Friday, December 07, 2007

CIBC Q4 2007 Earnings

RBC Capital Markets, 7 Decembber 2007

We are lowering our 12-month target price per share from $105 to $95, based on lower valuation multiples and lower estimated excess capital in 12 months. Our new 12-month target price implies a forward P/E multiple of 10.0x, compared to the current trading multiple of 9.4x.

We are modeling $2.3 billion in pre-tax writedowns in Q1/08 related to unhedged and hedged exposures to U.S. CDOs and RMBS. We feel that this represents a scenario that is at the conservative end of the spectrum, but not impossible to fathom at this time.

We believe that CIBC will remain adequately capitalized if losses are limited to its unhedged exposures as well as to its exposure to an A-rated financial guarantor that is almost certainly ACA.

We believe that CIBC's stock will remain cheap relative to peers while the environment surrounding U.S. residential lending and financial guarantors remains clouded. The lack of certainty in performing worst-case analysis is a big negative for the stock price, in our view.

We maintain our Sector Perform rating. CIBC's stock has some attractive characteristics: (1) Expenses are being aggressively managed; (2) The bank has lower exposure to deteriorating business credit quality given the size of its loan portfolio; and (3) The dividend has upside potential as it currently only represents 40% of our estimated earnings for the next 12 months, which is the lower limit of the bank's target payout range is 40-50%.

Factors that we believe will keep the stock from outperforming those of its peers in spite of those positive factors are: (1) The environment surrounding U.S. residential lending and financial guarantors remains clouded, and the ultimate cost to CIBC is highly uncertain. (2) Domestic retail revenue growth lags the industry. (3) Shareholders that had bought CIBC as a low risk alternative to other banks may rethink their positions.
Financial Post, Duncan Mavin, 7 December 2007

Buying shares in Canadian Imperial Bank of Commerce is "essentially a bet on the subprime market," said Genuity Capital Markets bank analyst Mario Mendonca in a note after CIBC released a fourth quarter earnings statement that stunned the banking community by revealing the full extent of its multi-billion dollar exposure to the troubled U.S. housing market.

The bank said its writedowns have already reached $1-billion, and warned of significantly higher losses in the future related to its US$9.8-billion in hedged exposure to the subprime market. Some estimates suggest total writedowns could eventually be more than $3-billion, which would be significantly higher than any other Canadian bank has reported, putting CIBC in the same league as the big U.S. banks that have suffered badly from the subprime meltdown.

Shares of CIBC have dropped about 8% over the past two sessions. The revelations sparked a frenzy of activity among analysts on Bay Street, where fears are focused on the potential that counterparties to CIBC's hedges could fail outright and the potential that further weakening of the U.S. subprime market will cause CIBC's exposure to losses to get even bigger.

CIBC's stock lost ground again on Friday, sliding 3.5% after losing 5% on Thursday.

"The key risk area is to one counterparty [on a US$3.5-billion exposure] rated A," Mr. Mendonca said. "CIBC's credit protection (an asset) purchased from this counterparty is US$1.7-billion, but has likely increased to US$2.0-billion since the end of the quarter. We believe investors should prepare for a charge of US$2.18-billion or US$1.5-billion after tax. By our estimates, a charge of this size would reduce the banks Tier 1 ratio materially, but remain above 9.0%."

Mr. Mendonca's bearish view of the bank's subprime woes was echoed by a number of his peers.

Brad Smith of Blackmont Capital downgraded CIBC to a "sell" rating.

"Disclosure of the extent of the bank's gross US non-prime residential mortgage exposure can only be described as reflecting worst case scenario confirmation, reflecting a failure in certain internal risk controls," Mr. Smith said.

National Bank analyst Rob Sedran also downgraded CIBC's stock, and called the subprime exposure "troubling."

"The bank disclosed that its roughly US$10-billion in hedged exposure to subprime CDOs [collateralized debt obligation] and RMBS [residential mortgage backed securities] is hedged with eight counterparties, one of which (roughly 35% of notional exposure) is under credit watch with negative implications. As such, we believe CIBC's near-term risk profile is elevated."

RBC's Andre Hardy lowering his 12-month target price per share from $105 to $95.

"We are modeling $2.3 billion in pre-tax writedowns in first quarter of 2008 related to unhedged and hedged exposures to U.S. CDOs and RMBS. We feel that this represents a scenario that is at the conservative end of the spectrum, but not impossible to fathom at this time."

CIBC's fourth quarter earnings, revealed on Thursday, had surprised most observers because the underlying results were higher than expected. Profits for the final quarter of 2007 were $884-million, up from $819-million last year.

However, all eyes are on the bank's risky credit exposure "The near-term risk associated with subprime CDOs and RMBS is higher than we had previously assumed," Mr. Sedran said. "Moreover, we believe the uncertainty will remain as the bank works to lessen its exposure. Therefore, we are downgrading CM to Sector Perform."

The disclosure has also raised questions about how the bank could have run into trouble yet again. Chief executive officer Gerry McCaughey was supposed to have cleaned up the bank which had developed a reputation for being accident prone, especially after it took a $2.5-billion hit related to its role in the Enron scandal.

But it appears to be back to the drawing board for Mr. McCaughey, with some analysts even questioning whether his cost-cutting and belt-tightening measures may have contributed to the bank's latest problems.

Mr. Mendonca said CIBC's move into riskier wholesale banking be a function of, "Cutting too close to the bone in areas such as risk management, assessment, and monitoring; lack of growth in other areas, including and especially Retail Markets with the result that the bank was desperately searching for any form of revenue growth; and perhaps most importantly, a lack of experienced leadership at the very senior ranks."

Mr. McCaughey yesterday acknowledged the bank had understimated the extent to which the subprime market would deteriorate and the degree to which it would impact its structured products business. He also said the bank was working to reduce risk.

Mr. Mendonca said he can see "a scenario under which management so significantly downsizes the wholesale business as to make it only a very minor contributor to the bank's revenue and earnings."

Last month CIBC sold its U.S. investment banking business in a move that was widely perceived as a risk reduction measure.
Financial Post, 7 December 2007

Confirmation of CIBC’s credit default swap exposure has prompted Blackmont Capital analyst Brad Smith to downgrade his rating on the bank to “sell.”

“Disclosure of the extent of the bank’s gross U.S. non-prime residential mortgage exposure can only be described as reflecting worst case scenario confirmation, reflecting a failure in certain internal risk controls,” he told clients in a note.

However, Mr. Smith left his 2008 and 2009 earnings per share estimates unchanged given expectations that many of CIBC’s near-term losses anticipated in coming quarters will be considered “non-operating.”

He slashed his price target to $76 per share from $103 and his target price/earnings multiple to 8.5 times from 11.5 times.

The analyst said this reflects the level recently accorded to National Bank after its substantial asset-backed commercial paper exposure was revealed. However, National’s exposure may prove to be modest relative to CIBC’s newly confirmed challenges, Mr. Smith said.
The Globe and Mail, Sinclair Stewart & Tara Perkins, 7 December 2007

This year was meant to provide the capstone on Gerry McCaughey's quest to turn around the fortunes of Canadian Imperial Bank of Commerce. [CM-T] Annual profit was on pace for a record. The balance sheet was strong once again, and capital levels were high, meaning CIBC might finally be ready to follow its peers into the U.S. retail market. Most importantly, investors were beginning to believe Mr. McCaughey had righted the accident-prone bank, and eradicated a cowboy culture that has led to several costly — and embarrassing — problems.

They believed it until yesterday, anyway, when CIBC resurrected its well-worn reputation as the bank most likely to walk into a sharp object. The bank confirmed it has $9.8-billion (U.S.) worth of hedged exposure to the crumbling subprime mortgage market, and warned it could suffer "significant future losses" because of these positions. That number, which doesn't include an additional $741-million worth of unhedged exposure, was far greater than predicted, and several times higher than any of the other Canadian banks.

Unsurprisingly, CIBC's shares were hammered by the news, even though the full-year profit hit a record $3.3-billion.

Analysts scrambled to calculate the possible fallout. Ian de Verteuil, of BMO Nesbitt Burns Inc., said there is a risk the bank could be faced with $2-billion (Canadian) in additional charges during the first half of 2008, a figure which, combined with the $753-million in subprime writedowns CIBC has taken in the last two quarters, is bigger than the $2.4-billion (U.S.) in penalties CIBC paid three years ago to settle a class action lawsuit stemming from Enron Corp. Other analysts suggested the number could be even higher if ACA Capital Holdings Inc., a shaky bond insurer with which CIBC has $3.5-billion in exposure, tumbles into bankruptcy.

But the financial damage is only part of the problem. The bigger issue, arguably, is the credibility of Mr. McCaughey and his senior management team, who have repeatedly stressed the progress they've made at reducing the bank's risk profile. Several investors and analysts said yesterday that their faith in the bank had been shaken yet again, and predicted it will be a challenge for Mr. McCaughey to recapture that hard-won trust.

"Commerce unfortunately has a propensity to step in every pothole that there is along the road, and we were disappointed, as I guess the market was obviously too, with what's happened," said John Kinsey, a portfolio manager with Caldwell Securities Ltd. "I really don't want to come out flatly and say that it's bad management, but I mean it has to be something when you consider their record against the other four major Canadian banks. It's by far the worst and, as I said earlier, if there is a pothole in the road they just seem to be able to hit it."

Moody's Investors Service, meanwhile, placed the bank on credit watch negative, suggesting the magnitude of CIBC's exposure raised questions as to whether the bank's much-touted improvements in risk management had taken hold in the company.

"It pretty much looks like it's another Enron," lamented one analyst, who said the bank has a propensity to live up to even the more dire rumours in the marketplace. "All we need to do now is just walk up and down the street and any story we hear about CIBC is correct. They don't need an investor relations department — we'll just call up the hedge funds."

In a conference call to discuss the bank's fourth-quarter results, Mr. McCaughey acknowledged that he has more work to do on the risk management side.

"In our risk assessments, we 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 said. "This, coupled with an overdependence on the extremely high ratings of these securities, resulted in the build up of exposures that are too large for our risk appetite."

The question on many investors' minds is how did this happen under the watchful eye of Mr. McCaughey, a retail veteran who has repeatedly shown an intolerance for needless risk, particularly within the investment banking arm CIBC World Markets.

When he took over as CEO in the summer of 2004, CIBC had just recorded its Enron charge. It also became engulfed in a mutual fund trading scandal that resulted in costly settlements with regulators. His first order of business was restoring the bank's capital strength, sloughing the bank's reputation as a volatile performer, and eliminating risk. Despite the size of the subprime exposure, it was not seen as a high-risk area, given the assets' credit quality, and was not singled out for priority attention.

Part of Mr. McCaughey's strategy was to halve the amount of capital allocated to the investment bank, a move that, theoretically, would remove CIBC from a lot of undesirable businesses. But it is clear that these moves did not go far enough in reining in a culture known both for its aggression and its tendency to behave like a U.S. bulge bracket firm.

Indeed, most of CIBC's foul-ups have been related to the U.S. market, and banking industry observers note that CIBC has followed the lead of larger U.S. rivals to a much greater degree than other Canadian banks.

"When all the smart people have left the party, they're still partying away, saying we've got to be here," explained one money manager who has owned CIBC stock for several years. "I'd be shocked if this doesn't give him the excuse to get into that part of the operation and clean it up, big time.

Mr. McCaughey alluded to his clean-up efforts yesterday, pointing out that the bank has replaced its head of debt markets, added new hedges for its subprime exposure, and begun exiting some of its structured products business. Its biggest move came this fall, when Mr. McCaughey jettisoned CIBC's money-losing U.S. investment bank.

"The risk/return characteristics of these businesses were not consistent with our expectations or the strategic framework we have set for CIBC, a framework we intend to vigorously adhere to," he said. "We also intend to place additional emphasis on building capital strength, which we believe to be prudent given the uncertainty of the current market conditions."

This capital, which would normally be earmarked for a possible U.S. retail acquisition, will now double as a cushion against potential writedowns. CIBC said yesterday it would take an additional $225-million in charges in the month of November on its unhedged exposure — exposure that is not insured against losses — bringing the total so far on that portfolio to $978-million. The far bigger worry, though, is on the $9.8-billion hedged book, especially given the uncertain financial health of U.S. bond insurers who provide these hedging contracts.CIBC said almost half of its $9.8-billion in hedged exposure is spread across five triple-A-rated financial guarantors, and has purchased an additional $420-million of protection against this group. A further 18 per cent is with two double-A insurers.

What investors are focusing on, however, is $3.5-billion worth of exposure that is thought to be hedged with ACA. These assets have already declined by half in value, meaning that ACA would owe CIBC $1.7-billion. These assets have likely deteriorated even further in recent months, and the question now is how much, if any, money will ACA be able to pay.

"How does CIBC get this big of an exposure in the first place?" asked another analyst. "And why $3.5-billion to one counterparty? These are two massive mistakes, and they're going to pay the price."

One money manager, who said he is a fan of Mr. McCaughey's overall strategy, nevertheless said investors will want to see proof that CIBC is making more progress on uprooting its old culture. As part of that effort, he said, there should be changes in the senior executive ranks.

"He's going to be embarrassed by this, and i think embarrassment provokes a reaction, he said. "But no change in leadership equals no change in culture, as far as I'm concerned."
Bloomberg, Doug Alexander, 6 December 2007

Canadian Imperial Bank of Commerce had its biggest decline in more than two years after the bank said it may take additional writedowns on investments tied to the U.S. mortgage market.

Canada's fifth-biggest bank said it expects pretax writedowns of C$225 million ($223 million) for November, bringing total pretax costs to almost C$1 billion. The bank also said it has about $4.3 billion in hedged derivatives contracts tied to subprime mortgages that may face ``significant future losses.''

``They just seem to be able to run into every pothole on the road and the other banks seem to be much better at avoiding these kind of things,'' said John Kinsey, who helps manage about $1.9 billion for Caldwell Securities Ltd. in Toronto. ``They just keep seeming to surprise us with their inability to avoid any calamity that comes along.''

Canadian Imperial fell C$4.69, or 5.4 percent, to C$82.40 at 4:24 p.m. on the Toronto Stock Exchange, leading other Canadian bank stocks lower. That's the biggest drop since Aug. 3, 2005, when the bank reported costs of $2.4 billion to settle claims over failed energy trader Enron Corp. The decline today wiped out C$1.57 billion in market value.

Chief Executive Officer Gerald McCaughey, 51, who took over the top job a day before the Enron announcement, said the writedowns don't meet the bank's goal of reducing risk.

The writedowns ``were not in line with our strategic imperative of consistent and sustainable performance,'' McCaughey said in the statement. ``Our focus in this area is on reducing existing risk.''

Moody's Investors Service said today it may cut the ratings of Canadian Imperial because its build-up of collateralized debt obligations ``highlights the weakness in the firm's strategic risk management.''

``Moody's is also concerned that it has cited CIBC in the past for risk management weaknesses, and despite expected improvements, it now appears the bank has not fully addressed appropriate risk-taking at a senior, strategic level,'' the ratings company said in a statement. Moody's changed its outlook on the bank to ``negative'' from ``stable.''

Canadian Imperial joined four other Canadian banks that reported combined writedowns of about C$1.9 billion on asset- backed investments in the quarter after U.S. mortgage defaults soared. Global banks and brokerages have recorded writedowns and losses of about $66 billion this year from the credit-market meltdown. Canadian Imperial's pretax writedowns on securities tied to U.S. home loans were C$463 million in the period, bringing total costs to about C$978 million this year.

``We 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,'' McCaughey said in a conference call with analysts.

Canadian Imperial had $784 million in unhedged investments in U.S. mortgage-backed securities and collateralized debt obligations as of Oct. 31.

The bank also said it has about $9.9 billion in U.S. subprime investments through derivative contracts hedged with counterparties. The derivatives contracts have a ``fair value'' of about $4.3 billion, according to Canadian Imperial.

Canadian Imperial has insurance against these investments through credit default swaps, McCaughey said. He said 47 percent of the hedged investments are spread across five AAA-rated guarantors, while 18 percent is with two AA-rated guarantors. The rest, with a face value of $3.47 billion, is with one A- rated guarantor that's under credit watch.

``Market and economic conditions relating to these counterparties may change in the future, which could result in significant future losses,'' the bank said in a statement.

Credit ratings of at least eight bond insurers are being examined by Fitch, Moody's and Standard & Poor's after a slide in the value of mortgage securities the companies guarantee. MBIA Inc. and Ambac Financial Group Inc., the world's two biggest bond insurers, are among those seeking to ward off potential credit-rating downgrades.

``We cannot be sure of who the counterparties CIBC refers to are, but concern will be that it is to bond insurers like ACA, MBIA and Ambac, whose ratings are under review,'' Desjardins Securities analyst Michael Goldberg said in a note.

Canadian Imperial's net income for the fourth-quarter ended Oct. 31 climbed to a record C$884 million, or C$2.53 a share, from C$819 million, or C$2.32, a year earlier, the Toronto-based bank said. Revenue rose 1.9 percent to C$2.95 billion.

Net income beat the C$2.44-a-share estimate from Brad Smith at Blackmont Capital Inc. Excluding one-time items, Canadian Imperial said it earned C$2.30 a share, topping the C$2.10-a- share median estimate of 10 analysts polled by Bloomberg News.

Consumer banking profit rose 82 percent to C$912 million, driven by higher volume growth and contributions from its Barbados-based FirstCaribbean Bank. A C$456 million pretax gain from the lender's stake in the Visa Inc. credit-card company boosted earnings. CIBC set aside C$132 million for bad loans, up from C$92 million a year ago.

Investment banking had a net loss of C$64 million in the period, compared with profit of C$218 million a year ago, because of writedowns.

Canadian Imperial said it met seven of its eight objectives for the fiscal year, including earnings-per-share growth of 10 percent. The bank said it aims to increase per-share earnings by 5 percent to 10 percent a year, on average, over the next three years.
Financial Post, 6 December 2007

CIBC’s fourth quarter results were better than expected with operating cash earnings per share (EPS) of $2.30, which was 23¢ ahead of the Street. Blackmont Capital analyst Brad Smith expected EPS of $2.23. Operating revenues were $2.9-billion, which was below the analyst’s forecast of $3.2-billion.

Mr. Smith also noted that CIBC confirmed that $9.3-billionn of its estimated $11-billion in gross exposure to U.S. subprime mortgages is currently hedged with investment grade counterparties.

“This confirms that [CIBC’s] ultimate potential loss exposure could be materially higher than previously thought,” he told clients in a note.

Mr. Smith rates CIBC a “hold’ with a $103 price target.
The Globe and Mail, Sinclair Stewart & Boyd Erman, 30 November 2007

Canadian Imperial Bank of Commerce could have as much as $10-billion worth of hedged exposure to the troubled U.S. subprime mortgage sector, although only a fraction of that amount is believed to be at risk of a writedown, according to people who have studied the bank's dealings.

While this level of exposure would be higher than most analysts have forecast, sources who closely monitorthe bank said it appears that CIBC has spread these hedges among many different parties, several of which are in good financial health.

The view is that the risk would be limited to between 10 per cent and 30 per cent of the portfolio - roughly $1-billion to $3-billion - if some of CIBC's hedging partners were to collapse and the bank had to take a charge.

That damage may already be reflected in CIBC's market capitalization, which has dropped about $3-billion in value over the past three weeks.

CIBC is expected to reveal the precise amount of its exposure, along with some information about its hedging counterparts, when it reports its year-end results next week, sources said yesterday.

Investors have been anxiously awaiting some clarity on the matter amid the growing deterioration of bond insurers, which provide guarantees on complex debt instruments held by banks like CIBC. The weakened state of these insurers has prompted speculation about massive losses at investment banks, and provided ammunition to short sellers that have helped drive down the price of CIBC's stock.

CIBC officials declined to comment on the matter, stating that the bank was in a so-called media quiet period, due to its earnings release scheduled for next week.

Three weeks ago, the bank announced it would take $463-million in fourth-quarter charges related to its exposure to the U.S. mortgage market. That was on top of a $290-million charge in the previous quarter. Both of these writedowns stemmed from $1.7-billion worth of collateralized debt obligations that were unhedged.

CDOs are complicated securities that pool together various forms of debt, including subprime mortgages.

The remainder of the bank's mortgage-related CDO and bond portfolio is hedged, meaning - in theory, at least - that CIBC has offloaded risk to third parties.

The problem is that several of the bond insurers who typically provide these hedges have been whacked by the mortgage fallout. If some of these suffer credit downgrades - or even bankruptcy - as many analysts speculate, the hedges will be impaired and banks will have to bring these CDOs and other mortgage-backed securities back on their books.

That could spawn $77-billion (U.S.) in charges for the world's largest banks, according to a report issued this month by analysts at JPMorgan Chase & Co. Given the magnitude of these potential losses, some bankers believe U.S. regulators will intervene to help prop up the capital strength of these insurers.

None of the major North American or European banks have quantified their hedged exposure, or disclosed their relationships with various insurers and other counterparties. That makes it almost impossible to predict the size or likelihood of charges with any degree of certainty.

This lack of information has been a boon for hedge funds, many of which have filled the void by issuing dire predictions about potential losses and simultaneously shorting bank shares. Short sellers borrow stock and agree to repay it at a later date in a bet that it will drop in value and they can profit from the difference.

CIBC, in part because it is thought to be heavily exposed to the subprime market, and in part because of its reputation for giving investors unpleasant surprises, has been particularly vulnerable. The company's shares were hammered last spring, when hedge funds openly speculated about its ties to the melting mortgage market. However, they rebounded sharply during the summer, once the bank reported its unhedged exposure.

This fall, however, as bond insurers began to falter, the rumour mill kicked into high gear once again. Hedge funds began calling Canadian bank analysts and faxing money managers to persuade them of the potential writedowns CIBC could face. They also seized upon the fact that CIBC's chief risk officer, Ken Kilgour, recently left on a one-month medical leave - a sign, they said, of internal pressures.

A CIBC spokesman confirmed that Mr. Kilgour was on leave, but only said he was expected back in early December.

On Nov. 15, an e-mail said to have emanated from a U.S. investment banking firm began circulating in the markets, warning that CIBC could be facing a charge of as much as $4-billion (Canadian).

"Sounds like the ultra bearish view is that at the [minimum] they have $2-billion in future writedowns coming. I have heard in excess of $4-billion," the unsigned note stated, before estimating that such charges could cut the bank's share price by 20 to 40 per cent. "Buzz is that its biggest counterparty is on the verge of filing for Chapter 11."

Around the same time, a hedge fund amassed a short position of almost two million shares in a few days of trading through RBC Dominion Securities Inc. CIBC's stock, which slid from $102 at the end of October to $92.30 on Nov. 14, dropped 4 per cent on Nov. 15, and was down more than 9 per cent over the next three days.