January 29, 2019 | The Longs & The Shorts

Apparently a lot of people think Canadian real estate will collapse. When she blows, they believe, it’ll be an event similar to the US housing bust. Swept away, or grievously wounded, will be banks, credit unions and half of Bay Street.

This is based on real, and scary, facts. Households owe more than $2 trillion, about 70% of which is mortgages. That’s a record. Over $100 billion in HELOCs are not being repaid. Wages are less than inflation, making cash flow difficult. Four in ten say they’re struggling to pay monthly bills. Almost half are two hundred bucks from insolvency at any one time. Blah, blah, blah. You’ve read this stuff here routinely. It’s rooted in surveys, polls, reports and government stats. Most of it is doubtlessly true.

The conclusion then is that huge numbers of delusional Canadians have overreached to buy inflated real estate. They have unrepayable debt. They also have little in the way of savings, cash or investments. In other words, in an economic downturn or a time of job loss and spiking rates, they’d be seriously pooched. Many would default on mortgages they cannot service. Lenders would be stiffed. Because Canada’s major banks have massive mortgage portfolios, the system would be rocked. Some might fail.

After all, isn’t that why the last few federal budgets have contained bank bail-in legislation, which is now being enacted? Why would Ottawa go to the trouble of creating such a safeguard if the potential of a bank collapse were zero?

As stated, lots of people are betting it happens, and putting real money on the table as a result. A reminder of that came while reading a recent Motley Fool report on shorting the banks. Investors have just shorted TD shares to the tune of $3.5 billion, and Scotiabank for almost $3 billion. Going short is the opposite of going long (when you buy a stock because you think its price will increase). Investors who believe the opposite borrow and sell shares, figuring they can buy them later for a cheaper price, return them to the lender and pocket the difference. Yes, that sounds dangerous. It is. If prices increase, the shorts are screwed. If prices fall, they gamble and win.

Remember ‘The Big Short’? Lots of people do. Those who saw the American housing crash coming cleaned up using a similar theory and made fortunes. Now that real estate sentiment has turned negative in the land of house-horny and debt-infused beavers, an army of people are betting the banks will be in trouble – or at least suffer a run on their equity.

But I’m not one of them.

First, real estate is not collapsing. It’s correcting. I’m sticking with my long-held (and so far accurate) prediction that a 10-15% plop in prices in major markets would be followed by a years-long slow price melt. Second, house prices outside of the GTA and moronic patches in BC have never been in a bubble, and are not subject to a bust. It’s still cheap to live in Halifax, Winnipeg, Montreal or Windsor. Third, this is exactly why the banks are protected by CMHC insurance for large swaths of their home loan portfolios. It’s also why the stress test was enacted – to ensure lenders can withstand rising rates. Fourth, the bankers have had more than a decade to get ready for a Canadian crash. Capital reserves have been increased, borrowing requirements tightened and our banks have pushed hard into other areas – several are now major US players.

Besides, they’re massively profitable. RBC alone made more than $1 billion per month last year. That’s over $50 million each business day. Almost as much as a blog! No wonder financial outfits account for more than a third of the entire Canadian stock market. And each of the banks have steadily increased their dividends, so investors have seen capital growth as well as tax-efficient income. TD’s dividend growth, for example, has jumped 11% annually over twenty years.

As for stock prices, look at the 10-year track record for the Royal (click to enlarge):

But how did the banks do in 2008-9? Not so hot. Sometimes in a crisis all asset classes are dumped. RBC stock which was about $60 in 2007 tumbled to $30 in 2009. But even in the darkest hour, no Canadian bank missed or cut a dividend payment. Investors who saw intrinsic value and went long have scored. In fact, every time bank shares have dipped, it’s turned into a buying opportunity. And 2019 is not 2008.

So what if I’m wrong and Vancouver house prices crash by 70% (as happened in Phoenix), leading to mass defaults, foreclosures and losses to lenders? Well, you might regret owning a hunk of Vancity or Coast Capital, but not BeeMo or CIBC. Share prices of the Big Five might well decline in a real estate-induced recession, but the shorters’ euphoria would be brief. If history’s any guide, it would be time to take money out of the bank, and buy the bank.

Having said that, no crash. Go long or go home.

Garth Turner January 29th, 2019

Posted In: The Greater Fool

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