Steve Eisman, from the big short is back in the news. He has fully disclosed the banks that he’s shorting and explains exactly why he did so. In his view, he believes that overextended banks suffering is an absolute no-brainer, even without any particular 2008 Financial Crisis event happening. It’s simply inevitable.
The Big Short's Steve Eisman: Canada's bank CEOs 'extremely ill-prepared' for credit cycle - YouTube
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Steve Osmond made famous in the film of the big shore by betting billions against the US housing market prior to the 2008 financial crisis is now betting against Canada's banks Steve Eisman portfolio manager Neuberger Berman joins us now from New York Steve good to be with you thank you very much for your time to go through your call your thesis here what exactly Steve are you calling for 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's gonna fall into the ocean but I'm simply calling for is a normalization of credit 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 okay 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 gonna be this 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 one two and three stage one is the bulk of the loan book that's the loan book that is current and stage two is early stage delinquencies and stage three is late stage delinquencies last year they had they reserved against stage two and three and they had negative loan loss provisions for Stage one 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 loan loss provision represents 90% 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 you they still reserved 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 bulk 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 clear state stage 1 is is all the loans on the balance sheet which are current and that's the obviously the bulk of the loans now you're required to provision for that group of loans depending upon its it's a purely model-driven and the models are different by the banks 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 and that and that negative lone loss provision on stage 1 is what has contributed the most by far like 90% of the earnings growth of the Canadian bank is because of that negative provisioning I think at this point in the in the cycle I'm 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 bank should not be negative provisioning on stage 1 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 ok that's half we'll get to the other half what 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 experienced in 2018 by my calculations 90% of the earnings growth in 2018 from the Canadian banks was due to the fact that they're 2018 long lost 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 one right so you're saying that that the banks are not accounting correctly for the potential for for loan losses where we go where and why and when will we see these loan losses okay we'll see I mean we'll see if there's gonna be housing deterioration this year there's already been some you know there's signs of weakness of the Canadian economy that's why the central bank is people are thinking maybe they're gonna lower rates I mean we'll see how it emerges I just think even at this point in the cycle the Canadian banks are not a provisioning appropriately for their future losses you say that the Canadian banks aren't prepared how ill-prepared are they well let's get to the other half of the thesis so the Canadian banks when they report all report a capital ratio of around 11 to 12 percent I believe the minimum requirement is nine point seven five so on that basis they look well capitalized the problem is and there's again this is technical so I apologize to the viewers for this but the way you capital the way you calculate an eleven to twelve percent capital ratio is the numerator is capital the denominator is not assets it's risk weighted assets and that means every asset and the balance sheet is multiplied by its risk weight and most of the risk weights are created by the Canadian bank so for example Canadian banks assume almost no losses on their mortgage books and therefore they have risk weights of five to seven percent on their mortgage books which seems to me absurdly low my point is just that look Canadian banks are currently experiencing losses of 30 basis points if you get a normal credit cycle nothing catastrophic just a simple normal credit cycle those losses could easily go to a hundred basis points that's not a calamity it's just a normal credit cycle but what happens when losses go up is that risk weights go up and my calculation is that you could see capital ratios if losses go up to 100 basis points capital ratios could deteriorate by about 200 basis points so instead of being eleven to twelve percent capitalized they'd be nine and a half to ten and a half percent capitalized all of a sudden the Canadian banks would not be well capitalized anymore so that's the other half in other words there's a real multiplier effect yes as losses there too impacts as losses go up losses go up the provision has to go up so that hurts earnings but in my world the more important impact is the capital ratio banks go down when capital ratios deteriorate what kind of decline then would you expect to see given the capital ratios where you expect to see them what would that mean for the stock prices in terms of percentage declines I'm not gonna make that prediction that would go lower you know how much lower we'll see but every time I can tell you I could just tell you 20% plus that's about as much as I'll bet at this point okay but going back Steve you you're talking about low losses on on mortgages and and losses I'm talking about not just mortgages I'm talking about I'm trying I'm thinking a lot broader than that I'm talking about that the risk reward in owning the Canadian banks is very much one-sided on the wrong side because if they're in some ways their price for perfection they're among the most expensive banks on planet earth on a price of tangible book basis and they are not nearly as well capitalized as they appear because I think their risk weights are too low Steve some would say though that the Canadian banks particularly going through the financial crisis are some of the best managed banks that that the fundamentals actually warrant higher multiples on Canadian banks versus so many other banks around the world we do have the benefit or the bid perhaps of an immigration friendly country that helps of course the housing market we all seem to be living in a world of lower for longer interest rates as well why won't all of those factors help the Canadian banks help the Canadian market but also continue to have a little bit of a bid underneath the housing market and therefore the mortgage market well I mean Canada in that sense is like Australia similar oligopolistic oligopolistic banking models similar friendly regulators similar profitability dynamics similar risk in terms of housing and exposure to housing you know at this point Australia's housing market is down around eight to ten percent so excuse me my earbud came out if things go I mean if the global economy goes in a certain direction Canada will follow and I look I I like I said I'm just calling for a normalization of credit just that the way the Canadian banks have been provisioning is set up their capital ratios they're not they're very ill prepared even for just a normal credit cycle Steve it's interesting though when you short a Canadian bank there's the the cost to borrow there is the cost to carry paying the dividends hmm why not short something else somewhere else seems like it's an expensive trade tell us in Canada is a very nice country that people are extremely polite this is not personal but you know when some of the it's a Canadian executives say how could you short our banks it's a five percent dividend yield and like listen I'm not here for five percent a five percent dividend yield not that big a risk to me well that that's why I would think that you're upside by going betting against it's got to be more than twenty percent plus well maybe it is but I don't need to say that on television okay I do want to get a little bit more of your views though in terms of shorting when you took a look at the US market and some of the reasons to short thirty three to one leverage in the US banks we're where did the Canadian banks stand from a leverage perspective for you it's kind of complicated because half of their mortgage something like half of their mortgage books are guaranteed by the by the Canadian government so that really I don't think of that is risk so you need to take that out I mean they're not 11 33 to 1 I have I can't remember offhand how much they're levered it's probably at least 25 to 1 okay so when you do take a look at though and how the mortgage industry and the housing market is in Canada versus the United States the fact that we do have insured mortgages is that that doesn't seem to be a bit of an equation for you or factoring into the equation in terms of ever I'm not I'm not my my thesis has absolutely nothing to do with the insured mortgage books that sit on the Canadian bank balance sheets I mean the Canadian government will will back that up regardless of what the losses are like am i my focus in terms of the losses are the uninsured mortgage books the commercial loans etc etc what's your take on the commercial loans here in Canada then well I mean so far the credit seems okay you know if oil prices were to go down again that'd be issues I think the oil the mechana has written the commodity supercycle with Australia like professional surfers and they're to be congratulated for that but you know given the the growth in oil in the United States oil production Canada's oil is not needed nearly as much so the underlying strength of the Canadian economy I think is weaker the long-term growth prospects for the Canadian economy are not nearly as strong and you actually saw that when the Canadian banks all reported most recently their first quarter it was probably the worst quarter I've seen from Canadian banks in a very very long time and I'm not talking about credit I'm just talking about the lack of revenue growth there's no debt interest margin expansion anymore so I don't understand the bull case for owning the Canadian banks and that revenue growth under a best-case scenario I think is going to be extremely weak Steve what was the catalyst though for your call right now in the sense that you were short the Canadian banks or at least presented the idea at the iris own conference in 2013 in New York you were short for the summer of 2008 I understand her at least believe that you are increasing your short position what's the catalyst for your call when will when do you think this will happen is it a slow bleed or is there a catalyst so I think the catalyst well first one the when the canadian banks report second quarter numbers and i can't remember offhand when that is I think it'll be another punkish quarter from a revenue perspective to really get the story going you know last quarter CIBC I said again broke ranks it was the first Canadian bank to say that their models indicated a deterioration in the Canadian economy and yet still CIBC reported a negative lone loss provision for stage one so to really get the story going you need to have a Canadian bank come out and say there's some deterioration the Canadian economy and as a result we have a positive loan loss provision for stage 1 and that would crush arnux and that would crush crushes and crush it to again to what degree I mean if you look at the at at you know the models that that man will have the sensitivity analysis in front of me so I apologize but the Canadian banks would not be anywhere close to card to the estimates that are out there do you think that and you said that the Canadian banks the CEOs that there are an oligopoly do you think that they're too dismissive and Canadians perhaps are too dismissive in terms of the risks facing the Canadian banks or at least the Canadian bank earnings and therefore the stocks well I look I think Canada has not had a credit cycle in a few decades I don't think there's a Canadian bank CEO that knows what a credit cycle really looks like and so I just think psychologically they're extremely ill prepared and given how low the risk weights on their balance sheet are I think they're unprepared for how much their capital ratios could go down if there's just again I can't emphasize it enough just a simple normalization of credit not a calamity just a simple normalization of credit so see what does that look like what does it norm credit cycle look like well we I think if you accredits a normal credit cycle nothing calamitous would be going from the current 30 basis points of losses to a hundred believe me and you know compare that to what happened in the United States that's a walk in the park and what's the what's the reflexive impact on the economy not an economist I mean like I couldn't I couldn't tell you how you know how much snow the Canadian I don't think of it in those terms okay so just the the real focus on on the banks just focus on financial institutions so financial institutions are you looking at the mortgage insurance companies as well well does Genworth that that I I'm involved with and this home Capital Group and I'm involved with that as well and what are the Canadian banks are involved with well it's public so there's no point in hiding in that the three banks and I'm short in Canada and again it's not personal like I nothing against them a Royal Bank of Canada CIBC and Laurentian and Steve from a timing perspective again when do you think we're gonna start to really see this because you're gonna be depending on the banks to change their loss provisions well yeah that that's a problem that's problem but it's some but like I said you can't have negative loan loss provisions forever that's for sure when when they'll be forced to change I don't know but I'm pretty confident that this that this quarter big in report is not going to be a strong quarter by any stretch of the imagination okay I'm not talking credit I'm just talking revenue is gonna be again very weak Steve you know when you take a look at the banks and you take a look at the profit their growth etc we're so focused on on the mortgage well the loan side of the business what about the fact that so many these bank CEOs have been over the past couple of years diver sing during diversifying their business outside of the Canadian borders into different product areas into wealth management where does that factor into your modeling I mean look I have models and all the banks but you know still it's just just the way the math works if you if you change the loan loss provision on stage one from negative to positive the impact of that has just a much bigger impact on the income statement than anything else that's going on the Canadian banks period and the story and Steve then last question what got you interested in the Canadian banks and have you been here is there anything else that you're seeing as you do your analysis that that strikes you I like I like Canada I go there a couple of times a year I mean look I do for my whole career I've done I've examined one of the things that I've done is examined financial companies all over the world so I've done the US but I've also done a lot of research on Europe and I've done a lot of research in Canada for many many years ok it's not like I'm picking on Canada just to single them out no you just you just think that there's an opportunity for you that's correct ok like I said I just want emphasize enough this is not the Big Short Canada I'm not calling for some enormous massive of losses that Canadian banks are not going to have to be build up at the Canadian government there's none of that it's just a combination of going from a negative provision on stage one to a positive provision and the impact that that's going to have on risk weights which will hurt capital ratios ok at the end of the day the Canadian banks will still be standing
