30 September 2006

Day Pass Sought, so Fastow Can Testify

The Toronto Star, Tara Perkins, 30 September 2006

The University of California has asked that former Enron Corp. executive Andrew Fastow be allowed to leave prison for nine hours a day for 17 days in October so he can testify in a class-action lawsuit against numerous financial institutions, including the Royal Bank of Canada and Toronto Dominion Bank.

Fastow, the mastermind behind the financial schemes that sank Enron, was sentenced to six years in prison earlier this week.

His deposition testimony "will serve the public's interest," the regents of the University of California said in documents filed with a Houston court this week.

"The testimony of Enron's former CFO, who was the principal contact for the company's banks in structuring, designing and executing transactions that were done solely to manipulate reported financial statements, is crucial evidence that should be taken" before the court can decide a number of issues in the civil case, the documents said.

The university asks that Fastow be temporarily released from jail in Houston, between the hours of 8 a.m. and 5 p.m. His lawyers have agreed to his appearance, and to accompany him during those hours, the court documents state.

"Mr. Fastow will be questioned by as many as 10 financial institutions on a huge number of documents he has never seen before," the court documents say.

The university is the lead plaintiff in a suit billed as "the largest securities case in history" in the court documents.

It represents about 1.6 million people who lost money on Enron shares.

The university's board of regents says it lost more than $144 million (U.S.) on Enron shares.

Defendants in the suit include some of the world's biggest financial institutions, some individuals and Canada's RBC and TD banks.

CIBC reached a settlement in the case last year.

Spokespersons for RBC and TD would not comment yesterday, though the banks have denied wrongdoing, saying that they proceeded in good faith in relying on disclosures from Enron and were ultimately deceived by the Houston-based energy trader.

Fastow appeared to implicate numerous banks involved in the suit in a declaration he made before being sentenced. His comments focused on Merrill Lynch, Crédit Suisse First Boston, the Royal Bank of Scotland and Barclays.

Fastow said he had worked with RBC to structure off-balance sheet transactions for Enron, and "based on my conversations with RBC bankers, I believe they understood that certain structured finance transactions would have had a material impact on Enron's financial reporting."

He noted that RBC was viewed as a second-tier lender to Enron, but he saw Canada's biggest bank as a tier-one lender after the fall of 2000, when three British bankers, the so-called NatWest Three, joined the bank.

Fastow called TD simply "a tier-two bank with which I dealt," adding he was aware TD did six "pre-pay" transactions for Enron between 1998 and 2001.

The University of California has subpoenaed the three to give depositions in the suit.

That deposition was postponed, a spokesman for the case said earlier this week.

The three British bankers — Gary Mulgrew, Giles Darby and David Bermingham — once worked for Greenwich NatWest, but were hired in 2000 and stayed for a brief time at RBC, where they allegedly helped boost the bank's standing with Enron.

The United States extradited the men in July on wire fraud charges related to dealings with Enron while they were at NatWest.


The Globe and Mail, Sinclair Stewart & Geoffrey York, 30 September 2006

The world's largest IPO is still a month away, but Ding Qiang is already mapping out his strategy. It's not the money that's the problem -- the veteran Beijing stock investor has more than $300,000 (U.S.) of his own cash waiting at the ready -- but getting the opportunity to spend all of it.

China has been staging a series of progressively larger initial public offerings for its Big Four banks, and the attendant investor frenzy, some would say madness, is escalating in lockstep, conjuring images of the gold rush spawned by the Internet boom.

Hong Kong bank branches have resembled movie theatres on opening night, with lineups queuing out the door as hopeful investors jockey to buy shares. Such is the unabashed confidence in the prospects for these banks that one woman reportedly plowed three times her annual salary into Bank of China's $11.2-billion offering in June. China Merchants Bank, a smaller player, was so overwhelmed by the response to its $2.4-billion IPO this month that retail orders were oversubscribed by nearly 270 times.

Analysts are predicting this demand will reach even greater heights on Oct. 27, when Industrial & Commercial Bank of China launches what is expected to be a $19-billion IPO of its shares, beating the previous record set by Japan's NTT DoCoMo Inc. in 1998.

The febrile activity is easy enough to understand. The Chinese Economic Miracle is in full swing, and making a bet on the country's major banks is seen as one of the easiest ways to ride the wave. These are the institutions, after all, that are lending money to China's burgeoning industrial base, and that help to finance everything from new home purchases to the country's increasing need for foreign acquisitions. If you believe growth will continue at its double-digit clip, and that the country is serious about its privatization plans, the demand for Chinese banks stocks seems perfectly logical.

Lurking behind this infectious enthusiasm, however, is the bigger question of whether China's state-owned banks, riven as they have been by fraud, largesse, and hundreds of billions of dollars worth of bad loans, are stable enough to be foisted onto public shareholders. This is a country, despite its continuing reform efforts, where transparency remains dim, where ascertaining objective financial data can be an exercise in frustration, and where the state keeps a leaden hand even on the so-called "private" companies that have been spun off in the markets.

Few believe that these banks will collapse -- the popular view is that Beijing has too much at stake to let that happen -- or that the failure of one or two would incite an international financial crisis. Yet there are persistent concerns that the banks' well-rooted debt issues could rear their head during a recession and wreak some unanticipated havoc, not just with investors, but with China's increasingly important role in the global economy.

ICBC, because of its sheer size, looms as perhaps the biggest symbol of China's emerging promise.

China has traditionally favoured the Hong Kong stock exchange for IPOs of its state-run businesses, but now, for the first time, it will pursue a simultaneous listing on the Shanghai Stock Exchange, where it will sell about a quarter of ICBC's shares, providing mainland Chinese with a chance to get a piece of the action.

"We're all excited about the news," Mr. Ding said. "The Chinese economy has developed so fast, but until now the mainlanders had no way to enjoy the result of this fast development. But now China is trying to let us share in the economic results."

ICBC is the largest bank in the world's most populous country, with $815-billion in assets spread among about 18,000 branches. To give a sense of the sheer scale of the company, consider this: It has upwards of 150 million customers, or roughly five times the number of people who live in Canada. Analysts have crunched the numbers, and estimate that if demand is as heady as expected, ICBC will boast a market capitalization of around $180-billion. That's good enough for fourth-place worldwide, and about three times the size of Canada's biggest firm, Royal Bank of Canada.

In the eyes of investors, ICBC also comes with a guarantee of sorts, however implicit: That as the nerve centre of the Chinese financial system, its IPO-driven reformation is a "political task" the government cannot allow to fail.

"The main buyers in the mainland listing will be government-owned institutional investors, such as insurance companies and state investment companies," said Victor Shih, a political scientist at Northwestern University in Evanston, Ill., who specializes in the Chinese banking system.

"Under the current macroeconomic policies, those entities are under pressure to invest in 'safe' instruments, and ICBC shares would fall in this class. I have no reason to think that ICBC shares will not do well."

Zhiwu Chen, a professor of finance at the Yale School of Management, has seen the challenges of Chinese privatizations up close as an independent director of a handful of firms there. For him, China's decision to invite investors into its "Big Four" banks (ICBC, Bank of China, China Construction Bank, and, if it ever sorts out its problems, Agricultural Bank of China) is the only way to cure these institutions of their ills, and at the same time incite more profound political and economic change.

"The semi-privatizations have turned out to be the only way that the Chinese government can really shake things up and remove the entrenched interests in some of these state-owned banks," he said in a recent interview. "[The banks] will never be ready unless they are forced to take the challenge."

Not everyone is so certain. The chief issue dogging the sector is a residue of profligate, indiscriminate lending that left many banks saddled with staggering amounts of bad loans. For decades, banks functioned as thinly guised financing arms of the government, handing out money to all manner of state-owned enterprise.

"The big banks are junk," said Kent McCarthy, founder of U.S. hedge fund Jayhawk Capital Management LLC, which specializes in Asian securities. "They're less junky now than they were 10 years ago, but they'll still be junky 10 years from now."

Mr. McCarthy, a former Goldman Sachs banker in Hong Kong, described the valuations some of these banks enjoy as "ridiculous," and likened reading the prospectuses for their offerings to a "comedy show." While he acknowledged public shareholders should accelerate the pace of banking reform, he predicts there will be two or three painful blowups in the sector before it gets its house in order. "It's going to end badly," he promised. "We're in the 'nuts' stage -- we're not at 'super-nuts.' This could be one of those things where they shoot up another 20 per cent or 30 per cent first."

In the mid-1990s, the soured loan problem was so crushing that China injected more than $60-billion into its main banks to keep them solvent. It also created asset management companies whose function was to siphon off more than $150-billion worth of bad loans from the Big Four's balance sheets.

The result, Chinese authorities say, is that non-performing loans at the Big Four have been winnowed down to just $133-billion. Yet there are more than a few skeptics who believe Beijing is radically understating the problem. Several analysts have estimated problem loans at between $400-billion and $600-billion. (Ernst & Young, which put the figure at $358-billion, retracted its projection after a sternly worded rebuke from Chinese authorities, and sanctioned the official estimates.)

"You can't blow up your balance sheet at 20 to 25 per cent a year and not incur a very substantial portion of bad loans," said Gordon Chang, an outspoken critic of China's debt problems and author of The Coming Collapse of China. "You can't do that with a well-managed bank in a well-regulated society. How the devil can you do it China? This is just ludicrous."

The U.S. investment banks advising on the IPOs stand to make a healthy profit. The fees themselves are very lucrative: a 2.5-per-cent cut on the ICBC offering alone will yield nearly half-a-billion dollars in commissions. The far bigger payoff could accrue to firms like Goldman Sachs, which in May injected $2.6-billion for a stake in ICBC. Analysts say that investment could easily double. China Construction Bank has gained 45 per cent since going public with a $9.2-billion offering last October, and China Commercial Bank rocketed 25 per cent on the first day of trading in Hong Kong last month.

"People are going to make money in the short term, but long term, these have got to be bad investments because the banks are not as solid as the government says they are," Mr. Chang insisted. "They've got better systems, they've got better computers, their offices look nice, all sorts of things. But these banks are essentially weaker than they were before. China is just piling up more and more non-performing loans, and eventually it's going to come crashing down, because economically this doesn't make any sense."

Last year, bank lending in China increased 9.7 per cent, and was up another 10.4 per cent in the first half of 2006 alone. At that pace, insist investors like Mr. McCarthy, China must be inhaling vast amounts of additional bad loans.

The government has said it is fully committed to reforming the sector on the eve of a massive deregulation set for the end of the year. That's when foreign banks can open branches across the country and offer local currency services.

But a cleanup of these banks will take more than commitment, analysts say. Beijing still faces the huge and time-consuming challenge of transforming the banking culture, re-educating staff, centralizing lending decisions, and learning how to market new products.

"There's definitely a 'China hype' story that's behind a lot of this," said Michael Pettis, a finance professor at Peking University and a director of the New York hedge fund Galileo. "It's linked to the excess of global liquidity, the huge amount of risk appetite and a tendency to focus on the positive, rather than the negative. China is one of the hottest areas of international interest, and there's perhaps an overexcitement about China investments."

Don't tell that to Mr. Ding. He's less worried by the pitfalls than by the ability to get his hands on $300,000 worth of ICBC shares. "I don't worry about the risks of investing in ICBC," he says. "Every bank has bad loans, but ICBC is the most powerful bank in China, with the biggest market share, and it is reforming continuously. Unlike other big Chinese banks, no big scandal has ever been reported at ICBC. Every rich person in the world would like to buy shares in Chinese banks."

China's Big Four

• Industrial and Commercial Bank of China

ICBC, the country's largest bank by assets, is preparing for a record-setting $19-billion IPO on Oct. 27. It is the third of the Big Four to tap the public markets with an offering, and the first to do it simultaneously in Shanghai and Hong Kong.

Assets: $815-billion
Branches: 18,764
Ratio of non-performing loans: 4.7 per cent
Date founded: 1984

• Bank of China

The country's most international lender traces its roots back almost a century and was once the official bank for all foreign exchange. It unveiled an $11.2-billion IPO in June, and the stock has since climbed 14 per cent.

Assets: $661-billion
Branches: More than 11,000
Ratio of NPLs: 4.4 per cent
Date founded: 1912

• China Construction Bank

CCB was the first of the Big Four to list its shares in Hong Kong with a highly successful $9.2-billion offer one year ago. The bank's shares are up roughly 45 per cent since that time.

Assets: $534-billion
Branches: 14,250
Ratio of NPLs: 3.9 per cent
Date founded: 1954

• Agricultural Bank of China

The last of the Big Four, while one of the biggest by assets, is viewed as the weakest because of its issues with bad loans and surfeit of branches. The bank has been restructuring its operations, and market watchers say it will eventually follow its peers into the public markets.

Assets: $603-billion
Branches: 31,000
Ratio of NPLs: 26.2 per cent
Date founded: 1949

29 September 2006

CIBC CEO Gerry McCaughey

The Globe and Mail, Sinclair Stewart, 29 September 2006

There was a time, not really that long ago, when Gerry McCaughey would have been considered the wrong man for the top job at Canadian Imperial Bank of Commerce. Scratch that. He wouldn't have even been considered.

McCaughey is regarded as a fine operator, and he has successfully, if quietly, tackled several tricky assignments for the bank. It's just that…well, he's considered a bit eccentric by Bay Street standards.

This is a man without much in the way of identifiable charisma, a man whom the media has described (with some polite restraint) as Melba toast, and whom one former colleague dismissed (with much less restraint) as a walking ATM machine.

This is a man without an Ivy League pedigree, much less an MBA after his name, a man who recoils from the social circuit and the limelight with equal distaste. (He politely but firmly declined requests to be interviewed and photographed for this story.) This is a man who makes millions of dollars a year, yet doesn't own a car. A man who has shunned an exclusive address in Rosedale in favour of a modest condo within strolling distance of work. A man who has never mastered the art of small talk, but who can sermonize, ad nauseum, on the Peloponnesian War.

This is a man, in other words, who is defined by dissonance in an industry that thrives on conformity.

"When you first meet him, you think, God, well, he's a bit different," says Tony de Werth, a retired CIBC executive who handpicked McCaughey in 1993 as his successor at the head of the bank's retail brokerage division, Wood Gundy. "There were some raised eyebrows on the rest of the executive committee at Gundy when I decided that I wanted him to come down and ultimately take over. They weren't too sure about Gerry."

Nobody was, really. Not that McCaughey wasn't admired: He was recognized as someone who always got the job at hand done, flawlessly, regardless of its complexity or tedium. Yet McCaughey lurked as an almost invisible presence at CIBC, and his quirks always seemed to be a tacit argument against his potential as a leader.

"I think if you look back through his entire career, people never saw him as the next big promotion," said Stuart Raftus, a CIBC alumnus who now runs Seamark Asset Management Ltd. in Halifax. "I got into CIBC, and I remember at the time everyone was telling me I had to meet David Kassie [the former head of the investment banking arm, CIBC World Markets] because he was going to be the next CEO. And from very, very early on, I remember telling everyone that in my opinion Gerry was without question the next CEO. And it was amazing to me—you couldn't find a person who believed that."

Of course, that was before CIBC stumbled through a looking glass into a cycle of scandal, blunder and internecine fighting that reached an almost hallucinatory climax with a $2.4-billion (U.S.) payout to Enron investors in 2005. The investment bankers who had imposed their swing-for-the-fences mentality on the rest of CIBC fell from grace. The bank's damaged reputation—not to mention its precarious financial situation—demanded a fix-it-man, not a visionary.

Thus Gerry McCaughey awoke one day to find himself the beneficiary of a rare planetary alignment. He was, as de Werth succinctly phrased it, "the right man, in the right place, at the right time, for CIBC."

That time was last summer, when McCaughey was passed the CEO's mantle from the singed fingertips of John Hunkin. Now, with a year of results under his belt and the foundation of his rebuilding effort plainly visible, McCaughey faces a crucial test. Will he be remembered as the incidental CEO, the man whom fortune, more than any innate leadership skills, happened to deposit atop the bank? Or is he the man to continue shaping CIBC's future, even once the mess has been cleaned up? Is he the right man, period?

Several years ago, at a financial services conference in Palm Beach, a well-regarded broker from CIBC's Calgary office strutted to the lectern to give a speech to a room of colleagues from the bank, including Gerry McCaughey. The purpose was to share his secrets for success, but he couldn't resist a little inside jab at his boss.

"Unaccustomed as I am to public speaking," the broker told the gathering, "and having only spent five minutes with Gerry McCaughey, I haven't yet learned the art of taking a five-minute chat and turning it into a two-hour dissertation."

McCaughey doesn't merely talk. He expounds. He perorates. He declaims. Ask him what time it is, and he'll tell you how to build a watch. If the discussion veers toward Rome or military history, well…you had better cancel all your plans for the afternoon. Like many autodidacts, McCaughey can't resist the urge to share the fruits of his learning, regardless of whether listeners share his fascination with the subject.

"Gerry loves the sound of his own voice," says a former colleague, who nevertheless stresses his fondness for McCaughey. "I talked to a guy at CIBC the other day. He said the meetings are a killer."

The tic extends beyond the hallways of the bank. At Frontier College, a literacy foundation that includes McCaughey among its volunteer directors, he has been known to begin meetings by diagramming the Russian army's position at the battle of Stalingrad, or by analyzing a turning point in Roman history.

"He can get up and say, Here's the Alps, here's the Rhine River, here's the Rhone River, the 10th legion was here, the ninth legion was bogged down here, the Huns were coming over here, they didn't see this. …He'll go into this tremendous detail," says John O'Leary, the charity's president, himself a self-described Sunday afternoon historian. "I find it fascinating. I'm not sure everyone does, but I sure do, and I think a lot of people are quite impressed by it."

O'Leary once set up a lunch for McCaughey with military historian Desmond Morton, and then watched as the two men volleyed back and forth, "like a tennis match," over the causes of the Luftwaffe's failure in the Second World War.

There is one topic, however, on which McCaughey is decidedly less voluble: himself. He would say there really isn't much to tell, and in some ways, he would be right.

He is a pedantic man, and his explanations are often indebted to the Socratic method, teasing out the answers from others by way of roundabout, and often expansive, inquisition. There is something earnest, if not nerdy, in his appearance: compact and trim, with wire-rimmed hexagonal glasses, inexpensive suits and an obligatory banker's coif, with hair parted desultorily to one side.

It is a workmanlike look for someone who works, and works, and works some more. When he's not punching the clock, he's either swimming (he religiously swims 2.5 kilometres four days a week, a habit he developed to help his back after a horse-riding accident 20 years ago), indulging his fascination with movies or reading one of the multiple books he always has on the go. He hasn't had a proper vacation in several years.

McCaughey lives an ascetic life with his long-time partner, Joanne, an interior designer. They don't drink, have never formally married and don't have kids. He has a small circle of friends he socializes with, including Richard Nesbitt, a one-time member of the CIBC investment-banking fraternity who now heads the Toronto Stock Exchange. McCaughey prefers the working-class patter of Shopsy's Deli to the crisp linen and starched service of the Four Seasons.

"He is a very nice man," says a former colleague. "His life is work. Gerry probably has the first commission cheque he ever made sitting in a drawer. He has no interest in spending money on any of life's pleasures."

Gerald T. McCaughey was born in Winnipeg in 1956, the son of an Irish father and French mother. He and his four siblings attended parish school there until 1970, when the family moved to Montreal and his father, Tom, became head anesthetist at Montreal General Hospital. (Now, at the age of 80, he spends much of the year in Nepal, where he helps run a training program in anesthesiology.)

Shortly after McCaughey turned 17, he left the family fold. His parents had separated just as he was finishing high school, so he packed his bags and headed west to work on the railroads. It was an odd choice for a kid: The work was both dangerous and gruelling, especially in the "rock and tunnel gang," which McCaughey opted for because it offered one extra hour of overtime pay.

For four years, he spent summers wielding a pick or a shovel in the B.C. Interior, and winters back in Montreal, taking courses at Concordia and McGill universities for his bachelor of commerce degree. It was annealing work, which likely helped to form McCaughey's stoic constitution. A shipbuilder would have difficulty improving the man's even keel, and he rarely—if ever—has been known to lose his temper.

He is fond of talking about his railway days, one analyst speculates, because it reaffirms his status as an outsider: It is a reminder of just how far he had to reach for his bootstraps.

McCaughey returned to Montreal to settle in 1976, and toiled at a meat-packing plant—again, overtime was a key selling point—until, by chance, he met a local real estate appraiser, George Debelle. Modestly successful, Debelle became a mentor to McCaughey, encouraging him to better himself and to come work for him as a bookkeeper-cum-accountant.

Just 23 years old and armed with a pair of introductory accounting courses, McCaughey agreed to help out. By day, he imposed some discipline on the company; by night, he completed his degree. One evening, in 1980, he arrived at class to find that a guest from Merrill Lynch was about to speak. McCaughey knew Merrill Lynch was one of the world's great financial brands, and he was impressed by the presentation. He asked the speaker for his business card and quickly set up an investment account for himself (his first stock was Pembina Pipeline Corp.).

If McCaughey had cut class that night, it's anybody's guess where he would be now. As it turned out, McCaughey eventually asked his contact for information on the Merrill training program, and was in New York the following spring, taking his place alongside other would-be trainee recruits at 1 Liberty Plaza. By June, just after he had graduated with his business degree at Concordia, McCaughey was a broker.

Over the next decade, McCaughey methodically scaled the organizational pyramid at Merrill, moving to Winnipeg, then Edmonton, then back to Montreal, by which time he was regional manager. Then, in 1990, Merrill retreated from Canada, selling its retail brokerage division to CIBC. The bank thereby acquired several hundred brokers, one of whom, its leadership little suspected, would be its future CEO.

In the mid-to-late 1990s, CIBC underwent a profound cultural shift. For decades, Canadian banks had been hulking retail monoliths, dominating the landscape for loans and deposits. It wasn't until the late 1980s that they were granted permission to extend their reach into the brokerage business. A feverish round of consolidation followed, as the banks took over long-standing independent firms like Nesbitt Thomson, Richardson Greenshields, McLeod Young Weir and, in CIBC's case, Wood Gundy Inc.

Wood Gundy was an investment bank, advising companies on mergers and acquisitions, and helping them finance their public offerings. This business, all about the deal, turns on swagger and competitive fire. At most of the big banks, this style was gradually subsumed into the more docile, but preponderant, retail stream. But in CIBC's case, the current ran the other way, thanks in part to the force of personalities at Wood Gundy—and in part to their ability to generate tremendous amounts of cash. The investment bankers emerged as the golden boys of CIBC.

By this point in CIBC's evolution, McCaughey had established his signature pattern. Someone gave him a job—at this point, dealing with some difficult personalities in Montreal amidst the uncertainty of a large merger with CIBC—and he got it done, quietly and largely alone.

So effective was he that de Werth, who was heading the merged retail brokerage, singled out McCaughey as his successor and, with the blessing of senior CIBC management, asked him to relocate to Toronto in 1993.

McCaughey wasn't completely taken with the idea, de Werth recalls. He enjoyed running his own unit and being in the field; head office was still a foreign concept, a place involving high-level political manoeuvring, and filled with ambiguous terms like "vision." Nevertheless, he was eventually persuaded: This was a big job, the chance to lead one of the largest retail sales forces in the country.

CIBC sent him to New York for a couple of years in the late 1990s to help integrate its newly acquired brokerage, Oppenheimer. But McCaughey didn't like the deal, chalking up the brokerage's decent returns to the bull market, and instead recommended that the bank sell it—drawing stunned looks from most members of the bank's executive team. It took several years and some failed negotiations, but with the support of Hunkin, McCaughey eventually parcelled it off in 2002.

"One of the transactions that was most impressive to the board was the decision and the ultimate sale of the Oppenheimer retail sales force in the United States, which Gerry really led," says one CIBC director. "It was done quietly. He found the buyer, he worked with the buyer and found a way to keep the team together. As he brought that in through the board, what we saw was this incredible focus—results-oriented—and nothing gets in Gerry's way when he's on track. It was very clear that this was a man who was steady, knowledgeable and could get the job done. He delivered."

CIBC as a whole was on a roll, buoyed by the aggressive investment banking team that seemingly could turn any investment into gold. That unit made an estimated $2.6-billion killing on telecom Global Crossing, and its push into U.S. investment banking landed it enviable assignments with up-and-coming powerhouses like an energy trader named Enron. Hunkin and his right-hand man, Kassie, drank up the increasing plaudits of investors.

To many of the investment bankers that ruled CIBC, the retail brokerage was merely a distribution pipeline to move product. McCaughey, accordingly, was destined to be marginalized, and his unusual mien only heightened the divide.

"It's a number of things put together that make him an outsider," says Stuart Raftus, who once headed CIBC's U.S. wealth management division. "A lot of these guys, when they sit down and have a couple of martinis, probably don't want to talk about ship battles of the 14th century."

McCaughey may not have won any popularity contests, but the Wood Gundy boys were still able to recognize an asset when they saw one. When Hunkin was named CEO of the bank in 1999—capping a bloody succession feud with retail veteran Holger Kluge, and cementing the bank's cultural tilt toward the investment bank—McCaughey was promoted to head the bank's newly formed wealth management arm, which disentangled the retail brokerage from CIBC World Markets, the investment bank.

McCaughey was content to stay beneath the radar, identifying needs or problems and then addressing them through an assortment of deals: He sold the bank's Guernsey operations (which had managed money for well-heeled customers), acquired TAL Global Asset Management, consummated the disposal of Oppenheimer and, most notably, pulled off one of the most successful financial services mergers Bay Street has seen in years: the $550-million purchase in 2001 of Merrill Lynch's Canadian brokerage business, which Merrill had rebuilt with the purchase of Midland Walwyn Inc. a few years earlier. It was a pivotal deal, one that immediately transformed CIBC into a dominant brokerage house, and simultaneously buttressed its already strong investment bank with a powerful distribution force.

But by 2002, cracks began to show. Global Crossing went bust, and CIBC was criticized for exiting early with a tidy profit while investors bore the pain. Amicus, CIBC's much-touted U.S. electronic bank, fizzled quickly, costing more than half a billion dollars.

Then Enron imploded, and CIBC suddenly found itself under investigation by U.S. regulatory authorities. It was forced to pay $80 million (U.S.) to settle allegations that it had abetted the accounting scandal at the disgraced energy trader— a pittance, it turned out, compared with the $2.4 billion (U.S.) it agreed to pay last summer to settle a class-action suit by Enron investors. The bank also had to pay $125 million (U.S) to forge a settlement with Eliot Spitzer as part of his probe of the U.S. mutual fund industry's market-timing shenanigans. It even got on the wrong side of a junkyard operator after repeatedly faxing him other people's financial information, prompting a wave of media-induced schadenfreude and a review by the federal Privacy Commissioner. CIBC appeared to be dangerously close to the breaking point.

Kassie, the presumptive heir to the throne, was dismissed from the bank in 2004, and within a year had started up a rival investment banking shop, Genuity Capital Markets, stocked with many of the top dealmakers he had worked with at CIBC. Cue another lawsuit, this one from the bank, which accused Kassie of poaching, a charge he flatly denied. Cue the mutual recrimination. Cue another black eye for CIBC, the bank one analyst memorably described as "most likely to walk into a sharp object."

Hunkin was under siege, investors were screaming and the board of directors, led by former IBM Canada CEO Bill Etherington, had had enough. They wanted to stop the headlines, and they wanted to deracinate the investment banking culture that had given them both heady scores and miserable afflictions. They wanted to convince investors that CIBC could morph into a stable, steady company, with an emphasis on lower-risk retail banking. They wanted, more than anything, to revive the bank's reputation. They looked around, and decided they needed Gerry McCaughey.

There is a debate, which rages intermittently in boardrooms and business schools, about the relative merits of insider and outsider CEOs. Entire forests have lent themselves to the effort, supporting case studies, PhD dissertations, consulting surveys and the like, all geared to determining which companies tend to perform better: those who hire from within, or those who hire from without.

If you distill all the work down to its essence, you're left with a couple of fairly agreed upon theses. Insider CEOs tend to have a better track record in the stock market, if for no other reason than they know the company intimately and require less time for transition. When a company is in a groove, most experts would say that insiders are the safe bet.

But what happens if a company is strategically challenged? What happens if it has been paralyzed by crisis? What happens if it has to restructure? These are the clarion calls for outsider CEOs. The rationale is fairly straightforward: Outsiders tend to be more comfortable with the tough decisions, like slashing jobs, since they have fewer existing relationships with employees. The outsiders are turnaround artists, but that in itself can cause longer-term issues. A Booz Allen study found that during their first couple of years on the job, outsider CEOs produced returns to investors that were four times higher than insider CEOs. As the tenure increases, however, the insiders' performance looks much better.

CIBC certainly met the classic criteria of the company in need of outside help. But at Canadian banks, recruiting an outside leader is anathema. Perhaps it is because these are large, complicated organizations—financial services conglomerates, really—with increasingly global operations. Maybe it is because they are clubby, and the hire-from-within culture is too deeply engrained to rub out. Maybe, though, it's because they are rarely in the sort of trouble that CIBC found itself in.

In McCaughey, the bank discovered an elegant solution: an outsider's insider. Here was an insider who was fully familiar with the bank's operations, and had more than a passing familiarity with its challenges. He also came from the retail side of the business, which is where CIBC was retreating to as it licked its wounds.

At the same time, he was a cultural outlier who bore none of the taint from CIBC's investment banking follies. He was capable of cleaning house at CIBC World Markets, and he was in no apparent danger of getting sucked into warring factions. Retail banking head Jill Denham was once thought to be a possible contender for the CEO's job, but it didn't help that she was groomed by Hunkin in the investment bank. She preceded him out the door in 2005, following a shakeup orchestrated by none other than McCaughey.

"John [Hunkin] had a unique personality—very personally visible, very charismatic. People followed him easily. People liked John," says the CIBC director quoted earlier. "But we also said that the attributes that Gerry had, given where the bank was in its history, were probably more attuned to what we needed. He didn't come from the World Markets business. That was a significant plus—it wasn't a showstopper, but we felt that as we needed to restore shareholder confidence, having someone who had not been part of the World Markets team was important."

De Werth, the CIBC executive who brought McCaughey to Toronto, is adamant that his protégé deserves the top job at CIBC. Yet he confesses that, like many others, he was surprised that McCaughey actually got it.

"The personality is very different. I thought the bank directors might say, 'Yes, but...his public persona is not really good enough to have this job. He's just not that kind of a guy.' But to their credit, they've given the best guy the chance to do it, I reckon. He's done a good job all of his life and he's getting his just rewards for it."

In early August, exactly one year after he had taken over as CEO, McCaughey strolled into a CIBC board meeting. It had been an awkward start, to be truthful—first on McCaughey's to-do list was announcing the $2.4-billion (U.S.) Enron payment, the most punishing bill yet for any of the U.S. and Canadian investment banks that settled with the energy trader's investors.

Plenty of water and red ink had flowed under the bridge in the intervening year. McCaughey had thrown himself into the job with his usual discipline, embarking on a multistep fix. He pledged $250 million in annual cost cuts to improve profitability, and is on track to beat that number by the end of the year. He promised to rebuild the bank's decimated Tier 1 capital ratio— a measure regulators use to assess a bank's financial strength—to 8.5%, and got there ahead of time. He painstakingly set to work cleaning up the bank's abysmal retail lending portfolio, dumping unsecured loans in favour of less profitable—and less risky—secured loans.

He managed to get the bank back to business and out of the headlines, and caught nearly everyone by surprise when he found time to pull off a deal: doubling CIBC's 44% stake in FirstCaribbean International Bank, in a $1.1-billion (U.S.) deal with Barclays.

When McCaughey entered the boardroom on the 56th floor of CIBC's Toronto skyscraper that day, he was by himself. The CEO typically spends an hour addressing the board, after which he is joined by a select group from his executive team. Before he could begin his briefing, however, the directors, including chairman Bill Etherington and former federal finance minister John Manley, rose to give him a spontaneous round of applause—the first time in a long time, conceded one, that they had had the occasion to clap for a CIBC CEO.

McCaughey was taken aback, and quickly switched the room's attention to a discussion of the business at hand.

He knew as well as anyone that investors weren't quite ready to give him their own ovation. McCaughey's critics have two lingering concerns. One is that his aggressive restructuring and "de-risking" operation, particularly on the retail lending side, has hurt the pace of revenue growth.

The second, longer-term question is whether McCaughey has a strategic vision. There are those who think he's merely an operator dressed in CEO garb, and that once CIBC is functioning cleanly again, it should find someone capable of charting its future: a visionary, rather than a tactician.

"He's a spectacular number-two guy. He's so detail-oriented," insists a former colleague. "Gerry would make a great COO, but a lousy CEO. To be a great CEO in any sales organization, you have to be a great salesman. When things go off the rails, they wanted Mr. Control Freak in. They don't want Mr. Business Builder."

Mind you, many current CIBC investors would argue that business builders are precisely what got the bank into this mess in the first place. Those investors like the fact that CIBC has been steadily returning cash to them over the past couple of years, both through aggressive stock repurchasing and healthy dividends, and they don't want to see the bank make another ill-fated run into the U.S. market.

"I think the biggest mistake any CEO in the Canadian banking industry could make would be to underestimate Gerry, which I think people do just naturally," says Stuart Raftus. "I think people on Bay Street get so caught up with what you're supposed to look like and talk like. He's not an overtly charismatic, flamboyant kind of guy. What he is, in my opinion, is just an outstanding leader."

For all the gripes about McCaughey's long-winded oratory, and for all the talk about his idiosyncracies, everyone agrees he is an incredibly smart man, with the ability to think several moves in advance. But can he do this for CIBC, given the relatively weak hand he has been dealt? Those close to the CEO say it would be premature to present investors with a strategic blueprint before he concludes the pressing task of whipping the bank back into financial fitness. Yet if one looks closely, there are some clues as to which direction he might take the bank. He is prudent, without doubt, and is not the sort of trigger-happy gunslinger to fashion a blockbuster—and dilutive—acquisition. But he may indeed pursue smaller, "bolt-on" purchases in his comfort zone of retail banking and wealth management, and it would be a mistake to think he wouldn't consider deals outside of Canada.

"I think he probably has a vision," said Robert Wessel, an analyst at National Bank Financial Inc. "But I think if you're him, you have to follow two steps: First, fix the bank and get it in good operating condition. The second step is implementing whatever your long-term vision is. How successful you are on your first determines the options you have for the second."

"He's the right man for the job right now," echoed another analyst who tracks the bank. "But at some point, CIBC has got to pick its destiny."

Their heyday over, the investment bankers who ruled CIBC have dispered to new positions of power—or of repose

CIBC World Markets, the investment bank formerly known as CIBC Wood Gundy, has endured its share of controversy and turmoil over the past decade. Along the way, it has witnessed considerable turnover among its top executives, many of whom have gone on to noteworthy new jobs. Here are a few of the names that have dropped off the CIBC World Markets roster:

Richard Nesbitt

The chief executive officer of TSX Group, the parent company of the Toronto Stock Exchange, Nesbitt spent five years at CIBC World Markets in the 1990s. A close friend of Gerry McCaughey, Nesbitt left the bank in 1997 to head up the Canadian investment banking arm of HSBC. He headed to the TSX in 2001 and was named CEO at the end of 2004.

Don Lindsay

Lindsay joined Wood Gundy in 1985, prior to its takeover by CIBC. He ran the firm's mining finance team, then worked his way up the organizational chart, culminating in his promotion to president of CIBC World Markets. He left in January, 2005, to become president (and soon, CEO) of Vancouver-based miner Teck Cominco, and has spent much of 2006 working on an unsuccessful attempt to seize control of Inco Ltd.

Wayne Fox

Fox worked closely with former CIBC head honcho John Hunkin when the two were still ensconced at the bank's investment banking arm. The 33-year CIBC veteran was once president of CIBC Wood Gundy, and later became the bank's vice-chairman and chief risk officer following an internal reshuffling. He retired from the bank in August of last year, just a few weeks after Hunkin officially stepped down. He is now chairman of the TSX.

David Kassie

Kassie joined Wood Gundy in 1976. He started CIBC Wood Gundy's merchant banking operations and rose through the ranks under Hunkin, replacing him as head of CIBC World Markets in 1999. Kassie was also heir apparent to Hunkin as CEO of CIBC, but Hunkin and the board ousted Kassie in 2004 after the bank's Enron debacle. In 2005, he started Genuity Capital Markets, sparking a fight with CIBC over his alleged recruitment of former colleagues.

Jill Denham

Denham joined Wood Gundy in 1983, and spent five years in corporate finance. After earning a Harvard MBA, she joined the merchant bank. In 2001, she was a surprise choice to take over retail banking. Her ties to the investment bank were seen as a detriment when the bank considered succession, and McCaughey replaced her with one of his own team, Sonia Baxendale. Denham is spending time with her three children, and has joined the board of the Ontario Teachers' Pension Plan.

John Hunkin

Hunkin became CEO in 1999 with a vow to take the volatility out of the bank's earnings and bring CIBC World Markets to heel, neither of which he really accomplished. The long-time CIBC executive spent the last year of his tenure trying to restore the bank's reputation. He left in July, 2005, planning to spend more time sailing at his Nova Scotia retreat. But he maintains an office at CIBC and is involved in several charities.

28 September 2006

BMO to Buy First National Bank & Trust

BMO Capital Markets, 28 September 2006

Details & Analysis

Harris Bank, BMO’'s U.S. operation, announced yesterday that it has entered into an agreement to acquire First National Bank & Trust, a privately held bank with 32 branches in and around Indianapolis. The purchase price is US$290 million, and we believe it marks the first meaningful thrust for Harris into a new geographic market since the bank was purchased in 1984.

The transaction price is 24.8x last 12-month earnings and 2.7x tangible book value. BMO management has indicated that there are various tax implications (including the deduction of the purchase price premium) and unusual items in the bank’s past 12-month earnings which, when incorporated, produce takeover multiples of 22.5x earnings and 2.3x tangible book value. Management also indicated that exclusive of one-time items (a US$20 million charge), the deal is modestly accretive in the first year. We estimate that the accretion is less than $0.02 per BMO share. We provide some summary metrics on the acquisition in the table below.

From our perspective, this deal is interesting in that it is somewhat different from previous deals done by Harris. The acquisition moves the bank out of its stronghold of Chicagoland. FNB has 10 branches in Indianapolis and the majority of the rest are north and north-west of the city in MSAs such as Kokomo and Terre Haute. In considering the FNB footprint (and inclusive of Indianapolis), we would estimate deposit market share to be between 2% and 3%.

Another difference of this deal is that FNB has faced its share of problems over the past couple of years. The entity has lost deposit market share in all regions over the past year, and revenues appear to have been essentially flat over the past three years. BMO management indicated that it believes recent restructuring activities and head count reductions over the past 12 months (which resulted in a loss in the third quarter of last year) position the company well for the future. Earnings in the past three quarters have been quite stable.

Despite these subtle differences, this deal is certainly in line with the bank’s slow, steady approach to building its U.S. retail banking footprint. Assuming that the problems are behind it, and backed by the Harris brand and product lineup, this is a good deal for the bank to start its geographic build out.

Forecasts & Valuation

Given the modest scale of the impact of this deal, our forecasts are unchanged. We continue to believe that BMO shares are reasonably valued. The shares trade in line with the bank group despite BMO’s below-average ROE, due to the defensive nature of the bank.


The Globe and Mail, Sinclair Stewart, 28 September 2006

Bank of Montreal took another modest step in its cautious U.S. expansion strategy yesterday, acquiring an Indiana retail bank for U$290-million in a move to help it branch out beyond its home base in Chicago.

BMO is buying First National Bank & Trust, an Indianapolis-based outfit with 32 branches and $920-million in deposits.

It is the first deal that BMO's U.S. subsidiary has made under Ellen Costello, who replaced Frank Techar as head of Harris Bankcorp. this summer after a senior management shuffle at the parent in Toronto.

BMO said the purchase will increase its U.S. branch network by about 15 per cent to 233, more than halfway to its goal of between 350 and 400 locations in the U.S. Midwest. The bank's previous significant U.S. acquisition, made two years ago, was also in northwestern Indiana. In the fall of 2004, the bank snapped up Mercantile Bancorp. Inc. for just under $200-million to gain its first branch foothold in the state.

Analyst Jason Bilodeau at UBS Securities Canada Inc. noted First National has "struggled" with its operations, and cautioned that while the Indiana market is attractive, it is still challenging for foreign banks.

The Indianapolis area has 1.7 million residents, a population that would rank among the largest cities in Canada. It is also a relatively well-off service economy, with low levels of unemployment and better than average household income.

BMO chief operating officer Bill Downe, who is to replace Tony Comper as the bank's CEO next spring, said First National has improved over the past three or four years. However, he said BMO has an opportunity to gain a "lift" by introducing better customer service systems and folding in the bank's wealth management offerings as a complement. "We are quite satisfied that the bank is in really good shape," he said in an interview.

Almost two years ago, BMO said it had laid the proper foundations for an accelerated push into U.S. retail banking. At the time, chief financial officer Karen Maidment said the bank was preparing to step up the pace of acquisitions and consider deals of $2-billion or more.

Yet that has failed to materialize. There has been no flurry of deals, let alone a sizable purchase that could instantly transform the bank's presence in the Chicago area.

Mr. Downe, however, said the strategy is "disciplined" rather than cautious.

"As far as the transaction pipeline, we haven't missed any deals because there hasn't been much movement in the market."

Mr. Bilodeau said one of the risks for BMO investors is that the bank will pursue one of these big deals, potentially at a high price in a less familiar market. In a research note, he said he believes Mr. Downe and others will still consider a large acquisition if the right bank materializes, but suggested management appears "appropriately" focused on smaller add-ons.


Bloomberg, Doug Alexander & Sean B. Pasternak, 27 September 2006

Bank of Montreal, Canada's fourth- biggest bank by assets, agreed to buy First National Bank & Trust of Indiana for $290 million, its biggest U.S. bank acquisition in 22 years.

First National has 32 branches in Indianapolis, Kokomo and Terre Haute, with $1.3 billion in assets and $920 million in deposits, Toronto-based Bank of Montreal said today.

"It's right on strategy. We are making serial transactions and this is a nice one," said Bank of Montreal Chief Operating Officer William Downe, in a telephone interview today. ``It just really fits perfectly into the footprint."

The purchase is the first under Ellen Costello, appointed chief executive officer of the Chicago-based Harris Bank unit in July. First National will increase Harris's branch count by about 15 percent to 233 offices. The bank wants to have 350 to 400 branches in the U.S. Midwest within five years.

"This transaction confirms that Bank of Montreal is serious about expanding Harris through the Midwest,'' said Michael Goldberg, an analyst at Desjardins Securities, in a research note today.

Bank of Montreal has invested about C$1.86 billion ($1.67 billion) to buy banks in the U.S. since it entered the market with the purchase of Harris in 1984. The Canadian government has blocked mergers among the country's largest lenders, forcing them to expand in the U.S., Europe and Latin America to increase earnings. Chief Executive Officer Anthony Comper has said he'll spend as much as $2 billion to expand Harris Bank.

Bank of Montreal said U.S. consumer banking profit rose 3.3 percent to C$31 million in the fiscal third quarter. Profit at the unit has grown at less than half the rate of the Canadian consumer bank business over the past two years.

The acquisition, expected to close in January subject to regulatory approvals, may add to earnings in the first year, excluding $20 million in one-time items. The purchase price is 2.2 times the book value of closely held First National, compared with the average price of 2.56 times book value paid for U.S. banks in acquisitions this year.

"We're certainly in a position where we can do more transactions like this with the resources that we have,'' Downe said. He didn't say when he expects the next U.S. acquisition.

"It's a little bit like fishing, you don't know exactly when you're going to get a bite," Downe said.

First National had revenue of $47.7 million last year, little changed from the previous year. Revenue was $28.6 million for the first half of 2006, according to Bank of Montreal.

Canadian Press, 27 September 2006

Aiming at the high-growth Indianapolis market, a Bank of Montreal subsidiary has agreed to pay US$290 million for First National Bank & Trust in the United States.

Chicago-based Harris Financial Corp. will expand its community-focused personal and commercial banking services further into Indiana, Toronto-based Bank of Montreal said Wednesday.

First National Bank & Trust has 32 branches and 33 automated banking machines in Indianapolis and the surrounding communities of Kokomo and Terre Haute.

With US$1.3 billion in assets and US$920 million in deposits, as well as more than US$500 million in trust assets, First National Bank & Trust offers a wide range of retail and commercial banking products, as well as trust, investment and insurance services.

With more than 200 branches and nearly 550 Harris-branded ABMs across Chicago, its suburbs and northwest Indiana, Harris is already the second-largest bank in the Chicago market, based on branches.

After the acquisition, Harris will have 233 branches and will move closer toward its goal to become the leading personal and commercial bank in the U.S. Midwest by building a network of 350 to 400 branches.

"This acquisition provides a base from which we can grow in the important Indianapolis market," said Tony Comper, CEO of Bank of Montreal, or BMO Financial Group.

"Indianapolis is the second-fastest growing market in the U.S. Midwest and, with a population of about 1.7 million, it presents significant opportunities for us as we move toward our ambition of being the leading personal and commercial bank in that region."

The acquisition, subject to approvals from U.S. and Canadian regulators, is expected to be completed in January and be "modestly accretive" to cash earnings per share in the first year.

Fastow Accuses Several Banks of Involvement in Enron Scam

Canadian Press, Gary Norris, 28 September 2006

Royal Bank of Canada and Toronto-Dominion Bank reacted cautiously yesterday to being mentioned by Enron's former chief financial officer before he was taken away to prison.

Andrew Fastow, in a statement presented as he received a six-year sentence on Tuesday in Houston, said RBC and TD were among 10 banks that aided him in assembling financial structures that hid debt and boosted Enron's reported financial results before the energy trading enterprise collapsed in late 2001 in one of the biggest corporate scandals in U.S. history.

His statement was seized on by lawyers pressing multibillion-dollar litigation launched by Enron shareholders against the two Canadian banks and other financial institutions after Enron's bankruptcy wiped out $60-billion (U.S.) in stock market value.

"This matter is still before the courts; we don't have anything new to report," TD spokesman Simon Townsend said yesterday.

"We are going to aggressively defend ourselves against the allegations," said RBC's Beja Rodeck, who like Mr. Townsend declined to say anything further on the case.

Mr. Fastow declared that he "viewed certain banks as problem solvers" -- a statement seen as possibly adding pressure on banks that have not settled a shareholder class-action lawsuit.

The University of California, the lead plaintiff in the litigation, stated that Mr. Fastow's testimony "makes it very clear that, in many cases, Enron didn't tell these banks what to do -- but just the reverse."

William Lerach, the lawyer leading the class action, said Mr. Fastow's statement, "coupled with the smoking-gun e-mails, memorandums and other documents that we have uncovered, make it clear for all to see that the Enron banks were not innocent drivers but served as the actual masterminds behind the scheme to defraud investors in one of the greatest financial frauds in history."

Investors have so far received close to $8-billion arising from various Enron-related legal actions, notably $2.4-billion in a settlement last year with Canadian Imperial Bank of Commerce.

Citigroup, Bank of America and JPMorgan Chase have also settled but a half-dozen banks have refused to do so, including RBC and TD -- both cited by Mr. Fastow as "tier-two" lenders to Enron.

His statement cited Merrill Lynch, Credit Suisse First Boston, Royal Bank of Scotland and Barclays as the banks most actively involved in his machinations.

Although Mr. Fastow, 44, had inside knowledge of the off-balance-sheet transactions that obscured Enron's shakiness, his statement might be seen as tainted by his desire for leniency -- a 10-year sentence had been expected -- and by his admitted criminality.

While the Royal Bank of Canada is fighting the shareholder lawsuit, it paid $49-million in July, 2005, in a settlement with Enron itself, which said then that RBC "played the smallest role of any of the financial institutions involved in this case."

But Mr. Fastow stated he "had worked with RBC on structuring off-balance-sheet transactions to help Enron meet its financial reporting objectives as far back as 1991," and "based on my conversations with RBC bankers, I believe they understood that certain structured-finance transactions would have had a material impact on Enron's financial reporting."

He also said that although RBC was viewed as a second-tier lender to Enron, he regarded it as a tier-one bank after the autumn of 2000, when a team he had worked with previously at Royal Bank of Scotland's NatWest subsidiary joined the Canadian bank. TD, meanwhile, received a brief mention in Mr. Fastow's declaration as "a tier-two bank with which I dealt."

His statement had no discernible effect on investors, as the shares of all five big banks made modest gains yesterday on the Toronto Stock Exchange.

The Globe and Mail, Sinclair Stewart, 27 September 2006

In one of his final acts before heading to prison yesterday, former Enron Corp. chief financial officer Andrew Fastow personally implicated a handful of financial institutions --including Royal Bank of Canada and Toronto-Dominion Bank -- in the massive accounting fraud that precipitated the energy trader's collapse.

Mr. Fastow was sentenced to six years in prison by a Houston judge for his role in masterminding a series of complex transactions that led to Enron's demise and that ultimately swindled investors out of more than $60-billion (U.S.).

As part of his sentencing hearing, the disgraced executive provided a declaration that could ratchet up the legal fight between the energy traders' investors and several of its former lenders.

Mr. Fastow told lawyers waging a class-action lawsuit on behalf of Enron investors that these banks helped him to devise complex structures that enabled Enron to artificially achieve its financial targets and mask the company's debt.

"I and others, including certain of Enron banks, worked together, intentionally and knowingly, to engage in transactions that would affect Enron's financial statements," he said in the declaration submitted at the hearing yesterday.

"I believe that my work made the company look more healthy and profitable than it actually was. I worked with certain banks to accomplish this goal and I viewed certain banks as problem solvers."

William Lerach, the lawyer leading the class-action effort, suggested yesterday that Mr. Fastow's evidence will help extract lucrative settlements for investors from the company's bankers.

"The testimony provides a clear road map of how the banks were an integral and active player in perpetrating the Enron fraud," he said in an e-mail.

"Fastow's co-operation will help us hold the banks accountable and further our ultimate goal of a substantial recovery for Enron investors."

These investors have already received more than $7.3-billion from numerous settlements, including a record $2.4-billion agreement last year with the Canadian Imperial Bank of Commerce. Six banks, however, have refused to settle, and one -- Barclays Bank PLC -- won a major victory in July when a judge removed the British bank from the class-action suit.

Mr. Lerach is trying to have the bank reinstated among the list of defendants for a planned trial next year, but David Braff, a New York lawyer for Barclays, dismissed any notion that Mr. Fastow's testimony might sway the court.

Mr. Braff pointed out that lawyers for the class-action case were among those who asked the judge to extend leniency to the once high-flying Enron official for his co-operation.

"Given the source of the Fastow declaration, and the circumstances of its filing, its credibility is highly suspect," Mr. Braff said.

Mr. Fastow highlighted Merrill Lynch & Co., Credit Suisse First Boston, Royal Bank of Scotland, and Barclays, as among the banks most intimately involved with Enron. Yet he also singled out RBC and TD, two others that have not settled.

Spokesmen for the two banks declined to comment.

Mr. Fastow said that although RBC was only a "Tier-2" lender to the company, he treated it like a "Tier-1" after the bank hired a trio of British investment bankers in 2000 from Greenwich NatWest. He acknowledged he had a "close, personal relationship" with Gary Mulgrew, who along with David Bermingham and Giles Darby have become known as the "NatWest Three."

The men lost a lengthy extradition hearing on fraud charges relating to their former employer, and were recently granted bail by a Houston court.

"I believe that they knew what I expected of RBC, and that they structured transactions at RBC that contributed to causing Enron to manage its balance sheet and generate funds flow from operations," Mr. Fastow stated. He added that he worked with RBC on off-balance sheet arrangements dating back to 1991.

RBC, Canada's largest bank, paid $49-million a year ago to settle a separate legal action in which Enron itself targeted former lenders.

At the time, Enron interim CEO Stephen Cooper provided RBC with an endorsement of sorts, explaining the relatively low sum reflected the fact that RBC "played the smallest role of any of the financial institutions" involved in the Enron affair.

TD received the least attention in Mr. Fastow's declaration. He simply described the bank as a Tier-2 lender, and said it was involved in six "prepay" transactions between 1998 and 2001 that were designed to create "funds flow from operations" at the end of a specific quarter.

Enron engaged in numerous prepay transactions, according to the declaration. These deals made it look as though the company was booking income from selling assets, when in fact it was incurring a future debt to its banks.

27 September 2006

Bank Dividend Yields - Compelling Versus Bonds & Equities

Scotia Capital, 27 September 2006

• Bank dividend yields are near or at all time highs versus bonds, overall equity markets, Pipes/Utilities and Income Trusts; at the same time the bank group's one year beta has declined to the extremely low level of 0.39.

• In our view, although bank share prices have done exceptionally well, they still do not fully reflect the magnitude of dividend increases and the significant decline in bond yields. In fact reversion to the mean against bond yields (currently 3.3 standard deviations above the mean) would result in the bank index increasing by 56% or bond yields rising to 6.1%. If we assumed the bank dividend payout ratio increased to 50%, reversion to the mean would result in bank index gains of 74% or 10-year bond yield of 6.8% (Exhibit 2).

• Bank dividend yield reversion to the mean versus equity markets, Pipes/Utilities and Income Trusts would result in relative bank share gains of 32% - 39% (Exhibit 3). The potential gains for the bank index does not include the impact of future dividend increases.

• Banks have grown their dividends in the past five years at unprecedented rates and consistency as highlighted in Exhibit 10. Bank dividends have increased 176% since the beginning of 2000 with the bank share price increase of 161% over the same period. Banks have led all equities in dividend growth in the past four decades with a CAGR of 9.6% since 1967, more than double the market's growth of 4.6%.

• Despite the significant growth in dividends particularly since the beginning of 2000 the bank dividend payout ratio (Exhibit 11) remains low in our view at 45% trailing, although slightly above the historical payout ratio of 41% since 1967. Given the dramatic revenue mix shift to less capital intensive businesses and the record level of capital and profitability as well as level of free cash flow generation we believe the payout ratio will expand to 50% (see report titled Four Decades of Dividend Growth March 2002). Our long term growth rates and long term profitability estimates would theoretically equate to a 65% payout ratio however other intangible factors will likely result in the payout ratio being checked in the 50% range at least in a five to ten year horizon.

• The 10-year Canadian bond yield has recently declined to 3.97% from a high of 4.58% in June 2006. Canadian bond yields have declined from 6.54% in 2000 while the bank dividend yield has remained relatively constant in the 3% range as bank share price increased 161%, keeping pace with bank dividend growth but not reflecting lower bond yields (Exhibit 12). As a consequence bank dividend yields relative to 10-year bond yields have increased to 82% versus the historical mean of 53% or 3.3 standard deviations above the mean which is near a historical high (Exhibit 4). Thus bank valuations are very compelling versus bonds.

• The bank dividend yield relative to the S&P/TSX is near the highest in history at 1.9x, except for a brief period in 2000 with the Tech Bubble (Exhibit 5). The bank dividend yield relative to the S&P/TSX is almost double the level recorded from 1956 - 1978, a period of very sound bank fundamentals and low interest rates. Our view remains that longer term this relationship will trend back towards these levels.

• Bank dividend yields versus the Pipes/Utilities (Exhibit 6) and Income Trusts (Exhibit 7) are at or near their highest level in the past six years. In fact reversion to the mean would result in the bank index increasing on a relative basis by 32% and 39% versus pipes/utilities and income trusts respectively. The bank group's attractive dividend yields are supported by an extremely low one year beta of 0.39 (Exhibit 1).

• We reiterate our Overweight Bank recommendation based on compelling valuation and strong fundamentals and extremely low betas. Valuations are compelling on a yield basis and attractive on a P/E multiple basis. Strong fundamentals include low credit risk, record profitability, low financial leverage, low earnings volatility, reasonable earnings growth outlook and ability to increase dividends.

• Maintain 1-Sector Outperforms on RY, 2-Sector performs on TD, NA, CWB and LB and 3-Sector underperforms on BMO and CM. On an absolute return basis we would have no sells in the bank group.

• Our bank index 12 month target is unchanged at 27,000 based on 15.1 P/E our 2007 earnings estimates for total expected return of 25%. Individual banks' share price momentums relative to the bank index are highlighted in Exhibits 13 to 18.

26 September 2006

Blackmont Capital Initiates Coverage of Banks

• Bank of Montreal (good progress on costs. next up? revenues) was rated new "hold." The 12-month price target is C$71.00.

• Bank of Nova Scotia (internationally diversified, high relative operating efficiency) was rated new "buy." The price target is C$55.00.

• CIBC (rebuild well underway) was rated new "hold." The 12-month price target is C$88.00.

• National Bank of Canada (solid performer with limited regional diversity) was rated new "hold." The 12-month price target is C$65.00.

• Royal Bank of Canada (scale and diversity: a clear advantage) was rated new "buy." The 12-month price target is C$55.00.

• Toronto-Dominion Bank (solid strategic execution, rising risk profile due to acquisitions) was rated new "hold." The price target is C$68.00.

25 September 2006

Dundee Bank of Canada Launched

Lynne Olver, Reuters, 25 September 2006

Dundee Bank of Canada, a recent entrant into the country's big-bank-dominated financial services sector, is betting that ageing Baby Boomers will opt for one-stop service through their financial advisors.

The tiny bank, formerly called Dundee Wealth Bank, got its charter from federal regulators a year ago and began limited operations in January this year.

After taking some time to build up technical capability, it launched a marketing campaign yesterday under the new Dundee Bank of Canada banner.

The first wave of the Boomers is hitting age 60, and they are looking for objective advisors to help make sense of their financial affairs, said Greg Reed, Dundee Bank president and chief executive.

"Our way to market is to make it very easy for those advisors to access initially our savings accounts, and our other products as they come along," Mr. Reed said in an interview.

Dundee Bank, which does not have any bricks-and-mortar branches, is hoping to acquire customers from the Big Six Canadian banks, as well as virtual banks such as ING Bank of Canada, he said.

"There are a number of people who switched into alternative banks to get higher rates than they were getting from traditional banks and were prepared to put up with having to do it on a computer or punch numbers on the phone, but they're now at the point where the novelty of that has worn off," Mr. Reed said.

Dundee Bank customers will be able to speak to their third-party financial advisors and move money in or out of their bank accounts in a day, Mr. Reed said. The bank offers two investment savings accounts: one pays 3.85% and the other, for clients who already pay fees to financial advisors, pays 4.10%. That is competitive with rates paid on some guaranteed investment certificates, Mr. Reed noted.

ING Bank of Canada, the unit of Dutch ING Groep ING.AS known locally as ING Direct, offers 3.5% interest on its investment savings account and 4.25% on one-year GICs. It has more than$14-billion in assets, according to its Canadian Web site.

Dundee Bank only has about $140-million in deposits and $90-million in residential mortgages, the latter primarily offered through mortgage brokers. But it plans to eventually offer loans, personal lines of credit, credit cards and debit cards.

Mr. Reed declined to reveal specific targets for customer or asset growth.

The bank is a unit of Dundee Wealth Management Inc., which manages or administers about $50-billion in assets through various subsidiaries.

The Canadian market has seen many niche banks emerge in the past decade, including banks set up by retailers, credit card issuers and credit unions.

Earlier this month, insurance giant Manulife Financial Corp. said assets managed by its Waterloo, Ont.-based Manulife Bank had grown to more than $7-billion, good enough for eighth spot in the domestic bank rankings, ahead of Edmonton-based Canadian Western Bank , which had $6.9-billion in assets at the end of July.

Manulife Continues to Gain US VA Market Share

Scotia Capital, 25 September 2006


• U.S. Variable Annuity Q2/06 industry stats were released late last week.

What It Means

• For the 11th quarter in a row, Manulife gained market share in terms of U.S. variable annuity assets, with market share reaching its highest level ever. For the 12th quarter in a row, Sun Life lost market share in terms of variable annuity assets, with market share reaching its lowest level in over six years.

• Sun Life's heavy investment (we estimate $10 million) in expanding U.S. variable annuity distribution is expected, as per management, to bear fruit in the second half of 2006. As we have yet to see any market share gains in variable annuity sales we remain somewhat sceptical.

• We expect Manulife's valuation premium, relative to the group average, is more likely to remain at current levels if not modestly contract, as opposed to expand, simply because we expect its exceptional top-line growth in the U.S. to moderate somewhat going forward. This moderate contraction in its premium to the group in the last three months (down from 11% to 9% on a forward P/E) is consistent with its modest reduction in market share of U.S. VA sales, declining from 6.4% in Q1/06 (as reported three months ago), to 6.2% share as at Q2/06.

U.S. VA market stats out - Sun Life continues to struggle to gain share

• While Manulife continues to gain market share in terms of assets, the same cannot be said for Sun Life. In terms of assets, Sun Life's market share continued to decline (from #16 and 1.32% at Q4/05 to #17 and 1.29% at Q1/06 to #17 at Q2/06 with 1.21%), as negative net sales for the insurer continue to hurt asset growth. The big continue to get bigger in U.S. variable annuity, and cracking the top 10 in terms if assets and/or sales is becoming increasingly difficult in this business.

• Sun Life's heavy investment (we estimate $10 million) in expanding U.S. variable annuity distribution is expected to bear fruit in 2006 - we remain somewhat sceptical. The company notes that there is a lag before the impact of the 50 wholesalers recruited over the last 15-18 months begins to significantly impact the bottom line. We remain somewhat sceptical. Despite efforts to ramp up distribution and improve product, Sun Life's market share in terms of U.S. variable annuity sales, at 1.0%, has not moved in the last five quarters, and it remains below 2004 levels and well below 2001-2003 levels. Furthermore, net sales continue to be negative, and at negative US$926 million in 2005 and negative US$396 million in 1H/06, are well below top ten players such as Manulife (at positive US$4.6 billion in 2005 and positive US$2.4 billion in 1H/06), Lincoln (at positive US$3.7 billion in 2005 and positive US$2.0 billion in 1H/06), and Prudential (at positive US$1.4 billion in 2005 and positive US$1.3 billion in 1H/06.

• Manulife's exceptional U.S. VA sales growth is likely to return to more "normalized" levels for Q3/06 and Q4/06. At the company's recent Investor Day (June 13, 2006) management indicated that the 41%, 61%, 63% and 60% sales growth in U.S. variable annuity for Q2/06, Q1/06, Q4/05 and Q3/05, respectively, would likely not be sustainable, for two reasons. One, we are over a year following the May 2005 launch of the Second Generation Product, the highly successful VA product that drove the growth, and two, competitors have now copied the product to various degrees. We would expect the company to maintain market position and share until its next new product launch, which we anticipate could be late 2006 or early 2007, and expect that going forward the exceptional gains in market share experienced of late, aided also by new found momentum post the Hancock close, will more likely be harder to duplicate. We saw the beginning of this trend in Q2/06, with the company slightly losing market share (from 6.4% at Q1/06 to 6.2% at Q2/06); the first time we've seen a slip in market share for the company in nearly three years.

• Manulife's premium to group - less likely to continue to expand. We expect Manulife's valuation premium, relative to the group average, is more likely to remain at current levels if not modestly contract, as opposed to expand, simply because we expect its exceptional top-line growth in the U.S. to moderate somewhat going forward. Manulife is currently at a 9% premium on a forward P/E basis to the group average (or a 13% premium to Sun Life, a 5% premium to Great-West Lifeco and an 18% premium to IAG), well above its average, since the close of the John Hancock acquisition of a 5% premium to the group (or a 7% premium to Sun Life, a 2% premium to Great-West Lifeco and a 11% premium to IAG). The 9% premium to the group is down from an 11% premium three months ago. This moderate contraction in its premium is consistent with its modest reduction in market share of U.S. VA sales, declining from 6.4% in Q1/06 (as reported three months ago) to 6.2% share as at Q2/06.

TD Banknorth in the US Northeast

(AP) -- A Ryan Beck analyst on Monday downgraded a slew of banking companies, said the industries faces obstacles ranging from an inverted yield curve to slowdowns in auto sales and the housing market.

Analyst Jacqueline Reeves downgraded TD Banknorth Inc. to "Underperform" from "Market Perform" because she thinks the bank's parent, Toronto-Dominion Bank, is going to keep buying U.S. banks. TD Banknorth should trade at a discount to other banks because of the risks posed to earnings from integrating more acquisitions.
Analyst Anthony R Davis of Ryan Beck & Co downgrades TD Banknorth from "market perform" to "underperform." The target price is set to $29.

In a research note published this morning, the analyst mentions that the company has pre-announced its 3Q06 EPS significantly short of the consensus due to slowing fee income and loan growth. The downgrade in the rating is based on valuation, the analyst adds. Ryan Beck & Co expects TD Banknorth’s cash EPS to decline by 12% in the current year, partly on account of increased operating expenses and additional margin compression.
Duncan Mavin, Financial Post, 23 September 2006

Ridgefield, Conn. - Once-rural Fairfield County, Conn., today is littered with chic little towns crammed with bistros and high-end delicatessens, spas and art galleries.

It's one of the richest counties in the wealthiest country in the world, thanks to an influx of commuters from New York City -- less than a couple of hours' drive away -- and executives from nearby corporate offices belonging to IBM Corp. and Pepsico, for instance.

Average household income in Connecticut is US$63,500, well above the U.S. national average of US$49,700. In Fairfield County, which borders New Jersey and is closest to Manhattan, incomes are even higher -- they often range from US$100,000 to US$200,000, compared with about US$40,000 in areas further to the east.

It's no surprise, then, that retail banks are desperate for a piece of the action in an area local banking executives call the "Gold Coast." None more so than Toronto-Dominion Bank's U.S. subsidiary, TD Banknorth.

As its Canadian parent searches for new sources of profit away from the overcrowded domestic battleground, Portland, Me.-based TD Banknorth has targeted the U.S. Northeast for a major chunk of its growth in the next several years.

TD is not alone in looking for growth outside its home territory. Canadian banks are sitting on piles of cash and the quest for growth has taken the banks to unchartered territory, and each bank has its own story to tell. Bank of Nova Scotia is in Latin America and Central America; Bank of Montreal says it is poised to add to its Harrisbank in the Chicago area; Royal Bank of Canada recently added to its RBC Centura franchise with an acquisition in the Atlanta area; and even cost-cutting Canadian Imperial Bank of Commerce is doubling its presence in the Caribbean later this year.

"Twenty years ago, the Canadian banks were world-class banks," Bill Ryan, TD Banknorth's straight-talking chief executive, told a conference in Boston last week. But the Canadians have slipped, especially because merger restrictions have prevented significant growth at home. Instead, the only way to expand is to look abroad -- and with 9,000 banks, the United States has plenty of targets, Mr. Ryan said.

TD's U.S. focus, through 56%-owned TD Banknorth, is mostly in the Massachusetts, Connecticut and metro New York areas. By acquiring one to two banks a year for the next several years, the bank hopes to boost assets to between US$60-billion and US$100-billion, a significant jump from its US$40-billion in assets today, and a far cry from the US$2-billion it had in 1991.

"We did the deal [with TD] to get their capital to acquire more companies, and they did it to use their capital," Mr. Ryan told the conference. "We [TD and TD Banknorth] are both out to make money. We are both out to grow our customers."

TD Banknorth picked up a slice of the coveted Connecticut market in January when it acquired Mahwah, N.J.-based Hudson United Bancorp for US$1.9-billion. The deal brought it 43 branches in the state and US$1.6-billion in deposits -- of which 19 branches and US$757-million of deposits were in Fairfield County.

TD Banknorth's incursion into the riches of Fairfield County and other wealthy parts of the northeast U.S. isn't without its challenges -- intense competition in the region is perhaps chief among them.

TD Banknorth now owns 17 branches within a 15-mile radius of Ridgefield, one of the toniest towns in this affluent county. But inside Ridgefield -- where townsfolk pay Manhattan prices at glass and chrome sushi restaurants and upscale furniture stores -- there are already 14 banks, some with multiple branches, serving a town with a population of only 24,000.

Everyone in the industry knows the area is "overbanked and overbranched," says Gary Smith, president of locally based Ridgefield Bank. The expansion of bank branch networks in the area has been "like watching water boil," says Mr. Smith. "First it gets warm, then it gets warmer, then it gets hot, and then it starts to boil. This has been going on for the last 20 years, but it's really boiling now."

Still, the acquisition of Hudson United has established TD Banknorth as a Connecticut player, says Mr.Smith. "They're now in the ball game in the richest county in the nation," he says.

Indeed, if you are a local, regional or even national bank president, you wouldn't want to be left out -- Realtors like Sotheby's International on Danbury Road don't put dollar figures on the lists of houses they are selling, but the generally accepted starting price for a home here is US$700,000, and most cost well over a million dollars.

"There was a time when there were far more gas stations in town than banks," says Mr. Smith. "Now there are far more banks than gas stations. And it isn't that people are using less gas," says Mr. Smith. "If you were to go back five or six years in Ridgefield, there might have been a thousand households per bank. Now there might be eight hundred."

Ridgefield bank is a white-shuttered red-brick colonial style mansion with plush carpets, cozy armchairs and bronze ornaments overseeing the edge of a town where Mr. Smith himself is head of the local

Lions club and other employees are prominent in local organizations.

His analysis of the number of households per bank spots the trend, but it's already out of date according to statistics from the local chamber of commerce -- there are only 650 households per bank in Ridgefield at last count, in 2005.

There are so many banks here now the town no longer allows more than one on any block -- finding the right locations in such a saturated market is just one of the problems for a growing bank, admit TD Banknorth executives.

In fact, the bank is facing "fierce" competition throughout the territory it covers right now.

Mark Wetmiller is chief retail banking officer at TD Banknorth. On his office wall in Portland, Me., a map shows the bank's "footprint" stretching from the border with Quebec and New Brunswick down past New York City. It is littered with dots locating TD Banknorth's almost 600 branches, and it's also divided into colour-coded regions, with labels "acquire," "hold" or "grow," indicating the bank's strategy in each area.

But while Mr.Wetmiller is looking to add more dots to the map, he is also wary of an intensely competitive environment that is eating into profits for everyone in TD Banknorth's home patch.

Large global players such as Citibank and HSBC, as well as regionals including Commerce Bank, are eyeing the same wealthy counties in Connecticut and other New England states as TD Banknorth.

"You are really seeing the big regional and national players come in to the market," says Brian Arsenault, head of investor relations at New Haven, Ct.-based NewAlliance bank, which has 71 branches in New England. "Just here in Connecticut we've seen Commerce Bank move in from New Jersey. Citi has expanded its presence, Chase has, HSBC has. These are banks that had no presence or a very small foothold."

Even in Portland, where TD Banknorth dominates -- the bank is No. 1 in deposit market share in Maine -- its sizeable head office is surrounded by buildings owned by Key Bank, Maine Bank and Trust and Bank of America.

But at least the big banks "play fair," says TD Banknorth's Mr. Wetmiller, noting that smaller competitors don't have shareholders to worry about or earnings targets to meet.

For example, a small bank that recently opened near a TD Banknorth branch in Burlington, Vt., is offering deposit rates that are well above the market. "We've been competitive in the Vermont area with a [deposit] offering of 4.75% for nine months, but right now to commemorate their new opening we're battling up against a 5.55 rate on the same terms with absolutely no hooks attached," says Mr. Wetmiller.

Competition is just as tough on the loans side of the business, with a noticeable tightening of competitive pressure even since TD bought into Banknorth in 2005, says John Fridlington, TD Banknorth's chief loan officer.

For large loans -- more than US$8-million -- TD Banknorth used to battle with three or four competitors, but now eight or more come "sniffing around," says Mr. Fridlington. On smaller loans, customers who would have negotiated with a single lender are now talking to three or four.

Not only does that mean it is harder to seal the deal -- the bank will likely try to win more loans than usual this year, but will probably end up with a lower rate of loan growth -- but typical rates are being driven down too, says Mr. Fridlington, by as much as 100 or 125 basis points. With smaller banks in particular also "pushing the envelope" on terms -- guarantees, fees and covenants -- "You need to have the pencil sharp and understand where your limits are," he says.

This month, TD Banknorth revealed that it is already feeling the heat from all that competition. The bank issued a profit warning stating expectations of third quarter 2006 earnings of about US58 cents a share were overly optimistic. The bank offered a downgraded outlook of US51 cents to US54 cents a share, "in light of current interest rates and the competitive environment."

Observers say the bank is also struggling with the cost of integrating and updating some of the branches it has recently acquired. TD Banknorth executives acknowledge that the Hudson United branches in particular reflect the fact the previous owners "consciously under-invested" in its branches.

"Some of [the existing locations] are tired old cavernous spaces with nothing in them except maybe a desk here or there," says Wendy Suehrstedt, president of the mid-Atlantic division of TD Banknorth.

In Montclair, N.J., for instance, another New York City commuter hotspot with a downtown crowded with dozens of banks, the TD Banknorth branch is tucked away on a corner location that doesn't get much pedestrian traffic. Inside, the decor is washed out and the branch manager sits at a desk in the middle of the room, with little privacy for customers who want to discuss their finances.

Still, TD Banknorth is pouring resources into supporting its new acquisitions. The Montclair branch, like dozens of others, is scheduled for an overhaul and will soon move from its tight 1,400 square foot unit to a spanking new 3,800 square foot location around the corner.

The bank has also got its hands on US$25-million from parent TD for a marketing campaign to promote the bank's brand. On the highways that circle commuter-land around New York City, billboards proclaim in TD green and black the new "Bank Freely" strategy, in which the bank is offering a no-fee ATM card to customers in some areas. It is aimed at providing the convenience of a much larger branch network for customers who, for instance, live in the commuter-belt but work in downtown Manhattan, where the bank has almost no presence.

Ms. Suehrstedt says the bank's own surveys show that TD Banknorth's brand recognition in some former Hudson United areas has gone from non-existent to 18% in just a couple of months, while the no-fee ATM card has helped the bank triple new account openings in some areas and has led to several copycat measures from other banks in the region.

It's all eating into profits in the short term but it shows the lengths TD Banknorth is prepared to go to get a bigger share of this wealthy part of the United States.

But while profits are hurting right now, TD chief executive Ed Clark has always preached a long-term view for the Banknorth investment. Indeed, the Canadian bank has shown its commitment to further growth, dispatching TD veteran Bharat Masrani to help run TD Banknorth, and freeing up chief executive Mr. Ryan to search for more targets.

In fact, the intensely competitive environment could be playing right into TD Banknorth's long-term growth strategy. Ultimately, if smaller competitors begin to struggle, that will mean there is more room for banks such as TD Banknorth to grow.

"[The smaller banks] are going to come under tremendous pressure," says Ridgefield's Mr. Smith, with the result they will likely seek the shelter of a merger. Although banks such as his own may be too small for a TD Banknorth to bother with just now, the more consolidation that takes place, the more acquisition targets are likely to appear. Mr. Smith predicts that in the next couple of years the number of banks in the U.S. could fall to perhaps 4,000 or 5,000 from about 9,000 today.

Mr. Ryan was unusually bearish on the opportunities for acquisitions this week. He said prices are worse now than even a few months ago with smaller U.S.-based banks holding out for a good deal.

"It's going to be difficult right now to buy banks at a price that makes sense," said Mr. Ryan. Many banks in the United States have a built-in premium in their stock price and are looking for something extra on top of that.

He knows that can't last forever.

"We do have cycles," he said, forecasting a possible turn in his favour in late 2007 or early 2008 when competitive pressures will finally start to take their toll.

When that happens, and with TD's deep pocket to back him, "we'll be aggressive," he says.

Banks Outperform the Market in Q4

BMO Capital Markets, 25 September 2006

Seasonality is one of the more compelling concepts in investment strategy, for more than just its simplicity. Theories that attempt to explain changes in stock prices not attributable to fundamental operating activities can resonate well with investors, particularly in between earnings seasons.

It is in the spirit of seasonality that we are releasing an updated version of our report discussing the patterns of Canadian bank stock performance relative to the TSX (first released in October 2004). In the original report, we considered Canadian banks stock performance relative to the market in each of the four calendar quarters over four decades. We found that bank share returns appear to have a seasonal component to them and tend to outperform the market in the fourth calendar quarter.

Sunshine in the Fourth Quarter

In examining the performance of the Canadian bank group relative to the TSX, we found that the incidence of outperformance was meaningfully higher in the fourth calendar quarter. Since 1960, banks have outperformed the market in the fourth quarter about 70% of the time—meaningfully higher than the incidences of outperformance in the other three quarters (Chart 1).

In addition, the extent to which banks outperform the market in the fourth quarter appears to be meaningful (Chart 2). Over the past 45 years, the average scale of outperformance by the banks relative to the market has been meaningfully higher in the fourth quarter than in the other three. Banks, on average, have outperformed the market by just over 3% in the fourth quarters, compared to under 1% in the second and third quarters, and actually underperforming the market in the first quarters.

The prospect of average outperformance of 3% is of course attractive but is also, by our own admission, only half of the story. A word on volatility is certainly warranted. In our examination of the standard deviation of bank returns across the quarters, we found that the variation did not change materially from one quarter to the next (Table 1). The volatility of returns of the banks relative to the market over the past 45 years has been roughly 6% across all four quarters.

Meteorology Anyone? Trying to Justify this Phenomenon

We conclude from the analysis above that, over time, we would expect banks to produce meaningfully higher returns compared to the market in the fourth calendar quarters. Furthermore, this outperformance should be achieved without a corresponding increase in volatility. Justifying why this occurs, however, is a more difficult task. To this, we offer a couple of suggestions.

First, from the perspective of a money manager, the last quarter of the year is equivalent to the home stretch of a race, with performance typically measured on an annual basis to December 31. This period tends to be one characterized as a time when managers shy away from taking risks, for fear of jeopardizing their annual performance record. Banks, because of their defensive nature, are often popular to managers looking for higher predictability of returns to sustain them until the end the year.

It is interesting to note that this reasoning can similarly be used to explain bank underperformance in the first quarters (Charts 1 and 2). Investors, with a full year ahead of them, tend to be willing to take greater risks comforted by the knowledge that there will be time to correct any missteps.

Second, we believe it is meaningful that bank earnings are reported on an atypical schedule with their fiscal year-end falling on October 31—two months ahead of the majority of organizations on the TSX. Typically, as year-ends approach, earnings estimates for the upcoming year are published, giving investors insight into analysts’ expectations of company strategy and growth. Because ‘next year’s’ earnings estimates are published earlier for the banks than for other stocks, we believe they benefit from this ‘sneak-peak’ phenomenon. Investors are exposed to the generally more attractive P/Es on growing earnings earlier than for other companies. We must point out that these ‘sneak peaks’ are, of course, merely psychological, as they predict only 10 months into the next calendar year. Nevertheless, we believe it can skew investor perception.

The Summer is Getting Longer and Hotter

It is interesting to note that, over time, the trends in bank seasonal performance have become more pervasive. Both the incidence and the scale of bank outperformance relative to the market have increased since the mid-1960s (Tables 2 and 3). In the decade ending 1975, banks outperformed the market in the fourth quarter half of the time. By the decade ending 2005, however, banks were outperforming 70% of the time. The trends in the scale of outperformance are very similar: between 1966 and 1975, banks outperformed the market in the fourth quarter by roughly 1.7%, but between 1996 and 2005, banks were outperforming the market by 4.6%.

Shelter in the Storms

It is all well and good to say that banks tend to outperform the market in the fourth quarters. In order to provide well-rounded research, however, we thought it important to examine the incidences in which this trend did not appear to hold true—in order to gain insight into what this might mean to our overall analysis.

In the 40 years between 1966 and 2005, banks underperformed the market in the fourth quarter a total of 12 times. We decided to investigate these incidences in two ways; first, from a rearview mirror perspective (examining the first three quarters to determine if performance in these nine months was correlated to performance in the last three). Second, we analyzed each incidence from the perspective of the overarching economic environment (examining the operating environment of the quarter to try to determine the factors that might have led to the underperformance).

With regard to our examination of the first three quarters of the year, we found that there was no meaningful correlation. Bank performance in the last quarter did not seem to depend on performance in the three quarters preceding. In the 12 underperforming quarters, the incidence of underperformance in the first nine months was exactly equal to the incidence of outperformance.

In investigating the macroeconomic environment of the individual fourth quarters in which the banks underperformed, we attempted to determine what the context of underperformance was. In other words, in the 12 quarters of relative underperformance, what happened to investors’ banks shares? Did investors actually see negative returns? Were their returns roughly flat? Or was it simply that the market performed unusually well, thereby outperforming relative to banks.

In our analysis of each of the 12 quarters (Table 4), we determined that there were three broad circumstances:

• First, there was the circumstance we see in the latter part of the study (1999–2003) where the market saw remarkably strong gains while banks performed somewhat more modestly. We view this situation as the least threatening. Given the defensive nature of bank stocks, it is reasonable to assume that they would not perform as well during particularly bullish periods.

• Second, there is the circumstance in which we saw the market realize modestly positive returns while the banks remain largely flat or slightly positive (years 1970, 1972 and 1988). These situations cause us slightly more concern than the first, but we remain comforted by the fact that bank investors were not losing any money; they were simply performing slightly less well than the market overall. Having said that, we note that a ‘rip roaring rally’ in equities (due to stronger oil or gold prices) would likely see bank shares lag materially.

• Finally, there is the circumstance in which we see the banks realizing negative returns. This situation is most alarming to us for obvious reasons. Through further investigation, however, we determined that of the five quarters in which this occurred, there were only two quarters where banks lost more than 1%. These were the fourth quarters of 1975 and 1976.

In these two quarters, banks meaningfully underperformed the market as well as realized signifi cantly negative returns. In examining the macroeconomic environment underlying these two years, we investigated long-term interest rates, oil shocks, gold rallies and the slope of the yield curve. None of these variables gave us any illuminating reason for the material bank underperformance.

Our interpretation of the situation during this period is the turbulence experienced in Quebec surrounding the election of the Parti Quebecois and the looming referendum. During this divisive period, Canadian companies, particularly those with significant exposure to Quebec consumers, saw their share prices heavily impacted. The oil shock of the mid 1970s also appeared to weigh on bank stocks.

The Farmer’s Almanac

If history plays any part in foretelling the future, we can expect that bank stocks should outperform the market in the fourth quarters. Moreover, in the periods in which this does not occur, assuming the market grows at a reasonable rate, investors are unlikely to see meaningful underperformance.

We believe energy prices and energy stocks pose the major risk to bank relative share price performance. With energy shares making up roughly 30% of the market, and with a meaningful correction in oil prices now possibly behind us, this is the one group that could cause banks to lag the market meaningfully. A significant back-up in long rates would also be an issue, but this appears unlikely.

On a year-to-date basis, the bank index has outperformed the market by a resounding 9%. We continue to rate the Canadian bank sector Outperform. Domestic retail earnings continue to see strong results, loan losses have remained obstinately low and opportunities for growth and diversification continue to emerge.