This post was originally published on April 26, 2023. It was updated on May 11, 2023.
You may have seen recent headlines that TD Bank – Canada's second-largest lender in terms of deposits and revenue – has been the target of short sellers, following banking instability in the US. But what does this mean, exactly – and should the bank's clients be concerned? Let's break it down.
What is a bank short?
If you’ve got two hours and 10 minutes, The Big Short is available on Netflix in Canada until April 30th and explains everything you need to know. If you don’t have that kind of time, I’ll try to explain it as succinctly as possible. Read this section in Christian Bale’s voice for cinematic effect.
Short selling, or “shorting” is a method of making money from stocks when they lose value by selling them first, and then buying them later. If the price falls in the interim, you can pocket the difference.
While it sounds sketchy in this context, this kind of thing happens all the time in the real world.
Let’s say a band is going to be performing later this summer and tickets are only available through scalpers resellers who are asking $250 per seat, which you think is way too high. You decide to take advantage of the situation by selling tickets at their current market value but waiting until the price falls to buy them.
To do this, you advertise tickets for a slightly better price than can be had elsewhere: $240 per seat. You find 20 buyers and pocket $4,800. But you yourself haven't actually purchased any tickets yet; you're betting that their price will go down in the near future before you shell out your cash.
Two months later, your prediction comes true and the resellers have lowered their price to $200 per seat. You pay $4,000 to buy 20 tickets and deliver them to your buyers. Your profit is $800, a return on investment of 20%. The risk lies in the chance that those ticket prices may not come down; if that's the case, you still need to purchase them and honour the sale you made to your own buyers.
A bank short is when investors follow this same principle but using shares of a major bank. These investors are selling shares today in hopes the share price will fall before they have to buy them.
What is happening with TD Bank?
When short sellers target a single asset like shares in TD en masse, people like me take notice and start writing about it. And that’s exactly what’s happening.
TD's shares are traded on the Toronto and New York Stock Exchanges and are worth a combined $151 billion. Its shares reached a low price of $76.40 in March and have since rebounded to a value of roughly $83. Speculators evidently believe that’s too high and BNN reports investors have short-sold $3.7-billion US worth of TD shares, more than any other bank in the world.
The short is part of a trending contempt for bank stocks in general, and particularly in the United States where three small banks failed in March of this year. TD is the 11th-biggest bank in the United States and the most active Canadian bank in that market by far. Over one-third of TD’s retail revenue comes from its US business and short sellers evidently believe that’s a big source of risk.
Compounding that risk is TD’s failed plan to acquire a Texas-based bank and wealth management company, First Horizon. The $13.4-billion deal was reportedly scuttled due to US regulators’ concerns that the Bank’s fraud compliance measures aren’t robust enough, with the lender ultimately walking over the “timing” of regulatory approvals.
However, the dropped deal may actually be good news for the bank as it now leaves TD extremely well-capitalized, sitting on nest egg of cash originally earmarked for the sale, with its stock rising 0.15% on the news.
Another red flag short sellers are targeting is TD’s exposure to the Canadian housing market. TD holds $244.5 billion in Canadian residential mortgages, making it the second-largest mortgage lender in the country. There are widely held beliefs that Canadian housing is grossly overvalued, as well as fears that rising interest rates could cause the bubble to burst. If the housing market’s resilient track record comes to an end, TD has a lot to lose.
Are bank stocks a good/safe investment right now?
While Canadian financial institutions are still widely viewed as the most solid in the world, bank stocks have been volatile as of late due to rising recession concerns. That’s prompted notable bank analyst John Aiken, from Barclays Bank PLC, to downgrade the ratings of several Canadian banks on May 9, including TD, Scotiabank, and RBC. In response, the S&P / TSX financials index, which tracks bundled bank stocks, dipped by 1%, and stocks for the individual banks fell by by a similar extent.
While Aiken acknowledged that Canadian banks have been more resilient to the factors that caused the US banking defaults, they’re still challenged by the rapidly rising interest rate environment, the extent of which will become evident when they report on their Q2 earnings.
“While we do not anticipate that the Canadian banks’ second quarter will demonstrate much earnings weakness, we believe that cracks in the foundation will become evident,” he wrote in his note to investors. “Further, with an uncertain outlook and a looming recession, we anticipate that there will continue to be pressure on the banks’ valuations and declining confidence in their earnings outlook.”
However, it’s been shown that trying to pick which stocks are good and bad investments is basically impossible. An S&P Dow Jones study compared actively managed investment funds, which are run by stock pickers to try to beat the market, with the S&P 500 Index, which simply comprises the 500 largest companies in the United States. The study found that after 10 years, the S&P 500 gave better returns than 85% of managed funds.
The takeaway from this is that it’s better to invest in broad segments of stock markets than to try to pick and choose individual stocks. Some will rise and some will fall, but the market as a whole will gain value and yield a decent return on your investment.
It’s true that bank stocks are volatile right now, but I won’t advise for or against investing in them specifically. Instead, exchange traded funds (ETFs) that cover broad segments of the market could be an option. There are several good investment platforms in Canada that can help you choose the right ETFs for your needs and take care of the details automatically.
Are Canadian banks still safe?
Canada has some of the safest banks in the world thanks to strict regulations and a strong social safety net. And while 565 American banks have failed since the year 2000, only three Canadian banks have failed in modern history – two in 1985 and another in 1996.
That’s not to say it’s impossible for a bank failure to happen in Canada, but even if your savings or investments were lost in a bank failure, your wealth is protected by insurance. The money you deposit in a major bank is protected by the Canadian Deposit Insurance Corporation (CDIC), a crown corporation with the backing of the federal government. Meanwhile, while your investments are covered by the Canadian Investor Protection Fund, an independent organization with a mandate from Canada’s provincial and territorial securities regulators.
The bottom line
As day traders and active investors hope to win big by betting against TD Bank, there’s little to do or worry about for the average Canadian. Focus your investment strategy on broad market segments and ignore the ups and downs that happen in between, and you’re likely to come out ahead in the long run.