Big Banks on deck as earnings season begins

Economists will be keeping a close eye on Canadian bank earnings, due out this week, for signs that a nascent economic recovery has any sort of staying power.

Canada's well-capitalized banks have fared much better than their counterparts south of the border and throughout the world as the worldwide recession unfolds.

Canadian employment, wholesale tradeand retail sales data have shown signs of a rebound in recent weeks. That hassparked even more interest in how Canada's major banks, seen as bellwethers of thecountry's economy,are performing.

Still, economists are anticipating earnings will come in 15 per cent less than where they were last year, on average.

BMO reports first

Thebank earnings season that begins Tuesday is of particular note because some of Canada's major lenders recently took tiny steps toward international expansion after an extended period of retrenchment.

Earlier this month, reportssaid Royal Bank and CIBC were kicking the tires on a possible minority stake in Irish bank Allied Irish. And TD Bank, with a strong U.S. banking presence, is considering stepping in with a bid for troubled Texas lender Guaranty Financial, the Financial Times reported.

'Commercial real estate losses arrive late in the [economic] cycle, which implies the bulk of the problems are ahead' National Bank analyst Robert Sedran

Bank of Montreal on Tuesdaywill be the first of Canada's major banks to report earnings for the period ended July 31.

One of the major factors expected to push banks' earnings lower for the quarter 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 indicate 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 comparedwith 6.4 per cent a year earlier.

U.S. exposure a liability?

The situation is even worse in the United States, where the value of commercial real estate hasn't bounced back like home prices and in many places 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 recently completed third quarter.

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

Sedran said the commercial real estate market is more stable in Canada than in the U.S.So banks with exposure to U.S. commercial real estate, like Royal Bank,BMO and particularlyTD,are more at risk.

Blackmont Capital analyst Brad Smith agreed, noting recent data from reports to the U.S. Federal Deposit Insurance Corporation for the American subsidiaries of BMO, Royal and TD all showed credit pressures.

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, comparedwith $1.4 billion or 0.47 per cent of loans a year earlier.

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

Effect on stock prices unknown

What remains to be seen is to what extent a decrease in profits will impact 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."

Dundee Capital Markets analyst John Aiken, though,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.

With an average price-to-earnings ratio of 12.5, bank shares have risen "back to pre-credit crisis levels," Smith said. The six-year average is 11.5, he said.