I first read an article about Canada’s housing bubble back in late 2009, during my former life as a tracker of investment newsletter performance at The Hulbert Financial Digest.

While perusing a kitchen-table publication called The Contrarian’s View, whose candid editor once cautioned that he’s a rotten stockpicker, I encountered an excerpt from an article that had originally been published on a popular blog called Mish’s Global Economic Trend Analysis.

At that time, we were all still reeling from the collapse of the U.S. housing market and eager to extrapolate that experience to high-flying housing markets in other countries. Misery loves company, after all.

Anyway, the aforementioned excerpt showed a listing for a modest mid-century fixer-upper in Vancouver that was listed for C$1.05 million, or around US$997,000 at the time.

Source: REALTOR.ca

The sad-looking house in this ad, which noted “house is livable” and that the basement had been subdivided into three bedrooms, was all too reminiscent of what had happened in the U.S. just three years earlier, when similarly sad-looking houses in need of TLC were being listed for upwards of $500,000 in the less-fashionable areas of the D.C. suburbs (in other words, my milieu).

However, this listing shows that, at the time, the price for such a property in Vancouver was roughly double that of what I had previously considered excessive in the D.C. area. Furthermore, this may have simply been the going rate for the land, itself, since the ad implies the value is in the lot more so than the house.

The blog’s proprietor, Mike “Mish” Shedlock, warned that prices on such properties would eventually crash 75% or more. And based on this listing alone, I was ready to believe that the implosion was imminent.

But here we are more than seven years later, and the debate between those warning of a hard landing in Canada’s real estate market and those hoping for a soft landing continues.

Meanwhile, the price of Canadian real estate has continued to rise, even as policymakers have made significant efforts to dampen demand.

The average single-family home now costs C$1.5 million in Vancouver, while the average home price in Toronto is nearly C$917,000. And those are just the averages across the metro areas. In the actual cities, prices are significantly higher.

The First Cracks?

However, Canada’s housing market may have just had its New Century Financial moment. At least, that’s what the cynics are saying.  

For those who don’t remember, New Century was the first major U.S. subprime lender to blow up during the period leading up to the Global Financial Crisis.

As borrowers began to default on their New Century-originated mortgages in late 2006, the mortgage lender’s own sources of capital began to dry up, culminating in the firm’s death spiral during the spring of 2007.

But the situation in Canada is markedly different. Indeed, it’s almost stereotypically Canadian because so far it does not actually involve borrowers defaulting on their loans, but rather a breach of regulatory decorum, albeit a serious one at that.

The company in question, Home Capital Group Inc. (TSX: HCG, OTC: HMCBF), is one of Canada’s largest alternative lenders and is known colloquially among mortgage brokers as “the lender of last resort.” Borrowers in the alternative mortgage category are typically self-employed, new immigrants, or small business owners. These are the riskier credits that the country’s Big Six won’t touch.

Home Capital’s problems began in early 2015, when the board was tipped off that certain members of the company’s outside broker network had been falsifying borrowers’ income statements.

In response, the firm initiated a six-month investigation that prompted it to terminate its relationship with 45 brokers, as well as fire a handful of employees on its in-house underwriting team.

The company also identified the relatively small subset of mortgages that were originated under questionable circumstances and flagged them for close monitoring. And it made its underwriting process much more stringent.

These steps subsequently led to a substantial decline in lending volume. Instead of immediately disclosing the situation to investors, however, Home Capital’s executives blamed the results for the first quarter of 2015 on seasonal factors.

Only during the following quarter’s earnings call, which occurred after the company completed its internal investigation, did management finally acknowledge the real situation—a lag of about five months. At the time of that revelation, Home Capital’s share price plunged sharply, but then later recovered.

Fast-forward almost two years, and the Ontario Securities Commission decided that the company did not properly fulfill its responsibilities for disclosing the situation to investors. We agree.

With three current and former longtime executives under investigation for temporarily hiding fraudulent mortgage activity, Home Capital’s share price plummeted and was, at one point, down more than 80% over the trailing year.

Most alarming, perhaps, is the fact that Home Capital’s financial straits precipitated a run on the company’s banking operations, with customers having redeemed about C$1.9 billion of high-interest deposits over the past month, reducing the company’s balance to just C$146 million as of Monday, May 9.

With access to capital quickly disappearing, the company was able to secure a crucial C$2 billion emergency line of credit to remain operating, though the loan was obtained on onerous terms (the effective interest rate is 22.5%).

Firmly in survival mode, earlier this week Home Capital announced that it had agreed to sell C$1.5 billion worth of mortgages to an unidentified buyer, an amount that’s equivalent to about 10% of the company’s total mortgage book.

Then came news on Thursday that Home Capital is reportedly looking to divest another C$2 billion of assets, including its commercial mortgage portfolio, consumer-finance business, and possibly another slice of its residential mortgage portfolio.

Although these dramatic moves have given Home Capital crucial liquidity and equally crucial time to restore order to its operations and shore up its financials, they still may not be enough for the company to remain a going concern.

As one analyst put it, the company has essentially acknowledged that its business model is broken. Odds are it will end up selling off the rest of its mortgage book to other lenders.

Crisis of Confidence

Incredibly enough, as of the fourth quarter, the ratio of Home Capital’s non-performing loans to total loans stood at just 0.30%, which is just below the company’s five-year average of 0.31%. By contrast, the same ratio averaged 0.63% across Canada’s Big Six banks.

In other words, thus far, Home Capital’s woes were precipitated by a crisis of confidence, rather than a wave of defaults.

History, as the old saying goes, doesn’t repeat itself, but it often rhymes. With headlines reminiscent of those that appeared prior to the U.S. housing crash, people are apt to panic first and ask questions later.

The details here may be different, but the human reaction could end up being the same nonetheless: a liquidity crisis for one firm rapidly evolves into a contagion.

In the wake of this debacle, one of Home Capital’s primary competitors in the Canadian alternative-lending space, Equitable Group Inc. (TSX: EQB, OTC: EQGPF), has seen its own shares take a dive.

More disturbing is that Equitable’s customers also made a run on the firm’s banking operations, with what management characterized as “elevated but manageable” average daily net deposit outflows of C$75 million during the final week of April, equivalent to about 2.4% of its total deposit base.

To ensure liquidity if it suffers a run of similar magnitude as Home Capital, Equitable secured a C$2 billion loan facility from Canada’s Big Six.

For now, that show of financial-sector strength means this particular mess will likely be contained, even if there’s an elevated possibility of systemic risk.

However, the near-term result is some tightening of credit across the board, which could weigh on real estate prices, since it will drag out deals or cause them to come undone.

Although Home Capital’s mortgage book accounts for just 1% of Canada’s C$1.45 trillion mortgage market, the loss of this lender of last resort could cause a slowdown in real-estate activity at the margins.

Of course, the other concern is that the practice of falsifying borrowers’ income statements is much more widespread in Canada than this episode indicates.

After all, Home Capital may have terminated its relationship with a bunch of shady brokers, but they probably just took their business elsewhere.

The good news is that the types of loans in which Home Capital and Equitable specialize account for just 13% of Canada’s mortgage market.

Still, even if the financial sector and policymakers successfully stem the contagion, this is a situation that bears watching.

Ballooning Debt

Despite the risk of a systemic crisis, Canadian consumers are still managing their debt responsibly. Even so, the country’s consumers are definitely stretched—the ratio of debt-to-disposable income for the average borrower recently hit 169.2%, just above the peak in the U.S. prior to the Global Financial Crisis.

Source: Bloomberg

Credit-card delinquencies are a key metric for keeping tabs on the financial health of consumers. On this score, at least, Canadian borrowers seem to be doing just fine.

Though delinquencies of 90 days or longer recently ticked up to 0.96%, they remain comfortably below the longer-term average, and just 18 basis points worse than the U.S. rate.

Source: Bloomberg

Historically low interest rates are a big factor in this performance. When rates finally go up, Canadians will have a harder time shouldering their debt burdens.

Fortunately, the Bank of Canada is expected to maintain its benchmark overnight rate at 0.50%, at least through the end of the year, if not longer.

Nevertheless, at least one credit rater is starting to sound the alarm—or what passes for sounding the alarm among bond analysts.

On Thursday, Moody’s Investors Service downgraded Canada’s six biggest banks for the first time in four years, citing concerns about consumer debt and a runaway real estate market.

While an across-the-board downgrade is an important wake-up call, Moody’s lowered its ratings by just one notch, which means all six banks remain in the upper half of the investment-grade category.

Still, no amount of nuance is enough to dismiss the fact that risk to Canada’s financial sector is elevated. After all, the country has already been weakened by the energy crash, and the implosion of another asset bubble during this period would be devastating, especially since housing has been a key part of the country’s economic growth engine.

While it’s entirely possible that the country’s policymakers could successfully engineer a soft landing for the real estate sector, human nature inevitably confounds central planners’ best efforts.

Consequently, if you are a risk-averse income investor, you should consider reducing your exposure to the country’s financial sector, or eliminating it altogether.

To help in this exercise, we’ve compiled a table that shows which of the country’s Big Six are most exposed to the housing sector.

Source: Bloomberg, company filings

This exercise revealed that while all have sizable mortgage books, a significant portion of residential mortgages are insured by the government, while loan-to-value ratios are reasonable at this juncture.

Also reassuring is the fact that non-performing loans to total loans remain at relatively low levels.

In reviewing each bank’s financials, we went one step further and also tallied their home equity lines of credit (HELOCs) to get a fuller picture of each bank’s exposure to the housing market.

Source: Bloomberg, company filings

While Income Portfolio holding Toronto-Dominion Bank (TSX: TD, NYSE: TD) has one of the smaller exposures to residential real estate among its peers, residential mortgages plus HELOCs still accounted for a substantial 43.2% of its total loan book.

Here, we should note that the data in these tables don’t include non-Canadian mortgages. Some of the banks do business in the U.S. and internationally, so their full exposure to real estate may be somewhat higher than the numbers in the tables reflect.

Although Canada’s Big Six have faced selling pressure in recent weeks, all remain within shouting distance of their all-time highs. That means it’s not a bad time to consider taking some money off the table.