Petrocapita UpdateOctober 22, 2012
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THE GREAT CANADIAN BANK BAIL-OUT
TheCanadianbankingsystemissound,wedidn’thavetobail-outourbanks-right?Certainlythat’swhatwearecontinuallytold:
“...we have not had to put any taxpayers’ money into our financial system in Canada, nor do I anticipate that we’ll be obliged to do so.”JimFlaherty,MinisterofFinance
“Without wanting to appear arrogant or vain, which would be quite un-Canadian...while our system is not perfect, it has worked during this difficult time, I don’t want the government to be in the banking business in Canada.”JimFlaherty,MinisterofFinance
Thenagainwewerealsoassured:
“We will not run a deficit.”JimFlaherty,MinisterofFinance(Oct.2008).
Sopoliticalremonstrancesnotwithstanding,isanyofthistrue?Doubtsdidbegintosurfaceearlyin2012butinterestintheissuequicklydiedout.Thestabilityofthebankingsectorisacriticalquestion.Itisworthmorethanthecursorycoverageithasreceivedtodatesolet’sspendabitoftimeonittoday.
Didwebail-outtheCanadianbankingsystemfollowingthe2008financialcrisisandmoreimportantlymightwehavetobailitoutinthefuture?TosetthestagehereissomequickbackgroundontheCanadianbanksthenwecanmoveontothe“no bail-out here”premise.
Petrocapita Update
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Petrocapita Update (continued)
Canadian Banking Sector 101 - Concentrated, Large & Levered: Networkswithhighlyconcentratednodesarenotrobust-thepresenceofsinglepointsoffailurecanhavehugeconsequences.TheCanadianbankingsectorresemblessuchanetworkinthatitisdominatedbyjustfivebanks.Thesebanksarecolloquiallyreferredtoasthe“BigFive”.GiventheirsizeandmarketpresenceIamsurethenameswillbefamiliartoyou:
(APPROX C$ BILLIONS DEC 2011) ASSETS
BankofMontreal $500
BankofNovaScotia $575
CIBC $360
RoyalBankofCanada $750
Toronto-DominionBank $690
NotonlydoesthissmallgroupdominatetheCanadianbankingsector,thesectoritselfisverylargeinrelationtodomesticGDP.Thelargerthesizeofthebankingsector,thegreatertherisktothedomesticeconomyormoreaccuratelythewalletsofthetaxpayersintheeventthatabailoutisrequired.Ofcourse,beyondacertainsizebanksaresimplytoolargetobebailedoutwithdomesticcapitalortoputitinmorecolourfulterms-domesticbanksrunoutofdomestictaxpayersubsidiesandthenusuallythegameisup-seeGreece,ItalyandSpaininthelistbelow.
BANK ASSETS AS A PERCENTAGE OF GDP
Ireland 872
UK 389
France 338
Spain 251
Australia 205
Canada 157
Italy 151
Greece 141
U.S. 82
Itisnosecretthatbanksuseleveragetogeneratereturns.Additionalleveragecreatesadditionalriskbutwiththehopeofsufficientlyoffsettingprofit.Thetrickistouseenoughleveragetogenerateanattractiverateofreturn,butonewhichdoesnotleavethebanksusceptibletobeingrenderedinsolventbyahighimpactevent(e.g.housingmarketcollapse).Thatisthetheory.Sadly,giventheexplicitgovernmentsupportfor“too-big-to-fail”financialinstitutionswhichremovestheconsequencesofsuchinsolvencies,inpracticelargebankswilltendtocarryexcessiveleverageandmis-pricedriskatalltimes.
AnacceptedmeasureforbankleverageistheTangibleCommonEquityratio-“the ratio used to determine how much losses a bank can take before shareholder equity is wiped out. The Tangible
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Petrocapita Update (continued)
Common Equity (TCE) ratio is calculated by taking the value of the company’s total equity and subtracting intangible assets, goodwill and preferred stock equity and then dividing by the value of the company’s tangible assets. Tangible assets is the company’s total assets less goodwill and intangibles.”
AroughestimateisthattheBigFiveTCEratiohoversaround3-4%.ItgoesalmostwithoutsayingthatCanadianbankingexecutivesrejecttheTCEtestasameasureoftheirleverageandriskforpreciselythereasonthatTCEtendstoshowthattheyareover-leveragedandrisky.
Inordertoensureareliablesupplyofbail-outfundsitiscriticalthatbanksareabletoarguewithastraightfacethattheeventthatbankruptsthemwasentirelyunforeseeable-atleasttothem.SodespitewhatCanadianbankssayIwouldarguetheCanadianbankingsystemhasalltherawmaterialthathasmadeforcriseselsewhere-concentration,largesizeinrelationtodomesticGDP,highleverageandmis-pricedresidentialrealestaterisk.
No Bail-out in 2008-2010? TheCCPA’sstudy,”The Big Banks’ Big Secret: Estimating Government Support for Canadian Banks During the Financial Crisis”,convincinglyrefutesthebeliefthatCanadianbanksdidnotneedorreceiveabailoutduringthecrisis.Directlyfromthereport: “Canada’s banks received $114 billion in cash and loan support between September 2008 and August 2010... They were double-dipping in not only two but three separate support pro grams, one of them American....At its peak in March 2009, support for Canadian banks reached $114 bil lion. To put that into perspective, that would have made up 7% of the Can adian economy in 2009 and was worth $3,400 for every man, woman and child in Canada.”
Perhapstheydidnotneedthemoneyandjusttookitbecauseitwasoffered?Thatdoesnotappeartobethecase.TheCCPAstudyestimatesthatthreeofCanada’sbanks-CIBC,BMO,andScotiabank-receivedbailoutsthatexceededtheirmarketvalueatthetimewhichdoestendtosupporttheconclusionthattheywereunderextremefinancialstress.
ESTIMATED EXTRAORDINARY SUPPORT SUMMARY
Bank Peak Support Date Peak Support Value ($bil) Peak Support to Co. Value (Date of Peak)
CIBC2 March09 $21 148%(March2009)
BMO3 January09 $17 118%(Feb2009)
Scotiabank4 January09 $25 100%(Feb2009)
TDBank5 September09 $26 69%(Feb2009)
RoyalBank6 March09 $25 63%(Feb2009)
Source:CCPA
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Petrocapita Update (continued)
Mortgagesweretheusualsuspectatthecentreofthe2008Canadianbankingbail-outandsomortgagesprovidedtheconduitforgovernmentassistance.Thedefaultriskonapproximately50%ofCanadianmortgagesisinpracticeback-stoppedbytheCanadiangovernmentviatheCanadianMortgageandHousingCorporation.BanksdopaytoinsuretheirmortgageswiththeCMHCbutatwhatcouldbe
arguedarefarbelowmarketratesgivenglobalrealestatevolatilityandtheescalationofpricingrisksintheCanadianmarket.
OfcoursewhentheBigFivegotintotroublethetaxpayerCHMC,theBankofCanadaandsurprisinglyeventheUSFederalReservesteppedintobreach:
Source:CCPA
120
100
80
60
40
20
0Aug
2008Oct
2008Dec
2008Feb
2009Apr
2009Jun
2009Aug
2009Oct
2009Dec
2009Feb
2010Apr
2010Jun
2010
TOTAL SUPPORT TO CANADIAN BANKS
$B
illion
s
BankofCanadaU.S.FederalReserveCMHC
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Petrocapita Update (continued)
Clearly,nomatterhowmuchtheBigFivewouldlikeustobelieveotherwise,theyexperiencedasevereliquiditycrisisin2008-2010hencetheneedtosellperformingbutilliquidCMHCguaranteedmortgages.TofillthisliquiditygaptheyreceivedemergencyfundingontheorderofsizeonapercapitabasisofthatreceivedbytheUSbanks.Itisworthelaboratingonthisasitpointsthewaytosomeseriousconcernsinthefuture.Canadianbanksneededabailoutthatamountedtoapproximately7%ofGDPwhenthelargepartoftheirassetbase-Canadianmortgages-wasnotinanyapparentdistress.
WhatwouldhappentoCanadianbanksiftheCanadianresidentialrealestatemarketweretoexperienceaUSstylecorrectionandinsteadofaliquiditycrisistheBigFiveactuallyhadasolvencycrisis?ForthisthoughtexperimentwehavetoassumeasharpfallinCanadianresidentialreal-estateprices-basedoncurrentpricesversuslong-termhistoricalaverages,rentsandincomeallbeingathighsthatdoesnotseementirelyimplausible.
5.0
4.5
4.0
3.5
3.0
2.5
2.019901995200020052010
HOUSE PRICES VERSUS INCOME
160
140
120
100
80
60
1995200020052010
HOUSE PRICES VERSUS HISTORICAL AVERAGES
VancouverCanadaUSA(Case-Shiller)
30
25
20
15
10
0.5
0.0
-0.5
-1.0
-1.5
-2.08083868992959801040710
HOUSE PRICES VERSUS RENTAL COSTS
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Petrocapita Update (continued)
AccordingtoresearchbyDemograhia:“Historically,theMedianMultiple has been remarkably similar in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States, with median house prices having generally been from 2.0 to 3.0 times median household incomes, with 3.0 being the outer bound of affordability. This affordability relationship continues in many housing markets of the United States and Canada. However, the Median Multiple has escalated sharply in the past decade in Australia, Ireland, New Zealand, and the United Kingdom and in some markets of Canada and the United States. Housing in Canada is moderately unaffordable with a Median Multiple of 4.6 in major metropolitan markets.”Emphasismine.
Insummary,hereistheveryapproximatestateoftheCanadianbankingsectoranditscoreholding,Canadianresidentialrealestate(“RE”)mortgages:
– HighlyconcentratedwiththeBigFivedominatingthesector
– TotalassetsheldbytheBigFivearemuchlargerthanthesizeoftheCanadianeconomy
– BigFiveareusinghighleveragebasedonaconservativemeasuresuchastheTangibleCommonEquityratio
– ResidentialREpriceshaveanaverageMedianMultipleof4.6inmajormarketsversusthehistoricaverageof2.0to3.0
– C$1.3trillioninresidentialREmortgages,50%heldbytheCMHC,50%byCanadianbanks
– ResidentialREmortgagesrepresentapproximately40%ofbankassets
I’llleavethefinalconclusiontoyouaboutwhetherCanadianbanksareasrobustastheyaremadeouttobe,butIbelievethatgiventhestructureoftheCanadianbankingsectorandthelevelofresidentialREpricesthereisahigherchanceofacrisisandafuturebail-outthaniscommonlyperceived.
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