Canada's Curious Case

Canada's economy has been the best performing of the G8 nations coming through 2008 with flying colors.

It has been heralded by many in the U.S. business media as being an example for the U.S. to follow. It's common now to hear pundits suggest Americans to seek the safe haven of the Canadian dollar from the risk of the US dollar's debasement. Recently, no less an authority than Bill Gross suggested savvy investors buy Canadian debt as a hedge to what's on offer here in this country.

Canada deserves pats on the back for its ability (and good fortune) to steer itself through the last few years. However, there are some ominous warning signs on the horizon for its economy and it's not entirely clear where it -- or its currency -- is headed next.

First, let's review what Canada's done right.

1. In housing, Canada kept strict oversight of income verification and documentation. You just never could walk in to the equivalent of a Countrywide in Canada and get approved for an obscene amount of money.

2. All mortgage loans in Canada are "full recourse," meaning that the borrower is fully responsible for the mortgage even if he or she defaults. Banks can keep coming after the individuals who took out the loans, long after the property has gone into foreclosure.

3. No tax deductibility of mortgage interest. Although some Canadians complained about this in 2005 when house prices were booming in the U.S. but flat in Canada, this conservatism looks very wise today. What's the point of goosing as asset-class with a tax break, when it contributes to the devastation we've had in America in housing for the last three years?

4. More conservative lending and fewer mortgage brokers. Canadians often like to say they don't/didn't have subprime mortgages in Canada. That's not correct. Subprime mortgages exist, but are far less common than in the U.S.

Part of the reason is that the five Canadian banks are the major way most Canadians originate their mortgages. Only 35% of Canadian mortgages are originated by mortgage brokers, whereas the equivalent number in the U.S. is 70%. Therefore, there were far fewer subprime mortgages made available in Canada over the last decade - another conservative point for the housing economy.

6. Canada's debt to GDP is still very low. Because of not needing to bail out its economy to the same extent as other countries, Canada is still doing well from a debt-to-GDP perspective. The IMF recently estimated its ratio was at 77%, compared to 98% for the US, 121% for Italy, and 227% for Japan.

7. Canada is blessed with a lot of commodities. Think of Canada as being part of the lucky sperm club. Some countries were born with lots of commodities that are needed in the world today while others weren't. Energy and mining resources will allow Canada to be a seller to the world of critical commodities for years to come.

8. The country just lowered its corporate tax rate to 16.5% -- far below the U.S. -- which will help attract new businesses who like its educated workforce.

Now, what are the problems with Canada which have gone unnoticed by many to this point?

1. Canadians now have a higher household debt-to-income ratio than Americans. It seems inconceivable that Canadians would have not learned a lesson from the U.S. misfortune over the past few years, yet it seems to be the case. Canadians now owe 148% of their annual income on average.

What's more, the pace of borrowing has dramatically increased over the past three years even as incomes have been stagnant. If we've learned anything over the last decade is that debt growth cannot persist forever without income growth. A day of reckoning comes and it appears it is near for Canada.

2. Canada's central banker has made ominous warnings to Canadians about their debt levels, which have so far gone unheeded. I attended a conference last Fall at which Neel Kashkari, former Treasury staffer and TARP overseer, answered a question about why his old boss, Hank Paulson, hadn't made more warnings about the looming threat of subprime.

Kashkari said part of government officials' roles is to be positive, even when they see the problems ahead. He and Paulson worried that the markets would be spooked if they had discussed the threats as they truly saw them, so they instead decided to cheerlead the economy while preparing the "break-the-glass" emergency plan in private.

Canada's Ben Bernanke, Mark Carney, is taking a different tack. He's been sounding the alarm about Canada's household debt problems since he went on CNBC in September. If he is speaking out as strongly and as frequently about this, the reality is that the hidden problems are likely much worse than what is recognized.

3. Consumer spending has hit a wall. Since last summer, when new mortgage restrictions were implemented and new taxes imposed in Canada's two largest provinces, consumer spending is way down despite a seemingly healthy economy.

The biggest part of Canadians' debt loads are from their mortgages. Now that they're not buying homes at a frenzied pace, the "housing multiplier effect" on the rest of the Canadian economy is working in reverse. And there is not the same new credit forthcoming to consumers as before. Consumer bankruptcies are at new highs and the interest rate rise hasn't really started yet.

4. The increased strength of commodities has killed Canadian manufacturing. Because traders on the global forex markets keep bidding up the Canadian and Aussie dollars relative to the U.S. dollar every time there's another move up in the price of commodities, the Canadian dollar is now worth more than the greenback.

Ten years ago, the Canadian dollar was worth 30% less. But this move has killed Canadian manufacturers whose biggest trading partner is the U.S. Their goods are no longer as competitive (although the Canadian government picking up health care costs helps).

Banks don't want to slow down consumer lending. TD Bank's ( TD) CEO, Ed Clark, recently gave an interview in which he chastised Mark Carney for warning about the problem of Canadians' increased debt.

5. In a recent interview, Clark said, "No bank wants to be the first to impose stricter requirements on borrowers out of fear that it will suffer a major loss of customers to rivals. Personal banking "is a highly competitive industry."

"If we said 'Look, we're going to be heroes and save Canada from itself, and we'll impose a whole new mortgage regime on everyone else,' the other four large banks would say 'Let's carve them up.' "

When I read this, I thought of Chuck Prince's -- ex- Citigroup ( C) CEO -- quote from 2007 about leveraged buyout lending: "As long as the music is playing, you've got to get up and dance. We're still dancing." We'll see if the Canadian banks can dance more deftly than Citi.

So, on the one hand, Canada is a country with a relatively clean balance sheet, rich with resources that are only likely to go up along with its dollar. Yet, that scenario would make its manufacturers even less competitive and would require an increase of interest rates that would further weaken its real estate sector and consumer spending.

Mark Carney sees this debt problem as his subprime which Greenspan and Bernanke both failed to see. He will try to balance keeping rates low while tamping down growth in the Canadian dollar. It will be a very delicate balance.

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At the time of publication, Jackson did not hold positions in any stocks mentioned.

Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd. You can follow Jackson on Twitter at www.twitter.com/ericjackson or @ericjackson

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