31 March 2009

Global Bank Regulators Likely to Strengthen Capital Standards Over Time

RBC Capital Markets, 31 March 2009

Global banking regulators are committed to strengthening capital requirements over time.

• The Basel Committee on Banking Supervision put out a press release yesterday providing colour on initiatives banking supervisors might undertake long term in response to the events of the last two years.

• We had highlighted most of these issues in a July 2008 report ("Bank capital ratios high but face pressure"), and do not believe that they have implications for share prices near term.

• The new capital requirements, if implemented, would lead to lower and more stable ROEs for the global banking system versus the pre-crisis model, in our view.

• The impact on Canadian banks is less clear as they already operate under stricter capital constraints than many of their global peers.

Key highlights and some colour:

• Reforms would be phased in over time as regulators do not want to further disrupt the banking system in the near term.

• Supervisors want to increase how much capital is in the global banking system AND the quality of the capital. All else equal, this has negative implications for ROE.

• Canadian banks already operate under higher minimum capital requirements than most of the rest of the world, and must have more of their capital as common equity than most of the rest of the world.

• Specific areas to be addressed for higher capital requirements include securitization activities and trading books. Higher capital requirements have negative implications for ROEs.

• The Committee wants to introduce a non-risk based measure to supplement risk-weighted approaches such as Tier 1. In other words, a non-risk adjusted leverage constraint would keep banks from putting on outsized balance sheet leverage on the premise that the assets are low risk but then finding out that they are not low risk, which is what got many European banks in trouble.

• Canadian banks already operate with a leverage constraint – not just risk-based ratios.

• The Committee is spending more time on banks' liquidity management practices. More cautious liquidity management generally leads to greater holdings of cash and short term securities and/or more holdings of Government securities, both of which are detrimental to margins in our view.

• Other areas of potential interest to bank investors that are addressed in the release (which can be found on http://www.bis.org/review/r090330a.pdf ) include pro-cyclicality, transparency and supervision process.
Bloomberg, Doug Alexander, 31 March 2009

The Group of 20 countries may agree to impose tighter lending limits on banks when they meet this week in London, said Royal Bank of Canada Chief Executive Officer Gordon Nixon.

“Coming out of this, you will have global standards which will place leverage tests across financial institutions,” Nixon said in an interview today in New York. “That’s a good thing.”

U.S. President Barack Obama and his G-20 counterparts aim to merge their national plans’ strengthened regulation into a united front to rein in hedge funds, derivatives trading and excessive risk-taking by financial firms.

Nixon said global leaders may borrow from the Canadian banking model, which limits bank lending to about 20 times their capital base. He said these restrictions have helped Canadian lenders avoid most of the writedowns and credit losses that have buffeted global banks.

“The leverage ratios in Canada, clearly, have proven to be a positive as the asset problems worldwide have spread, simply because we’ve had a little less leverage on our balance sheets.”

The country’s six biggest lenders reported less than C$20 billion ($15.9 billion) in debt-related writedowns since the credit crisis began in 2007, about 2 percent of the $914 billion recorded by banks and brokerages worldwide.

Canada’s government may adopt a G-20 recommendation to revamp the country’s financial system regulation. The banks are regulated by the Office of the Superintendent of Financial Institutions, or OSFI.

Nixon said he doesn’t expect the central bank to take on the role of regulating the nation’s banks.

“There’s almost been this impression that the Bank of Canada is going to be a ‘super regulator’ of financial institutions and banks and displace a lot of activities” of the regulators, Nixon said. “I don’t think that’s the case at all.”
The Canadian Press, 31 March 2009

Amid a sinking economy and a crash in the car business, the chief executive of the Bank of Nova Scotia continues to exude confidence about his bank and the Canadian banking sector as a whole.

"We are maintaining our 2009 targets, which are going to be challenging but provide for growth," Rick Waugh told a financial services conference Tuesday.

"The operating businesses are performing satisfactorily."

Scotiabank has become the seventh-largest bank in North America – courtesy of the shrivelling of big American competitors – and the banking sector in Canada "is still in fine shape," he said.

"We are starting to see repricing in our asset portfolios," and first-quarter earnings were held flat by higher costs of funding, he added, but corporate lending is "in better shape than in previous downturns."

"We do expect, obviously, our loan losses to increase," but ``taking risk is part of our business, it's part of our cost, and it's built into our spread."

With revenue flows "less predictable," Waugh said, Scotiabank is maintaining stringent risk management and putting greater emphasis on cost control.

"We have cut back substantially our travelling and our marketing; we are slowing down what I call our non-critical projects, and we have also slowed down our new branch openings, both here in Canada and internationally," he said.

"This does not mean, though, we're going to stop looking to the future; we're not going to stop looking at what we can do in terms of growth initiatives," in particular in wealth management and international operations.

And "we don't have to do the slash and burn" that other banks and other industries are enduring.

Canadian banks as a group entered the global downturn with the most solid balance of loans to core capital in the world – their Tier 1 ratios were nine to 10 per cent, above the Canadian regulatory minimum of seven per cent and far above the four per cent ratios at many global peers – and Waugh said Scotiabank's loan book has become more conservative in recent years.

Corporate and commercial loans amount to 45 per cent of the total portfolio, down from 55 per cent in 2000. And within the retail portfolio, residential mortgages now represent 75 per cent of assets, up from half.

Asked about exposure to the troubled automotive sector, Waugh said, "We are an auto bank – it's been a great business for us over many decades," and he predicted that "like houses, people will buy cars."

He said Scotiabank's loans to automakers are minimal, with its main exposure being to individual car buyers, parts suppliers and auto dealers.

On the positive side, he said, parts makers "have been under pressure for a long time" and most have built their businesses beyond the Detroit Three to Japanese and other customers, while dealers in Canada generally carry multiple car lines.

Scotiabank's strategy is "being there for customers who want to drive a car," and "that market its looking very attractive to us" as non-bank competitors fall by the wayside.

In the vehicle segment as a whole, "I think we're in the end game, and that's dealing with the legacy issues that are in the three big (U.S.-based) manufacturers."

Overall, the economy is likely to start reviving by the end of this year, though "there's lots of people who've got lots of different views and I respect them all," Waugh said.

"When we come out of this crisis – and we will, crises do end ... I see ourselves in a great position to maximize what I think will be some outstanding opportunities."
The Toronto Star, Rita Trichur, 31 March 2009

Canada's slumping economy, including escalating job losses and personal bankruptcies, is weighing on consumer lending at major banks.

Industry executives told a financial services conference in Montreal today that more cracks are appearing in credit-card lending. Faced with higher loss rates, banks are moving swiftly to mitigate their risks by stepping up collections and cutting credit limits to high-risk clients.

Confirmation that more consumers are falling behind, though, is bound to fuel the debate on whether the federal government should step in and regulate the credit card industry.

Canadian Imperial Bank of Commerce, which administers Canada's largest credit card portfolio, is accepting fewer new clients and is keeping a watchful eye on existing accounts.

Sonia Baxendale, head of CIBC's retail operations, said higher unemployment and bankruptcy rates prompted the bank's proactive stance.

"While the overall industry growth rates have slowed, we have intentionally reduced our growth faster and deeper than our competitors in light of our size and economic uncertainty," she said.

CIBC began curbing credit-card lending during the second half of fiscal 2008 and will remain prudent this year.

"Collection activities have increased and so we're managing our collection processes differently," Baxendale said.

"(We are) monitoring our accounts earlier and ensuring that we get to our clients and either assist them in other ways of managing their credit ... or simply reducing the available credit where we feel that is absolutely necessary."

Robert Sedran, the conference's host and an analyst with National Bank Financial, said the industry's credit-card loss rates already appear to be outpacing levels recorded in previous recessions. "Already, where we are seems to be worse," he said.

Baxendale, however, said CIBC's loss rates are matching those of previous downturns. Nonetheless, she conceded the sputtering economy is impacting other aspects of the bank's loan book. Mortgage lending has slowed amid the cooling housing market, while more consumers appear to be relying on their personal lines of credit.

"We are seeing the natural draw down of lines of credit authorized over the past two years," she said. "Our average authorized line of credit to home value is approximately 60 per cent and we continue to see well below 50 per cent of the total available facilities being utilized."

The Bank of Montreal is also taking action to limit loan losses, said Frank Techar, head of personal and commercial banking.

"We've maintained conservative underwriting practices over the years and over the last 12 months we've made targeted adjustments to lending strategies to ensure our underwriting is appropriate given the environment," he said.

BMO has increased staff in its collection department and its proactively identifying "high-risk" accounts.

"The consumer loss ratio is rising but it is expected to remain within historic loss," Techar said. While credit-card losses are certainly picking up pace, BMO's losses are less severe than those of other banks.

"In fact, for the last three months that data is available, we are 100 basis points better than the average for the Canadian banks for credit-card loss," Techar said.

"We're ready to do everything we can for our customers that are in distress to get them back on their feet."

The Bank of Nova Scotia, meanwhile, is tightening up its overall risk management strategy and cutting back on expenses. That involves "countless stress testing" in numerous portfolios and slowing down new branch openings.

Despite those measures, Scotiabank's overall loan losses are expected to increase this year, conceded chief executive officer Rick Waugh. "They have to reflect the realities of this market."

Those market conditions, however are looking increasingly grim. Mounting job losses pushed the national unemployment rate to 7.7 per cent in February and some economists believe it could climb as high as 10 per cent before the economy rebounds.

Those shrinking payrolls are also fuelling an increase in consumer bankruptcies. According to the Office of the Superintendent of Bankruptcy, there were 7,944 consumer bankruptcies in January, almost 22 per cent more than a year earlier.

Against that backdrop, Ottawa is facing growing pressure to regulate the credit card industry. A Senate committee is holding hearings again this week on that topic and the NDP is signalling plans to introduce a consumer bill of rights.

"While banks and credit card companies are entitled to earn a fair profit, it shouldn't be generated by ripping off consumers and forcing them into accepting higher interest rates and inexplicable fees," said NDP consumer critic Glenn Thibeault in a release last week.

Credit card companies, however, are warning that heavy-handed regulation in the credit and debit markets will stifle innovation and consumer choice. Yesterday, Tim Wilson, head of Visa Canada, told a Toronto business audience that government regulation would ultimately hurt consumers by limiting competition.

30 March 2009

PM Tells Canada’s Banks to Expand Abroad

Financial Times, Julie MacIntosh, Francesco Guerrera and Bernard Simon in New York, 30 March 2009

Canada’s banks should capitalise on the relative strength of their balance sheets by acquiring assets in the US and other countries, Stephen Harper, Canada’s prime minister, told the Financial Times on Monday.

Canada’s leading banks have stayed profitable and maintained dividends throughout the collapse of financial markets in other developed countries. Five of them – Royal Bank of Canada, Toronto-Dominion, Bank of Nova Scotia, Bank of Montreal, and Canadian Imperial Bank of Commerce – now rank among the 50 largest banks in the world.

Mergers between struggling global banks have been scarce, aside from those forced by governments, because few institutions have stayed strong enough to position themselves as buyers.

Mr Harper indicated Canada’s banks could lead an eventual charge toward consolidation, and said he would support such efforts as “an opportunity for Canada to expand its role in the world financial sector”.

“I’m not going to try running banks, but I hope our banks will see this as an opportunity to build the brand – the country’s brand, their own brand – and to expand their scope and profitability over time,” Mr Harper said. “I can assure you that the steps we’re taking in the financial sector will not be designed to promote greater protectionism.”

Several Canadian banks have a US presence. Toronto-Dominion sold its US TD Waterhouse brokerage operations to Ameritrade in 2006 in exchange for a stake in the new company. It took control of Banknorth in 2007, and bought Commerce Bank in 2008. Bank of Montreal owns Chicago-based Harris.

Mr Harper said he was frustrated some countries had loosened regulations that might have prevented the need for intervention in global banking systems.

“In the name of conservatism or free markets, in some cases, governments ignored very fundamental lessons we knew from history,” he said.

“Canada itself has shown that if you have a reasonable system of regulation, there is no need for governments to be nationalising banks and directing executive compensation and trying to micromanage economic activity,” he said.

“One could say we were over-regulated, but our solution is going to lead to us having the most free-enterprise financial sector in the world. We’re the only one not nationalising or partial-nationalising or de facto nationalising.”

Still, Canadian banking shares have suffered from scepticism over whether banks can maintain their dividends.

The potential for Canada’s banks to suffer a disadvantage against government-supported institutions was a “very real worry” in the short term, Mr Harper said, but not a long-term concern.

“I think in the longer term this government intervention in the final sector, if it’s not unwound, will lead to politicisation of the sector and poor management. I just don’t think government-run or partially run banks are going to be very effective institutions over time.”
Financial Times, Steven Bernard, Jeremy Lemer, Helen Warrell, Cleve Jones, Peter Thal Larsen and Simon Briscoe, 22 March 2009

• Top 20 financial institutions, by market capitalization (U$ billion)

Royal Bank of Canada and Toronto-Dominion Bank – are among only seven institutions worldwide that still retain a Moody’s triple-A credit rating.

Source: http://www.ft.com/cms/s/0/ea450788-1573-11de-b9a9-0000779fd2ac.html

22 March 2009

Race Discrimination Suit Filed Against CIBC in the UK

Financial Times, Megan Murphy, 22 March 2009

A City banker is suing one of Canada’s biggest financial institutions for making him redundant, allegedly because he is not Canadian, in one of the more unusual cases to emerge from the credit crunch.

Achim Beck, a German national, claims that Canadian Imperial Bank of Commerce (CIBC) had a secret policy of favouring “Canada-connected” employees when making job cuts.

The case, due to come before a UK employment tribunal earlier this month, has been delayed by a row over CIBC’s refusal to disclose internal documents that Mr Beck alleges lend support to his claim.

CIBC said his claim was “without merit” and it intended to defend the matter “vigorously”.

Lawyers have been gearing up for a surge in disputes brought by formerly high-earning bankers and traders caught up in cuts across the financial services industry and in the mounting furore over their compensation. A large group of employees at Dresdner Klein­wort, the investment bank taken over by Germany’s Commerzbank, for example, recently instructed solicitors in an escalating row over unpaid bonuses.

Mr Beck, a former managing director within CIBC’s fixed income and currencies division, brought his race discrimination complaint after he was made redundant last May.

He is now fighting to force the disclosure of what a tribunal described as a “smoking gun”– statements from a former senior CIBC executive to the effect that Canadians tend to be “looked after” at the bank and had been promoted or spared redundancy at the expense of non-Canadians.

The employment appeal tribunal has ruled that CIBC must disclose the correspondence, which formed part of a separate grievance brought by another emp­loyee. The bank’s appeal against that decision has pushed back the hearing for the case to September.

Race discrimination cases, like all forms of discrimination complaints, carry the threat of unlimited damages in the UK. For City workers in particular, claims can quickly run in to the millions when loss of earnings is taken into account. Caroline Carter, an employment lawyer at Ashurst, said the big question was whether financial institutions in the current economic climate would still be more likely to settle potentially embarrassing – and expensive – claims, or contest them.

Mr Beck’s complaint is not unprecedented. Australian-born Malcolm Perry brought a £10m claim against Dresdner Kleinwort in 2007 for allegedly treating him less favourably than the bank’s German and German-speaking employees. An employment tribunal rejected his claims after a full hearing.

20 March 2009

TD Bank to Expand Wealth Management Operations in the US

Dow Jones Newswires, Evelyn Juan, 20 March 2009

Toronto-Dominion Bank isn't only expanding its retail-banking and discount-brokerage operations in the U.S. The Canadian bank is also setting its sight on bolstering its wealth-management footprint there.

TD Wealth Management is planning to open a standalone private-client services unit in New York and Philadelphia early next year to expand its operations for serving affluent clients in the U.S, said Bill Hatanaka, head of TD Wealth Management.

The move underscores the bank's plan to capitalize on cross-selling investment products to TD's growing number of retail-banking customers, following TD's acquisition Commerce Bancorp Inc. last year and of Banknorth before that.

"We are working now to establish our wealth-management strategy with our U.S. personal and commercial bank," Hatanaka said. "We think we'll resonate well with our retail partners in the U.S...we can take the retail-bank-branch continuum and move it to the basic investing continuum."

TD has about 150 financial advisers in the U.S. who are spread across its retail bank branches, or in standalone trust offices, or trust and investment offices throughout the eastern U.S.

Out of TD Wealth Management's C$170 billion in assets under management as of end of January, the U.S. accounts for just C$8 billion, or roughly 4% of the retail brokerage unit's total AUM pie.

"We're in a very early stage of setting up wealth-management capability in the U.S.," Hatanaka said. "The mandate is not to grow the number of financial advisers in the U.S. this year, but to make sure that we set up our initial infrastructure for the U.S. model."

TD's strategy to link wealth management with retail-banking operations isn't a foreign concept to the Canadian bank. The firm's wealth management's lifeblood has long been tied to its retail-banking operations in Canada, where bankers and advisers have historically been housed under one roof to facilitate cross referral of business. "Every time a retail branch is being built, quite often we put a financial planner in there," Hatanaka said.

In Canada, TD has 650 financial planners who serve mass affluent customers (those with around less than C$500,000 in assets to invest). The wealth-management arm also has 700 investment advisers who cater to affluent and so-called high-net-worth customers (around C$500,000 to C$10 million in assets to invest), and 350 investment counselors or portfolio managers, and other employees who work in its private-client-services unit that caters to ultra-high-net-worth clients (around C$10 million and up in assets).

Average production per investment adviser in TD Wealth management stands at C$700,000, and assets under administration per investment adviser average about C$75 million. Assets under management stood at C$170 billion, and total assets under administration stood at C$163 billion as of end of January at TD Wealth Management.

While TD has found success in capturing clients who are mostly in the process of accumulating wealth, the next focus will be targeting retirees who are leaning towards wealth preservation and transition in Canada and in the U.S. "The preservation and transition zone will be even more important as we go forward in the future," Hatanaka said. "A lot of our resources are being applied in those areas."

In Canada, TD has private-client-services offices that offer trust and estate services, and other type of products and services that are geared more towards wealth preservation and transfer.

TD has also started to create standalone offices for some senior financial planners from the retail bank branches, depending on their years of service, book size and number of clients. "This makes way in the retail branch for a financial planner with a developing book who can better take advantage of the referral system," Hatanaka said.

In terms of recruiting, TD plans to hire 80 net new advisers in Canada, 40 of whom will be investment advisers catering to the affluent and high-net-worth market, while the rest will be financial planners and rookies. In the U.S., TD plans to add 20 advisers for its private-client-services group this year. TD has 15,000 global high-net-worth clients, but wouldn't disclose the total number of clients.

"We have fewer investment advisers," Hatanaka said. "But we're the fastest-growing investment-advisory business in Canada over the last four years."

18 March 2009

Dundee Capital: Long Insurance Cos & Short Banks

Financial Post, Jonathan Ratner, 18 March 2009

Go long on Canadian insurance companies and short on banks. That’s the advice from Dundee Capital Markets stragetist Martin Roberge, who says this recommendation is mostly a valuation call.

“With Canadian banks facing a technical roadblock, and lifecos deeply oversold and undervalued relative to banks, we believe the time has come to initiate a pair trade between the two groups,” he told clients.

Lifecos have deeply underperformed banks over the past six months as concerns about their hedging strategies on segregated funds and guaranteed notes weighed on market sentiment. The group has rebounded more than banks since the March 6 low, but at this stage in the stock market rally, Mr. Roberge believes that lifecos offer more upside potential – or lower downside risk.

If we are in fact past the worst point in the financial crisis, the strategist insists lifecos are too cheap relative to banks. He points out that lifecos trade at a 30% discount to banks on a price-to-book value basis. The lifeco group also has a higher dividend yield than banks for the first time in history.

“The last time that such depressed valuation metrics were seen was prior to the 2001 recession when investors became concerned about the economy,” Mr. Roberge said.

From a technical perspective, he noted that the Canadian bank index has ralled back to its 100-day moving average, which acted as an important roadblock in this bear market.
Financial Post, Levi Folk, 16 March 2009

The last bastion of safety for bank dividends has to be with Canadian banks. The economic recession is laying siege to their gates, but so far dividends are intact and will remain that way according to a recent report by Canaccord Adams – assuming the “poor earnings” scenario does not last into 2011.

The US$1.1-billion payout to Bank of Montreal by the U.S. government in the wake of the AIG bailout is evidence that BMO took in at least one Trojan horse when it bought credit default swaps from the insurer. If it wasn’t for the U.S. government, those dividends indeed may have been cut.

The Canaccord report relays conversations with the CFOs of the five banks (CIBC to come) with focus on banks’ capital. The conclusion is that dividends and banks’ capital ratios hold up well under stress testing – a major earnings recession in 2009, for example.

In the case of RBC, Tier 1 capital would apparently fall from 10.6% to 9.7% were earnings to evaporate as happened in the early 90s recession. This is the end of the story for report authors Nick Majendie and Melanie Jenkins given the regulatory requirement for banks to maintain Tier 1 capital of 7%. That factor and added capital raisings from DRIP programs means dividends should are intact assuming the recession ends this year.

Tell that to investors in Citigroup who have completely lost faith in U.S. banks. Citigroup cut its dividend to a penny on acceptance of government money in January despite a Tier 1 capital ratio in near 12%.

There is also the burning question of the duration the current recession. Bank of Canada governor Mark Carney sees a big snap back to growth in 2010. His U.S. counterpart, Ben Bernanke has warned the recession could last into 2010. For Canadian bank dividends, the outcome is highly optimistic, but the jury is still out.

16 March 2009

Canadian Banks Climb Ranks as US Banks Fall

Bloomberg, Sean B. Pasternak and Doug Alexander, 16 March 2009

Royal Bank of Canada, Toronto-Dominion Bank, Bank of Nova Scotia and Bank of Montreal pushed deeper into the ranks of North America’s 10 biggest banks after U.S. counterparts stumbled or disappeared in the past year.

Royal Bank, Canada’s biggest bank by assets, is now seventh- largest in North America after tripling assets in the past decade, according to data compiled by Bloomberg from company filings. Toronto-Dominion, Scotiabank and Bank of Montreal rank eight, ninth and 10th. At the end of 2007, Toronto-based Royal Bank was the sole Canadian firm among the top 10.

Canadian banks have remained profitable, outperforming their peers, because of tighter government restrictions on lending and capital requirements. The country’s six biggest lenders reported less than C$20 billion ($15.7 billion) in debt-related writedowns since the credit crisis began in 2007, about 2 percent of the $887.1 billion recorded by banks and brokerages worldwide.

“It’s a combination of the deleveraging that you’re seeing at some of the U.S. banks and, frankly, the relative strength of the Canadian banks,” National Bank Financial analyst Robert Sedran said in a March 13 interview. “They’ve been less disrupted on a relative basis than a lot of their U.S. peers.”

While New York-based Citigroup Inc. lost $17.3 billion in the fourth quarter, San Francisco-based Wells Fargo & Co. had a net loss of $2.55 billion and Bank of America Corp., the biggest by assets, lost $1.79 billion, Canada’s six largest banks were profitable in the quarter ended Jan. 31, and each beat analyst estimates.

Canada’s performance has been noticed. U.S. President Barack Obama said in a February interview with Canadian Broadcasting Corp. that Canada has been “a pretty good manager of the financial system and the economy.” In October, the World Economic Forum ranked Canada as the soundest financial system.

“The Canadian system is more or less working,” Scotiabank Chief Executive Officer Richard Waugh, 61, said in a Feb. 25 interview. “Even during this crisis, we have a lot of good assets on our balance sheet that are earning good, sustainable revenue.”

U.S. banks have racked up record losses and received unprecedented financial support from the government in the past year. Shares of Citigroup, once the world’s biggest bank by market value, dropped below $1 in New York Stock Exchange composite trading March 5.

Canadian banks have climbed in rank as U.S. banks collapsed or were bought in the past year. Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection in September and Bear Stearns Cos. agreed to be purchased by JPMorgan Chase & Co. last March. Wachovia Corp., which ranked sixth last year, was acquired by No. 4 Wells Fargo & Co. and Merrill Lynch & Co. was bought by Bank of America Corp., which ranked third at the end of last year.

A decade ago, Canada’s banks failed to make the top 10 list. Royal Bank had the equivalent of $183.9 billion in assets at the end of 1999, making it the 12th-biggest bank on the continent. Royal’s assets more than tripled to $577.6 billion by the end of January, in part by adding a U.S. franchise based in Raleigh, North Carolina.

Toronto-Dominion has spent more than $15 billion in the past four years expanding in the U.S., including purchases of Portland, Maine-based TD Banknorth and Cherry Hill, New Jersey- based Commerce Bancorp Inc. The lender’s U.S. branches exceed its Canadian network. Scotiabank and Bank of Montreal have expanded from their Canadian base in recent years to increase revenue.

Shares of Canada’s banks dropped amid the global financial crisis. The nine-member S&P/TSX Banks Index has dropped 2.6 percent so far this year, less than the 42 percent drop among the 24-member KBW Bank Index.

“We’ve beaten expectations to some degree, but I wouldn’t overplay that,” Royal Bank CEO Gordon Nixon, 52, told reporters in Vancouver on Feb. 26. “The expectation is the Canadian banks will continue to generate profitability throughout this turmoil and I think that’s a real positive.”

10 March 2009

Scotia Capital: Bank Earnings Reinforce Sustainability of Dividends

Scotia Capital, 10 March 2009

• Canadian banks release of first quarter results reinforces their status as the global bank model. The market’s comfort with the sustainability of bank dividend levels should be increasing given the solid first quarter results. However, Canadian bank stocks are facing global valuation contagion driven by fear and panic. Bank earnings this quarter absorbed further mark-to-market writedowns in their trading and available-for-sale (AFS) books as well as absorbing higher loan losses. Book value growth was double digit, with strong underlying operating earnings. The major earnings drivers were exceptional wholesale earnings, aided by large trading revenue, that are not fully sustainable and solid results from retail banking. In addition to earnings resilience, the bank group remained extremely well capitalized with Tier 1 ratio of 10.1% and TCE to RWA at 7.4%.

• Mark-to-market (MTM) losses remained high this quarter at $2.0 billion after tax, essentially flat from the previous quarter but down from $2.9 billion a year earlier.

• The MTM writedowns this quarter reflect a further widening of corporate bond spreads by 45 basis points (bp), higher CDS spreads, and an 11% decline in equity markets. This quarter was more benign than the fiscal fourth quarter where spreads widened 130 bp and equity markets tumbled 28%. Thus we believe the banks were much more proactive this quarter in managing and reducing risk in their portfolios in order to redeploy capital towards more profitable and less risky businesses.

• The bank group’s fully loaded return on equity after all writedowns was 11.3% in the first quarter, with operating return on equity of 18.3%.

• Bank earnings this quarter also absorbed a doubling of loan loss provisions (LLPs) to $2.1 billion from $1.0 billion a year earlier. Loan loss provisions this quarter were modestly higher than our forecast of $1.8 billion. LLP levels at 66 bp this quarter are up from 48 bp in the previous quarter and 37 bp a year earlier. Loan loss provision levels were particularly high in U.S. Personal and Commercial for BMO, RY, and TD. We have increased our 2009 LLP forecast to $8,510 million, or 65 bp, from $8,000 million, or 61 bp. Our 2010 LLP forecast has also increased modestly to $9,900 million, or 73 bp, from $9,700 million, or 70 bp.

• We believe that RY and NA reported the strongest results this quarter, followed by BMO, TD, and BNS with CM the weakest. In terms of domestic bank earnings including wealth management, BNS led with growth of 17%, with BMO at 2%, RY and NA flat, and TD and CM lagging with declines of 9% and 16%, respectively.

• RY and BMO earnings levels were driven by impressive results from wholesale, with these business units outearning their respective domestic retail businesses for the first time, we believe, in history. In our opinion, wholesale earnings or trading revenue this quarter are not sustainable at these levels, but the trend of growing earnings power from wholesale versus retail is very much intact; in fact it is just beginning. The reduction in capacity in wholesale and the major dislocation of this market has created significant opportunities. At the same time, retail is facing the structural difficulties and revenue/earnings/ margin pressures from very low interest rates. The concern about retail margins has only been exacerbated by the January 20, 2009, 50 bp reduction in prime and the further 50 bp rate reduction announced March 3, 2009. The impact of low interest rates (2.5% prime rate) will be very evident, we believe, in the second quarter.

• Canadian banks continue to suffer from valuation contagion as they are being priced in a global context of widespread chaos in financial and banking markets. Bank dividend yields have spiked to 7.6% versus 10-year government bond yields of 3.0%. Clearly, the market continues to heavily discount bank dividends despite solid financial performance thus far during the banking siege, and despite not only a 50-year track record of sustainability of dividends but a 10% CAGR, double the growth rate of the overall equity markets.

• Bank P/E multiples have declined to 6.5x, not seen since the early 1990s when the 10-year bond yield was 10% and bank ROEs dropped to below 6%, half the fully loaded ROE of 12% recorded in fiscal 2008. In the early 1990s, Canadian banks had double the exposure to commercial real estate than their U.S. counterparts had, with far greater concentration by name and project.

• We are optimistic that banks will be able to weather the recession, growing their book values and recording double digit return on equity. The Canadian banks are also exhibiting controlled offence by reinvesting in their businesses for future growth, acquiring small business units and select teams of people, as well as looking for opportunities that do not risk the bank.

• We believe that a major bank rally is pending. The crisis of confidence needs to subside before any sustained rally is possible. We believe a bank rally will follow some signs of stability in the U.S. and U.K. banking systems and continued reporting of solid quarterly results by Canadian banks. First quarter earnings calmed some fears about dividends, and as investors’ confidence in the sustainability of dividends increases, we expect share prices to be revalued more in line with fundamentals and earnings power of these companies. The low yield on government bonds and attractive yields on bank dividends will eventually be the major catalysts, in our opinion. We expect a significant positive revaluation of Canadian banks versus global peers as we believe Canadian banks will maintain their dividends and grow their business through this crisis.

• Also Canadian banks are now a recognizable part of global bank indices. Canadian banks now represent 12% of the MSCI Global Bank Index and nearly 11% of the FTSE Global Bank Index (RY sixth largest weight in this index).

• Canadian banks have been virtually ignored over the past number of decades given their insignificant weightings on global bank indices. However, with the global banking meltdown, Canadian banks have increased to 10.8% of the FTSE Global Bank Index, up from an insignificant 1.9% in 2000. Therefore it was easy to ignore Canadian banks in 2000 but, given the recent weightings, global bank funds at least have to make the decision not to own Canadian banks. Canadian banks do not have the beta of a number of global banks but we don’t know if that should necessarily be an investment deterrent.


• We remain overweight the bank group with a bias towards wholesale business versus retail as the area of strongest growth over the next several years. We believe RY (1-Sector Outperform) is the best positioned of the Canadian bank group in terms of the breadth and depth of its wholesale platform as well as its favourable retail deposit mix, which is expected to show relative strength due to the very low level of interest rates that we believe will place greater pressure on the other banks in the group.

• Our stock selection is based on the theme of leverage to wholesale versus retail. We believe the low level of interest rates will place greater pressure on retail net interest margins while wholesale margins have and should improve. Retail loan losses are expected to trend much higher versus historical peaks of the early 1980s and early 1990s with corporate and commercial loan losses trending lower than previous peaks.

• We have a 1-Sector Outperform rating on RY with a 2-Sector Perform rating on National Bank, Bank of Nova Scotia, Bank of Montreal, Canadian Western Bank, and Laurentian Bank. Our 3-Sector Underperforms are Toronto-Dominion Bank and Canadian Imperial Bank.

• Our stock selection in order is RY, NA, BNS, BMO, CWB, LB, TD, and CM.

09 March 2009

RBC CM: Banks Should Consider Suspending Dividends

RBC Capital Markets, 9 March 2009

We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.

Going into the quarter, our two favourite bank stocks were National Bank and Royal Bank and our two least favourite were TD Bank and Scotiabank.

• National Bank’s stock appears best positioned over the near term, with lower exposure to U.S. and Ontario credit, a clean securities book and a valuation at the low end of the peer group. We are reticent to upgrade the stock, however, given our view on the group in general and the stock’s strong performance relative to peers so far in 2009.

• We are less negative on Bank of Montreal. Bank of Montreal’s credit issues in 2008 were much worse than its peers. We expect the difference to be less noticeable in 2009 as the credit cycle broadens geographically and by product line. We are concerned, however, that the bank’s dividend is least sustainable and that as long as the risk of a cut is in place, the stock is unlikely to rally. Unlike the situation in the U.S., we would expect dividend cuts to be viewed negatively as they would probably be perceived as a sign of lower confidence in the outlook, whereas in the U.S. most investors have a pessimistic outlook on U.S. banks and dividend cuts are viewed as positive since they reduce a drain on capital.

• We are less negative on TD relative to peers as the bank’s capital position is better than what we had forecast and, while signs of increasing credit deterioration concern us relative to peers, the pace at which the deterioration has occurred has been slower than we had expected. We still believe, however, that the stock is likely to lag its peers largely on increased loan losses, but also because of potential valuation adjustments on securities depending on the outlook for the housing market/securitized residential mortgages. Those issues are not crippling but we believe that they might disappoint investors.

Based on our earnings estimates, which include our best guess on securities writedowns, we estimate that the six Canadian banks can maintain their dividends and have TCE to risk weighted ratios of 6.4% to 7.8% by the end of 2010. We believe that the Canadian banks have enough capital to handle loss rates in line with those of the early 1990s. However, we no not believe that they have enough capital to handle loss rates in the 1.5-2.0x range when compared to the early 1990s and sustain dividends. Given how weak the economic environment is, the prospects of loan losses that exceed the early 1990s is certainly something banks and investors must consider in their investment decisions. It might not be the base case but it is a possibility if the economy does not improve by 2010.

We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.

• Markets would initially likely react negatively to a dividend cut as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:

• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s. On top of reducing risk, it might improve cost of funds as debt investors would have less to worry about, and it might also stabilize share prices if tail risk (having to raise capital at low share prices) becomes more remote.

Key highlights from Q1/09 results

• The deterioration of credit quality that started in late 2006 accelerated in 2008 and Q1/09. Credit losses continued to rise in Q1/09, with Bank of Montreal and Royal Bank seeing the highest YoY increases in loan loss rates, driven by their U.S. businesses. Scotiabank and TD Bank are also beginning to see loan loss rates increase as the credit cycle is spreading to areas that were less impacted in the early stages of the credit cycle (which was mainly driven by U.S. residential-related exposures). Losses are spreading to other geographic and product areas. National Bank and CIBC have been less impacted, although CIBC’s credit card loss rates are clearly under pressure in our view (benign credit experience in the bank’s business loan book has offset the rising card losses on overall loss rates).

• Margin pressure, difficult equity markets and rising loan losses offset still-solid loan growth in domestic retail businesses. Scotiabank and Bank of Montreal had the strongest combination of revenue growth and net income growth, although we believe that was partly helped by how they allocate treasury expenses (Scotiabank) and loan losses (Bank of Montreal). We expect top and bottom-line growth to remain slow compared to pre-2008 years, especially now that loan losses have begun to rise.

• Wholesale earnings on a GAAP basis were well up from Q1/08 on lower writedowns and better underlying profitability. Many trading businesses did well while others were negatively impacted by writedowns. Underwriting and corporate banking revenues were strong, while M&A advisory was quiet for most. Core earnings were more than double reported earnings (and were up 65% QoQ and 46% YoY), although the factors that caused trading losses (volatility and wide spreads) also undoubtedly led to the establishment of trading positions that generated gains that would not have occurred in a normal environment.

• The Canadian bank’s solid capital markets results were partially offset by continuing writedowns1. Total writedowns amounted to $3.0 billion, down from $4.6 billion in Q1/08 and $4.1 billion in Q4/08. CIBC and Royal Bank recorded the largest writedowns ($1.3 billion and $636 million, respectively). The exposures that led to the writedowns remain, although in many cases the size of those exposures, on a net basis, is down. We believe that a tightening of credit spreads would alleviate concerns over potential writedowns but, as long as they remain wide, securities writedown risks will likely remain.

• Canadian banks generally saw capital ratios increase during the quarter as income from operations and capital raises offset writedowns and dividend payments. The median Tier 1 ratio rose from 9.6% to 10.0% during the quarter, while the median TCE to RWA ratio rose from 6.7% to 7.3%.

2009 and 2010 expectations

We expect 2009 earnings per share to come short of consensus estimates. Our current EPS estimates for 2009E are a median 6% below consensus, and 11% below consensus for 2010E (Exhibits 2 and 3).

• Our 2009 GAAP EPS estimates represent a median 18% decline in profitability compared to a 15% decline in 2008, even with lower expected writedowns. Our 2009E core cash EPS represent a median 17% decline in profitability versus a 4% decline in 2008, driven by rising loan losses and pressure on retail banking and wealth management revenues.

• We expect the core cash ROE will drop to 16% from the 20%+ levels in the past few years.

• Provisions for credit losses are likely to be the biggest swing factor in earnings results. The indicators we track for both retail and business lending are all pointing toward an increase in loan losses. Furthermore, the formation of impaired loans has accelerated in recent quarters, initially driven by banks with exposures to the U.S., with weakness now also becoming noticeable in Canada. We believe that the trend will continue and that higher than normal provisions for credit losses should be expected in 2009 and 2010. When there are high levels of new impaired loans and low levels of collections and loans returned to performing status, banks typically record higher provisions in following quarters.

• We believe that loan losses will increase at an accelerated pace in 2009, and rise further in 2010. We believe that specific provisions for credit losses will reach $11.3 billion (or 0.92% of loans) in 2009 for the Big 6 banks, and $15.0 billion in 2010 (1.18%), which compares to $2.8 billion (0.28%) in 2007 and $5.0 billion (0.45%) in 2008.

Still too early to buy

We continue to believe that it is too early to buy Canadian bank shares. Canadian banks have higher capital than many of their global peers, and their capital levels and profitability would allow them to sustain dividends if loan losses were in line with the early 1990s. However, we find it hard to recommend buying the banks’ shares today as (1) valuations are well above where they were in early 1990s (which is in part deserved but the gap is nonetheless large), (2) leading indicators of profitability and stress remain negative, (3) if the economy does not recover and banks experience loan losses that are higher than in the early 1990s, dividend policies might have to be reviewed.

We would not focus on our 12-month target prices as the primary decision factor in determining when to buy bank shares but rather on when leading indicators of profitability might turn. Our reasoning is as follows:

• Canadian bank shares have seen lower valuations in the past and as such, as long as important indicators of future bank profitability remain weak, bank shares could drift lower (Exhibit 4).

• On the other hand, we do not believe that the Canadian banks face the same pressure on capital as some of their European or U.S. bank peers, and we believe that Canadian bank shares have upside at current valuations that is likely to begin being realized when the economic environment shows signs of troughing and the prospects of writedowns are more clearly behind.

• If the economy continues to deteriorate, we believe that tangible book value is the best way to set a rough estimate for downside risk. For the industry, that would represent downside valuation risk of about 50%. Note that this is not a forecast, this is an attempt to quantify downside risk in a depressed economic environment that does not recover in the next 12 months.

• Upside potential can be estimated by looking at normalized earnings and valuation multiples. For the industry, when the market starts to focus on “the other side of the valley”, we believe that valuation upside over the next two years could be as much as 50-100%.

• A trough in bank stocks is likely to come before the peak in credit loss provisions. Bank share prices often move in concert with leading economic indicators and about 6 months ahead of employment growth. As such, our sector view (“too early to buy”) is more based on looking for the turn in leading indicators rather than what price appreciation might or might not be implied by our 12-month target prices (Exhibits 5 and 6).

Given that the leading indicators we track are still mostly negative (although, admittedly, not as negative as a few months ago), we continue to believe that it is too early to buy Canadian bank shares.

• Outside of valuations, we are watching indicators in four key areas to look for a bottom in Canadian bank shares: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth.

• Those indicators are sending mostly negative messages (although not as negative as a few months ago), which, combined with valuations that are not extremely low by long term averages considering the state of the economy, and consensus estimates we think are too high, support our belief that it is still early to buy Canadian bank shares.

• Our approach will likely lead us to miss the bottom in bank shares but we feel that upside on a 3-5 year basis is attractive enough that one does not need to catch the exact trough to make money in these stocks over that period. Taking this approach avoids being lured into the names on valuation-driven reasons, which should work over time but can often fail in the near term, and it should also allow us to have better visibility on the economic outlook and potential writedowns when we eventually recommend buying the sector.

Leading Economic Indicators need to stabilize in our view. Leading economic indicators are a good advance indicator of employment growth as well as loan losses and bank share performance. Bank shares have historically not done well in periods of rising loan losses and some leading economic indicators currently point to a U.S. recession as bad as that seen in early 1980s, and the Canadian leading indicator is trending negatively as well. A stabilization in those indicators would be a positive for our view on the bank shares. In the U.S. the indicators appear to have thankfully stopped worsening, although they remain very weak. In Canada, the trend remains negative (Exhibits 6 and 7).

The valuation of credit assets, particularly highly rated ones, has been a source of major problems for financial institutions, and funding costs have risen compared to normal environments. Paying attention to signs of increasing or decreasing stress in credit and funding markets is crucial in our mind, and some (but not all) of the indicators we watch have improved in recent months:

• Spreads on investment grade bonds have tightened but are still near record levels and pressure on structured finance assets continues as shown in Exhibits 8 and 9. A tightening of credit spreads would alleviate concerns over potential writedowns.

• Funding conditions have improved in the past few months as the LIBOR-OIS and spreads on Canadian bank short-term wholesale funding rates have tightened since peak levels in early October. More importantly, medium term funding spreads have also come off of their highs. Continued tightening in funding spreads would indicate greater confidence from credit markets in banks and it would lead to lower concerns over net interest income margins, in our view (Exhibit 10).

We also keep an eye on house price changes as well as employment growth as signs of consumer health, although we suspect these indicators will be more lagging than leading economic indicators, credit spreads and bank funding costs.

• House prices in Canada declined 11% YoY in January, while the U.S. monthly house price decline is 15% YoY. Excesses in the U.S. housing market have created a lot of the problems facing financial services companies worldwide, and we still do not see clear signs of bottoming which would be positive for bank shares. The decline in house values in Canada will, in our view, exacerbate consumer loan losses (Exhibit 11).

• Employment growth has turned negative in Canada. Employment growth is not necessarily a leading indicator of economic strength but it is a leading indicator of credit losses in banks’ retail portfolios as well as retail loan growth. Employment in Canada fell by a record 129,000 in January, which sent the unemployment rate to 7.2% from 6.6% in December (February data is expected to be released on March 13). U.S. labour markets also continue to be very weak, with employment dropping 651,000 in February and unemployment spiking to 8.1% from 7.6%. (Exhibit 11).

Book value-based valuations best way to assess downside risk

Price to earnings is the most commonly used way to value banks in “normal times”, but we do not believe it is as useful in determining valuation-based downside risk for banks as the earnings outlook is murky. To us, it is clear that earnings will be negatively impacted by credit losses but the magnitude of the impact is difficult to determine as every credit cycle is different, hence our reluctance to place a lot of emphasis on price to earnings. Furthermore, different accounting treatment of similar securities can lead to discrepancies between banks in terms of timing and magnitude of writedowns.

We continue to believe that price to book methodologies are the best way to determine a potential valuation floor. Current median price to book valuations of 1.2x and price to tangible book of 1.6x compare to the 0.8x trough of the early 1990s. If the economy continues to deteriorate, we believe that valuations are likely to settle somewhat higher than the early 1990s, with the most stringent test of downside risk being tangible equity.

• Compared to the early 1990s cycle, in which banks traded below book value, we believe trough multiples should be higher in this cycle as banks are less exposed to credit risk and to business lending than in prior cycles, they have more exposure to wealth management, they have higher capitalization ratios, and risk free rates are lower (Exhibits 12 and 13).

o Relative to 20-year trough valuations, the two banks closer to their historical troughs are TD and Bank of Montreal, while the other four look more expensive. Part of the reason for TD trading closer to its historical trough is that more of its book value is now made up of goodwill and intangibles, on which, for recently acquired goodwill/intangibles, we believe the banks will earn low returns.

o ROE potential also needs to be considered. Using our 2009 estimates, Bank of Montreal, and TD are expected to earn lower ROEs, which all else equal should lead to lower price to book multiples.

• Looking at price to tangible book is a more stringent test of downside risk as it awards little value to goodwill and intangibles.

o Relative to 20-year trough valuations, the current industry median valuation is 50% higher. Looking at individual banks, the one closest to its historical trough is Bank of Montreal. TD Bank and Royal Bank have higher P/TBV valuations. Our view on those banks is that, so as long as it continues to be viewed as a going concerns, we believe that they have historically earned higher returns on their tangible equity.

- Using our 2009 estimates, Bank of Montreal, Scotiabank and National Bank are expected to earn lower returns on tangible equity, which all else equal should lead to lower price to book multiples. We expect ROTEs for the group will come down to a median 21.5% in 2009E from 25.9% in 2008 and 27.8% (Exhibit 14).

Normalized P/E and P/B are the best way to assess upside potential

Under a scenario where there is no share dilution, there are two quick and relatively easy ways to determine upside potential for bank shares. We’d characterize this as the “banks have enough capital to withstand writedowns and loans losses so what are they worth on the other side” scenario.

Price to book is the simplest way to determine upside, particularly if one looks at price to tangible book, given that banks that added significant goodwill and intangibles in recent years are not likely to trade at similar price to book multiples. Based on where banks have traded in the last 10 years, upside would range from 50% to 150%.

One can also look at normalized profitability given current capital positions and then apply a reasonable P/E multiple. We suggest the following: estimating normalized earnings power by taking average ROTE for the 2003-2007 period, excluding unusual items, and reducing that return by about 8% to reflect the fact that the industry had unusually low loan losses. We then apply a P/E multiple of 11-12x to those earnings. This would provide upside of between 40% and 110%.

While simple, those scenarios are useful in determining potential upside. There are two important questions (1) when will bank stocks trade on that basis, and (2) what if there is dilution along the way.

• With regards to the first question, we think that investors need to focus on the metrics we look at outside of valuations, which we highlighted earlier in this report: (1) leading economic indicators; (2) signs of stress in credit and funding markets; (3) housing market strength; and (4) employment growth. Once those indicators stabilize/show signs of improvements, we believe that the market might start looking ahead to “the other side of the valley”.

• With regards to the second question, we do not believe that significant dilution will occur if the economic environment improves by 2010. If the environment keeps deteriorating, we believe that the banks can keep their upside potential if they suspended dividends as it would take very stressed scenarios to push capital below adequate levels if the banks did not have to pay dividends. Obviously, the timing of the upside potential would be pushed later in the future and the share price would likely not react well to a dividend cut.

o In the capital section “Pressure to Keep capital ratios high will continue”, we detail some stress tests we did and will be following up with an interactive excel-based stress-test for investors who wish to use different assumptions.

o In the dividend section “We think that banks should consider suspending their dividends,” we detail why we believe it might make sense to temporarily suspend their dividends.

We think that banks should consider suspending their dividends

We believe that the Canadian banks should consider suspending their dividends. They have historically been reticent to do so (the Big 5 banks have not cut dividends since the Second World War) and might maintain their long standing record of paying dividends, so our view may ultimately be nothing but that: an opinion.

Markets would initially likely react negatively to a dividend cut, in our view, as (1) income-focused investors might sell their shares and (2) investors who view Canadian banks as “bullet-proof” would likely be disappointed. However, the reason why we think temporary dividend suspensions might make sense is:

• It would materially increase internal capital generation and thereby reduce the need for banks to raise capital if loan losses and writedowns prove greater than in the early 1990s.

• It would materially decrease the tail risk of a bank finding itself in a situation where it needs capital but its share price is trading at such a low valuation that raising equity capital proves to be very dilutive – a situation many U.S. and European banks are facing.

o If the Canadian banks cut their dividends today, they would have ample capital, in our opinion, to handle credit losses 50-100% higher as the worst experience of the last 20 years, even after reducing capital for potential writedowns at some banks.

• The Canadian banks are among the few banking systems around the world that have not received capital injections from a Government, which has positive implications from a future regulation and freedom of operations standpoint. It also means that when the environment improves, banks can focus on deploying capital rather than repaying the Government.

Suspending dividends would help ensure that the banks remain privately capitalized, in our view.

• Suspending dividends would probably reduce banks’ cost of funds as it would reduce their risk profile.

• It would probably set a floor in share prices. The shares of banks that are in U.S. and European banks that are in serious difficulty and trade well below tangible book value do so for one of two reasons: (1) investors do not trust the book value and (2) investors believe that those banks need to raise equity at very dilutive prices. Suspending dividends would greatly reduce the probability of a capital issue.

• The market is not valuing the banks as if their dividends are sustainable. Dividend yields are median 7.2% in the context of risk free rates of 2.9% (5-year Government of Canada bond yield). Even if using a “normal” bond yield of 4-5%, the dividend yield to bond yield ratio is very high by historical standards.

• Many banks around the world have cut their common dividends. While not great comfort to investors who rely on dividends, the institutional investor base would not be entirely shocked, in our view, if dividends were reduced given what worldwide banks have done and how weak the economy is.

Bank boards would undoubtedly alienate many long-term shareholders if they cut dividends, in our view, and they would likely regret their decision if the economy recovered quickly as there is a reputational cost to cutting dividends (National Bank is still oft mentioned as the only bank that cut dividends even though that is a decision that is nearly two decades old). The decision to cut dividends is not therefore not as clear cut is not as clear cut as our prior statements would indicate – Canadian banks have gone through periods of severe profitability declines and not cut dividends before.

• Dividend payout ratios reached over 70% in the mid-1960s, 88% in late 1990 and 119% in early 1993. Only one bank has cut dividends since the 1940s – National Bank cut dividends in the early 1980s and early 1990s (Exhibit 18).

• Dividend payout ratios were a median 48% in 2008. We expect the median payout ratio to rise to 59% in 2009 and 56% in 2010. Canadian bank target dividend payout ratios have been in the range of 40% to 50% in recent years (Exhibit 19). We believe that Bank of Montreal’s dividend would be most at risk of a cut (if it were to happen) as it has a higher dividend payout ratio than the others. If Bank of Montreal were to cut dividends, the likelihood of others following suit would increase as a precedent would have been set (Exhibit 20).
Bloomberg, Doug Alexander, 10 March 2009

Krystal Koglin didn’t think twice when Toronto-Dominion Bank offered to boost the limit on her Visa credit card 11-fold a couple of years ago.

She went on a spending spree, hitting department stores like Holt Renfrew, treating friends at restaurants, splurging on designer jeans and buying “needless things” on EBay Inc.

“Being a young adult and irresponsible, I spent a lot of money that I shouldn’t have,” the 24-year-old salon manager and BCE Inc. employee in Toronto said. “I couldn’t handle having the responsibility of a C$5,500 ($4,237) limit.”

Toronto-Dominion and other Canadian banks are suffering from a rise in credit-card losses from clients such as Koglin, who cut up her Visa card in December after skipping payments. Four of the country’s biggest banks set aside 51 percent more cash on average in the first quarter for card losses, and these costs may rise further this year, bank executives said.

“If there’s another shoe to drop, credit cards are going to be it,” said John Kinsey, who manages about C$1 billion including bank stocks at Caldwell Securities Ltd. in Toronto. “It’s probably going to be the Achilles heel this year for the banks.”

Credit-card delinquencies and losses have risen with higher unemployment and personal bankruptcies, according to Moody’s Investors Service. Those trends will continue through 2009, even as issuers reduce credit limits and scale back on offers to entice clients.

Canadian card losses in the third quarter rose to 3.1 percent of average balances, the seventh straight period of year- over-year increases, according to Moody’s. By comparison, U.S. card losses rose to 6.6 percent of balances.

Canadian Imperial Bank of Commerce, the country’s No. 5 bank, set aside C$152 million for card losses for the period ended Jan. 31, nearly double a year ago. Royal Bank of Canada earmarked C$83 million, a 28 percent increase, while Bank of Montreal reserved C$56 million for losses in its MasterCard portfolio, up 47 percent.

Canadian Imperial, Canada’s largest card issuer, is “slowing growth” of credit cards, says Chief Executive Officer Gerald McCaughey. Cards were the second-biggest revenue generator for CIBC’s consumer bank in 2008, bringing in C$1.75 billion.

“The card portfolio continues to grow, but at a much slower rate,” McCaughey told reporters after the bank’s annual meeting in Vancouver on Feb. 26. “In difficult times it’s quite normal that you would slow the growth of credit granting.”

CIBC has the most consumer credit-card loans among Canada’s five-biggest banks with C$10.5 billion, representing 6.3 percent of total loans, according to filings. Royal Bank of Canada has the second highest, followed by Toronto-Dominion, Bank of Nova Scotia and Bank of Montreal.

Royal Bank CEO Gordon Nixon said he’s more concerned about rising defaults from credit cards than mortgages in the recession. Royal Bank had C$8.93 billion in credit-card loans as of Jan. 31.

“There is a natural deterioration in credit in a recessionary environment,” Nixon said on Feb. 26. “Credit-card deterioration always happens much sooner and much more dramatically than you’d have in a mortgage portfolio because they are unsecured loans.”

Conservative lending practices and regulations allowed Canadian banks to escape the worst of the writedowns faced by U.S. banks from the collapse of the subprime mortgage market. The lenders don’t have such protection for credit cards, aside from charging interest rates as high as 19.75 percent on outstanding balances, compared with a prime rate of 2.5 percent on loans to their best customers.

Canadian banks will see “earnings headwinds” from significant increases in provisions for card losses, Dundee Securities Corp. analyst John Aiken said in an interview. A deteriorating credit-card business is a sign of worsening credit among consumers, which will hurt the banks’ other businesses, he said.

“It’s definitely the canary in the coal mine,” Aiken said. “If these customers aren’t paying their credit cards, that means they’re not buying anything else and you’ll see a ripple effect.”

Banks have been bracing for a slump as Canada struggles in its first recession since 1992. The economy will shrink by 1.2 percent this year, the Bank of Canada forecast. Companies shed a record number of jobs in January, pushing the jobless rate to a four-year high of 7.2 percent.

Credit-card balances at Canadian banks have risen by almost 40 percent since 2004 to C$49.9 billion as consumers took on more debt, Deloitte said in a report last month. Banks and issuers may post an additional C$800 million in credit-card losses this year, rising to about C$4 billion, the consulting firm said.

Canadians owned 71.6 million cards issued by Visa Inc., MasterCard Inc. and American Express Co. at the end of 2007, according to The Nilson Report, an industry publication.

“The impact of credit deterioration in Canada -- and I’m talking about all banks -- is going to be felt across everybody’s product groups, whether it’s in credit cards or mortgages,” Bank of Nova Scotia Chief Risk Officer Brian Porter said in a March 2 interview.
The Globe and Mail, Tara Perkins & Boyd Erman, 6 March 2009

Canada's banks are finally getting some respect.

Derided for years as meek and mild while banks around the world expanded wildly, suddenly the reputation of Canada's big lenders as prudent and sometimes downright boring has become an asset instead of a liability.

U.S. President Barack Obama has heaped praise on the management of this country's financial system. Ireland is considering overhauling its system to look more like Canada's. Financial papers around the world are running headlines such as “Canada banks prove envy of the world.”

Whether measured by market value, balance sheet strength or profitability, Canada's banks are rising to the top. Since the credit crunch began in the summer of 2007, the Big Five banks have booked a total of $18.9-billion in profits.

In roughly the same period, the five biggest U.S. banks have lost more than $37-billion (U.S.). One, Wachovia Corp., was forced to sell out to avoid failing. Another, Citigroup Inc., long the world's largest bank, may have to be nationalized and this week became a penny stock. The picture is similar in Britain.

The U.S. has spent most of the $700-billion the government earmarked for bank bailouts, and there are estimates that the final tally could be more in the trillions of dollars. The head of the Bank of England said last month that it's “impossible” to know how much money it will take to fix his country's banks.

Canada, by contrast, has not had to inject capital directly into banks, other than starting a program to buy from banks $125-billion (Canadian) of insured mortgages – any losses from which the government was already on the hook for anyway.

The reason comes down to a fundamental conservatism. From lending practices to bets on trading to financial reserves and takeovers, the Big Five banks have long tended to be more careful than their global peers. And when they did want to get aggressive, government and regulators held them in check.

“The Canadian banks were under a significant amount of pressure from both the analysts and the marketplace in general to be more aggressive in expanding into international markets, particularly the United States, and I think to some degree resisted partially because of a more conservative approach,” says RBC chief executive officer Gordon Nixon.

Still, the industry has had stumbles, most notably Canadian Imperial Bank of Commerce's misadventure in derivatives, which led to a $2.1-billion loss for 2008.

And shareholders in Canadian banks have been battered. As a group, the banks' shares are down almost 50 per cent since Aug. 1, 2007, with most of the decline in the past six months as the economy worsened.

The concern weighing on these bank shares, for starters, is that profit growth in general is a thing of the past until the economy picks up. Most analysts say the banks' profits will shrink in coming quarters as more loans go sour and margins on lending tighten up. There's also nagging doubts that dividend payments are unsustainable and that something bad is still lurking on balance sheets.

More writedowns are likely in store for banks such as Toronto-Dominion Bank and Royal Bank of Canada, both of which made big acquisitions in recent years that now look overpriced.

Still, bank bosses such as Rick Waugh, CEO of Bank of Nova Scotia, say the banks are insulated from lingering problems because they have profits rolling in from many sources.

“We have made mistakes,” he says, “but we made sure that we were well diversified.”

That's a result of a conservatism not just among executives. That same approach extends to consumers, helping the banks sail along on the strength of their domestic lending businesses.

“You've got a more balanced cultural approach towards consumption and savings than we do in this country,” says Charles Dallara, head of the Washington-based Institute of International Finance, and a former managing director at JPMorgan Chase & Co.

Much of that stems from the pain of the last recession. While the downturn of the early 1990s was short and sharp in the U.S., it was drawn out in Canada, leading to more of a social evolution, says CIBC chief executive officer Gerry McCaughey.

Former central bank governor David Dodge agrees. Canadian bank executives keenly remember that period, “and there was therefore perhaps a degree of prudence, a lack of aggressiveness, in comparison with major banks around the world,” he said.

And he gives top marks to the Office of the Superintendent of Financial Institutions, Canada's banking regulator, for being more conservative than those in the U.S. or Britain. “I think that, from a regulatory point of view, you can say that the Canadian banks were more appropriately regulated.”

The final key is the structure of the mortgage market.

While U.S. banks sold a large proportion of their mortgages, Canadian banks held the bulk of theirs on their balance sheets, giving them an incentive to make sure they were good loans. Riskier ones are backed by government insurance. And the law here makes it tough for consumers to walk away from a mortgage because banks can go after other assets.

Still, the banks are wary of getting cocky when a careful approach has worked well.

“It's a good thing for us to recognize the things we do very well, but maybe do it in what is appropriately a Canadian way – with modesty,” said Bank of Montreal CEO Bill Downe.

• Royal Bank of Canada

First quarter profit: $1.05-billion, down from $1.25-billion.

What's working: The bank's securities arm makes big bucks, and its huge retail bank in Canada generates steady earnings. RBC benefits from strong loan growth and expense control, notes UBS analyst Peter Rozenberg.

What's worrying: A foray into the U.S. leaves it exposed to the sagging American economy. Investors never like to see too much of a bank's earnings come from capital markets, because it's a volatile business. And while the securities division is doing well, it's also booking big writedowns. “RBC's Achilles heel, in Moody's view, is its U.S. operation,” the rating agency says.

What the CEO says: “As a Canadian bank with global operations, RBC does have a competitive advantage relative to many of our global peers. The fundamentals of our domestic economy, while stressed, appear stronger than in Europe and the United States, having benefited from a public policy agenda that for many years valued prudent fiscal management.”

Total assets: $713-billion

Tier 1 capital ratio (Jan. 31): 10.6 per cent

Provision for credit losses: $747-million, up from $293-million

• Toronto-Dominion Bank

First-quarter profit: $712-million, down from $970-million.

What's working: Retail arm TD Canada Trust is a dominant force across the country. “The bank's sizable capital cushion, combined with the recurring earnings from its Canadian franchise, leave it well positioned to manage through a period of economic headwinds,” says Moody's Investors Service.

What's worrying: TD expanded in the U.S. just as things were getting really bad. Now, the bank has the biggest U.S. retail banking presence of any Canadian bank – half of all the bank's branches are in the U.S. Plus, TD owns a big U.S. wealth management operation that may suffer as markets plunge. The consensus among analysts is that the bank's securities and trading side isn't big enough to make up for declining performance in other areas of the bank.

What the CEO says: “We are living in unprecedented times. So what we consider solid performance in the current environment is certainly not what we would be happy with in the long term. … We are going to take some bruises if the situation gets worse, but we're still going to be able to deliver solid earnings.”

Total assets: $585-billion

Tier 1 capital ratio (Jan. 31): 10.1 per cent

Provision for credit losses: $537-million, up from $255-million

• Bank of Nova Scotia

First-quarter profit: $842-million, up from $835-million.

What's working: The bank's international business – the largest of the Canadian banks – posted a record quarter, and Scotiabank's reputation for risk management remains intact. The bank's securities and trading arm, Scotia Capital, had a near-record quarter.

What's worrying: Investors are leery of exposure to car loans and the auto industry. They are also keeping an eye on the bank's corporate loan book, the biggest of any Canadian bank.The bank's large international division, with a big presence in Latin America, was much more profitable than anticipated in the latest quarter, but the macro environment in Latin America has deteriorated in recent months, notes RBC Dominion Securities analyst André-Philippe Hardy.

What the CEO says: “The banking sector in Canada is still in good shape. Some say the best in the world. As a group, we are all very well capitalized by global standards. And Scotiabank clearly demonstrated this by the fact that we were able to raise more capital this quarter, all of it from the market, from private sources.”

Total assets : $510-billion

Tier 1 capital ratio at Jan. 31: 9.5 per cent

Provision for credit losses: $281-million, up from $111-million

• Canadian Imperial Bank of Commerce

First-quarter profit: $147-million, up from a loss of $1.46-billion.

What's working: Most of the big problems relating to exposure to subprime-linked investments are behind the bank, and its balance sheet is rock solid after raising another $1.6-billion of capital this week. Analysts and investors like the fact that its Canadian-focused business means bad U.S. loans aren't a big issue.

What's worrying: The bank is getting out of or cutting back in so many business lines to avoid problems that it's unclear where growth will come from. Investors worry that the bank is becoming so risk-averse that it won't be able to compete.

Its core consumer lending segment saw earnings decline 14 per cent in the latest quarter, due in large part to rising provisions for bad credit card, manufacturing and real estate loans, notes Blackmont Capital analyst Brad Smith.

What the CEO says: “Market conditions worldwide for banks remain difficult. Yet arguably one of the better places to be right now is in Canada. At CIBC, the majority of our revenue is derived from retail markets, where we enjoy strong market positions in a broad range of products and services.”

Total assets: $354-billion

Tier 1 capital ratio at Jan. 31: 9.8 per cent (it's now a whopping 11.5 per cent)

Provision for credit losses: $284-million, up from $172-million

• Bank of Montreal

First-quarter profit: $225-million, down from $255-million.

What's working: The bank's trading operations are buoying profit, and its retail operations are rebounding after lagging for years. A switch toward more profitable products, such as lines of credit, is helping the core operations churn out strong earnings.

What's worrying: Investors are concerned that trading profits can disappear fast, and the bank has a U.S. loan portfolio by virtue of its presence in the U.S. Midwest. There's also a nagging worry that the bank will cut its dividend that won't go away no matter how many times CEO Bill Downe says the payout is safe.

Credit Suisse analyst James Bantis is watching for rising credit losses in the $42-billion (U.S.) U.S. loan portfolio. He sees a large drop-off in the quality of the U.S. portfolio, which accounts for 27 per cent of BMO's loan book, compared to the Canadian portfolio.

What the CEO says: “Financial institutions everywhere continue to face headwinds in credit markets and the capital markets environment. BMO is well positioned to meet these challenges, having accessed markets to bolster our capital position and having further strengthened our strong liquidity in the period, albeit at a higher cost.”

Tier 1 capital ratio at Jan. 31: 10.21 per cent

Total assets: $443-billion

Provisions for credit losses: $428-million, up from $230-million

07 March 2009

Manulife Judged Hedging to be Costly & Unnecessary

Financial Post, Eoin Callan,7 March 2009

On a chilly evening early in 2004, Dominic D'Allessandro was treated to warm applause from his peers during an exclusive event at the historic Carlu in Toronto, where he accepted the award for Canada's Most Respected CEO of the Year.

The head of the country's largest insurer regaled the black-tie audience with the secrets of Manulife Financial Corp.'s charmed existence as a solid-yet-fast-growing public company.

But what the CEO refrained from sharing with his audience was that management were so convinced of their own prowess they had just decided to gamble the company's fortunes on a one-way bet on financial markets.

With stocks on a roll and the company on a winning streak, Manulife had begun pushing the envelope of risk-taking in the insurance industry, putting such competitors as Sun Life Financial Inc. under pressure to keep up.

The fateful decision that would contribute to a dramatic destruction of the company's value began with an offer to customers of guaranteed minimum payouts each year if they put their money in special new funds created by Manulife that it would in turn invest in stocks.

This type of quasi-retirement fund was becoming popular in the industry as a way to cash in on ageing Baby Boomers and enhance income from more staid life-insurance offerings.

But Manulife decided to go one step further, finding a clever way to increase returns that would leave rivals scratching their heads.

It dispensed with the industry practice of hedging bets to help cover guaranteed payouts in the event markets crashed, judging this to be too costly and unnecessary.

To even the closest observers, this increase in risk-taking that began in 2004 and continued into 2007 was almost imperceptible, even as it helped shape the competitive landscape for products such as segregated funds.

"If you really step away from it, you realize the risk that was added over time. But it didn't feel like it when it was happening on a day-today basis. It was gradual," said Jukka Lipponen, an analyst with Keefe, Bruyette & Woods, an investment bank that specializes in the financial sector.

Yet people inside the industry point to a deliberate strategy by Manulife to gain an edge on rivals by avoiding the costs of hedging.

"We felt that retaining the risk would give us a little more volatility and a little more return," Peter Rubenovitch, Manulife's chief financial officer, said during an industry conference this week.

He said the "2004-2007 period is where we differentiated ourselves, in hindsight unfavourably, by assuming more risk than most of our competitors."

That extra little bit of volatility Manulife banked on has turned into a relentless downward spiral as markets have tanked.

Manulife's shares dropped about 20% this week, contributing to a staggering 75% drop in the company's value from a year ago amid a broad decline in stocks.

People close to the company defend the decision to skip the step of hedging bets, acknowledging that while it is unfortunate in retrospect, it is preferable to be exposed to markets that may bounce back than to have loaded up on subprime mortgages.

They also are unrepentant about not factoring into their planning the type of crash that has occurred, adding that no one person was solely responsible for the strategy.

While an overconfident streak at the top may have played a role, the board of directors were briefed on the key decisions. "They were well aware. The board was totally familiar, " said a person close to top management.

People close to the company also point out that while Manulife is more heavily exposed to falling equity markets because it did not hedge its bets, it was not alone in rushing to offer overly generous guaranteed minimum withdrawal funds to clients.

Having raced to keep up with Manulife, Sun is now also reeling. Sun's shares fell 20% this week, and are down more than 65% in the last year.

"Clearly, companies miscalculated," Mr. Lipponen said. "Competition drove the product features to a point they were simply too rich. They were priced for equity markets that would not have this kind of a dramatic drop."

The once rock-solid, even boring insurance companies are now bound inextricably to the performance of financial markets.

Kin Lo, a professor at the Sauder School of Business, said Canada's top insurance companies had strayed from responsible business practices.

"Insurance is about protecting people from risk and what we have seen is the insurance industry going out and seeking risk," he said.

"It is in the nature of insurance that these companies should be fairly conservative in how they go about their business.

"What we saw in the last few years is insurers getting away from conservatism," he said.

Both of Canada's top insurers are now on the watch-list of credit-rating agencies. Sun was downgraded yesterday by Standard & Poors, while Manulife was moved d own a notch earlier by Moody's.

However, neither has strayed as far beyond the pale as American International Group Inc., the collapsed insurer in the United States.

AIG was brought down by a relatively small unit in London that sold protection on complex credit instruments to sophisticated financial clients that it did not hedge and which led to a call on its capital it could not meet.

The breakup of AIG's global empire is adding to the uncertainty for Manulife and Sun because it is creating tempting takeover targets even for severely weakened insurers.

Compounding the uncertainty is pending upheaval at the top of both Sun and Manulife, which are each led by two elder statesmen in the final days of their careers.

Mr. D'Alessandro has announced his intention to retire in May but has remained at the helm as the company has nose-dived.

"It is a terrible shame. He has given his heart and soul to the company. I have enormous respect for him. He has built a true northern tiger, a global company headquartered here in Canada," said Dick Haskayne, a former member of the board of Manulife.

"It is terribly disappointing what has happened to the stock price. The whole market has brought everybody down," he said.

Sun is headed by Donald Stewart, a veteran of the industry who is expected to step aside for a recently hired heir apparent waiting in the wings in the company's small, under-performing U. S. operation.

Despite their diminished state, both chief executives are making desperate bids to do one last international takeover that could help restore their legacies and mark their final acts with a flourish rather than a near-death experience: Manulife in Asia and Sun in the United States.

"Don always wanted to do the big deal in the U. S., but could never pull it off," said an industry veteran of the Sun chief executive.

But it is looking increasingly likely that even if both executives succeed in making long-shot acquisitions, it would not have much impact on the rot underway. It could also make matters worse in the short term.

To understand why the insurers' share prices kept falling this week, it helps to have an understanding of the company's investment portfolios.

U. S. regulatory filings show a Manulife subsidiary, for example, holds at least US$200-million in long-term bonds in Citigroup, US$500-million in exposures to Bank of America and US$260-mill-lion in Wells Fargo securities.

So, it weighed on the stock this week when concerns about the capital reserves of U. S. banks prompted Moody's to downgrade the ratings of long-term bonds in Bank of America and Wells Fargo, and Citigroup's share price dropped below US$1.

Also hanging over Manulife and Sun is growing pessimism about the U. S. commercial-property market, which had held up better than the housing sector but saw an even bigger fall in prices last year than the hard-hit residential market.

"Canadian life insurers are still relatively more exposed to the property markets than their peers in other countries," said Peter Routledge, of Moody's.

Shares in Manulife and Sun also came under pressure after AIG this week wrote off 25% of the value of its portfolio of complex structured products linked to the commercial-property market, called commercial-mortgage backed securities.

A similar writedown by Canada's insurers would cost them dearly. In addition to direct investments in property developments, Manulife also holds $5.7-billion in commercial-mortgage backed securities, while Sun has a $2.6-billion portfolio dominated by the instruments.

Manulife also has niggling tax issues that were the subject of private discussions on Capitol Hill this week, according to people familiar with the discussions.

Both Democrats and Republicans participated in the meetings, which discussed Manulife's participation in an alleged tax shelter in which the insurer assumed the tax benefits of a rural industry electricity co-operative in Indiana.

The company has acknowledged it may have to surrender some tax benefits to U. S. authorities. In the first quarter it set aside extra funds for "possible disallowance of the tax treatment," adding that the full amount the company would have to cough up could climb to $643-million though this was "not expected to occur".

But lawmakers have also discussed applying an extra penalty to Manulife after they became incensed over the company's attempts to claim cash from the tax shelter early through legal action against the Indiana co-operative.

"We are talking about serious punitive measures against the Manulifes of the world," said one person briefed on the week's dialogue, adding a 200% excise tax on any funds recovered from these alleged tax shelters was being considered.

The tax exposure is a relatively minor matter for the insurer compared with the scale of the upheavals in world markets, but it underscores the steady stream of setbacks for Canadian insurers.

"Asset impairments and losses in the investment portfolios of life insurers are expected to increase materially over the next few quarters," Mr. Routledge said.

This would continue to put pressure on the capital that insurers must hold in reserve to cover guarantees to customers, he said

"In 2009, the overriding credit issue for the Canadian life insurers will be managing dramatically higher demands on their capital--as reserves for variable annuity guarantees rise -- as well as higher capital requirements," Mr. Routledge said.

The country's top insurance regulator has already come to the aid of insurers with one round of moves that loosened capital reserve requirements. But it is unclear it is prepared to do so again.

"We aren't planning any imminent material changes to [capital requirements]," said an official at the Office of Superintendent of Financial Institutions. "However, it is possible that economic and market conditions or business developments, for example, new products or changes in risk, may necessitate the review of certain rules before the usual three-year cycle," the official said. "It's everyone's ultimate goal to have a safe and sound financial system."

Two senior insurance executives said they anticipated Ottawa might permit insurance companies to sell illiquid assets to the federal government to give them more financial flexibility.

Yet insurers have already tested the limits between Bay Street and Ottawa about how to achieve a sound financial system while still allowing them to reward shareholders with aggressive expansion.

Manulife even went so far as to approach Ottawa with a plan to change the law restricting foreign ownership of financial institutions so it could make an offer for the Asian assets of AIG. The plan included handing a stake in the Toronto-based insurer to the U. S. and Chinese governments.

Ottawa decided to take a pass on the plan, according to people familiar with the matter, leaving the $15-billion company to raid $10-billion to $20-billion if its bid succeeds.

Sun Life has also hit hurdles as it pursues target companies that have applied for bailouts from the U. S. government. As it tries to avoid taking on massive new risks or getting caught up in a part nationalization, it could wind up with only a tiny slice of a U. S. insurance company. While this might not faze shareholders, it could throw a spanner in the works of its informal executive succession plan, which was built around the idea that it will appoint a veteran of the U. S. industry in the wake of a big U. S. acquisition.

While the Conservative government places a premium on helping Canadian insurers compete internationally and is prepared to provide limited support, it is also mindful of the sensitivities of voters.

Brenda Sansregret said customers who stop into her insurance brokerage in North Battleford, Sask., have one question on their minds: Is my insurance company safe?

"No matter what they do -- farmers, average working families, businesses owners -- they are all asking," said her colleague Deanna Mclay.

The answer brokers are giving their clients is that at least 85% of their policies are protected through an industry self-insurance scheme called Assuris.

"We are here to protect Canadian policyholders in the event that their life-insurance company should fail," said Gordon Dunning, the head of Assuris.

But the scheme -- backed by a $100-million liquidity fund and member commitments of up to $4.5-billion -- offers no protection to shareholders in insurance companies, which do not enjoy the same explicit backing from the central bank as deposit-taking banks.

So what can shareholders expect? Like many financial analysts, Darko Mihelic expects Canadian insurers to weather the storm. The CIBC analyst views the stocks as oversold because of irrational fear that is coursing through markets and driving investor behaviour.

He even sees a strong possibility of a major rally in insurance stocks, though this may not prove sustainable until the credit crisis has peaked.

"I stick by that view. But I still lose sleep at night," he said.