The Great White Short finally paid off.

For years, a small but determined group of investors has been betting that Canada’s biggest banks were destined to stumble under the weight of hundreds of billions of mortgages issued in bubbly housing markets such as Toronto and Vancouver. Investors can bet against a stock by short-selling them, which involves borrowing shares of a company, selling them, and then hoping those shares decline in value enough so that when they must be bought back and returned, the investor is earning a profit.

Bets against nine Canadian banks, including the Big Six, increased by US$1.57 billion in March, according to Ihor Dusaniwsky, head of predictive analytics at New York-based S3 Partners LLC, a financial-data analysis firm. As bank stocks fell (along with most others), the bets against them also became more profitable. Short-sellers were up almost $2.61 billion, or 26.32 per cent mark-to-market, from March 1 to Tuesday morning, Dusaniwsky and S3 found.

But Dusaniwsky observed something else with the stream of bets against the Canadian banks: investors cashing in. This month, as stock markets began to pull themselves out of their epic collapse, some short-sellers were taking profits by buying back the stocks they had borrowed and sold. S3 observed short-covering in all but two of the nine Canadian bank stocks it was watching this month (Toronto-Dominion Bank and Royal Bank of Canada being the exceptions), totalling US$137 million.

“The old adage, cut your losses but let your profits run, will begin to play out in this sector,” Dusaniwsky wrote in an email. “As stock prices rebound, short sellers will be buying stock side-by-side with long shareholders helping drive bank stock prices higher and higher.”

The latest “Great White Short” argument against Canada’s banks has included at least one of the main players in “The Big Short,” the Michael Lewis book about a few investors who hit it big by betting the U.S. housing market would collapse in 2007 and 2008. Neuberger Berman money manager Steve Eisman sparked a fresh round of skepticism about the soundness of Canada’s housing market last March, by calling out the lenders that underpin it in the pages of the Financial Times, one of the world’s most influential business publications.

Canadian banks are now facing a storm that will test their celebrated soundness

However, a number of factors have kept a Canadian housing disaster at bay, such as stricter regulation, low interest and unemployment rates, and strong population growth. The banks also enjoy the backing of the Canadian government via mortgage-default insurance.

While the loan losses of the banks did indeed begin to increase over 2019, their shares were still up for the year when it ended and the shorts were still waiting. Year-over-year shorting of the banks was down approximately US$650.4 million, according to S3, to nearly US$9.7 billion as of the morning of April 7.

Some countries have restricted short-selling during the coronavirus. Canada, however, has not.

In a joint statement on Thursday, the Canadian Securities Administrators and Investment Industry Regulatory Organization of Canada said short-selling activity continues to make up a low percentage of total market activity and that there is no evidence shorting has driven recent market declines. Still, the watchdogs said they would remain vigilant and that, if necessary, “we will consider limiting short selling on particular securities.”

Meanwhile, Canadian banks are now facing a storm that will test their celebrated soundness.

Canada’s big banks have agreed to defer mortgage payments for those customers under financial difficulty due to COVID-19.

Canada’s big banks have agreed to defer mortgage payments for those customers under financial difficulty due to COVID-19.

Cole Burston/Bloomberg files

Canada’s unemployment rate has already begun to skyrocket, as the coronavirus has prompted travel restrictions and the closure of non-essential businesses. The federal government has stepped in to support cash-strapped consumers and businesses, but it has also prodded the banks to cut customers some slack. Lenders responded by agreeing to defer mortgage payments and to shave interest rates on credit cards, among other things.

All of this likely will make it tough for bankers to turn a profit in 2020. On March 23, Fitch Ratings revised its outlook for the Canadian banking sector to negative from stable, citing “increased concerns over the spread of coronavirus and related impacts on banks’ asset quality and profitability,” which the rating agency said “may be materially outside” its previous expectations. The S&P/TSX Banks Index, which includes all bank stocks on Canada’s chief stock index, is also down about 20 per cent for the year, after rebounding from lows it hit last month.

Even so, most bank analysts are still of the opinion that the lenders will be able to stomach the current crisis. The leaders of Canada’s banks have assured shareholders they will be fine, promising that they will continue to pay dividends, unlike some of their European counterparts.

“The most important difference between Canada’s banks and those in other jurisdictions is the high structural profitability,” CIBC’s Ian de Verteuil and Shaz Merwat wrote on March 31. “This is always the first line of defence against economic stress and allows banks to buffer economic shocks.”

Bank towers in Toronto's financial district.

Bank towers in Toronto’s financial district.

Brent Lewin/Bloomberg files

But the coronavirus may also bring about something short-sellers had been eyeing for some time: consequences.

The current situation is like a Category Five hurricane being visible offshore, “and the Canadian banks are still partying on the beach,” wrote Bradley Safalow, founder and CEO of Atlanta, Ga.-based PAA Research, in a report released Wednesday.

The recession that will result from the coronavirus crisis could force the banks to update risk models and their assumptions around the probability of default, which could also force them to raise equity capital to shore up their balance sheets, wrote Safalow, who is short Canadian Imperial Bank of Commerce and Royal Bank of Canada.

“We do not think the stocks of the Big 6 Canadian banks in general, and (CIBC) and (RBC) in particular reflect the drastic decline in earnings power and sudden need for capital these institutions could face over the next 6-12 months,” he added.

Financial Post

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