29 September 2007

Banks & Wealth Management

The Globe and Mail, Tara Perkins, 29 September 2007

This summer, Bank of Montreal sent a press release to newspapers across the country with the title “Boomers Baffled about what it means to be Executor of a Will.”

In a recent survey, the bank had found “mass confusion” among baby boomers over what the role of an executor entails, it said. It also found that most baby boomers had no idea that being executor of an estate is a job that usually takes more than a year to complete.

Surprise, surprise – just this spring, the Bank of Montreal had been training staff in its branches across the country in the area of bereavement services.

If a customer's mother dies, that customer can now walk into a branch and request that BMO Trust Company do everything from planning her funeral to asking Canada Post to redirect her mail to settling her outstanding debts.

BMO is not alone. Royal Bank of Canada is rolling out a similar service through its massive branch network under which the bank will pick up many of the duties of the executor of an estate.

The banks are going to new lengths to become closer to their customers – and their wealth.

They know that a greying population means now is the time to push the envelope in wealth management, which is why it has become one of the hottest games on Bay Street.

‘The growth rate for this industry is probably twice what the GDP growth rate is,” said Gilles Ouellette, chief executive officer of BMO's private client group and deputy chairman of BMO Nesbitt Burns.

“Because it's attractive, it's attracting more and more competition. The banks are competing in this, the independents, the life insurance companies, everybody's in this space because of its growth prospects. I mean, it's the most attractive part of the finance industry.”

That's why some of Canada's biggest financial institutions, such as Bank of Nova Scotia and CI Financial, are clamouring over the chance to gobble up DundeeWealth Inc., with its 600 full-fledged brokers and 1,200 advisers who can sell mutual funds. CI's $2.36-billion hostile bid for the business is 52 per cent higher than the price DundeeWealth's shares closed at before the bid was made.

“If there was to be an auction process for Dundee, every single Canadian bank would be kicking the tires there,” said Dan Richards, an industry consultant and president of Strategic Imperatives.

Once upon a time, Canadians identified themselves as Royal Bank of Canada or Toronto-Dominion Bank customers the way they identified themselves as a GM owner or a Ford owner, he said. Some bank executives became complacent.

“We've seen a transition away from a relationship-driven world, where people make decisions based on who they've done business with historically, to a value-driven world,” Mr. Richards said. “The banks clearly dropped the ball in the 1990s in terms of aligning what they were offering – advice and performance – with what customers were demanding,” Mr. Richards said.

A research study in the mid-nineties found that when mystery shoppers posed as prospective customers with $100,000 to invest and wandered into bank branches seeking advice about mutual funds, they were generally handed a pamphlet and told to come back after they had decided what they wanted to buy, according to Mr. Richards. Less than one-quarter of the customers were invited to sit down. One in ten were asked what their name was.

In the years since, the banks have made huge inroads in wealth management, becoming the dominant force in the industry. They've once again demonstrated the ground-shaking power they have in Canada when they put their collective minds to something.

They used different strategies and some were slower than others to wake up to the opportunities. But now all of the big banks are forging ahead in the wealth management arena, and working to recapture those customer relationships that breed loyalty.

Bet your mother's banker never asked her whether her kids might fight over her estate, or when her daughter is getting married, or how her divorce is coming along. Depending on their level of wealth, Canadians might be surprised to find out some of the things some banks are willing to do for them these days – for a fee, of course – from guiding boomers on how to get proper health care for their elderly parents, to helping them decide which child to leave the family business to, to connecting them with a good dog-walker.

While many of these services are still only offered to private banking clients – those with a high net worth, who deal with the big banks' private bankers – they are beginning to trickle down into the branches.

“There are a number of things that are driving the focus that the banks have on wealth management,” Mr. Richards said. For one, it's a high-growth area at a time when many of the traditional banking products – mortgages, and GICs and the like – are slowing down. Moreover, “it's a high-margin, high-profit area, at a time when banks are being squeezed on their traditional spread-based businesses.” They're being squeezed because customers are becoming more picky, Mr. Richards said. They are smarter and tougher, and they know that the posted interest rate on, say, a mortgage, is just a starting offer.

“Canadians are very much speaking with their feet when it comes to deciding where they're going to do business,” he said.

At the same time, the banks are aggressively expanding their private banking businesses, one of the key segments of wealth management right now. BMO Harris Private Banking, for example, plans to double the number of offices it has in Canada from 20 to 40 over the next five years, with the accompanying goals of doubling its assets under management and revenues.

While the phrase “wealth management” likely brings to mind mutual funds, it's increasingly much more than that. The goal is to be a one-stop shop for Canadians' financial needs, and to develop a rapport that keeps the customer coming back.

While there are a host of different ways to rank the players – from number of advisers, to client assets under management, to profitability – it's clear that this country's biggest bank, Royal Bank of Canada, is one of the leaders in Canadian wealth management.

It has roughly 15 per cent of the market in what is still a relatively fragmented industry, according to George Lewis, the bank's head of wealth management.

But RBC's head start hasn't stopped it from pouring more resources into the business and tweaking its model to find new ways to grow.

For instance, it now does 25 per cent of its fund sales outside of its branch network. “If you go back to 2000, we didn't even try to market our funds outside of the bank branch network,” Mr. Lewis said.

RBC has come to put such a focus on wealth management that, earlier this year, it rearranged itself into new divisions to carve out a global wealth management division.

“It's a business that we view very attractively, and our shareholders do as well in terms of the valuations that pure wealth management companies trade at,” Mr. Lewis said.

The shift to fee-based revenues makes wealth management a lot less cyclical. And “our business grows with our client assets, and does not rely on the growth of the bank's balance sheet,” he said.

A high-flying wealth management business sucks few resources out of the banking and capital markets businesses, which both rely on the balance sheet.

RBC's Canadian wealth management business saw revenue rise $53-million or 17 per cent in the most recent quarter to $369-million.

Despite advantages, some Canadian bank executives are playing catch-up in the wealth management business now because their predecessors in the early 1990s were fearful of cannibalization – that a push into mutual funds would divert money out of savings accounts, for example.

These days, you would be hard-pressed to find an executive who didn't extol wealth management's virtues. It's not difficult to see the rationale.

As Sun Life Financial's president for Canada, Kevin Dougherty, points out, about 80 per cent of the household assets in this country belong to people aged 45 and older. About half that would be people who haven't retired yet.

“A lot of the money in motion, if you like, is with people age 45 to 60, the boomers really, who are on the home stretch to retirement,” he said. “And then people in retirement, who are increasingly concerned about things like outliving their assets, and estate planning.”

According to Investor Economics, Canadians had $2.39-trillion of financial assets at the end of 2006, and roughly three-quarters of that, or $1.83-trillion, was held by the 853,000 households that have half a million dollars or more in savings. Ten years out, there are expected to be more than 1.78 million households with half a million or more, and the financial assets they hold will have risen to about $4.63-trillion.

It's demographics 101; the first boomers have just turned 60. “It ties in with the aging of the baby boomers, people living longer, people being more affluent,” said Roy Firth, Manulife's head of wealth management in Canada. “As a result, this is a market that's exploding, quite frankly, in terms of size and importance.”

Aside from just managing these assets, the trends open up a whole host of opportunities, from bereavement services to succession planning. About half of this country's privately held companies are expected to change hands in the next decade, says Graham Parsons, executive vice-president of global private banking at BMO.

It's not just that there are a plethora of clients with bundles of money. There's also a school of thought that those bundles will move into the hands of fewer institutions over time.

“One of the things that happens as people age that's a very interesting phenomenon is that they tend to deal with fewer and fewer financial advisers; they consolidate their wealth in one place,” Mr. Firth said.

“People in their 40s have three of four different financial advisers, one being their bank, one being their stockbroker, one being their insurance agent, one being somebody else. And, as they move into their 50s or 60s, they actually consolidate a lot of that. And so [financial institutions] want to be able to provide all the services.”

There's yet another factor at play here. There's been some neglect when it comes to pitching wealth management services to the baby boomers.

“What's happened is, there's a belief that this market has been considerably underserved,” Mr. Firth said. “As a result of that, there are a lot of people trying to move into this space and provide the advice and the counsel and the products that are required by this large demographic group.”

But a strong wealth management business isn't built overnight.

There are plenty of profits to be had once a business is established, but assembling the building blocks, such as a large team of advisers, takes time.

Just ask Bill Hatanaka, the head of wealth management at Toronto-Dominion Bank. While its self-directed online discount brokerage business is the industry leader, TD is still in the early stages of building up some of its advice-based businesses. That's something that Mr. Hatanaka, a former pro football player in the CFL, sees as a significant opportunity for the future.

“We have a huge opportunity, in that we have entire cities with very few investment advisers right now,” he said.

With roughly 600 advisers, the bank lags many of its rivals who have networks of 1,000 or more across the country. But rather than instructing the head of the bank's private investment advice business to flood the market with help-wanted signs, Mr. Hatanaka's instructions have been that the next hire made must enhance the organization, as must the one after that, and so on.

This is a business where people, and the relationships they create with their customers, are invaluable. TD sees one of its key differentiators as its staff's reputation for being highly approachable, Mr. Hatanaka said.

“Demographics mean the wind is at our backs right now,” he said of the industry. He believes those who do a “great job” in the next 10 to 20 years will have “as much business as they can handle.”

So, yes, TD's open to merger possibilities. “Our general view on acquisitions is that it was important to get our own shop into great shape,” Mr. Hatanaka said. “After five years, we believe we have our business humming,” he said, and TD would now look at opportunities that made sense.

Mr. Richards said “TD really marched to its own drummer in saying ‘we think there's a better opportunity by being the first-mover in the discount brokerage business, rather than acquiring a full-service firm.' And they're still benefiting from that today; they're the dominant player with Waterhouse. But what they began doing in the mid-nineties is saying ‘we're going to build our own full-service brokerage firm.' And the reason that TD is behind – in terms of numbers and assets – RBC and CIBC and Bank of Montreal on that is fundamentally their decision to build, rather than acquire,” he said. “Because any time you build rather than acquire, it's going to be a slower process.”

The problem for those who might want to grow through acquisitions is that the opportunities are few and far between.

“One of the challenges today is you say ‘who's left out there that's an interesting candidate that has significant scale?' Well, there's Dundee, there's AGF and there's AIC. And what those three have in common is that they're all controlled by their founders, [and there's] no clear sign that they're up for sale,” Mr. Richards said.

There are some other players scattered across the country. For instance, Winnipeg-based brokerage Wellington West is quietly shopping itself. And National Bank of Canada CEO Louis Vachon said this week that the problems in credit markets might create an opportunity for National to buy up some wealth management businesses.

What Mr. Vachon is seeking is more stockbrokers and money managers, he said in an interview.
“Scale is important in this business, and where companies don't have scale, and aren't growing, there will be acquisition opportunities,” he said.

The need for heft is another factor driving the hunger among some institutions for DundeeWealth.

Scotiabank, which has historically been a bit of a laggard in areas such as mutual funds, is one of the institutions with a strong motivation to snag DundeeWealth, if the chance arises.

Scotiabank's wealth management business has been on a roll this year, earning it kudos from analysts and the investment community, after CEO Rick Waugh made it a top priority.

Executives at rival banks say they respect Mr. Waugh's decision to put more muscle in this area, and that it's a wise move. No one wants to be caught missing the boat.

While Scotiabank's success in the fund business this year might look like it's come overnight, “it's been a lot of heavy lifting for quite a while,” said Glen Gowland, managing director of wealth management.

It required the hiring of some key people in investment management, a broadened product group, and new technology, tools and training for staff in the bank branches.

Lastly, there was “a very big focus on raising the profile of the fund business over all, because we did have some very good investment solutions for customers, and we weren't good at telling everybody about it,” Mr. Gowland said. “So you'll certainly see now everything from television advertising to in-branch posters, etcetera.”

Now that Scotiabank's catching up, it's shifting its focus back to other revenue streams.

“We certainly wanted to ensure that we had the asset management quality and the breadth of product that we need in the mutual fund space,” said Barb Mason, executive vice-president of wealth management.

“I think now we're turning to ensure that the broader team of experts we have – whether it be private banking, charitable foundations, insurance – that we've got great quality service there, so the advisers in our various channels have access to those additional revenue streams, and are able to offer our clients that range of services,” she said.

From will and estate planning to financial planning to charity donations, “we're seeing increasingly, from our research and experience in our businesses, that our clients are looking for more and more of those services,” she said.

And so it comes full circle, with Scotiabank and its rivals looking to expand their grasp on the wealth of Canadians by becoming a more integral part of their lives.

“We're certainly seeing that, as the demands on peoples lives continue to increase, whether it's in the baby boomer segment, the preretirement segment, the concept of one-stop shopping, of being able to get all of your financial needs serviced by one entity, is increasingly popular,” Ms. Mason said.

Some executives are travelling across the country to help coach staff on how to build relationships with their customers. And others are going halfway around the world to scope out opportunities for their clients to give to charity.

Marvi Ricker, BMO Harris Private Banking's vice-president and managing director of philanthropic services, recently took a trip to Africa, because it's a region where many Canadians want to use their money to make a difference and she wanted to be sure she knew the local charitable landscape.

Whether it's creating a foundation or donating to a local hospital, Ms. Ricker sits down with BMO's wealthy private banking clients and their families to help walk them through the process.
As BMO's Mr. Ouellette says: “I think what you're going to be seeing over time is that organizations like ours are going to be expanding the services that we offer in areas that have not traditionally been considered to be banking.”

Scotiabank to Buy Dundee Bank, Stake in DundeeWealth

The Globe and Mail, Tara Perkins, 29 September 2007

Bank of Nova Scotia successfully closed its acquisition of 18 per cent of DundeeWealth Inc. yesterday, a deal that was only made possible by happenstance.

DundeeWealth, with its 600 full-fledged brokers and 1,200 advisers who can sell mutual funds, is described by Blackmont Capital analyst Brad Smith as one of Canada's "premier wealth management platforms."

Mr. Smith recently pointed out in a note to clients that DundeeWealth's mutual fund assets have grown at a compound annual rate of 21 per cent over the past two years, compared with a combined rate of 17 per cent for similar assets at the six biggest banks in Canada.

More than half of DundeeWealth is owned by the Goodman family's holding company. Their controlling stake gives them a veto over any transaction, and they've said time and time again that they don't want to part with their wealth management business.

But fate turned against them this summer when turmoil erupted in the credit markets.

About one year ago, they had created Dundee Bank, which attempted to lure customers with high interest rates on its savings accounts. That meant that the bank had to invest its deposit base in something with an even higher return, to profit from the spread. Dundee Bank put much of its money in areas such as non-bank-sponsored asset-backed commercial paper and collateralized loan obligations, which fell into trouble as liquidity dried up in August.

DundeeWealth was forced to buy up some of those assets to keep the bank's balance sheet in shape, and it had to take on extra debt.

The situation created an opening for Bank of Nova Scotia, whose chief executive officer, Rick Waugh, had been coveting DundeeWealth for some time.

Scotiabank agreed to fork over $260-million for the unprofitable Dundee Bank in order to be allowed to buy 18 per cent of DundeeWealth for $348-million.

The agreement also gives Scotiabank a right of first refusal if the Goodman family ever decides to sell its stake.

Scotiabank is not the only one that wants DundeeWealth. Mutual fund giant CI Financial has already tossed in a bid that far exceeds Scotiabank's on a per-share basis. Shortly after the Goodmans rejected it, CI's CEO, Bill Holland, removed some of his offer's conditions in an attempt to make it more palatable. His offer is still on the table, despite the deal with Scotiabank.

Others are also sniffing around.

Some observers speculate that minority shareholders will resort to lawsuits if necessary in order to realize the potential gains from CI's bid.

Manulife's head of wealth management, Roy Firth, describes the saga as a soap opera. "I don't think the story's at an end yet, let's put it that way, but it's an interesting one to watch," he said.

"We obviously have made acquisitions in the past, and while we have nothing on the planning table at this point in time, it's certainly something we monitor and certainly don't exclude the possibility of acquisitions in the future," he added.

If the Goodmans were to open the process to a full-fledged bidding battle, both Manulife and CI are seen as top contenders because of how closely their operations resemble Dundee's.

But if determination counts for anything, then a winning Scotiabank bid cannot be ruled out.
The Globe and Mail, Derek DeCloet, 27 September 2007

Well, this is quite a box he's got himself into now, isn't it? No, not Ned Goodman: We're talking about his new pal, Rick Waugh.

Last week, the Bank of Nova Scotia boss looked like Bay Street's new master of the deal. First, he gave a big loan to help DundeeWealth, the Goodman-controlled financial services group, out of a tight spot. Then he used that position to buy 18 per cent of that business, at a very reasonable price, and negotiated first dibs on the other 82 per cent to boot. Such a clever lad, Rick Waugh. Who says Winnipeg produces nothing but hockey players and frostbite?

But it's all part of the plan. Scotiabank's Achilles heel is money management, a great business opportunity that it has largely squandered. Of the Big Five banks, it's dead last in mutual fund assets, with $18-billion (Bank of Montreal, the next-smallest, has $38-billion). It employs 30 per cent fewer investment advisers than the brokerage arms of either Royal Bank or BMO. Scotiabank is so far behind, it needs binoculars to see the competition's backside.

This is the kind of problem that bankers don't usually like to talk about. On second thought, maybe they do. Here's Mr. Waugh in 2004: "We will find new ways to grow in wealth management." In 2005: "We are making wealth management a top priority." After the annual meeting in 2006: "It's very important for us to grow in wealth management, and particularly here in Canada." The man has staked a lot of his credibility as CEO on solving this.

Trouble is, there's virtually nothing to buy. Of the Canadian fund companies with at least $15-billion in assets, every one is owned by a big bank, a big foreign company, or the employees, with two exceptions: DundeeWealth, and AGF Management, each run and controlled by the founding family, neither willing to sell.

This summer, fate gave Mr. Waugh his chance when Dundee got caught in the credit squeeze. The result was a nice, clubby little deal that gave Scotiabank a toehold in one of the fund industry's fast growers. Over the past five years, while Scotia was adding $5-billion in mutual fund assets, Dundee grew by about $15-billion (more on that in a moment).

Then Bill Holland of CI Financial had to go and ruin everything, lobbing a bid for the whole company at a huge premium to the market and to what Scotiabank paid. There are only two possible outcomes now: (1) the Goodman family refuses to sell at any price or (2) Dundee will start a full-blown auction that will see Mr. Waugh bidding against CI, Manulife Financial and God-only-knows who else. Let's consider these one at a time.

In scenario one, Mr. Waugh gets his 18 per cent, but with little chance of getting the big prize - control - in the future. Ned Goodman will turn 70 in November. If he isn't going to sell the business now, that implies the decision will be left to his son, David Goodman - who, by the way, is 43 years old and has been the CEO of DundeeWealth for exactly 99 days. Do you really think he'll be anxious to sell? The Americans might get a man to Mars first.

In scenario two - the auction - Mr. Waugh has the upper hand. The minority stake, and the right to match any offer, are powerful advantages. But they are offset by a couple of factors. Scotiabank trades at 12 times earnings; CI's bid, $2.36-billion, values DundeeWealth at about 30 times profit. Matching it would require the bank to deplete its excess capital.

Ian de Verteuil, the sharp-eyed bank analyst at BMO, figures that at that price, Scotiabank could still make the deal and not hurt its per-share earnings, if it cut $75-million in costs. It could surely do that, as there's overhead to chop; David and Ned Goodman together received $5-million in salary and bonuses last year. But what then? The big reason Dundee has grown so fast is that it was early to spot some investing trends (real estate, income trusts, natural resources). Part of the credit, surely, belongs to Ned Goodman and his intuition for the market. Removing him would hurt the business. And what about Dundee's star money managers - would they work for a bank?

You can see Mr. Waugh's predicament if this goes to a bidding war. If he wins, he will be paying full price - certainly more than CI's proposed $2.36-billion - for a business that would not be quite the same once he owns it. But if he loses, he's blown a chance to fulfill his promise to get serious about wealth management. Scotiabank has done some of its best deals buying broken or temporarily distressed assets, such as Montreal Trust or Mexico's Inverlat. Mr. Waugh thought he had done it again with Dundee, until Bill Holland got in the way.
The Globe and Mail, Shirley WOn & Tara Perkins, 27 September 2007

CI Financial Income Fund yesterday revised the terms of its $2.36-million hostile bid for DundeeWealth Inc., fuelling speculation about an imminent takeover battle for the financial services company.

The mutual fund giant is still offering $20.25 per share for DundeeWealth, but dropped a condition that it scuttle its $348-million deal to sell its bank unit and an 18-per-cent stake in the firm to Bank of Nova Scotia.

"The CI bid is an opening bid - not the winning bid," said Ron Mayers, a vice-chairman of Desjardins Securities who specializes in arbitrage trading and bought DundeeWealth shares this week. "I wouldn't own it if I thought I was going to lose money," Mr. Mayers said in an interview. "DundeeWealth could go for $25 or $26."

Shares of DundeeWealth, which owns Dynamic Mutual Funds, surged 8 per cent yesterday to close at $18.30 on the Toronto Stock Exchange with 4.8 million shares changing hands. That's on top of a 28-per-cent price jump on Tuesday.

"This is an ongoing soap opera," said Westwind Partners analyst Horst Hueniken. "The market is saying that the odds of a transaction have gone up.... Beyond that, it's all speculation."

Analysts have suggested that other potential bidders could be Scotiabank, which has the right of first refusal through its deal with DundeeWealth, or other financial players like IGM Financial Inc. - which owns Investors Group Inc. and Mackenzie Financial Corp. - or Manulife Financial Corp.

CI chief executive officer Bill Holland said he is "optimistic" about a possible deal with his new offer that would cost $3.2-billion when including the additional shares that Scotiabank will hold in DundeeWealth.

Toronto-based DundeeWealth also has 1,800 advisers in its financial planning and mutual fund dealer arms. "It recognizes the value that they have built over the last 20 years," Mr. Holland said.

Any takeover depends on Ned Goodman and his family - who control a 56-per-cent stake in DundeeWealth through parent company Dundee Corp. - putting the company up for sale. And David Goodman, CEO of DundeeWealth, recently told The Globe and Mail that "we're not sellers."

The unsolicited offer by CI is 52 per cent above the closing price of DundeeWealth on Monday. Under a private placement, Scotiabank is buying its minority stake in DundeeWealth for $12.76 a share. The Scotiabank transaction is set to close this week.

While the Goodman family - who control Dundee through a dual-class voting structure - may have the law on their side in not budging on a sale, "the optics are terrible for them," argued Mr. Mayers.

"At some point, the premium becomes so high that someone could make a case for shareholder oppression."

Toronto-based CI rushed to change the conditions of its offer after Dundee on Tuesday rejected the "terms and conditions" of CI's surprise bid, but did not appear to rebuff the offer outright. The move came after Mr. Holland had a conversation with Ned Goodman. "He did not tell me what the conditions were," he said. "So I looked through the logical conditions and eliminated them."

CI's offer also requires the recommendation of the six-person DundeeWealth board, which includes four independent members. "If the board is supportive, that could place more pressure on the parent company and its willingness to sell," said CIBC World Markets analyst Stephen Boland.

DundeeWealth spokesman Robert Patillio would only say that it was just "business as usual" at DundeeWealth. "The only thing we are focused on at the moment is the completion of the Scotia arrangement," he said.

Scotiabank spokesman Frank Switzer would not comment on CI's new offer.

CI, which is 36 per cent owned by Sun Life Financial Inc., is Canada's third-largest fund company with $64-billion in assets. Like DundeeWealth, it also has financial planning and brokerage arms.
The Globe and Mail, Sinclair Stewart, Tara Perkins, Boyd Erman, 19 September 2007

Bank of Nova Scotia has long coveted Dundee Corp.'s vast network of investment advisers as a way to narrow the gap with its Big Five rivals, but could never find a way to persuade the controlling Goodman family to relinquish a stake in its brokerage.

That is, until credit markets seized up in mid-August.

Dundee's year-old banking business was dealt a blow by the crisis in the asset-backed commercial paper sector, forcing the company's asset management unit, DundeeWealth Inc., to orchestrate a bailout by taking on additional debt. Suddenly, Scotiabank had the catalyst it needed.

A telephone conversation between Scotiabank chief executive officer Rick Waugh and DundeeWealth CEO David Goodman on the last Saturday in August rekindled talks that had gone cool after a year of fruitless back-and-forth.

By Monday night, the companies had nailed down the terms of the deal that they announced yesterday: Scotia would buy Dundee Bank, an unprofitable business that sources said Scotiabank never really wanted, for $260-million as a quid pro quo for being allowed to purchase 18 per cent of DundeeWealth for $348-million or $12.76 a share.

Scotiabank also gets right of first refusal should more of DundeeWealth ever be for sale.

The acquisition is "very attractive from a strategic perspective" for Scotiabank, because the purchase aligns the bank with a highly regarded business in Dundee, analyst Brad Smith of Blackmont Capital said in a note to clients. "With three board seats and a right of first refusal on any future sale of the controlling interest, the acquisition positions [Scotiabank] to substantially expand its domestic wealth business should an opportunity present itself down the road."

Scotiabank's network of about 900 brokers has for years been dwarfed by those of Royal Bank of Canada, Bank of Montreal and Canadian Imperial Bank of Commerce. Although the bank has identified wealth management as a priority, the brokerages available for sale in Canada tended to be either too small, or a poor cultural fit. A stake in Dundee, with about 600 full-fledged brokers and another 1,200 advisers who can sell mutual funds, provides the bank with a much bigger sales force.

In addition, Dundee's Dynamic mutual fund arm is the 12th-largest fund company in the country.

"The investment in DundeeWealth is a perfect strategic fit with Scotiabank's commitment to grow our wealth management business," Scotiabank spokesman Frank Switzer said.

For Dundee, the plan is now to focus on the wealth management business and potential expansion opportunities in the United States and Europe, without the distraction and expense of trying to right an unprofitable bank.

Dundee Bank was created to offer loans to people through investment advisers, providing an alternative to the big banks. But while its high interest rates attracted deposits quickly - the bank now has over $2-billion - the business lost money because it was difficult to find ways to invest those deposits at even higher returns. And what's more, the country's banking regulator demanded that increasing amounts of capital be set aside to cover the growing depositor base.

In search of those higher returns, the bank invested more than $380-million in asset-backed commercial paper, which tempted investors with better returns than other short-term investments, but which became frozen when the sector was gripped by a liquidity crisis.

The bank's sister company, DundeeWealth, agreed to buy the paper at par to get it off the bank's balance sheet, but that still promised to constrain Mr. Goodman's ability to follow through on plans for expanding the asset management side of the business. To make the purchase, Dundee had to increase its line of credit with long-time banker Scotiabank to $500-million.

The sale to Scotia "represents a very big opportunity for our company to get back to its money management roots and to get back to the business model that we understand," said Mr. Goodman, the son of Dundee founder Ned Goodman.

DundeeWealth shares, which had fallen by almost about a quarter since August, rebounded yesterday, and shares of Dundee Corp. also jumped.

The discussions, in which Dundee was counselled by GMP Securities, were exclusive, cutting out any other potential bidders.

But Mario Mendonca, an analyst with Genuity Capital Markets, said he believes Dundee is now in play, adding that its rising stock price suggests the market believes there are other bidders out there.

The end game for Scotiabank, ideally, would be a full takeover of the DundeeWealth business.

However, the Goodmans have never displayed a public interest in selling the company they built, and David Goodman said that's not about to change.

"We're not sellers," he said.
Financial Post, David Pett, 18 September 2007

Bank of Nova Scotia increased its domestic wealth management platform Tuesday, after agreeing to buy an 18% stake in DundeeWealth with a right to acquire 20% for $348-million. The "big six" bank also agreed to buy Dundee Bank for $260-million.

DundeeWealth stock jumped more than 8% following the news. Scotiabank shares, meanwhile were up only slightly in morning trading.

Blackmont analyst Brad Smith said the acquisition is a positive strategic fit for the bank, telling clients in a note "it aligns Bank of Nova Scotia with a highly regarded domestic wealth platform in Dundee."

He added that with three board seats and right of first refusal on any future sale of the controlling interest in DundeeWealth, Scotiabank is in a great position to expand its wealth interest, should it choose to go down that road in the future.

In the near term, Mr. Smith said he expects limited impact on Scotiabank's earnings per share and left his "buy" rating and $62 price target unchanged.
Bloomberg, Sean B. Pasternak, 18 September 2007

Bank of Nova Scotia, Canada's second-largest bank, will take an 18 percent stake in DundeeWealth Inc. and buy the firm's banking unit for C$608 million ($594.5 million) as it pushes deeper into asset management.

Scotiabank agreed to buy 27.3 million DundeeWealth shares for C$348 million, or C$12.76 a share, and buy Dundee Bank of Canada for C$260 million in cash, the Toronto-based bank said today in a statement.

Bank of Nova Scotia, which owns the smallest mutual-fund business of Canada's five largest banks, has said expanding its money management business is a priority. The bank hired three fund managers from Royal Bank of Canada and boosted sales through its branches, contributing to a 19 percent gain in asset-management revenue last quarter.

Wealth management firms are ``very attractive for their fee income,'' said Stephen Jarislowsky, chief executive officer of Montreal-based Jarislowsky Fraser Ltd., Scotiabank's third- biggest shareholder, according to Bloomberg data.

DundeeWealth manages almost C$63 billion in assets, and its Dynamic Mutual Funds unit is the eighth-biggest non-bank mutual fund seller in the country. Scotiabank will appoint as many as three directors to the DundeeWealth board, and has the right to increase its stake to 20 percent.

The acquisition is ``an important step in our continuing strong focus on wealth management,'' Scotiabank Chief Executive Officer Richard Waugh said in the statement. The transactions are scheduled to close this month, subject to regulatory approval.

Scotiabank's Scotia Securities unit had C$17.9 billion in mutual fund assets at the end of August, compared with C$19.8 billion at Dundee's Dynamic, according to the Investment Funds Institute of Canada.

Buying Dundee Bank of Canada allows Scotiabank to offer high-interest deposit accounts without ``mass cannibalization of its own deposit base,'' John Aiken, an analyst at Dundee Securities, wrote in a note to investors today. The bank may also be able to buy the rest of DundeeWealth if it were put up for sale, he said.

DundeeWealth is selling its bank less than a year after it was formed to offer savings accounts and other bank products through its investment adviser network. DundeeWealth said it will post a loss of about C$70 million from the sale of Dundee Bank because of a decline in some of its investments.

DundeeWealth said last month it reduced its holdings in asset-backed commercial paper by half, or about C$400 million, after the market seized up amid concerns over links to U.S. subprime mortgages.

While reducing the asset-backed commercial paper had ``something to do with'' selling the bank, DundeeWealth wants to focus on increasing its asset-management business, spokesman Robert Pattillo said.

Ned Goodman, chairman of DundeeWealth parent Dundee Corp. has had a ``personal relationship'' with Waugh, and previous Scotiabank CEOs Peter Godsoe and Cedric Ritchie, Patillo said.

GMP Securities advised Dundee on the sale.

Scotiabank shares rose 70 cents to C$52.65 at 4:10 p.m. on the Toronto Stock Exchange. DundeeWealth rose 90 cents, or 7.4 percent, to C$13.

28 September 2007

CIBC World Markets Will Have Weaker Q4 2007 Results

The Toronto Star, Rita Trichur, 28 September 2007

Canadian Imperial Bank of Commerce says tough market conditions are weighing on its World Markets business and warned the division's fourth-quarter results will be weaker than levels achieved earlier this year prior to the full-scale meltdown in U.S. subprime residential mortgages.

CIBC World Markets, the bank's wholesale and corporate banking arm, has already taken $290 million in mark-to-market writedowns in securities related to the U.S. residential mortgage market during the third quarter.

Millions more in writedowns are expected in the current quarter as the bank continues its market-value assessment of its collateralized debt obligations and residential mortgage-backed securities, which are investments related to U.S. subprime mortgages.

That mark-to-market process determines the current market price for those securities versus their previously assigned book value.

CEO Gerald McCaughey said at an investor conference in Mont-Tremblant, Que., yesterday that "market and industry conditions are challenging and our fourth-quarter results are not likely to match the strength in the World Markets business that we have seen in the earlier parts of 2007."

CIBC has previously stated that its "target business mix" is to invest 25 to 35 per cent of its capital in its wholesale business. Last March, McCaughey told investors at the bank's annual meeting that CIBC had "room" to provide additional capital to its World Markets division and improve its productivity.

But yesterday, McCaughey cast a more sombre outlook vis-à-vis those previously stated scorecard objectives: "Currently, we are at 24 per cent and, given the more difficult market conditions, we do intend to remain near the low end of our range at this time."

Last month, CIBC revealed its exposure to troubled subprime mortgages though collateralized debt obligations and residential mortgage-backed securities was about $1 billion (U.S.).

Executives also estimated the bank would take another $90 million in markdowns for August based on preliminary data. Those further markdowns for August could reduce the bank's per share fourth-quarter earnings by an estimated 18 cents (Canadian), according to RBC Capital Markets.

Analysts have also warned that more fallout is possible if U.S. subprime securities continue to undergo price erosion. McCaughey gave no further hints yesterday about the expected value of CIBC's investments in subprime-related securities for the fourth quarter. He conceded, however, the securities have ended up being "riskier" than originally thought despite their high credit ratings.

"The volatility that we've experienced and the fact that we ended up with large holdings and a large writedown is not something that we would like to have on an ongoing basis," McCaughey said. "We're trying to dampen volatility and so we are examining how we can look through this type of thing in the future."

CIBC is not the only bank re-evaluating its risk exposure. The Bank of Montreal, too, has learned lessons from its mounting commodity-trading losses, which have already had an impact of $829 million before taxes so far this year.

The losses mostly occurred from natural gas trading involving New York-based brokerage Optionable Inc. and are now being scrutinized by regulators and law enforcement officials.

Karen Maidment, BMO's chief financial and administrative officer, said at the same conference the bank is continuing its enterprise-wide review of risk management practices: "We're changing a lot of monitoring and limits and measures and things like that to ensure that we stay within the risk profile."

BMO's exposure on its commodity book is about $11 billion and it plans to work it down over the next two quarters. And while analysts have warned of more trading losses, Maidment said the bulk of the losses have already been incurred.

RBC CM on Manulife

RBC Capital Markets, 28 September 2007

F/X drag and low interest rates should not negatively impact Manulife's target of 15% organic EPS growth. Manulife believes that it can reach its target of 15% organic EPS growth in the current environment as long as it achieves 10% year over year growth in Premiums and Deposits, which it views as possible now that Japan variable annuity sales have returned to previous levels. Manulife delivering on its objectives should be a positive for its shares. We are estimating 11% EPS growth in 2008, which is slightly below consensus estimates of 12%.

Credit issues in the US may be a catalyst for US insurance consolidation. If consolidation occurs, we believe Manulife is well positioned to make acquisitions in the US because: (i) Manulife's valuation has improved compared to US lifecos, currently trading at a 22% premium to selected US lifecos versus 6% in June 2007; (ii) Manulife has $3+ billion in excess capital that it can deploy for acquisitions; (iii) the rising Canadian dollar, versus the US dollar, makes potential US acquisitions larger; and (iv) Manulife would be able to generate significant synergies in most lines of business'.

Management was very positive on Q3/07 variable annuity sales results in Japan. We believe that Q3/07 Japanese VA sales results may top Manulife's previous best quarter of US$1.05 billion (Q1/06). Manulife's shares should react positively to an improvement in sales as sales had declined to approximately US$400 million per quarter since July 2006, when a key product was shelved for regulatory reasons.

Manulife is currently trading at 14.0x NTM earnings compared to its 5-year average of 13.1x and the current lifeco median of 13.0x. We believe that Manulife deserves the premium valuation it trades at compared to Canadian financial services companies and life insurers worldwide, based on the company's sales and earnings growth track record, excess capital holdings, growth prospects in Asia, and lower credit risk profile than U.S. lifecos and Canadian banks. Diversity of operations limits downside earnings risk and reserves appear conservative, with large provisions for adverse deviations relative to reserves and a track record of booking experience gains. The company remains well positioned if long-term interest rates increase.


Our 12-month price target of $47 is a combination of our P/E, price to book and embedded value methodologies. It implies an approximate forward multiple of 14.5x earnings, compared to the 5-year average forward multiple of 13.1x. Our P/B target of 2.9x in 12 months is at the high end of our target for lifecos given a higher expected ROE than average. Our target P/E multiple of 14.5x 2008E earnings is above the company's 5-year average forward P/E to reflect potential benefits from higher interest rates, rapidly growing value of new business, and potential for upward EPS revisions as our expected earnings growth is below what the company has historically achieved and is targeting, partially offset by deteriorating credit quality, uncertain equity market performance and lack of benefits from transformational acquisitions. Our target multiple on embedded value of 2.0x is higher than for the other two Canadian lifecos, reflecting higher prospects for growth in value of new business, because of the company's positioning in Asia and the U.S.

Price Target Impediment

Risks to our price target include persistently low interest rates, deteriorating equity markets, adequacy of actuarial assumptions, acquisition/execution risk, unfavourable political and/or economic developments in Asia and appreciation in the Canadian dollar. To the extent that the appreciation in the Canadian dollar is due to improved bond yields, Manulife has a natural hedge to help offset its F/X drag due its asset/liability mismatch.

Company Description

Manulife is Canada's largest insurer, with 45% of net income generated in the U.S., 36% in Canada and 19% in Asia. Manulife has delivered 12 consecutive years of record earnings growth, registering a 25% CAGR during that time frame, and is the fourth-largest life insurer globally as measured by market capitalization.

27 September 2007

Scotiabank to Buy 3 Banks from Altas Cumbres

BN Americas, Maria Alejandra Moreno, 27 September 2007

Scotiabank is about to buy three banks from Chile's Grupo Altas Cumbres for US$200mn, Chilean newspaper Diario Financiero reported.

The three are Banco del Trabajo in Peru, Banco de Antigua in Guatemala and Banco de Ahorro y Crédito Altas Cumbres in the Dominican Republic, according to the report.

All are small players. Banco del Trabajo has a loan market share of 2% and Banco de Antigua around 1%.

The acquisitions would fit Scotiabank's strategy as Latin America has been a key driver of overall earnings growth for the Canadian group, Joseph Scott, senior director at Fitch's Financial Institutions Group, told BNamericas.

With Canadian law currently prohibiting mergers among major banks, Scotiabank is looking to expand in markets offering better growth opportunities and wider spreads than its domestic market, Scott said.

Scotiabank's Mexican unit, with Cnd$21.1bn in earning assets at end-September last year, generated 15% of overall net income. By contrast, the group's US operations, with Cnd$41.9bn in earning assets, generated 9% of total net income.

Executives from Altas Cumbres were unable to comment as they are traveling abroad. A Scotiabank's spokesperson said the bank does not comment on speculation.

Last August, Scotiabank agreed to buy Chile's seventh largest bank Banco del Desarrollo for some US$1.03bn. This month the company said it would pay US$50mn for Spain's BBVA pension and insurance units in the Dominican Republic.

'True Yield' of Dividend Paying Stocks

Financial Post, David Berman, 27 September 2007

Any investor who chases after dividend-paying stocks knows yield is only part of the attraction. A low payout ratio is also good, not to mention the ability to raise a dividend over time.

George Vasic, strategist at UBS, revisited his regular look at Canadian dividend-paying stocks recently, fine-tuning a stock screen to select the best of the best.

Using his approach, the best dividend-paying stocks have yields above 1.5%, a "true yield" (that is, taking into account share buybacks) above 3%, no share dilution over the past three years and five consecutive dividend increases above 10%. Finally, these stocks should have a payout ratio that is below 50%.

What stocks make the grade? There are just nine of them: Methanex Corp., National Bank, Canadian National Railway Co., Manulife Financial Corp., CIBC, Bank of Montreal, Bank of Nova Scotia, Sun Life Financial Inc. and Royal Bank of Canada.

Yes, the list includes a lot of banks and insurance companies. "The bottom line is that when share count is included, the large cap financials look even better than their already attractive dividend yield would suggest," Mr. Vasic said in a note to clients.

Banks Unable to Roll Over All of Their Own ABCPs

Bloomberg, Sean B. Pasternak, 27 September 2007

Canadian banks haven't been able to roll over all of their asset-backed commercial paper amid the global credit crunch, Bank of Montreal Chief Financial Officer Karen Maidment said.

``We've seen the rollovers haven't been 100 percent, so there has been some support provided to those,'' said Maidment, speaking at an investor conference today. ``That was particularly a problem in August, and it's much improved into September.''

Bank of Montreal spokesman Paul Deegan said in a telephone interview that Maidment was referring to the banking industry as a whole, and not her bank. Canada's fourth-largest lender continues to roll over commercial paper at ``prevailing market prices,'' Deegan said.

The failure of Canada's biggest banks to refinance all their commercial paper coming due shows the gridlock in the short-term debt market in Canada hasn't been limited to non-bank dealers such as Coventree Inc. Canadian banks are paying record interest-rate premiums to get investors to buy their asset- backed commercial paper amid the U.S. subprime crisis.

``It's been a disruptive market, but I think we can foresee it working through,'' Maidment said at a conference in Mont-Tremblant, Quebec sponsored by CIBC World Markets.

Canadian Imperial Bank of Commerce Chief Executive Officer Gerry McCaughey said the commercial paper market is ``better'' and has ``a feel of equilibrium right now.''

Canadian lenders such as Bank of Montreal have committed to provide so-called ``back-stop'' liquidity to finance their asset-backed commercial paper if investors refuse to roll over the debt, which have maturities of up to 364 days. The Toronto- based bank had C$42.7 billion ($42.7 billion) set aside for this purpose at the end of 2006, more than any other Canadian bank, according to CIBC World Markets estimates.

The bank-sponsored market for asset-backed paper contrasts with the debt sold by non-bank dealers such as Coventree. That market seized up last month after foreign banks such as Barclays Plc declined to provide emergency funding. A group of investors and banks said today it needs more time to convert some of that commercial paper into notes maturing in five to 10 years.

Big 5 Not Increasing Presence in Quebec: National Bank

Canadian Press, 27 September 2007

Canada's five largest banks have failed to dramatically increase their physical presence in Quebec or provide a consistent approach in the province, says the head of the National Bank of Canada.

“To have an impact on a mature market like Quebec, you need a consistent approach to that market and I think for our competitors, their approach has been anything but consistent regarding Quebec,” CEO Louis Vachon told analysts Thursday at a CIBC investors conference in Mont-Tremblant.

Mr. Vachon heads Canada's sixth-largest bank. His comments were directed at Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, Royal Bank of Canada, and TD Canada Trust.

Mr. Vachon said the impact of the leading banks over the last 18 to 24 months has primarily been to tighten spreads in mortgages and some commercial banking — essentially using competitive pricing to attract customers.

Louis Vachon maintains that the Big Five banks have an inconsistent approach to the Quebec financial services market.

He noted the National Bank has not been as disciplined as it should have been in some of its pricing.

Meanwhile, Mr. Vachon said National Bank will continue to focus part of its growth strategy on expanding its presence outside Quebec, which accounts for 65 to 70 per cent of its business.

Early next year, it plans to disclose its expansion plans. But Mr. Vachon said the bank has preferred to focus on areas where it already has a presence in francophone areas of New Brunswick and Ontario, particularly in the Toronto area and Windsor, Ont.

It is also working on replicating its success in servicing the agricultural community of Quebec by expanding in Western Canada. It has offices in Calgary and Lethbridge.

Mr. Vachon said it has expanded its market share over the past five years in the oil and gas sector based in Calgary, where it has been active for nearly a quarter century.

He said the current crisis in credit markets may also pave the way for it to make acquisitions in the brokerage and wealth management businesses.

On the dividend front, Mr. Vachon said the bank is guided by caution and seeks only to increase the return to shareholders when it “is sustainable in any circumstances.”

As for the future, Mr. Vachon had this warning to those who question the future of the country's sixth-largest bank.

“Do not underestimate the strength of the franchise and the capacity of the franchise to generate earnings growth.”

Banks Sell Medium Term Debt at Premium Yields

Financial Post, Sean Silcoff, 27 September 2007

Faced with dwindling demand for their short-term debt offerings, Canadian banks have lured investors in the past month by selling massive amounts of medium-term debt securities at bargain prices.

The biggest issuer so far has been Royal Bank of Canada, which has sold $4.4-billion worth of three-to-five-year senior deposit notes in five separate offerings since mid-August, an amount and volume of deals market observers characterized as unusually high.

RBC typically raises such funds outside Canada, but "we tapped the Canadian market this time around because it was the most attractive source of funding," said Katherine Gay, a spokeswoman for the bank's RBC Capital Markets division.

"We're very active in the Canadian debt markets now because it's the most effective source of funding for us and the fact we're getting very strong investor support for the RBC name. We simply did the math, and it's the right thing to do."

But bond investors doing the math have come to their own conclusions: The price for such high-quality debt is a steal. RBC's debt has been sold at spreads as much as 93 basis points (93/100ths of 1%) above comparable government of Canada bonds. Those spreads are double or more what such securities yielded in June, offering a significant premium for bond investors accustomed to earning 5% to 6% per year.

"When you look at where spreads have traded, it's kind of a gift," said Marc-Andre Gaudreau, vice-president of corporate bonds with Mont-real-based Natcan Investment Management, which manages $16-billion in fixed-income assets. "It tells me that the banks from a historical standpoint are cheap relative to the rest of the market. To me it's just a sign investor appetite is not as high as it was before."

Bank of Montreal also last week sold $800-million worth of 10-year subordinated notes at 135 basis points above Canadian bonds. That spread was about 70 three months ago.

Mr. Gaudreau said he expected more large debt offerings from Canadian banks before their fiscal years end next month.

The well-priced issues of high-end bank paper have sold quickly as shrewd bond investors -- who are typically happy to beat the returns of their peers by 2/10th of 1% -- pounce on opportunities created by the global credit crunch.

"This is a very unusual circumstance and an extremely attractive one as long as you do the work to make sure securities you are buying are high quality," said Scott Lamont, head of fixed-income at Phillips, Hager & North, a Vancouver-based fund manager with $45-billion in fixed-income assets. "These are the kinds of opportunities we wait for as active managers."

But Mr. Lamont said he didn't expect the good deals to last for much longer. The banks "have concluded in the last two weeks they can sell as much as they want at [higher yields]," he said. "But they've probably concluded they don't want to continue to have to pay these kinds of yields to attract investment dollars. Rather than issue at those spreads, they'll [keep assets] on their balance sheet. Either spreads will come down or they'll issue less of it."

Some seasoned bond investors speculate the large debt offerings are part of an effort by the banks to free up their balance sheets so they can "repatriate" assets such as car and mortgage payments that were previously rolled into short-term securities called "asset backed commercial paper. " The ABCP was typically rolled from one 30-to 90-day issue into the next. But because of a meltdown in one part of the ABCP market in August, investor appetite for all such securities has dropped in Canada -- even the offerings sponsored by the banks. "It's part of a flight to quality," said Mr. Lamont. "A lot of people will go to the most risk-averse alternatives," such as government bonds.

As a result, banks are expected to wind down these instruments and take the assets back on to their books. This could increase their cost of capital and weigh on their returns, as ABCP has become a convenient way for banks to turn assets into tradeable securities they sell to investors, allowing them to deploy capital more effectively.

"Now they will have to hold them on their balance sheet, and have more assets to fund than they planned to" said Mr. Gaudreau.

21 September 2007

Outlook for Capital Markets Business

RBC Capital Markets, 21 September 2007

The outlook for Canadian wholesale businesses may not be as bad as feared back in August, but risks related to economic growth have grown

• Three of the four U.S. brokers' Q3/07 results were close to or above street expectations despite major losses and write-downs taken by each in fixed income businesses, alleviating concerns of potentially disastrous results. Goldman Sachs posted the strongest results, and Bear Stearns the weakest.

• These results, combined with the Q3/07 results and disclosures by the Canadian banks on "hot topics", lead us to believe that the outlook for capital markets businesses, although not as good as in the last 12 months, may not be as bad as feared back in August.

• The bigger risk to Canadian bank earnings relates to economic growth; a decline would negatively impact loan growth and credit losses. If there was a recession, which our economists do not envision at this time, the implication for both bank profitability and valuation multiples would be negative and investors would be better off holding lifeco stocks, in our view.

Key themes from the U.S. brokers' results:

1) Diversity of businesses helped weather the credit and liquidity crisis in Q3/07.

2) Managements appeared confident in valuation write-downs and losses taken, and in their capital and liquidity positions.

3) The brokers' outlook is "cautiously optimistic".

RBC Fires Bond Salespeople in `Challenging Market'

Bloomberg, Caroline Salas, 21 September 2007

RBC Capital Markets, the investment-banking arm of Canada's biggest bank, is firing employees in its U.S. fixed-income division as a slump in credit markets curbs revenue on Wall Street.

The Toronto-based bank reorganized its U.S. fixed income unit "in the face of challenging credit markets," Chuck Powis, head of U.S. fixed-income sales in New York, said in an e-mail to clients this week that was obtained by Bloomberg News. "This reorganization involves changes that we feel are necessary to better align our business to these volatile markets." The e-mail didn't refer to job reductions.

RBC cut 40 fixed-income sales positions and may close its Fort Lauderdale, Florida, office, people with knowledge of the reductions said. Powis confirmed the contents of his e-mail. He wouldn't discuss the job reductions.

Bond traders in the U.S. are losing or leaving their jobs as losses sparked by defaults on subprime mortgage securities spread throughout the credit markets.

Royal Bank of Scotland Plc's RBS Greenwich Capital unit ``resized'' a department that deals with collateralized debt obligations, according to an e-mailed statement last month. Merrill Lynch & Co. said last week that Kenneth Margolis, 53, a managing director who helped oversee its CDO underwriting business, left as sales of the securities tumbled.

Kevin Foster, a spokesman for RBC, wouldn't comment on the firings and declined to say how many salespeople remain employed by the U.S. fixed-income unit.

``We have made some changes to our operations -- this is a strategic response to changing opportunities in the U.S. fixed income market,'' Foster said in an e-mailed statement. ``Our fixed income and currency business is not experiencing a significant change in business performance.''

As investors fled to government debt, more than 50 companies postponed or reworked bond sales in June, July and August, and demand for mortgage securities dried up.

Bear Stearns Cos., the securities firm hit hardest by the collapse of the mortgage market, yesterday reported its third- quarter net income dropped 61 percent, the New York-based firm's biggest profit decline in more than a decade. Morgan Stanley and Lehman Brothers Holdings Inc., both based in New York, also posted declines.

As part of the changes, RBC this week named Powis, 44, head of sales after previously serving as head of U.S. structured credit and rates at RBC. Mike Quinn, 42, was also appointed head of U.S. credit trading and remains co-head of structured credit, financial products.

RBC, a unit of Toronto-based Royal Bank of Canada, elevated Powis and Quinn after the departures of sales chief Brian Shapiro, head of high-grade trading Stuart Alper and Robert Lambert, who ran high-yield trading. Lambert quit to join Harbinger Capital Partners.

``We remain committed to building a top tier fixed income business globally with a significant presence in the U.S. market,'' Foster said in the statement.

17 September 2007

CIBC to Test Sunday Branch Hours

The Globe and Mail, Tara Perkins, 17 September 2007

Any notion that bank machines and the Internet will replace the teller and local bank branch were put further to rest Monday with Canadian Imperial Bank of Commerce's announcement that it is going to test Sunday branch hours in select locations.

The big banks are falling back in love with their expensive branch networks as the battle for customers heats up.

While some major banks once offered Sunday hours, they have been phased out and none currently has standalone branches open Sundays.

Some banks have smaller pavilions in grocery stores or malls that are open seven days a week.

CIBC's decision to start opening some of its Toronto- and Vancouver-area locations on Sundays, beginning later this year, comes as Toronto-Dominion Bank is aggressively recruiting staff in preparation for Nov. 1. That's the day TD rolls out its new extended hours.

The change will bring the number of hours the average TD branch is open each week to more than 60 from about 50.

And a Royal Bank of Canada spokeswoman said Monday that all of its main market branches are moving, or have moved, to extended hours.

Rivals who are jumping into the fray with banking products that are only available online, by phone or through independent advisers are part of the reason that the big banks are now trying to make the most of their physical locations.

TD's head of personal banking, Tim Hockey, said "competition continues to increase. It's a good thing for Canadian consumers, they get to reap the benefit of it."

"Those of us that have branch networks realize it's a great strength and tend to want to optimize that, and really make it stand out relative to those that don't," he added.

TD, which has the longest hours of operation of the big bank networks, doesn't currently have any plans for Sunday hours. But it's keeping an eye on CIBC's experiment.

"We know that customers like hours and if it turns out the customers really respond to Sunday hours, then we'll give them Sunday hours," Mr. Hockey said.

While it may seem counterintuitive that the banks are putting more money into their branch hours as Internet banking evolves, Mr. Hockey suggested online banking isn't quite as prevalent as some people might think.

TD has the highest proportion of customers who are actively banking online, but it's still less than one-third, he said.

Stephen Forbes, CIBC's senior vice-president of communications, said "branch banking is foundational to the service we provide. Many of our clients, particularly new Canadians, prefer to visit a branch, and by providing our clients with the ability to bank on Sunday, we are providing more flexibility and choice."

And branches are still the best place for customers to get advice-based products, and to multitask, CIBC said.

"Whether our clients want to sit down and talk about a mortgage, set up an account for their child or get a mortgage or line of credit, the branch is generally the best place for our clients to do multiple things at the same time," said Christina Kramer, senior vice-president of CIBC retail markets.

CIBC will gauge the success of the new Sunday hours in its test markets before deciding whether to bring them to other locations.

13 September 2007

Review of Banks' Q3 2007 Earnings + Outlook

National Bank Financial new analyst's ratings and target prices:

• BMO is rated "underperform," 12 month target price is $67.00

• CIBC is rated "outperform," 12-month target price is $105.00

• RBC is rated "sector perform," 12-month target price is $58.00

• Scotiabank is rated "sector perform," 12-month target price is $57.00

• TD Bank is rated "outperform," 12 month target price is $80.00
• Credit Suisse upgraded BMO from "underperform" to "neutral." The target price is set to C$73.

Credit Suisse mentioned that revenues and profits at the BMO's core retail banking activities seem to be improving. BMO's Canadian retail and wealth operations posted robust bottom-line Q3 2007 results due to impressive revenue growth and efficient cost management; BMO continues to face difficulty in improving its share in the personal deposit market, Credit Suisse added.

• Dundee Securities cuts CIBC to 'neutral' from 'outperform'

• Dundee Securities cuts RBC to 'under perform' from 'neutral'

• Dundee Securities cuts Scotiabank to 'neutral' from 'outperform'
BMO Capital Markets, 11 September 2007

Sector Downgraded to Market Perform: The Cumulative Weight of Events
Industry Rating: Market Perform

We are downgrading Canadian banks to Market Perform from Outperform. We moved to an Outperform rating in early 2005, driven by our confidence in the domestic banking business and our view that the appreciation in other yield vehicles highlighted the attractive valuation of bank shares. Since then, banks have produced over a 50% return over the 30-month period and have matched the returns from the TSX overall. This was achieved in an environment when both oil and gold prices moved meaningfully; not bad relative performance for a defensive group like the Canadian banks.

Our downgrade to Market Perform is based on three basic tenants:

1. We are witnessing a significant re-pricing of risk across several credit and cash markets. To date, this has been occurring in a less-than-orderly fashion, which creates some short-term risks to earnings.

2. The domestic environment in Canada has been incredibly strong. It is likely that we will witness slower loan growth and higher loan losses as we move forward. In addition, with the volatility in wholesale funding rates (and some short-term pricing moves by competitors), there could be some short-term pressure on core spreads.

3. The decline in the valuation of global financials is likely to continue to weigh on Canadian bank stocks. Canadian banks are now at 140% relative P/BV when compared to their U.S. peer group. We don't know how much wider this spread can get.

We aren't crying fire in a crowded movie house. Banks are off about 8% from their all-time highs, and though they have lagged the resource-heavy TSX over the past 12 months, they are still up 9% and have provided a rewarding 3-4% yield. We are very comfortable that banks have the liquidity and capital to deal with the current challenges.

Indeed, Canadian banks will likely benefit from the current volatility. Other financial intermediaries, finance companies, etc., will likely have less availability to funding than banks in this environment. The issue for us is timing, and the volatility in the short term is somewhat concerning. As such, we are moving to a Market Perform rating, and have reduced our bank share price targets.

The Past 30 Months Have Produced Solid Returns

Canadian Banks have produced excellent returns over the past 30 months (see table below). Indeed, Royal, TD, CIBC and BNS have been great performers with BMO and NA having lagged. The ability of the Canadian bank stocks to match the market (essentially) is impressive in the context of massive upward moves in commodity prices. In early 2005, crude oil was about US$40 a barrel and gold was just over US$400 an ounce.

A Disorderly Re-pricing of Risk

We have been struck by the significant volatility in what have traditionally been stable cash markets. We show the yield on U.S. 3-month T-bills in the chart below. This volatility has been driven by a flight to quality, as investors have shied away from various vehicles where there is limited visibility. Examples of this have included the asset-backed commercial paper (ABCP) market here in Canada, the structured investment vehicle (SIV) market in the U.K. and the collateralized debt obligation (CDO) market in the U.S. ABCP, SIV and CDO have all become worrisome acronyms, at least for equity investors.

We believe that the root cause of the problem is the lack of confidence of buyers in ratings and rating agencies; ratings that were formerly trusted no longer seem to cut the mustard and buyers are becoming more (read very) selective. We aren't pointing the finger at rating agencies here; the reality is that many of these structures are still performing well on the asset front.

The issue seems to be that buyers have lost confidence in the ratings process. It is clear that the demand for credit analysis (and hopefully credit analysts) in North America is rising. However, this process will take time and we would be surprised to see it occur in a smooth fashion.

The Domestic Environment Remains Strong, but for how Long?

We are confident that the Canadian economy will remain strong. Canada is an 'oasis of stability' in an uncertain world. The fact that Canada is a resource economy, that the fiscal situation at most levels of government is good and the strength of the Canadian dollar all support this view.

However, the reality is that the environment is likely to be less robust over the coming quarters. As we show in the chart above, loan growth over the past three years has been spectacular and in July was over 12%. Over the past two decades, loan growth has occasionally exceeded 10%, but normally only for short periods. The fact that loan growth has exceeded 10% for close to three years surely suggests that slower growth is ahead. We don't anticipate loan growth falling off a cliff, but if bank stocks can't perform when the environment is this strong, one wonders what happens when loan growth slows to more normal levels (say in line with nominal GDP growth).

So far, mainline banks have been quite disciplined on pricing so that spreads have stabilized after experiencing declines from late 2001 until the start of 2006. One element that has helped has been stability in the Prime-BA spread and relatively easy access to wholesale funding. This appears to be changing (see chart below) with little sign that the Prime Rate (which prices most of the banks' loan books) is moving higher. National Bank's recent decision to significantly increase posted rates across GICs is, in our opinion, not a positive development and adds to the uncertainty in an already unclear environment.

Canadian Bank Valuations Have Already Widened Dramatically Versus Global Peers

In terms of stock price performance, Canadian banks have handily beat their global peers (see table below) over time. Since the start of the current decade, Canadian banks have more than doubled the performance of U.S. and U.K. banks. This outperformance has continued year to date and is a testament to the better banking model in Canada (heavy retail emphasis, consolidated banking system, etc), and to the strength of the Canadian economy.

Having said that, we believe that it will be difficult to have much more multiple expansion when global financials are in turmoil. As we show in the chart below, Canadian banks now trade at a 40% premium to U.S. bank stocks on a P/BV basis. We believe that Canadian ROEs are sustainably better than their U.S. peers; we just aren't sure if they are sustainably 40% better. Remember that U.S. banks have some potential for consolidation whereas Canadian banks have lived in a world of 'no mergers' for several years.


Essentially, we are saying that Canadian banks will probably continue to beat their global peers, but are unlikely to beat the TSX overall, particularly if we get the performance we expect from the oil and gold sectors.

None of the issues listed in this report are brand new, although the first two have only surfaced in the past couple of months. We remain confident that banks can deal with them. The issue is that, taken together, they put additional pressure on bank balance sheets. We are downgrading the bank sector to Market Perform and have reduced our share price targets across the board

Canadian banks still derive 60% of earnings from domestic banking and wealth, and have excellent balance sheets and solid dividends. Individual investors should be aware of tax implications of selling bank shares, particularly if the shares have been held for an extended period and the cost base is low.

New target prices:
• BMO $67.00
• CIBC $106.00
• National Bank $56.00
• RBC $58.00
• Scotiabank $53.00
• TD Bank $75.00
Investment Executive, James Langton, 7 September 2007

Canadian financial stocks could be the place to wait out the market’s current turmoil, suggests a new report from UBS Securities Canada Inc.

UBS says that, “the abstruse nature” of the credit crunch issue “means that a definitive all-clear signal is unlikely”. Rather, markets are likely to regain their footing gradually, it says. “What are investors to do in the interim? Our answer is Canadian financials.”

The report says that while Canadian financials have not been immune to the market turmoil, “they still have a very attractive reward/risk profile relative to both the TSX and the S&P 500 financials.”

“Essentially, the credit crunch is a deflationary shock which tends to hurt resources and cyclicals more than financials,” it says. “And importantly, since confidence looks likely to be only gradually restored, the financials should also lead in the early recovery.”

Back in 1998, when markets stumbled in August and floundered throughout much of the fall, resources trailed to the end of the year, UBS recalls. “The 1998 pattern has already been borne out since the July 19 peak, and we expect the recovery phase is a good Plan A until the dimensions of the credit crunch become clearer,” it advises.
The Globe and Mail, 6 September 2007

In a vote of confidence for profits in the battered financial sector, Desjardins Securities has upgraded Canadian Imperial Bank of Commerce to “strong long-term buy” from “buy,” matching the ratings on Royal Bank of Canada, Toronto-Dominion Bank and Bank of Montreal.

The one problem child is National Bank of Canada, which was cut to a “long-term hold.”

Desjardins strategists also say Canada’s major insurers are showing accelerating profitability, prompting upgrades of Manulife Financial Inc. and Great-West Lifeco Inc. to “strong long-term buys” from “long-term buys.”

Power Corp. of Canada and Power Financial Corp. were raised to “long-term holds,” as profitability is now stabilizing, Desjardins predicts.
RBC Capital Markets, 4 September 2007

All six banks reported Q3/07 EPS that were higher than expectations, driven by better than expected wholesale banking earnings and continued strong retail earnings growth.

• It appears that bank trading rooms, broadly speaking, were well positioned to (1) avoid large negative marks to markets that could have occurred on inventory holdings and proprietary trading positions as debt and equity markets weakened in the latter part of July (the banks' quarter end), and (2) many were actually positioned to take advantage of widening credit spreads and interest rate volatility, as evidenced by surprisingly strong fixed income trading revenues for the group.

We expect total returns of 15% from holding bank stocks in the next 12 months, but believe that the price appreciation is likely to come in the latter half of those 12 months.

• We remain concerned that Canadian banks could trade sideways or down in the near term on negative news flow out of world financials, as well as potential earnings disappointments in Q4/07.

• Bank valuations have declined from 13.2x to 11.6x on a NTM P/E basis since the year began. We believe that bank valuations could trade back up to their 5-year average forward multiple of 12.2x if credit conditions remain benign, capital markets stabilize and interest rates do not rise meaningfully.

• If capital markets remain weak and capital market issues become economic issues, we believe there would be further pressure on valuation multiples (and earnings).

TD is our favourite bank stock

• We have an Outperform rating on TD. Domestic retail momentum and higher earnings from the U.S. should drive above-average retail earnings growth for TD. We also believe that there is less downside risk to our earnings forecasts for TD than for the industry as the bank is less exposed to wholesale earnings, and appears to have a more conservative mix of businesses within its wholesale division.

Positive on 12-month outlook for bank stocks; still cautious near term

All six Canadian banks reported Q3/07 EPS that were higher than our expectations (and consensus), driven by better than expected wholesale banking earnings and continued strong retail earnings growth. The release of the banks’ Q3/07 results showed that their trading rooms, broadly speaking, were well positioned to (1) avoid large negative marks to markets that could have occurred on inventory holdings and proprietary trading positions as debt and equity markets weakened in the latter part of July (the banks’ quarter end), and (2) many were actually positioned to take advantage of widening credit spreads and interest rate volatility, as evidenced by surprisingly strong fixed income trading revenues for the group. We were comforted that the banks did not take major hits (two exceptions: the trading revenues of both Bank of Montreal and CIBC were affected by large losses in commodities and U.S. sub-prime securities respectively), although surprises may still spring up as the month of August proved to be even more volatile in equities and interest rates.

We expect total returns of 15% from holding bank stocks in the next 12 months, but believe that the price appreciation is likely to come in the latter half of those 12 months. We remain concerned that Canadian banks could trade sideways or down in the near term on negative news flow out of world financials, as well as potential earnings disappointments in Q4/07. The increased risk aversion seen in capital markets and tightening of liquidity, if it continues, could have a much larger impact on wholesale revenues in Q4/07 than it did Q3/07, in our view. Our positive 12-month outlook is predicated on continued strong growth in retail earnings and a benign credit environment. The biggest risk to our positive outlook is that capital market issues become economic issues; a scenario that our economists do not envision at this time.

Bank valuations have declined from 13.2x to 11.6x on a NTM P/E basis since the year began. We believe that the banks could trade back up to their 5-year average forward multiple of 12.2x if credit conditions remain benign, capital markets stabilize over the next 12 months and interest rates do not rise meaningfully. The 5% increase we expect in valuation multiples, combined with 9% expected earnings growth in 2009, would provide attractive returns for banks’ shareholders over the next 12 months.

If capital markets remain weak and capital market issues become economic issues, we believe there would be pressure on valuation multiples (and earnings). In such an environment, we believe that the 5-year valuation trough of 10.3x is indicative of where banks may trade – an 11% drop in valuation multiples.

Things we like about the Canadian bank stocks:

There are many things that we like about Canadian bank stocks, in spite of our concerns about potential negative surprises and disappointing capital markets revenues in the near term:

• Retail and wealth management businesses are strong;
• Direct exposure to most troubled parts of capital markets appears limited;
• Capital ratios are high;
• Widening credit spreads should eventually create opportunities;
• The interest rate environment is better for bank stocks than it was a few months ago;
• An economic cycle is needed to see trough ROEs; and
• Prior periods of fear for the financial system in the last decade were unfounded.

Retail and wealth management businesses are strong

Retail banking and wealth management businesses continue to perform well, and those generate about 70% of Canadian banks’ earnings. Canadian loan growth remains very strong, and the conditions that have driven the strong loan growth remain in place: employment growth, rising incomes, low interest rates and a solid housing market. The outlook for wealth management growth is heavily influenced by equity markets (the majority of revenues are asset management and brokerage) and, although choppy this summer, Canadian equity markets are up 4.5% year to date.

The negative news flow surrounding financial institutions is mainly centered around capital markets issues, which generates about 30% of earnings for Canadian banks. A spillover of the credit-related issues into equity markets has negative implications for retail wealth management businesses, but the revenue sensitivity of asset management and retail brokerage businesses is lower than capital markets revenues in our view, particularly as banks have all strived to increase the proportion of retail brokerage revenues that are fee-based versus commission-based.

Direct exposure to most troubled parts of capital markets appears limited

The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets, including U.S. sub-prime mortgages the Canadian third-party asset backed commercial paper market, and LBO underwriting commitments. There are exceptions, which we highlight later in this report, but we think it is still fair to say that the Canadian banks are less exposed to these three areas than many U.S. and European banks, and the Canadian banks’ exposures come in the context of an earnings mix that is dominated by retail banking and wealth management.

Capital ratios are high

Canadian banks have high capital ratios compared to banks in other developed markets, with Tier 1 ratios ranging from 9.3% to 10.2%. Their ability to grow their capital is also quite high, as approximately 70% of their income comes from retail banking and wealth management, two sources of revenues that are not overly capital intensive. We also believe that the banks’ reputation as conservative institutions allows them easier access to liquidity and capital than some other financial institutions.

Widening credit spreads should eventually create opportunities

The repricing of credit risk is likely to create money-making opportunities for well capitalized financial institutions, including the Canadian banks. The current capital markets turbulence and expansion in credit risk spreads will likely create opportunities for trading businesses, it should be a positive for margins in commercial and corporate lending, it should help well-capitalized organizations get higher returns on capital as competition for investments becomes scarcer, and acquisition opportunities may arise. This period of opportunity does, however, typically come after a period of pain in which assets get marked to market, and banks generally are conservative in deploying capital until market conditions show signs of stabilizing. We do not believe that this adjustment period is over.

The interest rate environment is better for bank stocks than it was a few months ago

The interest rate environment has improved for bank stocks in three different ways:

• 10-year Government bond yields have dropped 31 basis points in Canada from their peak of 4.73% on June 12th. There is a very strong inverse correlation between bank P/E ratios and long-term interest rates given their high dividend yields and the beneficial impact of lower interest rates on loan growth and credit quality. RBC Economics expects 10-year Government of Canada bond yields to rise with a target of 5.45% by the end of 2008 so there may be pressure on bank valuations if those estimates prove correct.

• The outlook for short-term rates in Canada has also changed, with the Bank of Canada no longer expected to raise rates in the near term given the volatile capital markets conditions. Rising Bank of Canada rates have historically been negative for bank stocks more often than not so a probable delay in rate hikes is a positive. RBC Economics believes that worries about the spillover from the financial markets into the economy will likely keep the Bank of Canada on the sidelines and have shifted the timing of the next rate hike to the first quarter of 2008 (a change from their previous view of a rate hike by 25 basis points on September 5th) and forecast the overnight rate to rise 75 basis points over the first half of 2008 to 5.25%.

• The steepening yield curve, which resulted from short-term Government securities rallying on a flight to quality, has made the carry trade a possibility again.

An economic cycle is needed to see material reductions in ROE

We are forecasting a median ROE of 21.0% in 2007 for the Canadian banks. Capital markets profitability is clearly at risk of dropping in the near term, but even a drastic decline in wholesale net income – let’s use 50% to illustrate our point – would leave ROEs high. Given that wholesale income accounts for approximately 30% of earnings for the system, a 50% drop in profitability would knock ROEs off by about 3%, leaving them a still high 18%. In order to see ROEs head toward the low teens, we believe that we need to see an economic cycle, which would have negative implications for loan losses and retail loan growth.

Prior periods of fear for the financial system in the last decade were unfounded

The financial system has skated through many incidents that raised concerns over widespread financial market health in the last decade. Examples include the Asian crisis, the Long-Term Capital bailout, a corporate credit loss cycle, Amaranth, 2 major hurricanes in one year, and Argentina’s economic crisis. Those events caused material losses to individual financial market participants but ultimately did not impair the health of the financial services industry.

Risks for Canadian bank stocks have risen

We have a positive view on bank stocks over the next 12 months, but risks to continued strong stock price appreciation are higher than in recent years in our view. We highlight five concerns:

• Illiquidity and rising risk aversion is not an ideal environment for capital markets revenues;
• A lasting credit crunch could lead to economic issues;
• News flow is likely to continue to be negative, with the potential for surprises not over;
• Key earnings drivers of last five years at risk of weakening; and
• Capital ratios could decline, albeit from high levels.

Illiquidity and rising risk aversion is not an ideal environment for capital markets revenues

We believe that Q3/07 wholesale banking results were not indicative of the deterioration in revenues that could occur in the next few quarters. The Canadian banks reported strong wholesale earnings in Q3/07, continuing on a trend that has seen those divisions exceed expectations. The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets but, we still feel that their wholesale income is likely to decline in the next two quarters and, if liquidity problems become economic problems, possibly longer.

• Trading revenues were strong in Q3/07 but the quarter ended in July, and August saw more volatility and credit spread widening. Liquidity also became scarcer in August.

• Q3/07 benefited from strong M&A and underwriting revenues but the outlook for new assignments is on hold in our view. The closing of previously announced deal may mask underlying weakness in new originations in the near term.

• Liquidity should improve but it may not be as high as it was before the summer. Following sharp increases in credit spreads, liquidity typically returns as spreads stabilize; buyers emerge as that they stop believing price will get better and sellers get over sticker shock. The concern we have, however, is that a good portion of the liquidity of recent years came from highly levered strategies and is unlikely to come back in the near term. This includes “short low risk, buy high risk” and “fund short, invest long” strategies, that led to the development of Structured Investment Vehicles and risky ABCP structures, highly levered hedge funds, rapidly growing private equity funds and, most likely, more levered proprietary trading desks looking to replicate strategies that were successful for clients.

A lasting credit crunch could lead to economic issues

The most negative environment for bank stocks would be continued weakness in capital markets, and a weaker economic environment. Our outlook for the banks does not assume a recession, which is in line with our economists' outlook, which believe that the impact of rising defaults in the U.S. sub-prime mortgage market will not have a crippling impact on the broader economy. Our concern is that if liquidity continues to be a concern and credit availability is restrained for an extended period as a result of financial institutions’ concerns over their and others’ exposure to U.S. sub-prime real estate and/or levered credit investing strategies, it would have a negative impact on the economy. If the economy turned sour, it would accelerate the long-expected normalization of credit losses and the argument that the current risks facing banks are isolated to capital markets businesses would be out the window. We believe that such a scenario would have negative implications for both bank profitability and valuation multiples.

Capital ratios could decline, albeit from high levels

We believe that there is a risk that the Canadian banks’ Tier 1 ratios could decline from their high levels as:

• Banks could potentially bring on balance sheet some of their asset backed commercial paper conduits. They may do so by choice in Canada as the spreads over bankers acceptances are high enough that it does not make sense, in our view, for the banks to fund themselves in that market while spreads remain this high. If the commercial paper market remains tight, it is also possible that some of the conduits to which that the banks provide liquidity backstops would tap these lines.

• If credit spreads widen further, corporations may hold off on issuing debt and tap existing credit lines for funding needs.

It is important to point out that banks would generate additional net interest income as a result of adding assets to their balance sheets, and they would have adequate capital to fund those assets. The impact on ROE would depend on the mix of assets – banks putting retail mortgages on their balance sheets would not see their capital usage go up as much as if business lending suddenly soared. Even if all bank backstop liquidity facilities (i.e. including U.S. Commercial Paper programs) were fully drawn, the banks would have enough capital to handle those assets coming on their balance sheets, although funding those assets may be challenging.

News flow is likely to continue to be negative, with the potential for surprises not over

We are concerned about news flow out of financials because:

• There is still no or very little liquidity for many structured finance assets, most of which have not been marked to market and many of the esoteric structures have not traded, U.S. subprime mortgage delinquency rates are likely to increase as interest rate resets take effect, and there are still many LBO loans that are waiting to be distributed. The risk of downgrades in certain CDO tranches also introduces the risk of selling by investors with strict requirements on the types of risk they may own. If those investors drive down the price of certain assets, it may force others to mark their portfolios lower, which can cause major issues with levered investors.

• We realize that those issues are less material for Canadian banks than many U.S. and European ones, but we doubt Canadian bank stocks will perform well if negative news flow leads to weaker share prices for financial institutions worldwide.

• It is not inconceivable that there could be more large funds or institutions that run into financial difficulties, in which case markets are likely to push down valuations of worldwide financials.

• Equity markets (and Canadian banks) have also rebounded solidly since mid-August, partly on the expectation that the Fed is likely to cut rates in September. No action by the Fed would be negative for equity markets, in our view, while the expected action probably would not drive much more upside.

The Canadian banks appear to have manageable exposure to the most troublesome areas of capital markets, although that is not to say they are not exposed at all:

• National Bank is most exposed to the challenged third party ABCP market in Canada. In our view the risks are as follows:

o The bank will be exposed to credit risk as it is well on its way to repurchasing approximately $2.0 billion in ABCP from its mutual funds and retail customers. The bank is relying on DBRS in its assessment of the credit quality of the underlying assets at this point, and had the following to add in its Q3/07 press release: "At this time, the Bank can not quantify the financial impact, if any, of these initiatives mainly for two reasons. First, most of such ABCP has been issued by non-bank sponsored conduits which are subject to a restructuring proposal, which is at a very formative stage and the outcome of which could have a material effect on the value of such ABCP. Second, there is insufficient information available about the current value of the assets which underlie the ABCP being purchased and about any other contingent liabilities which may exist. The magnitude of the sums involved and the uncertainties referred to above could give rise to a material charge to the Bank's earnings. The Bank will address this issue when it publishes the fourth quarter results for fiscal 2007."

o Quantifying the damage to the bank's reputation is near impossible, but the impact is nonetheless meaningful in our view. Commercial and corporate clients that bought ABCP via National Bank face an extension of term and/or losses given that the purchase of ABCP by National Bank covers only holdings of under $2.0 million. This will undoubtedly disappoint some of the bank's clients, and may lead to lost business.

o The bank may provide credit lines to commercial and corporate customers whose cash balances were negatively impacted by the developments in the ABCP world. This may also add to the bank's credit risk, depending on the creditworthiness of the customers. The bank cited on its Q3/07 call that the liquidity advances have been done on normal banking terms and that it has not changed its underwriting criteria.

o Legal risk also arises, as some clients may seek recourse in the courts over their holdings in ABCP.

o Capital flexibility will likely be reduced. The bank's capital position is strong, with a Tier 1 ratio of 9.4%. The purchase of $2.0 billion in ABCP will lower the Tier 1 ratio by 0.35%, but the potential capital drag from providing liquidity lines is unknown.

• CIBC appears most directly exposed to weakness in the U.S. residential mortgage market.

o The bank incurred a loss of $290 million in Q3/07 due to the impact of mark-to-market write-downs, net of gains on related hedges, on collateralized debt obligations (CDOs) and residential mortgage-backed securities (RMBS) related to the U.S. residential mortgage market.

o The bank also estimates approximately $90 million in further CDO and RMBS markdowns in August.

o CIBC's exposure to the U.S. residential mortgage market before write-downs is approximately US$1.7 billion, invested in 5 or 6 structures, and is entirely held in a mark-to-market book. The bank has sub-prime index hedges of approximately US$300 million.

• TD has underwritten $3.3 billion of a $34.3 billion credit facility and provided a $500 million equity bridge facility to a group of institutional investors led by Ontario Teachers' Pension Plan Board in support of their bid to acquire BCE. The banks have mostly adopted “underwrite and distribute” philosophies in the last five years. In a rising credit spread environment, the risk of taking losses after having committed financing but before distributing the loan/debt rises. Banks can avoid near-term losses by holding onto loans, but at a cost of increased concentration risk. The bank’s $3.8 billion in commitments represent only 0.9% of assets but 34% of net tangible common equity.

• Royal Bank is exposed to headline risk as it is a more active participant in the U.S. than its peers. The bank has $1.1 billion in U.S. subprime RMBS and CDOs, a manageable amount relative to the bank’s asset base but nonetheless a sign of potential negative headlines if that market witnesses further deterioration.

• BMO manages two Structured Investment Vehicles in the UK, with assets totaling about $30 billion. Leverage in those conduits is about 10 to 1 (low by industry standards), there is essentially no exposure to U.S. subprime securities, and underlying assets are 100% investment grade, 88% of which are AA or better. Both conduits are self-funding at this time, and the bank's financial exposure appears limited to a $76 million equity interest and letters of credit and commitments to extend credit of $184 million (as at October 31, 2006). Unlike the asset backed commercial paper market, liquidity backstop lines are limited in the SIV market. The bank's risk is therefore more reputational if the SIVs face funding (or credit) issues, although the structure of the assets in the two SIVs (no U.S. sub prime) and use of leverage (which can be as high as 70 times) appears conservative compared to more aggressive structures.

Key earnings drivers of last five years likely to weaken

We believe that banks’ EPS growth is set to slow. The Canadian banks have had an excellent track record of earnings growth since the credit cycle of the early part of this decade, growing EPS at double-digit rates as a group since then. The major drivers have been: strong retail loan growth, declining provisions for credit losses, the positive impact of very strong equity markets on wealth management businesses and capital markets revenues that were fueled by high liquidity (some of which came from added leverage).

As we look out over the next two years, it is difficult to anticipate those earnings growth contributors being as strong

TD is our favourite bank stock

Our investment ratings are unchanged from our view going into the quarter:

• We have an Outperform rating on TD. Domestic retail momentum and higher earnings from the U.S. (driven by cost synergies at TD Ameritrade, and by higher ownership of TD Banknorth) should drive above-average retail earnings growth for TD. We also believe that there is less downside risk to our earnings forecasts for TD than for the industry as the bank is less exposed to wholesale earnings, and appears to have a more conservative mix of businesses within its wholesale division. TD trades at 11.8x 2008E EPS, compared to a group median of 11.5x.

• We have an Outperform rating on CIBC shares because of (1) the potential for further material increases in dividends; (2) lower exposure to wholesale income and deteriorating business credit quality; (3) tight expense management, which leaves room for upside earnings surprises in our view; and (4) our expectations for improved retail revenue growth. Exposure to U.S. sub-prime securities is a risk if there is further deterioration in that market. CIBC trades at 10.9x 2008E EPS, compared to a group median of 11.5x.

• We believe that Royal Bank’s stock is attractive given: (1) leading, and rapidly growing retail banking and wealth management franchises; (2) a more diversified capital markets business, which should lead to lower volatility in revenue and earnings than some of the other Canadian banks' investment dealers; and (3) A superior outlook for near-term revenue growth, driven by a 15% increase in risk weighted assets in the last twelve months, a result of organic growth and acquisitions. Royal Bank trades at 11.8x 2008E EPS, compared to a group median of 11.5x.

• We have a Sector Perform rating on Scotiabank. We believe that the bank has above-average medium- and long-term growth prospects compared to its peers due to its presence in Latin America and the Caribbean. Near-term revenue growth should also benefit from a 16% increase in risk weighted assets in the last 12 months. We are concerned, however, that bank's 0.5x P/E premium could narrow because (1) the high Canadian dollar hurts the bank more than its peers; (2) rising risk aversion could affect the multiple paid on earnings from emerging markets; and (3) we believe that net income for Scotiabank's key Mexican division may disappoint in the near term. Scotiabank trades at 12.0x 2008E EPS, compared to a group median of 11.5x.

• We continue to believe that Bank of Montreal's stock is likely to underperform those of Canadian peers. (1) We believe that BMO will struggle to bring its domestic retail revenue growth up to the industry's leading banks at the same time as it embarks on cost cutting initiatives; (2) We expect slower dividend and earnings growth; and (3) The bank derives a higher proportion of earnings from wholesale banking. To be clear, our Underperform argument is relative; our 12-month target price of $69 is 6% higher than the current stock price, and the stock's dividend yield is 4.3%. Bank of Montreal trades at 11.2x 2008E EPS, compared to a group median of 11.5x.

• We rate National Bank’s shares as Underperform. The bank trades at the lowest multiple of the 6 Canadian banks but (1) we expect slower retail earnings growth; (2) there is significant uncertainty related to the ultimate outcome of the bank's ABCP-related challenges; and (3) the bank is has greater reliance on wholesale markets as a percentage of total income. The two major risks to our rating would be (1) a rapid and favourable resolution to ABCP challenges; and/or (2) improving relative retail revenue and earnings growth. In both cases, a clarity is unlikely in the near term. National Bank trades at 9.7x 2008E EPS, compared to a group median of 11.5x.