In Parts I and II we saw that Canadian banks trade as the most expensive bank shares in the G7. The articles discussed the reasons for this premium price, including growth in household debt and generous government subsidies from the Canadian taxpayer through the CMHC.
This week in Part III we’ll examine what is likely to happen to Canadian bank valuations when the Canadian housing bubble bursts.
Around the world there are many examples of what happens to bank shares in a hefty correction in house prices. In the US from 2005 to 2010 house prices corrected about 30 – 40 percent. And bank shares collapsed by 80% or more. In some cases, large financial companies such as Bear Stearns and Lehman Brothers disappeared altogether. Thousands of smaller banks were rescued by the FDIC.
In Canada the Big-Six banks won’t experience a complete loss (they are indeed “too big to fail”) but the housing bubble is a significant risk to the banks. The reason that the banks still trade at premium valuations is that few bank investors expect the housing bubble to correct, much less burst, and they don’t understand how such an event would impact the banks.
In the US the pace of mortgage lending growth declined from +10% per annum pre-crisis to -5% per annum in 2009-2010. This slowdown devastated bank shares as their average Price-to-Book-Value ratio went from 2.5 times to 0.5 times. That means a drop of about 80 percent.
How would Canadian banks fare in a similar correction? Will they survive?
The banks have several layers of protection to help them get through a difficult period.
First, they have some capital. As we saw in a previous note in the Canadian lending division RBC holds about 3.6% capital against more than $330 billion in loans. A 40 percent house price correction would cause a loss of more than 3.6% in those loans so that slim capital buffer wouldn’t be nearly enough.
Second, the homeowners are obligated to pay the loans, even if their house valuation drops below the mortgage debt. But in a recession hundreds of thousands of Canadians would lose their jobs. And unemployed people can’t make mortgage payments. So that won’t work either, even though mortgages are “recourse loans” for the most part.
Third, the banks can seize title to the property and put the house up for sale to recoup their losses. In 2014 the average down payment for a CMHC insured loan was 8%, so the sale of a property with such a skinny down payment would be at a loss. In the US the banks got very low prices because of the costs of foreclosure, such as legal fees and commissions and the fact that houses were sold in an auction process. Banks lost more than 50% on foreclosed properties so that won’t save the banks.
Fourth, the banks can make an insurance claim against the CMHC or the other insurers if the homeowner stops paying. And that won’t work very well since the CMHC has only 5 percent reserves, a tiny fraction of the $1.2 trillion in outstanding mortgages.
Finally, the banks will be saved because the Canadian taxpayer will ride to the rescue, as guarantor of last resort, to inject cash into the CMHC and make up the shortfall created by losses on insured mortgages. This cash injection into CMHC will save the banks but not the homeowners who lose their houses.
The banks will survive but they will suffer in the aftermath of a housing crash. After the housing bubble bursts, the taxpayers and the Canadian government will be very unhappy with the current lopsided arrangement between the CMHC and the banks. CMHC rules will be changed to remove the subsidy. As well, the bank regulator, OSFI, will demand that banks keep a much larger capital buffer, lowering the leverage ratio from 27 to one to a more normal 10-15 times perhaps. And that will mean a lower ROE, lower profit margin and a lower valuation for bank shares. Investors can expect to see the Price-to-Book-Value ratio decline to levels comparable to those in the US where that ratio averages 1.2 times.
Banks will survive; but after the Canadian housing bubble bursts they will be viewed like banks in Europe and the US and priced accordingly.
As most Canadian investors own an overweight in the banking sector, it’s time for them to reduce the concentration of their retirement assets in the one sector that has the highest exposure to housing and heavily indebted Canadian households. It will be harmful to an investor’s financial security to hold bank stocks, when the housing bubble bursts.