The Case For A Short Position On Canadian Banks: Laurentian Bank And CIBC

 |  Includes: CM, LRCDF
by: Grahamite In Training

The Canadian economy has been praised as being one of the most resilient during the financial crisis that has been hitting the world economy since 2007. While sharing the same characteristic booming real estate as the US economy during the last years of the past decade, the Canadian economy has not seen any sign of a slowdown. Data obtained from the Teranet-National Bank House Price index show that even following a mild slowdown in 2009, the value of Canadian homes has been steadily increasing to ever increasing heights.

Teranet National Bank House Price IndexClick to enlarge

This increase in the value of home is mostly visible in the historical spread of 200 basis points between the 3 year mortgage rate and the 5 year mortgage rate that has been a good proxy of the confidence of the banking lenders.

The following table, obtained from statistics Canada shows how conventional mortgage rates of different terms have evolved over the past four decades. They are currently sitting at their lowest point during that period.

Statistics Cadana - Chartered Bank Conventional MortgageClick to enlarge

Keeping decreasing interest rates over such an extended period has allowed Canadian borrowers wanting to become homeowners to be able to afford this luxury. In fact this has allowed the Canadian housing market to absorb over 10,000 homes monthly.

Canadian Monthly Home Sales - Seasonally adjustedClick to enlarge

After the 2007 mortgage shellacking, the U.S. Population has been steadily deleveraging. Meanwhile in Canada, the total personal indebtedness has been increasing with a vengeance since the 2008 economic crisis. Rising home prices is the main factor behind it. Since 1969, on a seasonally adjusted basis, total mortgage balances in Canada have gone from $16 billion to an incredible $1,155 billion at the end of 2012.

Canadian Total Outstanding Mortgage BalancesClick to enlarge

Bringing this information a little closer to the average Canadian, one more metric will tell the story in more details. Taking the average nationwide mortgage balance to income ratio, it is visible that this telling statistic went from roughly 30% in the mid 1980s to 80% at the end of 2012. Thankfully for Canadian households, interest rates have been going steadily down to compensate for that increase in personal leverage.

Canadian Nationwide Mortgage Balance to Income RatioClick to enlarge

This is the reason why I think that Canadian banks are dangerously exposed to a potential reversal in this trend that has been in place for the past 40 years. There are currently 8 banks that are publicly traded on the stock market. Going from the least fragile to the most fragile as of December 2012, we find the Canadian Western Bank, the Bank of Montreal (NYSE:BMO), TD Bank (NYSE:TD), Bank of Nova Scotia (NYSE:BNS), the Royal Bank of Canada (NYSE:RY), the National Bank of Canada, the Canadian Imperial Bank of Commerce (NYSE:CM) and finally, the Laurentian Bank of Canada as the least safe. Looking at the evolution of the financials of the most important publicly traded banks in Canada, it is obvious that some are acting very recklessly. Two of the publicly traded Canadian banks have been growing their mortgage portfolios at a higher rate than the competition. This is currently a good think for the shareholders of those banks who seem to be enjoying great returns at a low incremental risk but the reality will prove to be more complex than their financial statements currently imply.

Canadian Banks Total Equity to Mortgage Portfolio RatioClick to enlarge

As of 2012, comparing the ratio of all equity to their mortgage portfolio as disclosed in their most recent annual financial statements, the Canadian banks that seem to be well prepared in case of a reversal in the Canadian real estate market are Bank of Montreal and the Canadian Western Bank at 20% and 16% respectively. This is in sharp contrast to the Laurentian Bank and the Canadian Imperial Bank of Commerce that are faring not so well at 7% and 9% respectively.

Once again, we can also compare Canadian banks by another significant metric, the ratio of loans portfolio to total assets. The story here tells that here again, the Laurentian Bank and the Canadian Imperial Bank of Commerce have been relying more and more on consumer debt and real estate mortgages to grow their business. The most fragile banks are pretty easy to identify.

Canadian Banks Total Loans Portfolio to Total Assets RatioClick to enlarge

The current interest rate environment has been fueling the rise in home prices for quite a while but it is obvious that things are about of change. For the past two years, Bank of Canada governor Mark Carney has been warning Canadians that the current low interest rates are not an excuse to binge on easy money.

In a hypothetical case, let's see how a household that recently purchased a $200,000 condo would be affected. They were able to lock in a favourable 3.2% fixed mortgage with a 5 year term at the end of 2012. The monthly payment on this mortgage stands roughly at $960 on a 25 amortization period.

At the end of their typical 5 year term, the remaining balance on the mortgage would be around $170,000. Let's assume now that the spread between the 3 and 5 year mortgage disappears as in any time of interest rate rise during the past 40 years. With the 5 year interest rate now at the 2008 level of 7.1%, we get to a monthly payment of $1,200, a 25% increase in the monthly payment. This is not a significant increase for most households but it will have a major impact on buyers who entered into a mortgage at the top of the market.

If Canadian home sales start to stagnate, or even worse, go down, these two banks might experience dramatic losses. This will provide a great opportunity for investors who are willing to position themselves short against the Laurentian Bank and CIBC.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in OTCPK:LRCDF, CM over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.