As mentioned Part-1, Canadians like to think they are 'different' than their southern neighbors. That is certainly true in some respects, but not in the accumulation of debt. Canadian households debt to disposable income versus that in the USA is shown in the below chart, however Canadians went quite a bit further in debt! Well at least that's different, right?
Chart-5: Credit Market Debt to Household Disposable Income (%). This chart shows how Canadian households compare to their American counterparts. Canadian households held more debt (to disposable income) than Americans for every single year of data shown. American households started the process of deleveraging in 2007, but Canadians have yet to start.
Click images to enlarge
Mark Carney, the Governor of the Bank of Canada (BoC), made a speech last year at the Vancouver Board of Trade about the Canadian housing market. Some of the highlights included:
- The value of housing-related debt in Canada has nearly tripled over the past decade to $1.3 trillion.
- This debt is also the single largest exposure for Canadian financial institutions, with real estate loans making up more than 40 per cent of the assets of Canadian banks, up from about 30 per cent a decade ago.
- The average level of house prices nationally now stands at nearly four-and-a-half times average household disposable income. This compares with an average ratio of three-and-a-half over the past quarter-century.
Another difference between Canada and the USA is that you can't get a 30 year fixed rate mortgage in Canada, but you can in the USA. Canadians have to use ARMs (adjustable rate mortgages), or a maximum of 10-year fixed rate, but most Canadians use 5-year fixed rate mortgages and hence have to refinance every 5 years.
The day the BoC start raising rates (which they will one day - see below chart), there will be homeowners in every market that cannot afford to refinance at higher rates and hence the default rate will rise.
Chart-6: Canadian Historic Mortgage Rates & Inflation. Clearly there is a downtrend in the mortgage rates over the last 25 years, and this can't last forever.
Source: IMF for inflation; CIBC/Firstline Mortgages for rates.
The BoC will raise rates eventually and when they do a lot of households are going to have difficulty adjusting to the higher interest payment.
Canadian Banking System
Something should be said about the 'rock solid' Canadian banking system, which is another point of pride for us Canucks! I read a great article on ZeroHedge titled: Is The Next Domino to Fall… Canada? (Aug, 2011), which discusses the (in)solvency of various banks around the world.
The authors compared 30 of the world's large banks and ranked them by their TCE ratio (tangible common equity). One might expect most of these banks to be European, which is true, but 6 of them (or 20%!) come from Canada. Even worse, 30% of the banks that have 4% TCE or less are Canadian.
Table-5: Reprint of ZH Article "Is The Next Domino to Fall… Canada?". I don't have my own Bloomberg terminal to make an updated list, so I have to use the ZeroHedge data from August 2011.
TCE is used to measure how much leverage a bank has based on its assets, and hence the lower this ratio, the more highly levered the bank is. TCE is a better judge of the financial strength of a bank than the average pundit's preferred measure: Tier-1 capital. This is because Tier-1 capital can be generated with snazzy accounting tricks, whereas TCE is based on actual equity (i.e.: customer deposits).
A McKinsey paper (Capital Ratios and Financial Distress: Lessons from the Crisis, Dec 2009) stated the following about TCE versus Tier-1:
Specifically, our analysis of bank distress during the credit and liquidity crisis of 2007 to 2009 suggests that the tangible common equity to risk-weighted assets ratio (or TCE to RWA) was the strongest predictor of future bank distress (with a Gini coefficient of 0.42) of the commonly measured capital ratios, and appears to be a significantly better predictor than other traditional risk-based measures of capital, including Tier 1 capital to RWA (Gini coefficient of 0.27) and Tier 1 capital plus Tier 2 capital to RWA (Gini coefficient of 0.26).
When one considers the following points, it's easy to see that Canadian banks are not as 'rock solid' as commonly believed:
- Canadian banks have some of the worse TCE ratios in the world (i.e.: they are extremely over leveraged), even worse than many of Europe's sick banks.
- Governor Carney noted in his speech that more than 40% of bank assets are in mortgages.
- If I'm right, Canadian real estate prices will likely drop around 30% on average across all markets. These losses will show up on the balance sheets of the banks.
It's interesting to see that Canada's banks are already Basel-III compliant and also rated number 1 for soundness (and may need a government bailout) by the World Economic Forum, Global Competitiveness Report 2010-11. Regardless, when mortgage default rates start to increase in Canada, banks with low TCE ratios may quickly see their losses dwarf their assets, and it's possible Canada will have a banking crisis that requires a US-style bailout.
I guess we may not be so different from our southern neighbor after all.
It is clear that the Canadian housing market has undergone a debt-fueled asset price inflation (i.e.: a bubble) that has greatly outpaced inflation. It is equally clear that Canadian home prices have not yet begun their price reversion to the mean.
On average, I suspect that housing prices will correct by about 25-30% across Canada, with some of the extremely overvalued markets (i.e.: Vancouver) declining more like 40% or more.
If the Canadian housing market crash behaves like the USA one, expect most of the losses to occur in the first two years, and then slow down after that.
Canadian banks will suffer, and may need a bailout. They are over-leveraged and over-exposed to housing market debt. I will not be surprised to see a Canadian banking crisis emerge in the next few years, and government bailouts to go with them.
If there is interest I will write another part to this article with a detailed look at which companies to short, and why.