Friday, November 23, 2007

Preview of Banks Q4 2007 Earnings

Financial Post, Jonathan Ratner, 23 November 2007

2008 is shaping up to be a year of slower growth in terms of both income and revenue, as well as for dividends at Canada’s banks. Why? The cost of credit is expected to go up, while its availability falls.

That’s the opinion of Desjardins Securities analyst Michael Goldberg, who nonetheless sees share prices for the Big Six banks rising anywhere from 8% to 27% during the next 12 months.

In a preview of their fourth quarter earnings that kick off with Bank of Montreal on Tuesday, he highlighted the banks’ weak performance in the period from August to October. While they rose 3.9%, the S&P/TSX composite index gained 5.5% and TSX-listed lifecos increased 10.1%.

So while some may think Canadian bank stocks have reached bargain prices, Mr. Goldberg warns that current uncertainty could persist, which will hold back their performance.

“Overall, we see this as an investment banking meltdown, not a commercial banking meltdown,” he said.

He cited structured credit concerns in the U.S. and liquidity in the Canadian asset-backed commercial paper (ABCP) market as the primary sources of continued volatility.

He is particularly concerned about National Bank given that it has the most capital market exposure – at 2.5 times the leverage of other majors banks – to ABCP.

Mr. Goldberg considers BMO’s relative risk to be much lower than National’s, although above the other banks.

Each of the six banks have made pre-announcements recently and the are viewed as having plenty of flexibility when it comes to determining their loss provisions.

“They can also choose when to realize investment gains, or not to,” the analyst said, adding that this can be unpredictable and do not reflect ongoing earnings power.

Mr. Goldberg prefers to monitor operating profit trends. Based on these figures, with pre-announecments excluded, he expects the best year-over-year growth from Toronto-Dominion Bank, BMO and Bank of Nova Scotia.

On a quarterly basis, he anticipates modest gains from everyone except National and TD.

And what about dividends?

Mr. Goldberg only expects a boost from Scotiabank, noting that every bank but National hiked their dividends last quarter.

While National may be due, he thinks it is unlikely given their recent $365-million ABCP markdown.

Finally, the analyst said he expects lifecos will continue to outperform banks in the short and medium term.

Mr. Goldberg rates BMO, CIBC, National and Royal Bank at “hold” with price targets of $72.50, $108, $56 and $61.50, respectively. He rates both Scotiabank and TD “top pick” with price targets of $60 and $84, respectively.
Financial Post, Jonathan Ratner, 23 November 2007

As investors fear the broader economic fallout and impact on global banks from subprime-related problems, they’ve caused double-digit declines from their 2007 highs recently for shares of Canada’s banks. But the damage pales in comparison to the U.S. Regional Bank Index, which had losses of roughly 26%, equivalent to twice the size of declines for its Canadian counterpart.

So with writedowns on risk exposure, trading portfolio losses, balance sheet issues and the rising Canadian dollar cited as just a few of the key issues for the fourth quarter, management actions are also being closely monitored.

What are they saying?

“Think long-term, this crisis will pass,” says Credit Suisse’s Jim Bantis. While acknowledging that we are still in the midst of a restructuring of the global credit markets, the analyst sees an opportunity in Canadian bank stocks.

Mr. Bantis notes that they are trading at levels well below historical averages, compressing by 2 points to 11 times trailing earnings in recent weeks. However,he doesn’t expect them to fall to the 10x level reached during the Russian debt and Long-Term Capital Management crises.

So why does he like Canada’s banks?

Solid earnings and dividend growth are forecasted for 2008. He also expects lower relative exposure to underlying credit problems, as well as positive domestic retail banking trends.

As for dividends, Mr. Bantis expects Scotiabank will boost its payout by 7% to 10%. Meanwhile, he thinks National will stay put given its ABCP woes.

The analyst rates BMO at “neutral” with a $73 price target and forecasts earnings per share of $1.45 for Q4. Scotiabank gets the same recommendation with a $58 price target (EPS expected at $1.03), as does CIBC at $112 ($2.02) and National Bank at $66 ($1.39).

Royal Bank is rated “outperform” with a $65 price target ($1.05), as is Toronto-Dominion Bank at $82 ($1.40).
Financial Post, Jonathan Ratner, 23 November 2007

While Canadian banks pre-announced roughly $2-billion in credit-related charges for the fourth quarter (TD did not), thus providing some useful insight into their exposure, structured credit products and potential losses at the banks will surely remain on investors’ radar next year.

Citigroup analyst Shannon Cowherd is expecting earnings to fall short in the quarter compared to the same period in 2006.

Given her estimates that indicate the size of the reported impact on the banks’ securities is in the range of 1% to 14%, Ms. Cowherd thinks those numbers are too low. She points to Merrill Lynch & Co. as an example of a company with similar assets and its estimate rate of 45%.

Applying charges of that magnitude to Canada’s banks, she suggests another wave of charges ranging from $1.5-billion to $15.3-billion could result.

“As we see it, National would be near the low end of such a range and Royal at the high,” Ms. Cowherd said.

She also pointed out that while Toronto-Dominion Bank escaped the structured residential mortgage fallout, its $10-billion of non-residential mortage holdings is the largest among the Big Six.

The analyst considers Bank of Montreal, CIBC and Royal Bank the most likely candidates to report further markdowns.

She estimates that provisions for loan losses should double in the fourth quarter, primarily as a result of more “liquidity” loans coming onto bank balance sheets.

Ms. Cowherd rates BMO a “buy” with a $77 price target, Scotiabank a “buy” with a $64 price target, and CIBC a “buy” with a $121 price target.

She has a “hold” on each of National, Royal Bank and TD, with price targets of $57, $58 and $75, respectively.
The Globe and Mail, Angela Barnes, 23 November 2007

Could the mess in the U.S. housing markets and its spillover into U.S. financials set off the third major banking crisis in the United States since the Great Depression? Myles Zyblock, chief institutional strategist at RBC Dominion Securities Inc., thinks the answer is yes and that it is likely already starting.

And while he doesn't expect bank failures in the United States will be the main problem this time around, as they were in the 1930s and the 1980s, he won't rule out the "possibility of a few sinking ships."

Not surprisingly then, he is not recommending investors step up to the plate and buy the U.S. banks, even though U.S. bank stocks have dropped more than 20 per cent this year. He said in a report yesterday that he feels that valuations on those stocks still don't reflect the severity of the situation.

"In past crises, banks have traded down to book value on an absolute basis and to 0.4 times book on a relative basis," he said. They stand well above that - at about 1.5 times book on an absolute basis and 0.53 times on a relative basis.

In arguing his point about the likelihood of a major banking crisis, Mr. Zyblock trots out some disturbing statistics on the U.S. housing market and the fallout on the financials. He noted, for example, that more than 20 per cent of the value of U.S. mortgage loans made in 2005 and 2006 is linked directly to subprime situations, and another 19 per cent is linked to alt-A loan situations. Both are types of loans made to those who don't qualify for prime mortgages.

And it is those loans that are running into trouble, as evidenced by the fact that 16 per cent of subprime mortgages are now past due. To make things worse, problems are starting to rise in the prime mortgage space as well as in the face of what he says is the worst case of national price deflation in the U.S. housing market in at least 40 years. And inventories of unsold houses are nearing multidecade highs with foreclosures adding to the supply.

Mr. Zyblock believes that the worst is probably still to come in terms of bank writedowns arising out of the real estate situation. But he noted that while profitability in the banking industry is under pressure, it still isn't as bad as it was in the early 1990s.

He added that he would not be surprised to see some sort of government intervention in the situation. There is a precedent for that. In 1989, the U.S. Federal Deposit Insurance Corp. set up the Resolution Trust Corp. to manage and sell failed savings and loans associations.

But while Mr. Zyblock suggests investors pass on the beaten-up U.S. banks others feel now is the time to buy.

Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets Inc., upgraded U.S. banks to overweight from market weight last week, on the basis of what he calls "compelling valuation, depressed earnings revision data and awful investor sentiment." Moreover, he said, "dividend yields have climbed to near previous peaks, which have been associated with stock price lows in the past."

And billionaire investor Warren Buffett obviously feels there is value to be had in the U.S. financials. His Berkshire Hathaway Inc. recently raised its stake in U.S. Bancorp and Wells Fargo & Co., according to the Sept. 30 regulatory filings.

Mr. Zyblock also referred to the Canadian banks, noting that since 1942, they have traded down in more than half the years that the U.S. banks declined. "That said, TSX banks should outperform their U.S. peers as we work our way through this problem," he said.
Scotia Capital, 21 November 2007

Banks Begin Reporting Highly Anticipated Fourth Quarter Results

• Canadian Banks have pre-announced over the past few weeks write-downs for the fourth quarter of $2.2 billion or $1.4 billion after-tax as well as credit card gains of $1.0 billion after-tax essentially offsetting the write-downs from the liquidity and credit crunch.

• Banks begin reporting their much-anticipated fourth quarter results on November 27. Bank of Montreal leads off (BMO) on November 27, followed by National Bank (NA) and Toronto-Dominion Bank (TD) on November 29, Royal Bank (RY) on November 30, Laurentian Bank (LB) on December 4, and Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), and Canadian Western Bank (CWB) closing out reporting on December 6. Scotia Capital’s operating earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, reported earnings estimates in Exhibit 3, and conference call information in Exhibit 4.

• The write-downs announced by the Canadian Banks are very modest at only 1.5% of common equity and pale by comparison to a number of global players reflecting Canadian banks' low exposure to the high risk areas. Canadian Banks have the lowest relative exposure in history versus global players to high risk assets. Canadian Banks had more than their share of LDC loans in the early 1980's, excessive exposure to Commercial Real Estate (O&Y Canary Wharf) in early 1990's and Telco/Cable/Power in 2002. The banks have incredibly low exposure to U.S. sub-prime, CDOs and LBOs. The market has not differentiated much between Canadian Bank balance sheets and U.S. and other global players.

• The market's reaction has been severe (no differentiation) peeling off $38 billion in bank market capitalization or an excessive 27x the amount of the write-downs. Bank valuation has become extremely compelling with market being driven by sentiment and momentum. Individual bank relative P/E multiples have started to diverge following the debt markets.

• Conclusion: Major market overshoot on discounting balance sheet risk. Best Buying Opportunity in five Years. Reiterate Overweight. P/E Divergence favours RY and TD - 1 Sector Outperforms.

Fourth Quarter and Fiscal 2007 Earnings Estimates

• We are presenting our operating earnings estimates (Exhibit 1) for Q4/07 and 2007 excluding pre-announced write-downs and one time gains which is the method that the banks have gathered consensus numbers in Exhibit 2.

• We are also presenting the expected reported earnings (Exhibit 3) including all items and earnings (Exhibit 5) including the write downs as well as excluding the Visa/Master Card Gains.

• We expect bank operating earnings (excluding write-downs) to increase 9% YOY but decline 8% sequentially. TDand RY are expected to lead the industry with earnings growth of 17% and 7%, respectively. NA, BMO and CM earnings growth is expected to be much weaker at -1%, 3% and 4% respectively. Cash ROE for Q4/07 is expected to be 21.4% a modest decline from 23.3% in the previous quarter and 21.9% a year earlier. We are expecting operating earnings growth of 19% for fiscal 2007 earnings.

• However on a reported basis earnings (Exhibit 3) in the fourth quarter are expected to grow 1% YOY but decline 11% sequentially with ROE of 20.6%.

• If we view the commodity trading losses, CDO write-downs, ABCP write-downs and credit card reserve increases as operating and exclude the VISA gains as one-time, bank earnings (Exhibit 5) would be expected to decline 17% from a year earlier with a very resilient ROE of 16.1%. On this basis TD and RY are recording the strongest earnings momentum.

• The cloud over the banking sector is not likely to be completely removed with the release of fourth quarter earnings as liquidity and credit jitters may continue, and global peers that are on a calendar year-end will not have released year-end earnings and concerns about further deterioration in the U.S. housing and potential negative impacts to the overall economy persist. But we believe it will be positive in calming market fears and affirming the modest balance sheet and earnings impact on Canadian banks. In fact, Canadian banks have an opportunity over the next several years to expand their businesses both organically and via acquisitions given the high Canadian dollar, strong balance sheets, relatively sound valuations, and the financial weakness of many of their global competitors.

Bank Write-Downs - $1.4 Billion

• The banks have pre announced write-downs (Exhibit 6) for Q4/07 totalling $2.2 billion or $1.4 billion after-tax as well as VISA/MasterCard gains of $1.3 billion or $1.0 billion after tax.

• NA, BMO and CM announced the largest write-downs of $575 million or $2.31 per share, $530 million or $0.69 per share, and $463 million or $0.90 per share, respectively. RY write downs were $480 million or $0.19 per share and $190 million or $0.14 per share, respectively with TD not having announced any write-downs. Total write-downs of $1.4 billion after-tax represent 5% of the banks' $20 billion earnings base which we estimate is two weeks' worth of bank earnings.

• In terms of write down impact NA represented 8.1% of common equity, followed by CM at 2.7%, BMO 2.4% with RY nominal at 1.1%, and TD no impact.

Visa/Master Card Gain - $1.1 billion

• The bank group announced gains from the restructuring of VISA International and sale of Master Card holdings (Exhibit 7) totalling $1,254 million or $1,031 million after tax. CM and RY recorded the largest gains at $456 million and $325 million respectively. TD gains were $163 million with BMO selling shares in Master Card to realize $110 million.

Dividend Increases Expected Despite Financial Turmoil

• Canadian banks have established a pattern beginning in 2002 and 2003 of increasing their common dividends every second quarter. Banks have grown their dividends by 229% since the beginning of 2000. The bank that is due to increase its dividends this quarter is NA, with an expected increase of and 5%. However, NA may decide to defer the dividend increase due to its expected writedown of its non-bank ABCP portfolio. The bank group’s dividend payout ratio is 46% and 40% on our 2007 and 2008 earnings estimates, respectively. TD’s payout ratio on 2008E is a low of 36% with BMO at a high of 47%.

U.S. Commercial Real Estate – Slight Earnings Drag

• Loan loss provision increases are also expected from the Canadian banks’ U.S. banking operations over the next two years, particularly in the U.S. commercial real estate (CRE) loan portfolio. We estimate the Canadian banks (TD, RY, and BMO) have US$19 billion of U.S. CRE exposure, including US$7 billion in construction loans. On a pro forma basis, including Commerce Bancorp (CBH.N) and Alabama National BanCorporation (ALAB.O), the total U.S. CRE exposure increases to US$28.5 billion, including US$10.3 billion in construction loans. In terms of exposure, Alabama National is at risk of heightened supervision for having total CRE exposure (including construction) over 300% of common equity.

• Despite relatively high credit standards we believe that higher losses are likely from this portfolio over the next two or three years. The loss ratios on this portfolio could increase to as high as 1.0% on the non-construction portion of the CRE portfolio and 2.0% on the construction portion. Loss ratios on U.S. CRE in the early 1990s were in the 150 basis point (bp) range. We estimate that the three major Canadian banks – TD, RY, and BMO – have potential higher loan losses on this portfolio of $335 million, reducing earnings by 2%-3% over a three-year period. The loan losses on these portfolios may be less; however, we are attempting to quantify potential downside risk and believe these losses are very manageable. Commerce Bancorp and Alabama National could take higher loan loss provisions prior to the transactions closing, thus reducing future loan loss provisions post acquisition. In fact, Commerce Bancorp did increase its loan losses meaningfully in its Q3/07.

Canadian Banks – Lower Balance Sheet Risk

• We believe Canadian banks have lower balance sheet risk than most of their global peers. Canadian banks have no direct exposure to the U.S. sub-prime market, nominal to negligible exposure to CDOs, and minimal exposure to LBO loans.

• At present, asset quality in Canada has held up extremely well with the main problem centering on liquidity problems in the non-bank ABCP market. The level of capital in the banking system has improved immensely, with financial leverage and leverage to credit declining to historical lows while profitability is at record highs. Securitization utilization in Canada is modest at 10% of assets. Canadian banks’ investment holding of MBS/ABS (relatively high quality versus the U.S.) represents 2% of assets versus 12% in the U.S.

• Canadian bank exposure to problem loan areas pales today in comparison with past cycles. Problem loans relative to capital and earnings base are a fraction of what they have been historically. Bank exposure to LBOs, a current high-risk loan area, is very manageable, estimated at $7 billion against the $91 billion equity base and a $20 billion earnings base, which compares immensely favourably with the three major problem loan areas the banks have encountered over the past 25 years. This comprises Telco/Cable/Power/Power Generation in 2002, Commercial Real Estate in the early 1990s, and less developed countries (LDCs) in 1982. In addition to the low dollar exposure to LBOs, we believe Canadian banks have maintained higher underwriting standards.

Best Buying Opportunity in Five Years

• Fourth quarter earnings carry the greatest uncertainty of any bank quarterly earnings release since the fourth quarter of 2001. In the fourth quarter of 2001, banks doubled their loan loss provisions sequentially due to trouble in the Telecom/Cable industry, including such names as WorldCom, Teleglobe, Global Crossing, and Adelphia Communications. The uncertainty created by credit concerns in the Telecom industry spread to the Power/Power Generation industry, culminating in the Enron bankruptcy. The credit cloud that appeared over the banking sector did not clear until the fourth quarter of 2002 when the damage was fully tallied, with banks’ profitability holding up remarkably well with a 15% return on equity, the highest trough ROE in history on low financial leverage. The market rewarded bank stocks by expanding their P/E multiple from 11x trailing at the end of 2002 to 15x by 2004 on very rapidly rising earnings. Banks stocks appreciated 39% and 96% in the proceeding two and four years, respectively.

Bank Relative P/E Multiples Taking Cue from Debt Markets

• Bank P/E multiples have started to diverge after a period of abnormal P/E convergence. This trend is following the same pattern that has happened with the debt markets and corporate spreads. Just as the debt market was not differentiating for risk, bank P/E multiples were not reflecting differences in profitability, quality of earnings, business mix (retail versus wealth management versus wholesale) or growth prospects (including degree of reinvestment).

• The debt market is now discounting for risk as corporate spreads have blown out and we are now seeing bank P/E multiple divergence. Individual bank P/E differentials generally tend to mirror bond spreads over time and this cycle seems to be no different. We expect divergence in P/E multiples will favour Royal Bank and Toronto-Dominion based on the quality and size of their retail and wealth management (especially RY) platforms, relatively low earnings exposure to wholesale, high profitability and growth prospects.

Valuation - Extremely Compelling

• Bank valuation is extremely compelling. Bank dividend yield relative to bonds is 97% or 4.6 standard deviations above the mean and with dividend growth projected at double digit over the next five years this valuation is extraordinary.

• Bank dividend yield relative to the TSX is also at a record high except for the 1999/2000 peak caused by the major appreciation in Nortel's share price. Bank dividend yield is 2.2x that of the TSX.

• On a price earnings basis we believe we bottomed at 11.7x (LTM restated earnings) and look for major P/E expansion post the credit and liquidity crisis. Bank earnings need to be stressed tested in order to garner higher P/E multiples from the market.

Recommendation – Maintain Overweight

• We are optimistic that bank stocks will show market leadership as financial fears subside and certainty about risk levels improves. We remain overweight the bank group based on fundamentals, valuation, and the belief that central banks will be able to manage systemic risk. Maintain 1-Sector Outperform on TD and RY based on quality and size of their large retail and wealth management platforms and superior profitability. Maintain 2-Sector Perform on CIBC, CWB, and NA with 3-Sector Underperform on BMO and LB.

Fourth Quarter Highlights

• Bank of Montreal is expected to report operating earnings of $1.37 per share versus $1.33 per share a year earlier, an increase of 3% YOY and a decline of 8% sequentially. We are looking for reported earnings of $0.85 per share including pre-announced write-downs of $0.69 per share and a gain on MasterCard of $0.17 per share. BMO announced it will issue up to a maximum of $1.6 billion in senior debt in order to fund its SIVs. Canadian P&C and Wealth Management earnings should be relatively strong with Wholesale extremely weak due to trading losses, with U.S. P&C earnings continuing to underperform.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $2.10 per share, an increase of 4% YOY but a 14% decline from the record high Q3/07. Reported earnings are expected to be $2.34 per share including a $1.14 per share VISA gain and $0.90 per share write-down on CDOs. Revenue growth is expected to remain challenging. We expect cost reductions to continue to drive earnings.

• National Bank is expected to report operating earnings of $1.30 per share in the fourth quarter, a decline of 1% YOY and a 12% decline from the previous quarter. Reported earnings are expected to be a loss of $1.01 per share including a write-down of $575 million or $2.31 per share on ABCP. The tier 1 ratio is expected to be above the bank's target of 8.5%. We expect slightly better results from Retail banking. A dividend increase of 5% to $2.52 per share is expected, although it may be deferred in light of the magnitude of the potential writedown.

• Royal Bank is expected to report operating earnings of $1.04 per share, an increase of 7% YOY and a decline of 4% quarter over quarter (QOQ). Reported earnings are expected to be $1.06 including a $0.21 per share gain on VISA and a $0.19 per share of write-downs. Strong earnings growth is expected from RY’s Retail and Wealth Management businesses with potential weakness from U.S. and International Banking and RBC Capital Markets due to the appreciation of the Canadian dollar, reduced capital markets activity, and lower trading revenue.

• Toronto-Dominion Bank is expected to report operating earnings of $1.40 per share, an increase of 17% YOY and a decline of 13% QOQ. Reported earnings are expected to be $1.59 per share including a $0.19 per share VISA gain. Retail and Wealth Management earnings are expected to continue to drive earnings. We expect earnings to decline from very high levels in Q3, especially given a more difficult capital market environment. We believe TD Banknorth is now refocusing on organic growth building, realigning distribution, and improving efficiency. We expect better operating results going forward from TD Banknorth. TD Ameritrade earnings contributions for Q4/07 are estimated at $0.10 per share versus $0.08 per share in the previous quarter and $0.07 per share a year earlier.
The Globe and Mail, Roma Luciw, 21 November 2007

Canadian banks have already revealed nearly $2-billion in credit-related market charges, but one U.S. analyst expects further mark-downs will be in the cards when the Big Six start reporting earnings next week.

Citigroup Global Markets analyst Shannon Cowherd said that the Canadian banks have announced charges ranging from 1 per cent to 14 per cent of her estimate of the amount of securities impacted. That range seems low, she said, given that companies with similar assets — such as U.S. financial giant Merrill Lynch & Co. Inc. — announced charges at an estimated level of 45 per cent.

“Based on our analysis of potential securities impacted, if the magnitude of the charge were 45 per cent we'd face another wave of charges ranging from $1.5-billion to $15.3-billion,” Ms. Cowherd wrote in a fourth-quarter preview released Wednesday. According to her calculations, National Bank of Canada would be near the low end of such a range while Royal Bank of Canada would be at the high end.

Canada's biggest banks have not been immune to the credit crunch that has hammered U.S. financial institutions, who have taken tens of billions worth of writedowns on their exposure to subprime mortgage-related securities.

To date, the Canadian banks have collectively pre-announced nearly $2-billion in credit-related charges for the fourth quarter, which ended Oct. 31, Ms. Cowherd said. National unveiled the largest quarterly charge, a $575-million writedown while Canadian Imperial Bank of Commerce has said it will take a $463-million fourth-quarter charge on its exposure to the U.S. mortgage market.

Toronto-Dominion Bank is the only one of the Big Six that has not announced any charges.

“The most prevalent topic since the third quarter will likely remain the hot topic for the fourth quarter — structured credit products and the banks' potential for losses,” Ms. Cowherd said.

She expects provisions for loan losses to nearly double from last year's fourth quarter, primarily driven by the increased “liquidity loans” on the banks' balance sheets. “The non-performing ratios on both residential and commercial loans are picking up and the banks need to increase their credit coverage ratios,” Ms. Cowherd said.

Another aspect of the credit crisis that could emerge in the quarter is credit default swaps, she said. “Most likely, in our view, many of the downgrades by the rating agencies have been credit events driving a credit default swap pay out,” Ms. Cowherd said.

The Citigroup analyst cut her fourth-quarter earnings estimate for National Bank by $2.27 to $3.40 a share, reflecting asset-backed commercial paper related charges. But she maintained her “buy” ratings on all of the banks, citing their depressed valuations.
Financial Post, Duncan Mavin, 21 November 2007

Canadian bank stocks are nearing bargain prices heading into fourth quarter earnings season beginning when Bank of Montreal reports its annual profits on Tuesday, says Desjardins Securities analyst Michael Goldberg.

Banking sector share prices have lagged the TSX (bank prices have increased 3.9% on average compared to 5.5% for the index) in the final quarter of 2007.

“In our view, weak performance is tied to concerns about a possible systemic decline in trading revenue more recently compounded by the liquidity problems of a number of ABCP issuers in Canada who are having trouble rolling their paper,” Mr. Goldberg says.

But the Desjardins analyst is still cautious about the relatively cheap bank stocks.

“Persisting uncertainty is expected to continue to hold back performance,” he notes. In 2008, he anticipates slower top-line, bottom-line and dividend growth.

Mr. Goldberg’s top picks among the big six are Toronto-Dominion Bank and Bank of Nova Scotia. He forecasts the lowest level of growth among the big banks will be at National Bank
Financial Post, Jonathan Ratner, 21 November 2007

While global financial stocks haven’t seen the same kind of declines witnessed back in third quarter of 1998 when the MSCI AC World Financials Index fell 34%, Citigroup’s chief global equity strategist, Robert Buckland, says the relative performance is comparable. And the success of the broader market may be to blame.

Nearly a decade ago, investors were reeling from the Asian financial crisis in July 1997, the global recession had begun and the Ruble crisis arrived in August 1998. These days, the crisis is credit.

Financial troubles have sent the MSCI index down 11% from its all-time high and 6% so far this year. But Mr. Buckland said similar sell-offs in the sector have come every year since the market turned upward in 2003.

“Just looking at the index all the ‘worst credit crisis in my lifetime’ rhetoric seems overdone,” he wrote in a note to clients. He added that not only should global equity markets be able to make further gains, but selective opportunities remain among the financials.

U.S. and U.K. banks may be getting the majority of the negative headlines these days, but Japanese banks have had it just as bad, according to Mr. Buckland. Meanwhile, Asia-Pacific and emerging market banks have done very well.

So while it may not be 1998 all over again, looking at today’s situation in relative terms does present some serious concerns. Mr. Buckland points to the 15% fall for global financials when measured against the broader MSCI AC World Index, which is up 9% since June. He says this represents the worst performance since 1998-2000.

“Perhaps this is why the Financials sell-off feels so bad for fund managers,” he said. “The opportunity cost of owning global financials is now the largest it has been for eight years.”

So with the financials taking a beating, investors may be starting to think that the rest of the market may no longer be able to defy gravity. This decoupling – when the global equity market climbs and financials decline – is considered somewhat rare.

Nonetheless, Mr. Buckland says opportunities do exist. Among the names he considers reasonably priced with strong earnings momentum include U.S. insurers Ace Ltd., MetLife Inc., Lincoln National Corp. and Hartford Financial Services Group Inc., while the only other North American name on his list is Canadian Imperial Bank of Commerce.
Financial Post, Grant Surridge, 21 November 2007

Most Canadian banks will likely be happy to see the back end of November, and none more than CIBC. The bank’s shares are down about 18% so far this month, the most of any Big Six bank, as investors fret over its exposure to mortgage-backed securities in the U.S.

CIBC has so far announced total writedowns of $750-million in connection with these holdings, as well as continuing exposure to the tune of $1.7-billion.

“Investors do not know enough about the hedges against this exposure... and are speculating that the hedges may not be fully effective,” Desjardins Securities analyst Michael Goldberg wrote in a note to clients on Wednesday morning.

And he says CIBC’s refusal to discuss the details, including the gross exposure to such debt instruments, prior to its Dec. 6 earnings release is not helping.

“CIBC’s silence fuels the concern that where there is smoke, there is fire,” the analyst said.
Dow Jones Newswires, 9 November 2007

Investors now know size of write-down at Canadian Imperial Bank of Commerce on US subprime exposure, and can pretty much assume Toronto-Dominion Bank doesn't have any. Both banks announced Visa restructuring gains, with CM noting they'll cover the CDO hit. But jury still out on Royal Bank of Canada, Bank of Montreal and Bank of Nova Scotia. Genuity Capital Markets says BMO likely to take charge on asset-backed CP exposure, and if it does, others will probably do the same. There's also likely to be trading losses, even at CM, which left open question of health of credit trading derivative portfolio.
Financial Post, Duncan Mavin, 9 November 2007

Despite market expectations for heavy write-downs for Canadian banks in the fourth quarter, Dundee Securities analyst says the fundamentals remain relatively positive for the sector and it will easily withstand these losses. He sees no real threat to the quality of their credit, while trading revenues should partially offset lower advisor activity.

Nonetheless, he suggests investors take a defensive approach given the difficulty in figuring out the size of charges the banks may take, as well as where they may stem from. Take a market weighting at most for the banks heading into the fourth quarter, but be selective in the names you choose, the analyst advises. And expect to see more valuation pressure as their upcoming earnings approach.

In a note to clients, Mr. Aiken laid out the level of charges the bank’s could take without impacting their potential for future growth, by examining excess capital and how earnings could cushion losses.

Excluding TD Bank, which has set aside its excess capital for the purchase of Commerce Bancorp, Mr. Aiken estimates that each of Canada’s Big Six banks could incur write-downs of at least $1-billion before their future growth would be impaired.

Other than CIBC, who has collateralized debt obligations and mortgage-backed security exposure Mr. Aiken labels “apparently manageable,” the Canadian banks’ direct U.S. subprime exposure is limited, he said. Mr. Aiken also noted that they have sufficient capital to withstand recent speculated write-downs.

Nonetheless, he recommends focusing on those most likely to be unaffected by the subprime situation, like regional banks Canadian Western Bank and Laurentian Bank, while highlighting Bank of Nova Scotia as likely the best of the Big 6. He also considers Royal Bank a defensive bet.

“While we also believe that TD should be able to side-step charges this quarter, its relative lack of excess capital does not provide any cushion,” Mr. Aiken wrote.
He thinks BNS, TD and Royal are the least likely to generate one-time charges in the third quarter.

“That said, both Bank of Montreal and National Bank have the ability to generate the greatest shareholder returns through the reporting season, if current speculation regarding anticipated write-downs ends up being too bearish,” Mr. Aiken said.
BMO Capital Markets, 7 November 2007


We have changed the structure of our quarterly preview slightly this quarter. In the past several years, there have been fewer quarterly unknowns so that we could pick the variables and deal with them separately. Not so this quarter, where every line on the income statement has a relatively large margin of error. As such, we have approached the major income statement lines separately: Net Interest Income, Non-Interest Revenue (inclusive of trading revenues and securities gains), loan losses and expenses.

Having said that, if there is one major theme this quarter, it will likely be the increased importance of the balance sheet as a harbinger of problems. Simply put, earnings should be good, but the balance sheet and the capital analysis will show less clear signs, and this will be an issue. To paraphrase our strategist, Don Coxe, “In good times, income statements are important. In less certain environments, balance sheets and capital become paramount.”

As such, we have devoted a more meaningful proportion of this report to the balance sheet and to capital. In aggregate, we expect to see a few banks with Tier 1 ratios of close to (and, dare we say, even below) 9%. Tangible common equity will continue to weaken as banks experience some risk-weighted asset (RWA) growth without significant build in common equity. These are still robust capital positions, but with clear pull on bank balance sheets, there will be further pressure in coming quarters.

We will end this preview with a look at the individual banks. If there is one that could surprise on the upside, it is TD Bank. The bank and its management team have been preparing for a difficult environment, so one would expect their balance sheet to weather the current situation well. On the downside, we believe that Scotiabank faces the biggest hurdles with the move in the currency and the bank’s larger corporate loan book. The one offset is that Scotiabank could well report strong trading revenues. They appear to have taken the most realistic view of the current turmoil, so could actually benefit.

We downgraded the Canadian Bank sector to Market Perform two months ago. We are confident that their balance sheets and strong domestic loan book will underpin strong performance relative to their global peers. On the other hand, we aren’t so sure that they can escape the fall-out from what appears to be unwinding of most fixed-income structured products. We currently recommend TD, CM and NA (all rated Outperform), which have more exposure to domestic retail and wealth than their peers.

Balance Sheet – A New Awakening

We, like most analysts and investors, have been unusually focused on income statements over the past few years. This made sense, as bank stocks are generally valued off their P/E rather than any other metric. We believe that this is changing. The real issue for all banks is the re-intermediation of risk. Effectively, banks are being asked to provide liquidity for customers who are less able than in the past to finance their activities in capital markets. We don’t know how long this will last, but it does mean that the balance sheet will become a better window into the current environment for banks than the income statement.

To deal with this, we review a variety of items—including book value, growth of assets, and capital ratios. We note that the conclusions arrived at from this perspective are less comforting than those from an income statement perspective (which we believe will be quite immune from the problems of the current market).

It is difficult to be pessimistic on Canadian banks given the strength of the core franchises and balance sheets. It would take a real cynic to worry about banks with Tier 1 ratios of 8.5–9.5%. Having said that, Canadian banks do not operate in isolation and it seems as if bank balance sheets (like those of their global peers) will be getting weaker over the coming quarters. One major variable in establishing the degree of balance sheet strain is the Income Statement, and particularly net interest income, non-interest revenue and loan losses. The news here looks quite solid, as we detail below.

We note that the balance sheet may also show several other changes this quarter. Loan quality (covered later in this report), securities portfolios and derivative positions will also provide some insights into the stresses on bank liquidity and potential earnings power.

Net Interest Income – Top Line Stability Hides Underlying Volatility

Net interest income for banks seems to be a relatively simple concept: loan growth drives balances, while spreads are the difference between the yield of loans and the funding costs distributed to funding sources. Taken as a product of each other, we derive net interest income. In reality, however, the situation is far more complex, as mix of assets and liabilities as well as the duration of both sides of the balance sheet can dramatically affect how these variables interact.

In considering the outlook for bank NII this quarter, we believe that it is best to individually consider loan growth (with some analysis of loan mix), deposit mix and indicative spreads. In addition, this quarter included material securitization activity which could translate into large gains.

In a quarter such as this, we are reminded of the mid-quarter comment of a senior bank executive who eloquently said, “We have no idea what spreads are going to be this quarter, but we’re pretty sure they aren’t going to be up!” Having said that and given robust loan growth, we expect net interest income to be strong— up 2–3% in quarter—and that banks will likely record good securitization gains. (Note that because of generally accepted accounting methodologies, securities gains show up in non-interest revenue even though they really are a funding issue).

Many of the comments we have made in this section on NII relate directly to the core P&C operations and, as such, tend to impact the “retail segment.” Having said that, some investors and analysts (not us) focus on the overall bank’s NII, which is further complicated by the financing of the trading and derivatives books. Most banks, however, run their securitization thorough the “Corporate” segment, as it is a quasi-treasury function. As such, there is real potential to see “weaker retail but stronger corporate earnings”—a mix shift that investors generally abhor.

Non-Interest Revenues – Expect the Unexpected

Non-interest income of Canadian banks incorporates trading gains and losses, underwriting and advisory revenues, mutual fund and credit fees, commissions, insurance revenues, securities gains and a host of other items. Trading is the biggest of these revenues, producing 8–10% of total bank revenues and over 15% of non-interest revenues. Outside of trading (which we deal with in some detail in this segment of this report), some of these revenues are stable (credit and banking fees, insurance revenues, etc.), some are predictable (capital markets revenues inclusive of underwriting, advisory and commissions) and others are highly unpredictable (securities gains). Given the volatility of some of these items, we limit our comments to trading revenues and the other less stable revenue streams.

Loan Losses – The Gradual Creep Continues

Quarterly loan losses were relatively stable for the Canadian Banks for most of 2004, 2005 and 2006. Since the fourth quarter of last year, loan losses have begun to exhibit a well-telegraphed trend—gradual increases. So far, much of the increases have come from TD and RY on the retail side of the loan book, while Scotiabank and BMO have continued to benefit from reversals in the corporate book. CIBC has, as usual, marched to its own drum as it reworked its non-residential mortgage consumer loan book.

We expect to see loan losses continue to track higher. Particularly interesting will be the U.S. consumer and commercial loan books of BMO, Royal and TD Bank. With clear signs that the U.S. loan book is experiencing higher losses, the scale of deterioration for these three banks will be a focus.

Any signs that the Canadian loan book is weakening would certainly spook the market. Remember that loan losses for Canadian banks continue to be at historically low levels, so the potential certainly exists for a fairly significant ramp-up in losses. For perspective, a normal mid-cycle level of loan losses would be $1.5 billion higher than what banks are currently reporting. On its own, this would be a 5% headwind to bank earnings growth over the next year. Of course, history tells us that loan losses go from unusually low levels to unusually high levels, so the trend is probably as important as the level. In addition, the market tends to anticipate loan losses rather than simply accept them. The bottom line on loan losses is this: the environment cannot remain as good as it has been for the past few years, and the best we can hope for is a gradual deterioration.

Expenses – Well Controlled

Over the past several years, Canadian Banks have been very successful in managing non-interest expenses lower, when compared to revenues. The fourth quarter is, however, always a difficult one to gauge. Non-incentive expenses are relatively predictable, but there is some ability to move the needle with acceleration or deferral of specific project spending. We would expect (and hope) that banks attempt to be conservative to ensure that they start 2008 without any headwinds. Typically, NIX ratios spike higher in the fourth quarter and this should also be the case this year.

The reality, however, is that the accrual of incentive compensation (accrual because of the annual disbursement calendar for the investment banks which produce most of the bonuses) means that banks only really pay incentive compensation in the fourth quarter. With the fourth quarter having ended on a weaker note, there will be real debate on whether banks have overaccrued in anticipation of a good year. Despite the vagaries of the fourth quarter, the reality is that the Investment Banks have had an outstanding year. Inclusive of the BMO’s natural gas trading snafu and the CIBC’s CDO charges, we estimate that after-tax profits for the dealers will be close to $5 billion—very comparable with year-ago levels. The question will be whether, with U.S. investment banks being hit much harder, and with a less-than-auspicious end to the year, bonuses will also be hit.

All in, we expect bank managements to show good expense control as evidence of their ability to earn through difficult operating conditions.

Taxes – Steady to Lower Rates, but Deferred Tax Charges

We expect bank tax rates to be stable to lower in the current quarter. Given the outlook for lower statutory rates in 2008 and 2009, this trend will be beneficial in the medium term for Canadian bank earnings (Mini-Budget 2007: Declining Tax Burden Continues to Benefit Bank Shareholders).

Having said that, nothing is ever that simple. With lower statutory rates, deferred tax assets actually lose some of their capacity to screen future earnings and may need to be revalued lower. As such, there is reasonable likelihood of tax charges this quarter. We have not attempted to estimate these charges, but they could be in the order of $25–75 million per large bank.

Individual Bank Comments

Bank of Montreal – More Clean-up

It is widely expected that the Bank of Montreal will take hits on its holdings of third-party ABCP. Given the estimated size of its portfolio, we estimate losses in the $100 million range. We note, however, that there is a real potential for additional losses on other securities holdings and unlike four of the other banks, BMO has no one-time Visa gains to offset potential charges. We forecast cash EPS of $1.20, inclusive of $0.14 of ABCP losses.

The Retail businesses should, on the surface, look very good compared to a year earlier (remember that year-ago results in Canada were extremely weak). In Canada, we forecast a cash contribution of $351 million, essentially fl at with the linked quarter. Despite the industry-wide pressure on Prime-BA spreads, the domestic bank continues to benefit from better pricing on mortgages (at least when compared to last year). Harris will continue to struggle, as spreads remain very tight in the U.S. One area of focus will be loan losses. Loan losses at Harris have began to track higher and it will be interesting to see the rate of new formations. This could spook the market.

On the wholesale side, we have assumed that the natural gas trading problems are behind BMO. Furthermore, we have included the ABCP loss provision in the Corporate segment. As such, BMO Capital Markets should have its best quarter this year (over $200 million) with activity levels remaining robust and with loan losses well controlled. Expenses will be difficult to evaluate given the trading losses, which will offset what otherwise appears to be an excellent year.

Wealth Management should continue to be ahead of last year. Activity levels are certainly up from the year-ago quarter, but are down from the second and third quarters. Mutual fund assets are up roughly 13% over the year.

We have included $100 million (pre-tax) in writedowns for ABCP and other issues. As such, the Corporate segment will see a loss of about $90 million. This segment also includes securitization revenues (which could be massive) and tax issues (which could be positive or negative). Needless to say, an analysis of earnings contribution this quarter will be more qualitative than in previous quarters.

On the balance sheet front, BMO could well show significant changes this quarter. Tier 1 will likely drop to about 9% compared to roughly 10% a year and a quarter ago. There is some concern on our part that OSFI will require more capital behind back-stop liquidity lines. In addition, book value will, at best, be stable with the currency impact offsetting retained earnings. The bank has aggressively raised liquidity in the past few months, so it will be interesting to see whether this has been reactionary (to fund draws on lines) or anticipatory (to raise core liquidity).

National Bank – Hard Hat, Please

This quarter will be most interesting for National Bank—and not just because of the need to take a charge on third-party ABCP. The second most interesting issue will be the impact on the bank’s balance sheet from the current turmoil. We are forecasting a $500 million pre-tax charge ($2.00 per share after tax). We also expect Tier 1 to decline to 8.4% from the 9.4% at the end of the third quarter.

Retail banking has had a difficult year, and there is little indication that this will change in the short term. The fourth quarter of last year was very weak, so the 8% gain year over year is a scant achievement. National should provide good insight into core spreads, as it uses the BA market more than most. Having said that, volumes remain very good in Quebec and there was some increase in their deposit balances following the mini-run on money market mutual funds in August. Wealth management will also see profits close to third-quarter levels.

NB Financial, the wholesale arm of National Bank, should have a much weaker quarter compared to the first three quarters f the year. Trading revenues will likely be quite weak and activity levels were disappointing—not surprising given the focus by senior executives on ABCP this quarter. As always, there is very little visibility into potential gains from Treasury. Loan losses should be well controlled. We have assumed that the ABCP charge is included in the Other segment.

We remain cautious on dividends. It has been two quarters since the bank last raised its dividend, but it would be a surprise if this did occur. Given the state of cash and credit markets, we believe it would be better to wait. The bank still has its normal course issuer bid, which it could use if the environment improves.

TD Bank – Their Time in the Sun

If there is any bank that has prepared for the current environment, it is TD Bank. The shift to retail banking, the exit of the structured product business in Europe and the move to change management at Banknorth all point to a bank that has moved to insulate itself from credit and liquidity risk. Having said that, the deal for Commerce Bancorp produces its own complexities (flow-back, more goodwill, execution risk, etc.). The good news for shareholders is that this quarter should show all of the stability and none of the impact of the CBH acquisition. We expect to see robust EPS of $1.32 compared with $1.16 a year earlier. We have assumed that the Visa gain will be in the corporate segment, offset by securities/LBO bridge finance writedowns.

Retail should still show the momentum of the past couple of years. Volume growth is excellent and spreads should be more stable than the peer group (we believe that TD does more to insulate itself from short-term changes in rates). Loan losses continue to track higher, reflecting strong growth in balances. Any progress on slowing this trend would be quite positive. The good news is that the comparison is getting easier. Banknorth is well up from last year due to the lack of one-time charges.

Wealth management should have a solid quarter. The contribution from AMTD was a bit above our expectations, at $75 million. The domestic business tends to be a bit weaker in the fourth quarter, but given market volatility in recent months, there is some chance that discount brokerage volumes were good. Remember that TD is disproportionately levered to this factor.

TD Securities will likely have a disappointing end to an excellent year. With relatively low credit risk, there should be no surprises on the loan loss front. During the quarter, there was some focus on the bank’s agreement to bridge the BCE privatization—both on the debt and the equity front. It is difficult to gauge the potential for a writedown here, but with the Visa gain, it is safe to say that management will attempt to take its medicine this quarter. For simplicity purposes, we have assumed that trading revenues are $100–150 million below “normal.” Essentially, this means no trading revenues in the quarter.

On the capital front, we believe that Tier 1 (at 10.2% last quarter) and book value per share should be largely unchanged this quarter. TD will be the only bank with a Tier 1 of over 10% this quarter. Over the next couple of quarters, the bank will be much more focused on reducing its risk-weighted assets and retaining capital in advance of the closing of the Commerce deal. Simply put, buybacks and dividend increases will be tepid at best over this period.

Royal Bank – Can a Global Fixed Income Franchise Be Unscathed?

It is without doubt that Royal Bank has moved beyond its Canadian peers in building a global fixed income presence. Its operations in the U.S. and the U.K. ensured that the bank would win in the Maple Bond market, and this success has spilled over to reinforce its powerful M&A and underwriting franchises. This quarter will provide some insight into whether the bank can drive unscathed through what appears to be very difficult times. Were this the case, Royal would need to be compared with Goldman, which has done this in the U.S.

We see few signs that there will be any specific problems this quarter. The bank’s retail business should be quite a bit stronger than in the third quarter, while the ongoing stream of acquisitions suggests no lack of confidence in the outlook. We forecast Cash EPS of $1.01, up 8% from last year. The $300 million Visa gain should be offset with a raft of “conservative” marks on the securities book.

In Canadian Banking, we expect to see strong operating leverage after a disappointing third quarter. Royal continues to drive volume growth, though margins could well be pinched. The insurance business has developed a reputation for volatility and after “one good, one bad and one so-so quarter,” who knows what results will be this quarter. We have stayed securely in the middle and assume a contribution of close to $100 million. Whatever the result, the volatility of these earnings have resulted in them being heavily discounted. Simply put, the only one of these two businesses that matters is the non-insurance business.

The Wealth Management business should have another strong quarter, though there will be some headwind from the U.S. business due to currency. This tends to be one of the bigger quarters of the year and given the ongoing strength of fund fl ows and the level of equities, there appears to be limited risk this quarter.

Much of the focus will be on RBC Capital Markets. We note that the bank had several wins on the M&A front this quarter, and the franchise remains in great shape. There is little visibility into trading or securities gains (or losses). We forecast trading revenues of $200 million—the lowest of the year. As we already mentioned, however, the bank is likely to book some mark-to-market losses to clear up the portfolio going into 2008. This will either show up in securities losses, or in the trading line—we have assumed the latter. The bottom line is that even with a hit of $300 million pre-tax (roughly offsetting the Visa gain), we expect to see a result that is solidly profitable, but down from the first three quarters of the year and year-ago levels.

The U.S. and International business will face strong currency, spread and loan loss headwinds. We expect the contribution to be down on a year-over-year basis and on a linked-quarter basis. We are assuming that Global Private Banking offsets the problems at Centura. With the Visa gain to be included in the Corporate segment, we expect an unusually strong result from this segment.

The balance sheet of Royal should reflect many of the pressures in the group this quarter. Book value will likely be down and, with some pull on balance sheet assets (both off- and on-balance sheet), the Tier 1 could fall below 9% for the first time in over five years. The bank was very quiet on its buyback in the quarter—a prudent move to build capital.

Scotiabank – Diversified Growth Continues

We expect another solid quarter from Scotiabank. The major cross-currents include the currency headwinds, securities gains or losses, uncertainty on trading and the growth from recently acquired businesses. We have incorporated our estimate of the gain on Visa ($100 million), but expect securities writedowns that will largely offset this. Our estimate of $0.97 is unchanged.

In domestic retail banking and wealth management, Scotia has had a much stronger first nine months than we expected at the start of the year. Revenue growth has been robust and expense control has been excellent. We are forecasting a solid gain year over year (but lower than the 20%+ achieved in the first nine months) largely because the fourth quarter was quite weak last year.

Scotia Capital should have a much weaker fourth quarter after three “barn-burner” quarters in 2007. Fourth-quarter trading and capital markets activity seems to be quite weak and loan loss reversals will continue to normalize. Furthermore, we believe that all banks will attempt to take very conservative marks on illiquid positions. We have assumed $100 million in “unusual” trading hits. All in, we expect weak revenue performance—but this should be partially offset by reversal of expense accruals.

The International business should be able to withstand the impact of the rapid increase in the Canadian dollar because of the incremental contribution from Peru, Costa Rica and the DR. Mexican earnings (already announced) are essentially flat year over year and quarter over quarter. The corporate segment will include the Visa gain ($70 million after tax), so the profitability will be above average—comparable to the third quarter.

On the capital front, the news should be relatively benign. Scotia completed an issue of non-common Tier 1 in the quarter and this will partially offset what should be solid RWA growth. The bank is scheduled to bump its dividend this quarter, and we would bet it is the only bank to do so (by $0.01 to $0.46). It would be a tremendous statement of the bank’s financial strength to raise its dividend in the current environment. With the Chilean deal coming on in the next quarter and the potential for further good demand from corporate clients, BNS will probably err on the side of caution (i.e. carrying more rather than less capital). We expect to see a noticeable decline in unrealized securities gains, and book value per share will likely drop due to the aforementioned writedowns and the move in the currency.

CIBC – This Bank Has Grown Up

The market has remained quite focused on CIBC’s holdings of CDOs. So are we. What does give us some comfort, however, is the fact that we believe we can size the problem—the bank has $1.7 billion of exposure, partially mitigated by $300 million of subprime index hedges. So far, writedowns (inclusive of our estimates in the second quarter) are above $600 million. The bank will be carrying the CDO position at 60% of cost.

Following management comments from the conference call on the Oppenheimer (OPY) transaction, we adjusted our forecasts for CIBC to include a $400 million Visa gain, $300 million on CDO writedowns, $50 million for the OPY deal and a further $100 million in mark-to-market losses. Based on these assumptions, we estimate Cash EPS of $1.90—not meaningfully different from our fourth-quarter estimate of six months ago.

Essentially, we are saying that CIBC will manage though another earnings headwind this quarter. We hope that the market ultimately realizes that CIBC has “grown up.”

Retail Markets (which includes wealth management) should have another solid quarter with some continued progress on revenue growth. Loan losses will be higher than a year ago, but should moderate from the high levels of the third quarter. Effectively, we are looking for a repeat of the third quarter. Note that FirstCaribbean is a more meaningful part of earnings in this business and will face the translation challenge of the stronger Canadian dollar.

CIBC World Markets will have a disappointing quarter, as we expect more writedowns in CDOs. We had forecast $200 million after the close of the third quarter, but with further deterioration in the market, particularly in the closing days of the quarter, we believe that a loss closer to $300 million likely. We have also assumed a further $100 million in other mark-to-market losses. Of course, with the $400 million Visa gain, the pain will be soothed somewhat. We note that the Visa gain will be included in the Corporate and Other segment. Outside of the Visa gain, there should be few surprises in the corporate segment.

Two big issues for CIBC will be capital and loan losses. We expect to see less of the former and hope to see less of the latter too. First, on capital, CIBC should have the same issues as its peers: declining book value due to currency and lower unrealized gains. We believe that Tier 1 will be solidly above 9%, but will be down in the quarter because of some ramp-up in risk weighted assets. On the loan loss front, the retail loan losses should start to stabilize at current levels.

From our perspective, another key variable will be the “residual exposure” from the bank’s CDO holdings. Clearly, the conditions were difficult in the quarter and liquidity was atrocious, but if the bank was able to reduce its aggregate exposure, either through sales or hedging, this would be a positive. It is also noteworthy that, assuming our guess of $300 million of additional charges, the “net exposure” will fall dramatically and will be under $800 million.