Vijai Mohan has made an all-in bet against Canada.
The founder of a small San Francisco-based hedge fund called Hyphen Partners LP has staked 95 per cent of his investors’ assets on a wager that the country’s housing market and banking sector are about to come apart at the seams. Mr. Mohan has amassed large short positions on Canadian bank shares and the loonie, betting their values will fall sharply.
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“Canada faces two risks,” said Mr. Mohan in an interview. “Very few people are looking at those risks simultaneously. That collectively presents a lot of opportunity” – for someone looking to profit from Canada’s misfortunes.
If he’s wrong, Mr. Mohan will be easy to dismiss. Even one of his backers, Walter Burlock – a former managing director with hedge-fund heavyweight Soros Fund Management – is uncertain. “It’s usually the ideas I don’t fully understand or take issue with that are the right ideas,” said Mr. Burlock. “This falls into that category. But these things, if they play out, do play out in unexpected ways, and it comes as a shock to most people.”
Mr. Mohan is no lone pessimist about Canada. Speculators have turned on the loonie: U.S. Commodity Futures Trading Commission data show that, as of mid-April, the number of bets that the Canadian dollar will fall in value against the U.S. greenback exceeded the number of rising-value bets by almost 76,000 contracts – “the sharpest reversal on record” since last fall, when traders were bullish on the loonie, according to Bloomberg News. Betting against the Canadian dollar is a popular trade right now among hedge funds, Bay Street sources say.
But many of those trades are nothing more than bets that a slowing global economy and falling commodity prices will hit our currency. What sets Mr. Mohan apart is his particularly bleak view for Canada, and particularly the banking sector, based on a chain of events that have yet to unfold globally – and that some view as extremely unlikely. “The idea there will be a banking crisis in Canada is ludicrous,” says Rob Wessel, managing partner of Hamilton Capital, a Toronto-based asset manager that specializes in financial services.
‘A big-picture guy’
The man making a bold bet against Canada is the 36-year-old son of Indian immigrants who grew up a Midwestern middle-class kid in Akron, Ohio. His parents expected him to become a doctor, but instead he went to Wall Street after university to work as a research analyst. By age 25, he was portfolio manager Mr. Burlock’s San Francisco-based Origin Capital Management, quickly working his way up to become chief investment officer before starting Hyphen in 2009.
“He’s rare – a big picture guy who is also detail-oriented, with an incredibly comprehensive view,” Mr. Burlock said.
Not surprisingly, Mr. Mohan’s take on Canadian banks starts with housing. Property prices are among the most expensive in the world relative to income, rents and per-capita GDP, and fuelled by record levels of consumer debt. For years, housing starts have far exceeded what is needed to accommodate new households, and condo development is rampant, creating what he believes is a supply glut.
Many observers have questioned the growth prospects for Canadian banks given how tapped out Canadian consumers have become. But Mr. Mohan sees other challenges, including the possibility that Canada’s banking regulator, the Office of the Superintendent of Financial Institutions, will tighten risk-assessment standards that could force some of them to raise capital.
Most analysts argue that Canadian banks are largely shielded from the effects of a housing downturn because government-owned Canada Mortgage and Housing Corp. insures 64 per cent of Canadian mortgages, which in turn allows the banks to greatly discount the size of their asset base when calculating their Tier 1 capital ratio -- a measure of how much capital they have available to absorb losses.
Overall, the big Canadian banks put a “risk-weight” of just 9.9 per cent on total mortgages, according to Citi Research analyst Stefan Nedialkov. That means $100 billion worth of mortgages on a Canadian bank’s balance sheet is considered to be worth just $9.9 billion in calculating the capital ratio. By comparison, banks in the U.S. generally apply 35 to 75 per cent risk weights to mortgages while the big banks in Australia are at 15 to 20 per cent. The average in Europe is about 20 per cent.
The Canadian Bankers Association says the lower risk-weighting allowed by OSFI is justified because Canadian banks are prudent lenders and Canadians are prudent borrowers. But there is growing skepticism worldwide about the reliability of risk-weighted assets calculations, which vary between banks and countries. As part of an agreement between national banking regulators, the Basel Committee of Banking Supervision is assessing how banks calculate risk weighted assets (RWAs) to ensure rules are consistently applied. This, argues Mr. Nedialkov, will lead OSFI to impose a 15 per cent “risk weight floor” on uninsured residential mortgages and secured consumer loans. If that were applied overnight, it would force Canadian Imperial Bank of Commerce, Bank of Nova Scotia and Royal Bank of Canada to either raise capital or temporarily reduce their dividends to meet regulatory requirements, Citi estimates.
Peter Routledge, an analyst with National Bank Financial, agrees that OSFI, which has made no such announcement, could apply a risk-weight floor. But he believes the regulator would ease in the change over a couple of years.
Still, the fact that Canada’s banks apply one of the lowest risk weights overall compared to their global peers makes some observers nervous. “The perception is that our banks are the strongest capitalized, yet, when you consider equity to total assets, ours are the weakest capitalized,” said Keith Graham, founder of Bay Street investment management firm Rondeau Capital.
Mr. Mohan’s bet against Canada isn’t just about potential regulatory changes. He believes that the world is due for an emerging-markets crisis, which will drag down the Canadian economy and dollar with it. Combined with a home-price bust, the impact would “cause direct and specific risks for the Canadian financial system.”
Mr. Mohan thinks the explosive growth of Brazil, Russia, India and China is not an indication of a changing world order, but merely the latest in a long line of emerging-markets bubbles. His forecast: a crisis akin to Russia’s debt default in 1998 within the next two years. “I have a lot of confidence a crisis will happen,” he says, “but I don’t have a pinpoint on time.” Such a crisis would trigger a selloff in commodities, with harsh effects on the Canadian currency and economy – a catalyst for higher unemployment, a downdraft in the housing market and higher loan losses for the banks.
It is hard to find a bank analyst who takes Mr. Mohan’s warning too seriously. Scotia Capital analyst Kevin Choquette notes in a recent report that Canadian banks survived the 2008-09 economic crisis well, and have sustained little more than blemishes from past downturns. Even if housing prices were to decline by up to 35 per cent – far greater than any drop in the past 40 years – the impact would be “manageable” and would reduce, but not reverse, the enormous profits of our banks, he estimates.
Then again, the events of the credit crisis taught us to expect the unexpected in the event of a global shock. Besides, Mr. Mohan doesn’t need an apocalypse - only enough of a drop in the value of our dollar and bank stocks - to cash in. “I needed an instrument to bet against [emerging markets] that would not hurt me if I was wrong in the short term – but would still give me staying power in the long-term – and make me a lot of money,” he said. “It led to one strange and consistent conclusion, which was Canada.”
With files from reporter Boyd Erman in Toronto