Should Alarms Be Ringing for Canadian Banks?

by Will Ashworth | July 31, 2012 1:12 pm

Canadian banks have been the pride of the world[1] in recent years, but cracks in the system are now appearing. On July 27, Standard & Poor’s cut its outlook[2] on seven Canadian banks to negative from stable. The ratings agency cited a prolonged increase in housing prices and rising consumer debt as specific concerns regarding Canada’s future financial stability.

Should investors be worried? That’s a complicated question, which I’ll attempt to answer.

The alarm bells have been going off for some time, so S&P’s lowered outlook shouldn’t surprise anyone who follows the Canadian markets. Google the words “Mark Carney Warns,” and you’ll find at least four occasions in the past year where the head of the Bank of Canada has raised a flag about the level of consumer debt, fueled mostly by runaway housing prices. The average house price in Canada has increased 34% to $362,204 since January 2009, while they’ve basically flat-lined in the U.S.

Yet Canada’s ratio of household debt to disposable income is now 154% compared to 141% in the U.S. We Canadians have been using our homes as personal ATMs to the detriment of our financial health, and now it’s coming home to roost (this sounds all too familiar in the U.S.).

S&P’s worry is that once housing prices stall and begin to moderate, and if the economy doesn’t pick up, Canadian banks aren’t going to be making nearly as many loans. As a result, their profitability will suffer.

The Canadian government’s concern over an overheated housing market and the resulting debt effect came to a climax in June, when it announced changes to the rules governing the Canada Mortgage & Housing Corp. (CMHC), the government agency responsible for insuring a majority of Canadian mortgages. Any mortgage obtained with less than a 20% down payment must have insurance.

The big change was lowering the maximum amortization period from 30 years down to 25, essentially adding 0.9% interest to an existing mortgage. As recently as 2008, mortgages with 40-year amortizations could be insured.

This means Canadians will have a tougher time buying homes, which isn’t a bad thing. In addition, anyone looking to refinance will  be able to borrow only up to 80% of the home’s value, down from 85%. This is to prevent consumers from taking on too much debt — also a good thing.

Lastly, CMHC mortgage insurance will no longer be available for homes of more than $1 million, meaning anyone who wants a monster home will have to come up with the full 20% down payment. The Canadian Real Estate Association didn’t like the moves, but I do. The U.S. experience demonstrates that it shouldn’t be easy to own a home. It’s not a right, it’s a privilege.

Let’s assume that everything I’ve discussed up to this point suggests Canadian banks are going to see a reduction in mortgage activity in the next couple of years. How will it affect their profitability?

Not as much as you might think. All of the banks have moved aggressively into wealth management. Although iShares has a commanding 78% share of the Canadian ETF market with $38.6 billion in assets under management, Bank of Montreal (NYSE:BMO[3]) is the second largest player at 12.5%. Vanguard has recently gotten into the fight, but you can expect the other banks to get involved because Canadians are traditionally more agreeable to high fees.

Canadian Imperial Bank of Commerce (NYSE:CM[4]) and National Bank of Canada (PINK:NTIOF[5]) plan to expand their domestic wealth management businesses in 2012 and beyond, while Royal Bank (NYSE:RY[6]), Toronto-Dominion (NYSE:TD[7]), Bank of Nova Scotia (NYSE:BNS[8]) and the Bank of Montreal have international wealth management practices to lean on as well.

In 2011, these Big Six saw their wealth management net income increase by an average of 28.3%. Look for acquisitions to fuel further growth in this area.

Finally, let’s look at how a reduction in residential mortgages will hurt the banks directly, using Royal Bank as an example. At the end of 2011, Royal Bank had residential mortgages totaling $132 billion in Canada, the largest amount outstanding of the Big Six. Those mortgages generated approximately $3.6 billion in net interest income (using its net interest margin as an estimate) in 2011.

Assuming the outstanding mortgages drop by 10% to $118.8 billion and the NIM stays the same, Royal Bank would lose approximately $321 million in net interest or 22 cents a share. That’s 4.9% of its $4.45 a share in earnings for 2011. Royal Bank will figure out how to replace this income.

Ten years ago this would have taken the banks for a loop. Not anymore. Their businesses have become far more diversified accompanied by strong balance sheets. It’s a combination that will continue to make them a threat on the global banking scene.

So, should investors be worried? No — this is a blip on the radar. But it doesn’t mean you should take your eye off the screen.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

  1. Canadian banks have been the pride of the world:
  2. cut its outlook:
  3. BMO:
  4. CM:
  5. NTIOF:
  6. RY:
  7. TD:
  8. BNS:

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