NEW YORK - The difference between Canadian, American and European institutions is one thing assets. Canadian and European institutions tend to be over leveraged while American ones have significantly less leverage. Canadian and European institutions and American institutions operate under the belief that sovereign debt is risk free (that is debt issued by countries). Currently Canadian banks hold mostly sovereign Canadian debt, while European banks own junky European debt. While, U.S. Banks hold very low amount of U.S. debt. This is because of Fannie Mae and Freddie Mac. Typically U.S. banks buy Fannie Mae and Freddie Mac mortgage backed securities which are guaranteed by these institutions and ipso facto guaranteed by the U.S. Government. These securities yield typically less than mortgages but typically more than treasuries. However these assets typically get a larger risk weighting and U.S. Banks do not overlever themselves to buy these assets. These assets are also of better quality than sovereign debt because it is backed by mortgages.
Fannie Mae and Freddie Mac were created during the great depression to enhance liquidity. This notion that the financial crisis was caused by bundling mortgages and selling them is 100% false. Banks would have caused a recession if mortgages were not bundled. The cause of the financial crisis can be explained in one sentence. When banks have a fundamental belief that real estate prices can never decline drastically and loan money to everyone which creates a bubble in the most important asset of a country, housing: a recession is always going to come of it.
That one sentence explaining the financial crisis, is depicted in millions of videos explaining the complex inner workings of the financial system and saying the complexity killed us. The financial system and its workings have nothing to do with the recession. The inner workings have existed for a long time. The problem was poor lending standards. A recession is caused when a bubble like real estate explodes and banks use lots of leverage and housing prices drastically decline.
The idea for Fannie and Freddie were to buy mortgages from the banks give the banks cash so they could lend more. This obviously stimulates financial growth. Fannie Mae and Freddie Mac would then pool these mortgages and sell them for a price which they guaranteed. For this guaranty fee they took part of the interest on the mortgages. We know what happened next and thankfully for U.S. Banks, Fannie and Freddie were bailed out by the U.S. government or every financial institution in America would be gone. Having said that the U.S., System and holding MBS's are inherently less risky then sovereign debt. As mentioned above this is because MBS's are backed by something and are on top of that guaranteed by Fannie Mae and Freddie Mac which are guaranteed by the U.S. Government. Hence its sovereign debt with less risk and way higher returns. This makes the U.S. system fundamentally safer as their banks don't use excess leverage to get reasonable returns. Canadian and European banks earn very low amounts on their assets while U.S. Banks typically earn 2 to 3 times more.
To make up this return disadvantage, Canadian and European Banks use leverage. U.S. Banks used leverage before the financial crisis but never to the extent of Canadian or European institutions (UBS had leverage of 100 to 1). However Canadian institutions have nowhere close the leverage as ones in Europe. BAC had leverage similar to some Canadian Banks, pre-recession but banks like J.P. Morgan had leverage of a much lower number as did regional banks.
This is why Banks such as PNC Financial have leverage of less than 10 to 1 and earn a return on equity of 16%. This means that PNC backs up its assets with less leverage. For instance lets say PNC had $110 M of assets and 10 million of capital. Which would be leverage of 10 to 1 (110/10). Lets say there loans drop by 7% in value than PNC's equity would drop to $2.3 and if all their depositors cashed out they could theoretically pay everyone back. This is why banks have capital standards. The idea is that banks may fail if there is a run on the bank but depositors should not be bailed out by the government. However if leverage at PNC was 30 to 1 as it is in the Canadian banks a 7% drop in value with assets of $310 million to $10 million of capital would lead to -11 balance. This makes Canadian and European banks inherently risky.
Lets look at leverage and returns for Canadian banks vs. PNC Financial and U.S. Bancorp.
Lets also add in Canadian Banks typically pay 18% in taxes and U.S. Banks are paying close to 35%. So a tax change good or bad is also a big risk or gain for U.S. Banks. Though we here are advocates of raising personal taxes in the U.S., the U.S. corporate tax rate is to high and it is the second highest in the world. click here for link. I think the U.S. Corporate tax rate will be lowered over time since it is way to high at this time. A business is not a person and it will likely spend its extra earnings ie hiring more workers or giving it to shareholders. Taxing at such a high rate is a very big reason not to business in the U.S. This again is another risk factor for Canadian Banks, that their tax rate will be raised. Or a reason to buy U.S. Banks that their tax rate will be lowered. (understand here I am not talking about personal taxes just corporate).
Royal Bank of Canada has $730 billion of assets and $25.4 billion of capital or leverage of 27.3 to 1 (calculation excludes goodwill and intangibles from assets base, and preferred shares from tangible equity, all done for the following transactions). Royal Bank had a Return on tangible equity (ROTE) of 23.7% in their last quarter.
TD Bank equity has assets of$650 billion excluding goodwill and intangible and equity of $23.7. The company has leverage of 26.4 to 1. The company also has an ROTE of 23.7% to match its tangible common equity.
CIBC has assets of $360 billion and common tangible equity of $11.6 billion or leverage of 30 to 1. Its return on tangible is difficult to calculate due to the wide fluctuations in their results. Its 26% based on their last quarter and 16% based on the year.
BMO has assets of $472 billion and tangible common equity of $22.2 billion, this is a low for a Canadian company with leverage of only 20 to 1. Their return on tangible equity was only 13.6% based on their last quarter.
Bank of Nova Scotia has assets of $560 billion and common equity of $19.9 billion or leverage of 27 to 1. The company had return on tangible equity of 24.1% in their last quarter.
Canadian Banks also have inherently more risky business models. Most own stakes in international banks and most make much more money from trading revenue than do simpler U.S. Banks.
PNC Financial had leverage of 10 to 1 and had a return on tangible equity of 16%. U.S. Bancorp had leverage of 15 to 1 and a return on tangible equity of 24.2%.
It just does not seem to make a lot of sense that these safer U.S. institutions trade at a large discount to their Canadian peers which are much riskier.
Based on USB and PNC's safety and less exposure they should trade at much higher multiples than their Canadian counterparts. Though we here don't value anything by multiples because they are simplistic it is a good way to show a value for illustration. Currently Canadian banks have PE's of around 12. This compares to 10 for USB and 8 for PNC. I here also believe Canadian banks are cheap; My point is just to say they are not cheap when compared to some U.S. Banks. So at the current multiple it would make sense for USB to trade at 16 to 17 times and it good times perhaps 20 times. And for PNC right now at 13 to 14 times and in good times 16 to 17 times. While Canadian Banks should trade around 15 to 16 times in good times.
Since U.S. Banks are safer the ones that can generate good returns should be soon rewarded. This means buy PNC, WFC and USB. The three best U.S. Banks. These banks offer better rewards and less risk than their Canadian counterparts. Certain banks like BAC have lots of safety but are not generating income so we would not be recommending a bank like that. While most U.S. Banks have had trouble there are 3 special stars in the U.S. Banking sector which have found a way to earn a large amount of profit with U.S. safety. Almost every top 20 bank today in the U.S. is inherently more safe than any Canadian Bank. However only a few U.S. Banks which are safe have learned how to make money. For investments we need a mix of safety and returns.
I bet you are an US banker or you have significant stocks on US banks. The alternative would be that you have a strong patriotic sense. I understand that you want to see US on top of everybody and you can go on with your dreams, but to get to the point where you see US banks as the safer banks (even safer than Canadian banks which were classified as the safest banks in the world for five years in a row and which didn't require any bailout while the US banks were saved with money from taxpayers) it is just ridiculous.
ReplyDeleteActually I never said U.S. Banks used to be safe. I wrote here in the article
ReplyDelete"BAC had leverage similar to some Canadian Banks, pre-recession but banks like J.P. Morgan had leverage of a much lower number as did regional banks.'
I didn't say U.S. banks were safe back then. I said now they are. Back then U.S. Banks had leverage similar (but still lower) to Canadian Banks and much worse assets but both countries had much lower leverage than Europe. Today its very different.
BUT, Second I only really signalled out 3 U.S. Banks which are much safer currently than Canadian Banks (PNC, USB and WFC).
in 2008 BAC was not safer then Royal Bank. It had similar leverage and much worse assets.
Today BAC is a little safer then Royal Bank but it has no returns anymore which is why the stock price is so low. But I was saying certain U.S. Banks like PNC USB are 10 times safer than Royal Bank.
Does the idea that backing by the US Government makes them inherently less risky? I guess US government funds are infinite... might as well borrow another trillion but at least our banks are safe!
ReplyDeleteThere is no way, that Canadian banks are riskier than US Banks. They are well capitalized and mainly operate in Canada, which has a triple A rating, in contrast to dowgraded economies with trillions of dollars in debt. These banks were never bailed out by the government and handled got through the 2008 crisis with flying colours.
ReplyDeleteCanadian debt is safer than than that of many economies in the world at the present time. The Canadian Government operates as a fiscally responsible entitiy and does not show the instability and gridlock exhibited by other world governments.
Why argue about which is worst a black eye or blue eye. Methinks the lazers should be pointing to the lenders of last resort. The first to fall will cause a ripple effect, none of which we have ever seen.
ReplyDelete"Canadian debt is safer than than that of many economies in the world at the present time. The Canadian Government operates as a fiscally responsible entitiy and does not show the instability and gridlock exhibited by other world governments."
ReplyDeleteI don't think that is true. I feel both countries have equally safe debt but the market views U.S. debt as safer which is why the U.S. dollar goes up vs. the Canadian dollar right now when there are more worries on the economy.
Second I think you guys need to understand how things change. U.S. Banks have raised lots of capital since the recession. The U.S. banking industry is transformed. At this point banks like WFC, USB and PNC are far safer than Canadian Banks, it is not even close.
"Does the idea that backing by the US Government makes them inherently less risky? I guess US government funds are infinite... might as well borrow another trillion but at least our banks are safe!"
ReplyDeleteA country is not the same as you running out of money and asking the bank for a loan.
It would be equivalent to you paying everything in IOU's. Over time if you don't have good control on fiscal policies you will need to pay with more IOU's (inflation) However this does make money infinite for the U.S. and countries with a printing press (Countries in The European Union no longer has one which is why they have problems and this is why the UK does not) My point is the U.S. can't keep printing money because that would cause massive inflation. At the same time they would do this in a way to decrease their debt over time. Which is why the U.S. currency has declined for years.
The key will be restoring the fiscal house by raising taxes and cutting spending. Which will raise government revenues to a surplus. That way you begin to pay back the debt you use a little inflation to pay back the debt and you eliminate the deficit.