The Unintelligi...'s  Instablog

In my last article, I made the case that tales of the Canadian housing market's demise were somewhat exaggerated. While housing prices might 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 US-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"

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 US and BNS has invested heavily in Latin emerging markets. This is important because, with the US 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"

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 30Sep2012. But some lenders have relied on the insurance more heavily than others and, all else equal, the 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.

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 US 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-fuelled, 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).

Insufficient Funds

So what would happen if Canada did experience a US-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 US 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?

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 US-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?

To put this in perspective, JP Morgan Chase (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 US-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.

So, again, even in a US 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 US. Bloomberg News estimated that the total bailouts provided by the US government reached a whopping $12.8 trillion. Even if 20% of the US 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, HMCBF.PK. 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.

Additional disclosure: Note I am also long Canadian Imperial Bank of Commerce (CM)

Mini-Me?

Where there's smoke, there's fire … except for those times when there's a production crew with dry ice, a wind-machine, and the soundtrack from the Fireplace channel.

Sensationalism in the market equals big dollars for media companies. I'll bet my life you are more likely to read a story titled "Market on Verge of Collapse!" than you are "market to remain relatively stable to forseeable future." Sensational headlines tap into our carnal emotions, inspiring fear in many, anxiety in most … and excitement in nut-jobs like me always looking for a calamity to profit from.

Enter the worst kept secret in the economic universe these days: the Canadian housing bubble … an epic, titanic bubble 3,708lbs in weight with 30 million cubic feet of air capacity stretching 55 stories high at its peak altitude. Sorry, that's the Red Bull Stratos high-altitude balloon … but you get the picture.

Many point to the marked similarities with the US housing bubble, still so vividly entrenched in our memories, haunting us like the threat of another sequel to the Paranormal Activity movie series.

And the similarities are striking.

*Estimates on outstanding non-prime Canadian mortgage loans range from $86 billion to $500 billion depending on the definition chosen and how much you want to scare people.

Price increases in Canada have far outstretched rents. The Home Price-to-Rent ratio so far above historical averages even Felix Baumgartner finds it nauseating.

It seems that finally the air is being let out of the balloon, as prices began to stall during the summer of 2012 and declined substantially in the city of Vancouver.

Looks Can Be Deceiving

But if you can clear the fog from your glasses, you'll see there are some major differences between the two markets that expose the Canadian housing bubble as an imposter with dwarfism.

Low Interest Rates

A good friend told me people don't buy homes, they buy payments. The sticker price of the home is basically meaningless. What matters is how high their monthly payment is. Put another way: Household Debt-to-Income is much less important than Household Debt Service Requirements-to-Income.

And, of course, current Canadian interest rates are much lower than the equivalent American rates at the peak of the US housing bubble.

For mortgagees, the increased principal portion has been offset by a declining interest portion, leaving payments relatively flat. And the evidence is in housing affordability as tracked by RBC.

Their measure tracks pre-tax household income required to service a standard home. Canada-wide, the index reached 43.4%, just 4% higher than its 30+ year average and still well below the peaks reached in 1992 when Canada suffered its worst housing-related recession since the Great Depression. This is hardly the sign of a distressed borrower.

Of course, there is a legitimate possibility that rates could increase quickly. The impact in the short term would be muted, however, given over 70% of Canada's outstanding mortgages are closed and have terms greater than 5 years. This shields borrowers from a dramatic increase in their payments, at least for a short while.

Better Lending Standards

Canada and the US have 2 very different approaches to financial oversight and this has manifest itself in tighter lending standards north of the border. The Canadian federal government regulates financial institutions to such a degree it makes Barack Obama look like Ron Paul. Lending in Canada is a lot like being in high school detention … and lending in the US is a lot like, well, this.

Suffice to say that the US housing market went outright crazy in 2005 and 2006 … what with its 0% down payments, interest-only loans, no doc loans, liar loans, no able anglais loans, and no-income no job no asset loans. And when the borrower was so strapped for cash it could even come up with the 0% down payment, they dreamed up negative equity loans.

In Canada, the maximum loan-to-value ever available was 95% and any down payment less than 10% had to be fully insured by CMHC (for Schedule 1 banks). So-called 'stated income' loans were available for self-employed individuals, but not for any less than 20% down and insured.

Also, the qualifying rate used is not the actual contracted rate of the loan, but a mythical, seemingly produced from thin air, rate posted by the Bank of Canada. The conventional mortgage rate was 5.24% the week of 10Oct2012. On that date, essentially all the banks had 'Special Offer' rates in the 3.5% range.

What's more, the Canadian government has actually moved to tighten these standards in 2012 to reel in the "loose" lending years of 2010 and 2011.

This is financial regulatory proof that Canadians are boring.

One Bad Apple Spoils the Whole Bunch

Back to the RBC Affordability Index. RBC breaks down the index by major cities. Calgary, Edmonton, Toronto, Montreal, and Ottawa are all within 5 points of their long run averages (plus or minus). Even in Toronto, where there are a record number of cranes erecting a record number of downtown condominiums, the Affordability index is only 5.5 points above average and still well below the nosebleed levels of the early 90s.

And then, there's Vancouver. In Vancouver, a standard 2-storey home costs more than $850,000. At today's interest rates, payments eat up a stunning 93.8% of the average homebuyers pre-tax income. That barely leaves enough money left over to support the average Vancouverites specialty coffee addiction, never mind furnishings, a vehicle, a gym pass … and that extravagant luxury called 'food'.

There is surely some pain coming in Vancouver and, in fact, it's already here.

CMHC

Remember September 29, 2008? The Dow collapsed 800 points after the US House of Representatives voted down the Emergency Economic Stabilization Act. In hindsight, it was a fitting end for a month that saw the government takeover of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the $85 billion bailout of AIG, and the FDIC-sponsored fire sales of Washington Mutual and Wachovia.

It was a torturous and petrifying month for corporations, small business owners, employees, and others as the US government grappled with a intractable dilemma. Should it bail out these gigantic financial institutions and effectively socialize the losses of incompetent, greedy financiers that deserved to suffer the consequences of their actions? Was it fiscally capable? Was it politically-feasible? Was it morally justifiable?

While I can understand not wanting to bailout bankers that wouldn't pull a thread out of their Gucci suit to help clothe a homeless man, the 'No' vote that September was the economic equivalent of cutting off your nose to spite your face. Without the certainty of government backing of the financial system, businesses across the globe clammed up like a vampire on a sunny afternoon on South Beach.

By the time the act was tabled for a second vote, passed on October 3, 2008, and then switched from an asset purchase program to a recapitalization program … the damage had been done. The US economy ground to a halt and bled millions of jobs. If the housing bubble was a tsunami, the uncertainty surrounding the US government's role was the equivalent of a bad early warning system.

There will be no such uncertainty in Canada. The Canadian government has already nationalized the losses. No voting required, no politicking behind closed doors, no intensive economic and social debate. They skipped all that nonsense with what may be the first pre-emptive financial sector bailout in economic history.

The Canadian Mortgage and Housing Corporation (CMHC) is a federally owned and operated entity, which, among other functions, provides default insurance to banks and other finance companies that provide residential mortgages to personal borrowers. The guidelines for obtaining CMHC insurance are such that they insure some of the riskier loans in the market. After all, the banks don't need insurance for the strong loans.

As of 30Jun2012, CMHC has insured $576 billion worth of mortgage loans. That's more than 50% of all mortgages outstanding in the whole country! That's almost as much as TARP! That's almost as much as Jerome Kerviel owes Societe Generale! And it's enough to ensure the viability of Canada's financial system well into the future.

Coming Up Short

So, just because it is a little different this time, doesn't mean there isn't a way to profit from what still could be a very real slowdown in housing construction and prices ….. but its not in the way you think it is.

Stay tuned for part 2.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.