Wednesday, February 20, 2008

BMO to Take $490 Million Charge

RBC Capital Markets, 20 February 2008

Bank of Montreal pre-announced a number of items that are expected to lower Q1/08 EPS by about 70 cents:

• $60 million ($40 million after tax) general allowance increase to reflect portfolio growth and risk mitigation;

• $175 million pre-tax of mark-to-market losses in trading and structured credit positions, preferred shares, third party Canadian conduits and other losses;

• $160 million pre-tax valuation adjustment related to hedges with ACA Financial Guaranty. BMO liquidated these positions and has no further exposure to ACA. We do not know, but will try to find out if there are exposures to other monolines.

• $130 million pre-tax charge for BMO's investment in Apex and Sitka Trust, two structured finance vehicles to which BMO has not provided backup liquidity;

• $25 million pre-tax mark down in Links and Parkland capital notes. The bank also announced that it would provide liquidity facilities to its Structured Investment Vehicles, and that it expects to restructure Apex/Sitka Trust. In addition, a number of senior management changes were made. Details on page 2.

Lowering 12-month target; Maintain Underperform rating

We are lowering our 12-month target price to $54 from $58 to reflect a lower projected book value and a lower valuation multiple. The implied forward multiple to our new 12-month target price is 9.1x (versus the current 9.4x multiple) and the implied price to book multiple is 1.8x (versus 1.9x).

This announcement does not give us comfort that the headline risks that plague BMO are behind it, as we believe the bank is still exposed to more writedowns and many questions remain unanswered. Outside of these headline risks, the bank is weaker than its peers in retail banking, has more exposure to low multiple wholesale earnings, and more exposure to potential calls on liquidity if the financial services system sees more liquidity contraction.

BMO's stock closed at 9.4x 2008E EPS on Friday. The Canadian bank median was 10.2x, cheaper banks (CIBC and NA) were at 8.7x and 9.1x.
Financial Post, Jonathan Ratner, 20 February 2008

A day after UBS surprised global markets by revealing that is has US$26-billion of additional exposure to U.S. mortgages, the Swiss bank said the situation continues to look grim for others.

In addition to the already US$150-billion in credit market-related write-downs, analyst Philip Finch is forecasting US$40-billion to US$120-billion more in collateralized debt obligation (CDO) and subprime-related write-downs, depending on the outcome of the monoline crisis. Conduits and structured investment vehicles (SIVs) could face US$50-billion in write-downs, while commercial mortgage-backed securities could see US$18-billion more, and leveraged buyouts US$15-billion, he added.

Mr. Finch said delinquency risk is spreading from subprime and Alt-A mortgages to home equity and prime mortgages, credit cards, auto loans and potentially commercial real estate as well.

“Risks are rising and spreading, and liquidity conditions are still far from normal,” he said in a note. “Valuations appear to be more interesting, but sector earnings remain at risk. Until there is clearer earnings visibility, global banks are unlikely to see a sustainable sector re-rating.”

The analyst estimates that a 10 basis point increase in credit costs would reduce estimated earnings growth for 2008 from 10.3% to 5.9%, while a 20-point hike would cut it to 2%.
The Globe and Mail, John Partridge, 19 February 2008

Bank of Montreal warned Tuesday that it will take a pre-tax charge of about $490-million in the first quarter relating to various trading activities and structured finance holdings.

This will lower profit by about $325-million or 70 cents a share after tax, the bank said, adding that it could also face another hit of about $495-million before taxes, if talks aimed at restructuring a trust that holds non-bank asset-backed commercial paper do not produce an agreement.

The betting on Bay Street is that given the deterioration in the capital markets in the past few months and the continuing fallout from the U.S. subprime mortgage debacle, BMO's warning is just the first, and that other banks will likely follow suit.

BMO also said it is proposing to provide up to $12.2-billion (U.S.) in “senior ranked support” — including amounts it already has provided ($1.6-billion in the fourth quarter) — to two structured investment vehicles (SIVs), Links Finance Corp. and Parkland Finance Corp.

The purpose is to enable the SIVs to obtain additional senior funding and also continue to sell assets in an orderly manner, the bank said. Links will get up to $11-billion under this scheme, and Parkland up to $1.2-billion.

However, BMO also said it expects the amount that will be drawn against these facilities to be about half their maximum amount because of the “terms and conditions of the proposed liquidity facilities and the maturity profile of the senior notes.”

The bank, whose announcement brought downgrades and price-target reductions for its shares from several analysts, said the figures for the charges are estimates and subject to change.

As well as the financial hit, BMO announced five high-level executive changes, including the appointment of a new chief risk officer, although an official at the bank said it would be wrong to draw a link between this appointment and the writedowns.

The biggest of the pretax charges BMO will take in its fiscal first quarter, which ended Jan. 31, is $175-million (Canadian) against various trading and structured credit related positions, preferred shares, exposure to Canadian third-party conduits and other mark-to-market losses.

The second largest pre-tax charge is for $160-million related to charges previously hedged with ACA Financial Guaranty, a so-called monoline bond insurer. BMO said it has liquidated all its positions with ACA and has no further exposure to the company.

In the past seven years or so, ACA and other U.S. monoline insurers, have branched out from their traditional business of guaranteeing municipal bonds and added insurance for more sophisticated securities, including collateralized debt obligations (CDOs), which pool various forms of debt, including subprime mortgages, which, with the collapse of the subprime market, has left them in dire financial straits.

BMO also is taking an $130-million charge against its investment in Apex/Sitka Trust, a Canadian conduit for asset-backed commercial paper. This is in addition to an $80-million writedown it took on this investment in the fourth quarter.

The bank, which is scheduled to report its results on March 4, warned that it could face an additional pre-tax charge of about $495-million — its entire net investment in the trust — if talks under way with the aim of restructuring Apex/Sitka do not succeed. It added that it may provide “additional support” to the trust.

The final $25-million charge is against capital notes issued by Links and Parkland. BMO said it still holds notes valued at about $30-million.

In addition to the charges, the bank said it is boosting its general allowance for credit losses by about $60-million pre-tax, “to reflect portfolio growth and risk migration.”

A survey of 11 analysts by Bloomberg News recently pegged the average forecast for BMO's first quarter profit at $1.39 a share. Barring surprises, the 70-cent charge would reduce this to just 69 cents.

Investors reacted to the bank's announcement by bidding down its shares, despite a broad market rally. In mid-morning they were down by 48 cents to $53.35 on the Toronto Stock Exchange about half an hour after the opening bell.

One analyst, who spoke on condition he not be named, said BMO's move comes as no surprise and that, under the circumstances, the hit it is taking is not alarming.

“Remember that the banks' year-end was Oct. 31 and conditions in the capital markets have deteriorated since then,” he said. “So a $325-million after-tax hit is not bad considering other announcements out there.”

The “real takeaway” is that there will likely be similar announcements from the rest of Canada's Big Six domestic banks.

He noted that BMO had already disclosed its ACA exposure when it reported its year-end results. “All the other banks have ACA exposure, but in the small hundreds of millions,” he said. “There's nothing to be worried about here.”

To put BMO's news in context, Canadian Imperial Bank of Commerce last month announced a $2-billion (U.S.) writedown on its exposure to ACA. At the other end of the scale, Royal Bank of Canada has already disclosed that it would write off its $104-million (Canadian) exposure to a monoline analysts have identified as ACA.

Another analyst, John Aiken at Dundee Securities, told clients in a note that although the individual charges BMO is taking are “not overly material,” he is “disappointed” at how wide ranging they are, given previous hits the bank has taken, including a $680-million pre-tax hit last May on natural gas trading , the biggest trading loss ever reported by a Canadian bank.

“ Investors may begin to question when the litany of charges from BMO, typically thought of as a steady bank, will come to an end,” said Mr. Aiken. He also cut his rating on the stock to “sell” from “hold” and chopped his target price by $6 to $56.

“Since the energy trading losses have come to light, BMO has incurred almost $850-million, pre tax. In addition, BMO also announced over $300-million in pre tax losses related to items similar to today's announcement.”

Mr. Aiken also argued in his note that the $12.2-billion (U.S.) liquidity backstop the bank plans to provide to Links and Parkland will weigh even more heavily than the charges on its stock price.

“It took investors some time to get comfortable with the roughly $1.6-billion of senior support announced in conjunction with BMO's fourth-quarter results,” he said. “Now, over $12-billion in support has been committed on assets of over $13-billion. In fairness, BMO has suggested that its maximum exposure is likely to be one half of this amount, however, $6-billion remains an extremely large exposure for BMO, even if the assets are of relatively high quality.”

Analyst Brad Smith at Blackmont Capital also cited the liquidity backstop as his reason for chopping BMO to “hold” from “buy” and reducing his price target for the shares to $57 from $63.

“Rather than putting the SIV issue behind it, today's announcement sets the stage for it to migrate to BMO's balance sheet over time,” he said in a note to clients. “While funding is not expected to have a material impact on BMO's capital initially, this action increases the potential for additional losses should asset sales prove more challenging than currently anticipated.”

BMO also used its news release to announce a number of senior executive changes that will take effect March 5.

Interim chief financial officer Thomas Flynn, 44, is taking over as the bank's chief risk officer from Robert McGlashan, whose decision to retire was announced internally at the bank Dec. 8. Mr. McGlashan is just 55, but has worked at the bank for 35 years.

The bank has imported Russell Robertson, 60, formerly vice-chairman of accounting firm Deloitte and Touche LLP, as its new interim CFO to fill in for Karen Maidment, who has been on sick leave since last fall.

Thomas Milroy, 52, currently co-president of BMO Capital Markets will take over as its chief executive officer Yvan Bourdeau, 59, who will become its vice-chairman, while the other co-president, Eric Tripp, 52, will take over as its sole president.
Financial Post, Duncan Mavin, 19 February 2008

Vernon Hill must seem like the unshakable ex-boyfriend of your new girlfriend for executives at Toronto-Dominion Bank.

The Commerce Bancorp founder has poked a stick at the Canadian bank that muscled in on his baby twice in two weeks now, his latest rant against banks-- like TD-- that carry billions of dollars of goodwill on their balance sheets.

TD wooed Commerce last year after Mr. Hill was ousted in June when regulators began investigating dealings between the bank and members of his family. He is suing Commerce for US$57-million for wrongful dismissal.

Commerce shareholders gave their consent to TD's US$8.5-billion offer this month, but if TD's executives thought they had seen the last of Mr. Hill, they were wrong.

He may have lost the bank he launched in 1973, but he is still emotionally attached, insisting on a blog two weeks ago that the TD deal ended "a small part of the American Dream" because TD would cut costs and dismantle Commerce's high-service level model.

Then last Friday, Mr. Hill launched another Web-based missive -- titled "Bank's Don't Need Goodwill" -- that will look to TD's executives like more sour grapes.

"Goodwill is an accounting fiction," Mr. Hill said. "It distorts our understanding of bank financials."

TD has $7.4-billion of the stuff, almost as much as the other four big Canadian banks combined. TD's goodwill balance will probably exceed the rest of the combined Canadian banking sector once the Commerce deal is accounted for.

Goodwill, in this usage, does not refer to relations between the flamboyant Mr. Hill and TD's down-to-earth chief executive Ed Clark, but to an accounting quirk that arises when banks buy other banks.

It "represents the excess pur-chase price paid on acquisitions over the fair value assigned to identifiable net assets, including identifiable intangible assets," according to TD's 2007 financial statements.

In other words, it is the amount the bank paid for acquisitions over and above the value of tangible assets like loans and mortgages. The balance is not amortized in the way a company reduces the value of its buildings by recording depreciation, but is "assessed for impairment annually," according to TD's disclosure. Why is that a problem?

"Here's why," writes Mr. Hill. "If you pay too much for an acquisition, you should have to live with the consequences, which are diminished returns. In such a case, almost no acquirer can report an acceptable return on capital and almost no acquisition justified."

Mr. Hill notes some U.S. banks, including Bank of America and Wachovia, have ended up with 50% or more of their capital made up of goodwill.

"Goodwill obviously can't be deployed or invested -- it's intangible -- and so generates a return of zero," wrote Mr. Hill. The number is so meaningless, he argues, that regulators strip it out for the calculation of a bank's minimum capital requirements.

Historically, the goodwill balance is rarely written down as it is assumed that acquisitions are always on the up-and-up. But that has been changing recently as the downturn in the U.S. economy casts a different mood on the financial sector there.

A report in American Banker this month said at least 16 publicly traded banks, including big regional players like Washington Mutual Inc. and Sovereign Bancorp Inc., "took significant impairment charges to reflect the declining value of goodwill, accumulated largely through acquisitions."

The total amount of goodwill written down by U.S. banks in the fourth quarter of 2007 was US$4.2-billion, according to the report. It is a relatively small amount compared with massive subprime problems, for instance. But the charges in the final three months of last year were more than the industry took in the previous 27 quarters combined, and were 350 times as large as the US$12-million of goodwill charges in the same quarter of 2006.

At TD, most of the goodwill has arisen from acquisitions in the U.S. including struggling TD Banknorth based in Portland, Me., and the collection of multi-billion-dollar fixer-uppers that have been added to that franchise like Hudson Bancorp. Even before the Commerce deal goes through, TD is carrying $6.3-billion of goodwill from U.S. acquisitions.

Meanwhile, the Canadian bank's U.S. retail banking operation is facing the same U.S. economic downturn as some of the banks that have taken goodwill charges, and its recently acquired banks still need some time and hard work before they are producing the sort of returns the Canadian bank expects.

Still, whatever Mr. Hill's rants about bloated balance sheets and distorted returns, analysts in Canada say it is unlikely TD will write down its goodwill balance any time soon. The bank is due to report its first-quarter numbers next week. If a writedown had been coming it would have happened in the fourth quarter of 2007, when TD undertook its annual goodwill impairment review and "when all the other banks were taking a miscellany of charges," one analyst said,
Financial Post, Sean Silcoff, 19 February 2008

As the credit crisis continues to grip the global financial sector, most Canadian banks are in embarrassingly good shape. Want to buy a U.K. bank for six times profit and a 6% dividend yield? Or would you rather pay 12 times for a Canadian bank with a 4.5% dividend?

Still, Canadian investors should remember two things: Bad news from our banks tends to come out gradually. Second, the good fortunes of Canadian banks are due to a prolonged economic boom that won't last forever. From the lofty heights at which Canadian banks are perched, the fall could feel steeper than it actually is.

Consider yesterday's news out of Bank of Montreal. The headline: "$490-million in charges before tax." That includes a $160-million hit for BMO transactions hedged with troubled monoline insurer ACA Financial Guaranty and $330-million of assorted other credit crunch-related booby traps. More fallout is likely to come.

Within the fantasy realm in which Canadian banks operate, however, a small write-down tucked in at the bottom of the charges should cause just as much concern: a $60-million pre-tax hit to reflect "an increase to the general allowance for credit losses to reflect portfolio growth and risk migration."

This marks the second quarter in a row in which BMO has increased its kitty for expected loan losses. If BMO's financial wizards are right, the canary in the coal mine of the Canadian economy has just keeled over.

For five years, loan-loss provisions have declined among Canadian banks; at BMO, they fell to $888-million in the third quarter of 2007 from $1.18-billion at the end of 2002, reflecting improving credit quality. Suddenly, BMO is one-third of the way back up to where it was five years ago. Add to that recent comments by Ed Clark, chief executive of Toronto-Dominion Bank, that a U.S. slowdown would hit Canada, and it's time to ask what other bad news is coming from the core operations of the big banks.

"This is the start of the momentum for material increases in provisions for credit losses as the Canadian banks face a difficult credit environment in 2008 and 2009," said John Aiken, Dundee Capital Markets analyst.

Loan-loss provisions among Canadian banks, which have averaged a modest 0.4% over the past dozen years, are now just under 0.3% and, by Mr. Aiken's estimate, heading back to the average. That's hardly earth-shattering, but we're talking Canada, where fat profits, 20% returns on equity (ROE) and high valuations are the norm. If the loan-loss ratio rises by 10 basis points, it will reduce Big Bank earnings this year by 4%, Mr. Aiken estimates. Analysts, on average, estimate profits will grow by 5%. "This change could wipe out all growth, with obviously negative impact on valuations." Mr. Aiken said. ROE would likely fall by 300 to 400 basis points.

That won't exactly prompt Ottawa to nationalize the banks, as the U.K. is doing with Northern Rock PLC. But it could lead to a 20% drop in price-to-book multiples, and corresponding stock prices, for Canadian banks.

If you're a long-term investor, fear not. If you're bottom fishing, be patient. "Two to three years out [Canadian bank stocks] will be good value," said Nick Majendie, chief portfolio strategist with Canaccord Capital. "But there's not a desperate rush to take positions if you don't have them already."
Financial Post, Duncan Mavin, 15 February 2008

More weakness for monoline bond insurers generally means more bad news for Canadian Imperial Bank of Commerce.

Thursday’s announcement from Moody’s that it has downgraded monoline FGIC was no exception, prompting Blackmont analyst Brad Smith to issue a note on CIBC headed “Loss risk escalation continues.”

CIBC has potential hedge exposures with FGIC of several hundred million dollars, says Mr. Smith.

The troubled bank is not the only Canadian company exposed to the monolines — U.S. companies that were set up to insure municipal bonds before they got into guaranteeing riskier and more complex investments like collateralized debt obligations backed by subprime mortgages.

But CIBC’s performance has been tied to the ups and downs of the struggling monoline industry after first revealed the multi-billion dollar extent of its subprime related investment last year. The bank has since written down its subprime investments by $3.3-billion, including $2-billion tied to a single failing monoline.

Proposed bailout plans for the monolines’ municipal bond business might not offer much comfort to CIBC either.

“While a resolution would be good news for municipal bond investors generally, the newly emerging urgency could reduce regulator willingness to seek a broad-based solution,” Mr. Smith said. “This would result in a rising risk that weaker monolines could be sacrificed in the interest of stabilizing the muni bond market.”

In other words, municipal bonds would be saved, leaving the monolines’ riskier guarantees of subprime and the like still in limbo.

CIBC has as much as $30-billion of subprime and non-subprime investments hedged with monolines, says Mr. Smith.

The Blackmont analyst rates CIBC a sell, with a $66 target price.
Financial Post, 14 February 2008, Jonathan Ratner

As the Canadian economy continues to show signs of health despite weakness in the U.S. and fears of a recession there, many investors are wondering if Canada’s bank stocks have bottomed. The seemingly endless string of writedowns from global banks has produced what many consider the most challenging environment for the sector in a long time.

But one of the key factors that could boost valuations for banks later this year – particularly in Canada – is lower interest rates. However, the credit concerns that have caused much of the recent pain for Canadian financials isn’t going anywhere, according to UBS analyst Peter Rozenberg.

With this in mind, he suggested that while the price-to-earnings ratios for Canada’s banks are good at 11 times, they're not great. His target is 12 times.

Nonetheless, he expects Canadian bank stocks will produce an average one-year return of 18%. Earnings per share growth is expected to be 3% in 2008, compared to the consensus estimate of 4% and management guidance of 5% to 10%, he noted.

“Liquidity is good, CDO/monoline exposure is measured (except at CIBC), and asset quality remains strong,” Mr. Rozenberg said in a report. “However, capital markets, which are 29% of EPS, and loan growth are expected to decline.” At the same time, the weak U.S. outlook, and low and rising provisions mean the recent volatility will likely continue.

Mr. Rozenberg, who recently took over the banking beat from Jason Bilodeau, who moved to TD Newcrest, considers Toronto-Dominion Bank and Bank of Nova Scotia to be in the best position in terms of sustained growth and low risk. He rates a “buy,” while Royal Bank, Bank of Montreal, CIBC and National Bank are all rated “neutral.”