Is it time to worry about our banks?

To say it was a bad day to be invested in banks would be an understatement. The collapse of Bear Stearns, America’s fifth largest investment bank, has sent bank stocks the world over into a tailspin as investors question who’s next.

A more pressing question to Canadian investors may be Are our banks safe?

After commodities, financial stocks make up the heaviest weighting on the S&P/TSX index and form the backbone of most Canadian investment portfolios. The collapse of Bear Stearns has investors worried about this asset class and rightly so, says Eric Sprott, president and CEO of Sprott Asset Management. Sprott says the amount of leverage being used by financial institutions is subjecting them to the possibility of a very sudden and quick collapse if they lose access to liquidity.

“The fact is that financial institutions are levered too much — whether it’s 20:1 or 25:1 — it’s always been my belief that it’s way too much. A 5% decline in your assets when you’re leveraged 20:1 wipes out your capital, and 5% is a pretty modest decline when we look at what various asset classes have done recently,” he says. “What the Bear Stearns situation tells you is what can happen when things de-lever rather quickly. It impinges on your capital so fast, you don’t have a chance to react properly.”

Sprott says investors can protect themselves from the bank downturn by looking at the assets of every financial institution they have invested in and trying to determine their vulnerability in comparison to their amount of leverage.

“It’s the leverage that creates the vulnerability,” he says.

But the transparency of the banks and their balance sheets can leave much to be desired. The frequency of problems being reported means that issues in the global financial system are widespread.

“Looks like what happened to Bear Stearns is happening in other companies,” Sprott says. “You can see that the anxiety quickly gets into the financial system and the way we value things. Almost without fail, every day that goes by, somebody warns us about a problem, which means the problem is pretty universal.”

This manifests itself in a liquidity problem, Sprott says. “There are no bids for most of the assets around these days, other than treasuries. There aren’t many bids in the fixed income market for anything. Even if you wanted to sell, you can’t sell.”

According to HSBC Securities market strategist Stewart Hall, confidence and anxiety are fuelling much of the current crisis. Fear deters investors from lending or buying, which creates liquidity problems for financials, further fuelling the crisis.

“In a fiat monetary system, confidence is the true gold standard upon which all else is measured,” Stewart wrote in his Monday market commentary. “Waning confidence manifests itself in concern for counter-party risk. Counter-party risk knocks on into the financial sector and its role as the disseminator of credit and liquidity.”

Stewart notes that newer accounting rules may also have ratcheted up anxiety in the markets.

“Illiquid financial assets are being written down in keeping with dealer indexes that may not be reflective of underlying asset quality or expectations with regard to the surety of the underlying principle,” he says. “[Federal Reserve] chairman Bernanke at his February 28th testimony suggested that accounting rules that were forcing companies to mark-to-market illiquid securities were perhaps exaggerating the state of affairs among U.S. financials. The difference between write-offs versus write-downs may be somewhat lost on the market, although of key import.”

To help quell the market hysteria over illiquid assets, the U.S. Federal Reserve took an unprecedented action late last week to create a lending facility for primary dealers that allows them to get access to liquidity for up to six months using “a broad range” of investment grade securities as collateral.

This has been interpreted as allowing primary investment dealers to use their illiquid investment grade mortgage-backed securities to secure a line of credit.

Sprott believes the creation of this facility is confirmation that the problems in the financial sector are much more widespread than originally thought.

“It’s just confirming that there are problems running rampant in the financial system,” he says. “To me it was the Fed’s way of saying we have problems in the system that you don’t know about yet, but trust us, we know they are there.”

Apart from problems in the asset-backed commercial paper (ABCP) market, Canada’s big banks have proven relatively resilient to the credit crisis, at least in comparison to their U.S. and European counterparts.

Diane Chant, a partner with PricewaterhouseCoopers and leader of its financial services group, says Canadian banks face challenges, but their focus on wealth creation through retail banking, as opposed to the wholesale finance, which banks like Bear Stearns relied on, allows them to weather the storm.

A PwC study on Canada’s banking industry released last Thursday noted that the country’s banks were not able to meet their record 50% growth in revenue from 2006, but they were still able to eke out 2.2% growth for the 2007 fiscal year — a lot better than the losses experienced by many of their global counterparts.

“When you look at banks like Northern Rock and Bear Stearns, their initial challenges come from holding securities that are challenged,” she says. “There is also the secondary issue of confidence in the marketplace and the type of funding [they rely on]. Bear Stearns had wholesale funding largely. The institutions that were vulnerable in particular were those that relied on wholesale funds.”

Chant says relying on retail deposits is a much more stable source of funding and an area of growth in Canada, as more affluent immigrants move to Canada.

“[The retail market] has been a very attractive market for the last couple of years. It’s certainly a very stable source of funding and quite attractive for its revenues,” she says. “Our Canadian market is very different from the U.S. and European marketplaces. We’ve got a very positive economy and a fair bit of wealth generation and stability. Right now the Canadian market is very attractive.”

Sprott is not convinced things are even remotely stable in the domestic financial sector, and he says his company is going to continue following its investment discipline of investing in precious metals and energy.

“The deposit is a liability of a financial institution,” he says. “Just imagine you were a customer of Bear Stearns. Would you much rather have your money in Bear Stearns or gold on Monday or Friday? You have to think about that for a while. These are real people with real deposits, and maybe they wouldn’t have been bailed out by the Fed. What would have happened?”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(03/17/08)

Mark Noble