Rational Advisor

Pretty much everything in financials looks garbage right now. Note - the Canadian financial system is not broke. Also note that we have not seen the spiraling down in the rest of the economy.

Yes, there are issues with the US and European financial systems. They can’t make their minds up about a bailout plan – which will eventually happen, and in Europe many banks are flat lining.

The craziness right now is not about the assets in the banks, but the liquidity and the lending practices. It was all about these Financial mega-brains funding mortgage loans to people who could not afford it, all in the name of increasing bottom line earnings. Bankers, brokers, mortgage agents and insurance guys got greedy!

But here in Canada, it was different. Our Banks and lending practices are more conservative. Oh yea, we had our share of nutzo no payment down loans – but they were small.

Hate them all you want, but our Banks never came close to the stupidity of the US Banks.

According to Don Drummond, chief economist of TD Bank, 4% of Canadian mortgages written were subprime, while the comparable number in the US is 40%. The Canadian banks have lots of capital, and none of them have large quantities of these toxic assets.

In the US, the Banks are returning back to their basics – bread-and-Butter banking. The deposit-poor investment lending banks (Lehman, Merrill Lynch etc) begin taken over by the deposit-rich Commercial banks (JP Morgan Chase, Wells Fargo, Bank of America). These giant commercial banks have emerged as some of the most powerful players in and industry that is likely to be safer but less lucrative. They have more rigid reserve requirements, which helps protect, but also means less money is out there at risk.

Not only in US, but also in Europe banks are returning to their old functions. Germany’s Deutsche Banks, which had been focused on building its global investment banking business, recently agreed to pay$4.3 Billion in a two-stage deal to acquire the 850 domestic branches of deutsche Postbank AG, the retail banking arm of the German postal system. Santander, paid $2.6 Billion in July for troubled UK mortgage lender Alliance & Leicester.

I know a lot of interest has now jumped to the “safer” investments of CSBs, GICs, Principal Protected Notes and segregated funds. Just remember the oldest investing lesson of them all: When you reduce risk down to nearly nothing, your returns follow along.

Truth be told this is not a smart time to be jumping on the guaranteed band wagon, now that the plunge has occurred.

The Financial system here in Canada is sound. Fortunately, even though they made plenty of stupid moves, the banks are not quite as stupid as they are presently being portrayed.

Some Key points to consider:

- The $700B bailout TARP package is not an investment in non-performing loans. These are assets (mortgages) that are deemed risky; in there is also some recoverable ones. I believe the government might actually turn a profit on TARP. Mortgage pricing has already overshot on the downside and the actual securities are certainly not all “bad” or “toxic” as we constantly read in the press. The problem is that good mortgages are priced as though they are mediocre, the mediocre are priced like they’re bad, and the really bad stuff is priced as if it’s worthless (which most, but not all, probably are). There is still real value in most of the mortgage debt the banks hold. And because it’s valued at flea market prices, the US government has a chance to create one of those rare win/win outcomes.

- The beneficiaries of the Wall Street bailout will be second tier banks, such as RBC. As large investment clients that previously would have moved to the Lehman’s, Merrill’s now move to the safer Canadian banks for investment lending. It would have taken years for banks like RBC and TD to have got clients like these.

- Warren Buffett is buying $5 Billion in perpetual bonds of Goldman Sachs– that means it is like an equity. This is a vote of confidence not just in financials, but also in the economy as a whole

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