In one of our most anticipated emails every quarter, we will be having a look over the banks’ earnings this quarter. These 6 institutions are a major indicator of where the country is heading economically.
And to go along with this, they’ve also been one of North Americas best-performing large-cap segments over the last 10-15 years.
However, the banks have now strung together 3 relatively weak quarters as loan losses mount, consumer borrowing shrinks, and more pressure is put on Canadians due to high interest rates.
In fact, from a total return standpoint, the Canadian banks have underperformed the Toronto Stock Exchange over a 5-year timeframe (image below.)
**Of note, make sure you have images enabled. There will be a lot of charts in this email.**
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A tailwind turned into a headwind
Typically, rising interest rates are a good thing for financial institutions. You would have heard even us say this just a year ago. However, the pace at which rates have accelerated, which is the fastest in history, has reversed this into a significant headwind.
Why? Primarily provisions for credit losses (PCLs). We can think of PCLs as money the bank sets aside for loans it expects to go unpaid.
Although these loans are not yet unpaid, the expectation that they could go unpaid in the future causes the bank to set aside this money.
The money being set aside cannot be claimed as income. The bank must take those PCLs out of its net income per the rules.
In the end, we end up with a lower earnings per share. When we look to many of the banks, most earnings on a trailing twelve-month basis are down 18-20% despite revenues being at all-time highs.
This is what you are witnessing. Rising revenues due to higher rates charged on loans. However, delinquencies and possible delinquencies are more than offsetting this, reducing overall net income and, thus, earnings per share.
Bank earnings
With the heightened escalation of PCLs, which we’ll talk about in this email, we’ve decided to dedicate most of this email to each bank’s exposure to residential real estate, the prime culprit for a lot of bearish sentiment and declining earnings.
These mortgage portfolios are front and center for many analysts and investors. So, we did the dirty work and have compiled everything for you in one place.
Let’s first speak on earnings in general.
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For the most part, banks disappointed relative to expectations. Most of the misses on the top line were marginal relative to analyst estimates and are, in our eyes, negligible.
The bottom line is one to keep an eye on, at least for a few banks. Regarding BMO, a sizeable one-off cost related to severance and legal costs in their capital markets department impacted the company by $0.32 a share.
If we adjust that out, the company came relatively in line with earnings. So, although the miss looks drastic, it was not something analysts could have priced in.
Overall, Foundational Stock Royal Bank had the strongest quarter out of the major institutions, which we will talk about near the end of this newsletter.
As for the bottom line, in every case, the miss against earnings expectations was because of larger-than-expected PCLs.
Provisions for credit losses
As mentioned above, PCLs are money the bank sets aside to account for loans it does not believe will be paid. For the third straight quarter, banks reported escalating PCLs. Besides Royal Bank of Canada, every bank exceeded analyst expectations.
The two largest standouts from this point are National Bank and Canadian Imperial Bank of Commerce (CIBC), which both saw PCLs double. However, in terms of analyst expectations, CIBC was the most considerable shock to the market, reporting $736M in PCLs when analysts only expected $444M.
The total PCL ratio, which represents the losses a bank sets aside as a percentage of their loan portfolios, all sit at elevated numbers relative to last year. The most notable number, however, was, once again, CIBC. Its PCL ratio has gone from 0.19% last year to 0.54% this quarter.
CET 1 Ratios
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To explain the CET 1 ratio in the simplest way possible, it is the amount of high-quality capital the bank has in the event of a financial shock. The banks must keep a particular amount of their capital in high-quality assets to have enough liquidity in the event of a credit crisis or just overall financial shock.
The minimum CET 1 ratio for the banks following the raise earlier this year is 11.5%, and all the banks remain healthy in this regard. The CET 1’s of all the banks outside the Bank of Montreal increased year-over-year.
Of note, the Bank of Montreal’s decline is nothing to worry about, as the company was flush with capital, and the drop is mainly due to closing its Bank of the West acquisition.
Toronto Dominion’s CET 1 ratio sits relatively high on the opposite end of the spectrum because the First Horizon deal did not go through. This is why the bank initiated an extensive buyback program, and we can expect to see that CET 1 normalize down to the levels of the other major banks over the next while.
Mortgage Exposure
As mentioned, we didn’t want to focus too much on the individual earnings of the banks outside of Royal Bank. They were all weak quarters. Instead, we wanted to focus on what everyone is wondering about these days: which banks are at the largest risk when it comes to mortgage exposure here in Canada.
Residential mortgage exposure
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As we can see by the chart above, all the banks have a material interest in the residential loan market, with National Bank and CIBC having the highest percentage of their total loan book exposed to residential mortgages.
Keep in mind that these total numbers above not only include mortgages themselves but also home equity lines of credit (HELOCs).
CIBC and National are heavily focused here in Canada. For the most part, our real estate market is a strong driver of the economy. So, seeing this level of residential mortgage exposure is not surprising.
It is also interesting to note that outside of National Bank, all the major banks have significant exposure to Ontario, with anywhere from 50%-57% of their loan portfolios coming from the province.
This does make sense, as this is where most of the population lives. However, it is also notable because this is where many believe a large-scale real estate bubble is occurring.
Variable vs. fixed rate exposure
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Much of the current talk regarding Canadian banks is about their overall exposure to variable-rate mortgages. So, we did the digging and came up with each bank’s exposure to the two main types of mortgages.
However, our overall commentary on this is the opposite of what many investors are thinking.
If we assume (with no guarantees, of course) that interest rates are at the highest levels they’ll go, the variable rate mortgage, often considered riskier, is the safer one.
Suppose rates are not only capped but continue to go down. In that case, variable rate holders will see some relief regarding payment pressure. In contrast, fixed-rate mortgages, particularly those signed 3 years ago, will still see a significant jump in interest rates upon resigning, even if the rates start to come down now for everyone else.
However, the benefits of this are offset by the fact that outside of Scotiabank and National Bank, all the major institutions have healthy chunks of their mortgage portfolio (often more than 25%) with 35-year amortizations or longer.
A decline in rates would simply bring variable rate purchasers back to “normal” amortization rates.
And with that, we can look at the overall renewal schedule of the banks, which is quite possibly the most important element in predicting the performance of these institutions over the next year.
12-month renewal outlook
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This table is a little sporadic as the banks are not required to report this data. If they isolate it and provide it in a quarterly report, they do so voluntarily.
We put asterisks beside Royal and National, who don’t necessarily report the data needed to fill the table out but provide some insights.
National Bank states that 11% of its fixed-rate mortgages are coming due next year. It expects the average fixed-rate holder to see a 13% increase in their mortgage payment upon renewal.
Royal Bank states that the average remaining term on its outstanding mortgages is 28 months, with an average original term of 39 months.
What we can make of this data from Royal is that it seems reasonably sheltered from short-term renewals. This is reiterated by the bank’s management this quarter when it stated that Fiscal 2025 and Fiscal 2026 would be the real challenge regarding renewals.
Toronto Dominion has the lowest exposure to renewals over the next year. With it having the highest exposure to variable rate mortgages out of any Big 6, we can assume it also has the lowest exposure to fixed rate mortgage renewals this upcoming year.
The most concerning bank on this list is, again, CIBC. With 16.5% of mortgages coming due and 81% of them being fixed rate, a large chunk of mortgage holders at CIBC will be undergoing material changes to their mortgage payment to the upside in the next year.
This is highly likely why CIBC set aside a large chunk over and above expectations for PCLs.
Credit card spending
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One thing we didn’t plan to highlight this week but found it worthy of mentioning due to the numbers was credit card spending.
Outside of Toronto Dominion, which surprisingly saw lending activity slow across nearly all segments, credit card loans saw a significant rise year over year among all major institutions.
CIBC, which didn’t report total credit card increases, simply noted an “increase in credit card activity driven by the return towards pre-pandemic levels and rising interest rates.”
Overall, this isn’t cause for alarm. Still, it indicates how tight money is becoming in this high-rate environment.
Key isolated notes
Outside of all the numbers we totalled above, we’d like to highlight some key takeaways from the quarter.
CIBC negative amortization
Quite possibly the most eye-opening comment this quarter, CIBC noted that $50B of its $267B residential loan portfolio is currently non-amortizing variable rate mortgages.
In the simplest terms possible, this means that around 19% of CIBC’s mortgage holders are not only not paying any of their mortgage off, but their mortgages are also growing.
This is from the bank offering some leniency regarding variable rate holders hitting their trigger rate, which is when a holder’s mortgage payment is not paying any principal off, strictly interest.
There is no sugar-coating this. The number is not good, and coupled with the fact that CIBC has possibly the worst short-term outlook when it comes to mortgage renewals, they’re the bank that will be impacted the most if the Bank of Canada decides to go “higher for longer” when it comes to rates.
BMO Amortizations year-over-year drop
Last year, during this time, the Bank of Montreal reported that 60% of its mortgages had amortizations of 25 years or less. One year later, the company reported this number has dropped to 51%.
This can mean a few things, of which neither are good from a lending perspective. This can be variable rate holders who are currently contributing less towards the principle of the loan, therefore extending the total time it will take to pay off the loan (amortization).
It could also be those renewing at a fixed rate have been forced to extend their amortizations beyond 25 years to bring payments down.
Overall, the Bank of Montreal does have relatively low residential mortgage exposure. However, it does have the highest percentage of mortgage amortizations over 35 years out of any of the six major banks. It will be a number we continue to keep an eye on.
Overall, the mortgage situation will likely continue to bring weakness
We want to state one important thing. We’re still fans of Canada’s banks. Mat and I own positions in BMO, Royal Bank, and Toronto Dominion, and we do not intend to sell any of them.
However, it is not difficult to see that the environment moving forward for Canadian banks may be difficult, and we can likely expect higher loan losses and lower earnings in the near future.
How quickly the banks can turn things around will depend on how fast the Bank of Canada decides to lower rates or keep them stable for a long time.
As mentioned at the start of this piece, higher rates are typically a tailwind for banks. This is why we saw them have an outstanding 2021 in anticipation of rising rates.
However, when coupled with the fastest pace of rate increases in history, sky-high real estate prices, and an unstable housing market, the loan losses the banks expect will more than offset the benefits of higher rates.
This is why we see revenue continue to rise, but earnings shrink.
Foundational Stock Royal Bank has one of the more diverse loan portfolios and one of the residential loan portfolios that likely has the most buffer in terms of short-term renewals.
CIBC, on the other hand, is a bank that clearly cannot handle higher for longer.
Overall, our three core banks and Equitable Bank will continue to be regular dollar cost average additions in our portfolios. However, we wouldn’t expect any significant turnaround in Canadian banks over the short term and expect earnings to come in soft unless the current policy rate environment changes.
