27 February 2009

Reconfiguring the American Banking Structure to Look More Like the Canadian Model

The New York Times, Theresa Tedesco, 27 February 2009

Has the world turned upside down? America, the capital of capitalism, is pondering nationalizing a handful of banks. Meanwhile, Canada, whose banking system had long been notorious for its stodgy practices and government coddling, is now being celebrated for those very qualities.

The Canadian banking system, which proved resilient in the global economic crisis, is finally getting its day in the sun. A recent World Economic Forum report ranked it the soundest in the world, mostly as the result of its conservative practices. (The United States ranked 40th).

President Obama has joined the adoring throng. He recently said that Canada has “shown itself to be a pretty good manager of the financial system in the economy in ways that we haven’t always been here in the United States.” Paul Volcker, former chief of the United States Federal Reserve, commented that what he’s arguing for “looks more like the Canadian system than the American system.”

Most people don’t know that the vision behind Canada’s banking system, made up of a few large, national banks with branches from coast to coast, actually had its beginnings in the United States. Canada’s system is the product of a banking framework inspired by Alexander Hamilton, the first American secretary of the Treasury. Hamilton envisioned the First Bank of the United States, chartered in 1791, as a central bank modeled on the Bank of England.

Canadians found inspiration in Hamilton’s model, but not all Americans did. In the 1830s, President Andrew Jackson opposed extending the charter of the Second Bank of the United States, perceiving it as monopolistic. Money-lending functions were then assumed by local and state-chartered banks, eventually giving rise to the free-market, decentralized system that America has today.

Today, Canada’s system remains truer to Hamilton’s ideal. The five major chartered banks, the few regional banks and handful of large insurance companies are all regulated by the federal government. Canadian banks are relatively constrained in the amounts they can lend. Canadian banks are required to have a bigger cushion to absorb losses than American banks. In addition, Canadian government regulations protect the domestic banks by limiting foreign competition. They also keep banks broadly owned by public shareholders.

Since Canada’s financial services sector was deregulated in 1987, permitting the banks to buy brokerage houses, they have enjoyed vast earnings power because of their diverse businesses and operations. And in contrast to the recent shotgun marriages at bargain prices between ailing Wall Street brokerages and American banks, Canadian banks paid top dollar decades ago for profitable, blue-chip investment firms.

Canadian banks are known to be risk-averse, and this has served them well. While their American counterparts were loading up their books with risky mortgages, Canadian banks maintained their lending requirements, largely avoiding subprime mortgages. The buttoned-down banks in Canada also tended to keep these types of securities on their books, rather than packaging them and selling them to investors. This meant that the exposures they did have to weak mortgages were more visible to the marketplace.

The big five Canadian banks — Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia, Canadian Imperial Bank of Commerce and Bank of Montreal — survived the recent turmoil relatively unscathed. Their balance sheets remain intact and their capital ratios are comfortably above requirements. Yes, Prime Minister Stephen Harper’s government may buy as much as 125 billion Canadian dollars (about $100 billion) worth of mortgages, increasing banks’ capacity to lend. But this is small change compared with the scale of Washington’s bailout.

Few would have predicted that Canadian banks, long derided as among the least autonomous because of stringent government oversight, would emerge from the global mayhem as some of the more independent international players.

Since Mr. Obama seems to admire the Canadian banking system, his administration might want to take a page out of its playbook.

This would entail building a national banking system based on a small number of large, broadly held, centrally and rigorously regulated firms. Imitating the Canadian model would require sweeping consolidation of American banks. This would be a very good thing. Washington had difficulty figuring out the magnitude of the financial crisis because there are so many thousands of banks that it was impossible for regulators to get into all of them.

Washington is already on the path to achieving consolidation. Eventually, some of the larger banks into which the government is injecting taxpayer money will probably be deemed beyond help, and will either be allowed to die or be partnered with other banks. The market will take its cues from this stress-testing, and make its own bets on which banks will survive. It’s hard to predict how many will have survived when the dust settles, but the new landscape might consist of only 50 or 60 banking institutions. More radically, Washington could take over the licensing of banks from the states, or, at the very least, consider more stringent regulation of global and super-regional banks. After all, the Canadian system is considered successful not only because it has fewer banks to regulate, but because regulation is based on the tenets of safety and soundness.

There is no time to waste. Reconfiguring the American banking structure to look more like the Canadian model would help restore much-needed confidence in a beleaguered financial system. Why not emulate the best in the world, which happens to be right next door? At the very least, Hamilton would have approved.

RBC Q1 2009 Earnings

TD Securities, 27 February 2009

The bank reported core cash FD-EPS of C$1.15 v TD Newcrest of C$0.90 and Consensus of C$0.94.


Positive. Helped by substantial trading revenues the bank managed to earn through significant write-downs and higher credit costs. That said, we remain mindful of the ongoing business mix shift, challenges in the medium-term growth strategy and some near-term credit pressures and exposures. As such, it is still not our favorite name in the group, but the stock has lagged in a weak tape and the quarter lifts some immediate concerns.


Credit costs running a bit hot. Credit costs came in comfortably above consensus. The bank feels it is well reserved and contends that it is well secured on a large portion of its impaired loans. Difficult for us to dispute these claims, and the trends are not shocking. However, the issue is likely to remain front and center in coming quarters and at face value the bank appears to have less ''padding" than some peers should the downturn worsen.

Exposures yield losses. We have previously noted the breadth of the bank's risks/exposures and in Q1 the result was surprisingly large write-downs (C$1.3 billion pretax). They were tolerable in the context of stronger overall earnings and management remains comfortable with the ongoing exposure. However, they are a reminder of the risks in the context of a weaker market.

Trading: Cyclical or Structural. The bank continues to invest in the build out of its capital markets and trading operations helping the bank to gain share from weakened competitors. Sustainable earnings are thus likely to be higher going forward, but we doubt they are 2-3x higher (as they were this quarter) on a sustainable basis.

Business mix concerns appear valid. Following on the above, Royal is increasing its Wholesale mix relative to its Retail operations. Thus far the shift has been helpful, but to us it carries negative implications for relative valuation and earnings volatility over the medium-term.

Supporting a return of the relative premium? Our standing contention with the stock has been its relative valuation in the context of the medium-term strategic and operating outlook and potential near-term risks. The stock has recently given up much of its premium as industry multiples have compressed. The stock looks attractive to us on an absolute basis (as does the industry), but we remain skeptical of the prospects for it to return to a material relative premium.

Conference Call Highlights

• Business Mix. The bank continues to target a business mix of 20-30% wholesale versus 70-80% retail, although it has been much higher in recent quarters and that would still put it comfortably ahead of retail focused players.

• Acquisitions. Management is very reticent about making acquisitions in this environment given uncertainty around 1) balance sheet quality and 2) regulatory uncertainty.

• Write-downs/Charges. The bank has significantly reduced its exposure to some areas that drove writedowns this quarter which should reduce future charges even in weak markets (our best guess remains a few hundred million in any given quarter). Further, management argued that mark-to-market (MTM) understates the value they are ultimately likely to realize.

Segment Highlights (growth rates are year-over-year unless otherwise stated)

• Domestic P&C. Results here were decent with Net Income -1.9% (adjusted) on good volume growth and expense control against ongoing margin pressure (-27bp) and rising credit costs.

• International. The segment continues to struggle under the weight of the bank’s U.S. P&C credit portfolio which continues to suffer material credit expense.

• Wealth. Consistent with a challenging market, the segment saw Net Income down over 30%; including the addition of recent acquisitions.

• Wholesale. The trading business produced another significantly outsized quarter with trading revenues (adjusted) on the order of C$1.442 billion compared to recent ranges of C$600-700 million. We believe that the bank has materially improved its trading platform, but do not believe it can produce over twice the revenue on a run-rate basis.

Operating Outlook. Outsized trading activity can readily account for the outperformance of adjusted earnings this quarter. Therefore, we are leaving our quarterly path unchanged through year-end which continues to reflect our outlook for a moderating environment and rising credit costs.

Segment Outlook. Domestic P&C continues to moderate inline with industry trends and should show modest trends through year-end. We assume Wholesale will perform at elevated levels, but below Q1/09's outstanding performance. International is likely to continue to struggle for the foreseeable future, while Wealth will remain largely market dependent.

Credit Outlook. Costs were lifted by an exposure from the bank's prime brokerage business (approximately C$100 million). Core Specific PCLs were not materially off our above consensus estimates and we expect credit expense to remain elevated through 2009. Reserves look light, but management maintains that many of their impaired loans remain well secured and have minimal expected loss.

Capital Outlook. The bank came out of the quarter with improved metrics, helped by some reduction in RWA. We expect the ratios to improve modestly over the coming quarters, barring additional potential writedowns (we assume they are unlikely to be materially more than a few hundred million in a weak market environment).

Our Target Price reflects a discount to our estimate of equity fair value 12 months forward (based on our views regarding sustainable ROE, growth and cost of equity), implying a P/BV of 1.75x.

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

We remain mindful of the ongoing business mix shift, challenges in the medium-term growth strategy and some near-term credit pressures and exposures. As such, it is still not our favorite name in the group, but the stock has lagged in a weak tape and the quarter lifts some immediate concerns.
Financial Post, David Pett, 27 February 2009

RBC's first quarter earnings have received solid enough reviews from the Street, but Canada's largest financial institution can be added to the list of banks who might be headed for trouble due to credit quality problems.

With its first quarter results, John Aiken, an analyst at Dundee Securities, said Royal Bank was able to address market concerns about its capital levels, but while that should generate some support for the stock near term, he says "the underlying concern remains credit quality.

"We are not optimistic that this situation will remain static and, as with TD, we believe that the first quarter earnings will represent a high water mark," said Mr. Aiken in a note to clients. "Consequently, we would recommend that investors sell into the rally we anticipate over the next week."

Longer term, Mr. Aiken remains "neutral" on the stock and maintains his $35 price target.

UBS analyst Peter Rozenberg remains more bullish on Royal Bank's prospects and called first quarter profits "striking" when compared to global bank peers. Still, he acknowledged that provisions of credit losses are likely to increase further given the negative economic outlook. He cut his price target from $44 to $42 but maintained his "buy" rating.

CIBC Q1 2009 Earnings

RBC Capital Markets, 27 February 2009

• CIBC's Q1/09 results were neutral to our view on the stock. Capital ratios were lower than expected, credit performance was better than we expected and earnings were close to our estimates on a GAAP basis, and higher on a core basis.

• We increased our 2009 core cash EPS estimate to $5.60 from $5.32, reflecting the Q1/09 earnings results relative to our estimates.

• We rate CIBC's stock as Sector Perform, which is the highest rating we have for a Canadian bank. For the next three to six months, CIBC's stock should benefit from low exposure to U.S. credit and lower exposure to corporate credit risk. Offsetting these positives is continued lackluster relative retail revenue growth and weaker than peer domestic retail credit trends, which reflects the bank's leading position in Canadian credit cards. Earnings risk related to structured finance exposures should be lower than it was in 2008, although we expect writedowns to continue.
Financial Post, David Pett, 27 February 2009

CIBC may have swung to a first quarter profit, but analysts weighing in on the results aren't ready to start dancing in the streets. Instead many of them remain extremely concerned about the bank's credit woes and warn investors to proceed with caution.

"For fiscal 2009 and fiscal 2010, we see a weak credit outlook, driven by the slumping economy as the key driver of bank earnings prospects, said Michael Goldberg, analyst at Desjardins Securities.

"While this is expected to cause higher on-balance sheet loan losses, CIBC faces the added risk of markdowns from its off-balance sheet non-mortgage structured credit exposures."

Mr. Goldberg reduced his fiscal 2009 EPS forecast from $4.85 per share to $3.85 per share due to higher expected loss provisions and his fiscal 2010 earnings forecast from $6.60 to $6.20. The analyst added that his earnings estimates could be worse if markdowns in the structured credit run-off books continue. He maintained his "hold" rating and left his $59 price target unchanged.

Blackmont Capital analyst Brad Smith called CIBC's first quarter a "disappointing start to the year" and reiterated his "hold" recommendation and $46 price target.

"The so-called 'run off' structured credit business net loss increased 49% sequentially to $483-million after tax, and is unlikely, given current market conditions, to get much better any time soon.

Ian De Verteuil, analyst at BMO Capital, downgraded his rating on CIBC from "outperform" to "market perform" and left his price target unchanged at $49. Although he acknowledged his concern regarding CIBC's credit, Mr. De Verteuil also expressed worry about the bank's Tier One Capital in relation to its peers.

"While we believe that the bank is making progress on structured credit, this remains an issue. Given the premium price/book value and price/tangible book value and the bank's below-average capital position, we believe that the upside is now more modest."

National Bank Q1 2009 Earnings

RBC Capital Markets, 27 February 2009

• We view National Bank's Q1/09 as mildly positive to our view on the stock. Credit performance was better than peers, as expected, and capital ratios were in line with our expectations.

• Operating EPS were stronger than we expected while reported EPS were lower on higher than expected ABCP-related charges.

• We increased our 2009 core cash EPS estimate from $4.77 to $5.00, primarily reflecting the Q1/09 earnings coming in ahead of our estimates.

• National Bank has been one of our favourite bank stocks for the following reasons: (1) the bank is less exposed to U.S. credit than some of its peers; (2) the bank is less exposed to Ontario than most of its peers; (3) the bank's securities portfolio is cleaner than some of its peers, in our view, and the bank has less exposure to off balance sheet commitments (other than ABCP, which has been restructured and we believe will be less impactful to NA shares in the foreseeable future, although exposures do remain).
The Globe and Mail, Tara Perkins, 27 February 2009

Canada's banks are living up to their growing reputation as a safe haven in the midst of the storm that's threatening financial institutions, but their pivotal lending businesses are beginning to stall.

Four of the country's top six banks have disclosed their first-quarter performance, and each churned out a profit during three of the ugliest months in decades.

In comparison, figures released by regulators yesterday show that U.S. banks collectively lost $26.2-billion (U.S.) in their most recent quarter, the first sector-wide loss since 1990.

"Market conditions worldwide for banks remain difficult," Canadian Imperial Bank of Commerce chief executive Gerald McCaughey said yesterday. "Yet, arguably, one of the better places to be right now is in Canada."

The financial results that Canadian banks released this week handily eclipsed analysts' predictions, said Shane Jones of Scotia Cassels Investment Counsel. While the banks face possible losses on their credit portfolios if markets and the economy continue to sour, the banks are strengthening their capital levels to buffer against future hits.

Canadian banks "deserve all the credit they are getting," Mr. Jones said.

But the banks are unlikely to hit the same level of profitability this year as last, as borrowers struggle to pay back debt and growth in the lending business slows down.

"Similar to TD Bank, RBC's Canadian banking earnings have hit a wall, with net income of $660-million [Canadian] down 2 per cent," Credit Suisse analyst Jim Bantis wrote in a note to clients.

The expectation is that the big banks will continue to generate profitability throughout this turmoil, Royal Bank of Canada chief executive Gordon Nixon told reporters after the bank's annual meeting.

He even suggested that dividends are safe. "As long as banks continue to perform at a reasonably strong level, I think dividends will continue to be a real priority," he said.

But while the Canadian industry has distinguished itself during this crisis, "I don't think we want to get smug about that," Mr. Nixon added. "It's not as though we've not had issues."

RBC reported a 15-per-cent drop in profit, to $1.05-billion. It took roughly $1.3-billion in pretax charges relating to the declining value of illiquid securities.

CIBC's problem-plagued U.S. credit portfolios spurred $708-million in writedowns, but the bank still managed to impress analysts with a profit of $147-million.

National Bank of Canada's exposure to asset-backed commercial paper caused its profit to slump from $255-million a year ago to $69-million this quarter.

Many of the banks benefited from unexpectedly high trading revenue.

Despite their issues, Canadian banks are being carried by the muscle of their core lending operations, which are largely dependent on the precarious health of this country's consumers and businesses.

Credit-rating agency DBRS is to release figures today suggesting that average Canadian credit card loss rates increased from 3.75 per cent in July to 4.53 per cent at the end of last year, although that's "in stark contrast to average U.S. prime bank card losses, which reached 6.7 per cent at the end of 2008," said managing director Jerry Marriott.

Banks are signalling they expect to cover more bad debts and are significantly raising their provisions for troubled loans. RBC, for instance, raised provisions for soured loans in its Canadian lending business by 26 per cent because of higher loss rates. CIBC's lending operations posted loan losses of $327-million, up from $189-million a year ago, with bankruptcies and economic pain leading to higher losses in its credit card business.

Now, the challenge for the Canadian banks is to retain their advantage. Executives say many of the factors behind the advantage are long-standing characteristics of the system here, and that other countries will now try to emulate those.

"I think going forward you'll see more and more people move a little bit closer to the way we do residential real estate lending," Mr. Nixon said, adding that Canadian banks keep most mortgages on their balance sheets rather than selling them off, and benefit from strong government-backed mortgage insurance.

26 February 2009

TD Bank Q1 2009 Earnings

RBC Capital Markets, 26 February 2009

We view TD's Q1/09 as neutral to our view on the stock: core operating results were close to our expectations and the capital position was higher than we expected. On the negative side, provisions for credit losses were higher than we expected and GAAP EPS fell short of our estimates.

We have lowered our 2009E core cash EPS to $4.55 from $4.80.

• About 60% of the decline reflects higher expected loan losses.

• Management noted on the call that it would be an accomplishment if TD had flat EPS in 2009 (TD views its 2008 EPS as $4.88 on an adjusted basis).

• We will publish our estimated EPS for 2010 for TD and other banks as part of our industry review following the release of all of the banks' Q1/09 results.

Our Underperform rating on TD has reflected our view that:

• TD has the second-largest exposure to U.S. lending and has a large presence in Ontario - two areas where the outlook for credit is poor. We also think that the bank's outperformance in U.S. credit will not be as strong as it was in 2008. Q1/09 results did not change our view.

• Unrealized loss on available for sale securities are larger than for other Canadian banks, relative to Tier 1 capital. We need to see other banks report but unrealized losses on AFS securities grew to 12% of Tier 1 capital from 7% in Q4/08.

• Capital ratios were in the bottom half of the Canadian banks. Q1/09 capital ratios were higher than we had anticipated for TD; we have yet to see the results of other banks.

• Price to tangible book was highest among the Canadian banks, but the currency-driven increase in tangible book value (31% sequentially) has lowered the bank's trading multiple.

• TD trades at 0.9x BV versus a range of 0.8x - 1.5x for peers, 1.8x TBV versus 0.9x - 2.2x and a dividend yield of 6.8% versus 6.7% - 10.9%.

As is normally the case during bank reporting periods, we will wait until after all of banks have reported to reassess our relative rankings and to review our 12-month target prices.
Financial Post, David Pett, 26 February 2009

While Toronto-Dominion Bank is receiving kudos on the Street for its capital position, analysts remain less than impressed with the bank's eroding credit.

"We view TD's results quite positively and believe that its share price will likely benefit in the near term on both an absolute and relative basis on the strength of the quarter."said Dundee Securities analyst John Aiken in a note to clients. "However, we do not believe that TD (or its peers) will be able to fight off the pending additional credit deterioration and earnings will continue to decline,"

While TD's Tier 1 capital ratio, now above 10%, is less of a concern now for Mr. Aiken than it was a week ago,, he remains worried about the fact TD's credit provisions increased significantly from the previous quarter. He maintained his "neutral" rating and cut his price target from $44 to $41.

Brad Smith, analyst at Blackmont Capital downgraded his rating from "hold" to "sell" after cutting his price target to $38.

"In addition to confirming the long anticipated acceleration of credit deterioration in the bank's US lending portfolios, the results also evidenced a growing deterioration in both domestic commercial and consumer credit portfolios," he said in a note to clients.

The Blackmont analyst reduced his cash EPS outlook for 2010 to $4.80 per share and looks for additional capital pressures to unfold in 2009.

Others on the Street are less bearish, including UBS' Peter Rozenberg. Despite the credit loss provision rising earlier than expected, the analyst thinks TD's valuation at 7.4x EPS and 0.86x P/B continues to discount a worst case outlook for PCL’s. He maintained his "buy" rating and cut his price target from $57 to $53.
Bloomberg, David Scanlan, Theophilos Argitis & Sean B. Pasternak, 25 February 2009

David Denison, who oversees investments for Canada’s pensions, says his country’s banks are the best in the world right now and Barack Obama, like so many money managers from Beijing to Paris, can’t disagree.

Before President Obama made Ottawa his first visit to a foreign capital earlier this month, he couldn’t resist telling the Canadian Broadcasting Corp.: “In the midst of the enormous economic crisis, I think Canada has shown itself to be a pretty good manager of the financial system and the economy in ways that we haven’t always been.”

The comment was something of an understatement, as no country among the so-called industrialized nations is showing as much confidence in its bankers as Canada. Not one government penny has been given to any of the 21 banks from British Columbia to Quebec since credit worldwide seized up in August 2007. Since then, American taxpayers have provided $300 billion to bail out more than 450 companies, led by Citigroup Inc. and Bank of America Corp., two of the three largest banks measured by assets.

Obama isn’t the only important person “looking at Canada” in a belated attempt to figure out how to fix a broken financial model, Denison said.

“Solid funding and conservative consumer lending criteria are key features” of Canadian banks, said John Haynes, senior U.S. equity strategist at Rensburg Sheppards Plc in London, which oversees the equivalent of $17 billion. “This has meant that they have had their hands caught in the cookie jar to a much more limited extent than their American and European counterparts.”

Money managers from Brazil, China, France, Ireland and Australia scheduled visits to Denison’s Toronto office in the past two weeks to learn how Canada and its banks and pension funds are weathering the financial crisis. The visitors include the AustralianSuper Fund and the French National Reserve Fund, which together have assets of $53 billion, he said.

“They have assembled a high-quality team,” said Ian Silk, chief executive officer of AustralianSuper, who visited Denison in May along with three other executives from the Melbourne-based fund and remains in contact with the Canadian money manager.

Canada’s higher capital requirements and loan limits that European banks exceeded by 50 percent helped Canadian lenders avoid most of the writedowns and losses crippling competitors worldwide, even as the nation’s economy slipped into a recession and the jobless rate jumped to a four-year high.

Just two Canadian regional banks have failed since 1923. The only government support has been a pledge to buy as much as C$125 billion in mortgages, allowing the banks to increase lending to companies and consumers.

“The Canadian banking system is a very good story,” said Denison, chief executive officer of the Canada Pension Plan Investment Board, which manages C$108.9 billion ($86 billion) for retired Canadians. “People are looking at Canada” to determine how to fix their broken financial models, he said.

Canadian banks are more constrained than their international peers in the amount of loans they can extend. The nation’s lenders are required to set aside a minimum 7 percent for Tier 1 capital, compared with 6 percent for U.S. commercial banks. At the end of October, Canada’s eight publicly traded banks were above the minimum, at 9.6 percent, according to data compiled by Bloomberg.

Canada’s banking regulator says institutions can lend as much as 20 times their capital base. According to Bank of Canada data released in December, European bank non-risk weighted assets were more than 30 times capital, while that ratio for U.K. banks and U.S. investment banks was above 25.

Europe’s largest financial companies have reported $321 billion in writedowns and credit-related losses since the collapse of the U.S. subprime mortgage market in 2007 spread to other continents. The market turmoil has forced European lenders to raise $370 billion in fresh capital and sparked government-led bailouts in countries including the U.K., Germany and Switzerland, according to Bloomberg data.

European deficits have ballooned as governments committed more than 1.2 trillion euros ($1.5 trillion) to save their banking systems from collapse.

“When the crisis started emerging on those fronts, Canada was less affected,” said Matthew Strauss, a senior currency strategist in Toronto at RBC Capital Markets, a unit of the country’s biggest bank. “Canada has always had a fairly conservative banking sector.”

While Bank of America and Citigroup cut their dividends to 1 cent a share from as high as 64 cents, the payouts at Canada’s five biggest banks haven’t been reduced since the Great Depression. Toronto-based Royal Bank of Canada is now the third- biggest bank in North America by market value, almost three times the size of Citigroup, while Toronto-Dominion Bank ranks fifth. Royal Bank is almost three times bigger than European lenders Royal Bank of Scotland Group Plc and Deutsche Bank AG.

The Canadian banks, which begin reporting first-quarter results today, probably will say profit declined an average of 12 percent, the biggest drop in almost seven years, according to Scotia Capital analyst Kevin Choquette. By contrast, Bank of America reported its first quarterly loss since 1991 last month, and Citigroup posted a fifth straight loss.

The World Economic Forum in October ranked Canada’s financial system the soundest in the world.

The Canadian banks haven’t been in this position of global strength since between the two World Wars, said Charles Goodhart, a professor of finance at the London School of Economics, and a former Bank of England policy maker.

“They’re very diversified, didn’t get heavily involved in the international investment banking industry and they’ve benefited from good central banking,” Goodhart said.

Countries need more “boring” financial systems like Canada’s, Finance Minister Jim Flaherty said Feb. 14 in Rome, where he was attending a meeting of finance ministers and central bankers from the Group of Seven industrialized nations.

The federal government in October set up a C$218 billion program to guarantee bank debt to help Canadian lenders compete in international markets with government-backed U.S. banks. None of the country’s lenders has tapped the credit.

“The Canadian government has a lot of firepower these days, not just because this has been such a well-managed economy, but frankly, because the Canadian government has not been bailing out the Canadian banks,” Toronto-Dominion Chief Financial Officer Colleen Johnston told investors Jan. 28 in New York.

Toronto-Dominion reported today that fiscal first-quarter profit fell 27 percent to C$712 million, or 82 cents a share, because of higher loan-loss provisions. Results topped analysts’ estimates.

Toronto-Dominion and Royal Bank are among just seven banks in the world with the top credit rating of Aaa from Moody’s Investors Service.

Canadian regulators resisted pushes from some bank executives to loosen lending restrictions when the economy was booming, says David Dodge, 65, who stepped down as Bank of Canada governor a year ago.

“The banks at the top of the cycle thought we were being too tight-assed,” Dodge said in a telephone interview.

Even the strength of Canada’s banks hasn’t kept the economy from being dragged down by the global crisis. The world’s eighth- biggest economy will shrink by 1.2 percent this year, in part due to falling exports of oil and other commodities, according to Bank of Canada projections. Employers cut a record 129,000 jobs in January.

“We have major problems,” said Stephen Jarislowsky, the 83- year-old chairman and founder of Montreal-based money manager Jarislowsky Fraser Ltd., which manages about $31.8 billion. “Our commodity boom is over for a long time.”

Canada recorded its first monthly trade deficit in more than three decades in December, as exports plunged 9.7 percent. The country ships more than three-quarters of its goods to the U.S.

“We have some unique advantages, but we are being profoundly affected by the global crisis,” Bank of Canada Governor Mark Carney said in a Feb. 14 interview from Rome.

Canada’s housing market has also held up better than in the U.S., where prices declined a record 19 percent in December from a year earlier, according to the S&P/Case-Shiller index. Resale home prices dropped 9.9 percent in Canada during the same period, the Canadian Real Estate Association said. Last year, Finance Minister Flaherty scrapped 40-year mortgages when they started to gain popularity among homebuyers seeking to reduce their monthly mortgage payments.

Canadian banks are less willing to lend to homebuyers with low credit scores: Subprime loans account for just 5 percent of the total. That compares with 20 percent in the U.S., where independent mortgage brokers and lenders competed with commercial banks to win business by attracting high-risk borrowers.

Another restraining factor is that Canadians, unlike their U.S. neighbors, can’t take mortgage interest as a tax deduction, removing an “inherent bias” to take on too much debt, Prime Minister Stephen Harper said in September.

Canada was the only Group of Seven nation to balance its budget for 11 consecutive years, before a stimulus package aimed at sparking growth pushed the country to a deficit for the fiscal year ending March 31, according to a government forecast.

The relative strength of the financial system may help Canada recover from the recession faster, Carney said. The Bank of Canada is forecasting growth of 3.8 percent for 2010, in anticipation of rising commodity and oil prices. Canada’s oil sands in Alberta contain more reserves than any region outside Saudi Arabia.

“Once this uncertainty is removed, and it will be removed ultimately,” Carney said in an interview, “these strengths will kick in and that will have a bigger impact in our opinion in terms of the recovery in Canada.”

19 February 2009

Preview of Banks' Q1 2009 Earnings

Scotia Capital, 19 February 2009

Banks Begin Reporting February 25

• Banks begin reporting first quarter earnings with Toronto Dominion (TD) on February 25, followed by Canadian Imperial Bank of Commerce (CM), National Bank (NA), and Royal Bank (RY) on February 26, Bank of Montreal (BMO) and Bank of Nova Scotia (BNS) on March 3, Laurentian Bank (LB) on March 4, and Canadian Western (CWB) closing out reporting on March 5. Scotia Capital’s earnings estimates are highlighted in exhibit 1, consensus earnings estimates/target prices in exhibit 2, and conference call information in exhibit 4.

Negative Earnings Momentum – ROE 17.2%

• We expect first quarter operating earnings to decline 12% year over year (YOY) and 2% sequentially due to retail margin pressure, increasing loan loss provisions, and modest dilution from equity issues. These negative factors could be partially offset by improving wholesale spreads, a depreciating Canadian dollar, and increased investment banking activity. This is expected to be the sixth straight quarter of negative earnings momentum. Operating ROE is expected to remain solid at 17.2%, with the higher ROE banks’ profitability at 18% plus.

• Reported earnings are expected to double from a year earlier due to the moderating of writedowns from the record $4.4 billion in Q1/08.

• We are forecasting an 11% earnings decline in 2009 and a 5% increase in 2010. Return on equity is expected to be 16.3% in 2009 and 16.0% in 2010. Our earnings estimates reflect recession level loan loss provisions (LLPs).

• We expect dividend increases to remain on hold throughout most of 2009 due to increased focus on capital positions, continued difficulty in credit markets, and short-term uncertainty. We believe that the market is currently pricing in a 35% probability of dividend cuts for the bank group; however, we believe that bank dividends are safe. In addition, we believe that dividend increases could resume as early as the fourth quarter of 2009, with RY the most likely to increase.

• We expect overall writedowns this quarter to be modest compared with Q4/08 and Q1/08. The potential writedowns this quarter are highlighted in Exhibit 3.

• We expect loan losses in Q1/09 to increase to $1.8 billion or 0.57% of loans, which represents a 75% increase from $1,033 million or 0.37% of loans a year earlier and an 18% increase from $1,531 million or 0.48% of loans in the previous quarter. We expect LLPs to accelerate throughout 2009, totalling $8.0 billion or 61 basis points (bp) of loans and ultimately peaking in 2010 at $9.7 billion or 70 bp of loans. We expect banks to be able to grow earnings while absorbing these higher credit losses over the next several years. Interestingly, banks have recorded strong absolute and relative returns in the face of rising LLPs in each of the past three credit cycles, which seems counterintuitive.

• Canadian banks grew book values by 14% in 2008, despite $10 billion in writedowns. After issuing $5.2 billion in common equity in early fiscal 2009, we expect that book values will continue to grow in 2009 as a result of capital build from earnings and foreign currency translation from a depreciating Canadian dollar. We expect charges to other comprehensive income (OCI) from available-for-sale (AFS) securities to be moderate in 2009.

• Bank dividend yields have spiked to as high as 7.5%. The bank dividend yield relative to 10-year government bonds is an astonishing 10.4 standard deviations from the mean. The bank dividend yield relative to the TSX is 2.3 standard deviations above the mean. The market is clearly discounting dividend cuts. We expect catalysts to a bank stock rally will be stability in the U.K. and U.S. banking systems and continued solid earnings from the Canadian banks, and once the market feels comfortable with sustainability of dividends, the stocks will likely rally sharply.

• Canadian banks are well capitalized, with high-quality balance sheets, diversified revenue mix, a solid long-term earnings growth outlook, low exposure to high-risk assets, and compelling valuations on both a yield and P/E multiple basis.

• We are downgrading NA to 2-Sector Perform from 1-Sector Outperform based on significant relative outperformance and relative P/E multiple expansion. We are upgrading LB to 2-Sector Perform from 3-Sector Underperform based on weak relative performance and low relative P/E multiple.

• We continue to recommend overweight bank stocks. We have a 1-Sector Outperform rating on Royal Bank and CWB, with 2-Sector Perform ratings on BMO, and CM, and a 3-Sector Underperform rating on TD. Our order of preference has shifted to RY, CWB, NA, BMO, LB, CM and TD.

Retail Net Interest Margin Compression

• The retail net interest margin is expected to come under significant pressure, as continuous rate cuts by the Bank of Canada have reduced prime to 3.00%, the lowest level in history. We view this as entering the “Red Zone” (Exhibit 9), which begins to structurally impact bank margins and profitability. The banks’ decision to reduce prime in line with the Bank of Canada rate reduction is negative for bank earnings and will likely be fully felt in the second fiscal quarter. We believe the prime rate descent, with deposit costs being at or very close to their floor, creates enormous retail margin pressure, especially on TD with its deposit mix.

• Banks with a large percentage of demand and notice deposits such as TD, BMO, and NA will be more susceptible to margin compression. We are forecasting a 10 bp decline in retail net interest margin in 2009, which is expected to negatively impact bank group earnings by 4%.

• Retail margin pressure may be eased somewhat by favourable transfer pricing from Treasury, as wholesale spreads have widened out in the first quarter of 2009. The average prime-BA spread in Q1/09 improved significantly to 1.82% from 1.47% in the previous quarter and 1.54% a year earlier.

Bank Capital Positions Strong

• The Canadian banks raised nearly $9.5 billion in Tier 1 capital throughout Q1/09 ($5.2 billion in common shares, $3.2 billion in preferred shares, and $1.1 billion in innovative Tier 1), bringing the bank group total Tier 1 ratio to 10%. Canadian banks, we believe, have strong Tier 1 capital levels and should be able to increase easily to the 11%-13% range over the next few years without issuing further equity, but rather via internally generated capital and preferred shares and innovative capital issuance. We estimate that bank net earnings in fiscal 2009 would add 80 bp with preferred share and innovative capacity being 230 bp.

LLPs Increasing – Expect 2010 Peak at 70 bp

• On a quarterly basis, We expect loan losses in Q1/09 to increase to $1.8 billion or 0.57% of loans (Exhibit 12), which represents a 75% increase from $1,033 million or 0.37% of loans a year earlier and an 18% increase from $1,531 million or 0.48% of loans in the previous quarter. We expect more significant upticks in LLPs from NA since their loss ratios lagged the bank group in 2008.

• We are forecasting LLPs of $8.0 billion or 61 bp of loans in 2009 and $9.7 billion or 70 bp of loans in 2010. We continue to forecast a peak LLP level this cycle of 70 bp, lower than 1982 at 1.00%, 1992 at 1.61%, and 2002 at 0.87%. However, it is important to compare peak LLPs with consideration to the major shifts in loan mix. Our LLP forecasts are based on a bottom-up approach of loan type by bank with credit card loss ratios at 5.0%, unsecured personal loans at 2.0%-3.0%, corporate and commercial at 0.50%-0.75%, CRE at 1.0%, and U.S. CRE Construction at 5.0%. These loss ratios are derived using historical peaks by loan category in conjunction with comparing unemployment levels, non-financial corporate debt levels, single name limits, industry concentration, and equity levels in real estate.

Wealth Management Earnings to Remain Weak

• Wealth management earnings are expected to be weak in Q1/09 and remain lacklustre for most of 2009 due to significant declines in AUM, lower retail brokerage revenue, and a shift into lower-margin money market funds.

• The Canadian bank group’s average mutual fund AUM declined 12% sequentially in the first quarter. AUM declines were largely the result of equity markets declining 35%-40% from a average AUM of 15%, with CM, NA, and TD each declining 12%. RY fared better, with a decline of 11%.

• In addition, money market funds accounted for 25% of total bank AUM as at the end of Q1/09 versus only 17% a year earlier. Although the banks have been the main beneficiaries of inflows into money market funds, the shift in fund mix reduces profitability, as money market funds are lower-margin products.

U.S. & International Banking

• U.S. banking earnings will benefit from the significant depreciation of the Canadian dollar in the first quarter; however, earnings are expected to be depressed due to higher LLPs. The Canadian dollar depreciated (Exhibit 11) an average of 19% versus the U.S. dollar and an average of 10% from the previous quarter. This currency move would result in a positive earnings pickup of 1.4% for the bank group, with TD, RY, and BMO having the greatest exposure to the U.S. dollar.

• We remain concerned about the earnings power of BMO’s, RY’s, and TD’s U.S. subsidiaries. Declining prime rate, increasing cost of deposits, rising loan loss provisions, a weakening U.S. consumer, and competition from government-supported institutions make the U.S. banking environment a difficult one for Canadian banks. We expect U.S. and international banking platforms to underperform for the bulk of 2009 and 2010.

Wholesale Earnings to Improve

• Wholesale earnings are expected to improve in Q1/09 due to the widening of wholesale spreads, high volume of activity in secondary financing, the demise of U.S. competition, slight improvement in credit markets, and a typical seasonal high in trading revenue in the first quarter.

• Underwriting and advisory fees are expected to be very strong, as secondary financing increased 18% from a very strong Q1/08 and increased fivefold from the previous quarter. There was also a slight pickup in IPO activity after a benign Q4/08. M&A activity remained weak this quarter as the value of closed and pending deals in the quarter declined 76%.

• Trading revenue and brokerage commissions are expected to be strong, as TSX trading volume improved from a year earlier by 33% due to extreme volatility in equity markets in what is traditionally a seasonally high quarter for trading revenues.

First Quarter Highlights

• Bank of Montreal is expected to report operating earnings of $1.26 per share versus $1.21 per share a year earlier, an increase of 4% YOY and 6% sequentially. Reported earnings are expected to be $1.02 per share including an estimated $200 million ($130 million after-tax or $0.24 per share) in writedowns on U.S. conduit – Fairway. We expect Canadian P&C earnings growth momentum to continue to improve in Q1/09 and U.S. P&C earnings to continue to underperform. Wealth Management earnings are expected to be extremely weak, driven by large declines in AUM. Wholesale earnings are expected to improve due to a pickup in capital markets activity.

• Canadian Imperial Bank of Commerce is expected to report operating earnings of $1.59 per share, a decline of 21% YOY and an increase of 1% sequentially. Reported earnings are expected to be $1.25 per share including an estimated $200 million ($130 million after-tax or $0.34 per share) in writedowns on the bank’s collateralized loan obligations (CLOs) and U.S. residential mortgage market (RMM) portfolio. We expect wholesale earnings to improve sequentially due to an increase in capital markets activity but to be down YOY due to the bank’s shift towards a more risk-averse strategy. Retail banking earnings are expected to be under pressure as a result of margin compression and increased loan loss provisions. Revenue growth is expected to remain a challenge.

• National Bank is expected to report operating earnings of $1.25 per share in the first quarter, a decline of 14% YOY and 8% from the previous quarter. Reported earnings are expected to be $0.84 per share including an estimated $100 million ($65 million after-tax or $0.41 per share) in writedowns on $248 million of loan commitments (sub-prime with no recourse) on non-bank ABCP ineligible under the Montreal Accord. NA also has $828 million (no sub-prime with recourse for first 30%) in loan commitments for non-bank ABCP eligible under the Montreal Accord. We expect Retail and Wealth Management earnings to be flat YOY and wholesale banking earnings to improve slightly. Trading revenue, which has been surprisingly strong, near record levels over the past few quarters, may continue to be supportive to earnings. We expect loan loss provisions to increase.

• Royal Bank is expected to report operating earnings of $1.04 per share, a decline of 7% from a year earlier, but an increase of 3% quarter over quarter (QOQ). Reported earnings are expected to be $0.99 per share including an estimated $100 million ($65 million after-tax or $0.05 per share) in writedowns on the bank’s bank-owned life insurance (BOLI) and trading securities. Solid earnings growth is expected from RY’s Retail and Insurance platforms, despite a projected increase in loan loss provisions. Wealth Management is expected to be weak this quarter due to the equity market sell-off. We expect RBC Capital Markets earnings to improve due to the increase in capital markets activity. U.S. and International earnings are expected to remain weak due to continued high loan loss provisions and difficult operating environment.

• Toronto-Dominion Bank is expected to report operating earnings of $1.14 per share, a decline of 21% YOY and 7% sequentially. Reported earnings are expected to be $1.07 per share including an estimated $100 million ($65 million after-tax or $0.08 per share) in writedowns on the bank’s credit trading book. Retail earnings momentum is expected to slow due to margin compression and increase in loan loss provisions. Domestic wealth management earnings are expected to be weak. TD Ameritrade is expected to contribute C$77 million or C$0.09 per share versus C$0.07 per share in the previous quarter and C$0.12 per share a year earlier. U.S. P&C Banking earnings are expected to be under pressure due to a difficult operating environment and an increase in loan loss provisions. Wholesale earnings are expected to improve, although recently have represented only 10% of TD Bank’s total earnings.
Financial Post, Eoin Callan, 19 February 2009

Canadian banks face a steady erosion of their profitability in the coming months as the economy slows and more loans go bad, according to Brad Smith at Blackmont Capital.

“Given the rapid pace of deterioration in North American employment and the anticipated knock-on effect on credit performance, we are compelled to again reduce our expectations for near-term earnings for Canada’s major banks,” said the analyst.

The warning comes after a precipitous decline in Canadian bank shares, which have slid about 40 per cent in the last year amid a crisis in the financial system that has dragged the global economy into recession.

“Notwithstanding the substantial efforts of central bankers and politicians, the economic consequences of the credit dislocation that has prevailed for a now unprecedented 18 months runs the very real risk of being more severe and potentially lasting longer than current consensus expectation,” said Mr. Smith.

Blackmont is anticipating an increase of 15% in funds set aside by Canadian banks to cover credit losses. Mr. Smith has also detected “significant credit deterioration” last quarter at the U.S. affiliates of Canadian banks.

The firm has also diagnosed a slowdown in the growth of lending to consumers, with “aggregate personal and commercial loans outstanding reported by domestic chartered banks declin[ing] $23-billion or 1.8% sequentially in the three months ended December 31, 2008.”

The drop “is assumed to reflect increased securitization volumes as domestic banks availed themselves of the opportunity to sell insured mortgages to the [Canada Mortgage Housing Corporation] through the $75 billion facility established by the government in the fall of 2008,” Mr Smith said in a note to clients. “While upward revisions to cyclical credit provisioning levels contribute the bulk of the earnings estimate decline, roughly 3-4% results from the recent issuance of a raft of preferred, innovative, and common share capital designed to ensure that Canadian banks remain well capitalized relative to many of their global peers,” he added.
Financial Post, Jonathan Ratner, 19 February 2009

Mortgage insurer MBIA Inc.’s announcement on Wednesday that it is separating its traditional municipal business from its more troubled line of insuring structured-finance products serves as a reminder of potential losses at two Canadian banks.

“In reorganizing its corporate structure to improve its ability to continue to write public finance credit insurance, MBIA has necessarily undermined the claims paying ability of its structured finance insurance subsidiary and provided a mechanism that may be replicated by other monoline insurers facing similar loss pressure in their structured finance insurance pools,” said Blackmont Capital analyst Brad Smith in a note to clients.

Based of fourth quarter disclosures, he estimates that a worst case loss potential from direct MBIA credit default swap counterparty exposure for Royal Bank and CIBC could be $2.20 and $2.80 per share, respectively.

While Royal’s monoline exposure is limited, Mr. Smith noted that CIBC has more than $10-billion of net notional exposure to a wide variety of monlines, “many of which continue to struggle under the pressure of their structured finance related CDS exposures.”

Despite what the analyst said is an increased likelihood of a “manageable” writedown of Royal’s remaining MBIA exposure, he maintained a “buy” rating and $42 per share price target on the stock. This is a reflection of Mr. Smith’s view that the bank’s scale and diversity will help it emerge from this stressed environment with new opportunities to resume growth.

However, the higher potential monoline related loss exposure at CIBC had the analyst reiterating a “hold” and $46 price target on the stock.
TD Securities, 18 Feburary 2009

Group suffering under weight of global financial fears. Relative valuations and broad concerns around the health of the global economy and the financial services industry continue to weigh heavily on the group.

Q1 results could offer some respite. We do not think Q1 will be received as poorly as Q4 which saw a number of negative pre-announcements, sizeable write-downs, cautious guidance and rising concerns around capital levels. Trends will still be modest, but the quarter is likely to play much better compared to the on-going challenges seen elsewhere.

Capital levels remain in focus. Look for management to try and control asset growth and hoard internally generated capital. Overall, capital levels look comfortable pro-forma recent issues.

Write-downs likely to be less traumatic. Lower balances and increased accounting flexibility should see smaller write-downs even as markets weaken. There will still be hits and CIBC is still likely to be among the largest.

Credit remains our key focus. We expect credit conditions to continue to deteriorate and credit costs to climb toward cyclical peaks over the coming year. U.S./International exposures are likely to continue to be the most problematic, creating challenges for BMO, BNS and RY.

CIBC our best idea for the times. Expectations are low and write-downs/capital are becoming less of an issue. Meanwhile, the core operating business mix is attractive in our view (85% retail) and is delivering at a respectable pace and the bank’s credit picture looks better than most.
Blackmont Capital

• BMO target price cut to $32 from $36
• CIBC target price cut to $46 from $50
• National Bank target price cut to $37 from $44
• RBC target price cut to $42 from $45
• Scotiabank target price cut to $36 from $40
• TD Bank target price cut to $40 from $63
Financial Post, Jonathan Ratner, 17 February 2009

Bank of Nova Scotia may have avoided problems associated with the mark-to-market and off-balance sheet phase of this cycle, but expectations that it will face more headwinds from the weak credit environment has prompted a downgrade.

BMO Capital Markets analyst Ian de Verteuil reduced his rating on the stock from “market perform” to “underperform” and lowered his price target from $36 to $29. His 2009 and 2010 earnings per share forecasts also fall from $3.45 and $3.95 to $2.60 and $2.35, respectively.

The analyst noted that Bank of Nova Scotia trades at an average price to book value but a premium price-earnings ratio. He told clients this reflects the Street’s confidence that this credit cycle will be different for Scotiabank

18 February 2009

TD Bank Increases Stakes in TD Ameritrade & Internaxx

Asociated Press, 18 February 2009

The family of TD Ameritrade founder Joe Ricketts will sell 34 million of its shares in the online brokerage back to the company in a deal valued at almost $403-million (U.S.) to help finance the family's bid to buy the Chicago Cubs.

Ameritrade announced the stock purchase agreement Wednesday morning before its annual shareholder meeting.

Ameritrade agreed to pay the Ricketts family $11.85 per share. After the transaction, the Ricketts family stake in the company will shrink from about 22 per cent of Ameritrade's stock to about 17.7 per cent.

The Ricketts family will control two seats on Ameritrade's board instead of three after the deal.

Ameritrade said the purchase of the Ricketts' shares will complete its existing planned buyback programs, including the 28 million shares it planned to repurchase as part of its pending acquisition of thinkorswim Group Inc. Ameritrade's shares fell 16 cents to $12.40 in morning trading Wednesday after the announcement.

Last month, the Cubs' owners at Tribune Co. chose to enter exclusive negotiations with the Ricketts family.

“Our family is working to close a deal for the Chicago Cubs, and we are pleased to have reached a mutually beneficial agreement with the company that will help us to do so,” Joe Ricketts said in a statement.

The Ricketts family said last month that its winning bid for the Cubs was worth about $900-million, and it would include Wrigley Field and a 25 per cent interest in a regional sports network. But the family still must reach a final agreement with Tribune, which filed for bankruptcy protection in December.

In addition, a sale must be approved by Major League Baseball team owners.

One of Joe Ricketts' sons, Tom, has represented the family in its bid to buy the Cubs. Tom Ricketts is an Ameritrade board member, and he leads Chicago-based investment bank InCapital LLC.

Ameritrade shareholders will gather in Omaha Wednesday morning to hear the online brokerage's new CEO give an update.

Chief Executive Fred Tomczyk has been leading the Omaha-based company since October. Wednesday's annual meeting will be the first at which he'll preside.

Ameritrade has avoided most of the problems that plagued other financial services companies, because it didn't invest in U.S. subprime mortgages.

But the recession prompted Ameritrade to announce plans in January to cut $60-million in expenses. The brokerage predicted that its 2009 earnings will end up between 90 cents and $1.15 per share.

Ameritrade said Tuesday that it handled an average of 306,000 trades per day during January. That was 8 per cent from the 346,000 trades a day Ameritrade handled last January, but it was up 1 per cent from December.

Last month, Ameritrade announced plans to buy options trading specialist thinkorswim Group Inc. in a cash and stock deal worth roughly $606-million. Ameritrade officials said the thinkorswim deal, which is expected to close within six months, will strengthen the brokerage's trading business and add better tools for advanced options trades.

The shareholders meeting features only routine votes on electing five directors and choosing an auditor.
Bloomberg, Sean B. Pasternak, 17 Feburary 2009

Toronto-Dominion Bank, Canada’s second-largest bank by assets, agreed to increase its stake in Internaxx Bank to 75 percent to expand its online brokerage business in Europe.

Toronto-Dominion previously owned 25 percent of Luxembourg- based Internaxx, the Toronto-based bank said today in a statement. BGL, a lender in Luxembourg, will keep a minority stake. The price wasn’t disclosed.

13 February 2009

Manulife Q4 2008 Earnings

Scotia Capital, 13 February 2009

Increasing EPS Sensitivity to Equity Markets But Capital is Fine

• Slight EPS miss. An EPS loss of $1.24 versus our $0.84 estimate, consensus of $0.94 and company Q4/08 guidance (December 2, 2008) of a loss of $1.00. A $0.40 EPS charge due to the sharp drop in December in swap interest rates used to value segregated fund liabilities accounted for the bulk of the difference, offset by $0.20 EPS in reserve releases. With swap interest rates back up through December 2, 2008 levels this EPS hit should reverse itself in Q1/09.

• Messy quarter - lots of moving parts, but underlying EPS in the $0.57 range. The 23%-24% drop in equity markets hurt EPS by $1.94, with $0.08 EPS in credit hits, offset by $0.21 in reserve releases. Ex these items EPS is in the $0.57 range, similar to the $0.55 EPS underlying we get from our source of earnings analysis exercise in Exhibit 1. Adding to the confusion was a change in basis for segregated fund reserving from CTE80 to CTE65 (which will be, with no change in actual dollar amount of reserve, more like something above the company's target of balance sheet reserves of CTE70 once a more accurate and OSFI approved method is employed, one which uses corporate rates rather than swaps). It is all just noise. We anticipate MFC will hold seg fund reserves at CTE70 going forward, which, assuming Mar 31, 2009 is exactly the same as it was on Dec 31, 2008, would imply no change in seg fund reserves, no EPS hit, and no change in required capital or MCCSR.

• Increasing sensitivity to equity markets - MFC is becoming more and more of a call on the equity markets. The earnings sensitivity for a 10% decline in equity markets has moved from $840M at Q3/08 ($0.56 in EPS) to $1.6B at Q4/08 ($0.99 in EPS). This assumes a CTE70 level is maintained. We noticed the same relative increase for the other lifecos. SLF upped its sensitivity from a $0.40 EPS to a $0.49-$0.62 EPS range, and that assumes the CTE is lowered from its current CTE75 level, so the sensitivity would be more if the CTE was assumed to be frozen like in MFC's case. GWO upped its sensitivity to a 10% equity market decrease from $0.08 in EPS to $0.18 in EPS. We've decrease our estimates for all the lifecos to assume a modest 1%-2% increase in equity markets in 2009, down from a 6%-7% increase. Obviously if/when markets rebound MFC will have the most upside torque.

• Capital remains strong. MCCSR was 233% and RBC of U.S. sub was 400%. A 10% decline in markets hurts MCCSR by 20 points. We estimate the S&P 500 would need to fall to 650 before the company would approach the bottom end of its 180%-200% MCCSR target, and to the mid 500s before it would approach 150%, a level where OSFI might become concerned. Debt-to-total capital is 23%, and if MFC were to be downgraded from Aa1 to Aa2 it would still be at least a notch ahead of most of its peers, and would likely be able to increase its debt-to-total capital ratio to 30%. Moving from 23% to 30% would suggest $3B in debt/preferreds. Each $1B in debt carries about a $0.02 EPS hit, but increases the MCCSR ratio by 11 points, and moves the point at which the company would hit the bottom end of its MCCSR target from 650 to around 600.

• Credit hits just $0.08 in EPS - high asset quality. Just $128 million or $0.08 EPS in credit impairments and downgrades (about half impairments and half downgrades). SLF's EPS hit in this regard was $0.95. Gross unrealized losses on fixed income securities trading below 80% of acquisition cost for more than 6 months was just $998 million or 0.8% of fixed income securities, well less than the corresponding figure for SLF, at 3.0%, and GWO at 1.8%. Lots of detail provided but of note is after-tax exposure to U.K. hybrids, at just $0.21 EPS ($0.08 of which is RBS), and a $5.9B CMBS portfolio (just 3% of invested assets) that is 85% 2005 and prior and all 2006 and later is AAA.

• Once again a very good top line, much better than peer group - franchises remain strong despite the market conditions. Canada individual insurance sales up 2% YOY (peer group down 1%) and up 2% QOQ (peer group down 2%). Canadian individual wealth management sales up 11% YOY (peers down 3%) and 34% QOQ (peers up 1%). U.S. VA down 18% YOY (peers down 37%) and up 11% QOQ (peers down 20%). U.S. individual insurance sales were down 33% YOY over a tough comparable (peers down 16%) but down just 1% QOQ (peers down 2%).
The Globe and Mail, Fabrice Taylor, 13 February 2009

When Dominic D'Alessandro joined Manulife 15 years ago, the company lost its triple-A rating within a month. It took a decade to get it back, and it was during that time that Mr. D'Alessandro cemented his reputation as a world-class chief executive officer, a run capped off by the acquisition of John Hancock.

Now, in essentially his final month with the insurer, Manulife is poised to lose its gold-plated rating again, and Mr. D'Alessandro's once-unassailable reputation is tarnished. Manulife has cost investors a lot of money over the past year. In fact, it's even cost investors money over a five-year period.

It's possible that the damage inflicted on the company's balance sheet will be reversed, or some of it. The company may be more conservative than need be. The stock may well be scraping along the bottom now. Or things could deteriorate. But if the worst is done, Mr. D'Alessandro will sadly be long gone before a redeeming final verdict is in. And because of massive writedowns no one cares that the core business is doing pretty well.

Insurers like Manulife are horridly complex beasts, but Mr. D'Alessandro's troubles have a pretty simple cause: He bet very heavily on positive stock market returns. Manulife sold a lot of products with some type of guaranteed protection, such as segregated funds and variable annuities, on which it would earn a profit if stock markets performed along historical lines.

Unfortunately, the formulas were way too optimistic, in retrospect, and expected profits turned to losses. The charges the company has taken, such as the $3-billion in the latest quarter, mean that Manulife's past earnings were too high, because they were based on stock return assumptions that subsequently came up way short of estimates - and continue to do so.

The upshot is that it has to set aside money to pay the "insurance" on these products, which are massively under water because stock markets have cratered. How deeply submerged? By about $26-billion. Manulife has taken charges of about $5.8-billion to account for that deficit. (If that seems low it's because the liability stretches out a long way into the future, so anything you set aside today will grow with interest such that it will cover off future payments - if the assumptions are right.)

And things could get worse. In fact, they have. Yesterday's results were up to Dec. 31. Since then, the S&P 500 is down about 8 per cent. For every 10-point drop in equity markets, Manulife "loses" $1.6-billion. I put "loses" in quotes because that's a mark-to-market figure that can be reversed if markets do better than expected.

Why is Manulife so exposed to equity markets compared with other insurers? Partly because it heavily flogged the products mentioned above, partly because it didn't hedge its positions. A contrite-sounding Mr. D'Alessandro acknowledged this.

Is the worst over for the business? Probably not. Mr. D'Alessandro joked on yesterday's conference call that incoming CEO Don Guloien would probably want him to handle the next conference call. It was gallows humour.

More serious is a private placement debt portfolio worth more than $26-billion, which has some black-box qualities to it - although the company pledged to shed some light on what's inside. Manulife says it has better credit quality than other insurers. So far yes, but that could change, although executives are insistent that the big portfolio isn't in hot water. And then there's that equity market exposure.

Is the worst over for the shares? Analysts are all over the place, although the stock, by some yardsticks, is looking very cheap historically.

Ultimately the question for investors is whether stocks are at or near their bottom, and to a lesser degree how strongly and quickly will they rebound. If they do so quickly, charges could be reversed and become profits. If not, there's supposedly not much downside since the company insists it's being conservative in its reserves. But if stocks fall, as mentioned, the company's earnings get crushed.

And of course the insurer's financial models will play a big role in determining the outcome. But as Mr. D'Alessandro said about the assumption inherent in accounting for this stuff, "there's no lab where you can assay this and tell if it's 18 carat or 24."

The same goes for his legacy.

Sun Life Q4 2008 Earnings

Scotia Capital, 13 February 2009

• $1.25 EPS loss (ex the $1.48 EPS gain from sale of CI), well below our $0.14 loss estimate and consensus of a $0.10 gain.

What It Means

• 2/3 of miss was due to much higher credit hits than anticipated (total credit hits were $0.95 EPS) and 1/3 of miss wasdue to higher equity market hits than anticipated (total of $1.22 in EPS).

• Credit woes continue - company suggests this could extend well into 2010. In Q3/08 ex LEH/Wamu and AIG credit hits for SLF were $0.25 in EPS, versus about $0.05 for the other Canadian lifecos. In Q4/08 it got worse. Credit hits were $0.95 EPS for SLF, versus $0.08 for MFC and $0.01 for GWO.

• MCCSR is 232%. A 10% decrease in equity markets hurts the MCCSR by just 3 to 5 points, so SLF's capital is fine even if markets fall very significantly.

• SLF upped its sensitivity from a $0.40 EPS to a $0.49-$0.62 EPS range. We've decreased our estimates for all the lifecos to assume a modest 1%-2% increase in equity markets in 2009, down from a 6%-7% increase.
The Globe and Mail, Tara Perkins & Andrew Willis, 13 February 2009

Canada's biggest life insurers are scaling back takeover plans after an ugly quarter that saw their investments hammered.

The big three players in life insurance are still weighing acquisitions, but executives at Manulife Financial Corp., Sun Life Financial Inc. and Great-West Lifeco Inc. are more focused on hunkering down and preserving capital in the wake of fourth-quarter results.

"We are going through some extraordinarily difficult times," said Manulife chief executive officer Dominic D'Alessandro. "We've not seen markets behave like this in 100 years."

The insurers are focusing on their financial cushions and preparing for any trouble on the horizon.

"The theme for our whole industry is to build and maintain a strong capital position," said Sun Life chief executive officer Donald Stewart. Sun Life sees "considerable opportunities for acquisitions," and the price of deals has fallen, but the overall mood is cautious in the wake an unprecedented swoon in debt and equity markets, Mr. Stewart said.

Like Sun Life, Manulife is in the midst of exploring a few specific takeover opportunities. Both firms are expected to bid on small units of American International Group Inc., but not AIG's Asian crown jewels, which they coveted in the past. "It doesn't mean we're still not interested, but our primary focus is on maintaining our capital levels close to where they are," Mr. D'Alessandro said.

"And if we were to undertake M&A activity, it would be financed with capital appropriate not to weaken our overall position," Mr. D'Alessandro added.

As stock markets plunged by more than 20 per cent in the last three months of 2008, Manulife lost $1.87-billion. Sun Life lost $696-million, if a big gain from the sale of its stake in CI Financial Income Fund is factored out, although its final profit came in at $129-million in the quarter. Winnipeg-based Great-West Life lost $907-million after writing down the value of Putnam Investments, the U.S. investment business it bought in 2007, by $1.35-billion.

"Clearly we've got some tough slugging ahead and it's better to be safe than sorry and we're going to look at ways to bolster our capital," Mr. D'Alessandro said in an interview.

"I hope that at some point we'll be able to report to you that the tide has turned, and we're regaining or we're stopping the bleeding at least, and the strength of the franchise and our businesses will become apparent to you once again," Mr. D'Alessandro, who is scheduled to retire in May, told analysts on a conference call.

"Our facts are that our contracts are under water by about $26-billion," he said of Manulife's troubled variable annuity and segregated funds business.

Plunging stock markets have caused a shortfall in the amount of money the insurer has invested for payments that are due to be made to customers decades from now.

As a result, it is having to sock away billions of dollars, although it can release the reserves in the future if markets improve.

The situation overshadowed Manulife's underlying operating results, which executives say are among the best ever.

"Virtually every other measure of our operating success would indicate that this is one of our best years, but for that theoretical charge associated with the market," Manulife chief investment officer Don Guloien, who will succeed Mr. D'Alessandro in May, said in an interview.

"We've written a hell of a lot of profitable new business," Mr. D'Alessandro said.

During a conference call with analysts, Mr. Stewart faced criticism of the insurer's risk management skills, and the dependability of its dividend. His response was to point to Sun Life's strong balance sheet and explain: "While the dollar values [of the losses] are large, so too is the magnitude of the economic events we have experienced."

Great-West chief executive officer Allen Loney said that despite the writedown on Putnam, the company plans to keep expanding its U.S. wealth management division, but growth in that sector will likely slow.

"Our core continuing operations performed well, especially considering the global economic environment," Mr. Loney said.

Great-West Lifeco Q4 2008 Earnings

Scotia Capital, 13 February 2009

• EPS of $0.59 beat our $0.54 estimate (consensus at $0.49), ex a $1.51 goodwill hit and $0.08 EPS in other Putnam-related items (restructuring charges and income tax valuation allowance).

What It Means

• GWO continues its track record of posting results essentially in line. Always encouraging, especially in these markets.

• A $1.51 EPS goodwill hit (essentially all of the $900 million in goodwill plus 35% of $2.5B in intangibles) of this size was somewhat of a surprise. Outside of the charge Putnam results were poor with margins at negative 12%. No doubt these unprecedented markets have hurt Putnam, and long-term sustainable growth at Putnam will take some time, despite the significant changes to investment management personnel, processes, and product.

• No material equity market issues and no capital issues. No credit issues in quarter - but $0.77 in after-tax exposure to U.K. Banks Tier 1 and upper Tier 2 (SLF had $0.50 after-tax exposure and MFC had $0.10).

• Fundamentals good outside of Putnam.

Bank Dividend Cuts Unlikely, but Risk Remains

Financial Post, Jonathan Ratner, 13 February 2009

Nobody wants to say it will happen, because it probably won’t. But given what we’ve seen in the U.S. banking sector and elsewhere in the world, the prospect of dividend cuts for Canadian banks continue to weigh on investors minds as the economic uncertainty persists.

Plunging share prices have pushed dividend yields for Canadian bank stocks to their highest level in 24 years. At 6.8%, the last time they were this high was in June 1984, when yields climbed to 7.0%. However, bond yields were 13.8% back then, versus just 2.9% today.

So while the Big 5 Canadian banks have not made a dividend cut since World War II in 1942 and before that the Great Depression in the 1930s, climbing yields have looking at what might force them to make such reductions.

UBS analyst Peter Rozenberg continues to project surplus capital generation even with peak provisions for credit losses (PCLs). However, he thinks an extended period of very low earnings or unexpected government intervention could have a negative impact on dividends.

A weaker economy could push PCLs higher than expected. Assuming they climb to a similar level to the 1992 peak, which Mr. Rozenberg does not expect, profits could decline an estimated 27% to 33%. This would result in “moderately high” dividend payouts of 76% versus 52% currently. Banks target a range of 40% to 50%.

However, the analyst said historically low corporate leverage, average consumer debt service and lower exposure for both the sector and individual names, make peak PCLs unlikely.

Current dividend payouts combined with a 10.1% Tier 1 capital ratio suggest lower dividends are not on the horizon, Mr. Rozenberg told clients. However, higher potential payouts mean the risk remains.

He suggested that Toronto-Dominion Bank appears to be least vulnerable to a dividend cut and Bank of Montreal the most at risk. Meanwhile, Mr. Rozenberg does not anticipate any dividend increases in fiscal 2009.

“Concerns regarding higher PCLs and implied equity dilution continue to weigh on global sector valuations,” the analyst said. ”However, we think valuations reflect peak PCLs and we continue to expect Canadian banks to outperform.”
The Globe and Mail, David Parkinson, 13 February 2009

The rich dividends at Canada's big banks look safe, but further substantial erosion in the banks' earnings base would put those dividends at risk this year, UBS Securities Canada Inc. said Friday.

In a new report, UBS banks analyst Peter Rozenberg noted that the banks' current dividends represent a ratio of 52 per cent of forecast fiscal 2009 net income – not far off the banks' typical payout targets of 40 to 50 per cent. But he said the threat of rising loan-loss provisions could drive earnings below current projections, which would raise those payout ratios well above the banks' comfort levels and potentially convince some of them to trim their dividends.

For example, if earnings were to come in 10 per cent below current forecasts, the payout ratio for the major banks would rise to 59 per cent. At a 20-per-cent earnings reduction, the ratio would be 66 per cent; at a 30-per-cent earnings decline, the ratio would jump to 76 per cent.

He said, though, that even this might not be enough to trigger dividend cuts, if they considered the rising ratios to be a short-term phenomenon.

"While this would be outside of the banks' targeted range … management would likely consider its dividend policy and capital requirements over the medium term.”

Most at risk, Mr. Rozenberg said, is Bank of Montreal, whose payout ratio already stands at 68 per cent based on the current consensus fiscal 2009 earnings forecast. If earnings came in at 30 per cent below that forecast, BMO would be looking at a dangerously high payout ratio of 97 per cent.

The bank least at risk, he said, is Toronto-Dominion Bank, whose payout ratio would still only be 65 per cent even with a 30-per-cent drop in projected profits.

But even if you take seriously the risk of a 30-per-cent undershoot of profits, it doesn't necessarily follow that you should sell Canadian bank stocks. Mr. Rozenberg noted that at current stock prices, the market has essentially already priced in such an earnings erosion this year. And he considers that such a decline would represent loan-loss-provision peaks that he considers “unlikely.”

12 February 2009

RBC CM: Still Too Early to Buy Banks

RBC Capital Markets, 12 February 2009

We are lowering our estimated 2009 EPS by a median of 7% based primarily on higher retail loan loss expectations, and reiterating our message that it is still too early to buy Canadian bank shares.

• The reason for our greater concern since we last updated our loan loss forecasts (in early December) is that the Canadian employment reports that have come out since have been much more negative than anticipated.

• We have lowered our 2009E EPS estimates by a median of 7%, and they are now 11% below consensus estimates.

• While we have high conviction that loan losses will rise and that the street's EPS estimates need to be revised down, we also have high conviction that the banks are in better shape to go through a credit cycle than in the early 1990s, given their higher capital positions and reduced exposure to lending in general (and particularly to business lending).

We continue to believe that it is too early to buy Canadian bank stocks based on: 1) valuations that are not overly cheap on a historical basis considering the economic environment we think the banks will face, 2) our expectation for continued pressure on profitability due to both a slowing economy and credit/funding markets that remain challenged, and 3) our belief that the street needs to lower its profitability estimates.

For investors that need to be in Canadian banks, we favour the shares of:

• National Bank - less exposure to Ontario and the U.S., cleaner securities book and off-balance sheet exposures, and valuation at the low end of the group;

• Royal Bank - capital strength, strong core earnings base and headline risk that we believe is better reflected in valuation than for some peers.
Financial Post, Eoin Callan, 11 February 2009

Bay Street is likely to suffer less than Wall Street as global economic conditions worsen and international banks continue to grapple with bad loans and toxic assets, according to UBS. Researchers at the Swiss bank “expect Canadian banks to continue to outperform their global peers given superior asset quality, capital, liquidity, and return on equity.”

While shares in U.S. and Canadian banks both hit historical lows in January, UBS points out that Bay Street banks have suffered a 38% fall while Wall Street bank stocks have fallen 66%.

Researchers at the investment bank say they “remain negative on the outlook for global banks due to a weaker economy,” but see less risk lurking in the books of Canadian banks.

“Exposure to high risk toxic assets is fundamentally lower in Canada,” according to the UBS team.

The researchers also point to several other key metrics that indicate a healthier banking system, including more stringent underwriting standards for home loans. The bank points out that Canadian banks are less leveraged than international peers, with a “a low loan-to-deposit ratio of 78% versus 83% in the U.S., 96% in the U.K.”.

In particular, the bank argues investors should not use the same conservative metrics to evaluate the riskiness of Canadian banks that are in vogue for measuring U.S. banks. U.S. investors have been increasingly ignoring measures of banks’ capital reserves that are based on elaborate systems of risk-weighting arrived at by executives and regulators.

Instead, they have been stripping balance sheets down to so-called tangible common equity, because “all assets have become more risky in this environment”, making “risk weightings less reliable, according to UBS.

Using this risk-averse metric, Canadian banks look significantly less well capitalised. But UBS argues this is misleading. It points to a number of conditions in Canada that, including strong earnings flows.

“We think that earnings are the most important cushion for credit losses,” the researchers say, adding: “therefore their implicit pro forma capital levels are higher than their US peers regardless of what number is used.”
Financial Post, David Pett, 9 February 2009

Investors will likely be pleased with upcoming first quarter bank earnings, but according to one of the Street’s more pessimistic onlookers, the results may only represent a temporary calm before the storm, which has ripped apart the sector these past eighteen months, blows wild once again.

“The first quarter’s earnings should be reasonably benign, which in this environment may be viewed as a huge positive,” said John Aiken, analyst at Dundee Capital Markets. “That said, we believe that the first quarter will likely be a near-term anomaly.”

The analyst said the banks as a group should benefit in Q1 from stable net interest margins, strong capital markets revenues due to numerous financial services
secondary offerings, and credit quality that, “whild still deteriorating, has yet to fall off the cliff.”

Unfortunately, Mr. Aiken thinks it is just a matter of time until credit quality does in fact fall off a cliff, and predicts the second half of 2009 will see accelerating loan loss provision growth.

In addition, he said recessionary headwinds will put future earnings to the test and fuel concerns about the banks’capital strength and also whether dividend payout ratios can be sustained.

“Thus we maintain that the challeging environment will carry on in the near term, and reiterate our cautionary stance on the sector to focus on downside protection until the full extent of credit deterioration can be better assessed,” he wrote.

In the meantime, Mr. Aiken upgraded his ratings on Bank of Nova Scotia, Toronto-Dominion Bank and Royal Bank of Canada from “sell” to “neutral.” Given their depressed values, he thinks all three banks can benefit near term from a stable first quarter.

The analyst continues to rate Canadian Imperial Bank of Commerce and Bank of Montreal “sell” and National Bank of Canada a “buy.”

07 February 2009

Barron's on Scotiabank

Barron's, Vito J. Racanelli, 7 February 2009

A Canadian Bank Plays It Safe…and Smart

During each ephemeral rally in financial stocks, hope springs anew for U.S. banks, whose shares keep getting battered. Investors pore over the same, ever-cheaper names, hoping to discover a diamond under the TARP -- the Troubled Asset Relief Program. Yet most of these banks seem to suffer similar afflictions: exposure to a decomposing economy; tens of billions in "toxic-asset" write-downs, with more to come; dividends cut or eliminated; and the need for huge capital infusions.

North of the border, however, there's a nice alternative: Toronto-based Bank of Nova Scotia, a big lender mostly free of the woes afflicting its U.S. peers. Scotiabank, as it's called, is Canada's third-biggest bank by assets, but isn't as well known as its similarly sized red, white and blue cousins. BNS, with a market capitalization of U.S. $25 billion, didn't leverage up the way American banks did, and sports a strong capital base, with a Tier 1 ratio of 9.3%. [The ratio, which measures shareholders' equity plus preferred stock as a percentage of total assets, reflects balance-sheet strength.] BNS also has a solid domestic-banking business, a 6.4% dividend yield, and a diversified geographic base.

What BNS lacks is even more attractive: Among big Canadian banks, it's the least exposed to assets south of the border, with no U.S. subprime residential debt. It doesn't need billions in government aid to survive, and won't have to take huge write-downs on exotic instruments gone bad. Thus, it should sail relatively smoothly through today's choppy seas, and shine when the global economy rebounds.

It doesn't hurt that the bank is tight-fisted and old-fashioned, and has boosted its earnings and dividends consistently for more than a decade, in part from traditional loans. Even without much of a pickup in lending, its Toronto-traded shares could generate a total return of 20% to 25% in next 24 to 30 months, rising to 36 Canadian dollars from the current C$30. A Canadian buck is worth about 81 U.S. cents. (The bank has American depositary receipts, which trade on the Big Board, also under the ticker symbol BNS .)

Many big U.S. banks have taken charges in the tens of billions of dollars on bad investments such as collateralized debt obligations (CDOs) tied to subprime mortgages. Markets fear that billions more are on the way. In comparison, Scotiabank charged off $822 million of soured assets, after tax -- mostly stemming from the Lehman Brothers bankruptcy and collateralized-debt obligations unrelated to subprime mortgages -- in the fiscal year ended October 2008. Charge-offs this year could be of similar magnitude.

Despite the bank's relative health, its shares have slid 45% from their record high of C$54.50, hit in May 2007. "Investors have convinced themselves that a bank is a bank is a bank," says Dom Grestoni, a portfolio manager with QV Investors in Calgary, which owned about 50,000 shares at the end of the third quarter. "Opinions have soured" on BNS because of its international operations, which are mostly in Latin America and contribute about 32% of net income, Grestoni says. (Scotia Capital, BNS's wholesale and investment bank, kicks in another 21%, with a significant portion of that earned outside Canada.) Investors fret that loan losses will rise this year in Mexico, Peru, Chile and other countries, as the global economy worsens.

Jackee Pratt, a fund manager with Toronto-based Mavrix Fund Management, notes that the bank's after-tax loan losses were C$630 million in 2008; she says that they could hit C$1 billion in 2009, though some analysts think the number could be higher. Even so, Pratt says, this should be counterbalanced by BNS's having avoided the subprime and derivatives write-downs afflicting other banks. Mavrix owns 24,500 Bank of Nova Scotia shares.

Bank of Nova Scotia'S CEO, Rick Waugh, won't be specific, but says there will be a "significant but manageable" increase in loan-loss provisions, which are incorporated into BNS's guidance for earnings per share to rise 7% to 12% in 2009.

Emerging-market economies are slowing, but geographic diversity, along with the quality of loans, contributes to the bank's ability to provide a "secure dividend," he adds. The bank currently pays C$1.92 a share.

Its global reach should help BNS shine in an economic recovery, particularly because some of its markets are under-penetrated. "Having that diversity is not a bad thing long-term, and it's certainly better than being in the U.S.," says Peter Jackson, a portfolio manager at Toronto-based Cumberland Private Wealth Management, which has about 29,000 BNS shares.

Canada's economy is inextricably linked with that of the U.S., and has slowed appreciably. It, too, could soon be in a recession. Yet, the Canadian housing market is in far better shape. Moreover, the northern nation's banking industry is much more consolidated than that in the U.S., notes Colum McKinley, a portfolio manager with Sionna Investment Managers in Toronto. There are just five major Canadian banks, and some have direct and significant exposure to the U.S. Only 7% of BNS's loans, however, have been made to American customers.

So far, McKinley adds, BNS's focus on Latin America has played out well and has helped the bank to avoid many of the problems that have emerged in the U.S. There could be a "spillover effect" in emerging markets from weakening commodity prices, but Bank of Nova Scotia is a better relative risk than some of the other Canadian banks, McKinley says. In fact, BNS is the only bank that Sionna rates Overweight. In the longer term, it could pick up share in Latin America at the expense of U.S. competitors.

In the year ended October 2008, BNS derived about 58% of its net income from its Canadian operations and the rest from its international units -- it had a small loss in the U.S. Overall, it posted net profits of C$3.14 billion, or C$3.05 per share. That's down from C$4.05 billion, or C$4.01 in fiscal 2007.

To boost profitability, BNS can cut costs. Waugh expects to ratchet down the bank's productivity ratio -- costs as a percentage of revenue -- to 58% from an already stingy 59%, with such a drop worth "hundreds of millions."

"It has a frugal culture," says Matt McCormick, a portfolio manager at Bahl & Gaynor Investment Counsel, in Cincinnati, which owns about 68,000 shares and has been buying more. "It's low-risk, and one of the few banks we own," he adds.

McCormick fondly recalls an initial visit to meet BNS management: "There was no food spread, and I was asked to share a bottle of water....It's the kind of place that reuses paper clips." McCormick expects the stock to return 20% to 25% in the next two or three years.

"Coming out of this [global recession], BNS has to make up less ground, has no TARP-related restrictions on its activity and doesn't have to reinvent the model," he says. Analysts' expectations of C$3.50 a share this fiscal year are probably still too high in his view, but McCormick figures that BNS can make about C$3 a share, while most big American banks will be in the red.

Mavrix's Pratt puts BNS's real value at roughly C$36 -- 20% above its recent price -- not including dividend returns. Although the bank's 10-year average price/earnings ratio is 13 to 14 times, she thinks it should sell for a more conservative 11 times analysts' fiscal '09 estimates of C$3.25 to C$3.85 a share.

One worry for Scotiabank is its auto-loan exposure of C$15.6 billion. A good chunk -- C$6.6 billion -- is from General Motors Acceptance Corp. (GMAC), "where we took credit enhancements," Waugh notes. That means the loans carry better collateral than normal car loans. Much of the remaining exposure involves consumer-auto loans and lending to car dealers. Although adequately reserved and performing in line with Bank of Nova Scotia's expectations, such assets tend to produce increased provisions during recessions. Yet, Sionna's McKinley thinks that the bank is unlikely to generate "big surprises on the balance sheet and write-downs."

So long as investors hate banks and their shares, Bank of Nova Scotia may continue to trade on emotions. But it is likely to remain nicely profitable -- and profitable enough to cover its lush dividend. When the global economy perks up, BNS will be ahead of the game, and so will its shareholders.

The Bottom Line:

Bank of Nova Scotia's Toronto-listed shares could rise to C$36 in the next two years, from C$30. Meanwhile, investors will be collecting a fat 6%-plus dividend yield.

Financial Post, Jonathan Ratner, 6 February 2009

They may have lost nearly 50% of their market capitalization since the end of May 2007 but Canadian banks continue to outperform their global peers.

The share of Canadian banks in the market capitalization of all the world’s banks hit a 22-year high of 6.2% in January, according to National Bank Financial. Canada is enjoying a sizeable lead on Swiss banks – traditionally considered a safe haven – for the first time since the mid-1990s.

So is it time to reallocate some banking exposure out of Canada? National Bank’s chief economist and strategist Stéfane Marion doesn’t think so.

“In our view, solvency standings coupled with high potential for domestic market share gains still argue for a continued overweight position in Canadian banks,” he told clients.
Financial Post, Eoin Callan, 4 February 2009

Bank of Nova Scotia has emerged during the credit crisis as one of the top 10 most stable banks in the world, according to a global ranking of the financial sector.

Canada's third-largest bank ranks alongside the likes of Berkshire Hathaway, run by celebrated investor Warren Buffett, as one of the steadiest investments for shareholders, according to the report.

The ranking reflects Scotia's efforts to draw on diverse sources of liquidity and develop sophisticated risk management systems that have held up relatively well during one of the worst financial crisis in decades.

The bank's performance has also been more steady to date because it is less exposed to corners of financial system hardest hit by the credit crisis like the wholesale banking markets in New York and London.

Scotia also performs better than its Bay Street rivals in the unique index because it does not have a retail branch network in the economically-weakened United States, and is instead spread more thinly across emerging markets like Latin America.

The ranking is increasingly closely watched because of the premium investors are placing on steady performance amidst extreme volatility in financial markets.

"If two firms have produced the same absolute return to shareholders, the one whose returns are less volatile is ranked higher," according to Oliver Wyman Group, the consultancy that developed the index.

To some extent, Canada's banking sector has not experienced as severe disruptions as the financial systems of other countries because its shareholder base is dominated by large domestic institutional investors seeking steady returns.

Oliver Wyman's forecast for the year ahead for Canada's banking sector is mixed but relatively rosy.

It notes that provisions increased last year for "credit losses and ill-fated structured product exposures" and that net income fell to about US$17-billion from US$22-billion, but added earnings have been "sufficient to maintain dividends and contribute to capital ratios".

But it cautioned that the "deteriorating employment picture will almost certainly lead to an increase in consumer defaults".

Moody's Investors Service Wednesday warned the strength of Canadian credit card portfolios would be tested in the year ahead as an economic downturn "lead[s] to higher delinquency and loss rates."
The Globe and Mail, Fabrce Taylor, 4 February 2009

Tipping the scales at an average 172 pages, a big-bank annual report is no cure for narcolepsy, but it might be cause for head trauma. I don't mean the damage done as your head bounces off the desk every time you doze off, although that hurts. I mean the brain-numbing effort of trying to understand what you're reading.

Banking sounds like a simple business: Borrow low, lend high, earn spread. That semblance of simplicity is rattled when you cast your eyes on the financial statements.

It's shattered when you venture into the notes. As investors we're always told to buy what we know. Do we really know with banks? Doubtful. We just have to buy their shares on a great leap of faith.

Take Royal Bank's balance sheet (you could take any one of them. This choice is random): The first line item on the asset side of the ledger is "cash and due from banks." That's pretty straightforward, as is "interest-bearing deposits with banks." The next item: "Assets purchased under reverse purchase agreements and securities borrowed." It's that "securities" item that is troubling. There are two kinds: "Trading" and "available for sale." Together they add up to $170-billion. So what are these "securities?"

For clarity, we turn to Note 3. I'd quote it but it's several pages long (and there are even notes to the notes). Let's just say that in the trading account, there are lots of government bonds, Canadian, U.S. and OECD. No major red flags there.

You'll also find some asset-backed and mortgage-backed securities - a little more complex but small in numbers, so, uh, not to worry. Equities? $42-billion of those, or a third of the portfolio. There's no breakdown. I'd like to know how much is the shares of other Big Five banks, but I'm more curious about the $39-billion "other" category.

I didn't find much clarity on that subject, mainly because I was distracted by another "other" category of assets on the balance sheet, which includes, among other things, $136-billion worth of derivatives. That sounds like a lot, about four times shareholders equity. It seems like a lot compared with last year too, when the derivatives balance finished the year at roughly half that much.

Off to Note 7 for an explanation. Again, I'd quote but it's four pages long. To summarize, there are a few different kinds of derivatives. Most are on the books to help bank clients hedge some kind of risk, it seems. But we also learn that more than $4-billion of the "replacement cost" of derivatives is tied to counterparties who lack investment grade ratings. I assume replacement cost means receivable. But I don't know. It doesn't say.

Finding the notes wanting, I head for the management discussion and analysis for insights into the inner workings of this mighty machine, whose shares I own. Looking for guidance, I found only headaches.

Consider, for instance, this: "The majority of our financial instruments classified as held-for-trading, other than derivatives and financial assets classified as available-for-sale, comprise or relate to actively traded debt and equity securities, which are carried at fair value based on available quoted prices. As few derivatives and financial instruments designated as held-for-trading using the FVO are actively quoted, we rely primarily on internally developed pricing models and established industry standard pricing models, such as Black-Schöles, to determine their fair value."

So it sounds like some of these assets are carried on the books at prices that may not be realistic; perhaps too high, perhaps too low. How much? About $20-billion of the bank's financial assets that are measured at fair value are done so using what are called "pricing models with significant unobservable market parameters," which, if I'm following, means there's nothing close to a market quote for them. Sadly, the bank's fair value liabilities appear to have much more accurate valuations.

I could go on but you get the picture. Or not. In any case, don't feel bad. Bank analysts far smarter than us probably don't have a total understanding of this mystery meat. Neither do most professional investors. And bank directors? I'll let you decide.
Reuters, 3 February 2009

Bank of Nova Scotia has again expanded its international presence by doubling its stake in a Thai bank for about $270 million, Canada's third-largest bank said on Tuesday.

Scotiabank said it has acquired an additional 24 percent stake in Thailand's Thanachart Bank, a subsidiary of Thanachart Capital .

That raises Scotiabank's stake to 49 percent, up from 24.98 percent, in Thailand's eighth-largest bank by assets and leading auto-finance lender.

Currently, Thanachart Capital Public Company Ltd is the largest shareholder of Thanachart Bank with a 50.9 percent interest. Retail investors hold the remaining 0.1 per cent.

"The Thai market has solid fundamentals with good long-term growth prospects. Scotiabank's increased investment in Thanachart Bank is a great opportunity for us to capitalize on the strength of the Thai market," Rob Pitfield, group head of international banking at Scotiabank, said in a statement.

The Canadian bank bills itself as the most international of its Canadian peers, with a long-term strategy of operating in some 50 countries around the world. Scotiabank's operations span 11 countries in the Asia-Pacific region, and the company has had a presence in Thailand since it opened a representative office in Bangkok in 1981.

Thanachart Bank plans to open 40 more branches by the end of the year to increase its total network to 255. It will also concentrate on maintaining its market share in automobile financing.

Thanachart Bank said it aims to grow its lending portfolio and step into corporate finance, housing loans, and trade finance.

Scotiabank's increased stake in Thanachart, now at the regulatory limit for foreign banks in Thailand, also gives it a third seat on the Thai bank's board of directors.
Reuters, 2 February 2009

Royal Bank of Canada's chief executive plans to forfeit nearly C$5 million in compensation as the country's biggest bank looks to weather the global financial crisis.

Gord Nixon will forgo his 2008 variable compensation package, made up of deferred share units and 10-year stock options, totaling C$4.95 million. It is part of his mid- and long-term compensation package at RBC.

He received a cash bonus of C$2.4 million in December, part of his short-term incentive package and down 40 percent from the prior year. Nixon said he will use the after-tax proceeds to buy Royal shares.

Nixon had a base salary of C$1.4 million in 2008 and his total direct compensation was listed at C$8.75 million in the proxy circular.

Battered by fallout from the global financial crisis and economic downturn, Royal Bank shares hit their lowest level in more than five years last week, but have since recovered a little. Royal was down 1 percent at C$30.10 on the Toronto Stock Exchange late afternoon on Monday.

"I have confidence in the future performance of Canada and RBC, but feel my decision is appropriate at this time," Nixon said in a statement that accompanied the bank's management proxy circular, adding his move was a "personal" decision.

"I believe as the global economic performance turns around, RBC has significant opportunities, given its strong businesses and relative global strength. And, as its CEO and a significant shareholder, I would benefit from any recovery."

Royal Bank reported more than C$4.5 billion in profit in 2008, though down 17 percent from the year before. Results in the latest quarter were down 15 percent on higher loan loss provisions.

The bank missed on its 2008 target to grow diluted earnings per share and return on equity, but topped expectations on its dividend payout ratio.

Bank of Montreal also announced on Monday that CEO Bill Downe would give up both his mid-term and long-term compensation of C$4.1 million for 2008.

"While BMO delivered solid financial performance in 2008 ... my decision to forgo this compensation is a result of my reflection upon the current economic environment," Downe said in a statement.

The banks said Downe plans to invest his 2008 short-term compensation of C$1.4 million in BMO's share units and common stock.

At Bank of Nova Scotia, CEO Rick Waugh's total compensation was cut to about C$7.5 million, down 20 percent from the previous year and in line with the bank's performance.

Due to the "unprecedented" economic environment last year, several key targets were not met at Scotiabank, including its missed aims for EPS growth and return on equity.

Waugh, the CEO at Canada's third-largest bank, will continue to earn a base salary of C$1 million in fiscal 2009, the circular said.

Canada's banking sector, described as one of the strongest in the world, has endured the financial crisis better than many of its international peers, which have needed massive amounts of government aid.