Picture the scene: house prices are out of control.
An aggressive lender struggles to raise money to keep writing new mortgages, as worried depositors start pulling their funds. It is forced to take drastic measures, battering its share price.
You might think we’ve travelled back in time, to August 2007 and the queues outside Northern Rock.
But you’d be wrong. This is happening right now, in Canada…
Could this be the canary in Canada’s property coal mine?
Home Capital Group is the holding company for Canadian mortgage lender Home Trust. Like many mortgage lenders, it takes money from savers (known as borrowing “short”), and lends it out to people who want to buy houses (known as lending “long”). It also happens to be the biggest subprime mortgage lender in Canada.
Right now, Canada is in the midst of a massive house-price bubble – we’ll get to the details in a moment. But the point is, we all know what happens in house-price bubbles (and any other asset-price bubble for that matter). People come to believe that prices can only go up. As prices go higher, everyone – from lenders to borrowers – starts to believe that the only real risk on the table is the risk of missing out.
Lending standards loosen up. Mortgage salespeople have targets to hit. Borrowers are desperate. Regardless of how tight regulations might be, they get bent. The “bezzle” – to use JK Galbraith’s ingenious term for it – builds up.
In the middle of 2015, Home Trust had to tell the market that it had been forced to stop using a large number of mortgage brokers, due to concerns that some of them were submitting fraudulent applications (in other words, “liar loans”).
But regulators feel that they hadn’t been forthcoming enough. In March this year, the company dropped its chief executive after revelations that the regulator (the Ontario Securities Commission) had issued enforcement notices to various current and former executives. And last week, the regulator accused the company of making “materially misleading statements” to investors. It reckons they should have been telling investors about the fraud a lot earlier than they did.
The cloud hanging over the company has unnerved savers, who have been pulling money out of their accounts rapidly. After all, if you are going to panic about a potential run on a bank, the only rational thing to do is to panic first before you have to join the back of the queue.
So, over the course of the past month or so, the level of savings in Home Trust’s high-interest saving accounts has dropped by nearly C$600m to just C$1.4bn.
As a result, this week, the company revealed that it had taken out a massive line of credit from an institutional investor – the Healthcare of Ontario Pension Plan, no less. The share price promptly plunged by more than 60% on the news.
The loan came to $2bn Canadian dollars (that’s roughly £1.14bn at current rates). That’s a lot of money. And according to Bloomberg, it’s paying a high price for the money. An effective rate of 22.5% on the first C$1bn, and 15% if it uses the whole C$2bn.
Who borrows money at 22.5% in an era of barely-there interest rates and rampant money-printing? A company that is in dire straits, is the only feasible answer to that question.
It’s a particular problem if your business model is built on the idea of borrowing at one rate, then lending at a higher rate. Not many people are in the market for a mortgage that charges a 25%-plus annual interest rate. And those who are, are not the sorts of people you’d lend any money to, let alone enough to buy a house in Canada right now.
As David Baskin of Canadian asset manager Baskin Wealth Management put it: “They blew up the income statement in order to save the balance sheet, which I guess if you’re facing an existential crisis is what you have to do.”
Why does the Canadian house-price bubble matter to me?
OK, so a subprime lender in Canada is in trouble. At the end of the day, if you’re reading this, you are probably a British investor. You’ve never heard of Home Trust and ultimately, you could perhaps not care less about it. So why am I telling you this?
Firstly, I know that you – like me – have a morbid obsession with house prices. Gawping at house price bubbles is just a thing that British people like us enjoy doing. So let’s gawp away.
House prices in Toronto are up by 20%-30% in the past year alone. Home ownership is at roughly 70% – pretty much where both US and UK ownership peaked. Construction accounts for 12% of GDP – not far off a record. Consumer debt is at 169% of GDP – comparable to the US at its 2007 bubble peak, says respected analyst David Rosenberg of Gluskin Sheff, who adds: “Make no mistake, the Toronto real estate market is in a bubble of historic proportions”.
So while Home Trust may be a bad apple, the overall picture looks bleak. Home Trust may not be the trigger, but it has to be a sign that not all is well.
Secondly, you’re probably wondering if this monumental bubble in Canada is going to go the same way as the US bubble did back in 2006/07/08.
It could certainly damage the local banking system. According to the Bank for International Settlements, Canada is flashing red on three out of four early-warning indicators it uses to indicate stress in domestic banking systems. (Basically, property prices are too high; there’s too much borrowing compared to economic growth; and if interest rates went up, people with debt would be in an awful lot of trouble).
Obviously, Canada is not systemically important in the way that the US is. But it is worth monitoring. The housing bubbles in both Canada and Australia have been strikingly durable up until now at least. If nothing else, it would be interesting to see if there is a limit to what low interest rates can achieve.
Also, if you feel daring, then there are ways to “short” the Canadian financial sector, although I’m not going to discuss them in a free email – mainly because it’s very risky and I don’t want anyone going out and trying it without putting in some serious legwork to get to grips with it in the first place. But we’ll keep an eye on the situation in the magazine and see how it develops from here.