May 2, 2013 Comments

Markets recovered the ground lost yesterday. Our Stock Picks had a particularly good day with Toll Brothers up 3.1%. Almost all of the stocks on the list were up.

Canadian Western Bank is updated and rated Buy at $28.42. I am comfortable holding it. I did not own it I would be comfortable buying some at this price. Since I already hold it I would be more likely to add to it if the price falls.

After an extensive look at its annual report I can boil down the economics of how it makes money as follows:

The bank takes in depositors at a weighted average interest of 1.88% and lends out money at an average of 4.77%. The net interest spread was most recently 2.62%. This spread (unfortunately) is falling as market interest rates drop but 0% interest deposits cannot decline any further. The range of deposit interest paid is 0% to 2.53% with most of the deposits being in the 2.53% category. The 2.62% gross profit is then reduced by the banks operating costs. The net interest after operating costs and income taxes is about 1.0%. With such a thin margin it becomes very important to avoid defaulting loans and where defaults occur to have security so that at least some amount is recovered. CWB’s allowance for bad debt runs at about 20 basis points. The 1.0% net profit on loans is then leveraged up by the fact that the loan assets are financed with only about 8% common equity (they are mostly financed with deposits) This results in an ROE on the lending business of about 14%.Residential mortgage loans average 4.06% interest while the much larger category of all other loans averages 5.57%. Business is competitive but some of it tends to be sticky to a good degree.

(Some of the math above does not work out exactly but the above represents the economics as I understand it)