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The Canadian Credit Crunch and Bitcoin

Sat Feb 18, 2017 10:21 pm

Canada is a large industrialized country. A credit crunch would devastate the economy for many years to come. I'm writing this post to try to understand what may trigger it and what will happen. I'm fairly confident if such an event does happen, bitcoin will see a very large influx of canadian dollars. We have exchanges, a bitcoin embassy and most canadians know what bitcoin is - at least they know the name. The conditions are there for much larger adoption.

Here it goes.

Since about 2003 people have been saying the housing market is overvalued. Since 2003 people have been dead wrong. For clarity when we talk about housing, we'll talk about Vancouver, Toronto, and other big cities making perhaps 25 to 50% of all mortgages in canada. Prices go up and up and up. Prices go up 20%+ in a year in Vancouver and Toronto. There are bidding wars and a steady foreign influx of money in the country. There is no sign that housing prices will stop accelerating despite efforts from the central bank and the government to effectively slow down the market. Larger down payments and stricter loan to income regulations have had little effect. A foreign buyer tax in Vancouver has had effect, but it has transferred the hysteria to Toronto. We now have one of the most expensive real estate markets in the world. We now have one of the most indebted household statistics in the world. The music keeps playing.

To get a mortgage in Canada, you go see a bank or a broker. You then usually take a 20 to 25 years loan, with a 5 years (1 to 10 years) term on it, fixed or variable rate. You cannot walk away from the house if you cannot pay like in the USA. We do not securitize our mortgages in CDO's or overly complex financial products. Most mortgages are guaranteed by the government, insured by CMHC, the housing corporation of canada - or by a few private insurers - whose insurance is guaranteed to the tune of 90% of loan value. So far, so good, what can go wrong ? We are a far cry from sub prime and USA style housing problems. So prices keep going up and up and up.

But. Since 2003, the market has changed noticeably. We now have MFC's, or Mortgage Financial companies. These MFC's make now over 25% of all new loans. Those loans are to riskier people. To riskier mortages. But still most of those are insured. So far so good. A smaller section of companies do second mortgages and these are not insured. But those do not represent systemic risk. So far still good right ? What can go wrong ?

What happens to the mortgages ? These, after being insured, are bundled into Mortgage back securities - Mortgage backed bonds, CMB's, and similar products. CMHC then sells these to institutional investors to the tune of billions of dollars per year, nationally, and mostly overseas. Guaranteed by the gov. Still good so far. Banks have tons of mortgages on their balance sheets. They bundle them together, and create Covered bonds - Mortgage covered bonds. These are sold to the same people CMHC sells to, pension funds, big money players. These are safe - if the bank goes under, they get the mortgages. If the mortgages goes under, the bank pays.

So far, everything seems fine. Everything seems okay. Most officials cannot see how this can be anything other than a soft landing, or a slow down. But as in every complex financial system, there are always feedback effects that will wreck havoc. And its actually pretty clear what that is.

The MFC's rely on very few funding sources. Mainly, from the banks and from selling the CMB's, the securitization process. So here is where it hurts. Remember the second mortgage companies ? If the person doesnt pay, they sell the house. So there are two possibilities that will make people not pay. A downturn, and an upturn. Here is why. We have survived an economic shock with 2008, and the oil price crisis without too much global canadian problems. Interests rates are obviously still low, fueling the speculation. If the USA renegotiates NAFTA (our biggest trading partner), two things can happen - one good, one bad. If oil prices move up or down, same thing. In one case, people lose their jobs, the economy goes down, we cannot really stimulate it further through budget deficits or monetary policy. People lose jobs, cannot pay their second mortgages first but its a small subset of the population. In the other, the central bank has no choice but to raise rates which will stress homeowners.

Once the marginal second mortgage lenders, which are unsecured and uninsured have defaults, they will move to sell the houses they now own. This will create a downwards pressure on prices. But this is not the problem. MFC's have their own mortgages insured, then sell them. They don't keep them. They may find that in adverse financial conditions that their borrowers no longer meet insurance minimums, thus raising the rate of rejected insurance claims on the mortgages. Since they have less than one dollar of capital per 100$ of lending, they will face significant losses with a small downturn if they are not able to insure the mortgages and pass them along.

The result is that with less capital, they will not be able to provide new mortgage loans. Since they are 25% of the market, this is a significant credit crunch. Furthermore, buyers of CMB's may decide to stop buying these securities - and only buy CMHC insured CMB's. Which means they will discriminate the originator of the CMB. The MFC's will thus lose their major source of funding. Without funding, they will fail.

The banks will be protected from this at first, but their lending will suffer too. With house prices starting to decline, and defaults in MFC's, homeowners will lose access to 25% of funding. At this point, it is possible a large number of homes may be on sale at the same time. Not only that, but home buyers will have less funding to buy - they will only be able to afford a much lower home price. House prices will fall, home lending will fall, and consumer spending will fall. Since banks are highly reliant on consumer credit, home equity loans, etc, they will suffer.

We have a very secure banking system, but credit will freeze up and this will require government intervention which may or may not be available at the time.

In conclusion, a small downtick in home prices or adverse conditions in the economy will lead to difficulty in insuring mortgages. This will create a negative feedback loop which will strain MFC's, because they will lose their funding options, and thus, they won't be able to loan. Without credit, people will put their houses for sale, creating pressure on prices. Buyers will have less credit and thus will not be able to afford high prices. Thus a housing downturn is a systemic risk for the whole of canada, and higher interest rates are not a pre-requisite for the problems to start. The central bank will find itself quite ineffective, and the government will not be able to provide enough emergency lending and funding. Public opinion will not be for bailouts either. A small shock will feedback into the entire system, freezing credit, eventually lowering consumer spending and will create a lasting recession. The canadian dollar may not be able to weaken enough to help the economy if oil prices recover and are high. Interesting times are ahead.

In this environment, I believe bitcoin will be an asset to hodl. HODL !

edit: In a really bad scenario, remember those covered bonds ? If the mortgages go bad, which are supposed to be very safe, then the bank is on the hook. This will create a massive capital hole in the balance sheet. They will require a bailout. This is unthinkable in canada. Perceptions are about to be challenged.

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