Stress testing Eisman's short call on the Canadian banks
Canadian households are wallowing in debt. Home prices are falling. Credit growth, the key driver for bank earnings, is hovering close to its slowest pace since 1983. All of which should be bad news for the country’s lenders -- and good news for investors betting against them.
“Should” being the operative word.
Even with danger signs piling up, the shares of the six biggest Canadian banks have stubbornly refused to drop, instead surging 9.4 per cent this year -- and frustrating short sellers hoping to make money on stock-price declines.
“This is a process, not an event -- that’s how I think about it,” said Bradley Safalow, whose firm PAA Research LLC advises investors to short companies including Canadian Imperial Bank of Commerce and Royal Bank of Canada, and who has short positions in those banks himself. “There is some patience that’s absolutely required.”
The bet against Canadian stocks has become known as the “Great White Short” and investors pushing it remain confident that the decline will finally come -- it’s just a matter of time. There’s simply too strong an argument against the banks, they contend.
Jump in Shorts
Canada’s six big banks had a 13 percent jump in the value of short-interest positions from the start of the year to the end of March, according to financial-analytics firm S3 Partners LLC. Those lenders had an average 3.4 percent of their outstanding shares in short-interest positions as of March 31, up 25 percent from a year earlier, S3 data show. CIBC’s stock has the greatest proportion of short-interest positions, at 6.4 percent, while Royal Bank is the lowest, with 1.5 percent of its shares shorted to the end of March.
Yet both banks’ shares are on the rise, with CIBC’s stock up 7.4 percent this year and Royal Bank gaining 11 percent.
In comparison, short-interest positions at the major U.S. banks range from about 0.6 percent of outstanding shares for Wells Fargo & Co., JPMorgan Chase Co. and Citigroup Inc. to 2 percent at Goldman Sachs Group Inc., according to S3.
“I don’t lose sleep over this question, personally,” Bank of Montreal Chief Executive Officer Darryl White said in an interview when asked about short sellers after the lender’s annual investors meeting on April 2. About 2.7 percent of his bank’s outstanding shares are shorted. “I think the market is a lot healthier than some people think it is.”
Toronto-Dominion Bank CEO Bharat Masrani said some investors have been trying unsuccessfully to short Canadian banks for the past decade. “I suspect the bet has not turned out too well if one has been trying it for 10 years,” he said in an interview after his bank’s annual meeting.
Indeed, the argument for being long on banks is a strong one. Canadian unemployment is at its lowest in at least four decades and economic growth is accelerating. And, despite some signs of deterioration, consumer default rates remain low. Banks have bolstered their case by diversifying beyond domestic consumer lending, delving deeper into wealth management, commercial loans and private banking while expanding operations in the U.S. and other foreign countries.
That’s not enough to scare off skeptics like Seth Daniels, of Boston-based JKD Capital LLC, who’s been betting against Canadian housing since 2014. They see a bubble about to burst.
Home sales have fallen in recent years across Toronto and Vancouver, the result of new taxes and government regulations -- including tougher mortgage-qualification rules -- to curb rising debt and speculative purchases. To ease affordability concerns, the federal government announced plans in March to take equity positions in homes purchased by first-time buyers.
Daniels said that years of lax lending standards, incentive-based loan approvals and monetary policy favorable to buyers drove prices up too quickly and by too much, “which will lead to a spike in defaults and a significant economic correction.”
The “Great White Short” isn’t new. The idea has been around since the financial crisis a decade ago, when investors predicted that the U.S. housing collapse would spread north. Instead, stimulative measures to blunt a global recession prompted record-low interest rates. That in turn fueled a borrowing binge and surging home prices in Canada, which has morphed into the current bursting-bubble bet.
“The trade is very cyclical -- it comes in waves,” said Barclays Plc banking analyst John Aiken. “Every six to eight months it suddenly hits this resurgence, and in the past has been beaten down and dies off.”
For short sellers to be successful, “you’ve got to have some sort of shock” to the housing market, Aiken said -- something unlikely to happen as long as the supply of homes remains tight in Vancouver and Toronto, which limits the amount prices can fall. With Canada recording its biggest influx of immigrants in more than a century last year, including 106,000 to Toronto alone, that shock may not come for some time.
Steve Eisman, who foresaw the collapse of subprime mortgages before the 2008 financial crisis, has shorted Canada a couple times over the years, with his most recent call reaching back almost two years. He hopes to profit from a milder swoon.
“I’ve never said that I thought there was going to be a housing collapse in Canada,” the Neuberger Berman Group money manager said in an April 5 phone interview. His argument relates to the country’s credit conditions. “You’re going to get some normalization of credit where you’re going to have normal levels of losses.”
That will translate into more bad loans for the banks, causing them to miss earnings, and force them to increase their capital levels to cover additional potential losses, according to Eisman, who’s shorting companies including Royal Bank and CIBC.
The reason short sellers have been unsuccessful can be partly attributed to one man: Warren Buffett, whose Berkshire Hathaway Inc. bailed out failing alternative lender Home Capital Group Inc. in 2017, said Jared Dillian, editor of The Daily Dirtnap market newsletter.
“That whole deal was framed as a seal of approval by Warren Buffett on the country of Canada,” Dillian said. “The effect on sentiment in Canada was massive, and that prolonged the trade easily for another two years. That single-handedly saved the country.”
Dillian started shorting Canadian stocks about six years ago and still holds short positions in Canadian banks he wouldn’t name. Dividends present a pesky problem for short sellers. The average dividend yield for Canada’s six biggest banks is 4.4 percent, giving shorts a high carrying cost.
“You need the stock to go down 30 percent from here just to break even, which is kind of the position I’m in,” he said.
Among other obstacles for short sellers: Practices that set the stage for the U.S. housing bust, including particularly risky loans, are nonstarters in Canada. And, unlike in the U.S., mortgages are “full recourse” in most of the country, meaning lenders can pursue borrowers even after they’ve walked away from their properties.
Short seller Marc Cohodes, whose Canadian bets have included Home Capital, said Canadian banks make for bad shorts because of the government and regulatory support they enjoy.
“I’ve never been short the Big 5 banks because it’s essentially like shorting the government,” Cohodes said in an interview. “They’re like national entities. The banks, to me, are the last to go.”