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Bank earnings expected to hit bottom in Q3 on commercial real estate loan losses

TORONTO - Canadian bank earnings, due out this week, are expected to hit bottom this quarter amid significant loan losses due in large part to the declining value of commercial real estate.

TORONTO - Canadian bank earnings, due out this week, are expected to hit bottom this quarter amid significant loan losses due in large part to the declining value of commercial real estate.

Canada's well-capitalized banks have fared much better than their counterparts south of the border throughout the recession, but are still taking hits as the downturn begins to slow.

One of the major factors expected to push banks' earnings lower for the quarter quarter ended July 31 is mortgages on commercial real estate.

Unlike residential real estate in Canada, which has rebounded sharply in recent months - residential resale activity jumped 18.2 per cent in July from a year earlier - commercial real estate, mainly the office building sector, is still struggling.

Data from CB Richard Ellis indicates commercial real estate transactions fell by more than half in the first half of 2009 compared with last year, while the vacancy rate for office space across Canada rose to 8.3 per cent in the second quarter compared to 6.4 per cent a year earlier.

And the situation is even worse in the United States.

As a result, the value of commercial real estate hasn't bounced back like home prices have and in many places it is still on the decline. This means banks that lent money to commercial office holders may end up losing money, particularly if the value of the property falls below the value of the mortgage.

Analysts from both Scotia Capital and National Bank Financial predicted that loan losses will hit their peak in the third quarter.

"Commercial real estate losses arrive late in the (economic) cycle, which implies the bulk of the problems are ahead," commented National Bank analyst Robert Sedran, who said commercial real-estate loan losses are the "one last hurdle" standing in between the banks and better results.

Sedran said the commercial real estate market is more stable in Canada than in the U.S. Therefore, banks like Royal Bank (TSX:RY), Bank of Montreal (TSX:BMO) and particularly Toronto-Dominion (TSX:TD) with exposure to American commercial real estate are more at risk.

Dundee Capital Markets analyst John Aiken said provision for credit losses "remains the greatest threat to our earnings forecasts this quarter."

He also cautioned that the banks have become more reliant on revenue from their corporate clients, which is of lower quality and more volatile than revenue from the more stable consumer banking segment.

Scotia Capital analyst Kevin Choquette said he expects loan-loss provisions in the third quarter to increase to $2.6 billion or 0.83 per cent of loans compared to $1.4 billion or 47 per cent of loans a year earlier.

"We believe that the bank group is nearing peak sequential loan loss levels," Choquette wrote.

He added that low interest rates are also hurting banks' earnings.

"The absolute low level of interest rates continues to be a major concern in terms of bank profitability," he said.

Forecasts compiled by Thomson Reuters predict BMO, which will report Tuesday, will see earnings per share of 95 cents, down 14 per cent from a year earlier.

Canadian Imperial Bank of Commerce (TSX:CM), reporting Wednesday, is expected to report EPS of $1.39, down 16 per cent.

Meanwhile, analysts expect TD, Royal and Bank of Nova Scotia (TSX:BNS), all reporting Thursday, to report EPS of $1.23, down 14 per cent; 91 cents, down 20 per cent; and 84 cents, down 16 per cent, respectively.

However, analysts don't expect the weak earnings will have much impact on the banks' share prices.

"The sustainability of bank dividends, scarcity of reliable yield, and the resumption of superior dividend growth are expected to be the catalysts for significantly higher bank share prices," Choquette wrote, adding that he believes dividend increases are "on the horizon."

Meanwhile, Aiken said he expects stocks to stay relatively flat as investors react to the latest round of earnings.

"While we do not believe that there will be much in the third quarter earnings to deflate the banks' current valuations, it is equally as unlikely that there will be anything to propel them forward," Aiken commented.

 
 
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