Calomiris vs Johnson

I've been reading Charles Calomiris' book Fragile by Design. Excellent book. Very well researched. Good combination of politics, history, and finance.

The conclusion I draw from it is that it is far better to invest in Canadian banks over the long run than in American banks. This is because the American banking system is too much influenced by populist groups (like ACORN operating under the provisions of the Community Reinvestment Act) that are intent on using American banks merely as a conduit for funneling cheap credit to borrowers who are inherently poor credit risks. To claim that this problem can be solved by greater regulation is nonsense because the degree to which banks are regulated is also determined by politics, and stricter regulation would only thwart the desires of populist groups for cheap credit, so that it will never happen. In other words, populist groups will lobby politicians to reject sound credit underwriting standards because such standards would guarantee that credit was never granted to their low-income constituents.

The Canadian banking system, on the other hand, has been shaped by a government that has managed to resist the influence of populist groups. So, the Canadian banks, while being highly leveraged, are much more stable than American banks over the long run because the former have not diluted their underwriting standards under political pressure in order to funnel credit to inherently uncreditworthy individuals.

All that said, there also seems to be a general consensus (for example, see here and here) that right now there is a significant housing and credit bubble in Canada. Household borrowing is at the same level it was at in the US right before the crash in 2008 and real estate prices are sky high (in particular, in places like Vancouver). Thus, although it is probably true that when this bubble bursts, Canadian banks will come out of it solvent and in far better shape than the US banks came out of 2008, nevertheless the inevitable crash will still have an impact on them.

So, I guess the general investment thesis to be derived from all these considerations is: watch for a bursting of the credit and housing bubble in Canada and for a significant pullback in the price of Canadian bank stocks (for example, RY, TD, BMO, CM), and then invest in Canadian banks.

For a contrary view (the Canadian banking system, composed of a few, very large, highly leveraged banks, is doomed), read the blog post entitled The Canadian Banking Fallacy by Simon Johnson. I think Johnson's arguments are weak in comparison to Calomiris'. For example, Johnson notes that at the beginning of the financial panic in 2008 Canadian banks were much more highly leveraged than American banks, and consequently were much more risky. Well, if that was the case, then why weren't their default rates as high as those experienced by American banks and why didn't more of them fail or require government bailouts?

Johnson wrote the book White House Burning, in which he argues that the reason why Americans weren't able to repulse the Brits in the War of 1812 is because American citizens weren't taxed enough in order for the government to be able to support an army; from this he draws the conclusion that we had better tax ourselves more today (presumably, to forestall another sack of Washington). IMHO, weak. To think, as Mr Johnson apparently does, that the additional revenues raised by increased taxes will be "invested" for the "general welfare" instead of being funneled by bought-and-paid-for politicians to special interest groups (whether ACORN or defense contractors) is sheer naiveté.