Sell the Banks - 2010 Remix

In 240 BC, a Libyan scholar named Eratosthenes calculated the circumference of the spherical planet earth within 1% of the value commonly accepted today.  His method was crude by contemporary standards – including measuring a 500 mile arc of the earth’s surface by timing a journey made by camel between the Egyptian cities of Alexandria and Syene.  But his geometry was impeccable.

 

Many centuries later, sailing ships proved empirically what Eratosthenes had deduced from sunlight, shadows and a trip on a camel.  And today, as visitors file by the scholar’s portrait at the rebuilt library of Alexandria, they stand in awe of a man whose unconventional insights were eventually proved right.

 

 

Figure 1:  Eratosthenes was Proved Right, Eventually

 

 

 

Investing, unfortunately, knows no such redemption.  Speaking now as one of the last guys who ever lost a job (in 2006) for unsuccessfully short-selling US real estate securities, I can assure you that “eventually proved right,” is not the sort of distinction one is hoping to achieve in the hedge fund business.  Bosses and clients are not kind to managers whose views are out of synch with the rest of humanity for even six months, let alone six centuries.

 

It is with these thoughts in mind that I return to the tender subject of Canadian bank equity valuation.  We have made rather emphatic calls on this subject in earlier posts.  While we stand by the essence of our argument, it is clear that to date we are lacking what a scientist might call corroboratory evidence in the form of price movements.  Since our July 2009 missive most Canadian bank stocks have appreciated by 20%.

 

 

Once More, From the Beginning

 

The short story on Canadian banks, in my view, has only become more compelling in the past nine months.  In a nutshell, these entities exhibit extremely high leverage, they have loan portfolios which look set to generate unprecedented levels of losses, and yet they trade near the north end of historic bank valuation multiples.

 

Tackling these points in turn, we start with leverage.  Using Bank of Nova Scotia as an example, the most recent quarterly statement shows tangible equity (that is shareholder’s equity net of goodwill and other intangible assets) of C$18.3 billion.  That is an impressive figure until one compares it to the bank’s asset base, which is $507.6 billion.  In other words, for every $100 of loans, trading securities and other assets that BNS possesses, there is only $3.60 of tangible net worth backing that up.  A loss of $10 billion, or only 2% on Bank of Nova Scotia assets would reduce tangible book value by more than half.  A loss of $20 billion would render the bank insolvent.

 

Leverage when underlying asset values are rising is, of course, a good thing.  But when the value of assets declines, it is not so good.  Looking category by category within the BNS balance sheet just raises more questions than answers.  Could this portfolio, in a scenario where the Canadian economy is stressed by an unwinding housing bubble, experience losses of $20 billion?  Quite possibly.

 

 

Figure 2:  Bank of Nova Scotia Asset Breakdown Q1 2010

Item	Value (C$ Billion)	Potential Issues
Cash and precious metals	$8.4
Deposits with banks	48.9	Counterparty risk
Securities	116.1	Potential for adverse price move (stocks, bonds, CDO’s etc.)
Securities purchased under resale agreements	16.9	Counterparty risk
Residential mortgages	105.4	Housing bubble, and risk that CMHC will not pay some claims on mortgages not written in accordance with rules
Personal and credit card loans	61.5	Similar risks to housing loans but without gov’t guarantee
Business and government loans	104.2	Loans to property developers, economically sensitive loans
Derivative instruments	25.3	Counterparty risk, adverse price movement
Other	20.2
Total	507.6

 

 

Finally, from a valuation perspective, the Canadian banks are still floating along at multiples that appear to assign almost zero probability of a housing price correction or another near-term recession.  The prospective collapse of the Euro, near double-digit unemployment in the US, these are not matters that concern Canadian bank equity holders.  Taking Bank of Nova Scotia as our example again, it trades at approximately 2.5x book value per share.  The simple average trading multiple for the past 30 years for North American banks is approximately 1.5x book value. 

 

However, for periods of choppy economic weather (such as the late 1970’s and early 1980’s) surviving banks traded at ratios below 1.0x book.  If we return to recession north of the border, I would expect that price ratio to become the benchmark for Canadian banks.  

 

 

Figure 3: 

 

 

I will add one last point, technically, looking at the Bank of Nova Scotia stock price.  The chart below shows a classic bubble formation from 1981 through 2007 that was miraculously revived through unprecedented governmental support.  Had the PIIGS crisis not erupted, perhaps the decline in 2008-09 would have been the first low point in a head-and-shoulders top out much higher than the 2007 peak.  But I believe the read-across from Greece and Spain is too obvious to the North American sovereigns.  The debt levels of the PIIGS just aren’t that different from any of the other rich countries, including Canada.  Therefore, governmental support for Canadian banks is pretty much a spent force. Already credit markets are beginning to sell off Canadian bank debt and the formation below is looking very much like a double top.

 

 

Figure 4:  Bank of Nova Scotia – Share price 1981-2010

 
 

Price Target

 

What is a reasonable price target for Bank of Nova Scotia?  What if it survived a housing correction or collapse by losing only $9 billion of its $507 billion asset base and its share price got marked down to 1.0x book from 2.5x on a trading multiple basis.  Such adjustments are by no means beyond historic precedent.  Still, these adjustments would imply a fall in the share price of BNS from $52 to $9, a decline of more than 80%.  A shocking decline, for sure, but it would be more shocking to me if that does not occur over the next two or three years.  And while we have discussed the Bank of Nova Scotia, there is no particular reason we have not chosen one of the other Canadian chartered banks.  The valuation and operational metrics appear to me to be very similar.

 

In advising a sale of bank shares, we do not have the fancy graphical tools or research teams available to flesh out this argument in a 35 page glossy document of the sort which generally accompanies a recommendation to purchase bank shares.  We have just the modern day equivalent of a camel, a clock and, if we are lucky, a sense of geometry.  Let us hope our thesis may be corroborated (or disproven) more quickly than that of our friend Eratosthenes.

Comments

[J Levy]

Hello
Great website, amazing research and content.

For this particular post, one thing that isn't clear is how you would approach shorting the banks. Because of the uncertainty over timing, would you recommend longer dated options (leaps)?

In addition to owning precious metals and shorting banks is there a bond index in Canada that carries the CMHC insured Mortgage Bonds (NHA auction)? If so, presumably one could short that as well...am I wrong in my deduction? Is that trade available to retail customers in Canada? In this way, you are replicating Paulson's trade in the US.

thanks in advance

[J Levy]

Thanks Geoff
To your point, if I look at the longer end of the options market it can get quite cheap. It's tough to time these things but I would imagine that by Jan 2012 the situation will be much worse than it is now.

To your other point, how does one short securitized credit card pools? I would imagine that as a retail guy, there is no chance of doing that.

What do you think about shorting some of the mortgage originators (i.e. XMC or HEQ)?

Finally, is it possible to buy CDS's on Canada? Can retail investors get access to that trade? If the CMHC is a pure play on Federal credit risk, an the mortgage market erodes, I would imagine that the CDS's on Canada would blow up

Thanks again

[gokou3]

Hi Geoff,

Thanks for the idea. I am also in the camp that believes in the imminent bursting of the housing bubble. However, I am uncertain whether this will lead to significant losses in the banks' mortgage book.

If I understand correctly, CMHC (and private insurers) insure high LTV mortgages. Wouldn't this cover the banks from a lot of losses - at least for the first 20-25% of housing price drop? Of course I am not saying the housing market can't fall more than 25%..

In addition, if a capital raise is done early enough, the banks' equity values could be shielded somewhat. The relatively smart ones, like RY & TD, may fare better than the others.

In any case, thanks for your articles. I have some paper profits on COA.

[robert]

Nice blog Geoff - someone posting a comment on Mish's site referenced you. As for the quaint notion that CMHC and by extension our government will simply roll over and cover the banks "insured" losses I think we have to look no further than our very instructive (at least in the realm of housing busts and fall-out scenarios) brethren to the south. Anyone who thinks these losses will be paid without scrutiny or question as to the diligence that occurred (or not) when the mortgages were issued has entered a delusionary state. Especially considering how pissed off the taxpayers have become with the socalization of bank losses. That the banks were loosey-goosey under the CMHC backstop is something that will come back and bite some if not all of them (guilt by association) hard in the ass. As a contrarian who is willing to bear some risk in the short term, accumulating some HFD at these levels is a no-brainer.

[DooDah]

Hi Geoff,

I'm curious to hear your thoughts on bank preferreds? Garth Turner is all hot and heavy on them these days. Do you have any thoughts or insights you can share?