Thursday, October 09, 2008

Ottawa Weighs Proposals to Aid Banks if Crisis Persists

The Globe and Mail, Kevin Carmichael & Sinclair Stewart, 8 October 2008

The Canadian government is discussing ideas to help Canada's banks weather the global credit crisis by giving them access to high quality assets backed by the federal treasury, people familiar with the matter said.

While Canada's financial institutions remain in good shape, high-level officials are taking a closer look at proposals from banking executives to ease credit markets should the financial turmoil that has gripped global credit markets for the past month persist.

One plan under consideration would require the participation of Canada Mortgage and Housing Corp., the Crown agency that buys mortgages from financial institutions and resells the loans as securities with the full backing of the Canadian government.

Under the proposal, CMHC would establish something called a term lending facility, under which the agency would absorb some of the banks' mortgages. In exchange, CMHC would give the banks securities with the CHMC stamp, the sources said. That would leave the banks with assets that other lenders, including the Bank of Canada, would be willing to accept as collateral for short-term loans. That, in turn, would allow them to increase their own ability to lend. “They have to do this – they need things in place just in case,” said a top executive at one of the Big Five banks.

The executive cautioned that although the banks do not need that added support today, the government is moving quickly to ensure they can react if the financing situation continues to deteriorate.

“You have to work on this like you need it tomorrow,” he said.

The banks have also put forward requests that the Tories consider a range of options, including an increase in deposit insurance in the wake of similar moves in the United States and around world. Deposits are currently insured up to $100,000 and the United States recently boosted coverage to $250,000 (U.S.).

Finance Minister Jim Flaherty told reporters yesterday in Toronto that the government is prepared to take further steps to fight the credit crisis, although he declined to elaborate on what he might do.

“If it is necessary to take further steps to protect the stability of the financial system in Canada from spillover effects from the United States, from the United Kingdom, from other G7 countries, we will take those steps,” Mr. Flaherty said.

The Finance Minister is scheduled to meet with reporters again this morning in Ottawa.

Kory Teneycke, a spokesman for Prime Minister Stephen Harper, said the Finance Minister isn't making any announcements. Mr. Flaherty's intention is to use today's meeting to discuss this weekend's gathering of finance ministers and central bankers from the Group of Seven nations in Washington, Mr. Teneycke said.

The goal of any plan to help the banks is to lower credit costs by offering them a chance to load up their balance sheets with safe assets at a reasonable price. In the wake of the failure of U.S. investment bank Lehman Brothers Holdings Inc. last month, lenders are hoarding their cash out of concern they might lose it if they do business with the wrong counterparty.

Their fear has caused the price that banks pay for short-term loans to jump to record highs. Central banks around the world, including the Bank of Canada, have flushed the financial system with billions of dollars in loans to give financial institutions access to the cash they need to balance their accounts.

The decision by the Harper government to take bolder measures is a reversal, reflecting the persistence of financial turmoil that continues to rage even after the U.S. government approved a $700-billion (U.S.) rescue package last week.

Since the beginning of the campaign for the Oct. 14 vote, Mr. Harper and Mr. Flaherty have insisted that Canada is relatively sheltered from the credit crisis because the country's banks remain well capitalized.

That position has drawn criticism from the government's political opponents as evidence that Mr. Harper is out of touch during the worst financial crisis since the Great Depression.

The Canadian banking system is widely viewed as the healthiest in the world, easily surpassing its peers in terms of stock market performance and capital strength. Banks here tended to keep mortgages on their balance sheets, rather than package them off as complex securities, and avoided much of the toxic sub-prime lending that punished their counterparts in the United States.

Yet even this conservatism hasn't immunized them against a global credit crunch that has frozen lending between banks and made it difficult for even the healthiest companies—including financial institutions—to obtain financing.

By expanding CMHC's involvement in the securitization market, banks would be able to move mortgages off their books and get access to a cheaper form of funding. This, in turn, would free up more cash for other lending efforts and hopefully help thaw some of the frozen credit markets.

“You're taking big chunks [of loans] off of balance sheets that are sitting there as unsecured money, funded by deposits,” one senior Canadian banker said. “You're essentially freeing funds that can be used as term lending.”

Here's how it might work: A bank will pool together a group of mortgages and package them off to CMHC. This is one of the cheapest ways for the banks to fund the home loans they make—especially today, when access to credit has shrivelled and borrowing rates have climbed.

Stephanie Rubec, a spokeswoman for CMHC, declined to comment.

CMHC, through its Canada Housing Trust arm, sell bonds comprising these insured mortgages to investors, who have the comfort of investing in a security that is backed by the government of Canada.

The problem is, there's a limit—total mortgage backed securities issued by the CMHC totalled around $190-billion at the end of August, or less than 25 per cent of the overall mortgage market. Banks have been lobbying Ottawa since the spring to expand the amount of mortgages CMHC will accept for securitization to help make funding cheaper and more accessible.

“The easiest way to support the Canadian banks is to expand the CMHC securitization pie,” added another banker. “It is a cheap funding vehicle.”

In recent weeks, some Canadian banks have urged Ottawa to increase the size of the current program substantially, to a few hundred billion dollars. Indeed, sources say that in a call this week between the heads of the big banks and Bank of Canada Governor Mark Carney, it was evident that the financing problems are becoming more of a strain for some of the Big Five.

Different options to help bolster bank financing were being discussed, including an expansion of the amount of bonds the CMHC issues, or a so-called “term repo” facility, which is akin to a sale and repurchase agreement: the banks would effectively be lent money for a specified period, and then be required to pay it back.

The Canadian Press, Rita Trichur, 8 October 2008

The federal government warned "a couple" of Canadian banks that their capitalization levels were on the brink of falling below accepted standards long before the credit crunch disintegrated into an outright global financial crisis, Finance Minister Jim Flaherty disclosed today.

Speaking to reporters in Toronto, Flaherty said the government began scrutinizing Canadian banks' capital rates following the onset of the credit crunch in August 2007, adding those efforts continue to the present day.

"We monitored carefully the capitalizations of our banks. And we had a couple of financial institutions in Canada that ran the risk of falling outside of the capitalization requirements in Canada - which are among the highest in the world," Flaherty said at a press conference to discuss an upcoming G7 meeting in Washington.

"We required them, through the Office of the Superintendent of Financial Institutions, to maintain the appropriate capital requirements and to raise capital as necessary, which was done. Which was done months ago.

"We have continued, and I have been involved in making sure that the Department of Finance and the Office of the Superintendent of Financial Institutions strictly monitor the capitalization requirements which we imposed on banks. So that I can say with confidence (to) Canadians today that are our financial institutions are well-capitalized in Canada, which cannot be said in a number of another countries in the world."

When pressed for specifics, Flaherty declined to say which Canadian banks were in danger of breaching capital requirements.

In January, however, Canadian Imperial Bank of Commerce announced plans to raise $2.75 billion by selling stock, most of it to blue-chip investors, in an effort to repair its balance sheet. Last week, CIBC struck a separate $1.05 billion (U.S.) agreement with a fund arranged by American private equity group Cerberus Capital Management to lower its exposure to the U.S. residential mortgage market and shore up capital.

CIBC has taken about $7.55 billion (Canadian) in debt-related writedowns since America's subprime mortgage market imploded last year, the most of any Canadian bank. The running tally of the "big six" now stands at about $11.6 billion, a mere drop in the bucket when compared to the near $600 billion (U.S.) in losses and writedowns posted by banks and security firms worldwide.

"I can reassure Canadians that we will watch very closely and not just lately. We've been watch very closely for a long time, and monitoring our financial institutions - not just our banks but our insurance companies closely," Flaherty said.

"I can assure Canadians that they are not only solvent but that they are within the capitalization requirements that we insist upon in the government of Canada which are among highest in the world."

Flaherty's comments about Canadian banks came on the heels of a co-ordinated round of interest rate cuts from the world's major central banks. British authorities, meanwhile, announced a whopping 50 billion-pound government-backed rescue package for that country's teetering financial institutions. Those dramatic efforts to unclog credit markets come on top of last week's approval of a $700 billion (U.S.) bailout for Wall Street banks.

Flaherty, will meet Friday in Washington with finance ministers from industrial countries to co-ordinate efforts to deal with the global economic crisis.

Earlier today, the Bank of Canada and other central banks cut interest rates by half a percentage point in a co-ordinated effort to stimulate lending and economic growth.

Flaherty said an International Monetary Fund report released Tuesday shows Canada will lead G-7 economies in 2009, with growth of 1.2 per cent, though overall global growth will slow down.

Meanwhile, the U.S. is forecast to grow only 0.1 per cent and Europe 0.2 per cent.

The minister also said he believes the Bank of Canada has done a sufficient job so far in providing money – or liquidity – to the markets.

Flaherty said he wouldn't advise Canada's banking system to decide whether to pass today's interest rate cut onto consumers.

"I don't give the banks guidance on what they should do or shouldn't do," he said.

"They respond to the steps taken by the Bank of Canada as they see fit. We have a competitive banking system."

Michael Goldberg, a financial services analyst with Desjardins Securities, said the British bailout package coupled with yesterday's $10 billion common stock offering by Bank of America should help restore confidence in the financial system but also "heighten near-term uncertainty" for Canadian banks.

"These developments raise two questions for Canadian banks: will they have to raise capital and will dividends have to be reduced as a result of earnings dilution? Our answer to the first question is "yes"--the likelihood of added capital is increasing," Goldberg said in a note to clients.

".....Our answer to the second question remains that the likelihood of dividend reductions continues to be remote, even for CIBC, which in our view, needs an injection of capital the most (even after its financing/insurance arrangement with Cerberus announced earlier this week)."
The Globe and Mail, Sinclair Stewart, 8 October 2008

Jean Chrétien is smiling.

Ten years ago this fall, after his government rejected a pair of proposed bank mergers, the financial community was awash in dire prophesy: Canadian banks were too small to compete with their bulked-up neighbours to the south, the critics complained.

They were too insulated to remain relevant in a global economy characterized by lightning change and mind-bendingly complex products.

Yet today, amid the worst financial crisis in a generation, those predictions have been turned squarely on their head. While Wall Street titans succumb to a credit meltdown, spreading their contagion to Europe, the Canadian banking system has emerged as the most stable and best performing in the world.

Three Canadian banks are now in the top 10 in North America by market value, and the remaining two are not far behind.

Mr. Chrétien, who faced considerable Bay Street backlash for his stance on the banks, now credits his government's policy with helping to ward off the financial meltdown currently gripping much of the G8.

“While everybody's in turmoil, Canada is not in turmoil,” Mr. Chrétien explained in a brief interview.

“And the two big reasons are that we balanced the books in '95, and we said no to the merger of the banks.”

Of course, it's impossible to say with any certainty whether the decision to quash two mergers – one between Royal Bank of Canada and Bank of Montreal, the other between Toronto-Dominion Bank and Canadian Imperial Bank of Commerce – shielded the Canadian industry from the mortgage-fuelled fallout that has ravaged Wall Street.

One school of thought is that if the Canadian banks gained scale through mergers in 1998, they would have made bolder moves south of the border, and perhaps become entangled in the same toxic lending activities that have prompted the collapse of several major U.S. banks.

Indeed, sources said that had RBC and BMO joined forces, one of their first acquisition targets would have been Wachovia Corp., the North Carolina bank that has been hobbled by soured mortgages, and is now the subject of a takeover battle between Citigroup Inc. and Wells Fargo.

“It was a crazy race they were in,” Mr. Chrétien said of the U.S. banks, which were expanding frantically in the belief that bigger was better.

“Our guys were not in that race because they claimed they were too regulated.”

Charles Baillie, the former head of TD, believes that had the Canadian banks merged, they would have been able to resist the temptation of reckless lending that consumed Wall Street, and might be in a better position now to participate in an industry-wide buying frenzy.

Yet he acknowledges it's no sure thing, and said that the current health of the banking sector probably nullifies any appetite for industry mergers.

“If we had been allowed to merge, we might have thought that we were big characters and played more aggressively,” he said. “But I think it's more likely we would have played by the same lending standards we have now.”

RBC, TD, and BMO have each established a presence in the U.S. market, albeit not in the transformative way they may have imagined when they lobbied for mergers. And CIBC's painful experience in investment banking there in the late 1990s proved that a bank can find trouble through foreign expansion regardless of whether they first tie the knot with a domestic partner.

Yet while the impact of merger policy is debatable, the issue of culture isn't: indeed, it is one of the main reasons why the Canadian industry has remained stable in the face of a global banking mess.

Canadian banks have historically been more cautious lenders than their U.S. peers, preferring to hang on to most loans they underwrite rather than package them off in complex securities to third parties.

The numbers bear this out: As of the end of last year, only 23 per cent of mortgage loans in Canada had been securitized, with the remainder sitting on the balance sheets of federally regulated institutions. In the U.S. market, by contrast, 51 per cent of mortgage debt had been moved off balance sheets through securitization, much of it Byzantine.

Ian de Verteuil, a BMO Nesbitt Burns analyst who compiled the numbers in a recent research report, noted that there are several problems with such a heavy reliance on securitizations. Underwriting standards become less stringent (if you're not keeping a loan on your books, there's less reason to be picky); the complexity of the securities backed by these mortgages require more reliance on rating agencies, which have shown themselves to be sorely lacking; and the fact that many of these securities are held by unregulated entities like hedge funds makes central bank interventions less effective.

“We believe the fundamental difference between the Canadian and the U.S. banking systems is that Canada still effectively runs an on-balance-sheet banking system, while the U.S. does not,” Mr. de Verteuil wrote in his report.

This is not to say there haven't been problems: several of the banks have had exposure to subprime mortgages and faltering bond insurers.

CIBC, the worst hit, suffered almost $7-billion in writedowns.

Even so, the capital position of these banks remains very strong, and investors noticed have this. Although the index of Canadian banks has fallen about 10 per cent this year, that is far less than the U.S. industry (25 per cent), Europe (38 per cent) or Asia (37 per cent). And this relative strength has catapulted RBC to the number four ranking among North America's big banks – a big leap, considering its planned merger with BMO in 1998 would have made the combined company a distant 10th.

Instead of being devoured, the Canadian banks might do some devouring of their own. Chief executives of the Big Five are being pitched daily on potential acquisitions in the U.S. sector, and most believe they will find some bargains to fuel their expansion.

Financial Post, Karen Mazurkewich and Eoin Callan, 7 October 2008

In a desperate bid to help U.S. banks recapitalize, Washington is dropping its inhibitions and reaching out to Canadian financial institutions to gauge their willingness to participate in rescue operations.

The Federal Reserve has activated a back channel that puts the central bank in direct contact with chief executives at Canada's largest banks and insurers, according to a person familiar with the dialogue.

They are approaching "banks with major assets in the U.S. like [Toronto-Dominion Bank] and Royal [Bank of Canada], because when they have a bailout situation they want everyone who is a potential buyer to look at it," the source said.

The ongoing conversations between the U.S. central bank and Canadian executives reflects the challenge facing Washington as it seeks to address both short-term liquidity and permanent capital needs of financial institutions crippled by more than $500-billion in losses and limited access to financing.

The communications have included phone calls from Fed officials pitching potential sales of assets of U.S. financial companies and at least one intensive discussion of a major rescue operation, according to people familiar with the contacts.

The Fed has been steadily widening the circle of foreign institutions it is working with as the banking crisis has deepened, according to a former Fed official now on Wall Street.

The outreach to Canadian companies signals a more permissive environment in which U.S. authorities would look very favourably on an intervention by a Toronto-based institution.

It comes as Washington deploys greater reserves than initially anticipated to restore liquidity, while still facing an uphill battle to help banks recapitalize at a point in the crisis when projected losses of up to $1-trillion still ahead for the global banking system.

The engagement of Canadian institutions follows U.S. federal assent for the acquisition of assets in bankrupt Lehman Brothers by the U.K.'s Barclays, in a deal that followed intensive discussions with the Federal Reserve and U.S. Treasury.

That deal was smoothed by good relations between the London and Washington and a lower level of resistance to a deal with the U.K. on Capitol Hill, where political disquiet over foreign interventions has helped keep some buyers at bay.

"Canada is not China," said a former Fed official.

A lobbyist for a Canadian bank said the political climate in Washington had changed markedly since the passage of a $700-billion bailout and that this country is now seen as a potential source of support.

Executives and advisors in the Canadian financial services industry indicated they still saw live opportunities for their sector to help drive consolidation and recapitalization in the U.S., despite limited flexibility at a time when sinking markets were lowering all boats.

"I don't think Canadian banks want to take a lot of balance sheet risk but I don't think they are going to have to," the source said, adding that while the target banks have many subprime mortgages, the Federal Reserve will backstop these high-risk liabilities.

"We could end up in a funny situation two years from now saying this was a once in a generational opportunity for Canadian banks."

U.S. regional banks remain in deep distress and an acquisition of this scale is seen as possible in the coming months, as Canadian banks cautiously explore possible buys and after TD Bank Financial Group put its name forward during an auction of Washington Mutual.

A broad sell-off in the U.S. insurance sector has also cut into the valuations and capital positions of U.S. insurers seen as possible matches for Sun Life and Manulife, the Canadian life insurers.

Sun is actively weighing the likelihood of an intervention in the U.S., according to one person in the industry.

A foreign bank executive who participated in a recent round of rescue talks with the Fed said U.S. authorities were also keeping national regulators informed of high-stakes negotiations.

It was not clear how deeply involved Canadian authorities were in the discussions.

The Bank of Canada declined to comment.