Canada’s Big Short? Not Likely.

April 28, 2017

By Craig Maddock, CFA, MBA, CFP
Vice President Investment Management

Last week I attended the Annual Forecast Dinner of the Chartered Financial Analyst (CFA) Society Ottawa, together with several hundred other charterholders and their colleagues. Replacing the usual economist panel format was keynote speaker, Steve Eisman.

Eisman rose to fame trading against the subprime mortgage market, and was one of the few money managers who predicted the collapse of the subprime market. His perspective was chronicled in the Michael Lewis book The Big Short: Inside the Doomsday Machine, and he was also portrayed by Steve Carell in the movie The Big Short.

Drawing parallels between Canada’s current hot housing market and the pre-2008 conditions in the United States, Eisman’s message could not have been more timely.

What caused the U.S. subprime mortgage collapse?

According to Eisman, three things are required for a situation to be called a crisis: leverage, concentration (in this case, real estate), and ownership (U.S. banks). At the time of the 2008 collapse, banks considered mortgage loans low-risk investments. The regulatory environment allowed for reporting that masked the true leverage—in other words, things didn’t look as risky as they really were. Meanwhile, bank executives continued to profit from the growth in the U.S. housing market. In Eisman’s words, “They mistook leverage for genius.”

Along came subprime mortgage loans...

Subprime mortgages in the United States were usually issued to borrowers with credit history or income issues. Typically 30-year loans, these mortgages offered a low teaser interest rate for the first couple of years, and then a much higher reset rate. As the teaser rate came to an end, the borrower could refinance at a new teaser rate, starting all over again. Everyone involved in the lending process was taking their fees, but borrowers were not paying back their principal.

And then the cracks began to appear …

Housing prices continued to rise, as they had since the Second World War. Even though mortgages were showing early signs of delinquency, incentives to approve more of these loans and resell them to investors continued to trump ethics and prudence. By August 2007, cracks in the mortgage market were obvious. Those left holding the loans (mostly large banks and brokerage firms) realized the biggest losses, and everything went downhill from there.

What’s the situation today?  

The mortgage market in the United States is in much better shape today, according to Eisman. New regulatory rules have meant deleveraging and de-risking in U.S. banks, and improved consumer protection. Eisman believes we are unlikely to see a relapse of the subprime mortgage crisis in the United States for many decades to come.

But what about Canada’s housing bubble?

Recalling the 2008 financial crisis invites natural comparisons with Canada’s current situation: an inflated housing market and our collective debt load. Obviously a similar event here in Canada could be disastrous for Canada’s banks.

Just this week, Home Capital Group—a small Canadian mortgage company that offers residential mortgages to individuals that don’t meet standard criteria—saw the largest stock drop in its history partly due to concerns over the company’s sustainability and ability to fund itself. Fortunately, companies like Home Capital make up a small share of the Canadian mortgage market and a very small portion of our investments. While Home Capital is facing challenges with its business model, our concerns are not with respect to borrowers repaying their loans. In fact, default rates remain at very low levels.

Why we’re not too worried

Eisman is, however, adamant that we’re not likely to experience anything similar to the U.S. subprime crisis in Canada. I fully agree. In a recent article, we explained why we don’t think Canada is at risk, in spite of our inflated housing market and collective personal debt load.

There are other reasons. Risks are already priced into our market, and we have a very conservative regulator and prudent lending practices at Canadian banks. While one could argue that we’re currently seeing Eisman’s three prerequisites for financial crisis (leverage, a big asset class bubble and the involvement of major financial institutions), the magnitude of these factors pales in comparison with those in play prior to the U.S. subprime crisis.

But, as Eisman so eloquently puts it, “Don’t mistake leverage for genius”. I’ll keep those words in mind while we keep a sharp eye on leverage levels and maintain prudent risk exposure in our portfolios as Canadian house prices continue to rise. 

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