Monday, April 30, 2007

BMO Commodity Losses Could Hit $450 Million

Financial Post, Jonathan Ratner, 1 May 2007

BMO announcement last week that it would incur a trading loss of $350-million to $450-million, primarily as a result of natural gas trades, not only surprised investors in Canada’s largest banks, it highlighted market risks that may be frequently ignored.

And while trading revenues are somewhat small in proportion to overall numbers, they still represent a hefty chunk of change for the Big Six banks.

For example, BMO’s trading revenue was $665-million in 2006, CIBC had $882-million worth, Bank of Nova Scotia came in at $1.031-billion and Toronto-Dominion Bank brought in $1.042-billion. Royal Bank of Canada topped the list with $2.117-billion, while National Bank had the lowest at $364-million.

These figures, from Desjardins Securities analyst Michael Goldberg, are expected to rise for most of the banks this year, from a total of $6.101-billion for the Big Six in 2006 to $6.589-billion in 2007.

He estimates that BMO’s 2006 trading revenue contributed 3% of its total net revenue of $8.6-billion, the smallest proportionally among its peers. National Bank topped the list with more than 6% from trading.

Mr. Goldberg is particularly troubled by the lack of useful barometers to gauge trading revenue, such as margin or volume, and finds it inconceivable that the banks do not have ways to benchmark their trading revenue, estimate or budget.

“But no one that we have asked has explained how they do it,” he said in a note to clients.

While maintaining a “buy” rating on BMO shares, Mr. Goldberg reduced his price target to $75 from $77, calling BMO “dead money” in the near term.
Financial Post, Duncan Mavin, 1 May 2007

Bank of Montreal's explanation for $450-million worth of natural-gas trading losses has been met with a wave of skepticism by energy-trading industry insiders who say the gaffe was more than a case of the market moving against the bank's star natural-gas trader, David Lee.

On Friday, Bill Downe. BMO chief executive, said the losses were caused by a drop in the volatility of natural-gas option prices to historically low levels, leading to a drying up of demand -- or liquidity -- in the naturalgas options market.

BMO also said the losses were partly caused by "a refinement in [the bank's] approach to estimating the market value of [the natural gas] portfolio."

But some industry insiders disagree with the bank's version of events. "First of all, volatility is not at historically low levels," said an executive of a U.S.-based energy trading business. "Secondly, there has been no dry-up in liquidity whatsoever."

Another executive with decades of experience in the U.S. energy trading markets said, "liquidity is not the issue at all. That's a go-to phrase people like to throw in as it makes it sound like it is not your fault."

Several analysts in the United States and Canada, speaking to the Financial Post on condition of anonymity, offered alternative explanations. BMO's traders simply made bad bets on natural-gas prices, or the bank has discovered that it previously valued their book of natural-gas trades inaccurately, they suggested.

"The meaningful question is, of the [$450-million] how much of it is related to revaluation, and why was the portfolio marked wrong to begin with?" said one energy trading industry insider. "Was it intentional, was it a mathematical model that blew up and no one caught it? It's definitely a lapse in risk management." BMO declined to comment.

Observers also questioned whether BMO exercised sufficient control over its energy trading team, and pointed out that the bank's energy traders were operating in a market that is normally considered high risk.

Standard & Poor's said there might be "some more profound structural issues with the bank's risk-management function."

Blackmont Capital analyst Brad Smith said the losses are "a wakeup call for investors who may not have appreciated how the risk profile of our domestic banks has shifted during the past 20 years, since being encouraged to enter the global capital markets."

The bank's natural-gas trading team is headed by Mr. Lee, considered to be the largest natural-gas option trader in the market. Mr. Lee's trading activity includes buying and selling options over the counter and on the New York Mercantile Exchange, and had proved a lucrative source of profits for BMO for much of last year.

Many of Mr. Lee's trades were conducted through Optionable Inc., a U.S. brokerage house whose stock fell 20% on Friday.
RBC Capital Markets, 30 April 2007


We are initiating coverage of Bank of Montreal with an Underperform, Average Risk rating on its shares.

Investment Opinion

• The stock trades at a slight premium to its peers on a P/E basis, whereas we feel it should be at a slight discount given retail banking challenges in both Canada and the U.S., less room for dividend increases and less earnings coming from retail businesses.

• Recently announced commodity-trading losses also bring into question the wholesale bank's earnings power as well as the strength of the bank's market risk management infrastructure.

• Bank of Montreal's valuation has historically been supported by the bank's potential as an acquisition target and a track record of improving efficiency. However, we do not believe domestic mergers are likely in the near term, and continued improvements in efficiency are proving difficult without hurting the franchise.

• The bank's high excess capital, combined with a conservative credit underwriting approach, limits downside.

• Valuation. Our 12-month price target of $70 is a combination of our sum of the parts and price to book methodologies. It implies a multiple of 12.2x 2008E cash EPS, compared to the current 13.0x multiple on 2007E earnings and a 5-year average forward multiple of 12.5x. Our P/B target of 2.3x book value in 12 months is at the low end of the banking sector given a lower ROE. Our sum of the parts target of 11.7x 2008E earnings is below our target industry average for banks, reflecting higher exposure to low-multiple wholesale businesses and retail banking execution challenges.
Scotia Capital, 30 April 2007

BMO Announces Large Natural Gas Trading Losses for Q2/07

• BMO announced mark-to-market commodity trading losses in the range of $350 million to $450 million or $0.45 per share to $0.55 per share in Q2/07. The losses were the result of positions in the energy market, primarily natural gas, that were hit by changes in market conditions.

• This is very negative given the magnitude of the loss and will likely further shake investor confidence in the operating capabilities of the bank.

• BMO management previously had stated and restated that the commodities trading business was a solid business driven by customer activity and the bank was not taking undue risk. BMO has stated this morning that it plans to reposition the portfolio to lower and sustainable levels.

BMO Valuation Implications

• We are reducing our Q2/07 earnings estimate to $0.83 per share from $1.33 per share to reflect the large trading loss.

• Our guesstimate is that commodity trading represented $0.20 per share in earnings in fiscal 2006 and reduced risk in this area will likely reduce the earnings run rate by $0.10 per share.


• We are reducing our 2007 earnings estimate to $4.90 per share from $5.40 per share while our 2008 earnings estimate remains unchanged at $5.80 per share. Our 12-month share price target is unchanged at $80 per share representing 16.3x and 13.8x our 2007 and 2008 earnings estimates, respectively.

• Reiterate 3- Sector Underperform based on low relative profitability, low revenue growth and weak operating performance in most of its business lines.
Financial Post, Duncan Mavin, 30 April 2007

Bank Of Montreal's $450- million energy trading losses are being linked to a New York based natural gas brokerage house whose stock plummeted 20% on Friday.

Optionable Inc. makes a quarter of its revenue working with BMO's energy trading desk.

Investors apparently made the link to BMO and punished Optionable's stock after BMO chief Bill Downe said the Canadian bank would take on less energy trading risk following the revelation that bad natural gas trades will slice as much as 55? a share off second quarter earnings and take a small bite out of the banks' regulatory capital.

The trading losses are estimated to be between $350-million and $450-million. But the bank said the cost could be even higher because of "subsequent gains or losses depending on future market conditions."

The trades at the centre of the BMO losses were conducted in New York, mostly on the New York Mercantile Exchange (Nymex) and the over-the-counter markets.

While BMO has not confirmed Optionable's involvement in the losses, the U.S. brokerage specializes in trading energy options in the over-thecounter broker markets and on Nymex.

Optionable's founder and chairman, Mark Nordlicht could not be reached for comment. Mr. Nordlicht is also a managing partner of Platinum Partners LP, where he manages an energy-focused hedge fund.

BMO has also been linked to Amaranth Advisors LLC, the U.S. hedge fund that collapsed last September after losing US$6-billion in a single week on natural gas futures.

Mr. Downe told investors on Friday that BMO was Amaranth's prime broker in Canada, meaning it was the primary processor of the hedge fund's energy trades.

Analysts have reacted with dismay to the announcement of BMO's losses from natural gas options -- a field regarded as high risk because it is effectively betting on the future price of natural gas.

The debacle "shakes our confidence," said Credit Suisse analyst Jim Bantis.

National Bank's Rob Wessel questioned how the losses could have happened at a bank where a low appetite for risk has often seemed its strongest asset.

"Given BMO's relatively poor operating performance, we believe many investors took solace in the bank's perceived very low risk profile," said Mr. Wessel. "This viewpoint will certainly weaken."

To explain how the losses arose, BMO's Mr. Downe said the bank ramped up its energy trading activity in the aftermath of Hurricane Katrina, which had caused volatility in the energy markets.

After volatility declined to "historically low levels", the bank said its positions quickly turned sour.

However, at least one senior executive in the commodity trading industry said it is not uncommon for the volatility in natural gas prices to flatten out, as was the case after Katrina

Others have questioned BMO's processes for controlling risk.

Ratings agency Standard & Poors said the losses "might suggest some more profound structural issues with the bank's risk management function."

BMO's Mr. Downe said the bank is conducting a thorough review and will take actions "to address the current situation and reduce the likelihood of a recurrence."

The bank said none of its staff have lost their jobs as a result of the losses.

Mr. Downe, who has only been in BMO's corner office for about two months, has had to endure a tough start to his tenure as chief executive.

In the first quarter of 2006, the bank took a $135-million hit to earnings and revealed plans to slash 1,000 jobs in efforts to revamp its under-performing domestic retail banking unit.

UBS investment research analyst Jason Bilodeau said the trading losses add to a growing list of challenges for the bank. BMO's stock will likely "re-rate" relative to the rest of the banking sector, said Mr. Bilodeau.
Financial Post, Duncan Mavin, Carrie Tait, John Greenwood, 28 April 2007

In late 2005, in the aftermath of the damage wreaked by Hurricane Katrina's passage through the Gulf, natural gas prices soared, and Bank of Montreal's energy trading group saw an opportunity to make some profits.

The increasingly volatile cost of gas was a concern to corporate gas customers. BMO's 25 strong group of energy traders located in offices in Houston, New York and Calgary was ready to cash in.

"Clients wanted to lock in prices and the bank increased its book of business related to this market," said Bill Downe, BMO's chief executive, who yesterday outlined how this lucrative source of earnings turned sour, resulting in trading losses estimated at between $350 million and $450 million.

Back in March, 2006, at BMO's annual meeting in Calgary, the same business was lauded as a success story.

In Canada's energy capital, the bank's then chief Tony Comper issued a first quarter earnings report that stated revenue at BMO's investment banking group increased $35 million, or 5%, "driven by much higher trading income due primarily to heightened volatility in commodities prices, particularly oil and gas."

However, the gas price volatility didn't last and by the latter half of last year, customer demand for the energy trading group's services slowed.

That alone wouldn't have been a problem. But BMO's energy trading business continued to grow, even as prices sank and volatility flattened out.

In particular, BMO's New York energy trading desk was buying natural gas options over the counter and on the Nymex, hoping for a turnaround in demand for energy derivatives that had been so profitable.

Now, Mr. Downe, who has been BMO's chief for less than two months, is the one having to pick up the pieces and explain what went wrong.

"As a bank we assume risk every day in our dealings with customers and the financial markets," Mr. Downe said in an e-mail to BMO staff. "That is the nature of our business and it's also true that things will sometimes have a different outcome than the one we planned for."

The bank's chief also said BMO is conducting a review of the events leading to the losses and is taking actions to prevent the same thing happening again. BMO said nobody has lost their job as a result of the announcement.

Still, some observers are questioning how the debacle could have happened.

Leigh Parkinson, an energy risk consultant at RiskAdvisory in Calgary, said the sheer magnitude of BMO's losses suggests the bank lost track of what its own traders were up to. "How all of a sudden does a $450 million loss just materialize like this?" he said. "Was it a lack of control from a risk perspective or was somebody hiding trades in a desk drawer?"

In recent years, natural gas trading has taken off, attracting players ranging from traditional oil companies to hedge funds and financial institutions.

Some on Bay Street say trading natural gas options is about as wild as it gets. "This is not for the faint of heart," said one oil and gas analyst yesterday.

Several observers also made the link to Amaranth Advisors LLC, the U.S. hedge fund that imploded last September after losing US$6-billion in a single week on natural gas futures.

BMO confirmed it was Amaranth's prime broker in Canada, meaning it was the primary processor of the hedge fund's trades, though not in the United States.

One of the factors behind the downfall of Amaranth and Brian Hunter, its Calgary-based star trader, was that it was common knowledge in the market that Mr. Hunter had made a huge bet on the direction of gas prices. BMO may have run into the same situation, according to Risk Advisory's Mr. Parkinson.

This isn't the first time BMO has been dogged by bad naturalgas trades. The bank posted a $30 million after-tax loss in the third quarter of 2000 after a single commodities trade went sour. The trade was in naturalgas futures, and originated out of BMO's New York investment banking group.

BMO's profit fell by 11 cents in that quarter, and the trader's involvement with the bank ended. The bad trade prompted the bank to put in fresh guidelines to avoid a similar blunder.

"We've got some new protocols so this won't happen again," said Joe Barbera, then a BMO spokesman.

Mr. Comper, who was BMO's CEO at the time, was criticized for the way he handled that situation and the timing of disclosure.

When the bank released its third-quarter results it referred to "weaker capital markets" performance and said there were "some losses" because of commodities, but the bank's executives did not discuss the magnitude of firm's trading troubles.

The details of the sour bet came out three days later.
Financial Post, Duncan Mavin, 28 April 2007

In Bill Downe's first couple of months as Bank of Montreal's chief executive, the corner office suite vacated by Tony Comper has not been a comfortable place.

Yesterday, Mr. Downe's initation at the top of Canada's banking hierarchy got a lot less comfortable as BMO announced it is taking a charge of up to $450 million in the second quarter as a result of commodity trading losses in energy markets.

"Ouch," said UBS Investment Research analyst Jason Bilodeau. The losses, equivalent to lopping about 45 to 55 a share off second quarter earnings, are "a negative data point out of nowhere," he said.

Mr. Downe took over the top job at BMO at the start of March. It is apparent he has inherited "a growing list of operational challenges," Mr. Bilodeau said.

The new chief's inauguration at BMO's annual meeting in Toronto came just weeks after his predecessor had announced 1,000 staff are to lose their jobs. The reorganization slashed $135 million from first-quarter profit, which fell 3.4% compared with the same period last year.

Meanwhile, BMO's Harrisbank subsidiary based in Chicago met with a potentially daunting threat this week. If all goes according to plan, Bank of America, the dominant retail bank in the United States, is set to muscle in on BMO's turf after announcing on Monday a proposed deal to pay US$21 billion for LaSalle Bank, one of Harris's main rivals.

In an e-mail sent to BMO staff, Mr. Downe expressed his disappointment at the latest problem. "In a situation such as this, the CEO must take responsibility," he said. "I take that responsibility."

Despite obvious concerns about the losses, Mr. Downe was keen to play down the impact. "The size of the loss is small in relation to the capital of the bank." The trading losses "will not impact the strategy or momentum of the company," he added.

Mr. Downe said BMO is "conducting a thorough review and actions have been taken to addess the current situation and reduce the likelihood of a recurrence." He said he is comfortable with "the direction the bank's trading activity has taken in the past."

He said there are no other businesses that BMO is in that would fit the same profile as the energy trading business, adding it will take on less commodity trading risk in future.
The Globe and Mail, Boyd Erman, 28 April 2007

Bank of Montreal has been steadily ramping up its trading business, but it is still among the lenders that is least reliant on trading to pump up profit.

In 2006, the bank brought in $633-million from trading, more than triple the total just two years prior, but that still was only 6 per cent of overall revenue.

By comparison, the massive trading desks at Royal Bank of Canada's operations in cities like Toronto, New York and London generated 14 per cent of overall revenue.

But Bank of Montreal has a much bigger exposure to commodities, with value at risk (the most the bank estimates it could lose in a single day) of $16.8-million, compared with $1-million at Royal Bank, according to figures compiled by Credit Suisse.

This isn't the first time the Bank of Montreal's commodity trading operations have cost the bank money. In the spring of 2000, it incurred a $30-million trading loss in commodities.

This time, according to Bank of Montreal, liquidity and volatility dried up in the natural gas market, driving down the value of derivatives it held.

Volatility is important because options, for example, are more valuable when there are wild swings in gas prices. That's because those big moves increase the chances of the commodity reaching the strike price of the options - putting them "in the money."

Liquidity, or the amount of trading, is important because it means there are willing buyers when a firm like Bank of Montreal needs to sell.

The problem is that when volatility dries up, liquidity tends to disappear too because traders need volatility to make money.

Traders at rival firms said there's a good chance that some of Bank of Montreal's losing positions are in gas trades based on the Alberta market, which is notoriously thinly traded and prone to causing such blowups.

What could bail Bank of Montreal out?

A big storm or hurricane that throws the gas market into turmoil would likely bring back volatility and liquidity in a hurry. June 1 is the official beginning of the Atlantic hurricane season.
Dow Jones Newswires, 27 April 2007

Several factors converged to cause steep losses for a Canadian bank in the natural gas futures market, bank executives said during a conference call Friday.

Bank of Montreal lost up to C$450 million ($403.4 million) in natural gas trades gone bad, company executives said in the conference call, ahead of the bank's second quarter earnings call on May 23.

The bank is said to have incurred the losses during its second quarter, which runs from Feb. 1-April 30, and as the portfolio is "repositioned," it could "experience subsequent gains or losses, depending on future market conditions."

The bank owed its losses to expanding its trading portfolio in gas futures in the latter part of 2006, said Bill Downe, the bank's president and CEO.

"Because of market making activities, we were unable to anticipate lack of liquidity would emanate from sharp decrease in volatility," he said.

Volatility dropped from 70% to 40% in the quarter.

Volatility in natural gas futures generally declines, if at all, during the "shoulder season," or in April and May, when demand for gas to heat or cool homes is generally slack and the market builds inventories to meet summertime cooling demand and wintertime heating demand.

"They must've had a view that the market would either maintain that level of volatility or exceed that level of volatility," said energy analyst Tim Evans, with Citigroup in New York. "That was their apparent position, if the source of their loss was a drop in volatility."

Natural gas futures traders capitalized on the bank's losses Friday, spurring a rally that boosted gas futures prices 3%. June gas futures on the New York Mercantile Exchange traded lower initially Friday morning, then began rallying in late morning floor trading.

Traders smelled blood in the water after the bank announced its losses and funds began "squeezing the shorts," sparking a rally, one trader said.

"If traders hear of a short squeeze because someone in trouble is getting out, they are not going to show offers in the market," the trader said. "There's not really much to say other than this is a classic squeeze."

On the first day of trading as the front-month contract, Nymex June gas futures settled 22.9 cents, or 3%, higher at $7.831 a million British thermal units. The sharp rally came as a surprise to some in the market that saw mild weather and low demand for the fuel amid an expected increase in gas inventories as reasons to sell the commodity.

BMO is the fourth-largest bank in Canada, but its commodity-trading business is about 15-20 times larger than that of Royal Bank of Canada, the largest bank in Canada, said Mario Mendonca, an equity analyst with Genuity Capital Partners.
Bloomberg, Doug Alexander and Sean B. Pasternak, 27 April 2007

Bank of Montreal said it lost as much as C$450 million ($404 million) from natural gas trading, just seven months after similar bets led to the collapse of hedge fund Amaranth Advisors LLC.

The pretax loss will reduce profit by 45 cents to 55 cents a share in the second quarter, or more than a third of forecast earnings, Canada's fourth-biggest bank said in a statement today. The Toronto-based company was expected to earn C$1.32 a share when it reports May 23, based on a Bloomberg survey.

``The loss that we announced today is outside our tolerance,'' said Chief Executive Officer Bill Downe, on a conference call with analysts. Downe took over last month when former CEO Anthony Comper retired.

Bank of Montreal has more at stake in commodities and foreign-exchange trading than any of its Canadian rivals, and its clients included Amaranth. The hedge fund collapsed last year after Calgary-based trader Brian Hunter lost about $6.6 billion betting on natural gas prices. Downe confirmed for the first time today the bank was a prime broker for the hedge fund in Canada.

Bank of Montreal shares fell C$1.27, or 1.8 percent, to C$70 at 4:10 p.m. on the Toronto Stock Exchange, the biggest drop in two months.

Bank of Montreal's overall trading revenue more than doubled in the first nine months of fiscal 2006 to C$564 million, outpacing gains at all of its rivals, before slowing after the September collapse of Amaranth. Trading revenue declined 59 percent to C$69 million in the fourth quarter and 62 percent to C$136 million in the first quarter this year.

``We think this raises significant questions about Bank of Montreal's trading business strategy and general risk oversight and management,'' UBS AG analyst Jason Bilodeau said today in a note to clients.

The bank said the energy trading market, primarily natural gas, became ``increasingly illiquid'' and price swings, or volatility, dropped to historically low levels. The bank also changed the way it estimates the market value of its trading portfolio.

``It's really in the last eight weeks that we have seen the move in the market and it's outside the range of what we have experienced,'' Downe said. He said the bulk of the commodities trading was done in the U.S., and the traders involved remain with the firm. Bob Moore, the executive managing director and head of the commodities group in New York, said he couldn't comment.

Natural gas prices traded within a $1.22 range in the bank's fiscal second quarter. That compares to a range of $3.37 during the same period a year ago. Increased volatility makes it easier for traders to make bets on gaps in prices between different natural gas contracts. That volatility declined in the second half of 2006, and the bank was left with more ``out of the money'' natural gas options contracts, Downe said.

``When you have a more narrow range you definitely have less volatility,'' said Bruno Stanziale, an energy derivatives marketer at Bank of America Securities in New York. ``We've seen volatility dry up.''

Downe said the bank may post additional losses, or gains, as the size of the energy portfolio is reduced. Those losses would be ``in a substantially lower range'' than the C$350 million to C$450 million announced today, he said.

Downe said the bank will reduce its bets on commodities trading.

``The amount of risk and the volume of trading risk in the commodity business is higher today than it's going to be, and when it comes down it's going to stay down,'' Downe said.

Bank of Montreal relied on trading, including equity and fixed-income, for about 6 percent of total revenue last year, tied with Bank of Nova Scotia and Toronto-Dominion Bank for the lowest rate among Canada's six biggest banks, according to Dundee Securities estimates.

``It's a bit of a double-edged sword,'' said Ian Nakamoto, director of research at MacDougall, MacDougall and MacTier Inc. in Toronto, which manages the equivalent of about $3.9 billion, including Bank of Montreal shares. ``When they call it right, it looks good for investors. When they don't call it right, it's not so great.''

The bank said its so-called Tier 1 capital ratio at the end of the first quarter was 9.9 percent, and the impact of the losses will be less than 20 basis points. The ratio measures a bank's equity as a percentage of assets.

Canadian Imperial Bank of Commerce, the fifth-largest bank, said in a statement it hasn't experienced any ``unusual'' gains or losses from commodities trading.

The trading loss for Bank of Montreal is one the largest ever for a Canadian bank, trailing some corporate lending losses at its rivals. In 2005, Canadian Imperial set aside $2.4 billion to resolve claims by Enron Corp. shareholders, leading to the biggest quarterly loss in its history. Toronto-Dominion, the country's second-largest bank, set aside C$2.93 billion in 2002 to cover loan losses after borrowers such as Teleglobe Inc. couldn't pay their debts.

National Bank of Canada spokesman Denis Dube said the Montreal-based bank hasn't had ``any unusual market behavior in any aspect of our commodities trading.'' Royal Bank of Canada spokeswoman Jackie Braden and Toronto-Dominion spokesman Simon Townsend declined to comment. Bank of Nova Scotia spokesman Frank Switzer didn't immediately return a phone call seeking comment.
Dow Jones Newswires, 27 April 2007

Standard & Poor's Ratings Services said today that its ratings on Bank of Montreal (AA-/Stable/A-1+) and its subsidiaries will not be affected by today's announcement of mark-to-market commodity trading losses estimated between C$350 million-C$450 million, pretax, which will be recorded in the second quarter of 2007. At the current ratings level, this one-time hit can be tolerated; however, this development might suggest some more profound structural issues with the bank's risk management function. We will continue to monitor developments in the company's trading risk management practices
The Globe and Mail, Tavia Grant & Tara Perkins, 27 April 2007

Bank of Montreal said Friday pretax commodity trading losses of between $350-million and $450-million will eat into second-quarter results.

The impact of this to the bank's second-quarter financial results, to be released May 23, is seen at between 45 cents and 55 cents a share. Much of the losses stemmed from betting the wrong way on natural gas.

Canada's fourth-biggest bank isn't the only one caught on the wrong side of a natural gas position. Amaranth Advisors LLC collapsed last year as more than $6-billion (U.S.) evaporated, in the biggest hedge fund failure ever.

But there do not appear to be any direct links between the Amaranth collapse and BMO's losses.

“We were not a prime broker to Amaranth in the United States, where our business centred,” said BMO chief executive officer Bill Downe on a conference call with analysts. “I do understand that we provided prime brokerage facilities to their Canadian operation.”

BMO shares slipped 1.9 per cent on the news.

Mr. Downe said that he's comfortable with the bank's trading strategy. “When I said that our trading revenue as a percentage of the total revenue of the company has historically been less than our competitors, that has been deliberate,” he said. “We have managed our trading businesses, all of them, for profitability, definitely not for league table status.”

The loss in the commodity business is “outside our tolerance,” he added, and “we will take less trading risk in the natural gas commodity area.”

Swings in commodity prices and a slowdown in the U.S. housing market may mean more financial institutions will take a hit, a money manager said.

Stephen Gauthier, a partner at Gauthier & Cie. in Montreal, which has cut its BMO holdings in recent months amid tepid revenue growth, said he “was surprised, it's quite a big number, it's certainly not positive for the bank.”

Analysts at Credit Suisse said they're “quite troubled” by the bank's risk management and oversight. It cut its rating on the stock to “underperform” from “neutral” and lowered its earnings estimates for 2007 and 2008.

“I guess you could look at it and say it's only 50 cents (Canadian) on a $70 stock, but one way of looking at it is that Bank of Montreal's total trading revenue last year was $665-million, and we've got a $400-million loss, so it's quite substantial compared to their trading revenue,” Bruce Campbell, president of Campbell & Lee Investment, told Business News Network.

Mr. Gauthier added that he thinks “financial institutions will see more and more problems like this down the road, so we have to be careful.”

CIBC said Friday that, to date, it “has experienced no material or unusual gains or losses in relation to its commodity trading activities.”

BMO's positions in the energy market in the quarter, primarily for natural gas, were sideswiped by changes in market conditions as the market became illiquid and volatility dropped to historically low levels, the bank said.

On top of that, BMO said it changed its approach to estimating the market value of this portfolio.

“The commodity trading losses were the result of decisions that did not adequately recognize the vulnerability of the portfolio to changes in market volatility,” Mr. Downe said.

“If you look at our business in the United States, and we have had an office in Houston since 1961, we're one of the most significant providers of capital on the banking side to the independent oil and gas sector, and that financing very often requires hedging at the same time as the financing is done,” he said.

“There are many transactions that actually hinge on price stability. And so, it is an integral part of the business, but I can say categorically that the amount of risk and the volume of trading risk in the commodity business is higher today than it's going to be and when it comes down it's going to stay down.”

It's been a bumpy start to the year, as BMO said in February it would cut 1,000 back-office employees and take a $135-million restructuring charge to boost efficiency. That was just before Mr. Downe took over from Tony Comper as CEO.

The bank is conducting a review and will take steps to cut the likelihood of a recurrence.

“The commodity trading losses are particularly disappointing as our company continues to experience good operating momentum,” Mr. Downe said.

BMO will reposition this portfolio to a “lower and sustainable level.” As a result, the portfolio could see more gains or losses depending on the market.

“However, BMO's expectation is that, even using adverse assumptions, any losses would be in a substantially lower range than those announced today,” the bank said.

John Aiken, an analyst at Dundee Securities, said in a note to clients that “the market will likely reassess its stance on the riskiness of BMO's operations. This, combined with anticipated lower than peer revenue growth will likely lead to a relative decline in BMO's valuation, with the end result of its current small premium multiple declining to a sustained discount.”

BMO also said its Tier 1 capital ratio at the end of the first quarter was 9.90 per cent and the impact of these losses will be less than 20 basis points on that ratio. “As a result this loss does not impair the ability of the company to pursue its strategic agenda,” BMO said.
Dow Jones Newswires, 27 April 2007

The huge commodity-trading losses that Bank of Montreal will take in the second quarter have raised a lot more questions than just who - or what - was at fault.

The banking industry's risk, metrics and calculations are now in question, said John Aiken at Dundee Securities, while Jason Bilodeau at UBS said the news raises concerns about Bank of Montreal's management, oversight and strategy.

And another immediate question was whether the losses were driving a rally Friday in the natural gas futures market.

Earlier Friday, Bank of Montreal said it will record mark-to-market commodity-trading losses estimated at C$350-C$450 million in its second quarter, or about 45-55 Canadian cents a share, cutting its net profit by about one-third.

The Canadian bank is to report its second-quarter results May 23. The Thomson First Call mean earnings estimate is for earnings of about C$1.33 a share.

"Given that BMO is generally regarded as the 'low risk' bank, what does this mean going forward?," Aiken said in a note.

Perhaps the bank wasn't such a low-risk candidate after all, said Rob Wessel of National Bank Financial. "Amazingly, this loss was within Bank of Montreal's risk limits," he noted. "This fact will call into question what is clearly the most important positive dimension to the bank's risk-reward profile."

He said many investors "took solace in the bank's (perceived) very low risk profile. In fact, it could have been argued that its below-average return on equity was a direct consequence of the bank's aversion to risk. This viewpoint will certainly weaken as a result of today's announcement."

The news hit Bank of Montreal's stock, as analysts suggested the bank's risk profile has now been raised, lowering its valuation.

All other banks were also trading lower, as industry watchers questioned whether their commodity-trading desks also could be using faulty algorithms, or overly-risky trading strategies. Canadian Imperial Bank of Commerce immediately issued a press release stating it hasn't experienced any material gains or losses in commodity trading.

But Wessel said in his note that he is "inclined to believe" Bank of Montreal's losses weren't relatable to its peers.

And Mario Mendonca of Genuity Capital Partners said he believes the issue "will be contained to BMO."

The bank's commodity-trading business is about 15-20 times larger than Royal Bank of Canada's (RY), the country's largest bank, Mendonca said in a note.

As well, Bank of Montreal's commodity VAR (value at risk) increased by C$8.4 million in the first quarter this year from a year-earlier. Mendonca estimated Royal Bank's VAR related to commodities is C$1 million, compared to C$17 million for Bank of Montreal.

Meanwhile, natural gas futures on the New York Mercantile Exchange reversed losses to gain 2.5%. Some traders attributed the jump, at least in part, to news of Bank of Montreal's natural gas market losses.

Speculative traders "are squeezing" other market participants who currently hold a lot of short positions in the market, one trader said. Traders who hoped prices would drop are buying back previously sold positions before prices rise any higher, he said.

Funds are "putting the pain to (BMO) knowing they have to get out," the trader said.

According to Bank of Montreal, its positions held in the energy market, mainly related to natural gas, were hurt by changes in market conditions. In particular, it said the market became increasingly illiquid and volatility dropped to historically low levels.

On a conference call to discuss the losses, bank officials said volatility dropped to 40% from 70% in the quarter.

"The markets moved very quickly," Chief Executive Bill Downe said. He said the bank had begun to manage its portfolio down, but was unable to do so in time to avoid the losses. Downe said that, after Hurricane Katrina in late 2005, volatility and prices in the natural gas market increased. Clients wanted to "lock in" prices and the bank increased its book of business. In fact, Bank of Montreal had historically high commodity trading revenues in the first half of 2006.

However, Downe said, as the bank's energy trading business grew "so did our position in out-of-the-money options."

Then, when prices declined, the market became very illiquid and volatility increased, he said.

"The commodity-trading losses were the result of decisions that did not adequately recognize the vulnerability of the portfolio to changes in market volatility," the bank said in a statement. "We are conducting a thorough review and actions have been taken to address the current situation and reduce the likelihood of a recurrence."

That probably means heads have rolled, said David Baskin of Baskin Financial. But he said it should come as no surprise that such losses could take place.

"Commodity trading is a zero-sum game," he said. "For every winner there has to be a loser. It shouldn't be surprising that this sort of thing is going to happen."

The greater concern, he said, is what sort of oversight is placed on commodities traders, and how much discretionary monies they have at their disposal.

Correct guesses in the commodity-trading market can net huge sums of money, Baskin said, which creates a "perverse incentive" for the trading desks.

However, he said the second-quarter charge could be viewed as a one-time event and shouldn't really hurt the bank's earnings going forward. Nor, said Baskin, should Bank of Montreal's dividend be at risk.

Company officials said on the conference call that the traders involved are still with the firm.

Bank of Montreal said the charge would lower its Tier 1 capital ratio by less than 20 basis points. Moody's Ratings Service reaffirmed its ratings on the bank's securities.

Aiken said he also viewed the losses as one-time in nature and does "not see this issue having an adverse impact on the bank in future quarters." He made no changes to his future earnings estimates.

But Bilodeau said the news adds to the operational challenges faced by the bank, including weak domestic retail operations and greater challenges facing its U.S. banking subsidiary Harris, as chief rival LaSalle Bank is likely to get new owners.

The bank also said it wasn't a prime broker in the U.S. to Amaranth Advisors, the US$9.3 billion hedge fund that imploded last September after losing US$6.5 billion on ill-conceived natural gas trades. However, it was a prime broker to Amaranth in Canada.

UBS makes a market in Bank of Montreal securities but doesn't have an investment-banking relationship with the company. It wasn't immediately clear whether Dundee or Desjardins has an investment-banking relationship nor whether the analysts own the bank's shares.

National Bank Financial does have an investment-banking relationship with the company, but the analyst doesn't own the bank's shares. Genuity doesn't have an investment-banking relationship nor does the analyst the stock.
Financial Post, Duncan Mavin, 27 April 2007

Bank of Montreal said on Friday that it is taking a charge of up to $450-million in the second quarter as a result of commodity trading losses in energy markets.

“We are conducting a thorough review and actions have been taken to address the current situation,” said chief executive Bill Downe, who took over the BMO hot seat last month.

The bank said the loss could range from between $350-million and $450-million, and would result in a hit of between 45 cents and 55 cents a share in the second quarter earnings due on May 23.

The losses relate to positions held primarily in natural gas markets, the bank said in a statement. Trading was “negatively impacted” as the market “became increasingly illiquid and volatility dropped to historically low levels,” the bank said.

BMO’s announcement will remind investors of the failure of Amaranth Advisors LLC, a hedge fund which collapsed last September after losing US$6-billion in a single week on natural gas futures.

Mr. Downe confirmed that BMO was Amaranth’s prime broker in Canada, though not in the United States.

UBS Investment Research analyst Jason Bilodeau said the losses will likely see BMO’s stock “re-rate to a lower multiple relative to the [banking sector] as concerns about management, oversight and strategy are raised.”

The trading problems adds to a growing list of operational challenges for BMO, he said. BMO's profits for the first quarter fell 3.4% to $585-million compared with $606-million a year ago.

The bank recently announced 1,000 job losses and a $135-million charge to earnings related to cost-cutting measures . And earlier this week, BMO’s U.S. strategy came into question with news that retail banking giant Bank of America could be about to buy LaSalle Bank, one of BMO’s main rival in its U.S.footprint in Chicago.

BMO’s executives were given a rough ride by analysts on a conference call to discuss the trading losses.

“When you think of the upper end range of this at $450-million, that’s nearly two thirds of the bank’s trading business in 2006,” said Jim Bantis of Credit Suisse.

“It just doesn’t seem consistent with how the bank has defined itself in the past as the best credit bank in Canada,” said TD Newcrest analyst Steve Cawley.

National Bank Financial analyst Rob Wessel said it is “amazing” that the losses are within the company’s limits and controls.

“I understand all the words it’s just when you put them together it’s not clear to me whether the [trading] models you were using were just wrong,” said Genuity Capital Markets’ Mario Mendonca.

Mr. Downe explained that the bank increased its energy trading book in the aftermath of Hurricane Katrina, which had resulted in greater volatility in the energy market, and lots of profits for the bank in the first half of 2006. However, as energy prices dropped and the market became less liquid, BMO’s energy trading positions have resulted in losses, said Mr. Downe.

“We were aware of the decay in the book and shrinking it down but the market moves very quickly,” he said. The markets turned against the bank only in the past eight weeks, he said.

BMO also confirmed that none of the traders involved has left the bank.

Mr. Downe said he is comfortable with “the direction the bank’s trading activity has taken in the past.” He said there are no other businesses that BMO is in that would fit the same profile as the energy trading business. The BMO chief also said the commodity trading losses are outside the bank’s tolerance and BMO will take on less commodity trading risk in future. The bank may also consider changing the way it discloses risk in its natural gas trading book.

Shares of Bank of Montreal were trading about 2% lower on the Toronto Stock Exchange in morning trading Friday.
Financial Post, Jonathan Ratner, 27 April 2007

Bank of Montreal’s announcement that it will record pre-tax trading losses between $350-million and $450-million in the second quarter, should reduce earnings per share by 45¢ to 55¢, it said. These results are due out on May 23, 2007.

BMO said the losses are primarily from natural gas trading, while Desjardins Securities analyst Michael Goldberg expects more losses in the future.

“The commodity trading losses were the result of decisions that did not adequately recognize the vulnerability of the portfolio to changes in market volatility,” Bill Downe, President and Chief Executive Officer of BMO Financial Group, said in a statement.

Mr. Goldberg interpreted this statement as “faulty trading algorithms were based on garbage in, and they generated garbage out,” he told clients in a note.

While he thinks BMO share’s high dividend yield may mitigate some of the negative reaction, he thinks the potential downside for the stock could be 5%.

Mr. Goldberg also thinks the news could produce a negative reaction for all major banks “as investors wonder where else there may be trading problems, or more importantly, where else there may be faulty algorithms.”

He reduced his 2007 earnings per share forecast for BMO to $4.50 from $5.15.

He rates BMO a “buy” with a $77 price target.

Meanwhile, John Aiken at Dundee Securities considers the losses a one-time event and at this point, does not think the announcement will have a material impact on his core earnings estimates for BMO.

However, he also notes that this development puts BMO’s, as well as the entire industry’s risk, metrics and calculations in question.

“The market will likely reassess its stance on the riskiness of BMO’s operations,” Mr. Aiken told clients in a note. “This, combined with anticipated lower than peer revenue growth will likely lead to a relative decline in BMO’s valuation, with the end result of its current small premium multiple declining to a sustained discount.”
Dow Jones Newswires, 27 April 2007

Canadian Imperial Bank of Commerce said that, to date, it "has experienced no material or unusual gains or losses in relation to its commodity trading activities."

The Toronto-based Canadian chartered bank said it will report its fiscal second-quarter results as planned on May 31.

As reported, another big Canadian bank, Bank of Montreal, said Friday that it will record mark-to-market commodity-trading losses estimated at C$350-C$450 million (US$312-US$401 million) in its second quarter.