Monday, September 22, 2008

RBC CM: Still Too Early to Buy Banks

RBC Capital Markets, 22 September 2008

We last wrote in detail on the Canadian banks on September 2, 2008, following the release of their Q3/08 results.

• What a three week stretch it has been: Lehman Brothers failed, Fannie Mae, Freddie Mac were placed in conservatorship, AIG was put on life support by the U.S. Government, and Merrill Lynch was essentially forced to sell itself. Credit spreads widened significantly and funding markets stopped functioning properly, until Thursday.

• Canadian bank stocks fared better than their European and U.S. counterparts as concerns over financial system stability grew, as their direct exposure to the rapidly deteriorating funding conditions was much lower. At their trough, though, the Canadian bank stocks were down 8% since our September 2 report.

• Recent initiatives (some actual, some announced) by U.S. Government and regulatory organizations should bring tremendous relief to the short term pressure on both credit markets and bank stocks.

• Canadian banks stocks understandably rallied from the 2-week trough Thursday afternoon and Friday as (1) bank shares worldwide rose, (2) systemic risk has declined, and (3) declining credit spreads from peak levels decreases concerns over writedowns of fixed income holdings. Share prices are now up 4% compared to September 2, 2008.

Still too early to buy

While the volatility of the last three weeks has been massive, our view on Canadian banks today is not different from what it was on September 2, 2008 when we last wrote a detailed report on Canadian banks: it is still too early to buy bank stocks.

• Canadian banks should (and do) trade higher than they did earlier last week given U.S. Government actions that greatly reduced systemic risk, but the operating environment is not that different from what it was three weeks ago for Canadian banks.

• We continue to believe that it is too early to buy Canadian bank stocks, reflecting our expectations for continued pressure on profitability due to both a slowing economy and credit/funding markets that remain challenged, and valuations that are not overly cheap on a historical basis considering the economic environment we think the banks will be facing. Median projected total returns to our 12-month target prices are 5%. (They were 4% on September 2, 2008).
The Globe and Mail, Tara Perkins & Kevin Carmichael, 22 September 2008

Canada's banks are expected to push to be included in bailout efforts that will buy risky exposures from financial institutions, but will be lower on the priority list because they've held up better than foreign counterparts during the liquidity crunch.

With U.S. administrators pushing through the largest financial intervention since the Great Depression, Treasury Secretary Henry Paulson is coming under fire for potentially using taxpayer money to bail out foreign institutions, and is pushing global counterparts to come up with their own rescue plans.

Mr. Paulson said yesterday that foreign banks affect the U.S. economy, and those with large U.S. operations should be eligible to participate in the government's $700-billion (U.S.) program to buy up troubled financial assets.

"If a financial institution has business operations in the United States, hires people in the United States, if they are clogged with illiquid assets, they have the same impact on the American people as any other institution," he said on the ABC network.

But he also said the United States is forcefully pushing other countries to come up with their own programs.

"We are talking very aggressively with other countries around the world and encouraging them to do similar things, and I believe a number of them will," he said.

A Finance spokesman declined to comment directly on Mr. Paulson's statement, but cited Prime Minister Stephen Harper's declaration last week that Canada's banks don't need rescuing. "There is no bailout package being considered for Canadian banks or financial institutions," Mr. Harper said on Sept. 19. "The overall balance sheets of the Canadian financial sector remain very healthy."

Group of Seven finance ministers, including Canada's Jim Flaherty, postponed a call yesterday and were scheduled to discuss the situation today.

Mr. Flaherty did not comment on whether Canada might adopt its own program.

However, he said on CTV's Question Period yesterday that Canada's banks remain healthy.

"As the Prime Minister has said, we have a solid banking system in Canada," Mr. Flaherty said. "Our banks are well-capitalized. Our households are well-capitalized."

Canadian chartered banks are following recommendations, "and I'm comfortable with the actions that they have taken, and their stability," he added.

This country's banks have already taken more than $10-billion (Canadian) in charges related to the liquidity crunch, and continue to hold tens of billions of dollars more in potentially toxic exposures. But their writedowns pale in comparison to those of their big European and American rivals, and they have relatively small exposure to U.S. subprime mortgages.

To be eligible for inclusion in the U.S. program, banks "must have significant operations in the U.S., unless [Mr. Paulson] makes a determination, in consultation with the chairman of the Federal Reserve, that broader eligibility is necessary to effectively stabilize financial markets," the Treasury said in a statement over the weekend. The program will buy up mostly mortgage-related loans and securities, but other assets could be considered if officials decide they must be bought for the stability of financial markets.

The Canadian bank that has taken the largest hit on U.S. subprime mortgage exposure is Canadian Imperial Bank of Commerce, which has relatively insignificant operations south of the border. CIBC wrote down about $6.8-billion in the nine months ended July 31. As the toxic exposure became more of a headache for chief executive officer Gerald McCaughey late last year, he decided to sell the bulk of CIBC's U.S. banking and trading operations, and the bank parted ways with about 600 employees when that deal closed at the start of this year.

Canada's banks "certainly will want to be included" in the U.S. program, but it's not clear which ones or which assets will be eligible, said an analyst who declined to be named.

An official at one of the big banks said they expected that, after U.S. financial institutions, European institutions would be the priority. But they noted that banks would want to have a level playing field globally.

Charles Geisst, professor of finance at Manhattan College, said in an interview yesterday that he thinks foreign governments have good reason to resist stepping up to the plate.

"It's an American problem," he said of the financial crisis. U.S. subprime mortgages wound up in a number of complicated financial instruments that banks around the globe were holding. "The U.K. was the closest to it, simply because of the interbank connection," Mr. Geisst said. But "the German banks who bought these mortgage-backed securities just as investments have got to be wondering what the hell they were sold, as would the Chinese and folks in Singapore. And I think they're right."
Associated Press, 22 September 2008

Twelve U.S. federally insured banks have been shut down by regulators this year:

Ameribank Inc. Northfork, W.Va., closed Sept. 19. $115-million (U.S.) assets, $102-million deposits.

Silver State Bank Henderson, Nev. closed Sept. 5. $2-billion assets, $1.7-billion deposits.

Integrity Bank Alpharetta, Ga., closed Aug. 29. $1.1-billion assets, $974-million deposits.

Columbian Bank and Trust Topeka, Kan., closed Aug. 22. $752-million assets, $622-million in deposits.

First Priority Bank Bradenton, Fla., closed Aug. 1. $259-million assets, $227-million deposits $72-million cost to fund, $13-million uninsured deposits.

First Nat. Bank of Nevada Reno, closed July 25. $3.4-billion assets, $3-billion deposits.

First Heritage Bank Newport Beach, Calif., closed July 25. $254-million assets, $233-million deposits.

IndyMac Bank Pasadena, Calif., closed July 11. $32-billion assets, $19-billion deposits.

First Integrity National, Staples, Minn., closed May 30. $54.7-million assets, $50.3-million deposits.

ANB Financial National, Bentonville, Ark., closed May 9. $2.1-billion assets, $1.8-billion deposits.

Hume Bank Hume, Mo., closed March 7. $18.7-million assets, $13.6-million deposits.

Douglass National Bank Kansas City, closed Jan. 25. $58.5-million assets, $53.8-million deposits.
Financial Post, David Pett, 22 September 2008

U.S. government intervention has the sick financial system back on its feet, but the drastic measures are far from a cure, says John Aiken, Dundee Securities analyst.

While the bail-out has alleviated matters near term and propped up the valuations of financial services stocks for the time being, Mr. Aiken says it does not solve the underlying problem: U.S. residential real estate prices.

"The U.S. government is buying time for the financial services sector to try to heal itself. However, unless significant changes are made to the proposal, which would delay implementation, there is no support for American consumers who are drowning in debt,"

He also said that liquidity will still be hard to come by – even though inter-bank lending spreads have eased – because of lingering distrust amongst various lending institutions. As well, he reminded clients that the U.S. economy is still heading towards a consumer driven recession.

As for the Canadian banks, who have varying direct exposure to the United States, Mr. Aiken said provisions for credit losses will no doubt increase while earnings growth in 2009 will continue to be challenged.

The analyst continues to recommend a defensive strategy regarding bank stocks, with Toronto Dominion Bank and Royal Bank of Canada his top picks. He has a "buy" rating and $71 price target on TD and a "buy" rating and $54 price target for Royal Bank.
Financial Post, Jonathan Ratner, 22 September 2008

National Bank Financial’s purchase of a 12.5% stake in Wellington West Holdings Inc. comes at an important time given that operating profit from National’s wealth management business has been flat for the past seven quarters.

National will pay $35.8-million and an additional $35-million if Wellington meets certain earnings targets over the next three years. It also has the right to buy an additional 5% of the company and has been granted right of first refusal if Wellington decides to pursue an outright sale or of a substantial block of shares.

While National’s revenues have been driven primarily by trading recently, the deal allows it to expand its wealth management platform and distribution alternatives nationwide, said Desjardins Securities analyst Michael Goldberg.

He considers the news as positive for National, which he rates a “buy” with a $60 price target.

Mr. Goldberg also noted that the Supreme Court’s decision not to hear the ABCP settlement appeal is good for the bank since its capital position had “large embedded risk due to its reliance on the outcome of the ABCP restructuring.”

He pointed to the bank’s valuation (based on internal models, not observable market values) of its ABCP exposure at $1.671-billion. This assumed a 90% probability that the restructuring would be a success and that a 5% change in probability would cut the valuation by $35-million.

This implied that the paper would be worth $1.74-billion assuming a successful restructuring and only $630,000 if it did not go through, Mr. Goldberg told clients. Therefore, $1.1-billion, or nearly 25% of its book value, was riding on the outcome.