As noted on last week’s blog (January 30), when measured by the Price-to-Book-Value Ratio, the most reliable way to value banks, Canadian banks trade at a significant premium to US and European banks.
Why do Canadian banks carry such a premium stock-market valuation?
(This is Part II of a three-part series on Canada’s banks)
Canadian banks trade up to 2.4 times book value, making their shares the most expensive bank investments in the G7. The universally-accepted myth is that the Big-Six Canadian banks are prudent, well-managed and more profitable than other banks and thus deserve this premium valuation. The reality is much more nuanced. In fact, the Canadian banks enjoy a generous subsidy from Canadian taxpayers, allowing them to use much higher-than-normal leverage ratios while avoiding the elevated risk that usually comes with leverage.
Here’s how it works:
CMHC, the government-owned insurer of all things housing related, guarantees the default risk for Canadian lenders if the mortgage is insured. In an ironic twist, the homeowners pay the modest one-time premium but the bank gets the protection. A Canadian bank can treat an insured mortgage as “zero risk weight”, the same as AAA-rated Government of Canada bonds. Of course, the high-ratio mortgage loan is more profitable than bonds making this scheme magical for bank profits. They can keep minimal levels of equity in the mortgage lending division while using extreme leverage.
For example, using The Royal Bank of Canada -RBC (largest Canadian bank and largest mortgage lender) - the leverage ratio in RBC’s Canadian personal and commercial division is about twenty-seven to one. This isn’t much less than Lehman Brothers just before that US firm went under and entered history as a primary cause of the global financial crisis in 2008-09.
Let’s compare RBC to a US bank. Wells Fargo, trades at a book value of 1.6 times. The ROE in that bank is about 13%. This is one of the best-managed banks in the world, owned partly and controlled by legendary investor, Warren Buffet. In one critical profit measurement used to compare quality of management - Net Interest Margin - RBC lagged well behind Wells Fargo with a margin of 2.7% versus Wells Fargo’s 3.04%.
In spite of this lower profit margin, RBC’s operations show a Return on Equity of 19%, about 50 percent higher than Wells Fargo. And it’s revealing to note that the Price-to-book-value premium of RBC versus Wells Fargo is directly comparable – RBC’s 2.4 times is exactly 50 percent higher than Wells Fargo’s 1.6 times.
So how does RBC get a 19% ROE when Wells Fargo manages only 13%?
It’s simple. RBC earns a 37% ROE in its Canadian personal and commercial lending - which is about 70% lending to households, mostly mortgages and HELOCs (Home Equity Line of Credit). That’s right 37% ROE, almost three times that of Wells Fargo!
Why does RBC earn such a high ROE compared to Wells Fargo, a bank doing essentially the same thing as RBC, lending to families who buy homes and borrow against the equity in their home?
That’s simple too. RBC maintains an extreme leverage ratio and keeps minimal capital against that group of loans because RBC IS NOT TAKING ANY RISK ON MOST OF THOSE LOANS.
The numbers tell the story on page 25 of RBC’s 2014 Annual Report, Table 18. The total “earning assets” are $338 billion with just $12.4 billion in “attributed capital”. An ROE of 37% and a leverage ratio of 27 to one! RBC keeps just 3.6% of capital against its largest assets, loans to Canadian households.
This is a “license to print money” with extremely high leverage and no risk. The CMHC, other insurers and Canadian taxpayers take on most of the risk while the bank and its shareholders keep all of the profits. Of course, the risk still exists somewhere in the system, it’s just transferred to the CMHC and government.
Evan Siddall, CEO of the CMHC, discussed his desire to remove the subsidy that the banks’ enjoy in a June 2014 interview with The Globe and Mail. He said, “We’ve got to make sure that we do it in a way that’s supportive of the market, that we do it in consultation with the banks so that we don’t disrupt their businesses.” It will be a tricky exit to manage for the CMHC, elected politicians, Canadian homeowners and bank shareholders.
Reform to this uniquely Canadian subsidy is urgently needed to protect Canadian taxpayers. But it’s very unlikely that the subsidy will be removed before the housing bubble bursts so the Canadian taxpayer will be forced to take serious losses.
Next week in Part III we’ll take a look at what will happen with share prices of the banks.