Canada's banks: Next dominos to fall?

Chers peuples Canadiens, souhaitons-nous qu’il n’y ait pas une crise immobilière, car nous sommes sérieusement dans le pétrin.

En tant que peuple nous sommes responsables de plus de 500 milliards de prêts par l’entremise de la SCHL (les prêts les plus à risques).

Et les banques par leurs effets de leviers ont accordés eux aussi 500 milliards de prêts, si seulement 4 % devient douteux, nous risquons d’avoir un beau tsunami sur les bras.

Extrait de: Canada's banks: Next dominos to fall? , boyd erman , Globe and Mail Blog, August 19, 2011

So far, Canada's banks have gotten a free pass from the mess for financial stocks. Sure, they have sold off, but nothing compared to what's happening to banks in Europe, which are getting savaged.

Do our lenders deserve the kid-gloves treatment? No, argues a blog post making the rounds from Zero Hedge blogger Tyler Durden, who despite inexplicably naming himself after the Brad Pitt character in Fight Club often makes some pretty good points about financial markets and has a large following.

So, is he right on his contention that "there is one place that has been very much insulated from the whipping of the market, and one place where banks are potentially in just as bad a shape as anywhere else in Europe. That place is....Canada."?

Banque - TSEHis argument is based on running a screen of global banks to look at their tangible common equity ratios. He's looking for banks that would have their equity wiped out by a smallish reduction (4 per cent or less) in the value of their assets. What does he find? A lot of European banks and a lot of Canadian banks.

Five of Canada's big six banks show up in the screen as lenders with tangible common equity ratios of less than 4 per cent, meaning that a drop in the value of their assets of 4 per cent would wipe out basically all the equity in the Canadian banking system. (Bank of Montreal is in best shape at 4.15 per cent.) Scary stuff at first blush.

Canadian Imperial Bank of Commerce (CM-T69.42-2.15-3.00%) is right at the top of the list, with a TCE ratio of 2.8 per cent, not even as good as BNP Paribas. National Bank of Canada (NA-T70.34-1.91-2.64%) Bank of Nova Scotia (BNS-T50.25-2.23-4.25%) , Royal Bank of Canada (RY-T48.97-1.48-2.93%) , Toronto-Dominion Bank (TD-T71.10-2.90-3.92%) and Bank of Montreal (BMO-T57.35-1.68-2.85%) are all right behind in the top (should we say bottom) 21.

Now wait, say those of you who have been paying attention to Canadian bank disclosure. Canadian banks routinely disclose TCE ratios north of 10 per cent. Well, yes, but it's a case of apples and oranges. The banks talk about tangible common equity to risk weighted assets, while Mr. Durden (am I the only one who feels strange calling him that?) is looking at TCE to total assets. Risk weighted assets adjust for the chance that the assets will go bad, and that's hardly a science. Total assets doesn't allow for such judgement calls.

On that basis, Canadian banks are just as leveraged as European banks, and far more so than American banks. Is the legend of Canadian bank invincibility starting to shake for you just yet?

Is Canada ready for a beatdown by the bond market vigilantes? Are Canadian sovereign and bank credit default swap spreads going to blast higher when people realize the hidden danger in Toronto's bank towers, as Mr. Durden argues they will?

Before you can answer that question you have to decide if the odds of an asset haircut are the same in Canada as they are in Europe.

Over yonder in the euro zone, the banks face the very real prospect of losses on the value of the bonds they hold that were issued by countries like Greece, Ireland, Spain and Portugal. Losing four per cent of total assets doesn't seem like a stretch.

In Canada, the concern would have to be the housing portfolios, the biggest chunks of Canadian banks' assets. If you believe that housing is in for a severe correction in Canada, and that Canadians won't repay their mortgages when the value of their homes falls, and that the banks will have to take significant write downs on the portions of their mortgage portfolios that are not insured by the federal government, then maybe you will come to the conclusion that Mr. Durden is onto something.

If you are one of those who believes housing can never fall, or if you believe that Canadians will continue to pay their mortgages even in a housing correction, as they have always done in past, then maybe you can breathe a little easier.