31 January 2008

National Bank - Investor Day

National Bank Investor Day Summary

• National Bank (NA) held an Investor Day in Toronto on January 30, 2008. Presentations were made by Louis Vachon, CEO, as well as the head of each of National Bank's business segments, namely Personal and Commercial Banking, Wealth Management and Financial Markets. Risk Management was also addressed in a separate presentation.

• Listed below are key takeaways from the presentation.

New Client Centric Strategy - Focus on Cross-Selling

• National Bank unveiled its new bank-wide strategy of becoming a more client centric bank. Management plans to shift the focus from selling products to servicing its clients and taking advantage of cross-selling activities across segments for a bigger share of wallet.

• NA has outlined four key areas where it will focus its efforts to ensure the change in strategy is successful: technology, culture, organization and market and client knowledge.

• Some of the initiatives that have already been taken include adjusting compensation and outlining expectations to take cross-selling goals into account, changing the bank's motto to "One client, One bank" to help create a new culture within the bank, and attempting to better integrate technology platforms across different business segments.

NA Addresses Recession Concerns - Believes Quebec Economy is Solid

• NA attempted to address concerns of a U.S. recession by assessing the risk-profile of the Quebec economy. Management identified that the industries with heavy exposure to the U.S. economy such as manufacturing and transportation & warehousing have declined as a percentage of the overall economy by 6% to 18% in 2007 from 24% in 2000. Also, exports as of 2006 were more concentrated in high-tech sectors and less in automotive and Quebec manufacturing insolvencies have been declining despite a sharp increase in the Canadian dollar.

ABCP Update - More Granularity

• Mr. Vachon indicated that he believed the level of the non-bank ABCP provision taken in Q4/07 was extremely conservative and only two scenarios would cause the bank to take additional charges; if the U.S. were to go into a severe recession or if there was a disorderly sale of non-bank ABCP conduits. Neither scenario is believed to be extremely likely.

• NA reaffirmed that there are fewer than 100 clients holding the non-bank ABCP and that liquidity lines of $580 million have been extended to these clients but only 1/5th of the value has been drawn down.

• NA confirmed that its holdings of non-bank ABCP with U.S. sub-prime exposure are not disproportionately higher than the industry which is less than 10%.

NA Maintains Positive Outlook for 2008

• NA remains comfortable with its previous earnings growth estimate of 3%-8% for 2008; however, management recognizes that the majority of growth may occur in the second half of the year. NA also outlined a longer term three to five year growth rate of 5%-10%. Our 2008 earnings estimate of $5.60 per share represents a 1% decline in earnings from 2007. We remain concerned about NA's high reliance on high risk wholesale banking and its concentration in Central Canada.

• Maintain 2-Sector Perform.

29 January 2008

2008 Citi Financial Services Conference

Reuters, 29 January 2008

Royal Bank of Canada will write down its exposure to a troubled bond insurer in its first-quarter results, the bank's chief financial officer said on Tuesday.

Janice Fukakusa said Royal, Canada's biggest bank, has already revealed it is exposed to one A-rated monoline bond insurer and had taken a provision against this exposure.

"The current mark-to-market (value of that exposure) as of October 31 was C$104 million ($104 million)," Fukakusa told a Citi Financial Services Conference in New York.

"That monoline subsequently is in difficulty so we have written off the balance of our exposure in our first-quarter results," she said.

Royal's first quarter ends on January 31 and the results are due to be reported on February 29.

Fukakusa did not specify the exact writedown nor name the bond insurer, but Blackmont Capital analyst Brad Smith said the only such firm with a single A-rating at the end of October was ACA Capital Holdings .

ACA is the same insurer causing headaches for Canadian Imperial Bank of Commerce

Some businesses that invested in subprime securities hedged these instruments with counterparties like monoline bond insurer ACA in case their value dropped, which has happened along with surging defaults on subprime mortgages.

But several monolines, which are insurers that only operate in one business line, are now at risk of failing themselves, meaning investors who purchased protection from them may not get their money back.

Royal has already taken a hit from the subprime turmoil in the United States, although it is small compared to that felt by CIBC. In the fourth quarter, Royal took a C$360 million pre-tax writedown for its exposure to structured products with subprime content.
Canadian Press, David Friend, 29 January 2008

Royal Bank of Canada will write down the full amount of its exposure to a U.S. bond insurer that was valued at $104 million months ago, the bank's chief financial officer said Tuesday.

The blue-chip bank's exposure to the monoline bond insurer was disclosed in its last quarterly report on Nov. 30. At that time, the bank took a writedown of $357 million pre-tax, or $160 million after tax and employee bonus reductions.

Since then, the monoline – not formally identified but assumed to be ACA Capital Holdings – has run into further trouble which forced Royal Bank to write down the remainder of its insurance value, CFO Janice Fukakusa said in a financial services conference call.

Fukakusa said that the mark-to-market value of the exposure was $104 million when the bank's financial year closed at the end of October.

The problems at the monoline insurer, whose business is to guarantee payment of principal and interest when a debt-security issuer defaults, are not regarded as significant for Canada's largest bank, which has a stock-market valuation of almost $64 billion.

RBC shares were ahead 34 cents to $50.04 on the Toronto Stock Exchange at midafternoon.

"If it was $104 million at the end of October it may have grown somewhat since then, and the ultimate charge-off of that amount would be something less than 10 cents a share," said Brad Smith of Blackmont Capital.

"If it was a material amount they would be pre-releasing it. I suspect from the way it's coming out . . . you're not even going to see this in the results."

Royal Bank spokeswoman Beja Rodeck said the bank will not issue a news release on the matter because it's not considered material.

The bank will report its first-quarter results Feb. 29.

Investors have braced themselves for ongoing Canadian bank writedowns connected to the crumbling U.S. subprime mortgage market, and Royal Bank's stock is off about 20 per cent from its highs of the past year.

The monoline Wall Street bond insurers have become a major focus of anxiety in anticipation that they will be unable to pay claims.

ACA Capital has fallen in danger of going bankrupt, though it has extended a waiver from its counterparties until Feb. 19.

New York insurance regulators met with a dozen banks last week to discuss ways to shore up MBIA Inc. and Ambac Financial Group Inc., two other players in the monoline industry which is estimated to have promised coverage on $2.3 trillion in debt.
Reuters, 29 January 2008

Toronto-Dominion Bank may struggle to meet its baseline 7 percent earnings-per-share growth target in 2008 due to the deepening turmoil in financial markets and a weakening economic outlook, the bank's chief executive said on Tuesday.

Speaking at a financial services conference in New York, CEO Ed Clark said he was more pessimistic than he was late last year, when he said TD's 2008 growth would likely be at the low end of its 7-10 percent target.

He said the bank's securities wing has suffered from falling asset prices, while the weakening U.S. economy and strong Canadian dollar have combined to pinch growth in the Canadian province of Ontario, particularly among manufacturers.

"If the markets stay this flat and (Ontario's economy grows at) 1 percent, we're going to have to work hard to stay in that range," he said.

Clark, who has remodeled TD as a low-risk retail-focused bank, while at the same time establishing a growing U.S. presence, reiterated the bank has no exposure to the U.S. subprime mortgage market.

He also said he was not worried about the bank's role in helping finance a $34.8 billion leveraged buyout of Bell Canada owner BCE Inc., which some investors have worried may be re-priced or abandoned. TD is providing $3.8 billion in financing for the deal.

"I don't think that the fundamentals of Bell Canada have changed in the last six months. The only thing that has changed is the capital market," he said.

"Our view is that if you underwrite something, you ought to be prepared to hold it."
The Globe and Mail, Tara Perkins, 29 January 2008

Toronto-Dominion Bank chief executive Ed Clark says a significant slowdown is coming, and the Canadian economy will not decouple from the United States.

Speaking to a financial services conference in New York, Mr. Clark spoke positively of the domestic banking environment.

“I always say to people if you don't buy me, buy one of the Canadian banks,” he told the room of investors. “It's been a terrific story in Canada.”

But he added Canada's economy will not likely escape troubles south of the border.

“Our outlook is that Canada will not decouple itself from the United States,” he said, adding there will be an impact on the bank's business.

“We're sitting here, the guns of August, waiting for the war to begin and anticipating it,” he said. “... Over a year ago, I announced it was coming, and all I did was end up cutting expenses probably a year in advance. But I do think this time it really is coming, and we are going to have a significant slowdown.”

28 January 2008

Implications on Banks of Basel II Capital Standards

RBC Capital Markets, 28 January 2008

The process that determines Canadian banks' regulatory capital will change beginning Q1/08.

• Regulators are introducing new capital standards that should better reflect individual banks' risk profiles and the banking world of today, than do the existing capital guidelines, which were initially established in 1988.

• We expect that the banks will hold less regulatory capital for credit risk, similar capital for market risk and more capital for operational risk. We do not expect overall regulatory capital to change materially for the industry in general.

• Large global banks' capital could decline by about 5%, which is made up of a 11% decline in capital allocated to credit risk and a 6% increase in capital coming from the introduction of capital requirements for operational risk.

• Regulatory capital requirements will be lower for retail exposures than for wholesale exposures, all else being equal. The lower capital requirements for retail exposures reflect lower and less volatile loan losses historically.

• Areas that will have higher capital charges include low rated corporate lending, bank and sovereign exposures, undrawn commitments and equity holdings.

• Banks will likely disclose significantly more details about their risk exposures than today. We expect enhanced disclosure on loan book composition, credit migration, and counterparty risk.

• The variability of capital ratios will increase under Basel II, with expected increases in risk weightings in tougher times and the opposite in good environments.

• The calculations of regulatory capital will incorporate some changes, with the most significant impact expected to be around general reserves and, for TD, its investment in TD Ameritrade.

Analysts' Outlook on CIBC

Financial Post, Duncan Mavin, 28 January 2008

Investors wondering when the steady stream of bad news out of Canadian Imperial Bank of Commerce will dry up should not expect to wait too much longer, according to TD Newcrest analyst Jason Bilodeau.

CIBC — which has revealed a stunning capacity to shock investors even when it seems the bank can sink no lower — has seen its stock price plummet of late.

The bank’s subprime-related writedowns have soared to $3.3-billion and it is likely there is more to come. Last week, it also emerged the bank has an additional exposure to the ill winds blowing through the U.S. economy in the form of as much as $25-billion in credit derivatives — this book of securities is not linked to subprime, but it has already suffered a decline in value of at least $750-million, and it is backed by guarantees from under-pressure monoline insurers.

But with so much negativity around the bank already, there is “limited room for additional disappointment,” said Mr. Bilodeau in a note to clients.

“Negative headlines are likely to be confined to confirmation of what is already largely expected; including BIG write-offs. Importantly, the bank’s capital strength appears sufficient to withstand our near worst case scenario.”

CIBC raised $2.9-billion in new equity to stiffen its balance sheet last week. The new capital includes $1.5-billion from sophisticated investors Manulife Financial Corp., Caisse de dépôt et placement du Québec, Cheung Kong (Holdings) Ltd. and OMERS Administration Corp., who all presumably took a long, hard look at the bank’s books before parting with their cash.

Looking forward, Mr. Bilodeau picks two important themes — “we believe management will put a choke hold on its risk culture,” while “CIBC is transforming into one of the purest plays on Canadian retail and wealth management.”

The TD analyst rates CIBC a “buy” with an $80 target price.

Financial Post, Duncan Mavin, 26 January 2008

Analysts are calling for yet more disclosure from Canadian Imperial Bank of Commerce about its book of credit derivatives, after it emerged yesterday the bank likely has as much as another $25-billion of securities that are partly tied to the uncertain U.S. economy.

The investments -- which the bank says are not subprime-related -- are already in the hole for $750-million, though CIBC has taken no writedown on this book so far.

The bank has not confirmed the size of its non-subprime book of credit derivatives, but it has said the securities are backed by 11 financial guarantors --a term that has recently been used in reference to the much-maligned monoline-insurance industry.

It is believed the underlying assets are mostly in North America and include collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBSs) and corporate loans.

There was frustration among analysts that more information about all of CIBC's credit derivatives has not been forthcoming, after CIBC provided details of its book of subprime derivatives in December and this month.

"We do not have a handle on exactly what CIBC owns," said Andre-Philippe Hardy, RBC Capital Markets analyst, in a note to clients. The "inability to estimate losses" will continue to weigh on CIBC's stock price, he said.

"We do not adequately understand the nature and extent of CIBC's credit derivative exposure," added Mario Mendonca, Genuity Capital Markets analyst, in a note. "Still not sure we have the whole story."

CIBC has taken $3.3-billion in writedowns from its portfolio of subprime investments -- that number is expected to rise by at least another $1-billion, possibly by the end of the current quarter -- and the latest revelations have raised fears of more writedowns to come.

"The good news is that the underlying assets are not subprime-related and the value, to Dec. 31, had only declined by 3.5%," Mr. Mendonca said. The bad news is that most of the decline in the underlying assets occurred in the last two months of 2007 and things may have worsened since then, he added. The Genuity analyst estimates the fall in the value of the non-subprime derivatives could have reached $1.4-billion.

The information about the CIBC's book of non-subprime credit derivatives also raised concerns about the bank's exposure to troubled monoline insurers.

Most observers agree monolines are key to the global financial crisis because they have provided insurance to many of the banks that are embroiled in the subprime mess, including CIBC.

The near-collapse of one of the monolines -- ACA Financial Guaranty Corp. -- has forced CIBC to writedown $2-billion this quarter related to its subprime investments.

A bailout plan for the monoline industry led by U.S. regulators is apparently in the works, but there are few signs of anything concrete so far.

RBC Capital Markets, 25 January 2008

• In our January 24th report on CIBC, we highlighted the health of the financial guarantors as a key driver for the bank's future stock price.

• The outlook for financial guarantors is deteriorating, with today's downgrade of Security Capital from AAA to A by Fitch as the latest illustration of this point. However, there were media reports on January 23 that New York State's insurance regulators met with US banks to discuss a plan to raise capital for the bond insurers. At this stage, we do not know whether a government led bailout would succeed.

• CIBC's exposure to financial guarantors via hedged CDOs of RMBS is well known. CIBC has US$3.9 billion hedged with four AAA-rated guarantors, and US$551 million hedged with Ambac. CIBC also has US$1.5 billion (after writedowns of US$2.0 billion pre-tax) hedged with ACA.

• CIBC also disclosed on January 14 that it "has exposure to 11 financial guarantors where the underlying assets are unrelated to US residential real estate. The fair value of this exposure is approximately $750 million as at December 31, 2007."

• The fair value of the hedge represents how much CIBC was theoretically owed by financial guarantors at that time. It does not represent how much notional exposure CIBC has to financial guarantors.

• Based on conversations with the bank, we believe that, when the hedge was fair valued at $750 million, it implied markdowns of 3-4%, which would mean the notional exposure is $18-25 billion.

• We understand that the assets that are hedged are mostly Collateralized Loan Obligations and baskets of investment grade loans, with some Commercial Mortgage Backed Securities as well.

• We do not have a handle on exactly what CIBC owns; we know that CLOs and CMBS have not seen the same price declines as CDOs of sub-prime RMBS but, we also know that spreads have widened further since December 31, 2007.

• We believe that the inability to estimate losses will keep CIBC's multiple low as risk to profitability and book value estimates are high, in our view. A successful resolution of financial guarantors' capital issues would be positive for CIBC, but the timing and chances of success is still uncertain.
Financial Post, David Pett, 25 January 2008

It seems even $2.9-billion of new equity can not dispel the clouds gathered around Canadian Imperial Bank of Commerce.

For now, the new capital boosts the bank’s key capital adequacy ratio — the regulated amount of capital the bank must set aside. But with more subprime-related losses to come at CIBC, the pressure is not off the bank’s balance sheet yet, says Blackmont Capital analyst Brad Smith in a note to clients.

“A distinct negative” for the bank was Thursday’s news that U.S. monoline insurer Security Capital Assurance has been downgraded by ratings agency Fitch. CIBC has hedged much of its exposure to subprime investments with monoline insurers, a number of which are struggling.

“Based on CIBC’s recently updated monoline hedge exposures and our thorough analysis of key monoline insurers, we believe there is an increased probability that the bank has a $2.6-billion subprime hedge exposure to SCA,” Mr. Smith said in his note.

“If this proves correct, the announced Fitch downgrade and rising probability of [other ratings agencies] following suit could strain CIBC’s Tier 1 ratio and accelerate loss emergence,” he added.

Blackmont has a “sell” rating on CIBC. Mr. Smith lowered his target price for the bank from $68 to $66.

26 January 2008

TD Bank's Commerce Buy Remains Unsure Bet

Financial Post, Duncan Mavin, 26 January 2008

Amid all the turmoil in global banking, Ed Clark has looked pretty smart of late.

The Toronto-Dominion Bank chief executive has steered his bank clear of subprime securities and asset-backed commercial paper. Mr. Clark perhaps also stood in the way of a merger between TD subsidiary TD Ameritrade and E*Trade Financial -- a role for which he was vilified by hedge funds last year, but which looks wise now that E*Trade is embroiled in its own subprime mess.

But there is a big outstanding question about Mr. Clark's otherwise glowing reputation: Has the TD chief struck gold or struck out with last year's transformational deal to buy New Jersey-based Commerce Bancorp?

Since TD announced the US$8.5-billion acquisition of Commerce in October, the U.S. bank has not put in a convincing performance.

Yesterday, Commerce reported its fourth-quarter results were only half what they were a year earlier.

Profit in the final quarter was US$33.4-million, compared with US$62.8-million in the same period of 2006.

The year-over-year comparison looks even worse after excluding a US$13.7-million gain this quarter on the sale of the company's insurance-brokerage business and a one-off hit of US$15.8-million related to certain legal settlements.

Take those two one-time items out of the equation and Commerce's results fell by 75%.

Commerce said part of the blame lies with rising loan losses in "residential real estate and related real estate development exposures, and exposures in the leveraged loan portion of the company's commercial loan portfolio."

The bank recorded a provision for credit losses of US$55.0-million, compared with US$26.0-million in the third quarter of 2007 and US$10.2-million in the fourth quarter of 2006.

Under founder Vernon Hill, Commerce was one of the fastest growing banks in the United States, expanding quickly, with a strong emphasis on customer service.

However, Mr. Hill left the bank last year when regulators began investigating dealings between the bank and members of his family, leaving Commerce without its charismatic figurehead.

Despite the pressures on U.S. banks and the problems specific to Commerce, TD did not get a cheap deal. The Canadian bank paid US$42 a share for Commerce, about 6% higher than its closing price of US$39.74 before the deal was announced.

Since then, U.S. bank stocks have been in meltdown mode.

Investors might be tempted to draw a link between Mr. Clark's previous big venture into the United States -- the acquisition of TD Banknorth. The Portland, Me.-based bank had grown quickly -- in contrast to Commerce, Banknorth's growth was via acquisitions -- before TD bought in.

But Banknorth has struggled to deliver in recent quarters, weighed down by yet more acquisitions that have taken more time than expected to bed in, as well as a tough banking environment in the United States.

Still, it is far too early to put the Commerce deal down as a mistake by TD's Mr. Clark.

A spokesman for TD declined to comment on the Commerce results yesterday, but the bank has made it clear the Commerce acquisition is one for the long term.

"I don't think they decided to buy Commerce Bancorp for what it would do to 2008 or 2009 earnings," said Rob Sedran, National Bank analyst.

"Even when they announced the deal, the U.S. economy was softening. When they bought it, it was part of a longer-term strategy to become a North American retail bank."

25 January 2008

Scotia Capital Recommends Aggressively Buying Bank Stocks

Scotia Capital, 25 January 2008

Banks Rebound Sharply From Underperforms

• Bank stocks, after declining 10% in 2007, have started the new year off declining a further 3%, representing one of the largest share price declines in decades and perhaps the only one not led by major earnings collapses. Bank relative performance in 2007 was the third worst in the past 40 or 50 years with only 1979 and 1999 being worse, despite the banks recording operating earnings growth of 10% and return on equity of 21% in fiscal 2007.

• Bank stocks have very rarely ever underperformed the market two years in a row. In fact the bank index typically rebounds very sharply. In 1980 and 2000 following the very weak relative performance in 1979 and 1999 the bank index appreciated more than 30% in each of those years. It is very early in the year but thus far in 2008 the bank index is outperforming the market by 4%.

Bank Earnings & Profitability Solid

• Bank investors remain nervous despite the release of fourth quarter earnings where the banks’ total writedowns represented a very modest 1.3% of common equity. The two banks (BNS and NA) that were due to increase dividends in the fourth quarter did so, although increases were modest. The bank group reported return on equity in the fourth quarter of 20% with a fully loaded ROE of 16%. Canadian bank writedowns pale by comparison to a number of global players. Banks’ return on equity for fiscal 2007 was 21%, which compares very favorably with the 11% recorded by the six major U.S. banks.

• Negative sentiment from headline news and troubled U.S. Financials has more than offset any comfort investors may have received from the release of solid fourth quarter results by the Canadian banks and the confirmation of their low exposure to high-risk assets.

• Bank share prices have continued under pressure early in 2008, driven by fears of monoline insurance companies defaulting, recession fears, and concerns about overall financial market instability. The insurance monolines Ambac and MBIA may fall under the category “Too Big to Fail.” Also they may be able to manage their commitments in a run-off scenario.

Bank Dividend Yields Relative to Bonds - Levels Never Seen Before

• Despite Canadian banks’ low exposure to high-risk assets (Exhibit 6) including monolines (except for CIBC), high capital levels, high profitability, resilient earnings base and a very stable residential mortgage market, Canadian bank stock price declines have pushed up dividend yields relative to long Canada bonds to levels never seen before. The bank dividend yield at 4.2% or 1.05x relative to long bonds is 5.0 standard deviations above the mean (Exhibit 15). This is the highest relative yield by a wide margin. Even if we look at a chart back to 1956, bank dividend yields would be 3.8 standard deviations above the mean, much higher than the 1958 peak of 3.3 standard deviations above the mean.

• This is astonishing especially if you believe, as we do, that the probability of dividend cuts is negligible; in fact we continue to look for dividend growth of at least 8%-10% per annum over the next five years. Hence the Best Buying Opportunity in Decades.

Stress Testing Earnings for a Recession - Payout Ratio 52%

• We are stress testing bank earnings (Exhibits 7-10) for a recession again this year following our fiscal 2006 analysis. In this year’s stress testing we have become more aggressive in haircutting earnings, with similar results and conclusion. Banks can weather a recession with return on equity troughing in the 17%-18% range. If we cut 2008 earnings to recession levels, banks would be trading at a P/E multiple of 12.4x with a dividend payout ratio of 52%. Thus the current dividend levels are totally maintainable and defensible.

• Canadian banks are not, however, immune to the turmoil in financial markets, and we expect earnings growth will be very challenging in the first half of 2008 as the higher funding costs and cost of carry on the banks’ excess liquidity and capital puts pressure on interest margins. The prime BA spread declined 22 basis points (bp) in the fourth quarter to 139 bp, with partial recovery in the first fiscal quarter by an estimated 15 bp.

Trimming Earnings Estimates

• We are trimming our 2008 operating earnings estimates by 5% due to expected margin pressure in the first half of 2008 because of an increase in bank funding costs and a lag in repricing assets, as well as negative carry on the banks’ excess liquidity and capital. Our earnings and share price target adjustments are highlighted in Exhibit 1.

• The operating earnings decline excludes the CIBC pre-announced special first quarter charge of $1.6 billion after tax or $4.75 per share comprised of $1.3 billion on hedged CDO/RMBS (ACA) and $0.3 billion on unhedged CDO/RMBS portfolio.

Resilient Earnings - Dividend Increases to Continue

• The potential further writedowns for the Canadian banks are expected to be modest, with Exhibit 13 highlighting possible future writedowns that are readily absorbable in operating earnings, except for CIBC.

• Our overall earnings outlook remains solid, with earnings growth of 3% expected in 2008 and earnings growth expected to rebound to 15% in 2009. Return on equity for 2008 and 2009 is forecast at the 22% level, with Tier 1 capital ratios remaining extremely high in the 9.5%-10.0% range.

• We expect earnings in the first half of 2008 (Exhibit 12) to be weak, with first quarter earnings declining 5% year over year and return on equity remaining stellar at 21.2%. We expect the four banks that are due to increase their common dividends to do so this quarter, with BMO and CM dividend increases expected in the 4% range and TD and RY increases expected in the 8%-9% range. There is some uncertainty with respect to a CIBC dividend increase given the recent equity issue. Earnings momentum is expected to pick up in the second half as credit markets and funding costs stabilize. We expect the banks’ very high trough ROEs to be supportive of higher share prices and higher valuation.

Bank Share Prices Expected to Double

• On an absolute return basis we have no sells in the bank group and, as fear subsides in the market, we expect significant appreciation in bank stocks over the next few years. Bank stocks, we believe, can easily double in the next three, four, or five years at the outside. We remain overweight the banks.

P/E Multiple to Recover

• In terms of bank P/E multiples, we expect the stress testing of bank earnings in fiscal 2008 will result in P/E expansion and higher multiples, as they did in 2002 (Telco & Cable) and 1998 (Asia Crisis), and that the longer-term trend of expanding P/Es will continue.

• Bank P/E multiples declined in 2007 (Exhibit 18) from 14.5x at the beginning of the year, closing the year out at a low of 11.1x with a further decline to the panic bottom of 10.8x trailing earnings in early 2008 (January 21, 2008). We have been searching for the illusive bottom since the 11.5x trailing range, with the panic selling on January 21, 2008 (bank stocks down 4%-5%) perhaps being the bottom.

• The P/E bottom in the Telco & Cable debacle was 10.9x, with the Asia Crisis being 9.0x. It seems that P/E multiples have bottomed in early 2008 at a similar level to Telco & Cable. Following this bottoming in 2002, the P/E multiples ran up to 15.1x. We are looking for a repeat.

• Banks are trading at a compelling 10.9x trailing earnings and 10.6x and 9.2x our 2008 and 2009 earnings estimates. Our target P/E multiples are 15.6x and 13.5x our 2008 and 2009 earnings estimates, respectively. The P/E multiple has significantly diverged from the trend line (Exhibit 17).

• Bank valuations on a yield basis relative to bonds, Pipelines & Utilities, Income Trusts, and the S&P/TSX Composite are all at unheard of levels.

• Reversion to the mean versus 10-year bond yields implies a 7.8% bond yield or 97% increase in the bank index. Bank dividend yields relative to TSX, Pipes & Utilities, and Income Trusts on reversion to the mean basis implies a bank index increase of 62%, 63%, and 38% respectively.

Recommend Aggressively Buying Bank Stocks

• We would be very aggressive buyers of bank stocks at these levels with the weakest Canadian banks having extremely strong fundamentals.

• We continue to believe the best long-term value and shareholder returns will be derived from the high revenue growth banks TD, RY, and BNS. These banks have high profitability, superior operating platforms, and solid growth prospects.

• It is no coincidence that the revenue-challenged banks CIBC, BMO, and NA got caught in 2007 as a result of going out of the risk curve in search of revenue and earnings. CIBC’s exposure to CDO/RMBS, BMO’s to SIVs and Commodity Trading, and NA’s involvement in non-bank ABCP were all divergent from the mainstream.

• A year ago we had all banks essentially trading at the same multiple, regardless of profitability, business mix, revenue growth, or strength of operating platforms, which was not normal. P/E convergence of this magnitude has occurred only half a dozen times in the past 40 years. However, the relative share price performance among the banks varied considerably in 2007, and we now have some divergence in P/E multiples, slightly greater than the historical means with severe overshoots possible.

• We are reinstating coverage of CIBC and maintaining our pre-restriction rating of 2-Sector Perform. CIBC is a trading buy (with some disclosure risk) based on a 35% share price decline from its high, deep P/E discount of 22% to the group, strong capital position post the equity issue, and potential resolution of the U.S. monoline debacle. If the U.S. regulators are able to help resolve the concerns surrounding Ambac and MBIA, no significant further writedowns would be likely, with some of this we believe currently priced in. In terms of the ACA-related writedown, we believe the risk is priced in, with some possibility that losses could be lower than expected depending on the ultimate fate of ACA and improvement in value of the underlying securities aided by significant Federal Reserve rate cuts.

• The retail bank (includes wealth management) of CIBC earned $7.31 per share in 2007, which would equate to $6.65 per share on a pro forma basis after the dilution from the recent equity issue. Thus CIBC is currently trading at an attractive 10.2x the diluted 2007 retail banking earnings, with no value attributable to the wholesale business.

TD and RY Remain 1-Sector Outperforms

• CIBC continues to be a higher risk bank than TD and RY, our long term core holding banks that we have 1-Sector Outperform ratings on.

• Our bank stock selection in order of preference is TD and RY with 1-Sector Outperform ratings, followed by, BNS 2-Sector Perform, CM 2-Sector Perform, and NA 2-Sector Perform and BMO as 3-Sector Underperform.
Financial Post, David Pett, 25 January 2008

Two analysts have weighed in with somewhat pallid outlooks for Canadian banks this morning.

Desjardins Securities analyst Michael Goldberg expects earnings to be flat (at least on a collective basis) this year, and for dividend growth to slow appreciably.

With banks tightening their purse strings and being restricted in access to structured credit, he believes further credit crunching is unavoidable, no matter how much central banks grease the wheel.

Mr. Goldberg expects more modest top line growth and worsening loan quality as a result. However, he expects things to improve in 2009, and sees upside, both in terms of stock prices and dividend growth.

"We continue to view bank stocks as a foundation for any Canadian equity portfolio for the dividend growth potential they provide over time," wrote Mr. Goldberg.

His top picks are TD, because it "has avoided the pitfalls of sub-prime mortgages and structured products in Canada and the US, while continuing to successfully build its Canadian and US franchises," and Scotiabank, because "in the current uncertain environment, steady performance is a good thing."

Over at RBC Dominion Securities, Andre-Philippe Hardy and his team write that they are "increasingly concerned over the economy and equity markets" because "these two factors could be material negative earnings drivers for all financial services stocks in Canada."

Like Mr. Goldberg, however, Mr. Hardy tempers his pessimistic short-term outlook with longer term optimism, saying Canadian banks and insurance companies should navigate choppy economic waters better than their global peers and that "the return from holding these stocks over the next two or three years could be attractive as a result."

Countrywide Fraud Suit Expands To 26 More Financial Services Firms

Dow Jones Newswires, 25 January 2008

The New York City Comptroller, New York State Comptroller and New York City Pension Funds expanded the consolidated class-action lawsuit against Countrywide Financial Corp. (CFC) and others to include 26 financial services companies that underwrote Countrywide's stock and bond offerings.

The expanded suit also named two global accounting firms and additional Countrywide officers and directors who signed Securities and Exchange Commission filings that allegedly contained false and misleading information about Countrywide's business and finances.

"As borrowers lost their homes and investors held onto artificially inflated securities, Countrywide executives cashed out to the tune of almost $700 million," said state comptroller Thomas P. DiNapoli. "We will pursue every avenue to ensure that those who defrauded investors are held accountable for their actions."

The class-action suit alleges that Countrywide, Calabasas, Calif., misstated and omitted information regarding its lending practices and other business information, resulting in the artificial inflation of its stock price. The suit also claims the company issued stock and bonds based on SEC filings that contained false information.

The expanded suit includes ABN Amro Inc., A.G. Edwards & Sons Inc., Banc of America Securities LLC, Barclays Capital Inc., BNP Paribas Securities Corp., BNY Capital Markets Inc., Citigroup Global Markets Inc., Deutsche Bank Securities Inc., Dresdner Kleinwort Wasserstein Securities Inc., Goldman Sachs & Co., Greenwich Capital Markets Inc., HSBC Securities (USA) Inc., J.P. Morgan Securities Inc., Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley & Co., RBC Capital Markets Corp., RBC Dominion Securities Inc., RBC Dain Rauscher Inc., Scotia Capital Inc., SG Americas Securities, TD Securities Inc., UBS Securities LLC., Wachovia Capital Markets LLC, Wachovia Securities Inc., Grant Thornton LLP and KPMG LLP.

National Bank Bails Out Insiders of Their ABCP Holdings

The Globe and Mail, Janet McFarland, 25 January 2008

Executives, directors and other insiders at National Bank of Canada had $7.8-million worth of asset-backed commercial paper investments bought back from them by the bank after markets collapsed in August, the bank has revealed.

In a shareholder proxy circular issued Friday, National Bank said a previously announced program to buy back $2.1-billion of ABCP investments from clients also included buybacks from 48 bank insiders.

They included five members of the board of directors, including chief executive officer Louis Vachon, as well as three other senior executives: Ricardo Pascoe, who is co-CEO of National Bank Financial; Luc Paiement, the other co-CEO of National Bank Financial; and Michel Tremblay, who was chief operating officer of personal and commercial banking but has since left the bank.

Mr. Vachon had the largest personal holding of ABCP investments at $2.54-million. Mr. Tremblay held $1.44-million.

Most of the insiders, including Mr. Vachon and Mr. Tremblay, held their ABCP investments through the bank's mutual funds.

The bank said the decision to include the insiders in the buyback was made by a committee of independent directors who had no interest in the ACBP buyback. André Caillé, who chaired the independent committee, said the insiders “had to be included in the transaction” which covered all individual retail clients.

“They, too, are clients who entrust the bank with their savings,” he said in a statement. “They could not be treated differently from other retail clients and penalized for doing business with their bank.”

Montreal-based National Bank, which is Canada's sixth-largest bank, has been at the forefront of the turmoil in Canada's ABCP market, which has been frozen since August. It was the lead dealer for commercial paper issued by Coventree Inc. that was sold to National Bank clients.

The bank was forced to take a writedown of 25 per cent of its $2.25-billion worth of paper in the fourth quarter last year, leading to its first quarterly loss in 15 years.

National Bank announced in August that it would repurchase ABCP holdings from individual retail clients and from corporate clients with total holdings of $2-million or less who were not considered accredited investors under regulations.

That means, however, that many corporate clients are still holding their ABCP investments, which have declined significantly in value.

The proxy circular said five directors and three executives accounted for $7.13-million of the total repurchased from insiders, while 32 other employees held another $704,031. The directors who held ABCP investments were Gérard Coulombe, Nicole Diamond-Gélinas, Paul Gobeil and Jean Douville, who is also chairman of the board.

Another board member who held ABCP investments was not covered by the transaction because his holdings did not fall within the parameters for the buyback.

The board said the three executives who had their ABCP repurchased put the money into a trust account so they could work on the issue “without any appearance of conflict of interest.”

Also Friday, the bank reported Mr. Vachon did not receive a bonus last year because financial results “fell short of the objectives set at the beginning of the year.”

He did, however, receive a mid-term compensation payment of 22,284 stock units valued at $1.2-million. They will only vest after three years if he remains in the job and will be based on the value of the bank's shares at that time.

He was also granted 196,464 stock options estimated to be worth about $2-million based on a calculation of their potential future value.

The bank's proxy circular also includes 20 shareholder resolutions proposed for a vote at the bank's annual meeting on Feb. 29.

They include four resolutions related to the bank's ABCP problems. One asks the bank to review the performance of the CEO and another executive in light of the ABCP losses the bank has suffered, questioning why the bank was allowed to hold such large positions in the financial instruments. Another calls on the bank to hire an independent investigator to review the decision to buy back $2-billion in ABCP holdings.

The bank has recommended shareholders vote against those proposals.

Banks Will Disclose More Details on Risk Practices

Bloomberg, Sean B. Pasternak, 25 January 2008

Canadian banks including Royal Bank of Canada and Toronto-Dominion Bank will begin disclosing more information on their risk management starting as early as next month when they release first-quarter results.

Under new rules set by Basel II, a global standard for capital and risk practices, banks will be required to disclose 14 measures to investors, said Vivek Wadhwa, a principal at consulting firm McKinsey & Co. Some of these measurements will be disclosed quarterly, while others will be annually.

The measures are ``to increase transparency and enable market participants to obtain and assess important information,'' Wadhwa, a Basel II expert, told a conference in Toronto today. ``You'll see a significantly higher level of disclosure in Basel II compared to what was in Basel I.''

The disclosures will include credit adequacy and investments related to counter-party risk, he said. Banks globally have spent as much as hundreds of millions of dollars to address operational risk under the new accounting standard, said Wadhwa.

Societe Generale SA reported the largest trading loss in banking history yesterday after the French bank said a rogue trader placed bets on stock-index futures.

The events are an ``example of a failure perhaps in internal processes,'' Wadhwa said.

Canadian banks have also taken losses in the past year, including Canadian Imperial Bank of Commerce, which has announced writedowns of about $3.2 billion on investments linked to the U.S. subprime mortgage market. Bank of Montreal took writedowns of C$440 million last year on losses from natural gas trading.

24 January 2008

Analysts Lower Earnings Estimates & Target Prices

RBC Capital Markets, 24 January 2008

Our investment strategy team has been increasingly concerned over the economy and equity markets. If proven right, as they have so far in 2008, these two factors could be material negative earnings drivers for all financial services stocks in Canada, which would add to existing pressure on the conversion of foreign earnings back into Canadian dollars and, for life insurers, low long-term interest rates.

We are lowering our 12-month target prices and earnings estimates to reflect what is fast becoming a difficult macro environment for financial services companies.

We believe that investors in financial services stocks can afford to be patient. We believe that credit quality will deteriorate, uncertainty surrounding the North American economy has risen, equity markets may not be as strong as they have been for the last five years and the potential for negative headlines remains.

We continue to think that Canadian banks and lifecos should manage through a slower economy better than many global peers, that they are financially solid companies, and that they are unlikely to cut dividends. The return from holding these stocks over the next two to three years could be attractive as a result.

We prefer lifecos over banks although our preference is not as strong as it was given declines in long-term bond yields. We believe that the life insurers are less exposed to deteriorating credit quality, and we feel that their exposure to capital markets is lower than for banks. We are less bullish on lifecos versus banks than we were, however, as the significant declines in interest rates and the high Canadian dollar are more negative for them than for banks.

We believe the potential variability around our forecast returns is higher for banks than lifecos. If the US economic issues lead to a Canadian recession, our target prices would likely decline to levels that would suggest negative returns from holding bank shares over the next 12 months. On the other hand, there is more upside to earnings estimates and valuation multiples on banks if the macro environment proves more accommodating than our strategy team expects.
Financial Post, David Pett, 24 January 2008

BMO Capital reduced its earnings forecasts for the bank by 7% Wednesday, telling investors to expect lower trading and capital markets revenues this year alongside higher loan losses.

Analyst Ian de Verteuil said lower expenses will cushion some of the impact but after removing all "unusual items" from his calculations he expects the sector to essentially have no earnings growth in 2008 when compared with 2007. He also said share buybacks are unlikely this year and broadly speaking, all banks are equally affected by his revised forecasts.

"To date, we believe the bulk of the market's concerns have been focused on liquidity pressures and securities valuation," Mr. de Verteuil wrote in a research note.

"There are more challenges ahead, includiing a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks.

That said, the analyst believes investors can take comfort in the fact that dividends appear very safe and bank business models remain very defendable.

He maintained his "market perform" rating on the overall sector and reiterated his "outperform" ratings on both TD Bank and National Bank of Canada.
BMO Capital Markets, 23 January 2008

No banker makes a loan if he thinks it will go bad, and no trader puts in a trade that she expects will lose money. That is why bankers, investment bankers and traders aren’t terribly good at predicting loan losses or trading and capital markets revenues. Against this backdrop, and despite the recently stated view by various bank CEOs (that we have little to worry about), we are reducing our earnings forecasts for Canadian banks by 7%.

This incorporates lower trading and capital markets revenues and higher loan losses. Some of the impact of this will be mitigated by lower expenses. We are also assuming that buybacks are virtually non-existent in 2008. All in, after removing “unusual items”, we expect the Canadian bank sector to have essentially no earnings growth in 2008 when compared to 2007.

Our revised forecasts for each bank are shown below. Broadly, all banks are equally affected. As one would expect, the smaller banks, which have less capital markets exposure, have a minor impact. Note we are restricted on CM shares.

We are maintaining our Market Perform rating on the Canadian bank sector. After an extended period of underperformance, the group is certainly more attractive on a relative basis. To date, we believe the bulk of the market’s concerns have been focused on liquidity pressures and securities valuation. There are more challenges ahead, including a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks. However, investors should take comfort, as bank dividends appear to be very safe and the business models of Canadian banks remain very defendable.


We are lowering our forecasted bank earnings by $1.6 billion after tax. This reflects $2.5 billion in lower revenues than we had originally forecast and $800 million of higher loan losses. The impact of these two negative headwinds will be offset by $1 billion of lower expenses. We have assumed a 32% tax rate, which also mitigates the impact. Our basic assumption is a material slowdown in economic activity in North America, but no recession in Canada. We are effectively pushing our earnings growth out 12 months (our 2009 forecast is essentially our previous 2008 expectation).

Loan Losses

We are raising our 2008 forecast for loan losses by $800 million from $3.6 billion to $4.4 billion. Our 2009 forecast is increased by $1 billion from $4.4 billion to $5.4 billion. We have assumed the deterioration is principally in the business loan book (about $400 billion) and the non-residential consumer book (about $275 billion) but not in residential mortgages. All in, we note that even with these increases, we are not assuming “recession-type” loan losses. If we did, we would expect a further $2-3 billion of losses, i.e., a further 7% reduction in our earnings forecasts.

This more cautious view appears to be at odds with many bankers who still believe that the environment remains benign and that the specific issues that are developing (e.g., Quebecor World, Ambac, etc.) are isolated. We are simply assuming that the traditional leading indicators (economic activity, unemployment, default rates, etc.) are a relatively good reflection of what happens next. The issue, as we see it, is one of timing – and it is likely that the higher losses are skewed to the second half of 2008.

Trading Revenues

We are cutting our trading revenues forecast for the Canadian banking system to $5 billion from $6 billion. As we show in Chart 1 below, Canadian bank trading revenues have been relatively stable through most of the past six years at about $5.5 billion despite additional capital that has been committed to the business. The reality is that trading revenues today have become more a reflection of the benefits of structuring off-balance sheet vehicles rather than gains or losses on the “good old” swap books.

The relatively poor performance in 2007 included numerous CDO writedowns, so we expect some improvement in 2008. However, we believe with the market volatility (and the general decline in most markets), the odds of a disappointing first half are high. Furthermore, we believe most banks are scaling back capital committed to the business as value-at-risk (VaR) and volatility rise. On a more optimistic point, we note that trading is still a very modest part of overall revenues.

We believe the majority of bank trading operations remain high quality with good diversification and solid profit dynamics. However, volatility is an important element of the business and this has not gone away. Even at revenues of $5 billion annually, the business of facilitating client needs and creating and managing some structure will remain an important part of Canadian banks.

Capital Markets

We have been impressed (and amazed) by the ability of the major players in the Canadian securities marketplace to show consistent growth in profits. The members of the IDA have achieved record profits for the sixth year in a row – an unprecedented performance.

We believe the IDA data excludes most of the trading books of Canadian banks (which are often held in off-shore banking subsidiaries for tax and other reasons) and the traditional corporate loan books. We are assuming that weaker activity in M&A, equity and fixed income underwriting will shave about 20% off of these revenues – down $1 billion off of a base of $6.5 billion.

Wealth Management

The management of Canadians’ wealth (or rather the provision of advice to Canadians to help them manage their own wealth) remains an excellent business for Canadian banks. And banks will likely continue to be relative winners. However, and after several years of strong equity market gains and very strong flows, we believe revenues will be weaker in 2008 than we had previously assumed. We estimate that bank revenues from mutual fund, brokerage (full-service and on-line), private banking and discretionary investment management activities generate about $10 billion of revenues for Canadian banks. All in, we are assuming that revenues will be down 5%, or about $500 million. We note that the effect is less than one might think because many client holdings are not simply equity based, and we are not forecasting net withdrawals.

Bye-Bye Buybacks

We had previously assumed share buybacks of about 1–2% of outstanding stock in 2008 and 2–3% in 2009. We are now assuming no buybacks in 2008 and 1–2% in 2009. Buybacks are additive to EPS because of the low P/E afforded to bank shares. Note that we are considering buybacks not issuance, which is already up meaningfully because of deal activity – TD buying Commerce Bancorp, and Royal’s purchase of RBTT and Alabama National.

What is particularly interesting is that despite comments of confidence in the future by bank CEOs, banks have all but turned off their buyback programs. Specifically, Canadian banks bought back virtually no stock in November and December. A more balanced approach to analyzing buybacks is by considering the six-month rolling average.

Manulife Could Profit from Bond Insurance Turmoil: Desjardins

Financial Post, Duncan Mavin, 24 January 2008

As monoline bond insurers suffer their fifteen minutes of infamy, opportunities may arise for other organizations including Manulife Financial to profit from the bond insurance industry instead.

The bond insurers — which operated for years in blissful obscurity as financial guarantors to U.S. municipalities and other government agencies — have lately stepped into the blinding spotlight of the global financial crisis.

“What we now understand is that these guarantors got into trouble as they 'diversified' their business from the relatively pedestrian business of guaranteeing local government and agency debt issues into more exotic debt securities,” with exposure to the “highly toxic” subprime mortgage market, says Desjardins Seurities analyst Michael Goldberg.

The monolines’ traditional customers — government agencies and the like — “appear to be the innocent bystanders in these developments, watching the protection for their debt issues potentially evaporating and their borrowing costs potentially rising,” Mr. Goldberg says.

Now, those traditional customers may be looking for other financial guarantors “without the taint of toxic subprime mortgage insurance,” he says. “Does this represent an opportunity for a company like AAA-rated Manulife? We think it does.”

Desjardins has a $48.50 target for Manulife’s stock price, and rates the shares a “top pick.”

23 January 2008

Downturn has Banks Ready to Cut Costs

The Globe and Mail, Tara Perkins, 23 January 2008

Toronto-Dominion Bank chief executive Ed Clark wants employees to cut back on their “nice to do” expenses, but is assuring his team that he plans to keep investing for future growth despite the increasingly worrisome business environment.

An e-mail he sent to his senior executives on Monday highlights the anxiety that has rippled through the financial services business this week as markets have seesawed.

“The downturn in the market hurts some of our businesses directly – TD Securities and TD Waterhouse,” Mr. Clark wrote in the e-mail.

“The uncertainty in the market has hurt spreads in both Canada and the U.S., and impacts on deposit growth,” he wrote. “If a major slowdown occurs, all of our businesses will be hurt and loan losses will rise.”

Analysts are more pessimistic about the outlook for the big Canadian banks' earnings, especially on the capital markets side of the business.

On Wednesday, BMO Nesbitt Burns analyst Ian de Verteuil reduced his 2008 profit forecast for the banks by 7 per cent, or a total of $1.6-billion after tax, based on his belief that trading revenues and capital markets revenues will suffer as bad loan losses rise. He expects the banks' expenses will be $1-billion lower than his previous estimate.

“There's a higher level of consciousness around it,” an investment banker at one of the big banks said Wednesday of costs and expenses. Bankers suggested the sector is entering a period of belt-tightening.

In his note, Mr. de Verteuil said he expects the Canadian bank sector to have essentially no earnings growth this year, after removing one-time items.

He lowered his trading revenue forecast to $5-billion, from $6-billion, saying it's likely the first half of the year will be disappointing because of market declines and volatility.

In his e-mail, Mr. Clark said the financial services industry remains under a microscope regarding further writedowns because of U.S. subprime mortgages and related issues.

“Even though TD doesn't have any exposure to these issues, the market mood is not yet in a place where major distinctions are being made between positive and negative outliers,” he wrote. “Over time though, the market should start to differentiate between banks on the basis of the quality of their earnings.”

The bank has had an economic view for some time to expect a slowdown in 2008, he said. And while “we have to be tough on ‘nice to do' expenses,” that's something that should be happening regardless of market conditions.

“What we are not going to do is have a fire drill just because the market is down,” he said.

CIBC World Markets analyst Darko Mihelic said, “Ed Clark is a worrier,” and seems to be “the first to admit that there will be difficulties ahead.”

Enron Investors Suing Banks Spurned by Top US Court

Bloomberg, Christopher Scinta, 23 January 2008

Enron Corp. creditors could see their original payout more than quadruple to as much as $31 billion after a trial against Citigroup Inc.

Enron Creditors Recovery Corp., the entity winding up the defunct energy trader's affairs, distributed $13.3 billion, or 36 cents on the dollar, since a bankruptcy plan was approved in 2004. That includes most of $1.73 billion in out-of-court settlements with 10 of the 11 banks creditors accused of aiding the fraud that wiped out the company. They argue that Citigroup, the only lender that hasn't settled, should pay the rest of the claims, about $18 billion. The amount is more than six times the $2.8 billion reserve for Enron, WorldCom Inc. and initial public offering-related litigation that Citigroup disclosed in a Nov. 5 regulatory filing.

Evidence at a trial set for April in New York may include an examiner's report citing bank e-mails as evidence Citigroup assisted in the fraud. Testimony against the bank by Andrew Fastow, Enron's imprisoned former chief financial officer, may also be introduced.

``There's a lot of evidence that financial irregularities occurred and they were aided and abetted and assisted by the banks,'' said John Coffee, a Columbia Law School securities law professor in New York.

The creditors' distribution from litigation and asset sales almost doubled to $11.5 billion in the year after April 2006. An $18 billion win this spring would bring the total to more than four times the 2006 figure.

The creditors say Citigroup should be forced to pay the remaining debt under a rule allowing recovery from one of a group of defendants for the total damages caused by all. The New York- based bank says the so-called deep-pocket rule shouldn't apply.

``Everyone is looking at Citi to see the kind of pocket it has left,'' said Nancy Rapoport, a law professor at the University of Nevada-Las Vegas and co-editor of a 2004 book on Enron. ``Citi has a lot to be worried about.''

The lawsuit is among legacies Vikram Pandit assumed in December on being named chief executive officer after Charles Prince III was forced to step down amid the global credit squeeze.

Citi reported the largest loss in its history, $9.83 billion, for the fourth quarter posted Jan. 15 after it wrote down the value of subprime mortgage investments by $18 billion.

The bank lost more than half its market value in the past year and fell yesterday to a 52-week low closing price of $24.40. It rose $1.96 to $26.36 today in New York Stock Exchange composite trading.

Citigroup considers the Enron lawsuit meritless and will fight it, spokesman Michael Hanretta said. No settlement talks are under way, said Harlan Loeb, an Enron creditors' spokesman.

There's an ``unprecedented'' amount of evidence against Citigroup, said John Ray III, chairman of Houston-based Enron Creditors Recovery. This includes the report by examiner Neal Batson, who quoted one internal bank e-mail as saying, ``Sounds like we made a lot of exceptions to our standard policies'' in setting up an Enron deal. ``Let's remember to collect this IOU when it really counts.''

The bank ``bent its own internal rules and participated in transactions about which it had substantial reservations, in order to accommodate Enron and maintain an important client relationship,'' Batson concluded about special-purpose entities, or SPEs, used to disguise loans as investments.

``There is evidence both that Citigroup knew Enron's SPE transactions would result in Enron's financial statements being materially misleading, and that Citigroup provided substantial assistance to Enron in completing those transactions,'' he wrote.

Creditors are ``anxious to get to trial,'' Ray said, calling a Citigroup effort to move the case from U.S. Bankruptcy Court a stalling tactic.

In December, the bank said the case should be heard before a U.S. District Court jury, not Bankruptcy Judge Arthur Gonzalez. Bankruptcy courts don't conduct jury trials and are below district courts in the federal judicial hierarchy.

Citigroup attorney Brad Karp of Paul, Weiss, Rifkind, Wharton & Garrison in New York declined to comment. Enron creditors' attorney David Stern of Klee Tuchin Bogdanoff & Stern in Los Angeles didn't return a call seeking comment.

Prince told Congress in 2002 the bank relied on Enron and its auditors for accounting advice in setting up transactions. Congressional investigators said Citigroup helped the energy trader hide debt by disguising loans as trades.

The bank asked Gonzalez Jan. 7 to throw out most of the suit, saying Enron Creditors Recovery doesn't have standing to pursue creditors' claims. Enron, not banks that lent it money, is to blame for its collapse, Citigroup said in court papers. Citigroup claims Enron still owes it as much as $5 billion.

Citigroup in 2005 agreed to a $2 billion settlement of another suit, in which Enron shareholders claimed banks helped executives including Kenneth Lay and Jeffrey Skilling commit fraud. The banks that refused to settle, including Merrill Lynch & Co., won when an appeals court ruled the shareholders couldn't sue as a group for the $40 billion they were seeking to recover. The U.S. Supreme Court yesterday refused to hear an appeal.

Ray, of Enron Creditors Recovery, declined to comment on what would be a fair settlement in his case, saying only that he will continue to fight for returns.

``Certainly it's the bold aggressiveness that got us from 17 cents to what today is 36 cents,'' Ray said.

Charles Tatelbaum, a bankruptcy attorney at Adorno & Yoss in Fort Lauderdale, Florida, said that while another $2 billion Citigroup settlement is possible, creditors are looking for more.

``They are gambling with house money,'' Tatelbaum said. ``The speculators that bought at 15 cents on the dollar are going to say go for it.''

The claims were bought from original creditors and may have been traded since. Bankruptcy claims are traded in private transactions whose terms are rarely disclosed.

Claims were traded by Lehman Commercial Paper Inc., SPCP Group LLC, Bear Stearns Investment Products Inc. and Ore Hill Hub Fund Ltd., according to court documents. All the buyers declined to comment or didn't return calls.

Even if Citigroup offers to bring the creditors' recovery to 50 cents on the dollar, that ``may not be enough to move the needle with this group,'' said Michael Sirota, a bankruptcy attorney with Cole Schotz Meisel Forman & Leonard in Hackensack, New Jersey.

Enron creditors settled with Royal Bank of Scotland Group Plc, Royal Bank of Canada, Canadian Imperial Bank of Commerce, Toronto-Dominion Bank, JPMorgan Chase & Co., Credit Suisse Group, Merrill Lynch & Co., Fleet Bank N.A., Barclays Plc and Deutsche Bank AG.

The case is Enron Creditors Recovery Corp. v. Citigroup Inc., 03-9266, and the bankruptcy case is In re: Enron Corp., 01- 16034, both U.S. Bankruptcy Court, Southern District of New York (Manhattan).
Financial Post, Duncan Mavin, 22 January 2008

Royal Bank of Canada and Toronto-Dominion Bank seem to have won a $1-billion Enron-reprieve thanks to a U.S. Supreme Court decision legal experts say ends the prospect the banks will face successful legal claims related to their role in the collapse of the failed energy trader.

The Supreme Court decision Tuesday also raises questions about Canadian Imperial Bank of Commerce's move to settle its Enron legal bill early, for US$2.4-billion, in 2005.

"For the people who are trying to maintain these suits against Enron and its advisors there are some options but it looks like it's a pretty long haul now," said Michael Peerless, a class-action lawyer with Siskind, Cromarty, Ivey & Dowler LLP based in London, Ont.

"It's a very serious blow to the [Enron] plaintiffs," Mr. Peerless said.

The U.S. court kicked out an appeal from former Enron shareholders. The appeal was against an earlier decision that barred them from suing banks that lent money to Enron including Merrill Lynch & Co., Credit Suisse Group and Barclays PLC.

Lawyers say the decision also impacts plaintiffs against other banks that have set aside reserves to cover legal claims against them. TD and RBC have set aside about $1-billion for Enron related suits between them.

"We're pleased with the decision of the court and at this time we are reviewing the implications," said a spokesperson for TD.

For TD and RBC, the court's decision is "some good news in a sea of bad news" for the struggling financial services sector said Desjardins Research analyst Michael Goldberg.

"While I don't think this means TD and RBC can release the reserves they previously set up for Enron, I'd like to believe they are breathing a little easier," added Genuity Capital Markets analyst Mario Mendonca.

A senior banker at another Canadian financial institution was critical Tuesday of CIBC's decision to settle early, saying the bank's payout was "a big number to be wrong on."

CIBC was one of a small group of banks that settled their high-profile legal claims early.

Shareholders have recovered more than US$7-billion from Enron's bankers and others, including US$2.4-billion that CIBC agreed to pay in August, 2005.

The bank's settlement also stepped into the spotlight last year when one of the lead litigators acting for Enron plaintiffs got himself into legal hot water. William Lerach -- who negotiated the CIBC settlement on behalf of

Enron investors -- pleaded guilty to a federal conspiracy charge in October last year after admitting making secret payments to plaintiffs in class-action lawsuits.

Executives at CIBC have defended their decision to settle which, they say, brought certainty to the bank's Enron issues.

Some observers agree that CIBC made a logical decision to pay out based on the facts available at the time.

"Hindsight is 20/20," said Chris Caparelli, a litigation lawyer with Torys LLP in New York. "At the time there was something to be said for settling on a value that seemed to make sense."

There has been a shift in the law in the U.S. in the past couple of years that makes it more difficult for investors to sue in cases like this, Mr. Caparelli added.

Class action rules in the U.S. have been getting tougher of late, agreed Mr. Peerless.

Tuesday's Supreme Court decision came on the heels of a ruling last week in an unrelated Supreme Court case that put new limits on shareholder suits against a company's banks and business partners.

"The way the law has developed in the U.S., investment banks are [now] kind of shielded from problems, unless you can prove that you relied on their representations. A passive class member has to show that even before a case can go forward and that's a tricky problem."

CIBC's executives insist that the particular circumstances of the claims against CIBC were different than those against some other banks. As early as 2003, CIBC was facing possible criminal indictments from the U.S. Department of Justice.

The bank acknowledged wrongdoing by some of its employees and agreed to pay a relatively inexpensive US$80-million settlement to the Securities and Exchange Commission. That settlement also meant CIBC could not defend itself from shareholder suits, leading to the mammoth payout in 2005.
Bloomberg, Greg Stohr, 22 January 2008

The U.S. Supreme Court rejected an appeal by Enron Corp. investors, refusing to resurrect a $40 billion suit against Merrill Lynch & Co. and other banks that lent money to the now-defunct energy trader.

The justices made no comment in turning away the appeal today, acting a week after putting new limits on shareholder suits against a company's banks and business partners. The Enron investors challenged a lower court ruling that barred them from joining together in a class-action suit against Merrill Lynch, Credit Suisse Group, Barclays Plc and other banks.

The rebuff likely means an investor group led by the University of California regents won't add to the $7.3 billion they collected in settlements with other Enron banks. More broadly, the Supreme Court sent a new signal about its skepticism toward shareholder suits, refusing even to order a lower court to reconsider the Enron case in light of last week's ruling.

The investors sought to distinguish their suit from the one rejected by the high court last week, saying the Enron case came ``in the context of fraud perpetrated by financial professionals engaged in fraudulent dealings in our securities markets.''

Last week's 5-3 Supreme Court ruling, Stoneridge v. Scientific-Atlanta, involved a suit by Charter Communications Inc. investors against two of the cable company's suppliers. The majority said the alleged wrongdoing in that case ``took place in the marketplace for goods and services, not in the investment sphere.''

The court's rejection of the Enron investor appeal came without any published dissent. The rebuff ``further confirms that there is no financial services exception'' to the Stoneridge ruling, said Stephen Shapiro, who successfully represented the suppliers in last week's case.

The lead lawyer for the Enron investors, Patrick Coughlin of Coughlin Stoia Geller Rudman & Robbins, said the group will try to revive its case by shifting the focus to analyst reports issued by the banks, rather than their role in setting up the mechanisms used to deceive investors.

``I'm disappointed, but we'll go back to the district court now,'' Coughlin said.

That legal theory isn't likely to succeed, according to James Cox, a Duke University securities law professor who has been supportive of the investor claims. The investors will have to show that the analyst reports, and not some other factors, caused them to lose money. The Supreme Court in 2005 made it harder for investors to make that showing.

The investors will face ``significant if not insurmountable loss-causation issues,'' Cox said.

Cox said the rejection of the Enron appeal ``just shows you how out of step the Stoneridge holding is with investor protection.''

Justice Anthony Kennedy, who wrote the Stoneridge decision, didn't take part in the court's consideration of the Enron case. Although Kennedy gave no explanation, his son, Gregory Kennedy, works as an investment banker at Credit Suisse in New York.

Credit Suisse spokeswoman Victoria Harmon said the company is ``pleased with the decision of the court.''

Houston-based Enron was the world's largest energy-trading company, with a market value of as much as $68 billion, before it collapsed in December 2001. The bankruptcy, the second-largest in U.S. history, wiped out more than 5,000 jobs and at least $1 billion in retirement funds.

Enron's investors accused the company's banks of helping late Chairman Kenneth Lay and ex-Chief Executive Officer Jeffrey Skilling disguise debt as loans, finance sham energy trades and use off-the-books partnerships to hide losses and inflate revenue.

Investors settled claims against JPMorgan Chase & Co. for $2.2 billion, Citigroup Inc. for $2 billion and Canadian Imperial Bank of Commerce for $2.4 billion.

The group's lead lawyer had been Bill Lerach, who in October pleaded guilty to secretly paying clients of his former firm, Milberg Weiss, to participate in shareholder lawsuits. Coughlin, Lerach's former partner, has since taken over the lead role.

In barring the suit from going forward as a class action, the 5th U.S. Circuit Court of Appeals in New Orleans said it couldn't presume that shareholders, when making investment decisions, relied on the alleged wrongdoing by the banks.

Last week's Supreme Court decision used somewhat similar reasoning, though not in the class action context. The court said the Charter shareholders didn't show they relied on the alleged deception by suppliers Motorola Inc. and Scientific-Atlanta Inc.

Kennedy said federal securities-fraud law ``does not reach all commercial transactions that are fraudulent and affect the price of a security in some attenuated way.''

``Having read Stoneridge, I can't imagine that the court would have anything to criticize in the 5th Circuit case in terms of its understanding of the law,'' said Georgetown University securities-law professor Donald Langevoort.

New York-based Merrill and the other banks in the Enron case urged the Supreme Court simply to reject the appeal, rather than send the case back to the lower court. The Stoneridge case ``involved facts extraordinarily similar to the facts that are present here,'' the banks argued.

The case is Regents of the University of California v. Merrill Lynch, 06-1341.

21 January 2008

Financial Sector Fell 3.9% on the TSX

Financial Post, Duncan Mavin, 21 January 2008

The best of Canada's financial stocks were dragged into the global stock market sell-off yesterday as panicked investors ditched just about anything for which they could find a buyer.

"In an environment like this people will sell what is saleable," said one Bay Street bank analyst.

Although financials fared better than most of the rest of the Toronto Stock Exchange, there was no hiding place for banks and insurers that are often regarded as a safer, quality bet.

Financial sector stocks fell 3.9% on the TSX, compared with a 4.2% decline in the S&P/TSX composite index.

Among the big losers were Royal Bank of Canada, Bank of Nova Scotia, and Toronto-Dominion Bank, which have all avoided the worst of the subprime meltdown that has dragged down financial stocks around the world.

RBC slipped 3.8% or $1.79, while Scotiabank was down 4.7% or $2.17 and TD fell 5.0% or $3.21. Canadian Imperial Bank of Commerce - whose stock has been battered recently by massive subprime charges and rumours of bigger losses to come - continued to slide, down 3.5% or $2.34, while Bank of Montreal was down 4.8% or $2.61.

Insurers Manulife Financial Corp and Sun Life Financial were also down - Manulife fell 2.4% or 88¢, and Sun Life sank 2.9% or $1.39.

Shares in banks and insurance companies are not usually as volatile as stocks in other sectors. But Canadian financial stocks have under-performed of late in part because of fears about ties to the U.S. subprime mess which has taken a huge bank out of the market capitalization of banks south of the border.

Most of the big Canadian banks - with the exception of TD - have announced significant subprime related writedowns that in total amount to more than $4-billion already.

But yesterday's sell-off of financials was largely "just a broader market move" and not a reflection of recent under-performance in the sector, said Blackmont Capital analyst Brad Smith.

"It is all based on rising awareness of the risk of a U.S. recession and a growing appreciation of the potential order of magnitude of what we might be facing," Mr. Smith said.

Fears about the U.S. economy have been "crystallized" by last week's announcement of the Bush fiscal rescue package, he added.

"This move is just the market catching up with the fundamentals," Mr. Smith said.

Investors are likely also concerned about the impact of a U.S. recession on banks such as RBC and TD, as well as insurers Sun Life and Manulife, which have extensive operations in the U.S.

"I've for some time been leaning toward the idea that we would see a credit correction spread beyond subprime in the U.S. and that is increasingly being shown to be a risk factor," said Blackmont's Mr. Smith. "To the extent you have significant credit exposures in the U.S. I think there are going to be some bumps in the road."

RBC CM Assesses Downside Risk of Banks & Life Insurance Cos

RBC Capital Markets, 21 January 2008

Two questions we receive most from investors are: (1) with Canadian bank shares down 24% from their 52 week highs and lifeco shares down 15%, are these levels where the stocks should be bought; and (2) if a recession hits the North America, what kind of downside risk could there be in bank and lifeco stocks.

We would not add to Canadian financial services positions at this time as we see increased downside risk to earnings and the economy, and we do not believe valuations are at "back up the truck" levels. Bank and lifeco stocks may trade higher in a year if the economy avoids a recession, but it is still too early to buy the stocks, in our view.

We believe the next set of earnings will be difficult for lifecos given the high Canadian dollar, shaky equity markets and declining long term interest rates. For banks, net interest income margins are likely to remain pressured this quarter, wealth management and capital market earnings growth may be weaker than in past years and we believe that companies with exposure to CDOs and AAA-rated monolines are at risk of further writedowns. Higher loan losses are expected for those with U.S. exposure in Q1/08, while normalization of loan losses may hit all banks as the year progresses. For banks, we believe that investors default to price to book in times of economic stress, a period in which credit losses rise rapidly and wealth management and capital market earnings become difficult to predict. The banks traded at an average 1.65x book at the last trough (fall of 2002), which coincided with rapidly rising loan losses and difficult equity markets. A decline from current multiples to 1.65x book would suggest 20-25% of downside risk.

Canadian lifecos have not been public for long, but if excluding the period in which they were expected to merge, they have traded at 10.0-14.5x earnings. They are currently trading at 12.0x forward earnings, suggesting 15% downside risk if valuations decline to trough levels. We emphasize P/E instead of P/B since lifecos may be able to post earnings growth close to estimates even if the macro environment worsened given the size of their actuarial reserves. Multiples could decline, however, as the perceived quality of earnings would be negatively impacted in an environment of lower interest rates and weaker equity and credit markets.

We believe the Canadian banks and lifecos are financially solid companies, which are unlikely to cut dividends, have well established franchises and should come out of a recessionary environment better than many global peers. However, there is downside risk to earnings and stock prices if economic news worsens and equity markets continue to decline.

18 January 2008

CIBC: The Bank Most Likely to Walk Into a Sharp Object


The Globe and Mail, Sinclair Stewart, Tara Perkins, Boyd Erman, 18 January 2007

The week before Christmas, a group of senior bankers gathered at the Toronto offices of Canadian Imperial Bank of Commerce to work out the details of an emergency funding effort.

For CIBC chief executive officer Gerry McCaughey, it had been both a miserable and taxing month, doubtless the most difficult of his 21/2-year reign atop the bank. The bank had taken $753-million in writedowns because of its entanglement with a spiralling subprime mortgage mess, and recently stunned investors with the acknowledgment that it had $10-billion worth of hedged exposure to that market.

What these investors didn't know was that CIBC was preparing to write down an additional $2-billion in a matter of weeks, enough to make it one of the costliest misadventures in Canadian banking history.

Mr. McCaughey, whose entire tenure to this point had been geared toward erasing the taint of previous scandals, methodically stripping away risk and rehabilitating the bank's maverick reputation, knew that he would have to make senior management changes, and was already in secret negotiations to recruit his close friend Richard Nesbitt, who runs the Toronto Stock Exchange, as a replacement for Brian Shaw as head of the gaffe-prone investment bank, CIBC World Markets.

Mr. Shaw, who probably suspected at this time that his days were numbered, nevertheless remained in Toronto while his family went to Mexico on vacation, helping to carry out one of Mr. McCaughey's imperatives: Defusing potential bombs by exiting whatever remained of the bank's structured product businesses. About 40 consultants had also been brought in to help CIBC clean up the debris.

The most pressing issue was the bank's balance sheet. Given the grisly prognosis for the subprime market, it had become clear that CIBC would likely have to take billions of dollars in additional charges to mark down the value of its holdings, a scenario that would erode the bank's capital levels and could put them dangerously close to minimum regulatory limits.

At a board meeting in December, Mr. McCaughey and his fellow directors agreed that the bank would have to approach private and public investors to raise close to $3-billion, and that it should do so as fast as practicable: Any delay could make the effort more costly, if not impossible, given that conditions were deteriorating almost daily.

On Dec. 18, Mr. McCaughey hired UBS as a financial adviser, in part because of the firm's strength in the banking sector, and in part because of his respect for Oliver Sarkozy, UBS's joint global head of financial institutions – and, incidentally, the half-brother of French President Nicholas Sarkozy. The two bankers had met when CIBC purchased an additional stake in FirstCaribbean International Bank in 2006, and had remained close since that deal, keeping in touch with regular telephone conversations.

The initial meeting, in Toronto, was supposed to last a half hour, but went much longer, thanks to an extended conversation about history between Mr. McCaughey and Mr. Sarkozy – surely no surprise to the CIBC contingent, who are well acquainted with their boss's tendency to digress.

When they did get down to business, Mr. McCaughey insisted that he would not merely issue a chunk of stock in a private placement to large institutional investors – he wanted a sizable piece to be sold to the public as well. The deal would also have to be straight equity: CIBC couldn't issue preferred shares, as many of its U.S. peers have done to bail themselves out of similar trouble, because the bank was already up against a cap on these securities.

Throughout the holidays – even on Christmas Day – the bankers finalized details of the plan, and kept in touch daily on 8 a.m. phone calls. As the New Year approached, they drew up a list of private parties who might be enticed to buy $1.5-billion worth of stock; an additional $1.25-billion would be sold in the market to regular investors.

The list included the Ontario Teacher's Pension Plan; Asian tycoon Li Ka-shing, once a major shareholder of the bank, and a customer dating back almost four decades; Canada Pension Plan Investment Board; insurer Manulife Financial Corp., once rumoured to be a possible merger partner for CIBC; the Caisse de dépôt et placement du Québec; and the Ontario Municipal Employees Retirement System.

On Monday, Jan. 7 – the first day back from holidays for many on Bay Street – the bank dropped the bombshell: Mr. Nesbitt would leave the TSX and replace Mr. Shaw as head of CIBC World Markets; Tom Woods, the chief financial officer, would be placed in charge of the faltering risk management operation, taking over from Ken Kilgour; David Williamson, a well-regarded former executive at life insurer Clarica, would be brought in as CFO; and Nick LePan, the past Superintendent of Financial Institutions, would join the board.

A few days prior to this announcement, CIBC had secretly begun to contact private investors, and initially the hope was to unveil the capital-raising effort in the second week of January. But there was a glitch. Teachers, which had contemplated taking a large piece of the deal, was demanding more stringent terms than CIBC was willing to offer. The bank balked, and Teachers left the table, forcing CIBC to bring in another investor.

Other than causing a small delay, however, this did little to upset the bank's plans; in fact, the participation was so strong – abetted by an offering price that was about 13 per cent lower than where CIBC's stock was trading – that another pension fund, the Public Sector Pension Investment Board, was refused a piece of the deal when it attempted to get in at the 11th hour.

But once news of the capital injection hit the markets, reaction was mixed. While some applauded Mr. McCaughey's prudence, and agreed that this would cushion the blow, others viewed it as a grim portent.

The bank could have absorbed the $2-billion it planned to write down in the first quarter of this year, but adding more capital was tantamount to an expectation – if not an admission – that more was to come.

New and improved CIBC

On the last day of May, 2007, a group of senior management at CIBC huddled in a boardroom and prepared to begin a conference call with analysts. It had been a good second quarter, for the most part. For more than a year, Mr. McCaughey had been painstakingly laying out his vision for the New and Improved CIBC: no more fumbling after Wall Street glory, no more over-the-top risk-taking.

This was a return to your grandmother's bank, a boring cash cow that catered to retail customers, lent money to Canadian corporate clients, managed financial wealth, and augmented this with a strong, but plain vanilla, investment bank.

So far, so good, investors seemed to be saying.

Of course, banks can't control the economy, and CIBC, like most in the industry, could see trouble on the horizon. In the previous few months, there were worrisome signs emanating from the U.S. housing market, which was suffering rising defaults among so-called “subprime” borrowers: that is, people with weak credit histories that had purchased a home at higher interest rates. Billions of dollars worth of these mortgages were bundled into complex securities known as collateralized debt obligations, or CDOs, and then sold off in chunks to large investors, including banks.

Smart investors were starting to ask questions. On the May conference call, a hedge fund manager, Mark Cicirelli, asked a seemingly arcane question about CIBC's exposure to a small CDO called Tricadia 2006-07, from which the bank had apparently purchased $330-million worth of securities backed by mortgages: How much money did the bank stand to lose if the mortgage market fell off a cliff, something that was now looking more and more likely?

Not much, replied Brian Shaw, head of CIBC's investment bank. He explained that Tricadia pooled together a series of reasonably good-quality CDOs, and the result was a security that was highly rated by the credit rating agencies.

“I guess I would just conclude,” he offered, “by saying in summary our risk in this space is not at all major.”

Mr. Cicirelli wasn't altogether convinced by the explanation. Nor, for that matter, was Mr. McCaughey.

‘De-risking the business'

For the next few weeks after the call, Mr. McCaughey attempted to get the measure of CIBC's dealings with the worsening subprime market and, autodidact that he is, make himself an expert on the subject. Although he was not intimately aware of the bank's CDO activities, given they were such a small part of the bank's overall business, sources said the Tricadia question left him uneasy: History had long since taught him that if someone smelled smoke at CIBC, a fire was probably not far behind.

As June progressed, this smoke only thickened. A growing host of subprime casualties was appearing, headlined by a major blowup at a hedge fund operated by Bear Stearns, Wall Street's fifth-largest player.

Despite reassurances from some of his managers that the majority of these CDOs were not merely safe, but also insured, Mr. McCaughey began questioning everyone, from department heads to front-line traders. Often, sources said, he would request sheaves of information, take it home on the weekend, and arrive Monday morning armed with a series of questions.

The answers, it soon became apparent, were of little comfort, either to Mr. McCaughey or the board, which received a debriefing on the issue during the middle of the month.

CIBC, a bank whose mantra had become “de-risking,” was sitting on $1.7-billion worth of unhedged CDOs, much of which were backed by subprime mortgages – in other words, the bank had not bought protection from insurers to guard against the possibility of default on this portfolio.

A further $10-billion worth – a staggering amount – had indeed been hedged, but $3.5-billion of that amount was hedged with a single insurer. Normally, that kind of concentration would elicit concern, but Mr. McCaughey was told by some managers that there was little to worry about: These securities were rated triple-A – in other words, very safe and low-yielding – and on top of that, CIBC had purchased protection from an A-rated bond insurer.

“As we were de-risking the business, it was an area we didn't get to,” conceded one director. “We didn't think of it as high risk.”

By the time they did, it was all but too late – in the second week of July, the CDO market collapsed, leaving the bank with little means of offloading its holdings or buying further protection.

Two years after arriving as CEO, and working to overcome a $2.4-billion (U.S.) settlement with Enron Corp. investors, Mr. McCaughey was facing the possibility he might have to write down most of the value of his $1.7-billion worth of unhedged positions, leaving the bank with a punitive charge. Little did he know at the time, that that was the least of his worries.

A triumph of alchemy

It's logical to ask, given the bank's self-proclaimed focus on risk, just how CIBC could blunder into what one director described as “a catastrophe.” To be fair, a good portion of the problem was systemic, and any investment bank that had the misfortune of playing in this game has been savaged, as the examples of Citigroup, Merrill Lynch, UBS, and Bear Stearns, among others, have made painfully clear. So far, global banks have written off more than $100-billion in subprime-related mishaps, and the toll continues to climb.

So how could some of the shrewdest minds in the financial world be so horribly gulled?

The explosion of CDOs in recent years is a triumph of alchemy; financial engineers, looking to create a more liquid market for asset-backed securities, devised a way to repackage questionable assets in a way that won top marks from credit rating agencies.

The process is notoriously complex, and has several permutations, but a basic scenario would look something like this. An investment bank pools together various forms of debt, like subprime mortgages, into a CDO structure. The structure is then divided into layers, or “tranches:” The top portion, the most highly rated, would have the least chance of default but would pay the lowest interest. As one descends through the layers, the risk climbs, and so do the premiums to investors.

The theory behind CDOs was that they could diversify risk by slicing it up and dispersing it widely throughout the financial system. Of course, the appetite for these securities fuelled the need for more and more product, which meant that many people who shouldn't have qualified for mortgages – or who were likely to default once their payments increased – were approved for homes they couldn't afford.

Once the mortgage market collapsed, it triggered a domino effect in the financial system, decimating the value of CDOs, forcing banks to take charges, and threatening the stability of the very insurers from whom banks like CIBC bought protection.

The glaring flaw in this meltdown was the ratings: In retrospect, these subprime-backed securities look nowhere near as safe as the triple-A paper issued by the world's bluest of blue-chip companies. Yet many were rated as such, thanks to clever financial manoeuvring by the originators of these products – and, many would say, sloppy procedures at some of the world's top credit rating agencies.

Which brings us back to CIBC. The important thing about ratings is how they affect a bank's capital position. Banks are required by regulators to backstop their investments with capital; the higher the rating, the less capital required, since the security is perceived as a relatively low-risk investment. That also means a bank can amass a much larger portfolio of triple-A securities than it could with lower-rated investments.

One of the first things Mr. McCaughey did when he arrived at CIBC was reduce the amount of economic capital at his investment bank by 50 per cent, in essence, drastically reducing its risk profile and tilting more of the bank toward predictable retail earnings.

In theory, that kind of move would force CIBC out of undesirable businesses by putting a chokehold on capital.

In practice, something rather different happened. CIBC migrated to more highly rated securities, in order to ease up on capital, and saw an opportunity in the burgeoning CDO market.

The bank accumulated much of its $12-billion worth of CDO exposure over the past 18 months. Sometimes it would act as guarantor. Sometimes it would actually help structure the deals. And sometimes it would simply be a buyer.

“They acted as sales agent, guarantor, underwriter,” said one person familiar with the bank's involvement. “It was for information flow; you create a body of knowledge, and you become a player.”

Picture this. An investment bank originates a CDO, and asks CIBC to guarantee – or essentially insure – a senior tranche of triple-A-rated notes. The bank says fine, since the capital requirements would be minimal, and then, for added caution, takes out the equivalent of a reinsurance policy with another bond insurer. The bank collects a premium as a guarantor, pays out a smaller premium to the insurer, and pockets the difference. In other cases, when the bank was trying to help a deal along, it would take a chunk of triple-A securities onto its own books without buying protection: The irony is that these securities were seen as having such low risk – and consequently, paid such meagre returns – that it wasn't easy to offload them.

Even so, as several executives and directors have privately pointed out, taking unprotected positions in complex derivatives was antithetical to the strategy that Mr. McCaughey had been preaching for the bank: Focusing on core areas of strength, and exiting some of the more exotic areas where the potential for damage far outstripped the possible rewards.

Other Canadian banks largely steered clear of this structured product market, but not CIBC, which has shown an almost genetic predisposition toward following whatever the pack is doing in New York or London, usually with abysmal consequences (Enron and the U.S. mutual fund trading scandal being two of the more recent examples).

“CIBC was not in the business of – and should not have been in the business of – investing in these things for their own account,” said one senior source at the bank.

“Somebody on the business side, early in the year, should have seen that this was occurring. We ended up sitting on stuff we shouldn't have been sitting on. It's a management and accountability issue.”

The hedged book bites

Initially, CIBC appeared to emerge somewhat less scathed than had been expected. In August, the bank ended weeks of speculation by revealing publicly it would take a $290-million charge on $1.7-billion worth of unhedged exposure to CDOs underpinned by residential mortgages.

At this point, other than a few pockets of muttering, no one paid much attention to the hedged book. There was even some cautious optimism. In September, the U.S. Federal Reserve cut the benchmark interest rate by 0.5 percentage points, triggering a mini-rally that appeared to cauterize the bleeding in the subprime market.

But the optimism was short-lived.

By October, the indexes that measure the health of the subprime market were foundering again. At the end of the month, Merrill Lynch reported $8.4-billion (U.S.) in charges, and fired its CEO, Stan O'Neal. Citigroup, meanwhile, unleashed the first in a series of writedowns – $5.9-billion – and its embattled leader, Charles Prince, soon resigned.

On Nov. 5, CIBC parted ways with the head of its debt division, Phipps Lounsbery, who ultimately had responsibility for the CDO book (the same day, incidentally, that Mr. McCaughey unloaded his money-losing U.S. investment bank to Oppenheimer Holdings).

But the trouble was just beginning.

Two days after Mr. Lounsbery departed, ACA, the insurer with which CIBC had hedged $3.5-billion worth of subprime-backed securities, reported a massive loss, and cratered in the market. Standard & Poor's responded by placing ACA on credit watch negative, signalling a possible rating cut.

Such a move would be disastrous for CIBC: If ACA was pushed into default, and could no longer provide insurance, CIBC could be forced to write off billions of dollars. Suddenly, the $10-billion hedged book – up to this point regarded as relatively safe – was in serious jeopardy.

“You expect hedges to work,” one director said. “We wished we didn't have one [large] single exposure … but most of our focus was on the unhedged.”

From a risk-management perspective, the decision to hedge so heavily with a single insurer – and a shaky one at that – appears foolhardy. Sources said CIBC risk experts and traders would “work down the book,” meaning they would hedge with a triple-A-rated insurer for what they could, and then migrate down through the ranks. Others have posited that ACA may have given them more favourable pricing terms for such a large chunk of business.

Regardless of how safe the underlying investments appeared, executives and directors at CIBC acknowledge it was a serious mistake to rely so heavily on one counterparty, and that the risk systems were flawed in that respect.

As ACA teetered, CIBC held a board meeting, and Mr. McCaughey and the directors ran through their options. In the short term, they would signal to the market an additional $463-million in charges on their unhedged securities, which had further declined in value throughout the fall. Longer term, however, they realized they faced more drastic measures.

“We had to keep the bank on the track of refocusing World Markets,” explained one director. “And then there was the need to bring in new management. We felt we had to move quickly on that to restore confidence. When all is said and done, we needed a new management team to continue Gerry's strategy and execution.”

Elsewhere, some investors have wondered why Mr. McCaughey's own job was not imperilled by this costly pratfall, seeing how similar mistakes sealed the fate of banking CEOs in the U.S.

But several directors at CIBC, who spoke on condition of anonymity, said Mr. McCaughey continues to have their full backing. For one thing, they noted, these securities had received the imprimatur of credit rating agencies, and their collapse gored just about everyone in this area of the market. Secondly, given CDOs were a small and esoteric part of the bank's overall business, the directors maintained the warning signs would not have naturally risen to the CEO's office.

“It's clear he got let down in one part of the business that no one expected to be a problem,” a board member said. “This is a damn shame, because that strategy [of reducing risk] is a good one, and Gerry was well down the track.”

The popular guessing game now is how much more pain CIBC will have to bear. The bank seems to believe the worst is over, but some analysts remain skeptical, especially in light of news this week surrounding bond insurers, the firms like ACA that provide hedges on the CDOs.

On Thursday, credit rating agency Moody's Investors Service put the ratings of bond insurer MBIA Insurance Corp. on review for a possible downgrade. That came just a day after Ambac Assurance Corp. reported record losses and was itself placed under review, along with all of the securities it guaranteed.

It's not known how much, if any, of CIBC's exposure might be hedged with Ambac or MBIA. In early December, the bank said it had five triple-A-rated counterparties and two double-A-rated counterparties.

Even if the worst of the storm has passed, CIBC still faces a difficult test, not only in recapturing the confidence of investors, who have seen this movie one too many times, but in fixing a risk-monitoring culture that clearly did not function properly.

“The changes that they've made – two very senior and respected board members, plus new members of their executive team – we looked at pretty favourably,” said Peter Routledge, a senior credit officer with Moody's.

“But capital isn't a cure for risk-management shortcomings.”