Canada's Housing Bubble

Aug 16, 2010 Zhong Jin seekingalpha.com

A Canadian housing market could be the biggest source of its domestic economic uncertainties. Housing prices have been rising significantly in Canada since 2009. The residential average house price, according to the Canadian Real Estate Association (CREA), rose from about $200,000 in 2003 to above $340,000 now. This is a nearly 75 percent jump over seven years.

The average family income after tax only rose from $65,000 in 2003 to $71,900 in 2007, according to the latest publication of Statistics Canada. If the income continues to grow at the same rate until today, then the average housing price-to-income ratio in Canada is going to rise from 3.08 in 2003 to 4.38.

As a comparison, at the peak of this most recent US housing bubble, the price-to-income ratio in the US reached its highest level of 4.7 in 2005. If we assume that the average family income in Canada is at the same level today as 2007 due to the recession, then the price-to-income ratio would also be 4.7 in Canada. The mortgage delinquency rate in Canada is currently still well below 1 percent and remains stable. But remember, the mortgage delinquency rate in the US in 2005 was also quite stable and low, while the housing market was at its peak.

Another source of pressure is that the Bank of Canada became the first central bank in the Group of Seven to raise rates since the onset of the global recession. If it raises interest rates again in the near future, it will put more pressure on homeowners in Canada.

If an investor believes that the Canadian housing market is vulnerable to a deep correction and wants to trade on this belief, there are some choices: RBC Royal Bank (NYSE: RY) and BMO Financial Group (NYSE: BMO). The Canadian dollar ETF, FXC, is another vehicle available for investors to trade this housing bubble in Canada.

The residential mortgage exposure ($126 billion) of RBC Royal Bank at the end of the second quarter in 2010 is 8.4% higher than the exposure ($116 billion) in the same quarter in 2009. That exposure is also 18% of the total risk exposure of RBC Royal Bank at the end of the second quarter in 2010. The stock price of RBC Royal Bank is currently near its pre-crisis high. Given that it expanded its residential mortgage business aggressively last year, when the housing market was developing the bubble, investors should keep a cautious eye on its performance.

On the other hand, the residential mortgage assets of BMO Financial Group have been reduced from $48.1 billion at the end of the second quarter in 2009 to $46.7 billion in the second quarter in 2010. However, in the past three quarters, the bank’s residential mortgage exposure has risen steadily. If BMO can keep its exposure to the housing market under check, then BMO Financial Group could be a good choice for investors who want to avoid the potential housing risks in Canada.

If the housing bubble in Canada does burst in the next few quarters, then I expect that many investors would want to leave Canada for safe assets such as US government bonds. As an ETF to track the Canadian currency value against the US dollar, FXC should be a potential target for shorts. However this FXC short play should be a long term strategy (1-2 years), since the value of Canadian dollar is closely linked to the commodity price and the stock market index.