TD Bank Is Now the Most Shorted Bank Stock. Should Investors Be Worried? | The Motley Fool (2024)

The banking crisis has been relentless since it started, dragging down bank stocks of all shapes and sizes and spilling into Europe, as well. Now, one of Canada's largest banks has found itself in the crosshairs of investors.

Toronto-Dominion Bank (TD -0.46%), often referred to as TD Bank, has a very large presence in the U.S. and is now the most shorted bank stock among its peers. Traders have taken $3.7 billion worth of bets against the bank.

With roughly $1.26 trillion in assets, TD Bank would certainly be considered too big to fail, and many believe the large banks are set to benefit from this recent banking crisis because they're likely to be seen as a safe place to transfer funds into. Let's take a look at why the shorts are betting against TD Bank and if their arguments have merit.

Connections to other banks

Unlike banks in the U.S. that collapsed due to bank runs and because they were sitting on lots of unrealized bond losses, TD Bank hardly had any unrealized losses in its securities portfolio. Furthermore, the bank has an incredibly diverse deposit base when you consider its global scale, whether in the U.S. or Canada, so a deposit run is unlikely.

However, TD Bank has exposure to some other banks that investors are taking a close look at. One is Charles Schwab (SCHW 1.71%), in which TD Bank acquired a 13.4% stake when it sold Ameritrade to Schwab.

Shares of Schwab have come under immense pressure since the onset of the banking crisis and are down 36% over the last month. The big reason is that Schwab is sitting on enough unrealized bond losses that could wipe out most of the company's tangible common equity if it ever had to sell them to cover deposit outflows.

Still, Schwab has more than $7 trillion of client assets, tons of access to liquidity, and more than 80% of its deposits insured by the Federal Deposit Insurance Corp. (FDIC), so a bank run and forced sale of securities while they are trading at a loss is extremely unlikely. I do expect Schwab's earnings to struggle in the near term as customers move their money into higher-yielding bank products.

Another bank TD Bank has a connection to is the U.S. regional bankFirst Horizon (FHN -1.20%). TD Bank announced its plan to acquire First Horizon in February 2022. Since then, it had to extend its merger agreement in February of this year and recently announced that it'll need to extend the agreement again before it expires in May. Regulators have gotten more strict when approving bank mergers since the Biden administration took over, and many investors are now concerned it won't be completed.

However, I don't view the outcome of this acquisition to be a huge problem for TD Bank. If it can't complete the merger, it could have to pay a termination fee under certain circ*mstances. That's not ideal, but then TD Bank would have additional capital flexibility and could repurchase its own stock at an attractive price.

It could also purchase another U.S. regional bank at an even cheaper price. If TD Bank does complete the acquisition, it gains a presence in the attractive Southeastern region of the U.S., which is experiencing some of the fastest population growth in the country.

Real estate exposure

TD Bank is also supposedly facing pressure as investors worry about the slowdown in the Canadian housing market. A recent report from economists at TD Bank said that housing prices in Canada are expected to continue to fall. They gained 47% during the early part of the pandemic, and economists think average housing prices will drop 21% before the market bottoms.

Furthermore, many Canadians took out variable-rate mortgages early in the pandemic when interest rates were at an all-time low. Since then, they've seen their mortgage payments rise as the Bank of Canada raised interest rates.

A home is a big part of a family's or individual's wealth, so if home prices fall a lot or mortgage delinquencies and defaults rise, it could cause pain in the Canadian economy, and TD Bank will be clearly impacted. However, at the end of TD Bank's first quarter of 2023, which is for the three months ending Jan. 31, gross impaired loans in the bank's roughly $180.8 billion mortgage portfolio was only 0.07%, and borrowers have strong equity in their homes, as well.

Since the banking crisis started, investors have also placed renewed focus on commercial real estate (CRE), particularly in sectors like office space, retail, and multifamily loans. TD Bank has nearly a $66 billion loan CRE portfolio, 29% of which is multifamily, 18% retail, and 10% office.

But total CRE exposure as a percentage of the bank's core capital is about 106%. While it might sound like a lot, U.S. regulators won't get too worried about a bank's CRE exposure unless it exceeds 300% of core capital. TD Bank's common equity tier 1 capital ratio, which looks at a bank's core capital expressed as a percentage of its risk-weighted assets, stands at 15.5%, which is higher than most major U.S. banks.

Should TD Bank investors be worried

Obviously, it's never great to see rising short interest in a stock, but TD Bank isn't facing liquidity issues. I'm also not overly concerned about its exposure to Schwab, which I don't believe faces any systemic risk.

While the pending acquisition of First Horizon is uncertain, I don't believe either outcome will be overly difficult for TD Bank to overcome. The bank will undoubtedly see loan losses rise as credit conditions normalize and the economy begins to struggle more, but TD Bank is extremely well capitalized and loans seem to be much better underwritten today than they were during the Great Recession.

TD Bank currently trades at about 178% to its tangible book value, lows that have only been seen at the very beginning of the pandemic. The bank, on average, has traded at about 314% to its tangible book value since 2003, so I think a lot of the fears regarding the current environment have been priced in.