Everyone thinks they’re safe from the current financial crisis.
No one thinks they’re doomed.
I’m talking about the Canadians, of course.
See, lately, I’ve read a lot about the superiority of the Canadian banking system. And naturally, my contrarian instincts prompted a search for a way for you to make money as the Canadian banks go down.
In the last 18 months, my readers had the chance to make 432% when Lehman failed, 162% when Allied Capital came clean, and 220% on PNC Financial… This month they’re poised to make money on the next bank drop.
And I’m going to give you a chance to join them.
If you think Canada escaped the downward trend in U.S. banking, think again. While the country may not have plunged headfirst into subprime mortgages, it did dip heavily into risky derivatives. The leverage it took on generated impressive returns on equity in good times, but that same leverage is set to wipe out equity today.
Shareholders in one “safe” Canadian bank will have to rethink their loyalty. Its looming solvency crisis practically guarantees a dividend cut. And that’s our catalyst for this month’s short play action - offering us a chance for 200% profit potential.
Accounting secrets have not yet obliterated Canadian bank earnings - like those of U.S. banks - because the Canadians have not yet accounted for the coming tsunami of mortgage, consumer loan, and corporate loan losses.
Here’s how they loaded those loan books with hidden risk.
The Basics of Bank Accounting
Bank shareholders leverage their capital by borrowing short-term money, primarily from depositors. Your bank account is an asset for you, but it’s a liability for your bank. For every dollar of capital, bank shareholders borrow 15, 20, or even 30 dollars from senior creditors - otherwise, they could not afford to own their huge portfolios of loans and securities. Here’s the core problem: Bank shareholders and their agents (bank executives) are lending other people’s money. So bankers are looser with lending than if they were lending their own savings.
The accounting process to determine commercial bank profits is inherently speculative, as well. Banks book an upfront profit on every new loan they make, minus a small “provision” for loan losses - just in case some loans wind up going bad. These upfront profits have the habit of disappearing when loans “season,” and banks discover how many deadbeats owe them money. In case you’ve been wondering what has wiped out the majority of the S&P 500’s trailing earnings, here’s your answer: Banks and brokerages reversing most of the profits they booked on loans made and securities bought at the peak of the bubble.
Banks claimed to make good money loans to every borrower. But somebody sure was lying, since they’re taking charges against these older vintage loans and securities left and right. And the industrywide provision for loan losses, which is the single most important - and unpredictable - cost in a bank’s income statement, has been soaring. Once these provision expenses soared on the backs of delinquent loans, the banking sector’s earnings plunged deep into negative territory.
Throw in a few more explosive ingredients like deposit insurance, central bank lending facilities, loan syndication, and securitization and we’re left with a system for which sales volume - not risk management - is priority No. 1.
Those who claim the banking system is well capitalized - including those who designed the unstressful “stress test” - hold rosy assumptions about how many loans will go bad and how much banks will earn from existing loans to have a shot at outrunning their credit losses.
Lots of bank stocks remain in a fragile state. This month, we’re going to buy puts on the Canadian bank most ready to fall.
A Primer on Put Options
As you may know, an easy way to play the downside of stocks is through put options. Here’s a quick primer on how they work…
Put options are a limited risk, leveraged way for you to make money when stocks drop.
For example — when a stock falls 5% in a day, put options may go up 50%. When big drops happen, puts can go up hundreds of percent in hours.
And since they’re limited risk, if you’re wrong, you’ll never lose more than you put up.
My point is — there’s no easier, safer, and faster way to grab huge gains from downward stocks than through put options.
Having said that, let’s take a look in on how you can use them to make money on the Canadian banks. First, the “macro view…”
The Canadian banking system has won accolades for avoiding direct exposure to the most tempting forbidden fruit: products like subprime mortgages, credit cards, leveraged buyout loans, and loans to finance insane commercial real estate purchases.
The financial press loves Canadian banks. On May 19, The Wall Street Journal ran a piece suggesting that these banks are a model of sustainability, and now have the opportunity to acquire U.S. banks on the cheap:
“Not long ago, Canadian banks were considered slow footed, provincial, and too conservative to flourish in the global boom for financial institutions. Now that banks in the U.S. and Europe are reeling from loan losses and face growing government scrutiny and ownership, Canada’s six major banks are seen as a potential model for battered financial institutions. TD Bank, Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal, Canadian Imperial Bank of Commerce, and National Bank of Canada posted more than C$3 billion (US$2.5 billion) in combined profit in the latest quarter.” [Ed. note: quarter ending April 30, 2009.]
Canada’s biggest six banks account for more than 85% of the assets in the country’s banking system. By and large, these banks made a smart decision to avoid securitization. Securitization refers to loans that banks originate, bundle together, and sell off to pension funds, money market funds, insurance companies, and other institutions.
But this doesn’t mean that Canadian banks have no credit risk. On the contrary, they have plenty. Mark to market accounting has not yet cut down Canadian bank earnings, because the Canadians have not yet accounted for the impending wave of mortgage, consumer loan, and corporate loan losses.
They will by the end of 2009. It’s impossible to avoid. And just to give a perspective on how quickly lending grew at the Canadian banks, the chart below shows that assets at the top six Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7 trillion in October 2008. Equity at these top six banks grew in line with assets; all six kept their ratios of assets to common equity fairly constant since 1999.
Growth in assets, even if accompanied by growth in equity, is always a risky proposition for banks. At the time the loans are made, everything seems fine. Then, when a serious recession arrives, and a dramatic credit loss cycle begins, the market value of loan portfolios can rapidly decline by 5% or 10%, pushing the banking system to the edge of insolvency. Insolvency is when the value of assets is less than the value of liabilities. Bank regulators don’t like this scenario and pressure weaker banks to raise very expensive, dilutive equity capital in order to protect more senior lenders, including depositors, from suffering losses.
Canada has just entered what will ultimately be an enormous credit loss cycle, and by the time it’s over, the Canadian banks could easily lose their pristine reputations. Until the middle of 2008, Canada’s economy was booming. Its mining, energy, and manufacturing sectors are world-class, and every other sector was pulled along for the ride.
But the wheels fell off last fall. According to Statistics Canada, the unemployment rate rose to 8.4% in May — the highest in 11 years. Ontario, with its heavy manufacturing base and ties to the “Detroit Three” auto companies, is especially hard hit; Ontario lost 234,000 jobs, or 14% of its entire manufacturing work force, since last October. Ontario will lose even more jobs this summer as GM and Chrysler dramatically cut auto production. Alberta has slowed dramatically too. Just a year ago in Alberta, every skilled construction worker was working overtime on oil sands projects. Now many projects are postponed and workers are getting laid off. The unemployment rate in Alberta nearly doubled from May 2008 to May 2009, to 6.6%, and is heading higher.
For Canada, this credit cycle will probably be worse than the one in the late 1980s. According to RBC Capital Markets, annualized loan loss provisions for the entire Canadian banking system peaked at 2.88% of all loans in 1988. As of April 2009, this figure was just 0.77%. Over the next year or two, loan loss provisions should easily triple or quadruple, which would cut deeply into profits and capital… sending the worst of the Canadian bank stocks down.
So how do you play it?
First, I recommend you dig in to the major banks to figure out the one with the most exposure to unemployment rates. Then, simply visit Yahoo! Finance, enter in their symbol and click on “options” on the top left hand side underneath “Quotes.”
You’ll see all of the put options available on that stock. Pick a good one and you’ll be able to double your money as these stocks go down.
Regards,
Dan Amoss
About the Author
Dan Amoss is the editor of Strategic Short Report and a contributor to The Penny Sleuth, which offers unbiased commentary from expert analysts and authors about penny stocks.
