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Canadian Credit Health Update

2011 Q4


Introduction

These Canadian Credit Health Updates are released every quarter. In these reports, I apply the same analysis techniques that I used when watching the American financial system through 2005-2009. If American and European-style problems develop in Canada, I expect that these metrics will show early warning signs just as they did in the USA. All data comes from public financial reports.

This report contains:

Summary for 2011.Q4

Big Five Banks: Balance Sheet Health

This quarter, TD changed how they report impaired (non-performing) loans. Approximately $2 billion (half of their impaired loans) has disappeared from the “gross impaired loans” report in the financial statements. These are American “debt securities classified as loans”, meaning packaged/collateralized debts such as mortgages (MBS, CMO, etc). Those loans are still bad loans, of course. Instead of reporting the amounts as “impaired”, TD has updated the carrying value of the loans to reflect anticipated losses. This is allowed under revised 2009 accounting standards.

In other words, TD is playing some accounting tricks to reduce their reported “impaired” loans. The bad loans are still there. I believe that TD is now under-reporting their impaired loans, which erodes my confidence in their loan book. At the very least, this indicates that TD holds U.S. loans which are difficult to properly value and evaluate for impairment.

Other banks likely use the same trick.



A. Gross impaired loans / Gross loans (higher = worse loan book): A rough measure of how bad the loan book is. Before 2008, these values were under 1%.

Bank

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

TD *

0.70%

1.32%

1.34%

1.43%

1.23%

1.24%

Royal Bank

0.78%

0.79%

1.31%

1.54%

1.65%

1.68%

CIBC

0.94%

0.91%

0.92%

0.98%

0.99%

1.09%

BMO

1.29%

1.11%

1.58%

1.71%

1.80%

1.78%

Scotiabank

1.32%

1.38%

1.43%

1.47%

1.50%

1.86%

Average *

1.01%

1.10%

1.32%

1.43%

1.43%

1.53%

* TD changed an accounting rule. Adjusting for this, the group average is 1.1%, same as last quarter.



B. Gross impaired loans / Total assets (higher = worse balance sheet): A quick measure of deterioration on the asset side of the balance sheet. In the USA, banks started having major problems at 1.5%, and critical problems including insolvency above 2.0%.

Bank

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

0.32%

0.32%

0.55%

0.65%

0.69%

0.71%

TD *

0.32%

0.60%

0.62%

0.66%

0.56%

0.55%

CIBC

0.52%

0.49%

0.45%

0.50%

0.52%

0.58%

BMO

0.56%

0.48%

0.68%

0.74%

0.78%

0.79%

Scotiabank

0.71%

0.74%

0.74%

0.80%

0.84%

1.03%

Average *

0.49%

0.53%

0.61%

0.67%

0.68%

0.73%

* TD changed an accounting rule. Adjusting for this, the group average is 0.53%, same as last quarter.



C. Gross impaired loans / Tier 1 capital (higher = worse balance sheet): This measure is very similar to the Texas Ratio, and compares the bad loans to adjusted Tier 1 (Basel II) capital, the core measure of bank capital which is primarily equity. If bad loans are a large % of the bank's capital, it means the bank can not easily absorb the losses.

Bank

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

Royal Bank

6.7%

6.9%

11.6%

13.9%

14.7%

15.0%

TD *

7.7%

15.0%

15.2%

16.1%

14.2%

14.1%

BMO

10.7%

9.4%

12.7%

14.3%

14.9%

14.7%

CIBC

11.4%

11.1%

11.1%

12.0%

12.4%

13.5%

Scotiabank

14.3%

15.3%

16.0%

17.1%

17.5%

21.6%

Average *

10.2%

11.5%

13.3%

14.7%

14.7%

15.8%

* TD changed an accounting rule. Adjusting for this, the group average is 11.3%, virtually unchanged from last quarter.



D. Tier 1 Leverage ratio (lower = more leverage): This doesn't measure loan quality, but rather the bank's leverage and aggressiveness. Tier 1 leverage = tier 1 capital / total assets. This measure is included because higher leverage translates to greater overall risk. The banks with the worse loan books (above tables) should exhibit less leverage (higher % here), otherwise it means they are being far too aggressive for their condition.

Bank

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

BMO

5.3%

5.1%

5.3%

5.2%

5.3%

5.3%

Scotiabank

5.0%

4.9%

4.7%

4.7%

4.8%

4.8%

Royal Bank

4.8%

4.7%

4.7%

4.7%

4.7%

4.8%

CIBC

4.6%

4.4%

4.1%

4.2%

4.2%

4.3%

TD

4.2%

4.0%

4.1%

4.1%

3.9%

3.9%

Average

4.7%

4.6%

4.6%

4.6%

4.6%

4.6%

Off Balance Sheet Derivative Exposures

Amounts are in trillions of dollars. All amounts are notional, which is the face value of a contract (the amount of underlying money represented by a contract). These are not prices or market values of contracts. In other words, $1 trillion of notional exposure does not mean the bank could lose $1 trillion; however, it shows the magnitude of money represented by the derivatives.

OTC exposures are included here because I believe OTC contracts are particularly dangerous since they are illiquid, difficult to value, and become worthless if the counterparty (another bank) collapses.

This derivative exposure is hidden off-balance sheet where it can't distress investors and depositors. The standard excuse given by banks is that they are long some derivatives, and short others – and the two (thanks to financial engineering) perfectly balance out risk, resulting in minimal net exposure. In reality however, all it takes is one bank failure to throw the entire derivative book into deep trouble. These things already caused significant problems in 2007-2009, and will cause problems again. Unfortunately the banks' derivative exposure continues to climb, which means that counterparty risk is increasing.

Bank

2011.Q4


Total notional exposure

OTC notional exposure

Royal Bank

$7.62 T

$7.10 T

BMO

$3.51 T

$3.26 T

TD

$3.32 T

$2.85 T

Scotiabank

$2.54 T

$2.26 T

CIBC

$1.59 T

$1.49 T

Total exposure

$18.58 T

$16.96 T

Bankruptcy Statistics

These numbers lag by a full quarter, but they are still valuable: this shows total Canadian bankruptcies over time. Bankruptcy rates closely relate to bank loan quality. Note however that banks with significant US/international operations have further credit exposure beyond Canada.

Bankruptcy rates continued to decline through 2011, and are still at pre-crisis (2007) levels.




- Perpetual Bull, perpetualbull@gmail.com