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While Canada’s biggest banks saw lower profits for a second straight quarter due to economic fallout from the COVID-19 pandemic, there are signs of improvement. Kim Parlee speaks with Mario Mendonca, Managing Director, TD Securities about whether bank stocks are poised to play catch up.
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- In March, my next guest upgraded the financial sector to overweight from market weight, based on the view that banks will emerge from the crisis with dividends, capital strength, and earnings power intact. Now with two quarters of COVID-19 under their belts, what's the outlook for Canadian banks?
Mario Mendonca is with TD Securities, and he joins us now. Mario, can we just start with this last quarter that just happened? What did you see?
- Bank earnings, as you might expect, were still down. They were down 21% year-over-year. That's a fair bit better than the 50%-plus declines we saw last quarter. One of the biggest differences we saw this quarter versus last is that credit losses, while still very elevated, were down substantially from last quarter.
Just as an example, overall credit losses-- performing loan credit losses, what we consider the losses on the loans that are still good-- were in the neighborhood of over $7 billion last quarter. They were more like-- call it 3 and change-- maybe about $3.6 billion this quarter. So a fair bit better. And I think that was one of the-- that was probably the main reason why earnings declined by 21% rather than the 50-plus percent we saw last quarter.
But there were also big changes as it relates to capital. The capital ratios went from 11.2-- yeah, about 11.2, 11.3-- all the way back up to 11.8. Now, that's a pretty solid move, largely because the banks had such strong earnings but also because we really didn't see what we call this negative migration, meaning a serious deterioration in consumer and corporate credit, that we expected to, let's say, last quarter.
- Let me ask you though-- I mean, this is still an evolving situation. And just going back to the credit side, if we could, and then obviously the knock-on impacts on the capital-- what's going to happen when deferrals expire?
- Yeah, there's no doubt that bank payment deferrals and government support played an important role in constraining the kind of credit deterioration that we would have expected to play out this quarter. Just as a way-- by way of comparison, credit losses measured as percentage of loans before the crisis evolved were in the neighborhood of about 35 basis points. In Q3 2020, the quarter that just passed, that number was around 38 basis points, so virtually no change in the credit environment relative to what it used to be.
Now, why was this? Probably the single most important reason was government support and, as we talked about, the deferrals. And the deferrals are set to expire. Right now, about 12% of personal loans in Canada-- I'm thinking mortgages, credit cards, personal loans-- about 12% of those are subject to payment deferrals.
Most of those will expire in the next three months. Some might extend maybe another three months after that. But for the most part, payment deferrals are about to end. And the question then becomes, will consumers, once they need to make these payments again, find themselves unable to, resulting in materially higher delinquencies and therefore higher credit losses? So far, the data is looking pretty good.
And what I would suggest to you is note that 90% of all deferred payments in Canada right now are mortgages-- mortgages with good security because they're secured by the value of the real estate, loan-to-values that are 50%, 55%. These are very low loan-to-values and strong FICO scores. So insofar as deferrals in Canada are concerned, I think the data is actually trending in their favor.
One data point that might be worth noting is that requests for deferrals have collapsed. There's very, very few requests for deferrals in the last quarter. And in fact, of the deferrals that have expired-- the ones that have already expired-- the banks are indicating that about 98% to 99% are current again, current on their payment. So insofar as Canada and the US is concerned, I'm not that sensitive to what the expiration of deferrals might mean to our Canadian banks, in part because it doesn't seem to me like government support is going to go away altogether.
- Let me ask. I mean, so much of this, I think-- we start getting to a much more individual story in this time of economic tumult because every banks have their strength in different places. You said Canada and the US in terms of what's happening with deferrals-- the data is looking good. What about Latin America, because that's a different profile and specific to Scotiabank?
- Yeah, that's very relevant. A moment ago, I said that about 12% of loans are in deferral in Canada. It's important to note that about 25% of all retail loans that Scotia has in the international segment-- about 25% are currently in deferral today. That's a meaningful number.
It's also important to note that about 55% of Scotia's loans that are in deferral are mortgages. That number was over 90% when I just referred to Canada. So the other 45% would, say, be personal loans including credit cards or auto loans. And those have higher loss rates.
And then, the final thing I'd mention regarding Scotia's exposure to international is while delinquency rates are as low as 1% or 2% on the deferrals that have expired in Canada, those delinquency rates are closer to 10% in Latin America. So you can see how this whole issue of deferrals is far more relevant to Scotia's international segment than it is to the rest of the Canadian banks in Canada or the US.
But I do want to offer one important offset to this. Scotia does hold a lot of credit reserve. Scotia is holding $3.6 billion of credit reserves specifically earmarked against $40 billion of retail lending exposure that they have in Latin America. So they have a lot of reserves against it. But no doubt, they're going to experience-- I think they're going to experience a lot more volatility in their PCLs than the rest of the bank.
- Let me-- I want to come back to the individual bank names. But before we go, just in terms of overview of the quarter, we mentioned obviously capital strengths and CET ratios looking good. You've got the deferrals starting to come down-- or the PCLs, I should say, coming down, which is positive. The capital markets really were buoyant for a lot of the banks going forward as well.
- They were very strong. This is two consecutive quarters of very, very strong results. They benefited in part from very good volatility. It created a lot of client activity, very wide bid-offer spreads. It was especially strong in the fixed income or credit trading for our Canadian banks.
We saw numbers that-- one way you might think about it is in any given quarter, the top six banks in Canada generate about $3 billion of trading revenue. This quarter was over $5 billion. And the biggest question we have going forward is, is this sustainable? Can we expect to see this level of trading revenue going forward?
The answer is no. But what I'm coming to believe, as I dig into the numbers a little more, is that we may remain at a rather elevated level of capital markets related revenue, in part because governments and corporates around the world need to finance all the debt and all these cash payments they're making. Just the act of financing all this, issuing all this new paper, both debt-- both corporate and governments-- will support bank capital markets revenue as well. So trading revenue may come off a little bit from these very strong results. But there are other areas that could be a lot stronger.
- I want to come back to overall valuations when we get to the individual names. But we talked a bit about Scotiabank. You currently have a buy on Scotia. Let's talk about BMO a bit. What did you see there-- anything that was notable?
- That was really-- what was really interesting about BMO is going into the quarter, there was concerns around the bank's capital. Their capital ratio was a little low relative to the group. They got a little bit of bad news from their US regulator, suggesting that they had more capital risk than their peers. This was happening weeks before they reported. There was concern that they would have higher credit losses in affected sectors like oil and gas, transportation, retail finance.
None of that played out. BMO beat the numbers nicely. Their capital ratio rallied back up to 11.6%. And to really make the point, BMO dropped their Dividend Reinvestment Plan-- their DRIP-- which showed a lot of confidence in their capital level. So BMO really did surprise on so many positive levels. And I think that's why the stock performed reasonably well coming out of the quarter. Their valuation is still very low-- yeah, about 1.1, 1.2 times book, so still a good value.
- Hmm, how's Royal looking? Again, you have a buy on this one. I think I was reading that when you talked about Royal in your notes-- something about the capital and credit losses were yesterday's story.
- Yeah, that was really the impression I got for Royal, probably National, maybe even CIBC and a few others, that we really shouldn't be that fussed about capital and credit going forward. That bank has built up a sufficient amount of credit reserves, a very strong capital level that really should support Royal through this. So I think in the context of Royal, a bank that trades at 1.8 times book-- well above the average of 1.4-- that bank-- we really should start focusing on what kind of earnings growth Royal is capable of producing, because I'm really not that sensitive to capital and credit insofar as Royal is concerned.
- CIBC-- you mentioned them. I think this is the only one of the banks that's on your action list right now-- buy, right now. Why is that?
- Yeah, and I'm pleased with that call. It is the only action list buy. The stock has done really well. The call there was I was looking at Scotia, BMO, and CIBC as the banks that all traded at about 1 or 1.1 times book a little while ago. And I made the call that CIBC would be the one that would likely break from the pack.
And the reason I did this was largely because of the bank's lower risk profile. They're overweight in mortgages. They're not overweight Latin America or commercial lending like Scotia and BMO might be. Their capital ratio looks very, very strong as well. So I'm glad I made that call to support CIBC over Scotia and BMO. And that call has worked. And I continue to believe that's the right place to be among the banks that are the lower value.
- Last question for you, Mario-- when you take a look at the banks, I know you look at price-to-book. But I'm going to throw a forward earnings number at you. Banks are trading at 10 and 1/2 forward earnings. The TSX is at 18.7. What's the bit of the disconnect here, would you say? Is there something that the markets know about what's coming for the banks, or are these undervalued right now?
- I still believe that the banks are undervalued. And that's why around March 20, when I made that call to go overweight the banks, I'm glad I did. The banks have performed well. But I don't think the call is over. I think the market continues to have concern around credit, perhaps less so capital.
I'm sure there's concerns around these deferrals and when they expire and how they could hit the banks. I think just generally, the banks are a reflection of the broad economy. And until people get really comfortable that unemployment is checking back to normal and GDP growth is improving, the banks could struggle to match up with the broader-- with the market index or the market PE.
In part also, the market really reflects a lot more tech names. And the tech names have been very strong. You can look at all the big tech names. They've had some great moves in the last few months. And the Canadian banks don't fit into that theme, right.
- I lied. I have one last question. With all the capital ratios so high, are there acquisitions coming?
- Unlikely in the near term-- I cannot see our banks using these very strong capital levels in the near term to make acquisitions, buy back stock, or raise their dividend. We have just come off of a period where there was concern that the banks were going to have to raise equity and cut their dividends. At a minimum, let's take a breather and say, they're not going to cut their dividends. They don't have to raise equity. But I think what they're going to do is continue to accrue capital.
But at some point, these capital levels will be awfully high, at which point we have to seriously consider, how will these banks allocate capital? It's a long way out. But at some point, perhaps late 2021, I think we should start talking about acquisitions and buybacks again. But we're not there yet.
- Mario, always a pleasure. Thanks so much.
- Thank you.
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- In March, my next guest upgraded the financial sector to overweight from market weight, based on the view that banks will emerge from the crisis with dividends, capital strength, and earnings power intact. Now with two quarters of COVID-19 under their belts, what's the outlook for Canadian banks?
Mario Mendonca is with TD Securities, and he joins us now. Mario, can we just start with this last quarter that just happened? What did you see?
- Bank earnings, as you might expect, were still down. They were down 21% year-over-year. That's a fair bit better than the 50%-plus declines we saw last quarter. One of the biggest differences we saw this quarter versus last is that credit losses, while still very elevated, were down substantially from last quarter.
Just as an example, overall credit losses-- performing loan credit losses, what we consider the losses on the loans that are still good-- were in the neighborhood of over $7 billion last quarter. They were more like-- call it 3 and change-- maybe about $3.6 billion this quarter. So a fair bit better. And I think that was one of the-- that was probably the main reason why earnings declined by 21% rather than the 50-plus percent we saw last quarter.
But there were also big changes as it relates to capital. The capital ratios went from 11.2-- yeah, about 11.2, 11.3-- all the way back up to 11.8. Now, that's a pretty solid move, largely because the banks had such strong earnings but also because we really didn't see what we call this negative migration, meaning a serious deterioration in consumer and corporate credit, that we expected to, let's say, last quarter.
- Let me ask you though-- I mean, this is still an evolving situation. And just going back to the credit side, if we could, and then obviously the knock-on impacts on the capital-- what's going to happen when deferrals expire?
- Yeah, there's no doubt that bank payment deferrals and government support played an important role in constraining the kind of credit deterioration that we would have expected to play out this quarter. Just as a way-- by way of comparison, credit losses measured as percentage of loans before the crisis evolved were in the neighborhood of about 35 basis points. In Q3 2020, the quarter that just passed, that number was around 38 basis points, so virtually no change in the credit environment relative to what it used to be.
Now, why was this? Probably the single most important reason was government support and, as we talked about, the deferrals. And the deferrals are set to expire. Right now, about 12% of personal loans in Canada-- I'm thinking mortgages, credit cards, personal loans-- about 12% of those are subject to payment deferrals.
Most of those will expire in the next three months. Some might extend maybe another three months after that. But for the most part, payment deferrals are about to end. And the question then becomes, will consumers, once they need to make these payments again, find themselves unable to, resulting in materially higher delinquencies and therefore higher credit losses? So far, the data is looking pretty good.
And what I would suggest to you is note that 90% of all deferred payments in Canada right now are mortgages-- mortgages with good security because they're secured by the value of the real estate, loan-to-values that are 50%, 55%. These are very low loan-to-values and strong FICO scores. So insofar as deferrals in Canada are concerned, I think the data is actually trending in their favor.
One data point that might be worth noting is that requests for deferrals have collapsed. There's very, very few requests for deferrals in the last quarter. And in fact, of the deferrals that have expired-- the ones that have already expired-- the banks are indicating that about 98% to 99% are current again, current on their payment. So insofar as Canada and the US is concerned, I'm not that sensitive to what the expiration of deferrals might mean to our Canadian banks, in part because it doesn't seem to me like government support is going to go away altogether.
- Let me ask. I mean, so much of this, I think-- we start getting to a much more individual story in this time of economic tumult because every banks have their strength in different places. You said Canada and the US in terms of what's happening with deferrals-- the data is looking good. What about Latin America, because that's a different profile and specific to Scotiabank?
- Yeah, that's very relevant. A moment ago, I said that about 12% of loans are in deferral in Canada. It's important to note that about 25% of all retail loans that Scotia has in the international segment-- about 25% are currently in deferral today. That's a meaningful number.
It's also important to note that about 55% of Scotia's loans that are in deferral are mortgages. That number was over 90% when I just referred to Canada. So the other 45% would, say, be personal loans including credit cards or auto loans. And those have higher loss rates.
And then, the final thing I'd mention regarding Scotia's exposure to international is while delinquency rates are as low as 1% or 2% on the deferrals that have expired in Canada, those delinquency rates are closer to 10% in Latin America. So you can see how this whole issue of deferrals is far more relevant to Scotia's international segment than it is to the rest of the Canadian banks in Canada or the US.
But I do want to offer one important offset to this. Scotia does hold a lot of credit reserve. Scotia is holding $3.6 billion of credit reserves specifically earmarked against $40 billion of retail lending exposure that they have in Latin America. So they have a lot of reserves against it. But no doubt, they're going to experience-- I think they're going to experience a lot more volatility in their PCLs than the rest of the bank.
- Let me-- I want to come back to the individual bank names. But before we go, just in terms of overview of the quarter, we mentioned obviously capital strengths and CET ratios looking good. You've got the deferrals starting to come down-- or the PCLs, I should say, coming down, which is positive. The capital markets really were buoyant for a lot of the banks going forward as well.
- They were very strong. This is two consecutive quarters of very, very strong results. They benefited in part from very good volatility. It created a lot of client activity, very wide bid-offer spreads. It was especially strong in the fixed income or credit trading for our Canadian banks.
We saw numbers that-- one way you might think about it is in any given quarter, the top six banks in Canada generate about $3 billion of trading revenue. This quarter was over $5 billion. And the biggest question we have going forward is, is this sustainable? Can we expect to see this level of trading revenue going forward?
The answer is no. But what I'm coming to believe, as I dig into the numbers a little more, is that we may remain at a rather elevated level of capital markets related revenue, in part because governments and corporates around the world need to finance all the debt and all these cash payments they're making. Just the act of financing all this, issuing all this new paper, both debt-- both corporate and governments-- will support bank capital markets revenue as well. So trading revenue may come off a little bit from these very strong results. But there are other areas that could be a lot stronger.
- I want to come back to overall valuations when we get to the individual names. But we talked a bit about Scotiabank. You currently have a buy on Scotia. Let's talk about BMO a bit. What did you see there-- anything that was notable?
- That was really-- what was really interesting about BMO is going into the quarter, there was concerns around the bank's capital. Their capital ratio was a little low relative to the group. They got a little bit of bad news from their US regulator, suggesting that they had more capital risk than their peers. This was happening weeks before they reported. There was concern that they would have higher credit losses in affected sectors like oil and gas, transportation, retail finance.
None of that played out. BMO beat the numbers nicely. Their capital ratio rallied back up to 11.6%. And to really make the point, BMO dropped their Dividend Reinvestment Plan-- their DRIP-- which showed a lot of confidence in their capital level. So BMO really did surprise on so many positive levels. And I think that's why the stock performed reasonably well coming out of the quarter. Their valuation is still very low-- yeah, about 1.1, 1.2 times book, so still a good value.
- Hmm, how's Royal looking? Again, you have a buy on this one. I think I was reading that when you talked about Royal in your notes-- something about the capital and credit losses were yesterday's story.
- Yeah, that was really the impression I got for Royal, probably National, maybe even CIBC and a few others, that we really shouldn't be that fussed about capital and credit going forward. That bank has built up a sufficient amount of credit reserves, a very strong capital level that really should support Royal through this. So I think in the context of Royal, a bank that trades at 1.8 times book-- well above the average of 1.4-- that bank-- we really should start focusing on what kind of earnings growth Royal is capable of producing, because I'm really not that sensitive to capital and credit insofar as Royal is concerned.
- CIBC-- you mentioned them. I think this is the only one of the banks that's on your action list right now-- buy, right now. Why is that?
- Yeah, and I'm pleased with that call. It is the only action list buy. The stock has done really well. The call there was I was looking at Scotia, BMO, and CIBC as the banks that all traded at about 1 or 1.1 times book a little while ago. And I made the call that CIBC would be the one that would likely break from the pack.
And the reason I did this was largely because of the bank's lower risk profile. They're overweight in mortgages. They're not overweight Latin America or commercial lending like Scotia and BMO might be. Their capital ratio looks very, very strong as well. So I'm glad I made that call to support CIBC over Scotia and BMO. And that call has worked. And I continue to believe that's the right place to be among the banks that are the lower value.
- Last question for you, Mario-- when you take a look at the banks, I know you look at price-to-book. But I'm going to throw a forward earnings number at you. Banks are trading at 10 and 1/2 forward earnings. The TSX is at 18.7. What's the bit of the disconnect here, would you say? Is there something that the markets know about what's coming for the banks, or are these undervalued right now?
- I still believe that the banks are undervalued. And that's why around March 20, when I made that call to go overweight the banks, I'm glad I did. The banks have performed well. But I don't think the call is over. I think the market continues to have concern around credit, perhaps less so capital.
I'm sure there's concerns around these deferrals and when they expire and how they could hit the banks. I think just generally, the banks are a reflection of the broad economy. And until people get really comfortable that unemployment is checking back to normal and GDP growth is improving, the banks could struggle to match up with the broader-- with the market index or the market PE.
In part also, the market really reflects a lot more tech names. And the tech names have been very strong. You can look at all the big tech names. They've had some great moves in the last few months. And the Canadian banks don't fit into that theme, right.
- I lied. I have one last question. With all the capital ratios so high, are there acquisitions coming?
- Unlikely in the near term-- I cannot see our banks using these very strong capital levels in the near term to make acquisitions, buy back stock, or raise their dividend. We have just come off of a period where there was concern that the banks were going to have to raise equity and cut their dividends. At a minimum, let's take a breather and say, they're not going to cut their dividends. They don't have to raise equity. But I think what they're going to do is continue to accrue capital.
But at some point, these capital levels will be awfully high, at which point we have to seriously consider, how will these banks allocate capital? It's a long way out. But at some point, perhaps late 2021, I think we should start talking about acquisitions and buybacks again. But we're not there yet.
- Mario, always a pleasure. Thanks so much.
- Thank you.
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