The Great Canadian Bank Bail-out


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The Canadian banking system is sound, we didn’t have to bail-out our banks - right? Certainly that’s what we are continually told:
“...we have not had to put any taxpayers’ money into our financial system in Canada, nor do I anticipate that we’ll be obliged to do so.” Jim Flaherty, Minister
of Finance

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The Great Canadian Bank Bail-out

  1. 1. Agcapita UpdateOctober 22, 2012
  2. 2. Agcapita UpdateTHE GREAT CANADIAN BANK BAIL-OUT The Canadian banking system is sound, we didn’thave to bail-out our banks - right?  Certainly that’swhat we are continually told:“...we have not had to put any taxpayers’ money intoour financial system in Canada, nor do I anticipatethat we’ll be obliged to do so.” Jim Flaherty, Ministerof Finance  “Without wanting to appear arrogant or vain, whichwould be quite un-Canadian...while our system is notperfect, it has worked during this difficult time, I don’twant the government to be in the banking business inCanada.” Jim Flaherty, Minister of FinanceThen again we were also assured: “We will not run a deficit.” Jim Flaherty, Minister ofFinance (Oct. 2008). So political remonstrances notwithstanding, is any ofthis true?  Doubts did begin to surface early in 2012but interest in the issue quickly died out.  The stabilityof the banking sector is a critical question. It is worthmore than the cursory coverage it has received todate so let’s spend a bit of time on it today. Did we bail-out the Canadian banking systemfollowing the 2008 financial crisis and moreimportantly might we have to bail it out in thefuture?  To set the stage here is some quickbackground on the Canadian banks then we canmove on to the “no bail-out here” premise. 1
  3. 3. Agcapita Update (continued)Canadian Banking Sector 101 - Concentrated,Large & Levered:  Networks with highly BANK ASSETS AS A PERCENTAGE OF GDPconcentrated nodes are not robust - the Ireland 872presence of single points of failure can have hugeconsequences.  The Canadian banking sector UK 389resembles such a network in that it is dominated by France 338just five banks.  These banks are colloquially referred Spain 251to as the “Big Five”.  Given their size and marketpresence I am sure the names will be familiar to you: Australia 205 Canada 157 Italy 151 (APPROX C$ BILLIONS DEC 2011) ASSETS Greece 141Bank of Montreal $500 U.S. 82Bank of Nova Scotia  $575CIBC $360 It is no secret that banks use leverage to generateRoyal Bank of Canada $750 returns.  Additional leverage creates additional risk but with the hope of sufficiently offsetting profit.  TheToronto-Dominion Bank $690 trick is to use enough leverage to generate an attractive rate of return, but one which does notNot only does this small group dominate the leave the bank susceptible to being renderedCanadian banking sector, the sector itself is very large insolvent by a high impact event (e.g. housing marketin relation to domestic GDP.  The larger the size of the collapse).  That is the theory.  Sadly, given the explicitbanking sector, the greater the risk to the domestic government support for “too-big-to-fail” financialeconomy or more accurately the wallets of the institutions which removes the consequences of suchtaxpayers in the event that a bailout is required.  Of insolvencies, in practice large banks will tend to carrycourse, beyond a certain size banks are simply too excessive leverage and mis-priced risk at all times.  large to be bailed out with domestic capital or to putit in more colourful terms - domestic banks run out An accepted measure for bank leverage is theof domestic taxpayer subsidies and then usually the Tangible Common Equity ratio - “the ratio usedgame is up - see Greece, Italy and Spain in the list to determine how much losses a bank can takebelow.   before shareholder equity is wiped out. The Tangible 2
  4. 4. Agcapita Update (continued)Common Equity (TCE) ratio is calculated by taking the No Bail-out in 2008-2010?  The CCPA’s study,”Thevalue of the company’s total equity and subtracting Big Banks’ Big Secret: Estimating Governmentintangible assets, goodwill and preferred stock equity Support for Canadian Banks During the Financialand then dividing by the value of the company’s Crisis”, convincingly refutes the belief that Canadiantangible assets. Tangible assets is the company’s banks did not need or receive a bailout during thetotal assets less goodwill and intangibles.”       crisis.  Directly from the report:  “Canada’s banks received $114 billion in cash and loan supportA rough estimate is that the Big Five TCE ratio hovers between September 2008 and August 2010...around 3-4%. It goes almost without saying that They were double-dipping in not only two butCanadian banking executives reject the TCE test as three separate support pro­ rams, one of them ga measure of their leverage and risk for precisely the American....At its peak in March 2009, support forreason that TCE tends to show that they are over- Canadian banks reached $114 bil­ion. To put that lleveraged and risky.  into perspective, that would have made up 7% of the Can­ dian economy in 2009 and was worth $3,400 aIn order to ensure a reliable supply of bail-out funds it for every man, woman and child in Canada.”is critical that banks are able to argue with a straightface that the event that bankrupts them was entirely Perhaps they did not need the money and just tookunforeseeable - at least to them.  So despite what it because it was offered?  That does not appear toCanadian banks say I would argue the Canadian be the case.  The CCPA study estimates that threebanking system has all the raw material that has of Canada’s banks - CIBC, BMO, and Scotiabank -made for crises elsewhere - concentration, large size received bailouts that exceeded their market value atin relation to domestic GDP, high leverage and mis- the time which does tend to support the conclusionpriced residential real estate risk.  that they were under extreme financial stress.   ESTIMATED EXTRAORDINARY SUPPORT SUMMARY Bank Peak Support Date Peak Support Value ($bil) Peak Support to Co. Value (Date of Peak)CIBC2 March 09 $21 148% (March 2009)BMO 3 January 09 $17 118% (Feb 2009)Scotiabank4 January 09 $25 100% (Feb 2009)TD Bank 5 September 09 $26 69% (Feb 2009)Royal Bank6 March 09 $25 63% (Feb 2009)Source:  CCPA 3
  5. 5. Agcapita Update (continued) Mortgages were the usual suspect at the centre argued are far below market rates given global real of the 2008 Canadian banking bail-out and so estate volatility and the escalation of pricing risks in mortgages provided the conduit for government the Canadian market. assistance.  The default risk on approximately 50% of Canadian mortgages is in practice back-stopped by Of course when the Big Five got into trouble the Canadian government via the Canadian Mortgage the taxpayer CHMC, the Bank of Canada and Housing Corporation. Banks do pay to insure and surprisingly even the US Federal Reserve their mortgages with the CMHC but at what could be stepped into breach: TOTAL SUPPORT TO CANADIAN BANKS 120 Bank of Canada U.S. Federal Reserve CMHC 100 80$ Billions 60 40 20 0 Aug Oct Dec Feb Apr Jun Aug Oct Dec Feb Apr Jun 2008 2008 2008 2009 2009 2009 2009 2009 2009 2010 2010 2010 Source: CCPA  4
  6. 6. Agcapita Update (continued)Clearly, no matter how much the Big Five wouldlike us to believe otherwise, they experienced a HOUSE PRICES VERSUS RENTAL COSTSsevere liquidity crisis in 2008-2010 hence the needto sell performing but illiquid CMHC guaranteed 30mortgages.  To fill this liquidity gap they received 25emergency funding on the order of size on a per 20capita basis of that received by the US banks.  It is 15worth elaborating on this as it points the way to some 10serious concerns in the future.  Canadian banks 0.5needed a bailout that amounted to approximately 0.07% of GDP when the large part of their asset base- Canadian mortgages - was not in any apparent -0.5distress. -1.0 -1.5What would happen to Canadian banks if the -2.0Canadian residential real estate market were to 80 83 86 89 92 95 98 01 04 07 10experience a US style correction and instead of aliquidity crisis the Big Five actually had a solvencycrisis? For this thought experiment we have toassume a sharp fall in Canadian residential real-estate HOUSE PRICES VERSUS HISTORICAL AVERAGESprices - based on current prices versus long-termhistorical averages, rents and income all being at 160highs that does not seem entirely implausible. 140 120 HOUSE PRICES VERSUS INCOME 100 5.0 4.5 80 4.0 60 3.5 1995 2000 2005 2010 3.0 Vancouver Canada USA (Case-Shiller) 2.5 2.0 1990 1995 2000 2005 2010 5
  7. 7. Agcapita Update (continued)According to research by Demograhia: “Historically, – Highly concentrated with the Big Five dominatingthe Median Multiple has been remarkably similar in the sectorAustralia, Canada, Ireland, New Zealand, the United – Total assets held by the Big Five are much largerKingdom and the United States, with median house than the size of the Canadian economyprices having generally been from 2.0 to 3.0 times – Big Five are using high leverage based on amedian household incomes, with 3.0 being the outer conservative measure such as the Tangiblebound of affordability. This affordability relationship Common Equity ratiocontinues in many housing markets of the United – Residential RE prices have an average MedianStates and Canada. However, the Median Multiple Multiple of 4.6 in major markets versus thehas escalated sharply in the past decade in Australia, historic average of 2.0 to 3.0Ireland, New Zealand, and the United Kingdom – C$1.3 trillion in residential RE mortgages, 50%and in some markets of Canada and the United held by the CMHC, 50% by Canadian banks States. Housing in Canada is moderately unaffordable – Residential RE mortgages representwith a Median Multiple of 4.6 in major metropolitan approximately 40% of bank assetsmarkets.” Emphasis mine. I’ll leave the final conclusion to you about whetherIn summary, here is the very approximate state of Canadian banks are as robust as they are made outthe Canadian banking sector and its core holding, to be, but I believe that given the structure of theCanadian residential real estate (“RE”) mortgages: Canadian banking sector and the level of residential RE prices there is a higher chance of a crisis and a future bail-out than is commonly perceived. 6
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