Canada's Housing Market: Look to the Banks for Clues About the Severity of the Bubble

by: Israel's Financial Expert

From Canada’s Housing Bubble- Déjà Vu from the Northern Side of the Border:

During the financial crisis of 2008, many praised Canada’s economy, its banks and regulators for the fact that it didn’t have the same loose lending practices that were common in the United States and therefore it didn’t suffer a similar bust. We have a different view on the matter.

In Canada, like other parts of the world such as China, Brazil, India, Australia and Israel interest rates were far from zero in 2002, when the real estate speculation orgy started in different places around the world. All of these countries closed the gap in the last two years, by slashing interest rates and increasing the money supply. Liquidity brings stupidity, and with stupidity came those reckless lending standards. Canada is one more example of a place was artificially low interest rates caused its citizens, corporations, and banks to lose their mind.

Is Canada’s Banking System Conservative as Many Claim?

A good bank is not measured by its ability to make money during the good years. Any bank can do that. It is a big mistake to follow the banks that report record profits when the economy, and especially the real estate market is booming and think that the stock and earnings performance indicate that those banks are well managed. According to such standards, Washington Mutual, Fannie Mae (OTCQB:FNMA), Freddie Mac (OTCQB:FMCC), Citigroup (NYSE:C) and others would be well managed banks with amazing risk management. However, since the fall of 2008, everyone knows that isn’t the case and that those financial institutions were not prepared for the great recession/depression that started in the years 2007-2008.

In Canada, like in Australia, Israel, Brazil, India and other countries around the globe, the housing bubble hasn’t popped yet. So the fact that they are reporting record profits while the banks in the United States and Europe are struggling is meaningless. What a prudent investor should examine is how these banks prepared for the inevitable downturn in real estate. Are they better off than the American banks in 2008?

What Can the Equity to Total Assets Ratio Tell Us About the Canadian Banking System?

The equity to total assets ratio reflects the basic leverage of a given bank, and in aggregate – the leverage of a given banking system. After examining this ratio in the largest Canadian banks one can discover that not only are the Canadian banks not prepared for a downturn, but they are less capitalized than the largest American banks ever were! (Stats From: Canada's Housing Bubble)

Click to enlarge

Source: Annual and quarterly reports. click to enlarge

An examination of the entire banking system reveals similar results (click to enlarge):
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Source: IMF

It may come as a shock, but not only are Canadian banks under-capitalized in comparison to the American banks today, but even when comparing the equity ratios to the levels of December 2008. Remember, in December 2008 the United States was in the midst of the worst economic contraction since the great depression and the banks had already written down hundreds of billions of bad loans. The Canadian banks in December 2009 are less capitalized than those banks were and they are in the midst of a housing boom!

Another interesting point is that the Australian banks are in even worse shape than the Canadian banks. (For more about Australia’s housing bubble please go to Australia’s Housing Bubble- Past the Point of No Return.)

Canadian Banks Are Extremely Vulnerable to a Housing Downturn

The Canadian banks have an equity to total assets ratio of less than 6%. That means that if their assets fall by more than 6% they will essentially be bankrupt. That is an unbelievable figure given that the American banking system collapsed under similar conditions, even though they had a much better starting point.

Does Canada Have the Money to Save Its Banks?

Canadian banks will need a bailout. That is for sure. The only question is will the Canadian government have the resources to rescue them?

The total assets of the largest banks in Canada are as follows:

  • Royal Bank of Canada (NYSE:RY) - $700 Billion USD
  • Toronto Dominion Bank (NYSE:TD) - $575 Billion USD
  • Bank of Montreal (NYSE:BMO) - $400 Billion USD
  • Canadian Imperial Bank of Commerce (NYSE:CM) - $350 Billion USD
  • National Bank of Canada (OTCPK:NTIOF) - $150 Billion USD
  • Bank of Nova Scotia (NYSE:BNS) - $525 Billion USD

Total: $2.7 Trillion USD

Let’s compare that to the largest banks in the United States:

  • Citigroup (C) - $1.8 Trillion USD
  • Bank of America (NYSE:BAC) - $2.3 Trillion USD
  • J.P Morgan Chase (NYSE:JPM) - $2.3 Trillion USD
  • Wells Fargo (NYSE:WFC) - $1.2 Trillion USD
  • U.S Bancorp (NYSE:USB) - $285 Billion USD
  • BB&T Corporation (NYSE:BBT) - $165 Billion USD

Total: $8.05 Trillion USD

The total amount of assets held by the six largest Canadian banks is $2.7 trillion U.S. dollars, or 168% of GDP, while in the United States it is only 57% of GDP.

What about Fannie Mae and Freddie Mac you may ask? Well let’s have a look. The total assets of Fannie Mae are about $3.3 trillion and of Freddie Mac, about $2.3 trillion.

If you add Fannie and Freddie the total assets of the 8 largest American financial institutions is still “only” $13.6 trillion which represents a smaller share of the United States’ GDP than the six largest Canadian banks represent of Canada’s GDP!

Please remember that Canada does not enjoy a reserve currency status and therefore will need to actually raise the capital needed in order to save its banking system. (As opposed to just printing it).

Canada will probably suffer from a weak currency when the crash comes, unlike what the U.S experienced, a fact that will keep both its central bank and government paralyzed. A fiscal or monetary stimulus may be out of the question, as is always the case when a credit collapse is combined with a collapsing currency.

A special advantage for U.S. based investors
All of the banks mentioned in this article are traded on the NYSE. A downturn in Canadian housing will most likely cause the Canadian dollar to fall. If that happens, then a short position on these stocks will make the trade even more profitable since the shares will fall not only because of the companies’ performance but also because of changes in the exchange rates.
Disclosure: Short Candian banks