Tuesday, July 31, 2007

Banks May See Decline in Trading Revenue

The Globe and Mail, Tara Perkins, 31 July 2007

Today is the last day of the fiscal third quarter for Canada's big banks, meaning what the markets do today will affect the profits they report.

While those profit announcements are still weeks away, Desjardins Securities analyst Michael Goldberg says he's going to be watching for possible profit warnings after today.

The banks need today's closing prices to determine the value of their trading books for the quarter. The prices will be used to figure out what the paper gains or losses are on securities the banks are holding.

The past week has seen concern intensify about the impact of credit related to U.S. subprime mortgages, as well as debt financing for leveraged buyouts. Mr. Goldberg said he now believes there is the chance of a systemic decline in banks' trading revenues for the first time since 1998.

Banks' trading revenues generally fluctuate from quarter to quarter, with the direction at each bank moving independently. The exception was the fourth quarter of 1998, when four of the big banks all suffered sharp declines in their trading revenue, driven by a downturn that followed billions of dollars in losses at the hedge fund Long-Term Capital Management.

Spreads on collateralized mortgage-backed securities have widened dramatically very recently, and that "could be the catalyst for another systemic downturn in trading revenue," Mr. Goldberg wrote in a report yesterday. The wider spreads may have serious negative repercussions for debt investors, he said.

"We believe that this increased risk explains the pullback that has taken place in many financial services stocks."

The situation might have an impact on investors far beyond just those that hold deeply subordinated exposure to collateralized mortgage-backed securities, he said. And he is not going to guess which banks may or may not be affected.

"It's very hard to tell where the actual exposures are going to turn up, because it's gone beyond just kind of junior exposures and it's widened out in the debt capital markets," Mr. Goldberg said in an interview yesterday. There is a lot of leverage that is related to the subprime mortgage-backed securities, and that adds to the complexity of figuring out where banks might be exposed, he said. "It may be in places that nobody has even thought of."

Increasing credit spreads, U.S. banks turning off the subprime lending tap, and the spectre of failed leveraged buyouts sent markets tumbling last week. And this time, the Canadian financial players saw their stocks fall along with the U.S. names, Genuity Capital Markets analyst Mario Mendonca pointed out in a note to clients yesterday. The bank stocks were down about 5 per cent on average.

"Like the U.S. financials, Canada's large-cap banks and insurers are trailing the composite by levels not seen in years," he wrote.

Shares of Toronto-Dominion Bank fell because the $3.3-billion in debt and $500-million equity bridge it had contributed to the buyout of BCE Inc. attracted renewed attention as other high-yield debt offerings had troubles, Mr. Mendonca said. With credit spreads widening, he said he would not rule out TD taking "at least a modest charge" as it tries to syndicate its exposure to BCE.

The market is not going to ignore the number of looming financial risks facing the banks in the near term. But that means that bank stocks are now heading toward attractive - i.e. reasonably priced - territory, Mr. Mendonca said.

There are numerous risks of bad headlines ahead, he said. Credit rating agencies are likely to downgrade some securities related to the subprime sector. There could be a leveraged buyout problem. A hedge fund could get into trouble, and "all of our banks have done some kind of lending to hedge funds." And, widening credit spreads are an indication that "this long period of the credit environment being perfect looks like it could be coming to some kind of end, or at least deteriorating."

While the potential headaches are numerous, and investors will react, Mr. Mendonca does not believe any bank will be crushed by any of these issues.

"So, I would say in the near term you're going to find opportunities to buy these banks cheaper."
Financial Post, Grant Surridge, 30 July 2007

More word today regarding the imploding subprime mortgage situation south of the border. In a note to clients this morning, Desjardins Securities analyst Michael Goldberg says Canadian banks and lifecos could see reduced trading revenues as a result of exposure to such debt.

He refers to a Web site (www.markit.com) that measures the spreads for collateralized mortgage-backed securities (CMBS). Recently the spreads for even the AAA-rated tranches of CMBS have risen steeply, which could affect investors beyond those exposed only to the subordinated debt.

The implication, writes Mr. Goldberg, is that banks and lifecos could see significant declines in their trading revenues. He sees this possibility as being behind the recent pullback in financial sector stocks, and advises investors to watch for possible profit warnings after the banks’ July 31 quarter end.