In 2005, after spending about a decade in various senior management roles in wealth management companies such as Bear Stearns and Legg Mason, Dallas-based Kyle Bass decided to start his own hedge fund, Hayman Capital. He started with just $33 million worth of capital from his own resources, family, and friends.
In 2007, after extensively researching the United States mortgage market, Bass invested most of the fund’s capital in collateralized debt obligations that bet against the worst subprime mortgages he could find. In two short years, Bass had turned that small investment into an estimated $4 billion profit.
Not content with predicting one huge economic disaster, Bass put a big chunk of his profits into betting against the government debt of many European nations, particularly Greece. He got that one right as well. Estimates are that Bass made a few additional billion from that deal as well.
Nailing these two big predictions made Bass into a bit of a celebrity. Noted finance author Michael Lewis profiled Bass in his 2011 book Boomerang: Travels in the New Third World, spending some time with Bass at his rural Texas mansion. In the book, Bass outlines his reasons for investing $1 million to buy 20 million nickels, stating that the metal in each coin is worth about seven cents. He thinks eventually the United States will stop producing nickels, leaving him free to melt down the coins and collect the profit.
Bass’s latest call
Bass has a history of making outlandish calls, but also has a history of getting them right. During his latest outlook and opportunities talk, Bass had this to say about Canadian housing.
“Look, one of the potential butterfly effects (of a Chinese slowdown) is Canada… Canadian home prices are, on a median, nine times median income. The U.S. hit seven times at the height of the subprime bubble. Where Canadian housing sits today is completely unsustainable… All of the prescriptions for a problem in Canadian housing are out there… It sure looks to me that Canada is all of a sudden coming to a halt.”
Bass tends to keep his investments close to his chest, so we don’t know if he’s actually short Canada, or if he’s just making an observation. If he was betting on a housing correction, he would probably be short these three Canadian lenders.
Home Capital (TSX: HCG) is the obvious stock to avoid if investors are convinced Canadian housing is overextended. It lends to people who normally don’t qualify at traditional lenders, and most of its new loans aren’t insured against default. It’s a good business when home prices are doing well, but has the potential to be a terrible business when home prices fall.
Right now, the company is firing on all cylinders. Loan losses are minuscule. New loan growth is solid. It doesn’t look like a stock that anyone would short. But if the market turns negative, it’ll be the high on the must-short list.
Royal Bank (TSX: RY)(NYSE: RY) is Canada’s second largest bank by total assets, with almost $200 billion worth of mortgages on its balance sheet. Since it has most of its assets in Canada, it’s the most exposed to domestic issues, like a potential housing slowdown. If you take a look at profit growth in the last few years, it’s obvious most of it came from mortgages. Forget mass foreclosures, even a sustained slowdown in new loan applications would hurt the company.
In late 2013, TD Bank (TSX: TD)(NYSE: TD) surpassed Royal Bank to become Canada’s largest bank as measured by assets. It’s Canada’s third largest lender, leveraging mortgage brokers to strengthen its branch network. Although part of the bank’s recent success is because of its big exposure to the United States, TD still has more than $175 billion worth of Canadian mortgages on its balance sheet, and is hugely exposed to any Canadian economic problems.
Foolish bottom line
It seems as though every week a new prominent investor stands up and expresses concern about Canada’s real estate market. If these predictions come true, it’ll be a world of pain for Canadian bank investors. Since Canadian financials make up such a large percentage of the overall market, this has the potential to have all sorts of ripple effects. Whatever happens, it’ll be interesting.
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Fool contributor Nelson Smith has no position in any stock mentioned in this article.