Canada’s big banks are laggards on the TSX this year. What is to blame? Slowing growth or a potential spike in credit losses? Kim Parlee speaks with Mario Mendonca, Managing Director at TD Securities.
- Hello, and welcome to the show. It is great to have you with us. As bank earnings start to come in, analysts and investors will be scrutinizing the numbers, looking to see if there will be a slowdown in earnings or even a painful credit downturn. Our next guest wrote a report called, "Preparing for the Next Credit Cycle." His name is Mario Mendonca. He is managing director at TD Securities. And I started by asking him what led him to write that report.
- It's difficult to tell with Canadian banks and how they're performing whether the performance reflects fear of a credit downturn, a severe credit downturn or just slowing earnings growth. My perspective is that it was slowing earnings growth. But there were some, particularly in the US, that were suggesting, no, this is really a harbinger of a material downturn in the credit environment.
- You took a look at this. And you called it a close look of capital from top to bottom. The one thing that's interesting with this as well as the timing of this report is you looked at the performance of the bank stocks, as you do all the time. And the bank stocks are materially underperforming the index and also the life insurance companies at same time. So is some of this fear, do you think, factored in right now?
- I think so, yeah. It's unusual for the Canadian banks to underperform the broader market, because the Canadian banks really are a reflection of the market. They lend to every sector. So when you see the Canadian banks either underperforming or outperforming the broader market in a material way, you should pay close attention. And seeing them underperform really got my attention.
- And just to be clear as well, it's not as though you think everything is rosy from here on in, because you've actually downgraded the sector, I think, back in March.
- March 5, I downgraded the sector from overweight to market weight. But I did so for a very distinct reason. I did it because I believe earnings growth is slowing, which is sort of what we saw from the banks in Q1 and again from CIBC in Q2. I didn't downgrade because I believe there's a big credit cycle coming that will hurt valuation. There's a normalization in credit that's playing out but not a painful credit cycle.
- Can you just distinguish between the two?
- Yeah, our Canadian banks right now, in 2013, credit losses were about 30 basis points of their overall loan portfolios. Previous credit cycles have reached about 100 basis points or 140 basis points. What normal is to me is something around 40 to 45 basis points. I think we're going back to normal, not to some painful credit cycle where we see PCLs, or Provisions for Credit Losses, exceed 100 basis points.
- OK, let's talk a bit about it. And what I like about this report is you basically said, look, if you think that we're going up to 100 basis points in terms of provision for credit losses, there are certain things that need to be true. You need to see, basically, a spike in loan losses right across all the banks. And so you actually crunched the numbers and said what would have to be true for that to happen.
So let's run through some of the parts of the bank and where they're working. Mortgages and consumer lending, what are you seeing there that has you think that will not happen?
- Well, first, mortgages. Right now, CIBC just reported again this morning. We saw mortgage losses running at one basis point. Over the last 25 to 30 years, the average has been about two basis points. In the model, to get to 100 basis points of credit losses, I'd have to see that loss rate reach seven basis points. That number, we might have seen briefly in 1992. But that level of loss would presuppose that there isn't a lot of capital built into these mortgages.
The loan to equity ratio for our Canadian banks right now, for the mortgages, rather, are about 65%. That means market values of homes would have to decline substantially for the banks really to be at risk. And that's just one category.
Take commercial loan losses. Commercial loan losses right now are running at about five basis points. The long-term average would be something like 55 basis points. In the model, I had to take that to something like 145 basis points to create 100 basis points of loss. The broader point I'm making here is, as you specified, you'd have to see loan losses across every loan category at peak or well above peak levels to create 100 basis points of loss.
- And I think that the thing that I liked about the report is the devil's in the details, because you actually go into each one. Take commercial real estate. One thing that you highlighted that I thought was interesting is that the way that loans are made are different than it used to be when those peak problems happened before. So talk a bit about that and why you feel more secure or confident now.
- Well, everybody will go back and look at previous cycles and say, well, back in 1992, loan losses reached 140 basis points. That was driven by commercial real estate. At the time, commercial real estate was 12% to 13% of a bank's total loan book. Today it's around 9%. But more important than just the decline and its importance is how lending standards have changed between then and now.
Today, the level of presales on commercial real estate lending are much higher than they used to be. The quality of the borrower has completely changed. Today, borrowers have to leave large significant deposits with the banks before the banks will even offer that kind of lending. But perhaps what's most important to me is that the underwriting standards are centralized very high quality today versus what they were in 1992. I don't think you can look at 1992's experience and imply something about today.
- Consumer credit, though, you talked about mortgages, and obviously, there are stricter regulations in place in Canada. So that does provide a bit more of a buffer. What about things like unsecured, like credit card and auto and those types of things?
- Yeah, let me give you credit cards, for example. Today, credit card loan losses are running, let's say, 250 basis points. I would have to take that to over 600 basis points of credit loss before we could get back up to that 100 basis points I was referring to. The long-term average is something like maybe 350 basis points of credit loss. So again, I have to assume a meltdown for loan losses to reach that 100 basis points. But what I will say, if unemployment moves higher, sure, we're going to see higher credit card losses.
- You also talk about-- and I'm not trying to poke holes in your theory, because you provide them-- but you talk about the mix of loans has also changed. So banks were traditionally lending more, I think, to commercial and less to consumer. But that has changed. So is that a vulnerability?
- Well, that's a really important point, because when the mix of loans increases substantially to mortgages, and mortgages have the smallest lost contents, say two basis points, it makes it especially difficult to get to that 100 basis points of loan loss, because the loan category that's the largest now, mortgages-- 42% of our overall loan book, versus, say, 26% in 1992-- the largest category of loans have the lowest loss content. And that's why the 100 basis points doesn't seem plausible to me.
- Unemployment rates, you took a look at that. I know you've got a graph showing in terms of when unemployment spiked when we saw the financial crisis and the technology crash at the same time too. And what's the correlation? I always think, just rule of thumb, is if people don't have jobs, they're not buying houses. Therefore, that causes problems in mortgages that you talked about. But not a concern for you?
- Not so much in mortgages. Where you would probably see it, I think, is in credit cards, maybe auto. People could default on their mortgage. But if the security on the loan is so good, then the bank still doesn't lose money.
The other thing to highlight here is that half of all our mortgages or maybe just under half are government-insured. So I feel like people are barking up the wrong tree when they focus on mortgages. When unemployment hits, and we will eventually have a cycle, look for it more in credit cards, maybe auto, commercial. But I don't think it's going to be mortgages.
- I know you're not worried about unemployment rates. The one thing, the US economy is strong. You've got tariffs. You've got some other stuff going on too. But the Canadian economy is not. I think it's not as strong as the US economy.
- At some point there's going to be a credit cycle. We all know that's going to happen. And in the report, I hypothesize that when it does happen, it'll hurt valuations. I'm clear on that in the report. The bigger question is, does that really matter to a long-term investor. And that's where the report really dives into the capital side of the story, because if capital becomes an issue, all bets are off.
- And the argument I make in the report is that capital will not be an issue. And that's why short-term pain because of higher credit losses, you can tolerate it.
- You talk about the fact that, I think, in the past, we saw, I think, in terms of provisions for capital losses, banks would take the provisions and then later on would get the bump up in capital aid wrong, because they didn't have to use them all.
MARIO MENDONCA: Right.
- So there's a bit of a cushion on that front too.
- Yeah, there's a technical side to this, which I'll be careful with. There has been a change in accounting starting off in 2018 where the banks are required to build expected losses. So it's not just what's actually gone wrong, it's what you may see go wrong. And what we're seeing the banks do now is build up higher expected losses. But if those expected losses don't come to fruition, they come back.
So when you see expected loss levels start to rise in the banks booking these losses, be careful in how you look at that. It doesn't mean the banks actually lost that money. I know it's negative to the earnings, but that could come right back as things improve.
- Let's try and delve into the capital side. And it is very technical. And I'm going to try and keep it a little bit at the top if I could. You have an interesting line in your report talking about pre-tax, pre-provision, and return on equity. It's cash earnings. This is what the bank is generating or banks generate day in, day out. And I love this, a nearly insurmountable buffer to the things that are going on. What do you mean by that?
- Very often, when people think about capital and they think about capital strength, what they'll turn to is they'll say, what is the bank's capital ratio. And TD's, for example, is 12%. The average bank might be around 11 and 1/2% capital ratio. And people will often say that capital is your buffer against losses and materializing. And I totally disagree with that.
The best buffer is not the capital you hold today but the capital you'll generate in the future. The best source of capital in the future is earnings. So if your pre-tax, pre-credit loss earnings are as high as I've suggested in the report, they generate a 24% return if you exclude taxes and you exclude provisions for credit losses. That means they're adding 24% to their capital every year on a pre-tax, pre-provision basis. It is virtually impossible to wipe that out with credit losses.
Just think about this for a moment. We are hypothesizing or theorizing on 100 basis points of credit losses. The pre-tax, pre-provision ROE is 24%. It's an enormous number. That's what I mean by an insurmountable buffer, because earnings are in fact your best source of strength, not the capital today.
- And let's be clear, insurmountable buffer does not mean the stock price will not go down.
MARIO MENDONCA: Oh, no.
- It does not mean that you're not going to see some moves in the cycle. You're just saying these are strong franchises.
- Yeah, let's be very clear on what I'm saying here. Stocks go down when guys like me lower our earnings estimates. When we take our estimates down because we think credit losses are going to go higher, stocks will go down. It always happens. Look at CIBC today. And we can talk about that in a moment.
But what I'm suggesting here is that capital will always-- that the level of earnings are so strong that they can absorb capital losses. And to me, where things really go crazy is when people start to question capital strength. Look at the US banks. The US banks during the financial crisis, the moment investors started to question their capital strength, the stocks fell apart.
- Let's talk about CIBC. The earnings did come out this morning. They missed estimates. Let me ask you what you thought of CIBC. And also, does it validate what you talked about in this report?
MARIO MENDONCA: Sure. So first, they missed earnings by about a penny. It really wasn't that bad. They reported $2.98 adjusted earnings. No, they reported $2.97. The Street was at $2.98, and I was at $2.99. So they barely missed at all.
The question wasn't earnings today, it's what they said about their earnings going forward. And they changed their outlook. They're now suggesting that EPS in 2019 will be flat with 2018. Their guidance is normally for 5%-plus, something like that. And the reason why this matters to me is they talked about how expense levels are moving higher. Their loan growth on the consumer side is low. And that was very clear. Their mortgage growth is going to be lower than their peer group. Personal loans looked OK. But credit cards were much lower. Small business lending was lower.
So we're seeing a real loss of momentum for CIBC on the consumer side. As well, they're guiding to higher expenses than we've seen in the past. And then finally, they talked about doing another US deal. And I don't think the Street wants to see that right now.
- So does that, again, validate the idea that this is not such a strong earnings story? But again, you're not worried about the capital side of things.
- Thanks for reminding me. The two things that I would highlight in that respect is credit conditions remain solid. There was no issue from a credit perspective. I think they had a credit loss ratio of 26 basis points, so well below 100 we're talking about. And their capital ratio was 11.2%, consistent with last quarter. So no real change in the capital ratio either.
So yeah, it entirely validates the notion that credit is not deteriorating, and capital is strong. The issue is earnings growth.
- Let me ask you, and final question. I know this report you put out in response to some stateside investors taking a look at-- does this change it? Or do you think it's just the fact that they're using US bank examples to understand what's happening in the Canadian sector?
- I feel like this happens a lot. People will use whatever lens is most familiar to them when they're looking at a problem in front of them. And very often, I find US investors and hedge funds will use their US experience, particularly during the financial crisis, to look at Canadian banks. That's where the errors are made. You can't look at the Canadian banks through the US lens.
- Mario, always a pleasure. Thanks so much.