14 November 2014

THE BIG SHORT II

Why shorting high loan-to-value Canadian mortgages may be the (second) greatest trade ever
Nigel R. DSouza

ndsouza22@gmail.com

TABLE OF CONTENTS
Introduction.........................................................................................................................3
Real Estate Valuation............................................................................................................4

Overview of the Canadian Mortgage Market..7

Outlook...35

Big Short II

The (Second) Greatest Trade Ever....16

INTRODUCTION

John Paulsons contrarian view on subprime mortgages resulted in one of the largest payoffs in financial
history. Paulsons trade exploited poor underwriting standards in an overextended mortgage market driven
by mortgage securitization . Paulsons bet against subprime mortgages via credit default swaps was coined
the greatest trade ever by Wall Street Journal reporter Gregory Zuckerman

This report asserts a similar opportunity, albeit via a different mechanism, is forming in the Canadian
mortgage market. Whereas the United States mortgage market was driven by subprime securitization and
poor underwriting standards the Canadian mortgage market is driven by the interaction and codependency
of regulatory underwriting standards, federally backed mortgage insurers and the expansion of mortgage
credit in a low rate environment. These conditions have resulted in a concentration of high loan-to-value
(LTV) mortgages in the Canadian mortgage market which exceeds the peak concentration of high LTV
mortgages in the United States mortgage market prior to the subprime crisis
This report will examine Canadian real estate prices in relation to historical valuation, the central agents
driving Canadas mortgage market, the ability of high LTV mortgage borrowers to make monthly mortgage
payments under rising rates as well as systemic exposure to the Canadian financial system from higher
default rates

Big Short II

In 2006, hedge fund manager John Paulson realized something few others suspected--that the housing
market and the value of subprime mortgages were grossly inflated and headed for a major fall. Colleagues
at investment banks scoffed at him and investors dismissed him. In the summer of 2007, the markets began
to implode, by year's end, John Paulson had pulled off the greatest trade in financial history, earning more
than $15 billion for his firm--a figure that dwarfed George Soros's billion-dollar currency trade in 1992
- The Greatest Trade Ever by Gregory Zuckerman

REAL ESTATE VALUATION

Canadian house prices are overvalued in relation to
historical valuations based on the price to household
income ratio, the price to personal disposable income
and the price to rent ratio

House Prices valuation relative to Household Income

The ratio of house prices to disposable income has

increased from a multiple of 8.3 in 2001 to 12.6 in
2014. A return to historical valuation would require a
correction of 34 percent. The current ratio of prices
to personal disposable income is the highest on
record

Big Short II

From 1990 to 2010, houses were priced on average at

3.8 times household income. As of October 2014, this
ratio has climbed to 5.5. Barring a rapid increase in
household income a 31 percent correction is required
for this ratio to return to historical levels

 A divergence of real estate prices from personal

disposable income, as shown on the bottom right, is
symptomatic of the decreasing affordability of
Canadian housing. The gap between disposable
income and house prices must be funded by
alternative sources of capital. In Canada, home
buyers have turned to mortgage credit priced at
historically low rates to finance purchases

Big Short II

Additionally, when measured on the ratio of real

estate prices to rent, Canadian real estate is among
the most expensive in the world exceeding the real
estate markets of Hong Kong and Singapore.
According to the Organization of Economic
Cooperation and Development (OECD), when
measured on a price-to-rent basis, Canadas real
estate market is overvalued by 60 percent

Big Short II

The reduction in the cost of mortgage credit parallels

the Bank of Canadas (BOC) bank rate policy. The BOC
has implemented an increasingly accommodative
monetary policy which has resulted in its bank rate
declining from a peak annual rate of 17.93 percent in
1981 to 1 percent in 2014. Central bank rates are the
lever on which credit is priced throughout the
economy with mortgage credit, for a fixed-rate five
year term, priced on average at the bank rate plus
300 basis points. Mortgage rates have tracked the
BOCs loose monetary framework and declined from
a peak in 1981 of 21.75 percent, for a 5 year fixedrate mortgage, to 4.8 percent in 2014
The decline in the cost of mortgage credit has lead to
an exponential increase in mortgage origination and
outstanding credit. Outstanding residential mortgage
credit in Canada has increased from $687 billion in
2006 to $1,266 billion as of September 2014; an
increase of 84 percent in 8 years

OVERVIEW OF THE CANADIAN MORTGAGE MARKET

1.

Mortgage originators: financial institutions that originate mortgage credit

2.

Mortgage insurers: government and non-government agencies that provide insurance for
mortgage loans specific to a set of regulatory underwriting standards

3.

Mortgage funding: sources of capital for funding mortgage origination

These three agentsoriginators, insurers and sources of capitalare linked together under a regulatory
framework whose policies shape the cost of mortgage credit, the underwriting standards for the
industry and the preferred structure of mortgage loans in terms of rate preference (fixed versus variable)
and length of term renewals

Big Short II

Canadas mortgage market is driven by three primary agents

An understanding of the role and characteristics of each agent is required in order to grasp the
idiosyncrasies of the Canadian mortgage market

 Canadas financial industry is dominated by its largest

chartered banks also known as Schedule 1 banks. In
turn, these banks account for 75 per cent of the value
of outstanding mortgages with the five largest
Canadian banksRoyal Bank of Canada, TorontoDominion Bank, Bank of Nova Scotia, Bank of
Montreal and Canadian Imperial Bank of
Commerceaccounting for 65 percent of the total
market
Canadas banking system is considered among the
safest in the world due to stringent regulation by the
Office of the Superintendent of Financial Institutions
(OSFI) which serves as the regulatory body for
Schedule I, II and III banks under the Bank Act of
Canada established in 1871. The majority of
mortgage origination occurs within the regulatory
purview of the Canadian government with 80 percent
of mortgages originated by lenders that are federally
regulated by the Office of Superintendent of Financial
Institutions (OSFI)

Big Short II

Mortgage Originators

Mortgage Insurers
As with Mortgage origination, mortgage insurance is directed and shaped by the Canadian regulatory
framework

1.

All federally regulated lenders are subject to OSFIs principles-based supervision in addition to
capital and other regulatory requirements

2.

A legal requirement for federally regulated lenders to insure high-ratio mortgages which are
defined as mortgages with a loan-to-value (LTV) ratio over 80 percent. This insurance is backed by
an explicit guarantee provided by the federal government

The regulatory framework for mortgage insurance has tightened considerably over the last five years
due to concerns of stretched housing prices. The government of Canada is attempting to engineer a soft
landing for Canadian real estate via the mechanism of regulation. For instance, the qualifying rules for
mortgage insurance were tightened from 2008 to 2012 in order to support the long-term stability of the
housing and mortgage markets. This tightening has an aggregate effect of increasing the cost of
mortgage credit via shorter amortization periods, lower loan-to-value ratios and higher mortgage rates.
The spearhead of insurance regulation is focused on high-ratio (i.e. high loan-to-value) mortgages as
these represent the greatest collateral exposure for mortgage lenders

Big Short II

Canadas regulatory framework with respect to mortgage insurance has two major components:

1.
2.
3.
4.
5.

A maximum amortization period of 25 years (compared to 30 years previously) and a maximum

loan-to-value ratio of 95 percent (i.e. minimum down payment of 5 percent)
A maximum loan-to-value (LTV) for mortgage refinancing and non-owner occupied (i.e.
investment) properties of 80 percent (compared with 95 percent previously)
Exclusion of insurance coverage for mortgages of homes with a purchase price in excess of 1
million
A maximum gross and total debt-service ratio (DSR) of 39 percent and 44 percent respectively
A requirement for borrowers to satisfy debt-service criteria using the posted rate for a 5-year
fixed-rate mortgage if they select a variable mortgage or a term less than five years

Big Short II

The current requirements for high-ratio mortgages (mortgages with loan-to-value ratios over 80
percent) to qualify for mortgage insurance include:

Note:
Gross DSR is the ratio of housing costs which include mortgage payments, property taxes and heating
expenses to gross income

Total DSR is the ratio of total debt costs which includes car loans, credit card payments and lines of credit
payments to gross income

10

Mortgage Funding

Big Short II

Funding of Canadian mortgages is provided by a variety of sources including retail deposits, brokered
deposits, covered bonds and mortgage securitization

11

Big Short II

Traditionally, Canadian chartered banks rely primarily

on retail deposits to fund mortgage loans. Deposits
with maturities of less than five years are insured by
the Canadian Deposit Insurance Corporation (CDIC).
The CDIC is a Crown Corporation (i.e. state owned
enterprise) created in 1967 for the purpose of
insuring Canadian deposits up to $100,000 held at
Canadian banks in the case of bank failures
Canadas mortgage market experienced a significant
shift to alternative sources of funding from mortgage
securitization post 2001 with a substantial
acceleration occurring post 2008 due to the
implementation of the Insured Mortgage Purchase
Program (IMPP). In October 2008, as a measure to
maintain the availability of longer-term credit in
Canada, the Government of Canada authorized
CMHC to purchase NHA MBS from Canadian financial
institutions through a competitive auction process.
IMPP remained available until the end of March 2010
with a total of $69.3 billion in NHA MBS purchased by
CMHC under the program
Total mortgage securitization in Canada has risen to
35 percent of outstanding residential mortgages from
less than 10 percent in 2001. The United States
mortgage market, in comparison, had a securitization
rate of 60 percent prior to the subprime crisis of 2008

12

 Mortgage securitization is primarily

provided by the Canadian Mortgage
Housing Corporation (CMHC) with
private securitization responsible for a
negligible portion of mortgage funding.
The CMHC is a government-owned
corporation, known as a Crown
Corporation in Canada, which was
established in 1946 to address Canadas
post-war housing shortage. The agency
has grown into a major national
corporation and is Canadas premier
provider of mortgage loan insurance,
mortgage-backed securities, housing
policy and programs, and housing
research

Big Short II

Mortgage Securitization

13

 The CMHC offers mortgage securitization through

two programs:

2.

National Housing Act Mortgage-Backed

Securities (NHA MBS). NHA MBS funding
currently accounts for 34 percent of residential
mortgages
Canada Mortgage Bonds (CMBs)

National Housing Act Mortgage-Backed Securities

(NHA MBS) program NHA MBS are issued by
approved financial institutions and are backed by
pools of insured, eligible residential mortgages.
Investors in NHA MBS receive principal and interest
payments passed through from the mortgages. CMHC
guarantees the timely payment of interest and
principal to investors.
Canada Mortgage Bonds (CMB) program CMB are
issued by Canada Housing Trust, a special purpose
trust that purchases insured, eligible residential
mortgages packaged into NHA MBS. Investors in CMB
receive fixed or floating rate coupon interest
payments and, at maturity of the CMB, the principal
payments. CMHC guarantees the timely payment of
interest and principal to investors.

Big Short II

1.

14

 The purchase of NHA MBS securities is funded by CMBs issued to investors and financial institutions. CMBs
are insured with premiums paid by borrowers of insured mortgage credit. NHA MBS purchases and CMB
issuance is undertaken by the Canada Housing Trust (CHT). The CHT is a special purpose trust created by
the CMHC which invests and makes loans under the National Housing Act (NHA) to social housing
sponsors. CHT funds its program with the issuance of Canada Mortgage Bonds under the CMB program
which is fully guaranteed by the CMHC. More than 70 percent of CMBs are held by banks, insurance
companies and pension funds. CHT assets represent approximately 77 percent of CMHCs total assets as of
December 2013

Big Short II

Financial institutions securitize mortgage loans in order to sell NHA MBS securities to investors or to the
Canada Housing Trust (CHT), a subdivision of the CMHC, under the CMB program. This mechanism is
symbiotic in nature with the CMHC purchasing NHA MBS from financial institutions with the underlying
securities of NHA MBS insured via premiums from insured mortgages originated by financial institutions.
The purchase of NHA MBS in turn provides additional capital for mortgage origination

Mortgage securitization risk is distributed across mortgage insurers and originators. Financial institutions
are exposed via CMB holdings, and mortgage insurers are liable for mortgage defaults on securitized
mortgages constituting NHA MBS and CMBs

15

THE (SECOND) GREATEST TRADE EVER

Canadas real estate prices are overvalued relative to historical ratios. Rising real estate prices were
supported by an exponential growth in mortgage credit. The rapid increase in prices, along with
mortgage credit, has led to declining affordability for first-time buyers. Record high household debt to
income in Canada is a symptom of mortgage credit saturation where mortgage payments, even at
record low mortgage rates, consume a significant portion of personal disposable income. The
distribution of loan-to-value ratios across the Canadian mortgage market poses a significant risk to the
Canadian financial system via high LTV mortgage defaults. Increasing default rates across high LTV
mortgages cannot be absorbed by mortgage lenders even when accounting for mortgage insurance .
Marginal increases in mortgage rates increases the likelihood of defaults in high LTV mortgages as
corresponding increases in monthly mortgage payments consume a greater portion of household income
The idiosyncrasies between the Canadian and US mortgage market creates a variance in the mechanism
of how a potential housing crisis unfolds in Canada. An understanding of the underlying mortgage
market and how a correction can effect originators, insurers and holders of mortgage securities is
required prior to examining potential trades

Big Short II

The thesis for the second greatest trade ever is as follows:

16

Increasing prices, ownership and mortgage debt

The increase in home ownership has paradoxically

occurred in concurrence with a decrease in
affordability. Home ownership is driven by the
accessibility of mortgage credit instead of a secular
increase in disposable income or a decrease in
housing prices

Big Short II

Canadas mortgage market is characterized by a high

rate of home ownership which recently eclipsed
home ownership rates in the United States

17

 Despite increasing debt levels, the cost of debt has

decreased along with interest rates on mortgages. For
instance, the household debt service ratio (household
mortgage and non-mortgage interest paid as a
proportion of disposable income) declined from over
9 percent in 2008 to 6.9 percent in the third quarter
of 2014
Canadian debt levels, although near record highs,
seem sustainable as a function of net worth. The ratio
of household debt to net worth declined from 22.5
percent in Q1 2013 to 22.3 percent in Q1 2014 which
represents a six year low. The decrease was driven
primarily by an increase in net worth due to higher
real estate prices. However, a low ratio of debt as a
function of net worth masks sensitivity to higher
interest rates

Big Short II

Increasing mortgage credit origination has led to debt

saturation. The ratio of household debt to disposable
income is near record highs with a reported ratio of
163.6 percent in 2014 down marginally from 164.1
percent in 2013. This figure contrasts with a peak
household debt to disposable income ratio of 128
percent for United States households in 2007

18

 An estimated interest rate floor of 6 percent, versus

the current average mortgage rate on a 5 year term
of 4.80 percent, raises housings costs as a percentage
of household income from 30 percent to 40 percent

The five year fixed-rate mortgage is the most popular

term chosen by Canadian home owners with 20
percent on fixed-rate mortgages facing renewal in the
next twelve months

Big Short II

Existing Canadian homeowners are at risk of a change

in long term interest rates at either the reset date of
variable-rate mortgages or at the time of term
renewal for fixed-rate mortgages

Variable-rate mortgages account for a significant

portion of total outstanding mortgages with variablerate mortgages holding a 30 percent share of new
originations

19

 At an average price of $408,795 as of September 2014, house prices are unaffordable for first-time
home-buyers
Assuming a five year fixed-rate term at the average mortgage rate of 4.80% and an amortization life of
25 years, household monthly mortgage payments for first-time buyers would equal $2,052. These
payments would nearly consume all household disposable income after expenditures even at record low
mortgage rates of 4.8 percent. A 50 basis point increase in mortgage rates would price first-times buyers
out of the market entirely barring an offsetting reduction in discretionary spending
As a result of decreasing affordability, first-time home-buyers plan to spend an average of $316K
(substantially below the current average price of $409K) on their first purchase with 2.3 out of 10
delaying their purchase due to higher home prices. Moreover, even at a reduced price of $316K housing
is unaffordable for first-time buyers if mortgage rates increase by 440 basis points or more

Monthly Household Budget*

Personal Disposable Income
$5,206.00
Total expenditures
$3,104.73
Mortgage Payment
$2,052.58
Savings
$48.69
*Assumes two individuals per household

Big Short II

Housing unaffordable for first-time home buyers

20

Big Short II

In addition to rising mortgage rates, an appreciation in house prices is unsustainable for first-time
buyers due to the corresponding increase in down payments
According to a BMO report released in March 2014, first-time homebuyers expect to make an average
down payment of $50,576. At current house prices this equates to a 12 percent down payment as well
as monthly mortgage payments which consume nearly 100 percent of personal disposable income after
expenditures
At current prices, first-time home buyers would require a down payment of $81,759 to qualify for an
uninsured mortgage. First-time buyers can afford down payments of 10 percent or less up to a house
price of 506K. However, first-time buyers are unable to absorb higher monthly mortgage payments from
lower initial down payments. Thus, Canadian real estate prices cannot be driven higher by first-time
buyers without a significant increase in personal disposable income and personal savings

21

 Housing remains affordable, as a function of mortgage payments, for existing home owners
Mortgage rates would have to rise over 500 basis points to 9.8 percent in order for the average
household to face difficulty in meeting monthly mortgage payments. This assumes at average loan-tovalue (LTV) of 55 percent which is in line with CMHCs reported LTV on its insured portfolio of 54 to 55
percent and the reported LTV range of 45 to 60 percent by Canadian chartered banks
Given the unaffordability of housing for first-time buyers and the ability to absorb higher mortgage rates
by existing home owners, we should observe a Canadian real estate market driven primarily by owners
who flip houses or by existing home owners who sell their current house to purchase or upgrade to a
new home

Big Short II

Existing home owners driving real estate market

Monthly Household Budget*

Personal Disposable Income
$5,206.00
Total expenditures
$3,104.73
Mortgage Payment
$1,288.31
Savings
$812.96
*Assumes two individuals per household

22

Big Short II

The Canadian Real Estate Association (CREA) currently does not provide data on the proportion of sales
made to first-time home buyers. However, the CREA does provide data on home resales
Given that housing is unaffordable for first-time buyers, the data should indicate a large proportion of
unit sales being constituted of home resales. This premise assumes home resales represent owners
selling their homes to finance an upgrade to a new home or investors flipping real estate properties
The data from the below charts show a high degree of tracking between home resales and total units
sold. For instance, home resales grew to 494,200 in June 2014 increasing 0.8 percent over home resales
in May. This tracks very closely to the range of total units sold monthly of 475k to 500k from Q2 2014 to
Q3 2014 . The high volume of home resales is characteristic of a market where participants chase capital
gains via real estate price appreciation

23

 Despite the ability of existing home owners to absorb higher mortgage rates Canadas financial system
faces significant risk due to high LTV exposure
As of 2013, mortgages with an LTV above 80 percent constitute 27.5 percent of all mortgages. This figure
is above the 22.9 percent of U.S. mortgages with an LTV over 80 percent prior to the subprime crisis in
the United States. The mean LTV ratio range of 45 to 60 percent reported by CMHC and Canadian banks
masks their exposure to high LTV loans
In contrast to the U.S. market where risk was driven by subprime lending and mortgage securitization,
risk in the Canadian market is concentrated in financial institutions with high LTV mortgages. Exposure is
dependent on mortgage insurance coverage and collateral value
The Canadian Mortgage and Housing Corporation (CMHC) is responsible for insurance on the majority of
mortgages with high LTV ratios with a negligible portion insured by private institutions

Big Short II

Stability of Canadian mortgage market threatened by loan-to-value (LTV) ratio distribution

24

Canadian Mortgage & Housing Corporation (CMHC) vulnerable to mortgage defaults

Big Short II

CMHCs insurance guarantee exposure is reported as off-balance sheet arrangements and contractual
obligations on NHA MBS, CMB and insured mortgages
As of June 30th 2014, these guarantees totaled $402 billion of guarantees-in-force on CMHCs
securitization program and $551 billion of insurance-in-force on insured mortgages. This coverage
represents 45 percent of residential mortgages and 32.5 percent of securitized mortgages
The ability of the CMHC to fund insurance payouts in the event of rising mortgage defaults is critical to
the stability of the Canadian financial system

25

Big Short II

CMHCs capital requirements for funding insurance payouts is set by regulations implemented by the
Office Superintendent of Financial Institutions (OSFI)
As of June 30th 2014, CMHC has set aside $1.53 billion to cover $402 billion in guarantees-in-force on
securitized mortgages and $15.32 billion to cover $551 billion of insurance-in-force on insured
mortgages. This equates to a coverage ratio of 0.3 percent for securitized mortgages and 2.8 percent for
insured mortgages
Current capitalization levels are adequate given a reported mortgage default rate of 0.3 percent in
August 2014 . Additionally, mortgage default rates never exceeded 1 percent since 1990 as reported by
the Canadian Bankers Association. However, Canadas current low default rate is not indicative of default
risk in an environment of rising mortgage rates

26

Default risk under rising rates

Monthly mortgage payments for 90 percent and 85

percent LTV mortgages exceed the average
households personal disposable income (PDI) after
non-discretionary expenses at mortgage rates of 8.3
and 8.8 percent respectively. At current rates monthly
mortgage payments on high LTV mortgages consume
nearly all household PDI after expenditures. Canadas
financial system faces significant systemic risk from
high LTV mortgage exposure when mortgage rates
move off record lows
The current default rate of 0.3 percent understates
the incremental risk of default. High LTV mortgage
borrowers may be unable to cut discretionary
spending to finance monthly mortgage payment
increases when mortgage rates rise. Unforeseen
expenses or a failure to cut discretionary spending
can lead to higher incremental default rates prior to
reaching the 8.3 to 8.8 percent mortgage rate target

Big Short II

Default risk is concentrated in high LTV residential

mortgages with an LTV from 80 to 95 percent. These
mortgages constitute 26.9 percent of outstanding
residential mortgages as of year end 2013. Risk
exposure to 95 percent or greater LTV mortgages at
0.6 percent of the overall market is not material

27

28

The Big Short 2.0

 As default rates increase with rising mortgage rates lenders will reduce mortgage origination resulting in
a contraction of mortgage credit. Canadian real estate prices will likely correct in an environment of
rising mortgage rates, increasing defaults and contracting credit. Given that the majority of the market is
driven by home resales rather than first-time buyers, this environment should correspond with a
significant correction in home prices as existing homeowners are not incentivized to upgrade to larger
homes and real estate investors can no longer generate positive returns from flipping properties. Based
on historical ratios, house prices are currently 30 to 35 percent overvalued. A 50% retracement to the
historical average will result in a significant portion of underwater high LTV mortgages. The combination
of underwater mortgages and insufficient capital for mortgage insurance payouts poses a substantial
threat to Canadas mortgage market

Big Short II

The Big Short: how to profit from rising defaults in high LTV mortgages

The following trades are recommended, from highest to lowest preference, to profit from shorting high
LTV mortgage exposure
1.

Credit Default Swaps on high LTV mortgage securities

2.

Shorting unregulated mortgage lenders with high LTV mortgage exposure

3.

Shorting financially regulated banks with high LTV mortgage exposure

29

Credit Default Swaps on high LTV mortgage securities

Credit Default Swap (CDS): The buyer of a credit default swap receives credit protection, whereas
the seller of the swap guarantees the credit worthiness of the debt security. In doing so, the risk of
default is transferred from the holder of the fixed income security to the seller of the swap. For
example, the buyer of a credit default swap will be entitled to the par value of the contract by the
seller of the swap, should the third party default on payments
Pros

Highly asymmetric trade: CDS is the functional equivalent of buying insurance. Investors pay
premiums and receive a payout in the case of an event (default triggers a CDS payout). CDS on
subprime mortgages and equity MBS tranches were priced at 150 to 250 basis points (bps) between
2005 and 2006. Assuming one can obtain similar pricing on Canadian MBS; to insure 1 billion in high
LTV mortgages an investor would pay 15 to 25 million annually. The ideal trade involves purchasing
CDS on high LTV mortgages (preferably 90 percent or higher) with a 3 to 5 year horizon. Assuming a
3 year horizon and a 150 bps pricing on CDS: this trade requires a default rate of 4.5% among
covered high LTV mortgages to break even. Incremental increases in default rates substantially
increase the estimated CDS payout with the return increasing from 25 percent at a default rate of
5.5 percent to 366 percent at a default rate of 20.5 percent. Assuming a 100 percent default rate on
covered high LTV mortgages; this trade generates a maximum estimated return of 2122 percenta
$1 billion payout over a $45 million cost at 150 bps over 3 years. However, mortgage rates would
have to exceed 8.8 percent for default rates to approach 100 percent

Big Short II

1.

30

The Big Short 2.0

Cons
Low liquidity: CDS contracts are illiquid and highly specialized. Even in the event of increased
defaults brokers may find price discovery challenging leading to inaccurate market quotes
Negative carry: CDS contracts are a negative carry trade. CDS payments are a sunk cost which are
only recovered upon default among the underlying mortgage securities

31

Shorting unregulated mortgage lenders with high LTV mortgage exposure

Unregulated mortgage lenders do not fall under the purvey of federal regulation. Unregulated
lenders do not have to adhere to strict underwriting standings required by OSFI and CMHC in order
to qualify for mortgage insurance. These lenders originate and invest in mortgages that cannot be
placed with financial institutions due to higher underwriting risk. The lowered underwriting
standards coupled with uninsured high LTV mortgages greatly increases the default risk exposure for
these lenders relative to federally regulated lenders
Pros
Liquidity: shares of non-bank mortgage lenders trade on public exchanges and are liquid securities
resulting in accurate market pricing
Short-selling execution: establishing short positions in non-bank mortgage lenders is
straightforward given availability of shares to borrow amongst brokers

Big Short II

2.

Cons
Muted asymmetry: the maximum return for shorting a stock is 100 percent. Compared to a CDS
trade the potential return is muted and unattractive relative to the asymmetry of CDS payouts
Unlimited downside: theoretically, short selling has an unlimited downside since there is no
theoretical upper limit to share prices. Pragmatically, it is highly unlikely for an investor to be unable
to exit a short position prior to 100 percent share price appreciation
Negative borrow rates: in the event of low availability brokers may charge negative borrow rates to
short securities. The negative borrow rate is dependent on share availability

32

Shorting financially regulated banks with high LTV mortgage exposure

Although Canadas financial system is viewed as one of the best regulated and safest among its
global peers, in reality, the Big Five Canadian chartered banksBank of Montreal (BMO), Royal Bank
of Canada (RY), Canadian Imperial Bank of Commerce (CM), Toronto-Dominion Bank (TD) and Bank
of Nova Scotia (BNS)are highly levered and have significant risk exposure to mortgage defaults
As shown below, in relation to American banks, with exposure to the subprime crisis, the big five
Canadian banks are more levered and have lower tangible common equity (TCE) ratios. TCE
represents the amount of losses as a percentage of assets a bank can experience before its equity is
wiped out. A lower TCE signifies greater risk of insolvency due to losses
Outside of Lehman Brothers (LEH), Canadian banks are more sensitive to losses in mortgage
securities than American banks at the forefront of the subprime crisis; Bear Stearns (BSC),
Countrywide Financial (CFC), New Century Financial (US) and American Home Mortgage Investment
Corporation (AHMIQ)

Big Short II

3.

33
TCE
Leverage

Big Five Canadian Bank Metrics

CIBC
RBC
BMO
TD
3.69%
4.14%
4.48%
3.94%
24.3x
24.3x
24.3x
24.3x

BNS
4.44%
24.3x

TCE
Leverage

Troubled American Bank Metrics

LEH
BSC
CFC
US
2.52%
11.91%
6.92%
7.88%
39.6x
8.4x
14.4x
12.7x

AHMIQ
4.68%
21.3x

Pros
Liquidity: shares of charted Canadian banks trade on public exchanges and are liquid securities
resulting in accurate market pricing
Short-selling execution: establishing short positions in chartered banks is straightforward given
availability of shares to borrow amongst brokers

Muted asymmetry: the maximum return for shorting a stock is 100 percent. Compared to a CDS
trade the potential return is muted and unattractive relative to the asymmetry of CDS payouts
Government support: the Government of Canada is likely to provide support to Canadian chartered
banks in the event of a liquidity crisis due to increasing default rates. However, it is assumed that
government intervention to support Canadian banks will occur after a significant decline in market
capitalization in an environment of increasing defaults. Any measures by the government to
intervene proactively in the event of a crisis will dampen the decline in share prices
Unlimited downside: theoretically, short selling has an unlimited downside since there is no
theoretical upper limit to share prices. Pragmatically, it is highly unlikely for an investor to be unable
to exit a short position prior to 100 percent share price appreciation
Negative borrow rates: in the event of low availability brokers may charge negative borrow rates to
short securities. The negative borrow rate is dependent on share availability
Dividend liability: short-sellers must pay out any dividends paid by the underlying short to the long
from which shares were borrowed. Canadian banks have a track record of consistent dividend
payments which the short-seller must pay out to the investor whose shares were borrowed

Big Short II

Cons

34

 Canadas mortgage market is nearing a plateau in mortgage origination and outstanding mortgage
credit. This plateau is a function of credit saturation where higher monthly mortgage payments cannot
be absorbed even at lower rates
Canadas financial system is exposed to systemic risk in an environment of rising mortgage rates and
declining real estate prices. Marginal increases in mortgage rates can create conditions leading to
increasing default rates, a contraction of mortgage credit and a modest correction (10 to 15 percent) in
real estate prices
The current distribution of loan-to-value ratios with 27.5 percent of mortgages at a LTV of 80 percent or
higher threatens the solvency of mortgage lenders and the liquidity of the mortgage market assuming
(i) mortgage rates increase from record lows and move towards 8.30 percent and (ii) that real estate
prices decline 10 percent or more
Shorting high LTV mortgage securities via credit default swaps represents a highly asymmetric trade. If
conditions outlined in this report come to fruition, this trade may be the greatest short ever against
mortgage securities second only to John Paulsons shorts on subprime mortgages

Big Short II

OUTLOOK

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