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canadian banks

Canadian banks are lauded as the world's best. Unlike their competitors in other countries, they survived the crash of 2008 practically unscathed and are serial profit makers.

But not all investors are buying the idea that Canadian banks are so great. Some money managers - most notably Sprott Asset Management LP, are selling the banks short, a tactic that will allow them to profit if their stock prices tank.

Given that Canada's banks are so well-regarded, questions abound about the trade: is it a risky, crazy bet that is almost certain to end in tears, or the ultimate contrarian move?

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Those selling the banks argue the shares are changing hands at such lofty multiples to book value - among the highest levels in the world - that the bullish story is yesterday's news and completely reflected in share prices.

Canadian banks are "totally priced for perfection," contends Geoff Castle, a financial blogger in Vancouver and former mutual fund manager who is shorting the industry by buying long dated, out of the money puts.

He said the banks as a group could easily fall by 30 per cent to 40 per cent if they traded at their average, historical multiples to tangible book value and far more if the economy dips back into recession.

In a short sale, an investor sells borrowed stock with the intention of buying the securities back later at a lower price, pocketing the difference as profit. The trade is not for the faint of heart because it exposes the short seller to unlimited losses and the requirement to cover dividends. Another way to do the trade is through puts, options to sell stock at a set price.

The most notable bank short-seller on the street is maverick money manager Sprott Asset Management LP, which has been targeting Toronto-Dominion, Bank of Nova Scotia, and National Bank for declines.

Sprott bases its short sales idea on an opinion that banks over all don't have enough tangible shareholders' equity (where items such as goodwill are deducted) to stand much adversity in their loan books.

High leverage means banks coin money when times are good, but can quickly lead to trouble when times are bad because it doesn't take much in loan losses to undermine equity levels.



Shorting the banks hasn't been a winning strategy, at least recently. The S&P/TSX capped financial index has risen about 92 per cent off its March, 2009, lows, so short-sellers have been getting clobbered. Bank shares remain about 20 per cent below peak levels before the 2008 crash, so those such as Sprott, a long-term bear on banks, might have modest profits.

"It hasn't worked as well in the last short period of time," concedes David Franklin, a financial analyst at Sprott.

Canadian bank shares are "still strong" but "they have the inherent problems of other banks in other countries," Mr. Franklin said.

To hedge its bets, Sprott has been shorting a basket of international financial stocks. Canadian names are "a very small position," Mr. Franklin said, adding that the idea has "been a killer trade in the U.S." more recently and a money-maker in both in Australia and Europe.

Mr. Franklin declined to name other bank shorts, but Sprott recently issued a report, which he co-authored, indicating that German banks are even more vulnerable to the downside than institutions in Canada.



Not everyone buys the idea that Canadian banks have too little equity. The banks are "well-capitalized … from our perspective," said Rod Giles, spokesman for the Office of the Superintendent of Financial Institutions, the industry regulator.

Many bank analysts say investors should be buying the shares, not betting against them. Bloomberg's top-ranked Canadian bank analyst, Michael Goldberg at Desjardins Securities, is bullish, saying most banks have "double-digit upside to my targets" over the next year.

Shorting "is not something I would do or that I would recommend at this time," Mr. Goldberg said.

Mr. Goldberg's top picks are TD and Scotiabank, institutions Sprott is betting against. He says industry profits stand to benefit from an improving trend in loan losses.

While bank leverage is high, Mr. Goldberg said it is a mistake to compare the financial sector to other industries, where having such thin equity cushions would be highly risky. Mr. Goldberg also says stripping goodwill and intangibles from balance sheets underestimates the value of the banks' brand names, national branch systems, and strong customer relations.

Still, the short-sellers might not be wrong, just early. When firm founder Eric Sprott wrote a piece in 2007 warning that Citibank, Fannie Mae and Freddie Mac were on shaky ground, the reactions at the time were "you're a raving lunatic," according to Mr. Franklin.

But Sprott moved from the madman category to prescient money-maker when the shares subsequently collapsed.

Downside protection

Canada Mortgage and Housing Corp. insures Canadian banks' riskiest home loans

Canadian banks have a not-so-secret weapon that protects them from some loan losses: the Canada Mortgage and Housing Corp.

Because the most risky home loans are insured by the CMHC, banks here have some protection against loan losses and therefore don't face as much risk on residential mortgages as their international counterparts.

How Canadian and other banks stack up

Those betting against the banks believe they don't have enough equity to absorb serious levels of loan losses in their assets. By this metric, Canadian banks typically have each $30 in tangible assets supported by only $1 in tangible equity, meaning it would take only a 3-per-cent loss in value in their loans and other assets to imperil shareholders. Goodwill and other intangibles aren't counted in the calculation because they're accounting entries that probably would have little value if the banks ever got into serious trouble.

Name

Price To Tangible Book Value Per Share

Tangible assets to tangible equity

Royal Bank of Cda

3.7

27.6

TD

3.6

30.2

Bank of Nova Scotia

2.9

28.5

Bank of Montreal

2.3

24.9

CIBC

3.2

36.4

National Bank

2.3

33.9

Deutsche Bank-RG

1.3

60.3

Commerzbank

1.1

124.0

Citigroup Inc.

1.0

16.8

Wells Fargo & Co.

3.1

22.1

Bank of America

1.6

19.7

Royal Bk of Scotland

0.4

27.4

Aust. and NZ Bank

2.5

19.8

Source: Bloomberg and staff

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