Sun Life Q1 2006 Earnings

Scotia Capital, 28 April 2006

Q1/06 - Slight miss due to unfavourable claims experience

• Sun Life reported Q1/06 operating EPS (f.d.) of $0.84 vs $0.77 for 9% YOY growth, $0.02 below our estimate, and $0.02 below consensus. Given the favourable economic "tail winds" (buoyant markets, excellent credit environment, rising long term rates) we believe the "miss," largely due to modestly unfavourable claims experience in both the U.S. and Canadian group insurance segments, was somewhat disappointing.

• Mixed results. What was likely needed to boost the stock just wasn't there this quarter. We believe Sun Life needs to have, amongst other things, exceptionally better-than-industry sales growth in U.S. variable annuity, positive net flows in U.S. variable annuity, increasingly positive net flows at MFS and significant margin improvement at MFS before we can ascribe an increasing multiple (relative to the group) to the stock. Unfortunately this wasn't the case in Q1/06.

• But relatively favourable macro-environment and hint of increasing buy-back activity should continue to provide support. The combined impact of rising interest rates, which help to mitigate spread compression concerns, buoyant markets, good credit, lots of buyback support, and a payout ratio still at the low end of the targeted 30%-40% range, should continue to provide support. Management indicated the company would likely increase the pace of share buybacks going forward (from the 2 million shares in Q1/06, most of which were in March), suggesting the company definitely will meet if not exceed its targeted $500 million spend on annual share buybacks.

• Still a "show me story" - and not showing positive net sales in either U.S. variable annuity or U.S. mutual funds, and showing no significant improvement in U.S. variable annuity market share. Although we find the 24% increase in U.S. variable annuity (VA) sales encouraging (after increasing 10% at Q4/05), we expect only very modest market share improvement at best, especially given that exceptional results from other U.S. lifecos so far this quarter (Ameriprise's U.S. VA sales were up 70%, Genworth's were up 50%, MetLife's were up 57% and Harford's were flat, after declining sharply for several quarters). With total sales growth from these five players, including Sun Life, up 25% (we would expect this figure to increase when we include traditional players such as Prudential, Lincoln and Manulife) we expect the company will gain little in the way of market share in the U.S. VA market, despite the $10 million spent in expanding its distribution. More importantly, net sales continue to be negative, and, with a large block of single manager variable annuity business with a current duration of 5-7 years, we expect this trend to continue, despite the improvement in gross sales. Finally, weaker-than-expected net sales in both retail mutual funds and institutional business, largely due to a "poor" January per management, contributed to a disappointing negative US$300 million in net sales at MFS. Management indicated flows at MFS were positive in February and March of 2006.

• Margin improvement at MFS due in part to the transfer of money losing retirement services operation from MFS to U.S. annuities. The company noted that pre-tax margins at MFS (10% of SLF's bottom line) improved 300 bps, with about 150 bps due to the transfer of a retirement services operation from MFS to SLF's U.S. annuity segment, and another 150 bps due to operational improvements. The retirement services operation, which lost US$4 million in Q1/06, includes roughly US$6 million in revenue and US$10 million in expenses in the quarter, and about US$15 billion in assets. While the transfer of this retirement services business makes MFS look better (we look for 18% CAGR earnings growth, ex f/x through 2007), the only way for a meaningful impact on SLF's bottom line is for the company's U.S. annuity segment to turn this business around. With little experience in the retirement services business, we remain somewhat sceptical.

• Canadian segment (50% of bottom line) reported a disappointing 4% YOY decline in earnings over a strong Q1/05 due to unfavourable group claims experience. Group long term disability claims experience, an often volatile business, contributed, in part, to the decline, as did a slight decline in the earnings contribution from SLF's 34% interest in CI funds. The 12% CAGR the Canadian operations had from 2003 through 2005 certainly benefited from CI's 38% CAGR over the same period. Excluding CI, earnings for Sun Life's Canadian division grew 9% (CAGR) over the same period, and just 6% in 2005. We expect 7% growth in 2006 and 10% growth in 2007, respectively, for the segment, assuming a return to a more "normal" claims experience in the group insurance segment.

• For the U.S. division we look for steady 11% growth (CAGR, ex fx) through 2007. Despite the somewhat mixed outlook for average asset growth in the U.S. annuity segment (for a business in which average assets increased ex f/x just 1% CAGR from 2002 through 2005, we forecast just 2% CAGR through 2007 largely due to continued negative net flows) we expect rising interest rates and continued buoyant markets to allow for margin improvement. Whether it be a yield pick-up program for the company's U.S. fixed annuity business (by investing at longer durations than the liability portfolio) or an innovative "surplus" type funding of U.S. individual AXXX reserves (whereby the company uses internal funds rather than bank letters of credit (LOC) to fund these reserve requirements thus generating additional yield and saving the LOC costs), Sun Life has done a very good job of engineering stable earnings growth in its U.S. division, despite the drag of currency. The yield pick-up in the U.S. fixed annuity business was the prominent contributor to the 64% YOY earnings growth in the U.S. division in Q1/06 (ex f/x), over a very poor Q1/05 that had a significant amount of reserve strengthening. Our 11% growth assumption assumes group insurance claims experience will return to more normalized levels. Poor group insurance claims experience was the primary contributor to the 22% QOQ decline in earnings for the division.

• CMG Asia acquisition progressing well and provides the necessary catalyst ($0.05 accretion in 2006, $0.07 accretion in 2007) for the company to exceed 10% EPS growth target in 2006 despite currency headwinds. We look for 11% EPS growth in 2006 and 10% in 2007, which combined with aggressive buyback levels should add 100 bps to ROE over the next two years, just shy of the company's target of 75 bps per year.

• We expect 100 bps improvement in ROE over next two years - 50 bps shy of target - which might suggest the company needs to do something other than buy back stock. With an estimated $1.5 billion in excess capital, we believe the company continues to look for deals. Our impression is prices are too high and the company remains patient. With the CFO set to leave within the next 10 months, and an expected detailed search for a replacement underway, we remain somewhat sceptical as to whether a large and/or complicated deal gets done before the end of the year. Clearly smaller and simple deals, largely accretive, like the CMG Asia acquisition ($560 million spend with $0.05-$0.07 per share accretion) are ideal.

• Asset quality remains strong. Net impaireds at 18 bps remain exceptionally low. With only 3% of bonds below investment grade, we believe Sun Life’s balance sheet is well protected should the credit environment become unfavourable.

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The Economist on Goldman Sachs

The Economist, 27 April 2006

By any measure, Goldman Sachs is a formidable company. The bank knocks the spots off its competitors, whether in pure “investment banking”, the traditional craft of underwriting and mergers and acquisitions in which it made its name, or in its new focus, trading for customers and its own account. Even compared with leaders in other industries, Goldman makes spectacular returns. Among its latest record-busting yardsticks was a 40% quarterly return on equity. The average pay-packet of its 24,000 staff last year was $520,000—and that includes a lot of assistants and secretaries.

This makes the bank an easy target for populist politicians and tabloid newspapers. The real reason why Goldman should matter to outsiders is not because it is a manufacturer of millionaires (good luck to it); but because it stands at the centre of a two-decade-long transformation of the financial markets and a new approach to risk.

Business risks that were once seen as a lumpy fact of life are now routinely sliced up and packaged into combinations that generally suit issuers and investors alike. At the heart of the change has been the development of huge markets in swaps, derivatives and other complex and often opaque instruments that allow the transfer of risk from one party to another. From small beginnings in 1987, the face value of contracts in interest-rate and currency derivatives is now more than $200 trillion—16 times America's GDP. A further $17 trillion is outstanding in (even newer) credit-default swaps, which allow bond investors to lay off the risk of issuers defaulting.

Led by Goldman, investment banks have innovated at a furious pace and changed the mix of their own businesses. They have taken on more risk as they have moved from more transparent markets, in which margins are slim, to more profitable portfolios of derivatives and direct private-equity investments. The face value of Goldman's derivatives exposure is more than $1 trillion, although the bank says that its net exposure, once you offset all its positions, is $58 billion, against shareholders' funds of $28 billion. The bankers' innovations have brought huge rewards to their industry. In the past decade it has garnered revenues of more than $125 billion, more than three times the level in the previous decade.

Simply the best

This huge new risk industry has produced gains for people far away from Wall Street and the City of London. Car companies have been able to hedge away many risks that once were seen as an incurable part of the business—and thus focus on what they do best. Pension funds have been able to shape their portfolios to fit their appetite for risk. Friction is bad for economies; the risk industry reduces it to all our benefits.

Yet the sheer size of the numbers involved does mean it is worth raising three questions. How exactly has Goldman and its industry achieved this? Can it be sustained? And what should happen if something goes wrong?

Like most of its rivals, Goldman is a difficult institution for outsiders to understand. Until 1999 it was a private partnership. With public ownership came greater reporting responsibilities, but precisely what Goldman is up to remains obscure. The bank likes to say that it still relies a lot on traditional investment banking, but Goldman's accounts show that its profits come increasingly from trading. The sharp-suited investment bankers act as a sales force for less-well-dressed colleagues who work out how to make money from swaps, options and direct investments.

Goldman was not the first to realise that new financial techniques had the potential to alter risk management for companies of all kinds. Bankers Trust, now part of Deutsche Bank, was arguably quickest off the mark. But once it joined the risk-management game, Goldman steadily accumulated market nous. It applied this by building a proprietary technology system, shunning the off-the-shelf products used by many of its competitors. People who have left Goldman say that this system is unmatched at rivals. One consequence is that Goldman seems confident that it can take more risks than its competitors do. Its trading revenues are the most volatile among big investment banks and it has the most days when it loses money. Overall, however, it makes the most money.

Inside the black box

But for how long? The market doubts the run of huge profits can last. Goldman's shares are valued less richly than those of competitors it so obviously outwits. Moreover, investment banks are less highly valued than less glamorous commercial banks and retail brokerage firms.

This could be because investors think Goldman will struggle to sustain the breakneck innovation that keeps it ahead of others. Goldman's ascendancy is already showing stresses—most recently the struggle to manage conflicts of interests across its business lines. Hank Paulson, Goldman's boss, recently chastised its London team of investment bankers for appearing too aggressive in their offers to buy companies, thereby threatening the bank's reputation for being an adviser. In Japan, for just this reason, some of Goldman's M&A customers have deserted it for rivals.

These kerfuffles show that conflicts of interest can probably be solved by market pressure rather than intervention by regulators. A bigger problem for both investors and regulators has to do with risk itself. Outsiders—and perhaps even insiders—find it hard to judge whether Goldman's business is sustainably good or has thrived thanks to a dose of unsustainable good luck and skill. In addition, the very improvements in risk management that have spread risk far and wide make it harder to know where risk is concentrated or how risks might combine to threaten the system's overall health.

So far central banks have concluded that the system is more robust than it was. But the trading models that have propelled Goldman will be tested one day. At worst, the bank itself—or, more likely, a second-tier rival or a hedge fund—might fall into the kind of dramatic spiral that killed off Long-Term Capital Management (LTCM), a hedge fund, in the late 1990s. Financial markets have always been subject to crises.

Any crisis would affect Goldman, because it is so intertwined with the system. The bank says it keeps plenty of liquid reserves against the dread day. It might well profit from any crisis (it did from LTCM). But the chances are that some banks, somewhere, will get into serious trouble.

If that happens, the losses of any bank will be for its shareholders; they should not expect any bail-out. The wider question has to do with systemic risk. If the much vaunted systems do not work, then the central banks will have to step in (as the Federal Reserve did with LTCM). In the past, though, such collapses did less damage to the financial system than the regulatory over-reaction that followed them. If policymakers were to respond to the next crisis by ushering in a more conservative regime that severely limited financial risk-modelling and risk-management, the global economy would be the poorer for it. That is what should stick in people's minds when the day comes. Until then, why not do something too often forgotten? Love Goldman or hate it, you ought to admire it and the system it epitomises. And hang on tight.

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TD Banknorth Q1 2006 Earnings

RBC Capital Markets, 26 April 2006

• Earnings Summary: 1Q06 operating cash earnings declined by 8.3% year-over-year, and declined by 11% sequentially.

• Overall, Trends Were Mediocre, In Our Opinion: Excluding acquisitions, consumer and commercial loans increased an estimated 1.5% -2.0%, total deposits contracted roughly 1%, the net interest margin contracted by 13 basis points, core fee income contracted fractionally and asset quality trends remained stable and solid.

• Looking Ahead: We are expecting loan, deposit and fee income to bounce back from a seasonally weak first quarter, which combined with a relatively stable margin and the realization of cost savings from the HU deal, should allow BNK to return to a more normalized sequential EPS growth trajectory in the second half of this year.

• Adjustments: We lowered our 2006 and 2007 operating cash earnings estimates to $2.23 and $2.48 per share from $2.38 and $2.62 per share to reflect the weaker than anticipated first quarter trends. We also lowered our 12-month price target to $27 from $28 per share.

• Thoughts On The Stock: We think the company can return to more normalized growth in late 2006 and in 2007, but view the stock to be lacking positive near-term catalysts (no earnings growth, little if any buyback activity), and we view the company as an ongoing acquirer. Therefore, we would continue to avoid the stock.

• Rating: The stock trades at a modest premium to our fundamental price target of $27 per share, justifying our Sector Perform rating with Average risk, in our opinion.

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TD Newcrest on RBC's Investor Day

TD Newcrest, 26 April 2006
Event

Yesterday RBC hosted an Investor Day, that clearly reaffirmed in our mind the strength and growth potential of the franchise. We maintain our Buy recommendation on the stock.

Impact

Neutral. We are maintaining our 2006 EPS estimate of $3.38 and our 2007 EPS estimate of $3.70. Our 12-month target price of $54.00 remains unchanged.

Details

RBC Canadian Personal and Business operations appear to be firing on all cylinders, with management focused on:
• Optimizing distribution,
• High return products, markets and clients, and
• Simplifying processes and structures.

Expanding distribution is a priority, with plans in place to increase:
• Client facing roles to approximately 27,000 by the end of 2006 (from 26,200 during Q1/06),
• Expand branches - over the next 5 years management are targeting to open 62 branches nationally (50 branches within the GTA over the next 3 years).
• To open another 10-15 insurance locations adjacent to branches, as initial customer response had been very positive.

Growing high return businesses is critical to RBC’s growth strategy. Again, we are impressed with RBC’s progress to date for example:
• RBC Visa’s outstanding balances increased 11% (versus the Canadian credit card market of 9%). RBC’s total market share was 16% at January 31, 2006). Visa’s purchase volumes rose 17% (versus market growth of 12%). We highlight that management is forecasting double-digit earnings growth going forward.

A key management focus is to obtain #1 or 2 market share positions for all products. At December 31, 2005, RBC achieved number 1 market share position for personal loans, cards and residential mortgages combined.

Management also commented that margins appear to stabilizing, particularly for deposits, and they believe BMO is less aggressively chasing mortgage market share.

Canadian wealth management businesses contributed 19% of total Canadian retail revenues during Q1/06. RBC Asset Management’s growth has been particularly impressive with long-term mutual funds increasing $26.7 billion since October 2002, well above its competitors.

During 2005, RBC US & International Personal and Business results have stabilized, particularly within retail banking. RBC Centura is focused on improving underlying fundamentals, and on expansion in faster growing metropolitan areas. Management indicated that progress has been made, for example:
• New branches break even quickly (20 months versus the industry average of 36 months).
• Accelerated branch openings are scheduled for 2007 - 15-20 branches will be opened in faster growing Atlanta and Florida.
• As of February 2006 there had been significant improvement in year over year key metrics, for example new personal chequing accounts opened per day increased from 1.0 to 1.56, and the cross sell ratio for new households rose from 1.0 to 1.27.

That said, clearly this franchise remains the weakling in the RBC stable of franchises. Total households serviced fell in 2005 and the bank’s rural branch positioning is less than optimal. Although management seems focused on restoring health to the operation, at some point in time, we believe an acquisition will be required to increase scale, or a disposition of the franchise will need to be considered.

Wealth management is a key business within the US franchise, contributing 2/3’s of the group’s revenues during 2005. Management is focused on organic growth, increasing sales staff and on cross selling.

Global Private Banking appears to be the key growth priority for the bank.. The bank presently operates in 21 countries and services 28,000 clients managing an average US$5.4 million per client. We highlight that ROE’s in this business are well in excess of 20%. We believe future acquisitions are likely in this area, particularly outside of North America, as this industry is considerably fragmented. Management indicated that even without acquisitions and new product introductions the business is expected to double over the next 5 years, as they are currently winning unprecedented levels of new business.

Valuation

We believe RBC will deliver strong earnings growth over the next 2 years, given the bank’s superior operating momentum and dominant Canadian retail franchise and that RBC deserves a premium multiple.

Justification of Target Price

Our $54.00 target is a product of adding 50% of the $48.90 value derived from our 2007 P/E valuation of 13.5 times to 50% of the $50.74 value derived from our 2007 price-to-book valuation of 2.86 times, to which we add a premium of 8% to account for the probable change to the dividend tax legislation.

Key Risks to Target Price

We believe the key risks are: 1) unfavorable interest rate movements; 2) a downturn in the credit cycle; and 3) additional acquisitions at premium valuations.

Investment Conclusion

Yes, RBC does trade at a premium valuation to the group, at 12.7 times 2007 earnings relative to 12.1 times for the other large Canadian banks. However, no Canadian bank offers the growth profile of this institution in our opinion, which is also in the middle of its three-year efficiency plan. Management’s confidence in the future was very apparent to us. In a Canadian market that we believe lacks true leaders, we believe that RBC is clearly at the top of the pack.

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NBF on Cdn Banks and EVA

National Bank Financial, 24 April 2006

• EVA rose 190% in two years : EVA for the sector rose to $6.7 billion in f2005 from $2.3 billion in f2003, or an impressive 190%. Over that time, improved profitability was the most important contributing factor to the higher EVA, followed by strong business growth, particularly in f2005. A declining cost of equity capital offset, in part, the penalizing effect on EVA of greater economic capital usage. We estimate EVA was 15% lower, as a result of excess common equity balances at all banks.

• Our EVA valuation work continued to produce accurate forecasts for relative share price performance, correctly predicting the relative performance for all 6 banks in f2004.

• More modest EVA growth of 12% forecast for f2006 : For f2006, we forecast EVA to grow, albeit more modestly (up 12%) than over the previous 2 years. We forecast another year of strong business growth with further profitabilty improvements to more than offset the impact of rising capital charges stemming from higher economic capital and increased cost of equity capital.

• From an EVA valuation perspective, the sector appears to be slightly overvalued at present. Our analysis indicates that BNS, CM, NA, and TD are currently fairly valued; (i.e. their overvaluations are within 5% of their EVA implied share prices) while the other banks are either overvalued (BMO) or significantly overvalued (RY).

Rankings for f2006 (Valuation/Profitability):

1 BNS - peer-leading forecast profitability and currently fairly valued
2 CM - relatively weaker profitability, but very favourably valued
3 TD - still weakest profitability despite improvements, most favourably valued
4 NA - forecast of continued strong profitability and fairly valued
5 BMO - improved, but below average profitability forecast and overvalued
6 RY - strong forecast profitability, but significantly overvalued

^ Economic Value Added (EVA) is the financial performance measure that comes closer than any other in capturing the true economic profit of an enterprise. Put most simply, EVA is net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true "economic" profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholders and lenders could get by investing in other securities of comparable risk.

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S&P Upgrades TD Ameritrade

TD Ameritrade : Ups to 4 STARS (buy) from 3 STARS (hold)
S&P, Robert Hansen, CFA, 24 April 2006

The company's March quarter operating EPS of 22 cents vs. 17 cents is below our 25 cents estimate. We were disappointed with its results and guidance, given stronger trading volumes and increased margin rates. But, we view favorably TD Ameritrade's cutting of its commission rates given competitors' price cuts, as we think this will help the company grow market share. We are lowering our fiscal year 2006 (ending September) EPS estimate to 85 cents from 95 cents. But we are raising our target price to $23 from $22, 27 times our fiscal year 2006 estimate. Despite our view of competitive challenges, we think shares are attractive following recent weakness.

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Merrill Lynch on Life Insurance Cos

The Globe and Mail, Roma Luciw, 24 April 2006

Merrill Lynch & Co. Inc. kicked off coverage of the Canadian insurance industry with a mixed review Monday, handing two of the biggest players — Manulife Financial Corp. and Sun Life Financial Inc. — “neutral” ratings on the basis of their valuation.

In a research note to clients, analyst André-Philippe Hardy said that Toronto-based Manulife has an attractive business mix with valuable Asian exposure, strong U.S. sales stemming from its takeover of Boston-based John Hancock Financial Services Inc., and a solid track record of earnings growth.

He noted, however, that at 14.8 times estimated earnings, Manulife's valuation is the richest among the four Canadian life insurance companies and high by global standards. Furthermore, Mr. Hardy said he does not think “further multiple expansion is likely, particularly since we believe Manulife is more exposed to weakening credit quality and currency fluctuations than its domestic lifeco peers.”

He has a $73.65 twelve-month stock target price on Manulife and a $48.93 on Sun Life, the other company he labelled “neutral.”

Mr. Hardy said that Sun Life's positives include its highly capitalization, large exposure to the asset-management business and to the attractive Indian insurance market, and a well-positioned domestic group platform.

On the downside, “the company's track record of embedded value growth is weaker than that of its two Canadian peers who provide disclosure,” it has greater exposure to deteriorating credit quality than some of its peers, and needs to improve its position in the key U.S. market, he said.

Sun Life stock trades at fourteen times this year's earnings and has a “relatively rich” embedded value, while prospects for further multiple expansion are limited, he said.

Mr. Hardy placed a “buy” rating on Winnipeg's Great-West Lifeco Inc. and Quebec City-based Industrial Alliance Insurance and Financial Services Inc., the smallest of the four Canadian insurance companies. He put a $33 stock price target on Great-West and a $38 target on Industrial Alliance.

Great-West stock has lagged its peers this year “on concerns that 2006 earnings will be hurt by currency fluctuations and by continued disappointing membership trends in the U.S. managed care business,” Mr. Hardy said, noting that the company's stock trades at a discount to Manulife and in line with Sun Life, despite having less exposure to weakening credit quality, industry-leading return on equity, and exposure to the high-multiple U.S. managed care industry.

Great-West operates in the U.S. annuity, group life and health care markets. According to Mr. Hardy, the implementation of new information technology systems in the U.S. health-care business during 2006 should improve Great-West's profitability, potentially place the company is a better position to seek new business and could lead to multiple expansion, Mr. Hardy said.

Industrial Alliance is “underappreciated,” he said, trading at the lowest valuation in the group. The company's earnings will benefit from the acquisitions of Clarington and the integration of National Life, and should not be harmed by the rising Canadian dollar.

Furthermore, Mr. Hardy said that Industrial Alliance has less exposure to deteriorating credit quality than Sun Life and Manulife and he believes the company will increase its market share of individual insurance and segregated funds.

Industrial Alliance “could eventually be a takeover target, in our view, given its smaller relative size,” Mr. Hardy said.

The company's size could hurt its group business — which represents about 30 per cent of earnings - because it is an area that is more dependent on size, he said. “Earning high returns on equity will be challenging, in our view, because market share is smaller in retirement services (a high-ROE business), while its most competitive product within that segment (insured annuities) earns a low ROE.”

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DBRS Affirms Ratings for Scotiabank

Investment Executive, James Langton, 19 April 2006

Dominion Bond Rating Service has affirmed its ratings on Bank of Nova Scotia.

“Scotiabank’s ratings continue to be supported by the bank’s level of diversification with balanced contributions from Domestic Banking, Scotia Capital, and the significant international operations,” it said. “Recent earnings have been strong in all divisions, with record earnings in 2005 and a solid result in the first quarter of 2006.”

The rating agency noted that Scotiabank’s financial risk profile is one of the strongest of its peer group, “as evidenced by solid capital ratios, high quality capital, consistently strong internal capital generation, a strong core deposit base, and reasonable market risk exposure levels.”

Scotiabank also has a competitive advantage as the cost leader among its Canadian banking competitors, it added. DBRS does not anticipate any significant changes in the bank’s financial risk profile or cost management.

“Domestic Banking remains the key to stability as both Scotia Capital and International Banking operations can have volatile returns. While International Operations has higher growth potential, these operations expose the bank to additional economic, currency, and operational risks,” it noted.

“Other challenges for Scotiabank include a higher reliance on net interest income than the bank’s peers, which is an important consideration, as DBRS expects domestic margin pressure to continue, due to competitive conditions,” it cautioned.

Scotiabank recently completed banking acquisitions in Peru and El Salvador and has acquired Maple Trust Company and some related assets domestically, DBRS noted. “While not a large acquisition for the bank, Maple Trust is one of the largest originators in the Canadian mortgage brokerage business,” it said.

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Scotiabank Buys Citigroup's Dominican Republic Unit

Canadian Press, 18 April 2006

Bank of Nova Scotia says it has acquired Citibank's retail banking business in the Dominican Republic, including three branches, for an undisclosed price.

The deal, announced Tuesday, consolidates Scotiabank's position as the Dominican Republic's fifth-largest private bank by assets, with 57 bank branches, 75 automated banking machines and more than 1,000 employees.

"As an international bank with more than 170 years of experience, we are optimistic about the future in the Dominican Republic and confident this acquisition will complement our level of customer service," Nicole Reich de Polignac, senior vice-president and country manager for Scotiabank in the Dominican, said Tuesday in a release

Federico Grigera, VP for Citibank in the Dominican Republic, said the Caribbean country remains an important market for his company, which will concentrate on the country's traditional corporate and international banking clients.

The acquisition includes three branches, retail loans, deposits and a credit card portfolio that significantly increases Scotiabank's credit card holdings in the Dominican Republic. A co-branding agreement with American Airlines will continue.

Established in the Dominican Republic in 1920, Scotiabank has had a continuous presence for more than 85 years in the country.

The Bank of Nova Scotia is Canada's most international bank. With more than 50,000 employees and $285 million US in assets, Scotiabank and its affiliates serve about 10 million customers in about 50 countries.

Scotiabank has been part of the Caribbean and Central America since 1889. It is now the leading bank in the region, with operations in 25 countries, 10,225 employees in the region and about 370 branches.

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DBRS Upgrades Ratings for Power Corp & Power Financial

Investment Executive, James Langton, 18 April 2006

Dominion Bond Rating Service is upgrading the ratings of Power Financial Corp. and its parent company, Power Corp. It says it expects the Power companies to remain active financial industry consolidators.

The financial strength of Power Financial is primarily derived from its controlling investments in two of Canada’s leading financial service providers: Great-West Lifeco Inc. and IGM Financial Inc., DBRS explained.

The ratings agency noted that both firms have been playing active roles in the consolidation of the financial services industry in recent years, with strategic direction and financial support provided by Power Financial. “The two major subsidiaries performed well with earnings per share growth of 11% in 2005; both have also recently been upgraded by DBRS,” it said.

The company’s remaining major investment, a net 27% equity interest in Pargesa Holding SA, a Geneva-based holding company, represents about 8% of the company’s net asset value. Pargesa indirectly owns non-financial service investments in Europe (oil & gas and chemicals; specialty materials and cement; entertainment & media; and energy, water, and waste services). “[It] provides a modest strategic advantage in the form of geographic and industry diversification,” DBRS said.

During 2005, Power Financial reported a 10.1% increase in operating earnings and a 16.7% increase in dividends received, the rating agency reports. “The company’s capitalization is conservative, especially when the market value and the diversification of its earnings and its asset portfolio are considered. Liquidity is adequate, enhanced by good capital market access for the company and its subsidiaries.”

“DBRS believes that Power Financial intends to play a prominent role in the further consolidation of the financial services industry. This intention raises the possibility of acquisition-related event risk. However, recent successful value-added acquisitions support the company’s reputation for strategic vision and excellent execution,” the ratings agency said.

The credit strength of Power Corp. is tied directly to its 66.4% equity interest in Power Financial, which represents over 90% of operating revenue, operating cash flow, and the net asset value of the company. The upgrade on its ratings relates directly to upgrade of Power Financial.

“With over $670 million of cash on hand, and strong discretionary cash flow driven by dividends received from Power Financial, the company is well-positioned to add to its investment portfolio or to retire shares. DBRS believes that any new investments will remain conservative, consistent with long-term strategies, and prudently financed,” DBRS said. “Succession issues are always a concern at closely held companies but Power Corp. has demonstrated a tradition of successful senior management transition and continuity.”

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DBRS Affirms Ratings for National Bank

Investment Executive, James Langton, 18 April 2006

Dominion Bond Rating Service has confirmed its ratings of National Bank, noting that expansion outside of Quebec remains a challenge.

The ratings agency said that the bank’s ratings are supported by its ongoing progress in strengthening its regional bank and national investment bank, while maintaining a favourable financial risk profile.

During the past 12 months, the bank has been solidifying its strong retail banking position in Quebec, DBRS notes. “Given its importance as a home base and revenue contributor, DBRS believes actions taken (including increasing client satisfaction, focusing on cross-selling of products to existing customers, and expanding the product suite) will further strengthen the franchise in the future,” DBRS said.

National Bank is solidly ranked second in Quebec retail banking, with the Desjardins Group holding the largest market share. The third-largest player has a significantly lower market share than National Bank, DBRS said.

“Despite the loan growth experienced over the past two years, DBRS anticipates that the more conservative lending philosophy adopted by National Bank over the past several years will contribute to respectable asset quality over the credit cycle,” it noted. “The favourable financial risk profile should position the bank for growth, either organically or through acquisitions; so far the majority of the growth has been organic.”

DBRS said it feels some progress has been made towards geographically diversify earnings, but regional concentration in Québec remains a long-term challenge. “The bank continues to grow earnings outside of Quebec through its strategic partnership program (with, among others, the Power Financial group of companies), expand its distribution capabilities, and increase the diversification of its financial markets businesses,” DRBS concluded.

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TD Spends Big on US Marketing Push

The Globe and Mail, Keith McArthur & Sinclair Stewart, 18 April 2006

Toronto-Dominion Bank is shooting for the bank marketing big leagues, with a massive U.S. advertising budget that will make it one of the most prominent financial marketers in the United States.

Despite its aggressive expansion into the U.S. market, the TD brand is still far from a household name in that country.

"You may not know us yet," the bank admits in a new U.S. TV commercial, which shows Americans watching curiously while a crane raises a TD logo over the downtown of a generic city.

But the bank hopes a U$150-million advertising budget will make a big splash and boost its brand awareness.

That dwarfs the C$28-million TD spent on advertising in Canada in 2004, according to Nielsen Media Research.

"There aren't a lot of banks that spend that kind of money on advertising," said Walt Albro, senior associate editor of ABA Bank Marketing Magazine, which is published by the American Bankers Association.

"That would appear to be fairly significant spending -- especially if they keep it going over time, not just for a few months."

TD launched the first part of a three-tiered ad campaign yesterday, a U$25-million brand-building effort designed to introduce the brand in northeastern states where it is expanding.

Next week, TD Ameritrade will introduce its first major ad initiative since Ameritrade Holding Corp. shareholders approved a merger with TD Waterhouse in January, forming one of the world's largest discount brokers. The final piece is slated for May, when TD Banknorth, TD's Portland, Me.-based retail bank, will unveil a new branding campaign.

Collectively, TD's annual U.S. ad expenditures will be more than five times the amount it spends in Canada -- a testament, the bank claims, to how committed it is to its U.S. growth strategy.

"It certainly is bigger than you would normally see in Canada because of the cost of buying media in Canada and the number of people you reach," said Dom Mercuri, TD's chief marketing officer. "But those are the numbers we felt we needed to get a reasonable impression in the markets that we're going to serve."

Because the on-line brokerage business is national in scope, the TD Ameritrade campaign will account for most of the budget: likely in the $100-million range, Mr. Mercuri confirmed. TD will not bear the entire expense because it owns less than 40 per cent of Ameritrade.

Mr. Mercuri said the top three or four financial advertisers in the U.S. market earmark about U$150-million a year for ad expenses, and said TD "would be in that range."

The initial brand campaign launched yesterday with a TV commercial and print ads in 50 daily newspapers including The Wall Street Journal and The New York Times. Through references to the bank's 150-year history and images of the bank's logo atop a corporate tower, the commercial attempts to show that TD is a reliable, established bank, even if most U.S. consumers haven't heard of it.

"This is a fairly major salvo to introduce TD Bank Financial Group into the U.S. market," said John Boniface, president of Foote Cone & Belding Canada Ltd., which produced the brand campaign.

TD gained a foothold in the U.S. two summers ago, when it announced it was acquiring Banknorth for C$5-billion. Since then, it has purchased a pair of New Jersey banks: Hudson United Bancorp., for U$1.9-billion, and Interchange Financial Services Corp.

TD has arguably the most aggressive marketing culture of the Big Six Canadian banks, in large part because of its 1999 purchase of Canada Trust. Canada Trust lacked the scale of its banking peers, and used innovative marketing to acquire new customers. "We don't look at marketing as an expense," Mr. Mercuri said. "It's in our DNA.

TD's ad budget is believed to be among the largest ever for a Canadian company in the U.S. market.

At the height of the technology boom, Nortel Networks Corp. launched a major global campaign featuring celebrities such as hockey star Joe Nieuwendyk and former astronaut Buzz Aldrin. But reports at the time pegged Nortel's annual ad budget at less than $100-million.

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Financial Post, Barbara Shecter, with files from Duncan Mavin, 18 April 2006

Toronto-Dominion Bank is backing a multi-billion-dollar U.S. expansion with a US$25-million advertising push to promote its banking, brokerage and investment businesses.

Ads will appear in more than 50 daily newspapers, including The Wall Street Journal, The New York Times and USA Today beginning on Thursday, as well as in regional editions of such magazines as Forbes, Fortune and Barron's.

There are also 30-second television spots that will air over the next three months in TD's northeastern U.S. retail stronghold, which includes New York, New Jersey, Pennsylvania, Connecticut, Massachusetts, Maine, New Hampshire and Vermont.

The promotion is intended to reach out to potential clients and investors in the United States by promoting TD's size and capabilities, said Dominic Mercuri, senior vice-president and chief marketing officer at TD.

"We have the physical assets," he said. "Now we need to continue to grow the brand and aggressively attract new customers to the bank and the discount brokerage operations."

TD was put on the U.S. map in March, 2005, with the US$4-billion purchase of a 51% stake in Maine-based retail bank Banknorth.

The U.S. presence of the Toronto-based bank was bolstered by last summer's merger of its discount brokerage TD Waterhouse with Ameritrade, and the purchase of retail bank Hudson United by TD Banknorth.

Last week, TD Banknorth agreed to pay a further US$480.6-million to acquire a New Jersey-based bank that pushed its presence in that state to 130 branches from 102. TD Banknorth is now New Jersey's ninth-largest bank.

TD is neck-and-neck with Canadian rival Bank of Nova Scotia for the final spot in the top 10 largest banks by market capitalization in North America.

In 2005, acquisitions boosted TD's U.S. market capitalization to US$6.7-billion. TD's market cap was $45.5-billion yesterday.

Ed Clark, TD's chief executive, is one year into a five-year plan to increase TD Banknorth's market capitalization to between US$10-billion and US$12-billion. One or two acquisitions are expected each year.

The advertising push is timed to coincide with the rebranding of recently acquired retail bank Hudson United bank branches as TD Banknorth branches, and the renaming of the combined discount brokerages as TD Ameritrade, Mr. Mercuri said.

The TV ad shows well-heeled people watching in awe as TD's signature green sign is hoisted by crane to the top of a skyscraper. The ads reference the key operations of TD Bank in the United States, including personal and commercial bank TD Banknorth, TD Securities, and TD Ameritrade.

The multi-million marketing spending is in addition to the budgets of each individual unit of the Toronto-based bank. When combined with those budgets, the spending exceeds that of top-tier U.S. banks, Mr. Mercuri said.

TD is not totally new to advertising in the U.S. -- albeit on a much smaller scale -- and its experience has not all been good.

Before the merger with Ameritrade, TD Waterhouse was sued by rival Charles Schwab Corp. over claims TD was unfairly portraying Schwab by lumping it in with more expensive brokers such as Merrill Lynch & Co.

The companies ultimately settled out of court, with TD required to apologize to Schwab and to cease airing the offending ads which featured actor Sam Waterston, the star of TV's Law and Order.

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BMO NB Preview of Life Insurance Co Q1 2006 Earnings

BMO Nesbitt Burns, 17 April 2006

The life insurers kick off Q1/06 reporting next Thursday, April 27, 2006 with Sun Life, followed by the other three Canadian lifecos the week of May 1, 2006 (see scorecard at the end of this comment). Overall, we estimate EPS growth of 10-13%, with Manulife expected to generate the highest growth in Q1/06 and for all of 2006.

On balance the macroeconomic conditions remain favourable for the sector. Strong growth in the Canadian equity markets, up 25% versus the same quarter last year, and respectable results from the S&P500, an increase of 8% versus Q1/05, augur well for the wealth management operations at the lifecos (see Table 1). Partially mitigating the strong equity markets is the 6% rise in the Canadian dollar versus the same quarter last year. While we remain sensitive to the strength of the Canadian dollar, earnings from the two largest life insurers- Manulife and Sun Life- have grown nicely over the last four years, despite the dramatic rise of the Canadian dollar. However, Great-West's results are expected to be negatively impacted by the lack of currency hedge (last year GWO hedged U.S. earnings at 1.32 versus the current rate of 1.17).

In addition to good equity markets, conditions in the credit market remain quite favourable. Spreads on 'BBB,' 'BB,' and 'B'-rated securities have been stable over the last few years. In fact, spread trends continue to remain historically low.

The interest rate environment also appears to be improving. The yield on the U.S. 10-year has risen above 5% and in Canada the yield on the 10-year has risen to 4.45% from under 4% a few months ago. Relatively higher long-term interest rates and a steeper yield curve should all be positive for the life insurers, as outlined in our research report entitled 'Interest Rates and Life Insurance: A Triple Triple,' released on January 20, 2006.

Sun Life reports on Thursday, April 27, 2006, and we are projecting EPS of $0.85, up 10% from $0.77 in Q1/05 and versus consensus of $0.86. We expect results to be driven by good equity markets, strong credit quality and continued strength from the Canadian operations, specifically Canadian group businesses. MFS should have another solid quarter and while we expect total net inflows to be positive, the net flows into retail mutual fund operations should continue to be negative. Of particular interest to us in the quarter will be the status of the share repurchase program, margins at MFS and sales results in Canadian individual life and U.S. annuities. Margins at MFS have been below peer group average as it absorbed costs related to the SEC investigation(s), which are nearing completion, and an expanded international platform to meet expected global growth requirements. Canadian individual life sales growth is expected to remain positive. Sales of U.S. variable annuities are expected to remain in net redemptions; however, recently announced new distribution arrangements may improve the outlook for variable annuity sales. Sun Life remains Outperform rated.

Manulife reports on Thursday May 4, 2006, and we are projecting EPS of $1.16 versus consensus of $1.18 and $1.03 in Q1/05. Once again, we would expect Manulife to show the strongest results not only in terms of earnings growth but also in terms of new sales, particularly in the U.S. and Japan. While the JHF acquisition is complete, we will continue to monitor the growth in Funds Under Management in the U.S. individual life and variable annuity operations- the two key U.S. segments for Manulife. We also expect to see further growth of wealth management sales from the company's Asian operations, and results from Hong Kong appeared to be improving over the last two quarters and we hope to see further evidence of this turnaround in term of insurance sales and growth in the sales force. Rising long-term interest rates in Japan should help results in that country. We would expect to see MFC's gross impaired loans to continue to grow, albeit at a very modest pace, given the size of the block of assets purchased from JHF. While the current credit market conditions are very favourable, the trend is also unsustainable. Accordingly, we expect credit to be a primary concern of Manulife investors in the event of adverse credit developments. Lastly, we will continue to monitor the company's buyback activity, which appears to have been more modest in the first quarter versus the last three quarters. Manulife remains extremely well capitalized, with excess capital in excess of $4 billion, in our view. We do not believe that Manulife is interested in any large transactions but it is clearly open to relatively smaller bolt-on acquisitions in the U.S. Manulife could entertain more ambitious acquisitions in Asia given the growth opportunities in those markets. However, we do not believe that a transaction is imminent. Manulife remains Outperform rated.

Great-West LifeCo also reports on Thursday, May 4, 2006 and we project EPS of $0.53 (consensus is $0.52), an increase of 12.8% versus $0.47 in the same quarter last year. Our estimate for GWO may be too optimistic given management's guidance during the Q4/05 conference call that EPS growth in 2006 is likely to be lower than growth in 2005 of 10%. The slowing trend is due to the absence of a favourable currency hedge (discussed above) and unsustainably high earnings growth, over 20%, in Canada over the last few years since the Canada Life acquisition. We expect the U.S. operations to remain the focus of investor attention, specifically the U.S. health care. While net new participants in the health care segment may range from 0-50,000, the debate is more focused on the company's strategic intentions in this segment. GWO shares have lagged the group over the last 12 months and we believe this situation reflects concerns on the currency hedge and the strategic direction of the U.S. operations discussed above. Over the last four years, GWO's shares have gone from trading at a 20% P/E premium to the group to a 15% discount to the life insurance group. This shift largely reflects the strong share price performance from Manulife as GWO's absolute valuation has remained relatively stable. Nonetheless, we doubt that GWO shares can reverse its relative valuation discount without greater clarity on the strategic direction of the U.S. operations. GWO is rated Market Perform.

Industrial Alliance, which is rated Outperform, reports Q1/06 results on Tuesday, May 2, 2006. We project that IAG will generate EPS of $0.61, largely driven by the wealth management operations. Forecast EPS growth of 13% in Q1/06 is above management's guidance of roughly 10% for 2006. Management effectively reduced EPS guidance to 10% from 10-12% during the Q4/05 conference call largely due to concerns on low interest rates and the impact that this may have on new business strain. While we sympathize with this view, we do believe that the strong equity markets, good credit experience and acquisitions should help mitigate the higher sales strain. Key issues during the quarter will be the growth in in-force business in individual life and an update on the Clarington acquisition. At some point in the future, we expect IAG to repurchase some, or all, of the $63 million in subordinated debt at Clarington used to finance commissions when it was an independent company. The repurchase of subordinate debt is likely to have a one-time impact on IAG's financial results. The appropriate allocation of this cost would be to the purchase price of Clarington. Longer term, the key issue is the sustainability of mutual fund net flows at Clarington and we believe that the evidence thus far is inconclusive except to say that Clarington did consistently generate net sales, despite as an independent entity in the face of volatile markets and relatively poor performance by some sub-advisors. The central issue focuses on whether IAG can keep the sales results positive with a change in ownership. We remain cautiously optimistic on this front; however, quarterly results over the next six months should be instructive.

Price Targets for Life Insurance Companies, as at February 2006;

TD Bank Raises its US Profile

Canadian Press, 17 April 2006

Fresh on the heels of its latest U.S. expansion, TD Banknorth Inc. is eyeing more acquisitions in the prosperous New England states over the next few years as it bolsters awareness of its American-based brands.

“If we had a perfect world, I’d love to buy a small bank in Massachusetts, in Connecticut and the mid-Atlantic region,” TD Banknorth CEO Bill Ryan said in a conference call.

“I think we could do one or two a year for the next few years, and maybe every 18 months we can do a larger acquisition. I still see a number of smaller banks that — because of the cost of regulation, the cost of computerization — are going to want to join somebody over the next few years.”

TD Banknorth, the majority-owned subsidiary of Toronto-based TD Bank Financial Group, has been on a U.S. expansion streak over the last two years.

On Thursday it announced plans to acquire Interchange Financial Services Corp. for $480.6 million, catapulting it to ninth place in the lucrative New Jersey market. There are plans to close eight to 12 branches to realize synergies of about $13.6 million in 2007.

“This is a perfect fit,” Ryan said. “It’s our sweet spot of $1 billion to $3 billion in assets, so we are really in a pretty good position.”

Headquartered in Saddle Brook, N.J., Interchange had $1.6 billion in assets and $1.3 billion in deposits at Dec. 31, and operates 30 branches in Bergen and Essex counties — which have some of the highest median household incomes in America.

“The demographics of this market are just outstanding,” observed Ryan.

The all-cash transaction would not only enlarge TD Banknorth’s footprint in that key northern U.S. state, but would also allow TD Bank to boost its stake in the subsidiary to 58.6 per cent.

The deal will be financed primarily through the sale of 13 million shares of TD Banknorth to TD Bank Financial Group at a price of $31.17 per share, for a total of $405.2 million.

“We also believe this acquisition is a great add-on to the footprint that TD Banknorth gained with the Hudson transaction and is right on the strategy that we want execute via TD Banknorth,” said Colleen Johnston, TD Bank’s chief financial officer.

Earlier this year, TD Banknorth completed its $1.9-billion (U.S.) cash and stock acquisition of Hudson United Bancorp Inc. and the sale of its TD Waterhouse U.S.A. brokerage division to Ameritrade Holding Corp. in exchange for a large stake in the combined U.S. company.

With domestic big-bank mergers on hold indefinitely, analysts say Canadian banks are hungry for scale and are looking to ride a wave of U.S. consolidation.

BMO Financial Group has also been bulking up its U.S. presence through its Chicago-area subsidiary Harris Bankcorp and is actively scouting for deals worth up to $2 billion.

RBC Financial Group also plans to ramp up its presence in the Atlanta and Florida markets with 15 to 20 new branches per year starting in 2007.

While plenty of U.S. opportunities still exist, it is a market that has proved challenging to Canadian entrants in the past. In 2005, RBC exited its U.S. mortgage business after suffering operational challenges in that division.

For its part, TD Banknorth said its Interchange acquisition — its 27th such deal — is a great opportunity to grow “in a way that doesn’t risk the company.”

Meanwhile, its Toronto-based parent, Canada’s No. 3 bank, also said it is eager to be recognized as a major player in that rapidly-consolidating market and has kicked off a $25-million (U.S.) advertising blitz to support its U.S. brands.

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Cdn Bank Index, Doubled Since 2002

The Globe and Mail, Derek DeCloet, 15 April 2006

Ed Clark has spent a career looking at the banking business from all sides. He's been a Finance Department mandarin, a deal maker at Merrill Lynch, head of a struggling lender and the top executive at Canada Trust. Now, at 58, the Toronto-Dominion Bank chief might be Bay Street's most popular CEO.

In all those years, have the Canadian banks ever had a streak of good fortune like this? “No. Absolutely not,” Mr. Clark says. “Maybe if you went back to the sixties.”

In the country's biggest financial district, there's a pervasive sense of calm, and why wouldn't there be? The banks have turned Murphy's Law on its head: Anything that can go right, will.

The economy is strong, inflation low. Unemployment? The lowest since Mr. Clark was a rookie bureaucrat in the Trudeau government. Interest rates? On the rise, but reasonably low. Stock market? Breaking records almost weekly.

The result is not only record bank profits — nothing's new about that — but surprising growth. In the past, senior bankers moaned that Ottawa's effective ban on mergers left them boxed into a stagnant market, but the financial results are making liars out of them. The Big Six banks' profit per share increased 11.1 per cent in the first quarter, calculates National Bank Financial, after a 15.2-per-cent gain last year. (The numbers exclude certain unusual items.)

The biggest surprise is the way corporate borrowers have stayed so healthy for so long. Moody's Investors Service Inc. says Canadian companies defaulted on just $86-million in bonds last year, the lowest since 1996. For the moment, at least, very few bank loans are going sour. Individual consumers are borrowing more, but paying their bills as reliably as ever.

“These are very unusual conditions, so it's hard to get yourself tossing and turning in the middle of the night,” Mr. Clark says. “So what you toss and turn on is, how long can this keep on going?”

That's the question investors are asking, too. The banks' outsized profit growth has brought huge stock gains, to the delight of the millions of Canadians who own bank shares directly or through their mutual funds.

But the S&P/TSX bank index has almost doubled since 2002, and valuations may be getting stretched. The Big Six banks haven't looked this expensive since they surged on merger mania in the spring of 1998. (That period ended when Russia defaulted on debt, Long-Term Capital Management collapsed, global financial markets convulsed and Canadian bank shares fell 33 per cent in three months.)

The banks, in fact, have done almost as much as the headline-hogging oil companies to lift the stock market to great heights. The S&P/TSX composite has gained about 5,630 points since Jan. 1, 2003. The six largest banks are responsible for nearly 1,000 points of that increase — more than EnCana Corp., Suncor Energy Inc., and Canadian Natural Resources Ltd. put together, despite the greatest bull market in energy stocks in a generation.

Three banks — TD, National Bank of Canada, and Canadian Imperial Bank of Commerce — have doubled their investors' money in that period. Even the worst performing, Bank of Montreal, gave its shareholders a total return of 71 per cent, including dividends.

It may seem churlish to cast a shadow over the banks in their moment of glory. But if things are as good as they've been in decades, as Mr. Clark says, doesn't that mean there's a lot of room for them to get worse? Few investors seem to think so, and even fewer are willing to bet that the market is wrong to be so wildly bullish.

Wade Burton is one of them. He manages about $4-billion in equities for Vancouver's Cundill Investment Research Ltd. His portfolio is an unusual one for a domestic money manager: It contains not a single share of any one of the Big Six, and has been that way for the past two years. Painfully so.

“You're going to say: ‘We missed the banks,' ” Mr. Burton says “And I'm going to say: ‘You can't say there's any margin of safety in these companies.' ” He thinks investors have underestimated the lending risks banks are taking in the amount of credit they are willing to give consumers, a belief that is partly based on experience — he used to be a commercial lender for Canadian Western Bank. “If you experience low loan losses, you become more aggressive in lending to that asset class.”

For most Canadian investors, though, a decision to avoid bank shares is highly unusual. Every one of the country's 10 largest domestic stock mutual funds has banks at or near the top of its largest holdings, and they continue to be among the most widely owned stocks in brokerage accounts.

“With these banks, I am on Mars and everyone else is on Venus,” Mr. Burton says.

But he is not alone in believing that Canadian banks have been so profitable and so popular for so long that they can't possibly reproduce the returns of the past three years. Price is the big reason. The Big Six now trade at nearly 2.8 times book value, to take one important industry measure. That's a sharp increase from two times book value three years ago. (Book value is a company's net worth — its assets minus its liabilities.)

“Shorter-term valuations, I think, are a little ahead of themselves,” says Suzann Pennington, a veteran portfolio manager who follows financial stocks for Toronto's Saxon Financial Inc. “When that happens, I get a little less comfortable because my [potential] downside is a little bit greater than I'd like to see.”

A large gap has opened up between them and some highly regarded foreign banks. Royal Bank of Canada, whose stock price is up 49 per cent in two years, now trades at 14 times this year's projected earnings. Even mighty Citigroup Inc. doesn't get the Royal treatment: It's valued at a little more than 11 times earnings.

“I'm of the view that Canadian banks should trade at a premium to many other countries' banks,” says Rob Wessel, a bank analyst at National Bank Financial. “But do they deserve a premium of this magnitude to the large U.S. banks? I would say no.”

That's especially the case if the Bay Street earnings machine is about to shift into a lower gear. The commodities boom and the hot stock market has boosted bank profits in numerous ways — through commissions, mutual funds and investment banking fees, but also increasingly from investing and trading their own money for profit. The Big Six earned $1.7-billion in trading revenue in the first quarter, a 12-per-cent gain from the previous year. In the long run, Mr. Wessel says, this is not sustainable.

Yet, some banks continue to expand their bets on buoyant markets, and may be taking more risk. While a few banks, such as TD, have been shedding some of their higher-risk business lines, others are taking bigger gambles, the results of which won't be apparent until there's something to shock the financial system or the market, as happened in 1998 (Long-Term Capital) and again in 2002 (the Enron and WorldCom bankruptcies).

In banking circles, one of the more talked-about developments is RBC's apparent decision to find growth by plowing more money into new areas, such as derivatives trading. Two years ago, the bank reported $9.1-billion in assets that were exposed to market fluctuations — such as foreign exchange contracts. Today, the total is $14.6-billion. The bank's disclosure on this is skimpy, but it appears the biggest part of the increase comes from trading in commodities, precious metals and other derivatives. (“I don't want us to overplay the significance of the market risk,” says Nabanita Merchant, the bank's senior vice-president of media relations, who points out that RBC's safer businesses, such as mortgages, have grown briskly, too.)

For all the alleged hatred the public has for banks, Canadian consumers are remarkably loyal to them. Remember the famous quote of Matthew Barrett, explaining why BMO needed to merge with RBC in 1998? “What we don't plan to be is the corner hardware store, waiting for Home Depot to put it out of business.” Throughout the industry there were dire predictions of American and European financial giants coming to Canada to cherry-pick the banks' best customers.

The foreigners showed up, but they've failed to crack open the oligopoly. Nearly a decade after its launch, ING Bank of Canada is profitable, but only modestly and it fell last year. MNBA Bank Canada, the credit card issuer that stuffs envelopes into your mailbox, also showed a decline in profit last year.

How did this happen? The Big Six have learned how to keep market share and elbow the foreign guys out — by matching ING's cheap mortgages, for example, or starting their own high-interest savings accounts. Their market share of consumer lending is higher now than it was when ING and MBNA got their bank licences in the late nineties, according to BMO Nesbitt Burns research.

That should mean less volatile earnings than in the last downturn, when both TD and CIBC were whacked with big corporate loan losses. In 2000, the Big Six earned 63 per cent of their profits from individual and small-business customers. This year, the number will rise to 77 per cent, BMO Nesbitt says, which is why so many people think you can throw away the old models for how to value bank stocks.

“When I look at these companies, they are more expensive than they've ever been historically,” says a top bank analyst. “But they're also more profitable than they've ever been. Their balance sheets are better than they've ever been. And their business mix is more stable that it's been in the past.”

Some day, of course, the economy will stumble, or there will be a big bankruptcy, and the banks' streak will end. No sign of it yet, though. “If General Motors collapsed, would that ripple through the auto sector? It's hard to believe that it wouldn't,” TD's Mr. Clark says. “But as a general statement, is the credit cycle moving? There's just no evidence at this stage that the credit cycle's moving.”

And when it does, banks' devotion to paying dividends will give shareholders some shelter, Ms. Pennington of Saxon says. RBC, for example, has not yielded less than 4 per cent since the early 1990s (with a couple of brief exceptions). That suggests that in a 1998-type financial shock, the share price probably wouldn't fall below $36, based on the current dividend — and that's in an extreme case.

“A 10 per cent correction [in bank stocks] would be healthy and normal,” Ms. Pennington says. “But longer term, I think they're still okay.” So, sure, maybe it's easy to hate the banks, but do you really want to bet against them? It's usually a bad idea — no matter what planet you're from.

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TD Banknorth to Buy Interchange for U$480.6 Million

The Globe and Mail, Sinclair Stewart, 14 April 2006

Ed Clark has pulled the trigger on his third cross-border acquisition in less than two years, bucking conventional wisdom that U.S. expansion has become prohibitively expensive for Canadian banks.

TD Banknorth Inc., the Portland, Me.-based subsidiary of Toronto-Dominion Bank, announced yesterday it is buying Interchange Financial Services Corp. of Saddle Brook, N.J., for $481-million (U.S.) in cash.

Mr. Clark, TD's chief executive officer, acknowledged in an interview that the price wasn't cheap, but said the bank wanted to bolster its presence in the "sweet spot" of New Jersey's affluent Bergen county. The combination will make TD Banknorth the No. 5 player in this market, and the ninth-biggest bank in the state.

"I think these are fully priced deals. I don't think there's any doubt," Mr. Clark said. "The reality is, it's hard to buy these things for significantly better than that . . . That's the choice that people have to make, and I can understand how some people would say: 'Well, I don't ultimately believe that having a U.S. retail franchise works for me,' and that's certainly a legitimate point of view. In our view, we're saying it will."

TD Banknorth has 21 branches in Bergen, through its purchase last year of Hudson United Bancorp., while Interchange has 29. The bank expects to close between eight and 12 of these branches, and estimates it can reap cost savings of 50 per cent by cutting out some of the overlap between the two operations.

"It fits exactly with what we're trying to do, which is to move ourselves up," Mr. Clark said. "In the areas where we're trying to compete, can we get ourselves top leadership market share?"

Most importantly, it will help strengthen Hudson United, the New Jersey bank TD Banknorth acquired last summer for $1.9-billion. Hudson has had some well-documented regulatory troubles, and there have been concerns about the quality of its earnings.

Bill Ryan, who heads up TD Banknorth, said there will be no more acquisitions this year, as the company integrates Hudson and Interchange.

Interchange had $1.6-billion in assets and $1.3-billion in deposits at the end of last year. The company turned out a profit of $19.7-million on revenue of $89-million.

TD Banknorth is paying cash for the acquisition, which values Interchange at $23 a share -- a 21-per-cent premium to its closing price of $19.07 on the Nasdaq Stock Market yesterday.

To finance the deal, TD will increase its ownership stake in TD Banknorth by purchasing 13 million shares of its subsidiary, a chunk of stock worth about $405-million. TD purchased 51 per cent of Banknorth in 2004 for $5-billion (Canadian), and its position will climb to almost 59 per cent when the Interchange acquisition closes in the first quarter of 2007.

The transaction isn't expected to have an impact on Banknorth's profitability next year.

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RBC Capital Markets, 13 April 2006

TD Banknorth Pays Full Price: Interchange Financial Services Corporation has agreed to be acquired by TD Banknorth Inc. in a cash transaction valued at $480.6 million, or $23 per IFCJ share, which is a 20.6% premium over the Thursday closing price of $19.07.

Full Value: IFCJ shareholders are receiving full value in our opinion at 16.4x estimated 2006 EPS, 1.6x stated book value, and 4.4x tangible book value, which compares with average multiples of 17.2x estimated EPS, 2.5x book value, and 3.3x tangible book value for the 25 largest deals since the beginning of 2004. The core deposit premium was 31% based upon year-end 2005 numbers.

Thoughts on IFCJ: We believe Interchange Financial Services Corporation's stock is fairly valued based upon the consideration to be paid by TD Banknorth. Our price target of $23 per share is based upon the purchase consideration in which shareholders will receive cash in the amount of $23 per IFCJ share. We rate the stock a Sector Perform with Above Average risk, as IFCJ shares trade approximately at our price target.

Company Description. Interchange Financial Services Corporation is a bank holding company for Interchange Bank, the 7th leading bank (by deposits) in Bergen County New Jersey. The company's bank subsidiary offers traditional commercial and retail banking services, including online banking and bill paying services through InterBank. Customers can also do their stock trading, obtain insurance services, and apply for a loan through Interchange Bank's Web site. Mutual Funds and Annuities are offered through Interchange's Investment Services Program. At the end of December 2005, the company had total assets of $1.6 billion and total deposits of $1.3 billion. Nearly two-thirds of its loans are made to commercial customers.

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Reuters, Jonathan Stempel, 13 April 2006

TD Banknorth Inc, a fast-growing northeast U.S. bank, said on Thursday it agreed to buy Interchange Financial Services Corp. for $480.6 million in cash, its second acquisition in affluent northern New Jersey this year.

TD Banknorth, majority-owned by Canada's Toronto-Dominion Bank, will pay $23 per share for Interchange, a 20.6 percent premium over the shares' Thursday closing price of $19.07 on the Nasdaq.

The transaction was announced after U.S. markets closed. Interchange shares, which fell 6 cents to $19.07 on Nasdaq during the day, rose $3.58, or 18.8 percent, to $22.65 after-hours on Inet. TD Banknorth shares on Thursday rose 23 cents to $29.31 on the New York Stock Exchange.

Based in Saddle Brook, New Jersey, Interchange operates 30 branches in Bergen and Essex counties. It ended 2005 with $1.6 billion of assets and $1.3 billion of deposits. The purchase will make TD Banknorth the ninth-largest bank in the state.

"They're a nice size for us, have a good commercial loan portfolio, and are in a large market with attractive demographics," said TD Banknorth Chief Executive William Ryan in an interview.

He said TD Banknorth is paying 22.1 times Interchange's estimated 2006 earnings, and 2.592 times book value.

In January, TD Banknorth paid about $1.9 billion for Mahwah's Hudson United Bancorp, adding more than 200 branches in New Jersey, Connecticut, New York and Pennsylvania.

TD Banknorth, based in Portland, Maine, now operates about 600 branches in eight northeast states.

"Banknorth has made a living on entering new markets through acquisitions, and building a presence through fill-in purchases," said Jim Ackor, an analyst at RBC Capital Markets in Portland, Maine.

TD Banknorth operates 102 New Jersey branches. Ryan said that to cut costs, it plans to close eight to 12 Interchange or former Hudson United branches located within about a mile of each other.

TD Banknorth will sell 13 million common shares at $31.17 each to TD Bank Financial, raising $405 million to help fund the Interchange purchase.

The Canadian company last year paid $4 billion for a 51 percent stake in TD Banknorth. The Interchange purchase will increase the percentage to 58.6 percent.

"Large mergers in Canada have been limited by the government, so that makes expansion of TD Banknorth (the Canadian bank's) major initiative for capital deployment," said Kevin Timmons, an analyst at C.L. King & Associates in Albany, New York.

The Interchange purchase is expected to close early in the first quarter of 2007 upon regulatory and Interchange shareholders' approval. TD Banknorth expects it won't affect 2007 earnings. TD Bank Financial expects it to add to profit slightly within one year.

Ryan is eyeing other mergers. "There are still a number of smaller banks in the metro New York/New Jersey area that have potential to be sold in the next two or three years," he said. "We've always been very aggressive acquirers, so we'll be in the mode of looking at them into 2007."

Keefe, Bruyette & Woods and the law firm Elias, Matz, Tiernan & Herrick LLP advised TD Banknorth. Goldman Sachs and the law firm Thacher Proffitt and Wood LLP advised Interchange.

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Scotiabank Gets Foreign Institutional Investor Status in China

Canadian Press, 12 April 2006

Chinese regulator gives Scotiabank approval to trade shares in local currency.

Chinese securities regulators have granted Scotiabank permission to trade shares and bonds denominated in Renminbi, the local currency.

The China Securities Regulatory Commission has granted the Canadian bank Qualified Foreign Institutional Investor status, Scotiabank announced Wednesday.

“We are very pleased to be the first Canadian bank to have been granted QFII status in the People's Republic of China,” Rob Pitfield, executive vice-president of international banking, said in a release.

In addition, Scotiabank said it recently received approval to conduct derivatives activities in China, allowing it to offer interest rate, currency, commodity and other derivative products to companies in China and abroad.

“We have been working to expand the services available to our clients in this country, and the addition of the QFII and the ability to offer derivative products mark further important milestones in this progress,” Pitfield said.

Scotiabank has had a presence in China for more than two decades, since opening the Beijing representative office in 1982. It subsequently opened branches in Guangzhou, serving the southern region, and Chongqing, serving the northern and western regions. Earlier this year, BNS announced that it had received approval to convert its representative office in Shanghai to full branch status, covering the eastern region and, when opened, will be the only Canadian bank in this important city. With this addition, BNS is the only Canadian bank in China with broad coverage from offices in all key regions.

Royal Bank of Canada similarly announced earlier this year that it received a full branch licence from Chinese regulators for its Beijing office.

RBC spokeswoman Beja Rodeck said Wednesday that obtaining a QFII license “is an option that is under consideration” for Royal.

Numerous foreign banks are looking for a foothold in China's rapidly developing economy.

BMO boasts that it was the eighth foreign bank permitted to operate in the capital city, Beijing.

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WSJ Article on HSBC

The Wall Street Journal, Dimitra Defotis, 13 April 2006

HSBC Holdings is building a string of pearls in the ocean of global finance.

But the global bank may not be getting its due in the stock marketplace. In the past year, the stock is only up 6%, underperforming the Standard & Poor's 500 index and moving only slightly ahead of rival Citigroup.

That performance, however, may reflect investors' narrow focus on the possible negative impact of rising interest rates on HSBC's U.S. operations, not the gem of a business it has created globally, especially in emerging markets.

That's why the stock could end up being a solid performer in the coming years. And investors get a juicy 4.3% dividend yield while they wait.

"This stock is a jewel that needs a little bit of polishing," says Reiner Triltsch, who owns the stock in the U.S. Trust Excelsior International Equity Fund. "I see good management, good geographic diversity, a good dividend, and 6% earnings growth that could be 10%."

Sir John Bond, HSBC's departing chairman, helped solidify HSBC's North American business, which accounts for a third of earnings. That matches earnings from Asia, where the former Hong Kong & Shanghai Banking Corp. got its start in 1865.

Measured by market value, HSBC is the third-largest bank globally, behind Citigroup and Bank of America. Emerging markets are roughly 15% of earnings, and HSBC expects growth from places like Mexico, Brazil, Turkey and China to boost profits.

Despite ramped up spending on investment banking globally, HSBC's performance last year was the best in nearly a decade: organic revenue growth of 10% and pretax profits of roughly $21 billion.

Roughly half of profits came from personal financial services -- deposits, loans and credit cards globally. Commercial banking and corporate investment banking each produced roughly a quarter of profits.

HSBC has 125 million customers in 76 countries and territories, but still holds court in Hong Kong, which contributed 21% of last year's profits. North America and Europe each accounted for roughly a third of earnings.

Despite this diversity, investors have focused on the consumer lending business of HSBC Finance, formerly Household International. As one of the largest providers of subprime home-equity loans in the U.S., it exposes HSBC to payment defaults as interest rates rise.

But with U.S. short-term interest rates likely to peak in the second half of 2006, net interest margin pressure should subside, writes Nomura International analyst Kevin Chan.

Douglas Flint, HSBC's finance director, says rate increases have been gradual and "unless you get an abrupt change in the economy...you adjust pricing."

HSBC shares, about 3% from their 52-week high, are roughly 11% since Barron's favorable article (see Barron's, "World Beater," Aug. 9, 2004).

Given "the best underlying growth and operating 'jaws' since the Asian crisis," Citigroup analyst Simon Samuels upgraded the shares to Buy in March.

And that's despite management change. Stephen Green, HSBC's chief executive, becomes chairman in May. Bond, 64, is leaving HSBC after 45 years, eight as chairman, to head telecom giant Vodafone.

Under Bond, HSBC maintained its reputation for conserving capital. With more cash on the books, HSBC has been able to pounce on good deals, says Alastair Ryan, an analyst at UBS in London.

Those include the 2003 purchase of Household for $14.5 billion and the 2002 purchase of Grupo Financiero Bital (now HSBC Mexico) for $1.2 billion.

"HSBC is always criticized in good markets for having too much cash sitting around, but you don't want banks leveraging up to make acquisitions," Ryan says.

Flint says that big acquisitions are not on the radar screen for 2006 because "it is difficult to see what the value proposition would be." But he expects emerging markets, improvements in Europe and expansion in the U.S. to drive profits.

Another advantage: HSBC has invested some $5 billion in China, setting it apart from other major banks for its early entry and influence. Its 20% stakes in two large Chinese financial enterprises, Ping An Insurance and Bank of Communications, have appreciated roughly 150%, Ryan estimates.

Shares of HSBC are trading at 11.4 times 2006 earnings, in line with Citigroup's multiple. And even if the price-to-earnings multiple doesn't return to higher historic averages, strong earnings should boost the share price.

HSBC is "executing well on a strategy to better sell products within its footprint, and the multiple has gone the other way," Ryan says. "They have accelerated revenue growth without hurting margins."

Of course, HSBC may be missing out on growth opportunities by waiting for acquisition price tags to fall.

And if the global economy falters, HSBC would suffer, too.

But HSBC is uniquely positioned to offer banking services to European and American customers doing business in emerging markets, and can also offer credit cards, loans and more to the rising middle class in those markets.

And while those opportunities may look as lumpy as freshwater pearls today, they are sure to produce handsome returns for long-term investors.

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TD Will Seek to Have Lawsuit Dismissed

Canadian Press, Rita Trichur, 10 April 2006

TD Bank, which is among a group of defendants named in a $45-million (U.S.) lawsuit involving the bank's 2001 acquisition of options-exchange company TD Options LLC, will seek to have the case dismissed when it formally responds to an amended complaint over the next week.

The lawsuit, entered in the Circuit Court of Cook County in Illinois, is being pursued by options traders at the Chicago Board of Options Exchange, who allege they were shortchanged by the bank and others when their share in the options business was acquired.

The allegations have not been proven in court.

Spokesman Jeff Keay told The Canadian Press that TD has until Monday to respond to the plaintiffs' third amended complaint which was filed with the Chicago-area court last month. Part of that response will be an application to dismiss the suit.

"We hold that their allegations have no merit whatsoever and we look forward to contesting this vigorously in court," Keay said.

The plaintiffs' new complaint is shorter, eliminating two previous legal counts, a source said on the condition of anonymity. Judge Lee Preston threw out a previous complaint last month, requesting more specifics, the source said.

"I am confident the third amended complaint contains the necessary information and legal theories in order to advance the case," said Randall Gold, a lawyer for the plaintiffs.

According to court documents, the roster of defendants also includes TD Holdings USA, TD Securities, TD Equity Options, TD Options, along with individuals Martin Walton, Jason Marks, Evan Kimmel, John Stafford Jr. and his son, John Stafford III.

His other son, James Stafford, along with Ronin Capital LLC and Quantitative Analytics LLC are no longer named as defendants.

The plaintiffs include Michael Benson, Edward Dolinar and Joel Stone, who are acting individually and as successors to Big Blue Trading LLC, in addition to Michael Hoban and William Johnson.

According to their complaint, the plaintiffs allege they traded as designated primary market-makers at the Chicago options exchange as joint venture partners with Stafford Jr. and businesses he controlled since about 1999.

Their complaint alleges that in early 2001, Stafford Jr. and his son, Stafford III, were privately negotiating to sell the joint ventures to TD as well as proprietary computer software and related technology owned by the Staffords.

The plaintiffs claim Stafford Jr. eventually informed them about the TD negotiations and asked for their joint consent for him to act as their agent in negotiating the sale of their interests in the joint ventures.

As a result, the plaintiffs allege they sold their interests in the joint ventures to TD for an up-front payment totalling $8.45 million.

They are seeking damages that include the recovery of losses in connection with the sale, back-end payments, lost bonuses, legal fees and related costs.

The complaint seeks damages ranging between $25 million to $40 million but there also remains the possibility of unspecified punitive damages.

The complaint also alleges that several plaintiffs were fired shortly after complaining to TD Options LLC about how the business was being managed.

A status hearing has been set for May 11.

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Barron's Cover Story on Goldman Sachs

Barron's, Michael Santoli, 10 April 2006

THE REMARKABLE THING ABOUT GOLDMAN SACHS Chief Executive Henry Paulson is not that he made $38 million last year, the most of any Wall Street chief. It's that he might have been underpaid.

Churlish as that sounds, consider Goldman's achievements on his watch, which began in mid-1998, a year before the storied investment firm came public. Through a bubble, bust and brutal bear market, revenues have soared 190%, to last year's $24.8 billion. Earnings have risen more than fourfold, to $5.6 billion, or $11.21 a share. And the stock, which started trading in May 1999, has rallied 203%, compared with a gain of 156% for the broader brokerage sector.

In the past 10 months alone, Goldman Sachs shares have tacked on 69%, endowing the firm, which was founded in 1869, with a stock-market capitalization of more than $70 billion.

Fueling much of Goldman's recent growth has been its prowess in trading fixed-income securities, commodities and currencies. Though it is often referred to as an investment bank, and has one of the largest and most successful advisory businesses in the securities industry, Goldman more than anything these days is an allocator of capital for the benefit of clients and its own account.

Indeed, trading activities accounted for two-thirds of revenue and three-fourths of profits in 2005, and contributed mightily to this year's stupendous fiscal first-quarter results. In the three months ended Feb. 28, the firm produced net income of a $2.4 billion, or $5.08 a share, a 62% increase over year-ago results and an embarrassing 50% improvement over analysts' expectations. Annualized return on equity for the quarter, the key measurement of a securities firm's profitability, was 39%, nearly double what is considered a strong performance industrywide.

CFO David Viniar, 50, takes pains to note that such results are not "sustainable" quarter to quarter. Yet, full-year earnings estimates have risen to just over $15 a share for the fiscal year ending in November.

Goldman's increasing dependence on trading has led to charges that the firm must be shouldering enormous risks to collect such winnings. Some skeptics glibly describe it as a house of cowboys, slinging shareholders' money around for their own benefit. Needless to say, the naysayers eagerly await its comeuppance.

It could be a long wait, however. While a summer slowdown in the stock and bond markets could rough up Goldman's shares, which Friday hit an all-time high, the odds are strongly against a calamity or implosion in the company's business.

SURE, GOLDMAN'S TRADING RISKS HAVE RISEN -- and management has promised they will continue to rise. But that's only because Goldman has figured out where the world of high finance is going, and is heading there faster than the competition.

As markets become more global, demanding greater expertise in complex instruments and requiring middlemen to put more of their own capital to work in the service of clients (and shareholders), Goldman "gets it," arguably better than anyone else on the Street. And its long lead promises to make it a long-term winner.

The new world of trading is not about flipping stocks for nickels and dimes ahead of client orders, or holding corporate bonds in inventory and selling them at a markup. It is about credit-default swaps and total-return swaps and volatility arbitrage, and all sorts of other investment exotica designed to give huge players even the slightest edge. Yet, only a sliver of this activity involves Goldman traders wielding the firm's capital to initiate bets across markets. Most involves client-initiated transactions that the firm facilitates and, increasingly, accomplishes by taking the other side with its own money.

Here is what Goldman is not, despite what alarmists say: It is not a huge hedge fund, or an impenetrable "black box," though the firm offers fewer details about its trading operations than some shareholders would like. Nor is it a leveraged proxy for stock prices, or a surfer of the yield curve, or a mere play on oil prices through its commodities business. Goldman is not a place where folks with MBAs and nice golf strokes simply roll the dice hoping for a seven. No gambler, it is much more like "the house."

Though the firm might bristle at the suggestion its clients are gamblers, the reality is that those clients, including many hedge funds, lay the bets, on which Goldman helps set the odds. And, like the casino credit window, Goldman can elect to lend them money on its own terms, or not.

Goldman's unabashed willingness to use its own capital to facilitate client trading also gives it an edge. There are attendant risks in this, and losses happen every day. But, on average, the firm's vast knowledge of the market has helped it price risk fairly, or at least better than the competition.

Merrill Lynch, in contrast, curtailed its risk-taking in debt markets several years ago, as did Morgan Stanley under former CEO Philip Purcell. New CEO John Mack, is working to enhance the firm's trading-risk profile.

Viniar countered attacks on Goldman in a recent interview with Barron's. "In the past five years we've had periods of falling interest rates and rising rates, a widening and tightening of the yield spreads, falling energy prices and rising energy prices, and a rising dollar and a falling dollar," he says. "And, we've had five consecutive record years in FICC."

FICC? That's Goldman-speak for the trading of fixed-income, commodities and currencies, and derivatives of same. Viniar notes that each business is larger today than the whole of FICC 10 years ago.

It is not the mere luck of Goldman to be in the right places at the right time. Its FICC business grew out of the firm's knack for discovering new opportunities ahead of the pack, and its discipline in sticking with them through tough times.

Says Glenn Schorr, who follows the brokerage industry for UBS: "Goldman is always early. Before anyone had heard of hedge funds [in the mid-1980s], they were inventing prime brokerage. Then there's energy trading, foreign exchange, commodities, electronic stock trading -- always early."

For example, Goldman acquired the J. Aron commodities business in 1981, not a great moment to dive into commodities trading. But the firm never wavered in its commitment to the business, from which it has reaped huge rewards in recent years. Merrill Lynch exited commodities near the bottom of the cycle, in 2001, and now is trying to rebuild its presence in the market.

Goldman made the sometimes ho-hum currency-trading business a priority, as well, even as others walked. Now it is the only non-bank among the top five foreign-exchange traders.

In fiscal 2005, trading and principal investments produced $16.3 billion of net revenue and $6.2 billion of the firm's $8.3 billion in pretax income. Asset-management and securities services, which includes prime brokerage for hedge-fund clients, kicked in $4.7 billion of revenue and $1.7 billion of operating profit, while investment banking contributed $3.7 billion of revenue and $413 million of profit.

Remarkably, where Goldman was not early, in the asset-management business, it methodically built Goldman Sachs Asset Management from scratch, beginning a decade ago. It now manages more than $500 billion across many asset classes, including private-equity and real-estate funds. GSAM produced an unexpectedly large $739 million in performance fees in the latest quarter.

GOLDMAN'S BANKING BUSINESS SEEMS SMALL by comparison with the rest of its operations, and has lower margins. But it is integral to the rest of the firm, Viniar insists. Advising on deals produces all sorts of related financing, hedging and co-investing opportunities.

Goldman's long-term perspective, perhaps rooted in its partnership heritage, also allows it to step aggressively into troubled markets and bid at advantageous prices. The firm took a preferred equity position in Sumitomo Matsui in 2003; it acquired power-generating assets in the aftermath of the Enron scandal and it became a large owner of golf courses in Japan -- all at times when those assets were in varying degrees of distress. (No risk taker gets them all right, of course. Goldman's $6 billion purchase of Spear Leeds & Kellogg, a stock and options market maker, occurred right at the top of the bubble, and the goodwill related to the hefty price still sits on the balance sheet.)

This steel-gut boldness has allowed Goldman to be the buyer of last resort at advantageous prices, leaving it to harvest gains at its discretion. The firm has taken some profits on the Sumitomo investment and has sold three of its 28 power-generating plants in recent months, including one this month to General Electric, at big prices.

"We have a culture of doing this for a long time," Viniar says, invoking legendary Goldman risk-takers such as the late Gus Levy, and his protege Robert Rubin.

"Culture" seems a squishy -- and self-serving -- explanation for an organization's strength. Yet, at Goldman, it's hard to escape. A securities firm is nothing more than a pile of money and a group of people, and by extension the reputation those people have built. Capital is neutral, every dollar or yen the same. But attracting, cultivating and retaining people is something all companies do differently.

Even seven years after it shed its status as a private partnership, Goldman seems to have an effective process for hiring and developing talent, and instilling the right combination of risk-taking discipline and bold opportunism.

The firm begins with a head start in recruiting, as a preferred employer of the brightest business-school, law-school and even engineering and mathematics graduates. Its evaluation and compensation systems are built to reward people for teamwork and effort, not the luck of having been in a particular division in a good year.

Goldman uses "360-degree" performance reviews, in which everyone, including Chairman and CEO Henry M. Paulson, is evaluated by peers, superiors and junior employees. The process can be entirely anonymous, if the evaluator chooses. There is an explicit social component in the reviews, meant to engender collegiality and weed out those who fail the teamwork test. Viniar personally reviews annual compensation for 10,000 employees.

EVERY SECURITIES FIRM TALKS ABOUT AVOIDING the star system and getting lots of ambitious, competitive achievers to work for the greater good. By most accounts and the preponderance of evidence, Goldman has succeeded better than most.

The firm boasts an unusual number of career employees, each with more than 20 years at Goldman, especially in senior management. This includes Paulson (32 years), President Lloyd Blankfein (23), who is likely to be the next CEO, and Viniar (25). Among the 24 members of the management committee, there is some 500 years of collective Goldman experience.

The focus on talent management and reputation is evident in the little things, as well as the big ones. Goldman barely was scathed, relative to competitors such as Merrill and Citigroup, by the post-bubble wave of Wall Street scandals, even though it caught flak more recently for operating on both sides of the New York Stock Exchange-Archipelago merger. The firm was an investor in and adviser to Arca and advised the stock exchange, which is headed by former Goldman President John Thain.

Yet Goldman's management pays more than lip service to ethical matters. When new managing directors gather for orientation-style meetings, they are told, among other things, that as Goldman MDs, they are not to pay their nannies off the books.

There is an alumni section on the firm's Website, further evidence of the pervasive nature of the Goldman culture. Sure, this is a networking measure, and many former employees do business with the firm. But in an industry in which departing workers often are escorted to the lobby by security guards, without so much as a detour to grab their coats, Goldman's familial ties stand out. There was some alarm last year when several highly regarded traders -- Eric Mindich, Dinakar Singh and William von Mueffling -- left to start multibillion-dollar hedge funds. But their funds became important new Goldman clients, and the firm's results suggest their labors as insiders weren't missed.

Goldman has tried to maintain something akin to the old partnership ranks, with about 300 of the firm's 1,300 managing directors sitting on a "partnership committee." In one key regard they're like the partners of old: They reportedly are compensated exceedingly well, even by Wall Street standards. Most managing directors receive a sizable portion of their annual compensation in stock, which helps bind their interests to those of the firm, and fosters more productive planning.

Nonexecutive employees, too, have shared in Goldman's good fortune. In the first quarter, the firm's compensation expense amounted to more than $800,000 for each of its 23,000 employees, every man and woman, banker and receptionist. Perhaps it is no surprise, then, that in a survey of financial employees in London by the industry trade publication www.hereisthecity.com, 89% of Goldman respondents said they were pleased with their 2005 bonus, the highest percentage of any firm.

Still, some former Goldman hands sense that parts of the old culture have eroded with the firm's huge increase in scale and its continued shift toward trading relative to banking. If Blankfein, 51, succeeds Paulson, 60, a former trader again will be at the helm. Paulson, a long-time banker, is rumored to be under consideration by the White House to replace Treasury Secretary John Snow.

WHILE GOLDMAN'S INTERNAL WORKINGS ARE a source of fascination -- and envy -- the length and breadth of the Street, what do things like culture and compensation mean for the shares at current levels?

There are several ways to view the stock. The view from 10,000 feet is that Goldman is a direct and leveraged play on increasingly global capital flows, rising asset values, the urgent search for returns and the markets' inexorable tendency toward greater complexity. The total value of global bond markets was $22.8 trillion at the end of 2005, up from $14.3 trillion four years earlier. Global equity markets were worth $24.2 trillion, up from $16.6 trillion. Then there's the notional value underlying all over-the-counter derivatives, which has more than tripled in the past four years, to a staggering $230 trillion.

There is more than $1 trillion of purchasing power each in hedge funds and private-equity funds -- active, highly motivated investors who need debt and trading counterparties, and advice. Mergers and acquisitions are in an uptrend, and commodities are regaining status as an institutional asset class. Goldman, along with a small handful of other institutions such as Citigroup and UBS, is at the center of it all.

To the extent that Goldman continues to skate to where the puck is going to be, as hockey great Wayne Gretzky once advised, the firm has a shot to outperform its peers. It did so in China last year; after decades of wooing the country's authorities, it became the first Western institution to gain a broker-dealer license to operate in China, via partly owned Gao Hua Securities.

For some investors, this is enough to know. Barring a major rupture in financial markets, Goldman over the long run will be able to capitalize on macro trends to boost its book value and share price. After all, the company has had only three annual earnings declines in the past 20 years (in '94, '01 and '02), notwithstanding a spike in interest rates, the Asian crisis and the stock market's meltdown after the dot-com bubble.

ON A NEAR-TERM BASIS, HOWEVER, GOLDMAN shares have come awfully far in a hurry. Although they sell for only 11 times this year's forecast earnings, a reflection of the relative opacity of the firm's trading business, they're richly priced at around 2.5 times book value, near the top of their historic range. A lot of hot money has climbed aboard the stock, which trades far more actively than its size would suggest.

Goldman's earnings momentum has continued into the current quarter, abetted by rising asset markets and a heavy merger backlog. In addition, the company should book a gain of 45-to-55 cents on the power-plant sale, and should have additional gains from its Archipelago investment.

The special items point up a crucial issue, however. How much should investors pay for an earnings stream that includes various gains from principal investments? "These are not one-off gains," UBS' Glenn Schorr says. "It happens all the time. These stocks trade off book value, and this builds book value."

TO BE SURE, THE BIGGEST RISK TO OWNING Goldman stock at current prices is an unforeseen financial calamity -- the "exogenous shock" that so many fear. Smaller disturbances -- from rising interest rates to the stock market's seasonal slow-down -- also could do damage, albeit to a lesser degree. Rare is the year, in fact, in which a fast-moving stock such as Goldman's fails to decline at least 10% from its high to its low, however. It has happened in five of the past six years.

If the shares hit a similar speed bump in coming months, and pull back to the 140s, investors will have an opportunity to own a world-class money mill at a considerably lower price. As any Goldman trader might tell you, that's a sweet deal.

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