How one bad loan played into Eisman’s short call on CIBC

It’s been an interesting couple of days in the debate over whether Canadian banks are adequately prepared for a significant deterioration in their loans books.

First, hedge fund manager Steve Eisman doubled down on his bear thesis. He told Catherine Murray on Monday he’s more confident than ever that Canada’s banks are not preparing adequately for a sustained increase in bad loans. Eisman has short positions on three Canadian banks – Royal Bank of Canada, Canadian Imperial Bank of Commerce and Laurentian Bank of Canada – and said his level of confidence in that call has climbed to “nine out of 10” since the recent second-quarter results.

Eisman also said Canada’s regulators should be forcing the banks to set aside more funds for weakening credit conditions.

Coincidentally, on Tuesday morning (not much more than 12 hours after Eisman spoke with Catherine) Canada’s banking regulator did just that. The Office of the Superintendent of Financial Institutions increased the required “domestic stability buffer” it requires Canada’s systemically important banks to hold. It’s an additional level of capital OSFI wants at the banks when credit conditions look likely to weaken. The buffer now sits at two per cent of risk weighted assets, up from 1.75 per cent.

Eisman pointed squarely at CIBC and its jump in impaired commercial loans as a prime example of why he’s so sure the bank stocks are headed for declines.

Here’s what CIBC reported, and what other experts have told BNN Bloomberg about Eisman’s go-short call.

CIBC did indeed report a very significant increase in its gross impaired loans. These are loans – excluding credit card accounts – that are at least 90 days in arrears. Total gross impaired loans were $2.04 billion in the second quarter. That’s up 34 percent from the second quarter of 2018 and up 14 per cent from the prior quarter alone.

The numbers were worse in the commercial loans segment (CIBC uses the term “Business and Government” for this part of its lending operations). There, the runup in impaired loans was 77 per cent from a year earlier – a figure Eisman seized upon in his conversation with us.

But a closer look shows one line in CIBC’s commercial impaired loans table accounted for most of that increase. 

There were $345 million in impaired utilities loans in the most recent quarter, versus zero a year earlier. Moreover, CIBC says a single loan to a utilities borrower is chiefly responsible. And on a conference call with analysts last month, CIBC’s chief risk officer pointed out the bank has sold its exposure to that troublesome loan.

Factor out the mess CIBC is in with one of its utilities clients and you get a 23 per cent pickup in commercial impaired loans over the year ending with the second quarter – and a decline of 11 per cent from the fiscal first quarter.

So Eisman may be making CIBC’s loan book look weaker than it really is, given that one single account has had a dramatically outsized effect.

But with or without the one-time bulge in bad utilities lending, Eisman says the increases need to be understood in the context of the slower pace of growth in allowances (or “reserves” as he calls them) for loan losses. This is money set aside to cover those impaired loans.

CIBC’s total allowance for credit losses stood at $1.86 billion at the end of the second quarter. That was up 7.6 per cent from the same quarter in 2018 – a much more modest increase than the buildup in bad loans those allowances are intended to cover. Here, it looks like Eisman is correct.

Tuesday was a good day to have John Zechner as my guest host on The Street.  Like Eisman, John also runs a hedge fund, and almost always has short positions in place on certain stocks or assets. He doesn’t agree with Eisman’s call.

“I don’t subscribe to his story that they are a short right now,” Zechner told me. He agrees the credit cycle is toughening, and agrees with Eisman that the banks need to be building reserves for the downturn. But he argues that banks are better run businesses, with much more diverse loan books, than they used to be.

John Aiken, an analyst at Barclays Capital, seemed to agree when he spoke with Amber Kanwar and Jon Erlichman on The Open.

He said loan-loss rates are still below historic run-rate averages, that loan losses are not showing strong sectoral trends, and – like the case of CIBC and its utilities lending – are strongly affected by single data points. To the degree that credit quality is weakening, Aiken said, bank executives are not turning a blind eye.

“They are not ignoring it,” Aiken said. “They are hyper-aware.”