July 09, 2012 - 11:40am EST by
2012 2013
Price: 100.00 EPS $0.00 $0.00
Shares Out. (in M): 100 P/E 0.0x 0.0x
Market Cap (in $M): 100 P/FCF 0.0x 0.0x
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 0 TEV/EBIT 0.0x 0.0x
Borrow Cost: NA

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  • Canada
  • Banks
  • Macro
  • Lending


We believe the time to short Canadian banks is at hand. We focus specifically on Royal Bank of Canada (NYSE: RY), Canadian Imperial Bank of Commerce (NYSE: CM), and Bank of Nova Scotia (NYSE: BNS).  While bubble crashes are notoriously hard to time, we will lay out key observations on the Canadian housing market and banking environment that indicate we may be at an inflection point where the bubble may finally burst.

The chart in the link below shows how frothy the Canadian housing market has become.  It is striking how U.S.and Canadian home prices decoupled in 2006-2007, when the U.S. began a sharp reversal even as Canadian home prices marched steadily higher.  Professor Robert Shiller, who created the S&P/Case-Shiller homer price index, and who correctly called the U.S. housing bust, attributes this to sharply rising oil prices during the financial crisis, which supported Canadian exports and boosted the economy as output fell.  Today, the Canadian housing market is the second most unaffordable housing market in the developed world.  Canadian home prices grew at a 7.5% CAGR between 2000-2011.  Meanwhile, the population of Canada is growing at slightly over a 1% rate.

The Canadian Real Estate Association (CREA) estimates that the average sale price of a home in Canada has increased by 35% since January of 2009.  For a more granular view of recent Canadian home price changes, note the below recent price history of CREA’s Aggregate MLS Home Price Index, which indicates continued price appreciation over the past year: 

12 Months Ago            148.0

6 Months Ago              149.2

3 Months Ago              150.9

1 Month Ago                154.7

May 2012                    155.7

Another indicator of the rich valuation of Canadian home prices is in comparison to global housing markets.  The table in the link below, from The Economist, compares current versus historical worldwide price/income and price/rent ratios.  Note that Canada’s ratios are suggesting a 54% overvaluation, a rate that ranks it among the most overvalued in the world.

Remember NINJA loans Alt-A, and subprime from the U.S. housing bust?  Well, they are alive and well in Canada.  The link below describes a Bank of Canada report that values the Canadian housing market at $1.1 trillion, and then cites conversations with lenders who estimate that up to 20% of the market is currently subprime.  That is a proportion that mirrors that for the U.S., which went from a historical 8% rate to approximately 20% just prior to its subprime mortgage crisis. 

We examined two regional bellwethers for the Canadian market--Toronto and Vancouver--which have both grown rapidly over the past decade.

The Toronto market was red hot earlier this year, with over 50,000 homes under construction, the vast majority of which were condos.  Currently there are 173 towers under construction in Toronto, far and away the largest number on the continent.  We remember driving through Miami during its manic condo phase just before the U.S. housing bust and seeing the skyline dotted with building cranes.  Recently, the Toronto skyline has been similarly crowded with cranes, yet as of very recently Toronto sales volumes have slowed ominously.  June home sales in the greater Toronto region were down by 5.4% versus June 2011, while in the City of Toronto sales were down by 13%, and the sale of condo units fell by 18%.  Some analysts estimate that a quarter of Toronto’s condo stock is sitting empty, suggesting a possible future “ghost city” condition.

Next consider Vancouver, where the slowdown is more pronounced.  Over the past decade, approximately three quarters of new housing in Vancouver has been condos.  In June, Vancouver hit its lowest level of home sales in over a decade, down 27.6% from June 2011, and 32.2% below the June 10-year sales average.  The Vancouver market’s total inventory is also up 22% versus 2011.

Although sales volumes have plummeted, prices are holding in both cities, but we wonder how long that can be sustained given the sharp slowdown in sales velocity.  TD Bank published a report last week that projected a 15% decline in prices in Toronto and Vancouver over the next two to three years.

Adding to Canadian bank’s concerns, Canadian household debt is at all time highs.  The ratio of Canadian household debt to disposable income has risen steadily over recent history – by 40% in the past decade – and now stands at over 150%, a rate that recently surpassed that for the U.S., which is currently deleveraging.  It would seem there are few marginal debt dollars left to push house pricing higher.

In Canada, mortgage credit makes up ~70% of outstanding household credit, with consumer credit, consisting of home-equity lines of credit (HELOCs), car loans, credit card debt, and the like, accounting for the balance.  Until the 1990s, changes in mortgage credit drove higher debt/income ratios, but recently it has been consumer credit, especially that related to home equity, that has driven debt/income higher.  Together, mortgages and HELOCs have been the primary growth drivers for the Canadian banking sector over the past decade.  In particular, the use of HELOCs has increased by 170% in the decade since 2001, and last year accounted for approximately 50% of consumer credit.  Barclays has estimated that the $183 billion of HELOCs made up approximately 13% of domestic loans by the big six banks in Canada.  Currently, Canadian home equity extraction as a percent of disposable income is approximately 8% – as high as for the U.S. at its peak.

The Bank of Montreal forecasted last week that the Bank of Canada would keep rates low through July of 2013.  Recently, Bank of Montreal conducted a stress-test against the possibility of rising interest rates.  The results indicate Canadians are not prepared for even a small increase in rates.

The survey revealed:

-The majority of Canadian homeowners (57%) say that they could still afford their home if interest rates were to climb by two per cent.

-However, one-in-five (20 percent) indicated that a two percent rise in rates would hamper their ability to afford their home; 23 percent indicated they were unsure if a rise in rates would affect them.

-Almost half of women (49 percent) would have trouble affording their home in the face of rising rates, while more than one-third (37 percent) of men claimed the same.

Remember residential mortgage-backed securities and “bankruptcy remote?”  We are experiencing déjà vu of our own experiences here in the U.S. 2004-2007.

Another concern for the financial stability of Canada generally is the way deposit insurance is structured for Canadian credit unions.

“Deposits at federally regulated financial institutions are insured by the Canadian Deposit Insurance Corporation, a federal crown corporation.  However, deposits at credit unions are guaranteed by the provinces.  Credit unions in Canada are not as tightly regulated as federally regulated banks yet they are very active in the mortgage market, particularly in BC and Quebec.

Few analysts cover them extensively since they aren’t publicly traded, but all analysts I’ve spoken to express some concern about the fate of credit unions, particularly in BC, in the event of a sustained housing correction coupled with rising unemployment and delinquencies.” –Mark Hanson Advisors, 4/5/12

-Quebec guarantees $85B in insured deposits or 26% of GDP.

-BC guarantees $45B in insured deposits, or 23% of GDP.

-Ontario guarantees $21.5B in insured credit union deposits, equivalent to 3.4% of GDP.

Provinces have individual levels of financial vulnerability, and each has its own deposit protection program.  The implication here is that a housing contraction could lead to a vicious negative feed-back loop that certain provinces are unprepared for.  If large swaths of the balance sheets of credit unions require a bailout from the provinces, it could stress segments of the Canadian economy. 

THE PLAYERS: Royal Bank of Canada (NYSE: RY), Canadian Imperial Bank of Commerce (NYSE: CM), Bank of Nova Scotia (NYSE: BNS)

Fitch recently conducted a stress test on Canada’s big six banks as to mortgage risk, applying what we feel were fairly modest three-year cumulative losses of up to 10% on residential mortgages and HELOCs.  Fitch found that Royal Bank of Canada and Canadian Imperial bank were the most vulnerable, due to the size of their domestic mortgage books.  Bank of Nova Scotia also faired poorly.

Bank    Res. Mortgage/Loans

CM      53%

RY       45%

BNS    41%

In RBC’s and BNS’s case, a higher proportion of uninsured mortgages also contributed to their poor performance in the stress test.

Bank    % Uninsured

RY       64%

BNS    44%

BMO   30%

PROFITABILITY: We believe ROE is useful measure when thinking in broad terms about bank profitability.  There are a number of factors that should pressure Canadian bank ROEs in the near term.

The Bank of Canada, and a number of regulators, have been increasingly concerned about underwriting standards.  Ottawa has tightened lending rules for mortgages insured by the Canada Mortgage and Housing Corporation (“CMHC,” who is responsible for mortgage insurance as Fannie Mae is in the U.S.) in two significant ways: 1) minimum equity capital requirements have been raised from 15% to 20%; and 2) maximum loan terms have been reduced from 30 years to 25 years.  The latter change is particularly significant, as during 2011 approximately 40% of all new mortgages were amortized over 30 years.

These new rules, which go into effect on July 9, could have unanticipated consequences, in light of the recent and dramatic changes the condo markets in Toronto and Vancouver discussed earlier.  If housing prices have peaked, then reduced buyer demand in a tougher financing environment could send prices spiraling lower.  Anyone who purchased near the peak could quickly find themselves upside down on their mortgage, leading to distressed selling, or foreclosure.

Taxpayer exposure to the CMHC is now a huge fraction of GDP.  There is growing concern at all levels of government that the tax payer should not be bearing these risks.  Further, banks have a heavy disincentive to write mortgages that are uninsured.  Reduced mortgage volumes will reduce their profit.

CMHC has suggested they will not exceed their stated CAD600bl insurance cap until 2016.  CMHC exposure is already near or at this level, and far beyond if one includes the implicit back-stopping of a private insurance company (Glenworth).  Some peg this figure at CAD840bl, or 140% of Canada’s public debt.  Suffice it to say, there is not a lot more mortgage availability left.

TD Bank CEO supports (quite surprisingly) not raising the CMHC insurance cap.

Another factor that could influence profitability for Canadian banks is the introduction in 2013 of Basel III, which will standardize minimum capital requirements.  While Canadian banks as a whole appear to be safely capitalized today, the full implementation of Basel III will take some time and may result in some unpredictable outcomes.

Additionally, according to PWC, 64% of Canadians plan to reduce debt, not increase it.  Banks require people to take loans.  This would suggest additional pressure on volumes.

In sum, we believe the current environment is exceedingly challenging for any Canadian bank trying to increase its ROE.  One can also make a case that today’s ROEs have been artificially inflated by mortgage derivatives backed by bulk-mortgage insurance from the CMHC, a source of profits that is now being reduced.  We believe ROEs will likely be pressured.

VALUATIONS: Below are P/TBV and TCE ratios for our chosen Canadian banks, along with those for comparable international banks.

Bank    P/TBV TCE Ratio

RY       2.81     3.42

CM      2.44     3.10

BNS    3.09     3.01

Avg.     2.78     3.18


Bank    P/TBV TCE Ratio

C         0.52     7.81

BAC    0.61     6.47

HBC    1.23     5.03

JPM     0.99     5.76

WFC   1.76     7.67

BCS     0.42     3.07

STD     0.92     4.02

BNP    0.64     2.78

NMR   0.82     5.37 (4th qr.2011/2011-03-31)

Avg.     0.88     5.33

As can be seen from the figures above, the Canadian banks appear to be significantly more expensive and also more thinly capitalized on the basis of P/TBV and TCE ratios than their comparable non-Canadian bank counterparts.

In connection with the TCE ratios, it is also worth noting that the mortgage insurance provided by the CMHC (as is typical with mortgage insurance), has put-back provisions in the case of misrepresentations by the borrowers.

The automated approval system of the CMHC simply acts as a rubber-stamp, and most “prime” originations in Canada are actually “Stated Asset, Stated Income,” with no actual full documentation provided for a huge proportion of originations.

The extraordinarily low TCE ratios of the Canadian banks means that if even a small percentage of their originations are put-back to them, their equity capital buffers could be compromised.

CONCLUSION: Canadian banks are near all-time highs price-wise, with lofty valuations and very low real capital levels (TCE being of paramount importance in a real crisis), with home-territory housing market (and with it profitability, let alone solvency) flashing large warning signals, with a consumer that is shouldering record debt, with likely very prevalent “soft fraud” and high chance of mortgage put-backs, and with already ultra-low interest rates. Yikes.


While the Canadian banks are compelling as stand-alone ideas, they are also compelling from a macro portfolio hedging level. 

  1. Highly correlated to the SP, trades decent volume on big board.
  2. Low short interest and cost of carry.
  3. Strong deflationary hedge.
    1. Canadian economy is levered to commodities.  If commodities deflate, Canada deflates, Canadian banks deflate.
  4. Where the U.S. economy goes, so goes Canada.
    1. Canada decoupling will not happen in the near term.
    2. U.S. economy struggling.

SUMMARY: Short a basket of Canadian banks, weighted toward RY and CM, with a lesser position in BNS. 


-Financial stress in the Canadian housing market

-Escalation of Euro-area sovereign debt crisis

-Economic slowdown in other advanced economies

-Increase in Canadian interest rates

-Rising unemployment

-Oil price shock

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