Saturday, March 08, 2008

BMO Leads Decline as Bank Stocks Sideswiped

The Globe and Mail, Derek DeCloet, 8 March 2008

Bay Street has the memory of a goldfish, so when the place is still buzzing with talk of a deal that happened two weeks ago, you know that people were caught by surprise.

Royal Bank of Canada's $1.4-billion score of Phillips Hager & North, the venerated, privately held Vancouver money manager, is that type of deal. Sure, it's only $1.4-billion. But in financial circles, a sense of shock lingers. Up and down the Street, they shake their heads. Can you believe PH&N's partners sold? Can you believe who the buyer is? Gordon Nixon, of all people. As if he needs it.

In banking, the rich have always gotten richer. But never before have we seen the kind of disparities that are emerging. Ten years ago, RBC, the biggest bank, was about $8-billion bigger by market value than the smallest member of the Big Five. How the gap has grown: the blue gorilla is $14-billion larger than anyone else and three times the size – nearly $38-billion larger – than Bank of Montreal. Hard to fathom that the two were plotting a “merger of equals” in 1998.

Why did this happen? It's easy enough to say that RBC went on an acquisition binge and BMO didn't. But why? Because it could and BMO couldn't, even if it wanted to.

The PH&N deal underscores the difference. The firm's partners were not forced to sell and, as a owners of a trophy asset, could have been mercenaries. But RBC had the inside track because it wasn't just about money; it was about culture, too. Those close to the situation say it's unlikely PH&N would have sold to BMO or Canadian Imperial Bank of Commerce – even at a higher price. Winners like to be with winners, after all.

Some investors are getting a hard lesson in BMO's culture, and its shortcomings, after a 10-day period in which its stock price dropped 21 per cent. There is no financial crisis at the bank but it's not a stretch to say there is a full-blown crisis of confidence. And that is a direct consequence of a serious cultural flaw: BMO seems to have a very hard time admitting mistakes.

Most other banks, when in trouble, try to get it out of the way at once. Several years ago, when Toronto-Dominion Bank began sinking in the quicksand of the telecom bust, it swallowed hard and wrote off $2.5-billion in corporate loans in a single year. CIBC took a $2-billion loss on subprime mortgages in January and announced a capital infusion the same day. But with Bank of Montreal, bad news is delivered like water torture.

Drip: One day the bank says it lost up to $450-million on natural gas trades. Drip: A few weeks later it's $680-million. Drip: The bank announces a grab bag of nearly $500-million in writeoffs, including some related to trusts called Apex and Sitka. Drip: Ten days later, it says those trusts are in trouble and more writeoffs seem likely. Drip: Here's another small loss on another structured investment called Fairway Finance. (By the way, try searching BMO's annual report for any mention of Apex, Sitka, or Fairway. You won't find it.) Now, at least one analyst is musing about a dividend cut (unlikely) or an equity sale to improve the balance sheet.

Is it any wonder that the market is expecting the worst? But poor disclosure is not the most insidious consequence of BMO's defensive, insular culture. When a company – any company – hates to own up to its mistakes, it usually declines to hold accountable the people who made them.

The bank seems deathly allergic to getting rid of the old guard or bringing in fresh talent. Check out the executive team – they're BMO lifers. Chief executive officer Bill Downe has been there since 1983. So has the woman who runs the Harris Bank division. The guy who runs the retail bank has been a BMO employee since about 1985.

If the bank was a stellar performer, some management stagnation would be understandable. But BMO's growth in revenue has been slow – below the average of other Canadian banks in each of the past three years. In retail banking, it has been losing market share. But it's hard to think up new ideas for fixing these problems when it's the same people sitting around the table. Even the recent management “shakeup” brought in only one new face, an interim chief financial officer.

So the talent, and the good assets, go elsewhere. BMO doesn't get to buy PH&N; Royal Bank does. BMO doesn't get Mike Pedersen, the highly regarded Barclays banker who returned to Canada last year; TD hires him instead. Good culture begets success, which attracts good people, which brings more success. This is the virtuous circle RBC and TD have created. BMO doesn't have it. What it desperately needs is some new blood.
The Globe and Mail, Tara Perkins, 8 March 2008

If Bay Street were a high school, Bank of Montreal would have been the kid who was always hanging out in the library. A little small for its age, it had earned a reputation for staying away from trouble. That is, until last year.

Canada's fourth-biggest bank has been shedding its reputation for risk aversion at a tremendous clip, and its problems have coincided with the tenure of Bill Downe, who marked his first anniversary at the helm on March 1.

A couple of months after taking over, Mr. Downe was forced to announce mysterious troubles in BMO's U.S. natural gas trading operations that wound up costing the bank more than $800-million. More land mines emerged when the credit crunch erupted and BMO's first-quarter earnings were shaved by $490-million as a result. Needless to say, BMO is no longer the bank you would bring home to meet the parents. BACK TO BASICS

Mr. Downe, 55, is embarking on a plan to bring it back to basics. “We're a fundamentally different company going into 2008 than we were going into 2007,” he said in a telephone interview yesterday. That ought to be a source of confidence, he added.

His plan includes a renewed focus on consumer and business banking, something that Canadian Imperial Bank of Commerce is also doing as an antidote to the injuries it has suffered in capital markets.

“We really have been shifting the centre of gravity in the company toward our personal and commercial banking business in Canada and the United States, and rebuilding our competitive position in those areas,” Mr. Downe said. Coupled with wealth management, he expects this area to grow to make up 65 to 70 per cent of the bank, up from roughly 60. “You're talking about an organization that has a $390-billion balance sheet and so a seven point shift in proportion is very large.”

But even if this means BMO's investment banking operations eventually shrink, for now they continue to eat up much of management's time – and the market's concern.

Mr. Downe's team is negotiating to restructure two Canadian asset-backed commercial paper (ABCP) trusts, collectively known as Apex. The bank faces a $500-million writedown if talks fail. One of Apex's investors is hanging on to a $400-million funds transfer that BMO wants back, while a counterparty isn't paying back $600-million BMO claims it's owed.

“We are offering to provide additional support to Apex in a controlled amount. We would expect other investors to do the same,” Mr. Downe said. “The parties have been basically sitting in a standstill mode, and I don't think you can stay that way forever. So, it's my hope that we'll actually see resolution of these things in the next couple of weeks. I think people will come to terms or they won't.”

If they do, BMO will have provided a level of financial support that's still up for debate, but Mr. Downe said the bank can resolve Apex and still have more than enough capital to satisfy regulators.

There has been talk the bank might sell a chunk of equity or cut its dividend. But Mr. Downe suggested neither option is in the cards. “The size of the issues that we're dealing with relative to the earning power of the bank needs to be kept in perspective,” he said.

In fact, he suggested BMO expects to have enough left over after the Apex restructuring to be able to participate in a backup credit line for the frozen $33-billion third-party Canadian ABCP sector. “I think both Apex and the Montreal Accord will get resolved relatively soon, they need to be resolved, and when Apex is resolved then we will signal that we're supporters of the Montreal Accord once again and we'll participate with the other Canadian banks.”

Analysts are also concerned about a U.S. ABCP conduit, Fairway Finance Company LLC, because BMO was forced to take some troubled mortgage assets on its books. “I would stand behind the quality of this portfolio,” Mr. Downe said.

One of the most surprising things to come out of BMO's reporting this week was a large increase in its provisions for bad loans. As the economic outlook diminishes, BMO has combed its books and put many companies with outstanding borrowing on a watch list. “I think, personally, it's going to be an industry-wide phenomenon,” he said.

Mr. Downe is splitting his time these days between customers, investors and employees, all of whom require extra attention.

Many want to know whether more nasty surprises lurk.

“The things you worry about are the things you don't know you don't know,” he said. But it comforts him that all of the recent trouble spots were already on his radar in August.

“They all fell into the category of ‘we knew what we didn't know,' and that was exactly how long markets were going to be difficult, what the resolution would be, [and] where the problems would show up outside of BMO that would impact us.”

He said that he and the team have benefited from the past six months because they've gone through the portfolios and balance sheet “in excruciating detail.”

The next couple of quarters will be rocky, no doubt, and challenges in the financial sector will continue. Most of the stimulus that's been applied to the U.S. economy doesn't kick in until the third quarter, and “there's clearly a huge volume of subprime debt sitting in different portfolios that people are going to have to deal with.”

But Mr. Downe, who has shuffled his management teams in risk management and investment banking, said “my optimism is born of the changes that are under way in the company.”
The Globe and Mail, Tara Perkins, 6 March 2008

Bank of Montreal bore the brunt of investor concern over Canadian banking's credit crunch woes yesterday, leading a dramatic stock market drop across the sector.

Speculation that Swiss bank UBS has sold a massive mortgage portfolio at a large discount, coupled with news that Citigroup Inc. plans to cut its U.S. consumer mortgage portfolio by about one-fifth in the next year, helped to drive down the shares of many banks around the world.

But while the Canadian banking sector fell roughly 4 per cent, BMO's shares lost 6.7 per cent to close at $41.97, as investors struggled to understand its latest troubled spot, a U.S. asset-backed commercial paper conduit it sponsors called Fairway Finance Company LLC.

The bank has lost $5.2-billion in market value over the past week as its stock dropped $10.38. While the sector is down about 10 per cent over that period, BMO shares have lost nearly 20 per cent.

Investors are increasingly lumping Bank of Montreal in the same camp as Canadian Imperial Bank of Commerce, which was punished for its oversized exposure to the struggling U.S. subprime mortgage market.

When it comes to the Big Six banks, "we are truly, truly in a freefall now," said Genuity Capital Markets analyst Mario Mendonca.

"If you want to be invested in banks, there are only two that will keep you from embarrassing yourself this year — TD and Scotiabank."

He places Royal Bank of Canada in the middle of the banking pack.

National Bank Financial analyst Robert Sedran downgraded BMO's shares to "underperform" this week, saying that the falling outlook for its earnings and continuing issues related to the liquidity crisis will likely weigh on its stock.

Some investors are waiting for another shoe to drop.

"There are obviously a lot of issues with their structured products, and now a new one has occurred — the Fairway one," said Shane Jones, managing director of Canadian equities at Scotia Cassels Investment Counsel Ltd. "What else is there?"

BMO said this week that it had taken a $39-million provision in the first quarter relating to Fairway Finance, which creates commercial paper by gathering up loans, mortgages and other interest-paying assets and repackaging them to be sold to investors as short-term paper. Fairway's problems stem from a $459-million deal it did with a company that buys troubled mortgages at a discount. Falling U.S. house prices caused the assets to fall below investment grade, so BMO took them onto its own balance sheet. The bank provides a $10.2-billion backup liquidity line to Fairway, and $624-million had been drawn at the end of the quarter.

RBC Dominion Securities Inc. analyst André-Philippe Hardy wrote in a note that BMO might have to take more of Fairway's assets on to its books, increasing the chance of writedowns. Genuity's Mr. Mendonca told investors to prepare for a charge of at least $400-million from Fairway.

Mr. Hardy added that he's worried investors in the commercial paper might be less attracted to it if they don't trust the underlying asset quality.

BMO says less than 0.5 per cent of the assets are subprime mortgages. Fairway does have about $2-billion of assets guaranteed by bond insurers, but none of the guarantees come from beleaguered ACA Capital Holdings. Fairway was established in 1997 by a team led by Jeff Phillips, currently the executive managing director of the bank's U.S. securitization group in Chicago.

That group parted ways with some key investment bankers early last year. Five former employees, led by Pete Walsh, who had been co-head of origination and structuring for about seven years, went on to start their own hedge fund and are still in the midst of a lawsuit with BMO over bonuses they say they are owed.

Investors are also fretting because BMO is still in negotiations to restructure two Canadian ABCP trusts. If the talks fall through, it will take a $500-million writedown in the coming quarter. And one of the trusts' investors is fighting BMO's demand that it return a $400-million funds transfer, while the bank is fighting a counterparty for $600-million it says its owed.

BMO has long been the big fish in Canada's ABCP market and is now dealing with its share of the problems.

"This is a good business," chief executive officer Bill Downe said after the bank's annual meeting Tuesday.

While many analysts say they would not rule out an equity infusion, Mr. Downe said he has not considered one.
Reuters, Lynne Olver, 6 March 2008

Shares of Bank of Montreal plunged 6.8% on Thursday, extending this week's slide, on concerns about the health of the bank's structured-credit investments and the higher provisions for loan losses it announced on Tuesday.

"The number that really spooked people was the jump in specific provisions," said Ohad Lederer, an analyst at Veritas Investment Research in Toronto.

That was just the latest in a string of bad news from BMO dating back a year, he noted.

If loan-loss provisions had been the sole issue, "investors would have taken the stock down a peg and that would have been the end of it, but this is coming on the back of what has been a pretty dismal year," Lederer said.

Bank of Montreal stock tumbled to $41.97 on the Toronto Stock Exchange on Thursday, down $3.05 on heavy volume. During the session it dropped as low as $41.57, its lowest level since June 2003.

The stock has lost just over a quarter of its value year-to-date, the worst showing among its peers in 2008. This week alone BMO shares have fallen 15.5%.

Last year, BMO took hundreds of millions of dollars in natural gas trading losses and missed many of its full-year financial targets as a result.

In 2008, ripples from the global credit crunch have hit various BMO sponsored asset-backed commercial paper and structured investment vehicles, prompting more writedowns.

And then the credit-loss provisions: BMO said on Tuesday that its specific provisions jumped in the first quarter and the bank raised its forecast for specific provisions to about $680 million for the year, well above its earlier estimate of $475 million.

Some analysts even suggest the bank, Canada's fifth-largest by market capitalization, may be forced to issue new shares or cut its dividend if things worsen.

Mario Mendonca, an analyst at Genuity Capital Markets in Toronto, said he "would not rule out" an equity issue or dividend cut if BMO faces additional charges from its exposure to several ABCP trusts, known as Apex, Sitka and Fairway Finance.

Asked about a potential stock issue or dividend cut on a conference call this week, president and chief executive Bill Downe said "it's not something that we have contemplated."

At the annual meeting in Quebec City on Tuesday, Mr. Downe said that his bank was not alone in taking structured-credit writedowns because of global events, but he acknowledged the bank's positions had grown too large for its risk tolerance.

With the slide in BMO's share price, its dividend yield rose to 6.7% on Thursday, double the Canadian industry average.

"A 6% dividend yield should offer some support at these levels against greatly reduced expectations, but operating challenges remain," TD Securities analyst Jason Bilodeau said in a research note.

Another analyst disagreed.

"Although it boasts a dividend yield of over 6%, we do not expect the bank's yield will provide much support or create a floor, despite our faith that the dividend remains safe," Dundee Securities analyst John Aiken wrote in a note.

Things may brighten if BMO can resolve its problems with the Sitka and Apex commercial paper trusts, another predicted.

"There is upside to the bank's share price, in our view, if BMO can quickly restructure these assets," RBC Capital Markets analyst Andre-Philippe Hardy said.

Canadian financial stocks retreated 3.4% on Thursday as part of a broad market decline.

The S&P/TSX financials index has fallen 13.5% year-to-date, outpacing the 3.4% drop in the S&P/TSX composite index.