Will Europe resolve its sovereign debt crisis and return to growth in 2012? Or will, as so many fear, the Continent’s economic unity dissolve and its banking system and common currency collapse, dragging the rest of the world into another recession?

Is the US banking system at last stable and ready to lend? Or will the legacy of the great American housing collapse keep the US banks and therefore the economy stalled?

And what about Australian banks, which Fitch–perhaps the only credit rater left with real credibility–put on ratings watch negative in late January?

Will their reliance on European and American wholesale funding trip them up this time around, pushing the country into a recession it miraculously avoided in 2008-09?

This year’s global stock market rally has pushed these questions off the front pages for now. But the threat they pose continues to lurk below the surface. And so long as Greece is still dancing on the edge of default, US housing prices are lagging and credit raters are on the warpath to avoid looking foolish again, they’ll remain a constant danger to derail global growth and to send stocks reeling–just as they have so many times since the recovery began in March 2009.

Conspicuously missing from the ranks of vulnerable financial institutions, however, are Canadian banks. In the same report it put Aussie banks on watch, for example, Fitch actually affirmed the health of Canada’s institutions.

One reason: Sharply lower reliance on “wholesale funding” from major US and European banks than, for example, Australian banks have. Wholesale funding is essential to liquidity, and greater reliance on homegrown sources simply makes Canada that much more resistant to external credit shocks.

Several Canadian banks do have major investments overseas. For example Bank of Nova Scotia (TSX: BNS, NYSE: BNS)–commonly known as Scotiabank–last month closed the purchase of a 51 percent stake in Colombia’s Banco Colpatria for CAD1 billion in cash and shares. The bank now operates in 13 countries across Latin America. Toronto-Dominion Bank’s (TSX: TD, NYSE: TD) head of wealth management Mike Petersen last month called the US a “wealth opportunity,” as the company continues to expand its deposits and loans presence here.

Foreign investments do expose their owners to the ups and downs of foreign economies. But unlike reliance on wholesale funding, they pose little risk to the home operation. In fact Royal Bank of Canada (TSX: RY, NYSE: RY) has been able to withdraw from its poorly managed US banking investment even while boosting its quarterly dividend 8 percent last year. Moreover, the apparent revival of the US economy–and its salutary effect on Latin America–should make these investments a growing profit center in 2012.

As for the health of Canadian banks at home, the industry’s loans-to-deposits ratio has fallen for the past decade and currently sits somewhere around 0.75-to-1, meaning deposits are consistently rising as a percentage of total loans. That’s an exceptionally conservative trend and stands in stark contrast to Australian banks’ 1.5-to-1 ratio as well as an average for the largest global banks that’s consistently above 1-to-1.

Deposits-to-total funding are also far higher in Canada than elsewhere. Canada’s net external debt as a percentage of GDP is by far the lowest of any major developed country. Finally, the country’s housing market is still in the pink of health, with average housing prices up more than 20 percent since 2007, versus steep declines in many countries.

Worries that Canada’s housing market has run too far too fast have begun to percolate in the country’s financial press. In fact, the consensus forecast seems to be for a slowdown, with some predicting an outright crash should Europe’s troubles worsen and shut down the global economy.

Canadian households’ debt-to-income ratio, for example, has risen to 153 percent, as consumers and businesses have taken advantage of low interest rates to use leverage as never before. Fitch also noted in its report that some of Canadians’ “personal loans” are secured against housing.

The combination of rising debt and rising property prices has sparked speculation about what could happen should credit conditions suddenly tighten. Some worry about a potential vicious cycle of falling prices and foreclosures as has happened in the US since 2006.

Where Conservative is Cool

Of course, none of these are immediate concerns for Canada’s banks, which are making record profits for everything from loans and deposits to wealth management. And so long as there is a gloomy consensus, we can all but rule out the kind of wrong-way leverage that makes a 2008-magnitude crash possible.

The fact that Canada’s bankers are talking about such issues means they’re preparing for such a possibility as well. Last month, for example, Bank of Canada Governor Mark Carney warned Canadians need to become “more careful” about the amount of debt they take on. And Scotiabank has launched a marketing campaign urging, in the words of one executive, a “need to get back to saving and get back to debt reduction.”

It’s hard to imagine a greater contrast to the marketing by US banks on the eve of the great property meltdown of the last decade. And Canada’s big banks have matched those words with deeds.

For one thing, even as mortgage rates have fallen underwriting standards for loans have remained quite stringent. The subprime loan market was less than 3 percent of total Canadian mortgages going into the 2008 meltdown and is basically negligible today. And putting up at least 20 percent of a home’s value in a down payment is the rule in Canada rather than the exception, the opposite of what is all too often the case in the US.

Canadian regulators have also established higher capital requirements for Canadian banks than those specified under Basel accords. The big banks are borrowing at the lowest rates in recent history, pushing out debt refinancings and cutting interest costs. And as Scotiabank’s CAD1.5 billion share offering announced this month attests, the cost of equity capital also remains quite low, particularly compared with major banks elsewhere around the world.

Major Canadian banks will announce their first quarter results for fiscal year 2011-12 in late February and early March. Based on last quarter’s results and strong guidance issued since then, we can expect another solid set of numbers.

This will be just the latest affirmation of the health of what’s arguably been the world’s strongest banking system for at least the past five years. And we can also expect management to continue or even intensify the kind of conservative financial policies that will ensure the system remains healthy, even if there are storms in the global financial systems this year.

Financial system weakness has been a drag on the US economy the past few years. And it’s a major threat to European growth now, with several countries nearing depression-like levels of unemployment.

Conversely, strong banks a major plus for Canada’s economy. They ensure Canadian Edge companies will have stable access to low-cost credit going forward, which, in turn, is critical to their financial health and growth prospects.

As I’ve said many times here, I prefer to own companies with no near-term refinancing needs, or at least little enough so they can wait out a potential near-term tightening in the credit market. That’s true of every CE Portfolio Holding now. Moreover, several, such as Conservative Holding EnerCare Inc (TSX: ECI, OTC: CSUWF), stand to gain from refinancings this year.

Low-cost capital is also enabling our picks to make strategic moves that will enhance long-term growth. This month, for example, Atlantic Power Corp (TSX: ATP, NYSE: AT) was able to spend CAD23 million to buy a 51 percent stake wind power project in Oklahoma slated to have 298.45 megawatts of capacity. The output is already 84 percent under contract and is slated for startup in November, in time to qualify for tax credits that under current law will expire Dec. 31, 2012.

The deal will immediately boost Atlantic Power’s cash flow when the plant comes on line. And it would have been inconceivable at higher interest rates. This deal is the first for Atlantic since completing the Capital Power LP acquisition last year, and it’s a fair portent of more low risk expansion to come.

I like Atlantic Power as a buy up to USD16 for those who don’t already own it. And it’s far from being the only CE Portfolio Holding using low-cost debt capital to grow. But there are also considerable opportunities to directly invest in the health and growth Canada’s financial system. Below, I highlight my favorites now.

Best of the Big

Unlike the US, Canada’s banking system is dominated by a handful of giants, all of which are tracked in How They Rate under Financial Services: Bank of Montreal (TSX: BMO, NYSE: BMO), Bank of Nova Scotia, Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM), National Bank of Canada (TSX: NA, OTC: NTIOF), Royal Bank of Canada (TSX: RY, NYSE: RY) and Toronto-Dominion Bank.

Canadian Edge Associate Editor David Dittman has highlighted the sector periodically in Canadian Currents as well as in CE Weekly. Better Banking Through Geography, the June 2011 Currents article, highlighted Canadian banks’ growth coming out of the 2008-09 crash. Financial Stability and Canada in the Jan. 30, 2012, edition of the Weekly focused on the country’s monetary policy.

A brief glance at the How They Rate reveals we’re hardly universally bullish on the Big Six here in early 2012. The Big Six comprise nearly 20 percent of the S&P/Toronto Stock Exchange Composite Index, and all move together to some extent, due in large part to the proliferation of mutual funds and exchange-traded funds.

Beneath the surface, however, there are large gaps in performance. Royal Bank of Canada’s post-crash foray into the US, for example, had all the marks of a “me too” move, with predictably disastrous results when it was ultimately forced to withdraw at a huge loss. But at the same time Toronto Dominion has continued to profitably build a franchise south of the border.

The Bigs do share a common strength that can scarcely be overestimated. That’s a strong relationship with Canada’s central bank and regulators.

Canada never had a Glass-Steagall Act legally separating investment banking activities from commercial banking. It never suffered a dismantling of regulations as happened in the late 1990s in the US, setting up the worst financial crisis in 80 years. And it’s not now going through a dramatic re-regulation, as has happened in the US the past few years.

What Canada has had is a consistent and stable regulator-banks relationship that’s promoted conservative financial policies. Banks weren’t ordered by regulators to refrain from activities that put Canada’s entire financial system at risk.

No one proscribed their actions. Rather, executives have consistently over time simply acted in the long-term interests of their institutions, which was to look ahead to avoid trouble rather than chasing a near-term dollar.

That unspoken code of conduct–not any specific ratios or laws–is the single greatest underpinning of Canada’s financial system today. And it’s why, so long as it lasts, even the most underperforming of Canada’s Big Six is at no risk of becoming another Citigroup (NYSE: C), whose size and periodic explosions of hubris seem to land it in extremely hot water at least once a decade.

That being said, some Canadian banks are definitely more attractive than others. In fact, we currently rate only two of the Bigs as buys now: Bank of Nova Scotia and National Bank of Canada.

National Bank and Scotiabank currently yield about 4 percent. That’s slightly above Toronto Dominion’s 3.5 percent but somewhat lower than the other Bigs. Both companies are, however, growing dividends considerably faster than their rivals. National Bank has raised its payout twice in the last 12 months for a total of 13.6 percent. Scotiabank raised once in 2011 by 6.1 percent  and is set for a similar increase next month.  By contrast Bank of Montreal CEO William Downe has warned investors not to expect a dividend increase in 2012. This will make five years for BMO shareholders  without a boost.

Both Scotiabank and National Bank have consistently posted strong operating and balance sheet numbers in recent quarters. And they look set to do the same when they report fiscal 2012 first-quarter results on Mar. 6 and Mar. 2, respectively.

Scotiabank’s fiscal 2011 fourth-quarter net income per share surged 10 percent, as return on equity rose to 18.8 percent. Core banking profit rose 4.3 percent, and the company continued to benefit from global expansion as well as the growth of its wealth management unit. Management forecast 5 to 10 percent earnings per share growth in 2012, and capital ratios far exceed regulatory requirements.

National Bank’s fiscal 2011 earnings hit a record, capped by a 10 percent boost in earnings per share. Return on equity was 17.7 percent excluding certain items, as the company rode an 18 percent boost in its wealth management profit for the quarter and 43 percent for the full year.

The biggest difference between the pair is Scotiabank’s now sizeable presence outside Canada. National Bank also has foreign operations, mostly in the US, though Canada still accounts for more than 96 percent of revenue. Scotiabank, meanwhile, pulled nearly half of sales from outside Canada.

Foreign exposure means Scotiabank is better able to ride out the ups and downs of Canada’s economy and that it enjoys a generally higher rate of growth. A relative lack of foreign investment means National Bank is probably better able to weather potential global turmoil, though it’s obviously more dependent on Canada.

But backed by very strong balance sheets, solid and growing niches and conservative operating and financial principles, both are suitable for conservative investors. And they’re far safer on their business fundamentals than any bank on the US side of the border.

Last autumn at the Toronto MoneyShow I participated on a panel with several highly respected Canada-based advisors, most of whom were convinced big Canadian banks were a sell, if not a short sell. Their reasoning was that a full-blown European banking crisis would drag down Canada’s Bigs, including those that didn’t have much direct exposure to the Continent’s banks or sovereign debt woes.

This worry has persisted since, despite the lack of an actual event. And not surprisingly Canadian bank stocks have been mostly flat to down-trending over that time. Scotiabank, for example, trades at less than 11 times consensus expectations for 2012 earnings. National Bank, meanwhile, trades at little more than 10 times expectations.

For their part, Bay Street analysts are lukewarm on these stocks, due to the same macro worries. Of the 14 analysts covering Scotiabank, for example, there are seven “buys,” five “holds” and two “sells,” with the most recent change a downgrade in early January. National Bank’s tally is six “buys,” eight “holds” and three “sells,” also with a downgrade in early January.

That’s a stark contrast with the insiders, who have been recent buyers of both banks. And it means that if Europe can avoid a complete meltdown, these stocks are likely to at least move back to last year’s highs, which would trigger a roughly 20 percent gain for Scotiabank and a slightly lesser boost for National Bank.

Bank of Nova Scotia rates a buy up to USD60. National Bank is a buy up to USD75.

Small and Surging

Prior to the 2008 meltdown, trying to do it all was the rule rather than the exception for US banks, who became brokers and wealth managers, insurance and mortgage salesmen and even traders. Today many are trying to get back to basics, focusing on loans and deposits and shedding assets and operations that got them in trouble.

Canadian banks face few if any legal and regulatory restrictions on what they do. Caution and conservatism, however, have led most to focus mainly on what they do best. That’s managing deposits, loans and a handful of low risk functions that leverage their expertise, immense reach and financial strength.

That’s left a large space for more specialized, smaller companies occupying valuable niches, with in many cases the Big Banks as customers. All are the case for Canadian Edge Conservative Holding Davis + Henderson Income Corp (TSX: DH, OTC: DHIFF), which basically provides digital and paper documentation for a wide range of banking functions, from student loans to mortgages.

Davis + Henderson named a new CEO this week, Gerrard Schmid, who has extensive experience in the domestic and international banking industry. This should position him well to continue meeting the needs of Canada’s Bigs.  Former CEO Bob Cronin will stay on through 2012 as an advisor to ease the transition.

Davis + Henderson returned to dividend growth this summer, boosting its payout 3.3 percent in the first increase since converting to a corporation in January 2011.

That’s likely to be the first of many steady and robust annual bumps in the payout, as the company continues to find more opportunities to grow its business organically as well as through acquisitions.

The purchase of Mortgagebot in April 2011 was a big contributor to last year’s double-digit profit growth, even as it widened the company’s geographic reach for the first time to the US and boosted its technical capabilities.

More deals are likely in 2012, as Davis + Henderson continues to successfully transition its business from the original focus of check-printing to a full range of services that for all practical purposes are as steady as if they were truly fee-based operations. The company has currently targeted community banks in the US for expansion, a strategy that takes advantage of its ability to reach smaller customers and the universal appeal of its service line.

We’ll hear more about its progress when the company announces earnings, which will take place on or about Mar. 8. In the meantime, the stock has staged a mighty recovery from its mid-December low and in fact is now up nearly 10 percent for the year. That’s still left the stock well below my buy target of up to USD20. Buy Davis + Henderson, which still yields nearly 7 percent, up to USD20 if you haven’t yet.

CI Financial Corp’s (TSX: CIX, OTC: CIFAF) forte is wealth management. That’s put the stock squarely in the takeover sites of the Bigs, particularly Scotiabank, which continues to sniff around despite an official rebuff from CI management.

As of Dec. 31, 2011, CI had CAD69.5 billion in assets under management and total assets of CAD91 billion. Both figures were off slightly for both December and the full year from 2010 totals. The declines, however, were less than half the drop in the S&P/TSX Composite Index, indicating the company is both beating the market and holding market share.

That’s no mean feat in a volatile market like this one, and it’s a direct consequence of offering solid mutual funds that meet investor demand, as well as prudent portfolio management. The company, which also holds CAD21.5 billion under administration at Assante Wealth Management, has already launched two more funds this year, both with an income slant.

CI won’t announce its quarterly earnings until on or about Feb. 16. The volatile markets may negatively affect those numbers. But with assets under management rising 2.7 percent in January (total assets up 2.3 percent), results look likely to turn increasingly robust in 2012.

CEO Stephen MacPhail noted this month that the company also continues to gain market share at the expense of competitors.

My first rule with takeover targets is to only buy companies you’d want to own if there were no deal. That’s definitely the case with CI, which has proven it can be an industry leader on its own.

Unfortunately, US investors will find it difficult to impossible to buy CI’s mutual funds. But the real leverage is in CI Financial shares, which should fetch close to CAD30 a share with an honest takeover offer. They also yield more than 4 percent paid monthly. The company raised its dividend 7.1 percent in late February for the April payment, and based on recent solid results another increase is likely by early March. Buy CI Financial up to USD22 if you haven’t yet.

In the US the residential real estate business still has more than few success stories, despite a continuing bear market in many areas. It’s hard to conceive of the business, however, as a source of income steady enough for a large company to pay a robust and regular dividend.

Brookfield Real Estate Services Inc (TSX: BRE, OTC: BREUF), by contrast, can pay a yield of nearly 9 percent, thanks to the benefit of operating in the far more steady Canadian residential property market. And some 68 percent of its revenue is essentially fixed fees, deriving from the number of agents licensed under its national brand.

This leaves just 32 percent to the vagaries of the market, mainly variable fees based on transactional dollar volume from real estate commissions by its member agents. Moreover, since the former income trust converted to a corporation in January 2011 its monthly dividend has been covered by better than a 2-to-1 margin by distributable cash flow.

Brookfield Real Estate Services, which is backed by the financial power of giant Brookfield Asset Management (TSX: BAM/A, NYSE: BAM), currently has about a 23 percent share of the Canadian residential real estate market by transactional dollar volume. There’s no debt due until Feb. 17, 2015, when a credit facility on which the company has drawn CAD20 million will either have to be paid off or rolled over. The company also has a CAD32 million bond maturity coming due that day.

The good news is the company has little reason to access either debt or equity markets until then, other than possibly for acquisitions that increase cash flow. The most recent of these was in late December, when a unit of parent Brookfield Asset Management essentially dropped down franchise agreements representing 17 real estate offices and 219 realtors.

Effective Jan. 1, the deal adds brokerage offices that generated CAD0.3 million in royalties last year previously operating under the Royal LePage brand. And it adds operations that generated CAD0.2 million in royalties from the Via Capitale brand. It will also be entirely funded from internally generated cash.

Dropdowns have provided a major boost to other members of the Brookfield family, notably Conservative Holding Brookfield Renewable Energy Partners LP (TSX: BEP-U, OTC: BRPFF). The company raised dividends each of the past two quarters (see Portfolio Update).

Given the widespread expectation for a slowdown in the Canadian residential real estate market, I don’t expect to see Brookfield Real Estate Services ramp up its dividend in 2012. Fortunately, the yield is already quite generous at nearly 9 percent. And a move back to last summer’s high–when it was arguably a less valuable company–would tack on another 20 percent in capital gains.

That’s certainly a reasonable expectation. Although earnings aren’t expected to come out before Mar. 14, based on the numbers and results we have seen there appears to be little to worry about, even if Canada’s property market does slow. Brookfield Real Estate Services is a buy for slightly more aggressive investors up to USD14.