RBC Capital Markets, 9 March 2009
We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.
Going into the quarter, our two favourite bank stocks were National Bank and Royal Bank and our two least favourite were TD Bank and Scotiabank.
• National Bank’s stock appears best positioned over the near term, with lower exposure to U.S. and Ontario credit, a clean securities book and a valuation at the low end of the peer group. We are reticent to upgrade the stock, however, given our view on the group in general and the stock’s strong performance relative to peers so far in 2009.
• We are less negative on Bank of Montreal. Bank of Montreal’s credit issues in 2008 were much worse than its peers. We expect the difference to be less noticeable in 2009 as the credit cycle broadens geographically and by product line. We are concerned, however, that the bank’s dividend is least sustainable and that as long as the risk of a cut is in place, the stock is unlikely to rally. Unlike the situation in the U.S., we would expect dividend cuts to be viewed negatively as they would probably be perceived as a sign of lower confidence in the outlook, whereas in the U.S. most investors have a pessimistic outlook on U.S. banks and dividend cuts are viewed as positive since they reduce a drain on capital.
• We are less negative on TD relative to peers as the bank’s capital position is better than what we had forecast and, while signs of increasing credit deterioration concern us relative to peers, the pace at which the deterioration has occurred has been slower than we had expected. We still believe, however, that the stock is likely to lag its peers largely on increased loan losses, but also because of potential valuation adjustments on securities depending on the outlook for the housing market/securitized residential mortgages. Those issues are not crippling but we believe that they might disappoint investors.
Based on our earnings estimates, which include our best guess on securities writedowns, we estimate that the six Canadian banks can maintain their dividends and have TCE to risk weighted ratios of 6.4% to 7.8% by the end of 2010. We believe that the Canadian banks have enough capital to handle loss rates in line with those of the early 1990s. However, we no not believe that they have enough capital to handle loss rates in the 1.5-2.0x range when compared to the early 1990s and sustain dividends. Given how weak the economic environment is, the prospects of loan losses that exceed the early 1990s is certainly something banks and investors must consider in their investment decisions. It might not be the base case but it is a possibility if the economy does not improve by 2010.
We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.
• Markets would initially likely react negatively to a dividend cut as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:
• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s. On top of reducing risk, it might improve cost of funds as debt investors would have less to worry about, and it might also stabilize share prices if tail risk (having to raise capital at low share prices) becomes more remote.
Key highlights from Q1/09 results
• The deterioration of credit quality that started in late 2006 accelerated in 2008 and Q1/09. Credit losses continued to rise in Q1/09, with Bank of Montreal and Royal Bank seeing the highest YoY increases in loan loss rates, driven by their U.S. businesses. Scotiabank and TD Bank are also beginning to see loan loss rates increase as the credit cycle is spreading to areas that were less impacted in the early stages of the credit cycle (which was mainly driven by U.S. residential-related exposures). Losses are spreading to other geographic and product areas. National Bank and CIBC have been less impacted, although CIBC’s credit card loss rates are clearly under pressure in our view (benign credit experience in the bank’s business loan book has offset the rising card losses on overall loss rates).
• Margin pressure, difficult equity markets and rising loan losses offset still-solid loan growth in domestic retail businesses. Scotiabank and Bank of Montreal had the strongest combination of revenue growth and net income growth, although we believe that was partly helped by how they allocate treasury expenses (Scotiabank) and loan losses (Bank of Montreal). We expect top and bottom-line growth to remain slow compared to pre-2008 years, especially now that loan losses have begun to rise.
• Wholesale earnings on a GAAP basis were well up from Q1/08 on lower writedowns and better underlying profitability. Many trading businesses did well while others were negatively impacted by writedowns. Underwriting and corporate banking revenues were strong, while M&A advisory was quiet for most. Core earnings were more than double reported earnings (and were up 65% QoQ and 46% YoY), although the factors that caused trading losses (volatility and wide spreads) also undoubtedly led to the establishment of trading positions that generated gains that would not have occurred in a normal environment.
• The Canadian bank’s solid capital markets results were partially offset by continuing writedowns1. Total writedowns amounted to $3.0 billion, down from $4.6 billion in Q1/08 and $4.1 billion in Q4/08. CIBC and Royal Bank recorded the largest writedowns ($1.3 billion and $636 million, respectively). The exposures that led to the writedowns remain, although in many cases the size of those exposures, on a net basis, is down. We believe that a tightening of credit spreads would alleviate concerns over potential writedowns but, as long as they remain wide, securities writedown risks will likely remain.
• Canadian banks generally saw capital ratios increase during the quarter as income from operations and capital raises offset writedowns and dividend payments. The median Tier 1 ratio rose from 9.6% to 10.0% during the quarter, while the median TCE to RWA ratio rose from 6.7% to 7.3%.
2009 and 2010 expectations
We expect 2009 earnings per share to come short of consensus estimates. Our current EPS estimates for 2009E are a median 6% below consensus, and 11% below consensus for 2010E (Exhibits 2 and 3).
• Our 2009 GAAP EPS estimates represent a median 18% decline in profitability compared to a 15% decline in 2008, even with lower expected writedowns. Our 2009E core cash EPS represent a median 17% decline in profitability versus a 4% decline in 2008, driven by rising loan losses and pressure on retail banking and wealth management revenues.
• We expect the core cash ROE will drop to 16% from the 20%+ levels in the past few years.
• Provisions for credit losses are likely to be the biggest swing factor in earnings results. The indicators we track for both retail and business lending are all pointing toward an increase in loan losses. Furthermore, the formation of impaired loans has accelerated in recent quarters, initially driven by banks with exposures to the U.S., with weakness now also becoming noticeable in Canada. We believe that the trend will continue and that higher than normal provisions for credit losses should be expected in 2009 and 2010. When there are high levels of new impaired loans and low levels of collections and loans returned to performing status, banks typically record higher provisions in following quarters.
• We believe that loan losses will increase at an accelerated pace in 2009, and rise further in 2010. We believe that specific provisions for credit losses will reach $11.3 billion (or 0.92% of loans) in 2009 for the Big 6 banks, and $15.0 billion in 2010 (1.18%), which compares to $2.8 billion (0.28%) in 2007 and $5.0 billion (0.45%) in 2008.
Still too early to buy
We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers, and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.
We would not focus on our 12-month target prices as the primary decision factor in determining when to buy bank shares but rather on when leading indicators of profitability might turn. Our reasoning is as follows:
• Canadian bank shares have seen lower valuations in the past and as such, as long as important indicators of future bank profitability remain weak, bank shares could drift lower (Exhibit 4).
• On the other hand, we do not believe that the Canadian banks face the same pressure on capital as some of their European or U.S. bank peers, and we believe that Canadian bank shares have upside at current valuations that is likely to begin being realized when the economic environment shows signs of troughing and the prospects of writedowns are more clearly behind.
• If the economy continues to deteriorate, we believe that tangible book value is the best way to set a rough estimate for downside risk. For the industry, that would represent downside valuation risk of about 50%. Note that this is not a forecast, this is an attempt to quantify downside risk in a depressed economic environment that does not recover in the next 12 months.
• Upside potential can be estimated by looking at normalized earnings and valuation multiples. For the industry, when the market starts to focus on “the other side of the valley”, we believe that valuation upside over the next two years could be as much as 50-100%.
• A trough in bank stocks is likely to come before the peak in credit loss provisions. Bank share prices often move in concert with leading economic indicators and about 6 months ahead of employment growth. As such, our sector view (“too early to buy”) is more based on looking for the turn in leading indicators rather than what price appreciation might or might not be implied by our 12-month target prices (Exhibits 5 and 6).
Given that the leading indicators we track are still mostly negative (although, admittedly, not as negative as a few months ago), we continue to believe that it is too early to buy Canadian bank shares.
• Outside of valuations, we are watching indicators in four key areas to look for a bottom in Canadian bank shares: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth.
• Those indicators are sending mostly negative messages (although not as negative as a few months ago), which, combined with valuations that are not extremely low by long term averages considering the state of the economy, and consensus estimates we think are too high, support our belief that it is still early to buy Canadian bank shares.
• Our approach will likely lead us to miss the bottom in bank shares but we feel that upside on a 3-5 year basis is attractive enough that one does not need to catch the exact trough to make money in these stocks over that period. Taking this approach avoids being lured into the names on valuation-driven reasons, which should work over time but can often fail in the near term, and it should also allow us to have better visibility on the economic outlook and potential writedowns when we eventually recommend buying the sector.
Leading Economic Indicators need to stabilize in our view. Leading economic indicators are a good advance indicator of employment growth as well as loan losses and bank share performance. Bank shares have historically not done well in periods of rising loan losses and some leading economic indicators currently point to a U.S. recession as bad as that seen in early 1980s, and the Canadian leading indicator is trending negatively as well. A stabilization in those indicators would be a positive for our view on the bank shares. In the U.S. the indicators appear to have thankfully stopped worsening, although they remain very weak. In Canada, the trend remains negative (Exhibits 6 and 7).
The valuation of credit assets, particularly highly rated ones, has been a source of major problems for financial institutions, and funding costs have risen compared to normal environments. Paying attention to signs of increasing or decreasing stress in credit and funding markets is crucial in our mind, and some (but not all) of the indicators we watch have improved in recent months:
• Spreads on investment grade bonds have tightened but are still near record levels and pressure on structured finance assets continues as shown in Exhibits 8 and 9. A tightening of credit spreads would alleviate concerns over potential writedowns.
• Funding conditions have improved in the past few months as the LIBOR-OIS and spreads on Canadian bank short-term wholesale funding rates have tightened since peak levels in early October. More importantly, medium term funding spreads have also come off of their highs. Continued tightening in funding spreads would indicate greater confidence from credit markets in banks and it would lead to lower concerns over net interest income margins, in our view (Exhibit 10).
We also keep an eye on house price changes as well as employment growth as signs of consumer health, although we suspect these indicators will be more lagging than leading economic indicators, credit spreads and bank funding costs.
• House prices in Canada declined 11% YoY in January, while the U.S. monthly house price decline is 15% YoY. Excesses in the U.S. housing market have created a lot of the problems facing financial services companies worldwide, and we still do not see clear signs of bottoming which would be positive for bank shares. The decline in house values in Canada will, in our view, exacerbate consumer loan losses (Exhibit 11).
• Employment growth has turned negative in Canada. Employment growth is not necessarily a leading indicator of economic strength but it is a leading indicator of credit losses in banks’ retail portfolios as well as retail loan growth. Employment in Canada fell by a record 129,000 in January, which sent the unemployment rate to 7.2% from 6.6% in December (February data is expected to be released on March 13). U.S. labour markets also continue to be very weak, with employment dropping 651,000 in February and unemployment spiking to 8.1% from 7.6%. (Exhibit 11).
Book value-based valuations best way to assess downside risk
Price to earnings is the most commonly used way to value banks in “normal times”, but we do not believe it is as useful in determining valuation-based downside risk for banks as the earnings outlook is murky. To us, it is clear that earnings will be negatively impacted by credit losses but the magnitude of the impact is difficult to determine as every credit cycle is different, hence our reluctance to place a lot of emphasis on price to earnings. Furthermore, different accounting treatment of similar securities can lead to discrepancies between banks in terms of timing and magnitude of writedowns.
We continue to believe that price to book methodologies are the best way to determine a potential valuation floor. Current median price to book valuations of 1.2x and price to tangible book of 1.6x compare to the 0.8x trough of the early 1990s. If the economy continues to deteriorate, we believe that valuations are likely to settle somewhat higher than the early 1990s, with the most stringent test of downside risk being tangible equity.
• Compared to the early 1990s cycle, in which banks traded below book value, we believe trough multiples should be higher in this cycle as banks are less exposed to credit risk and to business lending than in prior cycles, they have more exposure to wealth management, they have higher capitalization ratios, and risk free rates are lower (Exhibits 12 and 13).
o Relative to 20-year trough valuations, the two banks closer to their historical troughs are TD and Bank of Montreal, while the other four look more expensive. Part of the reason for TD trading closer to its historical trough is that more of its book value is now made up of goodwill and intangibles, on which, for recently acquired goodwill/intangibles, we believe the banks will earn low returns.
o ROE potential also needs to be considered. Using our 2009 estimates, Bank of Montreal, and TD are expected to earn lower ROEs, which all else equal should lead to lower price to book multiples.
• Looking at price to tangible book is a more stringent test of downside risk as it awards little value to goodwill and intangibles.
o Relative to 20-year trough valuations, the current industry median valuation is 50% higher. Looking at individual banks, the one closest to its historical trough is Bank of Montreal. TD Bank and Royal Bank have higher P/TBV valuations. Our view on those banks is that, so as long as it continues to be viewed as a going concerns, we believe that they have historically earned higher returns on their tangible equity.
- Using our 2009 estimates, Bank of Montreal, Scotiabank and National Bank are expected to earn lower returns on tangible equity, which all else equal should lead to lower price to book multiples. We expect ROTEs for the group will come down to a median 21.5% in 2009E from 25.9% in 2008 and 27.8% (Exhibit 14).
Normalized P/E and P/B are the best way to assess upside potential
Under a scenario where there is no share dilution, there are two quick and relatively easy ways to determine upside potential for bank shares. We’d characterize this as the “banks have enough capital to withstand writedowns and loans losses so what are they worth on the other side” scenario.
Price to book is the simplest way to determine upside, particularly if one looks at price to tangible book, given that banks that added significant goodwill and intangibles in recent years are not likely to trade at similar price to book multiples. Based on where banks have traded in the last 10 years, upside would range from 50% to 150%.
One can also look at normalized profitability given current capital positions and then apply a reasonable P/E multiple. We suggest the following: estimating normalized earnings power by taking average ROTE for the 2003-2007 period, excluding unusual items, and reducing that return by about 8% to reflect the fact that the industry had unusually low loan losses. We then apply a P/E multiple of 11-12x to those earnings. This would provide upside of between 40% and 110%.
While simple, those scenarios are useful in determining potential upside. There are two important questions (1) when will bank stocks trade on that basis, and (2) what if there is dilution along the way.
• With regards to the first question, we think that investors need to focus on the metrics we look at outside of valuations, which we highlighted earlier in this report: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth. Once those indicators stabilize/show signs of improvements, we believe that the market might start looking ahead to “the other side of the valley”.
• With regards to the second question, we do not believe that significant dilution will occur if the economic environment improves by 2010. If the environment keeps deteriorating, we believe that the banks can keep their upside potential if they suspended dividends as it would take very stressed scenarios to push capital below adequate levels if the banks did not have to pay dividends. Obviously, the timing of the upside potential would be pushed later in the future and the share price would likely not react well to a dividend cut.
o In the capital section “Pressure to Keep capital ratios high will continue”, we detail some stress tests we did and will be following up with an interactive excel-based stress-test for investors who wish to use different assumptions.
o In the dividend section “We think that banks should consider suspending their dividends,” we detail why we believe it might make sense to temporarily suspend their dividends.
We think that banks should consider suspending their dividends
We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.
Markets would initially likely react negatively to a dividend cut, in our view, as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:
• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s.
• It would materially decrease the tail risk of a bank finding itself in a situation where it needs capital but its share price is trading at such a low valuation that raising equity capital proves to be very dilutive – a situation many U.S. and European banks are facing.
o If the Canadian banks cut their dividends today, they would have ample capital, in our opinion, to handle credit losses 50-100% higher as the worst experience of the last 20 years, even after reducing capital for potential writedowns at some banks.
• The Canadian banks are among the few banking systems around the world that have not received capital injections from a Government, which has positive implications from a future regulation and freedom of operations standpoint. It also means that when the environment improves, banks can focus on deploying capital rather than repaying the Government.
Suspending dividends would help ensure that the banks remain privately capitalized, in our view.
• Suspending dividends would probably reduce banks’ cost of funds as it would reduce their risk profile.
• It would probably set a floor in share prices. The shares of banks that are in U.S. and European banks that are in serious difficulty and trade well below tangible book value do so for one of two reasons: (1) investors do not trust the book value and (2) investors believe that those banks need to raise equity at very dilutive prices. Suspending dividends would greatly reduce the probability of a capital issue.
• The market is not valuing the banks as if their dividends are sustainable. Dividend yields are median 7.2% in the context of risk free rates of 2.9% (5-year Government of Canada bond yield). Even if using a “normal” bond yield of 4-5%, the dividend yield to bond yield ratio is very high by historical standards.
• Many banks around the world have cut their common dividends. While not great comfort to investors who rely on dividends, the institutional investor base would not be entirely shocked, in our view, if dividends were reduced given what worldwide banks have done and how weak the economy is.
Bank boards would undoubtedly alienate many long-term shareholders if they cut dividends, in our view, and they would likely regret their decision if the economy recovered quickly as there is a reputational cost to cutting dividends (National Bank is still oft mentioned as the only bank that cut dividends even though that is a decision that is nearly two decades old). The decision to cut dividends is not therefore not as clear cut is not as clear cut as our prior statements would indicate – Canadian banks have gone through periods of severe profitability declines and not cut dividends before.
• Dividend payout ratios reached over 70% in the mid-1960s, 88% in late 1990 and 119% in early 1993. Only one bank has cut dividends since the 1940s – National Bank cut dividends in the early 1980s and early 1990s (Exhibit 18).
• Dividend payout ratios were a median 48% in 2008. We expect the median payout ratio to rise to 59% in 2009 and 56% in 2010. Canadian bank target dividend payout ratios have been in the range of 40% to 50% in recent years (Exhibit 19). We believe that Bank of Montreal’s dividend would be most at risk of a cut (if it were to happen) as it has a higher dividend payout ratio than the others. If Bank of Montreal were to cut dividends, the likelihood of others following suit would increase as a precedent would have been set (Exhibit 20).
We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.
Going into the quarter, our two favourite bank stocks were National Bank and Royal Bank and our two least favourite were TD Bank and Scotiabank.
• National Bank’s stock appears best positioned over the near term, with lower exposure to U.S. and Ontario credit, a clean securities book and a valuation at the low end of the peer group. We are reticent to upgrade the stock, however, given our view on the group in general and the stock’s strong performance relative to peers so far in 2009.
• We are less negative on Bank of Montreal. Bank of Montreal’s credit issues in 2008 were much worse than its peers. We expect the difference to be less noticeable in 2009 as the credit cycle broadens geographically and by product line. We are concerned, however, that the bank’s dividend is least sustainable and that as long as the risk of a cut is in place, the stock is unlikely to rally. Unlike the situation in the U.S., we would expect dividend cuts to be viewed negatively as they would probably be perceived as a sign of lower confidence in the outlook, whereas in the U.S. most investors have a pessimistic outlook on U.S. banks and dividend cuts are viewed as positive since they reduce a drain on capital.
• We are less negative on TD relative to peers as the bank’s capital position is better than what we had forecast and, while signs of increasing credit deterioration concern us relative to peers, the pace at which the deterioration has occurred has been slower than we had expected. We still believe, however, that the stock is likely to lag its peers largely on increased loan losses, but also because of potential valuation adjustments on securities depending on the outlook for the housing market/securitized residential mortgages. Those issues are not crippling but we believe that they might disappoint investors.
Based on our earnings estimates, which include our best guess on securities writedowns, we estimate that the six Canadian banks can maintain their dividends and have TCE to risk weighted ratios of 6.4% to 7.8% by the end of 2010. We believe that the Canadian banks have enough capital to handle loss rates in line with those of the early 1990s. However, we no not believe that they have enough capital to handle loss rates in the 1.5-2.0x range when compared to the early 1990s and sustain dividends. Given how weak the economic environment is, the prospects of loan losses that exceed the early 1990s is certainly something banks and investors must consider in their investment decisions. It might not be the base case but it is a possibility if the economy does not improve by 2010.
We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.
• Markets would initially likely react negatively to a dividend cut as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:
• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s. On top of reducing risk, it might improve cost of funds as debt investors would have less to worry about, and it might also stabilize share prices if tail risk (having to raise capital at low share prices) becomes more remote.
Key highlights from Q1/09 results
• The deterioration of credit quality that started in late 2006 accelerated in 2008 and Q1/09. Credit losses continued to rise in Q1/09, with Bank of Montreal and Royal Bank seeing the highest YoY increases in loan loss rates, driven by their U.S. businesses. Scotiabank and TD Bank are also beginning to see loan loss rates increase as the credit cycle is spreading to areas that were less impacted in the early stages of the credit cycle (which was mainly driven by U.S. residential-related exposures). Losses are spreading to other geographic and product areas. National Bank and CIBC have been less impacted, although CIBC’s credit card loss rates are clearly under pressure in our view (benign credit experience in the bank’s business loan book has offset the rising card losses on overall loss rates).
• Margin pressure, difficult equity markets and rising loan losses offset still-solid loan growth in domestic retail businesses. Scotiabank and Bank of Montreal had the strongest combination of revenue growth and net income growth, although we believe that was partly helped by how they allocate treasury expenses (Scotiabank) and loan losses (Bank of Montreal). We expect top and bottom-line growth to remain slow compared to pre-2008 years, especially now that loan losses have begun to rise.
• Wholesale earnings on a GAAP basis were well up from Q1/08 on lower writedowns and better underlying profitability. Many trading businesses did well while others were negatively impacted by writedowns. Underwriting and corporate banking revenues were strong, while M&A advisory was quiet for most. Core earnings were more than double reported earnings (and were up 65% QoQ and 46% YoY), although the factors that caused trading losses (volatility and wide spreads) also undoubtedly led to the establishment of trading positions that generated gains that would not have occurred in a normal environment.
• The Canadian bank’s solid capital markets results were partially offset by continuing writedowns1. Total writedowns amounted to $3.0 billion, down from $4.6 billion in Q1/08 and $4.1 billion in Q4/08. CIBC and Royal Bank recorded the largest writedowns ($1.3 billion and $636 million, respectively). The exposures that led to the writedowns remain, although in many cases the size of those exposures, on a net basis, is down. We believe that a tightening of credit spreads would alleviate concerns over potential writedowns but, as long as they remain wide, securities writedown risks will likely remain.
• Canadian banks generally saw capital ratios increase during the quarter as income from operations and capital raises offset writedowns and dividend payments. The median Tier 1 ratio rose from 9.6% to 10.0% during the quarter, while the median TCE to RWA ratio rose from 6.7% to 7.3%.
2009 and 2010 expectations
We expect 2009 earnings per share to come short of consensus estimates. Our current EPS estimates for 2009E are a median 6% below consensus, and 11% below consensus for 2010E (Exhibits 2 and 3).
• Our 2009 GAAP EPS estimates represent a median 18% decline in profitability compared to a 15% decline in 2008, even with lower expected writedowns. Our 2009E core cash EPS represent a median 17% decline in profitability versus a 4% decline in 2008, driven by rising loan losses and pressure on retail banking and wealth management revenues.
• We expect the core cash ROE will drop to 16% from the 20%+ levels in the past few years.
• Provisions for credit losses are likely to be the biggest swing factor in earnings results. The indicators we track for both retail and business lending are all pointing toward an increase in loan losses. Furthermore, the formation of impaired loans has accelerated in recent quarters, initially driven by banks with exposures to the U.S., with weakness now also becoming noticeable in Canada. We believe that the trend will continue and that higher than normal provisions for credit losses should be expected in 2009 and 2010. When there are high levels of new impaired loans and low levels of collections and loans returned to performing status, banks typically record higher provisions in following quarters.
• We believe that loan losses will increase at an accelerated pace in 2009, and rise further in 2010. We believe that specific provisions for credit losses will reach $11.3 billion (or 0.92% of loans) in 2009 for the Big 6 banks, and $15.0 billion in 2010 (1.18%), which compares to $2.8 billion (0.28%) in 2007 and $5.0 billion (0.45%) in 2008.
Still too early to buy
We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers, and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.
We would not focus on our 12-month target prices as the primary decision factor in determining when to buy bank shares but rather on when leading indicators of profitability might turn. Our reasoning is as follows:
• Canadian bank shares have seen lower valuations in the past and as such, as long as important indicators of future bank profitability remain weak, bank shares could drift lower (Exhibit 4).
• On the other hand, we do not believe that the Canadian banks face the same pressure on capital as some of their European or U.S. bank peers, and we believe that Canadian bank shares have upside at current valuations that is likely to begin being realized when the economic environment shows signs of troughing and the prospects of writedowns are more clearly behind.
• If the economy continues to deteriorate, we believe that tangible book value is the best way to set a rough estimate for downside risk. For the industry, that would represent downside valuation risk of about 50%. Note that this is not a forecast, this is an attempt to quantify downside risk in a depressed economic environment that does not recover in the next 12 months.
• Upside potential can be estimated by looking at normalized earnings and valuation multiples. For the industry, when the market starts to focus on “the other side of the valley”, we believe that valuation upside over the next two years could be as much as 50-100%.
• A trough in bank stocks is likely to come before the peak in credit loss provisions. Bank share prices often move in concert with leading economic indicators and about 6 months ahead of employment growth. As such, our sector view (“too early to buy”) is more based on looking for the turn in leading indicators rather than what price appreciation might or might not be implied by our 12-month target prices (Exhibits 5 and 6).
Given that the leading indicators we track are still mostly negative (although, admittedly, not as negative as a few months ago), we continue to believe that it is too early to buy Canadian bank shares.
• Outside of valuations, we are watching indicators in four key areas to look for a bottom in Canadian bank shares: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth.
• Those indicators are sending mostly negative messages (although not as negative as a few months ago), which, combined with valuations that are not extremely low by long term averages considering the state of the economy, and consensus estimates we think are too high, support our belief that it is still early to buy Canadian bank shares.
• Our approach will likely lead us to miss the bottom in bank shares but we feel that upside on a 3-5 year basis is attractive enough that one does not need to catch the exact trough to make money in these stocks over that period. Taking this approach avoids being lured into the names on valuation-driven reasons, which should work over time but can often fail in the near term, and it should also allow us to have better visibility on the economic outlook and potential writedowns when we eventually recommend buying the sector.
Leading Economic Indicators need to stabilize in our view. Leading economic indicators are a good advance indicator of employment growth as well as loan losses and bank share performance. Bank shares have historically not done well in periods of rising loan losses and some leading economic indicators currently point to a U.S. recession as bad as that seen in early 1980s, and the Canadian leading indicator is trending negatively as well. A stabilization in those indicators would be a positive for our view on the bank shares. In the U.S. the indicators appear to have thankfully stopped worsening, although they remain very weak. In Canada, the trend remains negative (Exhibits 6 and 7).
The valuation of credit assets, particularly highly rated ones, has been a source of major problems for financial institutions, and funding costs have risen compared to normal environments. Paying attention to signs of increasing or decreasing stress in credit and funding markets is crucial in our mind, and some (but not all) of the indicators we watch have improved in recent months:
• Spreads on investment grade bonds have tightened but are still near record levels and pressure on structured finance assets continues as shown in Exhibits 8 and 9. A tightening of credit spreads would alleviate concerns over potential writedowns.
• Funding conditions have improved in the past few months as the LIBOR-OIS and spreads on Canadian bank short-term wholesale funding rates have tightened since peak levels in early October. More importantly, medium term funding spreads have also come off of their highs. Continued tightening in funding spreads would indicate greater confidence from credit markets in banks and it would lead to lower concerns over net interest income margins, in our view (Exhibit 10).
We also keep an eye on house price changes as well as employment growth as signs of consumer health, although we suspect these indicators will be more lagging than leading economic indicators, credit spreads and bank funding costs.
• House prices in Canada declined 11% YoY in January, while the U.S. monthly house price decline is 15% YoY. Excesses in the U.S. housing market have created a lot of the problems facing financial services companies worldwide, and we still do not see clear signs of bottoming which would be positive for bank shares. The decline in house values in Canada will, in our view, exacerbate consumer loan losses (Exhibit 11).
• Employment growth has turned negative in Canada. Employment growth is not necessarily a leading indicator of economic strength but it is a leading indicator of credit losses in banks’ retail portfolios as well as retail loan growth. Employment in Canada fell by a record 129,000 in January, which sent the unemployment rate to 7.2% from 6.6% in December (February data is expected to be released on March 13). U.S. labour markets also continue to be very weak, with employment dropping 651,000 in February and unemployment spiking to 8.1% from 7.6%. (Exhibit 11).
Book value-based valuations best way to assess downside risk
Price to earnings is the most commonly used way to value banks in “normal times”, but we do not believe it is as useful in determining valuation-based downside risk for banks as the earnings outlook is murky. To us, it is clear that earnings will be negatively impacted by credit losses but the magnitude of the impact is difficult to determine as every credit cycle is different, hence our reluctance to place a lot of emphasis on price to earnings. Furthermore, different accounting treatment of similar securities can lead to discrepancies between banks in terms of timing and magnitude of writedowns.
We continue to believe that price to book methodologies are the best way to determine a potential valuation floor. Current median price to book valuations of 1.2x and price to tangible book of 1.6x compare to the 0.8x trough of the early 1990s. If the economy continues to deteriorate, we believe that valuations are likely to settle somewhat higher than the early 1990s, with the most stringent test of downside risk being tangible equity.
• Compared to the early 1990s cycle, in which banks traded below book value, we believe trough multiples should be higher in this cycle as banks are less exposed to credit risk and to business lending than in prior cycles, they have more exposure to wealth management, they have higher capitalization ratios, and risk free rates are lower (Exhibits 12 and 13).
o Relative to 20-year trough valuations, the two banks closer to their historical troughs are TD and Bank of Montreal, while the other four look more expensive. Part of the reason for TD trading closer to its historical trough is that more of its book value is now made up of goodwill and intangibles, on which, for recently acquired goodwill/intangibles, we believe the banks will earn low returns.
o ROE potential also needs to be considered. Using our 2009 estimates, Bank of Montreal, and TD are expected to earn lower ROEs, which all else equal should lead to lower price to book multiples.
• Looking at price to tangible book is a more stringent test of downside risk as it awards little value to goodwill and intangibles.
o Relative to 20-year trough valuations, the current industry median valuation is 50% higher. Looking at individual banks, the one closest to its historical trough is Bank of Montreal. TD Bank and Royal Bank have higher P/TBV valuations. Our view on those banks is that, so as long as it continues to be viewed as a going concerns, we believe that they have historically earned higher returns on their tangible equity.
- Using our 2009 estimates, Bank of Montreal, Scotiabank and National Bank are expected to earn lower returns on tangible equity, which all else equal should lead to lower price to book multiples. We expect ROTEs for the group will come down to a median 21.5% in 2009E from 25.9% in 2008 and 27.8% (Exhibit 14).
Normalized P/E and P/B are the best way to assess upside potential
Under a scenario where there is no share dilution, there are two quick and relatively easy ways to determine upside potential for bank shares. We’d characterize this as the “banks have enough capital to withstand writedowns and loans losses so what are they worth on the other side” scenario.
Price to book is the simplest way to determine upside, particularly if one looks at price to tangible book, given that banks that added significant goodwill and intangibles in recent years are not likely to trade at similar price to book multiples. Based on where banks have traded in the last 10 years, upside would range from 50% to 150%.
One can also look at normalized profitability given current capital positions and then apply a reasonable P/E multiple. We suggest the following: estimating normalized earnings power by taking average ROTE for the 2003-2007 period, excluding unusual items, and reducing that return by about 8% to reflect the fact that the industry had unusually low loan losses. We then apply a P/E multiple of 11-12x to those earnings. This would provide upside of between 40% and 110%.
While simple, those scenarios are useful in determining potential upside. There are two important questions (1) when will bank stocks trade on that basis, and (2) what if there is dilution along the way.
• With regards to the first question, we think that investors need to focus on the metrics we look at outside of valuations, which we highlighted earlier in this report: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth. Once those indicators stabilize/show signs of improvements, we believe that the market might start looking ahead to “the other side of the valley”.
• With regards to the second question, we do not believe that significant dilution will occur if the economic environment improves by 2010. If the environment keeps deteriorating, we believe that the banks can keep their upside potential if they suspended dividends as it would take very stressed scenarios to push capital below adequate levels if the banks did not have to pay dividends. Obviously, the timing of the upside potential would be pushed later in the future and the share price would likely not react well to a dividend cut.
o In the capital section “Pressure to Keep capital ratios high will continue”, we detail some stress tests we did and will be following up with an interactive excel-based stress-test for investors who wish to use different assumptions.
o In the dividend section “We think that banks should consider suspending their dividends,” we detail why we believe it might make sense to temporarily suspend their dividends.
We think that banks should consider suspending their dividends
We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.
Markets would initially likely react negatively to a dividend cut, in our view, as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:
• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s.
• It would materially decrease the tail risk of a bank finding itself in a situation where it needs capital but its share price is trading at such a low valuation that raising equity capital proves to be very dilutive – a situation many U.S. and European banks are facing.
o If the Canadian banks cut their dividends today, they would have ample capital, in our opinion, to handle credit losses 50-100% higher as the worst experience of the last 20 years, even after reducing capital for potential writedowns at some banks.
• The Canadian banks are among the few banking systems around the world that have not received capital injections from a Government, which has positive implications from a future regulation and freedom of operations standpoint. It also means that when the environment improves, banks can focus on deploying capital rather than repaying the Government.
Suspending dividends would help ensure that the banks remain privately capitalized, in our view.
• Suspending dividends would probably reduce banks’ cost of funds as it would reduce their risk profile.
• It would probably set a floor in share prices. The shares of banks that are in U.S. and European banks that are in serious difficulty and trade well below tangible book value do so for one of two reasons: (1) investors do not trust the book value and (2) investors believe that those banks need to raise equity at very dilutive prices. Suspending dividends would greatly reduce the probability of a capital issue.
• The market is not valuing the banks as if their dividends are sustainable. Dividend yields are median 7.2% in the context of risk free rates of 2.9% (5-year Government of Canada bond yield). Even if using a “normal” bond yield of 4-5%, the dividend yield to bond yield ratio is very high by historical standards.
• Many banks around the world have cut their common dividends. While not great comfort to investors who rely on dividends, the institutional investor base would not be entirely shocked, in our view, if dividends were reduced given what worldwide banks have done and how weak the economy is.
Bank boards would undoubtedly alienate many long-term shareholders if they cut dividends, in our view, and they would likely regret their decision if the economy recovered quickly as there is a reputational cost to cutting dividends (National Bank is still oft mentioned as the only bank that cut dividends even though that is a decision that is nearly two decades old). The decision to cut dividends is not therefore not as clear cut is not as clear cut as our prior statements would indicate – Canadian banks have gone through periods of severe profitability declines and not cut dividends before.
• Dividend payout ratios reached over 70% in the mid-1960s, 88% in late 1990 and 119% in early 1993. Only one bank has cut dividends since the 1940s – National Bank cut dividends in the early 1980s and early 1990s (Exhibit 18).
• Dividend payout ratios were a median 48% in 2008. We expect the median payout ratio to rise to 59% in 2009 and 56% in 2010. Canadian bank target dividend payout ratios have been in the range of 40% to 50% in recent years (Exhibit 19). We believe that Bank of Montreal’s dividend would be most at risk of a cut (if it were to happen) as it has a higher dividend payout ratio than the others. If Bank of Montreal were to cut dividends, the likelihood of others following suit would increase as a precedent would have been set (Exhibit 20).
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Bloomberg, Doug Alexander, 10 March 2009
Krystal Koglin didn’t think twice when Toronto-Dominion Bank offered to boost the limit on her Visa credit card 11-fold a couple of years ago.
She went on a spending spree, hitting department stores like Holt Renfrew, treating friends at restaurants, splurging on designer jeans and buying “needless things” on EBay Inc.
“Being a young adult and irresponsible, I spent a lot of money that I shouldn’t have,” the 24-year-old salon manager and BCE Inc. employee in Toronto said. “I couldn’t handle having the responsibility of a C$5,500 ($4,237) limit.”
Toronto-Dominion and other Canadian banks are suffering from a rise in credit-card losses from clients such as Koglin, who cut up her Visa card in December after skipping payments. Four of the country’s biggest banks set aside 51 percent more cash on average in the first quarter for card losses, and these costs may rise further this year, bank executives said.
“If there’s another shoe to drop, credit cards are going to be it,” said John Kinsey, who manages about C$1 billion including bank stocks at Caldwell Securities Ltd. in Toronto. “It’s probably going to be the Achilles heel this year for the banks.”
Credit-card delinquencies and losses have risen with higher unemployment and personal bankruptcies, according to Moody’s Investors Service. Those trends will continue through 2009, even as issuers reduce credit limits and scale back on offers to entice clients.
Canadian card losses in the third quarter rose to 3.1 percent of average balances, the seventh straight period of year- over-year increases, according to Moody’s. By comparison, U.S. card losses rose to 6.6 percent of balances.
Canadian Imperial Bank of Commerce, the country’s No. 5 bank, set aside C$152 million for card losses for the period ended Jan. 31, nearly double a year ago. Royal Bank of Canada earmarked C$83 million, a 28 percent increase, while Bank of Montreal reserved C$56 million for losses in its MasterCard portfolio, up 47 percent.
Canadian Imperial, Canada’s largest card issuer, is “slowing growth” of credit cards, says Chief Executive Officer Gerald McCaughey. Cards were the second-biggest revenue generator for CIBC’s consumer bank in 2008, bringing in C$1.75 billion.
“The card portfolio continues to grow, but at a much slower rate,” McCaughey told reporters after the bank’s annual meeting in Vancouver on Feb. 26. “In difficult times it’s quite normal that you would slow the growth of credit granting.”
CIBC has the most consumer credit-card loans among Canada’s five-biggest banks with C$10.5 billion, representing 6.3 percent of total loans, according to filings. Royal Bank of Canada has the second highest, followed by Toronto-Dominion, Bank of Nova Scotia and Bank of Montreal.
Royal Bank CEO Gordon Nixon said he’s more concerned about rising defaults from credit cards than mortgages in the recession. Royal Bank had C$8.93 billion in credit-card loans as of Jan. 31.
“There is a natural deterioration in credit in a recessionary environment,” Nixon said on Feb. 26. “Credit-card deterioration always happens much sooner and much more dramatically than you’d have in a mortgage portfolio because they are unsecured loans.”
Conservative lending practices and regulations allowed Canadian banks to escape the worst of the writedowns faced by U.S. banks from the collapse of the subprime mortgage market. The lenders don’t have such protection for credit cards, aside from charging interest rates as high as 19.75 percent on outstanding balances, compared with a prime rate of 2.5 percent on loans to their best customers.
Canadian banks will see “earnings headwinds” from significant increases in provisions for card losses, Dundee Securities Corp. analyst John Aiken said in an interview. A deteriorating credit-card business is a sign of worsening credit among consumers, which will hurt the banks’ other businesses, he said.
“It’s definitely the canary in the coal mine,” Aiken said. “If these customers aren’t paying their credit cards, that means they’re not buying anything else and you’ll see a ripple effect.”
Banks have been bracing for a slump as Canada struggles in its first recession since 1992. The economy will shrink by 1.2 percent this year, the Bank of Canada forecast. Companies shed a record number of jobs in January, pushing the jobless rate to a four-year high of 7.2 percent.
Credit-card balances at Canadian banks have risen by almost 40 percent since 2004 to C$49.9 billion as consumers took on more debt, Deloitte said in a report last month. Banks and issuers may post an additional C$800 million in credit-card losses this year, rising to about C$4 billion, the consulting firm said.
Canadians owned 71.6 million cards issued by Visa Inc., MasterCard Inc. and American Express Co. at the end of 2007, according to The Nilson Report, an industry publication.
“The impact of credit deterioration in Canada -- and I’m talking about all banks -- is going to be felt across everybody’s product groups, whether it’s in credit cards or mortgages,” Bank of Nova Scotia Chief Risk Officer Brian Porter said in a March 2 interview.
Krystal Koglin didn’t think twice when Toronto-Dominion Bank offered to boost the limit on her Visa credit card 11-fold a couple of years ago.
She went on a spending spree, hitting department stores like Holt Renfrew, treating friends at restaurants, splurging on designer jeans and buying “needless things” on EBay Inc.
“Being a young adult and irresponsible, I spent a lot of money that I shouldn’t have,” the 24-year-old salon manager and BCE Inc. employee in Toronto said. “I couldn’t handle having the responsibility of a C$5,500 ($4,237) limit.”
Toronto-Dominion and other Canadian banks are suffering from a rise in credit-card losses from clients such as Koglin, who cut up her Visa card in December after skipping payments. Four of the country’s biggest banks set aside 51 percent more cash on average in the first quarter for card losses, and these costs may rise further this year, bank executives said.
“If there’s another shoe to drop, credit cards are going to be it,” said John Kinsey, who manages about C$1 billion including bank stocks at Caldwell Securities Ltd. in Toronto. “It’s probably going to be the Achilles heel this year for the banks.”
Credit-card delinquencies and losses have risen with higher unemployment and personal bankruptcies, according to Moody’s Investors Service. Those trends will continue through 2009, even as issuers reduce credit limits and scale back on offers to entice clients.
Canadian card losses in the third quarter rose to 3.1 percent of average balances, the seventh straight period of year- over-year increases, according to Moody’s. By comparison, U.S. card losses rose to 6.6 percent of balances.
Canadian Imperial Bank of Commerce, the country’s No. 5 bank, set aside C$152 million for card losses for the period ended Jan. 31, nearly double a year ago. Royal Bank of Canada earmarked C$83 million, a 28 percent increase, while Bank of Montreal reserved C$56 million for losses in its MasterCard portfolio, up 47 percent.
Canadian Imperial, Canada’s largest card issuer, is “slowing growth” of credit cards, says Chief Executive Officer Gerald McCaughey. Cards were the second-biggest revenue generator for CIBC’s consumer bank in 2008, bringing in C$1.75 billion.
“The card portfolio continues to grow, but at a much slower rate,” McCaughey told reporters after the bank’s annual meeting in Vancouver on Feb. 26. “In difficult times it’s quite normal that you would slow the growth of credit granting.”
CIBC has the most consumer credit-card loans among Canada’s five-biggest banks with C$10.5 billion, representing 6.3 percent of total loans, according to filings. Royal Bank of Canada has the second highest, followed by Toronto-Dominion, Bank of Nova Scotia and Bank of Montreal.
Royal Bank CEO Gordon Nixon said he’s more concerned about rising defaults from credit cards than mortgages in the recession. Royal Bank had C$8.93 billion in credit-card loans as of Jan. 31.
“There is a natural deterioration in credit in a recessionary environment,” Nixon said on Feb. 26. “Credit-card deterioration always happens much sooner and much more dramatically than you’d have in a mortgage portfolio because they are unsecured loans.”
Conservative lending practices and regulations allowed Canadian banks to escape the worst of the writedowns faced by U.S. banks from the collapse of the subprime mortgage market. The lenders don’t have such protection for credit cards, aside from charging interest rates as high as 19.75 percent on outstanding balances, compared with a prime rate of 2.5 percent on loans to their best customers.
Canadian banks will see “earnings headwinds” from significant increases in provisions for card losses, Dundee Securities Corp. analyst John Aiken said in an interview. A deteriorating credit-card business is a sign of worsening credit among consumers, which will hurt the banks’ other businesses, he said.
“It’s definitely the canary in the coal mine,” Aiken said. “If these customers aren’t paying their credit cards, that means they’re not buying anything else and you’ll see a ripple effect.”
Banks have been bracing for a slump as Canada struggles in its first recession since 1992. The economy will shrink by 1.2 percent this year, the Bank of Canada forecast. Companies shed a record number of jobs in January, pushing the jobless rate to a four-year high of 7.2 percent.
Credit-card balances at Canadian banks have risen by almost 40 percent since 2004 to C$49.9 billion as consumers took on more debt, Deloitte said in a report last month. Banks and issuers may post an additional C$800 million in credit-card losses this year, rising to about C$4 billion, the consulting firm said.
Canadians owned 71.6 million cards issued by Visa Inc., MasterCard Inc. and American Express Co. at the end of 2007, according to The Nilson Report, an industry publication.
“The impact of credit deterioration in Canada -- and I’m talking about all banks -- is going to be felt across everybody’s product groups, whether it’s in credit cards or mortgages,” Bank of Nova Scotia Chief Risk Officer Brian Porter said in a March 2 interview.
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The Globe and Mail, Tara Perkins & Boyd Erman, 6 March 2009
Canada's banks are finally getting some respect.
Derided for years as meek and mild while banks around the world expanded wildly, suddenly the reputation of Canada's big lenders as prudent and sometimes downright boring has become an asset instead of a liability.
U.S. President Barack Obama has heaped praise on the management of this country's financial system. Ireland is considering overhauling its system to look more like Canada's. Financial papers around the world are running headlines such as “Canada banks prove envy of the world.”
Whether measured by market value, balance sheet strength or profitability, Canada's banks are rising to the top. Since the credit crunch began in the summer of 2007, the Big Five banks have booked a total of $18.9-billion in profits.
In roughly the same period, the five biggest U.S. banks have lost more than $37-billion (U.S.). One, Wachovia Corp., was forced to sell out to avoid failing. Another, Citigroup Inc., long the world's largest bank, may have to be nationalized and this week became a penny stock. The picture is similar in Britain.
The U.S. has spent most of the $700-billion the government earmarked for bank bailouts, and there are estimates that the final tally could be more in the trillions of dollars. The head of the Bank of England said last month that it's “impossible” to know how much money it will take to fix his country's banks.
Canada, by contrast, has not had to inject capital directly into banks, other than starting a program to buy from banks $125-billion (Canadian) of insured mortgages – any losses from which the government was already on the hook for anyway.
The reason comes down to a fundamental conservatism. From lending practices to bets on trading to financial reserves and takeovers, the Big Five banks have long tended to be more careful than their global peers. And when they did want to get aggressive, government and regulators held them in check.
“The Canadian banks were under a significant amount of pressure from both the analysts and the marketplace in general to be more aggressive in expanding into international markets, particularly the United States, and I think to some degree resisted partially because of a more conservative approach,” says RBC chief executive officer Gordon Nixon.
Still, the industry has had stumbles, most notably Canadian Imperial Bank of Commerce's misadventure in derivatives, which led to a $2.1-billion loss for 2008.
And shareholders in Canadian banks have been battered. As a group, the banks' shares are down almost 50 per cent since Aug. 1, 2007, with most of the decline in the past six months as the economy worsened.
The concern weighing on these bank shares, for starters, is that profit growth in general is a thing of the past until the economy picks up. Most analysts say the banks' profits will shrink in coming quarters as more loans go sour and margins on lending tighten up. There's also nagging doubts that dividend payments are unsustainable and that something bad is still lurking on balance sheets.
More writedowns are likely in store for banks such as Toronto-Dominion Bank and Royal Bank of Canada, both of which made big acquisitions in recent years that now look overpriced.
Still, bank bosses such as Rick Waugh, CEO of Bank of Nova Scotia, say the banks are insulated from lingering problems because they have profits rolling in from many sources.
“We have made mistakes,” he says, “but we made sure that we were well diversified.”
That's a result of a conservatism not just among executives. That same approach extends to consumers, helping the banks sail along on the strength of their domestic lending businesses.
“You've got a more balanced cultural approach towards consumption and savings than we do in this country,” says Charles Dallara, head of the Washington-based Institute of International Finance, and a former managing director at JPMorgan Chase & Co.
Much of that stems from the pain of the last recession. While the downturn of the early 1990s was short and sharp in the U.S., it was drawn out in Canada, leading to more of a social evolution, says CIBC chief executive officer Gerry McCaughey.
Former central bank governor David Dodge agrees. Canadian bank executives keenly remember that period, “and there was therefore perhaps a degree of prudence, a lack of aggressiveness, in comparison with major banks around the world,” he said.
And he gives top marks to the Office of the Superintendent of Financial Institutions, Canada's banking regulator, for being more conservative than those in the U.S. or Britain. “I think that, from a regulatory point of view, you can say that the Canadian banks were more appropriately regulated.”
The final key is the structure of the mortgage market.
While U.S. banks sold a large proportion of their mortgages, Canadian banks held the bulk of theirs on their balance sheets, giving them an incentive to make sure they were good loans. Riskier ones are backed by government insurance. And the law here makes it tough for consumers to walk away from a mortgage because banks can go after other assets.
Still, the banks are wary of getting cocky when a careful approach has worked well.
“It's a good thing for us to recognize the things we do very well, but maybe do it in what is appropriately a Canadian way – with modesty,” said Bank of Montreal CEO Bill Downe.
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• Royal Bank of Canada
First quarter profit: $1.05-billion, down from $1.25-billion.
What's working: The bank's securities arm makes big bucks, and its huge retail bank in Canada generates steady earnings. RBC benefits from strong loan growth and expense control, notes UBS analyst Peter Rozenberg.
What's worrying: A foray into the U.S. leaves it exposed to the sagging American economy. Investors never like to see too much of a bank's earnings come from capital markets, because it's a volatile business. And while the securities division is doing well, it's also booking big writedowns. “RBC's Achilles heel, in Moody's view, is its U.S. operation,” the rating agency says.
What the CEO says: “As a Canadian bank with global operations, RBC does have a competitive advantage relative to many of our global peers. The fundamentals of our domestic economy, while stressed, appear stronger than in Europe and the United States, having benefited from a public policy agenda that for many years valued prudent fiscal management.”
Total assets: $713-billion
Tier 1 capital ratio (Jan. 31): 10.6 per cent
Provision for credit losses: $747-million, up from $293-million
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• Toronto-Dominion Bank
First-quarter profit: $712-million, down from $970-million.
What's working: Retail arm TD Canada Trust is a dominant force across the country. “The bank's sizable capital cushion, combined with the recurring earnings from its Canadian franchise, leave it well positioned to manage through a period of economic headwinds,” says Moody's Investors Service.
What's worrying: TD expanded in the U.S. just as things were getting really bad. Now, the bank has the biggest U.S. retail banking presence of any Canadian bank – half of all the bank's branches are in the U.S. Plus, TD owns a big U.S. wealth management operation that may suffer as markets plunge. The consensus among analysts is that the bank's securities and trading side isn't big enough to make up for declining performance in other areas of the bank.
What the CEO says: “We are living in unprecedented times. So what we consider solid performance in the current environment is certainly not what we would be happy with in the long term. … We are going to take some bruises if the situation gets worse, but we're still going to be able to deliver solid earnings.”
Total assets: $585-billion
Tier 1 capital ratio (Jan. 31): 10.1 per cent
Provision for credit losses: $537-million, up from $255-million
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• Bank of Nova Scotia
First-quarter profit: $842-million, up from $835-million.
What's working: The bank's international business – the largest of the Canadian banks – posted a record quarter, and Scotiabank's reputation for risk management remains intact. The bank's securities and trading arm, Scotia Capital, had a near-record quarter.
What's worrying: Investors are leery of exposure to car loans and the auto industry. They are also keeping an eye on the bank's corporate loan book, the biggest of any Canadian bank.The bank's large international division, with a big presence in Latin America, was much more profitable than anticipated in the latest quarter, but the macro environment in Latin America has deteriorated in recent months, notes RBC Dominion Securities analyst André-Philippe Hardy.
What the CEO says: “The banking sector in Canada is still in good shape. Some say the best in the world. As a group, we are all very well capitalized by global standards. And Scotiabank clearly demonstrated this by the fact that we were able to raise more capital this quarter, all of it from the market, from private sources.”
Total assets : $510-billion
Tier 1 capital ratio at Jan. 31: 9.5 per cent
Provision for credit losses: $281-million, up from $111-million
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• Canadian Imperial Bank of Commerce
First-quarter profit: $147-million, up from a loss of $1.46-billion.
What's working: Most of the big problems relating to exposure to subprime-linked investments are behind the bank, and its balance sheet is rock solid after raising another $1.6-billion of capital this week. Analysts and investors like the fact that its Canadian-focused business means bad U.S. loans aren't a big issue.
What's worrying: The bank is getting out of or cutting back in so many business lines to avoid problems that it's unclear where growth will come from. Investors worry that the bank is becoming so risk-averse that it won't be able to compete.
Its core consumer lending segment saw earnings decline 14 per cent in the latest quarter, due in large part to rising provisions for bad credit card, manufacturing and real estate loans, notes Blackmont Capital analyst Brad Smith.
What the CEO says: “Market conditions worldwide for banks remain difficult. Yet arguably one of the better places to be right now is in Canada. At CIBC, the majority of our revenue is derived from retail markets, where we enjoy strong market positions in a broad range of products and services.”
Total assets: $354-billion
Tier 1 capital ratio at Jan. 31: 9.8 per cent (it's now a whopping 11.5 per cent)
Provision for credit losses: $284-million, up from $172-million
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• Bank of Montreal
First-quarter profit: $225-million, down from $255-million.
What's working: The bank's trading operations are buoying profit, and its retail operations are rebounding after lagging for years. A switch toward more profitable products, such as lines of credit, is helping the core operations churn out strong earnings.
What's worrying: Investors are concerned that trading profits can disappear fast, and the bank has a U.S. loan portfolio by virtue of its presence in the U.S. Midwest. There's also a nagging worry that the bank will cut its dividend that won't go away no matter how many times CEO Bill Downe says the payout is safe.
Credit Suisse analyst James Bantis is watching for rising credit losses in the $42-billion (U.S.) U.S. loan portfolio. He sees a large drop-off in the quality of the U.S. portfolio, which accounts for 27 per cent of BMO's loan book, compared to the Canadian portfolio.
What the CEO says: “Financial institutions everywhere continue to face headwinds in credit markets and the capital markets environment. BMO is well positioned to meet these challenges, having accessed markets to bolster our capital position and having further strengthened our strong liquidity in the period, albeit at a higher cost.”
Tier 1 capital ratio at Jan. 31: 10.21 per cent
Total assets: $443-billion
Provisions for credit losses: $428-million, up from $230-million
;
Canada's banks are finally getting some respect.
Derided for years as meek and mild while banks around the world expanded wildly, suddenly the reputation of Canada's big lenders as prudent and sometimes downright boring has become an asset instead of a liability.
U.S. President Barack Obama has heaped praise on the management of this country's financial system. Ireland is considering overhauling its system to look more like Canada's. Financial papers around the world are running headlines such as “Canada banks prove envy of the world.”
Whether measured by market value, balance sheet strength or profitability, Canada's banks are rising to the top. Since the credit crunch began in the summer of 2007, the Big Five banks have booked a total of $18.9-billion in profits.
In roughly the same period, the five biggest U.S. banks have lost more than $37-billion (U.S.). One, Wachovia Corp., was forced to sell out to avoid failing. Another, Citigroup Inc., long the world's largest bank, may have to be nationalized and this week became a penny stock. The picture is similar in Britain.
The U.S. has spent most of the $700-billion the government earmarked for bank bailouts, and there are estimates that the final tally could be more in the trillions of dollars. The head of the Bank of England said last month that it's “impossible” to know how much money it will take to fix his country's banks.
Canada, by contrast, has not had to inject capital directly into banks, other than starting a program to buy from banks $125-billion (Canadian) of insured mortgages – any losses from which the government was already on the hook for anyway.
The reason comes down to a fundamental conservatism. From lending practices to bets on trading to financial reserves and takeovers, the Big Five banks have long tended to be more careful than their global peers. And when they did want to get aggressive, government and regulators held them in check.
“The Canadian banks were under a significant amount of pressure from both the analysts and the marketplace in general to be more aggressive in expanding into international markets, particularly the United States, and I think to some degree resisted partially because of a more conservative approach,” says RBC chief executive officer Gordon Nixon.
Still, the industry has had stumbles, most notably Canadian Imperial Bank of Commerce's misadventure in derivatives, which led to a $2.1-billion loss for 2008.
And shareholders in Canadian banks have been battered. As a group, the banks' shares are down almost 50 per cent since Aug. 1, 2007, with most of the decline in the past six months as the economy worsened.
The concern weighing on these bank shares, for starters, is that profit growth in general is a thing of the past until the economy picks up. Most analysts say the banks' profits will shrink in coming quarters as more loans go sour and margins on lending tighten up. There's also nagging doubts that dividend payments are unsustainable and that something bad is still lurking on balance sheets.
More writedowns are likely in store for banks such as Toronto-Dominion Bank and Royal Bank of Canada, both of which made big acquisitions in recent years that now look overpriced.
Still, bank bosses such as Rick Waugh, CEO of Bank of Nova Scotia, say the banks are insulated from lingering problems because they have profits rolling in from many sources.
“We have made mistakes,” he says, “but we made sure that we were well diversified.”
That's a result of a conservatism not just among executives. That same approach extends to consumers, helping the banks sail along on the strength of their domestic lending businesses.
“You've got a more balanced cultural approach towards consumption and savings than we do in this country,” says Charles Dallara, head of the Washington-based Institute of International Finance, and a former managing director at JPMorgan Chase & Co.
Much of that stems from the pain of the last recession. While the downturn of the early 1990s was short and sharp in the U.S., it was drawn out in Canada, leading to more of a social evolution, says CIBC chief executive officer Gerry McCaughey.
Former central bank governor David Dodge agrees. Canadian bank executives keenly remember that period, “and there was therefore perhaps a degree of prudence, a lack of aggressiveness, in comparison with major banks around the world,” he said.
And he gives top marks to the Office of the Superintendent of Financial Institutions, Canada's banking regulator, for being more conservative than those in the U.S. or Britain. “I think that, from a regulatory point of view, you can say that the Canadian banks were more appropriately regulated.”
The final key is the structure of the mortgage market.
While U.S. banks sold a large proportion of their mortgages, Canadian banks held the bulk of theirs on their balance sheets, giving them an incentive to make sure they were good loans. Riskier ones are backed by government insurance. And the law here makes it tough for consumers to walk away from a mortgage because banks can go after other assets.
Still, the banks are wary of getting cocky when a careful approach has worked well.
“It's a good thing for us to recognize the things we do very well, but maybe do it in what is appropriately a Canadian way – with modesty,” said Bank of Montreal CEO Bill Downe.
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• Royal Bank of Canada
First quarter profit: $1.05-billion, down from $1.25-billion.
What's working: The bank's securities arm makes big bucks, and its huge retail bank in Canada generates steady earnings. RBC benefits from strong loan growth and expense control, notes UBS analyst Peter Rozenberg.
What's worrying: A foray into the U.S. leaves it exposed to the sagging American economy. Investors never like to see too much of a bank's earnings come from capital markets, because it's a volatile business. And while the securities division is doing well, it's also booking big writedowns. “RBC's Achilles heel, in Moody's view, is its U.S. operation,” the rating agency says.
What the CEO says: “As a Canadian bank with global operations, RBC does have a competitive advantage relative to many of our global peers. The fundamentals of our domestic economy, while stressed, appear stronger than in Europe and the United States, having benefited from a public policy agenda that for many years valued prudent fiscal management.”
Total assets: $713-billion
Tier 1 capital ratio (Jan. 31): 10.6 per cent
Provision for credit losses: $747-million, up from $293-million
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• Toronto-Dominion Bank
First-quarter profit: $712-million, down from $970-million.
What's working: Retail arm TD Canada Trust is a dominant force across the country. “The bank's sizable capital cushion, combined with the recurring earnings from its Canadian franchise, leave it well positioned to manage through a period of economic headwinds,” says Moody's Investors Service.
What's worrying: TD expanded in the U.S. just as things were getting really bad. Now, the bank has the biggest U.S. retail banking presence of any Canadian bank – half of all the bank's branches are in the U.S. Plus, TD owns a big U.S. wealth management operation that may suffer as markets plunge. The consensus among analysts is that the bank's securities and trading side isn't big enough to make up for declining performance in other areas of the bank.
What the CEO says: “We are living in unprecedented times. So what we consider solid performance in the current environment is certainly not what we would be happy with in the long term. … We are going to take some bruises if the situation gets worse, but we're still going to be able to deliver solid earnings.”
Total assets: $585-billion
Tier 1 capital ratio (Jan. 31): 10.1 per cent
Provision for credit losses: $537-million, up from $255-million
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• Bank of Nova Scotia
First-quarter profit: $842-million, up from $835-million.
What's working: The bank's international business – the largest of the Canadian banks – posted a record quarter, and Scotiabank's reputation for risk management remains intact. The bank's securities and trading arm, Scotia Capital, had a near-record quarter.
What's worrying: Investors are leery of exposure to car loans and the auto industry. They are also keeping an eye on the bank's corporate loan book, the biggest of any Canadian bank.The bank's large international division, with a big presence in Latin America, was much more profitable than anticipated in the latest quarter, but the macro environment in Latin America has deteriorated in recent months, notes RBC Dominion Securities analyst André-Philippe Hardy.
What the CEO says: “The banking sector in Canada is still in good shape. Some say the best in the world. As a group, we are all very well capitalized by global standards. And Scotiabank clearly demonstrated this by the fact that we were able to raise more capital this quarter, all of it from the market, from private sources.”
Total assets : $510-billion
Tier 1 capital ratio at Jan. 31: 9.5 per cent
Provision for credit losses: $281-million, up from $111-million
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• Canadian Imperial Bank of Commerce
First-quarter profit: $147-million, up from a loss of $1.46-billion.
What's working: Most of the big problems relating to exposure to subprime-linked investments are behind the bank, and its balance sheet is rock solid after raising another $1.6-billion of capital this week. Analysts and investors like the fact that its Canadian-focused business means bad U.S. loans aren't a big issue.
What's worrying: The bank is getting out of or cutting back in so many business lines to avoid problems that it's unclear where growth will come from. Investors worry that the bank is becoming so risk-averse that it won't be able to compete.
Its core consumer lending segment saw earnings decline 14 per cent in the latest quarter, due in large part to rising provisions for bad credit card, manufacturing and real estate loans, notes Blackmont Capital analyst Brad Smith.
What the CEO says: “Market conditions worldwide for banks remain difficult. Yet arguably one of the better places to be right now is in Canada. At CIBC, the majority of our revenue is derived from retail markets, where we enjoy strong market positions in a broad range of products and services.”
Total assets: $354-billion
Tier 1 capital ratio at Jan. 31: 9.8 per cent (it's now a whopping 11.5 per cent)
Provision for credit losses: $284-million, up from $172-million
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• Bank of Montreal
First-quarter profit: $225-million, down from $255-million.
What's working: The bank's trading operations are buoying profit, and its retail operations are rebounding after lagging for years. A switch toward more profitable products, such as lines of credit, is helping the core operations churn out strong earnings.
What's worrying: Investors are concerned that trading profits can disappear fast, and the bank has a U.S. loan portfolio by virtue of its presence in the U.S. Midwest. There's also a nagging worry that the bank will cut its dividend that won't go away no matter how many times CEO Bill Downe says the payout is safe.
Credit Suisse analyst James Bantis is watching for rising credit losses in the $42-billion (U.S.) U.S. loan portfolio. He sees a large drop-off in the quality of the U.S. portfolio, which accounts for 27 per cent of BMO's loan book, compared to the Canadian portfolio.
What the CEO says: “Financial institutions everywhere continue to face headwinds in credit markets and the capital markets environment. BMO is well positioned to meet these challenges, having accessed markets to bolster our capital position and having further strengthened our strong liquidity in the period, albeit at a higher cost.”
Tier 1 capital ratio at Jan. 31: 10.21 per cent
Total assets: $443-billion
Provisions for credit losses: $428-million, up from $230-million
