How to profit as Canada’s housing bubble pops

Bank of England boss Mervyn King gave his farewell speech yesterday.

He was putting a brave face on the economy, no doubt with his legacy in mind. But now all eyes are on his successor, Mark Carney, who takes over from July.

One reason Carney was picked is because he saved' Canada from recession as governor of its central bank. George Osborne is hoping he can do the same for Britain, by thinking outside the box' on monetary policy.

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But George should be careful what he wishes for because the Canada that Carney leaves behind is looking distinctly wobbly.

Canada's miracle recovery stored up trouble for the future

Canada is one of the few countries in the world that got off light during the financial crisis. Canadians might not see it that way of course. But while in the UK, we talk about the worst crisis in living memory, theirs was less severe than the downturns in the 1990s and 1980s.

The dominant narrative is that Mark Carney bailed Canada out by slashing interest rates, keeping banks lending and consumers spending.

It's a nice story. Trouble is, it seems far more likely that Carney's actions just stored up trouble for the future a future which looms closer by the day.

The most obvious threat to Canada's economy is its rampant house price bubble.

Most global property markets saw at least some sort of correction following the financial crisis. In real terms (after inflation), house prices in the US halved. Even in the UK, real prices are down by around 30% if you ignore trophy hunting in central London.

In Canada however, prices kept on rising. As a result, the nation now has some of the most overvalued real estate in the world. Not a bad achievement, given that Canada isn't exactly crowded.

How did this happen? One key cause of the US bubble was the banks' willingness to lend lots of money to borrowers who clearly couldn't pay it back. Lenders were aided and abetted by the existence of Fannie Mae and Freddie Mac, two quasi-state agencies which underwrote bank lending.

Supporters of Fannie and Freddie note that these institutions never underwrote the very worst loans. But that's not the point. The very fact that they were insuring mortgages at all encouraged banks to take ever more risky bets, knowing that a large part of their book was guaranteed.

It's called moral hazard'. And precisely the same thing has happened in Canada. Joelle Fricot of brokerage Euro Pacific Canada estimates that over half the outstanding mortgages are backed by Canada's equivalent body, CMHC.

However, the two private sector insurers, Glenworth Financial Canada and AIG, receive 90% state backing. This means that the government underwrites, directly or indirectly, nearly all of the C$1.1trn (the Canadian and US dollars are roughly equal at the moment) market.

The poor quality of the loans is such an open scandal that the government has been forced to try to toughen up standards. Last year, it tried to cap loan-to-value at 80%. In other words, you need a 20% deposit or equity before you can get a loan.

However, these restrictions are easy to get around. For example, many people now simply break the loans into two or more mortgages. And in any case, it's probably a case of too little, too late. Euro Pacific reckons that half of all outstanding mortgages are "high-risk".

No question about it Canadian property is in a bubble

Canadian papers and real estate brokers will debate the issue of whether or not there's a bubble until they're blue in the face.

But anyone with any kind of objectivity can see there's a problem there. House prices have risen by 123% since January 2000. Even at the peak, US prices were only 90% higher than they were in 2000 and in real terms, US prices are now slightly lower than they were back then.

According to the Royal Bank of Canada, the average bungalow goes for roughly six times household income. This rises to seven times household income for two-storey houses. According to the Halifax, the comparable ratio for London houses is only 5.6 times earnings and that's high by historic standards.

Meanwhile, The Economist estimates that the ratio of rents to prices in Canada is 78% higher than its long-term average. This is more extreme than any other major property market in the world even Hong Kong is only 68% above its long-term average.

So Canadian prices are in a bubble, no question about it. And now the bubble might be popping.

The first sign of an impending crash is falling sales. In Toronto, sales are down 40% compared with a year ago. That's led the property pundits to start talking of a "soft landing".

But this phantom soft landing goes against all past experiences of housing crashes. Like most investment markets, property prices are driven partly by momentum.

In the boom times, rising prices feed off themselves, as people rush in, hoping they can sell the house later for a profit. The same thing happens when prices fall. People rush for the exits all at once, and prices often end up under-shooting fair value' rather than simply plateauing.

Overall, it looks like the Canadian government will be facing a huge bill for bad mortgages, as well as the impact that a housing crisis will have on consumer spending. Throw in the uncertain outlook for commodity and energy prices, and the economic outlook for Canada is grim.

This is likely to lead to a long period of low interest rates and potentially even money printing, which will hit the Canadian dollar hard. It's straightforward enough to play it with a spread bet, although bear in mind that this is very risky if you want to know more about how to do it, sign up for our free MoneyWeek Trader email. You could also consider a short Canadian / long US dollar exchange-traded fund.

But perhaps more important to UK investors, is what Carney's arrival could mean for the pound. With the 2015 election uppermost in politicians' minds, Carney will be under pressure to work his magic over here.

While Mervyn King and the Bank of England have been talking down the prospects for radical' monetary policy, it's worth remembering that Japanese politicians did something similar just before their central bank unleashed the biggest tide of money-printing yet seen. Dampening market expectations before something big happens is one of the oldest tricks in the book for maximising the shock and awe' impact.

So we think it's a good idea to have exposure to non-sterling denominated assets in your portfolio. My colleague John Stepek has written more about this in the latest issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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