Paul Bagnell

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When an investor who has a track record of getting it right calls an asset class over-valued, you listen.

And that’s exactly what happened on Monday when Steve Eisman — whose bets against the subprime mortgage market were made famous in Michael Lewis’s “The Big Short” — took aim at Canadian bank stocks in an interview with Bloomberg Television at a conference in Hong Kong.

“Short Canadian financials,” he said, when asked what his top short-selling ideas are right now. “Canada’s going to have some issues with their housing market,” he later added.

It brings to mind the Great White Short of 2013, when several U.S. hedge funds bet against Canadian bank stocks, convinced that the Canadian housing market was overripe and set to plunge, taking bank profits and stock prices with it.

But neither the Canadian housing market nor the bank stocks cooperated. The housing meltdown never arrived.

Shares of the banks were flat for the first half of 2013, then began soaring. The S&P Banks index finished the year 17 per cent higher. 

And it got worse for the shorts: by the time the late summer of 2014 had rolled around, the index was up a further 13 per cent. The bank stocks declined in 2015 and early 2016, but then kicked into rally mode again. Today, the index is 60 per cent higher than it was in early 2013.

The Great White Short, in other words, blew up in the faces of most of the hedge funds that tried it.

But Eisman is no ill-informed hedge fund manager. He went short on collateralized debt obligations in a big way prior to the subprime meltdown of 2007 and made billions for his hedge fund. Is he right this time?

To be clear, he seems not to be calling for a full-fledged collapse in Canadian housing. But he does believe a housing correction will drive Canadian bank stocks lower.

None of the analysts who cover the Canadian banks are calling for a housing market crash in Canada. And, on this topic in recent years, they have been right – correctly pointing out that most of the apocalyptic forecasts from hedge funds south of the border have been based on a misunderstanding of Canadian mortgage rules. 

But they do see a direct connection between Ottawa’s tougher mortgage stress-test rules and profit growth at the banks. Some say the bank stocks that will fare the best over the next year will be those with the least residential mortgage exposure.

The new mortgage rules introduced by the Office of the Superintendent of Financial Institutions are formally referred to as “Final Revised Guideline B-20” and require all mortgage lenders in the country to “stress test” applications for uninsured mortgages by applying a hypothetical interest rate of two full percentage points higher than the rate being offered to the applicant (or the rate of the Bank of Canada’s five-year benchmark rate – whichever is higher).

B-20 means fewer Canadians will be able to afford mortgages, and many others will have to settle for smaller loans. And B-20 is the storyline investors will be watching most closely in the upcoming second-quarter bank results season.

“We are forecasting residential mortgage volumes to ebb modestly from Q1 levels,” analyst John Aiken told clients of Barclays Capital recently. He notes several of the big banks have estimated the B-20 rules will cut new mortgage originations by between five and ten per cent.

Sumit Malhotra at Scotiabank agrees. He notes the February-to-April quarter (fiscal Q2 for the banks) is traditionally the slowest of the year for residential mortgage growth in Canada. And, he adds, “our review of recent data clearly indicates the seasonal deceleration will be more pronounced in the upcoming Q2/18 results.”

For now, his preferred stocks in the sector are those with less proportionate exposure to residential real estate lending: Bank of Montreal, Scotiabank, TD Bank and Canadian Western Bank.

If those four banks have less-than-average exposure to home mortgages, who has the most?  Right now, that’s CIBC.

For that very reason, CIBC will be closely watched this quarter. Malhotra notes the bank has led the sector in residential mortgage growth since 2015 – a fact that he now calls “a source of concern.”

At Canaccord Genuity, analyst Scott Chan says he believes CIBC’s outsized mortgage exposure is the reason its stock has posted the worst year-to-date return of the group.

RBC’s Darko Mihelic says CIBC’s valuation is attractive at this point, but needs to show it can deliver solid retail banking results in the face of weakening mortgage loan growth.

And, on that point, there are indeed some strong positive forces in the Canadian economy that will push against the negative drag in the mortgage books at all of the banks. Canada’s unemployment rate stands at a 40-year low. Interest rates have ticked up, widening the banks’ net interest margins. And while consumer lending has slowed, business lending has remained robust.

“This is not to suggest that everything is coming up roses,” RBC’s Mihelic wrote in a report to clients, “but there are enough flowers to hide the odd weed in the garden.”

Or, perhaps, to prove the short-sellers wrong again.

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Here’s a quick look at what to watch for when each of the Big Six Canadian banks reports earnings:

CIBC:

May 23

EPS expected:  $2.81

What to watch: Without question, the focus will be on CIBC’s expanded mortgage book and what strains the new B-20 rules may have caused.

Dividend hike? No

Royal Bank of Canada:

May 24

EPS expected: $2.05

What to watch: Capital deployment. Will RBC keep up its impressive pace of share buybacks?

Dividend hike? No

Toronto-Dominion Bank:

May 24

EPS expected:  $1.50

What to watch: Commercial loans grew substantially in Q1. If that continues, TD should be able to overcome mortgage softeness.

Dividend hike? No

Bank of Nova Scotia:

May 29

EPS expected: $1.68

What to watch: Comments from management on NAFTA.  As the owner of Mexico’s second-largest bank, Scotia has a big stake in the tortured NAFTA talks.

Dividend hike? No.

Bank of Montreal:

May 30

EPS expected: $2.12

What to watch: U.S. loan growth. The bank is a big lender to businesses in the U.S. Midwest. Fresh numbers from the U.S. Federal Reserve indicate demand for loans is growing among businesses.

Dividend hike? No

National Bank of Canada:

May 30

EPS expected: $1.39

What to watch: The trading business. National’s financial markets division had 9 per cent revenue growth and 14 per cent profit growth in Q1. Investors would love to see a repeat performance.

Dividend hike? Yes