Shorting the Canadian Banks



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Everyone knows that Canada's banks weathered the financial crisis because they are the best in the world. We think this is nonsense.

We feel that the Canadian banks do have some protections that other world banks do not have and that they are less exposed to a housing downturn. However, we think that the Big 5 banks are overleveraged and will greatly feel the pain of the upcoming housing bust.

We're not here to discuss the fact that Canada is in a housing bubble, nor why they are in such a state. The fact of the matter is Canada has experienced the run up into a large asset bubble the same as the USA. Canada has managed to keep this bubble inflated, but there are now signs that it is weakening.

Shorting the Canadian Banks

We have long pondered how to play this bubble. There do not seem to be any USA style slam dunk shorts. You can't short Mortgage Backed Securities in Canada because they are the domain of the Canadian Mortgage Housing Corporation (CMHC). They are insured by, you the tax payer, against any loses. Many bank mortgages are backed by the CMHC and this will limit the downside on the banks. This exemplifies plus #1 that the Canadian banks have going for them

1) the government aka the Taxpayer will absorb many housing write-downs for the banks.

The other is:

2) The banking oligolopy (the big five banks) are able to charge fees and raise fees during times of crisis. Again, this hoses you, the consumer.

The two main things that the banks have protecting them from a major downturn are going to cost you in taxes and fees.

Now that we've gotten these major pluses out of the way, we can explore what we actually believe to make good shorting opportunities here.

Attitudes lead to Overvaluation

The media has gone crazy blathering on about how great the Canadian banks are and even going so far as to suggest the Canadian system as a model for the world. They go on and on about how well capitalized the banks are, how they don't loan sub prime and other such claims. Naturally, large banks in other countries would like to adopt the Canadian system because it would give them the opportunity to hose consumers the same way the Big 6 Canadian banks do.

We intend to prove that the above attitude is incorrect with the following financial bullet points.

  1. The Canadian banks are highly leveraged (eg. CIBC has about 27 tangible assets to 1 tangible equity.)
  2. The Canadian banks over value their assets.
  3. CMHC defaults will cover the banks capital loses, but not their lost interest payments from mortgage holders.
  4. Price/Tangible Book Values of the big 5 banks are very high (eg. Royal Bank has a p/b of 2.8)
  5. The banks have relatively low Tier 1 Capital Ratios (eg. Bank of Nova Scotia has 11%)

Below you can find a table that illustrates this:

TICKER NAME Market CAP Billions Share PRICE P/E Ratio Div. YIELD TAGIBLE BOOK Blns p/b tangible book goodwill Tier 1 Capital tangible assets to tangible book
ry Royal Bank 79.82 55 15.6 3.66 28.4 2.8106 8 bln 12.90% 24
td TD bank 65 73.6 14.6 2.37 24.9 2.6104 14 bln 12.50% 24.4
cm CIBC 30.7 77.7 12.6 4.5 12.9 2.3798 14.2 26.7
bns BNS 55 52 14.4 3.7 23.2 2.3707 11.70% 22.6
bmo Bank of Montreal 33.4 60 11 4.7 18.2 1.8352 13.50% 21
ny National Bank of Canada 11.23 69 12.3 3.55 5.7 1.9702 0.7 14 25

Below are a few select international banks that we have discussed on this site in the past. With the same headings as above.

HCBK HUDSON CITY BANCORP 6 11.53 10.3 5.2 5.5 1.0909 0.125 22.42 11
TNCC Tennessee Commerce 0.05 6.6 N/A 0.123 0.4065 0
STD Banco Santander 85 10.38 8.3 6.82 33.2 2.5602 23 BLN
BAC BANK OF AMERICA 111 11.07 NEG N/A 131 0.8473 75 BLN 11.16 17

As you can see, the Canadian banks are carrying a lot of leverage (the last column on the table). Compared to some banks, they write themselves a lot of goodwill, but compared to others, not so much. The item that is much higher is the price to tangible book value. RBC is the worst offender here. Their stock price has propelled them to multiples of book value. Hudsons Bancorp, a bank we have discussed on the site in the past, has a p/b of about 1.09. HCBK is a very well run bank in the US and has constantly increased profits - even during the financial crisis!

When comparing Canadian to US banks, it needs to be noted that the housing bubble has fully or mostly unwound in the south but in Canada it may have just peaked.

From the numbers presented above, we have determined the best shorts to be Royal Bank, Toronto Dominion, and CIBC. The Royal bank combines the worst of all the above factors. They have high leverage, low Tier 1 Capital, the highest p/b values of a Canadian big 5 bank. RY and TD especially pay lower dividends, so you will have to pay out less dividends as you short them. See our disclaimer and disclosure below.

Appendix

The Banks of Canada

Big 6 banks by market Cap The rest of the banks

 

Data tries to be current as of Dec 2, 2010.

Disclosure: the author is long TNCC, HCBK and short TD and RY at the moment. Dec 2, 2010.