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The red hot Canadian housing markets have lost their upward momentum. Helped by more stringent rules on home lending, which went into effect since June of this year, Canadian home sales are now plunging fast. Regulators are busy making a soft landing effective. We believe that even if a soft landing were possible, banks like the Royal Bank of Canada (NYSE:RY) and Toronto Dominion Bank (NYSE:TD) are bound to take a hit. Fewer mortgage originations will lead to lesser real estate-related income for these banks. The banks, as compared to their U.S. peers, have expensive valuations. Therefore, we have a bearish stance on the banks.

Canadian Housing a Soft Landing or Not?

The red hot Canadian housing market has significantly slowed down since we last reviewed its activity. Home prices throughout the country hit a record high in July this year for the third consecutive month. However, except Calgary, prices began to fall, even as the sales season arrived. The Teranet-National Bank Home Price Index National Composite 11, an indicator of home prices in Canada, is at 4.1, down from 4.8 in August. According to the latest figures released by the Canadian Real Estate Association, home sales for the month of September declined across all major cities in the country. Similarly, sales in the month of August declined by 5.8%, as compared to July. Regulators are attempting to avoid a bubble burst, and are working towards a soft landing. Capital Economics believes otherwise. In a statement, it said "the stalwart household sector now looks to be on the ropes, as sinking home sales and tighter credit conditions signal the beginning of what could be a very severe housing correction."

The introduction of more stringent rules in July this year was a part of this attempt to decrease the demand for mortgage loans. As a result, homes sales in the Greater Vancouver region plunged 32.5% when compared to the previous year, while the average home price in the region dropped by 0.8% over the same period. Therefore, there are fears that the Vancouver housing market might be slowing down faster than expected.

Canadian Banking:

Since mortgages with less than 20% down payment are insured because of regulations, the banks are not as exposed to defaults as their counterparts in the U.S. were. However, Canadian banks with large exposures to the country's housing markets may face pressure as far as their profits are concerned, due to the slowdown in the country's housing markets. Lower mortgage originations as a result of stringent lending rules will result in lesser income for the banks in the coming quarters. We believe, among the banks that operate in Canada, Royal Bank of Canada and Toronto Dominion Bank are the most exposed to the slowing Canadian housing markets. S&P also downgraded the two banks from stable to negative, owing to their exposures to the slowing Canadian housing markets.

Royal Bank of Canada is considered to be Canada's largest bank, both by assets and market cap, which provides diversified financial services to individuals and institutions. It has a robust capital position, with a Tier 1 capital ratio of 13% and a total capital ratio of 15% at the end of the most recent quarter. Residential mortgages form the largest part of the bank's retail loans portfolio, with a 66% weight. Only 0.33% of the residential loans are impaired and 3.5% are classified as high risk.

Toronto Dominion Bank is the sixth largest bank in North America on the basis of branches. At the end of the most recent quarter, the bank had a Tier 1 capital ratio of 12.2% and a Tier 1 common ratio in excess of 7%. Residential mortgage form a significant 59% of the bank's retail loans portfolio. 0.32% of the residential mortgages outstanding are considered impaired.

Valuations

The stock of Royal Bank of Canada trades at a premium of 113% to its book value, while the stock of Toronto Dominion Bank trades at a 71% premium to its book value. Comparatively, Citigroup (NYSE:C) trades at a discount of 31% to its book value, while Wells Fargo (NYSE:WFC), America's largest home lender, trades at a 36% premium to its book value.

As both the banks derive a significant chunk of their revenues from housing market, a housing slowdown will materially hit the top and bottom lines of these two banks.

Source: 2 Banks To Short On Canadian Housing Market Slowdown