Neuberger Berman’s Steve Eisman, the money manager made famous by the book ‘The Big Short‘, joins BNN Bloomberg Television to discuss why he’s short Canadian banks. (Source: Bloomberg)
Why Steve Eisman Is Shorting Canadian Banks
Q1 hedge fund letters, conference, scoops etc
Transcript
What exactly Steve are you calling for it to happen here in Canada to make your call betting against Canada's banks correct.
Well I want to start out by saying this is not The Big Short Canada. I don't think the housing market in Canada is going to collapse. I don't think Canada is going to fall into the ocean. But I'm simply calling for is a normalization of credit. What credit losses which Canada hasn't seen in over 20 years and I think the the banks in terms of their reserves and their balance sheets are woefully unprepared for that.
OK so let's start with the credit losses. Why would we start to see credit losses. What has to happen for that to happen.
Actually not much at all. I hope you'll bear with me because this is going to be a little technical but the way Canadian banks reserve every quarter is kind of interesting. They divide their loan books into three buckets they call them Stage 1 2 and 3. Stage 1 is the bulk of the loan book. That's the loan book that is current and say to early stage delinquencies and Stage 3 is late stage delinquencies. Last year they had a reserve against Stage 2 and 3 and they had negative loan loss provisions for Stage 1. And so if you added it all up in 2018 for all the Canadian banks the loan loss provisions in 2018 were almost all universally lower than 2017. And that lower long last provision represents 90 percent of the earnings growth for the Canadian banks. Now. Reserving for stage one is completely model driven. It depends on your view of the economy and the Canadian banks all adopted the position last year. For some reason I can't completely understand the Canadian economy is getting better now this year CIBC broke ranks. And said that their models are showing some deterioration and yet they still reserve negatively on Stage 1 and despite that their loan loss provision was up 120 percent year over year. So my view is that at some point this nonsense of negative reserving on Stage 1 is going to end and the loan loss provisions for all the Canadian banks are going to go up considerably. That's my thesis. How bad the credit cycle will be. We'll see.
So Steve you're saying though that the ball which is stage 1 accounts for a significant portion of the bank's profits. You're essentially saying that the profits are going to decline very clear state.
Stage one is is all the loans on the balance sheet which are current. And that's the obviously the bulk of the loans that you're required to provision for that group of loans depending upon it's a purely model driven. And the models are different by the bank. So for example if you think the Canadian economy is getting a lot better you could argue that you need to provision negatively. For. Stage 1 and the Canadian banks of doing that for at least for last year and the year before that and that negative loan loss provision on Stage 1 is what has contributed the most by far like 90 percent of the earnings growth of the Canadian bank is because of that negative provisioning. I think. At this point in the cycle I just went to a lunch about Canada where all the economists were all arguing whether or not Canada is going to have a soft landing or hard landing but it's going to be a landing of some kind of another. And therefore the Canadian banks should not be negative provisioning on stage one they should be positive provisioning on stage 1 and that's going to cause a very negative delta in terms of the earnings growth of these companies.
That's half the thesis. Okay that's half. We'll get to the other half. To what degree of a negative delta are you talking about.
So in other words if you take a look at all the large Canadian banks and take a look at the earnings growth that they all experience in 2018. By my calculations 90 percent of the earnings growth. In 2018 from the Canadian banks was due to the fact that their 2018 loan loss provision was lower than it was in 2017. That's just the math of it. So and the reason why it was lower is because they have very large negative provisioning for Stage 1 right.
So you're saying that the banks are not accounting correctly for the potential for loan losses where where and why and when will we see these loan losses.
I mean we'll see. I mean we'll see if there's going to be housing deterioration this year there's already been some signs of weakness of the Canadian economy that's why the central bank is people are thinking maybe they're going to lower rates I mean we'll see how it emerges. I just think even at this point in the cycle the Canadian banks and not a provisioning appropriately for their future loss.
You see that the Canadian banks aren't prepared. How ill prepared are they.
