Steven Eisman, of The Big Short fame, went on Canada's Bloomberg on April 9 and explained why he is shorting Canadian banks. He does not think the housing market in Canada is going to collapse. He does expect a normalization of credit losses. Canadian banks are woefully unprepared for even that normalization of credit losses, he said.
The way Canadian banks reserve every quarter is interesting. They divide their loan books in three buckets. These are called stages one to three. Stage one is the current loan book. Stage two is early stage delinquencies and stage three is late stage delinquencies. The loan loss provisions in 2018 were lower than in 2017. Those lower loan provisions provided almost all of the Canadian banks their profit. When they lower provisions for losses, that money gets added to earnings.
It was last quarter that CIBC (TSE:CM, Financial) broke ranks. This was the first Canadian bank to report that its models indicated a deterioration of the Canadian economy. CIBC still reported negative loan-loss provisions for stage one, meaning it provisioned less. At some point Canadian banks will come out and make positive provisions for stage one. That's going to crush earnings and at that time the market should wake up, Eisman said.
As of now, Canadian banks are still provisioning for an improving Canadian economy. Eisman has been listening to economists, and all they argue about is whether Canada will have a soft or hard landing. In the end, there will be some landing.
By Eisman's calculations, 90% of Canadian banks' 2018 profit was from their large negative provisioning. If they start provisioning the other way, profits get crushed. They will get nowhere near earnings estimates that are out there.
Catalysts could be:
- Housing deterioration.
- Economic slowdown.
Eisman does not seem very sure what will trigger the reversal in provisions, just that it will happen at some point.
The second problem he identified is that Candian banks all have reported capital ratios of 11-12% against a requirement of around 9%. But capital in this equation is risk-weighted. Canadian banks assume no losses on their mortgage books. Therefore these have risk weights of 5-7% on their mortgage portfolios.
If there is a normal credit cycle, losses could go to 100 basis points. Eisman's calculation is that capital ratios could deteriorate by 200 basis points and banks slide to 9-10% capital ratios, which is close to the required amount set by regulators.
The risk-reward of owning Canadian banks is terrible, Eisman said. The banks are priced for perfection. In reality, they are not nearly as well capitalized as they appear. Eisman seemed to expect a minimum of a 20% slide in the equities but did not expect them to get wiped out or bailed out.
Eisman is shorting the following Canadian banks:
Disclosure: no positions.
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Ray Dalio: The Dollar Could Depreciate 30%Â
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Gundlach: Focus on Preservation of Capital Into 2019Â
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