Canadian Bank Derivatives

Triage Investing Blog reader David asks,

“Hey Brad. Great to see you posting again! I know you told me once you have some pretty extensive spreadsheets on all your stocks and the Canadian Banks especially. How does an investor, when going through the financial statements, determine the risk that derivatives still have to these financial companies?”

Great question David and not one that has a simple answer.

Proper stock analysis is very important if you intend to invest in individual equities. I strongly believe that as an investor you shouldn’t invest in any individual stock until you know how to properly assess that company (as an investment) and have read a recent collection of financial statements including the annual reports. You don’t need to have a business degree or be a chartered accountant (CA) in order to get a fairly good idea of what a company does, what risks is it exposed to and what is the fair market value of the company now and in the future.

Yes it takes time, but completing even a simple stock analysis process will help set you in the right direction.

Remember that anyone can be easily intimidated by financial statements or an annual report. Even I have experienced frustrations from time to time when I’ve researched a company within an industry for the first time that I know very little about. To make matters worse each company has a slightly different format in delivering the information in an annual report. Financial statements are pretty straight forward (balance sheet, income statement, cashflow analysis, etc) but comparing information can still be challenging.

My main spreadsheet for the big five Canadian Banks contains data on Royal Bank (RY), TD (TD), Bank of Montreal (BMO), CIBC (CM) & Bank of Nova Scotia (BNS) since 1988. Each year I input new data from their most recent financial statements so I have a running record of their performance. What this allows me to do is visualize the changes in their operations as well as gain perspective on what long-term expectations I can place on performance no matter the economic climate. I can also look at quarterly or mid-year performance to gauge relative risk or reward.

I’ve tracked derivative exposure on each of my three bank holdings (BNS, TD & RY) since 1998. Derivative exposure has changed dramatically over the past five years in all the Canadian banks which isn’t a surprise since 2008 was the year that everyone got caught with their pants down and derivatives became a household investing term.

The most significant problems with derivatives are that they can be almost anything and worth almost anything. Companies such as financial institutions attempt to determine a fair market value (FMV), but even then FMV is simply what they know or believe someone else is willing to pay for that instrument. Derivatives can be valuable as a hedge against market movements or worthless depending on the underlying asset(s) or purpose of the contract. Remember, the fact they can be made up of almost anything makes them very risky.

I’m not a fan of derivatives because as an investor I want transparency; I want to know as much as possible related to the risks a company is exposed to.

I’ve talked to lots of my peers, and investors, about how best to evaluate derivative exposure in financial companies. The most simple method I’ve determined so far that fits my investing approach is by evaluating the FMV of a company’s exposure to derivatives in the context of its shareholder’s equity. You can attempt to use capital ratios, liquid assets or other metrics but shareholders equity for me makes the most sense.

Remember that Shareholders Equity is a company’s total assets minus total liabilities; the amount a company is financed.

As mentioned above there are other ratios an investor can assess in relation to derivative exposure but as an investor in a company I’m really only concerned with how much of my capital is tied up in a potentially cloudy financial instrument.

When I assess the three Canadian banks I have common equity positions in (BNS, TD & RY) I get the following information related to their exposure to derivatives:

Derivatives as % of Shareholder’s Equity

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In 2011 both TD and BNS have a ratio fairly close at ~130%. I’ve noticed a dramatic drop in the ratio for TD since 2008 (263.8% in ‘08, 124.4% in ‘09 & 122.2% in ‘10), but a continuing high level in RY over the same period of time (418.4% in ’08, 249.8% in ’09 & 272.8% in ’10).

The ratio alone doesn’t mean that Royal Bank is a riskier investment, but simply that the risk of derivative exposure to RY vs. other Canadian banks is higher.

At the end of the process what I attempt to do is gauge a relative risk for each of the banks I hold and balance that information with other factors such as allowances for credit losses, deposit growth, loan growth and changes to main ratios such as P/B, P/E, ROE & Margins (Gross & Profit).

Each investor needs to develop a comfort level with assessing a company and understanding relative risk of exposure. There’s no right or wrong method of assessing a company, but understanding the potential impact to the bottom line or risk to credit markets may help an investor structure a portfolio appropriately.

Derivatives expose companies to greater risk. Not even the companies themselves likely understand the full extent of their exposure (positive or negative). As an investor you have to decide whether or not you want to invest in companies that have exposure. You have to decide if their operations could be impacted dramatically enough to affect their stock performance and if that can affect the health of your portfolio.

So Why Own Banks At All?

As a young investor I can’t justify not having exposure to financials, despite the risks, because of the length of my investing horizon. The risks are likely real and could be significant. But the reward may be that derivatives have little to no impact on the operations of their businesses over the long-term.

Each investor needs to make the decision of whether or not the companies they invest in are worth the amount of capital they place within them. My exposure to Canadian banks (directly) is less than 10% of my Dividend Growth Portfolio and that allocation was done purposefully. Although I may miss out on some upside gain, I’m limiting my downside risk. Even though I expect all three of the banks I hold to continue performing well and provide me with dividend income for years to come I’m not foolish enough to think that one of them, at any given moment, could not be crippled by their exposure they have on their balance sheet to a financial product few reasonably understand.