With two Wall Street giants falling, and a third apparently on the brink, Canadian investors are casting a wary eye toward their domestic financial institutions. But analysts say Canadian banks should be able to avoid the trouble of their American counterparts.

Much of Canada's capital markets are intimately tied to the "Big Five" Canadian banks, and if they were to suffer a crisis similar to what's happening in the U.S., the effect on Canadian investors would be devastating. There are no signs that this will happen; however, investors should expect Canadian bank prices to take a haircut, says Chris Blumas, an equity analyst with Morningstar Canada who covers Canadian financials.

"Operationally, I don't think there is a huge effect on the Canadian banks. This is really about the investment banking space in the U.S. It does create a negative sentiment on financial service companies. That's what really affects the stock prices," he says. "It creates a treacherous environment and creates a lot of headline risk for the banks. You've seen all the Canadian banks down today around 2.5%."

If anything, Blumas says, with the acquisition of Merrill Lynch by Bank of America and the acquisition of Bear Stearns earlier this year by JPMorgan, the U.S. banking scene is beginning to take on the appearance of Canada's more stable banking sector.

"With Bank of America buying Merrill Lynch, the U.S. banking industry seems to be moving towards the model we have in Canada, where all the banking functions fall under one roof," Blumas says. "For investment banks, it's difficult to stand on their own if there is a liquidity crunch. In Canada, everything is brought together. Our Canadian banks have a broader platform. They do investment banking; they do retail banking. It creates a more stable foundation."

Still, in the short term, Blumas says, investors can expect a decline in Canadian bank prices, as investors try to determine if there was any counterparty exposure to Lehman Brothers. He expects RBC Financial's and TD Financial Group's stock prices to have the toughest time since they have large operations in the U.S., where profit margins will be tighter.

"Banks that operate down there are going to have to pay more for their deposits and more for their funds," Blumas explains. "That will compress profit margins even more. That will be the biggest short-term impact on the Canadian banks."

Having said that, he expects the direct spillover for the majority of Canadian banks to be relatively small. "There could be some peripheral effects we don't know about yet, particularly if Lehman was counterparty to any of our banks. Nobody has been disclosing that they had counterparty risk with Lehman in the past; it was more about their exposure to monoline insurance companies," he says. "The two companies that will likely be affected the most are Royal Bank and TD because they have a big U.S. presence."

With long-term prospects relatively positive, Blumas believes the uncertainty in the financial stocks may be creating a tremendous buying opportunity.

"There are some Canadian banks with really high-quality earnings, and their stocks have been hit really hard," he says, citing Canadian Western Bank as an example. "You can buy a few of these Canadian banks that have a really good competitive position with single-digit-multiples of earnings — that's not so bad. It might take a few years for things to shake out, so there may be some downside risk in the short term. I would assume your upside potential [over the long term] would become a little bit better than your downside risk."

On the mutual fund side, independent analyst Dan Hallett, principal of Dan Hallett & Associates, doesn't see much spillover into Canadian funds happening, althought there are some that have significant exposure to U.S. financials.

"There are a few U.S. dividend funds in the market, and that's probably the first sort of category that comes to mind," he says.

Hallett say investors have to look at their funds on a case-by-case basis because some managers have taken larger positions in financials under the belief they were bottoming out. Obviously, now with the bankruptcy of Lehman Brothers, the takeover of Merrill Lynch and with AIG hanging by a thread, that belief appears to have been wrong.

"A lot of managers were starting to buy financial stocks late last year. Many of these were good managers in my opinion. I think they got in quite early in terms of the timing to increase their weightings with certain stocks. They've definitely been hurt," he says.

The decline in Canadian bank prices can also present an opportunity for investors in dividend funds because many of these companies have either increased or kept their dividends the same, meaning the dividend yield can be purchased for less.

Hallett urges investors and advisors to do their homework before bargain hunting for Canadian dividend investments.

"The Canadian banks aren't suffering as badly as their U.S. counterparts. At the same time, they've certainly been beaten up," he says. "Whenever you see a company's dividend [yield] rise because its price has been punished, you have to ask 'how safe is the dividend?' You need to be looking at the balance sheet — the coverage ratio on an earnings cash flow basis — to ensure they have enough money coming in to cover the dividend."

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(09/15/08)