Wednesday, March 05, 2008

BMO Q1 2008 Earnings

  
Scotia Capital, 5 March 2008

• BMO reported an 8% decline in cash operating earnings to $1.21 per share from $1.31 per share a year earlier, below expectations. Reported cash earnings were $0.49 per share including $548 million ($362 million after-tax or $0.72 per share) in pre-announced charges.

What It Means

• The weak operating earnings were due to a $0.15 per share drag from the tripling of loan loss provisions along with weak earnings momentum from Canadian Retail. A 2% decline in revenue (excluding writedowns) compounded weak earnings growth.

• Uncertainty about potential losses on Apex/Sitka and SIVs persist

• We are reducing our 2008 and 2009 earnings estimates to $5.05 per share and $5.65 per share. We are reducing our 12-month share price target to $65 per share from $75 per share based on lower earnings outlook.

• Maintain 3-Sector Underperform due to continued concerns about relative earnings growth prospects.
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Financial Post, Jonathan Ratner, 5 March 2008

Bank of Montreal’s shares have fallen a whopping 14.5% in the last six trading days, dipping further on Tuesday after its first quarter results disappointed. They ended the day down just 3% at $46.89, after falling as low as $45.96.

RBC Capital Markets analyst Andre-Philippe Hardy, who shaved $5 off his price target to $49 per share, noted that BMO’s first quarter core cash earnings per share (EPS) came in at $1.21, lower than his estimate of $1.42. Roughly half of the shortfall was a result of higher-than-expected loan losses. The consensus estimate was $1.36.

The analyst cut his estimated core cash EPS for both 2008 and 2009 to reflect expectations for higher provisions for credit losses and lower estimates for the bank’s wholesale division.

While BMO’s valuation is now much lower that it has been in the recent past at 1.65 times book value, Mr. Hardy’s target price for the shares implies a valuation of 1.6 times.

“We believe that Bank of Montreal’s stock will underperform its peers as earnings revisions are likely to be more severe,” he said in a research note, adding that structured finance (Sitka and Apex) concerns may lurk over the stock for some time.

But if BMO can quickly restructure these assets, there is upside to the share price, he added.
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Financial Post, Duncan Mavin, 4 March 2008

Under the chandeliers of the Verchères ballroom in the historic Chateau Frontenac, Bank of Montreal's chief executive warned that BMO will not meet its profit targets for 2008 and also reflected on his turbulent first year at the helm of Canada's oldest bank.

"Where we fell short, I take responsibility," said Bill Downe at the bank's annual meeting in Quebec.

During Mr. Downe's first year in charge, BMO lost $850-million on a natural gas trading scandal, cut 1,100 positions at a cost of $159-million as it restructured a domestic retail franchise that has failed to keep pace with its peers, and took a $318-million writedown related to the credit crunch.

"It is hard to deny that this has been a challenging year for Bill," said BMO chairman David Galloway.

Those words will be of little comfort to investors who have seen BMO's stock price fall 14.5% in the last six trading session, to $46.89, a more sudden decline than any of its Canadian rivals have suffered since financial markets were gripped by uncertainty last year. It is the worst six-day performance for a Canadian bank stock in more than five years and the second steepest drop since the Asian financial crisis a decade ago.

If 2007 was bad, the continuing decline in BMO's stock price is because things have not become much better in the first quarter of 2008. Yesterday, the bank announced its profits for the quarter fell 27% compared to last year to $255-million. Mr. Downe said management no longer expects to meet earnings growth targets for the year.

"It is difficult to find many positives in the quarter," said Dundee Securities analyst John Aiken. "The outlook for Bank of Montreal is much weaker than it was at the end of the fourth quarter," he added.

BMO's capital markets group continues to be the source of most of the concerns.

The bank took $490-million of credit crunch writedowns in the quarter and admits it is likely to take another charge of $500-million if it can not restructure two struggling asset-backed commercial paper trusts known as Apex and Sitka.

Restructuring negotiations are ongoing, and the bank says there is still "underlying economic value" in the assets of the trusts.

But both Apex and Sitka have been downgraded and put under review by rating agency DBRS, and the bank revealed yesterday that there are disputes with two parties involved in the trusts worth a combined $1-billion.

BMO also confirmed it now has a definitive agreement to provide more than $12-billion in liquidity support to two structured investment vehicles (SIVs) that have been hit by the credit crunch. The quality of the assets in the two SIVs is high, the bank said.

BMO's management acknowledges further capital markets writedowns are possible, though Mr. Downe said the bank is not contemplating raising equity or cutting its dividend to shore up its balance sheet.

Still, there are other concerns for management, notably the impact of the slowdown in the U.S. economy on banking results in Canada and the U.S., especially higher than anticipated provisions for loan losses.

"About half of the shortfall [in first quarter earnings] versus estimates was due to higher than expected loan losses," said RBC Capital Markets analyst Andre Hardy in a note.

BMO said specific provisions for credit losses of $170-million is indicative of what should be expected for the rest of the year, implying provisions of $680-million for all of 2008. BMO had previously forecast lower specific loan losses of $475-million for the year.

"Credit quality is typical for this stage of the credit cycle, when we start seeing emerging deterioration in the performance of customer accounts," Mr. Downe said. "We have seen an increase in delinquencies which, while still below the industry average, is an early indicator of coming credit losses."
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The Globe and Mail, Tara Perkins, 4 March 2008

Bank of Montreal's board of directors is shopping for some extra expertise in risk management, as the bank seeks to return to its low-risk roots in the wake of several trading and investment stumbles.

The move, which follows a shuffle in senior management, came as chief executive officer Bill Downe acknowledged that the bank must change the way it handles some of its businesses.

"For us, 2007 was a year of transition — a year of many successes but also of challenges that tested and confirmed the resilience of BMO and the people who work here," Mr. Downe told shareholders yesterday at the bank's annual meeting in Quebec City.

"Where we fell short, I, as CEO, take responsibility."

The bank's first-quarter 2008 earnings further disappointed the market yesterday, despite its announcement weeks ago it would report $490-million worth of writedowns related to a host of problems stemming from the credit crunch.

Dundee Securities Corp. analyst John Aiken called it a "stunning earnings shortfall."

BMO chairman David Galloway told investors "the board has overseen a complete review of risk management systems and procedures in the bank.

"We are looking to strengthen our board with individuals with strong expertise in risk management," he said. "I've learned never to say never, but we are confident that we've taken positive steps forward."

Mr. Downe said it's now clear that, in a number of businesses, "our positions grew beyond what was in line with our risk tolerance and strategic direction."

And he promised change, including a reduction of capital in those businesses, a reduction in the size of the bank's off-balance-sheet business, a better balance between risk and return, tighter procedures and strong management oversight.

But Mr. Downe dismissed suggestions that there is something culturally amiss in BMO's investment banking division, BMO Nesbitt Burns.

The natural-gas-trading problem that cost the bank more than $800-million last year was a one-time issue that's separate from the current credit-crunch-related problems, he said.

Mr. Downe recently shook up his management ranks, and the new team will be in operation as of today.

But it's not yet clear when the end of the writedowns might come.

BMO is still in negotiations to restructure two asset-backed commercial paper trusts it sponsors, collectively known as Apex. If no deal is reached, the bank expects to take a $500-million writedown next quarter.

It also said yesterday that one Apex investor is fighting BMO's demand for the return of a $400-million funds transfer, while a counterparty is "disputing its obligations" to provide up to $600-million to the bank under a previous deal. Mr. Downe said he views those two amounts as "ordinary commercial transactions," rather than potential writedowns.

The bank said that while it "is confident in its position and will vigorously pursue its rights in these matters, it is not possible to determine the amount or probability of losses, if any, or whether any potential charges will be taken in the quarter ending April 30."

As it awaits the outcome of these negotiations and grows increasingly cautious about the outlook for the U.S. economy, the bank chose not to raise its dividend yesterday. And it's not likely to raise the dividend, or make any notable U.S. acquisitions, for the next while.

"Our first responsibility is to make sure the remaining issues are put behind us," Mr. Downe said. "I don't think that you have to rush to take advantage of those opportunities in the U.S."

BMO is also in the midst of looking through its lending portfolio to see whether it can reduce some of its business with "non-core" clients.

After reporting a 27-per-cent drop in first-quarter earnings to $255-million, BMO said yesterday it no longer believes it can meet its profit forecasts this year. However, Mr. Downe said the bank is not going to revise its target range. "Our management has to keep a focus."
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Dow Jones Newswires, 4 March 2008

Bank of Montreal down 16% in the past five sessions and it doesn't look like the slide is over. Whack of credit-related charges in 1Q chopped EPS by 72 Canadian cents, the third consecutive quarter of lower earnings. But analysts point to continued risks, including potential to move troubled SIVs on to balance sheet, and possible write-down of C$500M related to sponsored trusts facing margin calls. Potential litigation risks also. Loan-loss reservers higher, and BMO is exposed to US through Harris subsidiary.
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The Globe and Mail, Tara Perkins, 3 March 2008

Bank of Montreal executives will likely face tough questions from investors Tuesday as the bank failed to reach a restructuring deal on two asset-backed commercial trusts it sponsors by the close of business Monday, leaving the trusts vulnerable to meltdown as early as Tuesday if creditors seize assets.

Credit-rating agency DBRS placed the notes of Apex Trust and Sitka Trust, which are sponsored by BMO, "under review with negative implications," as the bank's negotiators continued talks with several banks that are counterparties to the trusts.

In total, the trusts face more than $500-million in potential collateral calls.

One counterparty to Sitka is now allowed to seize collateral, while a counterparty to Apex will be in a similar position Tuesday as grace periods to make payments expire.

"Counterparties to several additional transactions will be in a position to seize collateral before the end of this week if the trusts fail to fund outstanding margin calls or otherwise reach an agreement" with the counterparties, DBRS warned.

Bank of Montreal, which is holding its annual meeting in Quebec City Tuesday as it reports its first-quarter results, cautioned last month that it faced a $495-million writedown if the trusts were not restructured. More recently it added that there is also the risk of lawsuits.

Combined, investors including BMO hold $1.9-billion worth of paper from Apex and Sitka.

The bank has already taken $210-million in charges because of the trusts, which have become BMO's most pressing credit crunch-related problem. The bank has also disclosed that it will be taking a $160-million writedown Tuesday because of its exposure to beleaguered bond insurer ACA Financial; a $25-million hit due to structured investment vehicles and a further $175-million charge due to other issues related to the credit crunch.

Sources have told The Globe and Mail that BMO's credit troubles have pushed the bank to re-examine whether it can provide support to a backup line of credit for the restructuring of the $32-billion third-party asset-backed commercial paper (ABCP) market. That market has been frozen since it seized up in August as a result of the credit crunch, and a committee led by Toronto lawyer Purdy Crawford is still working to salvage it.

In early February, the committee announced that BMO, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Bank of Nova Scotia had each agreed in principle — subject to certain conditions — to join National Bank and other investors and asset providers who were providing support to a $14-billion backup credit line that's critical to a successful restructuring of the market. Canada's big banks were asked to contribute $2-billion in total.

The committee, which has repeatedly missed its self-imposed deadlines, was struggling to get firm commitments from the big banks in December as a key date loomed and so its financial adviser, JPMorgan Chase & Co., promised that if the banks didn't come through it would canvass the market for financing and, as a last resort, step in itself.

As the talks drag on, pressure is now mounting for the committee to turn to that alternative.

"The time is now to reassure the market and have JPMorgan come forward publicly with support and liquidity," said Ross Hendin, chief executive officer of Hendin Consultants. "If a bank like BMO is ready to suffer the public embarrassment of letting its conduits melt down, this is a clear indication of a very tough time in the market."

His associate Daryl Ching, managing partner of Clarity Financial Strategy, said that there's a growing chance the entire third-party ABCP committee will disband, given the problems.

"I would urge the committee to get it done as soon as possible," Mr. Ching said.

With all of the noise in the market concerning the credit crunch and bank writedowns, "it's a very scary time and the margin facility is much less attractive today than it was in December," he added. There's talk that the margin facility might become more expensive, because banks would want to hedge their exposure to it and that's becoming increasingly difficult to do, he said.

The committee said in December that it would likely pay 160 basis points for the credit line.

Other Canadian banks have indicated that they're still willing to contribute to the line.

"The issue has always been about the exact amount" that each bank would contribute, one source said Monday.

Mr. Crawford could not be reached for comment.

Prior to DBRS's announcement BMO shares fell 2.7 per cent, or $1.34, to close at $48.36 on the Toronto Stock Exchange Monday after suffering their biggest one-day drop in more than six years on Friday.

Influential Citigroup Inc. analyst Shannon Cowherd downgraded the stock to "hold" because of its significant exposure to the credit crunch.
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The Globe and Mail, Boyd Erman & Jacquie McNish, 29 February 2008

Bank of Montreal has signalled it may pull out of an effort to restructure $33-billion in stranded asset-backed commercial paper, as mounting woes in the global credit market leave the bank facing margin calls of more than $500-million on two of its own ABCP trusts.

According to sources, bank officials recently advised the group of ABCP investors seeking a fix for the market, known as the Crawford Committee, that BMO may no longer be able to honour its commitment to contribute to a $14-billion line of credit.

That credit line is the centrepiece of a plan to swap the frozen notes into new long-term bonds.

Bank of Montreal's specific commitment to the so-called liquidity line has never been disclosed, but it is one of four Canadian banks that agreed in December to provide as much as $2-billion in total. The remaining $12-billion is backed by a group of international banks.

Global credit markets have sold off so much more since December that financial institutions are facing the renewed prospect of additional losses on such structured products as ABCP.

Yet, if banks balk at helping the Crawford Committee, they raise the prospect of a fire sale of assets that would further drive down credit markets and exacerbate losses in other areas of their businesses.

BMO's problems are particularly acute, with the bank last week announcing $490-million in writedowns and this week facing as much as $495-million more because of the unravelling of two trusts that it runs.

"We are no longer in the same world that we were in December," said a person familiar with the discussions between the banks and the committee.

"We are struggling to hang on."

A spokesman for the committee said the group is still expecting all Canadian banks to support the restructuring.

"The negotiations with the banks are still ongoing, and Bank of Montreal is still very much a part of that," spokesman Mark Boutet said.

"The discussions are taking longer than we anticipated back in December given that market conditions are tougher than they were then."

The result is more delay for a restructuring process under way since August.

That's when the ABCP market went into convulsions as buyers boycotted amid concern that the paper was tied to U.S. subprime mortgages. The committee won't be able to send out documents detailing the planned restructuring this week, as planned, and sources said instead it will aim to do that by mid-March.

BMO's troubles are a vivid illustration of how the disintegration of so-called structured products like ABCP is undermining the financial industry's ability to cure its ills and aid clients stuck with foundering investments. More and more banks are finding that they don't have the capital because all available money is tied up plugging holes in their own balance sheets.

BMO is facing demands to post more than $500-million in new collateral for two trusts that it runs, known as Apex and Sitka, because their assets have slumped in value, sources said. The trusts have about $1.9-billion of paper outstanding that could be at risk if BMO doesn't ante up, because the financial institutions on the other sides of the derivatives in Apex and Sitka can begin to seize assets.

Ratings firm DBRS Ltd. yesterday slashed the ratings on the paper to the last grade before default, saying that the collateral calls were "significant." Bank of Montreal and DBRS both declined to comment on the size of the exposure.

BMO is facing a stark choice. On the one hand, if BMO decided to save its own trusts by anteing up to meet the collateral calls, it would avoid a $495-million writedown. That option comes with a heavy cost, because it would leave the bank with less capital to lend to its clients and for the liquidity line desired by the Crawford Committee.

If, on the other hand, BMO declines to save its own trusts, more money will be free to help the Crawford Committee bail out ABCP sold by smaller, non-bank companies such as Coventree Inc. This move would expose the bank to criticism that it sacrificed its own customers to aid those of other players.

Being part of the liquidity line "is hard to justify if you're a BMO executive or if you are a shareholder," said Colin Kilgour, who formerly ran a business setting up conduits such as ABCP trusts and is now helping ABCP investors navigate the restructuring. Analysts said it's likely that BMO has already decided to let Sitka and Apex go down, even though it would probably damage the bank's larger business in the securitization sector. BMO is the largest player in Canada and securitization generated $296-million in revenue for the bank in the last fiscal year.

Even if the bank propped Sitka and Apex up now, after one near-collapse and the downgrade from DBRS there would be likely be few buyers for the paper issued by the trusts and they would likely have trouble surviving for much longer anyway. Already, Apex paper is going unsold.
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The Globe and Mail, Boyd Erman & Tara Perkins, 27 February 2008

Bank of Montreal is facing the prospect of as much as $495-million in further writedowns unless it can find a way to save two asset-backed commercial paper trusts that are facing big losses.

The bank, which sponsors the trusts, was in last-minute talks Wednesday night to save them from a fire sale. Credit-rating company DBRS Ltd. said that BMO had until the “close of business” Wednesday to reach an agreement with a counterparty to swaps agreements held by Sitka Trust, otherwise the trust could end up facing a collateral call that could trigger losses.

Officials at BMO, which warned of the potential losses last week, declined to comment on the state of the talks Wednesday evening. DBRS said that it would provide an update as soon as more information became available.

Unless the bank reached a deal or anted up more collateral, after a grace period, “the swap counterparty will be entitled to seize the existing collateral” which could “lead to substantial losses for note holders,” DBRS said.

One of those note holders is another BMO-backed ABCP trust known as Apex, which has more than half its assets tied up in Sitka paper. Between the two trusts, there were about $1.9-billion of notes outstanding as of August, when the market went into crisis as buyers of the paper disappeared and the value of assets in the ABCP trusts began to fall.

BMO is in a tough spot because if it supports the trusts, it opens itself up to further losses should credit markets continue their downward spiral. If the bank doesn't offer up more collateral, and instead cuts the trusts loose, losses would be likely be limited to the $495-million in writedowns the bank warned of last week, but buyers of Apex and Sitka paper likely would be furious with BMO.

BMO has more than one counterparty seeking collateral, sources said, meaning that that even if the bank does get a deal in with the one party that set the Wednesday deadline, there could be more tense negotiations ahead with other financial institutions.

“The issue here is that, not only will BMO lose money, but so will the other investors in the notes of Sitka and Apex,” said Mario Mendonca, an analyst at Genuity Capital Markets. “I'm not sure BMO can stomach having these investors lose a lot of money.”

The trusts run by BMO were created to earn money by selling short-term notes that paid relatively low interest rates and investing the proceeds in so-called swaps that brought higher returns. The value of those swaps has plunged in the past six months as credit markets have swooned, leading the parties on the other side of the swaps to demand more collateral.

Toronto-based BMO has already taken charges in the past two quarters that total $210-million in relation to Apex/Sitka, leaving a net position of $495-million that could be written off if there was no restructuring of the trusts, the bank said last week.

The problem may bode ill for the restructuring of the $30-billion non-bank ABCP sector that's taking place under the auspices of the Crawford Committee. Some of the same counterparties that are pushing BMO are also involved in the other ABCP trusts, sources said.

A similar standstill with the swap counterparties to the non-bank trusts covered by the Montreal Accord expired on Feb. 22, with no word since on an extension. Those working on a deal say that an update should be forthcoming soon and that talks are productive.

“If the delay is due to swap counterparties becoming less supportive of the restructuring and they ask for margin to be posted, it could derail the restructuring,” said RBC Dominion Securities analyst Andre-Philippe Hardy.
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The Globe and Mail, Tara Perkins, 25 Feburary 2008

The Canadian credit card market is starting to show some signs of strain, but it would take severe cracks before banks backed off from this lucrative but little-understood business.

Rising credit card delinquency rates in the United States have reportedly prompted banks to tighten up their lending standards, making it hard for some consumers with maxed cards to borrow more.

Losses and delinquencies have also been ticking upward in Canada, according to credit rating agency Moody's Investors Service Inc. It has an index that tracks about $59.9-billion, or more than 80 per cent, of the Visa and MasterCard credit card receivables outstanding in Canada. It found that the charge-off rate – a measure of credit losses – climbed to 2.8 per cent in the third quarter of 2007 from 2.49 per cent a year earlier. The 90-plus day delinquency rate rose to 0.73 per cent, from 0.63 per cent a year earlier.

Moody's is still waiting for fourth-quarter data, but it's safe to say the market here is not eliciting the same level of concern as in the United States, where the agency has a negative outlook for the weakening credit card sector.

Canadian bankruptcies increased marginally in the fourth quarter, but employment levels were very strong, said Moody's vice-president Sumant Inamdar.

“We have no concerns about any of the Canadian credit card transactions that we rate,” echoed DBRS Ltd. senior vice-president Jerry Marriott.

In fact, it's clear banks here are salivating over this business and there's plenty of room for growth.

“Every bank suggests that the competition is more intense now than it has been in some time, and there's some evidence of that simply because you see all the loyalty programs offering more and becoming a little more creative,” said Genuity Capital Markets analyst Mario Mendonca.

One big new growth area is prepaid cards. “The marketing guys haven't even really turned their brain to how they can use MasterCard and Visa in that world,” said one industry veteran.

An example is Bank of Montreal's recent experiment with a prepaid travel Mosaik MasterCard, a type of hybrid between a credit card and a traveller's cheque.

Part of the reason for the lack of concern in the Canadian market is the relative strength of the economy.

There are also major differences between the businesses on either side of the border. The average Canadian adult has half as many credit cards as the average American, but uses each more often.

Canadians held 61.1 million credit cards at the end of 2006, up from 50.4 million in 2003. The annual amount spent on them rose to $214.70-billion from $150.49-billion during that period.

Importantly, it's estimated that roughly two-thirds of Canadian cardholders pay off their balances regularly, making cards more a payment tool than a method of borrowing.

That means less money to be made from interest payments, but banks also make large profits from fees that are paid by retailers when consumers pay with credit cards.

Banks that issue cards recoup about one to 1.5 per cent of the value of each dollar spent on the card through these fees. And there's more money to be made on foreign exchange when consumers shop abroad.

Add it all up, and there's still plenty of room for growth in the Canadian credit card market, where the number of cards has been increasing in recent years as the number of cards in the United States dropped.

“The big competition to card payments is cash, and cash is still king,” said the industry veteran.
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The Globe and Mail, Boyd Erman & Derek DeCloet, 23 February 2008

Inside his boardroom, Prem Watsa keeps an unusual artifact: a bronze bust of Sir John Templeton, the 95-year-old legend of value investing.

The item was a 50th birthday gift for the chairman of Fairfax Financial Holdings Ltd., but also serves as a source of inspiration. The Templeton principles, after all, underpin much of Fairfax's investment philosophy: Be flexible; search around the world for the best bargains; and above all else, go against the crowd - buy when others are pessimistic, and sell when optimism rules.

It's the last of these that led Mr. Watsa - until recently one of the most beleaguered executives on Bay Street - to one of the most stunning investments of his career, and has given him a way to silence his many critics.

Fairfax this week disclosed an annual profit of $1.1-billion (U.S.) for 2007, nearly four times what the insurance and investment company had earned in its best year the year before. Much of that was the result of a single, contrarian bet the firm made that the world had got it wrong about risk.

Starting in 2003, and continuing through early 2007, Fairfax began to buy credit default swaps on U.S. companies. The buyer of such a derivative is essentially betting that the company's debt is overpriced - that the market has underestimated the odds of a financial failure.

Some of Fairfax's swaps were against the debt of so-called monoline insurers, companies like MBIA Inc. and Ambac Financial Group Inc., that guaranteed U.S. municipal bonds but had massive exposure to subprime mortgages and other risky debt.

"All you had to do was take a prospectus or you take their 10-K and you open it up and you say, 'Let me look at the risk factors,' " Mr. Watsa said. "It's all there. And what's amazing is that when you read it, you can't believe that these guys did what they did.

"They never worried about risk."

Neither did a lot of other people, until the credit crunch exposed tens of billions in toxic consumer debt, high-risk business loans, and complex, structured investment products. Some have called the U.S. mortgage crisis the biggest risk-management failure in financial history. Soothed by triple-A credit ratings, a strong economy and intricate risk-management plans, financial institutions and investors took on far more risk, and paid a much higher price, than they realized at the time.

The cause of their complacency, Mr. Watsa said, was the low volatility that prevailed between 2003 and 2006. "The only way that that could happen is we have to have a long period of stability - a long period where there wasn't any accidents. You'd never take that risk otherwise."

It also happened because too many banks, insurers, hedge funds and rating agencies were given a false sense of security by statistical models that told them the probability of a financial "accident" was low. Where they used spreadsheets and algebra, aging investors like Mr. Watsa, 57, relied on their instincts and decades of experience to tell them something was amiss. And the grey-hairs won.

"We were shocked at how low the risk premiums went," Mr. Watsa said.

"People thought, if there were any problems, the Federal Reserve would fix the problem. After all, we'd gone through the Russian crisis, we'd gone through Long-Term Capital Management, Asia went into [crisis], the tech bubble - we'd gone through a whole bunch of things and it seemed like it was okay. It's not that bad."

Risk, what risk?

Risk has a price, just like anything else. For the right return, people will take almost any chance.

Until last summer, as the economy and credit markets boomed, investors were clamouring for risk, taking on more and more for less in return. Optimism ruled.

The most tangible result was that market interest rates dove to record lows relative to government bonds, with even risky products such as junk bonds earning investors a scant premium to "risk-free" debt such as Treasury bills.

Fairfax won its bet when that trend reversed, starting last summer, as investors spooked by U.S. mortgage defaults once again demanded more compensation for taking chances.

For winners like Fairfax and U.S. hedge fund manager Bill Ackman, the windfalls are tremendous, but for the losers, the costs are staggering.

The Group of Seven recently estimated that the total writedowns stemming from the mess may reach $400-billion (U.S.) - equivalent to about a third of Canada's annual economic output.

Right now, the financial sector is only about a third of the way there, but with more writedowns coming almost every day, the tally is mounting fast.

Bank of Montreal this week unveiled $490-million (Canadian) of pretax writedowns and Canadian Imperial Bank of Commerce has been hit even harder, with more than $3.2-billion of writedowns so far. The chief risk officers at both firms have stepped down.

But those are mere bruises relative to what's happened in the United States and Europe. The British government nationalized mortgage lender Northern Rock PLC after failing to find a buyer for the bank, which was crippled by a liquidity squeeze. In America, financial giants such as Citigroup Inc. and Merrill Lynch & Co. have been forced to sell stakes to foreign sovereign wealth funds to shore up their capital.

How could this happen?

Many of the answers lie in the uncertain science of risk management, which banks depend on to avoid pitfalls.

As markets flourished, financial institutions poured vast intellectual and electronic resources into creating fancy new products such as collateralized debt obligations (CDOs). At the same time, in a parallel universe also populated by PhDs and supercomputers, risk managers used statistical models in hopes of simulating what sudden market moves would do to the value of those securities and derivatives.

In all financial institutions, there is a daily battle between the risk takers and the risk managers. The takers push for bigger positions to make bigger profits, while the managers push for prudence and caution.

But as their warnings of potential loss were proved false each day by the soaring financial markets, many risk managers lost the ear of management teams focused on the vast profits generated by the people in the business of creating the structures. That led banks to take bigger and bigger bets.

"In a lot of these organizations that have had difficulties, the chief risk officer's role wasn't that meaningful or the business lines had more power and authority than the risk function did," said Brian Porter, 50, chief risk officer at Bank of Nova Scotia, which has largely avoided the financial mess.

But some of the fault also lies with risk managers who relied too much on their tools, the statistical models, which were rapidly eclipsed by the rapid innovation in financial markets that begat complicated structures such as CDOs, so-called CDO squareds and structured investment vehicles (SIVs).

"Risk management tools are blunt instruments, which calls for prudence," said Louis Gagnon, a former Royal Bank of Canada risk-management executive who now teaches business at Queen's University. "If you know you are driving your car on a foggy evening, you are supposed to go easy on the gas, but it's not necessarily what happens."

Correlation's domino effect

Banks reeling from the massive losses are coming to realize that two of their key tenets of risk management - diversification and dependence on the so-called "normal distribution of events" - have been weighed in the balance of the credit crisis and found wanting.

Diversification has proved illusory because of a greater degree of correlation between asset classes and world markets than almost anybody expected.

The concept of avoiding correlation through diversification stems from the world of insurance. If you're going to insure homes, you have a greater chance of a big loss if all the houses you protect are on one street, or even in one town. There's too much risk of correlation, because a single hurricane or big fire could wipe them all out. One answer is to seek wider geographic diversification to cut correlation. Another is to insure in different markets, perhaps adding life or auto coverage to reduce the chance that all your customers will make claims at once.

In investing, money managers and risk officers seek to spread their risks over different geographies and markets for precisely the same reason.

The problem is, what works in insurance doesn't necessarily work in financial markets, because markets are prone to contagion.

A house fire in Saskatoon won't spark a conflagration in Tokyo, or any reaction at all, for that matter. But faced with something that shocks the financial world, such as falling U.S. home prices, investors on all continents and in all markets tend to react in a similar manner. Stocks, bonds, fancy CDOs and credit default swaps - the knee-jerk reaction is to sell them all, whether they trade in Toronto or New York or Tokyo.

In statistical terms, markets that don't show much correlation on good days can be very correlated in bad times, and there are no current models that reflect that fact.

"Historically, you see correlation between markets is not that high," said John Hull, a risk-management specialist who teaches at the University of Toronto's Rotman School of Management. "But it's dangerous to base your risk management on those correlations because when things start to go wrong, the correlations start to go up."

Tripping over the tail

Along with correlation, another term has come to haunt risk managers: "tail risk."

It's an odd name for the statistical chance that returns on any given investment will fall outside the normal probability of events. (When plotted on a graph, the statistically probable events are grouped in a bell curve, but there's a long tail of improbable events that trails off to one side, hence the name.)

In other words, most of the times markets behave normally. But every so often they don't. Those abnormal events fall in the "tail" of the risk curve.

Many risk managers, especially those at banks, use the normal probability concept to develop a yardstick called Value-at-Risk (VaR), which measures the amount a position taken by traders could lose on any statistically "normal" day. Normal is defined as a move of less than three standard deviations from the mean, and the assumption is that normalcy will reign for all but one day in a hundred, or even a thousand. That's when the tail comes into play.

Most banks look back three or four years to determine the likelihood of loss - meaning that just before last summer's blowup they were looking only at years of unnatural calm. Markets fooled the models.

"The tail events happen far more often than we would predict," Mr. Gagnon said. "But what are the predictions based upon? The normal distribution of events."

As a result, VaR failed investors. For example, CIBC had a daily VaR in the third quarter of 2007 that averaged $9.9-million, according to the bank's quarterly investor presentations. Yet three times in that quarter, as the credit crunch picked up steam and the bank booked writedowns, it lost more than that in a single day, including one loss of $120-million.

"The tails are always fatter than you think and the correlations are always higher than you expected," Mr. Hull said.

Terra incognito

Financial institutions augment VaR with stress tests, in which a range of possible outcomes are run through the models to see what happens. What if interest rates rose three percentage points in two months and the price of oil doubled?

Scotiabank, for example, can run 75 stress tests a day on its balance sheet. In fact, if Mr. Porter, the chief risk officer, thinks of a potential situation that worries him, he can have a test turned around by his team in as little as 24 hours.

But even stress testing fell short at many institutions during the credit crisis.

"VaR, stress tests and other risk measures significantly underestimated the magnitude of actual loss from the unprecedented credit market environment," Merrill Lynch said in its third-quarter earnings filing, which revealed a writedown $8.4-billion of CDOs, mortgages and loans.

The problem, risk managers now say, is that there were no models that could accurately predict how the products would react because of the way that innovation had outpaced risk controls. In such a situation, there was no hope of coming up with an accurate estimate of the losses.

"When you're dealing with an opaque structure, there's no amount of stress scenarios that will reveal the true exposures you're putting on the balance sheet," Mr. Gagnon said. "It all becomes a theoretical exercise. There's just no model."

The problem, however, is not just with the models. It's also with the human brain. Because of the way humans think, they are unlikely to dream up the kinds of havoc that markets can wreak. People are just too programmed to think within the box, Mr. Hull said.

"The unfortunate thing is that human beings have this tendency to latch on to the most likely scenario, and as soon as they start thinking about that scenario they convince themselves that's what's actually going to happen," Mr. Hull said. "That's the danger, that you become complacent, and you don't think about the range of alternative outcomes."

The experience premium

The answer, then, may be a renewed deference to grey hair. The same experience that helped Mr. Watsa make his winning bet may help keep financial institutions on the right side of the risk curve.

The result is a renaissance for the credit officers who came of age in an era when banks largely only needed to focus on the risk of a client skipping out on a loan, only to be eclipsed by youngsters versed in the markets and slicing, dicing and repackaging loans for trading.

Those experienced managers were around to see the crash of 1987, the Russian debt crisis and, in many cases, the sky-high interest rates of the early 1980s. In other words, they have been around long enough to have seen markets move irrationally. That makes them invaluable for their ability to dream up scenarios to test the balance sheet, because they are unlikely to say: "That could never happen."

"We have about a dozen PhDs in mathematics," says Scotiabank chief executive officer Rick Waugh, 60. "We probably need about another dozen PhDs in human behaviour. And we probably need at least 12 risk officers with grey hair, because you need this balance."

The result of the newfound respect for grey hair is that risk managers are starting to win the fight on at least one front - the cultural battle. Headhunters report that top risk managers have become one of the hottest commodities in the financial world.

Merrill Lynch CEO John Thain reached out to a veteran of Goldman Sachs Group Inc., home to perhaps the top risk culture, making him co-chief risk officer. The new risk czar, a 20-year veteran of markets named Noel Donohoe, will report directly to Mr. Thain, giving him the clout that risk managers need.

The pendulum is swinging back from the risk takers to the risk managers.

"If we eliminate risk, we eliminate the bank," Mr. Waugh said. "We have to make money. But they [risk managers] have to have an independent voice. They have to call it the way they see it."

Contagion and crises

Tail risk and correlation have reared their heads before, with at least four major occurrences in the past 21 years of an unexpected risk causing contagion in financial markets.

1987

On what's now known as Black Friday, U.S. stocks unexpectedly plunge, with the Dow Jones sliding 508 points, triggering similar drops around the world. The causes are still open to debate - many blame a confluence of program trading - but the result is not: It was a global contagion.

1994

Mexico's peso is suddenly devalued in a surprise move by a new government. The move triggers selloffs in currencies and stocks across Latin American, and sends tremors through Asia.

1997

The Thai government abandons a peg to the U.S. dollar for the baht, another surprise move. The effects reverberate through stock and currency markets all across Asia.

1998

The Russian government shocks the world by defaulting on debt, causing a massive flight to quality. Investors flee any market with risk, including stock markets around the world, and snap up government bonds. This unlikely event leads to the failure of hedge fund Long-Term Capital Management.
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