CIBC Is An Accident Waiting To Happen

Relatively recent events in 2023 in the financial sector have left some investors wondering how financial institutions could implode almost overnight. A little bit of financial statement analysis, however, readily reveals that the recently failed banks (Silicon Valley Bank, Signature Bank, and Credit Suisse) were slow-motion train wrecks. The fact the regulatory authorities did not step in sooner is what I consider puzzling.

While I spent ~30 years working in the Canadian banking industry, I think my greatest learning experience was during The Great Financial Crisis. This is when I learned how things could turn ugly very quickly…and in a big way! As a result, attractive dividend metrics and valuations are of lesser importance to me than risk metrics when I determine whether to invest in a company.

While the Canadian financial sector is dominated by 6 large banks, they are not created equally.

In my March 21 TD Bank Is A Top 10 North American Bank post I disclosed why I encouraged my daughter to purchase a few hundred TD shares.

Before my TD guest post, I wrote why Scotiabank (BNS) Is A Terrible Long-Term Investment.

In this post, I look at The Canadian Imperial Bank of Commerce (CIBC) which is Canada’s 5th largest bank from a market capitalization perspective. CIBC’s ticker symbol is CM.

For the sake of full disclosure, I do hold CIBC shares. My exposure, however, is only 1,328 shares in a ‘Side’ account within the FFJ Portfolio; it was not a top 30 holding when I completed my January 2023 Investment Holdings Review and is still not a top 30 holding.

NOTE: All dollar values reflected below are in CAD $ unless otherwise noted.

Overview

CIBC came about through the largest merger of two chartered banks, The Canadian Bank of Commerce (established 1867) and the Imperial Bank of Canada (established 1875), in Canadian history on June 1, 1961. Information about its history is accessible here.

CIBC has been predominantly a Canadian-based bank. However, discussions between PrivateBancorp, an American commercial bank headquartered in Chicago, and CIBC commenced in 2013. These discussions culminated in CIBC acquiring PrivateBancorp in June 2017 and the US entity adopting the CIBC branding in September 2017. This acquisition marked CIBC’s 2nd formal entry into the American retail and investment banking market.

CIBC’s first attempt to expand into the US market in a meaningful way was in 2000. CIBC National Bank and Amicus Federal Savings Bank were founded to provide co-branded banking services for supermarket chains. These 2 entities ultimately filed with the Federal Deposit Insurance Corporation (FDIC) for voluntary liquidation; operations ceased on September 29, 2003.

The Q1 2023 Investor Fact Sheet is a good very high-level source of information that allows investors to quickly familiarize themselves with the bank. The 2022 Annual Report and 2023 Proxy Report which are accessible here, provide far more comprehensive information.

CIBC consists of 4 Strategic Business Units (SBUs).

• Canadian Personal and Business Banking provides personal and business clients across Canada with financial advice, services and solutions through banking centres, as well as mobile and online channels.
• Canadian Commercial Banking and Wealth Management provides high-touch, relationship-oriented banking and wealth management services to middle-market companies, entrepreneurs, high-net-worth individuals and families across Canada, as well as asset management services to institutional investors.
• U.S. Commercial Banking and Wealth Management provides high-touch, relationship-oriented banking and wealth management services across the U.S., focused on middle-market and mid-corporate companies, entrepreneurs, high-net-worth individuals and families, as well as personal and small business banking services in four U.S. Midwestern markets.
• Capital Markets provides integrated global markets products and services, investment banking advisory and execution, corporate banking solutions and top-ranked research to our clients around the world. It includes Direct Financial Services which focuses on expanding CIBC’s digital capabilities to provide a cohesive set of direct banking, direct investing and innovative multi-currency payment solutions for CIBC’s clients.

Legal Issues

It is to be expected that legal issues will arise from time to time in the normal course of business. CIBC is no exception, however, it is notorious for being an accident waiting to happen!

Long-time CIBC investors will likely remember the Enron (and the long-running tax battle with the Canada Revenue Agency (CRA) over its attempts to deduct legal settlements tied to CIBC’s alleged dealings with Enron), Global Crossing, and Teleglobe legal issues. In addition to any losses incurred in these matters, investors must not overlook how much CIBC must have paid in legal fees over the years!

More recently, CIBC has made headlines related to the following 2 legal disputes.

Cerberus

This lawsuit stems from a 2008 transaction in which CIBC issued a limited recourse note to Cerberus Capital Management LP, which significantly reduced CIBC’s exposure to the U.S. residential real estate market. In 2011, CIBC sold a residual interest in the specified payment streams to Cerberus.

In 2015, Cerberus alleged that CIBC defaulted on certain payments and it filed a lawsuit seeking damages of US$1.067B.

In December 2022, a judgment by a New York State court ordered CIBC to pay damages.

On February 17, 2023, CIBC said it agreed with Cerberus to pay USD $0.77B to fully settle the lawsuit.

Overtime Class-Action

In CIBC’s 2022 Annual Report (page 5 of 216) we see the following regarding CIBC’s ESG strategy:

‘We’re activating our resources to create positive change for our team, our clients, our communities
and our planet, contributing to a more secure, equitable and sustainable future where everyone’s
ambitions are made real.’

However….

In June of 2007, a class action lawsuit was launched against CIBC in respect of unpaid overtime; the action was certified as a class proceeding in June of 2012.

The action was brought on behalf of current and former non-management, non-unionized employees of CIBC in Canada who are or were tellers or other front-line customer service employees (limited to personal bankers, commercial bankers and account executives, working at CIBC retail branch offices across Canada).

In 2022, The Ontario Court of Appeal dismissed an attempt by CIBC to overturn a lower-court ruling in favour of the class-action case on behalf of about 31,000 retail bank employees.

After 15 years of contested litigation, and months of negotiation, CIBC agreed to pay a total of CAD $0.153B to employees who were uncompensated for overtime work.

A big advantage of this settlement is that class members will not have to prove their claims, a task that could be challenging in cases where some claims may go back nearly 30 years.

It took CIBC 15 years to activate its resources to create positive change for its team members. That is an impressive ESG strategy!

On the bright side, the legal firms involved in this class action generated significant fees.

Miscommunication

On February 27, 2023, CIBC issued a letter to customers outlining changes to account agreements for customers holding unregistered Guaranteed Investment Certificates (GICs); the discussion forum at the Canadian High Interest Savings Bank Accounts website has an image of the last of the four page letter that reflects:

‘We have added a new clause as follows, which allows us to change any term of your agreement with at least 30 days notice. If you do not wish to accept, you may close your account free of charge.’

This should have been an innocuous letter to some of its customers. In typical CIBC fashion, however, this clause was included in a letter related to fixed-rate deposit instruments!

As to be expected, this resulted in some recipients of this letter questioning whether CIBC can adjust (reduce?) the interest rate on GICs before maturity.

Interestingly, ConservativeInvestors’ Services checked account agreements with 10 random GIC issuers and found no such terms or conditions.

You really have to hand it to CIBC! If you are patient, this bank is bound to experience another ‘accident’.

CIBC’s Financial Results

Q1 2023

Material related to CIBC’s Q1 2023 February 24, 2023 earnings release is accessible here.

The GAAP results were affected by the following items that aggregate to a negative impact of $1.55/share:

• $1,169 million ($844 million after-tax) increase in legal provisions (Corporate and Other);
• $545 million income tax charge related to the 2022 Canadian Federal budget (Corporate and Other); and
• $26 million ($20 million after-tax) amortization of acquisition-related intangible assets.

In its infinite wisdom, the Canadian Federal Government introduced a Canada Recovery Dividend and additional tax on banks and life insurers; details are accessible here. Although this tax is imposed for the 2022 taxation year, it will be payable in equal instalments over five years.

As much as the Federal government tries to put a positive spin on whatever it implements, history suggests that this tax increase will ultimately be borne by the Canadian banks’ customers; I doubt the Canadian banks are not going to find a way to somehow pass on a portion/all of this additional cost to its customers.

Personal Loan / Mortgage Portfolio

While Canada is the world’s 2nd largest country from a geographic perspective, its population pales in comparison to many other countries. The current population of Canada is ~38.66 million based on Worldometer elaboration of the latest United Nations data. Its population is equivalent to 0.48% of the total world population and the country ranks 39th in the world by population.

Canada’s resident population by metropolitan area (in 1,000s) is reflected below (the top 25).

We see that Canada’s population is heavily concentrated in a few large urban areas.

In the last couple of years, real estate values have skyrocketed in these heavily populated areas. This has been fueled by a low interest rate environment and a housing shortage.

Starting in March 2022, however, the Bank of Canada has raised the policy interest rate quickly and forcefully from 0.25% to 4.5% in an effort to bring inflation under control. These rate increases have led to interest rate increases by Canadian lenders as depicted below. In addition to increases in the Prime Rate, mortgage rates have also increased significantly.

Mortgage amortizations are typically 25 – 30 years. Unlike in the US, mortgages in Canada do not come with a fixed rate for the entire amortization. Rates are typically negotiated for fixed terms of 5 years or less. At the end of the fixed term, the mortgagor must renegotiate the terms of their mortgage.

In some cases, mortgagors opt to borrow by way of a variable-rate mortgage. This might work well in a falling interest rate environment. It doesn’t work quite so well when interest rates are rising unless the borrower expects to come into some money that will enable them to make a huge dent in the amount owing.

We can see from the table above that interest rates have jumped significantly since early 2022. Now, homeowners with variable rates mortgages or whose fixed rate terms have recently ended, are in a predicament where their new mortgage payments are considerably higher.

Circumstances are so dire for some borrowers with variable-rate mortgages that they have to resort to tacking unpaid interest onto their mortgage’s principal instead of paying the full amount each month. Others are paying interest only and nothing is being applied toward the principal.

By being somewhat lenient with borrowers (banks typically have limits on the extent to which they will accommodate customers), CIBC and its peer group are helping to stave off defaults and forced selling.

At the end of Q1 2023, CIBC had about $52B of variable-rate mortgages, or ~20% of its Canadian portfolio, where the borrower’s fixed monthly payments no longer covered interest. By adding any shortfall to the principal amount of the mortgage (negative amortization), the amount of the mortgage is effectively increasing despite payments being made. By providing this flexibility to consumers, CIBC now expects many of those mortgages to be amortized over more than 30 years!

The Toronto-Dominion Bank (TD) and The Bank of Montreal (BMO) are also allowing variable-rate borrowers to extend their amortization. The most recent statistics from these banks show that mortgages with an amortization beyond 30 years now account for ~30% of their respective Canadian mortgage book; this is an increase from ~0% at the end of Q1 2022.

The Royal Bank of Canada (RY) does not allow negative amortization. However, it is permitting some variable-rate borrowers to stop paying down their principal each month and it is also extending amortization periods to more than 30 years. Roughly $75B (or ~20%) of RY’s total domestic residential loan book consists of borrowers who now pay interest only.

You would think people learned their lesson, or at the very least, learned from mistakes made by other homeowners; less than 20 years ago we saw this movie before in the US.

Despite the leniency being extended by the Canadian banks, this leniency has its limits. At some point in time, some struggling homeowners are going to hit a brick wall and may be forced to sell their homes at a loss or face the likelihood of foreclosure.

For now, however, the flexibility extended by the Canadian banks is paying off. Canadian home prices have slumped ~16% (this is average and the price slump is more dramatic in some areas). Borrowing costs, in many cases, have at least doubled since early 2022.

According to data from the Canadian Bankers Association for the month ended January 31, 2023, the number of residential mortgages in arrears by 3 months or more, is only 0.16%.

April 30th is the end of Q2 for the major Canadian banks. CIBC will be reporting its Q2 and YTD2023 results on May 25 before the market opens; the other major Canadian banks will be reporting their results around the same time. It will be interesting to see the extent of any change in mortgage delinquencies!

In addition to homeowners who borrowed from the major Canadian banks, we also have a subset of homeowners who could not qualify for mortgages from conventional lenders. This group turned to alternative lenders and/or private money; mortgages from such lenders typically carry a much higher interest rate than what can be obtained from the major Canadian banks. Fees, terms and conditions, and any penalties are also generally not nearly as favourable as those when borrowing from the major Canadian banks as private lenders do not come under the same scrutiny as the major Canadian banks. When a private lender wants the loan/mortgage repaid, borrowers can find themselves in a predicament they never imagined would arise.

It is not only homeowners who are experiencing financial challenges. Many people who rent are finding that their housing expenses are consuming a healthy percentage of their net earnings.

This is partially attributed to some landlords who are struggling to hold on to their rental properties; investment property owners who are selling their properties due to financial stress have increased 300% YoY in Toronto.

Investment property owners currently operating at a loss may be forced to sell or increase rental rates to keep up with rising costs. If landlords are forced to sell their investment properties, tenants face the risk of being displaced into a sky-high rental market.

A new survey shows more Canadians are taking money from savings to cope with the rising costs of living. The latest data from the Angus Reid Institute finds that two-in-five people dipped into their saving accounts to cover living expenses.

While Canadian banks have historically managed their book of business extremely well, the financial sector is cyclical. As a result, investors should expect periods of weakness. Given that the string of aggressive hikes by the Bank of Canada has yet to be fully reflected within the economy, I expect an increase in loan and mortgage delinquencies over the coming quarters.

For further details on CIBC’s mortgage portfolio, you may wish to review the Q1 2023 Earnings Presentation.

Funding Strategy and Sources

If the Silicon Valley Bank and Signature Bank debacles have taught investors anything about the financial sector, it is the importance of liquidity. Both banks were extremely poorly managed and SVB was under scrutiny by the U.S. Federal Reserve for 1 year for its risky practices before it collapsed on March 10. One has to wonder why more severe measures were not taken within this 1 year timeframe!

Silicon Valley Bank and Signature Bank investors, unfortunately, had to learn the hard way that a mismatch between a bank’s assets and liabilities and an absence of ‘sticky deposits’ is an invitation for problems.

Looking at CIBC’s funding strategy, we see that it has access to funding through retail deposits and wholesale funding and deposits. Its wholesale funding strategy is to develop and maintain a sustainable funding base through which funding can be accessed across many different depositors and investors, geographies, maturities, and funding instruments.

Furthermore, CIBC’s 3-year funding plan is updated at least quarterly. I have no idea if Silicon Valley Bank and Signature Bank performed a similar analysis at least quarterly. If they did, they clearly had no idea what they were doing.

We see from the following image that CIBC sources its wholesale funding from various regions in the world.

Additional slides related to CIBC’s Funding Strategy and Sources are found within the February 24, 2023 Investor Presentation.

Credit Ratings

It is imperative that investors pay particularly close attention to the risk aspect of their investments.

The following are CIBC’s current credit ratings.

As noted in all my previous posts, I look at the credit ratings assigned by the major rating agencies. These ratings, however, only form part of my risk analysis because I know the ratings are not entirely reliable. We only need to look at the ratings just prior to the failure of Silicon Valley Bank and Signature Bank! Clearly, the rating agencies were asleep at the switch!

I typically look at the ratings assigned to a company’s domestic long-term subordinated debt. Knowing that my risk is even greater than debtholders, I shy away from companies whose debt is rated at the bottom of the investment grade ratings.

In response to the 2008 financial crisis, the international committee on banking oversight set new standards, such as new and higher capital requirements, to make banking systems more resilient in the event of future financial or economic downturn. This is why we see ratings whose descriptions include NVCC (see table above); the Ontario Securities Commission provides a good overview of the key features in banks’ debt and preferred share offerings.

CIBC’s subordinated debt ratings are similar to those assigned to The Bank of Nova Scotia (BNS) with the exception of the rating assigned by DBRS; DBRS assigns an A (low) rating to BNS versus A (high) to CIBC. While the ratings are investment grade, I don’t like BNS as a long-term investment and CIBC falls in the same ‘bucket’.

The ratings assigned to TD Bank are superior to those assigned to CIBC and BNS. In a world of uncertainty, I see no reason to take on additional risk. TD is a far superior bank than BNS and CIBC so I would put my money on TD as opposed to the other two.

NOTE: Links to my prior TD and BNS posts are provided at the beginning of this post. Within those posts is information regarding the credit ratings of those 2 banks.

Dividend Metrics

Dividend metrics should not be the primary reason by which to invest in a company. However, some investors focus heavily on dividend metrics when making investment decisions.

While past performance is not indicative of future performance, CIBC’s dividend track record over the last ~15 years is nothing to ‘write home about’.

CIBC proudly claims that it has not missed a regular dividend since its first dividend payment in 1868 (see dividend history dating back to 1997). Who cares!? This milestone is like looking in the rearview mirror while driving.

I am not sure how meaningful CIBC’s dividend track record is when we see that CIBC’s Average Annual Total Return (with reinvested dividends) over the past 15 years is 6.70% versus 9.72% for the S&P 500 Index. When dividends are not reinvested, the Average Annual Total Return drops to 5.15% versus 8.64% for the S&P500.

Furthermore, when we look at CIBC’s dividend history dating back to 1997, we see various timeframes where the dividend was frozen for several consecutive quarters.

Share Repurchases

CIBC split its stock in 1967, 1986, 1997 and 2022; the split in 2022 was a 2-for-1 stock split. Investors need to consider this when looking at CIBC’s historical EPS and adjusted EPS results.

The average number of outstanding diluted shares (in millions of shares) in FY2013 – FY2022 is 803, 797, 796, 792, 827, 889, 891, 892, 900, and 906. At the end of Q1 2023, the diluted number of outstanding shares had risen to 911.6.

CIBC’s Valuation

CIBC’s FY2009 – FY2022 P/E ratio is 25.72, 13.34, 10.09, 10.19, 11.02, 12.70, 10.28, 10.24, 10.90, 8.73, 9.66, 13.23, 10.59, and 8.20.

While CIBC does not issue guidance, we have adjusted diluted earnings estimates from 14 brokers by which to gauge CIBC’s valuation.

Using a ~$58 share price and the current adjusted diluted EPS broker estimates, CIBC’s valuation is:

• FY2023 – 14 brokers – mean of $7.06 and low/high of $6.90 – $7.23. Using the mean estimate, the forward adjusted diluted PE is ~8.2.
• FY2024 – 14 brokers – mean of $6.98 and low/high of $5.38 – $7.57. Using the mean estimate, the forward adjusted diluted PE is ~8.3.

Shares are currently attractively valued on an adjusted basis. However, we see that there can be a sizable variance between GAAP and non-GAAP earnings.

• In FY2021, CIBC reported GAAP EPS of $6.96 and Non-GAAP EPS of $7.23.
• In FY2022, CIBC reported GAAP EPS of $6.68 and Non-GAAP EPS of $7.05.
• In Q1 2023, CIBC reported GAAP EPS of $0.39 and Non-GAAP EPS of $1.94.

I like to look at a company’s valuation on an adjusted basis since I can gauge how a company is performing when large non-recurring items are excluded. However, I also consider the nature of the adjustments and the large non-recurring items.

In some cases, companies may report significant GAAP gains or losses because they must mark to market their investments. Their investment holdings could skyrocket or plunge in value yet the investments have not been sold.

Berkshire Hathaway is a good example of this. In FY2020 – FY2021, it reported ‘Investment and derivative contract gains’ of $40.746B and $78.542B on its Income Statement. In FY2022, however, it reported ‘Investment and derivative contract losses’ of $67.899B on its Income Statement. Despite not having sold investments to generate such gains or losses, Berkshire Hathaway’s results can fluctuate widely because of this GAAP rule.

Some of CIBC’s large non-recurring line items, however, impact GAAP earnings because it had to lay out billions of dollars because poor business decisions came back to haunt it. These are not merely paper losses as with Berkshire Hathaway’s ‘Investment and derivative contract gains/losses’. CIBC’s large one-time items are very real ‘cash out the door’ losses.

Final Thoughts on CIBC

While I am critical of the magnitude of some of CIBC’s losses related to legal matters over the years, I am fully cognizant that it is not alone in this camp. Just recently, TD Bank Group agreed to pay USD $1.205B to settle a lawsuit in connection with a multi-year Ponzi scheme operated by the Stanford Financial Group. TD, however, is a lower credit risk, has a superior franchise, and is a much larger bank than CIBC; its market cap is ~2.85x that of CIBC. These are two VERY different banks.

The banking sector is cyclical, and therefore, investors should brace themselves for periods of ‘soft’ results. The recent string of rate increases by The Bank of Canada in an effort to bring inflation under control has yet to fully work its way through the system. As a result, I think investors should brace themselves for ‘soft’ results from the major Canadian banks over the next few quarters.

The Q1 2023 personal loan/mortgage book does not yet reflect the full impact of higher interest rates. I expect we will see higher delinquencies in the coming quarters. Furthermore, we need to consider that delinquencies would be much higher if the banks were not bending over backwards to help their customers!

Having said this, the Canadian banking sector is highly regulated and the banks are well-capitalized and well-managed. Therefore, the likelihood of a Canadian bank meeting the same fate as Silicon Valley Bank, Signature Bank, and Credit Suisse is, in my opinion, very remote.

I know CIBC’s dividend metrics and valuation will appeal to some investors. Now, while past performance is not necessarily indicative of future performance and CIBC could (although unlikely) prove me wrong, investors need to keep in mind that CIBC has a knack for finding a way to mess up. It is, essentially, an accident waiting to happen and investors would be wise to look beyond the dividend metrics and attractive valuation.

If you decide to invest in a Canadian bank, I recommend The Royal Bank of Canada (RY) or The Toronto-Dominion Bank (TD). Both these banks are far superior to CIBC from a risk perspective.

Although I currently own CIBC shares, I have reduced my exposure over the years. Once circumstances are more favourable, I plan to exit this position and to redeploy the sale proceeds toward the purchase of shares in companies I think offer the potential for far superior long-term total investment returns.

Author Disclosure: I am long CM, BMO, TD, RY, and BNS. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

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