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Headwinds grow for Canadian banks: Morningstar

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Canadian banks have fared better in recent years than many of their peers in the developed world. But a new report from Morningstar warns the good times may be coming to an end and investors should tame their expectations for increases in Canadian bank stock prices.

"We think current multiples of 2-3 times tangible book value offer investors little margin of safety," analyst Dan Werner said in a note to clients. "Furthermore, we see dark clouds forming on the horizon and think there is a reasonable likelihood of slower growth and higher loan losses in the near future."

Similar to other commentators, Werner says a flat yield curve is putting pressure on net margins -- the spread that banks earn on the cost of raising money and then loaning it out to businesses and consumers. Banks have helped offset this pressure on their margins by increasing the number of new loans, a move that has been made possible by record low interest rates, he says.

"Since the early 1990s, the Bank of Canada has kept interest rates low, which has fueled a credit boom. As in the U.S., the Canadian yield curve has flattened over the past year," Werner says.

The real estate sector has benefited most from increased lending activity as home prices have continued to rise. But Werner believes that era may be coming to a close and with it, the banks will experience growing pressure on their bottom lines.

"About two thirds of Canadian banks' loans are in either home mortgages or personal loans (which usually include home equity lines)," Werner says. "While some of the Canadian banks had nearly double-digit loan growth over the past five years, we expect that growth to slow in the near term as the demand for credit declines in a slower economic environment."

And similar to warnings from Bank of Canada governor Mark Carney, Werner believes the record levels of debt that have accompanied soaring home values are "unsustainable" and house prices will be pulled down "when the Canadian consumer decides (or is forced) to deleverage."

Recent moves by Canadian banks to offset a consumer slowdown in Canada may actually increase their risk, Werner says.

"With all of this acquisition activity, particularly in asset management, we think there is an increased risk that banks will destroy shareholder value by overpaying for assets," he says. "While Canadian banks' foreign bank acquisitions offer access to markets with much higher GDP growth, there is increased credit risk, given the higher nonperforming loan levels at these target institutions."

Of the Big 6 banks in Canada, Werner prefers Toronto Dominion (TD-T) due to its strong presence in Canada and the Northeast U.S and Royal Bank of Canada (RY-T) because of its high dividend yield and move to dump its U.S. operations.

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