Thursday, December 20, 2007

CIBC Expects Huge Writedown in Q1 2008

Scotia Capital, 20 December 2007

CM - ACA Downgraded - US$2.0 Billion Write-Down or $3.88 per share Expected in Q1/08

• CM announced that there is a reasonably high probability that it will incur a large write-down in Q1/08 as a result of ACA's downgrade to CCC from A.

• CM has a US$3.5 billion hedge against U.S. sub-prime exposure with ACA Financial Guaranty Corp (ACA). As of November 30, 2007 the mark-to-market write-down on this position would be US$2.0 billion (US$1.3 billion after-tax or $3.88 per share) versus US$1.7 billion (Exhibit 1) at the end of October. CIBC projects that its Tier 1 ratio will remain in excess of 9% as at January 31, 2008.

• CM's US$2.0 billion estimate on mark-to-market losses likely has some subjectivity to it where actual losses could potentially be US$500 million to US$1.0 billion higher or another $1.00 to $2.00 per share. We estimate the bank could take a maximum charge of up to $4.2 billion pretax and still maintain a capital ratio of 7%. We do not think the bank needs to issue common equity in the face of these write-downs, however, they may feel compelled to do so.

ACA Downgraded to CCC from A by S&P

• On December 19, 2007, S&P downgraded ACA to CCC, one notch above default, from A and changed the financial insurer's outlook to CreditWatch Developing. CreditWatch Developing reflects the possibility of an upgrade or further downgrade in the not-too-distant future. In the case of ACA an upgrade could come as the result of a potential capital rescue or take over while a downgrade would be the result of default.

• S&P indicated that the credit downgrade is the result of the capital adequacy stress test which applies default assumptions to various subprime transactions that have been insured by the company and then compares the losses to the capital cushion (in excess of minimum requirements) the insurer has. ACA's test losses amounted to approximately US$2.2 billion in excess of the US$650 million capital cushion (at December 31, 2007).

• Ambac Assurance Corp and MBIA Insurance Corp ratings were affirmed by S&P, however, outlooks were changed to negative reflecting the potential for further market deterioration.

• On December 14, 2007, Moody's affirmed Ambac and MBIA ratings at Aaa with Ambac's outlook remaining stable and MBIA's outlook changed to negative from stable.

Potential Bail Out of ACA?

• The New York Times reported on December 19, 2007, that Bear Stearns and Merrill Lynch were in talks about a potential bail out of ACA Capital. Both companies are thought to have substantial stakes in ACA. Talks have not been confirmed by either Bear Stearns or Merrill Lynch.

• Bear Stearns owns 29% of ACA with two executives from their Merchant Banking on ACA's board including David E. King, Chairman of the Board. Merrill owns less than 1% and is rumoured to have US$5 billion of CDO hedges with ACA Capital. Goldman Sachs also owns 1.4% of outstanding ACA shares.

• ACA was delisted on December 18, 2007 for not meeting market capitalization rules as ACA's market capitalization had fallen below $75 million for 30 consecutive trading days. ACA shares (Exhibit 8) have fallen from $15 per share in June 2007. Ambac and MBIA share prices have also declined significantly (Exhibit 9 and 10).


• Our 2008 and 2009 operating earnings estimates remain unchanged at $9.00 per share and $10.00 per share, respectively. This excludes the potential $3.88 per share write-down expected in Q1/08. We are reducing our 12-month target share price to $100 per share from $115 per share reflecting a weaker balance sheet and potentially lower earnings. Our target share price represents 11.1x our 2008 earnings estimate and 10.0x our 2009 earnings estimate.

• CM valuation has declined significantly with relative P/E (declining to 74% on our 2008 earnings estimates (excluding major write-downs) (Exhibit 3) and 83% on relative market to book value basis. The P/E multiple discount is now slightly greater than the 1998 Asia crisis where CM ended up with $600 million of trading losses. The magnitude of the potential loss in 2008 of $2B - $3B probably dictates some type of overshoot. The P/E discount widened through the Enron debacle but to a lesser extent due to market expectation of a shift in CM strategy away from risk taking that clearly hasn't occurred.

• We maintain a 2-Sector Perform rating on CM as we expect its share price to remain under pressure in the near term despite more favourable valuation as the Risk Management Debacle unfolds. BMO, NA and CM are significantly underperforming the bank group and are now trading at meaningful P/E discounts reflecting weaker operating platforms. However, we continue to recommend TD and RY based on expected higher earnings growth rates over the next five to ten years as well as superior operating platforms, high profitability and favourable earnings mix.
The Globe and Mail, Sinclair Stewart, Tavia Grant, Tara Perkins, 19 December 2007

Canadian Imperial Bank of Commerce set the stage Wednesday for a $2-billion (U.S.) writedown on its subprime mortgage exposure, although many analysts believe the figure will be much higher.

The bank and a number of other financial institutions bought themselves some time late yesterday by reaching an agreement with troubled bond insurer ACA Capital, which is struggling to avoid bankruptcy.

That scenario could force CIBC and a number of other banks that hold complicated securities guaranteed by ACA to collectively swallow tens of billions of dollars in charges. Yesterday's forbearance deal, which was reached just hours after credit rating agency Standard & Poor's downgraded ACA, will see the bond insurer's 30-odd lenders hold off on any calls for collateral in a bid to buy it some time.

CIBC has about $3.5-billion (U.S.) worth of U.S. subprime real estate exposure that's hedged with ACA. The bank has more than $6-billion in additional exposure that's hedged with other counterparties.

While CIBC suggested that its first-quarter writedown could be about $2-billion, most analysts believe it will be larger. And many observers suggested the bank should just clean the sleight.

"I think they have to take the writedowns and make some changes, senior management changes," said Shane Jones, managing director of Canadian equities at Scotia Cassels.

"Clearly there will be some writedowns, but will it be enough or do these issues continue to plague the bank and the stock?" he said. "If you look at the U.S. institutions, they are starting to throw everything including the kitchen sink into the writedowns."

Dundee Securities analyst John Aiken, who expects the bank to take a charge of about $2.4-billion, said "it would make sense for CIBC, if they're going to take a charge, to take it all in one quarter now and just try and be done with it."

One issue hanging over the bank is whether bond insurers other than ACA see their businesses deteriorate to the point that they won't be able to pay their debts, potentially putting in jeopardy the bulk of CIBC's exposure that is not hedged with ACA.

On a conference call yesterday afternoon, officials at S&P said the agency's "research has led us to the conclusion that the potential for further mortgage market deterioration remains uncertain and will challenge the ability of the insurers to accurately gage their ongoing additional capital needs in the near term."

While ACA was the only one to be downgraded, the agency put a number of other bond insurers on watch for possible downgrades.

S&P analyst Dick Smith said ACA's lower rating came as the agency's models determined that possible losses of nearly $2.2-billion were well above the company's capital cushion of roughly $650-million.

ACA has been diligently working to address liquidity concerns that S&P raised back in November, but "it has not focused significantly on raising additional capital," he said.

The company is doing less new business, which is helping but is not enough to close the gap between losses and its capital cushion, he said. "The gap is large enough to create significant doubt that the company could possibly access significant hard capital resources to resolve the problem."

S&P was aware that ACA was in negotiations with its counterparties, which is "why we instituted the developing credit watch rather than simply suggesting this will continue to decline," he said. "The 'developing' indicated that there was a positive outcome possible."

In a note to clients yesterday, CIBC World Markets bank analyst Darko Mihelic said he sees $4.4-billion as a plausible total loss from CIBC's subprime exposure.

If that were to happen, he thinks the bank might need to raise at least $1.5-billion of equity.

"We view a loss of $2.4-billion as manageable whereas anything around $4.4-billion or higher requires an equity issue," he wrote. "A significant gray area exists in between these two loss ranges. Given such uncertainty, we expect continued volatility in [CIBC]'s stock."

Peter Routledge, senior credit officer at Moody's Canada's financial institutions group, said yesterday that he wouldn't rule out the possibility of an equity infusion, but added it's "not terribly likely."

The bank has "a good solid franchise in Canada that generates a lot of earnings quarterly," he said. "And the second reason is their capital ratios are actually pretty strong."

CIBC said yesterday that a $2-billion (U.S.) charge would still leave its capital ratio higher than the level required by regulators.

Following Standard and Poor's announcement today that it had reduced the credit rating of ACA Financial Guaranty Corp. from "A" to "CCC", CIBC confirmed that ACA is a hedge counterparty to CIBC in respect of approximately U.S. $3.5 billion of its U.S. subprime real estate exposure.

It is not known whether ACA will continue as a viable counterparty to CIBC. Although CIBC believes it is premature to predict the outcome, CIBC believes there is a reasonably high probability that it will incur a large charge in its financial results for the First Quarter ending January 31, 2008.

As CIBC disclosed on page 52 of its Investor Presentation dated December 6, 2007, the mark of the hedge protection from the "A-rated" counterparty (ACA) as at October 31, 2007 was U.S. $1.71 billion. As at November 30, 2007, this mark was US$2.0 billion. If the charge in the First Quarter were to be U.S. $2.0 billion (US$1.3 billion after tax) CIBC currently projects its Tier 1 capital ratio to remain in excess of 9 per cent as at January 31, 2008.
Canadian Press, 19 December 2007

Royal Bank of Canada said Wednesday that Moody's Investors Service has given its highest rating, P-1, to Canadian asset-backed commercial paper trusts administered by Canada's largest bank.

Moody's previously rated three Royal Bank U.S. ABCP conduits, but this is the first time the bank has arranged to have Moody's rate its Canadian ABCP.

ABCP administered and supported by the big Canadian banks has not been entangled in the seize-up of the third-party Canadian ABCP market.

But Royal Bank said getting U.S. rating-agency assurances on its Plaza Trust, Pure Trust and Storm King Funding conduits “is consistent with the bank's goal of meeting global standards for the highest quality programs.”

Asset-backed commercial paper consists of short-term debt instruments that package underlying assets which can include mortgages, credit card receivables, car loans and other debt.

The Moody's rating complements the existing R-1 (high) rating from Toronto-based DBRS, and Nick Lewis, head of Canadian conduit programs at RBC Capital Markets, said that “we look forward to receiving additional third-party ratings in the coming months, which we hope will reinforce our clients' comfort with the quality of their commercial paper holdings with RBC's Canadian conduits.”

The RBC announcement comes as the market for $33-billion worth of non-bank commercial paper remains frozen.
Reuters, 14 December 2007

There was a time when people said Canada's "Big Six" banks were all the same. That has never been less so than now, analysts say.

If you had chosen to put money into Toronto-Dominion Bank at the start of this year, your investment now would be up 4%. If you had gone for Canadian Imperial Bank of Commerce, it would be down a whopping 25%.

The differences between the banks are only expected to become more stark next year if the global credit crunch continues to underline which of them embraced riskier business practices, and as lenders' traditionally solid Canadian retail operations face tougher conditions.

"Years ago people used to think of the Canadian banks as monolithic. Whatever one did, so did the other. That is just not the case anymore with strategies and managements really having diverged in recent years," said James Cole, senior vice president and portfolio manager at fund manager AIC.

He points to TD, Canada's second-largest bank, which had a tumultuous 2002, when its results were buffeted by big loans to the troubled telecom sector, but which subsequently pulled in its horns and made a pledge to stick to lower risk areas of banking.

As a result TD is the only one of Canada's big banks, and one of the few in the world, not to have any writedowns in 2007 for investments in some way linked to the default-hit U.S. subprime housing market.

By comparison, CIBC, Canada's No. 5 bank, revealed it had $11-billion (US$10.8-billion) exposed to the subprime market, and analysts say it might have to write off $2-billion of that in the first half of next year.

"We were sorely disappointed in CIBC and the extent of its exposure to subprime," BMO Capital Markets analyst Ian de Verteuil said in a report this week. "We had hoped that the relatively young management team was well along the path toward changing the bank's culture."

"In reality, the recent problems showed that the cost-cutting has been too extreme and that risk-management is not sufficiently independent of the business lines," BMO said.

Two years ago, CIBC replaced its chief executive and committed to conservative banking after paying out $2.4-billion for its role in the failure of Enron Corp.

Overall, though, Canadian banks are in much better shape than their counterparts in the United States, where the subprime debacle has hit much harder, analysts say.

That's reflected in the about 30% drop in the U.S. S&P Banks Index this year. By comparison, the stocks of Canada's Big Six banks are down by 11%, on average.

Banks globally have written off more than $50-billion of subprime and other assets since September, with U.S. banks accounting for the bulk of these charges.

"It's really looking through the clouds at this point and trying to identify how much of the negative news is priced in," said Vincent Delisle, director of portfolio strategy at Scotia Capital, which is recommending shareholders load up on financial stocks in 2008.

"Going overweight in financials, we would do it much more aggressively in a Canadian setting than in the United States," he said this week, adding that he believed 60% to 70% of the bad news was priced into stocks.

RBC Capital Markets banks analyst Andre-Philippe Hardy forecasts Canadian bank earnings will increase by a modest 4% to 7% next year, well down from the double digit growth investors have got used to in recent years.

He expects earnings from banks' capital market businesses to be flat or lower next year but says their flagship domestic retail-banking and wealth-management operations will remain fairly sturdy, although provisions for bad loans may creep up.

"This is a key difference with the outlook for U.S. banks, and it should lead to Canadian bank valuations remaining higher than in the U.S.," Hardy said in a note to clients.
Daily Telegraph, Jonathan Sibun, 12 December 2007

CIBC has become the latest bank to make widespread redundancies in London after axing more than 60 staff in what bankers fear could be the first of a series of cuts at the Canadian group.

CIBC employees, who total about 450 people in London, fear the redundancies could leave the bank with as few as 100 front-office bankers in the City, though sources close to the company said the cuts were mostly complete.

At least 60 bankers, working in debt capital markets and leveraged finance, have already been laid off or are in discussions with the bank about their positions. However, some back-office staff, including secretaries and those in IT and other support services, are likely to follow.

The redundancies come amid signs that banks in the City could be tightening their cost controls amid the downturn in the financial markets.

CIBC has been hit hard by the credit crisis and last week admitted that it could face "significant" losses on its C$9.3bn (£4.5bn) sub-prime mortgage portfolio. The portfolio is hedged but analysts fear that counterparties to the hedges may be downgraded or fail outright, landing CIBC with big losses.

In London, the bank also employs a corporate finance team and equity traders. A source close to the company said they had not been affected by this week's cuts.
Dow Jones Newswire, 12 December 2007

Bank of Montreal’s two structured investment vehicles that go by the names of Links and Parkland have outperformed many of their peers in portfolio market performance since July, “providing a reasonable basis for optimism with respect to future relative performance,” writes Blackmont Capital’s Brad Smith.
Moreover, the bulk of the underlying collateral investments are "marked to market" on a daily basis, instead of the riskier "mark-to-model" valuation method, he points out.

And even though BMO management is reluctant to increase liquidity support to the two SIVs, the analyst “stress tested” the valuation and found the bank’s capital ratio remains healthy.

As a result, he reiterated a “buy” on the stock, with a $72 price target, saying the current market valuation remains “deeply discounted relative to its domestic peers.”
At 12:45 p.m. EST on Wednesday, BMO has gained 1 per cent to $60.26
The Globe and Mail, Janet McFarland, 11 December 2007

Shareholder advocate Bob Verdun says Canadian Imperial Bank of Commerce awarded shares worth more than $100-million to top executives between 2000 and 2003 without clearly disclosing the value of the incentive program.

Mr. Verdun said on Tuesday he has analyzed the bank's shareholder proxy circulars to piece together the value of a special incentive program created in 2000 to link executive compensation to merchant banking investments.

Mr. Verdun, a long-time critic of Canada's big banks, believes most of the program was linked to the bank's investment in Global Crossing Ltd., a U.S. technology company that CIBC bought a piece of in 1996. The position was sold and hedged in 2000, earning CIBC total gains of $2.3-billion (U.S.), which were recognized over four years.

News reports in the past have disclosed that CIBC executives had compensation linked to merchant banking operations, but there have not been dollar values attached to the compensation program.

Mr. Verdun has called on CIBC to review its compensation disclosure.

CIBC spokesman Rob McLeod said yesterday the bank has disclosed far more than required about the special incentive program. Disclosure of the program began in the proxy statement for 2000 and has continued every year since then, he said.

“This disclosure has provided investors with an overview of the program, and, over time, the necessary information to calculate the potential benefits for named executive officers at a particular date,” he said.

In its 2001 proxy circular, the bank said four executives – including then-chief executive officer John Hunkin and current CEO Gerry McCaughey – got a total of 17,500 units based on “net gains from certain CIBC investment holdings.” Mr. Verdun said it was not clear enough to readers that the relatively modest number of plan units would be subsequently converted into a total of 1.09 million CIBC deferred share units before the program ended in 2003.

Executives were required to hold the special deferred share units until they left the bank. Mr. Hunkin, who retired in 2005, cashed out his units for a total of $25.7-million. The gain was disclosed in the company's shareholder proxy circular, but Mr. Verdun argues investors failed to understand the source of the units.

Mr. McCaughey, who has not left the bank, received a total of 219,095 CIBC deferred share units under the program, currently worth $17.6-million.
Financial Post, Duncan Mavin, 10 December 2007

There were more questions on Bay Street about Canadian Imperial Bank of Commerce's subprime losses yesterday as observers sought further clarity about just how big a mess the bank is in.

The latest speculation was around whether some of its multi-billion-dollar hedging contracts are heavily stacked against the bank. Rumours suggest financial guarantees the bank took out to cover US$4.6-billion of potential losses will not pay out for decades - in contrast, CIBC's losses would be booked in the accounts as soon as they arise, the speculation indicated.

Late yesterday afternoon, a spokesman for CIBC said payments to the bank under hedging contracts "mirror" payments it would have to make due to losses from subprime-related securities.

The speculation followed last week's revelation from the bank that its book of hedged collateralized debt obligations (CDOs) related to the U.S. subprime-mortgage market totals US$9.8-billion.

Already the bank has acknowledged its book is in the hole for billions of dollars, but CIBC said it had hedged those losses by taking out what amounts to its own guarantees with third parties, or counterparties.

But on Saturday, the Financial Post reported one of those third parties is facing financial difficulties of its own that might prevent it from paying out at all - a number of analysts say this will result in more than $2-billion of losses at the bank in the first quarter of 2008.

Any losses the bank eventually records in its hedged book of CDOs are in addition to almost $1-billion in losses the bank has already suffered in relation to its unhedged exposure to the U.S. subprime crisis.

Its total charges related to the mess are now expected to be at least $3-billion, significantly higher than those recorded by any other Canadian bank so far.

Yesterday's speculation, which the bank has denied, focused on questions about whether some of the bank's hedging contracts could see CIBC take US$2-billion or more in additional charges it cannot recover for decades.

If true, the bank could miss out on interest and would likely have to write down the value of such a long term interest payments, said one analyst who asked not to be named.

Also, "the longer away a payment is, the greater the potential you are never going to get it," the analyst said.

In a note on CIBC, Genuity Capital Markets analyst raised the issue of the timing of payments, saying "certain financial guarantors may be not required to settle in cash (on the principal) until the very end of the contract, which in this case can run for 30 to 40 years."

The issue "could have a significant impact on our estimates of core cash earnings per share, return on equity and ultimately valuation," he said.

Mr. Mendonca said the payment terms for CIBC's contracts are not yet clear.

As further details emerge about the full extent of CIBC's subprime mess, there is likely to be more focus on the bank's risk management processes.

Chief executive officer Gerry McCaughey took over the bank with a mission to rid it of a reputation for slipping up. As part of the process. Mr. McCaughey also clamped down on the bank's cost base.

However, with CIBC's capital markets division in trouble once again there will be question marks about whether Mr. McCaughey went far enough to eliminate risk at the bank, or whether his appetite for cost-cutting may have contributed to its problems if it reduced the bank's capacity to manage risk effectively.

Since the emergence of the bank's subprime problems, the CIBC CEO has acted decisively to eliminate capital markets risk - in early November, the bank agreed to the sale of its U.S. investment banking and related debt capital markets businesses to Oppenheimer Holdings Inc. The bank also parted company with Phipps Lounsbery, head of debt capital markets.

Last week, rating agency Moody's downgraded the bank from "stable" to "negative" saying it is concerned, especially because CIBC has been cited in the past for risk-management failings that appear not to have been fully addressed at senior levels.

Also last week, Mr. McCaughey said the bank had "underestimated the extent to which the subprime market might deteriorate and the degree to which that would impact securities that were structured to be very low risk."

He also said the bank's subprime exposure was too large for its risk appetite.