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Are you familiar with Fairfax Financial's (OTCPK:FRFHF) Prem Watsa? If you are an investor, you should be. The man can both make you a lot of money and steer you away from a lot of trouble.
You might not be familiar with Watsa, but there is no doubt that you recall the panic that followed the popping of the U.S. housing bubble in 2008. Had you been following Watsa in the years leading up to the financial crisis, you would not only have avoided financial loss, but also you would have profited from the collapse.
Watsa was warning investors of the impending disaster in the housing market as far back as 2005. He positioned his company Fairfax Financial to profit massively from it by owning credit default swaps on exposed companies. Here is a piece of what Watsa was saying in his 2005 letter to Fairfax shareholders:
As we have mentioned ad nauseam, the risks in the U.S. are many and varied. They emanate from the fact that we have had the longest economic recovery with the shortest recession in living memory. Animal spirits are alive and well and downside risks have long been forgotten. Having lived through the telecom bubble recently and the oil bubble in the late 1970s and early 1980s (and perhaps again today), we see all the signs of a bubble in the housing market currently. It appears to us that buying a house is today viewed as a sure shot investment - perhaps just as housing prices are on their way down, maybe significantly.
The U.S. consumer is overextended, savings rates are below zero, credit spreads are at record lows and even emerging market countries are borrowing long term at very low spreads above treasuries. We continue to be fascinated - morbidly - by the recent Japanese experience. The Nikkei Dow dropped from 39,000 in 1989 to 7,600 15 years later while 10-year Japanese government bonds collapsed from 8.2% to 0.5%, totally contrary to normal historical investment experience. Japanese market capitalization dropped from 149% of GDP to 53% in 2002.
The U.S. market capitalization is still at about 120% of GDP, down from over 170% in 2000, but way above its 80-year average of 58% and even higher than its 1929 high of 87%!!
What does all this mean? Well, for a few years now, we have said that we are protecting our shareholders' capital from a 1 in 50 year or 1 in 100 year event. By definition, this is a low probability event (like Hurricane Katrina) but we want to ensure that we survive this event if and when it happens.
That was written in 2005, with a little "Google" work, you can find that he was actually onto the overleveraged consumer and housing bubble as early as 2003. The man should definitely have had a part in the movie "The Big Short."
He Sees A Bubble Now In Canadian Housing - Especially In Vancouver and Toronto
You can read Watsa's annual shareholder letters here. We've read them all and wait excitedly to read them every year just as we do the letters from Mr. Buffett and a few other CEOs.
It would be hard to think of a man with a more credible view on spotting a housing bubble than Watsa. Today, he sees one closer to home in his own country of Canada.
Here is what Watsa had to say about the state of Canada's housing market in Fairfax's most recent shareholder letter:
As we have said a few times before, the collapsing commodity prices will not spare Canada. Canadian housing prices, particularly in Toronto and Vancouver, have gone up significantly, driven by lax policies at CMHC (Canada's equivalent to Fannie Mae and Freddie Mac).
Canadians have accessed their increasing real estate wealth through lines of credit easily available from the banks. Sounds familiar?
This is exactly what happened in the United States before the financial crisis in 2008/2009. If history is any guide, this will reverse and we continue to be shocked at the massive debt levels incurred by young people (below 45 years old), with no financial buffer against hard times as the C.D. Howe report, (Mortgaged to the Hilt), shows.
Reading this in Watsa's most recent shareholder letter made us want to look into the Canadian housing market a little further. What we found out about housing prices in the two cities that Watsa mentioned was staggering.
Vancouver Home Prices - Absurdly High (Toronto Not Much Better)
We would warn you that should you choose to "Google" and Vancouver housing bubble, be aware that you are likely going to lose a few hours of your time.
There is a lot to read and the numbers are hard to believe.
The chart below shows the history of Vancouver home prices right from the Greater Vancouver Real Estate Board. The prices of detached homes have gone absolutely parabolic in recent years.
In 2001, the average residential detached home sold for $400,000. At the end of 2015, that number was $1.8 million, up more than four times in a decade and a half.
Check the rate of the increase over the last year. The rate at which house prices went up was hard to fathom from 2000 through 2014. That last $600,000 that average prices has increased is positively nutty given how quickly it happened.
Unless the average person in Vancouver is the CEO of a Fortune 500 company, it only requires common sense to appreciate that $1.8 million is too much for an average house.
A look at how home prices relate to income hammers that point home.
The rule of thumb that we were always taught is that a house price should be roughly three times income. The chart above (which is from late 2014) shows that most Canadian cities are a little higher than that. New York is double that.
Vancouver home prices are 10.6 times income, which is more than three times the historical norm. We must also note that this chart is about a year old, so the number today is even worse.
Vancouver housing prices could lose 2/3rds of their value and still not really be considered inexpensive relative to what has historically been reasonable. The Canadian cities of Victoria and Toronto also look very expensive in the chart above.
41% More Expensive Than American Housing
We must recommend the blog of Garth Turner for anyone interested in reading about Canada's housing bubble. On Turner's blog, we found detail on how Canada's housing is priced relative to the United States.
Bank of Montreal
The chart above shows (in US dollars) that Canada's houses are on average 41% more expensive than the United States. The average Canadian house sells for $384,402 vs. $271,803 in the United States.
It is hard to understand why Canadian houses would be worth more. It is especially hard to understand when you stop to consider that Americans can deduct interest on mortgages, pay on average 30% less in income tax and are able to lock in fixed mortgages for 30 years (not an option in Canada).
If anything Canadian housing prices should be at a discount.
How Does One Short It?
The true bubble seems to be in Vancouver, Toronto, and Victoria where a quarter of all Canadians live. To successfully try and profit from this bubble collapsing would require the chosen vehicle to have lots of exposure to those markets.
When reading about the Canadian housing bubble, we came across an interesting argument that Home Capital Group (OTC:HMCBF) would be a way to do this. It doesn't get us exposure to Vancouver unfortunately, but it is a direct bet against the Toronto housing prices.
Home Capital markets itself as focusing on underserved customers such as the self-employed and immigrants who make up 20 percent of the housing market in Canada. We would take that to mean that Home Capital focuses on the customers that the rest of the sector view as unattractive credit risks.
The case for shorting Home Capital Group starts with the argument that the company has shoddy internal control procedures. In 2015, the company admitted that $2 billion of mortgages had been written by 45 mortgage brokers who had been sacked for submitting fraudulent mortgage applications.
Home Capital currently has non-performing loans of only 0.28%. That means there is huge potential for a hit to income and balance sheet charges if some of this poorly controlled loan portfolio turns sour. The company's valuation is currently based on a seemingly flawless loan portfolio.
The strong loan performance makes sense, it isn't hard to make interest payments when interest rates are at unprecedented levels.
Despite having exposure to what is generally thought of as the biggest housing bubble in the world, Home Capital Group, which trades at 1.8 times book value, actually trades at a premium to U.S. banks like Wells Fargo (NYSE:WFC) (1.4 times book value) and Bank of America (NYSE:BAC) (less than 1 times book value).
It makes no sense that this company would trade at a premium to American banks which have gone through brutal clean-up of their balance sheets and have had excruciatingly detailed oversight by the U.S. government because taxpayer bailout money that was injected into them. Especially given what we know about Canadian housing prices.
A fairly well-known short seller named Marc Cohodes notes that Home Capital Group has loss provisions of only 0.13% while during the subprime collapse in the U.S. loss provisions went as high as 12% to 17%. A U.S. style housing bust would cause Home Capital's loss provisions to soar and could wipe out its equity entirely.
We again should note that Home Capital is focused on subprime (sorry underserved) debt in Ontario so this is a play on the Toronto housing market and not Vancouver. If anyone has thoughts on how to short Vancouver directly please let us know in the comment section below.
If we continue down this Canada housing bubble road a little further, we expect that Genworth MI Canada, Inc. (OTC:GMICF) is another company that we would like to take a look at. While Home Capital lends to the borrowers that other lenders would prefer to avoid, Genworth insures the borrowers that Canada's CMHC refuses to insure.
That doesn't sound like a smart business to be in. More on that one in the future.
What Sets Off The Bust?
The U.S. housing bubble wasn't really a secret. Most people were aware that housing prices were going up very, very quickly. But since the party kept going, everyone kept dancing.
The oil collapse hasn't done anything to housing prices in Toronto and Vancouver. It is hard to say exactly what will, with one exception.
When interest rates start to rise, this party is over. There is an entire generation of people in Canada who have no idea that a six percent mortgage is a historically attractive rate. Many of these folks are going to be ruined at that kind of interest rate. We don't know exactly when rates will rise, but expect that eventually we will.
We will leave you as we started this article, with a reference to Prem Watsa's view:
"We continue to be shocked at the massive debt levels incurred by young people (below 45 years old), with no financial buffer against hard times as the C.D. Howe report, (Mortgaged to the Hilt), shows."
Make sure you click the follow button at the top of this article if you are interested in following this Canadian housing story that Prem Watsa introduced us to.
In the meantime, we will keep trying to track down the best ideas from the best investors in the world. Shorting housing bubbles isn't generally what we are into. Our preference is solid companies that have been temporarily misunderstood my Mr. Market.
Thanks for reading.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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