There's been some interesting discussion recently on whether the Canadian banks make better investments than the US banks. Maple Markets recently authored a good piece on the subject and Alex Rasmussen also did a favorable piece on Bank of Nova Scotia (BNS) and Toronto-Dominion (TD). Most investors bullish on Canadian banks cite attractive performance metrics, stringent lending standards, stronger balance sheets, and the higher dividend yields that can be found by holding the Canadian banks, as opposed to the American banks.
Conversely, there are a host of people that believe that there is a housing bubble in major cities like Toronto and Vancouver. Both cities have been routinely experiencing 5% - 10% price increases year-over-year. Toronto's now booming high-rise market, makes New York's market seem meager in comparison. It has been christened as the most expensive city in Canada, by more than a few sources. It has competition from Vancouver in that category, which has been proclaimed as the most expensive city in North America, by many economists. It begs the question of whether it's all a bubble, and whether the Canadian banks might make poor investments right now as a result.
A few bears are predicting an outright collapse in the Canadian real estate market - similar to the US collapse over the past few years. It's simple to see the case for this. You can see the housing price spikes in context at CanadaBubble.com, which shows real housing costs (as opposed to nominal costs) rising 25% in Toronto over the past decade, and almost 50% in Vancouver. Even vastly more affordable Ottawa has seen an 18% increase in real housing costs over the past decade, according to the website. We can see similarities between the unsustainable spike in US housing prices in the 00's and the current spike in Canadian housing.
Bulls might counter this analysis by suggesting that housing prices in Canada have increased at a much more steady rate than the US's housing market during the bubble (most major housing indices support this argument), and that tighter lending standards and stronger balance sheets help protect the Canadian banks more. As a result, Canadian banks don't make nearly as many sub-prime loans, and it's less likely that there would be a wave of defaults, as we've seen in the US.
A Bearish Thesis
In reality, however, the bearish case for Canadian real estate might have less to do with the prudence of Canadian banks, and more to do with China's bubbling economy. As China has directed more and more resources to real estate development and infrastructure, it has had to import a massive amount of natural resources, including metals.
Resource-heavy economies such as Canada (EWC) and Australia (EWA) have been huge beneficiaries as a result. While the US was suffering from a real estate market collapse, Canada and Australia have cruised along, relatively unscathed from the aftermath. Suddenly, it seems that America's cousins have economies that are more tied to China than the United States - a development that might have seemed odd a mere three decades ago. Now that China's boom seems to be on shaky ground, suddenly the Canadian and Australian economies are more vulnerable.
Likewise there's been no shortage of international investors flocking into the Canadian and Australian real estate markets. Vancouver has been the recipient of large swaths of Chinese money flowing into the sector. It's become a burden for many local business owners, who now have to deal with skyrocketing real estate costs that make them less competitive. It's easy to forget that high real estate costs, even more so than oil, are capable of stunting real economic growth.
Meanwhile, if overseas capital were to suddenly dry up, there's a reasonable probability that real estate prices will begin to fall to more sustainable levels, and mortgage activity will slow down considerably as a result. This could put a squeeze on Canadian banks that are dependent on residential mortgage lending in Canada.
It's worthwhile to note that even if the booms were limited to Vancouver and Toronto (and there's considerable evidence that this is not the case), those two metropolitan areas account for 22% of the Canadian population, and probably an even greater proportion of Canadian wealth. So even if the problems were "localized", they aren't, so to speak.
The Middle Ground
I'm more in the bearish camp on the Canadian banks, but I do think investors should be cautious not to make the mistake of analyzing things through the lens of the last crisis. And the last crisis was the American housing market collapse. This has made some bears more bearish than they should be, and some bulls more likely to disregard the possibility of a Canadian housing downturn, given a different lending environment in Canada.
I think there's a significant possibility of a Canadian housing downturn, but that it will be nowhere near as extreme as the recent American downturn. The major Canadian banks have strong balance sheets and probably face insignificant insolvency risks. Rather, there's potential for some of the Canadian banks to get hit on the income statement front instead.
Given the large dividend streams the Canadian banks pay out, and the high payout ratios, a lower-volume mortgage market could hit the stock prices of Canadian banks more than bullish investors might believe - even while not threatening the long-term position of the banks like the more bearish investors believe.
Meanwhile, US housing prices in many cities like Atlanta, Dallas, Charlotte, Orlando, and Phoenix are at such depressed levels, I see risks over the next five years being much less significant for US banks. In spite of this, the US banks trade at significant discounts to their Canadian peers, both in terms of Price-to-Book and Price-to-Earnings multiples. For these reasons, I view the US banks as being more attractive than their Canadian peers right now.
The US Crash and Declining Mortgage Volume
While mortgage delinquencies have been a huge issue in the US financial system over the past few years, the oft-missed issue (and probably the large issuer, in truth) is the declining volume of mortgage loans for most of the US banks. Before the crash, many US banks were acquiring other banks every year, and boosting loan income, and economies of scale via that route. Once the crash happened, some of the banks struggled with the declining volume of loans, which then reversed the entire process.
Though I did say we shouldn't extrapolate the issues of the US housing market onto Canada, it's still useful to see how the US housing crash has affected mortgage volume. The chart below examines a sampling of 5 regional banks that, to my knowledge, have not had many acquisitions since the downturn. As you can see, mortgage activity has plummeted for all five banks.
click to enlarge images
Synovus (SNV) and Regions (RF) have seen their lending activity drop in half since the 2007 peak. This reinforces the idea that the bigger problem for the US banks is loan volume, not delinquencies. And the question is, whether these banks can start to grow again once things bottom out,or whether this is a structural change in the US banking system.
Even the healthier Pacific Continental (PCBK), a favorite of mine, and Huntington Bankshares (HBAN) have seen loan volume drop off by about 25% since the peak. If these banks can suffer such a drop, it's at least possible that the Canadian mortgage market could slow down and experience a 5% - 20% drop over the next few years, as well.
How the Canadian Banks Can Get Hit
As alluded to above, the real risk for the Canadian banks is probably not on the balance sheet side. It's on the income statement side. On that front, it wouldn't take much a slowdown in the residential mortgage market to hit some of the more exposed Canadian banks.
There are five major Canadian banks that US investors can buy into on the US exchanges. The two big kahunas are Royal Bank of Canada (RY) and Toronto Dominion Bank . If you're an American, you probably know the latter as "TD Bank" and you might recognize the former as "RBC". The other three large Canadian banks are the Bank of Nova Scotia , Bank of Montreal (BMO), and Canadian Imperial Bank of Commerce (CM).
While I will delve into this issue further in a future article, for now, I will simply say that I view Toronto Dominion and Bank of Montreal as the least exposed to the Canadian residential mortgage market. Canadian Imperial Bank of Commerce is the most exposed of the bunch. For that reason, let's take a look at a simple income statement model that exemplifies how a mortgage market slowdown could hit CM.
Let's make this as simple as possible. The goal here isn't precision, as we will never find that. Rather, it's to understand how housing market dynamics could affect the income statement. Below, you can see a very simplified version of Canadian Imperial's income statement.
Now, we can take a look at how small hits to loan income can make a significant dent in the income statement
Note that Canadian Imperial's bottom line declines 24% if loan income declines by 10%; it falls by 37% if loan income declines 20%. This alone could make the small trailing P/E multiple of 9.5 rise all the way up to 14.9. While this doesn't sound too devastating in and of itself, it's important to remember that we're only considering the hit to loan income, and not delinquencies. Nor I am factoring in hits to other income, such as underwriting fees (a big source of profits), commissions, and income from securitized assets. In other words, it wouldn't be shocking if a Canadian real estate market downturn chopped into CM's earnings by 30% to 50% at one point, before a recovery took hold.
Of course, it's still worthwhile to look at the upside here. A P/E ratio of 9.5 is not astronomically high. In fact, it's quite low, suggesting that investors are a bit skeptical themselves. If a real estate downturn ends up being minor, or even if things stay relatively flat for a few years, before improving, then Canadian Imperial Bank of Commerce can look quite attractive, particularly with its handsome 5.1% dividend.
My objection, however, is that the risks with Canadian Imperial Bank of Commerce are more than they seem, and the risks with many of the US banks are lower than they appear. All the while, the US banks trade at major discounts to a bank like Canadian Imperial.
While I am in no way forecasting a Canadian housing downturn, I do at least see the risks as being higher on the Canadian side of the border, versus the already beaten-down US front. Even if a grand Canadian housing market crash is unlikely, a significant slowdown could nevertheless hit the income statements of some of the more exposed Canadian banks. This will hit the bottom line, potentially cause dividend cuts, and could trigger a sell-off.
Toronto Dominion and Bank of Montreal are probably the least exposed to Canadian residential mortgages, and may offer better value for investors who want to invest in Canadian banks, but have still have some fears about the real estate market. TD Bank's presence in the American market, coupled with its rapid deposit growth, are also factors that might help insulate it better than its peers.
Overall, however, I would view the US banks as being better investments right now. Coming off a real estate bear market, the downside risks to the US banks are lower over the next half-decade. Meanwhile, most of the major banks have the highest capital ratios they've seen in years, making them less vulnerable to major problems, and even regulatory concerns. Even if the Canadian real estate market is able to find its ground, without a significant slowdown, the US banks are much more attractively priced, and offer much better tradeoff between risk and reward.
In my next articles, I will examine the exposure of the Canadian banks in more detail, as well as compare them on a risk / reward basis to the major US banks.