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I EXPECT THIS BANK STOCK TO DROP BIG–EVERY QUARTER–But It Never Does
“The Canadian banks are just different, eh.” That is what we are told. While the US banking sector is going through a time of tumult, we are assured that in Canada everything is fine.
My instinct is to doubt that conclusion. Part of that is the contrarian in me. But part of it is that a bank is a bank. Why would a bank be different just because it is in Canada?
If there was any trouble, the Market is saying it’s going to happen in TD Bank (TD-NYSE/TSX). It’s one of, if not THE most shorted bank in the world. Their deposits are costing them an extra $8 billion per QUARTER than just five quarters ago.
Yet this team continues to show a remarkably resilient net profit margin. How do they do that? Could one of the next banks to fall really be from…Canada? (If it is, know that we are sorry, really sorry.)
Yet with another installment of quarterly earnings, we got more evidence that this is the case.
For some reason all Canadian banks report off quarter. While the usual reporting schedule for companies line up with year-end (December 31st, March 30th, etc) for the Canadian banks they report a month off: January 31st, April 30th and so on. Don’t ask me why.
Whatever the reason, the timing is helpful for deeper dives.
Last week all the big Canadian banks reported their fiscal second quarter earnings.
I went through most of those reports. The results were far from amazing. The Canadian banks have many of the same headwinds that their US counterparts do.
But the results also weren’t all that bad. I’m left thinking that if something bad is imminent, there are not a lot of signs of it. In the USA, that’s not the case—I always worry about the next shoe to drop.
IF TD IS A CANARY, IT’S STILL CHIRPING
Of particular interest for me is TD Bank (TD – TSX). TD has caught investor attention the last few months. Many headlines have been reporting that TD has a very large short-interest.
In reality, this is only kind of true. TD’s short interest in percent terms (the percentage of shares outstanding) is only around 3-4%. That isn’t all that large.
But TD is a really big company. The market capitalization of TD is over US$100 billion. Compared to the US banks, only JP Morgan (JPM – NYSE), Bank of America (BAC – NYSE) and Wells Fargo (WF – NYSE) are bigger.
That means that the actual $ amount of the shares short is quite large, probably the largest of any bank in North America.
Why is TD shorted more than other banks? There could be a bunch of reasons, but I think the main one’s are:
- TD owns a lot of Charles Schwab (SCHW – NYSE)
- A material amount of TD’s deposits are tied to Charles Schwab
- TD has a sizable US banking operation
TD’s SWEEP WITH SCHWAB
The worries about TD largely stem from their ties to Charles Schwab.
To understand the connection, we have to go back nearly 20 years, to a time when TD operated their own US based brokerage, TD Waterhouse.
In 2006 TD Waterhouse merged with another online-focused broker, Ameritrade. Ameritrade was a very well known and long-running discount brokerage. Together they formed an online-discount brokerage behemoth.
After the merger TD owned a sizable amount of shares in the combined public company, TD-Ameritrade.
In 2019 TD-Ameritrade was bought Charles Schwab. TD became a shareholder of Schwab. Today TD owns 12% of Charles Schwab.
TD receives their proportionate share of Schwab earnings every quarter. It is included as equity earnings in their financials. These earnings have declined recently due to reduced earnings at Schwab.
Source: TD Q2 2023 Supplemental Results
In addition to the equity ownership, TD also has a deposit relationship with Schwab.
This carries over from TD’s tie-in with TD-Ameritrade. TD has rights to something called a deposit sweep.
A deposit sweep is an agreement where, at the end of every day, TD “sweeps” unused cash from Schwab brokerage accounts to use as their own deposits.
This is a consistent source of deposits. While an individual account may see big swings in the cash (because someone could buy or sell a stock or bond and see their cash position change a lot) in the aggregate, the amount of cash available from all Schwab accounts does not vary all that much day to day.
What’s more, because Schwab is a brokerage account, their cost of deposits is quite low. For the last few years brokerages paid virtually no interest to cash holders.
The problem is that when the Fed raised rates a gazillion times in 12 months, depositors in brokerage accounts began to notice they were not getting any interest.
Schwab sweep deposits began to decline:
Source: Q2 2023 TD Supplemental Results
Deposits that TD received from Schwab were as much as $185 billion in Q3 2022. By Q2 2023, they had declined to $148.8 billion.
On the bright side, those deposits are still cheap. While TD doesn’t disclose how much those Schwab deposits cost them (ie. what interest rate they pay to deposit holders) we know what it is from Schwab’s own reporting. Schwab said in their last report that their deposit costs were 0.73%.
While that’s up significantly from the microscopic 0.01% that it was at a year ago it is still quite low.
The bigger problem is that the decline in deposits has to be made up elsewhere – at a higher interest rate. TD mde up for the ~$40 billion of Schwab deposits by issuing more certificates of deposit (CDs) and guaranteed Income Certificates (GICs). These have risen by about $40 billion in the last year and carry a much higher rate (4%+) than the Schwab deposits.
It is a microcosm of what is happening across the banking sector. Below I have calculated TD’s deposit cost for each quarter going back to the first quarter of 2022.
Source: TD Supplemental Disclosures
That is a steep rise! TD is paying out more than $8 billion per quarter more in deposit interest than they were 5 quarter ago!
DON’T WORRY, BE HAPPY
You might think this is a disaster! Surely such a large hit to deposit costs must be gouging profitability?
That is certainly what I expected. Every quarter. I wait for TD (and the other Canadian banks) to report wondering if this will be the quarter where TD’s net interest margin collapses and send the stock with it.
(Net interest margin is the difference between the interest TD earns on its loans and the interest TD pays for its deposits).
Yet every quarter I am left marveling at how it doesn’t happen.
The circled rows in the table below show TD’s net interest margin. It is remarkably stable.
Source: Q2 2023 TD Supplemental Results
In the last 4 quarters TD’s net interest margin has varied by, at most, 7 basis points! 7 basis points! That is 0.07%. While deposit costs have gone up nearly 3%!
What do you conclude? Is TD working some financial alchemy? Is this another example of a bank playing with the numbers?
I don’t think so. I think TD is just doing what they are supposed to do: managing the business.
Instead of sitting idly by watching their margin disappear TD is actively managing their margin and doing one heck of a job at it.
How are they pulling it off?
Some on this is secret sauce. TD doesn’t disclose all the ingredients. I can only guess at the levers they are pulling. But I can divine a few from what information they are required to provide.
TD’s loans are a mix of fixed and variable rate. The variable rate loans are re-rating to higher rates each quarter along with the deposits. Their Canadian mortgage portfolio, for example, is 43% variable rate. All those loans are adjusting upwards.
Second, TD is actively adding to their security portfolio of mortgage and government bonds. As lower rate bonds mature the proceeds are reinvested at higher rates. Interest income from securities rose from $1.4 billion in Q1 2022 to $5.1 billion in Q2 2023.
The biggest lever though is how TD is managing their loan/deposit ratio.
The loan/deposit ratio for a bank is a crude way of looking at its risk. The more loans a bank has per deposit, the more levered they are to problems if something goes south.
But if a bank has a very low loan/deposit ratio, it can also be a helpful lever for managing earnings.
TD has a very low loan/deposit ratio. Very low. In Q1 2022 it was only 64%. Most US banks are 80%+ and the highly levered banks are 100%+.
TD has steadily been increasing their loan/deposit ratio every quarter. In fiscal Q2, it was up to 71.4%.
Source: TD Supplemental Disclosures
71.4% is still low, so this is far from a warning sign. Yet it has provided TD with flexibility to counter their increasing deposit costs.
By adding more loans than deposits, and because those loans are being made at higher rates loans, TD is able to increase their overall interest income and help offset the increase in interest expense.
Now let me be clear: none of this is financial chicanery. There are no accounting gimmicks or anything like that. This is just good banking.
While I don’t know exactly how it works at TD, I imagine a bunch of suits sitting around the table every quarter and saying, how do we keep margins flat? And then have some backroom lacky model out the options by pulling all the levers they have.
Every quarter they come up with a way out.
It isn’t perfect of course. TD’s stock is still down year-to-date. All the Canadian banks are lagging.
Source: Stockcharts.com
TD adjusted EPS was $1.94 in Q2. This was down from $2.24 in Q1 and down from $2.08 in Q2 of the previous fiscal year. TD is fighting against headwinds, no doubt.
But they are also holding their own. The bottom isn’t falling out. Even as their deposit costs have absolutely skyrocketed.
For that you must credit the management team. It is a rough, rough time for banking, but good teams are finding ways to manage it better than others.
