TD Securities, 30 January 2009
• The risks/exposures you need to know about. We highlight the key risks and exposures for each name that are most likely to present challenges over the coming year across investment portfolios, derivatives and off-balance sheet exposures.
• Further impacts look manageable. Disclosure is limited and visibility is poor, but the worst exposures have been materially reduced and accounting treatment has become more flexible. We expect further write-downs, but they should be manageable relative to the respective platforms, improved capital levels and earnings generation
• Risk of another downturn. That said, the group is far from immune and another wave of financial/economic distress could offer potentially material downside risks in some cases.
• Disclosure still needs more work. Industry disclosure has evolved materially over the past year. Our work reflects our understanding of the available disclosure and additional clarification and discussion with the companies. However, there are still large pools of assets where there is little insight available and there is always the risk of new or completely unexpected exposures.
• Avoid higher risk/exposure business models. Against this backdrop, we continue to avoid those platforms with higher potential for exposure. In our view, Bank of Montreal appears most susceptible to incremental negative developments in a downturn. Royal’s business mix could also offer challenges amid further capital markets distress.
Investment Summary
We believe that 2008 will mark the low point for the Canadian banking industry with respect to the magnitude of asset write-downs and in terms of their shock value and disruptive impact on the industry and investor perceptions. Over the past year, disclosure and understanding has improved materially, while management teams have made significant strides in reducing exposures and rebuilding capital.
In the context of expected continued weakness in capital markets and the global financial system we anticipate further asset write-downs in 2009 across the group. However, they should be manageable relative to the respective platforms, capital levels and ongoing earnings generation.
Visibility remains relatively low, but with a number of the most problematic positions already materially reduced, and the introduction of increased accounting flexibility (i.e. the shift from Trading to Available for Sale) we do not expect to see amounts materially above several hundred million (pre-tax) from a given company in a given quarter.
There are still, however, some significant risks that could develop should we see another significant leg down for the industry such as the failure of another major global financial institution or the collapse to commercial paper markets (we view both examples as remote). As always, there is also a risk of completely unknown or new exposures.
Given the limited visibility and continued risk of further disruptions, our bias remains to avoid platforms with relatively large or broad based businesses that increase the potential for contact with troubled areas or where visibility is limited such as large trading and investment operations. As we discuss, Bank of Montreal has a number of issues to manage. Our review also highlights Royal Bank as a platform with a relatively outsized exposure to trading and investments.
In our 2008 Canadian Banking Handbook (November 3, 2008), we identified what we thought were the key Risk Hot Spots going forward. We have updated that commentary with this report.
1) Securities Trading and Investment Portfolios. Most integrated banking models have substantial asset portfolios as a result of facilitating various forms of client activity as well as proprietary investment strategies. Depending on how management positions the bank, weak capital markets can result in potentially sizeable losses. The industry has focused on a handful of particularly troublesome assets that have come to light, but banks have sizeable portfolios with limited disclosure to assess.
2) Derivative Exposures. Banks have massive derivative portfolios relating to credit, interest rate and foreign exchange risk. Most of the books are run on a matched basis, but remain subject to significant counterparty risk. Here too, disclosure is limited to areas of known problems, specifically the monoline insurance providers. However, the failure of a significant global financial institution posses significant risks, as was the case with Lehman.
3) Off-balance Sheet Exposures. In our view, this category holds one of the potentially largest risks, should we see another leg down in the current downturn. The ABCP (asset backed commercial paper) market is a significant source of financing for a wide range of credit financing. Not only do banks use it directly as a source of funding their own assets, but they also backstop (through liquidity commitments and forms of loss protection) a wide range of other facilities for clients and investment purposes. There have been some relatively isolated problems to date where banks have had to take responsibility for trouble assets or participate in restructurings. That said, the bulk of the assets are for the most part relatively plain vanilla and are of relatively high quality. To date the commercial paper market has continued to function reasonably well, although at materially wider spreads with less liquidity generally. However, if this industry were to seize up, banks could find their exposures increasing rapidly as the conduits drawn down on liquidity facilities that effectively transfer risk to the banks.
The key risks/exposures you need to know about
Bank of Montreal. We cannot define an impending material risk, but the bank has a number of potential problem areas under a downturn scenario including its investment in troubled assets originated in its U.S. ABCP conduits and ongoing liquidity facilities, efforts to support two SIV conduits and multiple exposures to a conduit of levered CDS exposure.
Scotiabank. The bank has weathered the downturn reasonably well and has been among the most proactive in rooting out and isolating exposures. The bank maintains a sizeable ABCP conduit program, but to date the assets have held up well. The bank is somewhat unique in its relatively outsized exposure to the auto sector. Exposure is mainly on the lending side, but the bank has invested in a structured product that holds consumer auto loans from GMAC. The product is conservatively structured and to date the bank has seen relatively minor mark-to-market losses which it views as temporary.
CIBC. The bank suffered materially in 2008 having found itself with significantly outsized exposures to extremely toxic assets. However, combined with substantial write-downs on the worst assets, management is effectively working down and isolating the situation. From here, additional write-downs are likely to be modest relative to what the platform has already endured, although the notional exposure remains substantial. Further, while it may appear remote at this juncture, we believe the possibility remains for substantial recoveries over the coming years.
National Bank. The bank appears to have avoided a worst case scenario with the success of restructuring efforts under the Montreal Accord, although there are ongoing exposures. Otherwise, the bank has very limited exposures to identified problem areas.
Royal Bank. The bank has managed to avoid any dramatic challenges, however it has suffered from a range of smaller exposures and write-downs. There is no single issue that alarms us, but across its businesses the bank has accumulated a number of watch items and overall has relatively outsized exposure to trading/investment activities that offer the opportunity for problems in a downturn.
;
• The risks/exposures you need to know about. We highlight the key risks and exposures for each name that are most likely to present challenges over the coming year across investment portfolios, derivatives and off-balance sheet exposures.
• Further impacts look manageable. Disclosure is limited and visibility is poor, but the worst exposures have been materially reduced and accounting treatment has become more flexible. We expect further write-downs, but they should be manageable relative to the respective platforms, improved capital levels and earnings generation
• Risk of another downturn. That said, the group is far from immune and another wave of financial/economic distress could offer potentially material downside risks in some cases.
• Disclosure still needs more work. Industry disclosure has evolved materially over the past year. Our work reflects our understanding of the available disclosure and additional clarification and discussion with the companies. However, there are still large pools of assets where there is little insight available and there is always the risk of new or completely unexpected exposures.
• Avoid higher risk/exposure business models. Against this backdrop, we continue to avoid those platforms with higher potential for exposure. In our view, Bank of Montreal appears most susceptible to incremental negative developments in a downturn. Royal’s business mix could also offer challenges amid further capital markets distress.
Investment Summary
We believe that 2008 will mark the low point for the Canadian banking industry with respect to the magnitude of asset write-downs and in terms of their shock value and disruptive impact on the industry and investor perceptions. Over the past year, disclosure and understanding has improved materially, while management teams have made significant strides in reducing exposures and rebuilding capital.
In the context of expected continued weakness in capital markets and the global financial system we anticipate further asset write-downs in 2009 across the group. However, they should be manageable relative to the respective platforms, capital levels and ongoing earnings generation.
Visibility remains relatively low, but with a number of the most problematic positions already materially reduced, and the introduction of increased accounting flexibility (i.e. the shift from Trading to Available for Sale) we do not expect to see amounts materially above several hundred million (pre-tax) from a given company in a given quarter.
There are still, however, some significant risks that could develop should we see another significant leg down for the industry such as the failure of another major global financial institution or the collapse to commercial paper markets (we view both examples as remote). As always, there is also a risk of completely unknown or new exposures.
Given the limited visibility and continued risk of further disruptions, our bias remains to avoid platforms with relatively large or broad based businesses that increase the potential for contact with troubled areas or where visibility is limited such as large trading and investment operations. As we discuss, Bank of Montreal has a number of issues to manage. Our review also highlights Royal Bank as a platform with a relatively outsized exposure to trading and investments.
In our 2008 Canadian Banking Handbook (November 3, 2008), we identified what we thought were the key Risk Hot Spots going forward. We have updated that commentary with this report.
1) Securities Trading and Investment Portfolios. Most integrated banking models have substantial asset portfolios as a result of facilitating various forms of client activity as well as proprietary investment strategies. Depending on how management positions the bank, weak capital markets can result in potentially sizeable losses. The industry has focused on a handful of particularly troublesome assets that have come to light, but banks have sizeable portfolios with limited disclosure to assess.
2) Derivative Exposures. Banks have massive derivative portfolios relating to credit, interest rate and foreign exchange risk. Most of the books are run on a matched basis, but remain subject to significant counterparty risk. Here too, disclosure is limited to areas of known problems, specifically the monoline insurance providers. However, the failure of a significant global financial institution posses significant risks, as was the case with Lehman.
3) Off-balance Sheet Exposures. In our view, this category holds one of the potentially largest risks, should we see another leg down in the current downturn. The ABCP (asset backed commercial paper) market is a significant source of financing for a wide range of credit financing. Not only do banks use it directly as a source of funding their own assets, but they also backstop (through liquidity commitments and forms of loss protection) a wide range of other facilities for clients and investment purposes. There have been some relatively isolated problems to date where banks have had to take responsibility for trouble assets or participate in restructurings. That said, the bulk of the assets are for the most part relatively plain vanilla and are of relatively high quality. To date the commercial paper market has continued to function reasonably well, although at materially wider spreads with less liquidity generally. However, if this industry were to seize up, banks could find their exposures increasing rapidly as the conduits drawn down on liquidity facilities that effectively transfer risk to the banks.
The key risks/exposures you need to know about
Bank of Montreal. We cannot define an impending material risk, but the bank has a number of potential problem areas under a downturn scenario including its investment in troubled assets originated in its U.S. ABCP conduits and ongoing liquidity facilities, efforts to support two SIV conduits and multiple exposures to a conduit of levered CDS exposure.
Scotiabank. The bank has weathered the downturn reasonably well and has been among the most proactive in rooting out and isolating exposures. The bank maintains a sizeable ABCP conduit program, but to date the assets have held up well. The bank is somewhat unique in its relatively outsized exposure to the auto sector. Exposure is mainly on the lending side, but the bank has invested in a structured product that holds consumer auto loans from GMAC. The product is conservatively structured and to date the bank has seen relatively minor mark-to-market losses which it views as temporary.
CIBC. The bank suffered materially in 2008 having found itself with significantly outsized exposures to extremely toxic assets. However, combined with substantial write-downs on the worst assets, management is effectively working down and isolating the situation. From here, additional write-downs are likely to be modest relative to what the platform has already endured, although the notional exposure remains substantial. Further, while it may appear remote at this juncture, we believe the possibility remains for substantial recoveries over the coming years.
National Bank. The bank appears to have avoided a worst case scenario with the success of restructuring efforts under the Montreal Accord, although there are ongoing exposures. Otherwise, the bank has very limited exposures to identified problem areas.
Royal Bank. The bank has managed to avoid any dramatic challenges, however it has suffered from a range of smaller exposures and write-downs. There is no single issue that alarms us, but across its businesses the bank has accumulated a number of watch items and overall has relatively outsized exposure to trading/investment activities that offer the opportunity for problems in a downturn.
