Thursday, September 13, 2007

Review of Banks' Q3 2007 Earnings + Outlook

  
National Bank Financial new analyst's ratings and target prices:

• BMO is rated "underperform," 12 month target price is $67.00

• CIBC is rated "outperform," 12-month target price is $105.00

• RBC is rated "sector perform," 12-month target price is $58.00

• Scotiabank is rated "sector perform," 12-month target price is $57.00

• TD Bank is rated "outperform," 12 month target price is $80.00
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• Credit Suisse upgraded BMO from "underperform" to "neutral." The target price is set to C$73.

Credit Suisse mentioned that revenues and profits at the BMO's core retail banking activities seem to be improving. BMO's Canadian retail and wealth operations posted robust bottom-line Q3 2007 results due to impressive revenue growth and efficient cost management; BMO continues to face difficulty in improving its share in the personal deposit market, Credit Suisse added.

• Dundee Securities cuts CIBC to 'neutral' from 'outperform'

• Dundee Securities cuts RBC to 'under perform' from 'neutral'

• Dundee Securities cuts Scotiabank to 'neutral' from 'outperform'
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BMO Capital Markets, 11 September 2007

Sector Downgraded to Market Perform: The Cumulative Weight of Events
Industry Rating: Market Perform

We are downgrading Canadian banks to Market Perform from Outperform. We moved to an Outperform rating in early 2005, driven by our confidence in the domestic banking business and our view that the appreciation in other yield vehicles highlighted the attractive valuation of bank shares. Since then, banks have produced over a 50% return over the 30-month period and have matched the returns from the TSX overall. This was achieved in an environment when both oil and gold prices moved meaningfully; not bad relative performance for a defensive group like the Canadian banks.

Our downgrade to Market Perform is based on three basic tenants:

1. We are witnessing a significant re-pricing of risk across several credit and cash markets. To date, this has been occurring in a less-than-orderly fashion, which creates some short-term risks to earnings.

2. The domestic environment in Canada has been incredibly strong. It is likely that we will witness slower loan growth and higher loan losses as we move forward. In addition, with the volatility in wholesale funding rates (and some short-term pricing moves by competitors), there could be some short-term pressure on core spreads.

3. The decline in the valuation of global financials is likely to continue to weigh on Canadian bank stocks. Canadian banks are now at 140% relative P/BV when compared to their U.S. peer group. We don't know how much wider this spread can get.

We aren't crying fire in a crowded movie house. Banks are off about 8% from their all-time highs, and though they have lagged the resource-heavy TSX over the past 12 months, they are still up 9% and have provided a rewarding 3-4% yield. We are very comfortable that banks have the liquidity and capital to deal with the current challenges.

Indeed, Canadian banks will likely benefit from the current volatility. Other financial intermediaries, finance companies, etc., will likely have less availability to funding than banks in this environment. The issue for us is timing, and the volatility in the short term is somewhat concerning. As such, we are moving to a Market Perform rating, and have reduced our bank share price targets.

The Past 30 Months Have Produced Solid Returns

Canadian Banks have produced excellent returns over the past 30 months (see table below). Indeed, Royal, TD, CIBC and BNS have been great performers with BMO and NA having lagged. The ability of the Canadian bank stocks to match the market (essentially) is impressive in the context of massive upward moves in commodity prices. In early 2005, crude oil was about US$40 a barrel and gold was just over US$400 an ounce.

A Disorderly Re-pricing of Risk

We have been struck by the significant volatility in what have traditionally been stable cash markets. We show the yield on U.S. 3-month T-bills in the chart below. This volatility has been driven by a flight to quality, as investors have shied away from various vehicles where there is limited visibility. Examples of this have included the asset-backed commercial paper (ABCP) market here in Canada, the structured investment vehicle (SIV) market in the U.K. and the collateralized debt obligation (CDO) market in the U.S. ABCP, SIV and CDO have all become worrisome acronyms, at least for equity investors.

We believe that the root cause of the problem is the lack of confidence of buyers in ratings and rating agencies; ratings that were formerly trusted no longer seem to cut the mustard and buyers are becoming more (read very) selective. We aren't pointing the finger at rating agencies here; the reality is that many of these structures are still performing well on the asset front.

The issue seems to be that buyers have lost confidence in the ratings process. It is clear that the demand for credit analysis (and hopefully credit analysts) in North America is rising. However, this process will take time and we would be surprised to see it occur in a smooth fashion.

The Domestic Environment Remains Strong, but for how Long?

We are confident that the Canadian economy will remain strong. Canada is an 'oasis of stability' in an uncertain world. The fact that Canada is a resource economy, that the fiscal situation at most levels of government is good and the strength of the Canadian dollar all support this view.

However, the reality is that the environment is likely to be less robust over the coming quarters. As we show in the chart above, loan growth over the past three years has been spectacular and in July was over 12%. Over the past two decades, loan growth has occasionally exceeded 10%, but normally only for short periods. The fact that loan growth has exceeded 10% for close to three years surely suggests that slower growth is ahead. We don't anticipate loan growth falling off a cliff, but if bank stocks can't perform when the environment is this strong, one wonders what happens when loan growth slows to more normal levels (say in line with nominal GDP growth).

So far, mainline banks have been quite disciplined on pricing so that spreads have stabilized after experiencing declines from late 2001 until the start of 2006. One element that has helped has been stability in the Prime-BA spread and relatively easy access to wholesale funding. This appears to be changing (see chart below) with little sign that the Prime Rate (which prices most of the banks' loan books) is moving higher. National Bank's recent decision to significantly increase posted rates across GICs is, in our opinion, not a positive development and adds to the uncertainty in an already unclear environment.

Canadian Bank Valuations Have Already Widened Dramatically Versus Global Peers

In terms of stock price performance, Canadian banks have handily beat their global peers (see table below) over time. Since the start of the current decade, Canadian banks have more than doubled the performance of U.S. and U.K. banks. This outperformance has continued year to date and is a testament to the better banking model in Canada (heavy retail emphasis, consolidated banking system, etc), and to the strength of the Canadian economy.

Having said that, we believe that it will be difficult to have much more multiple expansion when global financials are in turmoil. As we show in the chart below, Canadian banks now trade at a 40% premium to U.S. bank stocks on a P/BV basis. We believe that Canadian ROEs are sustainably better than their U.S. peers; we just aren't sure if they are sustainably 40% better. Remember that U.S. banks have some potential for consolidation whereas Canadian banks have lived in a world of 'no mergers' for several years.

Conclusion

Essentially, we are saying that Canadian banks will probably continue to beat their global peers, but are unlikely to beat the TSX overall, particularly if we get the performance we expect from the oil and gold sectors.

None of the issues listed in this report are brand new, although the first two have only surfaced in the past couple of months. We remain confident that banks can deal with them. The issue is that, taken together, they put additional pressure on bank balance sheets. We are downgrading the bank sector to Market Perform and have reduced our share price targets across the board

Canadian banks still derive 60% of earnings from domestic banking and wealth, and have excellent balance sheets and solid dividends. Individual investors should be aware of tax implications of selling bank shares, particularly if the shares have been held for an extended period and the cost base is low.

New target prices:
• BMO $67.00
• CIBC $106.00
• National Bank $56.00
• RBC $58.00
• Scotiabank $53.00
• TD Bank $75.00
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Investment Executive, James Langton, 7 September 2007

Canadian financial stocks could be the place to wait out the market’s current turmoil, suggests a new report from UBS Securities Canada Inc.

UBS says that, “the abstruse nature” of the credit crunch issue “means that a definitive all-clear signal is unlikely”. Rather, markets are likely to regain their footing gradually, it says. “What are investors to do in the interim? Our answer is Canadian financials.”

The report says that while Canadian financials have not been immune to the market turmoil, “they still have a very attractive reward/risk profile relative to both the TSX and the S&P 500 financials.”

“Essentially, the credit crunch is a deflationary shock which tends to hurt resources and cyclicals more than financials,” it says. “And importantly, since confidence looks likely to be only gradually restored, the financials should also lead in the early recovery.”

Back in 1998, when markets stumbled in August and floundered throughout much of the fall, resources trailed to the end of the year, UBS recalls. “The 1998 pattern has already been borne out since the July 19 peak, and we expect the recovery phase is a good Plan A until the dimensions of the credit crunch become clearer,” it advises.
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The Globe and Mail, 6 September 2007

In a vote of confidence for profits in the battered financial sector, Desjardins Securities has upgraded Canadian Imperial Bank of Commerce to “strong long-term buy” from “buy,” matching the ratings on Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal.

The one problem child is National Bank of Canada, which was cut to a “long-term hold.”

Desjardins strategists also say Canada’s major insurers are showing accelerating profitability, prompting upgrades of Manulife Financial Inc. and Great-West Lifeco Inc. to “strong long-term buys” from “long-term buys.”

Power Corp. of Canada and Power Financial Corp. were raised to “long-term holds,” as profitability is now stabilizing, Desjardins predicts.
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RBC Capital Markets, 4 September 2007

All six banks reported Q3/07 EPS that were higher than expectations, driven by better than expected wholesale banking earnings and continued strong retail earnings growth.

• It appears that bank trading rooms, broadly speaking, were well positioned to (1) avoid large negative marks to markets that could have occurred on inventory holdings and proprietary trading positions as debt and equity markets weakened in the latter part of July (the banks' quarter end), and (2) many were actually positioned to take advantage of widening credit spreads and interest rate volatility, as evidenced by surprisingly strong fixed income trading revenues for the group.

We expect total returns of 15% from holding bank stocks in the next 12 months, but believe that the price appreciation is likely to come in the latter half of those 12 months.

• We remain concerned that Canadian banks could trade sideways or down in the near term on negative news flow out of world financials, as well as potential earnings disappointments in Q4/07.

• Bank valuations have declined from 13.2x to 11.6x on a NTM P/E basis since the year began. We believe that bank valuations could trade back up to their 5-year average forward multiple of 12.2x if credit conditions remain benign, capital markets stabilize and interest rates do not rise meaningfully.

• If capital markets remain weak and capital market issues become economic issues, we believe there would be further pressure on valuation multiples (and earnings).

TD is our favourite bank stock

• We have an Outperform rating on TD. Domestic retail momentum and higher earnings from the U.S. should drive above-average retail earnings growth for TD. We also believe that there is less downside risk to our earnings forecasts for TD than for the industry as the bank is less exposed to wholesale earnings, and appears to have a more conservative mix of businesses within its wholesale division.

Positive on 12-month outlook for bank stocks; still cautious near term

All six Canadian banks reported Q3/07 EPS that were higher than our expectations (and consensus), driven by better than expected wholesale banking earnings and continued strong retail earnings growth. The release of the banks’ Q3/07 results showed that their trading rooms, broadly speaking, were well positioned to (1) avoid large negative marks to markets that could have occurred on inventory holdings and proprietary trading positions as debt and equity markets weakened in the latter part of July (the banks’ quarter end), and (2) many were actually positioned to take advantage of widening credit spreads and interest rate volatility, as evidenced by surprisingly strong fixed income trading revenues for the group. We were comforted that the banks did not take major hits (two exceptions: the trading revenues of both Bank of Montreal and CIBC were affected by large losses in commodities and U.S. sub-prime securities respectively), although surprises may still spring up as the month of August proved to be even more volatile in equities and interest rates.

We expect total returns of 15% from holding bank stocks in the next 12 months, but believe that the price appreciation is likely to come in the latter half of those 12 months. We remain concerned that Canadian banks could trade sideways or down in the near term on negative news flow out of world financials, as well as potential earnings disappointments in Q4/07. The increased risk aversion seen in capital markets and tightening of liquidity, if it continues, could have a much larger impact on wholesale revenues in Q4/07 than it did Q3/07, in our view. Our positive 12-month outlook is predicated on continued strong growth in retail earnings and a benign credit environment. The biggest risk to our positive outlook is that capital market issues become economic issues; a scenario that our economists do not envision at this time.

Bank valuations have declined from 13.2x to 11.6x on a NTM P/E basis since the year began. We believe that the banks could trade back up to their 5-year average forward multiple of 12.2x if credit conditions remain benign, capital markets stabilize over the next 12 months and interest rates do not rise meaningfully. The 5% increase we expect in valuation multiples, combined with 9% expected earnings growth in 2009, would provide attractive returns for banks’ shareholders over the next 12 months.

If capital markets remain weak and capital market issues become economic issues, we believe there would be pressure on valuation multiples (and earnings). In such an environment, we believe that the 5-year valuation trough of 10.3x is indicative of where banks may trade – an 11% drop in valuation multiples.

Things we like about the Canadian bank stocks:

There are many things that we like about Canadian bank stocks, in spite of our concerns about potential negative surprises and disappointing capital markets revenues in the near term:

• Retail and wealth management businesses are strong;
• Direct exposure to most troubled parts of capital markets appears limited;
• Capital ratios are high;
• Widening credit spreads should eventually create opportunities;
• The interest rate environment is better for bank stocks than it was a few months ago;
• An economic cycle is needed to see trough ROEs; and
• Prior periods of fear for the financial system in the last decade were unfounded.

Retail and wealth management businesses are strong

Retail banking and wealth management businesses continue to perform well, and those generate about 70% of Canadian banks’ earnings. Canadian loan growth remains very strong, and the conditions that have driven the strong loan growth remain in place: employment growth, rising incomes, low interest rates and a solid housing market. The outlook for wealth management growth is heavily influenced by equity markets (the majority of revenues are asset management and brokerage) and, although choppy this summer, Canadian equity markets are up 4.5% year to date.

The negative news flow surrounding financial institutions is mainly centered around capital markets issues, which generates about 30% of earnings for Canadian banks. A spillover of the credit-related issues into equity markets has negative implications for retail wealth management businesses, but the revenue sensitivity of asset management and retail brokerage businesses is lower than capital markets revenues in our view, particularly as banks have all strived to increase the proportion of retail brokerage revenues that are fee-based versus commission-based.

Direct exposure to most troubled parts of capital markets appears limited

The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets, including U.S. sub-prime mortgages the Canadian third-party asset backed commercial paper market, and LBO underwriting commitments. There are exceptions, which we highlight later in this report, but we think it is still fair to say that the Canadian banks are less exposed to these three areas than many U.S. and European banks, and the Canadian banks’ exposures come in the context of an earnings mix that is dominated by retail banking and wealth management.

Capital ratios are high

Canadian banks have high capital ratios compared to banks in other developed markets, with Tier 1 ratios ranging from 9.3% to 10.2%. Their ability to grow their capital is also quite high, as approximately 70% of their income comes from retail banking and wealth management, two sources of revenues that are not overly capital intensive. We also believe that the banks’ reputation as conservative institutions allows them easier access to liquidity and capital than some other financial institutions.

Widening credit spreads should eventually create opportunities

The repricing of credit risk is likely to create money-making opportunities for well capitalized financial institutions, including the Canadian banks. The current capital markets turbulence and expansion in credit risk spreads will likely create opportunities for trading businesses, it should be a positive for margins in commercial and corporate lending, it should help well-capitalized organizations get higher returns on capital as competition for investments becomes scarcer, and acquisition opportunities may arise. This period of opportunity does, however, typically come after a period of pain in which assets get marked to market, and banks generally are conservative in deploying capital until market conditions show signs of stabilizing. We do not believe that this adjustment period is over.

The interest rate environment is better for bank stocks than it was a few months ago

The interest rate environment has improved for bank stocks in three different ways:

• 10-year Government bond yields have dropped 31 basis points in Canada from their peak of 4.73% on June 12th. There is a very strong inverse correlation between bank P/E ratios and long-term interest rates given their high dividend yields and the beneficial impact of lower interest rates on loan growth and credit quality. RBC Economics expects 10-year Government of Canada bond yields to rise with a target of 5.45% by the end of 2008 so there may be pressure on bank valuations if those estimates prove correct.

• The outlook for short-term rates in Canada has also changed, with the Bank of Canada no longer expected to raise rates in the near term given the volatile capital markets conditions. Rising Bank of Canada rates have historically been negative for bank stocks more often than not so a probable delay in rate hikes is a positive. RBC Economics believes that worries about the spillover from the financial markets into the economy will likely keep the Bank of Canada on the sidelines and have shifted the timing of the next rate hike to the first quarter of 2008 (a change from their previous view of a rate hike by 25 basis points on September 5th) and forecast the overnight rate to rise 75 basis points over the first half of 2008 to 5.25%.

• The steepening yield curve, which resulted from short-term Government securities rallying on a flight to quality, has made the carry trade a possibility again.

An economic cycle is needed to see material reductions in ROE

We are forecasting a median ROE of 21.0% in 2007 for the Canadian banks. Capital markets profitability is clearly at risk of dropping in the near term, but even a drastic decline in wholesale net income – let’s use 50% to illustrate our point – would leave ROEs high. Given that wholesale income accounts for approximately 30% of earnings for the system, a 50% drop in profitability would knock ROEs off by about 3%, leaving them a still high 18%. In order to see ROEs head toward the low teens, we believe that we need to see an economic cycle, which would have negative implications for loan losses and retail loan growth.

Prior periods of fear for the financial system in the last decade were unfounded

The financial system has skated through many incidents that raised concerns over widespread financial market health in the last decade. Examples include the Asian crisis, the Long-Term Capital bailout, a corporate credit loss cycle, Amaranth, 2 major hurricanes in one year, and Argentina’s economic crisis. Those events caused material losses to individual financial market participants but ultimately did not impair the health of the financial services industry.

Risks for Canadian bank stocks have risen

We have a positive view on bank stocks over the next 12 months, but risks to continued strong stock price appreciation are higher than in recent years in our view. We highlight five concerns:

• Illiquidity and rising risk aversion is not an ideal environment for capital markets revenues;
• A lasting credit crunch could lead to economic issues;
• News flow is likely to continue to be negative, with the potential for surprises not over;
• Key earnings drivers of last five years at risk of weakening; and
• Capital ratios could decline, albeit from high levels.

Illiquidity and rising risk aversion is not an ideal environment for capital markets revenues

We believe that Q3/07 wholesale banking results were not indicative of the deterioration in revenues that could occur in the next few quarters. The Canadian banks reported strong wholesale earnings in Q3/07, continuing on a trend that has seen those divisions exceed expectations. The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets but, we still feel that their wholesale income is likely to decline in the next two quarters and, if liquidity problems become economic problems, possibly longer.

• Trading revenues were strong in Q3/07 but the quarter ended in July, and August saw more volatility and credit spread widening. Liquidity also became scarcer in August.

• Q3/07 benefited from strong M&A and underwriting revenues but the outlook for new assignments is on hold in our view. The closing of previously announced deal may mask underlying weakness in new originations in the near term.

• Liquidity should improve but it may not be as high as it was before the summer. Following sharp increases in credit spreads, liquidity typically returns as spreads stabilize; buyers emerge as that they stop believing price will get better and sellers get over sticker shock. The concern we have, however, is that a good portion of the liquidity of recent years came from highly levered strategies and is unlikely to come back in the near term. This includes “short low risk, buy high risk” and “fund short, invest long” strategies, that led to the development of Structured Investment Vehicles and risky ABCP structures, highly levered hedge funds, rapidly growing private equity funds and, most likely, more levered proprietary trading desks looking to replicate strategies that were successful for clients.

A lasting credit crunch could lead to economic issues

The most negative environment for bank stocks would be continued weakness in capital markets, and a weaker economic environment. Our outlook for the banks does not assume a recession, which is in line with our economists' outlook, which believe that the impact of rising defaults in the U.S. sub-prime mortgage market will not have a crippling impact on the broader economy. Our concern is that if liquidity continues to be a concern and credit availability is restrained for an extended period as a result of financial institutions’ concerns over their and others’ exposure to U.S. sub-prime real estate and/or levered credit investing strategies, it would have a negative impact on the economy. If the economy turned sour, it would accelerate the long-expected normalization of credit losses and the argument that the current risks facing banks are isolated to capital markets businesses would be out the window. We believe that such a scenario would have negative implications for both bank profitability and valuation multiples.

Capital ratios could decline, albeit from high levels

We believe that there is a risk that the Canadian banks’ Tier 1 ratios could decline from their high levels as:

• Banks could potentially bring on balance sheet some of their asset backed commercial paper conduits. They may do so by choice in Canada as the spreads over bankers acceptances are high enough that it does not make sense, in our view, for the banks to fund themselves in that market while spreads remain this high. If the commercial paper market remains tight, it is also possible that some of the conduits to which that the banks provide liquidity backstops would tap these lines.

• If credit spreads widen further, corporations may hold off on issuing debt and tap existing credit lines for funding needs.

It is important to point out that banks would generate additional net interest income as a result of adding assets to their balance sheets, and they would have adequate capital to fund those assets. The impact on ROE would depend on the mix of assets – banks putting retail mortgages on their balance sheets would not see their capital usage go up as much as if business lending suddenly soared. Even if all bank backstop liquidity facilities (i.e. including U.S. Commercial Paper programs) were fully drawn, the banks would have enough capital to handle those assets coming on their balance sheets, although funding those assets may be challenging.

News flow is likely to continue to be negative, with the potential for surprises not over

We are concerned about news flow out of financials because:

• There is still no or very little liquidity for many structured finance assets, most of which have not been marked to market and many of the esoteric structures have not traded, U.S. subprime mortgage delinquency rates are likely to increase as interest rate resets take effect, and there are still many LBO loans that are waiting to be distributed. The risk of downgrades in certain CDO tranches also introduces the risk of selling by investors with strict requirements on the types of risk they may own. If those investors drive down the price of certain assets, it may force others to mark their portfolios lower, which can cause major issues with levered investors.

• We realize that those issues are less material for Canadian banks than many U.S. and European ones, but we doubt Canadian bank stocks will perform well if negative news flow leads to weaker share prices for financial institutions worldwide.

• It is not inconceivable that there could be more large funds or institutions that run into financial difficulties, in which case markets are likely to push down valuations of worldwide financials.

• Equity markets (and Canadian banks) have also rebounded solidly since mid-August, partly on the expectation that the Fed is likely to cut rates in September. No action by the Fed would be negative for equity markets, in our view, while the expected action probably would not drive much more upside.

The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets, although that is not to say they are not exposed at all:

• National Bank is most exposed to the challenged third party ABCP market in Canada. In our view the risks are as follows:

o The bank will be exposed to credit risk as it is well on its way to repurchasing approximately $2.0 billion in ABCP from its mutual funds and retail customers. The bank is relying on DBRS in its assessment of the credit quality of the underlying assets at this point, and had the following to add in its Q3/07 press release: "At this time, the Bank can not quantify the financial impact, if any, of these initiatives mainly for two reasons. First, most of such ABCP has been issued by non-bank sponsored conduits which are subject to a restructuring proposal, which is at a very formative stage and the outcome of which could have a material effect on the value of such ABCP. Second, there is insufficient information available about the current value of the assets which underlie the ABCP being purchased and about any other contingent liabilities which may exist. The magnitude of the sums involved and the uncertainties referred to above could give rise to a material charge to the Bank's earnings. The Bank will address this issue when it publishes the fourth quarter results for fiscal 2007."

o Quantifying the damage to the bank's reputation is near impossible, but the impact is nonetheless meaningful in our view. Commercial and corporate clients that bought ABCP via National Bank face an extension of term and/or losses given that the purchase of ABCP by National Bank covers only holdings of under $2.0 million. This will undoubtedly disappoint some of the bank's clients, and may lead to lost business.

o The bank may provide credit lines to commercial and corporate customers whose cash balances were negatively impacted by the developments in the ABCP world. This may also add to the bank's credit risk, depending on the creditworthiness of the customers. The bank cited on its Q3/07 call that the liquidity advances have been done on normal banking terms and that it has not changed its underwriting criteria.

o Legal risk also arises, as some clients may seek recourse in the courts over their holdings in ABCP.

o Capital flexibility will likely be reduced. The bank's capital position is strong, with a Tier 1 ratio of 9.4%. The purchase of $2.0 billion in ABCP will lower the Tier 1 ratio by 0.35%, but the potential capital drag from providing liquidity lines is unknown.

• CIBC appears most directly exposed to weakness in the U.S. residential mortgage market.

o The bank incurred a loss of $290 million in Q3/07 due to the impact of mark-to-market write-downs, net of gains on related hedges, on collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS) related to the U.S. residential mortgage market.

o The bank also estimates approximately $90 million in further CDO and RMBS markdowns in August.

o CIBC's exposure to the U.S. residential mortgage market before write-downs is approximately US$1.7 billion, invested in 5 or 6 structures, and is entirely held in a mark-to-market book. The bank has sub-prime index hedges of approximately US$300 million.

• TD has underwritten $3.3 billion of a $34.3 billion credit facility and provided a $500 million equity bridge facility to a group of institutional investors led by Ontario Teachers' Pension Plan Board in support of their bid to acquire BCE. The banks have mostly adopted “underwrite and distribute” philosophies in the last five years. In a rising credit spread environment, the risk of taking losses after having committed financing but before distributing the loan/debt rises. Banks can avoid near-term losses by holding onto loans, but at a cost of increased concentration risk. The bank’s $3.8 billion in commitments represent only 0.9% of assets but 34% of net tangible common equity.

• Royal Bank is exposed to headline risk as it is a more active participant in the U.S. than its peers. The bank has $1.1 billion in U.S. subprime RMBS and CDOs, a manageable amount relative to the bank’s asset base but nonetheless a sign of potential negative headlines if that market witnesses further deterioration.

• BMO manages two Structured Investment Vehicles in the UK, with assets totaling about $30 billion. Leverage in those conduits is about 10 to 1 (low by industry standards), there is essentially no exposure to U.S. subprime securities, and underlying assets are 100% investment grade, 88% of which are AA or better. Both conduits are self-funding at this time, and the bank's financial exposure appears limited to a $76 million equity interest and letters of credit and commitments to extend credit of $184 million (as at October 31, 2006). Unlike the asset backed commercial paper market, liquidity backstop lines are limited in the SIV market. The bank's risk is therefore more reputational if the SIVs face funding (or credit) issues, although the structure of the assets in the two SIVs (no U.S. sub prime) and use of leverage (which can be as high as 70 times) appears conservative compared to more aggressive structures.

Key earnings drivers of last five years likely to weaken

We believe that banks’ EPS growth is set to slow. The Canadian banks have had an excellent track record of earnings growth since the credit cycle of the early part of this decade, growing EPS at double-digit rates as a group since then. The major drivers have been: strong retail loan growth, declining provisions for credit losses, the positive impact of very strong equity markets on wealth management businesses and capital markets revenues that were fueled by high liquidity (some of which came from added leverage).

As we look out over the next two years, it is difficult to anticipate those earnings growth contributors being as strong

TD is our favourite bank stock

Our investment ratings are unchanged from our view going into the quarter:

• We have an Outperform rating on TD. Domestic retail momentum and higher earnings from the U.S. (driven by cost synergies at TD Ameritrade, and by higher ownership of TD Banknorth) should drive above-average retail earnings growth for TD. We also believe that there is less downside risk to our earnings forecasts for TD than for the industry as the bank is less exposed to wholesale earnings, and appears to have a more conservative mix of businesses within its wholesale division. TD trades at 11.8x 2008E EPS, compared to a group median of 11.5x.

• We have an Outperform rating on CIBC shares because of (1) the potential for further material increases in dividends; (2) lower exposure to wholesale income and deteriorating business credit quality; (3) tight expense management, which leaves room for upside earnings surprises in our view; and (4) our expectations for improved retail revenue growth. Exposure to U.S. sub-prime securities is a risk if there is further deterioration in that market. CIBC trades at 10.9x 2008E EPS, compared to a group median of 11.5x.

• We believe that Royal Bank’s stock is attractive given: (1) leading, and rapidly growing retail banking and wealth management franchises; (2) a more diversified capital markets business, which should lead to lower volatility in revenue and earnings than some of the other Canadian banks' investment dealers; and (3) A superior outlook for near-term revenue growth, driven by a 15% increase in risk weighted assets in the last twelve months, a result of organic growth and acquisitions. Royal Bank trades at 11.8x 2008E EPS, compared to a group median of 11.5x.

• We have a Sector Perform rating on Scotiabank. We believe that the bank has above-average medium- and long-term growth prospects compared to its peers due to its presence in Latin America and the Caribbean. Near-term revenue growth should also benefit from a 16% increase in risk weighted assets in the last 12 months. We are concerned, however, that bank's 0.5x P/E premium could narrow because (1) the high Canadian dollar hurts the bank more than its peers; (2) rising risk aversion could affect the multiple paid on earnings from emerging markets; and (3) we believe that net income for Scotiabank's key Mexican division may disappoint in the near term. Scotiabank trades at 12.0x 2008E EPS, compared to a group median of 11.5x.

• We continue to believe that Bank of Montreal's stock is likely to underperform those of Canadian peers. (1) We believe that BMO will struggle to bring its domestic retail revenue growth up to the industry's leading banks at the same time as it embarks on cost cutting initiatives; (2) We expect slower dividend and earnings growth; and (3) The bank derives a higher proportion of earnings from wholesale banking. To be clear, our Underperform argument is relative; our 12-month target price of $69 is 6% higher than the current stock price, and the stock's dividend yield is 4.3%. Bank of Montreal trades at 11.2x 2008E EPS, compared to a group median of 11.5x.

• We rate National Bank’s shares as Underperform. The bank trades at the lowest multiple of the 6 Canadian banks but (1) we expect slower retail earnings growth; (2) there is significant uncertainty related to the ultimate outcome of the bank's ABCP-related challenges; and (3) the bank is has greater reliance on wholesale markets as a percentage of total income. The two major risks to our rating would be (1) a rapid and favourable resolution to ABCP challenges; and/or (2) improving relative retail revenue and earnings growth. In both cases, a clarity is unlikely in the near term. National Bank trades at 9.7x 2008E EPS, compared to a group median of 11.5x.
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