30 November 2007

TD Bank Q4 2007 Earnings

RBC Capital Markets, 30 November 2007

Domestic retail bank earnings growing faster than peers who have reported so far

Domestic retail banking net income was 5% below our expectations, but was still up 14% from Q4/06. Revenues were up a strong 10% but expenses rose more than we expected primarily because of costs related to preparing for longer branch hours that started on November 1st.

• Volume growth was a key driver of revenue growth, with real-estate secured loans growing 11%, consumer loans growing 8%, and business loans up 9%.

• Market share slipped in real-estate secured loans and personal deposits, although the bank claims that the personal deposit share losses have come in the less profitable term segment.

• Net interest income margins were down 4 basis points to 3.03% sequentially and versus Q4/06. We believe this is a very good achievement given the compressed Prime/BA spread in the quarter, competitive pricing conditions in deposits and rising wholesale funding costs (which would affect TD's retail business less than others' since it is fully funded by retail deposits).

• Efficiency improvements are unlikely to be as strong in 2008. Revenue growth is likely to remain strong in upcoming quarters, but expense growth is likely to increase as the bank extends opening hours and continues opening branches (500 new people were added in Q4/07, mostly in branches and call centers).

• The loan loss increase of $44 million versus Q4/06 to $176 million was higher than we expected.

• Unsecured lending volume growth is responsible for part of the increase, and pains typical of introducing new scoring methodologies as well as rapid growth are also affecting TD.

• We believe that loan losses will rise in central Canada in commercial lending given the high Canadian dollar and energy prices, and a potentially weaker U.S. consumer.

US retail banking earnings ahead of our expectations

TD Banknorth's earnings were 8% higher than we expected due to good expense control, in spite of the challenging environment in the U.S. banking industry.

• Loan loss provisions were in line with Q3/07 and Q2/07, and up $20 million from Q4/06 due to higher impaired loans, which is mostly due to a slowdown in the residential real-estate construction market.

• The loan losses are vulnerable to further weakening in the economy, in our view.

• Revenues were up 7% versus Q4/06 in U.S. dollars on higher fees and a stable net interest income margin (although interest recoveries probably masked underlying margin pressure).

• Expenses were down from US$263 million in Q4/06 to US$253 million, and efficiency improved from 61.5% to 55.4%.

• Staff reductions related to improved business processes and branch closings led to the improvement.

Other highlights

• Wholesale earnings were up 8% versus Q4/06, and decreased 38% from the exceptionally strong Q3/07.

• The division was not hit by large writeoffs as was the case for many peers, but it nonetheless was negatively impacted by the turbulence in credit markets as trading revenues of $219 million were well down from $308 million in Q3/07.

• New disclosure on financial assets was provided. Level 3 assets represent only 4% of common equity, a very low figure compared to U.S. financial institutions that have reported so far. This validates management's claims that it has focused its trading strategies on transparent businesses.

• TD Ameritrade's earnings contribution of $75 million net of $10 million in adjustments that are included in the corporate segment were in line with the pre-released amount, up 42% versus Q4/06.

• We believe that the announcement of a cash infusion into E*TRADE Financial Corp by Citadel Investment Group lessens the likelihood of a transaction between TD Ameritrade and E*TRADE in the near term.

• TD noted that its brokerage customer acquisitions in both Canada and the U.S. benefited from E*TRADE's well publicized banking struggles.

• Wealth management earnings of $119 million were close to our estimates, and up 25% versus Q4/06. Equity markets are an important driver of future revenue growth, as are continued strong mutual fund net sales and increases in financial advisors.

• Impaired loans were slightly below Q2/07 and Q3/07 levels, on both a gross and net basis.

• There was no new information on the proposed acquisition of Commerce Bancorp, other than the transaction may close slightly earlier than anticipated. The proxy statement and prospectus should be mailed to Commerce shareholders in December, and management hopes the transaction will close in February or March 2008, subject to Commerce shareholders' approval, and approvals from U.S. and Canadian regulators.


Our 12-month price target of $82 is a combination of our sum of the parts and price to book methodologies. It implies an approximate forward multiple of 12.2x earnings, compared to the 5-year average forward multiple of 12.2x. Our P/B target of 2.2x in 12 months is at the low end of the bank sector given a lower ROE. Our sum of the parts target of 14.3x 2008E earnings is higher than our target industry average, reflecting a superior domestic retail franchise and lower exposure to low multiple wholesale businesses.
Scotia Capital, 30 November 2007

Q4/07 Earnings Increase 17% - High Quality

• Toronto-Dominion Bank (TD) reported a 17% increase in operating earnings to $1.40 per share versus $1.20 a year earlier, in line with expectations.

• Fourth quarter earnings were high quality with lower reliance on security gains aided by large unrealized surplus and the lowest net impaired formations in five quarters. Cash ROE was 19.4% versus 18.1% a year earlier. Return on RWA was 2.65%.

• Earnings were driven by strong results from TDCT and Wealth Management and sequential improvement from TD Banknorth and solid results from Wholesale Banking.

• For TD to be able to generate the level of earnings and profitability in the difficult capital market environment clearly differentiates the bank's balance sheet and operating platforms.

• Reported earnings were $1.50 per share which included $0.19 per share gain from the VISA restructuring, $0.05 per share general loan loss provision release and $0.13 per share amortization of intangibles.

• Fiscal 2007 earnings increased 23% to $5.74 per share from $4.65 per share a year earlier. Return on equity for fiscal 2007 was very strong at 20.6% with RRWA of 2.84%.

Low Balance Sheet Risk

• Balance sheet risk is the lowest of the Canadian banks with no direct exposure to sub-prime, no Non Bank ABCP, no bank sponsored SIV and nominal LBO exposure.

Strong Results From All Business Lines

• Earnings growth was led by wealth management at 31%, domestic wealth up 24% and TD Ameritrade up 42%. TDCT earnings growth remained strong at 14% with wholesale earnings growth very solid at 8% despite a difficult capital market environment.

Impressive Operating Leverage - Revenue Growth 7%

• TD’s operating leverage was impressive in Q4 at 5%, with revenue growth of 7% and expense growth of 2%.

TDCT Earnings Up 14%

• TD Canada Trust (TDCT) earnings increased 14% to $572 million, primarily due to volume growth in real estate secured lending, credit cards, and deposits.

• Canadian retail net interest margin (NIM) declined 4 basis points (bp) sequentially and 4 bp YOY.

• Market share in personal deposits and personal loans declined 56 bp and 10 bp respectively over the past year.

• Loan securitization revenue declined slightly to $80 million from $97 million a year earlier and $86 million in the previous quarter. Insurance revenue increased to $243 million from $214 million a year earlier. Card service revenue was relatively flat at $120 million versus $119 million in the previous quarter and $113 million a year earlier.

• Operating leverage was very strong at 6.2% with revenues increasing 10.5% and expenses increasing 4.3%.

• The efficiency ratio was 51.8% versus 50.0% in the previous quarter and 54.8% a year earlier.

• Loan loss provisions increased to $176 million from $151 million in the previous quarter and from $132 million a year earlier, due to VISA and higher loan growth.

Total Wealth Management Earnings Up 31%

• Wealth Management earnings, including TD Ameritrade, increased 31% YOY to $194 million.

• Domestic Wealth Management increased 25% YOY. TD Ameritrade earnings contribution increased 42% to $75 million or $0.10 per share representing 7% of TD earnings.

• Operating leverage in Q4 was strong at 3.6%, with revenue increasing 15.3% and expenses increasing 11.8%.

• Mutual fund revenue increased 25% to $225 million from $180 million a year earlier.

• Mutual fund assets under management (IFIC, includes PI C assets) increased 15% to $60.1 billion.

• Wealth Management earnings for fiscal 2007 increased 29% to $762 million from $590 million in 2006.

TD Ameritrade – Earnings Increase 42%

• TD Ameritrade contributed $75 million or $0.10 per share to earnings in the quarter versus $59 million or $0.08 per share in the previous quarter and $53 million or $0.07 per share a year earlier. TD Ameritrade’s contribution represented 7.3% of total bank earnings. TD Banknorth Earnings Improve Sequentially

• TD Banknorth earnings increased 14% sequentially to $124 million or $0.17 per share, representing 12% of TD earnings. This compares to an earnings contribution of C$63 million or $0.09 per share a year earlier before the privatization.

• Net interest margin at TD Banknorth increased 14 bp from the previous quarter but declined 1 bp from a year earlier to 4.00%. The flat yield curve and strong competitive pressure continues to put pressure on the margin.

U.S. Platform Total Earnings - 19% of Bank

• TD Ameritrade and TD Banknorth contributed 7% and 12% of bank earnings in the quarter for a total of 19%.

Wholesale Banking Earnings Increase 8%

• Wholesale banking earnings increased 8% to $157 million from $146 million a year earlier although a decline from the $253 million record high in Q3/07.

• Revenue growth was solid at 6.5%, with expenses declining 6.5%. Operating leverage was strong at 13%.

• Wholesale Banking earnings in fiscal 2007 increased 24% to $824 million from $664 million a year earlier.

Capital Markets Revenue Solid

• Capital markets revenue was $349 million versus $398 million in the previous quarter and $335 million a year earlier.

• Trading revenue was solid at $219 million versus $308 million in the previous quarter and $174 million a year earlier.

• Trading revenue was driven by equity and equity derivatives which increased to $187 million from $75 million a year earlier. Trading revenue in foreign exchange products improved to $101 million from $54 million a year earlier. Interest rate and credit portfolios’ trading revenue was a loss of $69 million versus a gain of $77 million in the previous quarter and $45 million a year earlier.

• Fiscal 2007 trading revenue increased 10% to $1,146 million versus $1,042 million in 2006.

Lower Security Gains

• Security gains declined to $60 million or $0.05 per share (excluding VISA gain) from $98 million or $0.08 per share in the previous quarter and $87 million or $0.08 per share a year earlier.

Unrealized Surplus - $1.2 Billion

• Unrealized security surplus increased 22% to $1,236 million from $1,010 million from the previous quarter due to gains in the merchant banking portfolio.

Loan Loss Provisions

• Specific loan loss provisions increased to $199 million or 0.43% of loans (excluding $60 million in general loan loss provision release) versus $171 million or 0.37% of loans in the previous quarter and $142 million or 0.33% of loans a year earlier.

• Loan loss provisions for fiscal 2007 were $705 million or 0.38% of loans versus $424 million or 0.25% of loans in fiscal 2006.

• We are increasing our 2008 LLP estimate to $850 million or 0.44% of loans from $750 million or 0.40% of loans to reflect the Commerce Bancorp acquisition and higher loan volume growth. We are introducing our 2009 LLP estimate at $1 billion or 0.50% of loans.

Net Loan Formations Lowest in Five Quarters

• New gross impaired loan formations were stable at $387 million versus $375 million in the previous quarter and $326 million a year earlier.

• Net impaired loan formations declined to $199 million, the lowest level in five quarters, versus $209 million in the previous quarter but decreased from $233 million a year earlier.

• In fiscal 2007 net impaired loan formations increased to $954 million from $710 million in 2006. Gross impaired loan formations increased to $1,592 million in 2007 versus $1,082 million in 2006.

Securitization Activity Moderate

• During the quarter, TD securitized $1.5 billion in assets versus $2.2 billion in Q3 and $4.9 billion a year earlier. At year-end, TD had $28.3 billion in securitized assets outstanding.

• The economic impact before tax of securitization this quarter was $4 million versus a loss of $4 million in the previous quarter and a gain of $25 million a year earlier.

Tier 1 Capital High at 10.3%

• Tier 1 capital ratio increased to 10.3% from 10.2% in the previous quarter but declined from 12.0% a year earlier, primarily due to the privatization of TD Banknorth.

• Risk-weighted assets increased 7.5% from a year earlier to $152.5 billion, with market at risk declining 2.7% to $3.0 billion.

Exposure to High Risk Assets

• TD has no exposure to U.S. sub-prime mortgages, third party asset-backed commercial paper or TD Sponsored SIVs and nominal LBO exposure. Level three securities account for less than 1% of assets. The bank has no direct lending exposure to hedge funds and nominal trading exposure.

Recent Events

• On October 2, 2007, TD announced its intention to acquire Commerce Bancorp for US$8.5 billion or US$42 per share, a modest 5.7% premium from the previous day’s close. The transaction will be 75% stock and 25% cash for a fixed exchange ratio of 0.4142 TD shares and US$10.50 per share. According to TD management, the transaction price represents 22.5x 2008E earnings, 2.96x tangible book value, and a 13.5% core deposit premium. TD anticipates US$310 million pre-tax in synergies, representing a post-synergy multiple of 13.8x 2008E earnings. The transaction is expected to close in March or April 2008.


• Our 2008 earnings estimate remains unchanged at $6.30 per share. We are introducing our 2009 earnings estimated at $7.00 per share.

• We are increasing our 12-month share price target to $100 from $90 based on continued expected relative P/E multiple expansion based on balance sheet, business mix and growth prospects.

• We reiterate our 1-Sector Outperform rating of shares of TD based on strong high-quality earnings momentum, high relative profitability, growth potential from TD Banknorth and TD Ameritrade, and attractive valuation (slight P/E discount to the bank group versus our expected 10% to 15% premium).
Financial Post, Jonathan Ratner, 30 November 2007

Even after their recent gains, the 3.7% yield on Canadian bank stocks is the highest since 1996, according to UBS strategist George Vasic. Even more impressive is the fact that their dividend yields are approaching the long bond yield for the first time since the late 1950s.

“Are prospects that bleak or are banks poised for a further bounce?” he asked clients in a note. For Mr. Vasic, the answer is clear. He thinks investors should boost their exposure to the banks, even if they are from the more pessimistic camp.

Yes, bank yields have been higher in the past, peaking at roughly 10% in the early 1980s. But relative to bond yields, they were not as attractive as they are now, the strategist said.
The Globe and Mail, Andrew Willis, 29 November 2007

It appears Ed Clark has been watching Goldman Sachs’s approach to investment banking, and likes what he sees.

Buried in a set of terrific financial results from Toronto-Dominion Bank Thursday, including a 24 per cent jump in TD Securities’ profit to $824-million, was a line about where the CEO is pointing the bank in the coming year.

TD Securities, said Mr. Clark, is expected to remain a top-three player in the domestic market. That’s been the mission statement for some time. But there was also the following line: The dealer is “seeking opportunities to grow proprietary trading in scalable and liquid markets.”

That’s the Goldman Sachs approach. The most profitable dealer on Wall Street obtained that status in part by being deft with its own capital, playing credit and equity markets as a principal, not just as an agent for its customers.

TD Securities has been heading down this same road for some time. In John O’Sullivan and his team, the dealer has one of the best proprietary equity desks on the Street. However, a decision to expand these operations would have interesting implications for TD Bank’s stock.

Goldman Sachs makes its biggest scores in derivative and fixed income markets, and that’s where TD Securities would be forced to bulk up if the dealer adopts the mantra of pushing into “scalable and liquid markets.”

However, for all the money that Goldman Sachs makes, and all the bonuses that its employees take home, the market takes a dim view of the quality of the dealer’s earnings. Goldman Sachs boasts a relatively weak price to earnings multiple, because investors think there’s a risk that the profits can’t be maintained. TD, on the other hand, commands a premium multiple because the bulk of its profits come off dependable retail banking operations.

The fearless prediction here is that Mr. Clark will welcome every additional dollar of profit that TD Securities can squeeze out of proprietary trading. The dealer is going to be a fun place to work, as it will expand its trading operations.

But Mr. Clark is not going to start risking big chunks of TD capital behind the dealer, or start showing trading earnings that overshadow the incredible stream of cash pouring out that of the branch network, which posted a $2.6-billion profit in 2007 on both sides of the border.

The head of TD Bank is also a major shareholder. He’s going to do everything in his power to ensure the bank continues to command a premium valuation.
The Globe and Mail, Tara Perkins, 29 November 2007

Toronto-Dominion Bank reported fourth quarter profit of $1.094-billion on Thursday, up from $762-million a year ago, and managed to churn out rising earnings in its investment banking division despite the credit crunch.

TD's earnings per share came in at $1.40 for the three months ended Oct. 31, up 17 per cent from the same period a year earlier, and on par with what analysts had been expecting for this quarter.

TD was the only big Canadian bank not to pre-announce any writedowns related to the credit crunch. It did previously announce that it would book a $135-million after tax gain on its shares in Visa, which is preparing to go public.

“A strong fourth quarter financial performance wrapped up a tremendous 2007,” stated chief executive Ed Clark, who wasn't shy about noting that TD managed to avoid many of the pitfalls that caught its peers as the credit crunch unfolded.

“In a year of turbulent markets, clearly the successful altering of our risk-reward profile was a significant advantage for us,” he stated.

“This year was also defined by the investments we made to expand our U.S. platform, and we're excited about growing as a leading North American financial institution,” he added. Last month, TD unveiled plans for an $8.5-billion (U.S) takeover of New Jersey's Commerce Bancorp which Mr. Clark has said will make TD “the first North American bank.”

The deal will double TD's U.S. banking business, and result in the bank having about 2,000 branches in North America.

“The success of our Canadian franchise has had a lot to do with our ability to pursue U.S. expansion,” Mr. Clark stated.

“We're tremendously excited about how this acquisition is set to transform our organization into a North American powerhouse.”

TD Canada Trust, the bank's core Canadian consumer banking division, saw earnings rise 14 per cent from a year ago to $572-million, as it opened 38 new branches across the country. Volumes grew in real-estate secured lending, credit cards and deposits, it said.

TD suggested that stiff competition in the Canadian market is crimping bank profits, as many banks attempt to lure customers by bumping up the rates they offer on savings accounts. “Escalating competition in high-yield saving deposit accounts continued to put pressure on margins,” the bank said.

It added that “the outlook for revenue growth is expected to moderate in 2008 as volume growth slows in the credit cards business and margins continue to be vulnerable to volatility in the credit markets.” Volatility in credit markets since August has impacted margins on banking products that are based on the prime rate.

Meanwhile, TD's U.S. bank, TD Banknorth, saw its profits rise 97 per cent to $124-million in the fourth quarter thanks to the privatization of the division which TD completed in April.

“TD Banknorth's results exceeded expectations in the quarter despite the strengthening of the Canadian dollar,” Mr. Clark stated. “While we expect the U.S. operating environment to remain challenging next year, we're pleased with TD Banknorth's steady progress towards meeting its organic growth objectives.”

TD's wholesale or investment banking division managed to squeeze out profit gains of eight per cent for the quarter, despite the credit crunch. The division earned $157-million as foreign exchange, fixed income and equity trading businesses contributed earnings that more than offset weak credit trading results, the bank said.

“Although trading results were mixed in the fourth quarter, our transparent risk-reward oriented business helped TD avoid the major pitfalls of recent market turmoil,” Mr. Clark stated.

The bank said that “increased volatility and reduced liquidity in the capital markets experienced in the fourth quarter is expected to continue into 2008 and may result in reduced levels of capital markets activity, but it may also present additional trading opportunities.”

Finally, TD's wealth management division, which includes its stake in online brokerage TD Ameritrade, saw earnings rise 31 per cent from a year ago to $194-million.
Financial Post, Duncan Mavin, 29 November 2007

Toronto-Dominion Bank chief executive Ed Clark trumpeted his bank's avoidance of credit-crunch write-downs on Thursday and also delivered a statement of intent about the bank's U.S. growth plans.

TD is the only one of Canada's big six banks that has not announced a big credit-market write-down. The other banks have announced combined charges of about $2-billion.

Mr. Clark -- who announced the bank's profits in the fourth quarter were $1.1-billion, up 44% from $762-million last year -- said the bank was benefiting from a decision to stay away from the types of business that have been the source of the write-downs elsewhere.

"Our outperformance did not happen by accident," Mr. Clark said.

"Our philosophy guided us to avoid third-party asset-backed paper, to ensure we have no exposure to U.S. subprime lending and to exit the structured-product business. These decisions cost us income at the time. But as a result we have no write-downs this quarter."

Mr. Clark also said the bank's 2007 was "defined" by investments in U.S. retail banking, stressing TD's plans to grow throughout North America.

The TD chief started 2007 saying the bank would consolidate, not expand its U.S. operations. But TD increased its stake in Portland, Me.-based TD Banknorth from 57% to 100% for $3.2-billion in April. Then in October, TD announced it had agreed to buy New Jersey-based Commerce Bancorp for US$8.5-billion, an acquisition that executives say gives the bank "critical mass" in the United States.

Profits at TD's U.S. retail-banking platform almost doubled in the fourth quarter, up 97% to $124-million, largely reflecting the Banknorth privatization.

TD Ameritrade -- the U.S. discount broker in which TD owns an approximate 40% stake -- has also been the focus of speculation about a possible merger deal with rival broker E*Trade in recent months. Joe Moglia, Ameritrade CEO, says his company has held talks with other firms about a transaction.

Questions about a deal cropped up again yesterday when E*Trade disclosed it is getting a US$2.5-billion capital infusion from a group led by Citadel Investment Group.

E*Trade also said its CEO, Mitchell Caplan, has stepped down and revealed Citadel is buying E-Trade's entire US$3-billion asset-backed securities portfolio for the bargain-basement price of $800-million in cash. Some observers have said E*Trade's exposure to the credit crunch, partly through its holdings of ABCP, was an obstacle to getting TD's Mr. Clark on side for a merger of Ameritrade and E*Trade.

Robert Ellis, senior analyst with Boston-based consultancy Celent LLC, said ruling out a quick sale of E*Trade forced by Citadel would be foolish, though he also said an E*Trade deal with Charles Schwab or Bank of America might be more likely than a deal with Ameritrade.

On the TD earnings call, Mr. Clark anticipated questions about Citadel's investment in E*Trade, saying, "Obviously I'm not going to comment on another company's business decisions, but we have backed TD Ameritrade's consistent position that it will make acquisitions that make sense for shareholders."

"Ameritrade has no need to do an acquisition but it does remain open to opportunities," he said.

Elsewhere, TD's domestic retail-banking operations produced earnings of $572-million in the fourth quarter, up from $501-million in 2006.

"Fat profit margins and above-average returns on equity are generated on a consistent basis," said Morningstar analyst Chris Blumas in a note before the bank announced its results. "TD's domestic banking operation is a gold mine."

Revenue at the domestic retail bank jumped $204-million, or 10%, compared with last year, mainly due to volume growth, particularly in real-estate secured lending, credit cards and deposits, the bank said.

The bank also benefited from a pre-tax gain of $163-million relating to its part in the restructuring of Visa Inc.

Mr. Clark sounded a note of caution, however, saying that a slowdown in the Canadian and U.S. economies could limit growth next year.
Bloomberg, Sean B. Pasternak and Doug Alexander, 29 November 2007

Toronto-Dominion Bank said fourth quarter profit topped analysts' estimates on gains from its U.S. consumer bank.

Toronto-Dominion, Canada's third-largest bank, said profit for the period ended Oct. 31 rose 44 percent to C$1.09 billion ($1.09 billion), or C$1.50 a share.

Unlike National Bank and other Canadian lenders, Toronto-Dominion has avoided writedowns by eschewing investments in asset-backed securities.

``TD is not too involved in risky lending; National is further up on the risk curve,'' said John Stephenson, who helps manage the equivalent of about $1.62 billion as a portfolio manager at First Asset Investment Management Inc. in Toronto, including Toronto-Dominion shares.

Shares of Toronto-Dominion climbed C$1.42, or 2 percent, to C$71.80 at 4:10 p.m. on the Toronto Stock Exchange, capping the biggest three-day gain in five years.

Toronto-Dominion posted its biggest profit increase in five quarters as earnings from its Portland, Maine-based TD Banknorth unit almost doubled to C$124 million. Toronto-Dominion bought the 41 percent stake it didn't already own in TD Banknorth in April.

Toronto-Dominion in October agreed to buy Cherry Hill, New Jersey-based Commerce Bancorp Inc. for about $8.5 billion, which will double its U.S. business, adding almost 460 outlets and $48 billion in assets across nine states. The deal, expected to close in April, marks the biggest foreign takeover by a Canadian bank.

``They are paying a lot for the acquisition, but it looks like a growth bank and it looks like its assets-per-branch are superior to the industry average,'' said Jackee Pratt, who helps manage about $712 million at Mavrix Fund Management in Toronto, including Toronto-Dominion shares.

The bank expects to earn about C$1 billion from its U.S. consumer and brokerage businesses next year, Chief Executive Edmund Clark told investors today on a conference call. He reiterated a previous forecast of 7 percent to 10 percent overall earnings growth for 2008.

Toronto-Dominion's fourth-quarter results were also boosted by a C$135 million gain tied to the restructuring of Visa Inc. Excluding one-time items, the bank earned C$1.40 a share.

The bank was expected to earn C$1.36 a share excluding one- time items, according to the median estimate of six analysts surveyed by Bloomberg News. Brad Smith, an analyst at Blackmont Capital Inc., was expecting C$1.23 a share, according to a Nov. 26 research note.

Toronto-Dominion's profit from Canadian consumer banking climbed 14 percent to C$572 million, bolstered by real-estate lending, credit cards and deposits. Asset management, which includes the bank's stake in TD Ameritrade Holding Corp., climbed 31 percent to C$194 million, as trading volume offset a decline in discount brokerage commissions.

Investment-banking profit increased 8 percent to C$157 million because of an increase in equity and foreign exchange trading services.

The bank's TD Securities unit is ``not built on short-term gains or risky strategies that paid off,'' Clark said, referring to writedowns at other Canadian banks this quarter.

Toronto-Dominion's business ``is continually shifting more to a retail, lower-risk defensive type of earnings mix, which in my mind is a positive especially given the circumstances that we're in right now,'' said Craig Fehr, an analyst at Edward Jones & Co. in St. Louis, who rates Toronto-Dominion a ``buy'' and doesn't own the stock.
Financial Post, 29 November 2007

Fourth quarter operating earnings of $1.40 per share at Toronto-Dominion Bank compared to $1.20 in the same period a year earlier. The results beat Blackmont Capital’s forecast by 5¢ and the consensus by 2¢. Revenue of $3.6-billion meanwhile, was in line with the firm’s estimate.

Analyst Brad Smith, who maintained his “hold” recommendation and $77 price target on TD shares following the news, said the bank’s domestic result were steady (earnings up 14% year-over-year) and revenue growth came in at 10%.

“Market share in domestic personal loans and deposits continued to erode as did small business lending share,” Mr. Smith told clients in a note.

National Bank Q4 2007 Earnings

Scotia Capital, 30 November 2007

Q4/07 Earnings - Low Quality - Dividend Increase

• National Bank of Canada (NA) reported a modest 2% increase in fourth quarter cash operating earnings (excluding ABCP related write-downs and other charges) to $1.34 per share driven by strong trading revenue (highest in four years and second highest in history) and security gain of $0.13 per share offset partially by weak retail earnings growth.

• Fiscal 2007 operating earnings increased 12% to $5.65 (excluding ABCP write-downs) from $5.05 per share in fiscal 2006.

• Return on equity for the quarter was 18.4% versus 19.7% a year earlier. Return on riskweighted assets was 1.66%, down from 1.78% a year earlier.

• Reported earnings were a loss of $1.14 per share including $2.48 per share in charges. Charges included a $2.41 per share write-down related to ABCP, a $0.03 per share restructuring charge of Altamira's activities, and $0.04 per share charge for the impairment in value of an intangible asset.

• Earnings were driven by Wealth Management and Financial Markets growth of 27% and 19%, respectively with retail earnings growth weak at 5%. Revenue growth was negligible due mainly to lower net interest margin.

Dividend Increased 3%

• In a very positive development NA kept the Canadian Bank group's four to five year track record of dividend increases every second quarter intact. NA increased its dividend a modest 3.3% to $2.48 per share from $2.40 per share.

Personal & Commercial Banking Earnings Weak

• P&C Banking earnings growth was weak increasing a modest 5% to $111 million excluding a gain on securities from insurance activities in the prior year. Including the gain, earnings declined 4%.

• Revenue growth in retail was very weak at 1% due to a 20 bp decline in net interest margin which offset 7% loan growth. Retail expense growth was controlled at 2% although outpacing revenue growth.

• NA experienced growth in personal loans and deposits of 9% and 3%, respectively.

Commercial deposits increased 9% with commercial loans increasing 2%.

• Fiscal 2007 P&C Banking earnings increased 7% (excluding securities gain) to $466 million from $447 million a year earlier. Including the gain, earnings increased a modest 4%.

Retail NIM declines 20 basis points

• Retail net interest margin (NIM) was 2.71% in Q4, down 20 basis points (bp) from a year earlier and 7 bp sequentially. The increase in BA's spreads cost the bank approximately $25 million or $0.10 per share this quarter. Excluding this market impact on net interest margin, retail earnings growth would have been 10%.

Wealth Management - Earnings Growth 27%

• Wealth Management earnings increased 27% to $38 million, attributable to growth in mutual fund and private investment management (PIM) revenue. Mutual fund revenue increased 16% to $39 million.

• Wealth Management revenue growth was 2.8%, with expenses declining 2.5% for positive operating leverage of 5.3%.

• Mutual Fund assets increased a modest 4% to $11.8 billion from $11.3 billion a year earlier.

• Wealth Management earnings increased 16% in fiscal 2007 to $164 million from $141 million in fiscal 2006.

Financial Markets Earnings increase 19%

• Financial Markets Q4 earnings increased 19% to $93 million (excluding ABCP write-down), driven by 15% increase in revenue with expenses increasing 7% for strong operating leverage of 8%. Including the ABCP write-down, Financial Markets earnings declined 3%.

• In fiscal 2007, Financial Markets earnings increased 20% to $371 million from $308 million a year earlier.

Trading Revenue Highest Since Q4/03

•Trading revenue was strong at $121 million versus $90 million in the previous quarter and $118 million a year earlier, the highest level since Q4/03 and the second highest in history. Equities trading revenue was solid at $62 million versus $56 million in the previous quarter and $53 million a year earlier. Trading revenue represented 11.5% of total revenue.

•Trading revenue in fiscal 2007 increased 20% to $438 million versus $364 million in fiscal 2006.

Capital Markets Revenue

• Capital Markets revenue declined to $136 million from $165 million in the previous quarter and $168 million a year earlier due to lower M&A activity and the sale of the U.S. advisory practice.

• In fiscal 2007, Capital Markets revenue increased 3% to $647 million from $629 million a year earlier.

Security Gains Represent 10% Earnings

• Security gains remain relatively high at $33 million or $0.13 per share (excluding ABCP write-down) in the quarter, representing 10% of earnings versus $43 million or $0.18 per share, representing 12% of earnings in the previous quarter. Security gains a year earlier were $50 million or $0.20 per share representing 15% of earnings.

Unrealized Security Surplus $148 Million

• Total unrealized security surplus was $148 million versus $206 million in the previous quarter and $126 million a year earlier. Equity securities surplus increasedyear over year to $161 million versus $252 million in the previous quarter and $129 million a year earlier.

Operating Leverage Low

• Operating leverage in Q4 was low at 0.4%, with revenue declining 0.1% and non-interest expenses declining 0.5%.

Loan Loss Provisions Increase Modestly

• Specific loan loss provisions (LLPs) increased 28% on a very low base to $29 million or 0.22% of loans, versus $22 million or 0.17% of loans in the previous quarter and $23 million or 0.18% of loans a year earlier.

• LLPs for fiscal 2007 were $103 million or 0.20% of loans versus $77 million or 0.15% of loans in fiscal 2006.

• We are increasing our 2008 LLP estimate to $130 million or 0.24% of loans from $120 million or 0.22% of loans. We are introducing our 2009 LLP estimate at $150 million or 0.27% of loans.

• Gross impaired loans (GILs) were $249 million in the quarter (mostly in commercial loans) versus $236 million in the previous quarter. Net impaired loans (NILs) were negative $179 million versus $198 million in the previous quarter.

• Impaired loan formations in the quarter were $45 million versus $18 million in the previous quarter and $40 million a year earlier.

Tier 1 - 9.0%

• Tier 1 ratio declined slightly to 9.0% from 9.4% in the previous quarter and from 9.9% a year earlier primarily due to the write-down in ABCP. Risk-weighted assets increased 4.3% to $49.3 billion, with market at risk assets increasing 24% to $3.6 billion.

• Book value declined 1% YOY to $26.85 per share.

Exposure to High Risk Assets

• NA has $588 million of bank sponsored ABCP with liquidity support on balance sheet although the backstop liquidity facilities are not significant. This ABCP has no exposure to U.S. sub-prime mortgages and is not levered. The bank also has $1.7 billion in non-bank ABCP on balance sheet purchased from its mutual funds and retail clients in August 2007. Approximately 10% or $170 million of these holdings have exposure to U.S. sub-prime mortgages. Other than the ABCP holdings the bank does not have any additional level three assets.

• Hedge fund trading and lending exposure is fully collateralized and there are no credit issues with counterparties. The bank has no exposure to Structured Investment Vehicles (SIVs) and no LBO exposure.

Share Buyback Activity

• In fiscal 2007, NA repurchased five million shares at an average price of $62.94 per share. The bank repurchased 264,000 shares in the quarter prior to the ABCP debaucle.


• Our 2008 earnings estimate is unchanged at $6.10 per share. We are introducing our 2009 earnings estimate at $6.60 per share.

• Our 12-month share price target on NA shares is unchanged at $75, representing 12.3x our 2008 earnings estimate and 11.4x our 2009 earnings estimate.

• NA is rated a 2-Sector Perform as P/E multiple discount reflects lower profitability and capital ratios, higher earnings reliance on wholesale, particularly trading and security gains, and low retail banking geographic diversification (concentration in Quebec).

28 November 2007

BMO Q4 2007 Earnings

RBC Capital Markets, 28 November 2007

Investment Opinion

• Q4/07 core cash EPS of $1.38 were between our expectations of $1.40 and consensus estimates of $1.35, and were up 4% versus Q4/06.

• GAAP EPS were $0.50 lower than core EPS primarily because of large items negatively impacting capital markets and corporate results by $251 million after tax. Those items are operating events, in our view, but we exclude them because their magnitude is such that growth in 2008 would be overstated if we included them in core results.

• Management's 2008 GAAP EPS objective translates into approximately $5.85 to $6.10 on a cash EPS basis. Our 2008E EPS of $5.80 is unchanged.

• Capitalization was stronger than we expected, with the Tier 1 ratio at 9.5% as approximately $10 billion in Canadian residential mortgages were removed from the balance sheet during the quarter.

• Credit trends were not as favourable as in recent quarters, as provisions for credit losses and impaired loan formations both rose, and the bank added to its general reserves.

• Domestic retail earnings were not as high as expected due to net interest income margin pressure, offsetting a better quarter from the U.S. division on expense management.

We expect better risk-adjusted returns from peers' stocks

• We maintain our Underperform rating. We expect BMO's stock to continue trading at a discount to its Canadian banking peers on weaker retail banking growth, more exposure to low multiple wholesale earnings, and more exposure to potential calls on liquidity if the financial services system sees more liquidity contraction. The bank's stock currently trades at 10.0x NTM earnings, compared to the bank peer median of 10.7x

• If the economy remains healthy in 2008 and the U.S. financial services system does not go into a crisis, we would expect the Canadian bank stocks (including BMO) to provide attractive upside, but we do not expect the share price appreciation to occur in the near term given the capital markets and credit overhang in U.S. financial markets. The banks' median forward P/E multiple of 10.7x NTM is below the five year median of 12.4x, which we believe reflects the potential for near term negative earnings surprises and slower earnings growth in 2008.
Scotia Capital, 28 November 2007


• Bank of Montreal (BMO) reported an 8% increase in Q4/07 cash operating earnings to $1.44 per share, better than expected due to tax recoveries and security gains. ROE was very solid at 19.9%.

• Reported cash earnings were $0.89 per share including $0.55 per share in charges and write-downs.

What It Means

• Operating earnings growth (before write-downs) was led by BMO Capital Markets and Private Client Group with P&C Canada earnings growth modest at 4% and credit quality deterioration modest.

• The bank provided additional disclosure on SIVs.

• Tier 1 Capital remains strong at 9.5%.

• Our 2008 earnings estimate remains unchanged at $6.00 per share. We are introducing our 2009 earnings estimate at $6.50 per share. We maintain our 3-Sector Underperform rating on BMO based on expected lower earnings growth, low return on equity versus the bank group, earnings mix (too wholesale reliant) and absence of significant growth opportunities.
Financial Post, Jonathan Ratner, 28 November 2007

There’s a new “lightning rod” at Bank of Montreal, says Credit Suisse analyst Jim Bantis.

The natural gas trading scandal that broke earlier this year and which has cost the bank $860-million has more or less run its course. But concerns about the commodities debacle have been replaced by fears over the bank’s exposure to structured investment vehicles (SIVs).

“Given the uncertainty in the credit markets and ongoing concerns surrounding liquidity for SIVs in particular, multiple expansion is limited near term,” Mr. Bantis notes. “BMO’s current valuation discount of 9.7 times our 2008 earnings per share estimate (compared to peers of 10.7 times) is warranted at this time.”

BMO’s losses on SIVs are just $15-million to date. The bank, which reported its fourth quarter results on November 27, has decided to make available up to US$1.6-billion in senior debt to support its SIVs, which are faced with challenges because of the global credit crunch. Management says the SIVs are backed by high quality assets, and recent asset sales from the SIVs did not come at a big discount.

Mr. Bantis also notes problems in BMO’s domestic retail bank. Despite a record set of annual earnings for Canadian operations, the performance of BMO’s domestic retail franchise dipped in the fourth quarter, with market share losses in personal deposits and residential mortgages.

“Canadian retail banking results took a step back reporting their lowest net earnings for the year at $286 million, well below the trailing four quarter run rate of $312 million,” Mr. Bantis said.

Credit Suisse has a neutral rating on the bank and a $68 target price.
Financial Post, Jonathan Ratner, 28 November 2007

Blackmont Capital analyst Brad Smith reiterated his “buy” rating and $72 price target on shares of Bank of Montreal after encouraging fourth quarter results.

Operating cash earnings per share (EPS) came in at $1.36 compared to $1.33 in the same period a year ealier. While this number was below Blackmont’s forecast of $1.40, it beat the Street consensus by 2¢, Mr. Smith told clients in a note.

He also noted that BMO’s guidance range for 2008 EPS at 10% to 15% exceeded his existing target of 8.1%.

While exposure to asset-backed commercial paper (ABCP) and structured investment vehicles (SIVs) continues to pose a risk for BMO and many other global financial institutions, the Canadian bank’s comments on this exposure reinforced Mr. Smith’s opinion that the downside risk has already been priced-in by the market.
The Globe and Mail, Tara Perkins, 27 November 2007

A downturn in capital markets took a big bite out of Bank of Montreal's latest quarterly profit, but the bank beat market expectations by posting a record year in its domestic consumer banking operations.

The bank, whose stock had been most-battered by the recent credit crunch, kicked off the year-end earnings season yesterday by reporting annual profit of $2.1-billion.

The figure was down 20 per cent from the previous year due to a battery of writedowns that collectively sliced profit by $787-million, after taxes, but still managed to beat earnings forecasts.

“Looking back on the challenges of the last nine months, I take great confidence in the resiliency of our businesses,” chief executive officer Bill Downe said on a conference call. “Charges which related to capital markets, commodities, restructuring and an increase in our general allowance clearly weighed heavily on our reported results in 2007, and despite these conditions we earned a return of 14.4 per cent.”

The market reacted by sending BMO's shares up nearly 5 per cent. The bank made a profit of $1.42 a share, beating Thomson First Call analysts' expectation of $1.35.

Canadian bank stocks were up across the board yesterday, a phenomenon that Edward Jones analyst Craig Fehr attributed to the strength in BMO's retail, or consumer, operations. That's “encouraging to me, because one of the things I'm going to be looking at this quarter, and in quarters to come, is how well banks can flip the switch,” he said. “Capital markets revenues have been driving earnings for some time now. My expectation is that capital markets as a source of earnings are going to slow materially going forward,” he said.

“I think that the market is looking now to say ‘who has got the more defensive retail earnings that we can rely on going forward?' So you see that TD and [Bank of Nova] Scotia are up a little bit more than their peers,” he added.

John Aiken, an analyst at Dundee Capital Markets, said the core earnings momentum demonstrated by BMO in the fourth quarter bodes well for 2008.

It wasn't all roses for the bank's domestic banking division, though. RBC Dominion Securities analyst André-Philippe Hardy points out that spreads dropped to 2.96 per cent in the three months ended Oct. 31 from 3.08 per cent in the previous quarter. The bank attributed that to heightened competition and rising funding costs.

BMO is also still struggling to persuade its customers to park more cash in their accounts. The bank has been using the lure of Air Miles and other incentives in an attempt to increase its personal deposits, an effort that it said “continues to prove challenging.”

Despite the hurdles, profit from the domestic banking division rose 4.2 per cent from a year ago to hit $284-million in the quarter. That compares with a 74-per-cent drop in earnings from the capital markets division, which contributed $48-million.

The quarter was challenging for many investment banks as concerns over asset quality affected liquidity, credit spreads and valuations, the bank noted.

“Activity levels were down from the first three quarters of the year in most product areas.”

Mr. Downe said that “the environment in which [BMO Nesbitt Burns] operates will continue to be unsettled at least for the first half of 2008.” He expects the second half of the year to be stronger than the first.

This past quarter's earnings were walloped by a slew of one-time charges, many of which stem from the credit crunch that's been rippling through financial markets since mid-August.

The items, which had been announced ahead of the quarterly report, include a pretax hit of $169-million because of trading, structured credit-related positions and preferred shares; $134-million related to asset-backed commercial paper; and $15-million related to two structured investment vehicles (SIVs), Links Finance Corp. and Parkland Finance Corp.

BMO wrote down its holdings in some bank-sponsored commercial paper conduits (an $80-million charge), and in third-party ABCP (a $54-million charge) by 15 per cent.

The bank said it is in discussions with a number of counterparties about restructuring its bank-sponsored conduit.

As for the SIVs, BMO disclosed earlier this month that it would participate in the senior debt of the two vehicles up to a maximum of about $1.6-billion. Yesterday it said that it has bought about $1.25-billion of senior notes thus far.

BMO also said that it would take a $25-million writedown on its continuing effort to reduce its commodities portfolio, which has been a thorn in its side since the bank revealed this spring that it would record hundreds of millions of dollars in losses, relating mostly to its natural gas trading operations.

While the bank was unable to meet most of its financial targets during fiscal 2007 due to writedowns, it raised its target for share profit growth for next year to between 10 and 15 per cent from 5 to 10 per cent this past year.

“In our view, the biggest positive in BMO's fourth quarter reporting was its guidance for 2008,” Mr. Aiken wrote.

“BMO, typically known as a conservative bank, particularly when it comes to guidance, is providing for targets that are well above current consensus growth estimates for 2008,” he said. “Consequently, we believe that a more positive outlook for the banks may begin to be priced into their valuations in the near term, particularly if we receive similar targets/guidance from the other banks.”
Dow Jones Newswires, Monica Gutschi, 27 November 2007

Bank of Montreal said Tuesday it is unlikely to follow HSBC Holdings PLC's lead and take the assets held in the two structured investment vehicles it sponsors onto its balance sheet.

"We're not at the present time going through the process" of examining such a move, Bank of Montreal's chief executive, Bill Downe, said on a conference call. He noted the two BMO-sponsored SIVs have a "different universe of assets," among other factors.

Downe noted the assets held in BMO's SIVs are of high quality and said the bank's decision to provide liquidity through the purchase of senior notes "will assist the SIVs in restructuring."

As reported, HSBC became the first bank to bail out its SIVs, announcing it plans to gradually shut them down and take $45 billion in mortgage-backed securities and other assets owned by the funds onto its own balance sheet.

Bank of Montreal sponsors two SIVs - Links Finance Corp. and Parkland Finance Corp. - and had agreed to provide up to $1.6 billion in liquidity support to the vehicles.

It noted in its fourth-quarter earnings report that it has purchased $1.3 billion in the senior notes in order to provide liquidity. Other investors have also provided $1.1 billion in liquidity through the purchase of senior notes.

As well, bank executives said a large number of the assets held in the SIVs have been sold into the market at a relatively small discount. Links now has an asset market value of $18.7 billion, down by $4.0 billion, while Parkland has a value of EUR2.5 billion, down by EUR820 million since late August.

Bob McGlashan, BMO's chief risk officer, noted that no securitization has been downgraded by any ratings agency. He said the weighted average rating on the assets is AA. There is minimal exposure to U.S. subprime mortgages in Links and none in Parklands.

SIVs are structured financial products created to provide investment oportunities in customized, diversified debt portfolios. SIVs have been in trouble since the summer, when the markets for short-term debt, on which SIVs depended, all but dried up. After a brief revival, those markets have deteriorated further in recent weeks.

However, Yvan Bourdeau, head of BMO Capital Markets, said each SIV "has to come up with their own plan for a resolution. We feel that our plan is the proper one."

He also said that, if BMO were to take the SIVs onto its balance sheet, there would be minimal implications for the bank's capital.

In the fourth quarter, the bank took a C$15 million charge for its investment in the capital notes in Links and Parkland, reducing the book value of its capital notes to C$53 million.
Financial Post, Jonathan Ratner, 27 November 2007

Shares of Bank of Montreal traded up on Tuesday morning as investors breathed a sigh of relief after the company kicked of earnings season for the Canadian banks. BMO reported a 20% profit decline in 2007 on credit crunch-related charges. Fourth quarter profits fell 35% to $452-million compared to the same period last year, while full year earnings dipped $532-million to $2.1-billion.

Dundee Securities analyst John Aiken said the fourth quarter results look very solid and BMO’s core earnings momentum bodes well for 2008.

“In our view, the biggest positive in BMO’s fourth quarter reporting was its guidance for 2008,” he said in a note to clients, adding that the bank expects earnings per share growth of 10% to 15%. This was higher than Dundee was expecting, forecasting 10% as a high for all of the Big Six banks. Mr. Aiken expects this will provide positive support for BMO shares, but also the entire group.

“BMO, typically known as a conservative bank, particularly when it comes to guidance, is providing for targets that are well above current consensus growth estimates for 2008,” he said. “Consequently, we believe that a more positive outlook for the banks may begin to be priced into their valuations in the near term, particularly if we receive similar targets/guidance from the other banks.”

Mr. Aiken continues to rate BMO at “market outperform” with a $68 price target.
Financial Post, Duncan Mavin, 26 November 2007

The Canadian banking industry will see a slump in earnings growth in 2008, but the impact will not be enough to force a change to stable ratings outlooks, says Lidia Parfeniuk, an analyst at Standard & Poor’s. With plenty of capital, the banks could even step up their M&A activity in the U.S.

“S&P expects the Canadian banks’ well-capitalized positions to remain unchanged for their risks,” Ms. Parfeniuk says. “The more aggressive M&A activity south of the border should continue as the banks take advantage of the strong Canadian dollar and lower bank stock valuations.”

Despite the strong fundamentals though, earnings could suffer in the current tough banking environment. Revenue will be hit by a decline in capital markets activity resulting from the credit crunch, while loan loss provisions could start to climb, Ms. Parfeniuk says.

“For 2008, our baseline assumption is that revenue growth will slow from the high teens in 2007,” she says.

S&P also forecasts the banks will record further marked-to-market writedowns related to structured products linked to the U.S. subprime mortgage market and non-bank sponsored asset-backed commercial paper in Canada.
Financial Post, John Greenwood, 26 November 2007

Among the numerous commentators holding forth on the mess in asset backed commercial paper (ABCP), there are optimists and pessimists. Then there is Citigroup analyst Shannon Cowherd.

On Monday, Ms. Cowherd published a report predicting that Canada’s big banks could be in line for write downs of a whopping $14-billion as a result of potential losses from their own ABCP.

The market for third-party ABCP seized up in early August after investors started fleeing from exposure to the U.S. subprime mortgage crisis, which came mainly in the form of collateralized debt obligations (CDOs).

The larger bank-sponsored market has continued to function, partly because investors believe the quality of the paper is stronger. But Ms. Cowherd says that’s not the case. Bank-sponsored ABCP is headed for a cliff, and the banks will be on the hook for the losses, she warns.

However, before jumping to any conclusions, let’s look at her argument.

Ms. Cowherd assumes that because Canada’s third-party ABCP is made up of more than 76% of CDOs, the bank sponsored notes must contain a similar proportion. Pegging the total value of the bank-sponsored market at about $100-billion, she estimates there is about $63.8-billion of CDO’s in it. That’s a big number, but observers say it’s wrong.

“This doesn’t sound right at all,” said one analyst who asked not to be named. “The Canadian banks were a whole lot more conservative in their attitude to CDOs”

So what is the real level of CDOs in bank-sponsored ABCP? According to the rating agency DBRS, Ms. Cowherd is way off the mark. In a report that came out in August, DBRS calculated that bank-sponsored ABCP contained only about 9% CDOs. Moreover, it’s restricted to a handful of conduits and clearly identified in information provided to investors.

Ms. Cowherd was not available for comment.

24 November 2007

Rising Rates to Worsen Subprime Mess

The Wall Street Journal, Ruth Simon, 24 November 2007

The subprime mortgage crisis is poised to get much worse.

Next year, interest rates are set to rise -- or "reset" -- on $362 billion worth of adjustable-rate subprime mortgages, according to data calculated by Bank of America Corp.

While many accounts portray resetting rates as the big factor behind the surge in home-loan defaults and foreclosures this year, that isn't quite the case. Many of the subprime mortgages that have driven up the default rate went bad in their first year or so, well before their interest rate had a chance to go higher. Some of these mortgages went to speculators who planned to flip their houses, others to borrowers who had stretched too far to make their payments, and still others had some element of fraud.

Now the real crest of the reset wave is coming, and that promises more pain for borrowers, lenders and Wall Street. Already, many subprime lenders, who focused on people with poor credit, have gone bust. Big banks and investors who made subprime loans or bought securities backed by them are reporting billions of dollars in losses.

The reset peak will likely add to political pressure to help borrowers who can't afford to pay the higher interest rates. The housing slowdown is emerging as an issue in both the presidential and congressional races for 2008, and the Bush administration is pushing lenders to loosen terms and keep people from losing their homes.

Banc of America Securities, a unit of the big Charlotte, N.C., bank, estimates that $85 billion in subprime mortgages are resetting during the current quarter, and the same amount will reset in the first quarter of 2008. That will rise to a peak of $101 billion in the second quarter. The estimates include loans packaged into securities and held in bank portfolios.

Larry Litton Jr., chief executive of Litton Loan Servicing, says resetting of adjustable-rate mortgages, or ARMs, has recently emerged as a bigger driver of defaults. "The initial wave was largely driven by a higher frequency of fraudulent loans...and loose underwriting," says Mr. Litton, whose company services 340,000 loans nationwide. "A much larger percentage of the defaults we're seeing right now are the result of ARM resets."

More than half of the subprime delinquencies and foreclosures this year involved loans that hadn't yet reset, and thus were due to factors such as weak underwriting and falling home prices, according to Rod Dubitsky, an analyst with Credit Suisse.

The majority of subprime ARMs due to reset next year are so-called 2-28 loans, which carry a fixed rate for two years, then adjust annually thereafter. In a speech earlier this month, Federal Reserve Governor Randall Kroszner explained how a typical 2-28 subprime loan issued in early 2007 might work. He said the interest rate on the loan would start at 7%, then jump to 9.5% after two years. For a typical borrower, that would add $350 to the monthly payment.

Besides the $362 billion of subprime ARMs that are scheduled to reset during 2008, $152 billion of other loans with adjustable rates are set to reset, according to Banc of America Securities. The other resetting loans include "jumbo" mortgages of more than $417,000 and Alt-A loans, a category between prime and subprime. The latter category is the riskier, in part because it includes borrowers who provided little or no documentation of their income or assets.

The number of borrowers facing higher payments isn't growing merely because the amount of loans with resets is higher. Another factor is that those with a looming reset now have a tougher time sidestepping it by refinancing or selling their home. "There is a large amount of borrowers who are in products that either no longer exist or that they no longer qualify for," says Banc of America Securities analyst Robert Lacoursiere.

Falling home prices mean that many borrowers have little or no equity in their home, making it tougher for them to get out from under their loans.

Treasury Secretary Henry Paulson and the chairman of the Federal Deposit Insurance Corp., Sheila Bair, have been pressing lenders to modify terms in a sweeping way, rather than going through a time-consuming case-by-case evaluation that could end up pushing many people into foreclosure. Officials at the Federal Reserve and in the Bush administration have estimated that 150,000 mortgages are resetting a month.

Ms. Bair has proposed that mortgage companies freeze the interest rates on some two million mortgages at the rate before the reset to help borrowers avoid trouble. "Keep it at the starter rate," Ms. Bair said at conference last month. "Convert it into a fixed rate. Make it permanent. And get on with it."

Picking up on that theme, California Governor Arnold Schwarzenegger in the past week announced an agreement with four major loan servicers, including Countrywide Financial Corp., the nation's biggest mortgage lender, to freeze the interest rates on certain ARMs that are resetting. The freeze would be temporary, rather than for the life of the loan. The program is aimed at borrowers who are living in their homes and making their mortgage payments on time, but aren't expected to be able to make the higher payments after reset.

The mortgage industry opposes a blanket move to modify loans that are resetting, says Doug Duncan, chief economist of the Mortgage Bankers Association. While modification may make sense in some cases, he says, it may also simply postpone the inevitable or reward borrowers who didn't manage their finances wisely. Mr. Duncan says the industry is working with government officials and consumer groups to develop principles that could be used to determine quickly who qualifies for a modified loan.

The political efforts are aimed at keeping the U.S. economy out of a housing-triggered recession. The Mortgage Bankers Association estimates that 1.35 million homes will enter the foreclosure process this year and another 1.44 million in 2008, up from 705,000 in 2005.

The projected supply of foreclosed homes is equal to about 45% of existing home sales and could add four months to the supply of existing homes, says Dale Westhoff, a senior managing director at Bear Stearns. This is a "fundamental shift" in the housing supply, says Mr. Westhoff, who believes that home prices will drop further as lenders "mark to market" repossessed homes.

Foreclosed homes typically sell at a discount of 20% to 25% compared to the sale of an owner-occupied home, analysts say. Lenders are eager to unload the properties, and the homes tend to be in poorer condition.

"People didn't leave the house happily," says Jason Bosch, a broker with Home Center Realty in Norco, Calif. "There are often signs of that. There's used, dirty carpet. The grass is dead." Mr. Bosch says he now has about 120 bank-owned properties for sale or in escrow compared with none a year ago.

Federal Reserve Chairman Ben Bernanke told Congress earlier this month, "A sharp increase in foreclosed properties for sale could...weaken the already struggling housing market and thus, potentially, the broader economy."

The big concern is a vicious cycle in which foreclosures push down home prices, making it more difficult for borrowers to refinance and causing more defaults and foreclosures.

Real-estate agents, who look at prices for comparable homes, or comps, say the sale of bank-owned properties can have a big impact. "One month the comps are showing one price and then a bank comes in and sells a property for $30,000 less," says Randal Gibson, a real-estate agent in Henderson, Nev. "All of the sudden, that's the new comp. It hurts everyone in the neighborhood."
The Wall Street Journal, Kemba J. Dunham & Ruth Simon, 24 November 2007

For people hoping to refinance a home, it should be good news: Yields on U.S. Treasury securities are falling -- which translates into lower mortgage interest rates.

However, the upside of refinancing might not be as great as some expect, due to continuing turmoil in the housing market. Some borrowers could find the savings aren't as great as they expected -- or that they are being shut out of refinancing entirely, as lenders tighten their standards.

For weeks, yields on the 10-year Treasury notes have been moving lower. They fell to 4.02% on Wednesday and slipped to 4.01% on Friday, a new low since September 2005 -- and meaning they are low enough that mortgage rates are also starting to come down.

Despite the industry's problems, some lenders are trumpeting the news of lower rates to entice borrowers to consider refinancing.

Lenders, reeling from rising defaults and foreclosures of home loans, are being stricter about lending. They are also asking for higher "risk premiums," (the amount above Treasury rates that borrowers have to pay to compensate for the risk that the loan won't be completely repaid) even from the best borrowers.

"There's no question that risk premiums have widened," says Doug Duncan, chief economist of the Mortgage Bankers Association. As mortgage losses have climbed and the credit markets have dried up, so has this premium.

For example, interest rates on conforming 30-year fixed-rate mortgages dropped slightly in the past week to an average of 6.26%, according to HSH Associates, a publisher of consumer-loan information based in Pompton Plains, N.J. That is down from a recent high of 6.76% in mid-July, or 0.5 percentage point.

But Treasury rates have fallen further. The "spread," or gap, between 10-year Treasurys and 30-year fixed-rate mortgages has widened substantially, to 2.22 percentage points now from just 1.52 percentage points in June, according to HSH.

This explains why refinancing isn't delivering the savings that some homeowners had hoped for.

"I would have expected...rates to be better than they are," says Steven Walsh, a mortgage broker in Scottsdale, Ariz. Mr. Walsh says that some of his borrowers have called him looking to refinance and take advantage of lower rates, but are going away empty-handed.

In other cases, borrowers who want to refinance are being stymied by tighter lending standards, particularly in markets where home prices are declining and lenders are becoming particularly cautious about appraisals.

For the week ended Nov.16, the refinance share of mortgage activity increased to 50.3% of total applications from 50.2% the previous week, according to the Mortgage Bankers Association.

Borrowers with good credit and, if refinancing, a chunk of equity in their homes are best positioned to benefit. "To be a successful refinancer in this marketplace, you have to be much more of a traditional kind of borrower," says Keith Gumbinger, a mortgage analyst with HSH Associates. "You need to have some equity in your home. You need to be documenting your income or assets. You need to have reasonable or good credit."

Martin Quijada, an architect from Gilbert, Ariz., who has perfect credit, has been looking to refinance his mortgage loan recently. But two banks with good rates wouldn't sign off on the appraisal, says Mr. Walsh, his broker. Another bank agreed that the appraisal was fine but had "terrible rates," Mr. Walsh said.

"I was expecting a much simpler process," says Mr. Quijada, who plans to hold out for now, in hopes of getting a better rate later.

But Mr. Walsh warns that, even if rates drop further, Mr. Quijada will still have to deal with the appraisal issue.

Many borrowers with good credit have been running into such roadblocks recently. According to the Federal Reserve's Senior Loan Officer survey from October, 40% of the U.S. respondents reported that they have tightened their lending standards on prime mortgages, compared with only 15% that reported having done so in the July survey.

Borrowers with good credit can benefit from the lower interest rates, says Mr. Duncan of the Mortgage Bankers Association, "but if you're in a market where property values are falling, it may not make much of a difference." It is a particular problem if the loan balance is greater than the home's current value.

The news is mixed for borrowers seeking "jumbo" mortgages. These are the loans that exceed the $417,000 limit for those eligible for purchase and guarantee by mortgage institutions Fannie Mae and Freddie Mac.

On the one hand, rates on 30-year fixed-rate jumbo mortgages have dipped below 6.97%, according to HSH Associates, after reaching as much as 7.46% in August. But that is still well above the 6.60% average for these loans in early June, when the credit market was less jittery and the gap between conforming and jumbo loans was narrower.

For individuals looking to borrow or refinance, shopping around is particularly important in the current environment. For instance, Mr. Gumbinger says, banks or credit unions that hold onto the mortgages they issue -- as opposed to selling them on to other investors in the form of mortgage securities -- may now offer better rates because they aren't dependent on securitization and thus may have more capital available for lending.

"You can't make the assumption that the loan price at lender A is the most competitive price in the marketplace," he says. "There's a wide variety of prices."

Melissa Cohn, a New York mortgage broker, tells her clients who wish to refinance in the next three to six months to move quickly. "Lender guidelines will continue to get more stringent in the next few months before they ease up again," she says.

23 November 2007

Preview of Banks Q4 2007 Earnings

Financial Post, Jonathan Ratner, 23 November 2007

2008 is shaping up to be a year of slower growth in terms of both income and revenue, as well as for dividends at Canada’s banks. Why? The cost of credit is expected to go up, while its availability falls.

That’s the opinion of Desjardins Securities analyst Michael Goldberg, who nonetheless sees share prices for the Big Six banks rising anywhere from 8% to 27% during the next 12 months.

In a preview of their fourth quarter earnings that kick off with Bank of Montreal on Tuesday, he highlighted the banks’ weak performance in the period from August to October. While they rose 3.9%, the S&P/TSX composite index gained 5.5% and TSX-listed lifecos increased 10.1%.

So while some may think Canadian bank stocks have reached bargain prices, Mr. Goldberg warns that current uncertainty could persist, which will hold back their performance.

“Overall, we see this as an investment banking meltdown, not a commercial banking meltdown,” he said.

He cited structured credit concerns in the U.S. and liquidity in the Canadian asset-backed commercial paper (ABCP) market as the primary sources of continued volatility.

He is particularly concerned about National Bank given that it has the most capital market exposure – at 2.5 times the leverage of other majors banks – to ABCP.

Mr. Goldberg considers BMO’s relative risk to be much lower than National’s, although above the other banks.

Each of the six banks have made pre-announcements recently and the are viewed as having plenty of flexibility when it comes to determining their loss provisions.

“They can also choose when to realize investment gains, or not to,” the analyst said, adding that this can be unpredictable and do not reflect ongoing earnings power.

Mr. Goldberg prefers to monitor operating profit trends. Based on these figures, with pre-announecments excluded, he expects the best year-over-year growth from Toronto-Dominion Bank, BMO and Bank of Nova Scotia.

On a quarterly basis, he anticipates modest gains from everyone except National and TD.

And what about dividends?

Mr. Goldberg only expects a boost from Scotiabank, noting that every bank but National hiked their dividends last quarter.

While National may be due, he thinks it is unlikely given their recent $365-million ABCP markdown.

Finally, the analyst said he expects lifecos will continue to outperform banks in the short and medium term.

Mr. Goldberg rates BMO, CIBC, National and Royal Bank at “hold” with price targets of $72.50, $108, $56 and $61.50, respectively. He rates both Scotiabank and TD “top pick” with price targets of $60 and $84, respectively.
Financial Post, Jonathan Ratner, 23 November 2007

As investors fear the broader economic fallout and impact on global banks from subprime-related problems, they’ve caused double-digit declines from their 2007 highs recently for shares of Canada’s banks. But the damage pales in comparison to the U.S. Regional Bank Index, which had losses of roughly 26%, equivalent to twice the size of declines for its Canadian counterpart.

So with writedowns on risk exposure, trading portfolio losses, balance sheet issues and the rising Canadian dollar cited as just a few of the key issues for the fourth quarter, management actions are also being closely monitored.

What are they saying?

“Think long-term, this crisis will pass,” says Credit Suisse’s Jim Bantis. While acknowledging that we are still in the midst of a restructuring of the global credit markets, the analyst sees an opportunity in Canadian bank stocks.

Mr. Bantis notes that they are trading at levels well below historical averages, compressing by 2 points to 11 times trailing earnings in recent weeks. However,he doesn’t expect them to fall to the 10x level reached during the Russian debt and Long-Term Capital Management crises.

So why does he like Canada’s banks?

Solid earnings and dividend growth are forecasted for 2008. He also expects lower relative exposure to underlying credit problems, as well as positive domestic retail banking trends.

As for dividends, Mr. Bantis expects Scotiabank will boost its payout by 7% to 10%. Meanwhile, he thinks National will stay put given its ABCP woes.

The analyst rates BMO at “neutral” with a $73 price target and forecasts earnings per share of $1.45 for Q4. Scotiabank gets the same recommendation with a $58 price target (EPS expected at $1.03), as does CIBC at $112 ($2.02) and National Bank at $66 ($1.39).

Royal Bank is rated “outperform” with a $65 price target ($1.05), as is Toronto-Dominion Bank at $82 ($1.40).
Financial Post, Jonathan Ratner, 23 November 2007

While Canadian banks pre-announced roughly $2-billion in credit-related charges for the fourth quarter (TD did not), thus providing some useful insight into their exposure, structured credit products and potential losses at the banks will surely remain on investors’ radar next year.

Citigroup analyst Shannon Cowherd is expecting earnings to fall short in the quarter compared to the same period in 2006.

Given her estimates that indicate the size of the reported impact on the banks’ securities is in the range of 1% to 14%, Ms. Cowherd thinks those numbers are too low. She points to Merrill Lynch & Co. as an example of a company with similar assets and its estimate rate of 45%.

Applying charges of that magnitude to Canada’s banks, she suggests another wave of charges ranging from $1.5-billion to $15.3-billion could result.

“As we see it, National would be near the low end of such a range and Royal at the high,” Ms. Cowherd said.

She also pointed out that while Toronto-Dominion Bank escaped the structured residential mortgage fallout, its $10-billion of non-residential mortage holdings is the largest among the Big Six.

The analyst considers Bank of Montreal, CIBC and Royal Bank the most likely candidates to report further markdowns.

She estimates that provisions for loan losses should double in the fourth quarter, primarily as a result of more “liquidity” loans coming onto bank balance sheets.

Ms. Cowherd rates BMO a “buy” with a $77 price target, Scotiabank a “buy” with a $64 price target, and CIBC a “buy” with a $121 price target.

She has a “hold” on each of National, Royal Bank and TD, with price targets of $57, $58 and $75, respectively.
The Globe and Mail, Angela Barnes, 23 November 2007

Could the mess in the U.S. housing markets and its spillover into U.S. financials set off the third major banking crisis in the United States since the Great Depression? Myles Zyblock, chief institutional strategist at RBC Dominion Securities Inc., thinks the answer is yes and that it is likely already starting.

And while he doesn't expect bank failures in the United States will be the main problem this time around, as they were in the 1930s and the 1980s, he won't rule out the "possibility of a few sinking ships."

Not surprisingly then, he is not recommending investors step up to the plate and buy the U.S. banks, even though U.S. bank stocks have dropped more than 20 per cent this year. He said in a report yesterday that he feels that valuations on those stocks still don't reflect the severity of the situation.

"In past crises, banks have traded down to book value on an absolute basis and to 0.4 times book on a relative basis," he said. They stand well above that - at about 1.5 times book on an absolute basis and 0.53 times on a relative basis.

In arguing his point about the likelihood of a major banking crisis, Mr. Zyblock trots out some disturbing statistics on the U.S. housing market and the fallout on the financials. He noted, for example, that more than 20 per cent of the value of U.S. mortgage loans made in 2005 and 2006 is linked directly to subprime situations, and another 19 per cent is linked to alt-A loan situations. Both are types of loans made to those who don't qualify for prime mortgages.

And it is those loans that are running into trouble, as evidenced by the fact that 16 per cent of subprime mortgages are now past due. To make things worse, problems are starting to rise in the prime mortgage space as well as in the face of what he says is the worst case of national price deflation in the U.S. housing market in at least 40 years. And inventories of unsold houses are nearing multidecade highs with foreclosures adding to the supply.

Mr. Zyblock believes that the worst is probably still to come in terms of bank writedowns arising out of the real estate situation. But he noted that while profitability in the banking industry is under pressure, it still isn't as bad as it was in the early 1990s.

He added that he would not be surprised to see some sort of government intervention in the situation. There is a precedent for that. In 1989, the U.S. Federal Deposit Insurance Corp. set up the Resolution Trust Corp. to manage and sell failed savings and loans associations.

But while Mr. Zyblock suggests investors pass on the beaten-up U.S. banks others feel now is the time to buy.

Tobias Levkovich, chief U.S. equity strategist at Citigroup Global Markets Inc., upgraded U.S. banks to overweight from market weight last week, on the basis of what he calls "compelling valuation, depressed earnings revision data and awful investor sentiment." Moreover, he said, "dividend yields have climbed to near previous peaks, which have been associated with stock price lows in the past."

And billionaire investor Warren Buffett obviously feels there is value to be had in the U.S. financials. His Berkshire Hathaway Inc. recently raised its stake in U.S. Bancorp and Wells Fargo & Co., according to the Sept. 30 regulatory filings.

Mr. Zyblock also referred to the Canadian banks, noting that since 1942, they have traded down in more than half the years that the U.S. banks declined. "That said, TSX banks should outperform their U.S. peers as we work our way through this problem," he said.
Scotia Capital, 21 November 2007

Banks Begin Reporting Highly Anticipated Fourth Quarter Results

• Canadian Banks have pre-announced over the past few weeks write-downs for the fourth quarter of $2.2 billion or $1.4 billion after-tax as well as credit card gains of $1.0 billion after-tax essentially offsetting the write-downs from the liquidity and credit crunch.

• Banks begin reporting their much-anticipated fourth quarter results on November 27. Bank of Montreal leads off (BMO) on November 27, followed by National Bank (NA) and Toronto-Dominion Bank (TD) on November 29, Royal Bank (RY) on November 30, Laurentian Bank (LB) on December 4, and Bank of Nova Scotia (BNS), Canadian Imperial Bank of Commerce (CM), and Canadian Western Bank (CWB) closing out reporting on December 6. Scotia Capital’s operating earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, reported earnings estimates in Exhibit 3, and conference call information in Exhibit 4.

• The write-downs announced by the Canadian Banks are very modest at only 1.5% of common equity and pale by comparison to a number of global players reflecting Canadian banks' low exposure to the high risk areas. Canadian Banks have the lowest relative exposure in history versus global players to high risk assets. Canadian Banks had more than their share of LDC loans in the early 1980's, excessive exposure to Commercial Real Estate (O&Y Canary Wharf) in early 1990's and Telco/Cable/Power in 2002. The banks have incredibly low exposure to U.S. sub-prime, CDOs and LBOs. The market has not differentiated much between Canadian Bank balance sheets and U.S. and other global players.

• The market's reaction has been severe (no differentiation) peeling off $38 billion in bank market capitalization or an excessive 27x the amount of the write-downs. Bank valuation has become extremely compelling with market being driven by sentiment and momentum. Individual bank relative P/E multiples have started to diverge following the debt markets.

• Conclusion: Major market overshoot on discounting balance sheet risk. Best Buying Opportunity in five Years. Reiterate Overweight. P/E Divergence favours RY and TD - 1 Sector Outperforms.

Fourth Quarter and Fiscal 2007 Earnings Estimates

• We are presenting our operating earnings estimates (Exhibit 1) for Q4/07 and 2007 excluding pre-announced write-downs and one time gains which is the method that the banks have gathered consensus numbers in Exhibit 2.

• We are also presenting the expected reported earnings (Exhibit 3) including all items and earnings (Exhibit 5) including the write downs as well as excluding the Visa/Master Card Gains.

• We expect bank operating earnings (excluding write-downs) to increase 9% YOY but decline 8% sequentially. TDand RY are expected to lead the industry with earnings growth of 17% and 7%, respectively. NA, BMO and CM earnings growth is expected to be much weaker at -1%, 3% and 4% respectively. Cash ROE for Q4/07 is expected to be 21.4% a modest decline from 23.3% in the previous quarter and 21.9% a year earlier. We are expecting operating earnings growth of 19% for fiscal 2007 earnings.

• However on a reported basis earnings (Exhibit 3) in the fourth quarter are expected to grow 1% YOY but decline 11% sequentially with ROE of 20.6%.

• If we view the commodity trading losses, CDO write-downs, ABCP write-downs and credit card reserve increases as operating and exclude the VISA gains as one-time, bank earnings (Exhibit 5) would be expected to decline 17% from a year earlier with a very resilient ROE of 16.1%. On this basis TD and RY are recording the strongest earnings momentum.

• The cloud over the banking sector is not likely to be completely removed with the release of fourth quarter earnings as liquidity and credit jitters may continue, and global peers that are on a calendar year-end will not have released year-end earnings and concerns about further deterioration in the U.S. housing and potential negative impacts to the overall economy persist. But we believe it will be positive in calming market fears and affirming the modest balance sheet and earnings impact on Canadian banks. In fact, Canadian banks have an opportunity over the next several years to expand their businesses both organically and via acquisitions given the high Canadian dollar, strong balance sheets, relatively sound valuations, and the financial weakness of many of their global competitors.

Bank Write-Downs - $1.4 Billion

• The banks have pre announced write-downs (Exhibit 6) for Q4/07 totalling $2.2 billion or $1.4 billion after-tax as well as VISA/MasterCard gains of $1.3 billion or $1.0 billion after tax.

• NA, BMO and CM announced the largest write-downs of $575 million or $2.31 per share, $530 million or $0.69 per share, and $463 million or $0.90 per share, respectively. RY write downs were $480 million or $0.19 per share and $190 million or $0.14 per share, respectively with TD not having announced any write-downs. Total write-downs of $1.4 billion after-tax represent 5% of the banks' $20 billion earnings base which we estimate is two weeks' worth of bank earnings.

• In terms of write down impact NA represented 8.1% of common equity, followed by CM at 2.7%, BMO 2.4% with RY nominal at 1.1%, and TD no impact.

Visa/Master Card Gain - $1.1 billion

• The bank group announced gains from the restructuring of VISA International and sale of Master Card holdings (Exhibit 7) totalling $1,254 million or $1,031 million after tax. CM and RY recorded the largest gains at $456 million and $325 million respectively. TD gains were $163 million with BMO selling shares in Master Card to realize $110 million.

Dividend Increases Expected Despite Financial Turmoil

• Canadian banks have established a pattern beginning in 2002 and 2003 of increasing their common dividends every second quarter. Banks have grown their dividends by 229% since the beginning of 2000. The bank that is due to increase its dividends this quarter is NA, with an expected increase of and 5%. However, NA may decide to defer the dividend increase due to its expected writedown of its non-bank ABCP portfolio. The bank group’s dividend payout ratio is 46% and 40% on our 2007 and 2008 earnings estimates, respectively. TD’s payout ratio on 2008E is a low of 36% with BMO at a high of 47%.

U.S. Commercial Real Estate – Slight Earnings Drag

• Loan loss provision increases are also expected from the Canadian banks’ U.S. banking operations over the next two years, particularly in the U.S. commercial real estate (CRE) loan portfolio. We estimate the Canadian banks (TD, RY, and BMO) have US$19 billion of U.S. CRE exposure, including US$7 billion in construction loans. On a pro forma basis, including Commerce Bancorp (CBH.N) and Alabama National BanCorporation (ALAB.O), the total U.S. CRE exposure increases to US$28.5 billion, including US$10.3 billion in construction loans. In terms of exposure, Alabama National is at risk of heightened supervision for having total CRE exposure (including construction) over 300% of common equity.

• Despite relatively high credit standards we believe that higher losses are likely from this portfolio over the next two or three years. The loss ratios on this portfolio could increase to as high as 1.0% on the non-construction portion of the CRE portfolio and 2.0% on the construction portion. Loss ratios on U.S. CRE in the early 1990s were in the 150 basis point (bp) range. We estimate that the three major Canadian banks – TD, RY, and BMO – have potential higher loan losses on this portfolio of $335 million, reducing earnings by 2%-3% over a three-year period. The loan losses on these portfolios may be less; however, we are attempting to quantify potential downside risk and believe these losses are very manageable. Commerce Bancorp and Alabama National could take higher loan loss provisions prior to the transactions closing, thus reducing future loan loss provisions post acquisition. In fact, Commerce Bancorp did increase its loan losses meaningfully in its Q3/07.

Canadian Banks – Lower Balance Sheet Risk

• We believe Canadian banks have lower balance sheet risk than most of their global peers. Canadian banks have no direct exposure to the U.S. sub-prime market, nominal to negligible exposure to CDOs, and minimal exposure to LBO loans.

• At present, asset quality in Canada has held up extremely well with the main problem centering on liquidity problems in the non-bank ABCP market. The level of capital in the banking system has improved immensely, with financial leverage and leverage to credit declining to historical lows while profitability is at record highs. Securitization utilization in Canada is modest at 10% of assets. Canadian banks’ investment holding of MBS/ABS (relatively high quality versus the U.S.) represents 2% of assets versus 12% in the U.S.

• Canadian bank exposure to problem loan areas pales today in comparison with past cycles. Problem loans relative to capital and earnings base are a fraction of what they have been historically. Bank exposure to LBOs, a current high-risk loan area, is very manageable, estimated at $7 billion against the $91 billion equity base and a $20 billion earnings base, which compares immensely favourably with the three major problem loan areas the banks have encountered over the past 25 years. This comprises Telco/Cable/Power/Power Generation in 2002, Commercial Real Estate in the early 1990s, and less developed countries (LDCs) in 1982. In addition to the low dollar exposure to LBOs, we believe Canadian banks have maintained higher underwriting standards.

Best Buying Opportunity in Five Years

• Fourth quarter earnings carry the greatest uncertainty of any bank quarterly earnings release since the fourth quarter of 2001. In the fourth quarter of 2001, banks doubled their loan loss provisions sequentially due to trouble in the Telecom/Cable industry, including such names as WorldCom, Teleglobe, Global Crossing, and Adelphia Communications. The uncertainty created by credit concerns in the Telecom industry spread to the Power/Power Generation industry, culminating in the Enron bankruptcy. The credit cloud that appeared over the banking sector did not clear until the fourth quarter of 2002 when the damage was fully tallied, with banks’ profitability holding up remarkably well with a 15% return on equity, the highest trough ROE in history on low financial leverage. The market rewarded bank stocks by expanding their P/E multiple from 11x trailing at the end of 2002 to 15x by 2004 on very rapidly rising earnings. Banks stocks appreciated 39% and 96% in the proceeding two and four years, respectively.

Bank Relative P/E Multiples Taking Cue from Debt Markets

• Bank P/E multiples have started to diverge after a period of abnormal P/E convergence. This trend is following the same pattern that has happened with the debt markets and corporate spreads. Just as the debt market was not differentiating for risk, bank P/E multiples were not reflecting differences in profitability, quality of earnings, business mix (retail versus wealth management versus wholesale) or growth prospects (including degree of reinvestment).

• The debt market is now discounting for risk as corporate spreads have blown out and we are now seeing bank P/E multiple divergence. Individual bank P/E differentials generally tend to mirror bond spreads over time and this cycle seems to be no different. We expect divergence in P/E multiples will favour Royal Bank and Toronto-Dominion based on the quality and size of their retail and wealth management (especially RY) platforms, relatively low earnings exposure to wholesale, high profitability and growth prospects.

Valuation - Extremely Compelling

• Bank valuation is extremely compelling. Bank dividend yield relative to bonds is 97% or 4.6 standard deviations above the mean and with dividend growth projected at double digit over the next five years this valuation is extraordinary.

• Bank dividend yield relative to the TSX is also at a record high except for the 1999/2000 peak caused by the major appreciation in Nortel's share price. Bank dividend yield is 2.2x that of the TSX.

• On a price earnings basis we believe we bottomed at 11.7x (LTM restated earnings) and look for major P/E expansion post the credit and liquidity crisis. Bank earnings need to be stressed tested in order to garner higher P/E multiples from the market.

Recommendation – Maintain Overweight

• We are optimistic that bank stocks will show market leadership as financial fears subside and certainty about risk levels improves. We remain overweight the bank group based on fundamentals, valuation, and the belief that central banks will be able to manage systemic risk. Maintain 1-Sector Outperform on TD and RY based on quality and size of their large retail and wealth management platforms and superior profitability. Maintain 2-Sector Perform on CIBC, CWB, and NA with 3-Sector Underperform on BMO and LB.

Fourth Quarter Highlights

• Bank of Montreal is expected to report operating earnings of $1.37 per share versus $1.33 per share a year earlier, an increase of 3% YOY and a decline of 8% sequentially. We are looking for reported earnings of $0.85 per share including pre-announced write-downs of $0.69 per share and a gain on MasterCard of $0.17 per share. BMO announced it will issue up to a maximum of $1.6 billion in senior debt in order to fund its SIVs. Canadian P&C and Wealth Management earnings should be relatively strong with Wholesale extremely weak due to trading losses, with U.S. P&C earnings continuing to underperform.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $2.10 per share, an increase of 4% YOY but a 14% decline from the record high Q3/07. Reported earnings are expected to be $2.34 per share including a $1.14 per share VISA gain and $0.90 per share write-down on CDOs. Revenue growth is expected to remain challenging. We expect cost reductions to continue to drive earnings.

• National Bank is expected to report operating earnings of $1.30 per share in the fourth quarter, a decline of 1% YOY and a 12% decline from the previous quarter. Reported earnings are expected to be a loss of $1.01 per share including a write-down of $575 million or $2.31 per share on ABCP. The tier 1 ratio is expected to be above the bank's target of 8.5%. We expect slightly better results from Retail banking. A dividend increase of 5% to $2.52 per share is expected, although it may be deferred in light of the magnitude of the potential writedown.

• Royal Bank is expected to report operating earnings of $1.04 per share, an increase of 7% YOY and a decline of 4% quarter over quarter (QOQ). Reported earnings are expected to be $1.06 including a $0.21 per share gain on VISA and a $0.19 per share of write-downs. Strong earnings growth is expected from RY’s Retail and Wealth Management businesses with potential weakness from U.S. and International Banking and RBC Capital Markets due to the appreciation of the Canadian dollar, reduced capital markets activity, and lower trading revenue.

• Toronto-Dominion Bank is expected to report operating earnings of $1.40 per share, an increase of 17% YOY and a decline of 13% QOQ. Reported earnings are expected to be $1.59 per share including a $0.19 per share VISA gain. Retail and Wealth Management earnings are expected to continue to drive earnings. We expect earnings to decline from very high levels in Q3, especially given a more difficult capital market environment. We believe TD Banknorth is now refocusing on organic growth building, realigning distribution, and improving efficiency. We expect better operating results going forward from TD Banknorth. TD Ameritrade earnings contributions for Q4/07 are estimated at $0.10 per share versus $0.08 per share in the previous quarter and $0.07 per share a year earlier.
The Globe and Mail, Roma Luciw, 21 November 2007

Canadian banks have already revealed nearly $2-billion in credit-related market charges, but one U.S. analyst expects further mark-downs will be in the cards when the Big Six start reporting earnings next week.

Citigroup Global Markets analyst Shannon Cowherd said that the Canadian banks have announced charges ranging from 1 per cent to 14 per cent of her estimate of the amount of securities impacted. That range seems low, she said, given that companies with similar assets — such as U.S. financial giant Merrill Lynch & Co. Inc. — announced charges at an estimated level of 45 per cent.

“Based on our analysis of potential securities impacted, if the magnitude of the charge were 45 per cent we'd face another wave of charges ranging from $1.5-billion to $15.3-billion,” Ms. Cowherd wrote in a fourth-quarter preview released Wednesday. According to her calculations, National Bank of Canada would be near the low end of such a range while Royal Bank of Canada would be at the high end.

Canada's biggest banks have not been immune to the credit crunch that has hammered U.S. financial institutions, who have taken tens of billions worth of writedowns on their exposure to subprime mortgage-related securities.

To date, the Canadian banks have collectively pre-announced nearly $2-billion in credit-related charges for the fourth quarter, which ended Oct. 31, Ms. Cowherd said. National unveiled the largest quarterly charge, a $575-million writedown while Canadian Imperial Bank of Commerce has said it will take a $463-million fourth-quarter charge on its exposure to the U.S. mortgage market.

Toronto-Dominion Bank is the only one of the Big Six that has not announced any charges.

“The most prevalent topic since the third quarter will likely remain the hot topic for the fourth quarter — structured credit products and the banks' potential for losses,” Ms. Cowherd said.

She expects provisions for loan losses to nearly double from last year's fourth quarter, primarily driven by the increased “liquidity loans” on the banks' balance sheets. “The non-performing ratios on both residential and commercial loans are picking up and the banks need to increase their credit coverage ratios,” Ms. Cowherd said.

Another aspect of the credit crisis that could emerge in the quarter is credit default swaps, she said. “Most likely, in our view, many of the downgrades by the rating agencies have been credit events driving a credit default swap pay out,” Ms. Cowherd said.

The Citigroup analyst cut her fourth-quarter earnings estimate for National Bank by $2.27 to $3.40 a share, reflecting asset-backed commercial paper related charges. But she maintained her “buy” ratings on all of the banks, citing their depressed valuations.
Financial Post, Duncan Mavin, 21 November 2007

Canadian bank stocks are nearing bargain prices heading into fourth quarter earnings season beginning when Bank of Montreal reports its annual profits on Tuesday, says Desjardins Securities analyst Michael Goldberg.

Banking sector share prices have lagged the TSX (bank prices have increased 3.9% on average compared to 5.5% for the index) in the final quarter of 2007.

“In our view, weak performance is tied to concerns about a possible systemic decline in trading revenue more recently compounded by the liquidity problems of a number of ABCP issuers in Canada who are having trouble rolling their paper,” Mr. Goldberg says.

But the Desjardins analyst is still cautious about the relatively cheap bank stocks.

“Persisting uncertainty is expected to continue to hold back performance,” he notes. In 2008, he anticipates slower top-line, bottom-line and dividend growth.

Mr. Goldberg’s top picks among the big six are Toronto-Dominion Bank and Bank of Nova Scotia. He forecasts the lowest level of growth among the big banks will be at National Bank
Financial Post, Jonathan Ratner, 21 November 2007

While global financial stocks haven’t seen the same kind of declines witnessed back in third quarter of 1998 when the MSCI AC World Financials Index fell 34%, Citigroup’s chief global equity strategist, Robert Buckland, says the relative performance is comparable. And the success of the broader market may be to blame.

Nearly a decade ago, investors were reeling from the Asian financial crisis in July 1997, the global recession had begun and the Ruble crisis arrived in August 1998. These days, the crisis is credit.

Financial troubles have sent the MSCI index down 11% from its all-time high and 6% so far this year. But Mr. Buckland said similar sell-offs in the sector have come every year since the market turned upward in 2003.

“Just looking at the index all the ‘worst credit crisis in my lifetime’ rhetoric seems overdone,” he wrote in a note to clients. He added that not only should global equity markets be able to make further gains, but selective opportunities remain among the financials.

U.S. and U.K. banks may be getting the majority of the negative headlines these days, but Japanese banks have had it just as bad, according to Mr. Buckland. Meanwhile, Asia-Pacific and emerging market banks have done very well.

So while it may not be 1998 all over again, looking at today’s situation in relative terms does present some serious concerns. Mr. Buckland points to the 15% fall for global financials when measured against the broader MSCI AC World Index, which is up 9% since June. He says this represents the worst performance since 1998-2000.

“Perhaps this is why the Financials sell-off feels so bad for fund managers,” he said. “The opportunity cost of owning global financials is now the largest it has been for eight years.”

So with the financials taking a beating, investors may be starting to think that the rest of the market may no longer be able to defy gravity. This decoupling – when the global equity market climbs and financials decline – is considered somewhat rare.

Nonetheless, Mr. Buckland says opportunities do exist. Among the names he considers reasonably priced with strong earnings momentum include U.S. insurers Ace Ltd., MetLife Inc., Lincoln National Corp. and Hartford Financial Services Group Inc., while the only other North American name on his list is Canadian Imperial Bank of Commerce.
Financial Post, Grant Surridge, 21 November 2007

Most Canadian banks will likely be happy to see the back end of November, and none more than CIBC. The bank’s shares are down about 18% so far this month, the most of any Big Six bank, as investors fret over its exposure to mortgage-backed securities in the U.S.

CIBC has so far announced total writedowns of $750-million in connection with these holdings, as well as continuing exposure to the tune of $1.7-billion.

“Investors do not know enough about the hedges against this exposure... and are speculating that the hedges may not be fully effective,” Desjardins Securities analyst Michael Goldberg wrote in a note to clients on Wednesday morning.

And he says CIBC’s refusal to discuss the details, including the gross exposure to such debt instruments, prior to its Dec. 6 earnings release is not helping.

“CIBC’s silence fuels the concern that where there is smoke, there is fire,” the analyst said.
Dow Jones Newswires, 9 November 2007

Investors now know size of write-down at Canadian Imperial Bank of Commerce on US subprime exposure, and can pretty much assume Toronto-Dominion Bank doesn't have any. Both banks announced Visa restructuring gains, with CM noting they'll cover the CDO hit. But jury still out on Royal Bank of Canada, Bank of Montreal and Bank of Nova Scotia. Genuity Capital Markets says BMO likely to take charge on asset-backed CP exposure, and if it does, others will probably do the same. There's also likely to be trading losses, even at CM, which left open question of health of credit trading derivative portfolio.
Financial Post, Duncan Mavin, 9 November 2007

Despite market expectations for heavy write-downs for Canadian banks in the fourth quarter, Dundee Securities analyst says the fundamentals remain relatively positive for the sector and it will easily withstand these losses. He sees no real threat to the quality of their credit, while trading revenues should partially offset lower advisor activity.

Nonetheless, he suggests investors take a defensive approach given the difficulty in figuring out the size of charges the banks may take, as well as where they may stem from. Take a market weighting at most for the banks heading into the fourth quarter, but be selective in the names you choose, the analyst advises. And expect to see more valuation pressure as their upcoming earnings approach.

In a note to clients, Mr. Aiken laid out the level of charges the bank’s could take without impacting their potential for future growth, by examining excess capital and how earnings could cushion losses.

Excluding TD Bank, which has set aside its excess capital for the purchase of Commerce Bancorp, Mr. Aiken estimates that each of Canada’s Big Six banks could incur write-downs of at least $1-billion before their future growth would be impaired.

Other than CIBC, who has collateralized debt obligations and mortgage-backed security exposure Mr. Aiken labels “apparently manageable,” the Canadian banks’ direct U.S. subprime exposure is limited, he said. Mr. Aiken also noted that they have sufficient capital to withstand recent speculated write-downs.

Nonetheless, he recommends focusing on those most likely to be unaffected by the subprime situation, like regional banks Canadian Western Bank and Laurentian Bank, while highlighting Bank of Nova Scotia as likely the best of the Big 6. He also considers Royal Bank a defensive bet.

“While we also believe that TD should be able to side-step charges this quarter, its relative lack of excess capital does not provide any cushion,” Mr. Aiken wrote.
He thinks BNS, TD and Royal are the least likely to generate one-time charges in the third quarter.

“That said, both Bank of Montreal and National Bank have the ability to generate the greatest shareholder returns through the reporting season, if current speculation regarding anticipated write-downs ends up being too bearish,” Mr. Aiken said.
BMO Capital Markets, 7 November 2007


We have changed the structure of our quarterly preview slightly this quarter. In the past several years, there have been fewer quarterly unknowns so that we could pick the variables and deal with them separately. Not so this quarter, where every line on the income statement has a relatively large margin of error. As such, we have approached the major income statement lines separately: Net Interest Income, Non-Interest Revenue (inclusive of trading revenues and securities gains), loan losses and expenses.

Having said that, if there is one major theme this quarter, it will likely be the increased importance of the balance sheet as a harbinger of problems. Simply put, earnings should be good, but the balance sheet and the capital analysis will show less clear signs, and this will be an issue. To paraphrase our strategist, Don Coxe, “In good times, income statements are important. In less certain environments, balance sheets and capital become paramount.”

As such, we have devoted a more meaningful proportion of this report to the balance sheet and to capital. In aggregate, we expect to see a few banks with Tier 1 ratios of close to (and, dare we say, even below) 9%. Tangible common equity will continue to weaken as banks experience some risk-weighted asset (RWA) growth without significant build in common equity. These are still robust capital positions, but with clear pull on bank balance sheets, there will be further pressure in coming quarters.

We will end this preview with a look at the individual banks. If there is one that could surprise on the upside, it is TD Bank. The bank and its management team have been preparing for a difficult environment, so one would expect their balance sheet to weather the current situation well. On the downside, we believe that Scotiabank faces the biggest hurdles with the move in the currency and the bank’s larger corporate loan book. The one offset is that Scotiabank could well report strong trading revenues. They appear to have taken the most realistic view of the current turmoil, so could actually benefit.

We downgraded the Canadian Bank sector to Market Perform two months ago. We are confident that their balance sheets and strong domestic loan book will underpin strong performance relative to their global peers. On the other hand, we aren’t so sure that they can escape the fall-out from what appears to be unwinding of most fixed-income structured products. We currently recommend TD, CM and NA (all rated Outperform), which have more exposure to domestic retail and wealth than their peers.

Balance Sheet – A New Awakening

We, like most analysts and investors, have been unusually focused on income statements over the past few years. This made sense, as bank stocks are generally valued off their P/E rather than any other metric. We believe that this is changing. The real issue for all banks is the re-intermediation of risk. Effectively, banks are being asked to provide liquidity for customers who are less able than in the past to finance their activities in capital markets. We don’t know how long this will last, but it does mean that the balance sheet will become a better window into the current environment for banks than the income statement.

To deal with this, we review a variety of items—including book value, growth of assets, and capital ratios. We note that the conclusions arrived at from this perspective are less comforting than those from an income statement perspective (which we believe will be quite immune from the problems of the current market).

It is difficult to be pessimistic on Canadian banks given the strength of the core franchises and balance sheets. It would take a real cynic to worry about banks with Tier 1 ratios of 8.5–9.5%. Having said that, Canadian banks do not operate in isolation and it seems as if bank balance sheets (like those of their global peers) will be getting weaker over the coming quarters. One major variable in establishing the degree of balance sheet strain is the Income Statement, and particularly net interest income, non-interest revenue and loan losses. The news here looks quite solid, as we detail below.

We note that the balance sheet may also show several other changes this quarter. Loan quality (covered later in this report), securities portfolios and derivative positions will also provide some insights into the stresses on bank liquidity and potential earnings power.

Net Interest Income – Top Line Stability Hides Underlying Volatility

Net interest income for banks seems to be a relatively simple concept: loan growth drives balances, while spreads are the difference between the yield of loans and the funding costs distributed to funding sources. Taken as a product of each other, we derive net interest income. In reality, however, the situation is far more complex, as mix of assets and liabilities as well as the duration of both sides of the balance sheet can dramatically affect how these variables interact.

In considering the outlook for bank NII this quarter, we believe that it is best to individually consider loan growth (with some analysis of loan mix), deposit mix and indicative spreads. In addition, this quarter included material securitization activity which could translate into large gains.

In a quarter such as this, we are reminded of the mid-quarter comment of a senior bank executive who eloquently said, “We have no idea what spreads are going to be this quarter, but we’re pretty sure they aren’t going to be up!” Having said that and given robust loan growth, we expect net interest income to be strong— up 2–3% in quarter—and that banks will likely record good securitization gains. (Note that because of generally accepted accounting methodologies, securities gains show up in non-interest revenue even though they really are a funding issue).

Many of the comments we have made in this section on NII relate directly to the core P&C operations and, as such, tend to impact the “retail segment.” Having said that, some investors and analysts (not us) focus on the overall bank’s NII, which is further complicated by the financing of the trading and derivatives books. Most banks, however, run their securitization thorough the “Corporate” segment, as it is a quasi-treasury function. As such, there is real potential to see “weaker retail but stronger corporate earnings”—a mix shift that investors generally abhor.

Non-Interest Revenues – Expect the Unexpected

Non-interest income of Canadian banks incorporates trading gains and losses, underwriting and advisory revenues, mutual fund and credit fees, commissions, insurance revenues, securities gains and a host of other items. Trading is the biggest of these revenues, producing 8–10% of total bank revenues and over 15% of non-interest revenues. Outside of trading (which we deal with in some detail in this segment of this report), some of these revenues are stable (credit and banking fees, insurance revenues, etc.), some are predictable (capital markets revenues inclusive of underwriting, advisory and commissions) and others are highly unpredictable (securities gains). Given the volatility of some of these items, we limit our comments to trading revenues and the other less stable revenue streams.

Loan Losses – The Gradual Creep Continues

Quarterly loan losses were relatively stable for the Canadian Banks for most of 2004, 2005 and 2006. Since the fourth quarter of last year, loan losses have begun to exhibit a well-telegraphed trend—gradual increases. So far, much of the increases have come from TD and RY on the retail side of the loan book, while Scotiabank and BMO have continued to benefit from reversals in the corporate book. CIBC has, as usual, marched to its own drum as it reworked its non-residential mortgage consumer loan book.

We expect to see loan losses continue to track higher. Particularly interesting will be the U.S. consumer and commercial loan books of BMO, Royal and TD Bank. With clear signs that the U.S. loan book is experiencing higher losses, the scale of deterioration for these three banks will be a focus.

Any signs that the Canadian loan book is weakening would certainly spook the market. Remember that loan losses for Canadian banks continue to be at historically low levels, so the potential certainly exists for a fairly significant ramp-up in losses. For perspective, a normal mid-cycle level of loan losses would be $1.5 billion higher than what banks are currently reporting. On its own, this would be a 5% headwind to bank earnings growth over the next year. Of course, history tells us that loan losses go from unusually low levels to unusually high levels, so the trend is probably as important as the level. In addition, the market tends to anticipate loan losses rather than simply accept them. The bottom line on loan losses is this: the environment cannot remain as good as it has been for the past few years, and the best we can hope for is a gradual deterioration.

Expenses – Well Controlled

Over the past several years, Canadian Banks have been very successful in managing non-interest expenses lower, when compared to revenues. The fourth quarter is, however, always a difficult one to gauge. Non-incentive expenses are relatively predictable, but there is some ability to move the needle with acceleration or deferral of specific project spending. We would expect (and hope) that banks attempt to be conservative to ensure that they start 2008 without any headwinds. Typically, NIX ratios spike higher in the fourth quarter and this should also be the case this year.

The reality, however, is that the accrual of incentive compensation (accrual because of the annual disbursement calendar for the investment banks which produce most of the bonuses) means that banks only really pay incentive compensation in the fourth quarter. With the fourth quarter having ended on a weaker note, there will be real debate on whether banks have overaccrued in anticipation of a good year. Despite the vagaries of the fourth quarter, the reality is that the Investment Banks have had an outstanding year. Inclusive of the BMO’s natural gas trading snafu and the CIBC’s CDO charges, we estimate that after-tax profits for the dealers will be close to $5 billion—very comparable with year-ago levels. The question will be whether, with U.S. investment banks being hit much harder, and with a less-than-auspicious end to the year, bonuses will also be hit.

All in, we expect bank managements to show good expense control as evidence of their ability to earn through difficult operating conditions.

Taxes – Steady to Lower Rates, but Deferred Tax Charges

We expect bank tax rates to be stable to lower in the current quarter. Given the outlook for lower statutory rates in 2008 and 2009, this trend will be beneficial in the medium term for Canadian bank earnings (Mini-Budget 2007: Declining Tax Burden Continues to Benefit Bank Shareholders).

Having said that, nothing is ever that simple. With lower statutory rates, deferred tax assets actually lose some of their capacity to screen future earnings and may need to be revalued lower. As such, there is reasonable likelihood of tax charges this quarter. We have not attempted to estimate these charges, but they could be in the order of $25–75 million per large bank.

Individual Bank Comments

Bank of Montreal – More Clean-up

It is widely expected that the Bank of Montreal will take hits on its holdings of third-party ABCP. Given the estimated size of its portfolio, we estimate losses in the $100 million range. We note, however, that there is a real potential for additional losses on other securities holdings and unlike four of the other banks, BMO has no one-time Visa gains to offset potential charges. We forecast cash EPS of $1.20, inclusive of $0.14 of ABCP losses.

The Retail businesses should, on the surface, look very good compared to a year earlier (remember that year-ago results in Canada were extremely weak). In Canada, we forecast a cash contribution of $351 million, essentially fl at with the linked quarter. Despite the industry-wide pressure on Prime-BA spreads, the domestic bank continues to benefit from better pricing on mortgages (at least when compared to last year). Harris will continue to struggle, as spreads remain very tight in the U.S. One area of focus will be loan losses. Loan losses at Harris have began to track higher and it will be interesting to see the rate of new formations. This could spook the market.

On the wholesale side, we have assumed that the natural gas trading problems are behind BMO. Furthermore, we have included the ABCP loss provision in the Corporate segment. As such, BMO Capital Markets should have its best quarter this year (over $200 million) with activity levels remaining robust and with loan losses well controlled. Expenses will be difficult to evaluate given the trading losses, which will offset what otherwise appears to be an excellent year.

Wealth Management should continue to be ahead of last year. Activity levels are certainly up from the year-ago quarter, but are down from the second and third quarters. Mutual fund assets are up roughly 13% over the year.

We have included $100 million (pre-tax) in writedowns for ABCP and other issues. As such, the Corporate segment will see a loss of about $90 million. This segment also includes securitization revenues (which could be massive) and tax issues (which could be positive or negative). Needless to say, an analysis of earnings contribution this quarter will be more qualitative than in previous quarters.

On the balance sheet front, BMO could well show significant changes this quarter. Tier 1 will likely drop to about 9% compared to roughly 10% a year and a quarter ago. There is some concern on our part that OSFI will require more capital behind back-stop liquidity lines. In addition, book value will, at best, be stable with the currency impact offsetting retained earnings. The bank has aggressively raised liquidity in the past few months, so it will be interesting to see whether this has been reactionary (to fund draws on lines) or anticipatory (to raise core liquidity).

National Bank – Hard Hat, Please

This quarter will be most interesting for National Bank—and not just because of the need to take a charge on third-party ABCP. The second most interesting issue will be the impact on the bank’s balance sheet from the current turmoil. We are forecasting a $500 million pre-tax charge ($2.00 per share after tax). We also expect Tier 1 to decline to 8.4% from the 9.4% at the end of the third quarter.

Retail banking has had a difficult year, and there is little indication that this will change in the short term. The fourth quarter of last year was very weak, so the 8% gain year over year is a scant achievement. National should provide good insight into core spreads, as it uses the BA market more than most. Having said that, volumes remain very good in Quebec and there was some increase in their deposit balances following the mini-run on money market mutual funds in August. Wealth management will also see profits close to third-quarter levels.

NB Financial, the wholesale arm of National Bank, should have a much weaker quarter compared to the first three quarters f the year. Trading revenues will likely be quite weak and activity levels were disappointing—not surprising given the focus by senior executives on ABCP this quarter. As always, there is very little visibility into potential gains from Treasury. Loan losses should be well controlled. We have assumed that the ABCP charge is included in the Other segment.

We remain cautious on dividends. It has been two quarters since the bank last raised its dividend, but it would be a surprise if this did occur. Given the state of cash and credit markets, we believe it would be better to wait. The bank still has its normal course issuer bid, which it could use if the environment improves.

TD Bank – Their Time in the Sun

If there is any bank that has prepared for the current environment, it is TD Bank. The shift to retail banking, the exit of the structured product business in Europe and the move to change management at Banknorth all point to a bank that has moved to insulate itself from credit and liquidity risk. Having said that, the deal for Commerce Bancorp produces its own complexities (flow-back, more goodwill, execution risk, etc.). The good news for shareholders is that this quarter should show all of the stability and none of the impact of the CBH acquisition. We expect to see robust EPS of $1.32 compared with $1.16 a year earlier. We have assumed that the Visa gain will be in the corporate segment, offset by securities/LBO bridge finance writedowns.

Retail should still show the momentum of the past couple of years. Volume growth is excellent and spreads should be more stable than the peer group (we believe that TD does more to insulate itself from short-term changes in rates). Loan losses continue to track higher, reflecting strong growth in balances. Any progress on slowing this trend would be quite positive. The good news is that the comparison is getting easier. Banknorth is well up from last year due to the lack of one-time charges.

Wealth management should have a solid quarter. The contribution from AMTD was a bit above our expectations, at $75 million. The domestic business tends to be a bit weaker in the fourth quarter, but given market volatility in recent months, there is some chance that discount brokerage volumes were good. Remember that TD is disproportionately levered to this factor.

TD Securities will likely have a disappointing end to an excellent year. With relatively low credit risk, there should be no surprises on the loan loss front. During the quarter, there was some focus on the bank’s agreement to bridge the BCE privatization—both on the debt and the equity front. It is difficult to gauge the potential for a writedown here, but with the Visa gain, it is safe to say that management will attempt to take its medicine this quarter. For simplicity purposes, we have assumed that trading revenues are $100–150 million below “normal.” Essentially, this means no trading revenues in the quarter.

On the capital front, we believe that Tier 1 (at 10.2% last quarter) and book value per share should be largely unchanged this quarter. TD will be the only bank with a Tier 1 of over 10% this quarter. Over the next couple of quarters, the bank will be much more focused on reducing its risk-weighted assets and retaining capital in advance of the closing of the Commerce deal. Simply put, buybacks and dividend increases will be tepid at best over this period.

Royal Bank – Can a Global Fixed Income Franchise Be Unscathed?

It is without doubt that Royal Bank has moved beyond its Canadian peers in building a global fixed income presence. Its operations in the U.S. and the U.K. ensured that the bank would win in the Maple Bond market, and this success has spilled over to reinforce its powerful M&A and underwriting franchises. This quarter will provide some insight into whether the bank can drive unscathed through what appears to be very difficult times. Were this the case, Royal would need to be compared with Goldman, which has done this in the U.S.

We see few signs that there will be any specific problems this quarter. The bank’s retail business should be quite a bit stronger than in the third quarter, while the ongoing stream of acquisitions suggests no lack of confidence in the outlook. We forecast Cash EPS of $1.01, up 8% from last year. The $300 million Visa gain should be offset with a raft of “conservative” marks on the securities book.

In Canadian Banking, we expect to see strong operating leverage after a disappointing third quarter. Royal continues to drive volume growth, though margins could well be pinched. The insurance business has developed a reputation for volatility and after “one good, one bad and one so-so quarter,” who knows what results will be this quarter. We have stayed securely in the middle and assume a contribution of close to $100 million. Whatever the result, the volatility of these earnings have resulted in them being heavily discounted. Simply put, the only one of these two businesses that matters is the non-insurance business.

The Wealth Management business should have another strong quarter, though there will be some headwind from the U.S. business due to currency. This tends to be one of the bigger quarters of the year and given the ongoing strength of fund fl ows and the level of equities, there appears to be limited risk this quarter.

Much of the focus will be on RBC Capital Markets. We note that the bank had several wins on the M&A front this quarter, and the franchise remains in great shape. There is little visibility into trading or securities gains (or losses). We forecast trading revenues of $200 million—the lowest of the year. As we already mentioned, however, the bank is likely to book some mark-to-market losses to clear up the portfolio going into 2008. This will either show up in securities losses, or in the trading line—we have assumed the latter. The bottom line is that even with a hit of $300 million pre-tax (roughly offsetting the Visa gain), we expect to see a result that is solidly profitable, but down from the first three quarters of the year and year-ago levels.

The U.S. and International business will face strong currency, spread and loan loss headwinds. We expect the contribution to be down on a year-over-year basis and on a linked-quarter basis. We are assuming that Global Private Banking offsets the problems at Centura. With the Visa gain to be included in the Corporate segment, we expect an unusually strong result from this segment.

The balance sheet of Royal should reflect many of the pressures in the group this quarter. Book value will likely be down and, with some pull on balance sheet assets (both off- and on-balance sheet), the Tier 1 could fall below 9% for the first time in over five years. The bank was very quiet on its buyback in the quarter—a prudent move to build capital.

Scotiabank – Diversified Growth Continues

We expect another solid quarter from Scotiabank. The major cross-currents include the currency headwinds, securities gains or losses, uncertainty on trading and the growth from recently acquired businesses. We have incorporated our estimate of the gain on Visa ($100 million), but expect securities writedowns that will largely offset this. Our estimate of $0.97 is unchanged.

In domestic retail banking and wealth management, Scotia has had a much stronger first nine months than we expected at the start of the year. Revenue growth has been robust and expense control has been excellent. We are forecasting a solid gain year over year (but lower than the 20%+ achieved in the first nine months) largely because the fourth quarter was quite weak last year.

Scotia Capital should have a much weaker fourth quarter after three “barn-burner” quarters in 2007. Fourth-quarter trading and capital markets activity seems to be quite weak and loan loss reversals will continue to normalize. Furthermore, we believe that all banks will attempt to take very conservative marks on illiquid positions. We have assumed $100 million in “unusual” trading hits. All in, we expect weak revenue performance—but this should be partially offset by reversal of expense accruals.

The International business should be able to withstand the impact of the rapid increase in the Canadian dollar because of the incremental contribution from Peru, Costa Rica and the DR. Mexican earnings (already announced) are essentially flat year over year and quarter over quarter. The corporate segment will include the Visa gain ($70 million after tax), so the profitability will be above average—comparable to the third quarter.

On the capital front, the news should be relatively benign. Scotia completed an issue of non-common Tier 1 in the quarter and this will partially offset what should be solid RWA growth. The bank is scheduled to bump its dividend this quarter, and we would bet it is the only bank to do so (by $0.01 to $0.46). It would be a tremendous statement of the bank’s financial strength to raise its dividend in the current environment. With the Chilean deal coming on in the next quarter and the potential for further good demand from corporate clients, BNS will probably err on the side of caution (i.e. carrying more rather than less capital). We expect to see a noticeable decline in unrealized securities gains, and book value per share will likely drop due to the aforementioned writedowns and the move in the currency.

CIBC – This Bank Has Grown Up

The market has remained quite focused on CIBC’s holdings of CDOs. So are we. What does give us some comfort, however, is the fact that we believe we can size the problem—the bank has $1.7 billion of exposure, partially mitigated by $300 million of subprime index hedges. So far, writedowns (inclusive of our estimates in the second quarter) are above $600 million. The bank will be carrying the CDO position at 60% of cost.

Following management comments from the conference call on the Oppenheimer (OPY) transaction, we adjusted our forecasts for CIBC to include a $400 million Visa gain, $300 million on CDO writedowns, $50 million for the OPY deal and a further $100 million in mark-to-market losses. Based on these assumptions, we estimate Cash EPS of $1.90—not meaningfully different from our fourth-quarter estimate of six months ago.

Essentially, we are saying that CIBC will manage though another earnings headwind this quarter. We hope that the market ultimately realizes that CIBC has “grown up.”

Retail Markets (which includes wealth management) should have another solid quarter with some continued progress on revenue growth. Loan losses will be higher than a year ago, but should moderate from the high levels of the third quarter. Effectively, we are looking for a repeat of the third quarter. Note that FirstCaribbean is a more meaningful part of earnings in this business and will face the translation challenge of the stronger Canadian dollar.

CIBC World Markets will have a disappointing quarter, as we expect more writedowns in CDOs. We had forecast $200 million after the close of the third quarter, but with further deterioration in the market, particularly in the closing days of the quarter, we believe that a loss closer to $300 million likely. We have also assumed a further $100 million in other mark-to-market losses. Of course, with the $400 million Visa gain, the pain will be soothed somewhat. We note that the Visa gain will be included in the Corporate and Other segment. Outside of the Visa gain, there should be few surprises in the corporate segment.

Two big issues for CIBC will be capital and loan losses. We expect to see less of the former and hope to see less of the latter too. First, on capital, CIBC should have the same issues as its peers: declining book value due to currency and lower unrealized gains. We believe that Tier 1 will be solidly above 9%, but will be down in the quarter because of some ramp-up in risk weighted assets. On the loan loss front, the retail loan losses should start to stabilize at current levels.

From our perspective, another key variable will be the “residual exposure” from the bank’s CDO holdings. Clearly, the conditions were difficult in the quarter and liquidity was atrocious, but if the bank was able to reduce its aggregate exposure, either through sales or hedging, this would be a positive. It is also noteworthy that, assuming our guess of $300 million of additional charges, the “net exposure” will fall dramatically and will be under $800 million.