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Steve Eisman (NEXT)Big Short- Canadian Banks and Mortgage Lenders

Jim Grant writes in Grant Daily…“U.S. hedge funds from time to time have appeared in this country over the last 10 years, with the same hypothesis of shorting Canadian banks, and it hasn’t worked out very well for them,” Brian Porter, CEO of the Bank of Nova Scotia, said yesterday. “There are always going to be those that take an opposing view, and we’ll prove them wrong over the long term.”  

Gabriel Dechaine, banking analyst at the National Bank of Canada, likewise came to his industry’s defense in a note today: “A trend that is making us believe that sector sentiment is becoming too bearish is the re-emergence of a vocal ‘short Canada’ investment crowd.” Dechaine writes that a Stanley Cup victory for the woebegone Toronto Maple Leafs (last title, 1967) is more likely than a jump in loan losses. 

One well-known investor is publicly taking the challenge: Steve Eisman, portfolio manager at Neuberger Berman and a protagonist in Michael Lewis’ The Big Short. “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,” Eisman, who is short various Canadian banks and mortgage lenders, fired back in an interview yesterday with BNN Bloomberg television. “I just think psychologically they’re extremely ill prepared.”  

While Canadian bank advocates and their skeptics exchange words, the formerly-white hot housing market is now in deep freeze. March sales in Vancouver collapsed by 31.4% year-over-year according to the local real estate board, the worst showing since 1986 and down 46% from the 10-year average for March. Prices also lurched lower, with the benchmark detached home price falling 10.5% year-over-year to C$1.44 million ($1.08 million). Things are more stable in Toronto, where March sales and benchmark prices were little changed from a year earlier, but those figures remain 40% and 14% below their respective levels from March 2017.

As the housing market sputters, the highly-leveraged Canadian consumer displays increasing signs of distress. According to the Bank for International Settlements, Canada’s household debt stands at 100.2% of GDP as of the end of September, by far the highest ratio among G7 economies (the U.K. is next at 86.5%), while the debt service ratio, or the percentage of disposable income allocated to principal and interest payments, rose to 14.9% in the fourth quarter per Statistics Canada, just shy of the 2007 peak.

That debt burden is starting to weigh on consumers. Auto loan delinquencies rose to 0.97% at year-end according to Equifax, Inc., the highest since 2009. At the same time, 36% of new auto loans in the fourth quarter were leases, the largest such share since 2007.  Bill Johnston, vice president of data and analytics at Equifax Canada Co., noted that “we’re starting to see consumer behavior shift to keep the payments as low as possible.” 

On the credit card front, delinquencies of at least 90 days remained at a relatively low 0.79% as of February, down from 0.88% in the same month last year according to data from Bloomberg. But, as noted by the Royal Bank of Canada, consumers cut their average monthly payment to just 38% of outstanding balances in February, down from 50% in October and the lowest such ratio since 2015. RBC credit analyst Vivek Selot commented: 

That deterioration in payment rates may be attributed to some stress on the consumer. Considering that fragile household balance sheets could be a precipitating factor for the credit cycle to turn, any signs of consumer credit quality deterioration seem worthy of attention.

Indeed, the Office of the Superintendent of Bankruptcy reports that consumer insolvencies rose 5.4% year-over-year in February, bringing the rolling three-month average to its highest level since 2011.

The slowing housing market and increased consumer stress has taken a toll on one of the banks’ primary profit centers. According to the Bank of Canada, residential mortgage growth registered at 3.2% year-over-year in February, the lowest reading since 2001 and barely half of the 6% monthly average logged since the housing boom gathered steam in 2009. Back in March, Edward Jones & Co. investment strategist Craig Fehr noted to Bloomberg that mortgages frequently represent “the largest and most profitable and steady of the businesses that these banks operate.” Fehr concluded: “The bread and butter of profitability for Canadian banks – is going to have a little less butter on the bread.” Meanwhile, expectations remain high, with a 2019 analyst consensus of 15.7% return on equity for the S&P/TSX Bank Index, up from 14.2% last year and a five year average of 15%. For those unfazed by CEO taunts and eager to investigate the bearish case for Canada’s lenders, an analysis in the Feb. 9, 2018 edition of Grant’s Interest Rate Observer identifies one bank that stands out from the rest. 

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