For many years, I wandered through life as an agnostic. The supernatural beliefs of organized religion just didn’t make sense to me. But lately, I have been witness to evidence which has caused me to alter my views. There is a God, and He is a nineteenth century Russian novelist. For who else, I ask, could devise a tragedy so bitter as the one which appears to lie ahead for shareholders of the Canadian chartered banks?
Singled out for praise by the IMF and even complemented by President Obama himself, the big Canadian banks appear to be an island of calm amidst this financial tempest. We in Canada are the fortunate beneficiaries of a “conservative” banking culture and are blessed with excellent financial regulators. As other banks around the world are wiped out or trade at a fraction of tangible equity, Bank of Nova Scotia and Royal Bank of Canada now cruise serenely at 2.2X book. However, this comfortable situation may not persist for long. The Canadian banking crisis has not been averted. It is just arriving with a lag.
True, Canadian banks have avoided some of the sillier extremes, particularly those related to off-balance sheet leverage. But the key problem in Canada is precisely the same as it is in the other western countries now experiencing bank solvency crises. Home prices have grown to an abnormally high multiple of employment income, supported by a rapid expansion in mortgage debt.
Figure 1: Peak Home Prices as a Percentage of Avg. Income
Sources: World Bank, US National Association of Realtors, MLS, Nationwide
CMHC and the Canadian Housing Bubble
The key difference between Canada and other markets is that in Canada the cost of bad home loans have been socialized in advance. In Canada, we didn’t need to disguise our sub-prime excesses within dubious mortgage-backed securities. Why create an alphabet soup of bogus AAA paper when our government provides seemingly limitless quantities of underpriced mortgage insurance? As a formula for creating housing froth it has been virtually unbeatable. Housing markets may be cratering throughout the world, yet one observes a perverse new high in Canadian real estate prices in May of 2009.
The key to Canada’s bubbly housing success been the CMHC. The Canada Mortgage and Housing Corporation writes guarantees on most Canadian mortgages originated at greater than 80% Loan-to-Value. This agency has been on a massive expansion binge of late. In 2008, a year of synchronized global recession, the CMHC expanded its mortgage insurance in force by a whopping 18%. CMHC now guarantees $407.7 Billion of high loan-to-value mortgages and an additional $233.9 Billion of securitized mortgages.
In all, the CMHC mortgage guarantees are equal to slightly more than half of Canada’s GDP. Against this total, CMHC has miniscule equity capital of $8.1 Billion. How is it that more than $630 Billion of dodgy mortgages can be guaranteed by an entity posting just over 1% in equity? This is a question that curiously appears to have escaped the notice of Canada’s top notch financial regulators.
The role of the Canadian banks has been to commit capital to CMHC-insured mortgages as quickly as they receive applications. It is not mortgage lending in the traditional sense, more like underwriting government bonds and taking a 150 basis point spread as compensation. In this way, the Canadian real-estate bubble looks a lot like its American cousin. Home loans are being written for those who likely cannot pay by lenders who pass through the credit risk to a third party. However, in the case of Canada, the third party is our own government and not the Chinese or Saudis who snapped up American mortgage paper.
The Impact on Canadian Banks of a Bubble Burst
That which cannot go on forever will not. Sooner or later Canada’s housing market will conform with that of the rest of the world and begin to decline in earnest. What the specific catalyst will be, I do not know. Will unemployment spike, so that buyers disappear even for mortgages with favorable terms? Will Canadian sovereign interest rates rise, choking refinance? Will existing homeowners decide to dump their residences onto the market en masse? Maybe all three will occur. But the housing mania will stop.
When it stops, I expect the impact on the banks will be severe. In its 2008 “stress test” (which assumed an annualized 2% decline in GDP over six quarters, co-incident with modest housing market declines) the Bank of Canada estimated that losses to the Canadian banking system would amount to only about 10% of book equity. It would be nice if the “stress test” turns out to be accurate, but one gets the feeling that it contains more wishful thinking than serious confrontation of the problem.
The banks’ loan books face both short-term and long-term problems. In the short-term, we see US housing starts down by 60% and auto sales down over 40% this year. Therefore it seems quite possible that US GDP may shrink in 2009 by at least the 6.3% rate of the first quarter. In the circumstances, the Bank of Canada’s “stress test” of a 2% annualized decline in Canadian GDP seems optimistic.
Over the longer term, the Canadian banks face the familiar “black hole” problem created around the world by the real-estate bubble. Consumers will need to cut spending on other things in order to feed the massive debts incurred through real estate. Government will need to raise what little private capital is remaining in order to offset its suddenly shrinking tax base and to mop up the inevitable mess being created by the CMHC.
Levered “only” 12:1, Canadian banks may find that loan delinquencies rise beyond historic levels. The “good” mortgages, consumer credit and business loans all look vulnerable when one looks at individual cases with which we are familiar. Could the market value of the loan book of Canadian chartered banks be less than 92% of its face value? Quite possibly in my view.
Other business diversifications of recent years appear unlikely to offset pending difficulty in the banks’ Canadian loan book. Will the Bank of Nova Scotia’s recent string of Latin American bank acquisitions shore up its results? Will Royal Bank’s 2008 acquisition of a large Canadian mutual fund manager be viewed by history as a game-saving play? How about TD’s 2007 acquisition of US regional player Banknorth? My guess is that the strategic moves made at the market top may turn out to be ill-advised.
The Way Out
There is of course a way out. The Canadian state can print money to deleverage the economy. This is hardly an un-traveled path in global economic history. The classic formula is to withstand the shock of a brutal recession for about three years and then execute a back-door default on domestic and foreign loan obligations through debt monetization, devaluation and inflation.
There are banks which survive in such a meltdown, but they rarely do so at multiples of over 2X pre-crisis book equity. Frankly, I would expect most Canadian banks to require some form of bailout in the aftermath of a bursting real estate bubble. Given the lofty prices available now, there is only one rational move. Sell the banks.
Geoff Castle
marketdepth.typepad.com
Singled out for praise by the IMF and even complemented by President Obama himself, the big Canadian banks appear to be an island of calm amidst this financial tempest. We in Canada are the fortunate beneficiaries of a “conservative” banking culture and are blessed with excellent financial regulators. As other banks around the world are wiped out or trade at a fraction of tangible equity, Bank of Nova Scotia and Royal Bank of Canada now cruise serenely at 2.2X book. However, this comfortable situation may not persist for long. The Canadian banking crisis has not been averted. It is just arriving with a lag.
True, Canadian banks have avoided some of the sillier extremes, particularly those related to off-balance sheet leverage. But the key problem in Canada is precisely the same as it is in the other western countries now experiencing bank solvency crises. Home prices have grown to an abnormally high multiple of employment income, supported by a rapid expansion in mortgage debt.
| Canada | US | UK | |
|---|---|---|---|
| Average House Price (Peak, local currency) | C$ 319,957 | US$ 230,200 | 192,268 |
| Average House Price (Peak $US) | US$ 278,362 | US$ 230,200 | US$ 317,242 |
| Gross National Income per Capita (World Bank 2007 $US) | US$ 39,650 | US$ 46,040 | US$ 40,660 |
| Ratio of Peak Home Price to Income | 7.0X | 5.0X | 7.8X |
| Date of Peak | Q2 2009 | Q3 2006 | Q4 2007 |
CMHC and the Canadian Housing Bubble
The key difference between Canada and other markets is that in Canada the cost of bad home loans have been socialized in advance. In Canada, we didn’t need to disguise our sub-prime excesses within dubious mortgage-backed securities. Why create an alphabet soup of bogus AAA paper when our government provides seemingly limitless quantities of underpriced mortgage insurance? As a formula for creating housing froth it has been virtually unbeatable. Housing markets may be cratering throughout the world, yet one observes a perverse new high in Canadian real estate prices in May of 2009.
The key to Canada’s bubbly housing success been the CMHC. The Canada Mortgage and Housing Corporation writes guarantees on most Canadian mortgages originated at greater than 80% Loan-to-Value. This agency has been on a massive expansion binge of late. In 2008, a year of synchronized global recession, the CMHC expanded its mortgage insurance in force by a whopping 18%. CMHC now guarantees $407.7 Billion of high loan-to-value mortgages and an additional $233.9 Billion of securitized mortgages.
In all, the CMHC mortgage guarantees are equal to slightly more than half of Canada’s GDP. Against this total, CMHC has miniscule equity capital of $8.1 Billion. How is it that more than $630 Billion of dodgy mortgages can be guaranteed by an entity posting just over 1% in equity? This is a question that curiously appears to have escaped the notice of Canada’s top notch financial regulators.
The role of the Canadian banks has been to commit capital to CMHC-insured mortgages as quickly as they receive applications. It is not mortgage lending in the traditional sense, more like underwriting government bonds and taking a 150 basis point spread as compensation. In this way, the Canadian real-estate bubble looks a lot like its American cousin. Home loans are being written for those who likely cannot pay by lenders who pass through the credit risk to a third party. However, in the case of Canada, the third party is our own government and not the Chinese or Saudis who snapped up American mortgage paper.
The Impact on Canadian Banks of a Bubble Burst
That which cannot go on forever will not. Sooner or later Canada’s housing market will conform with that of the rest of the world and begin to decline in earnest. What the specific catalyst will be, I do not know. Will unemployment spike, so that buyers disappear even for mortgages with favorable terms? Will Canadian sovereign interest rates rise, choking refinance? Will existing homeowners decide to dump their residences onto the market en masse? Maybe all three will occur. But the housing mania will stop.
When it stops, I expect the impact on the banks will be severe. In its 2008 “stress test” (which assumed an annualized 2% decline in GDP over six quarters, co-incident with modest housing market declines) the Bank of Canada estimated that losses to the Canadian banking system would amount to only about 10% of book equity. It would be nice if the “stress test” turns out to be accurate, but one gets the feeling that it contains more wishful thinking than serious confrontation of the problem.
The banks’ loan books face both short-term and long-term problems. In the short-term, we see US housing starts down by 60% and auto sales down over 40% this year. Therefore it seems quite possible that US GDP may shrink in 2009 by at least the 6.3% rate of the first quarter. In the circumstances, the Bank of Canada’s “stress test” of a 2% annualized decline in Canadian GDP seems optimistic.
Over the longer term, the Canadian banks face the familiar “black hole” problem created around the world by the real-estate bubble. Consumers will need to cut spending on other things in order to feed the massive debts incurred through real estate. Government will need to raise what little private capital is remaining in order to offset its suddenly shrinking tax base and to mop up the inevitable mess being created by the CMHC.
Levered “only” 12:1, Canadian banks may find that loan delinquencies rise beyond historic levels. The “good” mortgages, consumer credit and business loans all look vulnerable when one looks at individual cases with which we are familiar. Could the market value of the loan book of Canadian chartered banks be less than 92% of its face value? Quite possibly in my view.
Other business diversifications of recent years appear unlikely to offset pending difficulty in the banks’ Canadian loan book. Will the Bank of Nova Scotia’s recent string of Latin American bank acquisitions shore up its results? Will Royal Bank’s 2008 acquisition of a large Canadian mutual fund manager be viewed by history as a game-saving play? How about TD’s 2007 acquisition of US regional player Banknorth? My guess is that the strategic moves made at the market top may turn out to be ill-advised.
The Way Out
There is of course a way out. The Canadian state can print money to deleverage the economy. This is hardly an un-traveled path in global economic history. The classic formula is to withstand the shock of a brutal recession for about three years and then execute a back-door default on domestic and foreign loan obligations through debt monetization, devaluation and inflation.
There are banks which survive in such a meltdown, but they rarely do so at multiples of over 2X pre-crisis book equity. Frankly, I would expect most Canadian banks to require some form of bailout in the aftermath of a bursting real estate bubble. Given the lofty prices available now, there is only one rational move. Sell the banks.
Geoff Castle
marketdepth.typepad.com
