Toronto-Dominion Bank’s Loan Losses Could Grow by 50% in 2016: Should You Be Worried?

According to Toronto-Dominion Bank (TSX:TD)(NYSE:TD), it could be in for an increase as much as 50% in how much it puts aside to cover expected loan losses. Is this a concern for investors?

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Without a doubt, one of the closest-monitored aspects of bank performance of late has been credit quality. Investors are closely monitoring credit—especially in the oil and gas sector—to notice increases in impaired loans and provisions for credit losses (PCL: how much the bank charges against its earnings to cover expected losses).

In this regard, Toronto-Dominion Bank (TSX:TD)(NYSE:TD) posted Q1 2016 credit performance that may, at first glance, seem concerning to investors. The bank’s PCL increased to $642 million—a huge 20% jump from the prior quarter (and a 77% jump from Q1 2015).

This basically means that the bank is either seeing deterioration in its credit quality, or it expects deterioration in its credit quality. More importantly, the PCL ratio (or PCLs of $642 million as a percent of total average loans) grew from 0.36% to 0.44% from the previous quarter.

While many will say this is simply a single quarter, TD stated on its recent conference call that the PCL ratio of about 0.45% is a good rate to expect for 2016. In dollar terms, this would translate to 2015 PCLs growing by almost 50% from $1.6 billion to about $2.5 billion (which is what analysts at RBC expect).

Caution about oil and gas is part of the increase

While this may seem worrisome at first glance, it is important to look at why there was such an increase from the previous quarter. Firstly, TD had a $65 million collective allowance build, which was up from $36 million the previous quarter (and compared to a total of $4 million for the remainder of 2015). This alone counts for 20% of the quarter-over-quarter increase in PCLs.

What is a collective allowance build? A collective allowance build is a type of PCL where the bank basically sets aside money for loans that it has not specifically identified, but may become impaired in the future. This is opposed to other types of PCLs where the bank may see a specific corporate loan that is impaired and set aside money to cover that particular loan.

In this case, the $65 million is set aside to cover expected losses in the oil and gas portfolio as well as in the consumer portfolios in that region. This is basically the bank being careful, and PCLs of this size could decline if oil prices increase (which the bank admitted). With oil prices in a steady uptrend since the bank released its results, it is possible this amount could decline in future quarters.

Currently, TD’s oil and gas loan book has had no issues. In fact, both PCLs and gross impaired loans in the energy sector actually fell in Q1 2016, and currently only 1% of TD’s loans are to the oil and gas sector (the lowest of its peer group). TD also has the lowest exposure to Albertan retail loans.

The rest of the increase in PCLs is not a huge concern

While the collective allowance build is responsible for part of the growth in PCLs, foreign exchange and growth in U.S. loans is responsible for the remainder. The U.S. dollar strengthened quite a bit in Q1 2016, and this means that TD’s U.S. dollar expenses (like the PCLs from its U.S. retail segment) will be worth more when translated back into Canadian dollars.

According to TD’s disclosures, foreign exchange was responsible for about 27% of the jump in PCLs from the previous quarter. The remainder of the increase is largely due to the fact that TD made acquisitions of two U.S. credit card portfolios late in 2016 (Target and Nordstrom).

This means TD’s loans increased, which also means PCLs need to grow to cover the greater amount of loans. It is important to note that PCLs increased more than proportionately with the loans, and this is because credit card portfolios usually have higher loss rates than a mortgage or other type of loan portfolio.

Going forward, while TD may see its loan losses grow in 2016, investors should feel comfortable that this growth is largely due to loan growth and caution on behalf of the bank about oil and gas rather than any actual deterioration in the quality of the bank’s loan book.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Adam Mancini has no position in any stocks mentioned.

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