31 July 2008

TD Waterhouse Fined for Improper Fund Sales

The Globe and Mail, Tara Perkins, 31 July 2008

TD Waterhouse Canada Inc. has been fined $2-million for not properly ensuring that only wealthy clients bought certain products and failing to ensure that staff only sold hedge funds to appropriate clients.

The Investment Industry Regulatory Organization of Canada said on Thursday that TD Waterhouse reached a settlement in which it admitted that, from 2001 to early 2005, it facilitated purchases of Olympus funds in client accounts without ensuring that clients were accredited investors. Accredited investors are generally those with more than $1-million in financial assets, or who make more than $200,000 a year.

Olympus funds were created by Norshield Financial Group, one of Canada's largest hedge fund companies, in 2001 to attract retail investors. Norshield was put into receivership in 2005 and, according to the Ontario Securities Commission, roughly 2,000 people had sunk a total of $160-million into the Olympus funds.

TD Waterhouse spokeswoman Susan Webb said that when the company learned that a “small number of Waterhouse investment advisers had made honest errors in allowing the non-accredited investors to purchase the funds, we ensured that the non-accredited investors received restitution.”

Alex Popovic, vice-president of enforcement at IIROC, said that TD paid $1,970,441 to put those people back in the position they would have been before they purchased Olympus funds.

TD Waterhouse also acknowledged that, from 2001 to the fall of 2004, it failed to establish and maintain alternative investment review or approval procedures; and from 2001 to 2005 failed to establish and maintain sufficient training and guidance to its investment advisers to ensure that the purchase of hedge funds was appropriate for its clients.

In addition to the fine, TD will pay $50,000 in costs.
Financial Post, Barbara Shecter, 31 July 2008

Brokerage TD Waterhouse Canada has agreed to pay a fine of $2-million as part of a settlement with regulators over the sale of hedge funds to clients who weren't qualified to own them.

The settlement reached with the investment Industry Regulatory Organization of Canada on Thursday stems from the sale of Olympus Funds between 2001 and 2005.

According to the settlement, TD "failed to establish and maintain alternative investment review or approval procedures" and failed "to ensure that the purchase of hedge funds were appropriate for its clients."

In addition, the brokerage failed to provide sufficient training and guidance to its brokers, IIROC said.

Alex Popovic, vice-president of enforcement at IIROC, said the size of the penalty was reduced by TD's co-operation, the repayment to clients of nearly $2-million, and a number of initiatives taken to correct the problems uncovered by the investigation.

"But for the fact they acted appropriately ... the fine would've been significantly higher," he said.

TD Waterhouse added training programs and internal controls, and fined or otherwise disciplined three brokers who sold Olympus funds to clients who were not deemed to have the required level of investment sophistication. Olympus funds were managed by Norshield Asset Management, a scandal-plagued fund manager that regulators ordered to cease doing business with clients in 2005.

An investigation into TD Waterhouse was started by IIROC's predecessor, the Investment Dealers Association, in the spring of 2006.

According to the settlement agreement, 31 TD Waterhouse clients subsequently complained about their investments in Olympus hedge funds, with most complaining that the funds had been portrayed as low risk, safe, or conservative.

The receiver for troubled Norshield Asset Management says about 1,900 retail investors in Canada invested in the group's funds. Olympus United Corp raised some $265-million from retail investors, according to RSM Richter Inc.

"TD was certainly involved in selling this particular product, and there were others," said Mr. Popovic.

The IDA began the investigation around April 2006. Ms. Webb said that, “since this goes back to 2006, we're confident that for some years we've had all of the right procedures and systems in place to make sure that things like this wouldn't happen. Outside of this investigation and process there are a number of changes that had taken place, so we're confident in all of the checks and balances that exist.”

Great-West Lifeco Q2 2008 Earnings

Scotia Capital, 31 July 2008


• Q2/08 EPS (ex $0.73 one-time gain) was $0.63, versus our $0.57 and consensus of $0.61.

What It Means

• A reasonably clean quarter, we would peg "underlying" EPS in the $0.61 to $0.62 range. Excellent expense control, despite acquisitions, with a very scalable platform especially in Europe and U.S. Financial Services. Europe still going strong, 401(k) and P/NP net flows continue to gain momentum, and Putnam net sales improve to just negative $0.2 billion.

• No credit issues - subprime securitized first mortgage loan exposure modestly declines 7% to $1.4 billion (1.4% of invested assets) and while three times the relative exposure of MFC and SLF, it is 1/3 the relative exposure of U.S. counterparts - company reconfirms its comfort level with credit.

• Negatives. Monoline wrapped asset exposure increases 11% due to Standard Life acquisition, but provisions for default increase by 1/2 the amount. Europe top-line sluggish do to poor equity markets.

• Net. Excellent GARP story, attractive valuation, 4% dividend yield and immaterial credit exposure - reiterate 1-Sector Outperform.


• A beat - always good to see in these difficult markets. Q2/08 EPS was $0.63, versus our $0.57 and consensus of $0.61. A reasonably clean quarter, we would peg "underlying" EPS in the $0.61 to $0.62 range, when adjust for "unusuals" or what could be construed as "onetimers." These consisted of a $0.01 EPS gain in the MV of the company's preferreds versus the underlying assets plus a $0.04 EPS gain from a currency hedge used to transfer U.S. dollar assets to back the Canadian portfolio, offset by an estimated $0.04 EPS increase in actuarial default provisions mainly associated with European financial guarantors. Our Source of Earnings analysis confirms the $0.63 reported EPS to be relatively clean.

• No credit issues - subprime securitized first mortgage loan exposure modestly declines 7% to $1.4 billion (1.4% of invested assets) and while three times the relative exposure of MFC and SLF, it is 1/3 the relative exposure of U.S. counterparts - company reconfirms its comfort level with credit. Detailed disclosure was once again provided, showing no adjustable rate mortgage loan exposure (all fixed and all first mortgages), 60% pre-2005 origination, 92% AAA, 99.6% senior bonds, with a cumulative loss to date of just 1.1%. We take comfort from the fact that since the sub-prime exposure was first identified in Q1/07 the company has continually provided more than sufficient detail on its exposure, has had excellent default experience, has, in our opinion, more than sufficiently scenario tested it, and has continuously demonstrated that its subprime mortgage portfolio is very different than the ones we've been reading in the press.

• Excellent expense control - despite acquisitions - a very scalable platform especially in Europe and U.S. Financial Services. We remain impressed. As outlined in Exhibit 2, general expenses in the company's Europe operations were up just 11% YOY, whereas gross profits were up 28%, and general fund assets were up 30% (largely due to the Standard Life acquisition of $12.6 billion in payout annuity assets). We see the same in U.S. Financial Services (largely 401(k), 457 and FASCore P/NP business) where, despite markets falling 8% YOY, gross profit is up 6% YOY, and expenses are up just 3% despite a 17% YOY increase in FASCore and P/NP participants. Finally, in Canada, the company continues to benefit from scale, with expenses up just 3%, far below the 10% increase in gross profits.

• Europe still going strong. 31% YOY growth (ex FX) clearly shows the company is benefiting not only from increased scale, as well as yield enhancements on its payout annuity business (we estimate $0.03 in EPS in the quarter, most of which is sustainable), and continued excellent growth in group insurance. When we adjust for an estimated $0.02 EPS hit due to a bump in actuarial default provisions for a tougher credit environment in the U.K. the growth would be 44%.

• 401(k) and P/NP net cashflow continues to gain momentum. At $508 million, up from $353 million in Q1/08 and negative $135 million in Q4/07, the company continues to gain traction in this high growth and highly profitable segment.

• Putnam net flows improve. At just negative $0.2 billion, net sales were better than expected, and much better than the negative $3.7 billion in Q1/08 and the negative $3.1 billion in Q2/07. Margins at 16.4%, primarily due to weak markets, remain below the company's 25%-30% target.


• Monoline wrapped asset exposure increases from $3.5 billion to $3.9 billion due to Standard Life acquisition. We take comfort however from the fact when monoline exposure increased by $400 million the company also booked a $166 million increase in default provisions in actuarial reserves, which, to the extent not needed would flow into income. As well, despite the increase, the less than BBB monoline exposure fell $76 million to $140 million. Finally, one-half of the $1.8 billion BBB monoline wrapped asset exposure is government related.

• Weak top-line in Europe. While Canada was reasonable (individual insurance sales up 11%, wealth management sales down 6%), Europe continues to be weak with revenue premium down 17% (ex FX), after declining 15% in Q1/08, largely due to the continuing effect of financial market volatility.

30 July 2008

Genuity CM's Analyst on Banks

The Globe and Mail, Tara Perkins, 30 July 2008

A top analyst at Genuity Capital Markets has caught some investors' attention with a method he uses to determine when to trade bank stocks in volatile times.

Three or four times since the credit crisis began last summer it has looked like the stocks of financial institutions were poised to recover, analyst Mario Mendonca wrote in a note to clients this week. "In each instance, certain observers stated that the worst was over."

But he believes that some recent rallies were not evidence the market was improving. Instead, they were simply a belief among investors that the stocks had fallen enough to make them worth the risk.

"This last rally was particularly telling, as the financials rallied violently in the face of [JPMorgan Chase & Co.'s] warning about a deteriorating prime mortgage book," he wrote. "In our view, the only absolute evidence that investors should focus on to support the belief that the worst is over is price stability in the U.S. housing market," he added. "Until there is evidence that U.S. housing supplies are declining (that is, resale activity is catching up with the pace of foreclosures) such that price declines will shrink, the environment will be one of trading around extremes."

With that in mind, Mr. Mendonca's tool of choice is the price-to-book to excess return framework: the Canadian banks' forward price-to-book ratio is compared with the excess of return on equities over the 10-year government bond yield. "Our analysis suggests that at a 20-per-cent discount or greater, the banks are cheap enough to support buying the group, particularly the underperformers, [Canadian Imperial Bank of Commerce and Bank of Montreal]," he wrote. "At a 10-per-cent or smaller discount, the model supports selling the group. There is less conviction in the calls between a 10-per-cent and 20-per-cent discount."

At the current discount of 18 per cent, he advocates an "add if underweight and hold if overweight" strategy.

In an interview, the highly ranked analyst said the concept is very theoretical, but investors are always surprised when he tells them it has an 80 per cent R-squared, meaning that it is correct about 80 per cent of the time.

"Really, it's a substitute for the bank to bond yield, because everyone agrees now that the bank to bond yield has no explanatory power whatsoever," he said.

Target Price and Rating

BMO $49 Hold
BNS $52 Hold
CM $78 Hold
NA $55 Hold
RY $52 Hold
TD $73 Buy

24 July 2008

TD Bank Abandons US Brand Battle

Dow Jones Newswires, 24 July 2008

Toronto-Dominion Bank's renaming of US retail subsidiary because of legal wrangle with competitor already using the Commerce brand, brings an "unwelcome complication" to an already "daunting integration exercise," Brad Smith says at Blackmont Capital. As well, the elimination of established brand "could be viewed as having implications for acquired goodwill should future earnings potential be negatively impacted," Smith notes, adding this is "particularly relevant" since TD recorded more than $6B of goodwill when Commerce Bancorp acquisition closed in March.
Boston Globe, Ross Kerber, 24 July 2008

Changing course in the face of a lawsuit, TD Banknorth picked a new new name to use following its merger with Commerce Bancorp Inc. of New Jersey - TD Bank.

Previously the combined banks were to be known as TD Commerce Bank. The bank has not decided what name it will put on the Boston sports arena now known as the TD Banknorth Garden, where it owns naming rights. Bank officials said they expect to decide on a name for the arena later this year. Any final name would include the word "Garden."

TD Bank chief executive Bharat Masrani said he switched to the new name for his institution because of a lawsuit brought by Commerce Bank & Trust Co., a 12-branch company in Worcester. In a federal suit earlier this year, it claimed the name "TD Commerce Bank" would confuse customers.

Earlier this year, the Worcester bank won an injunction from a federal judge barring the merged banks from using the name TD Commerce Bank in much of Massachusetts, including Boston and Worcester.

Commerce Bank branches in mid-Atlantic states will start using the TD Bank name later this year, Masrani said, while New England branches won't see their names changed until fall 2009.

That also will give the bank time to settle on a new name for the Garden, home turf for the Celtics basketball team and the Bruins hockey franchise. TD Banknorth is allowed one name change under the terms of the $6-million-a-year rights pact signed in 2004 with building owner Delaware North Cos.

Masrani said the company has not reached a legal settlement with Commerce Bank & Trust. David H. Rich, an attorney representing Commerce Bank & Trust, said the two sides have held talks to resolve the situation. "It would appear they've elected to go down a different road," Rich said.

Executives said TD Bank's marketing will be built around its motto of being "America's Most Convenient Bank." TD Bank is a unit of Toronto-Dominion Bank of Canada.
The Globe and Mail, Tara Perkins, 24 July 2008 12:48 AM

Toronto-Dominion Bank will have to pursue its ambitious U.S. strategy without the help of the Commerce Bancorp name, a respected and quirky brand that had high value in its home market.

The Canadian bank has agreed to choose a new name for its 1,100 U.S. branches after a showdown with a Massachusetts bank that has only 12 outlets.

TD is abandoning the name TD Commerce Bank, the U.S. moniker it had chosen in the wake of its $8.5-billion (U.S.) acquisition of New Jersey-based Commerce Bancorp Inc.

Commerce Bancorp made a name for itself over the last 35 years with a business model based on Burger King, projecting a fun attitude that differentiated it from its competitors.

Rather than incorporating that name, TD will rebrand its U.S. operations as TD Bank, losing any reference to Commerce.

The decision was announced Wednesday, more than two months after a Massachusetts judge blocked TD from using the name in a handful of Boston-area counties. A small local bank with a similar name, Commerce Bank & Trust Co., had gone to court for an injunction to stop TD from using the name TD Commerce Bank in its backyard. It was worried its customers would be confused.

"After several weeks of looking at options and looking at what makes sense here, we decided to move forward and rename our entity into TD Bank, America's Most Convenient Bank," Bharat Masrani, TD's chief executive officer of U.S. operations, said in an interview.

Both sides said there was no financial component to their settlement.

While it was a difficult decision, Mr. Masrani played down any concern about the loss of the Commerce name.

"Obviously, when you go through an event like this, it is never easy, but from my perspective, brands are what they stand for," he said.

"We love the position we have, and that positioning does not change. I'm feeling pretty relaxed about it going forward, that this is the right thing for our bank," he said.

The new name will be marketed in mid-Atlantic states in November, with the rest of the bank's branches (which Mr. Masrani now refers to as "stores," part of the Commerce Bancorp lexicon) in the New England area rebranded by the fall of 2009.

Mr. Masrani said he was disappointed by the court's decision to grant the injunction, "but rather than spend countless time as well as valuable resources fighting this legal challenge in court, we have decided to remain focused on our customers and employees and move forward under our new brand name of TD Bank."

Brian Thompson, a spokesman for Commerce Bank & Trust Co., said "We're pleased from our end, because we're going to be able to continue to use our name in the way that we have for the last 55 years."

Mr. Thompson noted that "in the banking business, it's hard to change your name. You have the goodwill built up over years and years."

He said the bank had been in discussions with TD, looking at ways to make the situation work for both financial institutions, but "not necessarily settlement talks.

"We really didn't see other options," he said. "We really felt that we had been in this market, had spent a lot of money over the years and developed a great reputation."

"We've had a lot of discussions here," Mr. Masrani said. "Again, the view we took is that it's better for us, all of our stakeholders, our customers, employees and our shareholders that we move forward here."

He added that the integration is otherwise on track, and he remains confident the bank will be "an outlier" during the U.S. slowdown, noting the bank concentrates on the Northeast U.S. and that both TD and its recent acquisition have maintained conservative risk-management practices.

The situation in the U.S. banking sector is "very fluid," he noted.

"We've seen a major slowdown in various sectors; some might argue we are in a recession, and those are obviously troubling signals," Mr. Masrani said. "But then, on the other hand, having been here for a while, I've learned to respect the resilience of the American economy and how quickly it is able to transform and reorganize itself.

"My view is the world is not coming to an end, and, at some point, we will come out of this."

23 July 2008

Preview of Life Insurance Cos Q2 2008 Earnings

RBC Capital Markets, 23 July 2008

Macro environment negative for lifecos (but not as bad as in Q1/08)

• We expect currency translation to negatively impact the big 3 lifecos' YoY earnings growth by 5% on average with Manulife being the most impacted (6%). The Canadian dollar strengthened against the US dollar (9%) and the British Pound (10%). Industrial Alliance is not impacted by currency movements.

• US and Japanese long-term interest rates were each up by 22 basis points sequentially - the largest positive move since Q2/06. Higher long-term interest rates positively impact all lifecos, but Manulife should benefit most due to its geographic and business mix.

• North American and Japanese equity markets were up during the quarter, which is positive for reserves, but their average levels were down YoY, which hurts growth for all lifecos' fee based businesses. We believe Great-West is least exposed to equity market volatility. Industrial Alliance should benefit most from the 8% sequential rise in the S&P/TSX index, given its exposure to the Canadian market.

• The ratio of downgrades to upgrades for North American high yield debt has increased in 2008, but remains well-below levels seen in 2002-2003. Also, there were no widespread defaults of corporate bonds, which we believe benefits Manulife and Sun Life the most since they have more exposure to lower quality classes of bonds.

• We have lowered Q2/08 EPS estimates for Manulife and Industrial Alliance. Our estimate for Manulife is down from $0.84 to $0.78 on the back of less favourable equity market movements. We have reduced our estimate for Industrial Alliance from $0.84 to $0.83 given expected weather-related weakness in its P&C insurance business.
Scotia Capital, 21 July 2008

Canadian Lifecos – Economic headwinds Slow EPS growth

• The weak macro environment will continue to take its toll on the lifecos. In terms of the economic backdrop, Q2/08 was another tough quarter, albeit not as tough as Q1/08 was. Given the weakness in equity markets in the United States in particular, as well as a modest increase in expected provisions with respect to credit concerns, in no way sub-prime related but more so due to the spillover effect of the sub-prime meltdown, we have reduced our EPS estimates. Exhibit 1 outlines the reduction (the majority of the 2008 reduction is expected to be in Q2/08), with Exhibit 2 detailing the corresponding reductions in our share price targets.

• Weakening S&P 500 hurts Manulife (MFC) the most. While the S&P 500 was up 1.3% on average QOQ, it was down 3% from Q1/08 to Q2/08, which could likely put pressure on EPS, more so for Manulife (Sun Life hedges this much more than MFC does), as reserves for guarantees on U.S. variable annuities, which are essentially mark to market, have increased. The 10% quarter-over-quarter Q1/08 decline in U.S. equity markets resulted in a $0.14 EPS hit for Manulife due to this reserve marking-to-market, so a 3% QOQ decline in Q2/08 could result in a $0.04 hit to EPS.

• Credit woes. Credit worries, more related to the spillover effect of the sub-prime meltdown, rather than the sub-prime issue itself (to which the Canadian lifecos’ exposure is immaterial), will likely continue to mount. Our concerns lie with financials and auto bonds. We expect some modest increases in default provisions, similar to what happened in Q1/08, when Sun Life increased provisions for Sprint/Nextel bonds, a move that hurt EPS by $0.05. In Q2/08, we might possibly see an increase in provisions related to the recent decline in GMAC bonds ($0.06 for GWO, $0.03 for MFC, and $0.05 for SLF), although we believe these could be securitized/pledged or already fully reserved for. As well, Sun Life’s larger exposure to financials (28% of bonds, versus 23% for MFC and 17% for GWO) could translate into an increase in provisions. Should Washington Mutual bonds continue to decline, we could see up to a $0.09 EPS hit for Sun Life, with no material hit for GWO or MFC. Finally, we see no material impact from the relatively small exposure to Fannie Mae and Freddie Mac bonds.

GWO’s exposure at $2.2 billion (2.2% of invested assets, 21% of common equity) ranks the highest, and would be comparable to the average Canadian bank exposure when measured as a percentage of common equity (23% for the banks, on average). MFC, at $2.3 billion (1.4% of invested assets and 10% of common equity) and SLF, at $0.8 billion (0.7% of invested assets and 5% of common equity) have significantly less exposure.

• Credit spreads remain wide – will continue to hurt Sun Life until it announces a hedging strategy (possibly this quarter?). Until these come in, Sun Life, which hasn’t been able to hedge the credit spread duration risk on its book value guarantee U.S. fixed annuity business, will continue to suffer. While we do not expect an increase in reserves to cover this risk, since the spreads at the end of Q2/08 were unchanged QOQ, we do not expect Sun Life to benefit from any potential release in reserves (likely $0.05 in EPS at least) until spreads come in. However, should the company announce a new hedging strategy to cover this risk (50% probability in our opinion), we suspect the stock should to react favourably.

• Nice rebound in S&P/TSX helps mitigate the pain from the S&P 500, but is this sustainable? While this will help, in our estimate, the S&P/TSX exposure of the Canadian lifecos is likely more bent towards financial services (MFC’s small position in CIBC for one) than oils.

• Reaching the end of the YOY negative drag from currency. While the negative impact of currency on a YOY basis will weigh on YOY EPS growth by upwards of 8% on U.S. business, this will likely become less significant going forward, forecast to be just a 4% YOY drag on Q3/08 and actually a 2% tailwind by Q4/08. On a QOQ basis, the impact of currency is neutral.

• A tough 2008, but 2009 should be significantly better. Assuming, as our strategist does, the S&P/TSX appreciates 8% on average in 2009 and the S&P 500 appreciates 5%, credit spreads gradually contract, the Canadian dollar remains at par to the U.S. dollar, long-term interest rates gradually increase, and increased provisions for default (likely hurting EPS by $0.05-$0.10 in 2008) are immaterial in 2009, we expect 13%-14% average EPS growth. It might sound high but we believe it is not. The group averaged 14% EPS growth from 2001 to 2007, and an impressive 16% excluding currency, at a time when equity markets were up on average 7%-8%. Plus, the group is coming off a low base, as we see 2008 EPS growth to be essentially flat YOY for the big three and just 5% for the whole group, excluding the impact of currency. Exhibit 3 shows EPS growth rates.

Great-West Lifeco Inc.

1-Sector Outperform – $34 one-year target, based on 2.6x 6/30/09E BV and 12.6x 2009E EPS
• We are looking for EPS of $0.57 for Q2/08, $0.05 below consensus.
• Putnam will likely continue to be weak, with assets down 3% QOQ and margins at 18%.
• More U.K. payout annuity (another $13 billion block added in February) means more yield enhancement opportunities to help drive EPS growth, especially now with wider credit spreads.
• We look for an update on tax reforms with respect to U.K./Isle of Man single premium bonds, where sales have recently been weak.
• We look for a 3% to 6% dividend increase.

Industrial-Alliance Insurance and Financial Services Inc.

2-Sector Perform – $37 one-year target, based on 1.5x 6/30/09E BV and 10.7x 2009E EPS
• We are looking for EPS of $0.79 in Q2/08, $0.02 below consensus.
• Wealth management top line could very well continue to be weak.
• We are paying close attention to group insurance claims experience which has been poor over the last two quarters.
• Industrial-Alliance is the most sensitive of the Canadian lifecos to declining interest rates and declining equity markets; this makes us somewhat cautious.
• Unless another acquisition is made, we see 2009 EPS growth in the 9%-10% range.

Manulife Financial Corporation

1-Sector Outperform – $41 one-year target, based on 2.3x 6/30/09E BV and 12.6x 2009E EPS
• We are looking for EPS of $0.69 for Q2/08, $0.05 below consensus.
• Weakening S&P 500 hurts MFC the most. The 10% QOQ decline in U.S. equity markets resulted in a $0.14 EPS hit for MFC in Q1/08 due to mark-to-marking of guarantees on variable annuities. The 3% QOQ decline in Q2/08 could result in a $0.03 EPS hit.
• Top-line momentum expected to continue across all divisions.
• Japan could continue to be strong.
• Any update on the acquisition front? – the buyback pace has slowed.

Sun Life Financial Inc.

1-Sector Outperform – $50 one-year target, based on 1.6x 6/30/09E BV and 11.1x 2009E EPS
• We are looking for EPS of $0.95 for Q2/08, $0.05 below consensus.
• Credit spreads remain wide – will likely continue to hurt Sun Life until it announces a hedging strategy (possibly this quarter?).
• We expect some modest increases in default provisions.
• We look for a 3% to 6% dividend increase.
BMO Capital Markets, 16 July 2008

Over the last year, the Canadian life and health index outperformed the Canadian bank index, the U.S. peers and the S&P 500, but underperformed the S&P/TSX Composite (Table 1). During the second quarter of 2008, the Canadian Life & Health index underperformed the S&P/TSX composite and the Canadian bank index. Year to date, the Canadian lifecos have underperformed. The recent underperformance may reflect concerns on future credit deterioration among the Canadian lifecos and concerns on future acquisitions given increased acquisition opportunities in the U.S. While we cannot gauge the impact of acquisitions until a deal is announced, we believe that the Canadian lifecos, in general, have a good track record of acquisitions. With respect to asset quality, we believe that the Canadian lifecos should distinguish themselves relative to their peers in terms of asset quality through the next credit cycle.

For the industry, we are projecting an average drop of 2% in EPS. In force profit growth, higher income on capital, lower new business strain, good expense gains and continued modest share buybacks, primarily from MFC and SLF, should be more than offset by a stronger Canadian dollar, lower investment gains and fee income, lower sales and a more challenging operating environment. Our Q2/08 EPS estimates are based on a C$/US$ exchange rate of 1.000 versus an average rate of 1.010 for the quarter and the current rate of 1.002.

In this preview, we discuss four industry-wide conditions that are important to all four insurers: credit and equity markets, low long-term interest rates, currency and buybacks. The last section of the report goes through each company independently.

Equity Markets Less Volatile; Credit Trends Weakening

One of the major drivers in lifeco earnings over the last five years has been the strong equity markets. Earnings from lifecos are increasingly sensitive to events in the equity markets, as the percentage contribution from wealth management (versus protection) has almost doubled since 2000. The average of the S&P 500 fell 7.6% year over year, while the average S&P/TSX Composite was up 2.1% on a year-over-year basis (Table 2). Performance in the major Asian markets was mixed with the average Hang Seng index in Hong Kong up 20% year over year, while Japan’s average Nikkei index was down 23% during the same time period. Accordingly, year-over-year growth in average equity market levels should be a positive for Q2/08 earnings in Canada and Hong Kong, with lower levels of investment gains from the U.S. operations and Japan. Versus Q1/08, the average composites have all increased by 2–6%. Some of the lost earnings due to the additional reserves required last quarter to support embedded product guarantees may be recovered during the quarter, but not all.

On the credit side, U.S. subprime (and Alt-A) mortgage exposure in the Canadian lifecos is low, averaging 0.7% of total assets versus a U.S. average of 3.2% (Table 3). We expect that credit will continue to deteriorate given the continued writedowns that have been taken by the global investment banks. However, widening credit spreads in Canada and the U.S. should help the life insurers improve portfolio yields over time. For a full discussion of credit quality and the impact of a weaker credit outlook at the Canadian lifecos, please see our report entitled “What to Expect When Expecting Weaker Credit Conditions” dated June 24, 2008.

Long-Term Interest Rates – Rate of Decline Decelerating

Long-term interest rates, as represented by the 10-year government bond yields, have been on a downward trend over the last year. The average 10-year rate for the quarter has fallen by 69 basis points year over year to 3.67% in Canada and 98 basis points to 3.86% in the U.S. Quarter over quarter, average rates in the U.S. have rallied modestly, up 22 basis points from 3.64%; however, in Canada, the average 10-year rate was down from 3.73%. Partially offsetting some of the recent weakness in long-term rates, credit spreads continue to widen. Lower long-term interest rates pose a variety of challenges to life insurers, most important of which is the impact on the discount rates used to calculate policyholder reserves and premiums charged on new products.

Interestingly, the Canadian Asset Liability Method (CALM) used to prospectively calculate policyholder reserves, as defined by the Consolidated Standards of Practice of the Canadian Institute of Actuaries, describes that the best estimate risk-free ultimate reinvestment rate (URR), beyond 40 years into the future, be the average of the 60- and 120-month moving averages of long-term risk free yields (Charts 1 and 2). In our case, we ave proxied the long-term yields with the 10-year government bond yield. While a discussion of CALM is beyond the scope of this preview, we believe there are some noteworthy observations:

• The CALM URR does not exhibit the same volatility as the actual rate.

• Despite falling rates, the Canadian lifecos have successfully managed to grow earnings through this environment since 2002.

• While current interest rates are below the URR, investors should note that a number of adjustments are applied to this URR to derive the valuation URR used in the calculation of actuarial liabilities. These adjustments include assumptions on credit spreads (net of defaults) and additional provisions for risk of asset depreciation (C1 risk) and interest rate mismatches (C3 risk), all subject to the lifeco’s current investment strategy and worst-case scenario. When applied, these adjustments will reduce the URR, reflecting the conservative nature required in valuing long-tailed liabilities.

• To the extent that the valuation URR is below the current rate, a margin of safety exists that can mitigate the requirement for additional reserve increases.

Under Canadian GAAP, reserves are “fair valued” quarterly and, as a result, reflect some impact of the decline in long-term interest rates. In addition, since pricing new policies is based on assumed investment returns, low long-term interest rates reduce potential future investment return assumptions and hence increase the cost of insurance. While it is difficult to isolate the impact of low long-term interest rates in any given quarter or year, we believe the current rate environment creates a long term earnings growth headwind for the life insurance industry.


The Big 3 Canadian lifecos generate approximately 29–47% of total earnings in Canada and the balance is generated outside of Canada, primarily in the U.S., or in U.S. dollar–based jurisdictions. We estimate that the U.S. and U.S. dollar–based jurisdictions accounted for 23–62% of total earnings a year ago and last quarter.

At the extremes, Manulife has the most U.S. dollar exposure and Industrial Alliance has the least. We estimate the average C$/US$ exchange rate of 1.0100 in Q2/08 versus 1.0985 a year ago, 1.0053 last quarter and the current rate of 1.0020 (Chart 3). It is important for investors to remember that the currency fluctuations are a translation issue rather than an economic issue.

Our 2008E EPS assume an average exchange rate of 1.0000 C$/US$ versus the current exchange rate of 1.0020 C$/US$. Earnings sensitivities to different F/X rates are shown in Table 4. In the past we have adjusted our exchange rate forecasts after quarterly results have been released. Of note, our EPS sensitivity analysis to changes in exchange rates has historically projected too severe an impact on lifeco earnings.

While the fluctuations in exchange rates have a short-term translation impact on earnings, the stronger Canadian dollar provides the Canadian lifecos with a more valuable currency to make acquisitions. We expect the Big 3 Canadian lifecos to remain very active in the U.S. market. Specifically, we expect that MFC would entertain large acquisitions such as Principal Financial Group, Lincoln National or Ameriprise, among others. SLF may also consider these types of deals but may be more willing to acquire blocks of business rather than entire companies. We believe SLF’s tolerance for larger deals (i.e. above US$1–2 billion) has increased. With the acquisition of Putnam, GWO is likely to focus on this integration over the next year but would probably continue to make relatively smaller 401(k) acquisitions.

Share Buybacks

The deterioration of the global credit environment coupled with the further asset writedowns by the U.S. investment banks continue to add fuel to the financial-led bear markets. Canadian banks have essentially stopped or dramatically slowed their buybacks during the last six months. Year to date, only Royal Bank has bought back 1.2 million shares. However, the Canadian lifecos continue to maintain balance sheets that support the return capital to shareholders through buybacks, with MFC and SLF being the most active participants. For the second quarter of the year, SLF is estimated to have repurchased 2.4 million shares, while MFC is estimated to have repurchased approximately 3.0 million. The sustained buyback activity among the lifecos has led to total payout ratios (dividends + buybacks)that were higher than the banks’ in 2007 and the start of 2008.

Sun Life – Partly Cloudy

Sun Life (SLF) will report its Q2/08 earnings on Thursday, July 31. We are projecting a decrease of 3% in EPS to $1.00 (mean estimate is $1.00) from $1.03 a year ago. The reduction in our estimate is driven by the rapid appreciation of the Canadian dollar over the past year and the more challenging operating environment. On a constant-currency basis, our estimate would have been $1.03, flat from Q2/07. Although we expect to see continued improvement in new business strain in U.S. individual insurance and scale improvements in U.S. group benefits, we are also expecting lower investment gains and the possibility of lower sales due to the current market volatility. A modest reduction in the weighted average shares outstanding should help partially offset the challenges to EPS growth (Table 6). In line with last quarter, we believe that investors will focus on the short-term impact of wider spreads, new business strain levels in U.S. insurance earnings in Canada, scale efficiencies in U.S. group, total company sales levels and net flows in U.S. VA and MFS.

Results from Q1/08 were relatively weak, reflecting the negative impact of severe spread widening in fixed annuities, weaker credit experience and some softness in Canada. Sales results were mixed across the organization, with strength in Asia and segregated funds in Canada offset by relatively weaker results in individual insurance and mutual funds. The company’s balance sheet remains very strong and SLF ended last quarter with roughly $1 billion in excess capital.

With the increased volatility in the equity markets, we expect to see moderating wealth management sales and AUM growth in the quarter, although the company’s Income ON Demand (IOD) VA should still generate attractive sales growth, given the lack of competition from its U.S. peers with similar product features. Net flows in the U.S. VA segment should continue to be supported by the IOD VA and the company’s recently launched living benefits rider for its Retirement Income Escalator, despite any lapses the company may experience on its legacy non-IOD VAs. We suspect that the market volatility may continue hinder net flows at MFS in the quarter. Pre-tax margins at MFS should remain in the mid-30s.

Canada remains the bread and butter for SLF. However, growth in Canada over the past several years has been disappointing. In Q1/08, earnings from Canada fell 1% year over year and were down 6% on a quarter-over-quarter basis. The key to earnings growth in Canada is to improve productivity among the company’s career sales force and continue growing its wealth management AUM and expense controls, trends which we will continue to monitor.

In force profits and income on capital should remain steady contributors to earnings in the quarter and benefits from finalizing its AXXX funding structure should continue to support earnings in U.S. insurance. As well, continued scale efficiencies from the EGB acquisition in U.S. group should help support earnings growth in the quarter.

Short-term earnings headwinds continue to include the volatile equity markets, uncertainty on credit (in conjunction with lower interest rates) and appreciation in the Canadian dollar. Although acquisition opportunities currently remain sparse, it may take another 3–12 months of volatile equity markets and/or bad credit to rejuvenate M&A activity, particularly in the U.S. SLF remains Market Perform rated.

Manulife – Credit and Capital

Manulife (MFC) is scheduled to report Q2/08 earnings on Thursday, August 7 and we are projecting EPS of $0.69 (mean estimate is $0.75), down 3% from $0.71 the same quarter last year. The reduction in our estimate is primarily driven by the rapid appreciation of the Canadian dollar over the past year and, on a constant-currency basis, our estimate would have been $0.73, up 3% from Q2/07. We are projecting in force profit growth from Canada and Asia and US Protection. Equity market volatility will slow AUM growth and may create earnings headwinds for wealth management businesses in the U.S. and Japan. US Fixed products may face a tough challenge due to the non-recurrence of strong investment gains experienced in 2007. Last year, earnings also benefited from very good credit experience with $16 million in credit recoveries, an event that is unlikely to recur in the near term.

Investment income in the U.S. should be lower in the quarter given the fact that the average S&P 500 has dropped by almost 8% year over year. However, with the new investment income allocation methodology adopted by MFC last quarter, actual investment earnings are expected to more closely match how the company manages its assets in relation to its risk positions. This may result in some modification of investment gains/losses between segments but the total company investment results do not change. We have not restated the historical segmented earnings to account for the new allocation methodology (Table 7).

Q1/08 results were very disappointing at $0.57 per share, well below the mean estimate of $0.71 per share. We believe this is the first real “miss” from Manulife since its IPO in late 1999. The primary driver of the decline in earnings was related to the equity markets, which caused a $265 million reduction in net income, or $0.18 per share. This non-cash charge, primarily due to the new investment accounting rules, should reverse over time as the equity markets recover; however, equity market performance in Q2/08 was not sufficient to recapture this expense and, as a result, we doubt that there would be any significant recovery in the second quarter. Although Q1/08 results were disappointing, they did mask some very positive underlying trends, specifically outstanding sales growth in all jurisdictions and a very strong balance sheet.

Credit remains strong at MFC, but, last quarter, credit provisions did rise while recoveries fell. The company maintains that it is not experiencing any significant credit deterioration, with the exception of housing industry in the U.S. Its “watch list” is not growing in any significant way, but it does expect that more normal credit conditions in the coming quarters will require taking the “occasional” provision. Sales growth may be a challenge in the quarter, but, steady in force profit growth and interest on capital should help mitigate (at least partially) the situation. Moreover, MFC should remain active in its share buyback program, estimated at 3.0 million in the second quarter.

Wealth management sales in the U.S. and Japan may face a difficult environment given the continued equity market volatility. In the U.S., VA sales competition remains high; however, we hope to see good VA sales given the very encouraging net flows over the past few quarters and strong demand for its US Income Plus for Life rider. In Japan, MFC posted strong sales last quarter. Although the volatile economic conditions could create some sales (and earnings) headwinds, we believe that MFC will continue to expand its distribution arrangement in an attempt to increase penetration. GMWB sales in Canada have been very promising over the past several quarters, and we believe that in the current market environment, minimum guarantee features continue to support good sales momentum. The company also recently launched Canada’s first group GMWB in June.

We continue to believe that MFC has the most attractive long term outlook for all the large Canadian financial services companies given its global reach and strong competitive positions in Asia and the U.S. Short-term earnings headwinds include the volatility in the global credit and equity markets, and low long term interest rates could be a long-term headwind to earnings. Because of MFC’s global diversification, the rising Canadian dollar may also moderate earnings growth; however, U.S. acquisitions will become cheaper. With a recent $1 billion debt issue, MFC now has an estimated $4 billion in excess capital, which we believe will give additional support to its already strong capital ratios. We also believe MFC still has additional leverage capacity (not to mention the ability to issue shares) to fund large acquisitions. While large acquisition targets dominate the market view on MFC, we would not be surprised to see MFC make smaller acquisitions in the 401(k) market and mutual fund segments in the U.S. MFC remains rated Outperform.

Great-West Life – More Than Putnam

Great-West Life (GWO) is expected to report its Q2/08 earnings on Wednesday, July 30. We are projecting EPS of $0.60 (mean estimate is $0.62) down from $0.61 a year ago and flat with last quarter. On a constant-currency basis, EPS would have been $0.61, flat with a year ago. Canada and Europe are expected to report another good quarter and the U.S. should show modest growth with increases from financial services, partially offset by poor performance at Putnam. (Table 8).

On April 1, GWO announced that it completed the sale of its U.S. healthcare operations to CIGNA. The sale completes the company’s repositioning in the U.S. to focus on financial services. While significant challenges remain at Putnam, we believe that the U.S. business is now poised for strong growth once industry conditions stabilize.

While we expect that investors are likely to remain focused on Putnam’s issues and fund performance, we believe that the Canadian and European results should remain strong. Growth in premiums and deposits in Canada have been very good for the company over the last 12 months and similar trends remain in Europe. Aside from Putnam, GWO’s U.S. financial services operation remains acquisitive, particularly in the 401(k) space.

Equity market volatility, however, has slowed the growth in AUM at Putnam and net flows will remain an issue; and are unlikely to show any sustained improvement until the end of 2009 at the earliest (Chart 4). Putnam mutual funds experienced US$4.3 billion in net outflows in Q1/08, and AUM growth was adversely impacted by poor equity markets.

European sales last quarter were down, primarily driven by lower sales of savings products in the U.K. and Isle of Man due to changes in capital gains taxes and new German insurance contract laws. GWO remains bullish on Germany and is in the process of introducing a new product in that country. Sales in Canada were also down in Q1/08, reflecting the challenges of the operating environment; however, the company managed to retain its lead position in the individual segregated funds market.

GWO’s asset portfolio remains strong. Gross impaired and net impaired assets continued to decline last quarter. Although GWO has the highest exposure to monoline wrapped bonds (approximately $3.5 billion) in the lifeco group, over half of the exposure (58%) is in Europe and does not cover structure financed transactions, but mainly traditional utilities, water, and other municipal services.

During the quarter, several management changes were announced at the company. Aside from the senior management changes at GWO, Putnam also announced a new CEO and the hiring of two new portfolio managers. Bob Reynolds, previously vice chairman and COO at Fidelity Investments, should help bring a new perspective to Putnam and aid in the turnaround as the new CEO. We believe that change is required at Putnam to revive the franchise and these steps represent a move in that direction. Nonetheless, mounting a turnaround at Putnam in the midst of volatile markets remains a long-term project.

We continue to rate GWO Outperform, based on strong growth outlooks in Canada and Europe, valuation improvement in the U.S. business as it focuses more on financial services rather than healthcare, and attractive valuation based on relative P/E and relative yield. Although faced with challenges, since the Putnam acquisition closed last August, its earnings represent less than 3% of GWO’s, and the remaining 97% of the company’s business operations are performing well (see our report entitled “Putnam Concerns Weigh on Share Price but May Be Overdone”, dated April 10, for our views on the Putnam acquisition).

18 July 2008

Merrill Lynch Economists Prognosticate the Direction of S&P/TSX Financials Index

Reuters, Lynne Olver, 18 July 2008

The huge recovery posted by Canadian financial stocks this week is actually a bad sign for the sector, as bear markets bring big bounces, Merrill Lynch economists said on Friday.

The S&P/TSX Financials index, composed of 28 bank, insurance company and asset management stocks, fell sharply on Monday and again Tuesday, with the country's largest banks hitting 52-week lows on Tuesday.

But on Wednesday, the financials index bounced up a "shocking" 5.5 percent, followed by a 3.2 percent climb on Thursday, Merrill economists David Wolf and Carolyn Kwan said in a weekly research note.

On Friday, the index gained an additional 1 percent.

Before this week, there had been only five days since 1988 when the S&P/TSX financials index was up more than 5 percent -- and four of them came during the financial crisis of 1998, Wolf and Kwan noted. The other was during the "Enron-inspired credit swoon late in 2002."

"Overall, we remain of the view that there are further declines in store for the Canadian financials," the economists stated.

As for daily bounces of just 3 percent in the financials index, none came between 2003 and 2006, a period in which the index more than doubled.

"We've already had seven such 3 percent up days in 2008, on track to break the previous record high of 10 in 1998," the Merrill note said.

While the problems facing Canadian financial stocks have not been as grave as those pressuring U.S. banks, "the market action of recent weeks has reminded us of how interlinked the sector is globally, and the domestic banks have their own challenges on the way, in the form of a slowing Canadian consumer and a weaker Canadian housing market."

Illustrating the volatility this week, investors who managed to buy Canadian bank stocks right at their 52-week lows would have reaped substantial gains in just a few sessions.

For example, Canadian Imperial Bank of Commerce hit a low of C$48.70 a share on Tuesday, and closed on Friday at C$57.76, for a gain of nearly 19 percent.

Bank of Montreal rallied 22 percent from its Tuesday low of C$37.60 to its close this week at C$45.96.

Royal Bank of Canada bounced 13 percent from its Tuesday low to Friday's close of C$44.70.

Bank of Nova Scotia rallied 14 percent from its Tuesday low, while Toronto-Dominion Bank climbed 10 percent.

Despite the recent swings, the Big Five bank stocks remain down from 2007 year-end levels, with year-to-date losses ranging from nearly 5 percent to more than 18 percent.
Reuters, Lynne Olver, 15 July 2008

Fears about the state of the U.S. financial system and the outlook for the U.S. economy battered Canadian bank stocks for a second day on Tuesday, with most share prices at or near 52-week lows.

In the case of Canadian Imperial Bank of Commerce, its stock plumbed five-year lows.

One analyst said CIBC, Canada's fifth-largest bank, could take as much as $1.9 billion in additional credit market-related writedowns in the current quarter.

The broad themes dragging down the Canadian sector were worries about the U.S. financial system and the broader U.S. economy, tumbling U.S. bank stocks, and signs of deteriorating loans at some U.S. regional banks.

"The situation in the U.S. is at the heart of what's happening now, first because of the credit crunch but secondly the increasing concern that this is going to translate into a U.S. recession, with Canadian banks and Canada not being immune," said Michael Goldberg, an analyst at Desjardins Securities in Toronto.

"I've been saying that (Canadian bank stocks are) all undervalued, but they could get more undervalued before the situation improves."

Federal Reserve Chairman Ben Bernanke warned on Tuesday that a weakening housing market, tighter credit and rising oil prices threaten U.S. economic growth, while inflation risks have become more intense.

Many financial markets and institutions remain under "considerable stress," Bernanke told the Senate Banking Committee.

His comments seemed to ruffle investors already anxious about the U.S. financial sector after Friday's seizure by regulators of IndyMac Bancorp Inc, the weekend pledge of U.S. government support for mortgage finance companies Fannie Mae and Freddie Mac, and this week's plunge in U.S. bank shares.

On the Toronto Stock Exchange on Tuesday afternoon, Toronto-Dominion Bank was off 4.1% at $53.45, after falling as low as $53.05; Bank of Montreal was down 1.1% at $39.65 a share, after trading as low as $37.60; while Canadian Imperial Bank of Commerce was down 3.0% at $49.62, after touching $48.70 in morning trade -- a level last seen in May 2003.
The Globe and Mail, Tara Perkins, 15 July 2008

Jittery investors dragged Canadian bank stocks down yesterday, dealing the biggest punishment to those with the greatest exposure to the United States, where continued mortgage woes are raising fears about the health of regional banks.

The market is on the edge of its seat after IndyMac Bancorp Inc. collapsed last week in the second-largest bank failure in U.S. history.

"I think the market is really recognizing the deterioration that's happening in the credit environment," said Edward Jones analyst Craig Fehr. "It's a classic case of what we've been seeing now for some time, indiscriminate selling. The market just doesn't want to own anything that's exposed to this credit risk."

National Bank Financial analyst Robert Sedran said it seems "the Canadians are taking direction from the U.S. banks right now, and that direction is not a good one. We believe the fundamentals behind the Canadian banks are better, but that matters little right now."

Among Canada's big banks, Bank of Montreal and Toronto-Dominion Bank have the highest gross loan exposure to U.S. borrowers, Blackmont Capital analyst Brad Smith said in a note to clients. BMO's exposure is $51-billion, or 25 per cent of its consolidated loans outstanding, while TD's is $46-billion, or 23 per cent, he said.

Investors appeared to be taking this U.S. vulnerability into account, with Toronto-Dominion the biggest loser of the Big Five yesterday, dropping by 5.1 per cent to $55.74. It was the stock's lowest close since November, 2005,with 6.87 million, or 2.3 times the average daily trading volume of shares, changing hands.

Bank of Montreal shares also lost a lot of ground yesterday, falling by 4.2 per cent to $40.09 on higher-than-average trading volume. This was the stock's lowest close since March 17.

The other banks, however, held up just slightly better, and all had heavier-than-normal trading activity.

Bank of Nova Scotia sank by 3.6 per cent to $43.82, its lowest point since March 19. Royal Bank of Canada shed 3.4 per cent to $41.03, touching its lowest close since October, 2005. Canadian Imperial Bank of Commerce lost the least amount of ground on a percentage basis, down just over 2 per cent. However, it's end-of-session price of $51.15 was the stock's lowest close since June, 2003.

"Despite its well-established U.S. retail banking and wealth operations, Royal Bank of Canada has only modest loan exposure at $25-billion, or 10 per cent of consolidated loans outstanding," Mr. Smith wrote. Scotiabank and CIBC have the lowest exposures, at 6 per cent and 3 per cent, although CIBC actually has the highest relative exposure to U.S. credit if its large credit derivative portfolio is included.

Mr. Smith believes that both BMO and TD could see their 2009 earnings chopped by roughly 7 per cent as a result of U.S. personal and commercial banking loan exposures. However, he noted that "estimating the potential impact on earnings from identified credit exposures is fraught with hazard as ultimate losses reflect a combination of factors, including macroeconomic conditions and company-specific credit underwriting processes."

Genuity Capital Markets analyst Mario Mendonca said the issue with TD's shares appears to be weakness in the loan books of two northeastern U.S. regional banks. M&T Bank saw credit losses spike, while Webster warned of higher credit losses, Mr. Mendonca said. (TD Banknorth Inc. is based in Portland, Me.) "This has the market wondering if in fact TD's Northeast exposure is really that much better than other parts of the U.S.," he said.

Shane Jones, managing director of Canadian Equities at Scotia Cassels Investment Counsel Ltd., said some of the bank weakness might stem from hedge funds that are selling.

Yesterday's share price declines were a continuation of weakness that has plagued the sector recently, with Canadian banks stocks having fallen about 5 per cent last week, Mr. Smith said in his note.

15 July 2008

Analyst Speculates on CIBC Takeover

Financal Post, David Pett, 15 July 2008

The possibility of more writedowns at CIBC could force the bank into another's hands, says John Aiken, analyst at Dundee Securities.

Following on the heels of the U.S. Federal Reserve's Fannie Mae and Freddie Mac intervention and the U.S. bank failure of IndyMac, Mr. Aiken said CIBC may be forced to raise common equity once again as a result of continued write-downs on its credit and liquidity exposure.

Mr. Aiken said CIBC is safe for now from needing to raise additional capital, noting it can withstand pre-tax charges of up to $2.5-billion. But with potential charges of roughly $4-billion to come, he believes CIBC would need more capital before all is said and done.

That won't be an easy task, he added, and could leave CIBC with possibly no other option than to be taken over by another bank.

"Should CIBC need to raise common equity, we believe it would be very difficult for the bank to gather additional public funding, given that it is currently trading well below the offer price of the previous offering and the fact that there is no guarantee that the write-downs have come to an end," he wrote.

"Should the regulator become concerned with its capital position and the bank is unwilling or unable to tap the market for incremental equity, CIBC could be forced into the hands of another financial institution as the best solvency alternative."

Mr. Aiken admitted that the process would require significant changes to the Bank Act and a considerable amount of political will, but told clients the benefit of allowing bank mergers in Canada would far outweigh the cost of losing one of the country's "Big 6" banks. .

The analyst said the most "politically-expedient method of salvaging CIBC", in the case that a common equity infusion was denied by the public market, would be a cross-pillar acquisition, most likely by Manulife Financial Corp.

"However, should CIBC fall into the hands of another suitor, it would be next to impossible for the government to stop the consolidation at that step, given the outsized assets and market capitalization that the new entity would have. Further, it would have a very significant advantage should insurance be allowed to be sold through the branches (which would be a likely concession that Manulife would demand for 'saving' CIBC)."
The Globe and Mail, John Partridge, 15 July 2008 10:56 AM

Continuing woes at Canadian Imperial Bank of Commerce could trigger a new round of consolidation in Canadian financial services, a Bay Street analyst contends.

John Aiken at Dundee Securities Inc. said Tuesday that additional charges CIBC is facing as a result of its exposure to U.S. bond insurers and subprime mortgages could force the bank to try to raise additional common equity from an unwilling market.

“Should the regulator become concerned with [CIBC's] capital position, and the bank is unwilling or unable to tap the market for incremental equity, CIBC could be forced into the hands of another financial institution as the best solvency alternative,” Mr. Aiken said in a note to clients.

The most “politically expedient” solution would be for Ottawa to allow a so-called “cross-pillar” acquisition, with Manulife Financial Corp. as the most likely buyer, he said.

Manulife made an unsuccessful run at CIBC in 2002, when the bank's U.S. operations were in crisis, but was blocked by the federal government.

However, if CIBC was taken over by another rival, Mr. Aiken said, this would likely create such a large financial institution in terms of assets and market capitalization that it would be “next to impossible” for Ottawa.

“We freely admit that this is not as simple a process as we make it sound, requiring extensive changes to the Bank Act and a multitude of politically charged approvals, including the Minister of Finance, among many other hurdles,” he said. “However, we believe that allowing financial services consolidation would be much more beneficial to the Canadian financial services sector and economy as a whole than a losing one of the country's Schedule I banks outright.”

“Therefore, while not a probable event at present, we believe that the possibility of financial services consolidation is closer than most investors would allow and significantly closer than it was even three months ago.”

A CIBC spokesman declined to comment on Mr. Aiken's report.

CIBC has been hit much harder than other Canadian banks in the current credit crunch because of its exposure to the U.S. bond insurer and sub-prime mortgage crisis.

Mr. Aiken estimates CIBC will likely take $1.5-billion to $1.9-billion in additional charges related to the problems when it reports third-quarter results next month, on top of the $3.8-billion in after-tax hits it has taken in the past two quarters.

And there is no guarantee that the third-quarter hits will be the last of the charges, he added.

The charges over the past two quarters have “completely swamped” the $2.9-billion in common equity that CIBC raised in January in both a public stock offering at $67.05 a share and a private placement at $65.26, Mr. Aiken said.

Like other financial services stocks, CIBC has been hit hard over the past few months and was trading at $49.20 on the Toronto Stock Exchange Tuesday morning, down $1.95 from Monday's finish.

This would probably make it “very difficult for the bank to gather additional public funding,” Mr. Aiken said.

Scotiabank Buys E*Trade Canada

TD Securities, 15 July 2008


Yesterday after market close, Scotiabank announced the purchase of 100% of E*Trade Canada.


Not our first choice, but deal adds clients and makes financial sense. We have made no changes to our estimates, and continue to view Scotia as one of the best operating outlooks in the group, although we note that the stock has now moved to trade at a healthy premium. Reiterate 'Buy.'


Wouldn't have been our first pick, but hard to argue with. Discount brokerage wouldn't have been our first priority for Scotia's expanding domestic wealth business as the industry continues to bear the pressure of ongoing price erosion and remains subject to volatile trading activity. That said, we find it hard to argue with the logic of acquiring one of the few remaining wealth management assets in the country, in a deal that adds a high margin business at a price that is accretive out of the gate and which contributes to Scotia's over-riding domestic objective; adding customers.

No change in our estimates. The acquisition is set to close in the fall of 2008 and is expected to be accretive in year one and add two cents in year three based on what the bank views as conservative assumptions that reflect the current challenging environment for trading activity and take into account the impact of E*TRADE Canada’s lower pricing alternatives. Also, the outlook has not factored in any potential revenue synergies.

The impact on capital is relatively modest (20bp) for a well capitalized bank; Scotia had a Tier 1 of 9.6% as of the end of Q2/08 (Basel II). We don't expect material integration challenges as Scotia has proven to be a capable buyer over the years and appears intent on moving judiciously. Ultimately, the key upside to the deal is likely to come from leveraging the potential cross-sell opportunities to the expanded client base, but that will likely only happen gradually.

What can we infer of ETFC's intentions? Beyond Scotia, the question remains; what will ultimately become of ETFC and a potential transaction with AMTD? To us this move, along with ETFC’s 2008 Turnaround Plan and other efforts to recapitalize, suggest a strong desire to remain independent. Quality story, premium valuation. Scotia remains one of the best operating outlooks in the group in our view underpinned by the strong medium-term outlook of the international business and increasingly supported by an improving domestic profile. However, on the back of strong relative performance amid a very weak tape for financial services, the stock has now moved to trade at a wide relative valuation premium. We still see attractive upside in the name on a 12-month view, although relative out performance may be constrained.

Conference Call Highlights

Transaction details. The purchase price of approximately US$442 million (or approximately C$444 million) will be made with 100% cash and is expected to close by the end of September/October 2008.

Market share. Scotia expects the addition of E*TRADE Canada to increase the banks market share from 6% to 10% (based on # of accounts), ranking Scotia #2 relative to the industry. The deal is expected to bring in over C$5B in Assets Under Administration and Scotia expects AUA to double by 2016.

Future cross sell opportunities. The bank expects opportunities to cross sell Scotia products to E*TRADE Canada customers and providing them the ability to transfer funds between their trading account and a Scotiabank retail account along with the full suite of Scotia banking products. Through this online channel, Scotia anticipates being able to offer their products on a lower cost basis.

Business mix. Scotia indicated that approximately 80% of E*TRADE Canada sales are retail focused and 20% are institutional. During year end December 31, 2007, E*TRADE Canada contributed nearly U$93M to ETFC’s net revenues. Also, the addition of E*TRADE Canada should complement the active trader focus with Scotia’s previous acquisition of Trade Freedom.

Margins. Margins from E*TRADE Canada are similar to ScotiaMcLeod Direct, which the bank views as a high/attractive margin business.


We have made no material changes to our outlook and our estimates remain unchanged at C$4.10 for 2008 and C$4.50 for 2009.

Justification of Target Price

We expect Scotiabank to hold its premium valuation relative to the Big-Five Canadian banks, reflecting superior growth prospects, strong return on equity and healthy excess capital. We base our target price on 12.50x forward earnings, a premium to our outlook for the group.

Key Risks to Target Price

The following are key risks that we have identified for Scotiabank and could prevent the stock from attaining our target price. These include: 1) the continued weakening of the U.S. dollar, 2) country and political risk in its international markets such as Mexico, 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

Bottom-line, this deal should help Scotia drive their ‘client acquisition’ strategy and adds to what we view as an improving domestic story. We view Scotia as one of the best operating outlooks in the group, but the stock’s premium valuation tempers our enthusiasm. Reiterate 'Buy.'
Financial Post, David Pett, 15 July 2008

The Bank of Nova Scotia's acquisition of E*Trade Canada could be followed by more acquisitions, says National Bank Financial analyst Robert Sedran.

On Monday, Scotia said it was purchasing E*Trade Canada from US-based parent E*Trade Financial Corp. for US$442-million in an all cash deal. In addition E*Trade Financial will withdraw US$69-million of capital from the Canadian division, bringing total proceeds to $511-million. The deal adds about $4.7-billion in assets under administration and 190 employees to Scotia's wealth management business.

"In our view, this transaction sharpens the focus on a key component of our investment thesis: those companies that do not have to concentrate on retrenchment and risk reduction are better positioned to grow - both organically and via acquisition," wrote Robert Sedran, analyst at National Bank in a research note.

"Given Scotiabank's well-earned reputation as a shrewd acquirer, we expect more transactions to be announced in coming quarters as this theme matures."

Mr. Sedran added that while the deal is not financially material, it does add to Scotia's wealth management earnings.

He maintained his "outperform" rating and left his $55 price target on the stock unchanged.

Desjardins analyst Michael Goldberg, meanwhile, reiterated his "top pick" rating and $57.50 price target for Scotia.

"Yesterday's announcement that Scotia will acquire E*Trade Canada is a tangible example of a Canadian bank benefiting from the US turmoil," he told clients in a note.

"While it is not an entré into the US for Scotia, it avoids the risk of doing so and instead furthers Scotia's goal of continuiing to strengthen its Canadian wealth management franchise."
The Globe and Mail, Tara Perkins, 14 July 2008

July 14, 2008 at 9:34 PM EDT

Bank of Nova Scotia is cashing in on the deal-making opportunities arising from the U.S. mortgage turmoil, picking up online brokerage E*Trade Canada for $444-million.

The deal becomes the biggest part of the turnaround plan that New York-based E*Trade Financial Corp. announced in January, after it dangled dangerously close to bankruptcy over worries about mortgage loan losses.

With this deal, E*Trade, which originally aimed to raise $500-million (U.S.) by selling non-core assets, will have raised more than $700-million this year.

In return for the cash, Scotiabank's Canadian wealth management business, which has become a key priority for the bank, will receive a major boost. The transaction will double the size of Scotiabank's presence in the direct investing sector while adding 125,000 active accounts.

“This is truly a unique opportunity to acquire the last significant independent player in the direct investing market in Canada, and one with an exceptionally strong platform,” Scotiabank chief executive Rick Waugh said on a conference call Monday.

Seeking to expand its wealth management operations, Scotiabank bought TradeFreedom Securities Inc., a Canadian online brokerage boutique, last year, and more recently acquired Dundee Bank and a stake in DundeeWealth.

“Direct investing is an important and growing segment in Canada, even much more so in Canada than other markets,” Mr. Waugh said Monday. “We see this acquisition as a unique opportunity to immediately become a leader in this very attractive market.”

The deal is expected to make Scotiabank the second-largest brokerage in the industry based on number of accounts, and third largest in assets.

E*Trade Canada has roughly $4.7-billion (Canadian) in assets under administration and 190 employees. Scotiabank executives said they recognize that E*Trade's pricing strategy is key to its success.

“Online brokerage is playing an increasingly significant role in wealth management as more Canadians are using online investing solutions, and many are becoming more active traders,” said Chris Hodgson, head of domestic personal banking at Scotiabank. “This is a growing market,” he added, noting that it has a compound annual growth rate of 15 per cent over the past five years and assets under administration are expected to double over the next eight years.

Scotiabank also hopes this deal will prompt some E*Trade customers to open bank accounts so they can easily transfer money between accounts. The bank will also pitch products, like mortgages, to E*Trade customers online.

In an interview, E*Trade Canada president Duncan Hannay said the deal represents a great opportunity for E*Trade Financial to free up more than $500-million (U.S.) of capital to move forward.

The Canadian brokerage business has been shopped around for a number of months, and “I think it's fair to say that we had a very robust process, there was lots of interest in the business,” he said.

Like its competitors, revenue growth at E*Trade Canada's operations has been stung this year by the market environment.

One analyst called the deal reasonable but expensive, noting it's one of the last books of business left to buy. However, he added that it's safe to say Scotiabank is benefiting from having been more patient than some of its peers to take advantage of the troubles in the U.S. financial sector. For example, TD's $8.5-billion acquisition of New Jersey-based Commerce Bancorp in March would have been significantly cheaper had the bank waited.

Analysts said the $444-million (Canadian) E*Trade purchase would not prevent Scotiabank from making another acquisition, such as a U.S. regional bank. This spring, the bank took a look at National City Corp., a troubled Cleveland-based bank that would have cost billions. However, executives at the bank have recently downplayed the idea of any imminent foray into U.S. retail banking.

The acquisition of E*Trade is expected to close in September or October, following regulatory approvals.
Duncan Mavin, Financial Post, 14 July 2008

Bank of Nova Scotia has boosted its online wealth-management business by picking up the Canadian unit of struggling U.S. broker E*Trade Financial Corp. which is in the midst of a turnaround plan.

The Canadian bank has made no secret of its aim to build a bigger presence in the lucrative wealth-management space and said Monday the $444-million acquisition of E*Trade Canada will double its online investing business, adding about $4.7-billion in assets under administration and 190 employees.

The all-cash deal "demonstrates our commitment to pursuing opportunities to grow our wealth-management business," said Scotiabank chief executive Rick Waugh.

Scotiabank pounced after E*Trade reported a record loss last year that led to several senior executives leaving the company. The U.S. discount brokerage was rocked by rising losses on home loans, and a new executive team committed to selling off parts of the business in an effort to steady the balance sheet.

After the deal with Scotiabank, E*Trade chief executive Donald Layton said, "We continue to make solid progress against our 2008 turnaround plan by monetizing non-core assets to generate capital."

Combined with the other planned non-core asset sales announced this year, E*Trade has generated more than $700-million in proceeds, Mr. Layton said.

E*Trade Canada was launched in 1994 as Versus Technologies Inc. and Versus Brokerage Services Inc. The retail business was launched in 1997 through a perpetual licence agreement with E*Trade. In 2000, E*Trade acquired Versus for US$174-million in stock. At the time, Versus had 37,000 retail clients and handled about 13% of all trading volume on the Toronto Stock Exchange.

The addition of the E*Trade Canada is the latest in a series of moves by Scotiabank to bulk up its presence in wealth management, where it has lagged its domestic rivals.

"This announcement is consistent with our overall strategic focus on growing our wealth management business in Canada and around the world," Mr. Waugh said.

After the deal, Scotiabank will become the second-largest online broker in Canada by number of accounts, with a 21% share of the trading volumes in the market, it said.

14 July 2008

League Tables • H1 / Q2 2008

The Globe and Mail, Boyd Erman, 14 July 2008

Royal Bank of Canada's securities division raised the most money of any firm selling Canadian stocks and bonds in the second quarter, dominating a sleepy three months as roller-coaster markets kept investors and issuers largely on the sidelines.

The bank's RBC Dominion Securities Inc. division topped market share rankings for stock sales in the quarter, helping to lead about a fifth of all sales by value, thanks to a run of relatively small deals, according to rankings prepared by information services firm Thomson Reuters. RBC also led in bond sales.

The slow times in April, May and June came on the heels of a quiet first quarter. So far this year, the overall amount of new stock sold in Canada has slumped by about 38 per cent, to $17-billion, compared with the same period last year. Companies are nervous about selling stock into such tumultuous markets, as banks and other financial companies continue to struggle, bankers said, and without some stability in global share prices it's hard to forecast when the doldrums will end.

"There's a number of issuers we're in discussions with and we know are likely to want to come to market; it's just they would prefer to do it when there's a bit better tone," said Doug McGregor, co-president of RBC Dominion.

"If you can get the financials back on their feet, that would be, I think, a step in the right direction."

RBC's winning quarter in the equity rankings helped it narrow the gap with Canadian Imperial Bank of Commerce's CIBC World Markets Inc., which leads the year-to-date Thomson Reuters rankings.

CIBC's position at the top of the stock sales table for the first half is controversial in the securities industry because the firm's biggest deal was a $3-billion equity offering for its parent bank.

While such "self-led" deals count in Thomson rankings, critics say self-led deals don't generate any real profit for an investment bank or demonstrate an ability to win business. However, self-led deals have been common around the globe as banks have been busy recapitalizing by raising money in markets.

In Canada, other than the big CIBC stock sale, most of bank fundraising has taken place in the debt and preferred-share markets, giving them a boost.

If markets don't get back on their feet soon, look for more investment banks to trim staff in Canada to compensate for slumping revenue, as CIBC World Markets and Bank of Montreal's BMO Nesbitt Burns Inc. have already done.

"I don't think the cuts will be really dramatic," Mr. McGregor said. "There will be some attrition; there will be some cuts - but I don't think it's going to match what's going to happen in New York."


10 July 2008

Genuity: RBC's Writedowns Could Double to > $3 Billion

Financial Post, Duncan Mavin, 10 July 2008

Royal Bank of Canada's writedowns could double to more than $3-billion as ongoing deterioration in U. S. credit markets takes its toll on Canada's largest bank, a report warned yesterday.

Worsening conditions in the United States may force RBC to take another $1.5-billion hit to add to the $1.6-billion in credit-crunch losses it has disclosed, said the report from Genuity Capital Markets analyst Mario Mendonca.

The potential losses would likely wipe out the entire quarterly profits at RBC, and would put a big dent in any hopes the worst of the credit crunch is behind Canada's banks.

Mr. Mendonca's warning comes a day after Mark Carney, the Bank of Canada governor, signalled a better outlook for credit markets here by saying he is closing an emergency fund set up to help the banking sector. But most of the recent trouble for the Canadian banks has come from their involvement in U. S. markets, where Ben Bernanke, chairman of the Federal Reserve, said this week he will keep the door open for emergency Fed funding into next year if market turmoil persists.

The announcement soothed the nerves of cash-strapped Wall Street banks but fuelled fears that the credit crunch is far from over.

Mr. Mendonca said his forecast of more writedowns at RBC is based on a further slide in the U. S. subprime mortgage market, plus weakening of mortgage-backed securities values and worsening conditions on a variety of structured products since late June. Another key driver is a recent fall in the credit rating of monoline insurer MBIA Inc., a counterparty to some of RBC's U. S. investments. "We re-examined RBC's exposures in this light and we estimate that [the bank] will take a third-quarter pre tax charge ranging from $900-million to $1.5-billion," Mr. Mendonca said.

The bank's stock fell almost 4% on the Toronto Stock Exchange yesterday, down $1.84 to close at $44.16. RBC's share price has fallen 28% in the past year, and is down 14% since the start of June.

Mr. Mendonca noted that the potential writedowns would not undermine RBC's strong capital position. But he also said the bank, which reports its third-quarter results on Aug. 28, is facing a variety of additional issues, including exposure to U. S. builder finance and tough conditions for generating profits from its significant capital-markets group.

A spokesman for RBC declined to comment on the analyst's report. However, Gord Nixon, chief executive of RBC, said in May that "a significant portion" of the $854-million writedown the bank took in the second quarter of 2008 "reflects liquidity pressures on assets that we continue to hold, rather than underlying credit quality."

Mr. Nixon has partly blamed the writedowns on new accounting rules that require banks to account for the investments based on their value in the market, which can result in fluctuating valuations.

RBC's total credit-crunch losses are the second-largest of any bank in Canada.

Canadian Imperial Bank of Commerce has recorded $6.7-billion in credit-crunch charges since last summer, and a number of bank-industry analysts say the bank could take another $1-billion to $1.5-billion in charges when it reports third-quarter results on Aug. 27. Bank of Montreal and Bank of Nova Scotia have recorded about $1.2-billion in writedowns between them, while Toronto-Dominion Bank has avoided similar writedowns.

07 July 2008

RBC Plans to Enter Islamic Finance Market

The Globe and Mail, Sonia Verma, 7 July 2008

When Ford Motor Co. sold the iconic British Aston Martin luxury car maker to a consortium led by British racing entrepreneur David Richards last year, the deal hinged on some unusual conditions.

Mr. Richards' Kuwaiti partners, Investment Dar and Adeem Investment, would only back the $848-million (U.S.) deal if it were done according to Islamic principals. So, in accordance with the Koran, 40 per cent of the deal was structured to avoid directly paying interest on a loan.

But to do their deal, Mr. Richards and his partners didn't turn to a Middle Eastern bank with an extensive background in Islamic, or sharia, finance. Instead, the buyers of Aston Martin – most famous as James Bond's car – went to a German bank, WestLB AG, for $450-million in sharia financing, through a structure known as murabaha.

The Aston Martin deal, as the first sharia leveraged buyout in Britain, was a watershed for Islamic finance and highlighted the growing influence of sharia banking in Western finance.

After a few years of strong growth focused largely in the Middle East, a new generation of Islamic bank startups is setting its sights on the West.

And as the wealth of Gulf countries swells with skyrocketing oil prices, more Western banks, including some Canadian banks, are looking to those pools of capital. Banks such as Citigroup Inc., Lloyds TSB Group PLC, Deutsche Bank AG and Barclays PLC are now offering services along Islamic finance lines. In the Muslim world, some have partnered with local sharia banks to form joint funds. In the West, London ranks as the leading Islamic banking centre, with conventional banks, such as HSBC Holdings PLC, opening Islamic banking units.

“Islamic banking is growing faster than any other sector of the banking industry and the West is just starting to wake up to its potential,” says Anouar Hassoune, a Paris-based senior analyst with Moody's Investors Service who specializes in sharia banking.

In February, Royal Bank of Canada hired Zaher Barakat, who teaches Islamic banking and finance at Cass Business School in London, as head of financial products for the Middle East.

RBC is targeting a variety of clients in the region, including sovereign wealth funds, private banking arms of local banks and government pension funds. While the priority is to market the bank's existing services and products into the Middle East, RBC is planning to enter the Islamic finance market, Mr. Barakat said. “We are working now on one fund to transform it to be sharia-compliant,” he said.

Bank of Montreal, through its London institutional management group Pyrford International, manages sharia-compliant products for Middle Eastern clients and is expanding the offering, said BMO spokesman Paul Gammal.

Islamic banking forbids interest and obliges deals to be based on physical assets, not on speculation. Sharia-compliant products seek to replicate the structure of interest through cost-plus transactions, leasing arrangements, or by linking payments to returns on assets.

Iran leads all countries with the highest level of sharia-compliant assets, surpassing $150-billion, the chief operating officer of HSBC, David Hodgkinson, told an Islamic finance forum last fall. But flush with petrodollars, the Gulf has become fertile ground for Islamic bank startups.

The launches of three new state-owned Islamic banks – Abu Dhabi's Al Hilal Bank, Saudi Arabia's Alinma Bank and Dubai's Noor Islamic Bank – highlight the sector's rapid growth, and also its ambitions to export Islamic banking around the world and reap the profits.

Soon after it was launched last year, the chief executive officer of Noor Islamic Bank said he intended to go on a shopping spree for financial institutions in the West in an effort to become the world's largest sharia lender within five years.

The bank aims to gain a foothold in Europe – where demand for sharia-compliant services is growing – by acquiring controlling stakes in British banks. “We would like to take the Noor brand outside the [United Arab Emirates] by acquiring other financial institutions,” CEO Hussain Al Qemzi said in an interview.

For Al Hilal Bank, which has more than $1-billion in capital, “any place that has a strong Muslim population and presents an opportunity is motivation for us,” said CEO Mohamed Jamil Berro.

Mr. Berro rejects the criticism that Islamic finance structures lack transparency, and argues that Islamic banking is inherently less risky than Western finance, which has been battered by the subprime mortgage crisis.

“One of the things we don't do is subprime … because it's prohibited for us,” he said, referring to the Islamic banking principal that deals be based on tangible assets. “These [plans for expansion] are not meant with any political agenda or anything. More or less, it's just investing and creating a return,” he said.

The banking community at large could learn from sharia-compliant products, HSBC's Mr. Hodgkinson said. The products provide stability because of Islamic finance's emphasis on ethics and self-regulation.

Mr. Hassoune, the Moody's analyst, says Islamic financing is using the credit crisis in the West to its advantage, offering liquidity and security where conventional banks are coming up short.

However, the market is not without its problems.

Islamic banks are typically ruled by a board of religious scholars who determine whether particular deals are compliant with Islamic law. There are growing indications that these religious scholars are challenging Islamic banks' unprecedented growth, questioning whether their products truly comply with Islamic law.

Sheik Muhammad Taqu Usmani, an influential sharia scholar from Bahrain, recently sent shock waves through Islamic finance circles by warning that 85 per cent of Islamic bonds, or sukuk, do not truly comply with Islamic law, undermining public confidence.

“People are getting worried. Islamic banking is not just a business. It's ethics-based, so the opinion of these scholars matters,” Mr. Hassoune said.

Experts say standardized practices and industry-wide regulations could address those concerns, but could also stymie growth, because Islamic finance has to evolve based on its clients of any country where it takes root.

In Canada, sharia-based banking is available, but on a limited basis. The issue sparked controversy earlier this year when the Canada Mortgage and Housing Corp. launched a study on Islamic banking, as Ottawa considered its first applications to start up Canadian banks operating within Islamic law.

The proposals drew fire from the secular Muslim Canadian Congress, which argued that faith-based banking had no place in Canada, and the presence of Islamic banks would pressure Canadian Muslims to subscribe to costlier products.

Walied Soliman, a Toronto-based lawyer at Ogilvy Renault, said “Canadian banks haven't been as quick either on raising money from the Middle East for financial institutions in Canada or in terms of offering up structured products or issuers for investment in the Middle East.”

But that may be changing, he said. “Canada is very quickly getting onto the radar of [sharia] investors and other issuers looking to engage in M&A transactions with Canadian issuers, and as a result we're going to see growing interest in Canada and the bankers will adapt to that and learn more about the sector as the demand grows.”

04 July 2008

2nd Reported Incident of Risk Management Failure at TD Securities' London Office in < 8 Months

The Globe and Mail, Tara Perkins & Paul Waldie, 4 July 2008

Toronto-Dominion Bank, which painstakingly avoided the subprime mortgage trouble that forced its peers to take massive subprime writedowns, said it was taking a $96-million hit on Friday after discovering that a London trader had deceived the bank about the value of securities he traded.

The bank will now join the ranks of its competitors pushed to review their risk controls in recent months.

Chief executive officer Ed Clark said TD has a strong culture of risk control and “we deeply regret this incident.” He has staked the bank's reputation on its ability to avoid exposure structured credit products that are too risky.

The writedown that TD revealed on Friday stems from a circumvention of controls, a spokesperson for the bank said. This is not an instance of complicated securities plunging in value, but of an individual mispricing the value of credit derivatives in which the bank trades openly.

“We will work aggressively to strengthen our controls,” the spokesperson said. “We are very disappointed, because we have a reputation for a very strong risk culture.”

The bank's examination indicates that the person was acting alone, she added.

Mike Peterson, managing editor of London-based Creditflux, an industry publication on structured credit, believes TD revealed the writedown Friday as a result of questions the publication put to the bank.

“We got a cryptic anonymous tipoff a few days ago, and a more specific anonymous tipoff at the beginning of our day today,” he said Friday.

Creditflux reported Friday that the book at the centre of the apparent mispricing is the structured credit element of TD's proprietary credit trading business.

TD would not identify the individual involved, citing individual privacy. In a brief statement Friday, the bank said it had “regrettably identified incorrectly priced financial instruments in its London office.” The office houses roughly 225 employees.

“This situation is associated with the activities of an individual who is no longer with the company,” the bank said.

TD spokeswoman Simone Philogène said the individual stopped working at TD as of June 23. When the bank was transferring the individual's responsibilities, it identified financial instruments that were priced incorrectly, she said.

The company has apprised the Financial Services Authority, which regulates financial services in Britain, and the Office of the Superintendent of Financial Institutions, which regulates Canadian banks.

“The bank is investigating the matter,” said Rod Giles, a spokesman for OSFI.

The financial instruments that were apparently mispriced are credit derivatives – a contract between two parties who agree to sell or buy credit risk. Specifically, the securities were investment grade indexes and index tranches, and prices should have been relatively easy to establish.

“We take this very seriously and will make every effort to ensure that this doesn't happen again,” Mr. Clark said.

Other banks have faced such a situation recently. Morgan Stanley suspended a London trader in June for overstating the value of credit securities on the books, forcing a $120-million (U.S.) writedown.

Last year, Bank of Montreal parted ways with a natural gas trader and his boss after discovering mispricing in its natural gas book, which cost the bank more than $800-million.
Reuters, 4 July 2008

Toronto-Dominion Bank, Canada’s second-largest bank, said on Friday it will take a pretax charge of about C$96 million ($94 million) for the mispricing of derivatives by a senior trader who has left the London office of its investment dealer unit.

TD Bank said that the charge in its TD Securities unit was tied to credit derivatives that were not properly priced, and said the unnamed trader left the bank on June 23.

TD discovered the mispriced credit index swaps the same day, spokeswoman Simone Philogene said.

The bank said it was cooperating with regulators.

A spokeswoman for Britain’s Financial Services Authority said that it does not comment on individual firms.

TD Bank President and Chief Executive Ed Clark said the bank was ”very disappointed” with the loss.

”Our company has a strong risk culture and we deeply regret this incident. We take this very seriously and will make every effort to ensure that this doesn’t happen again.”

TD shares closed down 25 Canadian cents, or 0.4 percent, at C$63.09 a share on the Toronto Stock Exchange on Friday.

Analysts said investors would probably overlook the charge, even though it exceeds the C$93 million in wholesale banking profit that TD reported in the second quarter.

”I think in this case, TD has done extremely well through the credit crunch so far, and I don’t think people are going to change their assessment of the risk management culture yet,” said Ohad Lederer, a banking analyst at Veritas Investment Research in Toronto.

In June, Wall Street bank Morgan Stanley said it had suspended a London-based credit trader who had overvalued positions by $120 million, prompting a writedown of the same amount, and in May, Lehman Brothers Holdings Inc suspended two London equities traders after identifying a similar problem.

TD has largely steered clear of harm during the credit crisis, in part because retail banking in Canada and the United States makes up the bulk of its operations.

In the most recent quarter, which ended April 30, retail businesses produced about 90 percent of the bank’s total profit of C$852 million.

TD Securities does currency and international fixed income trading in London, as well as institutional equity sales and trading.

TD will swallow a relatively small loss from the mispriced credit derivatives, a second analyst said, compared with the billions of dollars in writedowns taken at U.S., European and other Canadian banks as a result of weak credit markets.

”That’s a pretty small hit,” said Douglas Davis, president at Davis-Rea. ”I think TD wants to be known as the most defensive bank with the cleanest balance sheet.”

TD’s Canadian peers, Bank of Montreal, Canadian Imperial Bank of Commerce, and Royal Bank of Canada, have reported bigger charges in the past year.

In the case of BMO, the culprits were commodity trading and structured-finance losses. CIBC has taken hits for various credit-market securities and hedges with downgraded bond insurers. And RBC’s charges covered a variety of asset-backed, structured credit and auction rate securities.
The Canadian Press, 4 July 2008

Toronto-Dominion Bank has disclosed a $96-million loss caused by “incorrectly priced financial instruments” at the TD Securities office in London.

The bank blamed “an individual who is no longer with the company” and said Friday it is co-operating with regulators.

TD did not say whether the losses were linked to trading mistakes or whether any wrongdoing or criminal activity was involved.

The loss is nothing like the €5-billion ($8-billion) hit suffered in January by France's Société Générale SA and attributed to rogue activity by trader Jerome Kerviel. But it is an embarrassment for TD, which has prided itself on avoiding much of the trouble which has engulfed other banks worldwide since a global credit crunch swept the financial sector last summer.

“We are very disappointed that this has occurred,” TD chief executive officer Ed Clark said in a brief statement which offered no details of the malfunction.

“Our company has a strong risk culture and we deeply regret this incident. We take this very seriously and will make every effort to ensure that this doesn't happen again.”

A TD spokeswoman said the individual was a senior trader in the London office who traded credit derivatives. Discrepancies in his accounts were discovered after he left TD on Monday, June 23.

“We identified financial instruments that were priced incorrectly,” said Simone Philogène.

She declined to release the trader's name or where he went, saying she could provide very little information about the former employee due to privacy considerations.

“What I can tell you is we had a senior trader in our London office leave our employ on Monday, June the 23rd, and upon transitioning his accountabilities we identified incorrectly priced financial instruments,” she said.

The financial instruments were credit index swaps — complex futures or derivatives contracts used by traders to spread credit risks.

“It's an account we trade for the bank, so there's no client money involved,” Ms. Philogène said.

The bank is co-operating with Britain's Financial Services Authority which is investigating the incident.

The TD Securities division provides a wide range of capital market products and services to corporate, government and institutional clients, including investment and corporate banking and interest-rate, currency and derivatives instruments.

TD was widely hailed by analysts earlier this year for its tight risk-management practices, which helped the financial institution avoid the massive debt writedowns that dragged its five main Canadian rivals to post billions of dollars in losses linked to the subprime-mortgage market in the United States.

The charge the bank is taking is not a large one, amounting to only about 7 per cent of the bank's $852-million profit in the second quarter ended April 30. TD will report its fiscal third quarter results Aug. 28 and may include the latest charge in its finances then.