Short sellers of Canadian banks — of which there are many — must have felt some stomach flutters in August: all three of the main Canadian banks managed to handily beat muted expectations for third-quarter profits.

Each of the three top Canadian banks — Toronto Dominion Bank (TSX: TD, NYSE: TD), Royal Bank of Canada (TSX: RY, NYSE: RY) and Bank of Nova Scotia (TSX: BNS, NYSE: BNS) — reported mid-single digit earnings growth, and each increased its dividend by roughly the same margin compared to last year.

TD Bank had excellent results from its U.S. operations, which now contribute almost a third of profits. The much smaller brokerage division also made a very positive contribution. We’re somewhat disappointed with the sub-par performance of the bank’ Canadian retail division, where profits declined slightly. Elevated insurance claims as a result of the Fort McMurray wildfires was provided as a mitigating factor, but revenue growth was slow, and that had nothing to do with the fires. Overall, we were satisfied with the results, with no major concerns.

At Royal Bank, the traders turned in a super performance this quarter, posting 20% higher trading revenues while recording only one day of trading losses. Wealth management, which now includes the recently acquired U.S.-based City National Bank, also made a strong contribution. A further boost to profits came from a limited provision for credit losses. Overall, we were less impressed with Royal Bank’s results, as trading profits are volatile from quarter to quarter and we prefer conservative provisions for potential credit losses.

The profits at Scotia also received a considerable boost from trading operations. Investment banking was a big plus, too. Costs were well contained, resulting in the best cost to revenue ratio of the three major banks. Overall a reasonable result, although we are always wary of huge contributions from the more volatile trading and investment banking operations.

Some common factors were also noticeable among all three results. First, the Canadian dollar traded somewhat weaker during the third quarter, compared to the same quarter last year, which boosted the Canadian dollar profits of the bank’s substantial offshore operations. This tailwind will diminish or disappear as the Canadian dollar stabilizes.

Second, provisions for credit losses have declined in all cases when compared to the previous quarter, as the banks now seem to have moved through the peak in bad energy loans. Nevertheless, exposure to the energy sector remains relatively small, at around 2% of the loan books of the major banks.

Third, cost management was tight. Expense ratios (non-interest expenses as a portion of revenues) declined in all cases when adjustments for one-off items are factored in. This improvement resulted from cost-cutting measures introduced last year, including staff reductions and an increased focus on productivity improvements.

Lastly, growth in profits from the domestic Canadian operations, a core banking activity for all three banks, has dropped to low single digits for both TD Bank (excluding insurance) and Royal Bank. Consumers already have high levels of debt — resulting in low growth in loans — while low interest rates are compressing margins.

Our main concern remains the large exposure of these banks to the Canadian residential real estate market, which is showing signs of overheating in the core markets of Toronto and Vancouver.

A deterioration in the real estate market would reduce the considerable profits that the banks are deriving from mortgage lending. We foresee that provisions for credit losses on home loans, which currently is negligible, will rise sharply while growth in mortgage loans will vanish. This will hurt the profitability and profit growth of the banks.

As indicated in the table, the banks have all insured a good portion of their home loan books. That will help protect them against a meltdown in the housing market. In addition, the banks have reasonably conservative loan to value ratios, which also provides some downside protection.

The Canadian banks remain very profitable entities and core holdings for many portfolio managers. Dividend track records are formidable, and valuations are reasonable. However, these banks all have a substantial dependency on profits generated by their Canadian mortgage books. We consider this a considerable risk and have scaled back our banking exposure to what we consider to be the best Canadian bank, namely TD Bank.