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There is sufficient data to suggest that the red hot Canadian housing markets are now cooling down. In the wake of recent developments in the Canadian housing markets, we have buy ratings for Toronto-Dominion Bank (TD) and the Bank of Montreal (BMO). These buy ratings are justified on the basis of the banks' higher proportion of insured mortgages, lower proportion of mortgage lending to their overall lending portfolio, and attractive valuations. Since the Royal Bank of Canada (RY) has no insured mortgages, we believe it is poised to take the maximum hit if the Canadian housing market bubble bursts, which is why we are bearish on the bank.

Recent Developments in Canadian Housing Sector

Home prices have hit record highs in the Canadian housing markets. However, the upward momentum has slowed down. According to the Teranet-National Bank Composite House Price Index, the overall surge in July this year over the previous month was 70bps. The index does not measure actual prices and instead provides changes in repeat sales for single-family homes. The slower pace of home price appreciation and a decline in home prices in Vancouver suggest that the overall Canadian housing market is beginning to cool down. The Canadian government s efforts over the past four years to toughen mortgage rules are credited for such a cool down. We noted earlier that the new stringent rules will discourage mortgage originations and toughen refinancing in the country. The shortened duration for amortization has led to difficulties for first-time home owners in qualifying for new mortgages. According to the Canadian Real Estate Association, Canada's national resale housing activity stabilized in July. Prices in Vancouver and Toronto have started to decline. A macro strategist from TD Securities said, "Despite the string of fairly robust month-over-month gains, we do not expect this trend to continue, especially as the impact of tighter mortgage regulations weighs on housing market activity over the balance of the year."

According to Statistics Canada, household debt reached record levels during the first quarter of the current year. This was primarily associated to slower growth in income as compared to demand for loans. The credit market debt-to-personal disposable income ratio surged over the first quarter of the current year by 152% over the previous quarter's 150.5%, becoming a cause for concern for the Canadian banking regulatory authority and the Canadian economy. America's premier credit rating agency, Standards & Poor's, joined the Bank of Canada in voicing its concerns over the elevated debt related to households as the biggest domestic risk to financial stability. The rising household debt levels and falling home prices provide signals of a significant correction in the Canadian housing market.

Supporting our prior views, Standards & Poor's has downgraded its outlook for Canadian banks with large exposures to the Canadian housing sector. Although the ratings agency has reiterated its high ratings for the banks, it has downgraded the outlook for these banks to negative from stable. Also, the ratings agency issued warnings to the Bank of Nova Scotia (BNS), Toronto Dominion Bank and the Royal Bank of Canada, Canada's three largest banks that have large exposures to consumer credit. However, investors need to understand the difference between U.S. banks before the financial meltdown, and Canadian banks. Unlike U.S. banks, Canadian banks have the backing of Canadian government-sponsored agencies (the Canadian Mortgage and Housing Corporation). Furthermore, Canadian banks have also bought extra insurance on a low loan-to-value ratio. Additionally, Canadian banks have an option to pursue borrowers' unrelated assets in case home owners default on their mortgages. This means that in the event of a similar wave of defaults on mortgages, as was the case in the U.S., Canadian banks will not suffer huge losses. However, a matter of concern for these banks will be that fewer customers will be asking for loans, resulting in profit cuts. However, the structure of the Canadian Banking Industry has the potential to dampen the impact of such a scenario. The Canadian Banking Industry is structured as an oligopoly, enabling the largest banks to stretch their geographical footprint across the country. With this lack of competition, these banks have the potential to raise fees and cut expenses in order to cope with sluggish loan growth. At the beginning of the current year, the largest six banks had a combined exposure of less mortgage insurance to the Canadian residential mortgage market. The remaining thesis will aim to look into the Bank of Nova Scotia, Toronto Dominion Bank and the Royal Bank of Canada, and their exposures to the Canadian housing markets.

Royal Bank of Canada (RY)

The bank, with a Tier 1 capital ratio of 13% and a Tier 1 common ratio of 10.3%, is adequately capitalized when compared to BNS. RY relies approximately 70% on Canada for its revenues, while the rest accrue from other international markets where it has its operations. Fitch considers the bank to have considerable exposure to the Canadian housing markets and faces the largest risk, as it uses less mortgage insurance as compared to most of its peers in the Canadian Banking Industry. In their conference call, after reporting the results of the third quarter of the current year, the management noted that the bank has the lowest insured mortgages of all the banks in Canada. The bank also has a large portion of its domestic mortgage loans to its overall lending. Going forward, we believe the bank will face a challenging operating environment, however, the bank's concentration on its credit card and commercial businesses will partially offset any adverse impacts.

Bank of Nova Scotia (BNS)

BNS, with a Tier 1 capital of ratio of 12.6% and a Tier 1 common ratio of 10.2%, is also considered to have high mortgage lending as a proportion of its overall lending. The bank relied on retail mortgages to post a 2% growth in its assets in the third quarter of the current year. It has lent $239 billion in mortgages, which is 65% of the bank's entire lending portfolio. Approximately 60% of the bank's large mortgage lending portfolio is insured, while the rest has a loan-to-value ratio of 57%. This makes the Bank of Nova Scotia less exposed to the Canadian housing markets as compared to the Royal Bank of Canada.

TD and BMO are considered to have less mortgage insurance stemming from the Canadian housing markets. Approximately 70% of the real estate lending portfolio for TD is secured by the government-sponsored agency. This is a less mortgage insurance when compared to most of its peers. TD has a Tier 1 capital ratio of 12.2% and a Tier 1 common equity ratio of 7%.

The residential mortgage lending portfolio for the Bank of Montreal constitutes 6.5% of the total residential mortgage market of Canada, which is now over $1.1 trillion. Approximately 65% of the bank's mortgage lending portfolio is insured. This secured mortgage portfolio has a loan-to-value ratio of 64%. The reason why the bank is favored is that it has a less mortgage insurance of domestic mortgage lending as compared to its overall loans portfolio. The bank had a Tier 1 capital ratio of 12.4% and a Tier 1 common equity ratio of 10.3% at the end of the third quarter of the current year.

Valuations

The stocks of RY, BNS, TD and BMO trade at premiums of 106%, 85%, 70% and 46% to their book values. Both TD and BMO, the banks we are bullish on, are attractively valued when compared to RY and BNS.

Source: 2 Canadian Banks To Buy, 1 To Short On Housing Bubble Burst