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Canadian Bank Stocks Will Outperform Until This Huge Advantage Goes Away

A recent Royal Bank of Canada  (TSX:RY)(NYSE:RY) report listed the sectors that outperformed Berkshire Hathaway over the last 25 years.

The list was pretty short. In fact, there was only one sector on it: Canadian banks.

Investors have known that Canada’s banks have been terrific investment for decades now. They’ve consolidated the banking industry to the point where Canada’s top five financial institutions now control 80% of the market. Regulations also ensure it’s really hard to start a bank.

Canada’s banks are taking their Canadian profits and reinvesting them in other markets. Most acquisitions are done in the United States, but some banks are looking at more exotic locales. Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) is expanding into Latin America, for instance.

There are other factors that help explain Canadian bank success. It’s awfully hard for a new player to compete with an existing bank on everything from the cost of capital to branch locations. The existing players can also afford to collectively spend billions on marketing and technology, while smaller banks might have to forego those expenses.

But there’s one factor that gives Canadian banks the biggest advantage of all. They simply can’t lose if it continues to stay in place.

Mortgage default insurance

There’s no doubt in my mind. Mortgage default insurance means more to Canada’s banks than anything else. It’s the biggest factor behind those succulent returns.

Mortgage default insurance is purchased by the borrower to protect the lender just in case they can’t pay their loan. If the borrower can’t make their payments and the lender has to foreclose on the property, mortgage default insurance will ensure the lender gets what’s owing.

Default rates in Canada have traditionally been very low. Even during rough times, default rates rarely exceed 1%. These days, the default rate nationally is around 0.33%.

Even though folks not paying on their mortgages really isn’t that big of a problem, Canada’s banks still make borrowers insure against the risk. The party providing the insurance is the Canada Mortgage and Housing Corporation (CMHC), which is a subsidiary of the Government of Canada. There’s no way a bank can lose in that situation.

Oh, and the bank also gets to finance the insurance premium for most of its customers. What a terrific gig.

Will the advantage ever go away?

As long as Canada’s banks continue to have this advantage, I think they’ll be good long-term investments. It’s hard to lose money on the largest part of your loan book when the government guarantees the principal.

But this huge competitive advantage could very well go away. The Canadian government is finally waking up to the massive risk it’s taking on. As of June 30, 2016, nearly $525 billion worth of mortgages were insured.

Pundits everywhere are talking about Canada’s housing bubble with a focus on markets like Toronto or Vancouver. The Government of Canada is listening. It has made multiple changes to mortgage insurance qualifications over the last few years with the goal to make it tougher to qualify for big loans.

It hasn’t really worked. Sure, both Vancouver and Calgary’s real estate markets have weakened, but those markets were influenced by a foreign buyers’ tax and the price of oil. Many pundits still claim both Vancouver and Calgary are overvalued.

And then there’s Toronto, which is regularly listed as one of the world’s most overvalued real estate markets. CMHC rules have done nothing to slow down the market there.

There are also reports that the Canadian government approached Canada’s largest banks and asked them if they’d support a new mortgage default scheme where the bank shared some of the default risk with the insurer. The banks balked at the idea, obviously. Still, if the idea came to light, it’s clear that people are considering it.

The bottom line

Bank of Nova Scotia, Royal Bank, and all of Canada’s other banks have one huge competitive advantage. Mortgage default insurance really is a game changer. As long as it stays in its current form, you’ve got to like the Canadian banks as a long-term investment.

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Fool contributor Nelson Smith owns shares of Berkshire Hathaway (B shares). The Motley Fool owns shares of Berkshire Hathaway (B shares).

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