Toronto-Dominion Bank (USA) (TD), The Bank of Nova Scotia (USA) (BNS): Moody’s Downgrade of the Canadian Banks..Should Investors be Worried?

My coverage on the Canadian banking sector continues. In this brief analysis I will examine if the downgrade by Moody’s should be a major concern for potential investors.

Moody’s recently downgraded six of Canada’s largest banks primarily due to high levels of consumer debt and elevated housing prices, which forces a potential downside risk on the Canadian economy.

Irrespective of the downgrade, several Wall Street experts and trade pundits still maintain a stable outlook on the Canadian banking sector. Canadian banks are consistently ranked among the world’s safest and well regulated financial institutions by World Economic Forum.

A recent report published by the Economist predicted a strong correction in housing prices, as they are currently estimated to be overvalued by 73% relative to rental prices and 32% when compared to household income respectively.

Paul Krugman, renowned economist, seconds the view. “According to him, though Canadian banks are considered amongst the safest in the world owing to a well regulated environment, however, the current housing bubble will be a litmus test for the major banks.” Going forward, it will be interesting to see how the government and the big financial institutions react to the situations and counter this situation.

Toronto-Dominion Bank (USA) (NYSE:TD)

Toronto-Dominion Bank (USA) (NYSE:TD) was one of the last publicly traded banks to hold the coveted AAA rating from Moody’s until it was downgraded to Aa1 in January. It is notch below its highest rating grade, which implies Toronto-Dominion is a safer investment relative to its compatriots down south in United States. Most of the major financial institutions such as Citigroup, Bank of America and several other big banks are still rated Baa 2, which is tad above the junk status.

So why are the Canadian Banks reliable despite the downgrade?

Toronto-Dominion Bank (USA) (NYSE:TD) has focused primarily on meeting the BASEL III and Office of the Superintendent of Financial Institutions, or OSFI, requirements on capital and risk frameworks as it recorded a Common equity tier 1 ratio of 8.8%, which is well above the regulatory requirement of 7%.

Moreover, Toronto-Dominion is consistently rated a notch higher than all its Canadian peers, and in terms of risk management, it is considered far superior than any other U.S. based financial institution. This is  substantiated with Toronto-Dominion Bank (USA) (NYSE:TD) reporting an adjusted return on its risk weighted assets at around 2.59%, which is above its Canadian and American peers that currently stand at around 2.34% and 1.67% respectively.

Toronto-Dominion Bank (USA) (NYSE:TD)’s economist Diana Petramala conceded the potential risks associated with the housing market and consumer debt, however. She illustrated that a rise in mortgage interest rates and mortgage delinquencies increased simultaneously with consumer debt running up to the US financial crisis.

With a low interest rate environment prevailing in the Canadian economy, interest costs as a percentage of disposable income has drastically fallen despite the sharp rise in debt to disposable income, which at present stands at around at 165%. Furthermore, the mortgage delinquency rates (the percent of mortgages in arrears 90 days or more) in Canada is at around a third compared to the U.S. in the run up to the crisis, which certainly exhibits a better picture for the Canadian economy.