Banks: Don't rush out to buy them

Bank shares have fallen 25 per cent from their peaks in 2007. But investors have many reasons to be concerned

By Bruce Freedman
Globeinvestor Magazine Online, August 27, 2008

Canadian banks are in great shape relative to their neighbours to the south. They've escaped the worst of the subprime crisis, loans are still growing at double-digit rates and credit quality is holding up exceptionally well.

So, with bank stocks down some 25 per cent from their peaks in 2007, why aren't bank analysts pounding the table to buy?

Because they know that things can get a whole lot worse.

Banks take provisions for their best guess of loan losses during a reported period. During the good years, provisions can get really low, but when the economy turns sour, they can skyrocket. During the second quarter of 2008, the industry took provisions of 0.4 per cent of loans, up 60 per cent from the previous year, and just below the cycle average of 0.5 per cent.

As third-quarter results start rolling in, Bank of Montreal's provisions have surged on the back of U.S.-related problems to an annualized rate of 0.9 per cent of loans, up from 0.3 per cent in the second quarter. Bank of Nova Scotia's provisions, while up sharply from the prior year, are still holding flat at 0.2 per cent of loans quarter-on-quarter.

With the U.S. and Canadian economies now visibly starting to slow, the current low level of provisions does not appear sustainable. According to Credit Suisse bank analyst James Bantis, provisions rose to 0.9 per cent of loans in 2002, following the post-tech bubble collapse. It was far worse in 1992, with the recession driving provisions up to 1.7 per cent of loans.

Canadian banks are well-capitalized by international standards. Their average capital-adequacy ratio, which measures equity to risk-weighted assets, is 9.6 per cent. That compares with 8.1 per cent for Société Générale SA, 7.9 per cent for Barclays Bank PLC, and 8.7 per cent for Citibank.

But Canadian banks have only a dollar in earnings for every $50 in loans. Even a modest increase in impaired loans could damage their bottom line.

While credit quality is a concern, investors should worry about other influences as well.

"A cornerstone of Canadian banks' valuation premiums has been domestic personal and commercial results and these earnings, previously viewed as stable '10 per cent-a-year earnings growth machines,' are poised to drop and perhaps for a longer-than-expected duration," said Darko Mihelic, bank analyst at CIBC World Markets.

In recent years, much of the consumer loan growth was on the back of a buoyant housing market, Mr. Mihelic said.

"In a flat-to-falling property price environment, it's unlikely that we'll be seeing much in the way of revenue growth," he said. Property sales fell 14 per cent in July, while listings rose 11 per cent. Merrill Lynch recently concluded that Canada's housing market is now the most expensive since 1991.

Further, the banks' ability to cut expenses as the economy slows will be limited, since most costs are fixed and much of the heavy penny-pinching has already occurred. Since late 2005, banks have been expanding branches and automated banking machines on the back of the strong economy, and replacing administrative positions with relatively inexpensive front-line staff.

As the bottom-fishers in U.S. bank stocks have painfully learned over the last few months, low valuation is not always a good buy indicator. Not that Canadian banks are so cheap. They currently trade at two times price-to-book value, more than twice the level of their U.S. counterparts.

Mr. Bantis notes that this premium is with good reason. Still, he warns that with risks of acquisitions in the U.S. and his concerns that credit losses may be under-estimated, "it's unlikely that the present valuation level for the Canadian banks is sustainable."

Special to The Globe and Mail