09 August 2011

Bank Shares Retrace Under High Systemic Risk

Scotia Capital, 9 August 2011

Banks and Systemic Risk/U.S. Downgrade in a Fragile Market – Revisit Capital Markets Impact to Canada/Bank Downgrades in 1992

• S&P downgraded U.S. credit rating from AAA to AA+ on Friday August 5, 2011, placing additional stress on global markets and increasing overall systemic risk. Bank stocks in general do not do well with heightened systemic risk: however. banks with low balance sheet risk can hold up surprisingly well on a relative basis, although share price declines in the short term on an absolute basis are usually inevitable.

• As per our Daily Edge note published on July 29th titled "Bank Shares Retrace Under High Systemic Risk/Soft Earnings; U.S. Treasuries Exposure Very Manageable", we estimate Canadian banks' U.S. Treasuries exposure at $61 billion, or 2.1% of assets, with relatively modest duration estimated at 3.8 years. If we assume that U.S. Treasuries yield increases 50 basis points along the entire yield curve and there is no hedging or matching, earnings would be reduced by 3.0% on our 2012 earnings estimates. We also estimate the capital impact to be negligible (see note for details). Canadian banks' balance sheet risk, we believe, is very low with negligible exposure to PIIGS, very manageable exposure to U.S. Treasuries and OECD debt, and no U.S. legacy mortgage problems. Canadian banks also operate in a relatively stable industry environment with a non-hostile regulator/government in a country with a relatively sound fiscal position (Exhibit 2).

• The market's reaction to the S&P downgrade of the U.S. is certainly magnified as one would expect versus the reaction from the credit rating downgrade of Canada in the early 1990s, especially given the level of systemic risk that currently persists.

• Canadian bank stocks have now declined by 17% since they reached new all-time highs in April of this year due, we believe, mainly to systemic risk although soft earnings and weak economic growth also contributed to the share price retrace. The bank share price decline from their highs equates to a decline in market capitalization of $54 billion, which almost equals their entire $61 billion in estimated U.S. Treasuries exposure. However, bank share prices are expected to remain under pressure until systemic risk moderates, as high systemic risk typically outweighs fundamentals in the short term. In the medium to long term, heightened systemic risk should create buying opportunities for fundamentally sound banks. However, the difficulty is always gauging the market's reaction time and the magnitude of the response to systemic risk.

• Canadian bank stocks' performance has been weak in 2011 with the Bank Index down 7% year-to-date, partially offset by a dividend yield of approximately 4%. However, on a relative basis, bank stocks are outperforming the TSX, which is down 13% YTD and substantially outperforming global banks with the MSCI World Commercial Bank Index down 25%. Global banks are having a rough year, with the five large US banks down 32%, Swiss banks down 32%, UK banks down 24% and even the Australian banks down 15%.

• It is an interesting dilemma for global investors that have played the bank beta trade on the deep discount banks (market to tangible book not P/E) hoping for a return to a "normal" environment post Financial Crisis I versus the steadier low-risk banks (Canadian). Canadian bank stocks thus far are holding up relatively well in Financial Crisis II, not dissimilar to their performance in Financial Crisis I.

• To accurately predict how long Financial Crisis II will last and how low valuations will dip is not feasible. However, with Canadian banks' dividend yield now 4.3% with earnings yield 2.3x corporate AA bond yields, we are seeing glimpses of Financial Crisis I type discounting. The banks' P/E multiple is 11.5x trailing and 9.4x 2012 earnings estimate.

• On a long-term macro basis, if the next couple of decades have lower economic growth from government deleveraging and the equity markets have modest returns, dividends will likely represent a much larger portion of total market returns. According to Research Affiliates LLC, dividends have represented 25% of total market returns from 1989 to 2009 versus dividends representing 53% of total market returns on a longer-term basis from 1871 to 2009 (Exhibit 19). Thus, if we expect a shift towards the higher contribution from dividends, Canadian bank stocks that have increased their dividends at nearly 10% CAGR over the past 40 plus years fit this profile very well. Remain Overweight the bank group.

Revisit Capital Markets Impact of S&P Downgrade of Canada from AAA in 1992

• If we look at the S&P downgrade of Canada's credit rating in 1992 from AAA to AA+, we see a relatively modest response post the announcement (Exhibit 5). It appears the market discounted the downgrade one month prior as the TSX declined 8%, slightly less than the 9% decline for the Bank Index. The S&P 500 declined approximately 4% one month prior with TSX underperforming by 4%. The bond market also was very active one month prior with 10-year Canada bond yields spiking 66 bps and 47 bps relative to US 10-year Treasuries. Canada bond yields regained 42 bps of the spread one month post the downgrade.

• Canadian bank stocks did underperform the market by 7% one year post the downgrade but we believe this was impacted by the banks' large concentrated commercial real estate exposure to companies such as O&Y and projects such as Canary Wharf and low level of earnings (Exhibit 9).

• So it seems the market impact under a split rating was moderate and it was almost fully discounted by the time of the announcement. However, when Moody's downgraded Canada in June of 1994, the bond market reacted quite sharply in the three months prior to the downgrade, with 10-year bond yields spiking 163 bps and the spread with U.S. bonds widening 83 bps. Interesting that the peak Canada-U.S. bond spread was actually 269 bps in October 1990, two years before the first rating downgrade by S&P (Exhibits 12, 13)

• The banks declined 10% in a three-month period prior to Moody's downgrade versus the TSX declining 2% with the banks underperforming by 8%. Again, we believe that the bank underperformance was heavily influenced by earnings declines driven by the large loan losses it was booking on its commercial real estate portfolios.

Canadian Bank Credit Ratings – Downgrades/Upgrades

• S&P downgraded (Exhibit 7) two major Canadian banks in 1992: TD and RY. S&P downgraded TD from AA+ to AA on March 9, 1992, seven months before it downgraded Canada on October 14, 1992. RY's credit rating was downgraded from AA to AA- on October 26, 1992, less than two weeks after Canada was downgraded. The RY downgrade brought RY to AA-, in line with BMO's, BNS's, and CM's credit ratings, which were unchanged. NA's rating was unchanged at A.

• Further Canadian bank credit rating downgrades began in 1999 with both TD and BNS being downgraded, followed in 2002 by a downgrade (telco & cable exposure) for CM and a further TD downgrade. The TD and CM downgrades were despite Canada's upgrade back to AAA from AA+ on July 29, 2002.

• S&P did however upgrade BNS in 2004 to AA- and TD in 2007 to AA-. The last Canadian bank to be downgraded was BMO in 2007 to A+ from AA-.

• RY's share price relative to the bank group underperformed 13% in the year prior to its downgrade but outperformed for the most part after. TD's share price underperformed 16% in the year prior to the downgrade but outperformed after the announcement.

U.S. Banks Vulnerable – BAC, C

• The Canadian banks' credit rating are currently high relative to global peers as highlighted in Exhibit 4, and we would expect Canadian banks to fare relatively well on the rating front through Financial Crisis II. The five major U.S. banks are listed, with Bank of America and Citibank particularly vulnerable to the U.S. downgrade, both rated A with negative outlook. The market certainly appears to be discounting a downgrade and or at least some major concerns about balance sheet risk. BAC share price is down 51% year-to-date with Citibank down 41%.