on how devastated the world economy is. Britain and the EU will probably remain in this state, I am not sure about Canada or the US at this moment. This is a favorable outcome in which I will keep my shares due to the nature of banks and the fact that they are located in Canada. Bank’s income will probably increase with inflation and the 50% resources based economy will only help Canadian dollar in inflationary times.

My only beef is if the government of Canada buys US dollars again in order to stem the tide like they did in 2008. Then again, my job will be in danger if the CDN is valued too high. So it has pros and cons.

Scenario 3

1. Deflation
2. Low interest rate
3. Dividend cut

This is bad. This means that we, as a human race, have imploded and greed cannot push anybody to see any opportunity anywhere. It is the current state that we are in and if it continues for longer it means that we’ve been living a lie. Logically it is impossible but for humor’s sake let’s pretend it continues on and becomes reality.

Things will continue to get cheaper, which makes people hoard money in hope to buy things at an even cheaper price. People will not be tempted to borrow because the interest paid now means that, compounded for a few years, you lose big.  So you hoard money and you wait until things start to turn. The stock price itself will get decimated but my current interest cost will remain the same. My income will decrease as companies start reducing employee income. At one point, the % of income I use to pay interest will reach the breaking point.

Still, the low interest rate will prompt people to do something with it. I’d borrow it and buy bonds that pay more than the interest rate. (After the wave of bankruptcy of course). If not, just stay in cash. This brings up a good fact. The best investment in this type of economy is to invest in cash.

Scenario 4

1. Deflation
2. High interest rate
3. Dividend cut.

The great depression is sort of like this. So there’s no need to explain. In this case, I will simply sell my shares as there is no point in keeping it.

Conclusions

My decision of whether or not to get out and de-leverage will based primarily on whether or not the dividend will be cut and whether or not inflation will come back. The chances of a dividend cut now is high as we go into a year of bankruptcies. Business and consumer credit defaults will probably cripple a bank add to the sudden decrease in consumption of resources giving CDN economy a hit.

The conclusion therefore is to wait on the sideline and do not add to the dividend arbitrage play until the dividend and inflation direction is sure.