Seeking Alpha
Deep value, long/short equity, contrarian, hedge fund manager
Profile| Send Message|
( followers)  

Canadian banks with large exposure to Canadian residential mortgages have more significant risks than their U.S. counterparts; making certain Canadian banks unattractive investments for the next few years. Meanwhile, Canadian banks are selling at much higher multiples than their U.S. counterparts, which have been dealing with the fallout of a mortgage crisis for the past several years.

In reality, the depressed American housing market creates a bigger safety net for the U.S. banks moving forward, while the Canadian banks have higher risks, and sell at higher multiples. Due to this, I view a handful of U.S. banks as better investments than their Canadian counterparts. Moreover, some Canadian banks with lower Canadian mortgage exposure might also be worthwhile investments.

This is my second article examining and comparing the Canadian banks with the U.S. banks. In my first article, I outlined my basic thesis is that the Canadian mortgage market was vulnerable, due to too much money pouring into the sector from overseas. This could cause housing prices to fall, and create a slowdown in mortgages, which would hit the major Canadian banks on the income statement.

With this article, I'll focus on the "Big 5" Canadian banks and their varying level of exposure to Canadian residential lending. We'll also take a look at capital ratios, deposit growth, price multiples, and the sustainability of the dividend yields of the Canadian banks.

Residential Mortgage Exposure

First off, if we're working on a thesis that banks with large Canadian residential mortgage exposure might have higher risks, we should figure out which banks have the greatest exposure. We should also define our "Big 5" banks. Essentially, I'm examining the largest 5 Canadian banks that are also traded on the U.S. exchanges: Royal Bank of Canada (NYSE:RY), Toronto Dominion Bank (NYSE:TD), Bank of Montreal (NYSE:BMO), Canadian Imperial Bank of Commerce (NYSE:CM), and Bank of Nova Scotia (NYSE:BNS).

The chart below shows balance sheet exposure to residential mortgages for the "Big 5" Canadian banks. I've highlighted the most important metrics in green.


(Click to enlarge)

From this, we can see that Canadian Imperial Bank of Commerce appears to have the greatest exposure to residential mortgages. While I have not broken this down into Canadian vs. U.S. / international exposure, CM is definitely weighted very heavily towards Canadian mortgages.

Bank of Montreal and Toronto Dominion appear to have the least exposure to residential mortgages. Moreover, TD's exposure is likely more diversified, given its U.S. franchise.

Bank of Nova Scotia has fairly high exposure to Canadian residential mortgages. Perhaps surprisingly, Royal Bank of Canada's exposure is somewhat high, as well, when you consider their broader set of business activities, and more international orientation than some of the others.

While balance sheet exposure is one metric to look at, it's also useful to look at things on the income statement side. After all, my basic thesis here is that the "Big 5" Canadian banks have strong enough balance sheets to absorb any potential delinquencies. The bigger concern is how a slowdown in residential lending activity might affect earnings, and could potential hit the large dividend payouts.

The chart below provides a more income statement-centric examination.

This mostly reaffirms the info from the balance sheet chart, but also suggests that the Canadian banks might be very dependent on Canadian residential lending to bulk up their profits right now. Once again, Canadian Imperial Bank of Commerce shows high exposure, with over 40% of its loan income coming directly from residential mortgages, and almost all of that coming from Canada.

Royal Bank of Canada looks much more exposed using these metrics, with 31% of loan income being derived from residential mortgages. Toronto Dominion and Bank of Montreal, once again, come out looking to be the least exposed. Moreover, it would appear that TD and BMO have been more conservative in their loan loss provisioning than RY and BNS.

Capital Ratios

Next thing to look at are the capital ratios for the "Big 5" Canadian banks. I prefer to focus on Tier 1 capital, as well as Tangible Common Equity [TCE].


(Click to enlarge)

One thing to note here is that the Canadian banks tend to have much lower tangible common equity ratios than their U.S. counterparts (which I'll examine further in future articles). Just as a quick reference point; I calculated an 8.2% TCE / TA for Citi (NYSE:C), a 9.0% ratio for PNC Financial (NYSE:PNC), and a 7.8% ratio for Capital One Financial (NYSE:COF); all significantly higher than the figures you can see here for all the Canadian banks.

Amongst the Canadian banks, all the Big 5 have similar figures. Also note that these figures are based on financial statement info at Jan 1, 2012, so these numbers have probably improved slightly for all five. All five are well-capitalized, but note that RY, CM, and BNS have the lowest TCE ratios; we also noted that they have the highest Canadian residential mortgage exposure of the bunch.

Deposit Growth

I view deposit growth as a very important figure for banks, because being able to attract an inexpensive source of funding is one of the keys to growth. The chart below examines 3- and 5- yr deposit growth for the "Big 5".

You can see that TD has the most impressive track record on this front. TD's 3- and 5-yr annualized growth rates far outpace all the other banks. This is largely due to prudent management at TD, in my view. They've essentially disregarded "bankers' hours" and set up the most customer friendly retail banking system around in the US. They are open 7 days a week, and have late Thursday and Friday hours.

The strategy has worked well and has allowed TD to achieve significant U.S. growth. They've really only hit the Northeast / Mid-Atlantic thus far, and have a lot more room for growth, as well. Due to this, TD would appear to be the most attractive Canadian bank, when it comes to future growth prospects.

Bank of Montreal has also had some success in growing its deposit base. Royal Bank of Canada appears to be struggling the most, and floundered in the U.S. (contrasting itself with TD), eventually selling off its retail banking offices to PNC Financial. Canadian Imperial and Bank of Nova Scotia have achieved moderate growth.

This analysis makes TD look even more attractive compared to the others. It has one of the lowest levels of Canadian residential mortgage exposure, the highest deposit growth rate, and has very adequate capital ratios.

Comparative Analysis

Now that we've taken a look at risk and growth, we can compare the Canadian Banks on price metrics.


(Click to enlarge)

The interesting thing to note here is that TD, which I view as the most fundamentally attractive Canadian bank, actually sells at similar multiples to the other banks. In fact, TD's P/E ratio at 12.2 is a bit lower than RY's at 15.6. RY, TD, and BNS are priced almost at exactly the same levels when it comes to Price to Tangible Common Equity.

Based purely on the analysis in this article, Toronto Dominion and Bank of Montreal appear to be the most attractively priced of the "Big 5" banks. Both have implemented better growth strategies than their peers, and have lower Canadian residential mortgage exposure.

TD has the lowest payout ratio of the bunch, but that makes it's a bit safer, as well. At 64.8%, RY would appear to be the most vulnerable to a dividend cut in the event of a Canadian residential mortgage slowdown.

CM is priced the most conservatively, but given our analysis, that seems justified. However, if one wanted to bet on a continued booming Canadian real estate market, CM would be the best way to play that, given that it has the most significant exposure and the most conservative price multiples.

Conclusions

Overall, from the charts above, we can get a good idea of which Canadian banks are the most vulnerable to a housing downturn, and which ones are priced most attractively. Of the bunch, I would view TD as having the most attractive risk / reward trade-off, followed by BMO. CM is the most exposed in the event of a mortgage downturn, but also the most conservatively priced. RY appears to be the most aggressively priced, particularly when compared to BMO and TD.

If you believe a Canadian residential slowdown is in the works, but you want to invest in a Canadian bank, BMO and RY are the best bets. If you take the opposite position and believe that the Canadian residential market will perform well in the next few years, I'd view CM as your best bet of the five.

In my upcoming articles, I will examine large U.S. banks and show how many of them compare very favorably on a risk / reward basis to the Canadian banks.

Disclosure: Long on TD, C, and PNC. Short on RY, CM, and BNS.

Source: Residential Mortgage Exposure And Risk/Reward For The Canadian Banks