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Published: August 12, 2009
Everyone thinks they’re
safe from the current financial crisis.
No one thinks they’re doomed.
I’m talking about the Canadians, of course.
See, lately, I’ve read a lot about the superiority of the
Canadian banking system. And naturally, my contrarian instincts
prompted a search for a way for you to make money as the
Canadian banks go down.
As you may know, an easy way to play the downside of stocks is
through put options. Here’s a quick primer on how they work...
Put options are a limited risk, leveraged way for you to make
money when stocks drop.
For example — when a stock falls 5% in a day, put options may go
up 50%. When big drops happen, puts can go up hundreds of
percent in hours.
And since they’re limited risk, if you’re wrong, you’ll never
lose more than you put up.
My point is — there’s no easier, safer, and faster way to grab
huge gains from downward stocks than through put options.
Having said that, let’s take a look in on how you can use them
to make money on the Canadian banks. First, the “macro view...”
The Canadian banking system has won accolades for avoiding
direct exposure to the most tempting forbidden fruit: products
like subprime mortgages, credit cards, leveraged buyout loans,
and loans to finance insane commercial real estate purchases.
The financial press loves Canadian banks. On May 19, The Wall
Street Journal ran a piece suggesting that these banks are a
model of sustainability, and now have the opportunity to acquire
U.S. banks on the cheap:
“Not long ago, Canadian banks were considered slow footed,
provincial, and too conservative to flourish in the global boom
for financial institutions. Now that banks in the U.S. and
Europe are reeling from loan losses and face growing government
scrutiny and ownership, Canada’s six major banks are seen as a
potential model for battered financial institutions. TD Bank,
Royal Bank of Canada, Bank of Nova Scotia, Bank of Montreal,
Canadian Imperial Bank of Commerce, and National Bank of Canada
posted more than C$3 billion (US$2.5 billion) in combined profit
in the latest quarter.” [Ed. note: quarter ending April 30,
2009.]
Canada’s biggest six banks account for more than 85% of the
assets in the country’s banking system. By and large, these
banks made a smart decision to avoid securitization.
Securitization refers to loans that banks originate, bundle
together, and sell off to pension funds, money market funds,
insurance companies, and other institutions.
But this doesn’t mean that Canadian banks have no credit risk.
On the contrary, they have plenty. Mark to market accounting has
not yet cut down Canadian bank earnings, because the Canadians
have not yet accounted for the impending wave of mortgage,
consumer loan, and corporate loan losses.
They will by the end of 2009. It’s impossible to avoid. And just
to give a perspective on how quickly lending grew at the
Canadian banks, the chart below shows that assets at the top six
Canadian banks grew from C$1.3 trillion in October 1999 to C$2.7
trillion in October 2008. Equity at these top six banks grew in
line with assets; all six kept their ratios of assets to common
equity fairly constant since 1999.
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Growth in assets, even
if accompanied by growth in equity, is always a risky
proposition for banks. At the time the loans are made,
everything seems fine. Then, when a serious recession arrives,
and a dramatic credit loss cycle begins, the market value of
loan portfolios can rapidly decline by 5% or 10%, pushing the
banking system to the edge of insolvency. Insolvency is when the
value of assets is less than the value of liabilities. Bank
regulators don’t like this scenario and pressure weaker banks to
raise very expensive, dilutive equity capital in order to
protect more senior lenders, including depositors, from
suffering losses.
Canada has just entered what will ultimately be an enormous
credit loss cycle, and by the time it’s over, the Canadian banks
could easily lose their pristine reputations. Until the middle
of 2008, Canada’s economy was booming. Its mining, energy, and
manufacturing sectors are world-class, and every other sector
was pulled along for the ride.
But the wheels fell off last fall. According to Statistics
Canada, the unemployment rate rose to 8.4% in May — the highest
in 11 years. Ontario, with its heavy manufacturing base and ties
to the “Detroit Three” auto companies, is especially hard hit;
Ontario lost 234,000 jobs, or 14% of its entire manufacturing
work force, since last October. Ontario will lose even more jobs
this summer as GM and Chrysler dramatically cut auto production.
Alberta has slowed dramatically too. Just a year ago in Alberta,
every skilled construction worker was working overtime on oil
sands projects. Now many projects are postponed and workers are
getting laid off. The unemployment rate in Alberta nearly
doubled from May 2008 to May 2009, to 6.6%, and is heading
higher.
For Canada, this credit cycle will probably be worse than the
one in the late 1980s. According to RBC Capital Markets,
annualized loan loss provisions for the entire Canadian banking
system peaked at 2.88% of all loans in 1988. As of April 2009,
this figure was just 0.77%. Over the next year or two, loan loss
provisions should easily triple or quadruple, which would cut
deeply into profits and capital... sending the worst of the
Canadian bank stocks down.
So how do you play it?
First, I recommend you dig in to the major banks to figure out
the one with the most exposure to unemployment rates. Then,
simply visit Yahoo! Finance, enter in their symbol and click on
“options” on the top left hand side underneath “Quotes.”
You’ll see all of the put options available on that stock. Pick
a good one and you’ll be able to double your money as these
stocks go down.
Regards,
--Dan Amoss
Editor
Strategic Short Report
Editor's Note: This
article originally appeared in
Penny Sleuth. |
