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Is Toronto-Dominion Bank as Risky as the Short Sellers Believe?

Despite yet another solid reporting season for Canada’s banks, where combined net profit grew by roughly 20%, they continue to attract considerable attention from short sellers.

The second most-shorted stock on the TSX at this time is Toronto-Dominion Bank (TSX:TD)(NYSE:TD). U.S. hedge funds and other major investors believe that it is one of the most vulnerable financial institutions to Canada’s housing bubble bursting and the economy falling into decline. 

Now what?

Hedge funds have been making this bet for years. Many believe that the conditions in Canada’s red-hot housing market resemble those that existed in the U.S. in the lead-up to the housing meltdown, subprime mortgage disaster, and financial crisis.

Yet for years, those same short sellers have been incurring terrible losses because the housing market has remained buoyant, going from strength to strength. Those losses have been so severe that this has become known as a widow-maker trade.

Essentially, a widow-maker trade is a speculative trade that makes sense intellectually but confounds traders and subjects them to tremendous losses. The most well-known widow-maker is the huge bet that hedge funds have been making for over a decade on Japanese interest rates moving higher and government bond yields falling. While that trade makes sense fundamentally, those traders have been sustaining colossal losses for years.

Traders short selling Canada’s major banks are also incurring significant losses. This is despite the claims that the banks are vulnerable to excessive levels of household debt and that Canada’s housing bubble looks a lot like that which existed in the U.S. in 2007. Many short sellers are now pointing to the crisis engulfing Canada’s largest alternate mortgage lender Home Capital Group Inc. as a sign that the long-awaited financial meltdown has commenced.

Nevertheless, it is difficult to understand why Toronto-Dominion is such a prominent target.

The bank has a well-diversified business and is less dependent on Canada’s property market to generate earnings than other major banks because of its significant U.S. franchise. Toronto-Dominion is ranked as the 10th largest U.S. bank by assets and earns a third of its net income from south of the border.

It also possesses a well-diversified loan portfolio, where Canadian mortgages, including HELOCs, only make up 62% of its total loans under management.

More importantly, credit quality remains high, and gross impaired loans as a percentage of total loans come to less than 1%.

Just over half of all Canadian mortgages are insured, providing a crucial backstop should housing prices collapse. The loan-to-value ratio or its uninsured Canadian mortgages is a very conservative 53%, highlighting that there is plenty of wiggle room for the bank to manage delinquencies.

Investors should also not forget that Toronto-Dominion is well capitalized with a common equity tier one ratio of 10.8%, well above the regulatory minimum. 

So what?

While the risks to Canada’s banks posed by excessive household debt and a housing bubble remain high, it is difficult to understand why Toronto-Dominion is being targeted by short sellers. Its diversified earnings, more than adequate capital position, solid credit quality, and low-risk mortgage portfolio mean that in the event of a housing crisis, it would pull through in good shape.

Toronto-Dominion is attractively valued, has a history of regular dividend hikes, and has a 3.7% yield, making it an appealing buy at this time.

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Fool contributor Matt Smith has no position in any stocks mentioned.

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