When Steve Eisman warns about a downturn, investors listen – so his recent bet against Canadian banks is getting a lot of attention.
Famous for his prescient call against the United States housing market before the 2008 global financial crisis, one of the fantastically profitable wagers profiled in The Big Short, Mr. Eisman, a fund manager, is now predicting trouble for Canada’s largest lenders.
He is very clear that he does not expect a U.S.-style housing collapse, yet he worries that Canada’s housing market is cooling quickly. Mr. Eisman also fears the fallout from a sluggish economy. Because the Big Six banks dominate domestic lending, he expects they will suffer.
It is a compelling story, one that other hedge funds have been making as well. The problem with the thesis, however, is that there are a number of holes in it.
From afar, the statistics about Canadian debt are jarring. Household debt has risen to 179 per cent of disposable income. The bulk of that debt is from mortgages, and the vast majority of these loans are financed by the Big Six lenders. So the banks look particularly vulnerable in any downturn.
But the specifics about the market structure matter, and Canadian fund manager Rob Wessel, who runs Toronto-based Hamilton Capital Partners Inc., has zeroed in on these in a new research note to push back against the short trade. The same is true for Australia, he argued, a country whose banking system closely resembles ours.
“While the housing story has not yet been fully written, we believe the ongoing corrections will remain orderly and that a ‘big short’ position in the Canadian and Australian banks will continue to be challenging,” he wrote.
Mr. Wessel has an interesting vantage point. His firm specializes in investing in financial institutions around the world, and he personally knows the Canadian market intimately after spending years as an equity research analyst who covered the domestic banks.
Crucially, he noted, healthy levels of collateral and mortgage insurance “provide huge buffers to direct losses for the banks." He isn’t completely dismissive of the short story, but he believes "it would take a truly significant decline in home prices for Canadian and Australian banks to incur a large increase in direct mortgage credit losses.”
Major Canadian banks have an average loan-to-value ratio of 54 per cent on their mortgage portfolios. That effectively means that if a buyer were to default, the bank should be able to repossess the home and sell it for far more than the remaining loan value.
Mortgage insurance provided by Canadian Mortgage and Housing Corp. is also a crucial element of the Canadian market, protecting the lenders when they’re issuing mortgages with smaller down payments. On average, 44 per cent of Big Six bank mortgages are insured, so the lenders are protected if borrowers on these insured loans default.
As for the argument that a sluggish economy will cause problems, Mr. Wessel notes that the national unemployment rate of 5.8 per cent hasn’t been this low in decades. The broad labour market strength should do wonders because loan losses are positively correlated with unemployment rates. Plus, for all the doom and gloom, Canada’s gross domestic product is still predicted to increase over the next two years.
Lately, bearish investors have cautioned that the expected economic expansion is smaller than recently predicted. Yet, Mr. Wessel writes, that means interest rate hikes will likely remain on hold, and that has started to push borrowing costs down.
Despite the vocal arguments made by fund managers such as Mr. Eisman, recent statistics show broad swaths of investors aren’t growing intensely bearish – at least not yet. Since the start of the year, total short interest in the Big Six banks has remained flat around US$10-billion, according to S3 Partners, a financial analytics company. Of these lenders, Canadian Imperial Bank of Commerce has the highest percentage of its float shorted, at 5.6 per cent.
But bank CEOs have still had to defend their institutions. On Tuesday, Bank of Nova Scotia CEO Brian Porter spoke at the lender’s annual meeting and he provided a detailed riposte to the short narrative.
“We stress-test our portfolio on a regular basis, a daily basis. And we stress-test it against what we would view as very harsh metrics," he said, offering examples such as a 600-basis-point increase in interest rates and a huge jump in unemployment. Even in those scenarios, "our business is still profitable, the bank still pays a dividend and we carry on.”
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