Wednesday, March 30, 2016

Are Canadian Banks in Big Trouble?

Barbara Shecter of the National Post reports, TD expects ‘next shoe to drop’ on Canadian banks’ relatively low oil loan provisions:
Canadian banks are taking lower provisions for oil and gas related credit losses than their U.S. counterparts, prompting observers to dig into the reasons behind the trend.

Reserves related to oil and gas loans held by U.S. banks are four to five times higher than those held by the Canadian banks, according to analysts at TD Securities, who believe accounting treatments and interpretations are, at least in part, behind the striking difference.

In a note Tuesday, the TD analysts led by Mario Mendonca said loan quality within the portfolios could also be another reason, with historical loss trends suggesting Canadian banks are more conservative lenders.

Still, they said there is more to than that, including how aggressive each country’s regulators are, and interpretations under two different accounting regimes: U.S. Generally Accepted Accounting Principles (GAAP), and IFRS.

A close reading “reveals what we view as a material difference in loss recognition,” the analysts wrote.

Under U.S. GAAP, they said, a loan is impaired when it is probable a credit will be unable to collect on all amounts due, based on current information and events.

IFRS accounting considers a loan impaired based on “objective evidence” surrounding a financial asset or group of financial assets.

“We believe that either there is a very significant difference in the two accounting regimes or the standards are being interpreted in very different ways,” the TD analysts wrote.

In addition, they said U.S. banks are more likely than their Canadian counterparts to use a special form of provisioning known as a collective allowance because there is a greater acceptance in the United States of releasing these reserves in the future if conditions improve.

“In any event, the result is that the U.S. banks are likely to hold materially higher allowances on their oil and gas loans and, as they did post the financial crisis, release the collective allowances into earnings sometime in the future,” Mendonca and his team wrote.

Despite the differences, Canadian banks have begun to increase provisions for credit losses, reflecting the early impact of low oil prices.

The TD analysts said they expect “the next shoe to drop” in Canada when second-quarter results are posted this spring.

“Despite the recent move in oil, futures are flat year-to-date and prices are still down materially since the fall 2015 determinations,” they wrote. “This should result in further pressures on borrowing bases and the potential for covenant breaches.”

Combined with expected “prodding” from the Office of the Superintendent of Financial Institutions (OSFI), Canada’s key bank regulator, “we expect impairments and credit losses to climb,” the analysts said.
Canadian banks are already starting to put the screws on oil companies. Last week, Zero Hedge reported, A Glimpse Of Things To Come: Canadian Oil Company Liquidates Hours After Bank Demands Repayment.

It's no wonder Alberta's housing market is taking a beating after the historic plunge in oil prices. And as I wrote yesterday in my comment on shifting the focus on enhancing the CPP, I expect Alberta's woes to spill over to the rest of the country.

I've long been short Canada and despite the recent pop in oil prices and the loonie, I haven't changed my mind on that macro call. I fundamentally believe the worst is yet to come for Canada because my big picture outlook for global deflation hasn't changed.

And global deflation spells big trouble for all banks, not just Canadian ones. In fact, have a look at the U.S. Financial Sector ETF (XLF) and you will notice it's rising from its low in mid February but basically going nowhere as it's still below its 200-day and 400 day moving average (click on image):


Speaking at the Economic Club of New York on Tuesday, Federal Reserve Chairwoman Janet Yellen said that while the U.S. economy remains on track, the Fed still intends to pursue only a gradual increase in interest rates, stating global uncertainty justifies a slower path of rate increases.

I've already written about the sea change going on at the Fed, so none of this surprises me. Moreover,  Jeffrey Gundlach, the widely followed bond king who runs DoubleLine Capital, said on Monday that an interest-rate increase by the Federal Reserve in April is "inconceivable," given lower forecasts for first-quarter GDP growth.

What's worrying Janet Yellen? In my opinion, global deflation coming to America. The Fed is desperately trying to talk down the U.S. dollar, especially now that a profits recession has already hit the U.S. economy, threatening future employment gains (click on image): 



The latest strategic analysis from the Levy Economics Institute, Destabilizing and Unstable Economy, reveals that the US economy remains fragile because of three persistent structural issues: weak demand for US exports, fiscal conservatism, and a four-decade trend in rising income inequality. It also faces risks from stagnation in the economies of the United States’ trading partners, appreciation of the dollar, and a contraction in asset prices.

So here you have the U.S. economy slowing at a time when China, Japan and Europe remain mired in deflation, and we think little old Canada is going to do well in this environment? Sure, the lower loonie can help manufacturing exports, but if you ask me, many Canadian economists, especially bank economists, are way too optimistic on Canada's growth prospects going forward.

As far as Canadian banks, if you look at the BMO S&P/TSX Equal Weight Banks Index ETF (ZEB.TO), they too have performed better than their U.S. counterparts recently, basically bouncing up as oil prices rallied from their lows (click on image):


And when Canadian banks do well, the entire Canadian stock market does well (click on image):


But this countertrend rally won't be sustained as global deflation becomes more entrenched and as I've repeatedly warned you, use any spike in oil prices to short the loonie and lighten your position in energy and commodity shares.

I think what happened in Canada at the start of the year was a classic rotation into energy and commodity shares by global asset allocators who thought the loonie was cheap and these shares will bounce, which they did.

Now, if you're betting on a global recovery, you should continue buying Canadian banks, energy and commodity shares. If you think it's going to fizzle out in the second half of the year, stay away or sell these shares. This is all part of a global RISK ON/ RISK OFF trade that dominates markets.

When it comes to shorting Canada, however, I prefer shorting the loonie than Canadian banks. Why? Because every time they dip, all of Canada's big pension funds buy them and so do Canadian mutual funds. Canadian banks offer stable and attractive dividends, are well managed and they pass most of the mortgage risk from any potential housing crisis off to the Canada Mortgage and Housing Corporation (CMHC guarantees the bulk of the mortgages in Canada).

Still, a protracted global deflationary slump will present huge challenges to all global banks, including Canadian ones. This is why I agree with a buddy of mine who recommends Canadians buy shares of BCE in their retirement portfolio when they dip big, not now as they've run up too much as everyone chases dividends (click on image):


If you absolutely want to invest in Canadian banks, preferred shares are another option. One former colleague of mine loaded up on preferred shares of Canadian banks late last year as they got decimated. He rightly noted the risk/reward tradeoff at the time was much better than buying the common shares (read this article on preferred shares to understand why they got clobbered last year).

Finally, David Tavadian, founder of the Global Investment Strategy Institute (GISI), a new independent strategy & research firm based here in Montreal, sent me an interesting research paper on investing in U.S. relative to Canadian banks. You can contact David at davidt@thegisi.com and ask him to email you this Special Report which he co-authored with Jean Roy, professor of Banking & Finance at HEC Montreal. This report is excellent and well worth reading. 

Below, watch excerpts of Federal Reserve Chairwoman Janet Yellen speaking at the Economic Club of New York on Tuesday, warning that global uncertainty justifies a slower path of rate increases.  

I'm afraid the Fed and other central banks are realizing that there's little they can do to stem off the global deflation tsunami which is why markets are defying them right now. 

If global deflation sets in, the new negative normal will hit all countries, including Canada and the United States, placing huge pressure on all banks to deliver the return on equity (ROE) targets of the past.

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