Investment Banking Downturn in 2006?

The Financial Times, Lex, 28 December 2005

At the world's investment banks, 2005 will be celebrated as a vintage year. Merger and acquisitions volumes and equity markets have revived while the fixed income boom has continued beyond all expectations. Many markets experienced ideal trading conditions, with big, well-flagged movements - for example, in US interest rates.

In the traditionally slow third quarter, Goldman Sachs, Lehman Brothers, Merrill Lynch and UBS all announced their best ever revenues and profits - beating records set during the internet bubble. For the US houses, the bonanza continued in the fourth quarter with another set of excellent figures.

Globally, investment banking revenues will have risen 13 per cent to $205bn this year, estimates Morgan Stanley. While employees will be hoping for fat bonus cheques, shareholders have also done well. With the exception of Morgan Stanley, Citigroup and JP Morgan, the listed investment banks have handsomely outperformed the markets. Greenhill, the US boutique, saw its shares nearly double, while Lehman, Australia's Macquarie and Nomura of Japan are up by almost 50 per cent.

From such an elevated peak, the only way is down. The critical question for investors is how rapidly profits will descend in 2006. There are several factors arguing for a gentle decline. First, equity markets will start the new year at higher levels, boosting broking commissions and fund management fees. Second, the M&A cycle is only just past the trough. In Europe, 2005 was the first year in what tends to be a six or seven-year recovery in merger volumes; in the US, it was the second year. While M&A fees account for only about 7 per cent of industry revenues, takeovers feed through to other parts of the business since they require financing and hedging, boost stock trading volumes and create new private banking clients. This will give the banks a tailwind in 2006.

More fundamentally, investment banking is becoming a better, more stable business. Innovation, from equity derivatives - a speciality of two French retail banks, Société Générale and BNP Paribas - to leveraged finance and commodities is one explanation. UBS says half of its fixed-income trading revenues come from products invented in the last five years. This is a statistic of which a drug company would be proud. A broader customer base also helps. The rise of hedge funds has created a new class of clients, and the prime brokerage business that serves them now generates around $5bn in revenues and grew nearly 30 per cent in 2005.

Some investment banks, notably UBS, Credit Suisse and Merrill Lynch, also own large, generally undervalued wealth management operations that balance their business mix. These are not only growing rapidly, but are also highly cash generative and produce excellent returns since they require little capital. Yet brands and a global presence provide high barriers to entry. Finally, a case can be made that the banks have improved risk management since the last downturn. However, none of these positive developments will be able to offset a deterioration in the near-perfect trading conditions of the past year. This applies particularly to the fixed income business, which now accounts for half of industry revenues at more than $100bn a year. A flattening yield curve, declining volatility levels and narrowing credit spreads all suggest tougher times ahead. The first quarter, usually the strongest for trading income, will be a key test.

Meanwhile, the pure investment banks are experiencing greater competition from big commercial banks expanding their wholesale divisions, whether that is Barclays and Royal Bank of Scotland in Europe or Bank of America in the US. In Europe, this is leading to deteriorating loan spreads and looser lending standards. Spreads on syndicated loans for investment grade borrowers are at seven-year lows, according to CSFB. The average debt ratio for leveraged buyouts has risen to 5.5 times earnings before interest, tax, depreciation and amortisation, from 4.6 times in 2004.

Not only does this increase the risk of bad debts in a downturn, it also shows that investment banks are more often having to use their balance sheets to win or retain business. This rising capital intensity explains why this year's record profits have not gone hand-in-hand with record returns. Merrill's peak profits, for example, translated into only a 16 per cent return on equity for the first nine months of 2005. This has sparked a debate, primarily in the US, about what to do with the surplus capital the investment banks are generating. Given that all of them are currently producing returns well above their cost of capital, investors should be delighted that they are redeploying most of this into expanding their businesses. If market conditions turn down, however, managements that have until now jealously guarded their cash must be willing to start handing it back. An early sign that some companies are coming around to this point of view was the decision in September by Goldman Sachs to repurchase an additional $6bn or so of stock - the first buy-back intended to do more than merely offset the dilution of share option programmes.

The coming year, therefore, is likely to prove more difficult, with a decline in fixed income revenues - of, say, 15 per cent - outweighing further growth in equity trading and the primary businesses of merger advice and underwriting. Providing the downturn is fairly gentle, most banks should continue to be nicely profitable. A more challenging environment will, however, test not only their risk control but also their discipline on costs and management's willingness to put shareholders before employees. If they rise to the task, there will be something to cheer in 2006 as well.

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US Financials Took the Lead Late in 2005

Barron's, Getting Technical, Michael Kahn, 27 December 2005

each yeat, at this time, pundits take a look back to see just how right they were (they are never wrong, of course) in their predictions for the year.

For the financial media especially, it is a way to find meaning in what is normally a low-volume, low-interest time of year as traders and investors leave for the holidays.

Of course, Getting Technical is more interested in what the market is "predicting" than what analysts are crowing about, but as history is our guide so, too, must we take a quick stroll down memory lane here.

At the beginning of 2005, it looked as if the traditional leaders in the late stages of bull markets were gathering their forces (see Getting Technical, "Late-Stage Leaders May Set Pace in 2005," January 3). Such sectors as basic materials, health care and biotechnology were starting to outperform the market.

As the year unfolded, however, it became painfully clear that these late-stage leaders had passed the mantle of market leadership to energy and homebuilding stocks.

Only biotech -- arguably a subset of health care because of its heavy representation by pharmaceutical-related stocks -- was able to deliver on its promise of a healthy 2005, albeit after a rocky start in the first quarter (see Chart 1).

CHART 1

So much for punditry. Clearly, the bull market was not finished, despite not one but two major swoons that ended in April and October. Sector-rotation buffs were left with the bill for what originally appeared to be a real shift in tone.

Instead, for the fourth straight year, commodities prices rallied, sending the Commodities Research Bureau index to multi-decade highs (see Chart 2).

It wasn't difficult to translate the continued rally into the expectation that commodities-related stocks, which included gold and oil, would outperform -- and those stocks obliged, at least for most of the year.

CHART 2

On Main Street, the rising prices of heating oil and unleaded gasoline were no secret. Many are quick to blame Hurricane Katrina -- and, to a lesser extent, Rita -- for the spike in prices, but the chart of gasoline prices tells a different story (see Chart 3).

There has been a bull market in place here since late 2001. The hurricane-induced spike this year was really nothing more than an exaggerated cycle within an established trend.

CHART 3

The question is, will the trend itself continue now that the industry is rebuilding? We're not going to speculate on that now, but the point is that commodities soared this year, giving a relative boost to commodities-related stocks.

That is supposed to happen at the end of equities bull markets, not in the middle. Again, so much for what is supposed to happen! Had the theoretical become reality, then the bears should have wrested control of this market long ago.

So, here we are in December trying to learn from the past and get ready for the future. Energy, homebuilding, utilities, even gold stocks powered the market at various times in 2005, but their heydays appear to be over. October was more or less leaderless until the financial sector rose from the ashes to take the entire market higher.

That is where we are today. Technology enjoyed a brief resurgence in the fourth quarter, but that has ended. Utilities, cyclicals and staples are all underperforming, and even energy is losing ground to other areas.

What areas are in the lead as the year comes to a close? It's still the financials, with health care a distant second. In fact, the exchange-traded fund (ETF) tracking the financial sector broke out in November to multi-year highs. It is currently in a short-term triangle that is of the proper size and position to suggest a bullish continuation pattern (see Chart 4).

CHART 4

Early in the new year, Getting Technical will cover the prospects for the financials, drill down to specific industries within and then see if any other sectors are poised to join or even overtake the financials as the leader in 2006.

Until then, investors appear to have at least one area in which they can mine for opportunities. It didn't hurt that interest rates took a tumble last week, which investors believe helps this sector as well.

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Cdn Banks Post Solid Profits in 2005 Despite Enron Charges

Canadian Press, Rita Trichur, 24 December 2005

Toronto (CP) - The Canadian banking industry got sideswiped by the Enron scandal in 2005 after three of the country's six-biggest banks took billions of dollars in charges for their liabilities in related lawsuits.

Nevertheless, the industry affirmed its resiliency by mustering record profits as vigorous mortgage and consumer lending, along with roaring wealth-management sales, left the Big Six with brimming coffers.

"So, even when you get a bid torpedo like Enron, yes, you take on water, but you can repair it, patch it up, pump it out and keep steaming ahead at a reduced speed, said Gavin Graham, director of investments at the Guardian Group of Funds.

CIBC took the biggest bruising over Enron Corp., the U.S. energy trader that went bankrupt in 2001 amid a massive accounting-fraud scandal.

Earlier this month, the Toronto-based bank booked a rare full-year loss of $32-million as it slashed its executive ranks by 15 per cent and eliminated 900 other jobs.

That followed a whopping third-quarter loss of $1.91 billion - the biggest in its 138-year history - as its costly cleanup of Enron-related lawsuits resulted in a $2.53-billion after-tax charge.

Settlements on two Enron-related matters were completed in August, but CIBC remains a defendant in a number of remaining actions.

"CIBC lost money because of that writeoff but it will make that money back in the next 18 months," Graham said. "If you take out CIBC's Enron hit, they actually had a pretty decent year."

Rivals Royal Bank and TD also absorbed charges related to their respective Enron-related litigation but their exposure was considered minor compared with that of CIBC.

Both are defendants in a securities class-action lawsuit in U.S. federal court. The suit, which is pending in Texas, was filed by Enron's shareholders.

For its part, Royal Bank has set aside $591 million in reserves for Enron litigation but that did not prevent its annual profit from soaring 21 per cent year-over-year to a record $3.4 billion.

That upturn also came as the Royal booked hefty one-time costs for insurance claims arising from hurricanes Katrina, Rita and Wilma during its fourth quarter.

In a further testament to its financial strength, Canada's largest bank remains bullish about fiscal 2006 and has set aggressive goals, including 20 per cent plus growth in earnings per share and a six to eight per cent spike in revenues.

TD, meanwhile, has set aside $500 million to deal with any Enron fallout. Nevertheless, with litigation still pending, some observers have said it's impossible to estimate the scandal's final toll on Canadian banks.

"You go to court in Texas and anything can happen," commented John Kinsey, a portfolio manager with Caldwell Securities.

Enron woes aside, the banks continued to churn out robust gains in 2005, largely credited to the strength of mortgage lending and wealth-management sales.

"(It was) a pretty decent year after people started off being very worried about the squeeze on their margins because of a flattening yield curve," Graham said.

"The difference between the amount they very ungenerously pay you and me and what they charge us has been narrowing."

That shrinking difference between long and short interest rates squeezes the banks' profit margins and hampers earnings growth. The impact, however, was not as bad as previously feared because interest rates did not rise dramatically in Canada in 2005.

"Over half the banks' earnings these days comes from non-interest deposits," said Graham.

In particular, he added, it was a strong year for things like mutual fund sales, as some 70 per cent of all net new sales was into the country's biggest five banks - a roster that includes the Royal, Scotiabank, Bank of Montreal, TD and CIBC.

National Bank of Canada, the country's sixth-biggest bank, made its own headlines in 2005, reporting its best year yet, with an 18 per cent rise in profit to $855 million thanks to solid business growth and all-time low provisions for credit losses.

Primarily a Quebec-based bank, National expects continued favourable results in 2006 despite a "cautious" economic outlook.

Going forward, analysts expect rising interest rates to have a slightly negative impact on the banks' mortgage lending as the housing market cools. Meanwhile, loan loss provisions, which reflect the amount of anticipated bad loans, are expected to increase for most banks.

"The increase is more a reflection of the low level of losses and not a severe deterioration in credit quality," remarked Darko Mihelic, an analyst with Blackmont Capital in a recent note to clients.

Otherwise, observers predict TD will push ahead with Banknorth, as BMO scours for more tuck-in acquisitions for its U.S. Harris Bank and Scotiabank boosts its presence in Central America.

Earlier this month, Scotiabank announced a $390-million deal giving it 80 per cent ownership of Peru's third-largest bank. However, with plenty of capital still on hand there is also speculation that Scotiabank could be eyeing Canadian Western Bank to boost its domestic presence, as the Alberta-based bank is likely small enough to be excluded from the federal government's ban on big-bank mergers.

Big-bank mergers have essentially been prohibited in Canada since 1998, when Ottawa quashed two proposed deals. In September, Finance Minister Ralph Goodale said a lack of political consensus prompted Ottawa to once again delay its final rules governing the controversial deals.

Analysts have surmised that if mergers were allowed, the most likely pairing would be between Scotiabank and CIBC. But with country in the throes of its second federal election in as many years, observers say the issue is likely to be stalled indefinitely.

"All of them have managed to do very nicely, thank you, without any mergers," Graham said.

"The banks have moved on."

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RBC Expects US Bank and Thrift M&A Activity to Accelerate in 2006

SNL Financial LC, 22 December 2005

RBC Capital Markets' commercial banking research team delivered its forecast for M&A activity in 2006, saying that they expect activity to pick up after a slow 2005 because of the "completion of the 'digestion phase' of the acquisition cycle for selected acquirers," a coming slowdown in earnings growth and regulatory burdens starting to ease.

RBC noted that based on M&A activity through mid-December, they expect the number of banks acquired this year to fall 9.7% year over year and the total assets of sellers to drop significantly to an estimated $137 billion. That would represent a 78% decrease, the analysts said, demonstrating that the majority of sellers in 2005 were small banks.

The tide could be turning, the analysts said, as regulatory burdens such as the heightened enforcement of the Bank Secrecy Act, the Patriot Act and other regulation ease and enable more M&A activity. More M&A activity could also come from CEOs having less "fun" in their jobs, RBC said. The analysts noted that banks are sold and not bought, and as earnings growth slows and in some cases earnings decline, CEOs may have less fun in their jobs than in the recent past.

"Therefore, increased merger and acquisition activity could result from this unhappiness," the research team said in a report.

Additionally, RBC noted that sellers are still fetching attractive prices and that minimal stock-price penalization for dilutive deals exists, thereby further supporting increased M&A activity.

"The minimal penalty for announcing and completing a dilutive deal suggests to us that acquirers will continue to price deals at high prices. As a result, as potential sellers realize that managing a bank is not as much 'fun' as it used to be, selected banks may look to capitalize on the expected strong pricing levels in 2006," the research team said in the report.

RBC said that Astoria Financial Corp. ($22.6 billion), BankUnited Financial Corp. ($10.7 billion), CoBiz Inc. ($1.9 billion), Franklin Bank Corp. ($4.5 billion), Interchange Financial Services Corp. ($1.6 billion), Greater Bay Bancorp ($7.1 billion) and Valley National Bancorp ($12.5 billion) should be considered possible takeover targets over the next 12 to 24 months.

Among the firm's large-cap universe, RBC said that KeyCorp ($92.3 billion), U.S. Bancorp ($206.9 billion) and PNC Financial Services Group Inc. ($93.2 billion) could be considered as merger-of-equals partners or involved in no- or low-premium deals.

RBC said last May that Astoria, BankUnited, CoBiz, Franklin, Greater Bay, KeyCorp and PNC all could be possible sellers. At that time, the firm also named a handful of potential targets that did actually sell, including Gold Banc Corp. Inc., which inked an agreement to sell to Marshall & Ilsley Corp., Hudson United Bancorp, which sold to TD Banknorth Inc., and Independence Community Bank Corp., which handed over its reins to Sovereign Bancorp Inc.

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Takeover Potential Raises Value of Small US Financial Institutions

The Wall Street Journal, Ian McDonald, 22 December 2005

The stocks of little banks have big price tags -- and vice versa. For the scads of investors holding shares of small community banks hoping they will be acquired by a bigger player, that could be a problem.

When smaller banks trade at prices that are higher multiples of their per-share earnings than their bigger brethren, as they have for about two years, that is often a sign that investors are betting on takeover activity. But there is a catch: Today's lower valuations for shares of big banks -- despite fatter dividends than smaller banks -- could keep them from going on a buying spree. Purchasing higher-priced smaller fries would dilute the acquirer's per-share profits.

Shares of the nation's five biggest banks ranked by assets -- including titans like Citigroup and Bank of America -- trade at about 11 times their expected per-share earnings for 2006, according to Thomson Financial.

For their part, community banks with local branches sprinkled across a given region are trading at multiples of their earnings that are more than 30% higher, just a hair below the average earnings multiple for the broader stock market. Shares of small community banks like Century Bancorp in Massachusetts and Capital City Bank Group in Florida, for instance, trade at more than 19 times their projected per-share profits for next year.

The persistence of this valuation gap between big and small banks has many professional investors baffled. Indeed, many pros are now buying shares of big banks while eschewing the pricier shares of smaller players.

"I think the width of the valuation gap today is a bit of an anomaly, and it's preventing many deals from taking place," says James Schmidt, manager of the $2.1 billion-in-assets John Hancock Regional Bank Fund. "I'd say the bigger banks are undervalued. We have a lot of small banks in the fund that trade at 18 to 19 times their earnings, while names we normally wouldn't look at like Wachovia and Bank of America are looking attractive."

In addition to having lower valuations, bigger banks are also paying higher dividend yields than smaller players. A stock's dividend yield is the company's per-share dividend payout over the past 12 months divided by the stock's current market price.

The nation's five biggest banks all yield more than 3.2%. The average community bank yields a little over 2%, and the average stock in the Standard & Poor's 500-stock index yields 1.8%.

So-called superregional banks like Wachovia, Wells Fargo and BB&T also average yields of more than 3%.

"These banks won't do acquisitions that are dilutive," says Michael Holton, manager of the $374.3 million T. Rowe Price Financial Services Fund. "So you look at smaller banks trading at premium prices, and you think hardly any of them will be taken out at their current prices."

Others may have the same idea. The KBW Bank Stock Index is up more than 12% from its lows in October, with shares of many big banks leading the way.

So why the lower valuations for big banks? Investors may be worrying about the flatter "yield curve" -- another way of saying short-term and long-term rates are at similar levels -- because it cuts into these banks' profit margins. Banks typically make money by paying low short-term rates on deposits, lending that money at higher rates and pocketing the difference -- measured by a metric called "net interest margin." So, a flattening yield curve boosts the amount a bank has to pay depositors while lowering the amount it can earn on their loans.

Bank profits could also be hurt if overburdened consumers start defaulting on their loans or if the overall economy slows, which would hurt loan growth.

Yet professionals wonder if smaller investors have failed to note that smaller banks would face many, if not all, of these same problems. Also, recent earnings indicate that the yield curve isn't hurting profits at the big banks as much as some might have feared.

"What we saw in banks' third-quarter earnings reports was stabilized net-interest margins," says Jim Callahan, an analyst who covers regional and superregional banks at Chicago researcher Morningstar Inc.

To be sure, small banks sometimes get a premium valuation because a string of smart, small deals can increase a small bank's profits by leaps and bounds but wouldn't move the needle much for a behemoth bank. Also, some analysts and investors have theorized that small-bank valuations have stayed high because smaller players may merge to trim out costs and boost profitability.

But, as interest rates rise, small banks may be at a disadvantage in coming quarters since community banks typically lack the fee-based asset-management, investment-banking and capital-markets revenues of many big players. At most titans, more than 40% of revenues come from units with profits that aren't tied to the yield curve, Morningstar's Mr. Callahan notes.

The yield gap between big and small banks strengthens the case for owning the Goliaths. With many of the more-dour market shamans predicting mid-to-high single-digit annual returns from stocks in coming years, Bank of America's 4.3% yield would seem striking.

The higher valuations and lower yields found among many smaller banks imply that many investors may have wrongly been taking acquisition plans to the bank.

"I firmly expect the multiple premium for small banks to shrink over the next year," T. Rowe Price's Mr. Holton says.

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A Fresh Start at AIG

Barron's, Jonathan R. Laing, 19 December 2005

It has been a tumultuous year for insurance giant American International Group and its shareholders. But better times are coming for both of them.

For one thing, AIG's franchise, at home and abroad, seems as sound as ever. For another, its new leaders have been cooperating with ongoing investigations into abuses in the insurance industry, something that could convince regulators to be reasonable in reaching a settlement with the company for its own transgressions.

AIG's annus horribilis began in February, when it was subpoenaed by New York Attorney General Eliot Spitzer and the SEC, regarding its accounting for what turned out to be a sham 2000 reinsurance deal with Warren Buffett's General Re. Within months, AIG had admitted to a host of other accounting shenanigans that had artificially inflated its income and shareholders' equity by billions of dollars from 2000 through 2004.

By March, AIG's 80-year-old CEO, Maurice "Hank" Greenberg, had been ousted, along with his CFO, Howard Smith, and several other senior executives because of their apparent roles in the accounting problems. The split between AIG and Greenberg, an industry icon after nearly four decades at the insurer's helm, was nasty; the press had a field day covering the mudslinging. But the company has distanced itself from its former chief, whose woes seem to be mounting. Last week, Spitzer released a report contending that, 35 years ago, Greenberg had violated the will of AIG's founder, Cornelius Vander Starr, defrauded a foundation Vander Starr started and eventually wrested control of AIG via gains generated by the alleged fraud.

In April, AIG's stock fell some 30% below the 73.46 it had fetched in February. Since then, fear that AIG might be the next Enron or WorldCom has abated. The stock has recovered nicely, recently changing hands around 66. In fact, it still looks inexpensive and could very well be materially higher within 12 months.

John Hall, an insurance analyst for Wachovia Securities, argues that AIG could easily hit about 78 next year -- two times the $39 book value he expects the company to boast by the end of 2006. "This multiple is hardly a heroic assumption with the S&P 500 currently selling at three times its book value," says Hall. He arrives at that book value by adding his estimated 2006 earnings of $5.70 a share to his estimate of year-end 2005 book of $34.40, minus about 75 cents a share to reflect expected dividend payments and a conservative estimate of how much AIG will pay to settle the accounting scandal.

Even UBS analyst Andrew Kligerman, a onetime AIG bull who now has a Neutral rating on the stock and grumbles that the scandal left him feeling like he had been "kicked in the teeth," concedes that many portfolio managers think the big insurer deserves a multiple higher than the S&P 500's, because of its likely ability to deliver 15%-plus returns on equity and 10%-to-12% compounded annual earnings growth. Even using his conservative 2006 earnings estimate of $5.19 a share and assigning AIG a current S&P P/E ratio of 18 would yield a stock price above 93 next year.

Why is AIG's outlook strong? For one thing, the accounting restatements and adjustments made this year for 2000 through 2004, though stinging, weren't devastating. The first restatement's reduction in income for the five-year period -- $3.9 billion -- constituted only 10% of AIG's income for that period. The total hit to 2004 net worth or book value was $2.26 billion -- less than 5% of the $82.77 billion in shareholder's equity reported before the restatement. A second -- and, maintains AIG's new CEO, Martin Sullivan, last -- restatement last month had no meaningful impact on year-end 2004 shareholders' equity. It cut net by just $133 million for 2004 and by $84 million for this year's first nine months.

Likewise AIG's earnings appear to be back on its customary steep growth trajectory. In the nine months ended Sept. 30, the company reported a 21% jump in net income before capital gains or losses, to $10 billion, or $3.82 a share, versus $8.3 billion, or $3.14, a year earlier. The comparison was helped by the downward restatements and adjustments taken in 2004 that slashed full-year results by $1.32 billion, or 12%, to $9.73 billion. Also this year's nine-month results got a boost of $1.6 billion, compared with $617 million a year earlier, from derivative hedges that didn't qualify for hedge accounting.

The nine-month results for 2005 also had included the largest after-tax catastrophe losses ever suffered by AIG -- $1.6 billion from hurricanes and other storms. "In a year of record losses for our industry, our company's geographic and product diversity really were on display for all to see," Sullivan recently gushed to Barron's.

Much of the pessimism hanging over AIG revolves around the conviction that it will be slammed when it finally settles with Spitzer, the New York Insurance Department and the SEC. Estimates of AIG's eventual settlement costs, including class-action suits, run well above $1 billion. This number is partly based on the $850 million that insurance brokerage Marsh McLennan (MMC) paid out this year to settle charges that it had engaged in bid-rigging to collect kickbacks through "contingent commissions" from major insurers like AIG in return for sending them business from Marsh clients.

AIG under Greenberg frequently incurred regulators' wrath for its belligerence and grudging cooperation with outside inquiries. In 2003, the SEC excoriated AIG for allegedly withholding material information. The agency fined AIG $10 million for helping Brightpoint, an Indiana cellphone distributor, delay taking an $11.8 million loss via a sham insurance transaction that spread the deficit over future periods.

In the fall of 2004, the SEC and the Justice Department chastised AIG for allegedly making inadequate disclosure of a criminal investigation into the Brightpoint imbroglio and another case involving PNC Financial Services (PNC). AIG was accused of helping the Pittsburgh banking concern remove bad loans and venture-capital investments from its balance sheet. In the end, the insurer paid $126 million to settle both cases.

If, under Greenberg, AIG resembled the Kremlin, glastnost now reigns under Sullivan, the warm, black-slapping Brit who began working for the insurer in London as a 17-year-old telex clerk 34 years ago. Upon succeeding Greenberg in mid-March, he launched a full-bore investigation into the accounting and governance practices across AIG's 130-country empire, in addition to working closely with Spitzer's office on its original inquiry into AIG's reinsurance deals with Gen Re. Some 36 multi-discipline teams fanned out through the company, "turning over every stone in an effort to make AIG's operations completely transparent," as Sullivan puts its. The self-investigation found plenty. Over the next few months, results were posted on AIG's Website; ultimately, a 150-page special report detailing the accounting lapses went to regulators.

There was the off-shore reinsurance company Union Excess, secretly controlled by AIG, which used it to offload $1.2 billion in insurance claims from AIG's balance sheet, fraudulently pumping up reported earnings. A disastrous auto-warranty insurance program started by Greenberg's son, Evan, that generated $295 million in premiums and $777 million in claims was transmogrified from an underwriting loss into a capital loss (Wall Street pays scant attention to such losses, compared with underwriting deficits).

Gains in various AIG hedge funds and municipal-bond investments were transmuted into investment income via fancy option strategies that let the company harvest and alter capital gains while risklessly reinstating their investment positions in the funds. Why? Because Wall Street analysts value insurers' investment income more highly than capital gains.

But those were the bad old days. Now, AIG seems to be scoring points with regulators by being more open. And this may win it a more reasonable settlement. A person close to Spitzer acknowledges that nearly all the claims made in the office's May civil complaint against the company, Greenberg and Howard Smith came from data uncovered by AIG itself, save for the original Gen Re allegations. (In that case, Gen Re apparently ratted on AIG in order to reduce the heat it was taking itself.) "One can't say enough about AIG's cooperation," the Spitzer associate says.

Regulators may also go easy on AIG because its financial games, while clearly hurting shareholders, didn't victimize policyholders and other customers. In contrast, Marsh McLennan's price-fixing injured its clients, who had relied on the broker to find them the best coverage at the best price.

True, the company might never again be the growth machine it was under Greenberg, when it seemed to be capable of consistently delivering earnings gains of 15% a year. In fact, Greenberg himself couldn't hit that target in his later years, which may have encouraged the accounting abuses.

Still, after the various restatements and adjustments, AIG earnings did grow at a not-too-shabby compound annual 12.2% clip from 2000 through 2004. And that indicates how much AIG has going for it, particularly under its new, seasoned and well-regarded management team. It has pledged to tighten AIG's operating controls and to inject new discipline into the company's acquisition policies and capital deployment strategies. The forensic accounting exertions earlier this year uncovered AIG operations with substandard returns on investment.

And AIG has a myriad of growth engines. Its foreign life and retirement services unit, which chips in about 30% of operating earnings, should continue its lusty growth, particularly as the immense Asian market, in which the company is the top foreign player, expands. Growing affluence abroad figures to make AIG's higher-margin annuity products increasingly popular.

AIG's U.S. life and retirement services business likewise figures to enjoy a growth spurt, as aging baby boomers begin to live off of, rather than accumulate, wealth. With relatively few of them having traditional pensions, annuities will likely be a fast-growing part of their retirement plan because of the security of guaranteed payments for life these products afford.

Meanwhile, disasters like the recent spate of hurricanes, which damaged billions of dollars worth of homes, commercial structures and energy facilities, ironically help property and casualty insurers in the long run, by allowing them to boost premium rates more easily. This is precisely what is happening in the U.S. property and onshore and offshore energy sectors. The recent catastrophes have also helped insurers impose more stringent terms and conditions on commercial policies.

As always, AIG is less vulnerable to any rate-cutting within the insurance industry because it derives much of its operating income from less competitive markets overseas and in specialized exotic niches in the U.S., such as kidnap insurance.

The future also seems bright for AIG's airliner-leasing unit, ILFC, and its capital-markets operation, despite the higher financing costs both face because of AIG's credit downgrade to double-A. The worldwide aircraft market is starting a dramatic upcycle. And the booming growth in global derivatives and commodities trading will benefit the capital-markets group.

So, more than likely, the American International Group's soap opera of the past 11 months will have a happy ending for shareholders, if not for Greenberg.

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Expelling the Ghost of AIG Past

The New York Times, Jenny Anderson, 18 December 2005

Less than two weeks after Hurricane Katrina ravaged New Orleans, Scott Tramel, an insurance executive, was sitting in a makeshift office - a former filing room in a sales office - in Baton Rouge when he saw a shock of white hair cross the hallway. He turned to his colleague, a fellow underwriter at the American Home Insurance Company, a subsidiary of the American International Group, with a look of surprise. "I think that's Martin Sullivan," he said, referring to AIG's chief executive.

Less than a week after the storm, Mr. Sullivan, along with his wife, Antoinette, and a small group of employees, loaded the company's Bombardier Global Express, a high-speed business jet, with $5,600 in consumer goods, $1,000 worth of polo shirts and $1,300 in battery-operated electronics, which he delivered, unannounced, to offices in the region struck by the hurricane. "They weren't just worried about us being on the job; they were honestly concerned about our well-being as people," Mr. Tramel said.

Katrina is not the only storm that Mr. Sullivan has had to weather this year. After 34 years at AIG, the world's largest insurance company, he took over the top job in March amid a decidedly man-made disaster. Regulators had discovered accounting problems at AIG, and the board swiftly ousted the chairman and chief executive, Maurice R. Greenberg, who over the course of 38 years had built the insurer into a behemoth with a market capitalization of $170 billion.

Last week, regulators lashed out at Mr. Greenberg again, issuing a report accusing him and others of having cheated a foundation he runs 35 years ago. No charges have been brought, and Mr. Greenberg, who is known as Hank, denies any wrongdoing.

When Mr. Sullivan, 51, took the reins of AIG - whose 2004 revenue, $98 billion, exceeded the current gross domestic product of Venezuela - the company's lawyers and regulators were running it temporarily; its former boss and mentor was in exile (with acrimony between Mr. Greenberg and AIG growing by the day); and investors were wondering whether they might have the next Enron on their hands.

Nine months later, it is clear that AIG is no Enron. It has survived the restatement of five years' earnings and has reported three quarters of solid profit, and its army of lawyers is close to hammering out the final details of a civil settlement with federal and state regulators over allegations that ranged from bid-rigging to improper reinsurance arrangements.

Like some other chief executives catapulted into power amid crisis - Richard D. Parsons at Time Warner comes to mind - Mr. Sullivan has steadied the ship. He has done this through the force of his personality - he can be charming and ingratiating - and by the simple fact that he is not the manager accused of creating the problems. But with the skies clearing, investors are left wondering whether the nice, new chief executive will be able to match the performance of the company's former patriarch, architect and bully-in-chief.

"The big question they have is: What kind of growth rate can they achieve?" said David Schiff, the editor of Schiff's Insurance Observer, an industry newsletter. "In the old days, investors believed they'd have 15 percent growth year after year. If you are going to grow at 15 percent forever, that growth can make up for anything."

Andrew S. Kligerman, an analyst at UBS, added: "Hank Greenberg is a genius, he knows AIG like the palm of his hand and he can speak to any detail of his company without the assistance of any executive. Martin's certainly a capable executive, but whether he can master the intricacies of AIG is another question."

Those kinds of comments, which are common, suggest that AIG is Mr. Greenberg. Mr. Sullivan declined to discuss Mr. Greenberg, but he did make clear that he planned to keep AIG's entrepreneurial spirit and thought that the company could continue to grow at double-digit rates. "The single biggest question I get is, 'Will the culture change?' And candidly my answer is no," he said in his holiday-adorned 18th-floor office in Lower Manhattan. "The culture is the entrepreneurial culture, and my view is, it's in the organization."

As for whether he is tough enough, Mr. Sullivan said, "I would not be able to be in this position without tough choices." After all, Mr. Greenberg was ready to name him heir apparent.

Mr. Sullivan exudes a kind of ruddy optimism that, when combined with his broad smile and stocky stance, has a certain Santa Claus-like cheer to it. In conversation he laughs easily and does not shy away from jokes: he recently asked an analyst who was host for a lunch conference at the Pierre Hotel in Manhattan whether he could get some gin in his water glass. His warmth appears irrepressible and he seems to have charmed even the most irascible regulators. When he met the New York attorney general, Eliot Spitzer, who was leading the investigation into AIG, Mr. Sullivan, who is British, cheekily asked if he was part of the O'Spitzer clan.

While Mr. Greenberg also had a famous wit, it often appeared in public when he was using it against someone. He loved to deride analysts for what he felt were stupid questions, and managers for what he thought were lackluster results.

The contrast is lost on few: if Mr. Greenberg ordered, Mr. Sullivan asks. If the former chief knew more than everyone, Mr. Sullivan asks to be educated. Mr. Greenberg surrounded himself with a tight circle of senior executives, while Mr. Sullivan eats lunch with midlevel employees who are permitted to submit anonymous questions ahead of time, lest they be intimidated. And if the former chief executive and chairman took pride in how he built AIG, Mr. Sullivan loves to tell midlevel employees that if he can be chief executive, anyone can be chief executive.

"Martin's the first to find out, to listen and to get different points of view," said Frank G. Zarb, the chairman of AIG's board. "It's a great quality for a young C.E.O. He doesn't have his mind made up before he has the facts."

A native of London's gritty East End, Mr. Sullivan joined American International Underwriters as a clerk in 1971, when he was 17. It was his second job in insurance, and he earned £850 a year, or a bit more than $2,000 at the time, in his first year. He admired his boss, who he said taught him, "Always have standards; never let them slip." Within three years he had become an underwriter, and by 1983 he was running the insurance-property department for all of Britain.

AIG has diversified over the years, but underwriting - writing premiums and estimating the risk underlying them - is the heart of its business and where Mr. Sullivan made his career. He rose quickly through the European ranks, taking over AIG Europe in 1993. He was brought to New York three years later to become the chief operating officer of all foreign property and casualty operations, and in 2002, Mr. Greenberg chose him and Edmund Tse, then senior vice chairman of life insurance, to be co-chief operating officers. It was a clear horse race to succeed Mr. Greenberg.

Mr. Sullivan had to put his experience to the test last February. That month, federal and state authorities issued subpoenas to AIG over questionable accounting transactions, one of which Mr. Greenberg initiated himself, according to a lawsuit filed later by Mr. Spitzer.

It was not AIG's first round with regulators. In 2003, AIG paid $10 million to settle a civil suit brought by the Securities and Exchange Commission contending that it had helped Brightpoint, a struggling cellphone distributor, mask losses with certain insurance products. A year later AIG paid $126 million to settle all criminal and regulatory liabilities with state and federal regulators over the Brightpoint deal and similar allegations about products it sold to the PNC Financial Services Group.

Mr. Greenberg made clear that he did not welcome regulatory scrutiny. In the Brightpoint settlement, the S.E.C. cited a lack of cooperation by AIG in determining the fine, and Mr. Greenberg famously ended one earnings call by accusing regulators of turning foot faults into murder charges. "Hank's attitude was that we were interfering with his running of the business," said one regulator who was prohibited from talking on the record about continuing investigations.

While AIG had tussled with federal regulators, it was the February subpoenas that catalyzed AIG's board, which was already concerned about the handling of Brightpoint and other matters. After eight hours of contentious debate on a Sunday in March, the board decided to ask Mr. Greenberg to resign and to promote Mr. Sullivan.

Oddly enough, Mr. Sullivan had already been picked for the job. Earlier in the year, members of the board, with Mr. Greenberg's blessing, had decided that Mr. Sullivan would succeed Mr. Greenberg, though not right away, say two people briefed on the discussions. But the escalating investigation accelerated the timing of the transition and the heir apparent became king in the most unceremonious of coronations.

The conditions for Mr. Sullivan's arrival could not have been worse: the firm was virtually paralyzed by the investigations. Lawyers were running the company, his mentor of many years was in exile and Mr. Sullivan suddenly had one of the most complex financial-services companies on his hands. He knew the property and casualty business, which accounts for about one-third of AIG's revenue, but there were divisions, including capital markets and aircraft leasing, that he had to learn from scratch.

Both easing and complicating the transition was Mr. Sullivan's long tenure at the company. "I've grown up with these guys," he said of the management team around him. "We've worked together for so many years, it's not like I'm the new kid on the block." But there was also his personal relationship with Mr. Greenberg, for whom he had worked for decades. "I've put a lot of the feelings to one side," he said. "From Day 1, I have stayed focused on what's good for AIG"

One senior AIG executive said he had assumed that Mr. Sullivan was upset by what happened to Mr. Greenberg, but added that "he would feel it was poor form to show it." Others agreed that Mr. Sullivan has concealed his feelings about Mr. Greenberg's fate, focusing instead on what the senior executive said was a simple message: "We don't have the luxury of emotion. No matter how we feel we have to move forward."

He certainly had plenty to distract him in his first eight weeks on the job. Federal and state investigations widened, and investors feared that Mr. Spitzer might indict the company. It was unclear whether AIG's bizarrely consistent results were just a fiction.

As AIG's stock plummeted - it fell more than 30 percent from Feb. 10 to April 25 - Mr. Sullivan met personally with Mr. Spitzer and told him that he and AIG would cooperate, negating the need for any more subpoenas, according to someone briefed on the meeting. Mr. Spitzer put out a statement saying that he anticipated a civil resolution with AIG The stock's free fall halted.

Mr. Sullivan, meanwhile, had to move to get AIG out of the mess it had landed in. He oversaw an internal review of all of the company's businesses, which was no small challenge. AIG operates in 130 countries and has 92,000 employees. Domestic brokerage, for instance, which is just one unit of one business, has 49 companies.

The company's profile reads like a financial services yellow pages. It has four major businesses, and it is a giant in each of them. AIG is, for example, the largest underwriter of commercial and industrial insurance in the United States, as well as the top underwriter of director and officer insurance, professional liability insurance and environmental and aviation insurance, to name a handful. It is the top life insurer in Japan, the largest corporate investor in United States Treasury bonds and has the second-largest consumer finance business in the world.

The entire colossus had to be examined under a microscope. Thirty-seven internal teams were formed, reporting back to the board's outside counsel as well as to Mr. Sullivan and the company's chief financial officer, Steven J. Bensinger, who was also new to his post. They worked 15 to 18 hours a day, seven days a week, for two and a half months, Mr. Bensinger said. The message to employees was this: cooperate - or else. Many did. Some cooperated and then stopped; they were fired. Others cooperated and lost their jobs anyway.

"The sole objective of every person involved in this effort was to make the best reasoned judgments, get it right and put it behind us," said Mr. Bensinger, who, along with Mr. Sullivan, would have to sign the company's financial statement. The process took a toll. "No one involved in this process would ever want to repeat it," said Mr. Bensinger.

The internal investigation revealed widespread wrongdoing, much of which it laid on the doorstep of Mr. Greenberg and AIG's former chief financial officer, Howard I. Smith. On May 26, after the internal investigation was completed, Mr. Spitzer sued the company, along with Mr. Greenberg and Mr. Smith, accusing them of using accounting gimmickry to mask AIG's true financial condition. Both men deny any wrongdoing and say they plan to fight the charges.

Three days later, AIG restated five years' worth of earnings. Net income for 2004 was cut by $1.32 billion, or 12 percent, to $9.73 billion. Over all, the restatement reduced AIG's net income from 2000 through 2004 by $3.9 billion, or 10 percent.

The regulatory clouds have not cleared. The company is expected to settle civil charges filed by state regulators and the S.E.C. early next year, said two people briefed on the negotiations. The Justice Department continues to weigh potential criminal charges against Mr. Greenberg, and the United States Attorney's office in Manhattan is investigating whether Mr. Greenberg orchestrated an effort to manipulate the company's stock price, according to people officially briefed on the inquiry.

Mr. Greenberg has not faded into the background. He continues to control two former AIG affiliates - one that controls $25 billion worth of AIG stock and another that operates insurance brokerage agencies.

As Mr. Greenberg considers what to do in the ninth decade of his life, the company he built is thriving without him. AIG reported a profit of $1.72 billion in the third quarter, including after-tax catastrophe-related losses of $1.57 billion. "We've demonstrated a real resilience," Mr. Sullivan said.

There have been awkward moments. In October, Mr. Sullivan was in China meeting with government and business leaders when he ran into Mr. Greenberg, whose relationships in China are long and deep. "It was sad," one senior executive said, referring to the meeting of former friends halfway around the world. "It should not have come to this."

The challenges for Mr. Sullivan are formidable. He must prove that being different from Mr. Greenberg does not mean being not as good. He must deliver the double-digit growth that he has said is possible. And he would like to see more of his family. (At a recent dinner, he joked that he had not anticipated that an industry event would constitute a "date night" with his wife.)

Regardless of Mr. Greenberg's fate, the future of AIG is in the hands of a chief executive with deep loyalties and roots in the business. Mr. Schiff, the industry analyst, said that while Mr. Greenberg was certainly central to AIG, the company's future was not lost without him. "It's just one person," he said.

There is already a lot of work for the next person. Mr. Sullivan heads back to China for one last trip before Christmas. Is he concerned he might miss the holiday?

"Christmas? I haven't celebrated Easter," he laughed.

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Prudential Investing in No. 3 China Insurer

Reuters, George Chen, Sun Dec 18, 2005 11:56 PM ET

Shanghai, Dec 19 (Reuters) - U.S. buyout firm Carlyle Group, one of the biggest foreign investors in China, said on Monday it would lead a $410 million investment for a quarter of the third-largest life insurer in the fast-growing mainland market.

In a long-expected deal, Carlyle said it would buy a 25 percent in China Pacific Life Insurance with Pramerica Financial, the service brand of the U.S. Prudential in China and other major markets outside the United States.

Foreign insurers such as American International Group and Manulife Financial Corp. have piled into the market, where less than 4 percent of China's 1.3 billion people have insurance.

The companies did not provide a breakdown of which firm would contribute how much of the investment, but China Pacific's parent, China Pacific Group, has agreed to inject another $410 million into the insurance unit.

Carlyle, which agreed to buy 85 percent of China's biggest machinery company for $375 million in October, has been at the forefront of China's private equity market, which is being stalked by rivals like KKR and Warburg Pincus.

In April 2004, the company said it was aiming to invest as much as $1 billion in China over the next year and a half.

The China Pacific deal, which is expected to close within a month, took three years of negotiations and exemplifies the difficulty of completing big transactions through China's rigorous and often opaque approval process.

"We fell in love with each other at first sight but we spent three years to negotiate the price of such a marriage," said China Pacific's chairman Wang Guoliang.

Carlyle said it would hold its stake in China Pacific for at least three years under a lock-up agreement. The insurer plans to list its shares in Hong Kong or Shanghai within the next two years, Wang said.

Carlyle will eventually sell its stake to Prudential and sources previously told Reuters the two foreign investors plan to increase their stakes to 49 percent when rules allow.

Chinese life insurance premiums rose 12.8 percent between January to September from a year earlier to 247 billion yuan ($30.6 billion), state media said, as Beijing dismantles its cradle-to-grave welfare system.

China Pacific has 11 percent share of a rapidly growing life insurance market dominated by top two local players China Life Insurance Co. (LFC.N) and Ping An Life Insurance (Group) Co.

Carlyle will upgrade China Pacific's corporate governance, risk management, product sales and technology to help boost the insurer's performance.

"Carlyle believes China's life insurance industry is a relatively long-term investment and we believe the profitability of China Pacific will increase after Carlyle's joining," said X.D. Yang, co-head of Asia buyouts for Carlyle.

Yang said Carlyle would not invest in any other Chinese insurance companies after making the deal with China Pacific.

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Analysts Say Buy of TD Waterhouse Still a Good Deal

AP, Josh Funk, 16 December 2005

Omaha, Neb. (AP) -- More than a third of the nearly $2 billion online brokerage Ameritrade Holding Corp. plans to borrow to pay for its latest acquisition will go directly to the company's board and top executives in dividends.

Yet despite the increase in borrowing needed to help pay the $6 per share special dividend -- offered to encourage shareholders to approve the deal -- analysts said this week that Ameritrade's acquisition of competitor TD Waterhouse Group Inc.'s U.S. retail securities business is still a good deal.

Ameritrade expects to lead the online brokerage industry in trades after the acquisition by handling an average of 239,000 trades a day and build on its roughly 25 percent share of the active investor market. By comparison, Charles Schwab Corp. reported 194,000 trades a day, on average, and E-Trade Financial Corp. said it handled 125,000 a day in the quarter that ended in September.

With E-Trade hungry to expand, analysts expect more consolidation in the online brokerage industry. That makes sense, they say, because acquirers have been able to successfully move customers onto merged trading platforms that allow them to profitably reduce costs.

Ameritrade executives predict the new company to be named TD Ameritrade will save about $378 million in annual expenses by consolidating operations and have the opportunity to generate $200 million a year in new revenue.

Ameritrade rejected takeover and merger offers from E-Trade in May and June and vowed to plow ahead with the $2.9 billion deal hammered out in June to acquire TD Waterhouse. The $6 dividend would be paid to Ameritrade stockholders of record on Nov. 16 if they approve the transaction next month.

The company's board of directors and top executives stand to receive $752.6 million in dividends for the more than 125 million shares they control, according to documents filed with the Securities and Exchange Commission. Almost $536 million of that will go to Joe Ricketts, Ameritrade's 63-year-old founder and chairman.

After repaying a $65 million loan he and his wife received from TD Waterhouse Group's parent company last month, Ricketts will end up with $470.9 million in cash, the filing shows.

Despite the seemingly large payouts to the company's leadership, analysts say the rationale for the takeover remains sound.

Ameritrade should benefit because the company will be able to add financial advising and diversify its business, according to analyst Seth Dadds of Garp Research Corp. in Baltimore. "If you want to go out and compete with the (Charles) Schwabs of the world, you have to have some kind of advising business," he said.

Matthew Snowling, an analyst with Friedman, Billings, Ramsey and Co. in Arlington, Va., said Ameritrade needed to make an acquisition because the online brokerage industry is rapidly consolidating. E-Trade, spurned by Ameritrade, instead purchased rival online traders HarrisDirect and BrownCo.

"One could argue they played E-Trade and TD against each other until they got the best deal for themselves," Snowling said.

Ameritrade spokeswoman Katrina Becker said the acquisition was not designed solely to benefit the Ricketts family or private investors TA Associates Inc. and Silver Lake Partners. Together, the three own about 34 percent of Ameritrade.

"Obviously, they are going to benefit from this acquisition, but so will all shareholders," Becker said. "The Ricketts family is committed to the long-term growth of the company."

Ameritrade is obtaining the financing from a consortium of Wall Street firms, including Citigroup, Merrill Lynch & Co. Inc., UBS and JPMorgan Chase & Co. One loan of $1.65 billion is to be paid back in seven years, while a second loan of $250 million is due in six years. Ameritrade will also open a $300 million line of credit for operating capital.

The first mention of a special dividend as part of the TD Waterhouse deal came in May, two weeks after E-Trade offered $1.5 billion in cash to Ameritrade shareholders, according to the proxy, which would have included a dividend of $1 per share. In June, E-Trade sweetened its offer to $2.3 billion in cash.

Yet Ameritrade's board decided unanimously on June 21 that purchasing TD Waterhouse made more sense, strategically. That's also when they decided to offer the $6 special dividend.

The share price of Ameritrade, E-Trade and Schwab have been on the rise since May when news of the talks between Ameritrade and E-Trade were first reported. But while E-Trade shares have zoomed 41.5 percent higher this year, Schwab has gained 26.5 percent and Ameritrade is up only 10 percent year to date.

Details of what the deal will mean for Ameritrade and TD Waterhouse customers haven't been fully released, but Becker said Ameritrade has tried to keep customers informed through its corporate Web site, http://www.amtd.com..

Generally, the owners of TD Waterhouse's 2.3 million accounts will have to adjust to using Ameritrade's trading platform, and the owners of Ameritrade's 3.7 million accounts can expect to be offered investment advice through a nationwide network of branch offices created out of TD Waterhouse's 143 offices.

Company officials plan to design investment products, like the research and advising products TD Waterhouse offers now, to attract long-term investors, particularly those who may not have enough money to attract a full-fledged broker. Some products will also be designed to serve registered investment advisers who may use TD Waterhouse's research or trading tools to help their own clients.

In the past Ameritrade depended on trading commissions for most of its revenue. The new company will also be able to charge asset-based fees for advice.

The combined company will have the third-largest account base in the brokerage industry with about 5.9 million accounts, according to figures from March before the deal was announced. TD Ameritrade expects to manage about $219 billion in client assets.

A special shareholder meeting will be held on Jan. 4 for the vote on this acquisition, and the deal is expected to close on Jan. 24.

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Scotiabank Move May Have Rate Impact in Peru

Reuters, Teresa Cespedes, 16 December 2005

Lima, Peru -- Moves by Canada's Bank of Nova Scotia and Britain's HSBC Holdings PLC to set up shop in Peru's already crowded banking sector could spark a fall in interest rates and heat up the competition in the promising low-income loans segment, the country's banking superintendency said.

Last week, Scotiabank, Canada's No. 3 bank by assets, agreed to spend almost $600-million (U.S.) to buy Peru's Banco Wiese Sudameris and take a controlling stake in Banco Sudamericano as part of a growth plan in Latin America.

Peru's Banking Superintendent Juan Jose Marthans told Reuters in a recent interview that HSBC Holdings, one of the world's biggest banks, aims to move into Peru at the start of 2006. HSBC was not immediately available for comment.

Mexico's Banco Azteca, owned by retailer Elektra, has said it aims to move into Peru next year and extend its focus on low-income borrowers such as policemen, farmers and taxi drivers, who generally do not make enough money to qualify for loans at traditional banks.

"In retail banking, with the entrance of these active international banks, we expect an additional, aggressive fall in the cost of credit," Mr. Marthans said.

Interest rates, at a year-average of 23.9 per cent in Peruvian soles and 10.4 per cent in U.S. dollars, would fall for loans in the retail, credit card and mortgage segments, he said.

In impoverished Peru, where only 20 per cent of economically active Peruvians use bank accounts, Banco de Credito dominates the 12-bank retail market.

But it is being challenged by BBVA Banco Continental, an affiliate of Spain's BBVA, which last year cut its bad debt ratio and has begun moving into the riskier but growing low-income loans market.

"Assuming they don't have another strategy, which could be buying a bank here, I hope they organize their permit request and start operating in the first quarter," Mr. Marthans said. "We're already in conversations with them."

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National Bank's Quebec-centricity très Profitable

The Globe and Mail, Konrad Yakabuski, 14 December 2005

Montreal -- His predecessor used to bemoan the "Pepsi factor" -- his words, not ours -- but National Bank of Canada's Quebec-centricity has been très profitable for chief executive officer Réal Raymond.

Canada's sixth-largest bank has finally outgrown the "also-ran" label that used to sum up its status when analysts compared it to the Big Five. In fact, after posting a 20.7-per-cent return last week on common equity and record profit for fiscal 2005, Montreal-based National is getting the last laugh as a few of its Enron-racked rivals at King and Bay wipe the last traces of mud off their faces.

Mr. Raymond is one of the most polite people you will ever meet. He probably considers gloating inelegant. But he's earned the right to rub his critics' faces in National's results. Since taking over as CEO from André Bérard in early 2002, Mr. Raymond has produced 12 consecutive quarters of impressive earnings growth by doing what all the naysayers said he shouldn't: He has reinforced National's dependence on the Quebec market.

Back in 2002, not many were buying Mr. Raymond's sales pitch. Most dismissed his spiel that National could thrive as a "super-regional" bank as an excuse for the fact that it either couldn't find a merger partner in English Canada or that, as the only francophone-led member of the Big Six, it couldn't find one acceptable to the Quebec government.

As a result, National's shares consistently traded at lower multiples than those of its peers, weighed down as they were by the so-called "Quebec discount." Or, as Mr. Bérard used to call it, the Pepsi factor.

The negativity wasn't baseless. Ever since its creation in 1979, National had a choppy track record and its return on equity was almost always below the industry average. With two-thirds of its business in Quebec, its results reflected the province's slower-growing economy, lower per capita income and the absence of economies of scale.

When it did venture outside the province, the consequences were not often pleasant. In the early 1990s, it lost a bundle on Robert Campeau and the Reichmanns' Olympia & York. It bought Toronto-based First Marathon in 1999 to beef up its presence in investment banking. While the move was a smart one over all, the results have been volatile and the internal politics of integrating a Bay Street renegade into a blueblood French Canadian institution has been sometimes explosive. Meanwhile, the 2002 purchase of mutual fund manager Altamira Investment Services Inc., also Toronto-based, was generally panned by analysts.

So, as Mr. Bérard passed the reins to Mr. Raymond, National's motto as "the first bank of Quebec" was as much an avowal of its failure to successfully diversify its operations outside the province as it was a slogan to lure patriotic Quebeckers.

Flash forward to 2005. Quebec still accounts for 64 per cent of National's revenue. What has allowed Mr. Raymond to turn this concentration into an competitive advantage -- for now, at least -- is focus. The 55-year-old CEO, who started out as a teller in 1970, is single-minded in the pursuit of tangible objectives and has instilled among the bank's almost 17,000 employees a similar culture to succeed. Insiders say morale has rarely been higher.

It no doubt helps that the small-business, mortgage and consumer loans that remain the core of the bank's operations have been generating excellent returns in the past few years, thanks to low interest rates, a buoyant economy and a booming real estate market. None of those factors can be counted on over the next few years. Rates are rising, the high Canadian dollar and oil and gas prices are devastating Quebec's export-driven manufacturers and only the stragglers are still at the property party.

What might just help Mr. Raymond keep the good times rolling is National's alliance with Paul Desmarais' Power Financial Corp. No one much paid attention to the agreement they struck in 2002 whereby the 7,000-member sales force at Power's IGM Financial Inc. and Great-West Lifeco Inc. units (as well as the latter's London Life and Canada Life subsidiaries) pitch certain National products to their clients across Canada. These include RRSP loans, lines of credit and investment loans.

The alliance with Power was slow to yield results and National's disclosure is sketchy. But in fiscal 2005, fully 40 per cent of National's growth in the personal and commercial lending category was derived from business steered through alliances with third parties. By far the most important of these alliances is the one with companies in the Power Financial family. What's more, it gives National access to a revenue stream from outside Quebec without investing in bricks and mortar.

With a situation this advantageous, it's not hard to imagine the Desmaraises and Mr. Raymond doing more deals together.

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UK Consumer Spending on Banking Services

The Economist, 14 December 2005

Allegations of market failure plague banks in their most profitable year ever

For an industry that likes to think of itself as staid and grey-suited, Britain's banks have been getting far more attention than they would like. Last week the Office of Fair Trading (OFT), a competition watchdog, said that it planned to scrutinise the market for payment-protection insurance on loans, valued at £5.4 billion in 2003. Profit margins on loan-insurance policies appeared high, the regulator said. Just a month earlier, the Financial Services Authority (FSA), the industry's main regulator, said that investigators who went undercover to check into the matter found firms at risk of mis-selling these policies.

The OFT probe is just the latest in a long line of recent inquiries into British retail banking. The Competition Commission, another watchdog, has three investigations in progress. Other British regulators and a parliamentary committee have another ten or so in the works.

In fact, bank customers in Britain pay less overall than those in many comparable economies. As the chart shows, the average British consumer spends €65 (£44) a year on banking services, according to a 2005 study by Capgemini, a consulting firm. That compares with €113 in Italy, €98 in Germany and €93 in the United States.

Yet for all the rivalry between the country's banks, which include three of the world's ten largest, there is a disquieting lack of competition in some areas of the market. Lenders compete fiercely to make mortgage loans; and a review that David Miles, an academic, carried out at the government's behest said last year that the mortgage market was generally working well. But the same level of competition is not evident across all financial products. Several OFT studies have found restricted competition in store-branded payment cards, doorstep loans and credit-card transaction fees, for example.

This suggests that there has been relatively little change since 2000, when a government-appointed review headed by Don Cruikshank, formerly director general of Oftel, the telecommunications regulator, found market failure in the provision of banking services to consumers and small businesses.

“The government has a problem with the banking industry,” said David Lascelles, a director of the London-based Centre for the Study of Financial Innovation, a think-tank. “To some extent that problem is legitimate. There is a surprisingly small amount of competition.” Observers posit two contrary explanations for this: too much regulation and too little.

In an industry such as banking where there are high barriers to entry, adding rules simply makes it more difficult and expensive for new entrants to compete. It can also carry unintended consequences, as the Competition Commission found not long ago.

A two-year study into banking for small businesses, completed in 2002, found that weak competition was allowing big banks to charge excessive fees. The government ordered them either to provide free services to small businesses or to pay interest on their current accounts.

But the remedy may have compounded the illness. Abbey National and Alliance & Leicester, Britain's sixth- and eighth-largest banks, complained that the regulator's intervention in fact stunted their growth.

While the big banks were merrily whacking their small business customers over the head, their smaller rivals had been tempting clients with offers of free banking or interest-bearing accounts. When bigger banks were required to do the same, customers had less incentive to switch and, arguably, competitive forces in the market were reduced. The OFT plans to review the measures next year.

But there is also merit in the argument that more regulation can help to boost competition. Sir Callum McCarthy, chairman of the FSA, argued in a speech last month that to achieve competitive markets regulators must make detailed rules compelling firms to provide information to their retail customers. Only then can consumers make informed choices.

This, broadly, is the approach that regulators are now following. In the past year, they have made banks explain more clearly the interest rates they charge on credit-card debt and the fees for withdrawals from cash machines.

For transparency to succeed, however, consumers must exercise their power. Sadly, they cannot always be relied upon to do this. At least 75% of customers have never switched banks, according to figures from MORI, a polling firm.

Perhaps, however, this should not come as a surprise. According to the FSA, a fifth of all bank customers don't understand percentages.

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ScotiaBank Pays $390 million for 80% of Banco Wiese Sudameris SAA

The Globe and Mail, Sinclair Stewart, 10 Dec 2005

Toronto — A large, bronzed water gun, fastened to a plinth and inscribed with a warm dedication, sits on the floor beside Robert Pitfield's desk. It's an odd decorative touch for a banker, but not quite incongruous, considering the other bizarre bric-a-brac in the room: a small stuffed Big Bird; a Caddyshack-style outsized golf bag; a cricket bat, and two cans of beans -- one waxed, the other baked -- sitting in a glass display case, both Christmas gifts from the assistant of his former boss.

It's the water gun, though, that is the sentimental favourite. Several years ago, before he was running Bank of Nova Scotia's international operations, Mr. Pitfield was tasked with weaving together a disparate group of cultures in the wealth management division. The solution, though it took a while to figure out, was simple: Shoot people. Everyone brought water guns to the office, and Friday afternoons became an exercise in team-building-through-dousing. When Mr. Pitfield left, his staff presented him with the bronzed gun, thanking him for his years of "distinguished service."

It's a bit of a joke, of course, but it has come to symbolize what Mr. Pitfield views as his most challenging task: knitting together employees and operations in more than 50 countries and finding a way to inculcate the Scotiabank culture without overriding regional differences.

"There's a tendency for international companies, when they start . . . to control things centrally. It's an impossible thing to do," he says. "From my perspective, we have to be great enablers. What can I do personally to help you in your local market, right down to a teller? How do you get people like [yourself] in those individual markets . . . so that the sum is greatly superior to the individual parts? We're still very much working through that."

Scotiabank did not become the most international of Canada's Big Six overnight. It has proceeded cautiously -- some would say painstakingly --and spent decades building a platform in the Caribbean before slowly branching out into Mexico and Latin America.

Its latest deal came earlier this week, when it shelled out $390-million to create Peru's No. 3 bank. Scotiabank is acquiring 80 per cent of Banco Wiese Sudameris SAA, or BWS, and at the same time seizing majority control of Banco Sudamericano, another Lima-based financial institution in which it currently owns 35 per cent. If both moves are approved, the two banks will be combined to form the third-largest player in the country.

In dollar terms, this is peanuts: It will barely dent the $5-billion worth of excess capital that Scotiabank is hoarding. And it's hardly the kind of transformative deal that Bay Street (at least some on Bay Street) seem impatient for the bank to make.

But for investors who fret about the political environment in Peru, or the economic stability of Mexico, little deals like this are a good thing. Part of the bank's risk-mitigation strategy is to make smaller investments in several countries, reducing the chances that a single blowup (as happened in Argentina a few years ago, costing the bank $540-million) will have a significant impact on its operations.

"If you do it incrementally, step by step, you can grow your franchise safely," Mr. Pitfield said. "You can chew what you bite off."

He readily acknowledges that Scotiabank couldn't have done the Peru deal 10 years ago: It lacked the right people and language skills, the technology and systems, and the understanding of different regulatory regimes. Bulking up in Mexico with its Inverlat unit, however, has given the bank its foundation, so it can begin rounding out its operations in the Dominican Republic, Costa Rica, El Salvador, Chile, and Venezuela.

Scotiabank is also stepping up the pace of these smallish acquisitions, in part to help it learn more about integrating other companies. Becoming more active keeps the bank sharp, Mr. Pitfield says, both in terms of improving its integration skills and keeping in touch with the local markets. It's not that the bank is averse to doing big transactions: It just wants to nail the formula first.

Last year, international banking contributed $800-million in profit, roughly a quarter of the bank's overall bottom line. Mr. Pitfield predicts it could account for more than half within the next four to seven years.

His main challenge right now, however, is creating a base for expansion in Asia, much as the bank used its Caribbean beachhead to move into Mexico. Scotiabank is now in 11 Asian countries, including China and India. It recently attempted to buy the Bank of Punjab, but it failed because of regulatory issues. All of these operations are "chips in a poker game," Mr. Pitfield says, and the question now is figuring out where to place the bet.

Robert Pitfield, executive vice-president of international banking, Bank of Nova Scotia
Age: 50
Education: Political-science degree, University of Toronto; law degree, University of Ottawa
Family: Married, three daughters and a son
Hobbies: Reading, golf ("I love the game, but I'm not that good at it.")
What he's reading: Team of Rivals: The Political Genius of Abraham Lincoln (Lincoln is "absolutely inspiring"); Zen of Golf
Corporate bible: Good to Great: Why Some Companies Make the Leap and Others Don't
Riskiest thing he's done: Skydiving. "You have one whole day of contemplating your death. It's terrifying."
Little-known nickname: "Icepick" (conferred upon him by fellow parachutists)
Where he relaxes: The family cottage in the Thousand Islands
Who he's voting for: His wife, Jane Pitfield. The Toronto city councillor announced plans last week to run for mayor in 2006.
Most unusual items in his office: A large, bronzed water-gun, mounted like a trophy
How much of the year he spends visiting the bank's international locations: One-third
Favourite operation to visit: Jamaica
Languages: Taking courses in Spanish, the predominant tongue of Scotiabank's international employees
Management influences: Former CEO Peter Godsoe; former president Bruce Birmingham
Connections: His grandfather, Ward Pitfield, founded brokerage house Pitfield Mackay Ross & Co.; his uncle, also named Ward, was chairman of brokerage firm Dominion Securities Pitfield; his other uncle, Michael Pitfield, is a senator, and was clerk of the Privy Council under former prime minister Pierre Trudeau
Worst mistake: Not appreciating the importance of talent and building the best team possible when he ran his first branch in 1987.

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US Financial Stocks Look Golden in 2006

S&P, Beth Piskora, 12 December 2005

S&P has upgraded the sector to "overweight," along with consumer staples and health care. One reason: The Fed may quit tightening

On Dec. 8, Standard & Poor's upgraded its recommendation for the financial services sector to overweight from marketweight. "Financials look good to us fundamentally and technically," says Sam Stovall, S&P's chief investment strategist. "And they play into our 'quality' theme; we expect higher-quality companies to attract more interest in 2006 than they have in 2005." Financials join consumer staples and health care as the sectors for which S&P advises an overweight position. Financials make up 21.3% of the S&P 500 index.

"S&P is positive on equities in 2006, with an emphasis on dependable, high-quality companies as the economy slows and earnings decelerate," explains Stovall. S&P's proprietary quantitative metric, the S&P Earnings & Dividend Rank, also called the S&P Quality Ranking, measures the consistency of earnings and dividend growth over the most recent 10-year period. The financials sector, with 68% of the companies having superior S&P Quality Rankings (A- or higher), is second only to consumer staples.

In addition, S&P's forecast for a first-quarter 2006 end to Federal Reserve monetary policy tightening will likely bolster the financials sector's performance, Stovall says. S&P analysts have a positive overall fundamental view on the sector, which sports a market-cap-weighted STARS ranking of 3.9 out of 5, above that of the broader index at 3.7. From a technical standpoint, S&P has a positive outlook based on a recent breakout above five-year resistance and improved relative strength vs. the broader S&P 500 index.

Within the financial services sector, favored sub-industries include diversified banks, multi-line insurers, property and casualty insurers, and investment banking and brokerage. Investment banks look very attractive to Robert Hansen, an S&P equity analyst. "We believe higher investor confidence, higher trading volume, a rebounding equity market, and strengthening IPO and merger and aquisition activity will help investment banks," Hansens says. He recommends Goldman Sachs (GS ; ranked 5 STARS, or strong buy), Bear Stearns (BSC ; ranked 4 STARS, or buy), and Merrill Lynch (MER ; ranked 4 STARS, or buy).

Hansen also expects further consolidation among asset managers. His top-ranked picks in that industry group include T. Rowe Price Group (TROW , ranked 5 STARS, or strong buy) and Franklin Resources (BEN , ranked 5 STARS, or strong buy). Hansen notes that the potential depreciation of the U.S. dollar, which S&P expects in 2006, would particularly help Franklin, since 40% of that company's assets under management are held in foreign equity mutual funds.

Insurance is another strong industry group. Earlier this week, S&P insurance equity analyst Cathy Seifert raised her fundamental outlook for multi-line insurers to positive. Her favorite stock in the group is Hartford Financial Services Group (HIG , ranked 5 STARS, or strong buy).

Among all the sectors, Standard & Poor's recommends that investors have overweight positions in financials, consumer staples, and health care. It has an underweight recommendation on consumer discretionary, materials, and telecommunications services. And it thinks investors should marketweight energy, industrials, information technology, and utilities stocks.

Standard & Poor's Investment Policy Committee set a yearend 2006 target for the S&P 500 index of 1,360, representing upside of 6.7% for the year. The committee adjusted its yearend target for 2005 to 1,275. By June 30, 2006, the committee expects the S&P 500 index to hit 1,315.

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Scotiabank has Eyes on the Road with GM Deal

The Globe and Mail, Andrew Willis, Thursday, December 8, 2005

The rest of the Canadian banking community just doesn't get Bank of Nova Scotia's fascination with lending companies money.

Providing credit to corporate customers is a lousy way to make a living, according to conventional wisdom. The future is in retail banking, where bankers can provide high-margin wealth management to the masses, along with capital-lite products such as derivatives for the corporate crowd.

Loans, on the other hand, are leftovers from banking's distant past. Just look at the realities of the business. Companies pay rock-bottom rates to borrow, so margins are thin. Corporate borrowers make use of products such as lines of credit that tie up the bank's capital, yet offer minimal returns. And every so often the likes of Adelphia, White Rose, Bramalea or O&Y go bust -- they were all Scotiabank clients -- and take a big bite out of the balance sheet.

Yet credit-happy Scotiabank chief executive officer Rick Waugh just keeps on cracking open the vault. In fact, he threw it wide open this week for the car wreck that is General Motors, pledging to take a staggering $20-billion (U.S.) in loans over five years from the auto marker's financing arm, known as GMAC. Should this man be allowed behind the wheel?

Well, here's how the numbers work on Scotiabank's latest venture. Merrill Lynch analyst André-Phillippe Hardy figures that to take on that GMAC exposure, the bank has to set aside just $175-million (Canadian) to $200-million of its own capital. And Scotiabank is carrying more than $4-billion of excess capital these days.

Car buyers pay 6- to 8-per-cent rates for the loans that put them in new Chevy Suburbans, Cadillac Escalades and the rest of the GM fleet. GMAC takes a 1-per-cent fee for what is known as "origination and servicing" on these loans. The rest goes to the bank.

When Scotiabank gets its hands on the loans, the bank will likely find that deadbeat car buyers who renege on their loans eat up about 1.1 per cent of the portfolio, at worst. One final number: The bank's sterling credit rating allows it to borrow for about 4 per cent, well below the junk bond rates charged GM. (The auto maker is doing this deal in a desperate attempt to restore its credit ratings.)

Add it all up, and Scotiabank can expect to earn a 200-basis-point spread on these car loans and Mr. Hardy says the bank can anticipate 20-per-cent return on the equity it invests in the GMAC portfolio. In financial circles, this is an out-of-the-park home run.

Add in the fact that Scotiabank knows this sector cold as a top auto financier in both Canada and Mexico, and you've suddenly created a North American leader in an attractive, growing sector. That expertise can be exported to a growing South American network, where the third-largest bank in Peru is expected to soon join the fold. See where Mr. Waugh is driving?

Like predecessors Cedric Ritchie and Peter Godsoe, Mr. Waugh spent a big chunk of his career running Scotiabank's corporate lending operations. He and his colleagues have a credit culture that is second to none. By continuing to make the balance sheet available to corporate clients such as GM, Scotiabank is opening up new avenues for expansion. Defying conventional wisdom on lending should prove lucrative.

Strategy takes flak

Bank of Nova Scotia does take justifiable flak for one element of its credit-based strategy.

Most of the bank-owned dealers, including the major U.S. houses, have baked what amounts to tied selling into the services they offer corporations.

The bank will lend money to the company, but in return, they ask (or demand) that the company use their advisory teams on lucrative M&A assignments, or equity underwritings.

So on the proposed Inco purchase of Falconbridge, you'll find RBC Dominion Securities, Goldman Sachs and Morgan Stanley all providing advice on the $12.5-billion takeover, and also lending Inco the necessary funds. Only Scotiabank is stepping up to lend to Inco without getting a serving of advisory fee gravy.

To the extent Mr. Waugh and his colleagues at investment dealer unit Scotia Capital Inc. can use their credit relationships to win additional advisory work, they'll be doing better for the bank's shareholders.

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HSBC, Example of How Cdn Banks Missed the Boat

The Globe and Mail, Eric Reguly, Thursday, December 8, 2005

Vancouver -- Ever the diplomat, Sir John Bond, the outgoing chairman of HSBC, the world's third-largest bank, politely declines to comment on the growth strategies -- or lack thereof -- of the Canadian banks. "Thirty-two million people have a finite demand for financial services," is all he'll say.

When the stars align, banks are presented with opportune moments to make transformational decisions. Lose the moment and the bank can get stuck for years, maybe forever; seize it and a new world can open up.

HSBC knew this. The Canadian banks apparently did not. They did too little too late and the result is a no-show among the top players.

It's hard to say when HSBC decided to shed its status as a regional player. Trawl through its archives and you could argue the decision came on day one. It began as Hongkong and Shanghai Banking Corp. in 1865; within a year, it was operating in a dozen countries.

For more than a century after its founding, HSBC was a bit player, globally speaking. In 1961, the year Sir John joined the bank, it had a market value equivalent to $80-million (U.S.). In 1988, when he became an executive director, HSBC was worth $4-billion. That made it smaller than the Canadian banks.

About that time, HSBC decided to go on a takeover binge that vaulted it into the international big leagues. Sir John ramped up the growth strategy when he became group chairman in 1998. He made close to $50-billion of acquisitions, pushing especially hard in the United States, China and Western Europe. Household International, the consumer finance company bought in 2002 for $14.2-billion, was his biggest deal. In 2000, HSBC paid $11-billion for France's Crédit Commercial.

Sir John retires as chairman in the spring, when he turns 65. He leaves behind a bank with a market value of about $185-billion, assets of $1.5-trillion and more than 260,000 employees in 77 countries and territories, including Canada. "Half of the profits of this bank come in when I'm asleep," he says.

Only Citigroup and Bank of America are bigger. Royal Bank, Canada's largest financial services company, is a little more than a third the size of HSBC.

Why didn't the Canadian banks do the same? They could have made their move as late as the 1980s, when they, relatively speaking, had the financial heft to make a splash outside the country.

At the time, banks were fairly cheap and expansion opportunities were rife, especially in the United States. HSBC knew this: It bought Marine Midland Bank of Buffalo, N.Y., virtually in the shadow of the Canadian bank towers in Toronto.

Sir John won't say why the Canadian banks didn't move faster to expand internationally. "HSBC is resolutely international and 'international' is a mindset," he says.

The implication is that the Canadians never had it in them, possibly because life was comfortable in the home market and the profits never failed to roll in.

The Canadians did make an effort, to be sure. Bank of Montreal bought Michigan's Harris Bank in the mid-1980s, but failed to make it the platform for a broad U.S. expansion; it's still No. 3 in the Chicago market. RBC used a scattergun strategy that left it with relatively insignificant market shares in the United States. CIBC has largely retreated from the United States. TD Bank found that its Waterhouse discount brokerage wasn't big enough to survive among the U.S. giants and sold it. It is now buying regional banks in the U.S. Northeast. Scotiabank, which has been called a "mini-HSBC," had the most success outside of Canada, although it's a non-entity south of the border.

None of them has the potential to become an HSBC at this stage. The opportunity is gone. Values are too high and the big-bang takeovers have become the preserve of giants, such as HSBC, Citigroup and Wachovia.

Sir John was in Vancouver this week for his last official visit to HSBC Bank Canada. Trim and fit, and sporting his trademark banker-blue pinstripe suit, Sir John looks and sounds like the classic imperial banker. His English is precise and measured.

He travels constantly -- not surprising for someone atop an operation with 9,700 offices. "What's amazing is that he never looks tired for someone who lives on a plane," says Peter Godsoe, the former Scotiabank CEO.

Mr. Godsoe says Sir John's retirement after 45 years marks the "end of an era." Sir John is the classic boots-on-the-ground banker, as familiar with his own employees in far-flung lands as he is with heads of state, finance ministers and regulators. He can name cabinet ministers in countries you never heard of and has detailed knowledge of local economies, right down to which products are made in which factories.

"Did you know that one-third of the socks produced on the planet are made in Datang, in China?" he says. "Datang has gone from 1,000 people to 100,000 people in about 10 years."

Asia in general and Hong Kong and China in particular are closest to Sir John's heart. He spent almost three decades in that part of the world before moving to London, where HSBC is now based, in 1993. It's doubtful any banker on the planet knows what's going on there as well as he does.

China's economic miracle, he says, "is real" in spite of suggestions from various fund managers and economists that the country's growth rate of 9 per cent is unsustainable, at best, and possibly headed for a crash, at worst.

If anything, he says, GDP growth might even accelerate. That's because the 450 million Chinese in the coastal areas and main industrial centres are driving the growth. "Now, imagine what China would look like if the rural incomes started rising," he says. "You would have a massive boost to consumption. . . . So you have major potential boosts to the economy."

Sir John has made China a priority in recent years. One of his last acts as chairman was buying a stake in China's Ping An Insurance. In 2004, he bought 19.9 per cent of Shanghai's Bank of Communications, the country's fifth-largest bank and one of the few with a national banking licence. It was the biggest investment in a mainland Chinese bank by a foreign bank.

But even as HSBC is moving closer to its Chinese roots, it has no intention of being a "Chinese" bank. Its intentions are global -- it calls itself "the world's local bank."

Sir John will not fade into the sunset. He has already agreed to become chairman of Britain's Vodafone, the world's biggest mobile phone company. Vodafone went after him because, like HSBC, it intends to become global brand and wants to exploit his connections.

Canada's bankers must look at Sir John with amazement. Not long ago, he was one of them -- a smart executive at a middling bank. Then Sir John realized there was a whole world out there.

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UBS Adds TD to List of Top Picks

The Globe and Mail, Angela Barnes, December 7, 2005

UBS Securities Canada Inc. has dropped Bank of Nova Scotia and Meridian Gold Inc. from its list of top picks and added Toronto-Dominion Bank and Agnico-Eagle Mines Ltd.

In the energy sector, which the brokerage firm has as a "neutral," the choices are EnCana Corp. in the producer category, Suncor Energy Inc. among the integrateds and TransCanada Corp. among the power issues.

UBS also rates the consumer staples sector as a "neutral." The pick there is Shoppers Drug Mart Corp. because of "good demographics, projected continued growth from geographic expansion, increased square footage of existing stores and improved penetration of higher margin private label and health and beauty products," analyst Peter Rozenberg said.

The materials, industrials, information technology and telecom services sectors are all overweighted. Alcan Inc., Methanex Corp., Agnico-Eagle Mines Ltd. and Inmet Mining Corp. all got the nod in the materials group. And in the telecom sector, Rogers Communications Inc. was the preferred stock. Canadian National Railway Co. was the top pick in the industrials.

Consumer discretionary, health care, financials and utilities are underweighted. UBS top picks are TD, Manulife Financial Corp. and Brascan Corp. in the financials, Magna International Inc. in the consumer discretionary sector, Axcan Pharma Inc. in health care, and TransAlta Corp. in the utilities.

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Goldman Sachs Compensation Scheme

New York Magazine, Duff McDonald, 5 December 2005

It’s like buying a gift for the guy who has everything: What can you do to impress the boss for whom you’ve already been pulling all-nighters and all-weekenders? That’s the dilemma faced by thousands of investment bankers in New York every fall, when bonus season gets under way. Starting sometime after Labor Day and ending before Christmas, everybody in the financial industry is on their best, most obsequious behavior, hoping to curry the favor of those who divvy up the spoils. And what spoils there are this year—the 2005 bonus season looks to be Wall Street’s biggest haul in five years. Last year, the New York State Comptroller’s office estimated the average bonus on Wall Street to be a clean $100,600 (or $15.9 billion split among 158,000 employees). Early estimates of the 2005 bonus pool reach as high as $19 billion.

Typically, Goldman Sachs’s announcement of its third-quarter results kicks the bonus season into high gear. Long revered for being where the serious money gets made, the firm has had a blowout year even by its own standards. Announcing a record profit in the third quarter, Goldman also noted that it had set aside $9.25 billion, almost $420,000 per employee, in compensation. When fourth-quarter results are factored in, that total could swell to an $11 billion pool, or $500,000 per employee.

Naturally, money on Wall Street is not shared equally, not even close. Most Goldman employees will receive a good deal less than half a mil, while a few will make an ungodly amount more. It’s simply a matter of how much more. Is that guy on the commodities desk who bet right every time on the price of oil worth $20 million this year—or $25 million? Maybe it’s worth taking $5 million out of the pocket of that old-school investment banker who couldn’t close that simple snack-food takeover deal. Maybe it’s time he was sent a clear signal about the weight he’s been failing to pull.

Even in the land of seven-figure incomes—in fact, especially in the land of seven-figure incomes—bonus sensitivity runs high. “Most days, I think I’m one of the most overpaid people on earth,” a former Goldman employee told me. “But other days, I feel like I’m getting shafted. Everyone at Goldman is afraid of feeling that way.” The result of extensive interviews with both current and former Goldman employees, what follows is our best guess at how, exactly, that shafting takes place. That, and the names of a few people you’ve never heard of who make more money than A-Rod.

The standard portion of net revenue (total revenue minus interest expense) earmarked for compensation at Wall Street firms stands at an astonishing 50 percent. That’s because talent is the most precious commodity on Wall Street; it’s what they sell, so it’s also what they have to pay for.

“Wall Street is just a compensation scheme,” says Andy Kessler, a Wall Street veteran and the author of several books about its culture. “They literally exist to pay out half their revenue as compensation. And that’s what gets them into trouble every so often—it’s just a game of generating revenue, because the players know they will get half of it back.” Goldman Sachs is no exception to this lucrative rule. Through the first nine months of the year, the $9.25 billion that the company set aside for salaries and bonuses was precisely 50 percent of its net revenue.

Back in the late nineties, when Goldman Sachs’s partners were considering taking the company public, the resulting turmoil in their ranks led to the departure of Jon Corzine and the ascension of Henry Paulson Jr. to the position of sole chairman and CEO of the company. One of the primary questions Paulson faced was how Goldman could motivate its relatively underpaid junior staff if it couldn’t hold out the brass ring of Wall Street’s most coveted partnership as incentive. If the company was public, the partners couldn’t just split the profits among themselves as they always had. There would be other shareholders to think of.

As it turned out, however, not much actually changed when the company did go public. The partners still control the flow of money, and they still divert a disproportionate share of it to themselves. Although it’s no longer a partnership per se, the firm breaks down its executives into senior managing directors “PMDs” (for partner managing directors) and its junior ones “EMDs” (for executive managing directors) or “MD Lite.” Starting with the 50 percent of net revenue, the PMDs slice off a big chunk—a current EMD estimated it to be 15 percent of the total. If 2005 compensation comes in at $11 billion, as one analyst estimates, that’s $1.65 billion for the firm’s 250 or so PMDs to split among themselves. Each PMD has what are known as “points” in the partnership pool, and a quarter to a third of that 15 percent (stay with me here) is split according to those proportions. With all senior managers of Goldman taking home a $600,000 salary, an equal split of 30 percent of $1.65 billion would be worth almost $2 million, pushing their pay into the neighborhood of $2.6 million. But wait, there’s more.

The remaining $1.15 billion is then split among the PMDs according to the discretion of the top dogs, who evaluate each partner. “Having such a huge part of the partners’ pay package be discretionary is different from the way it used to be,” a former vice-president of the firm told me. “If there are partners they want to push out, they just fuck them on the discretionary part.”

For those in the highest standing, the estimated numbers run in the neighborhood of $20 million to $40 million. So massive are these sums that a secretary in the London office was able to steal £4.5 million from three of her bosses before they even noticed. In the meantime, she’d bought an Aston Martin, a villa in Cyprus, and £350,000 worth of Cartier jewelry.

Though the firm is very discreet about its discretionary bonuses, the requirements of being a public company have forced Goldman to reveal the compensation of its executive management team. They’re a well-paid lot, though not necessarily the best-paid at the firm. Last year, Paulson took home $29.8 million for his troubles, while Lloyd Blankfein, the firm’s president, made a shade less, $29.5 million. David Viniar, the chief financial officer, got $19 million, and vice-chairmen Robert Kaplan and Suzanne Nora Johnson scored $17.5 million apiece.

EMDs, for their part, might make anywhere from $1.75 million to $3 million, according to a knowledgeable employee at a rival firm. “Those guys are almost paying a fee to work at Goldman,” he says. “That’s one thing that hasn’t changed. Goldman is split between the haves—the PMDs—and the have-nots, which is everyone else.” That first point is only partly true, because when Goldman gave up the carrot of the partnership to motivate its employees, it received something in return: publicly traded stock. With an increasing part of its compensation coming in the form of stock grants that vest over time, EMDs still have a fancy set of golden handcuffs keeping them tethered to the firm. And though Goldman shares haven’t exactly rocketed to the moon since 1999, they have outpaced the Dow and the S&P 500.

So what of everyone else? Generally speaking, the remaining 35 percent of net revenue is split rationally at Goldman, based on a series of narrowing considerations: the performance of a particular division within the firm, the business unit within the division, the individuals themselves, and, increasingly, what you need to pay them to keep them from jumping ship. “You try to determine how much you have to pay to ensure their loyalty,” says a former EMD in Goldman’s fixed-income division who left the firm in early 2005. “Except at very senior levels, they’re almost always trying to find that point of indifference. Goldman is paying you $1.25 million and Lehman is dangling $1.5 million? After tax, what is that—150 grand or so? Is it worth switching? Without ever explicitly saying so, that’s precisely what Goldman tries to do—to find that number where someone says, ‘Screw it. It’s just not worth it to move.’ ”

Although the past five years have seen a huge amount of traffic from old-line investment banks to hedge funds, executive recruiters say that movement has slowed somewhat. The spate of hedge-fund scandals and spotty performance in 2005 will likely slow it even more. But that doesn’t mean Lehman Brothers and other investment banks aren’t chasing after Goldman’s top talent—and vice versa. “There’s a talent war out there in areas like derivatives, commodities, investment banking, and proprietary trading,” says Michael Karp, co-founder of executive-search firm Options Group.

So how do they keep their people from bolting when they find out the guy at the next desk got paid a little more? Trick No. 1: Demand secrecy. It’s not as difficult as it sounds; the employees themselves have an interest in not advertising their own bonuses. The only thing worse than getting shafted, after all, is having your colleagues know you’ve been shafted. “Everybody on Wall Street plays poker when it comes to compensation,” says that former EMD. “Even if you’re positively surprised, you hide it, because you want them to feel that was the least you expected.”

A current vice-president at the firm says that because everyone gets the news on the same day—“compensation day,” which is generally in the first half of December—the entire firm gets consumed in a frenzy of trying to read each other’s reactions. “All the offices have glass walls, so everyone is trying to read everyone else’s face, especially when they’re in there getting the news,” she says. “You wonder, Does she look happier than me?”

When I worked in Goldman Sachs’s investment-banking division in the early nineties, I knew of a group of more-senior employees who would sit together at the division’s annual party each year and throw their compensation numbers into a hat. A designated person would calculate the average and tell it to the table, just so all knew where they stood. But that was the extent of it—the actual numbers were not shared.

Trick No. 2: Tell people, unless it’s blatantly obvious otherwise, that they’re being paid “outside the top of the range.” This has a few beneficial effects. For starters, it makes the employees feel pretty good—at least temporarily. Second, it makes them even more reluctant to share their compensation around the water cooler. “Everyone was always telling me how great I was and that I was the only person in my division in my class being paid outside the top of the range,” says a former vice-president in Goldman’s equities division. “I ended up not wanting to ask people, because if it was true, and my number got around, it would be obvious it was me.”

As money-obsessed as Wall Street is, the taboo on discussing your own compensation remains very serious at firms like Goldman. At a conference several years ago that was being addressed by Jon Corzine—then head of the firm and now governor-elect of New Jersey—a vice-president I used to work for in corporate finance had too much to drink, stood up, and jokingly chanted something along the lines of “More pay! More pay!” He was met with looks of horror by the entire division and a withering stare from Corzine himself. That man, who by rights should have made partner at the firm given the revenue he brought in, never did get there. Everyone in the division remembers the incident. “A career-limiting move of epic proportions,” recalls an ex-colleague.

Trick No. 3: Because bonuses are based on everything from the performance of the firm down to the division and the individual, there’s always something else to blame when someone gets the shaft. “There was always an excuse about why you weren’t getting as much as you expected,” says the former equities VP. “If it wasn’t the division, it was your group; if not that, the firm itself.” Goldman’s problem this year: The firm seems to be hitting on all cylinders, so everyone expects a big payday.

Everyone, it should be noted, really means everyone. Goldman secretaries, I am told, now make anywhere from $50,000 to $75,000 a year—depending on whom they work for and their level of experience—and tend to earn anywhere from 10 to 25 percent more as bonus. The firm’s undergraduate hires, or “analysts”—which is what I was in the early nineties—now make $70,000 a year, with the potential bonus of $75,000, according to the career Website vault.com. Recent M.B.A. graduates, or “associates,” tend to make $95,000 or more and also have a shot at an equal amount as a bonus. Those numbers are pretty much Streetwide—like airlines, investment banks tend to move in lockstep when it comes to paying their grunts.

What doesn’t move in lockstep is the performance of the various businesses at Goldman, which are divided into four main groups: investment banking, asset management (known as GSAM), equities, and FICC (fixed income, currency, and commodities). All four divisions fight each year over that remaining 35 percent of net revenue, and the money tends to go to those divisions—and the business units within them—that are outperforming at the time.

The Goldman of today is a very different place than when its investment-banking franchise—still the envy of Wall Street—was the company’s crown jewel. As evidenced by the ascension of trading veteran Lloyd Blankfein to president, the banking division has been thoroughly eclipsed by the company’s traders, so much so that Goldman is now jokingly referred to as a hedge fund with an investment-banking arm stapled onto it.

In the third quarter of this year, the company’s trading and principal investments (both equities and FICC) pulled in $5.1 billion in revenue, 69.5 percent of the firm’s total; asset management and securities services, $1.2 billion (16.6 percent); and investment banking, $1.02 billion (13.9 percent). Although it’s the first time the investment-banking division has topped $1 billion in quarterly revenue since the third quarter of 2001, it’s quite clear where the bulk of the money’s going to go: to the company’s traders, particularly those who make massive bets with the firm’s own capital.

Ultimately, it’s those traders who are the toughest to replace. Depending on which “desk” they sit at—risk arbitrage, credit swaps, equities, and many others—these people operate almost like free agents within the firm, their market bets bankrolled to the tune of hundreds of millions of dollars. Although investment bankers can be—and often are—replaced, a talented trader is an asset worth paying to keep. And that goes for their off years as well. “Traders go hot and cold,” says Kessler. “But you’ve still got to pay them enough in the cold years if you want them to be around for the hot ones.”

The names that follow are notable for the quality they all share: Most people will have never heard of a single one of them, despite their place among New York’s and London’s wealthiest. It says a lot that the most famous Goldman veteran—even more so than Jon Corzine and former co-chairman Bob Rubin, who went on to become Secretary of the Treasury—is Kwame Jackson, from the first year of Donald Trump’s The Apprentice. Jackson reportedly asked for a leave of absence to participate in The Apprentice but was told it was “too much of a reputational risk.” So he quit.

Rumor has it that the man in line for one of the biggest paydays in the New York office in 2005 is Mark McGoldrick, co-head of global proprietary investment for Goldman. In English, that means McGoldrick is the co-chief of the division that makes bets with the firm’s own capital. One New York recruiter told me the word on the street was that McGoldrick’s group had delivered more than $2 billion in profits for the firm this year. That should put him in line for a payday in the realm of $40 million or more. Proprietary traders are the golden boys (and girls) of Goldman these days, and payouts of $15 million to $20 million will not be unusual for top performers.

Jeffrey Frase, head of crude-oil trading for the firm, made an estimated $20 million to $25 million last year, according to Trader Monthly magazine, and given the volatility of those same markets this year, he could be up for even more in 2005. Likewise, Robert Cignarella, a debt trader in the firm’s asset-management division, took home an estimated $25 million to $30 million last year and could do so again. Others who stand to make a substantial amount, given the strength of their divisions: Phil Hylander, co-head of global equity trading, Richard Ruzika, co-chief executive of global commodities, and Philippe Khuong-Huu from the fixed-income division.

Gene Sykes and Jack Levy, who run the firm’s mergers-and-acquisitions business, are also undoubtedly up for a substantial payday, given the recent tear of that division. The firm advised on huge deals like Ford’s sale of Hertz for $5.6 billion.

Across the pond in London, Goldman’s other center of power, the list of high earners is extensive, thanks to the intrusive capabilities of the British press. Michael Sherwood, co-chief of Goldman Sachs International and a protégé of Blankfein’s, is said to be in line for a bonus of $20 million or so. According to Trader Monthly, Driss Ben-Brahim, head of the exotics-and-derivatives desk in London, made anywhere from $25 million to $30 million last year, and he’s rumored to be in line for a similar payout in 2005. Likewise, John Bertuzzi, a top energy trader in London, is said to have made $20 million to $25 million last year and could be up for a similar amount once again.

Goldman also pays its supporting cast handsomely. Bankers whose jobs consist merely of pitching the capabilities of other people at the firm can make as much as your average NFL starter. “The amazing thing about Goldman,” says a hedge-fund executive who does business with the firm, “is not that a few talented people make $20 million—it’s all the mediocre talents that make over $1 million.”

What does the future hold for Goldman in the way it pays its people? It’s going to get messier. With the rise of the hedge-fund industry, more and more people are bolting every Wall Street institution to start their own shops, in pursuit of “2 and 20”—shorthand for customary hedge-fund fees of 2 percent of assets under management and 20 percent of any upside. Goldman recently lost one of its legendary “quants”—so-called for their quantitative trading skills—Eric Mindich, who founded his own hedge fund, Eton Park, last year with $3.5 billion from investors. In 1994, Mindich became the youngest partner in the firm’s history, although rumors swirl that he had fallen out of favor owing to the problematic acquisition of New York Stock Exchange specialist firm Spear, Leeds & Kellogg for $6.5 billion in 2000. Forbes magazine called the purchase a “billion-dollar blunder” in 2003.

In any case, Mindich is only the latest in a long list of Goldman defectors lured away by the possibility of making substantially more money on their own. It was recently suggested that 10 percent of all money in hedge funds had ex–Goldman people involved in managing it—some $100 billion in total assets. That number is probably overblown, but the anecdotal evidence is impressive: Top Goldman players who have left in recent years include Edward Misrahi and Scott Prince, who joined Mindich; super-trader Christian Siva-Jothy in London, who joined Fulcrum Asset Management; and Geoffrey Grant and Ron Beller, who formed Peloton Partners. Why? Shockingly, Goldman couldn’t pay them enough. On the other hand, Goldman is, in a sense, still paying them—the firm is rumored to be a seed investor in many of these funds. So these top traders get the 2 and 20 they want and still remain part of the extended Goldman family.

Because of its reputation and the incredible riches that came with making partner, Goldman used to enforce tight discipline in compensation. But the industry is more competitive now, and the firm has to fight along with everyone else to keep its top producers. One current EMD told me that Goldman is now prepared to pay its top traders 10 to 15 percent of the profits they make for the firm, a stark reversal of long-standing policy and a direct counter to the siren song of hedge funds. “There was always an implicit understanding that if you made $100 million for the firm, the last $50 million of it was a waste of your time—they were never going to pay you more than a certain amount,” says one former trader for the firm. “But that’s all changed now.”

In Goldman’s offices around the globe, but especially inside the gilded walls of 85 Broad Street, the annual bonus dance is about to reach its climax. On the day they’re told their numbers, those who are richly rewarded will do their best to contain the feeling that comes along with being $2 million, $10 million, or even $40 million richer. And what of those who get the shaft? “They try to be professional,” says the former EMD. “Although you can see from their trembling lips or the intensity of their stare that they’re disappointed. They’ll go out to their station, slam a few things down, grab their coat, and walk out. Some of them won’t come back for several days.” At which point, it will nearly be 2006, with the meter running on next year’s bonus.


The Goldman Sachs Diet

If the firm split its potential $11 billion pie equally among all 22,000 employees worldwide, they’d each get $500,000. But that’s not how it works.

The Big Piece

There are 250 or so partner managing directors, each of whom would receive an average bonus of $2 million right off the top. The rest depends on the success of their part of the business, and it can be massive. Top income-producers like Mark McGoldrick, co-head of global proprietary investment, can make upward of $40 million.

The “Tide You Over Until You’re a Somebody” Piece

Executive managing directors, also known as “MD Lites,” can make up to $3 million.

The Table Scraps

Just-out-of-college analysts make $70,000 and hope to match that in bonus. Associates, with M.B.A.’s, hope to match their $95,000 salaries with a bonus, too. Secretaries who make as much as $75,000 have their sights set on bonuses of roughly $15,000.

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