The Next Short

To borrow the title from Michael Lewis’s best selling book The Big Short, this article is
about another impending residential real estate crash, although this one is forthcoming
from North of the border.

For anyone with the belief that Canada’s financial regulations are superior or more
prudent than the United States, I strongly encourage you to read this article and others
like it.

Canadian Housing Market

While the overall size of the residential housing market is only $13.1 Mil. households the
total value of all outstanding residential mortgage loans in Canada is estimated to be
CDN $940 Billion* (USD $1.1 Tril.)*

Of these total loans outstanding approx. CDN $300 Bil. Are outstanding mortgage
backed securities created by the Canadian Mortgage Housing Corporation (CMHC)
which means that those MBS’s are residential loans made by Canadian banks with an
LTV of 95% and insured and subsequently securitized by the CMHC.

These loans which contain an LTV of 95% are typically made by first time home buyers,
which may or may not pose a greater systemic risk than home buyers which put an
average of 15% plus down. But as we just recently found out in the US the former case is
usually correct.

Another largely significant note is that because the CMHC is a crown corporation owned
by the Canadian government, the CMHC insured loans which were securitized are fully
guaranteed by the Canadian government and not MBS investors as was the case with
loans securitized in the US. Therefore, it is ultimately Canadian taxpayers which will foot
the bill in the case of defaults of these securities.

As evidenced by recent statistics the Canadian housing market which is currently well
above median price levels is starting to downtrend in major metropolitan markets such as
Toronto, Vancouver and Calgary.

According to the CMHC housing starts in Canada have declined for a fourth consecutive
month in August, a move which began in May. There was also a dip in new home prices
in May (-0.1) for the first time in over a year.
All this in a rising interest rate environment as evidenced by the Bank of Canada’s past
two consecutive quarter of a percentage point hikes in 2010.
While a significant downturn in the residential housing market is not expected under
current conditions, the accelerating condition of deterioration in the US economy (which
I fully anticipate) will serve as a further catalyst as Canada has traditionally been on an
economic lag with its largest trading partner.

The Short

Since (unfortunately) the CHMC is not shortable itself as its counterparts in the US,
Fannie Mae and Freddie Mac are. Nor are the MBS’s guaranteed by Canadian taxpayers
on banks books, short selling Canadian financial institutions is not relevant either.

In this case, we must turn to the various TSX listed Canadian REIT’s such as Northern
Property REIT (TSX: NPR.U) and Boardwalk REIT (TSX: BEI.U) as these REIT’s are
most exposed to multi-family residential properties in Canada.

While market timing in the strictest sense is not my particular area of expertise, I would
nonetheless advise a short position not to be undertaken until perhaps the end of the first
quarter or two of 2011 as I believe, as is widely expected that the US Federal Reserve
will announce further quantitative easing either at their Nov. 2-3 or Dec. FOMC meeting.

In the short term this will almost certainly cause a further uptrend in all securities
(precious metals, stocks, bonds) not only in the US market, but also in securities listed on
the TSX. After this initial euphoria by market participants, we will undoubtedly begin
seeing a reversion to the mean in the price of most classes of securities, including those
most intrinsically overvalued at the moment which I solemnly believe to be equities
(including the fore mentioned Canadian REIT’s) as well as US bonds, to say nothing of
the inflated US dollar.

* Statistics Canada

Sources: CCAMP: Annual State of the Residential Mortgage Market in Canada, Nov. 2009 |
Globe & Mail: How Canada’s Housing Market continues to cool | Statistics Canada | Bank of
Canada