Moody’s Downgrade of the Canadian Banks: Should Investors be Worried?

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My coverage on the Canadian banking sector continues. In this brief analysis I will examine if the downgrade by Moody's should be a major concern for potential investors.

Moody’s recently downgraded six of Canada’s largest banks primarily due to high levels of consumer debt and elevated housing prices, which forces a potential downside risk on the Canadian economy.

Irrespective of the downgrade, several Wall Street experts and trade pundits still maintain a stable outlook on the Canadian banking sector. Canadian banks are consistently ranked among the world’s safest and well regulated financial institutions by World Economic Forum.

A recent report published by the Economist predicted a strong correction in housing prices, as they are currently estimated to be overvalued by 73% relative to rental prices and 32% when compared to household income respectively.

Paul Krugman, renowned economist, seconds the view. "According to him, though Canadian banks are considered amongst the safest in the world owing to a well regulated environment, however, the current housing bubble will be a litmus test for the major banks." Going forward, it will be interesting to see how the government and the big financial institutions react to the situations and counter this situation.

Toronto-Dominion (NYSE: TD) was one of the last publicly traded banks to hold the coveted AAA rating from Moody’s until it was downgraded to Aa1 in January. It is notch below its highest rating grade, which implies Toronto-Dominion is a safer investment relative to its compatriots down south in United States. Most of the major financial institutions such as Citigroup, Bank of America and several other big banks are still rated Baa 2, which is tad above the junk status.

So why are the Canadian Banks reliable despite the downgrade? 

Toronto-Dominion has focused primarily on meeting the BASEL III and Office of the Superintendent of Financial Institutions, or OSFI, requirements on capital and risk frameworks as it recorded a Common equity tier 1 ratio of 8.8%, which is well above the regulatory requirement of 7%.

Moreover, Toronto-Dominion is consistently rated a notch higher than all its Canadian peers, and in terms of risk management, it is considered far superior than any other U.S. based financial institution. This is  substantiated with Toronto-Dominion reporting an adjusted return on its risk weighted assets at around 2.59%, which is above its Canadian and American peers that currently stand at around 2.34% and 1.67% respectively.

Toronto Dominion’s economist Diana Petramala conceded the potential risks associated with the housing market and consumer debt, however. She illustrated that a rise in mortgage interest rates and mortgage delinquencies increased simultaneously with consumer debt running up to the US financial crisis.

With a low interest rate environment prevailing in the Canadian economy, interest costs as a percentage of disposable income has drastically fallen despite the sharp rise in debt to disposable income, which at present stands at around at 165%. Furthermore, the mortgage delinquency rates (the percent of mortgages in arrears 90 days or more) in Canada is at around a third compared to the U.S. in the run up to the crisis, which certainly exhibits a better picture for the Canadian economy.

Moving further, I believe Toronto-Dominion stands on stable risk management framework and continued organic growth in all verticals will enable it to regain its AAA credit rating sooner than later.

Bank of Nova Scotia (NYSE: BNS) is another big Canadian bank, which was downgraded by Moody’s to Aa2 from Aa1 for long term deposits.

Bank of Nova Scotia is one of the largest banks in Canada, and its operations span across the entire American continent. Like Toronto-Dominion, Bank of Nova Scotia has consistently developed on its BASEL III common equity tier 1 ratio, which currently stands at around 8.6%, allowing the company a sufficient risk cover from any adverse downside in the economy.

With a consistently growing bottom line from all business verticals and a  year-on-year revenue growth of 15%, the bank was one of the best performers during the last quarter. The bank has actively taken initiatives in order to improve its risk status by reducing its exposure in Europe by approximately $3 billion from the previous quarter coupled with a low and well controlled market risk at an average one day all bank VAR reduced to $16.8 million compared to the $17.4 million during the first quarter of 2013.

The initiatives taken by the bank suggests it is on the path of growth with a better risk profile. Going forward, I don't see Moody's increasing its rating unless the consumer debt  falls drastically. 

Canadian Imperial Bank of Commerce (NYSE: CM)commonly known as CIBC, is deeply involved in managing risks in order to bolster the investor confidence much like all its Canadian peers. The company for the second quarter of 2013 reported strong performance in core business divisions.

BASEL III common equity tier 1 ratio for CIBC stands at around 9.7%. It should be noted, during the second quarter of 2013, it was one of the highest among all its Canadian peers. In addition, it must be noted, during January 2012, the debt-to-equity ratio stood at 4.8, whereas during April the same ratio came down to 1.6. This exhibits the banks continued focus on managing risk and creating a safety net in the event of any potential economic and liquidity risk.

However, relative to its peers, CIBC has not taken any noticeable measures to improve its risk profile. Yet, the bank is fundamentally strong, as illustrated in my previous article. I don't see the bank getting an upgrade from Moody's any sooner.

So Moody's downgrade: Does it matter?

Canadian financial institutions have been one of the best managed and safest in the world. World Economic Forum’s constant grading on such institutions as the best during the past five years is no coincidence, rather a culmination of the combined efforts of OSFI (Office of the Superintendent of Financial Institutions Canada) and the willingness of the institutions to strengthen the Canadian economy.

Though Canadian economy faces a serious threat with a high debt to disposable income ratio of 165% coupled with increasing housing prices, the Canadian government is involved in tightening the mortgage lending regulations in order to control the rising consumer debt.

The harsher lending regulations and government warnings on high debt has facilitated in reducing the ardor of home buyers, as the hottest markets such as Vancouver and Toronto gradually cooling off. 

Such strategic initiatives coupled with continued improvement in risk management fundamentals enables me to believe the downgrade by Moody's will not hold back investors.

Ashit Gulati has no position in any stocks mentioned. The Motley Fool recommends The Bank of Nova Scotia (USA). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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