Sat Post #1: More on Canadian Banking

Thursday's post, Will Canadian Banks will be in the market crosshairs soon?, profiled a chart posted over at Zero Hedge discussing Tangible Common Equity (TCE).

That's the ratio used to determine how much losses a bank can take before shareholder equity is wiped out.

Seems that if you rank global banks by tangible common equity, starting with the lowest first, then 30% of the worst banks in the world are our own Canadian Banks.

Bank	TCE ratio
Canadian Imperial Bank of Commerce	2.84%
National Bank of Canada	3.30%
Bank of Nova Scotia	3.37%
Royal Bank of Canada	3.43%
Toronto Dominion Bank	3.60%
Bank of Montreal	4.19%

We have covered this topic before. 

Back in December 2009, we talked about a report from Sprott Asset Management, that analyzed and compared the average leverage ratio of the Canadian banking system.

Sprott saw exactly what Zero Hedge noticed.

• "Looking at the Canadian system more closely, all five Canadian banks are levered at an average of 31:1, which is actually the lowest leverage ratio during the three years that we reviewed. This implies that if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would effectively be wiped out.
  
  Now, that doesn’t mean they would go bankrupt per se, but it does give us an indication of how little asset prices would have to decline in order to wipe out their tangible common equity. These leverage ratios worry us because they leave such a razor thin margin for error on the ‘tangible asset’ side of the leverage equation."

Sprott and Zero Hedge are thinking alike here.  But the Zero Hedge article came out on a day when the world's stock markets were crashing on concerns of the European Banks. And in a testimony to the growing influence of Zero Hedge, the Globe and Mail newspaper picked up on the story. 

G&M points out that Canadian banks routinely disclose TCE ratios north of 10%.

Why such a huge difference from the Sprott and ZH numbers?

The wide discrepancy is due to the fact that the banks talk about tangible common equity to risk weighted assets.  The Zero Hedge graph is looking at TCE to total assets (which is exactly what Sprott Asset Management did).

The Globe notes that risk weighted assets adjust for the chance that the assets will go bad, and that's hardly a science. Total assets doesn't allow for such judgement calls. On that basis, Canadian banks are just as leveraged as European banks, and far more so than American banks.

So do the concerns that Sprott and Zero Hedge raise mean investors should worry about Canadian Banks or not?

• "[In Europe], the banks face the very real prospect of losses on the value of the bonds they hold that were issued by countries like Greece, Ireland, Spain and Portugal. Losing 4%of total assets doesn't seem like a stretch.
  
  In Canada, the concern would have to be the housing portfolios, the biggest chunks of Canadian banks' assets.
  
  If you believe that housing is in for a severe correction in Canada, and that Canadians won't repay their mortgages when the value of their homes falls, and that the banks will have to take significant write downs on the portions of their mortgage portfolios that are not insured by the federal government, then maybe you will come to the conclusion that [Zero Hedge] is onto something.
  
  If you are one of those who believes housing can never fall, or if you believe that Canadians will continue to pay their mortgages even in a housing correction, as they have always done in past, then maybe you can breathe a little easier.

Do you get a sense here of just how much of our country's future is wrapped up in our housing bubble?

The bottom line is that if the bubble bursts, what we are watching play out in Europe this week will be repeated here with lightening speed.

And it will be ugly.

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