Bloomberg News

Consumer Debt Eroding Canada Banks’ Edge as S&P Cuts Outlook

July 30, 2012

Canadian banks are underperforming global counterparts by the most in a year as record consumer debt and a housing market that’s vulnerable to a correction weakens their earnings prospects and risks a credit downgrade.

Standard & Poor’s cut its outlook to negative from stable on seven Canadian banks July 27, including Toronto-based Royal Bank of Canada and Toronto-Dominion Bank (TD), citing a prolonged increase in housing prices and consumer indebtedness. The debt of Canadian financial companies is the second-worst performer this month after Japan among 35 global peers, according to Bank of America Merrill Lynch data.

“Were house prices to drop materially and over a prolonged period of time, then households would start to de-lever,” Peter Routledge, an analyst in Toronto at National Bank Financial, said in an e-mail yesterday. “We’re not there yet, but that issue is the elephant in the room.”

Yields on the debt of Canadian financial companies ended last week at 158 basis points over federal benchmarks, compared with 257 basis points for global financial firms, according to Bank of America data. The differential is the tightest on a weekly closing basis since July 2011, the data show, meaning Canadian financials are underperforming global counterparts.

“We’re highlighting the potential risks gathering in intensity,” Tom Connell, lead author of the S&P report, said in an interview yesterday from Toronto. “The Canadian economy is exposed to the global economy. Consumer leverage and housing- price dynamics are really closely linked to prospects for consumer income growth.”

Greatest Threat

Connell said the rating company is adjusting its systemic view. “We’re not anticipating a broad deterioration,” he said. “In no sense do we see ratings in an ongoing downward slope.”

Bank of Canada Governor Mark Carney has said since April that higher borrowing costs may become appropriate, even as global economic conditions deteriorate. He has called Canada’s rising household debt the greatest domestic threat to the country’s financial stability, as the country’s banks cut mortgage rates this year to a record low.

Carney has kept the central bank’s benchmark lending rate at 1 percent since September 2010, the longest period without a change since the 1950s. The ratio of household debt to disposable income reached about 154 percent in the first quarter, higher than the U.S. figure of 141 percent.

“There is currently growing potential for deterioration of Canadian bank credit profiles associated with scenarios incorporating consumer sector stress,” S&P said in the report. The negative outlook recognizes the potential for deterioration of Canadian banks’ financial performance and capitalization generally, it added.

Policy Changes

S&P, which said it might lower the ratings on Royal Bank of Canada (RY) and Toronto-Dominion one level, said it “will continue to consider the impact of recent government and regulatory policy initiatives to curtail potential systemic risk arising from the housing sector as well as assess Canada’s relative performance vis-à-vis its global peers.” Royal Bank of Canada and Toronto-Dominion are rated AA- by S&P, the fourth-highest level.

Debt of Canadian financial companies returned 0.5 percent in July, Bank of America data shows. Only Japanese banks, at 0.4 percent, returned less among the 35 countries’ lenders measured in the index, which averaged returns of 1.6 percent. Peru was the highest at 3.5 percent.

Marginal Exposure

S&P would only follow through with ratings downgrades on the Canadian banks “if the economy weakens to such an extent as to trigger job losses and income compression, or if the Bank of Canada carries through with its veiled threat to raise interest rates,” David Rosenberg, chief economist at Gluskin Sheff & Associates, said in an e-mail yesterday. “Either of these scenarios or both would likely impair debt-servicing capacity on the part of the consumer.”

Rosenberg said the former scenario is more likely, although it’s “premature to make that call” about what it might mean to the asset quality on the books of Canada’s banks.

He added Canadian banks have marginal exposure to Europe and strong capital cushions, making downgrades less likely. The earnings outlook for Canadian banks is much less cloudy than it is for U.S. banks because regulatory changes will hit harder there, Rosenberg said.

Earnings Challenge

National Bank’s Routledge added the impact of any credit downgrade would be felt on earnings rather than capitalization. “I do not see the banks’ capitalization in any way threatened by this, owing to their recurring earnings power and the prevalence of mortgage insurance,” he said. The scenario outlined by S&P, “would be an earnings, not a capital, challenge,” he said.

Canada’s government 10-year bond yields fell last week to the lowest level since 1950. Home prices have climbed 34 percent since January 2009 to an average of C$369,339 ($362,204), according to the Canadian Real Estate Association. Consumer debt has increased to more than 90 percent of gross domestic product, from 70 percent over the past decade, S&P said.

Finance Minister Jim Flaherty tightened mortgage rules at least three times and put the federal housing agency’s books under regulatory oversight, as the nation’s booming housing market drives banks’ profit.

In addition to Royal Bank of Canada and Toronto-Dominion Bank, S&P cut to negative its outlook on Bank of Nova Scotia (BNS), National Bank of Canada (NA) and Laurentian Bank of Canada (LB), based in Montreal, Vancouver-based Central 1 Credit Union and Home Capital Group Inc. (HCG) of Toronto. It said it was affirming the credit outlooks for Canadian Imperial Bank of Commerce and Bank of Montreal (BMO), among other banks.

Competitive Pressure

The company said one of the risks that might lead to downgrades is if risk appetite among banks increases amid growing competitive pressure for loan and deposit market share.

“S&P, like the other raters, have become far more proactive in their evaluation of the global banking system,” Adrian Miller, director of global market strategy at GMP Securities, LLC, said in an e-mail yesterday. “A negative outlook does not speak to an imminent downgrade, but just a warning that should the situation continue to deteriorate a downgrade could be coming, perhaps in the next six to 12 months.”

RBC clients and investors “can take confidence in the fact that RBC is one of the strongest banks in the world,” Gillian McArdle, spokeswoman for Royal Bank in Toronto, said by e-mail.

“This is an industry-related change in outlook and does not reflect an actual ratings downgrade,” Stephen Knight, spokesman for Toronto-Dominion in Toronto, said by e-mail.

Actual Downturn

Joe Konecny, spokesman at Bank of Nova Scotia, wasn’t immediately able to comment after regular business hours. Claude Breton, spokesman for National Bank and Mary-Claude Tardif, spokeswoman at Laurentian Bank declined to comment. Art Chamberlain, spokesman for Central 1, didn’t return after-hours telephone and e-mail requests for comment. Gerald Soloway, chief executive officer at Toronto-based Home Capital Group Inc. didn’t return a call after normal business hours.

“An actual downturn in the housing market -- by which I mean a pronounced and prolonged depreciation in house prices nationwide or in several major markets -- is not yet upon us,” said National Bank’s Routledge. “However the market is already discounting a rising probability of this event occurring.”

Ranked Soundest

Routledge said the S&P action “ratifies but does not alter” market expectations, and he therefore doesn’t see any major impact on bank valuations in its wake.

Canadian banks, ranked the soundest by the World Economic Forum, held four of the top 10 spots in Bloomberg Markets magazine’s annual ranking of the world’s strongest banks, released in May. Canadian Imperial Bank of Commerce placed third, followed by Toronto-Dominion in fourth, National Bank in fifth and Royal Bank in sixth.

“These risks have the potential to have an impact over time, but they are known issues,” Robert Sedran, an analyst at CIBC World Markets, said by e-mail. “It’s the outlook for those issues that remains unknown.”

To contact the reporter on this story: Chris Fournier in Montreal at cfournier3@bloomberg.net

To contact the editor responsible for this story: David Scanlan at dscanlan@bloomberg.net


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