23 January 2009

RBC's Exposure to Stable Value Products

Dow Jones Newswires, 23 January 2009

There may be more scuds hidden deep in Royal Bank of Canada's books - this time in the form of stable value products, a type of insurance on fixed-income portfolios. State Street took $450M in 4Q charges on these products, and BMO Capital Markets notes RY has C$24.9B of exposure. While losses would be substantially lower, BMO says the "odds are rising" that RY may have to take a charge in future quarters. Even a complete write-down is manageable, BMO notes, although the question remains why RY's Capital Markets unit had any involvement in these products in the US at all.
Financial Post, Jonathan Ratner, 23 January 2009

Shares of Royal Bank are taking another beating after BMO Capital Markets analyst Ian de Verteuil said he is concerned about the bank’s exposure to stable value products and potential charges it make take as result. However, he said the bank’s scale, with more than $27-billion of Tier 1 Capital and earnings of more than $5-billion, means even a "virtually impossible" complete writedown of its bank-owned life insurance (BOLI) shortfall would not be a major problem.

Nonetheless, the analyst said there will be questions as to why Royal is involved in this business – part of capital markets, not insurance – in the U.S at all.

“Based on the bank’s description, Royal sells these products to financial intermediaries or plan sponsors so that these customers can have book value protection on portfolios of intermediate and short-term fixed income products,” Mr. de Verteuil told clients.

The analyst’s focus on this area was highlighted by State Street Corp.’s year-end results, in which the bank took a US$450-million charge against its stable value fund protection.

Mr. de Verteuil noted that Royal Bank disclosed $24.9-billion of exposure to stable value products in its annual report.

“This is the maximum potential amount of future payments, but certainly far exceeds the potential loss that Royal Bank could incur from these products,” he said, adding that the bank provided fewer details before 2008 likely because the perceived risks were minimal.

The analyst also pointed out that Royal disclosed that the shortfall of the BOLI product exceeded $2-billion as of October 2008, while there is no disclosure on whether the $15.4-billion of ERISA (U.S. Employee Retirement Income Security Act) product has a meaningful shortfall.

Mr. de Verteuil said it is quite likely that the shortfall, inclusive of any ERISA shortfall, will approach $3-billion at the end of the bank’s first quarter.

“This amount is well less than the $24.8-billion notional amount, but it is still a large number,” he said. “We have no idea about the likelihood or the potential size of a Royal charge in the coming quarters, but we believe the odds are rising.”

Mr. de Verteuil doesn’t think any other Canadian bank has exposure to BOLI stable value products. He prefers CIBC, BMO and National Bank, “whose problems are well-defined and where the valuations are more attractive.”