The Canadian government is determined to slow down its housing market, even at the expense of cooling down its economic growth. The country has introduced new stringent rules in this regard to discourage mortgage originations, make refinancing tougher, which will inevitably result in falling home prices and increased defaults. We believe that the market is ultimately going to slow down, affecting Canadian banks' income from originations and refinancing. Across the border in the U.S., the situation is a little different. Despite the weakening economic data coming out from the U.S., its housing markets are showing signs of recovery. We therefore are bullish on U.S. banks that have large exposures to non-interest income from mortgages, particularly Well's Fargo (WFC). At the same time, we are bearish on Canadian banks with large exposure to residential mortgages, particularly the Canadian Imperial Bank of Commerce (CM) and Royal Bank of Canada (RY). The remainder of the thesis presents an actionable trading strategy along with reasons to support our recommendations.
Canadian Housing Boom
As previously reported in our July 2, 2012 report on "The Way To Play Canadian Housing Market Bust", the Canadian government is busy in aggressively taking steps to curtail the rapid pace of the Canadian housing market, in an attempt to avoid its consequent eruption. Home prices that have sky rocketed, cheap credit, lack of inventory and a stable Canadian economy are attributed to this boom in the Canadian housing market. Except for a dip in 2008, Canadian home prices have appreciated in value by about 85% over the past decade. 5-year mortgage rates, as illustrated by the graph, have reached 5.34%. To cool down some runaway price appreciation in the country, the government has taken some steps by reducing maximum amortization, decreasing borrowing amount and limiting government back insurance to homes with less than C$1mn. These steps would leave a fewer number of clients eligible for mortgage originations or refinancing.
Bottom In U.S Housing
Helped by continuous low mortgage rates (30-year mortgage rate at 3.62%), the U.S. housing market is seeing a recovery since the 2008 meltdown. The popular home price index, Case-Shiller Home Price Index National, is at a current level of 127.32, up by 110bps from the last quarter. The Mortgage Bankers Association (MBA) has forecasted an increase of 2.5% QoQ for total industry originations volumes to reach $372b in 2Q2012. These improvements are seen even when the U.S. jobs data shows disappointing results.
To play the American housing recovery and the expected Canadian housing bubble burst, we advise investors to long American banks and take short positions on Canadian banks' ADRs. In the event of a Canadian housing market slow down, Canadian banks that have tilted their holdings towards mortgages will be the ones most affected. Their income from mortgages originations and gain on sale margins will be negatively hit due to a strict credit policy and decreasing housing prices. Banks will have to decrease their mortgage rates in order to compete for fewer clients that will be eligible for mortgages, after the introduction of new stringent rules. Decreased mortgage rates would mean narrower spreads earned on those mortgages. On the other hand, when taking long positions in U.S. banks, we need to be cautious about the Fed's "Operation Twist" and the resulting flattened yield curve. The flattening of the yield curve has the potential to hurt interest income for U.S. banks. Therefore, it is of the utmost importance that we invest in banks that rely on non-interest income from mortgages (origination fees) rather than banks that keep mortgages on their balance sheets.
Among the U.S. money center banks, Well's Fargo & Company is the best candidate for a long position. The bank, as noted in our detailed report on WFC, has a 33% market share in mortgage originations in the U.S. The largest proportion i.e., 24%, of the bank's non-interest income accrues from mortgage originations. Therefore, despite the flattening of the yield curve, as a result of the Fed's actions, WFC is expected to benefit the most out of this anticipated U.S. housing market recovery.
On the other hand, Canadian large cap banks who have large exposure in the Canadian housing market are perfect candidates for short positions. The Royal Bank of Canada generates 69% of revenues from Canada, while the rest comes from other international regions, including the U.S. The Royal Bank of Canada has a huge exposure to Canadian residential mortgages. Residential mortgages account for 54% of its total assets on the balance sheet. The bank has earned a net interest margin of 2.72% in 2Q2012, which is 100bps below what it earned during 1Q2012. This margin is expected to shrink in the event of a mortgage rate war among banks. A large chunk (i.e. 60%) of the bank's revenues comes from non-interest income, which will be hit due to lower expected mortgage origination activity. Since 61% of its mortgage loans are not insured, the bank will face a substantial default risk if homeowners fail to pay. The bank trades at a 9% premium with regards to its price-to-tangible book value of 2.4x compared to its industry peers.
The Canadian Imperial Bank of Commerce's 40% assets are composed of Canadian residential mortgages and it earns 57% of revenues from interest income. The bank earned a net interest margin of 1.82% during 2Q2012, which deteriorated from 1.85% in 1Q2012. This is also 90bps below what RY earned in 2Q2012. CM's margin will be hit harder if it is forced to narrow its spread in order to compete for new mortgage clients. The bank has a Tier 1 capital ratio of 14.1%. The stock is trading at a moderate discount of 3% with regards to its price-to-tangible book value of 2.12x when compared to its industry peers. Consistent with our views, Fitch is also concerned about the Royal Bank of Canada's and Canadian Imperial Bank of Commerce's enormous exposures to Canadian real estate.
We believe that Canadian banks that are considered the world's soundest, are not immune to an American style housing burst. We also feel that the Canadian housing market bubble is on the verge of an eruption. In such a scenario, where the American housing market is showing signs of recovery, we recommend our investors to short Canadian banks and long American banks.