Thurs Post #2: Concern over Canadian bank exposure to overleveraged consumers

One refrain you have heard constantly during the inflating of our housing bubble in Canada is that 'Canada is different... Canadian banks did not lend money to those who couldn't pay it back.'

That, as this blog as insisted over and over again, is a crock.

Our banks permit liar loans - loans where a self-employed person can 'declare' their annual income to qualify for a mortgage.

Our banks offer cash back for mortgages (as much as 7%) which effectively means we have zero down mortgages. You can take out a mortgage, receive 7% back (which covers the 5% down payment) and this allows you to be PAID to buy a house.

And most significantly, CMHC is absorbing all lender risk.

Take away CMHC and there is no way twenty-something couples would qualify for a 5% down mortgage at the same rate as people with money.  Without access to this easy credit, the housing bubble would collapse.

As these measures have pushed up home values, Canadians have pigged out on an orgy of debt from HELOC's and credit cards fueled by the value of their houses.

Now, according to a report by Moody’s Investors Service, concerns are being raised about Canadian bank exposure to overleveraged consumers.

Observers are asking a question that would have been almost unthinkable a year ago: Would the big banks take a hit if the debt crisis spread here and consumer defaults spiked?

The biggest single asset on Canadian bank balance sheets is residential mortgages, more than 30% of which are insured by the Canada Mortgage and Housing Corp., essentially shifting the risk of default onto the shoulders of the government.

But banks also hold substantial uninsured assets such as credit card debt, and that leaves them vulnerable.

According to David Beattie, Moody’s analyst and author of the report, the Royal Bank of Canada is the most susceptible with 24% of its total managed assets made up of uninsured loans. Next is Bank of Nova Scotia at 21%, CIBC at 20%, Toronto-Dominion Bank and National Bank of Canada both at 18%, with Bank of Montreal the most protected at 14%.

“Canadian household debt as a share of personal disposable income stood at a record 150.8% at the end of June this year.” said Mr. Beattie. “We are concerned that, while taking advantage of low interest rates, consumers are also taking on debt the may not be able to service when rates inevitably go up.”

We haven't begun our downturn yet. And people have no idea how closely tied Canadian mortgage debt and consumer debt is.

As the Financial Post notes, the European debt crisis is already having a negative impact on the global economy.

The fear is that a significant rise in unemployment could leave many households unable to meet their obligations despite the record low interest rates.

Analysts are uncertain how Canadians would react in such a situation, whether they would stop paying their mortgages — as many Americans did when U.S. economy collapsed three years ago — or whether it would be credit card debt or auto loans that would take the hit.

Another area of uncertainty is the makeup of the banks’ consumer loan portfolios. There is limited detailed information on the various categories of loans, making it difficult to guage Canadian banks’ true exposure.

Certainly this blog suspects that if real estate turns in Canada, the resulting fallout will be catastrophic.

Perhaps that's when the ruling federal Conservative government in Canada moved heaven and earth to protect the real estate industry when the US market started going under in 2006.

We've had the zero down, forty year mortgage. The ability to raid the RRSP fund for down payments. The Home Reno Tax Credit. Emergency interest rates. First-time buyer’s closing cost credit. Regulations that permit liar loans. Regulations that permit zero-down payments with cash back from mortgage lenders. And CMHC increasing loan value on their books from just over $100 million to well over $700 million while assuming all lender risk.

Cheap credit, artificially supressed interest rates and government policy have attempted to fuel and protect the real estate boom in the hopes the Great Global Recession would pass before the impacts him home in the Land of the Maple Leaf.

In short our government gambled... much like the Trudeau government gambled on oil in the 1970s.

If it blows up... it is going to be really, really ugly.

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Thursday Post #4: Will Canadian Banks be in the market crosshairs soon?

Yesterday news broke that one European bank was in dire need of US dollars and ended up borrowing $500 million from the ECB. The information came via the results of the ECB's tender operation for emergency 7 day liquidity, arguably the closest the ECB has to a dollar denominated discount window.

One bank borrowed $500 million in a 7 day liquidity providing operation at a 1.1% rate.

This was significant because there had been no borrowing under this facility since March 2011, and the last time there was a sizable borrowing under the 7 Day OT was back in May 2010, when Europe was blowing up for the first time and the ECB was scrambling to contain the contagion.

The news of this borrowing sent the stock market plunging 5% today.

Investors freaked as speculation mounted as to which European Bank had to go crawling to the ECB for a sizable dollar-based capital injection (especially since this same bank is certainly using the ECB's various other liquidity providing lines of credit).

All eyes will be on the stock market again tomorow.

That's because it was revealled this afternoon that the Federal Reserve Bank of New York (FRBNY) just reactivated FX swap lines with Europe. 

The FRBNY  announced that in the week ended August 17, it lent out $200 million to not the ECB, not the BOE, but the "most stable" of all banks: the Swiss National Bank.

This is the first use of the Fed's Swap Lines since March, and the most transacted under this "last ditch global bailout swap line" since October 2010.

This event also gives us a hint that the European bank in question in dire need of cash is Swiss, which in turn means that it is not some usual PIIGS suspect, but one of the two "big ones."

If this is true, then the European insolvency and liquidity crisis is about to escalate.

We await the opening of the markets tomorrow with keen interest.

But this story doesn't end there. Let's ponder all this fervor about European Banks and their Tangible Common Equity ratio for a moment.

Is it just European Banks that investors should be worried about? Take a look at this chart (click on image to enlarge) posted on Zero Hedge:

This is a ranking of global banks by tangible common equity, lowest first, of the banks with a TCE ratio of under ~4%.

A whopping 30% of the Banks on this list are those situated in Canada. 

Canadian Imperial Bank of Commerce (5th spot), National Bank (11th), Bank of Nova Scotia (13th), Toronto Dominion Bank (14th), Royal Bank (15th) and Bank of Montreal (21st) are all on the list.

[For those unfamiliar with Canada, that's every large bank in our country]

Canada has been completely spared from the retribution of the bond vigilantes so far but one has to wonder how long before the contagion worries begin to take hold here.

How long before Canadian sovereign CDS, not to mention Canadian bank CDS, start to go quite a bit wider?

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We will pay you to take out a mortgage!

Just before the housing bubble collapsed in the United States, real estate mortgages had reached absurb proportions.

You could actually buy a house with nothing down and get money back from the bank when you bought... in essence you could get paid to buy a house.

One of the items making the rounds in the Canadian blogoshpere today is this article in the Globe and Mail which notes that Canadian banks are struggling to boost loans as demand ebbs in the weak economic rebound.

• Royal Bank chief executive officer Gordon Nixon said the banks must now find ways to build their lending operations – a key driver of their profits – without being coaxed into making unattractive loans just to get more business in the door.
  
  “What you hope you don’t see happen is banks starting to do stupid things again,” Mr. Nixon said in an interview, referring to the past several years where credit was easy to come by, and banks around the world were all too eager to lend.
  
  “Right now we’re in an environment where demand for credit is very, very low... It’s not that credit isn’t available – there’s not a lot of demand.”

Well I've got news for Mr. Nixon. Canadian banks are doing stupid things as he says this.

In the comments section from yesterday's post comes this link from Rob to an offer from CIBC.

Seems CIBC will you cash back based on your mortgage amount and term, and is available if you are approved for a 3, 4, 5, 7 or 10-year closed, fixed-rate residential mortgage. For example, if you have a $500,000 mortgage and select a 10-year term, you will receive 7% cash back, or $35,000!

And since your 5% downpayment is only $25,000, you can basically buy the home with nothing down and get PAID $10,000 for making the purchase.

Good thing our conservative banks aren't making the same mistakes the Americans did. Again I ask, is it so hard to see what is coming?

Meanwhile I am watching with keen interest as a colleague attempts to sell his one bedroom condo.

He bought the condo several years ago for %54,000 and has moved his girlfriend's house. As a result, the condo has been listed for sale.

After consulting with his realtor, the property was listed for $144,000 - right in the middle of the price range for what comparable apartments were selling for.

So I asked him, "if you get a low ball offer, what would you accept?"

His reply was that he would go as low as $139,000!

Now that's a measly 3.5%, but perhaps that sums up the current mindset of sellers right now. Despite having paid only $54,000 a few years ago, he firmly believes his property is worth almost three times what he paid. And he isn't prepared to move on the price... because 'that's what it's worth'.

Of course... that was three weeks ago.

After receiving the sum total of ZERO hits on the MLS listing, his realtor recommended adjusting the asking price.

This week it was dropped to $139,000. No comment on if he's adjusting the amount at which he is willing to accept.

I'll keep you updated on how things go.

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The Great Reckoning (... what'd I do?)

In April of 2009, Statistics Canada conducted a survey on financial capability.

The survey found that more than 1/3 of Canadians said they were either struggling or unable to keep up with their finances.

And you can bet your bottom dollar, dear blog reader, that a good portion of the other 2/3's (the ones that said they were not struggling to keep up with their finances) are probably in the blissfully ignorant camp.

Self-assessment scales need to be taken with a grain of salt. Most of us will report that we are good drivers. Not all of us are.

As I have said time and time before, the story of Canadian Real Estate is going to be the story of interest rates. And those rates are going to be going up. The only question is... how high are they going to go?

Over the past week I have tried show that the current economic 'recovery' is all based on massive amounts of government stimulus. That western governments were within hours of a complete meltdown of the world's financial system and - in a desperate attempt to prevent a nuclear meltdown - the braintrusts of our national finances responded with knee-jerk reactions to halt a complete financial collapse.

Now they are struggling with the repercussions of those moves.

Worse... key members of that braintrust now admit that they made key mistakes that lead us to this precipice in the first place.

This is important since the 'emergency measures' taken in September/October 2008 were based on the those very flawed strategies, strategies which were once again drawn upon and taken to the extreme in the heat of potential disaster.

In Canada our own 'braintrust' made several catasrophic moves that are going to wreak havoc on our country in the years ahead.

When the 2007 real estate crash swept across the United States, Canadians smugly looked down at their noses at our American cousins and exalted in the superiority of our Canadian banking system.

But as we would come to learn, our Canadian banks barely escaped their own meltdown in 2008.

All five Canadian banks are levered at an average of 31:1. According to a report by Sprott Asset Management this implies that, if the Canadian banks’ tangible assets were to drop by 3%, their tangible common equity would effectively be wiped out.

When the recession started to appear in Canada, and real estate values began dropping here; government moved quickly to intercede.

If asset prices could be protected, it was rationalized, our nation could weather the recession and minimize the fallout.

To achieve this 'asset protection', Canadian Banks received $65 billion in liquidity injections from the Insured Mortgage Purchase Program. This is the official way of saying the Canadian Government, through CMHC, purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.

The Bank of Canada then our Canadian Banks with an additional $45 billion in temporary liquidity facilities and there was also assistance from the Canada Pension Plan through the purchase of $4 billion in mortgages prior to the IMPP program for a total government expenditure of $114 billion.

But real estate values in Canada were plunging nothwithstanding. Que the next phase of the 'asset protection' strategy.

The CMHC was ordered by the Federal Government to approve as many high risk borrowers as possible to prop up the housing market (with entry level buyers) and keep credit flowing.

• In 2008 some 42% of all high risk applications were approved, a 33% increase over 2007.
• Between the beginning of 2007 and 2009 Canadian Banks increased their total mortgage credit outstanding listed on their books by only 0.01% -- possibly the smallest amount of change in post WWII history.

This bit of financial magic to securitized all these mortgages by the CMHC is the only reason credit continues to flow to our real estate industry.

And it worked. Canadians jumped on the cheap, easy money and continued with a debt orgy that started in 2001.

• The Canadian mortgage securitizaton market has grown from $100 billion in 2006 to $295 billion by mid-June 2009.
• CHMC plans to expand securitization of debt to $370 billion by the end of 2009 as per the conservative government request.
• CMHC indicates in its plan that it will insure $813 billion via a combination of mortgage insurance and mortgage-backed securities (MBS) by the end of 2009.
• According to CHMC figures from 2008 and 2007 it is clear that CMHC has drastically exceeded their planned figures. It is expected that $812 billion is more than likely to be a minimum target.
• At these rates of progression the Government of Canada will in effect be insuring well over $500 billion in securitized mortgages and lines of credit by the end of 2010. The Canadian Government will also have issued over $600 billion in outstanding mortgage insurance.

Make no mistake, the moves that the Canadian Federal Government took in 2008 forestalled the US financial meltdown from spreading to Canada.

By preventing the collapse of our real estate market; our financial system did not follow the path of our American cousins.

But at what cost?

Last Thursday we outlined the gigantic hole that Canadian households have plunged themselves into.

Debt held by Canadians is at an all-time high. Especially mortgage debt.

The policy of emergency interest rates and the moves to 'support' the Canadian banks can only succeed it there is a dramatic increase in the economic fortunes of the world economy.

But as I have outlined before, in order for the world economy to properly restructure we must still undergo a tremendous amount of deleveraging.

This will be a drag on any economic rebound for years to come.

Meanwhile, when the central banks start tightening monetary policy to mop up excess liquidity and stave off inflationary expectations and when capital markets start pushing back against massive government deficit funding and corporate debt rollovers, interest rates will have nowhere to go but up.

And, with it, will go mortgage servicing costs.

This process will not fully play out for 15 - 20 years, which means we will see very high interest rates for most of that period.

Since 2001 Canadians have been like the kids in the movie Ferris Bueller's Day Off. We have skipped class and finacially partied, having a grand old time.

At the end of that classic movie, Cameron Fry is left to deal with the ultimate reckoning from the reckless adventures of our heroes.

And while the movie glosses over that reckoning for Fry, that won't be the case for the 1/3 of Canadians say they are either struggling or unable to keep up with their finances when interest rates are at the lowest point in our nation's history.

Will Canada become a nation of Cameron Fry's?

When interest rates shoot up, Canadians are going to be caught in a debt vice of historic proportions. If 1/3 of Canadians are either struggling or unable to keep up with their finances now, what's it going to be like when the posted 5 year bank rate sits at 15%?

I distinctly remember a family friend, in the early 1970s, declaring that "the government will never allow mortgage rates to go over 10% because it would inflict too much financial harm on the people!"

By the end of the decade that family friend (as well as my parents) had to renew their home mortgages at 19% and 22% respectively.

How many are rationalizing in a similar delusional way today?

How many will be wiped out trying to service debt at interest rates at half of those 1980s levels?

How many will be uttering that infamous line... "what'd I do?"

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Apparently it's only a bubble... if the bubble bursts (note: G&M link repaired)

Okay... let me get this straight.

A senior bank executive, who spoke to the Globe and Mail on condition of anonymity, said, "we're not in a bubble yet, or a credit crisis."

But he then goes on to explain that the heads of the country's six largest banks have privately told federal government policy makers that they fear the wide-ranging economic fallout of a U.S. style binge-and-collapse in housing hitting Canada.

Say wha???

Now don't get me wrong. That's exactly what this blog has been saying for the past 14 months. But why, if the bankers don't believe we are in a bubble or face a looming credit crisis, are they worried?

The answer is simple - we are in one. That's exactly why they're worried.

It makes me wonder how all those perma-bulls, who have been deriding the likes of us contrarians, feel about the fact that our nation's banking elite is now sounding alarm bells?

Even the freakin' Wall Street Journal has come out and pinpointed the danger Canada is facing, a danger we all can see as plainly as the noses on our faces.

To wit: that household debt in Canada — largely mortgages — was 1.42 times disposable income during the second quarter of 2009, a record high. And because Canadian banks typically reset adjustable-rate mortgages every few years, those who are buying now at low rates will likely see major increases soon.

“This is exactly what happened in the U.S., when affordability had moved way out of whack with prices,” quotes the WSJ.

So what's wrong with this picture? I mean, why are the Canadian banks concerned?

You and I both know they aren't threatened by any collapse in home mortgages when these significant rate hikes kick in.

The vast majority of their housing mortgages are CMHC insured. So even though Canadian mortgages account for 40% of the loans of the six largest banks, and comprise the biggest chunk of their portfolios, Canadian banks face little risk of direct loss because of federal government mortgage insurance.

So again... what gives?

"It's not the potential of big losses on mortgages that scares banks," says Peter Routledge, an analyst at Moody's Investors Service. "But if there were a spike in foreclosures in Canada, as has happened in the United States, consumers would likely struggle to make payments on other loans that aren't insured, such as credit card debt."

"Imagine instead of a few hundred people in Toronto in any particular month being foreclosed upon, it's a few thousand. The impact on the broader economy would be significant," said Mr. Routledge.

Ahhh... the truth is revealed.

Our omnipresent (that's omnipresent, a latin term for 'weasel') Canadian banks know damn well that the future holds a dramatic upswing in interest rates, a development that will have crushing impacts on real estate.

But that's not what bothers them. Somehow these brain surgeons have only now realized that they have screwed themselves along with the rest of us - despite CMHC carrying the can on all this mortgage debt.

And now they desperately want to try and put the brakes on things before real estate spirals hopelessly out of control and comes crashing down.

Not because a collapsing real estate market will hurt the Canadian public, but because a hurt Canadian public will default on credit card and other uninsured debt.

Marvelous.

But I've got news for them... it's already too late. There are already so many Canadians who have jumped on the low-rate money gravy train (either by max'ing out on their purchases or by extracting from the home ATM) that the looming significant interest rate hikes will begin the domino process that dooms our bloated real estate bubble.

But it's nice to finally see these weasels recognize and acknowledge what they have done, even though the only reason they are speaking up is because it dawned on them they aren't as protected with CMHC insurance as they originally thought.

Interest Rates

So once again the story is all about interest rates.

Adding to the chorus of warnings is this one from Tim Bond of Barclay's.

Bond has been remarkably accurate in predicting the strength and length of the current global equity rally. He claimed that analyst estimates and high levels of bearishness would lay the foundation for a continuing equity rally - and he was right.

But yesterday he did an abrupt about-face.

“Fiscal dynamics point towards higher government bond yields in many economies, including the UK and US. History is unequivocal in linking fiscal deterioration to higher yields. This point is clearly becoming recognized by investors. As a result, a contagious process has started, during which risk premia in bonds, equities and currencies adjust higher to reflect the fiscal situation. This process is unlikely to remain confined to southern Europe, but will eventually embrace all those economies with sizeable budget deficits.”

That means Canada and, especially, the United States.

And what does Bond see on the horizon?

1)The majority of the G20 is a fiscal mess. 2)Demographic trends of the G20 are highly negative, and 3) Containing the long-term government debt problem will be painful.

Most alarming to Bond, however, is the close relationship between high debt levels and rising rates. In studying 6 developed nations over the last 20-30 years, Bond found that a 1% change in deficit/GDP caused a 32 bps increase in 10 year rates. Based on this, Bond says we are due for a substantial rise in global interest rates.

Not just an uptick, but a 'substantial' rise. Don't be surprised to see a return to late 1970s style rates.

It's coming.

And no five year fixed rate renewal is gonna save any Canadian family with a large mortgage - the time span of those high rates will easily surpass that period.

Bond sees it coming.

And the heads of the six major Canadian Banks see it too.

And if you read this blog all last year; you saw it coming as well.

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On another note... only two days to go.

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The 'B' Word

Today's post is brought to you by the letter 'B'.

It could be 'B' as in Bubble, as more and more people are starting to acknowledge here in Canada.

As faithful readers know, Bank of Canada Governor Mark Carney’s pledge to freeze record-low borrowing costs through June 2010 is single-handedly responsible for the stunning recovery in home prices.

'The Cabel' disputes this assertion, insisting that the state of the housing market is simply reflecting what Carney has called “an element of pent-up demand” (Carney speech to reporters Nov. 19).

“Rates are exceptionally low, affordability has improved in part because of the low level of interest rates and part because of some former price adjustments, and we are seeing a housing-price response,” said the Governor.

Pundits insist that they don’t believe that there’s a bubble, that most of the market action is from typical Canadians trying to buy their first home or move up. Rising prices? That's just an unintended consequence of the current low, low rates.

But when Canadians are waiving conditions and paying 10% (or more) than a home's asking price you know it's not a regular market - particularly when we sit in one of the worst economic times since the Great Depression of the 1930s.

The most notable thing here is that Carney insists that what's happening in the housing sector is simply an unintended by-product of his attempt to help the economy recover from its first recession in 17 years. Carney says he has given 'clear guidance’ on why he has taken the actions with interest rates he has.

“Rates are exceptionally low, they are exceptionally low for a purpose and we have given pretty clear guidance on how long we expect they will have to remain at these levels in order to achieve the inflation target,” Carney told reporters Oct. 22.

But Eric Lascelles, chief economist and rates strategist with TD Securities Inc., raises a point that more and more people finally raising. In Toronto Lascelles noted that the central bank hasn’t talked much about house prices, “to the bafflement of international investors.”

“It makes perfect sense that there is a good appetite for the housing market,” Lascelles said. What no one seems to want to address is “whether this is a bubble in the making or simply a recovery from earlier softness.”

David Laidler, a former visiting economist and special adviser at the Bank of Canada and now a fellow at the C.D. Howe Institute, a Toronto research group notes that “the worry has got to be that you might be getting a housing bubble out of this.” Laidler is a member of the institutes's Monetary Policy Council, which studies central-bank decisions and said in a Dec. 3 statement that a “possible unintended effect” of Carney’s commitment is “the buoyancy of mortgage lending, particularly variable-rate mortgages, and the housing market."

Unintended... there's that word again.

And it's that word that rankles the most.

Do people truly believe that the astonishing rebound in housing prices - with no intervention from the Bank of Canada - is simply an 'unintended' by-product of Carney's actions to recover from recession?

Maybe today's 'B' word actually stands for 'B' as in Banks.

In a fascinating report from Sprott Asset Management, the average leverage ratio of the Canadian banking system is analysed and compared.

Sprott notes that the average leverage ratio of the Canadian banking system is higher than that of the largest US banks in all periods reviewed.

Now each of the top ten US banks received common equity injections by both shareholders and the US government, thereby improving their respective leverage ratios during this economic crisis.

And the Canadian Banks?

• "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. We are always cautious about investing in companies that have zero or negative common equity - we’ve seen what happens to public companies that trade at those levels, General Motors being a good example.
  
  Acknowledging the leverage levels above, you may wonder how the Canadian banks escaped the 2008 meltdown unscathed. The answer is that they received significant assistance from the Canadian government. First, they received $65 billion in liquidity injections from the Insured Mortgage Purchase Program (IMPP), whereby Canada Mortgage and Housing (CMHC) purchased insured mortgages from Canadian banks to provide additional liquidity on the asset side of their balance sheets.
  
  Next, the Bank of Canada provided them with an additional $45 billion in temporary liquidity facilities. Finally, a Canadian Bank also received assistance from the Canada Pension Plan (CPP) through the purchase of $4 billion in mortgages prior to the IMPP program, for a total government expenditure of $114 billion."

When the Bank of Canada slashed interest rate to dirt they helped to artificially preserve real estate asset prices by creating another irrational housing euphoria in the country.

Unintended... Or a deliberate calculation to preserve the "razor thin margin on the tangible asset side" of the Canadian Banks leverage equation... a group the Canadian Government had just moved heaven and earth to protect?

Sprott goes on to note that,

• "for reference, the entire tangible common equity of the Canadian Banks in 2008 was $68 billion. Can you put two and two together?"
  
  "The Canadian government injected a sum through mortgage purchases worth more than the entire tangible common equity of the Canadian banking system! On top of that, the Bank of Canada provided more than 50% of the tangible common equity of the system in emergency liquidity facilities."

The Canadian housing market continues to baffle observers in the United States and around the world. We are daily fed propaganda that tells us that the dramatic performance of our nation's real estate during this worldwide economic crisis is all a result of the solid foundation of our nation's banks and the virtuous conservatism of the Canadian financial system.

Uh-huh.

The Sprott report is simply the latest that sumarizes the many concerns critics have had about what's happening with Canadian Real Estate, CMHC and the banking system.

Increasingly it seems we are only a couple moves away from the symbiotic relationship that exists between those two other well known 'B' words: Boom and Bust.

The 'Boom' is currently happening and observers are raising alarm bells.

Be wary. The next time you hear "give me a 'B'...", you might just see the market kick back the word investors dread the most... bust! A development which would lead to today's true 'B' word; a word that summarizes our thoughts on all this malarky about 'unintended' consequences .

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Bank of Montreal reports today

BMO UPDATE (15:23 EDT): Comments from 3Q Conference Call
BMO UPDATE (14:50 EDT): Globe & Mail - BMO defies newsletter naysayers
BMO UPDATE (14:35 EDT):Agora Financial: Amoss to digest earnings report and BMO conference call, will comment tomorrow
BMO UPDATE (14:26 EDT): Bank of Montreal defies bearish bettors - Stock up $3.43 (7%)
BMO UPDATE (07:51 EDT): Financial Post - BMO Profit rises 6.9%
BMO UPDATE (07:46 EDT): Globe & Mail - BMO Profit rises to $557 million
BMO UPDATE (07:36 EDT): CNW Group - BMO Financial Group Declares Dividend (unchanged from last quarter)
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The Bank of Montreal is scheduled to report earnings today and everyone is watching keenly for the results.

Will BMO cut it's dividend now, in the next earnings report or not at all? Will this initiate a collapse in the stock price?

Bloomberg reported the Amoss speculation yesterday and quoted John Aiken, an analyst at Dundee Securities Corp. in Toronto, as saying that "the speculation may have contributed to Bank of Montreal’s decline. Aiken's believes the bank’s dividend is safe. Bank of Montreal spokesman Paul Deegan declined to comment."

Google Finance has cited the Bloomberg report on it's BMO stock quote page, so the speculation has now entered the mainstream media.

Management will release results before the bell Tuesday, and hold a conference call at 2pm eastern time. BMO is up 25% since reporting better-than-expected profit and announcing 1,100 job cuts on May 26. Overall options activity in BMO was more than 12 times average, with puts outnumbering calls by 20 to 1.

We will keep tabs on this as it plays out over the next few months.

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New for Monday evening: Amoss, in his own words, on Bank of Montreal...

.

Here, in Dan Amoss's own words, are some of his thoughts on the Canadian banking system.

They were written by Amoss on August 12th, 2009.

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Everyone thinks they’re safe from the current financial crisis.

No one thinks they’re doomed.

I’m talking about the Canadians, of course.

See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts took over.

The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.

The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:

• “Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]
  
  

Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.

But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.

They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.

Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.

Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.

But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.

For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital…sending the worst of the Canadian bank stocks down.

So how do you play it?

I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates.

Dan Amoss - August 12, 2009

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And guess which bank that is?

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The Greatest Threat to the Canadian Economy? The BOC says Household Debt.

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The Bank of Canada released its bi-annual Financial System Review yesterday.

On the whole, the BOC says Canada's banks and credit markets are as strong as could be expected amid the deepest global recession since the Second World War.

The BOC has come to the conclusion that overall risks to the financial system are unchanged from its last report in December.

“Despite the severe impact of the global crisis, the Canadian financial system has continued to perform well compared with those of other countries.”

Hmm... somehow being front of the pack in a herd of turtles isn't all the comforting. And I wonder, how much of that performance is attributable to the hundreds of billions of dollars of liquidity that the Bank of Canada and other major central banks have injected into the global financial system?

Rock-bottom interest rates have lowered the cost of borrowing and slowed the the crashing housing market from it's perilous decline... at least for now.

But the Bank of Canada warns that a potentially catastrophic threat looms on the horizon: household debt. The risk posed by household balance sheets is significant. And it has grown.

The Bank of Canada reports that the level of debt to income reached a record in the fourth quarter as real net worth dropped 6.7% from the same period a year ago. While stressing that the possibility of a mass bankruptcy is remote, the ability of Canadians to repay their bank loans has replaced frozen credit markets as the main fear factor among policy makers, the report said.

“There has been a further deterioration in the financial position of the Canadian household sector as a result of the continued turmoil in financial markets, the deepening global recession, and worsening labour market conditions,” the report said.

Canadians' household debt is about 140% of disposable income, compared with about 150% in Britain and almost 190% in the United States.

The fact of the matter is that Canadians have been no different than Americans in using their homes as ATM machines and withdrawing equity to spend. That's why the Bank of Canada has been so desperate to halt the slide in real estate values. Should the economy worsen, global financial conditions could trigger a surge in interest rates. If that happens Canadian real estate values will come crashing down.

The end result? Negative equity and household debt combining to drown many Canadian families.

In the face of these conditions, Canadians are frantically trying to save more and spend less. Which is, of course, what politicians fear will devestate the economic recovery.

Unfortunately the only solution our government is working towards is trying to provide more credit for everyone.

Can you say Catch 22?

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The significance of the alternate lenders failing

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Yesterday we talked about how 12 alternate mortgage lenders were unable to secure funding with the credit collapse. Now they were unable to renew over 25,000 Canadian mortgages as they came due.

The 12 alternate lenders have gone to Ottawa to ask for financial assistance warning that - despite the fact all 25,000 Canadian homeowners have never missed a mortgage payment - the companies would have to begin initiating foreclosure proceedings against homeowners because the company was unable to find new money to lend to them.

These 25,000 Canadian homeowners were lenders who had been unable to secure loans through the traditional banks due to income or credit histories.

This story is just the start of what is coming. The fact of the matter is that Canada hasn't begun to feel the impact of housing crisis yet. This has lead many to smugly believe that Canada will not feel the same effects as the United States.

They are wrong.

The process in Canada is just getting underway. The depreciation in Canadian Real Estate didn't get started until one year ago, March 2008.

In the United States, the process has been playing out for several years. It started in 2005 and, contary to popular opinion, it didn't start with the subprime crisis. What started the problems was a MINOR collapse of about 10-15% in the value of real estate in several of the bubbly cities in Florida and California.

When mortgages came up for renewal in those cities in 2006, a calvalcade of foreclosures was triggered because those with subprime arrangements couldn't renew their mortgages in their underwater condition (the market value of their house was worth significantly less than the remaining mortgage amount).

This put even more downward pressure on real estate values. When regular homeowners with non-subprime mortgages went to renew, they couldn't. They were also too far underwater with the market value of their property.

This forced even more foreclosures and a massive domino process then devestated property values.

But it took a year before the problem even surfaced and another two years to play out after that. That same process is now starting in Canada.

Prices started to slide in March 2008. It takes about a year for risky mortgages to start to reveal themselves as they come up for renewal. Yesterday's post outlined that, not only do similar risky mortgages exist in Canada, but they are about to be placed in a foreclosure position.

It's playing out here exactly as it did in the United States.

The current price drops we have experienced from March 2008 until March 2009 have been caused by the collapse of the worldwide economy - not mortgage problems.

That collapse took away the wealthy Americans, Europeans and Asians and forced them to liquidate their Vancouver properties. This caused a drop in real estate values which, in turn, took the ever rising market out from underneath the local speculators... further exacerbating the price drops.

Until now the only mortgage-related stories we have seen are speculators unable to secure mortages for pre-sales contracts, placing them in defaut of their pre-sale contracts.

Only later this year will we really begin to see the real impact of mortgage issues on our real estate scene.

It won't become visible until later this summer/fall as the absence of these alternative mortgage suppliers leads to a further drop in real estate prices of another 5-10%.

Then the next mortgage domino will fall.

The 0/40 crowd and the 5% down group of home buyers who bought in 2004, 2005 and 2006 will surface. Most took out five year mortgages with the traditional banks. Those mortgages are coming up for renewal starting later this year.

Unless real estate values start re-inflating dramatically, these people will be in a serious underwater position of 15%-25% with their outstanding mortgage compared to the market value of their home.

TD, Royal, Scotia, BMO and CIBC will not renew their mortgages while they are in that kind of underwater state.

You simply cannot walk into a bank and receive a $600,000 mortgage on a property with a market value today of $480,000 (20% less). It doesn't matter that you have a spotless five year mortgage history of never missing a payment - it's just not going to happen.

And with the evaporation of the alternate mortgage lenders, it means Canadians won't have another avenue of securing a mortgage renewal after being denied by the regular Canadian banks.

This is exactly the way it played out in the United States between 2005 - 2009.

And now it is starting to play out here.