August 24, 2009 / 11:36 AM / 8 years ago

RPT-BAY STREET-Recession may start wearing on Canada's banks

(Repeats Sunday’s column)

* Major banks report results starting Tuesday

* Profits seen lower as bad loans bite

* Bank shares look pricey after run-up

By Andrea Hopkins

TORONTO, Aug 24 (Reuters) - When Canadian banks trot out yet another set of healthy profits and fat dividends this week, it might be tempting to think of the industry as forever immune to the ravages of recession.

But headline figures are often deceptive, analysts say. Just below the surface, the banks are likely to start showing some wear and tear, even as they cling to their well-earned reputation as the strongest survivors of the global financial meltdown. Loan losses are looming, analysts say, and as consequence, banking shares look heady.

Virtually no one sees Canada’s banks rattling investors with big losses when they start reporting third-quarter earnings on Tuesday. Profits are likely to come in between 10 percent and 16 percent lower, a result that investors will take in stride, given a still-sluggish economic climate.

In addition, the well-capitalized banks won’t follow the lead of Manulife Financial Corp (MFC.TO) by cutting their sacrosanct quarterly dividends. The big Canadian insurer chopped its payout earlier this month to preserve capital.

That said, serious credit clouds are gathering on the horizon and concerns about the sustainability of bank trading revenues are growing, analysts say. Many of them are beginning to wonder if the 46 percent run-up in bank shares since the start of the year is a little overdone.

“The lower-quality revenues are still going to be there and are going to be able to prop up earnings,” Dundee Securities analyst John Aiken said. “But we expect a selloff in the fall or winter, once we see tangible signs of deterioration in credit quality for businesses.”

This week, reports are coming from the five largest banks, all based in Toronto: Royal Bank of Canada (RY.TO), Toronto-Dominion Bank (TD.TO), Bank of Nova Scotia (BNS.TO), Bank of Montreal (BMO.TO) and Canadian Imperial Bank of Commerce (CM.TO). Smaller, Quebec-based National Bank of Canada (NA.TO) is also scheduled to post results this week.

BAD LOANS RISING

Not everyone is as gloomy as Aiken. The banks’ track record through the past year encourages optimism.

Canada’s banks have already taken some glancing blows from bad loans and slumping businesses, especially in the United States. where RBC, TD and Bank of Montreal generate a lot of business. But the damage has been minimal.

As a whole, the sector has emerged from the financial crisis relatively unscathed, having accepted no government bailouts and remaining mostly profitable.

The toll may start to mount, however, with consumer and businesses bankruptcies surging and unemployment rising, prompting banks to set aside more money to cover bad loans in the third quarter and beyond.

Analysts expect provisions for credit losses to double to about C$1.4 billion ($1.3 billion) from a year earlier. That will in part offset the benefits of higher trading revenues and securities gains the big lenders saw in the quarter.

The slimmer profits have several observers questioning the lofty share prices of the banks, which are up 92 percent since Feb. 23, according to UBS analyst Peter Rozenberg.

On a forward share-price-to-earnings basis, the group is trading at an average multiple of 12 or 13, near levels seen before the credit crisis and above historical averages.

“A strong third-quarter earnings showing may be required to limit profit-taking,” Blackmont Capital analysts wrote.

But Edward Jones analyst Craig Fehr said while the run-up may be losing steam on a very short-term view, several Canadian banks still look good as a three- to five-year investment.

“I think there are some banks that are still attractively priced when you look at what their long-term earnings power is -- those banks for me are Royal, TD and Scotia,” Fehr said.

BRIGHT SPOTS

While loan loss provisions are expected to cut into earnings in the quarter ended July 31, there are some bright notes. Trading revenues are expected to rise sharply from a year earlier and interest income should boost earnings as the lenders benefit from the steeper yield curve that has allowed them to borrow money more cheaply than they lend it.

“I do think this is one of the big tailwinds for the banks in terms of profits,” Fehr said of net interest margins.

But the earnings might be messy again, as the banks take small to medium writedowns from financial guarantor exposures and mark-to-market losses on fixed income securities.

Canadian banks have taken some C$19.2 billion in pretax charges, mostly due to capital-market related writedowns, since the seize-up in the credit markets in late 2007, Macquarie analyst Sumit Malhotra said in a research note.

While it will likely be two years before the banks offer cleaner earnings reports, Aiken said he is not expecting any big surprises. Capital levels will continue to tick higher from already “excessive” levels and there is no chance of dividend cuts, two metrics envied by global peers.

But the troubles remain far from over.

“I‘m still nervous about the Canadian banks. Not because of the results but because of the quality of the results and what the outlook on credit is,” Aiken said.

$1=$1.08 Canadian Reporting by Andrea Hopkins; editing by Rob Wilson

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