the big short ii

8/10/2019 The Big Short II

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THE BIG SHORT IIWhy shorting high loan-to-value Canadian mortgages may be the (second) greatest trade ever

Nigel R. DSouza [email protected]

14November2014


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INTRODUCTION

In 2006, hedge fund manager John Paulson realized something few others suspected--that the housing

market and the value of subprime mortgages were grossly inflated and headed for a major fall. Colleagues

at investment banks scoffed at him and investors dismissed him. In the summer of 2007, the markets began

to implode, by year's end, John Paulson had pulled off the greatest trade in financial history, earning morethan $15 billion for his firm--a figure that dwarfed George Soros's billion-dollar currency trade in 1992

- The Greatest Trade Ever by Gregory Zuckerman

John Paulsons contrarian view on subprime mortgages resulted in one of the largest payoffs in financial

history. Paulsons trade exploited poor underwriting standards in an overextended mortgage market driven

by mortgage securitization . Paulsons bet against subprime mortgages via credit default swaps was coined

the greatest trade ever by Wall Street Journal reporter Gregory Zuckerman

This report asserts a similar opportunity, albeit via a different mechanism, is forming in the Canadian

mortgage market. Whereas the United States mortgage market was driven by subprime securitization and

poor underwriting standards the Canadian mortgage market is driven by the interaction and codependency

of regulatory underwriting standards, federally backed mortgage insurers and the expansion of mortgage

credit in a low rate environment. These conditions have resulted in a concentration of high loan-to-value

(LTV) mortgages in the Canadian mortgage market which exceeds the peak concentration of high LTVmortgages in the United States mortgage market prior to the subprime crisis

This report will examine Canadian real estate prices in relation to historical valuation, the central agents

driving Canadas mortgage market, the ability of high LTV mortgage borrowers to make monthly mortgage

payments under rising rates as well as systemic exposure to the Canadian financial system from higher

default rates

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REAL ESTATE VALUATION

Canadian house prices are overvalued in relation to

historical valuations based on the price to household

income ratio, the price to personal disposable income

and the price to rent ratio

From 1990 to 2010, houses were priced on average at

3.8 times household income. As of October 2014, this

ratio has climbed to 5.5. Barring a rapid increase in

household income a 31 percent correction is required

for this ratio to return to historical levels

The ratio of house prices to disposable income has

increased from a multiple of 8.3 in 2001 to 12.6 in

2014. A return to historical valuation would require a

correction of 34 percent. The current ratio of prices

to personal disposable income is the highest on

record

House Prices valuation relative to Household Income

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Additionally, when measured on the ratio of real

estate prices to rent, Canadian real estate is among

the most expensive in the world exceeding the real

estate markets of Hong Kong and Singapore.According to the Organization of Economic

Cooperation and Development (OECD), when

measured on a price-to-rent basis, Canadas real

estate market is overvalued by 60 percent

A divergence of real estate prices from personal

disposable income, as shown on the bottom right, issymptomatic of the decreasing affordability of

Canadian housing. The gap between disposable

income and house prices must be funded by

alternative sources of capital. In Canada, home

buyers have turned to mortgage credit priced at

historically low rates to finance purchases

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The reduction in the cost of mortgage credit parallels

the Bank of Canadas (BOC) bank rate policy. The BOC

has implemented an increasingly accommodative

monetary policy which has resulted in its bank ratedeclining from a peak annual rate of 17.93 percent in

1981 to 1 percent in 2014. Central bank rates are the

lever on which credit is priced throughout the

economy with mortgage credit, for a fixed-rate five

year term, priced on average at the bank rate plus

300 basis points. Mortgage rates have tracked the

BOCs loose monetary framework and declined from

a peak in 1981 of 21.75 percent, for a 5 year fixed-

rate mortgage, to 4.8 percent in 2014

The decline in the cost of mortgage credit has lead to

an exponential increase in mortgage origination and

outstanding credit. Outstanding residential mortgage

credit in Canada has increased from $687 billion in

2006 to $1,266 billion as of September 2014; an

increase of 84 percent in 8 years

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OVERVIEW OF THE CANADIAN MORTGAGE MARKET

Canadas mortgage market is driven by three primary agents

1. Mortgage originators: financial institutions that originate mortgage credit

2. Mortgage insurers: government and non-government agencies that provide insurance for

mortgage loans specific to a set of regulatory underwriting standards

3. Mortgage funding: sources of capital for funding mortgage origination

These three agentsoriginators, insurers and sources of capitalare linked together under a regulatoryframework whose policies shape the cost of mortgage credit, the underwriting standards for the

industry and the preferred structure of mortgage loans in terms of rate preference (fixed versus variable)

and length of term renewals

An understanding of the role and characteristics of each agent is required in order to grasp the

idiosyncrasies of the Canadian mortgage market

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Mortgage Originators

Canadas financial industry is dominated by its largest

chartered banks also known as Schedule 1 banks. In

turn, these banks account for 75 per cent of the value

of outstanding mortgages with the five largest

Canadian banksRoyal Bank of Canada, Toronto-

Dominion Bank, Bank of Nova Scotia, Bank of

Montreal and Canadian Imperial Bank of

Commerceaccounting for 65 percent of the total

market

Canadas banking system is considered among the

safest in the world due to stringent regulation by the

Office of the Superintendent of Financial Institutions

(OSFI) which serves as the regulatory body for

Schedule I, II and III banks under the Bank Act of

Canada established in 1871. The majority ofmortgage origination occurs within the regulatory

purview of the Canadian government with 80 percent

of mortgages originated by lenders that are federally

regulated by the Office of Superintendent of Financial

Institutions (OSFI)


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Mortgage Insurers

As with Mortgage origination, mortgage insurance is directed and shaped by the Canadian regulatory

framework

Canadas regulatory framework with respect to mortgage insurance has two major components:

1. All federally regulated lenders are subject to OSFIs principles-based supervision in addition to

capital and other regulatory requirements

2. A legal requirement for federally regulated lenders to insure high-ratio mortgages which are

defined as mortgages with a loan-to-value (LTV) ratio over 80 percent. This insurance is backed by

an explicit guarantee provided by the federal government

The regulatory framework for mortgage insurance has tightened considerably over the last five years

due to concerns of stretched housing prices. The government of Canada is attempting to engineer a soft

landing for Canadian real estate via the mechanism of regulation. For instance, the qualifying rules for

mortgage insurance were tightened from 2008 to 2012 in order to support the long-term stability of thehousing and mortgage markets. This tightening has an aggregate effect of increasing the cost of

mortgage credit via shorter amortization periods, lower loan-to-value ratios and higher mortgage rates.

The spearhead of insurance regulation is focused on high-ratio (i.e. high loan-to-value) mortgages as

these represent the greatest collateral exposure for mortgage lenders


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The current requirements for high-ratio mortgages (mortgages with loan-to-value ratios over 80

percent) to qualify for mortgage insurance include:

1. A maximum amortization period of 25 years (compared to 30 years previously) and a maximumloan-to-value ratio of 95 percent (i.e. minimum down payment of 5 percent)

2. A maximum loan-to-value (LTV) for mortgage refinancing and non-owner occupied (i.e.

investment) properties of 80 percent (compared with 95 percent previously)

3. Exclusion of insurance coverage for mortgages of homes with a purchase price in excess of 1

million

4. A maximum gross and total debt-service ratio (DSR) of 39 percent and 44 percent respectively

5. A requirement for borrowers to satisfy debt-service criteria using the posted rate for a 5-year

fixed-rate mortgage if they select a variable mortgage or a term less than five years

Note:

Gross DSR is the ratio of housing costs which include mortgage payments, property taxes and heating

expenses to gross income

Total DSR is the ratio of total debt costs which includes car loans, credit card payments and lines of credit

payments to gross income

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Mortgage Funding

Funding of Canadian mortgages is provided by a variety of sources including retail deposits, brokered

deposits, covered bonds and mortgage securitization


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Traditionally, Canadian chartered banks rely primarily

on retail deposits to fund mortgage loans. Deposits

with maturities of less than five years are insured by

the Canadian Deposit Insurance Corporation (CDIC).The CDIC is a Crown Corporation (i.e. state owned

enterprise) created in 1967 for the purpose of

insuring Canadian deposits up to $100,000 held at

Canadian banks in the case of bank failures

Canadas mortgage market experienced a significant

shift to alternative sources of funding from mortgage

securitization post 2001 with a substantialacceleration occurring post 2008 due to the

implementation of the Insured Mortgage Purchase

Program (IMPP). In October 2008, as a measure to

maintain the availability of longer-term credit in

Canada, the Government of Canada authorized

CMHC to purchase NHA MBS from Canadian financial

institutions through a competitive auction process.

IMPP remained available until the end of March 2010with a total of $69.3 billion in NHA MBS purchased by

CMHC under the program

Total mortgage securitization in Canada has risen to

35 percent of outstanding residential mortgages from

less than 10 percent in 2001. The United States

mortgage market, in comparison, had a securitization

rate of 60 percent prior to the subprime crisis of 2008

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Mortgage Securitization

Mortgage securitization is primarily

provided by the Canadian Mortgage

Housing Corporation (CMHC) with

private securitization responsible for a

negligible portion of mortgage funding.

The CMHC is a government-owned

corporation, known as a Crown

Corporation in Canada, which was

established in 1946 to address Canadaspost-war housing shortage. The agency

has grown into a major national

corporation and is Canadas premier

provider of mortgage loan insurance,

mortgage-backed securities, housing

policy and programs, and housing

research

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The CMHC offers mortgage securitization through

two programs:

1. National Housing Act Mortgage-Backed

Securities (NHA MBS). NHA MBS funding

currently accounts for 34 percent of residential

mortgages

2. Canada Mortgage Bonds (CMBs)

National Housing Act Mortgage-Backed Securities

(NHA MBS) programNHA MBS are issued by

approved financial institutions and are backed by

pools of insured, eligible residential mortgages.

Investors in NHA MBS receive principal and interest

payments passed through from the mortgages. CMHC

guarantees the timely payment of interest and

principal to investors.

Canada Mortgage Bonds (CMB) programCMB are

issued by Canada Housing Trust, a special purpose

trust that purchases insured, eligible residential

mortgages packaged into NHA MBS. Investors in CMB

receive fixed or floating rate coupon interest

payments and, at maturity of the CMB, the principal

payments. CMHC guarantees the timely payment ofinterest and principal to investors.

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Financial institutions securitize mortgage loans in order to sell NHA MBS securities to investors or to the

Canada Housing Trust (CHT), a subdivision of the CMHC, under the CMB program. This mechanism is

symbiotic in nature with the CMHC purchasing NHA MBS from financial institutions with the underlying

securities of NHA MBS insured via premiums from insured mortgages originated by financial institutions.The purchase of NHA MBS in turn provides additional capital for mortgage origination

The purchase of NHA MBS securities is funded by CMBs issued to investors and financial institutions. CMBs

are insured with premiums paid by borrowers of insured mortgage credit. NHA MBS purchases and CMB

issuance is undertaken by the Canada Housing Trust (CHT). The CHT is a special purpose trust created by

the CMHC which invests and makes loans under the National Housing Act (NHA) to social housing

sponsors. CHT funds its program with the issuance of Canada Mortgage Bonds under the CMB programwhich is fully guaranteed by the CMHC. More than 70 percent of CMBs are held by banks, insurance

companies and pension funds. CHT assets represent approximately 77 percent of CMHCs total assets as of

December 2013

Mortgage securitization risk is distributed across mortgage insurers and originators. Financial institutions

are exposed via CMB holdings, and mortgage insurers are liable for mortgage defaults on securitized

mortgages constituting NHA MBS and CMBs

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THE (SECOND) GREATEST TRADE EVER

The thesis for the second greatest trade ever is as follows:

Canadas real estate prices are overvalued relative to historical ratios. Rising real estate prices were

supported by an exponential growth in mortgage credit. The rapid increase in prices, along withmortgage credit, has led to declining affordability for first-time buyers. Record high household debt to

income in Canada is a symptom of mortgage credit saturation where mortgage payments, even at

record low mortgage rates, consume a significant portion of personal disposable income. The

distribution of loan-to-value ratios across the Canadian mortgage market poses a significant risk to the

Canadian financial system via high LTV mortgage defaults. Increasing default rates across high LTV

mortgages cannot be absorbed by mortgage lenders even when accounting for mortgage insurance .

Marginal increases in mortgage rates increases the likelihood of defaults in high LTV mortgages as

corresponding increases in monthly mortgage payments consume a greater portion of household income

The idiosyncrasies between the Canadian and US mortgage market creates a variance in the mechanism

of how a potential housing crisis unfolds in Canada. An understanding of the underlying mortgage

market and how a correction can effect originators, insurers and holders of mortgage securities is

required prior to examining potential trades

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Increasing prices, ownership and mortgage debt

Canadas mortgage market is characterized by a high

rate of home ownership which recently eclipsed

home ownership rates in the United States

The increase in home ownership has paradoxically

occurred in concurrence with a decrease in

affordability. Home ownership is driven by the

accessibility of mortgage credit instead of a secular

increase in disposable income or a decrease inhousing prices

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Increasing mortgage credit origination has led to debt

saturation. The ratio of household debt to disposable

income is near record highs with a reported ratio of

163.6 percent in 2014 down marginally from 164.1percent in 2013. This figure contrasts with a peak

household debt to disposable income ratio of 128

percent for United States households in 2007

Despite increasing debt levels, the cost of debt has

decreased along with interest rates on mortgages. For

instance, the household debt service ratio (householdmortgage and non-mortgage interest paid as a

proportion of disposable income) declined from over

9 percent in 2008 to 6.9 percent in the third quarter

of 2014

Canadian debt levels, although near record highs,

seem sustainable as a function of net worth. The ratio

of household debt to net worth declined from 22.5

percent in Q1 2013 to 22.3 percent in Q1 2014 which

represents a six year low. The decrease was driven

primarily by an increase in net worth due to higher

real estate prices. However, a low ratio of debt as a

function of net worth masks sensitivity to higher

interest rates

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An estimated interest rate floor of 6 percent, versus

the current average mortgage rate on a 5 year term

of 4.80 percent, raises housings costs as a percentage

of household income from 30 percent to 40 percent

Existing Canadian homeowners are at risk of a change

in long term interest rates at either the reset date of

variable-rate mortgages or at the time of term

renewal for fixed-rate mortgages

The five year fixed-rate mortgage is the most popularterm chosen by Canadian home owners with 20

percent on fixed-rate mortgages facing renewal in the

next twelve months

Variable-rate mortgages account for a significant

portion of total outstanding mortgages with variable-

rate mortgages holding a 30 percent share of neworiginations

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Housing unaffordable for first-time home buyers

At an average price of $408,795 as of September 2014, house prices are unaffordable for first-timehome-buyers

Assuming a five year fixed-rate term at the average mortgage rate of 4.80% and an amortization life of25 years, household monthly mortgage payments for first-time buyers would equal $2,052. Thesepayments would nearly consume all household disposable income after expenditures even at record lowmortgage rates of 4.8 percent. A 50 basis point increase in mortgage rates would price first-times buyersout of the market entirely barring an offsetting reduction in discretionary spending

As a result of decreasing affordability, first-time home-buyers plan to spend an average of $316K(substantially below the current average price of $409K) on their first purchase with 2.3 out of 10delaying their purchase due to higher home prices. Moreover, even at a reduced price of $316K housing

is unaffordable for first-time buyers if mortgage rates increase by 440 basis points or more

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Personal Disposable Income $5,206.00

Total expenditures $3,104.73

Mortgage Payment $2,052.58Savings $48.69

*Assumes two individuals per household

Monthly Household Budget*


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In addition to rising mortgage rates, an appreciation in house prices is unsustainable for first-time

buyers due to the corresponding increase in down payments

According to a BMO report released in March 2014, first-time homebuyers expect to make an average

down payment of $50,576. At current house prices this equates to a 12 percent down payment as wellas monthly mortgage payments which consume nearly 100 percent of personal disposable income after

expenditures

At current prices, first-time home buyers would require a down payment of $81,759 to qualify for an

uninsured mortgage. First-time buyers can afford down payments of 10 percent or less up to a house

price of 506K. However, first-time buyers are unable to absorb higher monthly mortgage payments from

lower initial down payments. Thus, Canadian real estate prices cannot be driven higher by first-time

buyers without a significant increase in personal disposable income and personal savings


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Existing home owners driving real estate market

Housing remains affordable, as a function of mortgage payments, for existing home owners

Mortgage rates would have to rise over 500 basis points to 9.8 percent in order for the averagehousehold to face difficulty in meeting monthly mortgage payments. This assumes at average loan-to-value (LTV) of 55 percent which is in line with CMHCs reported LTV on its insured portfolio of 54 to 55percent and the reported LTV range of 45 to 60 percent by Canadian chartered banks

Given the unaffordability of housing for first-time buyers and the ability to absorb higher mortgage ratesby existing home owners, we should observe a Canadian real estate market driven primarily by ownerswho flip houses or by existing home owners who sell their current house to purchase or upgrade to anew home

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Personal Disposable Income $5,206.00

Total expenditures $3,104.73Mortgage Payment $1,288.31

Savings $812.96

*Assumes two individuals per household

Monthly Household Budget*


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The Canadian Real Estate Association (CREA) currently does not provide data on the proportion of sales

made to first-time home buyers. However, the CREA does provide data on home resales

Given that housing is unaffordable for first-time buyers, the data should indicate a large proportion of

unit sales being constituted of home resales. This premise assumes home resales represent ownersselling their homes to finance an upgrade to a new home or investors flipping real estate properties

The data from the below charts show a high degree of tracking between home resales and total units

sold. For instance, home resales grew to 494,200 in June 2014 increasing 0.8 percent over home resales

in May. This tracks very closely to the range of total units sold monthly of 475k to 500k from Q2 2014 to

Q3 2014 . The high volume of home resales is characteristic of a market where participants chase capital

gains via real estate price appreciation


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Stability of Canadian mortgage market threatened by loan-to-value (LTV) ratio distribution

Despite the ability of existing home owners to absorb higher mortgage rates Canadas financial system

faces significant risk due to high LTV exposure

As of 2013, mortgages with an LTV above 80 percent constitute 27.5 percent of all mortgages. This figure

is above the 22.9 percent of U.S. mortgages with an LTV over 80 percent prior to the subprime crisis in

the United States. The mean LTV ratio range of 45 to 60 percent reported by CMHC and Canadian banks

masks their exposure to high LTV loans

In contrast to the U.S. market where risk was driven by subprime lending and mortgage securitization,

risk in the Canadian market is concentrated in financial institutions with high LTV mortgages. Exposure is

dependent on mortgage insurance coverage and collateral value

The Canadian Mortgage and Housing Corporation (CMHC) is responsible for insurance on the majority of

mortgages with high LTV ratios with a negligible portion insured by private institutions


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Canadian Mortgage & Housing Corporation (CMHC) vulnerable to mortgage defaults

CMHCs insurance guarantee exposure is reported as off-balance sheet arrangements and contractual

obligations on NHA MBS, CMB and insured mortgages

As of June 30th2014, these guarantees totaled $402 billion of guarantees-in-force on CMHCs

securitization program and $551 billion of insurance-in-force on insured mortgages. This coverage

represents 45 percent of residential mortgages and 32.5 percent of securitized mortgages

The ability of the CMHC to fund insurance payouts in the event of rising mortgage defaults is critical to

the stability of the Canadian financial system


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CMHCs capital requirements for funding insurance payouts is set by regulations implemented by the

Office Superintendent of Financial Institutions (OSFI)

As of June 30th2014, CMHC has set aside $1.53 billion to cover $402 billion in guarantees-in-force on

securitized mortgages and $15.32 billion to cover $551 billion of insurance-in-force on insuredmortgages. This equates to a coverage ratio of 0.3 percent for securitized mortgages and 2.8 percent for

insured mortgages

Current capitalization levels are adequate given a reported mortgage default rate of 0.3 percent in

August 2014 . Additionally, mortgage default rates never exceeded 1 percent since 1990 as reported by

the Canadian Bankers Association. However, Canadas current low default rate is not indicative of default

risk in an environment of rising mortgage rates


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Default risk under rising rates

Default risk is concentrated in high LTV residentialmortgages with an LTV from 80 to 95 percent. Thesemortgages constitute 26.9 percent of outstandingresidential mortgages as of year end 2013. Riskexposure to 95 percent or greater LTV mortgages at0.6 percent of the overall market is not material

Monthly mortgage payments for 90 percent and 85percent LTV mortgages exceed the averagehouseholds personal disposable income (PDI) after

non-discretionary expenses at mortgage rates of 8.3and 8.8 percent respectively. At current rates monthlymortgage payments on high LTV mortgages consumenearly all household PDI after expenditures. Canadasfinancial system faces significant systemic risk fromhigh LTV mortgage exposure when mortgage ratesmove off record lows

The current default rate of 0.3 percent understates

the incremental risk of default. High LTV mortgageborrowers may be unable to cut discretionaryspending to finance monthly mortgage paymentincreases when mortgage rates rise. Unforeseenexpenses or a failure to cut discretionary spendingcan lead to higher incremental default rates prior toreaching the 8.3 to 8.8 percent mortgage rate target


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The Big Short: how to profit from rising defaults in high LTV mortgages

As default rates increase with rising mortgage rates lenders will reduce mortgage origination resulting in

a contraction of mortgage credit. Canadian real estate prices will likely correct in an environment of

rising mortgage rates, increasing defaults and contracting credit. Given that the majority of the market is

driven by home resales rather than first-time buyers, this environment should correspond with a

significant correction in home prices as existing homeowners are not incentivized to upgrade to larger

homes and real estate investors can no longer generate positive returns from flipping properties. Based

on historical ratios, house prices are currently 30 to 35 percent overvalued. A 50% retracement to the

historical average will result in a significant portion of underwater high LTV mortgages. The combination

of underwater mortgages and insufficient capital for mortgage insurance payouts poses a substantialthreat to Canadas mortgage market

The following trades are recommended, from highest to lowest preference, to profit from shorting high

LTV mortgage exposure

1. Credit Default Swaps on high LTV mortgage securities

2. Shorting unregulated mortgage lenders with high LTV mortgage exposure

3. Shorting financially regulated banks with high LTV mortgage exposure


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1. Credit Default Swaps on high LTV mortgage securities

Credit Default Swap (CDS): The buyer of a credit default swap receives credit protection, whereas

the seller of the swap guarantees the credit worthiness of the debt security. In doing so, the risk ofdefault is transferred from the holder of the fixed income security to the seller of the swap. For

example, the buyer of a credit default swap will be entitled to the par value of the contract by the

seller of the swap, should the third party default on payments

Pros

Highly asymmetric trade: CDS is the functional equivalent of buying insurance. Investors pay

premiums and receive a payout in the case of an event (default triggers a CDS payout). CDS on

subprime mortgages and equity MBS tranches were priced at 150 to 250 basis points (bps) between

2005 and 2006. Assuming one can obtain similar pricing on Canadian MBS; to insure 1 billion in high

LTV mortgages an investor would pay 15 to 25 million annually. The ideal trade involves purchasing

CDS on high LTV mortgages (preferably 90 percent or higher) with a 3 to 5 year horizon. Assuming a

3 year horizon and a 150 bps pricing on CDS: this trade requires a default rate of 4.5% among

covered high LTV mortgages to break even. Incremental increases in default rates substantiallyincrease the estimated CDS payout with the return increasing from 25 percent at a default rate of

5.5 percent to 366 percent at a default rate of 20.5 percent. Assuming a 100 percent default rate on

covered high LTV mortgages; this trade generates a maximum estimated return of 2122 percenta

$1 billion payout over a $45 million cost at 150 bps over 3 years. However, mortgage rates would

have to exceed 8.8 percent for default rates to approach 100 percent


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Cons

Low liquidity: CDS contracts are illiquid and highly specialized. Even in the event of increased

defaults brokers may find price discovery challenging leading to inaccurate market quotes

Negative carry: CDS contracts are a negative carry trade. CDS payments are a sunk cost which are

only recovered upon default among the underlying mortgage securities


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2. Shorting unregulated mortgage lenders with high LTV mortgage exposure

Unregulated mortgage lenders do not fall under the purvey of federal regulation. Unregulated

lenders do not have to adhere to strict underwriting standings required by OSFI and CMHC in orderto qualify for mortgage insurance. These lenders originate and invest in mortgages that cannot be

placed with financial institutions due to higher underwriting risk. The lowered underwriting

standards coupled with uninsured high LTV mortgages greatly increases the default risk exposure for

these lenders relative to federally regulated lenders

Pros

Liquidity: shares of non-bank mortgage lenders trade on public exchanges and are liquid securities

resulting in accurate market pricing

Short-selling execution: establishing short positions in non-bank mortgage lenders is

straightforward given availability of shares to borrow amongst brokers

Cons

Muted asymmetry: the maximum return for shorting a stock is 100 percent. Compared to a CDS

trade the potential return is muted and unattractive relative to the asymmetry of CDS payouts

Unlimited downside: theoretically, short selling has an unlimited downside since there is no

theoretical upper limit to share prices. Pragmatically, it is highly unlikely for an investor to be unable

to exit a short position prior to 100 percent share price appreciation

Negative borrow rates: in the event of low availability brokers may charge negative borrow rates toshort securities. The negative borrow rate is dependent on share availability


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3. Shorting financially regulated banks with high LTV mortgage exposure

Although Canadas financial system is viewed as one of the best regulated and safest among its

global peers, in reality, the Big Five Canadian chartered banksBank of Montreal (BMO), Royal Bankof Canada (RY), Canadian Imperial Bank of Commerce (CM), Toronto-Dominion Bank (TD) and Bankof Nova Scotia (BNS)are highly levered and have significant risk exposure to mortgage defaults

As shown below, in relation to American banks, with exposure to the subprime crisis, the big fiveCanadian banks are more levered and have lower tangible common equity (TCE) ratios. TCErepresents the amount of losses as a percentage of assets a bank can experience before its equity iswiped out. A lower TCE signifies greater risk of insolvency due to losses

Outside of Lehman Brothers (LEH), Canadian banks are more sensitive to losses in mortgage

securities than American banks at the forefront of the subprime crisis; Bear Stearns (BSC),Countrywide Financial (CFC), New Century Financial (US) and American Home Mortgage InvestmentCorporation (AHMIQ)

LEH BSC CFC US AHMIQ

TCE 2.52% 11.91% 6.92% 7.88% 4.68%Leverage 39.6x 8.4x 14.4x 12.7x 21.3x

Troubled American Bank Metrics

CIBC RBC BMO TD BNS

TCE 3.69% 4.14% 4.48% 3.94% 4.44%Leverage 24.3x 24.3x 24.3x 24.3x 24.3x

Big Five Canadian Bank Metrics


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Pros

Liquidity: shares of charted Canadian banks trade on public exchanges and are liquid securities

resulting in accurate market pricing

Short-selling execution: establishing short positions in chartered banks is straightforward given

availability of shares to borrow amongst brokers

Cons

Muted asymmetry: the maximum return for shorting a stock is 100 percent. Compared to a CDStrade the potential return is muted and unattractive relative to the asymmetry of CDS payouts

Government support: the Government of Canada is likely to provide support to Canadian chartered

banks in the event of a liquidity crisis due to increasing default rates. However, it is assumed that

government intervention to support Canadian banks will occur after a significant decline in market

capitalization in an environment of increasing defaults. Any measures by the government to

intervene proactively in the event of a crisis will dampen the decline in share prices

Unlimited downside: theoretically, short selling has an unlimited downside since there is notheoretical upper limit to share prices. Pragmatically, it is highly unlikely for an investor to be unable

to exit a short position prior to 100 percent share price appreciation

Negative borrow rates: in the event of low availability brokers may charge negative borrow rates to

short securities. The negative borrow rate is dependent on share availability

Dividend liability: short-sellers must pay out any dividends paid by the underlying short to the long

from which shares were borrowed. Canadian banks have a track record of consistent dividend

payments which the short-seller must pay out to the investor whose shares were borrowed


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OUTLOOK

Canadas mortgage market is nearing a plateau in mortgage origination and outstanding mortgage

credit. This plateau is a function of credit saturation where higher monthly mortgage payments cannot

be absorbed even at lower rates

Canadas financial system is exposed to systemic risk in an environment of rising mortgage rates anddeclining real estate prices. Marginal increases in mortgage rates can create conditions leading to

increasing default rates, a contraction of mortgage credit and a modest correction (10 to 15 percent) in

real estate prices

The current distribution of loan-to-value ratios with 27.5 percent of mortgages at a LTV of 80 percent or

higher threatens the solvency of mortgage lenders and the liquidity of the mortgage market assuming

(i) mortgage rates increase from record lows and move towards 8.30 percent and (ii) that real estate

prices decline 10 percent or more Shorting high LTV mortgage securities via credit default swaps represents a highly asymmetric trade. If

conditions outlined in this report come to fruition, this trade may be the greatest short ever against

mortgage securities second only to John Paulsons shorts on subprime mortgagesBigShort

II

35

the big short ii

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