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Canadian banks came in with mixed Q3 results. According to Mario Mendonca, Managing Director, TD Securities, the key question is when to price in the next credit cycle and how severe will the credit cycle be. Kim Parlee speaks with Mario Mendonca about what to watch for in this space.
Transcript
Kim Parlee: If we take a look at the overall results, mostly in line with what was expected. And I know there are a couple of headlines caught BMO and Royal Bank in terms of them missing expectations. But why do you think, given the results, which I think you characterize as not bad, why do you think investors were selling on those results?
Mario Mendonca: Well, investors have been selling for some time now on, not just the banks, the market as a whole. And I think the banks are just being caught up in the concerns around a potential recession and what it could mean to credit losses. I think it would be right to characterize the results as pretty good on an underlying basis. Credit losses remain very low. Margins improved significantly. Capital markets, of course, were weak. But I think the concern remains that higher interest rates will usher in a recession that will lead to higher credit losses. What’s interesting is that we’re not seeing any evidence of that right now. There really is very little evidence that the credit markets are in trouble. Certainly, leverage loan spreads didn’t move out in the quarter. But credit markets and credit conditions generally look really solid. The market’s just looking ahead right now.
Kim Parlee: Hmm. Let’s talk a bit about the interest rate situation. Rising rates can be good for banks, not so great for the economy, so you have to balance that, but also can’t be great for the consumer, especially when you look at things like variable rate mortgages, of which there are a few in Canada. So what do you see there? How do you see this playing out, the impact on housing prices, and the consumer with variable rate mortgages?
Mario Mendonca: Well, variable rate mortgages account for about one third, maybe a little less than one third of all mortgages outstanding in Canada. And when rates were very low, say 2020, 2021, people that got into a variable rate mortgage were paying very little, maybe 1 and 1/2%, 2%. Rates have moved materially higher now. Your mortgage payment doesn’t increase, but the amount of principal that your mortgage payment covers decreases substantially. And as a result, the amortization period of your mortgage gets extended quite a bit further. The banks disclosed this quarter that the number of mortgages with 35-year-plus amortization periods is now approximately 20%. It was single digits just a few quarters ago. Ultimately, if rates continue to move higher, and we expect they will over the next few quarters, we’ll reach what we call a trigger point. The trigger point is when your mortgage payment’s not covering any more than just the interest. At that point, you’ll probably get a call from your bank asking you to increase your payment or make a down payment.
Now, I don’t think that number is very big. We’re probably not talking about a lot of people in the next couple of quarters. The bigger issue is what happens to these variable rate mortgages, and even fixed mortgages, in 2025, 2026. That’s roughly five years after the very, very low mortgage payments, or mortgage rates of 2020 and 2021. At that point, we could have a lot of folks dealing with materially higher mortgage payments, both variable and fixed, if, in fact, mortgage rates remain this high three or four years from now. That’s really hard to say. We could enter into a recession, which is what we talked about a moment ago. And that could drive rates much lower again. But that’s one of the big topics that came up on the conference calls this quarter for the Canadian banks. And it’s one of the issues I’ll be focusing on over the next couple of years.
Kim Parlee: Let’s talk about the individual banks. And let’s start with BMO and Royal, if we could. Those banks, of course, have the largest capital markets. And both of those banks missed results. So let’s start with Royal. Maybe tell us what happened, and we can get into the rest, but what you’re seeing.
Mario Mendonca: Sure. Royal and Bank of Montreal, you can kind of think of these together. They have large leverage loan portfolios in their US business. These leveraged loan portfolios, there’s the loans that they want to hold in their balance sheet to maturity. And then there are loans that they originate with the purpose of syndicating or selling shortly after. But during the quarter, leveraged loan spreads increased substantially. Or the value of leveraged loans declined. That resulted in Bank of Montreal and Royal having to take these mark-to-market charges on their leverage loans. What’s interesting is that these charges are not, for the most part, realized losses. These are unrealized losses that have to be recorded in your current quarter earnings.
With leveraged loan spreads coming down a little bit, improving since the end of the quarter, it’s very conceivable that these mark-to-market charges in Q3 could be mark to market gains in Q4. It kind of depends on what the market feels like and how leveraged loans, leverage loan spreads evolve over the next few months. But I want people to keep in mind here, we are talking about unrealized losses. The other thing we should keep in mind is that these balances of unrealized, or rather, of leveraged loans that are mark-to- market every quarter. These are measured in the sort of $4 billion to $5 billion range for these two banks. That is a very small number in the context of trillion-dollar balance sheets. So I was a little surprised to see the market focus so much on the mark-to-market leveraged loans. They’re not that big a deal and, in fact, could be gains as early as next quarter.
Kim Parlee: Yeah, it’s an interesting — to see how this happens. Is there anything else with BMO and Royal that stood out, just individually?
Mario Mendonca: Yeah. Well, Royal showed that their business, or their deposit franchise, is very strong. We saw significantly stronger margins in both Canada and the US. And that certainly helped to support the results. We also saw from Royal, slightly better loan growth. They don’t appear to be losing share. They have been over the last few quarters. This quarter looked like they regained some share in consumer lending. In BMO’s case, what surprised me the most was that BMO’s margins held in really well as interest rates were falling. And then we saw margins improve quickly as interest rates were rising. That’s an unusual circumstance. In fact, BMO is the only bank where margins are higher today than they were in Q1 ’20. It probably relates to some effective hedging they’ve done, the variable rate nature of a lot of their lending. And I think they have a better deposit franchise than I gave them credit for. So those were the two sort of surprising things I saw from BMO this quarter.
Kim Parlee: What about — and I’ll remind everybody, we don’t talk about TD for obvious reasons. But let’s talk about CIBC. What did you see there?
Mario Mendonca: The market’s been very disappointed with CIBC results. I didn’t think the underlying results were that bad. But there seems to be some growing concern that CIBC will not benefit as much from rising rates as their peers. We didn’t see their US margin improve in a big way the way we saw for other banks, for BMO and Royal for example. I think there’s some ongoing concern that CIBC also grew their loans very abruptly over the last 12 months. And to the extent that you’re concerned about a credit — not crisis, but maybe a credit cycle unfolding, there’s some concern that CIBC might have more exposure there. But ultimately, the bad rap that CIBC often gets, and I think it’s a little bit overstated, is their housing exposure. They certainly do have more domestic mortgage exposure than their peers. But if the housing market really were to take a tumble here, everybody would get hurt, not just CIBC. But I think that’s one of the areas that’s sort of hurt the stock since they reported their Q3 results.
Kim Parlee: What about Bank of Nova Scotia?
Mario Mendonca: Scotia is not in a good place right now. I think they’re not seeing their margins expand. They were the only bank that didn’t report a year-over-year increase in their net interest margin in Q3 ’22 relative to Q3 ’21. They’ve hedged out that exposure. There’s also the nature of their Latin American business that has resulted in sort of modest margin expansion, or in fact, we saw a very sharp sequential decline in their Latin American margin. The bank is sitting on 11.4% capital ratio. On an absolute basis, that’s a fine capital ratio. On a relative basis, it’s light. So right now, we’re looking at Scotia, they don’t have a ton of capital to go out there and do acquisitions or to grow their risk-weighted assets, which supports growth and earnings. The margin performance isn’t that impressive. They would be at the bottom of my pecking order among the banks that I cover.
Kim Parlee: What are you going to be watching going forward, Mario, in the next quarter and the next year? You mentioned the capital markets have been weaker. I don’t — you tell me, but I don’t think they’re going to be sparking up in the same way for the next little while. You could have a weaker consumer, or we will. We don’t really know what the Fed’s doing. Some people are saying we could see rates as high as central bank 6%. Others are saying it’s probably going to break in around 4%. There’s a lot. There’s a lot of variables right now. So what are you going to be watching going forward?
Mario Mendonca: In any given quarter, credit matters. The credit performance matters for our Canadian banks. But in no quarter over the next few quarters is it more important. It’s more important now than it’s ever been. And the reason for this is there’s no evidence of a credit deterioration. But yet the market’s behaving like it’s imminent. So I’ll be following things like consumer delinquencies. Are delinquencies increasing? Gross impaired loan formations, are we seeing higher loans become what we call impaired? I’ll be watching the banks very carefully. The bank’s half the book. Every quarter, what we call performing loan reserves. These are reserves or credit losses related to loans that are still good. They book losses on those loans because they see something coming. So watching how the banks report their performing loan reserves, if that starts to increase, delinquencies gross impaired loans, those are the big ones, because what I’m most interested right now is, who’s right. Is it the market pricing in this big credit cycle? Or is it really what I’m seeing with my own eyes right now, which is no signs of a credit cycle? So which of the two is right? That’s what I’ll be watching for really carefully.
Kim Parlee: We’ll be looking forward to having that discussion to find out the answer to that. Mario, Thanks so much.
Mario Mendonca: Thanks.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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