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Canada's China Problem Is Greater than Its Housing Problem

Canada is likely to suffer a significant income decline when the China-inspired commodities supercycle ends.

Brian Bosse was the token Canadian this year at my annual Valuex Vail conference for value investors, his third time at the conference. Brian is vice president at Goodman & Co., Investment Counsel, where he works for one of the smartest, richest and nicest men in Canada: Ned Goodman.

When Brian and I discussed his presentation, I asked him to give us something on Canadian banks. I keep hearing that Canada is in the midst of its own real estate bubble, and I wonder if our northern neighbor will have its own banking crisis soon. Brian loved the idea of exploring this idea, but he did not really know what he would discover. (Also, when he gave his talk he felt the need to enlighten Americans by showing them pictures of Canada's largest export, movie stars, and every few slides he inserted pictures of Canadian actors we think are American — take a look at his presentation for examples.)

Brian made a very compelling case that even though housing prices look somewhat high in Canada, the bulk of appreciation is limited to Vancouver and Toronto. Moreover, Toronto is growing at a faster rate than the rest of the country — it has 154 construction cranes — and it is adding jobs faster than the rest of Canada. Thus real estate prices in Vancouver and Toronto should not be compared with those of most U.S. cities but instead with those of other destination towns, such as New York City.

There are also some major differences between Canadian and U.S. banks. In the U.S. mortgages are basically nonrecourse: You walk away from your house, the bank takes it, and that is as far as your liability goes. In Canada, if you walk away from your house, the bank will go after your other assets. In theory, this should lead to more-responsible behavior by homeowners, and there is more collateral in case of default. Because there are only five major banks in Canada, competition is less cutthroat than in the U.S., where we have hundreds of banks. So Canadian banks have been more responsible than their U.S. brethren (though my Irish editor can attest that having fewer banks does not necessarily cultivate more-responsible behavior). And troublesome condo loans are a tiny portion of total real estate loans in Canada, while underwriting standards are more stringent, with no teaser rates or so-called ninja loans ("no income, no jobs, no assets").

Canadian interest rates usually follow the interest rates of the U.S. (according to Brian, the correlation between U.S. and Canadian rates is 85 percent). So if U.S. interest rates continue to rise, it is very likely that Canadian housing prices will drop and defaults will go up. But two thirds of Canadian mortgages are insured by the Canadian Mortgage and Housing Corp. (CMHC), the Canadian version of Fannie Mae. CMHC is owned and guaranteed by the government. Thus the government will be on the hook, not Canadian banks. Canadians have therefore skipped a step: If (or, should we say, when) their housing crisis happens, there won't be any argument in the media about "too big to fail"; the government will take care of it.

Jim Chanos of Kynikos Associates (who is not short Canadian banks), made an interesting point after Brian's talk. He is more worried about problems in Canada from incomes declining once the China-induced commodities supercycle ends — after all, Canada has benefited tremendously from it. To Jim's point, Canada reminds me of Australia, another beneficiary of the Chinese commodities party: Low-skilled people who used to work at McDonald's restaurants in Sydney or Canberra began moving to the west coast and getting jobs driving trucks at iron ore mines, instantly making more than $100,000 a year.

So the good news for McDonald's restaurants across Australia and Canada is that their hiring difficulties are unlikely to persist for much longer.

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