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.