CM - Canadian Imperial Bank of Commerce: Better But Still Bad

2023-08-09 16:10:01 ET

Summary

• Canadian banks' growth is tied to residential real estate, which is increasingly unaffordable and may impact mortgage loan growth.
• Population growth in Canada has been anemic for decades, so making the argument that immigrants will suddenly solve the population crisis is very naïve.
• The Office of the Superintendent of Financial Institutions has clarified that extended amortizations offered by banks do not actually extend beyond the original contractual period.

Canada can be a myopic place. There, I wrote it. In some ways, this is understandable. If your next door neighbour was very loud, very friendly, blasted movies and music at you 24/7, and occasionally fired off a few hundred bazooka rounds in their big backyard with the neighbourhood biker gang, you’d be forgiven for not noticing the award winning rose garden down the street. It makes sense to me on some level, but it’s true. When Canadians think about the state of their world, they juxtapose it with what’s going on South of their border, and decide whether it’s “good” or “bad” based on the comparison to ‘Murica. So, when you talk to Canadians about Canadian banks, they’ll inevitably bring up “them Americans, eh.” When you tell them you don’t care about the Americans at the moment because we’re talking about Canadian institutions, they’ll look blankly at you, pause for a full minute, and say “yeah, but, more stable than the Americans.” Because you don’t want to offend, but feel the need to express yourself, you mumble “amaideach”, and wander off.

With all that out of the way, it’s time to venture down the rabbit hole of writing about yet another beloved Canadian bank. This time, I’m going to review the Canadian Imperial Bank of Commerce ( CM ), known from this time forward in my article as “CIBC.” I’m also going to try to address some of the responses to my Royal Bank article in this one. I’m going to start my discussion of this bank with a few more points about residential real estate in Canada. I’ll also include portions of an email exchange I had with a member of the Office of the Superintendent of Financial Institutions (OSFI), Canada’s banking regulator.

I know that my writing can be, uh, “a bit much”, and for that reason I post a thesis statement paragraph very near the beginning of each of my articles. This gives investors the chance to review my thinking and then get out before they’re exposed to too many bad jokes, and too much proper spelling. I think it behooves investors to seek the best risk adjusted returns, and I think the risk here is too great. The financial snapshot is not particularly inspiring in my view, and the exposure to Canadian residential real estate is troubling in my view. The mortgage book has grown dramatically over the past few years, so this problem has gotten worse not better. Additionally, those who think the regulators are going to “cut the banks some slack” in the parlance of our times, are in for a rude shock. Before getting into CIBC specific financials, though, I continue to dismantle the bullish case for Canadian residential real estate that I started when I wrote about Royal Bank of Canada yesterday.

Canadian Residential Real Estate is in a Precarious State

In this first section I want to make a few more arguments for why I think residential real estate in Canada is a ridiculous investment. For more, please review my article on Royal Bank. In my view, the fortunes of Canadian banks are inexorably tied to residential real estate for two reasons. First, and most directly, much of the growth the “big five” have enjoyed over the past several years has come from mortgages, and I think this growth will inevitably slow. Second, Canadian banks, particularly Royal and CIBC, “go as the Canadian economy goes.” The Canadian economy goes as Canadian residential real estate goes, and thus, a drop in residential real estate prices will have a knock on negative wealth effect for Canadians, which will harm loan growth. This will harm bank profits, obviously.

Population Growth, or “Everybody’s Competing Over Immigrants”

The people who are aware of the coming population crisis in the developed world will tell you that the problem will be solved with immigration.

This isn’t just a Canadian phenomenon, because I’ve heard the same solutions offered by Europeans, and Australians. When the subject of the demographic timebomb comes up in conversation, nearly every person I’ve talked to says some variation of “immigrants will solve the problem.” Well, that’s great in theory, and I’ll admit that Canada has been very welcoming to immigrants since about 1970, but immigrants are increasingly being wooed by a number of places that aren’t unbelievably cold.

Even with a welcoming immigration culture, though, population growth has been anemic for decades. For instance, in 1970, the population of the country was about 21.4 million people. Today, the population is about 39 million people, so it’s grown at a CAGR of about 1.12% over the past 53 years. This is because people also emigrate, and they also die. Further, the United Nations is projecting that Canadian population growth rate will actually slow to a CAGR of about 0.58% over the next 30 years .

Add to that the fact that prices are rising dramatically, and the “immigrants to the rescue” thesis seems even more absurd in my view. To sum up so far, in order to be bullish on residential real estate in Canada, you need to believe that the country will buck a 53 year trend and will start to grow more rapidly, in spite of what the United Nations is suggesting. Additionally, immigrants are going to want to flock to the place, in spite of the fact that Canada has some of the most expensive housing stock on Earth. What would be the marketing pitch to immigrants? “Come for the sometimes deadly cold, stay for the unaffordability of our housing!!”

Repeat After Me: Prices Can Fall in Spite of a Housing Supply Shortage

It’s time to write about supply. I would strongly agree with the notion that there’s a housing supply shortage in Canada. In my view, people misinterpret this, though. They take from this shortage of supply that prices will remain elevated. In my view, this justification of current house prices ignores a key element of the supply-demand relationship: demand. Demand for housing may be very inelastic, but the population is, as the kids say, “tapped out”, so they cannot afford continuously elevated prices, and thus price has nowhere to go but down. This is exactly what happened to Canadian residential real estate in the months after the above article from the Canadian Mortgage and Housing Corporation ( CMHC) was published. Prices have fallen in spite of the housing supply shortage mentioned by CMHC.

I admit that I forget the class at which I learned this, but I remember being tied to the oar of the MBA slave ship and hearing something about “supply and demand are not constants.” Translated, this means that sometimes supply is the pre-eminent determinant of price, and sometimes demand. I think falling prices in the teeth of a housing shortage convinces me that demand is key here.

I think the stress test, elevated interest rates, sclerotic population growth, the fact that Canadians, especially younger households, are some of the most indebted people on Earth. Younger households are particularly important to real estate demand for pretty obvious reasons. In my view, all of this conspires to make residential real estate a risky bet in Canada, shortage or no shortage.

Because a larger proportion of my audience for this article is likely Canadian, and I’ve just uttered some blasphemies, I’ll make the point by analogy. Let’s pretend that the year’s 1636 and a smaller and smaller percentage of the Dutch population can afford those beautiful Semper Augustus tulips that everyone’s always going on about. At some point, the price will have to fall, no matter how beautiful the resulting flowers.

That quick little analogy to tulipmania reminds me of a chart I included in yesterday’s article about Royal Bank. It’s relevant here, too, so, once again, feast your eyes on the relationship between income and house prices. Pay particular attention to that little spike of American house prices above affordability in 2008. Doesn’t it look kind of quaint when compared to the Canadian “leviathan bubble?”

So, if you’re buying CIBC based on the assumption that the past growth in the mortgage book will be repeated, I would suggest that you reconsider that notion. In my view, residential real estate is increasingly unaffordable in Canada, and this will impact mortgage loan growth. It may also impact the bank in unprecedented ways. The “ways” are unprecedented because we have no historical record of anything like this.

My Email Exchange with OSFI

I think when talking about Canadian banks, it would be a good idea to have an interaction with the one institution that they all seem to be terrified of: The Office of the Superintendent of Financial Institutions (OSFI), so I reached out to those good people via electronic mail, or “e-mail” as the young people call it.

A few real estate bulls I’ve talked to over the past while have suggested that people who took on huge mortgages to buy overpriced real estate will be fine, because the banks are just going to extend their amortization schedules to keep things nice and affordable. I reached out to OSFI to clarify this point. Below I’ve reproduced my question, and the response from the official.

Question: Does OSFI have a position on extended amortizations that Canadian banks are offering Canadian mortgage and HELOC holders? If so, what is that position?

Answer: The suggestion that VRMFP (Variable Rate Mortgage with Fixed Payment) allows extended amortizations is misleading. These amortization periods are not actually being extended beyond the original contractual amortization period.

The confusion stems from bank mortgage statements which project remaining amortization from the principal paid down in the most recent month. This may not accurately represent the remaining contractual amortization at renewal.

To be clear, the revised duration indicated on the statement is an illustrative indicator of the timeframe and should be treated by individuals as a reminder of the risk of not meeting the initial contractual obligations, and not as an invitation to prolong payments against mortgage balances. Borrowers should also understand that the remaining contractual amortization periods will come back into alignment when the mortgage is renewed – for most this is every 5 years. Indeed, at renewal, a borrower may have to increase monthly payments, make a lumpsum payment, or a combination of both, to return to the contractual amortization period to ensure that the total length of the mortgage remains the contractual amount . (Emphasis mine).

Ultimately, this may result in a sizable payment increase for VRMFP mortgagors when they renew. Banks and mortgagors may choose to lessen this increase by refinancing mortgages. Our ongoing conversations with financial institutions have highlighted the importance of being proactive in managing all types of mortgage accounts, and to act before levels of borrower stress become unmanageable.

While there are some limited forbearance conditions under which amortization periods can be extended, in most cases, the expectation is that at renewal, lenders will restore borrowers to their contractual amortization as articulated in OSFI’s Residential Mortgage Underwriting Policies. If contractual amortizations are not restored, this could lead to a greater persistence of outstanding balances, and greater risk of loss to lenders which are expected to be mitigated accordingly . (Emphasis mine).

So, we can dispense with the idea that people will be fine because they can simply extend.

Before we leave our discussion of OSFI, it seems that they’re imposing new capital requirements on lenders. To quote them directly:

For lenders, these changes will mean holding more capital that aligns with the increased risk of mortgages in negative amortization with a loan-to-value ratio (LTV) above 65% – that is, the outstanding balance is 65% or more of the value of the collateral. The proposed changes should encourage banks to lessen the number of mortgages that would otherwise go into negative amortization.

To beat the proverbial dead horse as is my wont, if the “Value” in “loan-to-value” declines as I think it will, this will impose greater capital requirements on the banks, which is not a wonderful development from their perspective.

Financial Snapshot

Returning to the discussion on CIBC, when reviewing the financial performance here over the past several years, a few elements pop off the virtual page at me. First, the most recent six months has been less profitable than the previous year, in spite of an uptick in revenue. Rising sales and falling profits is never a great sign in my view. Additionally, we can’t blame this on an unfortunate comparison period, given that net income over the past two quarters was about 17% lower than it was during the same period in 2019. I think a fair point could be made to suggest that the company hasn’t yet returned to pre-pandemic levels of profitability.

At the same time, the capital structure has deteriorated somewhat in my view, with total liabilities up from the previous year by about $33 million, or 3.9%.

Most worrying of all, from my point of view, is the fact that the mortgage book is today about 30% greater than it was in 2019, and now sits around $271.4 billion. For reference, shareholder equity currently sits at about $51.51 billion. Using the arithmetic skills not so lovingly beaten into me by the good sisters at Holy Spirit School many decades ago, I’ve managed to work out that equity represents about 19% of the current mortgage book.

All of this suggests to me that I’d need to be compensated for taking on the risks associated with this business. I’d be compensated for that with a higher than usual dividend yield, or a cheaper than usual stock.

The Stock

As my regulars know, I look for stocks that are trading at a discount to both their own history and the overall market. This is because I think cheap stocks represent that perfect combination of lower risk and higher return potential. They’re lower risk because much of the bad news has already been “baked in” to the price, so new bad news won’t drive things much lower. They offer great potential returns because any moderately good news drives the shares higher. Incidentally, this “keep expectations limited” has been the primary strategy I’ve used in my dating life, and it’s worked out pretty well, for me at least.

Anyway, I measure cheapness in a few ways, ranging from the simple to the more complex. On the simple side, I look at the ratio of price to some measure of economic value, like sales, earnings, free cash flow, and the like. I’d note that CIBC shares are cheaper than the overall market at the moment, but are hardly cheap when judged against their own history. This is troubling in my view, because the level of risk here has risen materially. The one thing the stock has going for it, though, is the fact that the shares are sporting a positive risk premium at the moment.

Source: YCharts

Source: YCharts

The question for most investors is whether this dividend yield is worth the risk here? Specifically, in the Great White North , you’re picking up an extra 124 basis points over the risk free rate, while in the land of the free and the home of the brave, you’re picking up only 72 basis points of extra yield over risk free government instruments. I like the fact that the dividend yield is at least positive, but I think the premia remains light, given the risks here. For that reason, I would recommend eschewing shares of CIBC and putting new capital to work in investments with a superior combination of risk and return.

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