About a month ago, a good friend of mine decided to buy some Citigroup stock. He reckoned since it had fallen 70% it was “cheap.” Since then the stock has deteriorated further, falling from his $15 purchase price to today’s close of $4.71. I don’t know if he still owns the stock, but if he does, he’ll realize that a stock can fall 70% twice.

For years, Canadian investors have thought of bank stocks as a safe haven. Today showed them to be wrong with the sector underperforming the index by 5 percentage points. I’ve actually been amazed at how well bank stocks have held up until now. I’m concerned that recent underperformance could be only the beginning.

Let me give you an analogy:

Let’s say you wanted to invest some money. There’s a long-time established diner just down the street that is for sale. The owner tells you that the business has no debt and typically earns $60,000 per year. He will sell it to you for $500,000. You think to yourself that at this price you are generating an earnings yield of 12% — which is actually another way of saying that you’re paying a P/E of 8x.*

Alternatively you might decide to buy a bank stock. You could for instance buy $500,000 of shares in Canadian ACME Bank. On last year’s peak EPS, your investment would work out to a P/E of 8x. The bank is currently seeing earnings weakness but the share price is also down 45% from its peak. It seems like a good investment doesn’t it? After all you’re only paying 8x “normal” earnings.

You could be sadly disapointed.

The diner’s business could be impaired in a recession, but for the most part it should be OK. It has no debt and other than rent, it has few fixed costs. It generates a nice recurrent income. So as long as it can keep its costs down, it should survive the recession.

Bank stocks though are a different story. They are the riskiest things you can buy into a severe recession for one simple reason:

Leverage

Unlike that diner — which had no debt — banks are laden with debt in the form of customer deposits. These deposits have been loaned out by the bank in the form of business loans and personal loans — some of which are to schmendricks like your cousin Louie.

So when you buy $500,000 worth of Acme Bank, you are not buying a debt-free business. You are buying a piece of a business that is leveraged. This leverage is huge relative to your investment.

The typical Canadian bank has less than $1 in shareholders equity for every $10 in loans. And profits? In 2007, the the typical Canadian bank had less than 20 cents in profits for that same $10 in loans.

So if just a tiny percentage of those loans go bad, your bank’s profits can be wiped out. In a buoyant economy, nobody worries about loans going bad. But in an environment where property prices are falling, it’s easy for pessimists to get concerned about the integrity of those loans. In fact, it doesn’t really matter now accurate the naysayers forecasts are. In a deteriorating economy, investors usually have a tendency to “sell banks now, ask questions later.” After all, if enough assets go bad, not just the profits will be wiped out, but potentially the equity as well — leaving the shareholders bankrupt.

At current levels, Citigroup is down 90% from its peak. So is the stock cheap?

Well — it’s not cheap if it goes bankrupt. You see at $4.71, the company still has a market value of $26bn.^ Is that cheap? You tell me! The company also has borrowings of $2tn that need to be repaid back. If its assets can’t cover it, than the shareholders will be left holding the bag.

The media is plumb with stories about how safe Canadian banks are relative to their global peers. That may well be true — they are as a rule less leveraged. But we won’t know the true extent of Canadian banks’ supposedly better lending practices until this is actually all over. Remember, the US has now been suffering for a couple of years from its housing crisis. Canada is a commodity-based economy so it’s only been the last six months that the stresses are really starting to be felt here. Is our economy going to play catch up? Only then will we see how truly vulnerable Canadian banks really are.

Read an earlier post of mine on this subject here: Clickworthy: Banks Riskier Than We Think

_______________________

* $500,000 divided by $60,000

^ $4.71 multiplied by the shares outstanding