Are Canada’s Big 5 Banks Set to Swoon?

By Dave Van Geem

Our Foolish cousins to the south recently posed a thoughtful question. Financial sector bureau chief Matt Koppenheffer and analyst David Hanson suggested that Canadian banks could be set up for a sudden meltdown based on some parallels they saw in the run-up to the U.S. banking collapse a few years ago. They point to an inflated housing market (echoed by a recent article in The Economist), high stock valuations, and overleveraging.

Is there really a problem? Let’s take a closer look.

Housing
Housing prices have risen over the past 10 years in Canada and the United States. The chart below compares Canadian New Housing Price Index information compared against Federal Housing Authority (FHFA) Expanded Index Values.

Source: Stats Canada, Federal Housing Finance Authority

Looking at the Canadian numbers, we see an overall increase of 43%, marking a steady rise over the past 10 years. This works out to a relatively modest compound annual growth rate (CAGR) of 3.64%.

The U.S. shows a much steeper initial increase in values up to 2006, followed by a fall predating the financial crisis. The past six quarters have brought a strong recovery. The 10-year CAGR in the U.S. is a meager 0.58%, but a recent rally has seen returns of an eye-raising 8%+ CAGR over the past 18 months.

The data make it clear how aggressive U.S. lending practices led to trouble. High advance loans, interest-only payments, and balloon payments — or combinations of all three — virtually guaranteed a home worth less than the money owed to lenders in a falling market.

Leverage
Leverage is a key metric of efficiency in banks. Like many household tools, if used carelessly, the results can be unpredictable. Are the Big 5 in danger of harming themselves, and others? One way to check is by monitoring historic leverage ratios.

Source: Google Finance

Based on the numbers, the banks appear to be very responsible in their use of leverage. TD in particular has moved up 18% from 2009, but is low when compared to peers. Three of the five banks actually have leverage ratios lower than those four years ago.

Valuation
Price-to-earnings is a good, if crude, indicator of whether a stock is overvalued relative to its peers.

Source: Google Finance, http://www.multpl.com/

These valuations don’t look out of place – if anything, they are weighted to the “cheap” side of 15, which is often put forward as an historically average number. With the S&P 500 at nearly 19x earnings, our banks are beginning to look like excellent value.

Here’s what was missed…
The Canadian mortgage market is fundamentally different than the one in the U.S. Here are three good reasons why you can sleep at night despite rising housing prices:

1. Standard mortgages in Canada have a maximum amortization of 25 years (how long until you are free and clear) and a maximum term of five years (how long before you need a new mortgage). The rate must be renegotiated when the term expires. In the U.S., 30-year terms are common. This transfers a lot of interest rate risk onto the banks.

2. Canada Mortgage and Housing Corporation (CMHC) rules require a minimum 5% down payment and no major bank in Canada will give out a mortgage without purchasing CMHC insurance. This forces customers to have skin in the game with an equity stake in the property. Recent changes to the lending rules, including the elimination of the brief 30-year amortization experiment and new restrictions on the amount of mortgages CMHC will underwrite, has acted to cool real estate lending.

3. Finally, and most importantly, no Canadian can easily “walk away” from properties that have upside-down mortgages (i.e., customers owe more than the property is worth). If money is owed after the bank sells the home, they can sue their customer to collect any remaining balance.

Confirmation bias happens when you filter out things that refute your beliefs and remember facts that confirm your beliefs. For most of us, this is a subtle effect that can sneak up on you. If quality analysts and various news sources draw parallels between the U.S. banking collapse and the current situation in Canada, a few hours of research is cheap therapy.

One of the strengths of the Motley Fool Community is hearing from other thoughtful Fools who force me to re-examine my investment thesis. What do you think? Let us know by emailing us.

And if you’re in the mood for a non-banking stock idea, The Motley Fool Canada’s senior investment analyst has identified his “Top Canadian Small Cap for 2013 — and Beyond” in a new research report. You can instantly access the report — and see the ticker — by simply clicking here now.

Disclosure: Dave Van Geem owns shares of Canadian Imperial Bank of Commerce as part of a balanced portfolio.