Like all the big five Canadian banks CIBC (NYSE: CM) looks like a great value. PE is 9x, the yield is above 5% and ROTE is 18%.
However, also like all other Canadian banks the problem is the "crash factor". Canada has looked like an accident waiting to happen for some time.
Household debt stands at an enormous 180% of disposable income, second only to Australia among G20 countries, and has been on an upward trajectory for years. House prices have soared, especially in Toronto and Vancouver and the nationwide house price index is 23% above its 2015 level. This is the biggest pace of increase in the G20 after China.
To put these numbers into perspective, US household debt is a frugal 107% of disposable income and house prices are up a modest 15% since 2015.
Source: Statistics Canada
Source: OECD
These issues are no secret to anyone. Forecasters have been prophesying an impending bust in Canada for years, even most Canadians. And bank investors haven't been exactly falling over themselves to buy Canadian banks, certainly not CIBC, the most domestically-geared of the big 5, which is up just 2% over 1-year during a period which JPM, for example, is up 23%
The question is not whether the risk of a crash exists. Clearly it does. It is how to factor it into valuations.
In CIBC's case the issue is especially pertinent because it has much less diversification outside Canada than its peers. As of 3Q19, domestic loans accounted for 85% of the loan book, the majority being Canadian residential mortgages (52%). Canadian credit card and unsecured consumer loans accounted for a further 14%.
If Canada does keel over under the weight of personal sector debt and the bursting of the house price bubble, CIBC will be the first casualty.
Source: company 3Q19 earnings supplement
This article tries to put a number on the size of potential losses CIBC might incur in a crash scenario. Given the peculiar risks CIBC and other Canadian banks face it's not just enough to say they're cheap on PE or P/TNAV. The question that needs to be answered is whether they're still cheap if Canada goes over the cliff.
If you just looked at CIBC's credit quality statistics you'd quickly conclude everything in the garden is rosy.
Impaired loans have been rising but at an almost imperceptible pace and they remain at very modest levels at just 45bps of total loans. Indeed this ratio is inflated by recent rapid growth in the US C&I market, where loss rates are structurally higher. If we just look at the stats for Canada, which is dominated by CIBC's big residential mortgage portfolio, the impaired loan ratio is 22bps. It's risen from 10bps at the end of 2017 but in absolute terms, 22bps is still a negligibly low number.
Source: company 3Q19 earnings supplement
The same is true of write-offs, which are flat to falling. On the $205bn mortgage portfolio, write-offs for 9m19 stand at just $17m.
Source: company 3Q19 earnings supplement
However, the problem with banks' credit quality statistics is they tend to be backward looking. This is especially true for the way banks provision for future loan losses.
The IFRS 9 accounting standard brought in during 2017 was supposed to fix the problem. Unlike the way things worked in the past, banks now have to make a loss allowance for loans when they are issued, not just when they become impaired as was the rule the previous IAS 39 "incurred loss" methodology.
This is known as "Stage 1" impairment and it is supposed to capture the future risk of currently performing loans going bad (as opposed to "Stage 2", which is impairments for performing but potentially problematic loans, and "Stage 3" which is impairments for non-performing exposures).
However, "Stage 1" allowances only need to be booked for expected losses over the next 12 months, not the lifetime of the loan. And there is a large element of discretion left to the banks as to how they assess and quantify 12 month expected losses.
Particularly for banks like CIBC, where the recent past has been one of trouble-free performance with little or no loan losses, the inclination is to assume the same will continue at least for the next 12 months, especially in secured lending categories like residential mortgages.
This explains why, in spite of most people thinking Canada is a powder keg, CIBC's allowances for loan losses are de minimus. There are currently allowances of just $0.6bn on the $207bn mortgage book, under 0.3%. Across the whole portfolio allowances are just 0.5% of total loans.
Source: company 3Q19 earnings supplement
If the recent past has taught investors anything it is that when things go wrong in bank-land they tend to go spectacularly wrong. In particular, housing market corrections are rarely slight, they are mostly abrupt and brutal. It is inconceivable that if Canada goes over the cliff CIBC will only experience losses of 0.3% on its mortgage book or 1.3% on its unsecured consumer book, as its current allowances imply.
How big could the losses be? The US experience post-2008 is a good one to look at. The markets aren't exactly the same. Notably, Canada has nothing like the scale of sub-prime mortgages the US had. But as a rough reference point for the broad magnitude of possible loss rates it's a reasonable comparison.
US delinquency rates on residential mortgages peaked in late-2009, not at CIBC's current provisioning level of 0.3% but at 10%.
Mortgages are secured so even if 10% of borrowers default, the bank won't lose 10% of its money. It will only lose the portion it can't reclaim on repossessed collateral. So the magnitude of the housing market price fall is as important as the delinquency rate.
For example, assuming a mortgage book with a loan-to-value of 100% and a 50% drop in average house prices the loss on delinquent loans would be 50%. Assuming 10% of the book defaults, the loss or write-off across the portfolio would therefore sum to 5%.
Source: US Federal Reserve
I've kept these numbers simple to illustrate the mechanics. Few if any banks have LTVs of 100% on their mortgage books and a 50% house price crash would be severe (but not unimaginable - it was the peak-to-trough fall experienced in Ireland post-2008 for example).
But it's also true that most of the losses happen at the margin, not at the average i.e. they occur on newer loans where LTV's are higher than the average of the book and where buyers are more likely to have paid an overgenerous price for the house. So a 5% write-off across an entire portfolio is not an extreme assumption.
Indeed this number is supported by the US write-off experience, which over the period 2008-2010 totaled 5.7% of aggregate residential mortgages. I've also included the data for the other main lending categories in the following table, showing that cumulative crisis-period write-offs on US credit card loans were 15%, 24% on other unsecured consumer loans and 2.6% on C&I loans.
US financial crisis loan write-off rates
Source: author's calculations based on US Federal Reserve data
If this style of crash were replicated in Canada it's a pretty easy calculation to tot up the hypothetical losses for the banks.
I've done the numbers for CIBC below. I've just stressed the Canadian part of the loan book, assuming this is an idiosyncratic crash isolated largely to the domestic mortgage and consumer lending markets.
Source: author's calculations based on US Federal Reserve data, CIBC disclosures
The US experience would imply CIBC could see cumulative write-offs of $25bn, the largest element being ~$12bn of losses on the Canadian mortgage book and a further ~10bn on the Canadian unsecured consumer book.
The company has some buffers to absorb these losses. The current loan loss allowance sitting on the balance sheet is $1.9bn. It looks woefully inadequate for this type of scenario but at least it's something. In addition, CIBC has some surplus capital as it operates with a CET1 ratio of 11.4% against a regulatory requirement of only 9.5%. That's a further $4bn buffer.
However, even allowing for these items, this stress calculation suggests shareholders would still be on the hook for ~$15bn of post-tax losses.
Remarkably, this may already be priced-in
CIBC's market cap is currently $68bn so at first glance $15.5bn of stress losses doesn't look great, implying possible 25% downside if this scenario came to pass, even before factoring in that the shares would inevitably overshoot on the downside.
However, things aren't necessarily so bleak. There's a strong case for saying CIBC is undervalued against its current fundamentals, which is probably because the market is already factoring in a turn for the worse.
ROTE for 9m19 was 18%. Using a 9% cost of equity and 2% growth factor this would give fair value P/TNAV of 2.3x whereas the shares currently trade on 1.7x.
On current TNAV of $68 per share a 2.3x multiple would get to a share price target of $153 compared to the current trading price of $115.
In absolute dollar amounts, that's a fair value market cap of $68bn compared to a current market cap of only $52bn, implying there's a ~$17bn imbedded discount in the company's valuation, probably reflecting the sort of risks I've described in this article.
$17bn of imbedded discount against stress-scenario losses of $15.5bn sounds like the market is already there in terms of pricing CIBC for a 2008-style housing crash.
For long-term holders of CIBC this is a comforting conclusion. If they're happy to ride out a likely short-term overshoot they'll probably emerge on the other side at a valuation not far from today's.
For shorter-term investors though, the idea of $15bn of losses is likely to be stomach-churning, knowing the shares would plummet first and only stage a slow recovery over several years as the losses were crystallized and booked to equity.
In conclusion, therefore, CIBC may already in theory be priced for a Canada crash. But it's not a stock I'll be hurrying to buy.
Source: author's calculations based on US Federal Reserve data, CIBC disclosures
Disclosure: I am/we are long JPM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
The rest is here:
CIBC - The 15 Billion Dollar Question - Seeking Alpha
