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Sunday, May 7, 2017

Book Review: When The Bubble Bursts

Hilliard MacBeth published When the Bubble Bursts: Surviving the Canadian Real Estate Crash in 2015. It is mainly targeted at Canadians, but it would be of interest for foreigners who wish to understand what is happening in the Great White North. Although real estate bubbles are a familiar international phenomenon, there are some institutional differences that matter.

Book Description

The book is 221 pages (excluding end matter), and published by Dundurn Press. The book is divided into three parts:
  1. The Bubble
  2. It Won't Be A Soft Landing
  3. Surviving the Canadian Real Estate Crash.
The paperback ISBN is 978-1-4597-2980-3; it is also available in electronic format.

Hilliard MacBeth has been an investment advisor for over 35 years, and wrote Investment Traps and How to Avoid Them in 1999, predicting the collapse of the dot-com bubble.


The book is aimed to be a personal finance book that can be read by a wide audience. However, he does a good job of capturing the various economic and financial forces in play in Canada. It is very easy to recommend this book to almost all Canadians who are interested in the housing bubble or personal finances.

However, the reality is that most of my readership is outside of Canada; currently, I am getting more site visitors from London England than I am from all of Canada. For these readers, there are some caveats to keep in mind.

If you are interested in personal finance. The details of how personal finances are arranged in Canada are different than elsewhere, so this would not be a first choice for personal financial reading. That said, MacBeth has an interesting, cautious approach to investing and home ownership, so it might be of interest if you understand the basics already.

However, if you are an investor or just interested in economics, this book will be of interest, so long as you accept that some parts of the book are not aimed at you. You will be getting a good view of what the situation looks at it from the inside of the bubble, which more technical macro approaches might gloss over. If you are interested in behavioural finance, this book offers a lot of anecdotes that might help develop your understanding why housing finance seems to be getting out of control in the modern world.

Given the nature of my audience, I will focus mainly on the macro side of the book.

Housing Mania Builds

The introduction describes the genesis of the book. During the 1990s, Canadians had been captivated by various bubbles in the stock market. During the mid-1990s, the Bre-X saga played out in the business press: was the company legitimate? Was it possible that other investors could make the same huge gains as the early investors? (No, and no.) Once Bre-X went onto the rocks, the tech bubble took over, with Northern Telecom (NorTel) eventually rising to be 30% of the market capitalisation of the S&P/TSX index in September 2000. 

Hilliard had managed to steer his clients clear of tech stocks, and so they did relatively well. Even so, their enthusiasm for equities dimmed. Capital was starting to be steered towards real estate. Since his clients were pulling money away from financial assets, he had an incentive to be concerned.

Hilliard is skeptical about housing as an investment (a feeling I share). He bought a house in 1990, and sold it for the same price in 2000. (I believe that the boom in national home prices can be dated to about 1998 or 1999.) There have been various booms and busts over the past decades, particularly in Alberta, as a result of the cyclical nature of the oil business. There was also a fairly mess bust in the condo market in 1990 in Toronto and Vancouver, which took most of that decade to unwind.

One thing to keep in mind is that Canadian home prices in many markets were extremely cheap when compared to a country like England. In most of Montreal, the normal valuation rule was that you could buy a duplex, and if the second unit was rented, it would pay the mortgage for the entire duplex. (I always enjoyed shocking my counterparts in London with the price of our three bedroom townhouse.) Vancouver and Toronto were the only exceptions to this rule of cheap housing.

In other words, Hilliard MacBeth's attitude reflects an old school Canadian view, that housing is not an investment, and should be quite cheap. Attitudes have changed.

Stay Liquid for a Buying Opportunity

MacBeth's advice is that investors should remain liquid, waiting for a buying opportunity. Buying during a panic provides a huge boost to returns. A meltdown in the Canadian housing market would provide plenty of ammunition for a panic, and you certainly do not want your capital tied up in housing at that point.

No Canadian Exceptionalism

Chapter 8 is titled "Canadian Exceptionalism." In it, he argues that Canada is not an exception (an argument that was parroted by various bullish Bay Street analysts). 

I disagree somewhat, but that is because I am taking a different view of the matter. MacBeth is viewing the situation from the perspective of a Canadian household. From this perspective, it does not matter whether Canada suffers a short meltdown in housing (as was the case in the United States), or a slow melt over a decade: in either case, your personal finances are stuffed if all your net worth is in rental properties.

However, from a macro or international perspective, those two scenarios are very different. A rapid meltdown will have fairly obvious investment and economic implications. A slow melt may matter for asset allocators, but it may not be otherwise visible. Almost all developed countries are struggling; weakness in the Canadian consumer sector would not be particularly remarkable.

In other words, I agree that a slow melt is probably the best Canada can hope for, but a rapid collapse (which is what raises foreign interest) could be avoided. The main arguments that a rapid collapse could be avoided revolve around the following:
  • the Canadian Mortgage and Housing Corporation (CMHC) has underwritten all the credit risk; and
  • the nature of the banking system.
I discuss these in turn.

The Ottawa Whale

Canadian mortgage lending practices were strictly regulated, and highly conservative. There were some regional booms and busts, but those largely followed regional fortunes.

As Hilliard MacBeth describes in Chapter 5 ("Blowing Bubbles: The CMHC and the Government"), the brain trust in Ottawa decided to bring Canadian practices in line with our wilder southern neighbours. As night follows day, a finance-driven bubble ensued. (Hyman Minsky was not too well known in Canada, other than at BCA Research, where I used to work.)

All high loan-to-value mortgages have to have mortgage insurance. The price of the insurance is embedded in the loan payments. The CMHC provides most of the insurance, the market was opened up to the private sector, but market penetration has been low. Once the mortgage is insured, the CMHC eats all the residual losses on the loan. (It presumably can push mortgages that were obtained fraudulently, which might be concern in Vancouver, which is notorious for fairly shady real estate practices.)

If we want to translate what the CMHC has done into the jargon used in the crisis, it has written CDS protection on pretty much the entire high risk mortgage market. 

Hilliard MacBeth suggests on page 137 that the CMHC would only be able to cover losses up to its reserves (typically around $30 billion). This does not seem to be correct; the CMHC is a normally described as a full faith and credit obligation of the Federal Government of Canada. (Importantly, this is not a legal opinion, which I am not qualified to give in the first place. You should contact your legal counsel to check whether there are any asterisks to full faith and credit status.)  In other words, the CMHC would likely get its board of directors canned, but the Federal Government will always step up to make CMHC mortgage payments whole.

Unless you want to entertain the possibility that the Government Canada will voluntarily renounce this obligation, the financial system cannot suffer the same meltdown as the solvency of protection sellers was called into question. (I discuss in Understanding Government Finance why I view default for a government like Canada to be voluntary.) Meanwhile, this protects the perceived solvency of private sector financial firms that rely upon the credit guarantee.

Banks: Earnings Risk, Not Credit Risk

Chapter 9 ("Banks: They Will Survive (But They Won't Thrive)") describes the outlook for the major Canadian banks. His view is similar to mine: a meltdown in the consumer sector greatly damages the earnings prospects for these banks, but their solvency is probably not in question.

This view might be viewed as complacent if there is a rapid global meltdown, and all of the banks' customers are at risk. However, a relatively slow melt of the Canadian housing market is not enough to be truly scary for the banks, given the nature of CMHC insurance.

Surviving and Profiting From the Downturn

For interests of time, I will not try to summarise the discussion in the third part of the book, which discusses how to position your personal finances. Needless to say, avoiding owning too many properties is a key point. He also discusses the difficulties with renting, which limits the attractiveness of dip-buying in real estate.

One of the questions that comes up among foreign investors: how do I position for a meltdown in Canadian housing? Where is the next subprime CDS trade? The book is aimed at retail investors, and so if any such trades exists, they are not really discussed. I could easily be wrong, but there do not seem to be any obvious macro trades to put on here -- other than for positioning for a rapid meltdown (which has obvious effects). Once again, the CMHC credit insurance acts to keep the really scary scenarios under wraps. As was seen recently, there may be some interesting stock-specific trades, but I am not the person to discuss such possibilities.

Concluding Remarks

When the Bubble Bursts is an interesting book, even for international readers with an interest in understanding the dynamics of the Canadian housing bubble.

(c) Brian Romanchuk 2017


  1. It takes money to buy into a bubble. Hence, if we add all the money on deposit at banks, if a bubble is in progress, the total of all bank deposits should grow from year-to-year. Hmmm. We see that that money growth has gone on for MANY years!

    Where is this new money coming from? My suggestion is that it comes from "tradeable loans". These are loans that are backed by institutions that have enough strength to make loan guarantees creditable. Such a guarantee allows to the loan to be traded with very little discount compared to the discount extracted when the loan is personally guaranteed by an individual.

    Couple "tradeable loans" with bank borrowing and you have a source of "new money".

    Who is a creditable loan backer that can be stable over many years? Stable central governments can fulfill that role. In my view, we can trace housing bubbles in both Canada and the US to mortgage backing by the federal governments. Take away federal government mortgage backing and you are left with private mortgage backing in some form. Private backing can be expected to be far less stable over the range of several years.

    So when does a central government driven bubble burst? When the population decides that the whole system no longer makes sense? That seems to have happened in the US in 2007-8. It has not yet happened in Canada so far as I can see.

    Your review of "when the Bubble Bursts" provides tantalizing incentive to read the book for myself. Thanks for the review.

  2. "Hyman Minsky was not too well known in Canada, other than at BCA Research, where I used to work."

    So you worked at Bank Credit Analyst?

    I would spend hours reading the latest BCA report to extract its wisdom, when I was cutting my teeth as an investment analyst in the late 1970s. It was a pretty much unique way of assessing the markets in the day.


    1. It was a very interesting place to work; I started there in 1998. Fairly unique views at the time, which was true for most of its history.

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