Forecast for Credit Loss Provisions at Canadian Banks - Dundee Securities Analyst

A bearish outlook for 2009 and expectations for a weak fourth quarter has prompted Dundee Securities to downgrade shares of Royal Bank (RY) from “buy” to “sell.”

Analyst John Aiken has increased his forecast for credit loss provisions in the quarter for those banks with material exposure to the U.S., which includes Royal, Toronto-Dominion Bank (TD) and Bank of Montreal (BMO). However, he expects the greatest impact will be felt in the latter part of 2009 as the U.S. recession truly takes hold and bankruptcies spread beyond sectors linked to real estate.

The risk that the Canadian economy could be impacted also forced Mr. Aiken to increase his provision estimates for each of the banks, with expectations that the third quarter will see the largest such increases.

With capital no longer as critical an issue as it was early in 2008, earnings growth concerns appear to be coming into focus. The analyst told clients “it is difficult to see how the Canadian bank valuations will receive any meaningful lift in the near term.”

While capital market revenues and spreads may moderate, Mr. Aiken said looming credit losses will be the next threat to bank valuations and earnings estimates going into 2009.

The traditional end-of-year balance sheet clean-up should therefore see a myriad of write-downs, he predicted, insisting that the banks will not do anything that could bring future earnings into question, given that they are all being valued off of 2009 expectations.

Mr. Aiken estimates that most banks could maintain their capital positions even with charges above C$2-billion, but doesn’t expect to see any (including CIBC) above C$1-billion.

The analyst also downgraded Bank of Nova Scotia from “neutral” to “sell,” and both TD and National Bank from “buy” to “neutral.” He now has no banks rated a “buy.”

Fourth quarter earnings are also expected to be negatively impacted by unprecedented interest rate spreads as banks shy away from lending to each other and make funding very expensive. Declining loan growth that is forecast to be a negative revenue headwind through at least the first half of 2009 and the evaporation of capital markets revenues are also causing pain. Volatility may be good for trading activity, but it is hurting banks’ higher margin advisory business. When the concerns do subside, Mr. Aiken anticipates that trading volumes will fall to levels not seen for several years “as investors hide and lick their wounds and participants disappear.”

And while credit quality is weakening, he does not see a sharp increase in provisions for related losses until later in 2009. He does expect a “plethora” of cost-cutting efforts.

The good news? Mr. Aiken says bank dividends are safe and National [NA/TSX], Royal and Canadian Western Bank [CWB/TSX] should announce fourth quarter increases, although they are not expected to be material.

He added:

With an average dividend yield above 5% for the Big Six, any increases would not have any real impact on valuations.