Monday, October 13, 2008

Banks Could be Due for a Short Term Rally: RBC CM

RBC Capital Markets, 13 October 2008

We believe that the recent decline in Canadian bank shares (-18% in the last seven trading days) might be overdone and there could be a short-term positive move.

• We think that the European and U.S. Governments understand the urgency in stabilizing their banking systems, and we believe there is a good chance they may succeed in the battle against the cost and availability of liquidity (which is currently frozen). If we are correct, this would be positive for Canadian bank shares.

• We think that if Governments do figure out how to stabilize the banking system's ability to fund itself in short-term markets (some Governments are starting to guarantee deposits and term funding), fears of short-term systemic risk should decline, and the pressure on near-term costs of funds in wholesale markets would also decline.

Sustainability of potential rally would be difficult

We continue to believe that the core businesses of Canadian banks will face deterioration in growth and profitability, which would put a cap on the magnitude and duration of a rally. We expect loan growth to decline, wealth management revenues to decline and loan losses to rise. Furthermore, the outlook for trading revenues is highly uncertain going into Q4/08 given the volatility experienced in many asset classes.

• In that kind of environment, we do not believe that today's median price-to-book multiple of 1.6x is particularly cheap given that that is where banks traded in the early 2000s when Canadian banks last dealt with rising loan losses, weak equity markets and slowing loan growth. We believe that, based on normalized profitability, 1.6x book value is an attractive multiple, but leading indicators in the following areas would need to turn more positive before banks can sustainably rally: credit market health, funding markets health, equity markets, housing markets, and unemployment.
Financial Post, Eoin Callan And John Greenwood, 11 October 2008

Ottawa yesterday committed to taking a sequence of escalating steps to protect Canada's banks and prevent a collapse in the financial system as part of a joint plan agreed to in Washington by the world's richest countries.

With Canada's banks caught in the grips of a worsening squeeze in global credit, the government agreed to a common international approach that could cost hundreds of billions of dollars if financial chiefs are unable to halt the downward spiral in markets.

Ottawa agreed to the plan during tense talks between the Group of Seven most-industrialized countries after unveiling a plan to buy $25-billion of mortgages from Canadian banks, which are unable to secure normal financing because of a crisis of confidence.

The scheme to buy up mortgages is expected to be extended to cover more of the $450-billion in conventional mortgages sitting on the books of Canada's top banks, if their access to international credit markets does not improve.

With the election three days away, Prime Ministger Stephen Harper said his government was "developing a series of market measures if [it's] necessary to intervene proactively."

The controversial blueprint approved in Washington by finance ministers and central bankers is designed to avoid systemic collapse, and came after a fresh rout in stock markets that pushed the TSX below the 9,000 mark for the first time in three years and saw the Dow plunge 18% this week in New York.

Amid bitter public feuding between nations, the agenda for the G7 meeting attended by Jim Flaherty, the Finance Minister, was torn up as tense negotiations edged toward a sweeping global plan to replace ad hoc interventions.

The plan would see countries agree to provide liquidity and capital as needed to financial institutions and money markets and follow a common approach to extending deposit guarantees.

The joint plan was hammered out after a series of unilateral actions by individual governments failed to halt a free fall in stock markets or restore confidence.

Under the plan, Washington agreed to buy equity stakes in a "broad" range of banks, said Henry Paulson, the U. S. Treasury Secretary.

The approach aims to learn from past mistakes and combine best practice, but goes far beyond what is seen as necessary for Canada, which would not immediately be obligated to take such steps.

"It is a matter of trying to instill some confidence on the global economy," said Maurice Greenberg, of the Peterson Institute for International Economics in Washington.

He said more limited steps would be expected of Ottawa, unless the impact on Canada's banking system continued to worsen.

A joint statement agreed to by Canada said countries would support "systemically important financial institutions and prevent their failure."

The extraordinary commitment means Ottawa has effectively agreed to save the country's top banks in the event they falter, although that was not seen as an immediate risk in Canada.

But Ottawa was reluctant to announce any major steps before election day after agreeing to buy up $25-billion worth of mortgages from Canada's banks by effectively lifting the limit on the pools of assets the Canada and Mortgage Housing Corp. is allowed to buy up. Financial institutions are having difficulty selling these loans into capital markets as mortgage-backed securities because of historically low demand from investors.

The message to Canada's banks from the government was: "Here's $25-billion now and if you need more, there is potentially a lot more behind that," said Michael Goldberg of Desjardins Securities.

"The purpose of the scheme is to put $25-billion of cash into Canada's banking system that can then be loaned out," said Andrew Fleming of Ogilvy Renault.

"This is going to make loans and mortgages more available and more affordable for ordinary Canadians and businesses," Mr. Flaherty said.

Several of Canada's leading banks responded by cutting their prime rates, passing on more of the emergency rate cut announced earlier this week by the Bank of Canada as Toronto-Dominion Bank was first out of the blocks, saying it would lower its prime rate 15 basis points to 4.35%, followed by Canadian Imperial Bank of Commerce. Bank of Montreal and Bank of Nova Scotia went further, passing on the full central bank rate cut by reducing the cost of prime lending to 4.25%.

Tim Hockey, the head of TD's retail chain, said the era when banks reduced interest rates in lock-step with the Bank of Canada was over.

"No longer is a Bank of Canada rate cut actually reflected 100% in the financial institutions' actual cost of funds," he said. "There are other forces at play, as you see, in the financial marketplace. The cost of funds generally [has] continued to increase dramatically."