Scale Your Mortgage Fund In 2024 - A Series - Part 6

Today, I'm going to start with a conspiracy theory. Not the tinfoil hat, Bigfoot exists kind of conspiracy, but an actual theory about multiple parties conspiring on something. I promise this has to do with private mortgage funds, just bear with me.

In 2022 the market was flush with cash. The pandemic precipitated a massive printing of dollars, money was practically free, and asset prices were going through the roof. The intended outcome was that government policy would save Canada from falling into a recession and consumer spending would keep things moving nicely. The unintended consequences, however, were that the wealthy (who already had the means) started to pickup more assets (stocks, real estate, businesses, debt portfolios) while the average citizen paid off the debt they were living on, bought vacations and steak dinners, and filled their Amazon carts with useless trinkets and toys.

Then things got expensive.

Remember in the summer of 2020 when Tiff Macklem, Governor of the Bank of Canada, said "interest rates are very low and they're going to be there for a long time"?

Theory 1 They were never going to stay low for a long time. The BoC needed people to keep spending, but it couldn't risk having the Big 5 banks (or CMHC) bear the longer-term interest rate burden. It could be detrimental to carry so many 2.5% 5yr mortgages. So in a not-so-subtle way, the messaging to take on more debt also came with the implication that it should be variable debt.

Ensuring that a large share of new mortgages were variable meant they were more attractive to the banks and investors buying Canadian RMBS pools (government-run Residential Mortgage Backed Securities that effectively fund Canada's housing market). The interest rate risk stayed with the borrower, not the lender.

Remember how the wealthy were buying assets? That also included buying shares in private mortgage funds. MICs saw a massive influx of investor dollars and cheap bank facilities enter the space at the beginning of the pandemic. Anecdotally, my average MIC client saw their AUM increase by at least 40% from 2020 to 2022. And every one of those dollars went out.

"You couldn't put money out fast enough" said one of my clients. "House prices are increasing, more money keeps pouring in, demand is at an all-time high, why not make it easier? Let's loosen our credit criteria..."

Theory 2 Private capital's share of the pie was always intended to grow. Too much of Canada's debt is in housing, and too much of that housing debt is federally guaranteed or overseen. To fix this, the banks had to de-risk. Tighten the credit buckets (B20 since 2017), offload the lowest 20-25% of your book down the credit curve, jack rates up so fewer folks qualify going forward.

As a result, B, B-, and C lenders saw the largest single-year increases in volume, probably ever.

So Canadians have been encouraged to take on more debt. That debt has been taken off the balance sheets of the banks and CMHC, and shifted to private capital. Rates have "normalized" to stifle the inflation caused by the excess cash and low rates the government originally started with in 2020.

One would think that we'd hit an equilibrium at that point. However, the sudden increase in rates typically isn't fully felt for ~18 months. Starting at the first increase in Mar 2022, that puts us at around Sep 2024 when we should start feeling the impact of those rate hikes.

But life has been insanely expensive since 2021. Consumer spending already slowed in 2022 and has continued to slow ever since. People aren't spending money on frivolous gadgets, they're spending handsomely on groceries, gas, and every other essential good whose price has skyrocketed due to carbon taxes.

Theory 3 Inflation is whatever the BoC wants it to be. If we strip away the high cost of housing (which is directly because of higher interest rates and unbridled immigration), we have inflation that now sits around the bank's arbitrary 2% target. So why aren't rates coming back down? Because the BoC is tracking the wrong parts of the consumer price index, and I would argue it's on purpose. The BoC doesn't want rates to come back down.

"Why not make it easier? Let's loosen our credit criteria..." Remember that MIC? Well they did loosen their credit criteria. In fact, most MICs did. And when rates eventually tripled in the span of a couple months, many MICs found themselves sitting on the largest book they'd ever had, unable to move it anywhere.

The client that was underwritten in 2022 at 4.99% entered the MIC with little to no income docs, a 600 beacon score, and 80% LTV. By 2023 their rate was 11.99%, house prices dropped such that they were now 102% LTV and more thorough underwriting showed their income was likely insufficient from the beginning. Quite the pickle.

So that private capital now had investors expecting higher yields, a book that was illiquid, and clients who likely couldn't afford a 3x hike in monthly payments. Can you imagine if people started losing their jobs, too? Ugly jobs numbers would be horrible for confidence in the non-bank lending space. Thank goodness we've always had strong jobs numbers - jobs numbers that are actually so good they warrant these higher rates, according to the Bank of Canada. Which leads us to Theory 4.

Theory 4 Jobs numbers are actually garbage, and have been for some time. Most data models and macroeconomic decisions are based on aggregate jobs numbers. Jobs created - jobs lost = aggregate jobs numbers. But have you been tracking jobs numbers for the last year? Most of the job losses are full-time in the private sector. Most of the job gains are either part-time or public sector jobs. Federal government jobs, alone, have increased more than 40%. There are provincial, municipal, and non-profit growth numbers above and beyond this.

Canada is in a recession. While it may not be technical, we have had stagnant growth and weak jobs for several years at this point. The only reason many economic numbers are up is because everything is so bloody expensive. High rates, increased carbon tax and other taxes, and booming corporate profits are leading to massive price growth.

Price growth leads to inflation, which triggers further rate pressure, and so on. But in absolute terms, people aren't consuming more. There's no more mania in Pokemon cards or furniture. We're simply paying more money for what we would have already consumed. Inflation, at least in 2024, is almost entirely nominal and not based on any increased demand.

Theory 5 My final rant, I promise. I believe that Canada has fallen into stagflation and there are multiple government agendas converging to make it look like something else. The fact is, we have an underproductive workforce, propped up by weakening public institutions, circulating an ever-decreasing dollar. (Compare CAD to Indian rupee, Aussie dollar, Yen, etc.) To the rest of the world, we are looking like a cheap runt of the litter. However, we find solace in our natural resources, vast amounts of land, and an educated population. We have little more downside potential and plenty of upside potential. Call me naive, but I think any outside investor is eyeing Canada over the next year and a half until the election.

So I understand that by now I sound like this guy above. But I think it's worth talking about. The majority of conversations I've had with MICs, fund managers, hedge funds, PE firms, and regulators have all felt like something along these lines.

There's domestic demand for debt in Canada and what appears to be a blessing from the powers that be to maintain that debt in private markets.

There's foreign interest in Canada as an underdog economy with an established banking system and growth potential in 2024/25

There's a finite amount of housing and a growing population to ensure real security.

The money is coming back into the MIC space, but not like it did in 2022. This time, we're going to see sophisticated macro players that want in and your fund needs to be up to a certain calibre to capitalize on that fact.

In the coming weeks, I'll be speaking about more advanced liquidity options that are coming to market. But let it be known, sophisticated money seeks sophisticated investment. Everything else is simply an arbitrage opportunity.

So going forward, let's practice operational improvement before we ask for more dollars. I promise, those dollars are waiting on the sidelines, begging for someone to stand out. The opportunities in the private mortgage space are only now starting to reveal themselves on a national scale.

For now, if anything above is starting to resonate with you, I'd be honoured if you share it with your network. Then, hit the follow button. Then let's get coffee.