25 November 2008

RBC's $670 Million Writedown for Q4 2008

TD Securities, 24 November 2008


Slightly negative. Royal reported adjusted earnings of approximately C$0.90 +/- per share compared to TD’s estimate at C$0.90 and consensus at C$1.02. The bank had several market related charges which reflect the extremely challenging market conditions and the size and breadth of the bank’s Wholesale business. We also saw a significant uptick in PCLs which exceeded both TD and consensus expectations. From current levels, we see upside across the group, but note that Royal trades at a premium.


Write-downs reflect business mix. The bank reported C$670 million in pre-tax write-downs (net of a C$330 million pre-tax gain on the Mark to Market (MTM) of the bank's own debt), mitigated by a C$540 million pre-tax release of Enron related reserves. The bank also took advantage of more relaxed accounting rules to shift securities to Available For Sale to shield earnings and regulatory capital from additional MTM. Overall, while undoubtedly reflective of an exceptionally challenging market, the losses highlight for us the ongoing risks associated with the size and breadth of the bank's wholesale operations.

Rising credit provisions. PCLs came in at approximately C$620 million including C$135 million in general reserve building materially above our expectations at C$445 million and consensus of C$388 million. The increase reflects primarily the weakening market conditions in the bank's U.S. loan exposure (approximately C$150 million). We had been hoping for some sign of stabilization here, but we believe ongoing deterioration, and some reserve building, continues to drive higher expenses.

Signs of decent operating trends. The release offered few details, but an adjusted number of C$0.90 (near our expectations) notwithstanding much higher PCLs suggests some help from other parts of the business (potentially trading again this quarter) but overall decent performance in the bank's retail operations. We will look for clarification in the bank’s full release on December 5.

Absolute upside, but still relatively expensive. We will update our outlook following the full release of quarterly results for the group, but from current levels, we see attractive 12-month returns across our names. Against that back drop, we continue to note that Royal trades at a premium to the group notwithstanding a larger mix of wholesale operations and below average capital levels.

Capital. Inclusive of the pre-announced charges and earnings, the bank expects a Tier 1 ratio of 9.0% (down 50bp from Q3/08). Yesterday after market close, the bank also announced a 9 million preferred share issue at C$25 per share totaling C$225 million. The Underwriters were granted the option to purchase an additional 4 million preferred shares at the same offering price.

Adjustments. The bank reported net earnings of C$1,100 million or approximately C$0.82 per share.

Market related adjustments of C$670 million pre-tax (C$360 million after tax) included:
- Losses on Held for Trading securities: C$645 million pre-tax
- Impairment on Available for Sale securities: C$355 million pre-tax
- Gain on RBC liabilities (where wider credit spreads reduce the value of the bank’s debt): C$330 million pretax
- Royal also reported an increase to earnings from a reduction in the estimated provision for Enron: C$540 million pre-tax (C$250 million after tax).

Accounting for these items, our adjusted net earnings increases to C$1,210 million or approximately C$0.90 per share.


We will revisit our estimates and Target Price when the bank reports their full results on December 5, 2008.

Justification of Target Price

Using fair value estimates in a Gordon Growth model, our target price reflects 2.7x P/BV.

Key Risks to Target Price

1) Increased competition and tighter margins in the U.S. banking environment, 2) integration challenges associated with recent acquisitions and 3) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

The bank reported market related charges amid the extremely challenging market conditions and highlights for us the risk from the size and breadth of the bank’s wholesale operations. PCLs remain a concern and increased significantly during the quarter. Despite these events, the bank was able to meet our arguably conservative estimates suggesting the bank’s operating performance was decent, or potentially lifted by other parts of the business like Trading. We will be looking for more clarity around the bank’s earnings when they report full results on December 5, 2008.
Financial Post, Jonathan Ratner, 24 November 2008

Nobody was surprised by the fact that Royal Bank pre-announced fourth quarter earnings after Toronto-Dominion Bank and Bank of Nova Scotia did so last week. But what is raising some eyebrows is the lack of pre-announcements by the remaining the of Canada’s Big Six banks.

“We cannot believe that arguably three strongest banks operationally incurred significant charges in the fourth quarter while Bank of Montreal, CIBC and National Bank of Canada were unscathed,” Dundee Securities analyst John Aiken told clients.

He noted that the deterioration in credit quality Royal is feeling from its U.S. operations is quite negative for the other banks, including BMO, TD and Scotia. As a result, the analyst recommends investors take shelter in those banks that have already pre-announced. He said, “we do not believe that no news is good news in this environment.”

Mr. Aiken said a few key points stick out for Royal. The bad news is that credit is deteriorating faster than expected, with an increase in provisions blamed on the bank’s U.S. portfolio. On the positive side, Royal appears to have been able to earn through this and will likely post core earnings that will beat the Street, he told clients.

When it comes to valuations in the current market environment, that fact is better than the unknown for Royal, he added, upgrading the stock to “neutral” from “sell.”

Mr. Aiken said core earnings look like they will be around 91¢ for the quarter, below consensus at 97¢. But until the full financials are released on December 5, the market won’t know what Royal’s true earnings strength and quality really are.
Financial Post, Eoin Callan, 24 Novemeber 2008

The Royal Bank of Canada warned it would be forced to take a $1.6-billion hit as market losses mounted and loans started to go sour.

The largest bank in the country cited "extreme volatility" as executives said they would writedown $1-billion in investments and set aside $620-million to cover credit losses.

The heavy blow underlines the damage being inflicted on Canadian financial institutions by the worst financial crisis since the Great Depression, as market turmoil and an economic downturn take their toll.

Gord Nixon, chief executive, warned of an "uncertain outlook" as political leaders acknowledged the country was sliding into recession and U.S. banks fell back on the government to prevent collapse.

The prospect of further losses and a slowdown in revenues has severely weakened bank shares in recent weeks, while RBC's peers have also registered writedowns, including Scotiabank and TD Bank Financial Group.

The investment losses and charges mean RBC's net income in the fourth quarter will fall 15 per cent to $1.1-billion, the bank said in a preliminary statement of results due out next week.

The charges will deplete reserves at RBC, which said its capital base would fall to a level of "approximately 9.0 per cent".

The bank said $645-million of losses were concentrated in its capital markets division, while a separate portfolio of securities saw a $355-million fall in value that was expected to be lasting.

Rob Sedran, any analyst at National Bank Financial, said RBC's "greater exposure to the capital markets" than its peers meant the months ahead were likely to prove particularly challenging for the country's largest bank.

John Aiken, an analyst at Dundee Capital, said: credit was "deteriorating faster than we had anticipated".

But he added that knowing the extent of the credit losses for RBC so far increased his confidence the bank would be able to sustain core earnings.

RBC said it was avoiding even bigger charges by taking advantage of new looser accounting standards to re-classify impaired assets so the losses would not have to be acknowledged.

RBC said it was retroactively shifting troubled portfolios of U.S. auction rate securities and mortgage-backed securities off its trading books, thereby avoiding bigger writedowns on these holdings.
Financial Post, Eoin Callan, 23 November 2008

If it seems as if the VIP boxes at the Air Canada Centre are a little roomier these days, it is probably because the guest list has been whittled down, along with the wine selection, by the suite's blue-chip hosts.

"They are inviting fewer people, ordering less food, or telling people to eat before they get here," says a staff member who has been catering for Bay Street clients since opening night at the Toronto arena.

Dozens of others who earn a living providing for the city's 220,000-strong financial workforce also testify to early signs of belt-tightening. Barbers say they have more time to sweep floors and maƮtre d's admit they've learned to smile even for those without reservations.

But the starkest evidence leaner times are coming to Bay Street can be seen on the scrolling tickers found in bank tower lobbies, which these days show the share price of each of Canada's top five banks are - despite frenetic competition, expansion and hundreds of millions in executive compensation - back at the same level at which they were trading five years ago.

Indeed, from here onward, the path appears to slope downward.

Financial analysts who have spent the past five years encouraging clients to buy bank shares now say there is "poor visibility," and demur when asked to pick a bottom.

Instead, they prefer to talk about looking "across the valley" to a time when growth will start picking up again.

When might that be? It could be next year. But investors will more likely have to wait until 2011, according to Michael Goldberg, an analyst at Desjardins Securities.

It took dramatic plunges in recent weeks to bring bank shares back down to ground zero after years of steady climbing. These tumbles were driven by two main factors: concern about the immediate fall out from the financial crisis; and worry about the impact of a prolonged economic slowdown.

Together, these interrelated forces are creating what is probably the worst climate for Canada's banks in at least two decades, possibly longer.

As Prime Minister Stephen Harper put it this weekend: "The world is entering an economic period unlike, and potentially as dangerous as, anything we have faced since 1929."

For Bay Street, this slowdown has a range of negative implications, including lower revenues from managing investment portfolios and retirement savings, and less profits from capital markets operations. It will also impact banks' core business model: borrowing money at one rate and lending it out a higher rate.

But next up is a more fundamental challenge that policymakers are not as well equipped to assist with: the worry people will not pay back the money they borrow.

It takes only a modest increase in defaults by consumers and small businesses, or a thin slice of corporate loans to go sour, to see bank profits wiped out as cash is set aside for bad debts. Research by Rob Sedran at National Bank Financial shows that banks are more exposed to personal loans and credit card lending than in previous cycles.

Bay Street has also depended for much of its growth in recent years on financing a domestic property bubble that is now deflating, and from bankrolling corporate deals laden with risks that probably seemed like a good idea at the time.

What has become increasingly clear in recent days is that the country's top banks are heading into this downturn significantly weakened by the systemic shock that has hit credit markets in the last nine weeks.

On Friday, ratings agencies said TD Bank Financial Group was being added to their negative watch-list for a potential downgrade after a $10-billion credit portfolio started to bleed losses.

Canada's second-largest bank had been the last big institution standing not to have made significant writedowns, but overnight saw its capital reserves pared to the lowest level of any bank in the country.

Ratings agencies have also identified key weaknesses at each of the other major banks, including BMO, which will tomorrow address concerns over its credit exposures, including more than $12-billion in potential liabilities related to two structured investment vehicles.

Structured credit products have also been a source of losses for Royal Bank of Canada, which reports next week after already incurring $1.8-billion in writedowns this year.

CIBC was the hardest hit of the banks during a first round of writedowns on subprime mortgages, but now has plenty of company as it counts the cost of a second wave of losses on complex credit products.

Close attention will be paid when it updates the market next week on the state of a $25-billion portfolio of impaired assets, while auto loans remain a potential oil slick for Scotibank.

Given this risk and the serious economic consequences of the banking crisis, it may be viewed as appropriate that premiere events at the Air Canada Centre are becoming notable for the scarcity of bank executives, who earn up to 500 times more than staff at the arena.

Mark Carney, governor of the Bank of Canada, said Sunday he had been somewhat troubled by the nature of his conversations with chief executives during the last five years. The central banker suggested in an interview with the British Broadcasting Corporation that bank chiefs should perhaps have spent more time reviewing their loan portfolios and less time thinking about the "opera or the ski slopes."