Thursday, December 08, 2005

Scotiabank has Eyes on the Road with GM Deal

The Globe and Mail, Andrew Willis, Thursday, December 8, 2005

The rest of the Canadian banking community just doesn't get Bank of Nova Scotia's fascination with lending companies money.

Providing credit to corporate customers is a lousy way to make a living, according to conventional wisdom. The future is in retail banking, where bankers can provide high-margin wealth management to the masses, along with capital-lite products such as derivatives for the corporate crowd.

Loans, on the other hand, are leftovers from banking's distant past. Just look at the realities of the business. Companies pay rock-bottom rates to borrow, so margins are thin. Corporate borrowers make use of products such as lines of credit that tie up the bank's capital, yet offer minimal returns. And every so often the likes of Adelphia, White Rose, Bramalea or O&Y go bust -- they were all Scotiabank clients -- and take a big bite out of the balance sheet.

Yet credit-happy Scotiabank chief executive officer Rick Waugh just keeps on cracking open the vault. In fact, he threw it wide open this week for the car wreck that is General Motors, pledging to take a staggering $20-billion (U.S.) in loans over five years from the auto marker's financing arm, known as GMAC. Should this man be allowed behind the wheel?

Well, here's how the numbers work on Scotiabank's latest venture. Merrill Lynch analyst André-Phillippe Hardy figures that to take on that GMAC exposure, the bank has to set aside just $175-million (Canadian) to $200-million of its own capital. And Scotiabank is carrying more than $4-billion of excess capital these days.

Car buyers pay 6- to 8-per-cent rates for the loans that put them in new Chevy Suburbans, Cadillac Escalades and the rest of the GM fleet. GMAC takes a 1-per-cent fee for what is known as "origination and servicing" on these loans. The rest goes to the bank.

When Scotiabank gets its hands on the loans, the bank will likely find that deadbeat car buyers who renege on their loans eat up about 1.1 per cent of the portfolio, at worst. One final number: The bank's sterling credit rating allows it to borrow for about 4 per cent, well below the junk bond rates charged GM. (The auto maker is doing this deal in a desperate attempt to restore its credit ratings.)

Add it all up, and Scotiabank can expect to earn a 200-basis-point spread on these car loans and Mr. Hardy says the bank can anticipate 20-per-cent return on the equity it invests in the GMAC portfolio. In financial circles, this is an out-of-the-park home run.

Add in the fact that Scotiabank knows this sector cold as a top auto financier in both Canada and Mexico, and you've suddenly created a North American leader in an attractive, growing sector. That expertise can be exported to a growing South American network, where the third-largest bank in Peru is expected to soon join the fold. See where Mr. Waugh is driving?

Like predecessors Cedric Ritchie and Peter Godsoe, Mr. Waugh spent a big chunk of his career running Scotiabank's corporate lending operations. He and his colleagues have a credit culture that is second to none. By continuing to make the balance sheet available to corporate clients such as GM, Scotiabank is opening up new avenues for expansion. Defying conventional wisdom on lending should prove lucrative.

Strategy takes flak

Bank of Nova Scotia does take justifiable flak for one element of its credit-based strategy.

Most of the bank-owned dealers, including the major U.S. houses, have baked what amounts to tied selling into the services they offer corporations.

The bank will lend money to the company, but in return, they ask (or demand) that the company use their advisory teams on lucrative M&A assignments, or equity underwritings.

So on the proposed Inco purchase of Falconbridge, you'll find RBC Dominion Securities, Goldman Sachs and Morgan Stanley all providing advice on the $12.5-billion takeover, and also lending Inco the necessary funds. Only Scotiabank is stepping up to lend to Inco without getting a serving of advisory fee gravy.

To the extent Mr. Waugh and his colleagues at investment dealer unit Scotia Capital Inc. can use their credit relationships to win additional advisory work, they'll be doing better for the bank's shareholders.