TD Bank Stock: Exaggerated Real Estate Bubble Risks (NYSE: TD)

Recently, I’ve seen analysts write bearish articles on Canadian banks, including the Toronto-Dominion Bank (NYSE: TD), Due to “imploding real estate bubble” in Canada. While I share some of analysts’ concerns about the housing market and the growing interest rate, I think the fears may be overstated.

While the headline that captures debt to disposable income and house prices to disposable income tells a straightforward tale of a housing crash and bankruptcies for Canadian banks, astute investors should realize that most loans Residential mortgages on TD’s balance sheet have low LTV. I think investors should watch for second-order effects such as delinquencies on credit cards and business loans.

Overall, TD has already priced in some slowdown, trading at a discounted price of 10.6x P/E. However, I wouldn’t be comfortable buying the stock until we have more clarity on the severity of the coming economic downturn and its impact on the bank’s earnings.

TD Bank Background

TD Bank, for those unfamiliar, is the 2nd largest bank in Canada by market capitalization and assets, behind Royal Bank of Canada (RY). It is also the 5th largest bank in North America by market capitalization, having overtaken Citigroup (C) in recent years. This is an impressive result, given that ten years ago Canadian banks were relatively minnows compared to the big four US banks (Figure 1).

TD achieved these results by gradually building its US retail banking franchise through acquisitions and strategic partnerships (Figure 2).

Since the initial investment in BankNorth in 2004, TD has become one of the top 10 retail banks in the United States. With the impending acquisitions of First Horizon Bank (FHN) and Cowen Inc. (COWN), TD will further expand its US retail and wholesale franchises in the coming quarters (Figure 3).

Canada’s debt frenzy

There is no doubt that Canada is a heavily indebted country. Figure 4 shows the ratio of debt to disposable income between Canada and the United States. It shows that while the ratio has improved significantly in the US (from ~140% to 100% by 2018), the figure has continued to increase to over 170% for Canada.

More recently, charts like the one in Figure 5 have made the rounds on Twitter and other financial sites. Figure 5 shows that while US house prices have increased at roughly the same rate as incomes, Canadian house prices have increased exponentially relative to incomes.

COVID and BoC added fuel to the fire

The COVID-19 pandemic and work-from-home (“WFH”) policies added to the demand for single-family housing (everyone needed a home office), especially in the suburbs. C$1 million has become a starting point for single-detached homes, with many homes costing 2, 3 or 4 times as much during the big 2021 buying rush in early 2022.

The Bank of Canada (“BoC”) did not help matters. Instead of preaching caution and rationality, the Bank of Canada fanned the flames of the housing bubble by telling Canadians that “interest rates are very low and will stay that way for a long time.” What do you do when the central bank opens the taps? You borrow! Nationally, the average house price increased by 53% between April 2000 and April 2022.

Now comes the hangover

Fast forward to 2022, with runaway inflation, the Bank of Canada made a 180 degree turn and began to rapidly tighten monetary conditions. Overnight interest rates have been raised in quick succession to 2.5% (including an aggressive 100 basis point hike in July), with the BoC declaring its willingness to raise the overnight rate at above its long-term target of 3.0% to quell an “overheating economy”. High levels of household debt and high house prices were highlighted as key vulnerabilities in the Bank of Canada’s annual review of the financial system, released in June.

Although we are not here to debate policy and point fingers, it is clear that the BoC deserves much, if not all, of the blame for the difficult situation in which the Canadian economy finds itself.

The combination of statistics like Figure 5 and the Bank of Canada’s insistence on raising interest rates create a simple narrative: “The Canadian housing market is in an epic bubble and the banks must go bust as real estate prices crash”.

Prime housing risk for TD exaggerated

To bring the discussion back to TD, we don’t believe in the housing crash doomsday scenario, at least not in secured home loans.

Looking at TD Bank’s presentation disclosures for the second quarter of 2022, we find that residential mortgages and home equity lines of credit account for over 84% of Canadian personal bank loans (Figure 6). However, we also see that the loan-to-value ratio (“LTV”) of the residential loan portfolio is 48%. This means that house prices will have to fall by more than 50% on average before loans suffer a loss.

Additionally, in Figure 7, we see that less than 1% of the real estate portfolio is uninsured, with a credit score below 650 and an LTV above 75%.

Low LTV is a key point that needs to be underlined again. In Canada, to buy a house with a down payment of less than 20%, the owner must take out “mortgage loan insurance” which protects the lender in the event of default. Default insurance can be purchased from a quasi-governmental entity called Canada Mortgage and Housing Corporation (“CMHC”), Sagen (formerly Genworth Canada) or Canada Guarantee. In addition, properties with a value greater than C$1 million are not eligible for default insurance.

This means that unless house prices fall rapidly by 50% and homeowners default en masse, the worst effects of the bursting housing bubble are unlikely to be felt by major Canadian banks like TD.

Instead, the pain will be borne by mortgage insurers (for loans with LTV >80% and property price below C$1 million), by alternative lenders (who made loans on properties > C$1 million), or by homeowners (who have significant equity in their home).

Investors must monitor 2nd and 3rd order risks

Instead of worrying about first-order effects on residential mortgages, investors should pay more attention to second- and third-order effects such as unsecured credit card loans, auto loans, and mortgage loans. businesses, because housing is becoming a drag on the Canadian economy.

For example, for credit card performance, TD, like many Canadian banking peers, has timely asset securitization statistics that investors can monitor. As of April 30, the 31-90 day delinquency rate was 0.65% of total receivables or 0.23% of total accounts (Figure 8). This is broadly in line with the October 31, 2021 figure of 0.70% and 0.25% respectively.

The more current monthly report shows a 31-90 day default rate of 0.67% as of July 31, 2022, about the same as the April figure (Figure 9).

Valuations already reflect some economic slowdown

TD is currently trading at a PER of 10.6×2022, in line with the industry’s 10.4x, but at a discount to its US peers like Wells Fargo (WFC), Bank of America (BAC) and JPMorgan (JPM) (Figure 10).

However, this multiple is a discount to TD’s historic forward multiple, which has averaged 11.4x (Figure 11).

This implies that some level of economic downturn has already been baked into the title.

Conclusion

While the headline grabbing debt-to-disposable income and house price-to-disposable income ratios tells a straightforward tale of a real estate crash and bankruptcies for Canadian banks like TD, savvy investors should understand that most of the residential mortgages on TD’s balance sheet have low LTV, which means the banks’ mortgage losses are not expected to be significant. Instead, investors should watch for second-order effects of a housing downturn such as credit card delinquencies and business loan performance. Overall, some level of weakness has been priced in to TD’s share price, which is trading at 10.6 P/E. However, I wouldn’t be comfortable buying the stock until we have more clarity on the severity of the coming economic downturn and its impact on the bank’s earnings.