While increasingly popular, the notion that the Big Six will take a hard hit runs up against a few key considerations
Several weeks after Steve Eisman expressed his pessimistic expectations for Canadian banks, he reiterated his view that banks are neither prepared for “a normalization” of credit conditions, nor “provisioning appropriately” for future loan losses.
“Canada has not had a credit cycle in a few decades and I don’t think there’s a Canadian bank CEO that knows what a credit cycle really looks like,” he said in an interview with BloombergBNN. “I just think psychologically they’re extremely ill prepared.”
Eisman’s bearish take on Canadian banks has translated into a prediction of a “20 per cent plus” decline as credit conditions normalize and loan losses jump; he said he’s taking short positions against RBC, the largest lender in the nation, as well as CIBC and Laurentian Bank of Canada.
But contrary to Eisman and other short-sellers, an analysis from Hamilton Capital argues that an imagined “direct hit” to Canadian banks from rising losses in huge mortgage portfolios will not lead to an unmanageable and direct hit to their bottom lines.
Drawing parallels to their counterpart banks in Australia, the note pointed to loan-to-value (LTV) ratios of loan-bought home properties as a buffer against direct mortgage credit losses. In case of a home loan default, the note said, banks can seize the home and sell it to repay the loan. Since the prices of homes change with the market over time, a dynamic LTV ratio is used to evaluate mortgage credit risk for banks; the lower the ratio, the lower the credit risk.
“For the Australian and Canadian banks, the dynamic (mortgage) portfolio LTV ratios are very low at around 50%,” the note said. And since holders of the riskiest mortgages are generally required to buy mortgage insurance, that provides an extra cushion for banks against loan losses.
The analysis also noted that historically, rapid or sustained rises in interest rates have been an important driver of home price corrections. Interest rate hikes have been used to curb inflation, and a strong economy increases policymakers’ willingness to raise rates. Since inflation is currently below 2% for both Canada and Australia, and both countries have recently exhibited soft GDP numbers, there’s less pressure to raise rates and arguably some flexibility to lower them.
“Should either central bank decide to reduce rates in a slowing economy, it would provide support to their housing market which could extend the cycle and increase the probability of an orderly rebalancing,” it said.
It went on to point out that since GDP growth forecasts for the next two years remain comfortably above recessionary levels for Canada and Australia, it would take stronger headwinds for a severe recession and housing correction to occur. But “GDP growth forecasts are certainly susceptible to downward revisions,” the note conceded, adding that “Canada appears somewhat more vulnerable” than Australia given GDP growth forecasts of 1.5% and 1.8% for 2019 and 2020, respectively.
Also helping insure against consumer credit risk is relatively low unemployment (5.6% in Canada, 5% in Australia) that has been trending lower and is expected to remain stable through 2020, a tendency among consumers to default on their home loans last, and efforts by both Canadian and Australian policymakers to avoid a disruptive decline in home prices.
