Shrinking Capital Causing Problems for Canada and the U.S.

No matter how deep you may put your head into the sand, subprime troubles are likely to hit you on some level. Now, in Canada, we have the benefit of a healthy economy and strong commodity demand worldwide. Unfortunately, sharing North America with Americans at this time appears to be ruining our little party up here. Regardless how strong our fundamentals, Canada’s domestic success may not be enough to stave off whatever is wrong with the economic giant south of the border.

I don’t have to remind you of the selloffs we experienced recently. Lacking the crystal ball, there are two possible explanations for poor stock market performances. First, we could be at the onset of a bear market. Second, this is only a sharper correction than usual, which could be setting up the stage for the year-end rally. In any event, we better brace ourselves for a bumpy ride.

But why is the market having such a violent reaction to the subprime loans calamity? The problem is that no one really knows how big the trouble is at this point. During the soaring real estate market, American lenders were only too happy to flush their money down the toilet, lending it to people that, in normal circumstances, would never be able to get a mortgage. And of course, the moment the bubble burst, borrowers started defaulting at alarming rates.

If only lenders and borrowers were suffering. Unfortunately, there are always plenty of fools to rush in whatever needs rushing in. The party was also joined by hedge funds and institutional buyers who invested their money into subprime mortgage-backed securities and are now looking for bailout money.

The trouble with banks is that we don’t really know what is held on their books. According to Canadian financial press, exposure of Canadian banks and hedge funds to subprime loans should not be significant. Namely, there is little evidence Canada’s financial institutions were any sort of players in the U.S. subprime market, let alone major ones. Plus, the subprime market in Canada never really developed roots. By the time we started with zero-down, interest-only, and 30-year mortgages, things got really bad in the U.S., resulting more or less in our withdrawal from the game.

Still, the risk to Canadian investors exists in a real way. For starters, spooked banks in Canada and abroad are already making it tougher to borrow money, even for people with good and excellent credit histories.

With shrinking pools of capital comes another problem: Declining economic growth. If the demand for our commodities declines, which is likely if there is not enough money to go around, our stock markets could be hit very hard. And while slower growth usually means interest rates go down, lower corporate earnings also usually translate into lower stock prices. Basically, regardless which side of the equation investors take, there is bound to be a losing side in the near future.