Canada has long been regarded as America's friendly, yet somewhat antiquated neighbor to the north. With a few exceptions (most notably, a continued dominance in Olympic hockey), Canada can often be found predictably lagging the American pace of development by a couple of years. And unfortunately, the American housing bubble may prove to be yet another example of Canada following America's lead.

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For all the recent bravado claiming that Canada's supposedly boring yet prudent financial regulations have steered it permanently clear of housing bubble territory, the simple truth is that key causes of the U.S. housing bubble have been sufficiently replicated in Canada.

CMHC: Fannie and Freddie's Canadian Cousin
For example, while it is technically true that Canada does not have its own publicly-traded GSEs such as Fannie Mae (NYSE: FNM) and Freddie Mac (NYSE: FRE) to artificially inflate its housing market, it has the next best thing. The Canadian Mortgage and Housing Corporation (CMHC) is Canada's national housing agency used to provide mortgage insurance, which is fully integrated by the federal government.

Created in 1946 to address the housing needs of Canadian soldiers returning home from World War II, CMHC has long since outgrown its well-intentioned roots. These days, CMHC provides mortgage insurance on residential mortgages with less than 20% down-payments. This practice of course began in order to facilitate the emotionally appealing, yet economically unsustainable, goal of getting banks to lend to risky borrowers who would otherwise be unable to buy houses.

CMHC then securitizes all these Canadian subprime loans into MBSs that, unlike those of its southern counterparts, are fully guaranteed by the Canadian government, ensuring that Canadian taxpayers, and not MBS investors, will ultimately foot the bill in the event of default. After all, it's the polite thing to do.

(Uh) Oh, Canada!
Since 2007, when the first effects of the credit crunch began to be felt, the Canadian government postponed the housing bubble's burst by dramatically loosening lending standards, allowing CMHC to insure mortgages with 40-year amortizations and 0% down-payments for the first time in history.

This of course flooded the market with new, high-risk borrowers, propping up already historically high prices with unsustainable, artificial demand. From 2007 to early 2009, the total dollar value of CMHC's outstanding MBSs grew from $138 billion to $265 billion, an increase of 92%. During this same time, the total mortgage credit outstanding on the collective books of Canadian banks increased by only 1% to $447 billion.

In other words, all the market demand that has been propping up Canadian house prices can be attributed to Canada's version of subprime loans that the free market was not willing to bear the risk of. As a (predictable) result of these and other market distortions, such as record-low interest rates and tax credits available to homeowners, housing prices in many Canadian cities are now some of the most severely unaffordable in the developed world. But as interest rates have begun their inevitable rise and CMHC's lending standards have been brought down out of the stratosphere, the end is near for the Canadian housing bubble.

REIT Place, Wrong Time
So, how can individual investors best-position themselves in the face of this potential upcoming housing bust - aside from not buying Canadian real estate, of course? This is where it gets a little different from the U.S. story.

Since CMHC is directly owned and operated by the Canadian government, there is no opportunity to short-sell CMHC or bet against it in the same way John Paulson profited immensely by betting on the demise of Fannie Mae and Freddie Mac. And since CMHC's toxic MBSs are guaranteed by Canadian taxpayers and are not on the books of Canadian banks, short-selling the banks or MBS investors is a dead-end as well.

For the typical individual investor, the best opportunities are probably to be found in short-selling Canadian REITs. Some of the likely candidates for research are Boardwalk REIT (TSX: C.BEI.U), Calloway REIT (TSX: C.CWT.U) and Northern Property REIT (TSX: C.NPR.U). All of these REITs have significant exposure to residential real estate and suffered price declines during 2008's calamitous credit crunch, but have since recovered.

The Bottom Line
Despite claims that Canada's boring but prudent financial system has somehow prevented the negative effects of its housing bubble from coming to bear, the reality is that the day of reckoning has only been postponed, not prevented. Canadian banks may indeed be some of the safest in the world, but that is arguably largely because CMHC is holding all the toxic Canadian subprime mortgages for them. Canada's residential housing market is anything but a safe place to be at the moment, and for aggressive investors presents an opportunity for betting against select REITs.

But these are not exactly the same types of low-hanging fruit that existed in the U.S. prior to the American housing bubble's burst, and so the best course of action may be just to watch the house of cards fall down from the (rented) sidelines. After all, as Warren Buffett has famously advised, "You only have to do a very few things right in your life so long as you don't do too many things wrong." For investors considering buying Canadian residential real estate at the moment, this could very well be one of those wrongs you absolutely need to avoid. (Looking for an income security that rivals small-cap stocks? It may be time to learn about real estate investment trusts. For more information, refer to What Are REITs?)

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