Royal Bank of Canada (NYSE:RY)(TSE:RY) — Canada’s largest bank — is viewed by many Canadians as a rock-solid investment. After all, who could ask for more than a low valuation, growing business, and high returns on equity? But there are issues under the surface. Canadian banks have just a sliver of equity capital amid rising loan impairments in Canada. These issues don’t show up on Royal Bank’s financial statements; they are hidden in the footnotes. Consequently, I’m bearish on Royal Bank of Canada stock.
Don't Miss our Black Friday Offers:
- Discover the latest stocks recommended by top Wall Street analysts, all in one place with Analyst Top Stocks
- Make smarter investments with weekly expert stock picks from the Smart Investor Newsletter
Royal Bank’s Loans Are Going Bad
Currently, 19% of Royal Bank of Canada’s mortgage loans are impaired (that’s nearly 1/5th of its mortgages). Amortization periods on these impaired loans stretch beyond 30 years (the normal period is 25 years). In Canada, many consumers took on variable-rate mortgages in 2020 and 2021 at extremely low interest rates. With rates having risen dramatically, these same consumers can’t afford their home loans.
Rather than having consumers default in mass, Canadian banks have stretched these loans out. Because of the time value of money, these loans are now worth significantly less. The problem is that Canadian banks are not writing down the value of these loans on their income statements and balance sheets. If they did, their earnings would have plummeted.
Royal Bank currently has $71 billion worth of underperforming loans that are in “Stage 2” or “Stage 3,” meaning the credit risk on these loans has increased substantially, and some of them have been deemed uncollectible. This isn’t showing up on Royal Bank’s balance sheet either, with just $5.7 billion of its $966 billion loan book having been set aside as an “allowance for loan losses.” That’s 0.59% of the loan book and seems to grossly understate what’s happening in Canada.
Just the Beginning as Unemployment Rises
In July of 2022, unemployment in Canada reached a 50-year low of 4.9%. However, unemployment has since been rising, reaching 6.1%. You’d have to go back to the 1990s to find the last time Canada had a bad recession and housing market troubles. In 1992, unemployment in Canada reached 12.1%. The last time there were bank failures in Canada was in 1985, when unemployment reached similar levels. How far will unemployment rise this time around? Nobody knows for sure.
I believe this recession may be particularly severe. Canada’s household debt to disposable income is currently just below 180%, eclipsing levels of around 140% reached in the U.S. in 2007 (right before the Great Financial Crisis).
I expect that the most pain will come in Canada’s hottest provinces, where consumers have gotten the most carried away with their financial decisions. This year, real estate prices have begun crashing in cities in Ontario and BC. People in these provinces may be fleeing to more affordable markets. Unfortunately, Royal Bank just paid a premium to acquire HSBC Canada. HSBC Canada’s assets revolve around BC’s huge property bubble. Vancouver, BC, for example, is the third least affordable city in the world.
Royal Bank’s Balance Sheet Has High Leverage
I believe Canadian banks have fairly extreme leverage on an assets-to-equity basis. Royal Bank is levered about 17-to-1 on this ratio, meaning there isn’t much equity to absorb losses.
Since the Great Financial Crisis, American banks like Bank of America (NYSE:BAC) have been forced to hold way more loss-absorbing capital. Bank of America now has an assets-to-equity ratio of 11-to-1. So, U.S. banks have significantly more capital to withstand losses than Royal Bank of Canada. If Canadian banks are eventually forced to strengthen their balance sheets, this could really weigh on returns to shareholders because buybacks would have to be postponed to build equity capital.
Now, you may say, “What about the CET1 ratio (a liquidity ratio for banks)?” Well, let’s not forget that this ratio assigns risk weightings to assets. Canadian CET1 ratios likely assign very low risk weightings to mortgage loans. This was the same mistake U.S. banks made in 2008 when there hadn’t been mass mortgage defaults since the 1930s, perhaps.
Is RY Stock a Buy, According to Analysts?
Currently, eight out of 10 analysts covering RY give it a Buy rating; two rate it a Hold, and zero rate it a Sell, resulting in a Strong Buy consensus rating. The average RY stock price target is $114.02, implying upside potential of 6.08%. Analyst price targets range from a low of $106.32 per share to a high of $118.79 per share.
The Bottom Line on RY Stock
Things are not what they seem for Royal Bank of Canada. Its resilient earnings may be the result of grossly understated provisions for credit losses. Currently, the company has $71 billion of underperforming loans.
Canadian consumers have extreme debt burdens amid high interest rates and localized housing bubbles. Thus, 19% of Royal Bank’s mortgages have been impaired and were stretched out to 30+ year amortization periods. None of this shows up in Royal Bank’s net income or shareholders’ equity. Meanwhile, the company doesn’t have much equity capital compared to its assets to absorb losses.
