Our supporters know we are bottom-up stock pickers and as a result our portfolios can often look very different than well-known indices or peers. One material difference which leads to a lot of questions is why we don’t hold any Canadian banks in our portfolios. We thought it would be helpful to lay out a few of the reasons and give some insight as to why we have historically found more attractive opportunities south of the border (U.S. financials had been some of our largest positions in a number of funds until recently.)
Let’s be clear from the start; Canadian banks are strong franchises operating in a cozy oligopoly and have created material wealth for shareholders over the very long term. That being said, these franchises are not immune to economic cycles and have a number of pro-cyclical operating characteristics which need to be thought about when making an investment in them (or any other investment for that matter.)
Our discussion will touch on three areas. This is not an exhaustive list, but rather provides some insight into the thinking that goes into our risk / reward analytical framework, which is the cornerstone of our investment process and ensures we are being adequately compensated for the risks we take. I would also like to acknowledge our financials analyst Dan Rohinton who has been instrumental in our efforts in this area among others.
The first point relates to capital. When a bank makes a loan, they earn the spread between the interest rate charged to the customer and its cost of funds; this is commonly referred to as the Net Interest Margin (NIM). They are also required to hold capital against the loan to protect against risk that the loan is not repaid in full. The less equity capital held against the loan, all else being equal, the greater return on equity (ROE) that is generated but also the greater the risk taken. Banks therefore aim to strike a balance between generating the highest Return possible, while also prudently managing risk through credit selection and holding an appropriate amount of Equity. Below we describe a few metrics which are commonly used to analyze balance sheets across the industry.
When comparing one of the large Canadian banks to a large U.S. peer on the frequently cited metric of “Common Equity Tier 1 Ratio” (CET1), there does not appear to be much of a difference.
The information presented in the following three visuals has been collected from the financial statements of a major Canadian bank and major US bank.
However the CET1 ratio is a product of using risk weights, which are subjective, can change over time and can vary by country. When comparing leverage ratios for these same two banks (with similar CET1 ratios), it is clear which one has more aggressive leverage ratios.
An important point to note is that minimum required levels of capital can differ quite substantially depending on the type of loan. This makes sense given the risk profile of a credit card and a secured mortgage is quite different. It’s even more interesting to note however that capital requirements for similar products can vary significantly between geographies such as Canada and the U.S. Below is an illustration of the different amount of leverage that a large (Canadian) bank holds in its U.S. vs. Canadian division.
Banks in the U.S. have spent the past number of years building capital following the great financial crisis, in some cases to levels that we believe are overcapitalized. There was little choice as the regulator required all banks operating in the U.S. to become far more conservative. While this has made the industry less risky, it also had the effect of lowering ROE’s (because they had to hold more Equity for a given line of business). Banks in Canada have been permitted to utilize lower risk weights than their U.S. peers which means they have been able to hold less capital for a similar loan (i.e. higher leverage), thereby earning higher ROE’s to their American counterparts all else being equal. It also has the effect of creating higher levels of risk.
What if rules change?
The regulatory environment in Canada continues to be reviewed and while we do not know exactly how the regulatory framework will evolve over time, our job is to manage risk and consider the different scenarios which could play out. Over time it’s possible (we would argue probable) capital requirements will become more onerous for Canadian banks as the government looks to reduce risk to the taxpayer. This would have the effect of reducing their inherent risk over the long term, but would also make them less profitable all else being equal.
One area that deserves attention is insured mortgages given their importance to the economy and the entire banking sector. Insured mortgages are explicitly backed by the Canadian government (and taxpayer) through the Canadian Mortgage and Housing Corporation (CMHC). The CMHC Third Quarter Financial Report states that we as taxpayers are effectively standing behind over $514 billion of mortgages. With the guarantee the CMHC provides, banks are able to issue mortgages that carry almost no risk. Since they have "near zero risk”, banks can hold almost no capital against these mortgages. Not a bad business when you’re earning the profits and tax payers are taking the risk of loss for a modest fee.
The Canadian government is making it increasingly clear they are looking to their level of risk exposure. Over time the CMHC could reduce its exposure in a number of ways including charging higher risk premiums, risk sharing, reducing gross exposure or a combination of these actions. Should the government follow through with some of these actions, it could have the effect of raising the cost of funds and/or the amount of capital required to be held by banks who retain the mortgages on balance sheet.
In addition, when bank capital ratios are calculated, risk weights are applied to determine the amount of capital that needs to be held. In the case of CMHC insured mortgages, according to the Q4 2016 MD&A section one of the Big 5 Canadian Banks financial statements, the risk weight is near 0%, meaning almost no capital needs to be held against them; this accounts for part of the gap in CET1 & Leverage ratios between Canadian & U.S. peers. A change in government policy could result in higher risk weights (there is only one direction to go from almost 0%) meaning reduced bank profitability (due to higher capital requirements) and/or higher cost mortgages for consumers.
Banking is a cyclical business... and we do not like where we are in the cycle.
It has been a long time (over two decades) since there was a material housing market correction in Canada. This is certainly a very long time, however it doesn’t mean we are immune to cycles. Banks everywhere are impacted by the environment they operate in. In good times, consumer and business loan demand is strong and credit quality is high; this is a very profitable combination. In challenging times loan demand weakens and banks face greater risks from deteriorating credit quality. During the lean years they are also often required to hold more capital to compensate for deteriorating credit quality which is pro-cyclical, further compounding the pressure on profitability (as we saw in the U.S. following the financial crisis.)
Our job is to manage risk, consider various scenarios and invest only when the odds are stacked in our favour. While someone can always build an optimistic scenario for the Canadian consumer, economy and housing market, we believe there are multiple red flags that warrant caution today. Here are some simple, but powerful charts that illustrate where some important long-term leverage metrics now stand.
We have all seen the news articles and studies of how stretched many Canadians are today.
“More than 700,000 Canadian borrowers could be facing payment shock on their debt obligations if interest rates rise by a quarter point, and that rises to as many as one million people should rates go up by 1 per cent, says a study by credit monitoring firm TransUnion.” – Marotte, Bertrand. “Canadian borrowers could face payment shock if interest rates rise.” The Globe and Mail, Sept 13, 2016.
“CMHC waves the red flag on Canada’s housing market… CMHC singled out nine of the country’s 15 biggest housing markets as being particularly overvalued” – Evans, Pete. “CMHC waves red flag on Canada’s housing market.” CBC News, Oct 26, 2016.
“Half of working Canadians are living paycheque to paycheque and would be hard pressed to meet their financial obligations if their paycheque was delayed for a week” – The Canadian Press, “Half of working Canadians living paycheque to paycheque: survey.” The Globe and Mail, Sept 7, 2016.
It is hard to argue that we have not been given plenty of warning that the Canadian consumer has taken on an increasing level of risk. This makes the customers of Canadian banks ever more fragile to a shock whether in the form of higher interest rates, a weakening housing market, deteriorating employment or an external shock.
So while we do not believe we or others can accurately and consistently predict how the future will play out, we do believe the best way to compound wealth over time is to avoid or manage risk as best as possible. While an upside scenario for Canadian banks can be built, we believe downside risks make the risk / reward balance insufficiently attractive to warrant an investment of our clients’ hard earned capital.
We thank you, our clients for your continued support and trust. It is your support that provides us the flexibility to construct portfolios using the Cambridge philosophy and framework.
This commentary is published by CI Investments Inc. It is provided as a general source of information and should not be considered personal investment advice or an offer or solicitation to buy or sell securities. Every effort has been made to ensure that the material contained in this commentary is accurate at the time of publication. However, CI Investments Inc. cannot guarantee its accuracy or completeness and accepts no responsibility for any loss arising from any use of or reliance on the information contained herein. This report may contain forward-looking statements about a fund, its future performance, strategies or prospects, and possible future fund action. These statements reflect the portfolio managers’ current beliefs and are based on information currently available to them. Forward-looking statements are not guarantees of future performance. We caution you not to place undue reliance on these statements as a number of factors could cause actual events or results to differ materially from those expressed in any forward-looking statement, including economic, political and market changes and other developments. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.