Marketdepth

Hedging Canada's Housing Market - Lessons from the South

An invisible line at the 49^th degree of latitude separates two of the most similar countries on this planet. Canada and the United States are united by language (mostly English, in both cases), by history (both populated by émigrés, from Europe first, then from elsewhere), by business and culture. 

There are a few differences of course.  Canadians say “zed”, Americans say “zee.” Americans fight wars, which sometimes they regret.  Canadians prefer to stay out of wars, but sometimes regret a dependency on America’s military strength.  And then, of course, there is housing.

America's private sector by means of complex financial mechanics inflated a widely acknowledged housing “bubble” in the middle years of this decade.  The bust has thrown the US into its deepest recession since the 1930’s. Canada, through transparent but aggressive state intervention, has managed to sustain average house prices higher than America’s bubble peak for the past three years.  Already backstopping $667B of higher risk mortgages, the Canada Mortgage and Housing Corporation plans to expand its mortgage credit exposure by a massive $271 Billion in its 2009 fiscal year.  America’s bubble, made of flimsier stuff, burst long ago.  Will Canada’s state-backed mortgage system prevent a similar house market decline?

 

Figure 1:  US Bubbles Burst; Does Canada Have Better Technology?

The future direction of house prices is a subject of intense debate in this country.  But let us avoid for the moment that specific question.  Rather, let us concern ourselves with whether homeowners in Canada can sidestep the consequences of a housing decline?  Can home equity be effectively hedged?

Hedge Construction

 

In a normal hedging scenario, such as a currency neutralization, one simply contracts to sell the precise item that one is buying.  If I buy, for example, 10,000 shares of Tokyo-listed Futaba Corporation and sell forward the commensurate quantity of Japanese yen, I can effectively eliminate my currency exposure for the duration of the trade. 

 

But for residential real estate, putting together a hedge is much more difficult.  For one thing, there is no secondary market in Canadian home equity, other than the occasional thinly-traded apartment REIT.  So there is no exact security that can be sold short to build a hedge position.  On top of that, residential real estate is heterogeneous.  Markets differ by geography, price point, and dwelling type.

 

In building a virtual hedge, perhaps it is better to think about fundamental drivers of home prices.  Real estate as an investment appears to behave as a levered play on domestic interest rates.  There are two positions which trade inversely to domestic interest rates.  The first is simply to be short bonds.  The second, less directly connected but much easier to execute for most investors, is to own precious metals.

 

A third leg of a hedge is simply to short banks.  Canadian banks write far more than half of their loans with security against residential real estate.  If the value of the security goes down, then the equity value of the banks ought to reflect that.

 

 

US Back-Testing

The United States housing market over the past ten years offers an excellent laboratory to study an effective home equity hedge.  As a proxy for the US housing market, we have the Case-Shiller index, which has ample historic data.  I have used the original 10 city composite. 

The indirect hedge construction is fairly simple.  One-third is applied to a long position in gold, one third into a short position in ten year US treasuries (I have used a zero coupon for simplicity), and one third into a short position in the heavily traded Keefe, Brunette & Woods US Bank Index.  By adjusting the weights of the hedge components on the attached excel file, one can fine-tune the hedge to taste.

 

 

Download Housing hedge jul 09 

 

The combined hedge, while not being an exact mirror image of US housing market performance, certainly performs the way one would hope.    The decline in the Case-Shiller index is 33% from the June 2006 market peak to the last full data of April 2009.  The hedge gains 40% in value over the same period.  The chart below tells the story.

 

Figure 2: US Home Prices vs. Multi-Factor Hedge 1999-2009

 

 

Canadian Market Adjustments

 

 

Making this hedge in Canada requires a few adjustments.  Rather than the KBW index, the i-Shares Capped S&P TSX Financials ETF (XFN.TO) provides a liquid and diversified substitute.  The SPDR Gold Shares (GLD.N) should be fine for precious metals exposure.  Central Fund (CEF.A.TO) with its physical metal ownership and 50% weight in silver may be a better choice, despite its routine NAV premium.

Shorting Canadian bonds is easier for institutional investors than for retail.  The retail investor might achieve this component of the hedge by locking in the trade with a matching term loan, perhaps one tied to an underlying real property.

 

Final Notes

 

Hedging exposure to a potential decline in the Canadian residential real estate market is an inexact science.  And, even if one counter-acts the impact on one’s own real estate investments, no doubt the ancilliary effects of a market meltdown would have a toll on most individuals.  However, borrowing from Mark Twain, we observe that in Canada everybody talks about a housing bubble, but nobody does anything about it.  Here, at least, is a trade likely to serve as an umbrella against a hard rain.

Sell the Banks

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.

 

Figure 1:  Father, I think he said, “Sell the banks”

 

 

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 2:  Peak Home Prices as a Percentage of Average Income

	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

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.