In my last article, I made the case that tales of the Canadian housing market's demise were somewhat exaggerated. While housing pricesmight appear to be in a bubble, housing affordability is actually in-line with historical norms. So while there may be no bubble per se and, therefore, no bursting of said bubble, the remarkable run-up in prices experienced in Canada this past decade has probably reached a crowd-pleasing crescendo with the denouement now sure to follow. Slowing foreign investment, tighter Canadian Mortgage and Housing Corporation (CMHC) insurance rules, and interest rates that can't physically get any lower (kind of like this guy) have led to a relative cool in prices so far this fall.
But what if we assume a U.S.-style housing collapse was imminent? What would happen to the Canadian financial system? I argued in my last article that government-backing via the CMHC insurance program could very well be history's first pre-emptive bank bailout. And as you'll see, this pre-emptive bailout will take the sting out of even the most vicious housing market debacle.
KYC - Know Your Canadian-Banking System
The Canadian banking system is dominated by 5 entities, commonly known in the media as the "Big 5" (also known among the Canadian public as the "Axis of Evil"). These 5 banks have residential mortgage portfolios totaling ~$793 billion, or ~80% of the total residential mortgage market. The Big 5 are national banks with branches all over the country, from the biggest cities to middle-of-nowhere towns consisting of a gas station, a motel, and a bank branch (like, say, Dog River, Saskatchewan).
"THE BIG 5"
Royal Bank of Canada
Bank of Nova Scotia
Bank of Montreal
Canadian Imperial Bank of Commerce
The Big 5 all have primary retail lending operations covering residential mortgages, consumer loans, and commercial financing. They also all have substantial wealth management divisions and investment banking and trading operations. Some, like RBC, also have substantial insurance operations.
Some of the Big 5 banks are not strictly "Canadian". TD has a substantial and growing presence in the northeastern U.S. and BNS has invested heavily in Latin emerging markets. This is important because, with the U.S. housing market well on the road to recovery, the more reliant a bank is on its Canadian operations, the more susceptible it is to a deteriorating Canadian housing market.
In addition to the Big 5, there are many smaller regional banks covering only certain geographies. There is also a large contingent of regional credit unions, which are essentially banking co-operatives owned by the depositors. There are also small independent lenders that specialize in non-prime mortgages.
Note the financial industry's cute attempt to rebrand "sub-prime" as "non-prime" … but much like Puff Daddy changing his name to P Diddy (and then to just "Diddy"), we still all know its garbage.
For brevity of analysis, I have singled out a few that are potentially most susceptible to a housing collapse. I have affectionately named them "The Other Guys".
"THE OTHER GUYS"
Canadian Western Bank
- 80% of business conducted in British Columbia "BC" and Alberta
Home Capital Group
- Canada's largest independent non-prime mortgage lender
- 86% of mortgages in Ontario
- Credit union with vast majority of lending in the Greater Vancouver Area "GVA"
All Canadian lenders have relied heavily on default insurance provided by the federally-owned CMHC, which has provided $576 billion of insurance to homeowners and lenders as of 30 Sep 2012. But some lenders have relied on the insurance more heavily than others and, all else equal, the more CMHC insurance a lender employs, the less it is exposed to a housing calamity.
Finally, housing price increases have been concentrated mainly in Vancouver and Toronto, so lenders with portfolios concentrated in those cities are more exposed to a housing decline than those that do not.
Tale of the Table
With all that in mind, I give you the following table.
Tier 1 Capital
Canadian Retail Banking
Residential Mortgages ($ bil)
1BMO reports an additional $61 billion of consumer debt, a good portion of which is probably Home Equity Lines of Credit that cannot be insured.
2 CWB: 40% of residential mortgage portfolio in BC.
3HCG: Vancouver/Toronto condo portfolio is only 7% of portfolio, 51% of which is insured.
It's depressing to think about how much work went into that little table. Note the table mixes data from the most recent 3Q reporting and the 2011 year-ends. I didn't bother highlighting which was which … so sue me.
Let's examine each entity in turn.
The Big 5
RY - Somewhat surprisingly, the Canadian powerhouse RY appears to have its tail feather sticking out the most. It has a relatively high reliance on its Canadian mortgage portfolio and the lowest proportion of insured mortgages. Tellingly, RBC noted a 31% increase loan loss provisions in its most recent quarter, with its CEO stating loan growth was likely to "moderate" in 2013.
TD - First, it must be said that TD has very poor disclosures. I searched high and low for details, which cost me valuable minutes I otherwise might have used to cure cancer or just stare vacantly at the wall. Anyway, it would be quite the story if the generally-accepted Best-in-Class of the Big 5 was concealing some not-so-great info regarding its residential mortgage exposure. My gut feeling, however, is that TD has a decent cushion given the size of its U.S. operations.
BNS and BMO - Both of these banks have relatively low reliance on the Canadian banking sector and the bulk of the residential mortgage portfolio is insured. Nothing much to fear here.
CIBC - CIBC is the most Canada-centric bank, which would raise alarms except for the fact that it also has the most insurance. CIBC is also kind enough to provide additional disclosure (I'm looking at you, TD!) with respect to its exposure to Vancouver and Toronto condominiums. The bank financed a hefty $17 billion in those 2 markets, but, again, 77% of that is insured.
Note that the Big 5 tend to be very conservative lenders and have used CMHC to participate in loans that wouldn't normally fit their tight standards. It's safe to assume, on average, that the uninsured portions of their mortgage portfolios are less risky than the insured portions. At the same time, the Big 5 have all, to varying degrees, participated in the non-prime market and so will have a small portion of their uninsured portfolios that is more risky.
The Other Guys
Canadian Western - Canadian Western's largest exposure is actually in Alberta and the stock recently hit a speed bump with fears that Alberta's epic, oils sands-fueled, 15-year economic run might be coming to an end thanks to shale gas and tight oil … as if a collapse in the BC housing market wasn't hard enough to deal with.
Home Capital - Unlike the Big 5, Home Capital's uninsured portfolio is more likely lower quality than the insured portfolio simply because a borrower that could qualify for a mortgage from a prime lender, and didn't need insurance, wouldn't go crawling to Home Capital. Home Capital's CEO was actually quoted as saying that HCG's credit quality was "improving" since the tightening of the CMHC rules, which doesn't exactly fill me with confidence concerning their credit quality prior to the rule-tightening.
Vancity - This credit union reminds me of the car accident I was in a few winters ago. At the top of a 45° hill, I pumped the brakes, only to realize that there was a one-inch thick layer of ice covering the road. My 2,300 pound '88 Dodge Aries morphed into a bobsled and cruised directly into a row of parked cars about 50 feet below. I knew right away it wasn't going to end well … and I was powerless to stop it (and since Vancity isn't publically-traded, I'm also powerless to profit from it).
So what would happen if Canada did experience a U.S.-style housing collapse? To get a quick feel for the sturdiness of the country's lenders, I decided to stress test them for a national average default rate of 2.23% on residential mortgages. This would match the U.S. collapse, which saw foreclosure rates peak nationwide at 2.23% in 2010. Only the states of Nevada (whose 9% foreclosure rate was high enough to give me a nosebleed), Arizona, and Florida exceeded 5% foreclosures at any point in the crisis. Also, a 2.23% default rate would dwarf Canada's record of 1.02%, reached in 1983.
The Big 5
As mentioned previously, the Big 5 are geographically diverse, so I have assumed they would each experience the national average across their mortgage portfolios. CIBC, for instance, pegged its exposure to the Vancouver and Toronto condo markets at $17 bil, which is just ~12% of its total portfolio in 2 city metropolises that account for almost a third of the country's population (yes, that is the plural of "metropolis"; I looked it up).
Also as mentioned previously, the uninsured portion of the Big 5 mortgage portfolios likely has a higher credit quality than the CMHC-insured portion. If we assume that all of the insured mortgages default before the uninsured mortgages … what impact on Tier 1 capital could we expect from a 2.23% default rate?
Residential Mortgages ($ bil)
Insured Portfolio ($ bil)
Loans In Default ($bil)
1I assumed TDs insured portfolio was equal to RBCs. That's what you get for bad disclosures TD!
That's right … there would be NO IMPACT! The Canadian banks would shrug off a U.S.-style housing collapse like Barack Obama did the first 2012 presidential debate.
What happens if we assume 50% of the uninsured portfolios were non-prime, meaning 50% of the defaulted loans must be absorbed by Tier 1 capital writedowns?
Tier 1 Capital
To put this in perspective, JP Morgan Chase (NYSE:JPM) wrote down $6 - $7 billion, or~33% of their 2011 earnings thanks to the London Whale. For JPM, the London Whale was really more like a sea urchin … and for the Big 5, a U.S.-style housing collapse would be nothing more than a proverbial fly on the windshield.
The Other Guys
Things are a bit more complex for The Other Guys.
First, they have regional exposure. Canadian Western Bank has 40% of its mortgage portfolio in BC and Vancouver accounts for more than half of BC's population. Vancity conducts effectively all of its mortgage lending in the GVA and, so, is even more directly exposed to the Vancouver market. Conversely, Home Capital is almost entirely concentrated in Ontario and the Greater Toronto Area accounts for about a third of the Ontario population.
With this in mind, I will assume a 9% default rate for Vancity, equal to the maximum default rate experienced in Nevada in 2010 … and I have subjectively eyeballed a 5% rate for Canadian Western Bank and 4% for Home Capital (hey, I'd rather be vaguely right than precisely wrong).
Second, with respect to Home Capital,it is likely that the credit quality of the uninsured portfolio is inferior to that of its insured portfolio … so I have assumed that Home Capital will have to writedown all of its defaulted loans against its own Tier 1 Capital and will not receive any support from CMHC.
Its not clear to what degree Canadian Western Bank and Vancity have participated in the non-prime market. The regional banks and credit unions do not necessarily have lower quality loan books than their Big 5 cousins. Therefore, I have assumed that 50% of their defaulted loans will be supported by CMHC insurance and half will be written down.
Loans In Default ($ bil)
Tier 1 Capital
So, again, even in a U.S. style housing collapse, Canadian Western Bank would emerge relatively unscathed. Home Capital and Vancity on the other hand ...
Complexity for Confusion's Sake
I concede that this is a simplistic analysis in that it doesn't consider the impact of a housing collapse on the Canadian banks' other business lines. Surely commercial banking, investment banking, and wealth management operations would also be impacted by a housing slowdown.
That's what happened in the U.S. Bloomberg News estimated that the total bailouts provided by the U.S. government reached a whopping$12.8 trillion. Even if 20% of the U.S. mortgage market defaulted, that would require "only" $2 trillion in capital.
So what was the rest of it for? The answer is derivatives: CDOs, CDSs, and insurance on CDOs and CDSs, which became an "side bet" that ultimately dwarfed the main bet because its notional value wasn't restricted by silly things like "tangible assets" or "reality".
The Big 5 do have some on- and off-balance sheet securitized assets, but these operations aren't nearly as significant as their southern neighbors 6 to 7 years ago. And, of course, a good chunk of those securitized assets are also guaranteed by CMHC through a separate program called "Canada Mortgage Bonds". When you combine the in-force CMHC insurance policies and their guarantees on securitized assets, the total support provided by CMHC reaches ~$900 billion … for a $1 trillion mortgage market!
The Unshortable Short Opportunity
Even if a Canadian housing collapse did occur, with CMHC backing essentially the entire Canadian housing market, there are appears to be no real way to profit from it … unless you live in Canada, where your best option might be the sale and leaseback of your home.
Disclosure: I am short RY, OTC:HMCBF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. I am long Canadian Imperial Bank of Commerce (CM)