Marketdepth

Sell the Banks

For many years, I wandered through life as an agnostic.  The supernatural beliefs of organized religion just didn’t make sense to me.  But lately, I have been witness to evidence which has caused me to alter my views.  There is a God, and He is a nineteenth century Russian novelist.  For who else, I ask, could devise a tragedy so bitter as the one which appears to lie ahead for shareholders of the Canadian chartered banks?

 

Singled out for praise by the IMF and even complemented by President Obama himself, the big Canadian banks appear to be an island of calm amidst this financial tempest.  We in Canada are the fortunate beneficiaries of a “conservative” banking culture and are blessed with excellent financial regulators.  As other banks around the world are wiped out or trade at a fraction of tangible equity, Bank of Nova Scotia and Royal Bank of Canada now cruise serenely at 2.2X book.  However, this comfortable situation may not persist for long.  The Canadian banking crisis has not been averted.  It is just arriving with a lag.

 

Figure 1:  Father, I think he said, “Sell the banks”

 

 

True, Canadian banks have avoided some of the sillier extremes, particularly those related to off-balance sheet leverage.  But the key problem in Canada is precisely the same as it is in the other western countries now experiencing bank solvency crises.  Home prices have grown to an abnormally high multiple of employment income, supported by a rapid expansion in mortgage debt.

 

 

Figure 2:  Peak Home Prices as a Percentage of Average Income

	Canada	US	UK
Average House Price (Peak, local currency)	C$ 319,957	US$ 230,200	₤ 192,268
Average House Price (Peak $US)	US$ 278,362	US$ 230,200	US$ 317,242
Gross National Income per Capita (World Bank 2007 $US)	US$ 39,650	US$ 46,040	US$ 40,660
Ratio of Peak Home Price to Income	7.0X	5.0X	7.8X
Date of Peak	Q2 2009	Q3 2006	Q4 2007

Sources:World Bank,US National Association of Realtors, MLS, Nationwide

 

CMHC and the Canadian Housing Bubble

 

The key difference between Canada and other markets is that in Canada

the cost of bad home loans have been socialized in advance. In Canada, we didn’t need to disguise our sub-prime excesses within dubious mortgage-backed securities.  Why create an alphabet soup of bogus AAA paper when our government provides seemingly limitless quantities of underpriced mortgage insurance?  As a formula for creating housing froth it has been virtually unbeatable.  Housing markets may be cratering throughout the world, yet one observes a perverse new high in Canadian real estate prices in May of 2009.

The key to Canada’s bubbly housing success been the CMHC .  The Canada Mortgage and Housing Corporation writes guarantees on most Canadian mortgages originated at greater than 80% Loan-to-Value. This agency has been on a massive expansion binge of late.  In 2008, a year of synchronized global recession, the CMHC expanded its mortgage insurance in force by a whopping 18%.  CMHC now guarantees $407.7 Billion of high loan-to-value mortgages and an additional $233.9 Billion of securitized mortgages.

In all, the CMHC mortgage guarantees are equal to slightly more than half of Canada’s GDP.  Against this total, CMHC has miniscule equity capital of $8.1 Billion.  How is it that more than $630 Billion of dodgy mortgages can be guaranteed by an entity posting just over 1% in equity?  This is a question that curiously appears to have escaped the notice of Canada’s top notch financial regulators.  

The role of the Canadian banks has been to commit capital to CMHC-insured mortgages as quickly as they receive applications.  It is not mortgage lending in the traditional sense, more like underwriting government bonds and taking a 150 basis point spread as compensation.  In this way, the Canadian real-estate bubble looks a lot like its American cousin.  Home loans are being written for those who likely cannot pay by lenders who pass through the credit risk to a third party.  However, in the case of Canada, the third party is our own government and not the Chinese or Saudis who snapped up American mortgage paper.

The Impact on Canadian Banks of a Bubble Burst

 

That which cannot go on forever will not.  Sooner or later Canada’s housing market will conform with that of the rest of the world and begin to decline in earnest.  What the specific catalyst will be, I do not know.  Will unemployment spike, so that buyers disappear even for mortgages with favorable terms?  Will Canadian sovereign interest rates rise, choking refinance?  Will existing homeowners decide to dump their residences onto the market en masse?  Maybe all three will occur.  But the housing mania will stop.

When it stops, I expect the impact on the banks will be severe.  In its 2008 stress test (which assumed an annualized 2% decline in GDP over six quarters, co-incident with modest housing market declines) the Bank of Canada estimated that losses to the Canadian banking system would amount to only about 10% of book equity.  It would be nice if the “stress test” turns out to be accurate, but one gets the feeling that it contains more wishful thinking than serious confrontation of the problem.

 

The banks’ loan books face both short-term and long-term problems.  In the short-term, we see US housing starts down by 60% and auto sales down over 40% this year.  Therefore it seems quite possible that US GDP may shrink in 2009 by at least the 6.3% rate of the first quarter.  In the circumstances, the Bank of Canada’s “stress test” of a 2% annualized decline in Canadian GDP seems optimistic.

 

Over the longer term, the Canadian banks face the familiar “black hole” problem created around the world by the real-estate bubble.  Consumers will need to cut spending on other things in order to feed the massive debts incurred through real estate.  Government will need to raise what little private capital is remaining in order to offset its suddenly shrinking tax base and to mop up the inevitable mess being created by the CMHC.

 

Levered “only” 12:1, Canadian banks may find that loan delinquencies rise beyond historic levels.  The “good” mortgages, consumer credit and business loans all look vulnerable when one looks at individual cases with which we are familiar.  Could the market value of the loan book of Canadian chartered banks be less than 92% of its face value?  Quite possibly in my view.

 

Other business diversifications of recent years appear unlikely to offset pending difficulty in the banks’ Canadian loan book.  Will the Bank of Nova Scotia’s recent string of Latin American bank acquisitions shore up its results?  Will Royal Bank’s 2008 acquisition of a large Canadian mutual fund manager be viewed by history as a game-saving play?  How about TD’s 2007 acquisition of US regional player Banknorth? My guess is that the strategic moves made at the market top may turn out to be ill-advised.

The Way Out

 

There is of course a way out.  The Canadian state can print money to deleverage the economy.  This is hardly an un-traveled path in global economic history.  The classic formula is to withstand the shock of a brutal recession for about three years and then execute a back-door default on domestic and foreign loan obligations through debt monetization, devaluation and inflation.

 

There are banks which survive in such a meltdown, but they rarely do so at multiples of over 2X pre-crisis book equity.  Frankly, I would expect most Canadian banks to require some form of bailout in the aftermath of a bursting real estate bubble.  Given the lofty prices available now, there is only one rational move.  Sell the banks.

The Value In Silver

Every good carpenter understands a little about wood.  Pastry chefs know flour.  Perhaps it stands to reason that investors should also think a little about money.  We live in a curious age, where money is intangible and created at no apparent cost by governments and their central banking bureaucracies.  It was not always that way. 

Figure 1:  If Money is Made for Free, Why is a Dollar Worth a Dollar? 

  

Prior to 1971 most wealthy countries issued scrip backed at least in principle by gold or silver.  However, today’s investor has precious few “hard currencies” from which to choose as a store of wealth.  In 2009, I see no government paper as attractive as silver, which may now be the world’s most undervalued currency.

 

That silver is a currency, of course, is a point of much contention.  Although accepted as such for thousands of years – to the extent that the word for silver, argent, literally means money in our country’s other official language – many investors think of silver’s monetary significance as a mere remnant of a barbarous past.  It is possible, however, that we are confusing fundamental debasement with technological advance. 

 

Growth in Money Supply, Shrink in Silver Supply

 

Since 1980, the supply of currency, bank deposits and other cash-like financial assets that the US government calculates as M2 has grown between five and six times.  Zero-maturity money has grown by over nine times.  The St. Louis Fed website offers wonderful charts outlining the spiraling growth in these monetary aggregates.

 

In lock-step with this increase in money supply, salaries, house prices (even now), stock market indices and many other assets have risen in sympathy.  Some factors have risen more quickly (baseball salaries, for instance, are up 22X), while others have risen more slowly (a brand new Pontiac is only up about 5X).  However, silver prices are actually lower in 2009 than they were in 1980, when the metal traded hands at an average price of US$20 per oz.  Adjusting the start point of this analysis can offer somewhat different results, but it is very difficult to conclude other than silver has lost considerable value share over the past few decades.

In stark contrast to the growth in money supply, the “silver supply” has been shrinking.  In 1975 silver inventories were 5 billion ounces, currently they are down to about one billion ounces.  Mine production has not kept pace with silver consumption.

Silver vs. Gold

A straight comparison against gold is also flattering to the pearly metal.  If we look back at historic money systems, the ratio of value between gold and silver was usually between 10:1 and 20:1 in favour of gold.  If one considers the ratios of physical inventories, then the scarcity factor is even less favorable to gold.  There is actually much more physical inventory of gold than there is of silver (5 billion oz of gold vs 1 billion oz of silver by one estimate).  While much silver exists in the form of cutlery and jewelry, it would be surprising to see that supply rush into the market unless prices were much higher.  Given this historical relationship, and the inventory levels, the current price relationship is surprising.  On yesterday’s fixing it took about 65 silver ounces to buy one gold ounce.

 

Weakness in silver has been partly due to the metal’s diminishing industrial use in the area of photography.  However, photography’s share of silver end use has already declined from almost a third of demand to about ten per cent.  The industrial use of silver is now far more prevalent in growing applications relating to electronic components, data storage and batteries.  An average cell phone, for example, contains about a third of a gram of silver.

 

As an overall proposition, silver at $14 per ounce seems to be a solid investment.  Compared to holding a bond denominated in paper currency, for which the marginal cost of production is zero, and the ultimate security of which depends on the success of heavily indebted western governments in holding back the forces of compound interest, holding a little silver seems like a fairly rational long-term diversification.

What to own

For the truly paranoid, nothing beats physical silver, preferably buried in a number of small quantities at locations known only to the holder.  However, for the foreseeable future, ETF’s are likely to do the trick.  The i-Shares Silver Trust (SLV) seems to be a pretty reasonably priced offering.  There are double-leveraged long and short ETF’s which have the unadvertised effect of magnifying longer-term gains and losses beyond the 2X factor due to their daily rebalancing.   I would tend to avoid these.

 

As for a target, how about 20:1 gold to silver?  At today’s prices that would imply about $50 per ounce silver.  That would be well within the bounds of historic precedent.