Banks walk tightrope while hoping to cushion profit fall

Bulls believe earnings season will signal turning point for industry, but the bears are still urging caution

Rita Trichur
BUSINESS REPORTER Toronto Star

Swollen loan losses, soaring writedowns and slumping profits – it's enough to make even seasoned bank shareholders run for cover.

But with Canadian bank stocks on a rebound since March, wary investors are wondering whether it would be wise to hang on for the long-term or head for the exits while the getting is still good. Analysts appear divided on the hold `em or fold `em debate, but surmise that next week's round of second-quarter earnings should provide some sense of direction.

Banks, meanwhile, are facing a delicate balancing act for the remainder of fiscal 2009. In order to stay profitable, they have to keep loans flowing, while boosting some rates because the recession is rife with risk. At the same time, they must sop up climbing credit losses and maintain plump capital cushions – all without jeopardizing the sanctity of their dividends.

While acknowledging that the economic outlook remains murky, bank bulls argue this earnings season marks a turning point for the industry. For the first time in about 18 months, those much-maligned capital markets-related writedowns are not expected to eclipse the earnings parade.

The running tally of those charges hit $20.24 billion for the "Big Six" at the end of January. While more writedowns are anticipated for the February-to-April quarter, some analysts suggest this batch of reports could signal those charges are on the wane. With capital markets on the mend, many are also betting that results from the banks' trading businesses could even surpass expectations.

Another plus, rebounding stock prices have taken the banks' dividend yields out of the danger zone, which has dampened speculation of cuts to those sacred payouts. In fact, Michael Goldberg of Desjardins Securities is actually expecting "minimal dividend growth" for the second half of fiscal '09.

Those in the bear camp, however, are advising investors to be extremely cautious because bank stocks remain fraught with risks. In short, "the economy still sucks," observed John Aiken of Dundee Capital Markets in a research note to clients. He has a majority of "sell" ratings on Canadian banks, most because they are bracing for more bad loans as the economy sheds jobs and consumer bankruptcies soar.

Provisions for credit losses, the money banks set aside to cover bad loans, have been rising in recent quarters. Craig Fehr, an analyst with Edward Jones, predicts credit conditions will worsen for the rest of this year.

"We are seeing some of the pressures that have existed for the last year or so, largely on the capital markets side, are starting to subside. And we're exchanging that a bit for the pressures that are coming from good old-fashioned credit deterioration – higher loan losses," Fehr said in an interview.

"I think that we are going to see pretty substantial year-over-year increases in provisions across the board – for all the banks. We're talking about 50 to 100 per cent increases in provisions year over year."

The key trouble spots are likely defaults in credit-card lending, while commercial mortgages are also expected to show increasing signs of stress. The Canadian Imperial Bank of Commerce administers Canada's largest credit-card portfolio. It began curbing lending during the second half of fiscal 2008 but remains at risk of more losses, Fehr said.

Toronto-Dominion Bank, meanwhile, has large exposures to the hard-hit U.S. commercial real-estate sector and the sputtering Ontario economy, suggesting its "results might disappoint," said André-Philippe Hardy of RBC Capital Markets. His research also proposes that results from the Bank of Nova Scotia could miss expectations because it "is also exposed to rising credit losses in Latin America and the Caribbean."

While all banks are expected to pad their provisions, it appears to be "less of a negative" for Bank of Montreal, while National Bank of Canada is "least exposed to deteriorating credit quality near term" because of its regional concentration in Quebec, Hardy said.

Royal Bank of Canada, meanwhile, is facing its own challenges south of the border. Last month, RBC pre-announced an $850 million (U.S.) goodwill impairment charge for its international banking business. "The impairment charge is the result of the prolonged economic difficulties in the U.S., in particular the deterioration of the U.S. housing market, and the decline in market value of U.S. banks," noted Scotia Capital's Kevin Choquette.

Despite those economic hurdles, some analysts contend the Canadian banks' penchant for being "boring" retail lenders is standing them in good stead for longer-term profit growth.

While the banks' net interest margins – the difference between the money they make on interest and their own interest expenses – are being squeezed because of historically low interest rates, that pressure is expected to ease going forward for a number of reasons.

First, banks have taken action to hike their rates on popular consumer loans such as personal lines of credit and float-rate mortgages. "Banks have repriced some of their mortgages and we believe banks are now charging a premium of about 75 to 100 basis points over prime on a five-year variable mortgage versus a discount of 75 to 100 basis points before the crisis," Hardy said.

Moreover, the banks' key short-term funding costs have fallen in recent months. Medium-term funding is also down from crisis levels, while longer-term funding remains elevated. Banks are also benefiting from a surge of new deposits as their customers hoard cash.

Fehr said those various factors have created a wider spread between short-term and longer-term interest rates, which suggests that banks are poised to reap profits from interest income in the not-too-distant future. That's because banks tend to borrow "cheap" short-term funds to make longer-term loans that feature higher interest rates, he said.

"As we reprice on the long end and keep the short end very cheap, that spread will increase for the banks. And it will actually be a very strong driver of profits for them going forward," Fehr said.

"There's no doubt in my mind that (loan) volumes will slow relative to peak years. The idea here is that the profitability of each loan they make now has the potential to be higher. So, net interest margins, in my mind, will probably increase as we move throughout the year."