Petrocapita Update October 22, 2012

Petrocapita Update

THE GREAT CANADIAN BANK BAIL-OUT

The Canadian banking system is sound, we didnt have to bail-out our banks - right? Certainly thats what we are continually told: ...we have not had to put any taxpayers money into our financial system in Canada, nor do I anticipate that well be obliged to do so. Jim Flaherty, Minister of Finance Without wanting to appear arrogant or vain, which would be quite un-Canadian...while our system is not perfect, it has worked during this difficult time, I dont want the government to be in the banking business in Canada. Jim Flaherty, Minister of Finance Then again we were also assured: We will not run a deficit. Jim Flaherty, Minister of Finance (Oct. 2008). So political remonstrances notwithstanding, is any of this true? Doubts did begin to surface early in 2012 but interest in the issue quickly died out. The stability of the banking sector is a critical question. It is worth more than the cursory coverage it has received to date so lets spend a bit of time on it today. Did we bail-out the Canadian banking system following the 2008 financial crisis and more importantly might we have to bail it out in the future? To set the stage here is some quick background on the Canadian banks then we can move on to the no bail-out here premise.

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Canadian Banking Sector 101 - Concentrated, Large & Levered: Networks with highly concentrated nodes are not robust - the presence of single points of failure can have huge consequences. The Canadian banking sector resembles such a network in that it is dominated by just five banks. These banks are colloquially referred to as the Big Five. Given their size and market presence I am sure the names will be familiar to you: (APPROX C$ BILLIONS DEC 2011) Bank of Montreal Bank of Nova Scotia CIBC Royal Bank of Canada ASSETS $500 $575 $360 $750

BANK ASSETS AS A PERCENTAGE OF GDP Ireland UK France Spain Australia Canada Italy Greece U.S. 872 389 338 251 205 157 151 141 82

It is no secret that banks use leverage to generate returns. Additional leverage creates additional risk but with the hope of sufficiently offsetting profit. The Toronto-Dominion Bank $690 trick is to use enough leverage to generate an attractive rate of return, but one which does not Not only does this small group dominate the leave the bank susceptible to being rendered Canadian banking sector, the sector itself is very large insolvent by a high impact event (e.g. housing market in relation to domestic GDP. The larger the size of the collapse). That is the theory. Sadly, given the explicit banking sector, the greater the risk to the domestic government support for too-big-to-fail financial economy or more accurately the wallets of the institutions which removes the consequences of such taxpayers in the event that a bailout is required. Of insolvencies, in practice large banks will tend to carry course, beyond a certain size banks are simply too excessive leverage and mis-priced risk at all times. large to be bailed out with domestic capital or to put it in more colourful terms - domestic banks run out An accepted measure for bank leverage is the of domestic taxpayer subsidies and then usually the Tangible Common Equity ratio - the ratio used game is up - see Greece, Italy and Spain in the list to determine how much losses a bank can take below. before shareholder equity is wiped out. The Tangible

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Common Equity (TCE) ratio is calculated by taking the value of the companys total equity and subtracting intangible assets, goodwill and preferred stock equity and then dividing by the value of the companys tangible assets. Tangible assets is the companys total assets less goodwill and intangibles. A rough estimate is that the Big Five TCE ratio hovers around 3-4%. It goes almost without saying that Canadian banking executives reject the TCE test as a measure of their leverage and risk for precisely the reason that TCE tends to show that they are overleveraged and risky. In order to ensure a reliable supply of bail-out funds it is critical that banks are able to argue with a straight face that the event that bankrupts them was entirely unforeseeable - at least to them. So despite what Canadian banks say I would argue the Canadian banking system has all the raw material that has made for crises elsewhere - concentration, large size in relation to domestic GDP, high leverage and mispriced residential real estate risk.

No Bail-out in 2008-2010? The CCPAs study,The Big Banks Big Secret: Estimating Government Support for Canadian Banks During the Financial Crisis, convincingly refutes the belief that Canadian banks did not need or receive a bailout during the crisis. Directly from the report: Canadas banks received $114 billion in cash and loan support between September 2008 and August 2010... They were double-dipping in not only two but three separate support programs, one of them American....At its peak in March 2009, support for Canadian banks reached $114 billion. To put that into perspective, that would have made up 7% of the Canadian economy in 2009 and was worth $3,400 for every man, woman and child in Canada. Perhaps they did not need the money and just took it because it was offered? That does not appear to be the case. The CCPA study estimates that three of Canadas banks - CIBC, BMO, and Scotiabank - received bailouts that exceeded their market value at the time which does tend to support the conclusion that they were under extreme financial stress.

ESTIMATED EXTRAORDINARY SUPPORT SUMMARY Bank CIBC2 BMO

3

Peak Support Date Peak Support Value ($bil) March 09 January 09 January 09 September 09 March 09 $21 $17 $25 $26 $25

Peak Support to Co. Value (Date of Peak) 148% (March 2009) 118% (Feb 2009) 100% (Feb 2009) 69% (Feb 2009) 63% (Feb 2009)

Scotiabank4 TD Bank
5

Royal Bank6 Source: CCPA

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Mortgages were the usual suspect at the centre of the 2008 Canadian banking bail-out and so mortgages provided the conduit for government assistance. The default risk on approximately 50% of Canadian mortgages is in practice back-stopped by the Canadian government via the Canadian Mortgage and Housing Corporation. Banks do pay to insure their mortgages with the CMHC but at what could be

argued are far below market rates given global real estate volatility and the escalation of pricing risks in the Canadian market. Of course when the Big Five got into trouble the taxpayer CHMC, the Bank of Canada and surprisingly even the US Federal Reserve stepped into breach:

TOTAL SUPPORT TO CANADIAN BANKS 120 100 80 $ Billions 60 40 20 0

Bank of Canada U.S. Federal Reserve CMHC

Aug 2008

Oct 2008

Dec 2008

Feb 2009

Apr 2009

Jun 2009

Aug 2009

Oct 2009

Dec 2009

Feb 2010

Apr 2010

Jun 2010

Source: CCPA

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Clearly, no matter how much the Big Five would like us to believe otherwise, they experienced a severe liquidity crisis in 2008-2010 hence the need to sell performing but illiquid CMHC guaranteed mortgages. To fill this liquidity gap they received emergency funding on the order of size on a per capita basis of that received by the US banks. It is worth elaborating on this as it points the way to some serious concerns in the future. Canadian banks needed a bailout that amounted to approximately 7% of GDP when the large part of their asset base - Canadian mortgages - was not in any apparent distress. What would happen to Canadian banks if the Canadian residential real estate market were to experience a US style correction and instead of a liquidity crisis the Big Five actually had a solvency crisis? For this thought experiment we have to assume a sharp fall in Canadian residential real-estate prices - based on current prices versus long-term historical averages, rents and income all being at highs that does not seem entirely implausible.

HOUSE PRICES VERSUS RENTAL COSTS

30 25 20 15 10 0.5 0.0 -0.5 -1.0 -1.5 -2.0 80 83 86 89 92 95 98 01 04 07 10

HOUSE PRICES VERSUS HISTORICAL AVERAGES

160 140

HOUSE PRICES VERSUS INCOME

5.0 4.5 4.0 3.5 3.0 2.5 2.0 1990 1995 2000 2005 2010

120 100 80 60 1995 2000 2005 2010 Vancouver Canada USA (Case-Shiller)

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According to research by Demograhia: Historically, the Median Multiple has been remarkably similar in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States, with median house prices having generally been from 2.0 to 3.0 times median household incomes, with 3.0 being the outer bound of affordability. This affordability relationship continues in many housing markets of the United States and Canada. However, the Median Multiple has escalated sharply in the past decade in Australia, Ireland, New Zealand, and the United Kingdom and in some markets of Canada and the United States. Housing in Canada is moderately unaffordable with a Median Multiple of 4.6 in major metropolitan markets. Emphasis mine. In summary, here is the very approximate state of the Canadian banking sector and its core holding, Canadian residential real estate (RE) mortgages:

Highly concentrated with the Big Five dominating the sector Total assets held by the Big Five are much larger than the size of the Canadian economy Big Five are using high leverage based on a conservative measure such as the Tangible Common Equity ratio Residential RE prices have an average Median Multiple of 4.6 in major markets versus the historic average of 2.0 to 3.0 C$1.3 trillion in residential RE mortgages, 50% held by the CMHC, 50% by Canadian banks Residential RE mortgages represent approximately 40% of bank assets Ill leave the final conclusion to you about whether Canadian banks are as robust as they are made out to be, but I believe that given the structure of the Canadian banking sector and the level of residential RE prices there is a higher chance of a crisis and a future bail-out than is commonly perceived.

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