Shorting Canadian Banks on Housing Fears

 | Oct 17, 2013 | 11:00 AM EDT
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I am massively short Canadian banks and the Canadian dollar. It is one of my largest positions. 

Canada has a housing bubble. It is indisputable. The only thing that investors are arguing about is how it is going to play out. To which I say: has there ever been a soft landing in anything, anywhere? 

Housing prices have risen dramatically across the country, but especially in Vancouver and Toronto, which are destinations for immigrants. Prices went parabolic in Vancouver (and have leveled off since) -- wealthy Chinese often buy Vancouver property to move money out of China and they are not terribly sensitive about price. 

In Toronto, there are more high-rise buildings under construction and more cranes in operation than any city in the world (including places like Beijing and Dubai). Tens of thousands of condos come online each year. It is not sustainable.

What's worse, debt-to-income levels in Canada have risen to levels that are much, much higher than the U.S. had at the peak of its own housing bubble. It is a classic case of over-investment and mal-investment. 

How did it happen? The usual culprit -- Bank of Canada Governor Mark Carney lowered interest rates to 1% in response to the financial crisis in the U.S. He kept them there for years, even as Canada's economy roared and housing prices ballooned. He literally made the same mistakes that Greenspan and Bernanke did -- there is no visible consumer price inflation in Canada, but considerable asset price inflation. And it looks likely that Carney's successor, Stephen Poloz, will only ease policy further. 

Canada bulls are quick to point out that the subprime market is not well developed in Canada like it was in the U.S., and that mortgage derivatives are virtually nonexistent. They also say the banks are healthy and well-capitalized. Additionally, the Canada Mortgage and Housing Corporation (the equivalent to the Federal Housing Finance Agency in the U.S.) tightened mortgage standards in the last year specifically to prevent such a crisis. 

Still, it does not take much of a house price decline to wipe out the equity in a mortgage. One could make the argument that the lack of a robust derivatives market has left all the risk concentrated on bank balance sheets. Bull markets and bubbles do eventually come to an end, and what follows boom is usually bust. 

It's hard work being short Canadian banks, for lots of reasons. 

First, they pay out massive dividends -- most of the big banks are paying 4% yields. That is a pretty steep cost of carry, especially when taking into account the cost to borrow the stock. I will point out, however, that financial stocks with high dividends make the best short candidates (think NEWC and LEND during the crisis) because the banks are slow to change their dividend policy and the high dividends serve as a defense against short sellers. 

Second, the Canadian stock market is pretty concentrated in two sectors: financials and basic materials, and the big banks are pretty much a part of every Canadian's portfolio. It seems as though there is a perpetual bid to these names. 

Third, the housing market is just some undead monster that refuses to surrender. Just the other day, the existing home sales number came out, and it's skyrocketing. It's hard to tell, but it looks to me like the Canadian housing is in blow-off phase. 

I'm short a lot of the Canadian Imperial Bank of Commerce (CM) and a little Toronto Dominion (TD), the U.S.-listed shares of each. CM has the most exposure to residential mortgage finance, and out of the Big Five, CM trades the worst. The others are the Royal Bank of Canada (RY), The Bank of Nova Scotia (BNS), and Bank of Montreal (BMO).   

I'm up a little on CM and down a little on TD. I would add to these positions if they traded lower, but I'm big enough as it is. The stocks have rallied in the last few months, making great entry points for new shorts. 

This is a high conviction idea. If the housing bubble plays out like I think it will, these stocks over the next few years will be worth something close to zero.

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