Bank Of Montreal's Earnings Call May Be Lone Bright Spot On Bleakest Of Horizons

May.29.13 | About: Bank of (BMO)

Canada is currently attempting to pump the brakes in its domestic housing market in the wake of fresh evidence that suggests an impending downturn. Canadian Finance Minister Jim Flaherty has made several attempts to gently deflate the market with macro-prudential measures, which in the absence of external forces may have produced stronger results than previously. The Bank of Canada has maintained a 1% benchmark interest rate in an attempt to stimulate those sectors of the economy that continue to lag behind housing, a policy which may have inadvertently offset the beneficial effects of Flaherty's intervention. Estimates as to just how overvalued Canadian housing is at this point vary, but the consensus is that prices will drop somewhere between 10% and 25% as parity is restored. A report by The Economist was decidedly grimmer, stating that houses were on average 73% overvalued versus rent and 32% against income.

Enter Canadian lenders. The Bank of Montreal (BMO) and others have, in the opinions of many, set an irresponsible precedent by maintaining excessively low mortgage interest rates in the face of macroeconomic patterns that are beginning to bear a striking resemblance to those seen in America before the recent collapse. The continually increasing value of residential properties in Canada, coupled with what appeared to be bargain mortgage rates, inevitably produced a frenzy of home buying and increases in household debt. Consumers tend to believe that the rising value of an asset (house or condominium, in this case) will offset any excess debt taken on in the leveraged purchase of that asset, and this notion encourages purchasers to buy as much house as a lender will allow.

The result of these combined effects is an average loan-to-value (LTV) ratio on mortgaged properties of 45%-60%. A higher LTV ratio represents, in theory, greater risk involved with the loan. Eerily, the median LTV ratio in Canada is currently nearly identical to that seen in the United States immediately prior to the recent housing market collapse, according to Dan Werner in a recent report from Morningstar. Mr. Werner's report also revealed that Canadian lenders have a higher concentration of loans in the 70-90% LTV range than did American lenders prior to the collapse.

These numbers are distressing, but Canadian authorities have certain measures in place that could, theoretically, mitigate some of the risk of a total collapse in housing values. Almost all mortgages in Canada are full recourse, meaning the borrower is on the hook for the full value of the mortgage even in the case of a foreclosure. In theory these laws should lead to more responsible borrowing practices and lower losses for lenders in the case of foreclosures. If the borrower will have to pay their loan regardless, this line of thinking goes, they are less likely to attempt to walk away from their mortgage and/or home, a problem that was the hallmark of the American collapse. The full recourse setup allows lenders (such as BMO) to more easily take action to recoup potential losses on foreclosures, etc. Taken at face value, this policy seems to possess the potential to shield lenders from any major shifts in home prices.

Unfortunately, this policy does not exist in a vacuum. Reports suggest that full-recourse policies have, historically, resulted in a moral hazard problem wherein lenders are more likely to make 'irresponsible' loans into a known asset bubble because their own risk is limited. As was noted by John Carney for CNBC, the Irish Brokers Association, an element of another country with primarily full recourse mortgages, has called for an outright ban on the practice because of this problem. Carney also notes that, in the face of a housing downturn, those who are inseparably linked with their mortgage payments will, if fiscally responsible, cut spending in other sectors, which, paradoxically, leads to a further economic downturn and pushes borrowers closer to a deficiency judgment. A recession would also further restrict lending activities.

BMO is only one of several large lenders in Canada, and compared to RBC (NYSE:RY) and others, holds something of a meager share of the Canadian mortgage market. What BMO lacks in market share, it has made up in cavalier lending policies and rates, having recently raised eyebrows by maintaining a 2.99% rate on its 5 year fixed rate mortgages. In prior operations of the same nature, BMO has scooped a healthy profit, and given the bank's past four earnings reports (all beating expectations), the bank seems to be doing the same in this round of lending.

Analyst expectations for this quarter's EPS (to be released before the open on Wednesday, May 29) have increased 2 cents in the past three months, and the stock climbed .12% in Tuesday's trading. An earnings beat in this report will undoubtedly boost the stock value in the near term, but the long-term prospects of the bank are inextricably linked to the housing market of the country in which it is based and into which it has sunk, the future of which is looking increasingly uncertain. BMO has already begun to reduce its exposure by increasing rates on its 30 year mortgages. However, the bank remains caught in a situation wherein it must either hold its nose and continue to offer low rates on mortgages to remain competitive in the near term and face the potential for a large-scale calamity in the event of the housing bubble 'bursting', or to shield itself from further risk but also face reduced profits by raising rates in the hopes of more capably weathering the storm. Neither option makes the stock particularly appealing as a long-term investment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.