Editor's Note: Click the play button or read the excerpt below for insight from a new conversation between hedge fund manager and MacroVoices podcast host Erik Townsend and Hedgeye Housing analyst Josh Steiner.
Erik and Josh discuss the state of the Australian, Canadian and U.S. housing markets (Click here to get a special offer on Market Edges, our weekly macro newsletter.)
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Erik: Let me ask a couple of questions about the Canadian situation before we move on to Australia. As I look at all these slides – I guess, when I think about the psychology of a bubble, it seems to me that the way they work is it starts with everybody thinks that something bad is not possible. You know, the famous comment from Ben Bernanke in 2005 about how housing has never gone down across the board, it couldn’t happen, nobody’s worried about it.
And then there’s a catalyst.
In the case of the US housing market, it was in the first quarter of ‘07. There was a big wave of adjustable rate mortgage resets, where all of a sudden people’s payments went up dramatically. And that was kind of the catalyst that caused everybody to wake up and say, wait a minute, this is crazy. And then, of course, the rest is history.
So what I tend to look for is, first, how is it possible in Canada – I mean, obviously the US housing bust was big news, everybody knows about that, so everybody knows it’s possible. It seems like it’s going anyway. A lot of it, maybe, is driven by foreign buyers.
So what would we be looking for as investors for the catalyst that’s going to pop this bubble? It’s not going to be adjustable rate mortgages like it was in the US, because it’s always something different. Is there a clear sign of what might be the pin that pops this bubble?
Josh: Well, I guess I would maybe disagree a bit with the premise. The way I think about housing bubbles is that housing sort of takes on one of two forms at any given point. And the curiously repeating phenomenon with housing bubbles is that housing undergoes, if you will, this phase transition from what’s called a basic good to what’s called a Giffen good.
A basic good being something you buy more of as the price goes down and a Giffen good the exact opposite, something you buy more of as the price goes up. And why on earth would anybody buy more of something as the price goes up? The reason is because it transitions from something you consume, a consumption good, to an investment good.
And you saw this in the US. You’ve seen it in every property bubble globally, historically. People buy the most of these things, the most housing, when the prices are at their most extreme, i.e. their most unaffordable. And then, conversely, when things are incredibly cheap, they buy the least. And that’s because people’s perception around what a house represents has undergone this phase transition from somewhere I live to an investment, back to somewhere I live.
And it’s this normal and recurring pattern. So what happens, or at least what happened in the US, is you have these 129s and 228 products – these resetting ARM loans and option ARM loans – they were coming up for renewal in early 2017. But the reality is these were largely one- and two-year products that had been in place for quite a while. And they had been coming up on resets repeatedly.
The issue wasn’t so much that. It was really that prices ran out of steam. In other words, you never have delinquencies when prices are appreciating rapidly because it’s almost impossible to fall behind, because you can just sell the property. It’s appreciated in value, it’s easy to get out of, you have a very liquid market.
So the issue in the US that – take a step back further – if you think about the sequencing of housing markets and the way they evolve, the first thing you see when a market starts to go in the other direction is you see volumes begin to roll over, meaning transaction volumes of homes. In the US that happened in the middle of 2005. Right around July ’05, you had the peak growth rate in transaction volumes in homes.
Home prices are a very sticky asset. It takes people a while for sellers to basically come to grips with reality i.e. realize the market isn’t what it once was. They’re very reluctant to lower the price at which they’re selling their house. So there’s about a one-year lag between when volumes inflect, from a second derivative standpoint, and when prices inflect.
So, again, if you look at the US, volumes peaked from a rate of change standpoint in mid-’05. But prices didn’t peak and begin to roll until mid-’06. And by the time you got to early 2007, prices were actually decelerating aggressively and it started to roll over negative. It was the fact that prices were going that made it impossible for people to roll over these mortgages.
That was the real catalyst.
So you hit peak buyer in mid-’05 and then a couple of years later you hit all these problems in the sub-prime market. This whole cottage industry of sub-prime originators basically collapsed and went bankrupt over the course of the first half of ‘07. And then it was even a full year and a half after that before you had the full-blown, full-throttle financial crisis that took down Lehman Brothers and the general banking system.
So there’s a long lead time, is kind of the point – between when you see the first signs of problems, which are peaks in volume, and when you see the obvious front page of USA Today when everybody is broadly aware. To come back to your original question, which is what’s the catalyst? Maybe it’s not a great headline, but I think the catalyst is really that you just run out of steam with new buyers. Affordability hits a critical threshold, and you experience this phase transition.
And what Canada is doing right now, between these foreign buyer tax disincentives, the B-20 guidelines making it much harder for people (first-time buyers especially) to qualify – all of this is sort of feeding that, fueling that fire that’s really going to suck the life out of the would-be first-time buyer.
Think of housing as a ladder where everybody simultaneously moves up a rung. But it’s not possible if you don’t have that first-time buyer getting on that first rung of the ladder.
So that’s our thesis – that all these new rules going into effect, and confluent with Chinese demand beginning to wane, are really going to impact the low end of the Canadian market. And that’s going to disrupt the whole property ecosystem across Canada.
Erik: My other question is, in the United States I think a big part of the reason there was contagion from the housing sector to the banking system and financial system in general is that almost all of the mortgages in question were securitized. And a lot of people who bought the paper didn’t understand what they were buying, and all the CDO tranches and so forth.
Now, as I understand it, for the most part Canadian real estate mortgages are not securitized that way. They’re portfolio lenders. So what do you see in terms of differences of how this would unfold? And how would that difference in terms of securitization of these loans change?
And I guess a particular question that’s on my mind is in the US nobody was immune because almost everybody had exposure to the paper if not to the real estate. If I think about the big Canadian banks – like the Royal Bank of Canada, which was famously immune to problems in the 2008 crisis when the rest of the world was going through a lot of trouble – are they exposed to this?
Or is it just mortgage lenders in Canada? Where’s the risk, where are the shorts, where is the investment trade here?
Josh: I think that’s a profoundly important distinction. But I have a lot of conversations with investors on this point – this exact point – and I guess I come at it from a slightly different angle. Which is those are definitely reasons why this is a different market than the US. It’s like the old Twain shtick about history doesn’t always repeat but it rhymes.
I think the reality here is a little bit different. I don’t think you have this ticking time bomb in the form of exotic CDOs, CDO-squared products, lacing the balance sheet across the entire banking system.
But what I do think you have is an enormous amount of concentration risk on the part of first and second lien mortgages across the “Big Six”. Like I said earlier, I think the Canadian economy has really become very much a one-cylinder economy that’s driven by this property bubble.
And then from a valuations standpoint, you have a lot of the large banks – you mentioned Royal Bank as being one – where valuations are north of two times tangible book value.
So think about what I said earlier, which is that when home prices are appreciating rapidly you have all-time lows in delinquencies. That’s an absolute function. It’s like the economic equivalent of a physical law, like gravity. When prices are appreciating rapidly and an asset class is inflating, naturally you’re going to have very low delinquency rates. And that’s exactly what the rear view of the last 12–18–24 months looks like across the big Canadian banks.
Our point is that when prices start to slow down – God forbid they should actually start to go negative – those delinquency rates are going to rise. And as they rise, the banks will have to provision for those loan losses. And that’s going to erode earnings power.
Kind of like what I was saying about the housing system, where you can have this collective mindset undergo this phase transition of thinking i.e. one day I think of housing as a consumption good (I need somewhere to live), and the next day I think of it as an investment good. All my friends and family made all this money on real estate, I should be there too. Then all of a sudden the bottom falls out and now it’s back to being a consumption good.
Bank stock investing is no different. When things are good, you trade these things on earnings. When things aren’t great, they start to converge between earnings multiples and book value. And when things are poor, then you throw out the book and you trade straight to tangible. And then it’s well, how low, how long, how fast? And then it’s what level of discount do I apply to tangibles?
Our thought process is that if you have a market that’s coming off its fastest rate of appreciation in history, and delinquencies are at all-time lows and understated, and you’ve got the banks reflecting that (trading north of two times tangible book value), and you think the earnings power is at significant risk because delinquencies are going to rise, then I think there’s a lot of downside.
And the way I frame it up is that it won’t take much of a property correction for earnings power to be largely impaired for the banks across Canada. In that scenario you can undergo this pretty rapid phase transition from trading from an earnings multiple to suddenly, well, what are the earnings? The earnings are shrinking. Are the earnings potentially going to go negative for a period of time? Therefore I trade to tangible. And that equates to 50%–60% downside for most of these banks.
So you don’t need, necessarily, this gigantic powder keg of CDO exposure to catalyze a significant amount of downside when you’re trading at pretty high multiples.
