31 March 2008

Financials Rated 'Underweight' at RBC CM

RBC Capital Markets, 31 March 2008

Our strategist Myles Zyblock wrote a piece entitled Swimming Upstream in the River of Opinion on March 26. In it Myles argues that investors should start thinking about adding to equity holdings and that economic risk should decline in H2/08.

We are still not ready to sound the "all clear" signal on Canadian financials, nor is Myles who carries an Underweight rating on financials in Canada. There are names we cover, however, that could benefit from a rally in equity markets, but also have defensive characteristics that could keep downside risk reasonable if a market rally did not occur. These names are not necessarily the ones we believe could have the most upside in an equity market rally.

We believe that the following stocks in our universe could allow investors to play Myles' theme, without deviating from our cautious outlook:

• Manulife's insurance and wealth businesses have strong sales momentum, the company is well capitalized and well positioned to make an acquisition, and an equity markets rally could be positive for its segregated fund/variable annuity businesses.

• Industrial Alliance is well positioned from a credit risk and currency exposure standpoint, while margin improvements and sales growth are helping individual insurance value of new business. Stronger equity markets could help retail wealth management (approximately 30% of income).

• ING Canada is also well positioned from a credit risk and currency exposure standpoint, is cheap in our view given the quality of the company, and could potentially be a takeover target. Its investment portfolio is more exposed to equities than peers.

• IGM Financial's AUM is overwhelmingly comprised of equities, like its peers, and we are relatively positive on future sales given growth in the consultant channel. IGM does not have as much upside from a rally market as its peers, in our view, but is the safest name to own if markets are flat to down.

• Royal Bank's stock should benefit from solid domestic retail results, a diversified capital markets business and a strong capital position. Stronger equity markets could help the bank's industry leading asset management and retail brokerage businesses.

• We like TD Bank given its retail strength, expected earnings accretion from the Commerce acquisition and relatively lower exposure to wholesale businesses. Stronger equity markets/lower US economic concerns could be positive for US businesses.
Financial Post, 28 March 2008

As we head into first quarter reporting season for U.S banks, Merill Lynch analyst Sumit Malhotra has an interesting take on the relative value of Canadian bank stocks versus shares in their U.S. counterparts.

“On a market-cap weighted basis the Canadian banks now trade at 9.6 times [analysts’ earnings estimates for 2009,] a modest 4% premium to the 9.3 times multiple accorded to the large-cap U.S. Banks,” Mr. Malhotra notes.

“This differential is well-below the one-year (15%) and three-year (14%) averages, suggesting to us that the possibility of mean reversion exists as U.S. bank estimates continue to be revised downwards.”

U.S. banks are facing margin compression, slow balance sheet growth, weakening credit quality and liquidity concerns. Canada’s big banks, with their strong domestic retail franchises, also face margin pressure but are less concerned by the other factors likely to hit U.S. bank results this quarter.

The Merrill Lynch analyst says he is “not bullish” on Canadian banks in the near term. But with limited opportunities for profitable long trades in the banking sector, “a relative value trade” of Canadian banks over big U.S. banks “makes sense,” he says.
The Globe and Mail, Fabrice Taylor, 28 March 2008

Here's two cents worth of asset-backed advice for Canaccord's beleaguered ABCP investors: Don't fall for the Montreal gang's bluff. You'll get your money if you don't panic and keep agitating.

This is such an embarrassment of bungling and typical big bank behaviour that the odds are the big boys will dig deep and make this go away.

Canaccord's motto is "independent thinking." In a word, "huh?" The firm has 1,400 unhappy clients who bought non-bank asset-backed commercial paper on its advice. Some are suing. Rather than making its clients whole, Canaccord is digging in its heels, insisting it can't afford to and blaming Scotia Capital. Scotia sold Canaccord the paper that ended up with Canaccord retail clients.

But Canaccord's Dept. of Thought isn't looking terribly independent. In its court filing, it basically says Scotia should have warned it that this paper was risky, or getting risky, because Scotia knew. That is quite possible. But Canaccord could have known too.

The main point of contention is an e-mail sent last July by Coventree, which sponsored the ABCP trusts in question. The e-mail was sent to Coventree's sales agents, including Scotia, and revealed that there were subprime assets in the trusts, although the percentages ranged.

A couple of weeks later, Scotia sold Canaccord another pile of paper from its inventory, most of which the brokerage placed with clients. Within days, that paper seized up and some clients face losing their homes.

Canaccord contends that Scotia had material information about the trusts and that had it shared this information, it would never have bought and placed the paper. Scotia says the information in the e-mail was incomplete and therefore not material.

Really? It was important enough that Royal Bank stopped selling Coventree paper, and CIBC stopped trading it. Point Canaccord.

That said, Canaccord had access to the list of assets the trusts held. Furthermore, Standard & Poor's published a research report in 2002 called "A leap of faith," which described the huge risks of owning non-bank ABCP. Canaccord tells me it wasn't aware of the report until after the market seized up last summer. Point Scotia.

I also asked Canaccord why, with a 5-per-cent share of the retail brokerage market, it has an 80-per-cent share of retail clients stuck with ABCP. The firm argues that this is only because other dealers have made their investors whole, buying the paper back. Other than National Bank, no big bank has acknowledged this (or denied it).

But to look at Bank of Nova Scotia's balance sheet, it doesn't seem to have had to buy back much paper from its clients. Scotia had $144-million of non-bank ABCP on its books, after having taken writedowns of about a little over $100-million. Some of that paper may have been bought back from clients directly, but there's also the possibility that some was bought from money market funds and yet more was inventory the bank couldn't move once the credit crunch hit. If Scotia did buy paper back from clients, it would probably be less than these figures suggest. Maybe a lot less.

And maybe it didn't have to buy back any because it didn't sell its clients any. Scotia was not only an official seller of Coventree paper, it also made money selling assets into the trusts. It was certainly familiar with some of the stuff backing the notes.

While the bank claims there's a Chinese wall separating the bank, which would have sold assets to Coventree, and the brokerage, which would have sold Coventree paper, the fact is that the institution's chief risk officer is responsible for the entire organization, brokerage and bank. So much for that Chinese wall.So while Canaccord's total exposure is disproportionately huge at about $300-million, it's hard to argue Scotia can't take any credit for that, having smartly moved a lot of its own inventory into the Canaccord selling chain.

As for why Canaccord was so eager to sell this paper, it's hard to know. It wasn't money. The firm insists it made no money selling the paper to its clients, that it was a service. What's obvious is that, whether hoodwinked by a self-interested bank or not, it should have known.

As for Scotia? It's role in this will come out in time.

But investors shouldn't have to wait. Purdy Crawford says retail investors are now his priority. And while he makes noises about how they should take a deal that involves getting paid back, hopefully, over a few years, I say don't.

First, you're not likely to get full recovery on your money. Second, why should you wait? To make retail investors whole will cost the Montreal Accord players nothing. Canaccord is willing to pay a big chunk of the penalty. The rest is chump change to the players. The only question is optics.

So keep embarrassing and threatening. They'll do the right thing soon enough.

27 March 2008

RBC CM: Not Yet Time to Buy Bank Stocks Aggressively

RBC Capital Markets, 27 March 2008

Bank stocks are up significantly in the last six trading days (Canadian banks 9%, US banks 10%). The reasons for the rally are clear and we highlight them in this report, but we continue to believe that the road ahead for bank shares will be bumpy and do not believe it is time to buy Canadian banks aggressively (especially after a 9% rally over six days).

Our caution is a matter of timing; we do not believe that the Canadian banking system is in as fragile a state as the U.S. banking system, but we believe that share price appreciation will be held back by: 1) high P/B valuations relative to banks worldwide and to prior troughs, 2) news flow related to the economy and banks that is likely to be negative in the near term, and 3) likely negative earnings revisions as Canadian banks release Q2/08 results.

We therefore do not believe that this is the ideal time to buy banks in spite of attractive dividend yields and valuations that are low based on forward earnings estimates. We hope that the time to be more positive on bank shares will be relatively soon (i.e. a matter of months) and are looking for one or more of the following to occur before we recommend bank stocks more aggressively:

• Evidence that the North American economic situation is improving or greater comfort that it should improve.

• Newsflow on U.S. financial institutions that turns less negative.

• Greater comfort that expected earnings for the Canadian banks accurately reflect current headwinds.

• Valuations that are more compelling relative to global peers or to historical troughs.

There have been positive developments in the last two weeks, and continued improvements in some factors, particularly credit spreads and equity markets, would make us less concerned about bank stocks.

• We are not yet switching to a bullish stance as many of the reasons for our caution have not changed.

• The risk of major writedowns at National Bank and Bank of Montreal in the near term were avoided, and we are therefore increasing target prices on both stocks. We maintain our Underperform ratings.

We believe that National Bank is still facing writedowns related to ABCP holdings (we are currently factoring $300 million pre-tax) but the court protection under the Companies' Creditors Arrangement Act (CCAA) awarded to the ABCP trusts subject to the Montreal Accord reduces the near-term chances of a disorderly liquidation, in our view, which we believe would have a significant negative impact on the value of the ABCP (the main risk to a successful restructuring now lies with retail holder support, in our view). We believe that the bank has enough capital to absorb a $300 million pre-tax charge without raising equity. Further tightening in credit spreads on investment grade debt would lead us to lower our estimated writedowns. (Please see our reports of March 24 (Update on ABCP restructuring) and March 17 (ABCP Committee to file court approval for restructuring plan) for greater detail. Our new 12-month target price per share of $45 compares to $43 previously, and is a result of a higher target P/B multiple, which is a function of a lower perceived risk profile given the rapid tightening in credit spreads.

o In the case of Bank of Montreal, the restructuring of Apex and Sitka avoided a near-term write-down of $495 million pre-tax, saved its clients from losing large sums, reduced the potential of losing clients and facing lawsuits, and eliminated two disputes totaling $1 billion. BMO avoided crystallizing losses and will be proven right if credit spreads tighten over the next five years and/or North America avoids a deep recession (it would probably reverse much of the write-downs to date as well). It will, however, suffer greater losses down the road in the low probability event that BBB-rated bond defaults surged to levels high enough to trigger losses at BMO. Please see our report of March 20, 2008 (Apex/Sitka: Near term risk down; tail risk up) for more detail. Our higher 12-month target price per share ($44 versus $43) reflects a higher estimated book value per share now that we estimate lower writedowns in Q2/08.
The Globe and Mail, Angela Barnes, 27 March 2008

Now is not the time to buy Canadian bank stocks aggressively, especially given the robust rally in those stocks in recent days, according to RBC Dominion Securities Inc. analyst Andre-Philippe Hardy.

“We continue to believe that the road ahead for bank shares will be bumpy and do not believe it is time to buy Canadian banks aggressively (especially after a 9-per-cent rally over six days),” Mr. Hardy said in a report Thursday.

While he doesn't believe that the Canadian banking system is in as fragile a state as its U.S. counterpart, he does think that the Canadian bank stocks will be held back by a number of factors, including likely negative profit estimate revisions following release of the banks' second quarter results.

The fact that the banks have price-to-book value ratios that are high relative to banks elsewhere in the world and to previous trough levels will also, he expects, keep the share prices from rising much. On top of that, he expects that the news flow out of the economy and the banks will likely be negative in the near term.

“We therefore do not believe that this is the ideal time to buy banks in spite of attractive dividend yields and valuations that are low based on forward earnings estimates,” he said, adding that he hopes to become more positive on bank stocks “relatively soon (i.e. a matter of months).”

But he cautioned that before he changes his view, he needs certain things to happen. The list of possible candidates includes evidence that the North American economy is improving, or at least greater comfort that it should improve, and greater conviction that the profit estimates for Canadian banks accurately reflect current headwinds.

Mr. Hardy's 12-month price targets for the banks indicate he is considerably less upbeat on the sector than some investors, who, he suggested, are probably looking for around 20- to 60-per-cent upside on average.

He rates Royal Bank of Canada and Toronto-Dominion Bank as “outperform” with price targets of $50 and $69 respectively. Royal on Thursday is trading at $47.78 and TD at $63.23. He has Bank of Nova Scotia and Canadian Imperial Bank of Commerce as “sector perform” with targets of $48 and $65, which compare with current prices of $46.66 and $66.50.

He says the risk of major writedowns at Bank of Montreal and National Bank of Canada in the near term have been avoided and he therefore has raised his target price on BMO to $44 from $43 and on National to $45 from $43. BMO shares stand at $45.89 and National at $47.07. He maintained his “underperform” on those two stocks.
RBC Capital Markets, 27 March 2008

The downgrades of SCA and FGIC, announced after the close yesterday by Fitch, as well as comments made by CIBC's CEO at a conference, confirmed our view that more writedowns should be expected in Q2/08 related to structured products hedged with monolines.

• We have been estimating $1.5 billion in pre-tax writedowns in Q2/08. This would leave CIBC with a Tier 1 ratio of 10.8%, down from 11.4% at the end of Q1/08.

• Management's comments, which confirmed our views, were as follows: "Since January, credit spreads have remained volatile. If current prices hold through the second quarter, we would expect the marks and valuation reserves against our financial guarantor hedges to be higher at the end of Q2".

• Fitch downgraded SCA's financial strength rating from A to BB with a negative outlook and FGIC's financial strength rating from AA to BBB with a negative outlook. Other rating agencies have higher ratings on both SCA and FGIC.

• Of CIBC's hedged CDO of RMBS exposure, we believe US$3.2 billion of notional value is hedged with SCA and FGIC. The current value of the CDOs was US$1.3 billion at Jan 31/08, which means there is US$1.9 billion of fair value that is owed by SCA and FGIC to CIBC. We estimate that CIBC took a valuation allowance of around $310 million against the US$1.9 billion in Q1/08.

• Of CIBC's hedged CLO exposure, we believe US$5.0 billion of notional value is hedged with SCA and FGIC. The current value of the CLOs was US$4.8 billion at Jan 31/08, which means there is US$123 million of fair value that is owed by SCA and FGIC to CIBC.

• CIBC also provided greater disclosure on its portfolio of non US RMBS structured products hedged with monolines. (1) The notional exposure is $25.1 billion versus our estimated range of $18-25 billion. (2) The marks as at Jan 31 imply 3.5% deterioration in asset prices, not far from our estimate. (3) Positively, the riskier monolines (SCA, FGIC, CIFG) account for $6.2 billion of $25.1 billion in notionals insured (25%), which is better than the average monoline quality in the CDO of RMBS portfolio.
BMO Capital Markets, 27 March 2008

In our opinion, it is relatively easy to see how the Montreal Accord for third-party ABCP gets settled in the coming months. We believe that a favourable settlement will be a positive development for National Bank, and indeed for Canadian financial markets generally. What many observers seem to be missing appears to be obvious to the small investor group and the large players in the whole debacle: the cost of settling this is small in the context of the overall problem. Here’s a simple analysis. We believe that small investors have less that $500 million of the total balance but the majority of the votes.

Assuming a successful restructuring would allow 85% recovery on this paper, the cost of having this settled is $75 million. We believe that this is probably less than the legal costs involved in the restructuring, and about three-tenths of one percent of the value of the assets in dispute. In many ways, the “one holder, one vote” has empowered small investors to ensure a more favourable deal than the larger participants. We have no idea who will bear the costs of settling this situation, but are confident that some of the larger stakeholders will.
The Globe and Mail, Tara Perkins, 26 March 2008

Canadian bank executives are skeptical the crisis rocking global financial institutions will be over soon, and Toronto-Dominion Bank chief Ed Clark says it could stretch into 2009.

Mr. Clark told an industry conference in Montreal yesterday he's been struck by how many financial institutions “have to go to church, do their penance, and recapitalize themselves to deal with what's coming down the pipe.”

“So I'm less confident today that this will cure itself quickly.”

The financial sector could recuperate in the second half of this year, but “I think there's equally a chance that it will take the full period of 2008 to cure itself, and therefore we will be living with this financial services crisis,” said TD's chief executive officer. “The longer this goes on, the higher the risk that we also then have a more severe economic slowdown.”

While TD's economists see a recession coming, Mr. Clark said he hasn't yet seen signs of it in TD's banking operations.

“But we definitely can see it in TD Securities and our domestic wealth management business, the significant impact of the result of the financial services crisis,” he said.

Mr. Clark's view that it will be a while yet before the crisis subsides was shared by many of his counterparts at the conference.

Canadian Imperial Bank of Commerce, which has been walloped by billions of dollars of writedowns, will likely conserve cash for now rather than buy back shares.

“As long as the environment remains as uncertain, balance sheet strength will be very important to us,” CEO Gerry McCaughey said.

“The marketplace has shown that there can be surprises out there,” he said. “I'd want to make sure that before we engaged in a buyback, that we were absolutely certain that we had it down pat.”

It's difficult to see CIBC's investment banking conditions improving in the near term, he added.

BMO Nesbitt Burns analyst Ian de Verteuil said that warning “is true for all banks, not just for CIBC.”

CIBC disclosed yesterday that it has $25.1-billion of securities that are hedged with monoline bond insurers but are not tied to the U.S. residential mortgage market. Analysts gave the bank kudos for the disclosure, and saw it as slightly positive that the portfolio and exposures seem to be well diversified.

As of Jan. 31, the most recent numbers available, CIBC still had more than $5-billion of risky exposure to the U.S. residential market.

While the extent of CIBC's exposure to securities related to the U.S. subprime market differentiates it from its Canadian peers, the bank is not alone.

Bill Downe, CEO of Bank of Montreal, pointed out that in the next couple of weeks there will be “emerging news” from U.S. banks that are due to report financial results, and “I expect that we'll see lots of news out of the European banks.”

“It looks to me like the period we're in right now is very choppy,” he said.

“I'm confident there will be a difficult trading environment for all capital markets businesses, certainly for the next quarter and probably for the next couple of quarters,” Mr. Downe added.

But the “enormous” stimulus package that will be disseminated in the U.S. beginning this summer should add as much as 2.5 percentage points to that country's growth, at which point financial institutions will again be able to focus on the future, said Mr. Downe, who is on the U.S. Federal Advisory Council that advises the central bank.

The co-president of National Bank Financial's investment banking business, Ricardo Pascoe, said “while we're optimistic and hopeful that we've seen the worst of the financial crisis, we think that liquidity will only come back into the market slowly. And, obviously, the real economy is just starting to experience a slowing.

“So, our view is for the next few months, and probably well into next year, volatility will continue and market positions will continue to be difficult.”

Royal Bank of Canada CEO Gordon Nixon likewise said signs of weakness remain, “and it will take some time for many of these financial assets to recover.”

But he's still hoping for a recovery in the second half of this year, and pointed out that Canadian banks have received at least one perk from the crisis that's reshaping the global banking industry: Dwindling market values of many banks around the world mean Canadian banks can add them to their potential shopping list.

“It's just staggering when you look at the ranking of banks around the world today versus a year ago, and banks that were significantly larger than us or other Canadian banks are now significantly smaller,” Mr. Nixon said. “So, I think we can look at things in the realm of possibility that weren't there in the past.”

RBC recently squeezed back into the list of the world's largest banks by market value, whereas it wasn't in the top 50 five years ago.

Mr. Nixon's not certain yet whether RBC is bold enough to consider some of its new options, but “as this whole thing shakes out we're certainly spending some time looking at what sort of bolder opportunities might be available out there.”

Royal Bank is interested in opportunistic acquisitions, but not on the investment banking side of the business.

“You can be cautious in this market, because this is clearly an investors' market or a buyers' market, not a sellers' market,” he said.
Financial Post, 26 March 2007

Canadian Imperial Bank of Commerce has at last revealed the size of its book of non-subprime collateralized debt obligations that are hedged with monolines, and its a whopping $25-billion.

That’s bigger than Blackmont Capital analyst Brad Smith had feared, though about the same amount some other analysts had forecast.

Nevertheless, Blackmont has upgraded CIBC to “hold” from “sell” and Mr. Smith has also raised his target price for CIBC stock from $62.00 to $74.00

Although the total amount is high, it includes only $6.5-billion of exposure to the weaker monolines, “which is about $3-billion lower than expected,” Mr. Smith said in a note.

Despite earning an upgrade from Blackmont, there are still some concerns about CIBC.

The bank has taken $4.2-billion in credit crunch writedowns, the most of any Canadian bank, and was forced to raise $2.9-billion of emergency capital funding in January to help steady its balance sheet. The risk of additional losses “remains elevated,” and that could lead to more new equity issues from CIBC, Mr. Smith said.

25 March 2008

Scotia Capital Cuts TD Bank to Sector Perform

Scotia Capital, 25 March 2008


• Downgrading TD to 2-Sector Perform from 1-Sector Outperform based on execution risk from the Commerce Bancorp (CBH) acquisition closing Mar. 31/08, strong relative share price performance in the past couple of years, expected slowdown in insurance earnings growth, market share declines in personal deposits and negative impact from appreciation of the C$.

What It Means

• In terms of the CBH acquisition, we are concerned about the value of its $26.5B securities portfolio and the potential for writedowns in the $1.5B range. We expect that the bank may have some discretion on approximately $1B of this potential writedown as it is in the Held-to-Maturity account. The dilemma is whether to take the full hit resulting in higher goodwill with higher future earnings or preserve capital. The share price could also be under near term pressure as TD share flow back into Canada maybe greater than index demand.

• Our 2008 and 2009 earnings estimates are unchanged at $5.95 and $6.70, respectively. Trimming share price target to $95 from $100. Our long term positive view on TD remains intact based on strength of its operating platforms.
Financial Post, Duncan Mavin, 24 March 2008

Trying to guess the bottom of the slide in Canadian bank stocks? You are hardly alone.

But now is the time to get back in to those battered banks, says Desjardins Securities Research analyst Michael Goldberg.

“Valuations remain exceptional and we believe it is now time to begin accumulating,” Mr. Goldberg says in a note.

There will be more bad news out of the banks, which have announced massive subprime-related writedowns and are also facing the prospect of weakening results from operations thanks to the economic slowdown in the U.S.

But bank stock prices should be buoyed by a “a classic group rotation” last week that saw investors switch from oil and gas, gold and base metal stocks back to financials, following support from the sector from the U.S. Federal Reserve last week, Mr. Goldberg said.

Desjardins is upgrading Bank of Montreal, Canadian Imperial Bank of Commerce, National Bank of Canada and Royal Bank of Canada to “buy” from “hold.”

Toronto-Dominion Bank and Bank of Nova Scotia have not seen their stock prices hit as heavily as the peers and remain the top pick at Desjardins.

24 March 2008

Scotiabank's International Wealth Management Business

The Globe and Mail, Tara Perkins, 24 March 2008

While much attention has been paid to Bank of Nova Scotia's Canadian wealth-management business lately because of its bid for DundeeWealth Inc., the bank is quietly working to build an international wealth-management business that it hopes will match the domestic one in size within a decade.

Wealth management incorporates things like mutual funds, brokerage businesses and private banking; players in the market here are binging on a frenzy of growth as baby boomers near retirement.

Different factors are at work in many southern countries that Scotiabank eyes, where populations are relatively young but, in many cases, the middle class is establishing wealth for the first time, and mutual fund industries are just getting off the ground.

About a year and a half ago, Scotiabank made the decision to develop a wealth-management business internationally.

As Canada's most far-flung bank has been bulking up its consumer and business banking network, it has made a number of acquisitions in the Caribbean and Latin America, "and if they came with wealth-management pieces of the business, we maintained those, but there was really no overarching strategy," Dan Wright, who heads the bank's efforts, said in an interview. "So that's when I came in."

Last year, the bank began opening Scotia Private Client Group offices outside of Canada, and now has four in locations such as the Dominican Republic and the Bahamas. It plans to have 14 offices by year-end, stretching to locations ranging from Trinidad to Costa Rica to Chile, where it is lusting after business from high-net-worth and ultrahigh-net-worth customers.

Scotiabank is increasing by one-third the number of adviser-brokers it has in its international wealth-management business, and is working on mutual fund businesses in some countries, such as El Salvador, where the concept is relatively new and regulations are still in development.

"There's certainly a new emphasis and focus on actually saving for their future, or saving for their retirement," Mr. Wright said.

"So, if you look at a country like Chile for example, that is probably most developed in terms of retirement savings and pension legislation, they recognized very early that there was a need to create a way for individuals to save for their future instead of just relying on the government to fund that future, and most of the other Latin American countries are now moving in the same direction."

As Scotiabank presses ahead in the southern regions where the bulk of its international consumer banking business is based, it's also cooking up a plan to build a wealth-management business in Asia.

"We're not ignoring Asia," Mr. Wright said. In fact, he's made a couple of trips to that region in recent months, and the bank has decided to build its strategy for the area within the next eight weeks.

Scotiabank made its first major foray into consumer banking in Asia last year, with the purchase of a 24.99-per-cent stake in Thanachart Bank, Thailand's eighth largest bank. As the bank builds on that consumer banking base, it will also forge into wealth management.

Meanwhile, Mr. Wright, who spends much of his time on the road, is watching for acquisition opportunities to speed along the bank's international wealth business. "The world is my oyster. I'm always looking, and quite frankly not a week goes by there isn't an opportunity that lands on my desk."

Scotiabank is not the only Canadian institution eyeing the global wealth management market. Last year, Royal Bank of Canada changed how its business lines are arranged to promote aggressive growth of wealth management abroad.

20 March 2008

Basel II Reduces RWA, but Challenges Tier 1 & Tier 2 Levels

Citigroup Global Markets, 20 March 2008

• Potential Capital Issuances — Based on our analysis and likely obligations to extend various forms of lending facilities, we think BMO, BNS, and RY likely to issue some form of capital to shore up balance sheet and regulatory capital ratios.

• On Average, Risk Weighted Assets Declined 5% — Implementation of Basel II reduced RWA by utilizing risk profile and activity. The reduction contributed to the average 40bp and 15bp gain in Tier 1 and Tier 2 Capital, respectively. TD benefited the most, RWA declined 11%; however, NA RWA increased 5%.

• Changes to the Components of Capital Reduced Capital an Average 4% — Using the new guidelines securitization gains are deducted and a smaller portion of the general allowance may be applied toward capital. Also, the banks have to deduct expected credit losses. To remain compliant 4 banks issued assorted capital.

• New Category, Operational Risk Contributed C$19B to RWA — Basel I did not incorporate operational risk. This new category significantly increased RWA. RY was the most impacted, +C$30B in RWA. However, the increase was offset by a 23% reduction in credit risk related RWA. Market risk related RWA increased 5% under Basel II.

• Bank Liquidity Ratios Depend on Value of Securities — If we assume the securities maintain the values on the balance sheet, as of Q108 the Canadian banks average a 41% liquidity ratio. The ratio declines to 31% if we assume valuations decline 35%. On average, the repo market contributes 25% to bank liquidity. Based on our analysis, NA is the most dependent on repo market.

Overview of Basel II and Liquidity Parameters

Basel II

The new framework for capital management and reporting, Basel II replaced Basel I which had been utilized for 20 years. The primary differences between Basel II and Basel I are:

• Introduction of Operational Risk

• Capital Requirements are based on Risk Profile vs. Volume by type

Liquidity / Funding

The state of the market since the 2H07 has created a liquidity crisis for certain financial institutions. Contributing to the effect are the credit concerns and significant valuation reductions to various securities. Market participants are unwilling to accept many of the structured instruments on bank balance sheets. The combined effect has led to a build up of cash on bank balance sheets as collateral for lending and as a component of regulatory capital.

Measures of Liquidity:

• Liquidity ratio – cash resources + securities as a percent of total assets. Provides a quick view on how easy assets can be converted into cash/cash substitutes to meet commitments

• Percentage of Securities borrowed/purchased under resale agreements – this component has had problems recently but typically can be used for commitments

• Core deposits – customer savings and deposits, fixed date deposits less than C$100k.

• Core deposits + Capital/Total Loans (excl reverse repos) ratio – Core funding reduces dependence on wholesale funding

• Assets to Capital Multiple – Gross adjusted assets divided by Total Capital. The OSFI regulated max is 20x, the regulator will allow up to 23x with special approvals.

As of Q108, the Canadian banks appear to be well capitalized. Many of them issued various forms of capital, most notably the nearly C$3B equity raise by CIBC. One of the primary risks to liquidity is reduced valuations of securities. Additional risks are: draw downs on credit facilities, liquidity facilities, and purchases of collateral for pledging.

Also of note are the debt maturities for the banks.

Asset to Capital Multiple

The regulatory guidelines for the asset to capital multiple are the multiple should not exceed 20x. With prior approval from the Office of the Superintendent of Financial Institutions, the multiple can be as high as 23x. In our view, this multiple will be challenged as the banks begin to build up their assets due to various liquidity or lending facilities. Royal has the highest of the banks and may need to issue capital to remain compliant.

Debt Securities on Balance Sheet

Based on size alone, Royal is the most exposed to foreign debt instruments, C$78B. However, given the massive size of Royal’s balance sheet, these asset comprise less than 15% of total assets. We are highlighting the amounts of “other” debt instruments on the balance sheet to shed some light on the magnitude of exposure for write downs. These securities are not issued or guaranteed by the Canadian government, province or municipality.

Comparison of Basel II to Basel I

Implementation of Basel II was widely expected to make regulatory capital ratios some what easier to achieve. However, the guidelines what is acceptable Tier 1 capital are more stringent and there are credit risk related deduction to capital. Combined, these impacts make it a tad more difficult to attain the regulatory ratios.


• Operational risk added C$16B to risk weighted assets
• The bank’s excess capital is C$2.2B, down from C$3.1B at YE07
• Assuming the same components, BMO can add a maximum of C$20B to RWA and maintain regulatory capital of Tier 1 8.5% and Total 10%.


• The bank’s nearly C$3B capital issuance significantly shored up the regulatory ratios and excess capital for CM
• At C$6.1B, the bank has the second highest excess capital of the six bank reviewed.
• Assuming the same capital components, CM could add C$50B to risk weighted assets and remain compliant with Tier 1 of 8% and Total of 10.7%

National Bank

• National did not benefit to the same degree as the larger banks. National’s RWA increased 5%, due in part to the bank using the standardized approach for much of their metrics. The advanced internal risk rating method contributed to the reduction in RWA.
• The bank could add just under C$8B to the RWA and remain compliant
• Innovative trust securities were issued during Q108 to contribute to the regulatory capital


• Royal could add approximately C$25 in RWA and remain regulatory compliant assuming same capital components
• Royal did not provide Basel I results detail for Q108


• Assuming the same components, BNS can add a maximum of C$3B to RWA and maintain regulatory capital of Tier 1 8.9% and Total 10%.
• Implementation of Basel II and q/q changes reduced excess capital to C$383 million from C$1.15B at year end. We would anticipate the bank would issue some form of capital to build its base.
• The bank benefited from a 21% reduction in credit RWA

TD Bank

• The most notable difference for TD is the placement of substantial investments as a component of Tier 1
• TD has solid capital ratios with excess capital over C$7B
• The bank has the capacity to add nearlyC$60B to its RWA and remain compliant. The stress for TD’s capital will come when the bank consolidates its most recent acquisition.


Overall liquidity levels at the banks appear sufficient. The key concern is the value of the securities on the balance sheet and any margin/collateral calls.

As Figure 10 details, Bank of Nova Scotia has the lowest liquidity ratio. The chart also shows the spike in liquidity maintained by National Bank of Canada during last summer’s Canadian ABCP crisis. As expected, National bank relies the most heavily on wholesale funding.
Financial Post, Duncan Mavin, 20 March 2008

Blackmont Capital analyst Brad Smith put out a note about two of Canada’s banks that have been heading in opposite directions lately, and for once the most positive news came from Bank of Montreal – at least on the surface.

BMO earns some plaudits for restructuring two asset-backed commercial paper trusts known as Apex and Sitka, whose troubles had threatened to cost the bank $1.5-billion. But the nature of the restructured notes, BMO is now exposed to $1.35-billion or more of risk related to collateralized debt obligations (CDOs) linked to the trusts, Mr. Smith said.

At Toronto-Dominion Bank, which has been a top pick in the sector for many analysts as it has avoided the worst of the credit crunch, the news this week revolves around its acquisition of New Jersey-based Commerce Bancorp. The deal is set to close in the next couple of weeks and TD has announced that its newly acquired operations, merged with its existing TD Banknorth franchise, will be renamed TD Commerce bank — that seems like a smart idea given that Commerce has a strong brand presence in the U.S. and a reputation for high levels of customer service. It also makes sense because Banknorth has struggled to provide the sort of returns TD hoped for when it bought the Portland, Maine-based bank back in 2005.

But Mr. Smith notes that once the Banknorth brand is gone, there will be a good case for TD to scrap roughly $6-billion in related goodwill that is currently sitting on the bank’s balance sheet. As discussed in a Financial Post story in February, TD has more goodwill on its balance sheet than any of its Canadian competitors.

With Banknorth out, can a goodwill writedown be far behind, asks Mr. Smith.

Blackmont has “hold” ratings on both TD and BMO. Mr. Smith has a 12-month target price for TD of $63.00 and for BMO of $54.00

BMO Restructures Apex & Sitka Trusts

RBC Capital markets, 20 March 2008

BMO announced yesterday that all four swap counter-parties and certain investors in Apex/Sitka signed agreements to restructure the trusts.

• By doing so, the bank avoids a near-term write-down of $495 million, saves its clients from losing large sums, reduces the potential of losing clients and facing lawsuits, and eliminates two disputes totaling $1 billion.

• The worst case scenario for BMO is now much worse, although we view the probability as low. The worst case financial loss previously was $1.5 billion. BMO will now own $815 million out of $2.1 billion in subordinated notes, it will be on the hook for a potential $850 million out of $1.15 billion margin facility which will be senior to the subordinated notes ($200 million has already been drawn), and, if mark to markets were to imply losses of 16% or more (or if losses reached that level), BMO has provided protection to swap counter-parties for the remaining $17.4 billion in net notional exposure.

• In essence, BMO avoided crystallizing losses and will be proven right if credit spreads tighten over the next five years and/or North America avoids a deep recession (it would probably reverse much of the write-downs to date as well). It will, however, suffer greater losses down the road if BBB-rated bond defaults surge to record levels.

• If bond defaults were to reach levels that cause losses above 16%, we would expect severe losses across all banks' business loan portfolios, not just in Apex/Sitka.

• We expect an overhang on BMO's share price to remain related to its various off-balance sheet conduits.

Restructuring highlights:

• The term of the notes will be extended to 5 - 8 years to match the term of the swaps.

• A senior funding facility is established, as described above.

• The bank's $705 million ($495 million net) has grown to $815 million.

• The Tier 1 ratio impact of the investment in subordinated notes and senior funding facility is expected to be 25 basis points (currently 9.48% at Jan 31/08).

• The two disputes totaling $1 billion related to the trusts are settled.

• Swap counter-parties appear to no longer have risk.
Scotia Capital, 20 March 2008

Restructuring of Apex/Sitka Trust - No Further Writedowns Expected

• BMO announced that it has reached an agreement in the restructuring of its Apex/Sitka Trust. The bank does not expect to take any further writedowns on the $495 million remaining net investment. Each of the underlying tranches has been rated AAA by DBRS.

• We view the restructuring agreement as a positive for the bank given the alleviation of uncertainty surrounding this issue and the avoidance of future writedowns.

• The terms of the restructuring are as follows:

• Note maturities will be extended to approximately five to eight years.

• An additional $1.15 billion senior funding facility will be provided to satisfy collateral calls. BMO will provide $850 million for this facility, $200 million of which has been advanced.

• BMO will have exposure to the swap counterparties for realized losses that exceed first-loss protection and the posted collateral. First-loss protection threshold is 17% of underlying positions with a range of 9% to 38%. Collateral and senior funding above the first-loss protection levels total approximately $3.3 billion and represent 16% of net notional credit positions.

• BMO will not be providing protection against actual realized credit losses to subordinated note holders.

• Restructuring includes resolution of two commercial disputes for the amount of $1.0 billion which were previously disclosed.

Tier 1 to Decline by 25 Bp

• BMO's total investment in the restructuring is $850 million in the senior funding facility and $815 million in the subordinated notes of the trust. The restructuring will reduce BMO's Tier 1 ratio by 25 bp. The bank's tier 1 ratio is expected to remain strong at 9.23% versus 9.48% at the end of Q1/08.


• Our 2008 and 2009 earnings estimates remain unchanged at $5.05 per share and $5.65 per share, respectively. Our share price target is $65 per share representing 12.9x our 2008 earnings estimate and 11.5x our 2009 earnings estimate.

• BMO is rated 3-Sector Underperform.
The Globe and Mail, Andrew Willis, 19 March 2008

Beleaguered Bank of Montreal finally has some good news, having skirted potential writedowns of up to $1.5-billion by successfully restructuring two asset-backed commercial paper trusts.

BMO announced late yesterday that it has reached a deal that will transform the ABCP trusts in a similar fashion to the restructuring that's being attempted in the rest of the $32-billion third-party ABCP sector.

DBRS structured finance analyst James Feehely said this is "another positive step in the restructuring of the ABCP market."

BMO's shares have been rising this week, moving against the general direction for bank stocks, closing at $42.10 yesterday on the Toronto Stock Exchange, up from Monday's close of $39.15.

The news comes after a lengthy standoff among investors in the Apex and Sitka Trusts. Earlier this month, BMO chief executive officer Bill Downe said the bank had offered to provide additional support to Apex and Sitka, and "we would expect other investors to do the same. The parties have been basically sitting in a standstill mode, and I don't think you can stay that way forever."

By fixing the trusts, BMO has managed to avoid a $495-million writedown that it had warned the market it might have to take.

But it's also cleared up $1-billion in related potential losses. One of Apex's investors had been hanging on to a $400-million funds transfer that BMO wanted back, while a counterparty was not paying back $600-million BMO claimed it was owed. Both of those situations have been resolved.

The restructuring will see investors who hold the trusts' short-term commercial paper exchange those investments for notes with maturities of five to eight years. The longer-term notes are a better match for the underlying assets, and this solution is similar to the proposal to fix the broader third-party ABCP sector.

BMO will supply about $850-million of a new $1.15-billion credit facility to support Apex and Sitka. The bank has already lent $200-million through this credit line.

The bank said that all four counterparties and "certain investors" have signed agreements for the restructuring.

"We are very pleased with the agreement to restructure," stated Tom Milroy, head of BMO's investment bank. "This was a complex deal that was achieved through the efforts of both the investors and the swap counterparties. It is beneficial to these stakeholders and supports the smooth functioning of Canadian capital markets.

"The restructuring will avoid unnecessary losses and will preserve the trusts' underlying positions," he added. "Based on BMO's own evaluation of the credit quality of the approximately 450 obligations and after incorporating the benefit of the substantial first-loss protection, we consider the risk of credit loss to BMO to be low."

Analysts expected pain from Sitka and Apex to be even worse than what BMO had forecast. Blackmont Capital's Brad Smith wrote last week: "It would appear that the potential loss amount is something higher than the remaining $500-million net carried value of the investment in the conduits."

After the restructuring, BMO said its total investment in the notes of the trusts will be about $815-million, and it will have the $850-million in the funding facility. All told, the effect on its Tier-1 capital ratio will only be 25 basis points, the bank said, which will leave it well above the minimum level that regulators require.
Financial Post, Duncan Mavin, 19 March 2008

Bank of Montreal says it has successfully restructured two asset-backed commercial-paper trusts known as Apex and Sitka that had threatened to cost the bank further writedowns.

"We are very pleased with the agreement to restructure," said Tom Milroy, the head of BMO Capital Markets. "This was a complex deal that was achieved through the efforts of both the investors and the swap counterparties."

The bank has already taken $210-million in charges related to the two trusts. BMO had warned more losses would follow if it could not restructure the trusts, although the bank insisted there is still "underlying economic value" in the assets of the trusts. Those writedowns will now not be necessary, the bank said.

The bank has provided additional funding and extended the terms of the two trusts.

BMO's stock price closed Wednesday at $42.10, down more than 42% from its twelve month high. On Monday, it closed at a low of $39.15 as investors punished the bank because of its exposure to the credit crunch.

Last month, the bank reported net income for the first quarter of 2008 fell 27% or $93-million from the previous year. BMO took $490-million of writedowns in the first quarter and announced it has agreed to provide more than $12-billion in funding to two structured investment vehicles (SIVs) that have been hit by the credit crunch.

Citigroup analyst Shannon Cowherd said investors should anticipate continued volatility at BMO in a note issued before the announcement about Apex and Sitka. Ms. Cowherd reduced her target price for the bank's stock from $54.00 to $43.00

The bank has endured a tough twelve months. BMO lost $850-million on a natural-gas trading scandal last year, cut 1,100 jobs at a cost of $159-million as it restructured its domestic retail franchise, and took a $318-million writedown linked to the credit crunch.

Chief executive Bill Downe has vowed to improve the bank's risk management operations in response to the series of costly problems.

"We are reducing the size of our off-balance sheet businesses and seeking a better balance between risk and return," he said last month. "Our risk management group will assume increased direct corporate oversight into risk-return decisions made by the businesses."

19 March 2008

Citigroup Cuts Target Prices for BMO & RBC

Citigroup Global Markets, 19 March 2008

• We are Maintaining Hold Rating but Elevating the Risk Rating — The Canadian bank stock prices have been adversely impacted along with other financial institutions on concerns of credit and liquidity. Considering the size of the banks, the significant reduction in valuations, the likely resolution to some of the credit concerns by the 2H08, we maintain the ratings, adjusting price and risk.

• Anticipate Higher Impaired Assets/Loans at BMO — Due to the bank’s credit related exposures we are reducing the target price to C$43 from C$54 and also changing the risk rating to High from Medium. To adjust for our increased provisions and lower Q108 results, we are reducing FY08E another -8%, bringing our estimated C$3.71 nearly 30% below consensus.

• Increased Funding Costs and Insurance Expenses at CWB — Our revised target price of C$23, down from C$36, reflects our lower FY08E of C$1.74 from C$1.87. The -7% decline in estimated earnings reflects higher funding costs, increased impaired loans and anticipated higher insurance related expenses. Our earnings estimate is fairly in line with consensus.

• Mono-line and Trading Related Credit Derivative Risk at RY — We are reducing the target price to C$47 from C$58, and elevating the bank’s risk rating to High. Both changes reflect the bank’s sizable securities holdings and derivatives trading related exposure to the U.S. We also reduced our FY08E -3% to reflect our views of higher PCL’s. Our revised FY08E of C$4.30/share is 1% below consensus.

Opinion - Summary

The current credit turmoil has increased the volatility and Risk associated with many financial institutions. As such, we are revising our risk rating on two of Canada’s large banks, Royal and Bank of Montreal. Both banks have a significant asset base with many potential points of exposure. Neither bank has recorded significant write-downs to reflect the potential exposures. Our view is the market has priced in C$14B for BMO and C$11B for RY. We are revising the risk rating on both to High.

Another aspect of the credit crisis is higher funding costs. Canadian Western relies on deposit brokers and the wholesale markets. As such, we are reducing our earnings estimate and price target on CWB to reflect the higher costs.

Bank of Montreal - Anticipate Higher Impaired Assets/Loans

Deteriorating Credit Trends to Impact BMO Assets — First quarter provisions were up over 300% driven by new impaired loan formations. We expect increased PCL ratio to cover impairments in current portfolio and any assets brought onto the balance sheet as a result of the SIV and Canadian ABCP restructuring efforts.

Expect Increased Funding Costs —We incorporated a 2 percentage point increase to the cost of equity to reflect the higher funding costs. Over 80% of the bank’s funding base is rate sensitive. Only 34% of the liabilities are comprised of individual deposits.

Anticipate Capital Markets Slow down and Higher Expenses — The pipeline for capital markets has been disrupted by the credit issues, we estimate 5% reductions to revenues. We estimate significant increases to non-interest expenses as the bank capitalizes on acquisition related disruption in the Midwestern U.S. to build out franchise teams.

Monoline, SIV, and Canadian ABCP Exposures — The bank disclosed C$3.8B direct notional derivative exposure, C$3.6B indirect notional derivative amounts, over C$10B in SIV related exposure, C$23.4B in ABCP liquidity, US$10.2B liquidity with exposure to U.S. sub-prime, and C$2B in Canadian ABCP. Market priced in estimated C$14B write down, bank announced less than C$1B.

Overall, Anticipate Continued Volatility — As such we are increasing the risk rating on the name to High from Medium. We are not recommending a Sell given valuation and likely resolution to outstanding credit concerns by 2H08.

Royal Bank of Canada - Mono-line and Trading Related Credit Derivative Risk

Risk Associated with Potential Additional Write-downs — To date the bank has announced less than C$1B in write downs resulting from disruption in the credit markets. Based on our estimates, the bank has disclosed at least $8B of exposure, which translates to approximately C$6.28/share loss to either earnings or book value depending on how it is accounted for.

Types of Exposures include: — US$4.938B CDO hedged with monoline insurers, US$9.126B credit protection by monocline insurers of which US$5.234B is subprime related, US$4.361B in U.S. ABCP that contains US$600mm non-agency, US$765mm in U.S, CMBS on the trading book, and a C$15.2B increased notional value of traded credit derivatives due to wider credit spreads.

Increased Our Provision for Credit Loss Estimate — PCL’s jumped 81% in the first quarter reflecting higher impaired loans in their U.S. residential builder finance business. The U.S. housing market remains weak therefore we expect continued loan losses.

Assets to Capital Leverage is High — As of YE07 the bank’s asset to capital multiple was 20x, the highest of the 8 large banks. The regulated maximum is 20x, and can be as large as 23x with OSFI approval. This indicates the bank will need to sell assets or raise capital to be within guidelines. Given reduced value of certain assets, either action will likely be an offset to earnings.

Maintain Hold Rating, with Increased Risk Rating — Based on the sell off in the stock since 2H07 estimate market has priced in approximately C$11B in write downs, furthermore given the bank’s size we expect long term resolution to the current credit related issues, as such we are not assigning a Sell rating. However, we do anticipate near term volatility, hence our revised High Risk rating.

Bank of Montreal

Company description

BMO Financial Group, with more than C$360B in assets and more than 34,000 employees, is a highly diversified financial services organization. The bank provides a broad range of retail banking, wealth management, and investment banking products and solutions in both the U.S. and Canada. In Canada, the brands are BMO Bank of Montreal, and BMO Nesbitt Burns. In the U.S. the brand is Harris Bank. In both countries the corporate and investment bank’s brand is BMO Capital Markets.

Investment strategy

We rate Bank of Montreal a Hold, High Risk Rating. The rating reflects our view that in the near term there is limited upside to the stock given the bank's exposure to structured products in Canada and the U.S. The bank had a higher risk profile than anticipated and has not been effectively managing the risk and related exposures.

The bank operates in two highly competitive arenas: Canada and Midwestern United States. The Canadian market suffers from slow population growth combined with 5 large banks all fighting to gain the few customers. The U.S. market where the bank operates (Midwest) has a similar set up, a few large banks fighting to acquire the same set of customers plus many small community banks also vying for the same customer base. Our rating reflects our view the bank could focus on the core retail operations, specifically in Canada to help provide a solid base to help stabilize the more volatile businesses.

Traditionally, the bank’s strength was credit risk management and we believe this will be needed as the overall credit environment continues to sour. We'd become more positive on the name once additional controls and checks have been successfully implemented. Furthermore, the bank's recent commodities and credit related exposures have adversely impacted the stock's valuation, making it inexpensive relative to the group. As such, we do not think a Sell Rating is warranted given valuation and the earnings potential of the retail franchises. The management team has taken steps to limit specific exposures and enhanced the risk teams.


Our revised 12-month target price of C$43 is derived using the same methodology as the prior target, utilizing an updated set of assumptions to reflect current market conditions. The revised assumptions are a group forward P/E multiple of 10.0x, which represents a 10% premium to the U.S. bank group but a 9-17% discount to the historical group average for the Canadian banks. We feel the current credit trends, deteriorating earnings estimates, and volume of risky assets warrant the discount. The 2009 EPS estimate of C$5.05 yields a C$50.50 target based on the forward P/E. The ERM generated C$35.65, based on a cost of equity of 12% (reflecting the current credit crunch) and a 2% long term growth rate (reflects economic slow down). The rounded average of both is C$43.

Our prior 12-month target price of C$56 was derived using the same methodology. The assumptions were 2009 EPS estimate of C$5.05, yielded a C$58.03 target based on the 11.5x group forward P/E. The ERM generated C$53.72, based on a cost of equity of 10% and a 2% long term growth rate. The rounded average of both was C$56.


We assign a High Risk rating because we think operating in highly competitive markets in two countries, the recent acquisitions, and the significant exposure to the credit crisis warrants a high risk rating. In our view, the bank might become aggressive with the acquisitions plans and over pay for a U.S. operation that does not add considerable earnings growth to the bank. Should that happen the bank’s capital ratios and earnings momentum would likely deteriorate and both the earnings and stock may not achieve our estimates. Our earnings estimates assume a rebound in fee businesses by 2009. If the pipeline remains dry there would be an adverse impact to earnings and our estimates would be overstated. This would likely lead to the stock not attaining our earnings estimates and price targets.

The bank attempts to hedge the associated risks of being exposed to credit, interest rates, currency, and market dynamics, on behalf of its clients but if it is not able to unload the risk into the market the bank holds it. We believe there is risk associated with these exposures and to hedge funds, SIV’s, and various counterparties. All of these could lead to performance results that would hinder the bank from attaining our estimates. There is potential litigation risk due to commodity trading losses and clients of the various structured paper products.

Conversely, the risk to the upside is the bank’s strategy in the U.S. and Canada may yield exceptional earnings growth that would drive the stock price well above our target.

Royal Bank of Canada

Company description

Royal Bank of Canada is the largest bank in Canada based on assets and market capitalization. Royal provides personal and commercial banking, wealth management services, insurance, corporate and investment banking, and transaction processing services. The bank’s primary operations are in Canada and the United States with exposure to the Caribbean, Europe, South America, Asia-Pacific, Australia, and the Middle East. Within Canada the bank has an exceptionally strong market position in most businesses. The bank has over C$600B in assets and approximately C$230B in loans.

Investment strategy

We rate Royal Bank of Canada Hold, High Risk (2H) and have a 12 month target price of C$47. In our view, as the largest of the Canadian banks, Royal likely has significant exposure to the deteriorating credit markets. Given the bank’s size, C$632B in assets, and diversified lines of business we think long term the bank will be able to withstand the current credit crunch. However, aside from the sector recovery we do not foresee any catalyst specific to Royal, to drive near term share price appreciation. The Canadian market is intensely competitive yielding minimal top line growth that falls to the bottom line. The bank has international exposure, particularly in the U.S. through its subsidiary Centura. The main driver for the U.S. business will be the recent acquisitions. The bank's capital markets businesses in both Canada and the U.S. will likely add to the growth engine for the bank after the financial sector recovery.


We derive our revised C$47 twelve-month target price by taking the equal weighted average of our excess returns model (ERM), and valuation based on the forward P/E multiple. We use the group forward P/E multiple of 10x our 2009 earnings estimate ofC$4.60/share, yielding C$46. The group P/E multiple 10x, reflects a discount to the historical group average that ranged from 11-12.5x. The discount reflects the current credit crisis and takes in to consideration where the comparable U.S. banks are expected to trade. The ERM derives C$48.58, both averaged is C$47.29 which we round to C$47.

We derived our prior C$58 twelve-month target price using the same method with a different set of assumptions. We used the forward P/E multiple of 12.5x our 2008 earnings estimate of C$4.45/share. The P/E multiple 12.5x, reflected a premium to the group average of 11.5x. The premium was driven by Royal's share of market, stability, and historical trends reflect Royal consistently trades at a premium to the group.

Additionally our estimated 3 year CAGR for Royal Bank of exceeds the group average. We believe this valuation method is appropriate given it employs a fundamental method and a market based multiple. The ERM derived $59.61 the P/E derived $55.51 for an equal weighted average target price of C$57.56, which we rounded to C$58.


We rate Royal High Risk because of the risks associated with being the largest financial institution in such a tight market given the current credit, and market related crisis. The bank has C$150B in trading securities, C$76B in reverse repurchases, and C$72B in wholesale loans on the balance sheet. The market for those types of assets has frozen in the U.S. and in Canada making it difficult to reduce balance sheet exposure to them. As such, we think the bank is at risk for credit crunch related write downs. The bank has announced less than C$1B in related write downs but has disclosed over C$5B in mono-line, CDO, and 3rd party exposure. The downside risk to the stock is that we think the potential write downs may reduce earnings preventing the stock from reaching our target price.

Additionally, excessive integration costs are a risk and could result in earnings below our estimates, which would likely have an adverse impact the stock price not meeting our established target. Royal may also be exposed to litigation risks from any follow on Enron related charges. This could pressure earnings and likely the stock price. Furthermore the projected rebound in capital markets related businesses, stable trading revenues, and alleviation of margin compression may not materialize, if these items do not develop the bank may not reach our earnings estimate which could adversely impact the stock.

The upside risk to our rating and price target is that alternatively, their may be a rebound in capital markets businesses that could exceed our expectations contributing favorably to earnings and the likelihood that the share price exceeds our target.

BoC Brought Banks on Board in ABCP Crisis

Financial Post, Duncan Mavin, 19 March 2008

Purdy Crawford and his team of lawyers have praised Bay Street for coming together to try to salvage Canada's non-bank asset-backed commercial paper market, citing a "spirit of compromise and goodwill."

But it was actually the backing of the Bank of Canada and the threat of financial meltdown that strong-armed domestic and foreign banks into supporting the restructuring plans.

Faced with the daunting task of delivering Canada's largest ever restructuring, Mr. Crawford had "no authority and no real instruments of power," said a well-placed source. As late as last week, two of the big Canadian banks were wavering over the level of support they had promised last year for Mr. Crawford's restructuring plans.

But the plan is back on track thanks to the influence of the central bank, which has been a key driver behind the restructuring efforts, calling Canada's big banks to order over a crisis still far from settled.

The role of the Bank of Canada - under former governor David Dodge and his successor Mark Carney - was confirmed when Toronto-Dominion Bank became the last of the big domestic banks to lend its support to the proposals put forward by Mr. Crawford and his committee, late on Monday.

TD had originally declined to support the restructuring plan because it did not have exposure to the non-bank ABCP market. The bank's commitment to support the plan will not be material to TD. Chief executive Ed Clark said in a statement his bank had been asked to "play a role" and agreed "on the basis that both the government and the [Crawford] committee indicated our participation is critical to the overall success of the restructuring process."

TD's decision to lend a hand comes after Mr. Dodge, Mr. Carney and others at the central bank spent months seeking the unanimous support of the banks -- their backing could help avoid the sort of crisis of confidence that has exacerbated global financial sector turmoil, and precipitated the collapse of Bear Stearns this week.

In December, Mr. Dodge told the Financial Post editorial board that all Canadians could pay a price if banks fail to come up with an agreement and $300-billion worth of leverage is allowed to unwind in a worst-case scenario.

Mr. Crawford's committee was tangled up in detail, banking regulators were apparently unwilling to apply any pressure, and the $32-billion ABCP crisis was going nowhere for several months last year, industry sources said.

Before the end of the year, the Bank of Canada set up meetings with banks and brokerages, where Mr. Dodge urged the banks to get on board to supply liquidity to the plan being hammered out for the frozen market.

"If the whole market goes into a shambles everybody gets affected, including Mr. and Mrs. Jones on Main Street," Mr. Dodge said at the time. "We have a collective interest in the whole thing not going into a shambles."

Many Canadians would be affected by a failure to restructure the ABCP and all the banks would feel some pain, the former central bank governor warned.

"Everybody, including the international banks, have a real interest in trying to somehow get this thing resolved."

Since then, the Bank of Canada has played a big part in trying to bring about an orderly resolution to the crisis.

When Mr. Dodge retired at the end of January, his successor Mark Carney - a seasoned investment-banker - took an equally active interest in the frozen ABCP market, said a source close to the restructuring efforts.

"The Bank of Canada and Mark Carney have been front and centre on this," the source said. "They did everything they could from a moral suasion perspective."

By the end of last week, the restructuring efforts were given extra impetus when Canadian bankers witnessed the U.S. Federal Reserve step in to avoid meltdown in the U.S. banking sector.

By Monday, the ABCP agreement was heading for the biggest insolvency filing in Canadian history, and there was at last some headway on the crisis that has bedevilled Canada's top corporate lawyers and bankers since last August.

The restructuring plans were given another confidence boost yesterday when National Bank of Canada said it has committed to provide $815-million in liquidity to support the efforts of the proposed restructuring plan. The other Canadian banks are providing a total of $950-million in support.

An orderly settlement is still some way off, and a number of small investors are disenchanted with a process they say is leaving them unfairly out-of-pocket. But and the central bank's efforts appeared to be paying off, at least in terms of bringing all the Canadian banks to the table.

"It has been difficult, it has been complicated, it's taken longer than people might like but by putting in place the standstill," Mr. Carney said. "I think the major participants (investors, asset providers, liquidity providers, agents of the paper) avoided the fire sale and very low returns for investors on this paper."
Financial Post, John Greenwood, 18 March 2008

Retail investors now hold the key to the unfreezing of $32-billion of seized-up asset backed commercial paper following on details released earlier this week concerning what amounts to the largest bankruptcy protection filing in Canadian history.

Among other things, it was disclosed that the key to the success of the restructuring lies with retail investors rather than big institutions because the plan must win support from more than 50% of note holders. Although players such as the Caisse de depot et placement du Quebec hold the lion's share of the affected paper by value, retail investors are far more numerous.

Ever since the rescue known as the Montreal proposal took shape last August, small investors have complained that their interests were being pushed aside in favour of the institutional players. Now, according to Purdy Crawford, the head of an investors committee overseeing the restructuring, their voices will be heard.

However, it was also disclosed that in connection with the restructuring, the banks, investment dealers and rating agencies such as DBRS that created the ABCP will be granted immunity from prosecution as a reward for supporting the restructuring.

"Key participants who are making a substantial and necessary contribution require the releases," Mr. Crawford said in an affidavit. "Simply put, there can be no [restructuring] unless these releases are included, and I believe the benefits of the plan, taken as a whole, justify the releases."

Most of the frozen ABCP is held by organizations such as the Caisse de depot, National Bank Financial and various government bodies. However, investors also include more than 1,600 individuals, many of whom were sold the notes by investment dealers and banks even though they may not have been part of the sophisticated investor category permitted under regulatory requirements to own the securities.

"I went ballistic when I saw the part about the legal release," said a small investor based in Toronto. "I couldn't believe they would let these guys off the hook."

"It's an extreme abuse of investors who were sold a savings product that was flawed," said Diane Urquhart, an independent analyst.

The noteholder vote is slated for the end of April, and observers say that given the ongoing turmoil in the credit markets and the level of investor sentiment, the result may be too close to call, at least for now.

As part of the restructuring, investors will receive longer term notes. Originally, the new notes were to have ratings from at least two rating agencies, but according to Mr. Crawford, they will have just one rating, from DBRS. Given that the bulk of the underlying assets will be highly complex credit default swaps that have fallen out of favour with investors, many observers expect they will trade well below face value.

The decision of whether to support the restructuring is "a bit of a high-stakes poker game," said Colin Kilgour, an industry consultant. "Either investors [support the plan and] take the new notes or they keep the bankrupt ABCP and pursue their legal options."
Bloomberg, Doug Alexander and Sean B. Pasternak, 17 March 2008

An investors' group ``substantially completed'' a restructuring of C$32 billion ($32.1 billion) in Canadian commercial paper that hasn't traded since August, and urged debt holders to support the plan to avoid ``significant losses.''

Twenty trusts received bankruptcy protection today in an Ontario court until April 16, giving investors time to review a plan drafted by a committee of some of the biggest debt holders. The proposal needs the support of a majority of noteholders, as well as investors holding a combined two-thirds of the debt.

``I am recommending that all noteholders approve the plan in order to avoid a forced liquidation of conduits and the significant losses that would likely ensue if the plan were not to move forward,'' committee Chairman Purdy Crawford said in a statement.

The group led by Crawford, a Toronto lawyer, has been working since September on a proposal to swap the short-term debt for longer-term notes, and aimed to submit the plan to investors by March 14. The creditor protection was needed ``in order to maintain a level playing field while allowing the debtor the breathing space it needs to develop the required consensus,'' the group said.

Crawford told reporters in Toronto he expects investors who hold their notes to maturity, in five to eight years, will recover most of their investment.

`Good Paper'

``It's good paper on the whole,'' he said outside the courtroom. ``But if they trade it, who knows?''

Investors who sell the notes after the restructuring is done may get about 70 cents to 80 cents on the dollar, said Colin Kilgour, a consultant advising commercial paper holders including clients of brokerage Canaccord Capital Inc.

Crawford said today that market turmoil will play a role in how much investors will receive. In a December conference call, he predicted that ``almost all'' of the value would be returned by the time notes would mature.

``It may be very difficult to predict in these markets,'' Crawford said today on a media conference call. ``If things stabilize, the chance of recovery will be much greater, but I wouldn't want to say that everybody's going to get their money back at maturity.''

Crawford also said today that the group will meet investors in major Canadian cities such as Toronto, Montreal, Edmonton and Vancouver.


DBRS Ltd., the Toronto-based rating company, downgraded the ratings of the 20 trusts to ``D'', its lowest non-investment grade rating.

The group has been working to restructure the debt after trading of the commercial paper halted in August as investors were concerned about possible ties to U.S. subprime mortgages.

A group of foreign banks, Canadian lenders and pension funds led by Caisse de Depot et Placement du Quebec negotiated the so-called Montreal Accord on Aug. 16, where banks wouldn't demand collateral from the affected trusts and those funds wouldn't ask banks for emergency funding.

Crawford's group had asked the Ontario Superior Court of Justice to call a noteholder meeting to approve the plan. Investors holding about C$21 billion of the notes have already agreed to the plan with some conditions, according to the filing.

Canadian Finance Minister Jim Flaherty encouraged ``all investors to consider it seriously and to participate in the voting process,'' according to a statement.

World Is Watching

Crawford said the world is watching whether Canada can be the first country to successfully restructure the asset-backed securities without a government bailout.

The biggest holders of the commercial paper include National Bank, the country's sixth-biggest bank, the Caisse pension fund, ATB Financial, an Alberta lender, and travel company Transat A.T. Inc.

``Our preferred solution is to get our cash back'' as soon as possible, Transat Chief Financial Officer Francois Laurin said in a telephone interview. ``You always hope they bring a better solution to the investors and holders like us, who don't want to be there for the long term because we invested on a short-term basis.''

Bank Credit

The restructuring includes a credit line of almost C$14- billion provided by institutional investors, foreign banks and Canadian lenders. Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada, Bank of Nova Scotia and Toronto- Dominion Bank indicated in a March 13 letter they would provide a combined C$950 million to support the new notes as part of that credit line, court documents show.

``In light of continued challenges facing financial markets, TD was asked to play a role and we've agreed on the basis,'' said Toronto-Dominion Chief Executive Officer Edmund Clark, in a statement.

The group asked the court to appoint Ernst & Young Inc. as the monitor in the restructuring.

The group said legal and banking fees paid to advisers including JPM Morgan Chase & Co. and Goodmans LLP have been about C$80 million to C$100 million.
The Globe and Mail, Tara Perkins, 17 March 2008

The committee working to restructure $32-billion of commercial paper has put the investments into bankruptcy protection, and will now work to sell investors on its plan.

The plan, if approved, would shield the market's key players from lawsuits. That is expected to be a big source of tension.

The restructuring will have an impact around the world, Toronto lawyer Purdy Crawford, who is heading the committee, said outside the courtroom after Mr. Justice Colin Campbell of the Ontario Superior Court approved the bid to put the sector under the protection of the Companies' Creditors Arrangement Act.

“Everybody's interested in whether we can be the first country to complete a successful restructuring without governments bailing anybody out,” he said yesterday. “And hopefully it will help cool out the markets worldwide; certainly that's the view of the head of the Bank of Canada.”

Central bank governor Mark Carney reiterated yesterday that he believes the committee's work avoided a fire sale in the sector by essentially freezing the paper through a standstill agreement.

Finance Minister Jim Flaherty said “the court has now approved a process for investors to vote on the restructuring proposal based on detailed information provided by the investors committee and its advisers. I encourage all investors to consider it seriously and to participate in the voting process.”

Mr. Crawford sought to head off what he knows will be one sore spot for some investors.

These are blanket legal releases, which will be given to nearly all participants in Canada's third-party asset-backed commercial paper sector if the committee's current plan is approved. The releases would be extended to banks, credit rating agency DBRS Ltd. and brokers, in addition to the companies that created the paper, making it more difficult for investors in the sector to successfully sue them.

“Some investors believe they have rights to sue parties on account of their losses,” and that the releases would take those rights away, Mr. Crawford said in an affidavit filed in court yesterday. “Some have told me they support the financial aspects of the plan, but do not wish to release the parties they believe should be held responsible to them for their losses.

“I understand these views. However, negotiation of the plan has been the art of the possible,” he said, explaining that some key players in the restructuring said they wouldn't participate without the releases.

It was a group of investors that hold more than $21-billion of the paper – including Crown corporations, financial institutions and companies – that pushed the 20 trusts that created the paper into court proceedings, under which the committee will finalize its plan to fix this market.

A key standstill agreement that had been keeping the market frozen, and preventing the paper's value from crashing, expired at midnight on Friday. The court protection now extends until April 16, at which point it could be extended, while the committee has negotiated a standstill agreement with the asset providers until the end of April.

Some key details of the plan are still being negotiated.

To date, the committee has secured 98.5 per cent of the $14-billion in backup funding commitments it needs for the smooth operation of the restructured market.

“The reality is we've gone through hell with the markets since we signed off in December,” Mr. Crawford said. At that point, they were asking the Canadian banks and other parties who were contributing to the standby line of credit to do so for 160 basis points, when the going market rate would have been 250 to 300 basis points. “Today, it would cost 500 to 600,” Mr. Crawford said, but the credit line is being obtained at the original price. (A basis point is 1/100th of a percentage point.)

The committee expects some of the new longer-term notes that will be created by the restructuring will receive investment-grade ratings by DBRS. It “attempted to obtain ratings from a second rating agency, but could not do so,” Mr. Crawford said in his affidavit.

A key aspect of the restructuring involves taking the short-term paper and transforming it into longer notes, with maturity dates of up to nine years.

Those who hold the notes to term should recoup much of their value, Mr. Crawford said yesterday. “What they get if they trade in the market over the next year or two, who knows, depending on the world markets,” he said.

Mr. Crawford will soon be travelling across the country to hold meetings with investors, who will be able to vote on the plan at a meeting that's expected to be held in late April.

In its request for bankruptcy protection, the committee said “in the absence of a successful restructuring, there will be serious losses, measured in billions of dollars, to investors and other market participants.”

Mr. Crawford said the Canadian banks – asked to commit $2-billion – are all on board, although “some negotiating” remains.

12 March 2008

Green Issues Move Up the Agenda at Banks

The Globe and Mail, Tara Perkins, 12 March 2008

Following a showdown with Ethical Funds Co., Bank of Montreal plans to detail its procedures for evaluating credit risk associated with climate change by April. It's one of a number of recent examples of the increasing environmental pressure banks are facing, and changes they're making as a result.

Examples of the banks going greener are not hard to come by. BMO is starting to replace its company service vehicles with hybrid sedans. Royal Bank of Canada executives have recently committed to schlep to the cooler rather than drink bottled water, a small part of RBC's broader water initiative. Bank of Nova Scotia announced last month that it was launching a fund aimed at investors looking for environmentally responsible companies, as a number of the banks push forward with environmentally conscious funds.

The country's largest banks are even considering working together on a carbon statement, said James Evans, a senior manager in RBC's environmental risk group.

Much of the pressure they are feeling is aimed not at internal changes but at the broader impact they can have by influencing customers through their lending practices.

Today, Ethical Funds will be releasing a report that ranks the Big Five banks based on their climate-related credit risk procedures. Toronto-Dominion Bank jumped to the top of the list and tied with Royal Bank. They were followed by Canadian Imperial Bank of Commerce, Scotiabank and BMO.

Prior to the recent round of bank annual meetings, Ethical Funds submitted shareholder proposals asking Scotiabank and BMO to disclose their procedures. It withdrew them after receiving assurances they would do so this year.

BMO had been working on the issue prior to the proposal, which brought it further into the light, said Jim Johnston, the bank's director of environmental sustainability.

Banks are being pushed to make some tough decisions. For instance, Ethical Funds says Scotiabank lags on the issue of biodiversity and boreal forest protection, but "we understand they are holding off on implementation in light of the accumulating challenges facing the forestry industry."

Corporate Knights editor Toby Heaps said he's not surprised RBC received top marks. The bank is probably the No. 1 player in the Western world when it comes to helping arrange financing for renewable energy wind projects, he said.
Financial Post, Gordon Hamilton, 12 March 2008

Canada's Big Five banks have woken up to the impact their financing has on climate change, according to a report released Wednesday by The Ethical Funds Company.

But some are doing better than others, says the report, by the socially responsible mutual fund.

TD Bank and Royal Bank come out on top of the ratings, with policies and practices on lending that address climate change. Bank of Montreal is at the bottom, offering little evidence it considers the environment in its lending portfolio.

In the middle are third-place Canadian Imperial Bank of Commerce, described as "climbing the ladder," and fourth-place Bank of Nova Scotia, improving, but slow to address climate change risk in its lending.

Robert Walker, vice-president of sustainability at Ethical Funds, said in an interview that banks play a crucial role in tackling climate change as they are the key lenders of capital to companies that create environmental impacts.

Like socially responsible funds, banks are now asking their clients questions about carbon emissions as part of their risk assessments, he said.

"It's one thing for Ethical Funds to be asking those questions. But if big banks are also asking those questions, that will have a large role to play in helping these emitters get carbon emissions down."

The report looks at three Canadian environmental issues: carbon-emissions management, efforts to preserve biodiversity and the role of Canada's boreal forest in reducing atmospheric carbon.

Walker said Ethical Funds undertook the survey because their own investors are concerned about climate-change issues and there are also broader risks to investors over carbon emissions.

"There is going to be some kind of price associated to emitting carbon down the road," Walker said. "But there are companies, that in some cases are large emitters, that do not incorporate any kind of cost of carbon into their present investment decisions."

TD Bank, which tied in the ratings with Royal Bank, is singled out for its progress in addressing climate change in lending policies.

"Once viewed as a laggard on environmental risk assessment, TD Bank now occupies a lead position," the report states.

TD was one of the first banks to be targeted by Canadian environmental protesters. In 2006 banners were draped from its Toronto head office, part of the battles over logging in mountain caribou habitat. At that time TD Bank president Ed Clark said imposing standards on clients is "a dangerous road" for a financial institution.

Today, TD is committed to carbon audits and assessment of climate risks faced by their clients, the report states.

Royal Bank is described as the leader on environmental issues for over a decade. It is singled out for not funding unsustainable forestry operations and encouraging companies to become eco-certified.

Sandra Odendahl, the bank's director of corporate environmental affairs, said Royal has taken a lead on climate change because a broad spectrum of stakeholders have urged it.

"As a large corporation we must absolutely pay attention to what they are telling us," she said from Vancouver, where she is moderating a panel at the Globe 2008 Conference on Business and the Environment.

Further, future government policies could be costly to carbon emitters.

"That very fact drives us to need to look at what those new costs will mean for sectors, for specific borrowers and in specific transactions, where before, it didn't cost anything to emit carbon dioxide."

CIBC is slightly behind. It has conducted a carbon audit of its lending portfolio and is improving its policies and disclosures.

Bank of Nova Scotia lags the top three but is drafting policies on how it will address climate change in its lending portfolio.

Bank of Montreal, at the bottom, has undertaken measures to manage its carbon footprint but so far has not seen the need to undertake a carbon-risk audit of its lending portfolio, the report states.

Jim Johnston, director of environmental sustainability at the bank, said in an interview that the bank is now in the process of revising its lending practices around climate change.

He said the bank will be making a statement at the end of April.

"It will be a statement of the revised way in which we look at our lending practices and the additional steps we will be taking," he said.

Review of Banks' Q1 2008 Earnings

Scotia Capital, 12 March 2008

First Quarter Overview

• Canadian bank stocks continue to be under selling pressure as the credit crunch grind enters its eighth straight month and still counting. This prolonged period of credit market uncertainty has shaken investors' confidence particularly in the ability of the regulators and the Federal Reserve to deal with the current crisis and the possibility of a deep economic recession.

• The bank index declined 13% in 2007 representing only the fourth time in nearly fifty years where the bank index has declined 10% or more. The last time the bank index was down more than 10% was 1990 and the time before that was 1981. The bank index has increased more than 20% in a year, 15 times over the same period.

• The bank index has declined 12% year-to-date in 2008 with the overall market down 6%. Sentiment and fear are dominating bank stock prices.

• The sell-off in bank stocks has resulted in unprecedented valuations against bond yields with P/E multiples back to levels not seen since the Asia crisis. Bank dividend yields relative to bond yields are 133% or 7.0 standard deviations above the mean, a record level by a wide margin. Bank dividend payout ratios are 44% slightly above the historical mean of 38% - 42%. The market is discounting a dividend cut and we strongly believe that dividends will not only be maintained but will continue to grow at an 8%-12% rate over the next five years with some slowdown in dividend growth in 2008.

Solid Operating Earnings - Writedowns Modest

• The bank group incurred modest writedowns for the second straight quarter as it marks-to-market its trading positions and security holding for the major price declines in the credit markets and counterparty risk.

• Banks operating earnings in the first quarter were very solid with a modest 2% decline from the record quarter a year earlier, slightly better than expected. ROE remained extremely high at 21.9%.

• Writedowns in the quarter were very modest except for CM and BMO. TD was the only bank to increase its dividend with a 4% increase.

• Operating earnings year-over-year comparisons are difficult versus a record quarter a year earlier due to the 16% appreciation in the C$, higher loan losses, lower net interest margin and the very difficult capital market environment.

• Reported earnings fully loaded declined 57% year over year including CM's and BMO's large writedowns. ROE on this basis was 10.2%. If we exclude CM, reported earnings declined 14% with 17.9% ROE. If we exclude CM and BMO reported earnings declined 12% with ROE remaining high at 19.8%.

Market Capitalization Decline Extreme vs. Writedowns

• The after-tax writedowns in the first quarter totalled $2.9 billion with $2.5 billion concentrated in CM ($2.2 billion) and BMO ($324 million) with writedowns equal to 3.1 and 0.5 quarters of earnings respectively. TD had no writedowns again for the second straight quarter with NA, and RY writedowns modest at 0.06 and 0.13 of quarterly earnings respectively (exhibit 1).

• Canadian banks' total writedowns including BMO's natural gas trading losses now stand at $4.7 billion after-tax which represents approximately one quarter of bank group earnings, with these losses concentrated in CM and to a lesser extent BMO.

• Bank stocks have sold off through the credit crisis with market capitalization declining a cumulative $76 billion or 28% from the highs. The market capitalization decline is 16.2x the writedowns to date or 29.5x excluding CM. This ratio is extremely high and is unprecedented. The ratio in the large LDC writedown years of 1987 through 1989 was 1.8x and 2.3x during the large commercial real estate loan losses booked from 1992 through 1994.

• The three banks TD and RY who have modest or no write downs have also seen a major decline in market capitalization. TD has had no writedowns but its market capitalization has declined by $11 billion. RY market capitalization has declined by $20 billion on cumulative after-tax write downs of $347 million.

• If we use CM and NA as a benchmark in terms of market capitalization decline in relation to writedowns and use the 6x multiple we reverse engineer future writedowns that the market is discounting in bank share prices (exhibit 2). Based on this methodology the market is discounting future losses for bank group of $12.3 billion or $8.0 billion after tax which does not seem feasible. The high quality Canadian Banks have suffered severe share price contagion as these future losses seem extremely unlikely even in this major credit crisis.

Strong Fundamentals - High Profitability & Capital Levels

• Canadian Banks continue to maintain large capital positions especially relative to global competitors with profitability remaining near record highs with ROE in the 20% range. Canadian banks' exposure to the high risk asset classes remains relatively low with CM, BMO and NA being the exceptions. CM, BMO and NA exposure remain manageable. We expect bank earnings to remain relatively resilient through a recession with dividends safe.

• Banks have grown their earnings at 15% per annum for five straight years with 2008 earnings expected to be a pause before growth starts again beginning in the fourth quarter of 2008. We expect a strong rebound in earnings momentum in the second half of 2008 and 2009.

P/E Divergence Favours TD and RY

• Our stock selection continues to favour TD and RY with their high revenue growth, high reinvestment, lower earnings dependency from higher risk areas and strength of their retail and wealth management platforms.

• Individual bank P/E divergence has finally occurred after the group was trading at an abnormal narrow P/E spread (convergence). The P/E multiples have diverged above the historical mean, however the divergence can be extremely wide for a period. Individual bank relative P/E multiples can decline to the 70% to 78% relative range. BMO's relative P/E multiple historical mean is 93% with one standard deviation below the mean at 78%.

• Maintain 1-Sector Outperform ratings on RY and TD, 2-Sector Perform ratings on CWB, CM, and NA and 3-Sector Underperform ratings on BMO and LB.

Recommend Aggressively Buying Bank Stocks

• Our view is that Canadian banks have solid balance sheets and strong underlying earnings and will be able to weather the prolonged and lingering credit crunch. As fear subsides, share prices should move up sharply. We continue to recommend aggressively buying banks at these levels.

• The current meltdown we believe is a tremendous buying opportunity and we would be at maximum possible weighting in the bank group with a focus on the high quality names: TD, and RY.

• Best buying opportunity in decades.
RBC Capital Markets, 11 March 2008

We believe that a price to book approach to valuations is now more appropriate than P/E for bank stocks given the deteriorating economic and credit markets environment, and decreasing confidence in our earnings forecasts. We have reduced our 12-month target prices as a result.

• 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; well below the current 2.0x P/B median.

• We are using an average 1.8x P/B multiple to derive our price targets, to reflect lower risk free rates than back in 2002.

• We are using lower P/BV multiples relative to expected ROEs for banks we view as having higher "tail risk": NA, if the Montreal Accord fails; BMO, if off-balance sheet exposures lead to the bank raising equity; and CIBC, if the outlook for financial guarantors worsens.

• Canadian banks have traded at lower multiples in the the mid and early 1990s (1.0x – 1.2x book) but we believe trough multiples should be higher in this cycle as banks are less exposed to business lending, they have more exposure to wealth management, they have higher capitalization ratios, and risk free rates are lower.

• Our 12-month targets suggest median returns of 10% from holding bank shares in the next 12-months (including dividends). If we apply our target multiples to the current book value (as opposed to estimated book values 12 months from now), it suggests about 8% of potential near term downside in share prices.

• TD and RY remain our favourite bank stocks. These banks have stronger domestic retail franchises, and we believe that the larger risk exposures they have are more manageable than those at BMO and NA, our Underperform-rated bank stocks.

• Our 2008 earnings estimates have been below targets established by management teams since the year started, and we continue to believe that, even on a core basis, growth will be well below the rate of recent years. Furthermore, our GAAP earnings estimates are lower than our core earnings estimates, reflecting writedowns already seen and our expectations for more to come.

• The industry's Q1/08 core cash EPS declined at a median 2% versus Q1/07. On a GAAP basis, the EPS decline was 18%.
Financial Post, Duncan Mavin, 12 March 2008

There will be more bumps along the road for Canada’s big banks, but a year from now their stock prices should mostly be trading higher on the back of modest earnings growth, said TD Newcrest analyst Jason Bilodeau in a note.

The global downturn in financial stocks, further credit market problems, and the worsening U.S. economy all overshadowed recent first quarter bank earnings, that were mildly disappointing, the TD analyst said.

But the banks are “fundamentally sound and well positioned businesses.” While the market remains sensitive to any potential exposures and negative headlines, the big banks will likely turn in higher earnings in 2008 compared to 2007, and their share prices should rise as a result, Mr. Bilodeau said.

Bank of Nova Scotia is TD’s top pick in the sector, in part because it has lower exposure to those risky areas than some of its competitors. TD has a “Buy” rating on Scotiabank, with a $56.00 target price.

Canadian Imperial Bank of Commerce and National Bank are also rated a “Buy” thanks to depressed stock prices that offer good value, according to TD.

Bank of Montreal is the negative outlier, because of higher than expected domestic retail banking costs, growing uncertainty around the bank’s credit crunch exposures, and higher loan losses.

“The most disappointing recent developments have occurred at BMO, and it remains the bank with the most uncertainty,” Mr. Bilodeau said. TD has a “Hold” rating on BMO, with a $53.00 target for BMO stock.