Canadian Banks May Be Risk-Averse, But They're Not Immune

The Canadian banks have been getting a lot of attention lately. Last October, the World Economic Forum rated them the best in the world, ahead of Sweden, Luxembourg and Australia.

Compared with their basket-case brethren in the U.S., they look positively healthy. They never took on excessive mortgage risk, as Canada was never awash with subprime mortgages or securitization of the loans after the fact. Things like "no documentation of income" never flew in Canada, where bankers have always tended to be pretty bankerish, generally demanding 20% down.

The Canadian economy hasn't been prone to economic booms and busts like the U.S.'s. Equities never went up as much in the dot-com heyday, and home prices increased over the last few years, but not like the overheated U.S. markets. Also, Canadians never had the same wealth created (or credit available to them) over the past few years to allow a large number of families to buy second, third and fourth investment properties to the extent that happened in the U.S.

So as the banks around the world have imploded, the six largest Canadian banks: Royal Bank of Canada (RY), Bank of Nova Scotia (BNS), Toronto Dominion Bank (TD), Bank of Montreal (BMO), Canadian Imperial Bank of Commerce (CM), and National Bank of Canada -- have looked like stalwarts.

Most are still reporting earnings, have relatively low exposure to U.S. loans, and are in strong capital positions to expand their market positions globally as others wilt.

So, the question is why haven't these banks' stocks done even better over the last few months. The five U.S.-traded Canadian banks have all lost over half their value in the last year. They've certainly done better than Citigroup (C) and Bank of America (BAC), but that stock performance is only roughly in line or worse than JPMorgan Chase(JPM). Shouldn't these stocks be doing appreciably better, if the banks are that much stronger?

I think the management teams and boards of the Canadian banks should be congratulated for managing their businesses so well, especially when compared to the greed and recklessness that their global competitors were operating under. I believe the market's discounting of the Canadian banks stock prices in the past year is not a reflection of what they've done, but concern over what's ahead.

The biggest concern facing Canadian banks is the future health of the Canadian economy. Although Canada rode the oil and resource boom through last June to low unemployment and a booming dollar (which at its peak was worth C$1.10 for every US $1), and many in Canada assumed that the country was "decoupled" from the problems afflicting the U.S. even as late as last September, we now know that the northern economy is tightly connected to the U.S. and world economies.

In the '80s and '90s, Canada consistently and stubbornly hung on to a higher unemployment rate than the U.S. Canadian workers have been less mobile than their American counterparts, and retraining certain swaths of society has been difficult. In the last major downturn or the early '90s, the spread between Canada and U.S. unemployment grew to over 4%.

What's more, this gap remained at these levels until 1998, when the gap started to close to only about 2% by 2002 and recently closed entirely as the U.S. rate started to tick up before Canada's did.

Quite simply, Canada lags the U.S. when it goes into an economic slowdown and takes longer to come out of it. Despite the resource boom, a large part of Canada's economy remains tied to manufacturing and shipping those goods to the U.S. A weaker Canadian dollar for much of the last decade gave these Canadian manufacturers a big advantage sending goods to the U.S. As the Canadian dollar rose to parity with the U.S. dollar in the last 18 months, that cost advantage went away, but oil, resources and the Canadian economy remained healthy.

Now, six months after Lehman collapsed and the world economy has gone into free fall, the Canadian economy is hurting. In January, the Canadian economy lost 129,000 jobs and saw its unemployment rise 0.6% to 7.2%. That same month, the U.S. economy lost more than 500,000 jobs and saw its unemployment rate climb 0.4% to 7.6%.

The rate of job loss is rising faster in Canada, and remember that Canada is 10% the size of the U.S. Imagine if the U.S. Department of Labor had announced the American economy had dropped 1.3 million jobs in the month of January, and you understand what is going on north of the border.

We know the U.S. unemployment rate is now up to 8.1% through February, but the Canadian government has yet to provide comparative data. You can expect the job losses to continue to pile up over the coming months. If the U.S. finally tops out at 10%-11% unemployment next year, as many economists call for, it is not unreasonable to expect Canada to go back to its 4% spread of 14%-15% unemployment. It is this scenario that worries Canadian bank investors and the banks' potential future losses on credit cards, auto loans and mortgages (both consumer and commercial).

There are silver linings for the Canadian economy and its banks. The Canadian dollar has already dropped to being worth US 80 cents and it could go lower, which helps Canadian manufacturers compete against U.S. companies for jobs. Canadian consumer indebtedness is healthier than in the U.S., which hopefully contributes to continued spending in the domestic economy. The Canadian government has also done little to stimulate the economy and is in a strong fiscal position to do so, if needed.

The Canadian banks are in a strong capital position to weather the coming storm and will certainly use that strength to expand into the U.S. opportunistically at some point in the next three years. But investors might choose to wait on buying these "soundest banks in the world" until they better understand how long and how deep the recession will last in Canada.

Disclosure: At the time of publication, Jackson had no positions in stocks mentioned. Eric Jackson is founder and president of Ironfire Capital and the general partner and investment manager of Ironfire Capital US Fund LP and Ironfire Capital International Fund, Ltd.

Comments

[Chezfrederick:]

Exellent article and perspective. A couple of other points that are worth mentioning:

While Canadian Banks resisted the temptation of high margin but highly risky business, this was in part because of strong oversight and conservatism, but also because of the more conservative compensation for executives and others who were not motivated to embrace risks for personal gains as compared to the prevalent practices in some US Institutions.

The fact that Canadian Banks are listed in the US meant that their stocks we browbeaten down by investors in the US who were spooked by financials and tended to punish all banks as a single class. Globalization has it's merits and it's drawbacks... Conversly, Witness the rise in prices yesterday in unison with US markets when nothing has fundamentally changed in Canada. I can see the headline "Citi's Pandit profit letter boosts RY, TD stock prices"

Finally, Canadian analysts in general, are mediocre, lack talent and credibility and this results in their constantly looking over their shoulders(over the border)before they issue any stock analysis report.

Thanks for you views.

Lastly, I

Mar 11 10:02 AM

[Jesse99:]

I agree with your analysis of relative change in unemployment rates, but the analysis of absolute levels may have less meaning. Different governments measure unemployment differently. As I understand it, Canada includes people who are currently not working but have a commitment from a company to start a new job. Also, the US excludes people who are currently suffering from temporary illness. I don;t know if differences like these make a difference - just a general caution about comparing across regions that use different measurement techniques - same goes for other economic figures too

Mar 11 10:14 AM

[Candor7:]

Mr. Jackson has done a fine piece of work of indicating how Canada is dependent on the USA for its economic well being.

But he did not indicate that the Canadian Bank Deposit Insurance Corp. is well positioned to insure depositers across Canada, unlike the presnt situation involving FDIC here in the USA.

Canada is not printing money as the USA is in order to meet the world shelter demand for the USD, its CD value is not being diluted in the same way.So you can at this time perhaps divide USD and Canadian dollars into categories respectively in terms of unreal vs real value. Eventually that dynamic may or may not have a real effect on the function of our internatioal trade reationship with Canada.

History shows us that in the posst 1929 period, not one Canadian Bank went into receivership, nor did they seize citizen owned gold as was done in the USA. Altigether Canada represents an excellent shelter and econommic recovery platform from which to invest, due to the fact that there is far less uncertainty in Canada's banking system and the role of its government.

In addition, Canada's Banks have written off all debt related to toxic paper, and have now recapitalized through the issuance of additional preferred shares to the public, almost all of which were subscribed before issuance.Thats a sure sign not only of stability, but of preparation to aid the recovery efforts in Canada , and world wide.


Of course Canada's economy is closely tied to what happens here in the USA, but Canada has a long history of predicting what the US economy will do, and has generally managed to configure itself accordingly to adapt in the best way possible. In other words the Canadian economy is buffered strategically and has been
for a very long time indeed.That is the origin of the conservative banking approach which is so evident in Canada.

Perhaps these comments might give a little more perspective to Mr. Jackson's genuine exposition on the topic.

Mar 11 11:13 AM

[Jim Hawthorne:]

A Very good analysis of what is right about Canadian Banks and the weaknesses of Canadian analysts. Thank you!

While Canada remains dependent on the US economy (and who is not?), Canada has also made strong efforts to de-couple from strict dependence on the US over the last 15 years, with considerable success. The danger is that there has been a 'new' dependency on the Pacific Rim to replace it.

Canadian currency is much more 'resource-industry dependent' than it is dependent upon government programs, policy or manipulation. As go basic materials, so goes the Canadian economy and with it, the Canadian banks. It is a truism that Canada's economy is much less 'Financialized' than that of the US and as such is more independent of the machinations and risks of that sector in the US.

It is also true that while US banks contract and struggle to raise capital, Canadian banks have generally been expanding their global reach and diversification.

Your recommendation to pause until the depth and breadth of the Canadian recession is determined before rushing to invest in Canadian Banks is very timely and reasonable.

Mar 11 12:37 PM

[Uncle Pie:]

Canadian banks enjoy an oligopoly...and can price their services accordingly. Home mortgage interest is not tax deductible in Canada, and there are no GSE-type institutions like Fannie Mae or Freddie Mac, so the house prices did not get as inflated by government subsidies as they did in the US.
Be careful of Scotia Bank, though. They have substantial exposure in Mexico, which some opine may become a "failed state" due to rapid depletion of their oil resources and the ongoing war on drug gangs. This writer reluctantly sold his BNS shares but retains a few shares of Royal Bank and Canadian Western Bank.

Mar 11 01:05 PM

[Chris B:]

Canada will absolutely reflect the US economy. It is ironic that they did everything right in terms of bank regulation, yet will suffer the same or higher unemployment as the US. So much for the concept of deservingness in macroeconomics.

That said, the question remains do you want to own US or Canadian banks right now? To ensure comparability, we should compare commercial banks to commercial banks, excluding investment banks, GE, and post-Glass-Steagal mutants like Citigroup, BAC, and AIG.

In a rebound, will US or Canadian banks move higher? Current valuations are similar, with single-digit PE's common.

The author suggests that the inevitability of a Canadian downturn will drive Canadian banks lower, which implies that this risk is not already priced into the shares. On the flip side, I would suggest that looser bank regulation and accounting rules in the US mean there could be more suprise write-downs.

A second consideration is survival during an even more severe downturn. Who is more likely to go bankrupt if things get really bad? I suspect more US banks would fail.

Mar 11 03:02 PM

[ValueInvestor:]

One other point, the the Canadian Banks haven't been forced to payback and then write-off the ABCP they sold. Most american, and swiss banks were forced to buy back their structured notes at 100%. Since the frozen ABCP debacle is worth $30 billion CAD, even a 25% write-off between all 5 banks would be substantial and force them raise capital.

Mar 11 03:56 PM

[ValueInvestor:]

Does anyone else think the author looks like Owen Wilson?

Mar 11 05:02 PM

[wise:]

Cdn banks learned their lessons over many years, and are by nature conservative. It helps to have a fluent economist as our prime minister.

Mar 11 06:08 PM

[Paulo:]

The worse case scenario (at the moment) is the possibility of a significant decline in the high dividends (but there are those who argue that this is already priced in).

Mar 11 08:06 PM

[samwise:]

Spectacular transportation system in having the Great Lakes/St. Lawerance river to move pretty much any good or resource imaginable throughout the world. As part of NAFTA can ship cheap resources to cheap labor creating highly competitive products. Collapse of Detroit a big deal to Canada--major auto producer. seems to have always had a terribly run central government, too, with consistently inflationary policies--and obviously you have French Canada and potential separatism. USA has a terrible fiscal crisis emerging--but that's because it's trying to do something other than collect taxes and cut checks since coming off its victory in Iraq. Could be a huge problem if USA gets some serious social unrest. On the other hand, social unrest could derail the "Canadian Agenda" at work with Obama so maybe that's good news. Massive amounts of left-over Cold War stocks of armor and ammo with the addition of battle hardened Iraq and Afghan war vets could from Ft. Hood alone make short work of Mexico perhaps calming down some of the American crankiness a bit. From what I've heard all Canada wants to do is get out of Afghanistan, the sooner the better. Don't know what they'd be coming back to, though, in a macro sense. Can't really recall any boom at all along American lines like what the USA has had in the 20's, 50's, 80's and 90's. While might be true, "no bust,"--inflation has always been the most pernicious killer of capital--and having lots of banks does not a healthy economy make per-se--sometimes doing nothing more than being money changing institutions. Has had some horrendous national champions in Nortel and Bombardier (though I do love my Ski-Doo snowmobile.) Bottom line--given historical booms in USA, darn near bottomless pit of liquidity in capital markets-- give USA the benefit of the doubt on this one for now since don't see any added problem of the "Vietnam syndrome" in the USA and indeed maybe the exact opposite. Could change, though, if Americans grab their pitchforks and march on Washington, though. As the vets of Korea said, "when the Chinese crossed the Yalu, it was every man for himself."

Mar 11 11:05 PM

[Aristophanes:]

The same Prime Minister who told voters to buy stocks in September 2008?

The same PM who sounded exactly like John McCain during the 2008 Canadian election?

Yikes. If that's a trained economist, I'll take the Jean Chrétien/Paul Martin duo anytime. If any credit is due, it's to them for sticking to conservative economic fundamentals.


On Mar 11 06:08 PM wise wrote:

> Cdn banks learned their lessons over many years, and are by nature
> conservative. It helps to have a fluent economist as our prime minister.

Mar 12 12:29 AM

[mac.barron:]

On Mar 12 12:29 AM Aristophanes wrote:

> The same Prime Minister who told voters to buy stocks > in September 2008?

He did? Wow, I missed that. What an ass.

Mar 12 02:24 AM

[Moon Kil Woong:]

First, it is obvious that even if FDIC ran out of funds the US will backstop deposits. There would be riots if they backstop banks but not individuals. However, I do commend Canada for its fiscal restraint. It will help when Canada experiences the strong recessionary winds that are going to affect every economy in the world.

It is quite natural that Canadian banks also drop. Not all banks and financial institutions in the US are bad, just the ones down over 75%. I think you know who we are talking about.

It is strange to say, but the US could learn a lot about financial regulation from Canada.

Mar 12 03:02 AM