Review of Banks' Q1 2010 Earnings

Scotia Capital, 19 March 2010

Strong Earnings, Ahead of Market Expectations

• Canadian banks reported another quarter of strong operating results. Bank earnings again exceeded Street expectations for the fourth straight quarter, thus further confirming that the bottom in operating earnings this cycle was Q2/09, which coincided with what we believe was peak quarterly loan loss provisions. Operating earnings this quarter increased 3% year over year (YOY) and 5% quarter over quarter (QOQ).

• Reported earnings this quarter were very much reflective of operating earnings, at only 2% below operating versus 8% below in the previous quarter, further confirming that the bottom of the cycle for reported earnings was Q1/08. Mark-to-market writedowns have generally fully dissipated for this cycle.

• Profitability for the bank group was solid with return on equity (ROE) at 17.4% versus 18.3% a year earlier as financial leverage continues to decline. However, return on risk-weighted assets (RRWA) at 2.12% improved 30 bp YOY based on lower leverage and banks’ active management of risk-weighted assets. Overall profitability, we believe, is high, especially given level of interest rates, low financial leverage, and high level of loan loss provisioning based on the stage in the credit cycle. This quarter earnings level, assuming 30 bp in loan loss provisions, would result in ROE of 19.3% with RRWA of 2.45%.

• First quarter earnings were driven by strong retail banking results, resilient wholesale, modest recovery in wealth management, overall net interest margin (NIM) improvement and lower loan loss provisions.

• Retail banking performance was supported by net interest margin improvement, solid volume growth, and cost control, resulting in very positive operating leverage.

• Wholesale earnings were resilient with strong recovery from TD and CIBC platforms and continued strength at the other banks. Trading revenue held up at historically high levels with capital market revenue solid. Wealth management also showed better results on higher asset levels.

• Credit quality showed further signs of improvement in the quarter, particularly in terms of loan loss provisions (LLPs). LLPs declined 15% QOQ to $2.1 billion in Q1/10, the lowest level since Q4/08. It is becoming more and more evident that LLPs peaked for Canadian banks in Q2/09 at $2,586 million. Bank loan loss provisions’ decline in Q1/10 was earlier in 2010 than expected, although they can still be lumpy. The Credit Cycle unfolds – loan loss provisions peak fiscal 2009 at 80 bp, next trough 2013E/2014E at 20 bp to 25 bp.

• Gross Impaired Loan (GILs) levels remain high; however, the rate of growth has moderated significantly, and appears to be peaking at $17.5 billion or 1.4% of loans.

• GIL formations did show solid improvement, declining 19% in Q1/10 to $4.4 billion, with formations at the lowest level since Q4/08.

• The recovery of the bank group’s net interest margin continued this quarter, providing some follow-through from the reversal that began in the last half of 2009 after an eight-year decline. The banks continue to benefit from the repricing of the loan book and solid growth in personal deposits.

• The bank group’s overall NIM improved 21 bp YOY to 1.92%; however, it declined 1 bp sequentially due primarily to RY’s negative margin impact from repositioning its U.S. securities portfolio and accounting adjustment related to securitization. Notwithstanding RY, the NIM improved sequentially.

• The retail NIM increased 13 bp YOY and 4 bp sequentially to 2.81% – the highest level since Q2/08 but substantially below the level of 3.60% in 2001.

• Bank earnings growth this quarter YOY was led by TD at 26%, followed by BMO, NA, and BNS at 4%, 3%, and 2%, respectively. RY and CM earnings were down YOY with RY considerably lower based on very difficult comps and relatively weak first quarter 2010 earnings.

• In terms of beats this quarter, TD and CM were the leaders with relative stock performance on a short-term trading basis following the earnings; thus, on a trading basis, we expect short term outperformance from TD and CM. In terms of disappointment this quarter, RY earnings were solid but uninspiring.

• The bank group’s strong operating earnings allowed the banks to continue to build capital. Bank dividends remain frozen pending regulatory clarity and/or a nod from the regulator. Banks paid out 47% of operating earnings in the form of common dividends this quarter. Banks continue to generate strong earnings and actively manage risk-weighted assets as a consequence. Tier 1 capital ratios increased 30 bp this quarter to an all-time high of 12.1%.

• The bank group RRWA was 2.12% this quarter, and based on a 47% payout to common shareholders, internally generated capital added 1.1% to capital ratios.

• Bank balance sheets remain high quality with an unrealized security surplus of $3.0 billion versus $2.6 billion in the previous quarter and a deficit of $3.3 billion at the apex of the financial crisis in Q4/08.

Upgrading to Overweight – Overpowering Fundamentals

• We are upgrading the bank group to overweight from market weight due to strength in operating earnings and risk of strong bank rally occurring earlier in 2010 than expected and the fact that the bank group is approaching the high end of its consolidation range that it has built over a healthy four to seven month period. The bank rally in 2009 was stronger than expected and the pending bank rally in 2010 may be earlier than expected.

• Bank fundamentals and earnings strength, we believe, are more than compensating for the regulatory uncertainty that still persists. Also, the market discounted the worst-case scenario from a regulatory perspective early, and is now looking at regulatory risk in a more balanced fashion.

• It appears that bank fundamentals are improving earlier in 2010 than anticipated and capital build is very strong. Strong inflows into the mutual fund industry in February, particularly into balanced funds, is supportive to high dividend yielding stocks, particularly bank stocks.

• We continue to expect a very strong bank rally later in 2010, but bank operating results may accelerate the time line. Also, we are not giving up hope that banks may increase their dividends in the fourth quarter, although at lower rates than operating results would dictate, due to regulatory oversight. We are hopeful that the regulator will be more balanced as the global banking system moves towards some type of normalization.

• Our guess is that systemic risk will be perceived as being lower by year-end, and with strong capital positions, the banks may be allowed to increase dividends, with RY, TD, and NA the most likely, with increases estimated in the 6%-8% range, and BNS and CM less likely, but with modest increases in the in the 4% range possible. BMO’s higher payout ratio may result in delaying an increase for a few quarters. We expect banks to allow their payout ratios to decline modestly in the near to perhaps medium term, depending on calibration from Basel on capital buffers and dividend distribution.

• Interestingly, bank relative share price performance had a distinct seasonal pattern of outperforming in the calendar fourth quarter (19 out of 21 years as at 2000, or 12 straight years) and we were very active with this research in the 1990s. However, the pattern became less predictable post-2000 and was further disrupted by the recent financial crisis. Consequently, it appears the market began to discount, or anticipate, fourth-quarter outperformance, and bank relative outperformance was accelerated to the third quarter. Hence, banks have outperformed in the third calendar quarter since 2000 – seven out of 10 years. Thus, bank share prices may start to discount dividend increases and earnings improvements well prior to calendar fourth quarter.

• We maintain healthy bank share price targets, as we expect P/E multiple expansion to continue off the 2009 lows. We believe bank P/E multiples are poised to again expand towards the 15x-16x range over the next several years based on high profitability and capital, improving fundamentals (including the positive side of the credit cycle), net interest margin stability/expansion, and an economic recovery. Bank dividend yields are attractive and dividend increases, which have stalled in the near term, will be a key catalyst for higher P/E multiples and another solid sustained bank share rally that may have already begun.

• We would recommend moving towards a 30% bank weighting, as YOY earnings growth is expected to increase to 12% in Q2/10, up from 3% this quarter, with the third quarter expected to moderate to 4% (tougher comp), and the fourth quarter expected to increase sharply, up 16% YOY (supportive of dividend increases).

• We have 1-Sector Outperform ratings on TD, RY, and BMO, and 2-Sector Perform ratings on CM, CWB, LB, NA, and BNS. Our order of preference is: TD, RY, BMO, CM, CWB, LB, NA, and BNS. On a trading basis, TD and CM have the strongest positive share price momentum.

First Quarter Highlights

• First quarter operating earnings increased 3% YOY and 5% from the previous quarter, due to lower loan loss provisions, strong Domestic Banking earnings, and resilient wholesale earnings supported by high trading revenue.

• TD, CM, and BMO beat consensus estimates by a wide margin of 20%, 16%, and 10%, respectively, with BNS and NA beating slightly, and RY coming in more or less in line. First quarter earnings were led by TD, with YOY growth of 26% due to stellar wholesale earnings. BMO, NA, and BNS earnings growth was modest YOY, with RY and CM declining.

Domestic Banking & Wealth Management – Strong

• Domestic banking earnings, including wealth management, were very strong at $3.7 billion, up 17% YOY and 12% sequentially. Earnings growth was led by BMO, up 32%, followed by BNS, TD, and RY up 28%, 25%, and 19%, respectively. CM and NA retail earnings continue to disappoint, declining 9% and 3%, respectively, from a year earlier.

Wholesale Banking – Resilient

• Wholesale earnings were resilient at $1.9 billion in the first quarter, increasing 2% QOQ but declining 7% from a near-record quarter a year earlier. Wholesale bank earnings were driven by continued high trading revenue.

• Wholesale earnings represented 34% of total operating earnings from operations in the quarter, with NA having the largest portion of its earnings coming from wholesale at 54%, followed by BMO and BNS at 38%, RY at 37%, CM at 27%, and TD at 26%.

Trading Revenue Solid

• Trading revenue in the first quarter was solid at $2.7 billion, although down from a record $3.4 billion a year earlier and down a modest 6% from the previous quarter. Trading revenue in the first quarter was 12.0% of total revenue, down from the Q4/09 level of 12.9%, but above the five-year average of 9.2%.

Net Interest Margin Continues to Improve

• The banks’ NIM continued to improve this quarter to 1.92%, reinforcing the reversal in the margin trend. The NIM improved 21 bp YOY and declined 1 bp sequentially. The NIM had been declining for eight straight years from the 2.20% level in 2001/2002 before bottoming at 1.70% in Q1/09. The banks’ NIM rebound has been supported by aggressive loan repricing, historically high wholesale spreads (Prime, BAs), a steep yield curve, lower cost of liquidity, a government mortgage securitization program, and improvement in deposit mix with a resurgence in personal deposits. We expect the NIM to continue to improve with controlled interest rate hikes beginning in the second half of 2010. The bank that is expected to benefit the most from rising rates is TD, based on its abundance of low-cost retail deposits (demand and notice).

• The retail NIM also rebounded with a 4 bp improvement sequentially and a 13 bp increase from a year earlier. We expect the retail net interest margin to continue to improve moderately with further loan repricing and favourable loan deposit mix shifts. However, gradually, Bank of Canada interest rate increases will likely provide for a more sustainable increase in the margin.

Mark-to-Market Writedowns Negligible

• Mark-to-market writedowns were a negligible $87 million in the first quarter, the lowest quarterly charge since the credit crisis began. Writedowns this quarter were almost entirely the result of NA’s administrative penalty related to non-bank ABCP. BMO, BNS, and RY did not have any writedowns, and CM and TD had negligible writedowns. Going forward, we expect writedowns to be negligible.

Credit Losses Decline

• Loan loss provisions this quarter were $2.1 billion or 68 bp of loans, down 5% $2.2 billion or 68 bp of loans from a year earlier and down 15% from the previous quarter level of $2.5 billion or 81 bp of loans. LLPs for BMO and RY declined significantly from a year a year earlier, by 22% and 23%, respectively. NA recorded an increase in LLPs of 13%, although loan losses remained at a bank group low of 0.28% of loans. We believe that LLPs have peaked on a quarterly basis and on an annual basis in 2009.

• CM recorded the highest LLP levels this quarter at 79 bp, followed by BMO and TD at 78 bp, RY at 68 bp, BNS at 53 bp, and NA at a bank group low of 28 bp.

• The hot spots were BMO U.S. P&C actual LLPs at 254 bp, Scotia Mexico at 234 bp, RY International/U.S. at 228 bp, and TD U.S. at 143 bp.

• Our 2010 and 2011 LLP forecasts declined to $8,900 million or 70 bp of loans and $7,110 million or 53 bp of loans, respectively, from $9,700 million or 76 bp of loans and $7,410 million or 56 bp of loans, respectively.

Gross Impaired Loan Formations Decline

• Gross impaired loan formations this quarter were $4.4 billion or 0.35% of loans, declining from $5.4 billion or 0.44% of loans in the previous quarter and from $6.0 billion or 0.47% of loans a year earlier. BNS and TD formations remained relatively flat sequentially, while BMO, CM, and RY formations declined 37%, 15%, and 33%, respectively.

Gross Impaired Loans Remain High

• Gross impaired loans for the bank group remained high this quarter at $17.5 billion or 1.41% of loans, largely unchanged from the previous quarter. Gross impaired loans increased for all the banks with the exception of BMO and RY, which had flat gross impaired loans from the previous quarter.

Higher Capital Ratios

• Tier 1 capital ratio for the bank group hit another all-time high of 12.1%, led by CM at 13.0%. The Basel Committee released consultative documents in December 2009 outlining possible changes to the calculation of regulatory capital. Although no potential minimum capital levels were outlined, we expect the minimum Tier 1 ratio will be raised to 8% from the current 7% and that a Tier 1 common ratio will be introduced at 4%. The consultative document was aggressive in nature; however, we expect Canadian banks to fare well versus global banks, given their high current levels of capital, superior business models, and profitability.

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TD Bank Q1 2010 Earnings

Scotia Capital, 5 March 2010

• TD reported an increase of 26% YOY to operating earnings of $1.60 per share, above expectations. Earnings were better than expected due to strong results from Canadian P&C and Wholesale Banking with credit quality stable. ROE was 15.5% with RRWA very high at 2.88%.

Implications

• Canadian P&C earnings were a record, increasing 23% YOY with revenue growth of 11% aided by improved NIM and loan growth. Wholesale earnings were very strong; flat sequentially, and well above sustainable levels, in our opinion. Wealth Management earnings were solid with U.S. P&C weak.

Recommendation

• We are increasing our 2010 and 2011 earnings estimates to $5.95 per share and $6.60 per share from $5.65 per share and $6.50 per share, respectively, due to stronger-than-expected earnings this quarter and strong operating leverage in domestic retail. We are increasing our 12-month share price target to $85 from $80.

• We are upgrading TD to a 1-Sector Outperform from a 2-Sector Perform based on superior positive earnings leverage to higher interest rates due to large core retail deposit base, strong retail franchise, and manageable U.S. credit risk.

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RBC Q1 2010 Earnings

Scotia Capital, 4 March 2010

RY cash operating earnings declined 16% YOY to $1.03 per share, in line with expectations. Operating ROE was 18.0% with RRWA of 2.32%.

Implications

• Earnings were driven by strong Canadian Banking results with wholesale earnings resilient. Credit quality improved in the quarter with lower loan loss provisions and lower gross impaired loan formations. Partially offsetting the strong operating results was a weak overall net interest margin that is expected to reverse itself in the remainder of 2010.

Recommendation

• We are trimming our 2010 and 2011 EPS estimates to $4.65 per share and $5.35 per share from $4.75 per share and $5.50 per share, respectively, due to slightly lower than expected net interest margin. Our one-year price target is unchanged at $75.

• We maintain our 1-Sector Outperform rating on the shares of Royal Bank based on its superior longer-term earnings growth prospects given the strength of its retail and wealth management businesses and its uniquely positioned capital markets platform (U.K. and U.S. presence). The bank has significant earnings recovery potential from its U.S. retail business. RY has high profitability and capital ratios.

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CIBC Q1 2010 Earnings

Scotia Capital, 26 February 2010

• CM reported a decline in cash operating earnings of 1% to $1.65 per share above our estimate and consensus due to higher net interest margin and stronger-than-expected results from wholesale with trading revenue flat QOQ. ROE was 22.5% with RRWA of 2.21%.

Implications

• CIBC Retail Markets earnings declined 9% YOY to $529M due mainly to loan loss provisions increasing 31%, but increased 12% sequentially. CIBC World Markets earnings were surprisingly strong at $181M, increasing 23% from a year earlier and 37% from the previous quarter.

Recommendation

• We are increasing our 2010 and 2011 earnings estimates to $6.40 per share and $7.20 per share from $6.05 per share and $7.00 per share, respectively, due to the improvement in net interest margin and higher level of earnings from World Markets. We are increasing our 12-month share price target to $80 from $75 based on higher earnings.

• We are upgrading CM to a 2-Sector Perform from a 3-Sector Underperform due to stabilization of wholesale platform, continued run-off in the structured credit portfolio and slight improvement in revenue outlook in Retail Markets.

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Veritas Investment Research, 26 February 2010

Q1 results were a step in the right direction for CIBC, with the bank taking steps towards delivering on the operating and credit recovery that Veritas considers already priced into the stock at $70. Reported earnings were $652M [compared to $644M in Q4-F09], and adjusted earnings of $654M were down 1.7% against adjusted earnings a year ago though up 13.5% against Q4. One-time items this quarter netted to between $2M and $20M, but the gross one-time items were material and necessarily complex – gains on improvements in sub-prime valuations and monoline spreads, further complicated by steps taken by CIBC to unwind its nettlesome sub-prime and non sub-prime exposures. The case for caution on CIBC is nevertheless compelling. Veritas remains concerned about the potential performance of the structured credit run-off book in another downturn. Quarter-in, quarter-out through the recovery, the $13B CLO portfolio and its underlying components continue to migrate while the aftershocks of the credit crunch – such as potential litigation from the Lehman estate – and the aftershocks of Enron continue to reverberate at CIBC. Veritas concludes that CIBC’s first quarter was positive in the sense that it was the second positive loan loss quarter in a row, the retail business may have bottomed out, and CIBC World Markets continues to generate above expectation earnings. Investors must decide, however, whether CIBC’s P/E discount to peers compensates for the following risks: the structured credit overhang, potential for capital markets earnings normalization, credit risk on cards and a few high-risk, high yield loan portfolios, and a few sharp objects still in its path.

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National Bank Q1 2010 Earnings

Veritas Investment Research, 26 February 2010

On first glance and deeper inspection, it is hard to find too many noteworthy aspects of the National’s solid & steady first quarter. Earnings were in line with Veritas’ expectations, which were themselves slightly above the consensus view. The quarter unfolded pretty much according to script: trading revenues normalized but didn’t melt away, while credit losses increased, but didn’t blow out. The bank’s transition from using standardized credit risk calculations to advanced credit risk models for capital purposes, along with internally-generated capital, resulted in a 180bps increase in the Tier 1 capital ratio. Balance sheet and revenue growth was solid if unspectacular. Having missed expectations slightly last quarter, NA delivered just a bit more this quarter – a bit more than last quarter and a bit more than expectations. But, Veritas thinks the results show that the most likely range for NA’s earnings is in the low- to mid-$6/share range this year and mid- to high-$6/share range next year. The bank’s normalized ROE this quarter was 18%, the Tier 1 ratio is 12.5%, and the dividend payout ratio is 40%. Though lower growth deserves a lower multiple, Veritas continues to recommend shares of NA with a $65 intrinsic value.

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Financial Post, 26 February 2010

National Bank of Canada was upgraded from Sector Perform to Outperform by CI Capital Markets analyst Brad Smith after the bank reported better-than-expected first quarter results.

Adjusted cash earnings per share of $1.55 were well ahead of his $1.36 estimate and consensus at $1.45. A 4% revenue shortfall, primarily due to lower trading revenues, was more than offset by an 8% lower-than-anticipated expense run after the $75-million penalty from the bank’s ABCP involvement was excluded.

The bank changed the way it measures risk-weighted assets during the quarter, which meant its Tier 1 capital ratio climbed to 12.5% from 10.7% at the end of the fourth quarter of 2009. Management confirmed that if recently proposed new capital rules are enacted as set out, the preliminary estimate of the impact on Tier 1 would be a reduction of 300 to 400 basis points.

Despite beating his quarterly estimates by a healthy margin, Mr. Smith left his 2010 and 2011 full-year estimates unchanged. He told clients this is due to lingering uncertainty relating to the sustainability of National’s reduced provisioning and expense efficiency levels.

Nonetheless, the upside the analyst sees in the stock justified to upgrade. Mr. Smith’s price target on National Bank shares is $65.

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Preview of Banks' Q1 2010 Earnings

Scotia Capital, 18 February 2010

Banks Begin Reporting February 25

• Banks begin reporting first quarter earnings with Canadian Imperial Bank of Commerce (CM) and National Bank (NA) on February 25, followed by Bank of Montreal (BMO) on March 2, Royal Bank (RY) and Laurentian Bank (LB) on March 3, Canadian Western (CWB) and Toronto Dominion (TD) on March 4, and Bank of Nova Scotia (BNS) closing out reporting on March 9. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 3, and conference call information in Exhibit 4.

First Quarter Earnings to Decline 5% YOY

• We expect first quarter operating earnings to decline 5% year over year (YOY) and to decline 1% quarter over quarter (QOQ). Bank operating results are expected to be stable and solid with a 16.3% return on equity and very impressive RRWA of 2.05% while absorbing what we believe are peak LLPs in the 80 bp range.

• We have trimmed our first quarter and fiscal 2010 earnings estimates (Exhibit 2) based on expected weaker trading revenue given the decline in volume and tighter asset spreads.

• Reported earnings are expected to closely parallel operating earnings with mark-to-market losses negligible following the trend in 2009 that saw mark-to-market losses decline throughout the year, reaching a nominal amount in Q4/09. Thus, banks are expected to continue to build capital via acceleration of internally-generated capital and aggressive management of risk-weighted assets, especially market at risk.

• In terms of operating earnings this quarter, we assume stable LLPs in the $2.5 billion range and weaker wholesale earnings partially offset by net interest margin improvement. The two most important factors this quarter are the impact of lower trading volumes and equity underwriting (although fixed income is extremely strong), and the net earnings impact on wholesale earnings and the magnitude of the potentially offsetting improvement in NIM.

• Bank earnings have beaten street expectations for most of fiscal 2009 with a substantial beat in Q4/09. Interestingly, bank share prices did not respond particularly well to the heavy Q4/09 beat.

• Wholesale banking earnings resilience will be tested this quarter especially in light of weak trading revenue from U.S. banks. However, it is important to note that the time period is different, with January being a very strong month versus October, especially from a fixed income underwriting perspective. Therefore, we would expect Canadian banks’ trading revenue/wholesale earnings to perform better in Q1/10 (ended January 31) than the U.S. banks’ in Q4/09 (ended December 31), although we expect lower trading revenue versus much of fiscal 2009. Wealth management earnings recovery is expected to continue to be driven by higher asset levels and positive operating leverage. Retail banking results are expected to remain solid, buoyed by stable-to-improving net interest margin.

• Banks’ earnings this quarter are being supported by continued loan repricing (mainly wholesale), stable interest rates, a steep yield curve, relatively high wholesale interest rate spreads, expected improvement in retail spreads, slight narrowing of bond spreads, higher LCDX Index, and significantly lower net security losses (perhaps security gains).

• The drag this quarter is expected to be the continued high level of loan losses, although they are relatively stable (flat QOQ, up 12% YOY), higher gross impaired loans (although gross impaired formations are expected to decline modestly), and the 2% QOQ, 16% YOY, appreciation in the Canadian dollar to the U.S. dollar (average), which will negatively impact foreign currency earnings. Lower securitization gains (narrower mortgage treasury spread), although not much of a factor in Q3/09 and Q4/09, and of course expected lower trading revenue, are expected to be a drag on earnings as well.

• Trading revenue reached record levels in both Q1/09 and Q3/09 at $3.4 billion, with a Q2/09 figure of $2.8 billion and Q4/09 at $2.9 billion. In terms of trading revenue, we continue to believe that there is both a cyclical and structural component to the high level of trading revenue, with the split very difficult to ascertain with any degree of accuracy. However, trading revenue is expected to decline this quarter (cyclical) due to lower volumes and tighter asset spreads.

• Loan loss provisions in Q1/10 are forecast at $2,475 million or 0.80% of loans, essentially unchanged from the past three quarters. Quarterly loan loss provisions are expected to be flat again this quarter down from a peak quarterly growth rate of 45% in Q1/09. We continue to believe that the bank group loan losses are at or very near peak levels for this cycle, in the $10 billion per annum range or 80 to 85 bp, in line with expectations from our report “The Credit Cycle”.

• Our forecast is for a 6% increase in operating earnings in fiscal 2010 and a 15% increase in 2011. Return on equity is expected to bottom in fiscal 2010 at 17.4%, increasing to 18.2% in 2011 as the banks move into a more favorable stage in the credit cycle and economic growth improves.

• The Canadian banks’ caution on the timing of dividend increases was very evident with the release of Q4/09 results. The uncertainty about bank dividend increases has increased with the release of the Basel consultative documents (see our report published January 27, 2010 entitled “Canada’s Dividend Culture – Caught in the Crossfire – Dividend Reset”).

• We expect Canadian banks will be able to meet any new capital requirements with very little disruption to their operating platforms, but dividend increases are likely on hold in the near term pending clarity from regulators.

• Bank fundamentals, we believe, are strong and are expected to improve over the next several years. We view Canadian banks as having low balance sheet risk, being well capitalized and highly profitable, and expect them to continue to generate superior shareholder returns.

• Long-term outperformance is expected, but in the near term we believe the bank group is in a consolidation phase pending some regulatory certainty. We need regulatory clarity, especially on capital and dividend policy, before bank valuations can expand further, in our opinion, thus our market weight recommendation (downgraded December 11, 2009). We expect dividend increases that are currently on hold will be the catalyst for substantially higher P/E multiples in the future.

• In terms of stock selection, we continue to believe RY to be a standout, given the strong reinvestment, competitive positioning in all its major business lines, the resulting industry high profitability and capital, and absence of a premium valuation. We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, LB, CWB, NA, and TD, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.

ABCP Settlements – BNS, CM, NA, and LB

• On December 22, 2009, the Ontario Securities Commission (OSC), the Autorité des marchés financiers (AMF), and the Investment Industry Regulatory Organization of Canada (IIROC) announced that settlements had been reached in connection with investigations into the Canadian ABCP market resulting in $138.8 million in administrative penalties and investigation costs. The settlements are as follows: National Bank Financial (NA), $75 million; Scotia Capital Inc. (BNS), $29.3 million; CIBC World Markets (CM), $22 million; HSBC Bank Canada, $6 million; Laurentian Bank Securities Inc. (LB), $3.2 million; Canaccord Financial Ltd., $3.1 million; and Credential Securities Inc., $0.2 million. ABCP settlement costs are non tax-deductible and will be items of note in first quarter 2010 earnings.

TD – TD Ameritrade Earnings Below Consensus

• On January 19, 2010, TD Ameritrade reported a decline in first quarter earnings of 26% YOY to US$0.23 per share, below consensus of US$0.26 per share. Earnings were negatively impacted YOY by higher expenses, particularly higher employee compensation and benefits and higher advertising spend. TD Bank estimates TD Ameritrade’s contribution from this quarter to be C$43 million or C$0.05 per TD share versus C$0.07 per share in the previous quarter and C$0.09 per share a year earlier.

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Financial Post, 17 February 2010

Toronto Dominion Bank’s US operation is facing a jump in “past due” loans in the fourth quarter that could herald a rise in defaults in future quarters, says Brad Smith, an analyst at CI Capital Markets.

Of the major domestic banks, TD has the biggest operation south of the border.

Citing U.S. regulatory filings, Mr. Smith said in a note to clients that TD’s U.S. banking group had a US$326-million or 48% increase in loans that were 30 to 90 days in arrears compared to the previous quarter. Of particular concern, he said, was a 134% hike in past due loans secured by non-residential properties.

The bottom line is that if the trend continues, it will likely translate into “upward pressure on future provisioning levels,” Mr. Smith said.

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Dominic D'Alessandro's Risk Management Approach Not Popular Among Manulife's Senior Ranks

National Post, Theresa Tedesco, 30 January 2010

The National Post investigates the impact of the global financial turmoil inside Manulife Financial Corp., Canada's most venerable life insurance company. The Post's examination reveals the drama behind the closed doors of the boardroom, the tense battle between the country's financial watchdog and Manulife's formidable former chief executive, and the reasons why the company's new CEO is bringing change to the insurance giant.

Donald Guloien, chief executive of Manulife Financial Corp., sits convivially in the boardroom adjacent to his 11th-floor suite at the insurer's downtown Toronto head office.

Sipping coffee from a large white mug, the 52-year-old betrays only momentary flashes of the conflict his organization has endured over the past 16 months. "I'm very proud to lead this company in good times and bad," Mr. Guloien said during a recent interview with the National Post. "But the last year has been interesting."

Nine months in the corner office -- one formerly occupied by the tough-minded Dominic D'Alessandro who, in 15 years, built Manulife into North America's largest life insurer-- Mr. Guloien believes it's a "charmed" life to lead the company and its 45,000 worldwide employees, despite its recent challenges.

Like other Canadian insurers, Manulife was sideswiped during the financial crisis due to its exposure to guaranteed annuity products it had sold to clients across North America and Asia. Most have issued significant amounts of new shares to raise their capital levels since stock markets plunged in the fall of 2008. A major player in the business, Manulife hadn't hedged its segregated funds. That exposure created a capital risk that attracted the attention -- and intervention-- of the Office of the Superintendent of Financial Institutions (OSFI), Canada's financial services regulator.

By the time the legendary Mr. D'Alessandro, 62, retired last May, Mr. Guloien began pulling back on selling variable annuities and lowering the life insurer's risk profile.

As a result, he admits he's landed in "very public disagreements" with Manulife's shareholders after making the unpopular decisions to cut the dividend and issue billions in shares.

"There's a real credibility issue here," says Len Racioppo, president at money manager Jarislowsky Fraser Ltd., which owns more than $1-billion worth of Manulife shares. "The credibility issue is not just with the current CEO. It's with past management and the board itself."

Mr. Guloien concedes it's all been "very humiliating." But he adds: "I don't get paid to have a happy ride. I get paid to make the right decisions for shareholders whether it causes me difficulty or not."

Since becoming a public company in 1999, Manulife delivered a steady ride for its shareholders. Now, many are wondering whether Mr. Guloien has embarked on a dramatic shift from the past or whether he's engaged in damage control.

Trouble began showing up on Manulife's radar in April 2006.

According to internal company documents reviewed by the Post, the insurer's chief risk officer made a presentation to the company's chief executive Mr. D'Alessandro, warning that the company's balance sheet at the time "could not absorb the growing equity risk."

According to the documents, Manulife had unusually high exposure to stock markets because of its large segregated fund variable annuity business. Manulife, like most insurance companies, cashed in as aging Baby Boomers flocked to the products to enhance their investment portfolios.

Back in 2004, Mr. D'Alessandro made a significant business decision: Manulife would dispense with the industry practice of hedging on equity positions in the variable annuity business to cover guaranteed payouts in the event of a market crash.

Sources told the Post that Mr. D'Alessandro had an aversion to hedging because it relied on derivatives. An accountant by training, the former CEO worried that hedging was not only costly, but could lead to unintended consequences. In his view, the practice was best avoided whenever possible.

Apparently, his approach to risk management was not popular among all members of the senior ranks at Manulife. Still, no one challenged the decision.

"Bringing up a topic like that wouldn't make you very popular," says the source familiar with Manulife who spoke on the condition of anonymity. "The decision wasn't discussed because no one wanted to oppose Dominic."

But by 2006, according to the company's internal documents, the insurer was now dealing with growing risk exposure caused by the gap between the amount it promised to pay its variable annuity customers in the future, and the amount set aside to meet those guarantees. The company decided to commence hedging, testing and refining various strategies.

By the end of 2007, Manulife was hedging a small percentage of its variable annuity business. But it would be too little, too late. By early 2008, the exposure had widened.

The company's board of directors was taking notice. According to sources familiar with events, some directors began asking Mr. D'Alessandro and then-chief financial officer Peter Rubenovitch pointed questions about the variable annuity business and the company's dependence on it.

"Most members of the board didn't really understand what was going on," said an official who asked not to be named.

Board members were urging Mr. D'Alessandro to hedge the insurer's exposure and curtail the sale of the profitable products. For Manulife's competitors, the costs of hedging cut into as much as one-third of profits. Although it's difficult to determine what percentage of overall earnings the products contributed to Manulife's bottom line, some say the company's strong growth was being driven by this division.

Mr. D'Alessandro acquiesced to the board by allowing some more hedging. He didn't want Manulife to lock in the losses, especially since the products wouldn't mature for years.

"There was this religion that Manulife had created a shareholder base that wanted a steady quarterly return, dividend and profit number," said the source familiar with the company. "Manulife wanted a predictable return and Dominic was going to supply it."

Then, the implausible happened. Stock markets around the world went into a free fall, shaving as much as 50% from leading market indices.

When markets collapsed in September 2008, Manulife's net exposure of guarantees from segregated fund products was $72-billion -- most of it not to be paid out for seven to 30 years. The company's capital levels, usually well above the minimum level set by the regulators, sank because of the massive stock portfolio associated with the variable annuities.

Inevitably, the country's financial services watchdog -- the Office of the Superintendent of Financial Institutions (OSFI) -- showed up at Manulife's door.

The giant insurer was assigned internal file number TP4300-MI-20/04-1-2 by the federal regulator, signalling the company would be subjected to a series of intensive "activity reviews" by OSFI. These included monitoring its financial condition, reviewing board mi nutes and scrutinizing selected presentations to the board, as well as various management committees.

Sources say the regulator felt Manulife wasn't moving fast enough to fix the problem of its growing risk exposure and capital shortfall.

OSFI also raised questions about Manulife's internal risk-control systems and sought a meeting to discuss its concerns with Manulife's new chairman of the board, Gail Cook-Bennett, and Richard DeWolfe, chairman of the audit and risk management committee in October 2008.

"Regulators tend to get very adamant when the horse is out of the barn. It should have had the conversation much earlier," says a money manager who asked not to be named. "Why weren't they aware of Manulife's position before the 2008 meltdown? Maybe because of D'Alessandro's [solid] reputation, they just assumed there was nothing really dangerous hiding there."

During its meetings with the watchdog, sources say Manulife's senior management explained the capital calculations on the variable annuity business had been stress-tested for a worst-case scenario of a 30% plunge in the stock market -- not the 50% nose dive experienced after September 2008. They sought to persuade OSFI that the capital requirements in the existing model didn't accommodate the new products. And Manulife officials argued that segregated fund guarantees are long-dated liabilities and that any return to normal market conditions would restore capital reserves.

But OSFI was adamant that Manulife shore up its capital position immediately. According to sources familiar with the meetings, the regulator wanted to know how Manulife's position could get so large. And couldn't the company see it was rolling the dice?

OSFI declined to comment for this article saying the regulator does not discuss individual institutions.

"OSFI got on Manulife because of its capital situation," said a source familiar with events who asked not to be named. "It insisted it do a series of transactions."

Among them, issuing common stock, preferred shares or bank loans to flush up Manulife's capital.

According to sources, this upset Mr. D'Alessandro, who found himself in the unusual role of having to defend himself to a blue-ribbon board of directors unaccustomed to being caught in the crosshairs of the federal regulator. He refused to consider diluting Manulife's shareholders with a share offering, insisting it was a last-resort option.

"OSFI wanted [Manulife] to raise more capital and [the company] kept complaining there was no way to raise capital in these markets because they were shut down," says the source familiar with events.

Claude Lamoureux, former chairman of the Ontario Teachers Pension Plan and a veteran corporate governance advocate, explained why OSFI might have taken such a position.

"The regulator is there for one thing -- to protect the policyholder," he said. "If the shareholder ends up with zero return, that's fine. That's not the concern of the regulator."

At the same time that OSFI was demanding Manulife bolster its capital levels, Mr. D'Alessandro took up his own fight with Superintendent Julie Dickson to loosen the capital requirements. His argument, embraced by others in the industry, was that insurers be made to set aside reserves only when there were large dips in the value of investments that back up those guarantees to customers.

He appeared to make headway when on Oct. 28, 2008, OSFI announced that after consultations with industry participants, it was making adjustments to its conditional tail expectation (CTE) requirements that would require levels of capital that better reflect when payments by insurers were likely to come due.

For Manulife, the amendments provided a little more breathing space.

But Mr. D'Alessandro didn't give up the battle.

Said another source close to events who asked not to be named: "She [Ms. Dickson] feels she's done enough but D'Alessandro is out of his mind [angry]."

The outspoken insurance executive argued that Ms. Dickson and her staff at OSFI were being short-sighted. His message: The capital requirements model used by OSFI was still exaggerated, punitive and regressive.

According to sources, Manulife's CEO apparently was also convinced the bureaucrats disliked him personally because of the strong stance he was taking.

Manulife's chief executive took his case to Ottawa, where he met with Bank of Canada Governor Mark Carney; Kevin Lynch, the Clerk of the Privy Council and Secretary to the Cabinet; and federal Finance Minister Jim Flaherty. He also requested time with Prime Minister Stephen Harper.

He warned it would become too expensive for providers, such as Manulife, to offer the guaranteed-income products because of OSFI's capital requirements. Sources say Mr. D'Alessandro questioned whether it was good public policy that these popular products would likely no longer be available to Canadians for their retirement planning.

In the end, his pleas fell on deaf ears. No one in Ottawa seemed anxious to wade into a battle between the formidable insurance executive and the emboldened federal regulator.

On Nov. 6, 2008, Manulife announced it had secured a $3-billion, five-year bank loan to strengthen its capital base. At the time, Mr. D'Alessandro reassured investors, "Even with the decline in global equity markets since Sept. 30, our capital position is a very comfortable one."

Meanwhile, OSFI was ratcheting up its scrutiny of Manulife.

According to documents reviewed by the Post, staff at the regulator began raising serious concerns about the "safety and soundness" of North America's largest insurance company.

In a confidential "supervisory letter" dated Nov. 12, 2008, OSFI informed Manulife that it had amended its intervention stage rating (ISR), from zero to stage one, an "early warning" level, indicating OSFI had identified deficiencies that needed to be addressed because they could lead to serious "material safety and soundness concerns."

In early December 2008, Manulife's board met with OSFI to discuss the intervention rating and ways to resolve the regulator's issues.

In a missive sent to Manulife after the meeting, OSFI staff said it continued to "express concern related to the company's relatively higher and growing exposure to equity markets and part of the products issued in the U.S., Canada and Asia." OSFI also highlighted "board-approved risk-tolerance policies," credit risk management and asset-liability risk management "as potentially higher risk areas."

In all, OSFI requested that Manulife develop a board-approved action plan with "specific trigger points" to demonstrate how the insurer would actively manage its capital and remain compliant with regulatory requirements. OSFI also recommended that the board consider adding members "with actuarial or risk-management expertise."

The deadline for delivery of the plan was March 31, 2009.

On Dec. 3, 2008, Manulife issued $2.275-billion in stock during a battered market, a move that executives described at the time as "humbling."

By the end of 2008, the insurer was hedging all of its new variable annuity business and its minimum continuing capital and surplus requirements ratio was a healthy 234%, well above OSFI's minimum target level of 150%.

A source familiar with the life insurer said senior management and the board not only thought they had "restored capital reserve levels" with the bank debt and share issue, they figured they had "weathered the storm."

They thought wrong.

The fallout from the financial meltdown -- and the subsequent regulatory intervention -- had put Manulife in the watchdog's penalty box.

Regulatory officials were increasingly concerned that Manulife's senior management may have taken risks without fully engaging the company's directors -- or worse, without the board's knowledge.

To that end, they met with Ms. Cook-Bennett and Mr. De Wolfe, who reassured the regulator that was not the case.

But OSFI staff was not persuaded. "OSFI had a theory that management had deliberately misled the board," said a source familiar with events who asked not to be named. "For a time, they became adamant, there's no question. It was really bizarre."

To allay its concerns, the federal supervisor demanded Manulife initiate an independent review of its internal practices.

The Post has learned that at OSFI's request, Manulife retained accounting firm Deloitte & Touche to conduct an independent examination of the insurer's risk-management processes for its segregated fund and variable annuity products.

A team of auditors from Deloitte spent the first two months of 2009 at Manulife's Toronto head office reviewing activities and documents dating back from Jan. 1, 2005 to Dec. 31, 2008. Twenty-four senior managers and board members were interviewed while the auditors communicated regularly with OSFI and Mr. DeWolfe.

Meanwhile, the regulator continued to actively monitor Manulife's financial condition.

In a "supervisory letter" dated Feb. 3, 2009, OSFI notified the company that it had assigned Manulife an "above average" composite risk rating. Generally, a financial institution with this rating is considered by the regulator to have above-average overall risk, which is not sufficiently mitigated by capital and earnings.

According to documents reviewed by the Post, OSFI raised its risk rating of Manulife because of the insurer's "continued exposure to negative movements in the equity markets and senior management's failure to effectively control the risk."

It was the first time the giant life insurer had been assessed such a high composite risk rating since becoming a public company.

Nine days later, on Feb. 12, Manulife reported another first -- a quarterly loss -a $1.87-billion loss for the fourth-quarter of 2008.

Less than two weeks later, the insurer announced it did not intend to raise common share capital over and above the $2-billion it already raised the previous December, in the absence of a strategic transaction.

In its Feb. 23, 2009 release, Manulife said that although equity markets had continued to decline, the company "continues to be well-capitalized and is able to withstand additional equity volatility."

However, the credit agencies -- Standard & Poor's and Moody's Investors Service Inc. -- responded by downgrading the insurer's ratings, citing Manulife's "weakened financial flexibility and capitalization, caused by the decline in equity markets globally."

Meanwhile, Manulife's hopes for acquiring the Asian assets of troubled U.S. insurance giant American International Group (AIG) were fading.

A month later, on March 23, 2009, Deloitte simultaneously delivered to Manulife and OSFI a draft of its findings in a 29-page report.

The review concluded that the insurer's internal risk reporting, including to the board, was "comprehensive."

Deloitte's review also found that Manulife had a "disciplined risk-management culture with a strong senior management team."

Still, the Deloitte report was not a complete vindication for Manulife. It outlined 14 key recommendations and observations, from "management should have initiated the required actions earlier," to the company's risk agenda also needed more focus and time at the board.

"We did not identify one overriding reason behind the challenging situation that Manulife faces with respect to its equity risk exposure," the report declared. "However, there appear to be a series of interrelated and complex factors that contributed to the significant equity risk issue."

Overall, Deloitte concluded it was clear senior management at Manulife had an "appetite for equity risk" and a number of executives and directors indicated there was a belief that the company's strong balance sheet could continue to support the growth of the products.

"We heard from most executives that many actions had been taken in recent years to address the growing risk exposure. However, the incremental nature of these actions was not sufficient to address the escalating magnitude of the total risk exposure," the review declared.

While Manulife began preparing to act on the recommendations, sources say OSFI was not satisfied and requested the report be revised. Mr. D'Alessandro and his senior management team agreed to allow Deloitte to modify the document as long as the substance of the findings was not changed.

When the final report was delivered to Manulife's board and OSFI in April, 2009, the executive summary, including laudatory comments about Manulife, were placed in the back and recommendations listing ways the insurer could improve its operations were moved to the front.

Amid this tense atmosphere -- and with millions of dollars shaved from the value of his own stock options -- Mr. D'Alessandro officially retired from Manulife as planned in early May 2009.

Publicly, he went quietly. Privately, sources say he was seething.

A proud man accustomed to calling the shots, not dodging them, Mr. D'Alessandro believed OSFI's intervention "dramatically disturbed a very important company that had everything going for it," said a source close to the former chief executive.

Mr. Guloien, a 28-year veteran of the company, became Manulife's new CEO on May 7.

In his inaugural address to shareholders, Mr. Guloien, who had also served as the life insurer's chief investment officer, said there was little difference in style or vision between himself and Mr. D'Alessandro-- only that they would be operating in different environments.

Yet in that first address to shareholders as CEO, Mr. Guloien gave early indications of the dramatic shift to come when he spoke of adopting a conservative approach to risk -- he advocated reducing it -- and strengthening capital levels. He also warned Manulife shareholders, who had learned of a $1.07-billion first-quarter loss, of "pessimistic scenarios" in capital planning.

Perhaps more important was what he didn't say. The company's board had begun mulling a possible dividend cut at a meeting on May 6 -the day before the annual general meeting.

Sources say most directors weren't comfortable with taking such a drastic step and angering shareholders.

"The last thing you do in this world if you're a financial institution is cut your dividend," said the source close to the company who asked not to be named. "You make sure you've examined every possibility because nobody will forgive you."

Manulife's board agreed to defer making a decision until a thorough review could be done by the new senior management team.

On Aug. 6, Mr. Guloien took his first dramatic first step away from his predecessor and made a move avoided by every other financial institution in Canada since 1992: Manulife slashed its dividend in half, from 26¢ to 13¢. The decision was estimated to save $800-million annually, but caused the stock price to tumble 15%.

"Cutting the dividend was a step toward building fortress capital," he said at the time.

Barely three months in the corner office, Mr. Guloien appeared willing to anger shareholders by making taking an unpopular measure to rebuild Manulife's balance sheet.

"Fortress capital" became his battle cry. Manulife's capital levels had to be boosted well beyond OSFI's minimum levels that it could withstand any a reasonable range of negative scenarios in the economy or financial markets.

Three months later, on Nov. 18, 2009, Manulife shareholders were faced again with a new money raise when the company issued a $2.5-billion share offer at $19 a share. The bought deal was the second largest in Canadian history.

"We believe this transaction achieves the fortress level of capital necessary to buffer against more conservative economic scenarios," Mr. Guloien said at the time of the issue.

After months of talk about fortress capital, the market began worrying there may be a deeper problem.

Genuity Capital Markets Inc. wondered "what exactly changed over the past few months and even weeks." In an analyst report, the Toronto-based investment firm noted that Manulife's management provided "comfort" on several occasions "(albeit nuanced) that an equity raise was not likely."

At the same time, credit-rating agencies and investors worried that Manulife still hadn't hedged most of its stock portfolio to avoid the risk of more capital troubles.

"They've taken a big reputational hit," says a major institutional shareholder who asked not to be named, referring to the two share issues and dividend cut. "I don't think the board gets the message about how disappointed shareholders are."

It was the kind of reaction Mr. D'Alessandro had feared.

Last year, Manulife was the worst performing stock of the top 10 financial institutions in Canada, declining in value by about 7%, while its major competitor Sun Life Financial gained 6.4%, and the rest appreciated by at least 29%.

Meanwhile, the company's double-A rating took another hit when it was lowered a notch by Standard & Poor's earlier this month.

Clearly, Mr. Guloien's challenge is weighing the interests of his various stakeholders -- policyholders, shareholders, debt holders and the requirements of the regulators.

In part, his early initiatives illustrate some of the difficult decisions many financial services executives have been forced to make in the post-meltdown environment.

"OSFI was not telling us to do this," Mr. Guloien said during his interview with the Post. "This was our read." He acknowledged that "it wasn't easy for me to do this," but added those who didn't support the equity raise, "don't have all the facts."

When asked about Manulife's relationship with OSFI, Mr. Guloien described it as "excellent." He added: "You know, when companies have challenges and I think it's only fair to say that Manulife had challenges, especially around the issue of these equity guarantees, people get unhappy on both sides."

On the topics of the regulator's increased intervention, the above average risk rating and the unusual Deloitte audit, Mr. Guloien had this to say:

"That's a matter of legality," he told the Post. "There are certain things that are absolutely privileged between the regulator and the company and we're not commenting."

Currently, the country's financial services regulator is conducting a comprehensive review of its guaranteed annuity requirements and is considering increasing the amount of capital insurance firms are required to hold against guaranteed annuities. As a result, most industry participants expect the requirements of insurers should increase this year.

His critics say that unlike Mr. D'Alessandro, the new CEO is genuflecting to the regulator. "Don Guloien is trying to buy himself a halo," said the money manager who asked not to be named.

They also point to his obsession with fortress capital.

"It's become a self-fulfilling prophesy," observed a source close to events. "He keeps talking about it and he keeps drawing attention to it. If the CEO of the company doesn't think he has enough capital, the rating agencies will start to question it as well."

Added the same source who asked not to be named: "What sane person behaves that way? If stock markets had collapsed further, maybe yes, but they didn't. It's not possible that he couldn't have foreseen the consequences [of a dividend cut and share issue]."

Still, there are others who believe Mr. Guloien is setting the right course for the company.

"I think they are in a lot better shape now," says Ohad Lederer, an analyst at Veritas Investment Corp. in Toronto, who switched his recommendation on Manulife's stock from a "sell" to "buy" after the equity offering. "He has taken defensive measures and the company now has more capital in the face of uncertainty."

Even Mr. Racioppo has found something to compliment.

"The board has gotten stronger with people who have more experience with finance and risk management," says the president of Jarislowsky Fraser. "They're going in the right direction but it's still a long haul as it is with any large organization."

Eventually, Mr. Guloien will have to take ownership of the life insurer's performance. "I want people to judge me by what happens on my watch," he says, adding that he's eager for that to happen. First, the new CEO will have to convince investors -and the regulators -- to put the past behind them.

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$4.3B : Manulife Financial shareholders net income for 2007

$517M : Manulife Financial shareholders net income for 2008

$533M : Manulife Financial shareholders net income first nine months of 2009

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Seg Funds 101

WHAT ARE THEY? Segregated funds are insurance (variable annuity) contracts. Like mutual funds, investors pool their money with others to share gains on professionally managed diversified investments. These include equity, bond, balanced and money market funds.

In addition to the return component, seg funds also come with an insurance policy that covers 75% to 100% of the principal investment if held for 10 years or upon death of the policyholder.

In either case, the contract holder or beneficiary will receive the greater of the guarantee or the investment's current market value.

The term "segregated" refers to the fact that investments are separated from the general assets of the insurance company.

All segregated fund contracts have maturity dates that are typically 10 years or longer.

HOW MUCH IS INVESTED IN THEM? Segregated fund assets were $79.5-billion at the end of 2009, the highest point in history and more than double the $36.8-billion of 10 years ago, according to Investor Economics.

HOW DO THEY WORK? While seg funds typically mirror the performance of corresponding mutual funds, higher fees have a negative impact on returns. The better the associated guarantee, the higher the cost or management expense ratio (MER).

WHAT ABOUT RESET OPTIONS AND WITHDRAWALS? In some cases, holders can lock-in or reset the protection on the principal when the policy has increased in value. This option also typically comes with a higher cost. Resets are available either twice a year or on the policy anniversary date.

HOW DO THEY DIFFER FROM MUTUAL FUNDS? Often referred to as "mutual funds with an insurance policy wrapper," seg funds are only sold by licensed insurance representatives.

Unlike mutual funds, they also offer a death benefit, maturity and reset guarantees. Seg funds provide the opportunity to bypass probate and may offer creditor and insurer insolvency protection.

Seg funds are deemed to be trusts for tax purposes.

Source: Jonathan Ratner, Financial Post, jratner@nationalpost.com

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3.1% : Manulife Financial share price performance for 2007

-48.7% : Manulife Financial share price performance for 2008

-7.1% : Manulife Financial share price performance for 2009

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What Toronto Can Teach New York and London

The Financial Times, Chrystia Freeland, 29 January 2010

There’s something about Canada that inspires gentle mockery from foreigners, especially those who live south of the border. Kelly Ripa, the co-host of a popular US talk show, this month engaged in an extended on-air riff with her husband (don’t ask) about the absurdity of Canadian place names; Regina came in for a particular beating. South Park once invented a ditty – “Blame Canada” – devoted to bashing the Great White North. And at the elite end of the spectrum, Michael Kinsley, then editor of The New Republic, wondered what the most boring possible headline for a news story might be, and determined that “Worthwhile Canadian Initiative” was the winner.

This tendency to react to the mere mention of Canada with either yawns or guffaws may be why, as the world struggles to figure out what went wrong in 2007 and 2008, not much international attention is being devoted to figuring out what went right in Canada. Canada is the only G7 country to survive the financial crisis without a state bail-out for its financial sector. Two of the world’s 15 most highly valued financial institutions – a list dominated by China – are Canadian and a recent World Economic Forum report rated the Canadian banking system the world’s soundest. Even Barack Obama, on the eve of a visit last year to Ottawa, the Canadian ­capital, admitted: “In the midst of the enormous economic crisis, I think Canada has shown itself to be a pretty good manager of the financial system and the economy in ways that we haven’t always been.”

One of the most important policy debates today – particularly in countries hardest hit by the crash, such as the US and UK – is what caused the crisis and what should be done to prevent a repetition. Inevitably, the discussion is hypothetical: even if we could agree on exactly what went wrong, no one can prove that any recommended policy changes would have averted the meltdown. That’s where Canada comes in. It is a real-world, real-time example of a banking system in a medium-sized, advanced capitalist economy that worked. Understanding why the Canadian system survived could be a key to making the rest of the west equally robust.

The first argument you are likely to hear when you start asking what made Canada different is cultural. Depending on your degree of fondness for Canucks, this thesis comes down to the notion that Canadians are either too nice or too dull to indulge in the no-holds-barred, plundering capitalism that created such a spectacular boom, and eventual bust, in more aggressive societies. A senior official in Ottawa likes to say that Canadian bankers are “boring, but in a good way. They are more interested in balance sheets than in high society. They don’t go to the opera.” Some of them – including the chief executive of the Royal Bank of Canada, the country’s largest bank – have never even been to Davos. According to Matt Winkler, editor-in-chief of Bloomberg News, “Canadians are like hobbits. They are just not as rapacious as Americans.” And Paul Volcker, the legendary inflation-slaying former head of the US Federal Reserve and an adviser to Obama, told me that Canada’s strength is “partly a cultural thing – they are more conservative”.

Roger Martin, dean of the Rotman School of Business at the University of Toronto – I should admit here that not only am I Canadian, but I also serve on Martin’s advisory board – went to Harvard and Harvard Business School and worked as a management consultant in Boston. His professional experience on both sides of the border has convinced him there is a meaningful cultural difference, one which he traces to the founding philosophies of the two north American states: “We are ‘peace, order and good government’. They are into the pursuit of happiness. The US banks were pursuing their own happiness, with sort of an ideological assumption that it would all work out fine.”

The culture of Canada’s bankers also gets high marks from the governor of the Bank of Canada. Born in the Northwest Territories, educated at Harvard and Oxford, and trained in global markets during a 13-year stint at Goldman Sachs, Mark Carney brings an international perspective to his elegant boardroom with its 10ft windows overlooking Parliament Hill. Asked to account for the resilience of his country’s banking system, Carney started with the fact that “Canadian bankers are still bankers. They still – through the organisations and up to the top of the organisation – are proficient at managing credit risk and market risk … they have retained a banking culture through[out] the organisation.”

In the skyscrapers of Toronto’s Bay Street, Canada’s banking hub, with their sweeping views over Lake Ontario, the cultural thesis wins some support, too. Sprawled in an armchair in his eighth-floor office, Gordon Nixon, the lanky, bespectacled chief executive of Royal Bank of Canada, admitted that “the US system is less risk-averse than the Canadian system”.

Ed Clark, CEO of TD, Canada’s second-largest bank, works from a fourth floor office just around the corner from Nixon’s. He told me that “I don’t take myself so seriously. US bankers maybe see themselves as more important than we do.” In Clark’s view, Canadian culture imposes a limit on CEO megalomania: “Canada is a more egalitarian society; Canadians are less hierarchical. In the US, you can tell people to do something. In Canada, you have to ask them to do something – and hope they will do it!”

The most convincing testimony I heard to Canada’s culturally distinct approach to banking came during an interview at RBC’s offices on the southern tip of Manhattan. There I met Kevin Lewis, a 44-year-old investment banker wearing a navy suit but no tie, with a shaven head. Lewis used to work at Lehman Brothers, one of Wall Street’s most aggressive firms, until it went bankrupt. “I don’t want to sound condescending to Canadians,” he said, “but there is a ‘being nice’ mentality that exists in the institution. There is a priority on decorum, on being friendly, on being collegial. It’s a subtle thing. It is like soft music playing, rather than hard rock.”

The financial crisis has given this sort of argument fresh intellectual respectability. One of the winners in the crash was behavioural economics, with its emphasis on the ways in which individual and group psychology shape financial outcomes. If you buy this approach, Canada’s small “c” conservatism and its egalitarianism may well have served as a check on excessive risk-taking: it is hard to be a shoot-’em-up frontiersman when your cultural hero is the law-enforcing Mountie.

Yet I’m cautious about buying the niceness argument wholesale. What seems prudent in the immediate aftermath of the crisis may well seem dangerously stagnant once we focus again on innovation and growth. Even now, Lewis told me, being nice is not exactly a compliment on Wall Street, and he was anxious to qualify such impressions: “We have all the competitiveness and drive to succeed, we just don’t have some of the hard elbows that characterise it elsewhere.” A friend who runs a hedge fund in Toronto and who conforms to the stereotype of that sub-species – a 51-year-old, loft-living bachelor who runs marathons and cycles competitively – put it more directly. “Please,” he wrote in an e-mail, “don’t say it is just because we Canadian bankers are all so boring!!!”

Moreover, while the Canadian hobbits are to the fore at the moment, the country has had its orcs, too. Indeed, two of America’s most notorious corporate felons were born Canadian: WorldCom’s Bernie Ebbers and Hollinger’s Conrad Black. There are other examples in Canada itself: BreX, one of the mining industry’s great scams, was a Calgary company. Canada even had its own home-grown embarrassment in the financial crisis when, in the summer of 2007, its asset-backed commercial paper market threatened to collapse.

Most important of all, one of the lessons of the global economic transformation of the past 20 years is that when incentives change, cultures can change, too. Two decades ago, selling a pair of jeans was illegal in Russia; now that country is home to some of the most aggressive capitalists on the planet.

If Canadian culture isn’t the key, the alternative explanation must be the country’s rules and institutions. TD’s Ed Clark, who spent a decade in federal government from 1974 to 1984, favours this argument. “There’s probably a range of views, from heroic bankers to heroic regulators,” he told me. “While it might make me unpopular in my industry, I think the key is the structure of the industry.”

The civil servants who police Canada’s banking system agree. The industry’s senior watchdog is Julie Dickson, a delicate-featured blonde who heads the Office of the Superintendent of Financial Institutions (OSFI). In person, Dickson is the embodiment of all of those putatively Canadian national virtues – she is quiet, deliberate and so much of a self-effacing team-player that she would not allow a national magazine to illustrate a recent profile of her with a photograph on its cover.

But Dickson believes it is rules and not individuals that account for her sector’s survival. She points to three specific restrictions: capital requirements, quality of capital and a leverage ratio. “We had a tier one capital target of 7 per cent going back to 1999,” she says, referring to the proportion of the bank’s equity considered to be of the highest grade. “We also paid attention to quality of capital, so 75 per cent of that tier one had to be in common shares [as opposed to preferred stock, which is considered a hybrid of equity and debt]. And our leverage ratio [of debt to equity], of 20 to 1, was very important, we think.”

Mark Carney at the Bank of Canada cited those same three rules, and this nearly word-perfect unanimity between the two speaks to a fourth, structural advantage – Canada’s uncomplicated and well co-ordinated regulatory framework. This consists of the central bank, which is responsible for the stability of the overall system; the superintendent, responsible for the stability of the financial institutions; a consumer protection agency, which looks out for individuals; and the finance ministry which sets the broad rules on ownership of financial institutions and the design of financial products such as mortgages and tax-deferred investment vehicles. The four actors meet regularly. As a result, says Robert Palter, director at ­McKinsey in Toronto, “there are no gaps.”

The way rules are enforced seems to matter, too. The Canadian system is based on principles, rather than rules. It is about the spirit, rather than the letter, of the law. For Dickson, that means “we want to be told everything that is going on. We don’t want to have a list of boxes that we tick because that’s not very effective.” She is particularly disdainful of a legalistic approach. “Having lawyers looking at this line or that clause and debating with you about whether something is do-able or not is not the right conversation to have. The right conversation is the principle. You have to know what risks you are undertaking.”

The bank chiefs seem to get the message. According to Clark, whose TD bank has significant operations in the US: “The message in the US is it’s your responsibility to meet our rules. In Canada, the responsibility is to run the institution right. Julie says [to the CEO]: you are the chief risk officer of the bank.”

Dickson gets executives’ attention in part by attending bank board meetings, including a session with just the non-executive directors. Geoff Beattie, one of Canada’s most influential investors and a member of the RBC board, says Dickson’s reports “have a big impact. It creates a nice check and balance in the boardroom when they are focused on being real risk managers and regulators for Canadian banks”.

With hindsight, all of this seems obvious: lots of quality capital, limits on leverage and a simple and co-ordinated regulatory system that forces bank bosses to take personal responsibility for managing risk. But it didn’t look that way five or 10 years ago when, across the world, financial engineering was in vogue and light-touch regulation seemed a prerequisite for success. The real mystery is why Canadian policy-makers weren’t tempted to get into that race to the bottom, and why their bankers didn’t push them into it.

One reason may be that on his first day as finance minister in 1993, Paul Martin got very scared. Martin, a snowy-haired, charming Anglophone businessman now living in Montreal, who went on to serve as prime minister, remembers that “the first file on my desk was Confederation Life” – an insurance company that eventually failed. “We had gone through a period of failures of trust companies,” Martin recalled. ­“Personally, the ­lessons … were very important.”

Martin decided that his job was to figure out how to make sure “these things never happened again”. David Dodge, who went on to become governor of the Bank of Canada, was deputy minister of finance at the time. He, too, remembers the early 1990s as a formative period. “We were starting out basically not knowing how to deal with this. It prompted a decade of legislative change.”

For Martin and Dodge, there was a shared conviction, as Martin told me, that “we could never afford to go through with our banks what we went through with our trust system. I knew there was going to be a banking crisis and so did everyone else who has read any history. I just wanted to be damn sure that when a crisis occurred it wouldn’t occur in Canada.”

Don Drummond, now the chief economist at TD, was a senior official at the finance ministry in the 1990s. “The perspective of government on the financial sector is: ‘We are the regulator – our job is to tell you what to do, not to help it grow,’” he told me. “The government has always felt its job was to say no.” Because of this, Martin and his team were uninterested in what became the contest to create the most attractive haven for global capital. Canada raised its capital requirements as they were lowered in other parts of the world. “I think one of the things that happened was the great competition between New York and London pushed the two into more of a light touch in terms of regulation,” Martin recalled. “I remember talking to [the regulator] and we agreed that we were not prepared to take that approach. Light-touch regulation in an industry that was totally dependent on solvency didn’t make any sense.”

Again, with hindsight, Canada’s opt-out seems logical. But it wasn’t seen that way at the time. One measure of how powerfully the country was swimming against the tide is that the International Monetary Fund chided Canada for not doing enough to promote securitisation – restructuring debt into tradeable financial instruments – in its mortgage market. Even communist China accused Canadians of being too cautious about capitalism. Jim Flaherty, Canada’s finance minister, recalls that on a visit to Beijing in 2007, “they were suggesting that maybe Canadian banks were too timid.”

Canada’s bright young things were sympathetic to this critique. One newspaper columnist liked to write about “the tale of two Royals”, comparing the stodgy Royal Bank of Canada with its buccaneering, world-beating Edinburgh cousin, the Royal Bank of Scotland. A Canadian finance executive who spent the 1990s in Toronto and now lives in Asia sheepishly recalls thinking: “Come on, guys, get in the game! The world’s changing.”

Although they don’t like to admit to it now, some of Canada’s bankers sang along with this deregulatory chorus. But somehow they failed to effect the kind of change seen elsewhere. One reason is certainly the resolute attitude of the Canadian government – its national-stereotype-busting toughness was most clearly seen when Martin refused to allow the banks to merge. But another reason Canadian banks didn’t persuade the government to loosen up was that they didn’t try very hard. “I received huge pressure on the mergers,” Martin told me. “But when I raised tier one capital I did not receive delegations of bankers to protest. They didn’t raise hell.”

The source of that restraint isn’t that Canadian bankers are culturally cautious or naturally nice. It is that the structure of their business allows them to make very healthy profits without taking extreme risks. As David Dodge puts it, “You had a set of banks that had essentially very profitable domestic commercial banking franchises. They had to be pretty bad in their other businesses to lose money overall.”

The heart of the franchise – and probably the true key to the stability of the Canadian financial sector – is mortgages. Unlike many of the economies that were hardest hit by the crisis, particularly the US and the UK, Canada has a highly restrictive mortgage market. All mortgages with less than a 20 per cent down payment must be insured. Adjustable-rate and interest-only mortgages are practically unheard of. One obvious result is a more robust mortgage market: Palter at McKinsey says that less than 1 per cent of Canadian mortgages are currently in default, compared with 10 per cent in the US, with almost no difference in the home ownership rate, around 67 per cent in both countries.

The regulator’s emphasis on quality of capital means that instead of securitising most of their mortgages – according to Palter, in 2007, 27 per cent of Canadian mortgages were securitised, compared with 67 per cent in the US – banks held on to them. According to Carney, the central banker, if you run a Canadian bank, your calculation is that “at the start of the year, I know I have got $1bn net of income, because they are Canadian mortgages. I know I have very low credit risk. Why would I get rid of that earnings base?”

Palter offers this comparison with the US banking sector: “The big ­Canadian banks typically generate return on equity of between 13 per cent and 20 per cent, and rarely produce negative returns on equity. Comparable US banks earn ROEs that range from negative 25 per cent to 10 per cent over the past 18 months.”

“We are extremely non-capital-intensive,” TD’s Ed Clark told me. “That is because of the regulatory regime. If we were an American bank I couldn’t do it. I would be forced up the yield curve.”

To figure out why Canada survived the banking crisis, I visited Ottawa and Toronto, talking to regulators, central bankers, investment bankers and investors. It turns out that I could have found the answer on the streets of my hometown, asking my father’s neighbours about the terms of their mortgages. For more credit-addicted societies, this may, however, be the hardest part of the Canadian experience to replicate: it is one thing for voters to support tougher rules for banks, it is quite another to agree to tougher rules for themselves.

“At the heart of the problem was the fact that you had this bubble in US residential real estate that was fed by inappropriate lending standards; it was fed by public policy,” RBC’s Gordon Nixon told me. “In Canada, that was the strongest asset class throughout this crisis.”

In my conversations with Canadian bankers, one of the things that struck me was how often they referred to mothers. Nixon mentioned his mother and her good opinion when explaining why he gave back his bonus in 2008; Clark uses the mother-in-law test, as in “Would you sell it to your mother-in-law?” to help TD employees figure out if they should be hawking a product to their customers. In an era when Wall Street investment banks issue notes warning their clients they may be short-selling the investments they are marketing, this sounds like a charmingly Canadian attitude. But it is easier to be nice if you don’t need to be nasty just to make a buck.

Canadian facts and figures

• 6 big banks, approximately 73 banking institutions in total
• The big banks are all universal – offering retail, commercial and investment banking services. Some boutique investment and commercial banks exist but they are relatively small
• Banks have minimal off-balance-sheet holdings
• Banks’ return on equity generally 13% to 20%
• Home ownership rate: 68.4% of the population
• Subprime less than 5% of the mortgage market
• Relatively low penetration of derivatives and securitisation (27% of mortgages repackaged and sold as bonds)
• Mortgage default rate less than 1%

Source: McKinsey
Dates: 2008 & 2009, except Canadian home ownership figures, which come from the 2006 census.

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The New York Times, Paul Krugman, 31 January 2010

In times of crisis, good news is no news. Iceland’s meltdown made headlines; the remarkable stability of Canada’s banks, not so much.

Yet as the world’s attention shifts from financial rescue to financial reform, the quiet success stories deserve at least as much attention as the spectacular failures. We need to learn from those countries that evidently did it right. And leading that list is our neighbor to the north. Right now, Canada is a very important role model.

Yes, I know, Canada is supposed to be dull. The New Republic famously pronounced “Worthwhile Canadian Initiative” (from a Times Op-Ed column in the ’80s) the world’s most boring headline. But I’ve always considered Canada fascinating, precisely because it’s similar to the United States in many but not all ways. The point is that when Canadian and U.S. experience diverge, it’s a very good bet that policy differences, rather than differences in culture or economic structure, are responsible for that divergence.

And anyway, when it comes to banking, boring is good.

First, some background. Over the past decade the United States and Canada faced the same global environment. Both were confronted with the same flood of cheap goods and cheap money from Asia. Economists in both countries cheerfully declared that the era of severe recessions was over.

But when things fell apart, the consequences were very different here and there. In the United States, mortgage defaults soared, some major financial institutions collapsed, and others survived only thanks to huge government bailouts. In Canada, none of that happened. What did the Canadians do differently?

It wasn’t interest rate policy. Many commentators have blamed the Federal Reserve for the financial crisis, claiming that the Fed created a disastrous bubble by keeping interest rates too low for too long. But Canadian interest rates have tracked U.S. rates quite closely, so it seems that low rates aren’t enough by themselves to produce a financial crisis.

Canada’s experience also seems to refute the view, forcefully pushed by Paul Volcker, the formidable former Fed chairman, that the roots of our crisis lay in the scale and scope of our financial institutions — in the existence of banks that were “too big to fail.” For in Canada essentially all the banks are too big to fail: just five banking groups dominate the financial scene.

On the other hand, Canada’s experience does seem to support the views of people like Elizabeth Warren, the head of the Congressional panel overseeing the bank bailout, who place much of the blame for the crisis on failure to protect consumers from deceptive lending. Canada has an independent Financial Consumer Agency, and it has sharply restricted subprime-type lending.

Above all, Canada’s experience seems to support those who say that the way to keep banking safe is to keep it boring — that is, to limit the extent to which banks can take on risk. The United States used to have a boring banking system, but Reagan-era deregulation made things dangerously interesting. Canada, by contrast, has maintained a happy tedium.

More specifically, Canada has been much stricter about limiting banks’ leverage, the extent to which they can rely on borrowed funds. It has also limited the process of securitization, in which banks package and resell claims on their loans outstanding — a process that was supposed to help banks reduce their risk by spreading it, but has turned out in practice to be a way for banks to make ever-bigger wagers with other people’s money.

There’s no question that in recent years these restrictions meant fewer opportunities for bankers to come up with clever ideas than would have been available if Canada had emulated America’s deregulatory zeal. But that, it turns out, was all to the good.

So what are the chances that the United States will learn from Canada’s success?

Actually, the financial reform bill that the House of Representatives passed in December would significantly Canadianize the U.S. system. It would create an independent Consumer Financial Protection Agency, it would establish limits on leverage, and it would limit securitization by requiring that lenders hold on to some of their loans.

But prospects for a comparable bill getting the 60 votes now needed to push anything through the Senate are doubtful. Republicans are clearly dead set against any significant financial reform — not a single Republican voted for the House bill — and some Democrats are ambivalent, too.

So there’s a good chance that we’ll do nothing, or nothing much, to prevent future banking crises. But it won’t be because we don’t know what to do: we’ve got a clear example of how to keep banking safe sitting right next door.

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Canada's Dividend Culture

Scotia Capital, 27 January 2010

• The following are excerpts from our full report titled "Canada's Dividend Culture".

• The main risk currently, in our opinion, to the Canadian banking industry and bank valuation is “regulatory” in terms of over-regulation and mis-regulation. The major uncertainty is what operating and financial constraints will be placed on banks by the regulator. We believe that the regulator will likely require excessive deleveraging in the near to medium term before adopting a more balanced approach to capital.

• Our concern about regulatory risk has been heightened with the recent release of the Basel consultative documents. We are particularly concerned about the potential impact to Canada's dividend culture, where Canadian bank dividend levels may increase in volatility, reducing predictability, or banks may have to lower dividend payout ratios longer term, freezing or reducing dividend increases in the near term in order to manage prudently under the Basel rules. This report focuses on Tier 1 common, potential capital buffers, and the maximum distributions, particularly dividends, to be prescribed by the regulators. Basel has not calibrated its capital conservation rules, but the tone and nature of the document has potential risk particularly for Canada given the bank group's dividend history and culture, not to mention the maintenance of healthy dividends through the recent financial crisis.

• If Canadian banks' dividend policies change, valuations will likely be impacted, and the risk is to the downside. We remain market weight as, in our opinion, we need regulatory clarity, especially on capital and bank dividend policy, before bank valuations can expand further. In fact, bank valuation may contract modestly in the near term under the uncertainty.

• The Bank for International Settlements (BIS) recently released (December 17, 2009) two consultative documents: (1) Strengthening the Resilience of the Banking Sector; (2) International Framework for Liquidity Risk Measurement, Standards and Monitoring. These documents were issued for comment by April 16, 2010.

• “As requested by the G20, the standards will be phased in as financial conditions improve and the economy recovery is assured, with an aim of implementation by end-2012. As part of this phase in process, the Committee will consider appropriate transitional and grandfathering arrangements.” (Strengthening the Resilience of the Banking Sector)

• It is generally believed that a number of proposals will be modified and others subject to country-by-country consideration. We expect that local regulators will have some discretion, with blanket global adoption unlikely.

• The two Basel documents are very detailed, technical, and are consultative, with no minimum capital levels indicated. It seems that Basel’s main focus in terms of capital ratios is on Tier 1 Common. The status of hybrid capital is questionable, especially Innovative Tier 1. We have fine-tuned our pro forma Tier 1 common ratios from our preliminary calculations published December 18 and December 21, 2009 (Canadian Banks Quarterly Overview, Daily Edge, “Banks – Fourth Quarter Overview,” respectively), extending the pro forma ratios to 2012.

• “The fully calibrated set of standards will be developed by the end of 2010 (calendar) to be phased in with implementation by end 2012 (calendar).” (Strengthening the Resilience of the Banking Sector)

• We expect Canadian banks’ capital levels to remain among the highest on a global basis. S&P calculated risk-adjusted capital (RAC) ratios for 40 global banks using detailed information provided by the banks (some non-public). S&P’s RAC ratios were released on November 23, 2009, as at June 30, 2009. S&P RAC ratios are relatively conservative, using stricter definitions of capital and higher risk weights. For the 40 global banks S&P calculated an average 6.7% RAC ratio, with Canadian banks in the high end of the range at 7.8%-8.3%. Thus, it is reasonable to expect Canadian banks to maintain their relative strength under the new Basel proposals.

• We expect that Canadian banks would be able to comfortably meet the Tier 1 common capital ratios stemming from these Basel proposals. However, the single biggest concern for Canadian banks from the Basel proposal, we believe, is the potential impact on dividends from the section titled “Capital conservation best practice” (Strengthening the Resilience of the Banking Sector). In our opinion, capital conservation best practices, depending on calibration, could unfairly threaten Canada’s dividend culture. In essence, Canadian banks are caught in the crossfire of regulators, central bankers, and politicians (populist agenda), mainly from the United States and the U.K. Thus, in our view, Canadian banks may have to maintain inefficient and uneconomical capital levels to be able to sustain dividends near their historical payout ratios or significantly change their dividend payout policy or be prepared to issue equity at likely a very inopportune time in the market. Global banks, at the same time, that have cut or eliminated their dividends would be able to operate with lower Tier 1 common ratios as they have lower capital buffer requirements given their low level of
dividend distribution.

Caught in the Crossfire

• The Basel proposal to place banks in a straight jacket with respect to dividends and regulate dividend payments based on capital cushions we believe is very harsh. This particular proposal could be very disruptive to Canada’s dividend culture. This proposal could result in significant changes to Canadian banks’ dividend payout targets and significantly impact dividend growth, certainly in the near to medium term, and/or result in equity issues, with Canadian banks forced to carry much lower leverage to sustain their healthy dividend payouts, or cause dividend cuts and lower dividend predictability. The Basel proposal in essence favours stock buybacks (likely at market peaks) over dividend increases.

• Canada’s major banks have a long history of superior dividend growth (Exhibit 10), as well as maintaining dividend levels even through severe economic downturns, setting Canada apart from many countries. Canadian bank shares are widely held in Canada by institutions including pension funds and individuals including pensioners who have come to rely on the stability and predictability of bank dividends. Many Canadians rely on bank dividends as a source of income. Canadian banks have the enviable track record of increasing their dividends at a CAGR of 10% over the past 42 years, with none of the large five Canadian banks ever cutting their dividend.

• A major attraction for investors to Canadian bank stocks has been their dividends. So the BIS proposal may put Canada’s dividend history/culture in jeopardy. We believe the BIS proposals in essence attack Canada’s bank culture of reliable steady dividend growth or at least may cause a major reset in the banks dividend payout ratio. Most of the major global banks have significantly reduced or eliminated their common dividend (Exhibit 9), so for them they can operate with much higher leverage with no impact to the current dividend situation. However, for Canadian banks they will have to operate with significantly lower leverage. Thus the BIS proposal in essence penalizes banks that have weathered the financial crisis with solid earnings, capital, and their dividends intact.

• Canadian banks may ultimately be forced to reduce their payout ratios over time so they can be more leveraged and/or provide more capital management flexibility. Canadian banks would have to maintain significant capital buffers to maintain their dividends at historical payout ratios with even moderate earnings cyclicality or issue equity at likely depressed prices or reduce dividends. So in every down cycle, in the absence of huge capital buffers, we believe banks must slash dividends and/or employee compensation, or issue common equity (to restore capital buffers).

• The unintended consequences may be increased volatility in bank share prices and perhaps lower valuations, thus reducing investor confidence and increasing bank cost of capital. In addition, overall confidence in the financial system may be lowered due to increased volatility, which is what the rules are intended to guard against. Major acquisitions that the banks may contemplate de facto must be done primarily with equity or with a reduction to the dividend to maintain the buffer.

• Also, a bank supervisor in charge of a bank’s capital plan (which seems intrusive in itself) may allow the bank to make an aggressive acquisition issuing equity, diluting shareholders, and/or reducing the dividend versus returning funds to shareholders through higher dividends. So the importance of the maintenance of dividends diminishes and substantially reduces the predictability of equity issuances. Thus the ideology of the current and future bank supervisor becomes important, introducing another layer of uncertainty for capital providers to the banking industry. Uncertainty generally pushes up costs and lowers valuation. We understand that the primary goal is to protect the depositor, but we don’t believe you have to disregard the interests of the capital providers in this pursuit.

• The four elements of distribution are common dividends, discretionary bonuses, discretionary payments on Tier 1 (non cumulative preferred dividends), and share buybacks. The two material elements subject to restriction that we are most concerned about are dividends and discretionary bonuses, which we believe could impact the valuation of the common shares and the operating businesses. Non-cumulative preferred dividends are modest and share buybacks are very discretionary with no real expectations, thus this constraint is not expected to be significant.

• The distribution constraint on discretionary bonuses may result in banks increasing base salaries and reducing bonuses, which has already occurred to some degree with a number of global banks. Thus an unintended consequence may be a cost mix shift for the banks towards fixed costs versus variable costs.

• We expect bank dividend payout ratio targets (Exhibit 5) to be reviewed, with payout ratios likely reduced or reset certainly in the near-to-medium term. In determining potential dividend increases between now and the end of 2012, we use the midpoint of the banks’ dividend payout target range. At the very least, the banks may start targeting the low end of the range as opposed to the high end.

• Dividend increase potential (Exhibit 5) in our view favours NA, RY, TD, and BMO, as we estimate they could increase their dividends by 40%, 36%, 17%, and 8%, respectively, using the midpoint of their targets while remaining below the maximum common dividend distribution, including a cushion for earnings cyclicality. On the other hand, CM and BNS have no dividend increase potential at the midpoint of their target payout range and would theoretically have to cut their dividends 21% and 9% to remain below the maximum common distribution including the cushion for earnings cyclicality. However, this is theoretical as they could easily issue common equity to allow a higher distribution, and the earnings cyclicality cushion does not apply until needed in perhaps 2020, which gives them plenty of time to build up this cushion through internally generated capital.

• The conclusion is NA and RY should have the highest dividend growth or flexibility to increase dividends over the next two or three years.

• It would seem from a distribution flexibility point of view a Tier 1 common ratio of 7% and 8% is very important, certainly under both Basel illustration and Scotia Capital calibration. Our pro forma Tier 1 calculations indicate that only BNS and CM fall below the 7% Tier 1 common level and would have to issue $2.8 billion and $1.0 billion in equity (Exhibit 6), respectively, to achieve these levels. To achieve an 8% minimum, Canadian banks would have to issue $11.3 billion in equity (Exhibit 6, row 12). RY is the only Canadian bank that would not have to issue equity as its pro forma Tier 1 common is 8.2%.

• Canadian banks’ pro forma return on equity would decline to 17.3% with a minimum Tier 1 common of 8% led by RY at 19.8%, with TD and BMO a low of 13.9% and 15.4%, respectively.

Investment Returns & Dividends

• Historically dividends have been the most significant contributor to total equity returns. According to Research Affiliates, LLC, dividends represented 53% of total equity returns from 1817 to 2009 (Exhibit 8). However, through the 1990s bull market (1989-2000), dividends declined to 18% of total return, recovering modestly to 32% of total returns from 2001 to 2009. Dividend growth has been a very solid predictor of share price performance historically. Dividends have also been more stable and predictable than earnings, EBITDA, or sales. The recent Basel documents are expected to increase dividend risk in terms of predictability and magnitude, thus potentially hurting long-term value and raising the cost of capital.

• We believe that banks will continue to generate superior profitability versus the market, but clarity on dividends is needed to expand valuation. A period of reset where dividend payout ratios decline in the near-to-medium term will likely mute growth through this period and thus mute valuation and performance. However, once dividend resets occur, we believe growth should return to more normal long-term rates.

Recommendation

• We downgraded the Canadian banks to market weight from overweight (December 11, 2009) due to their strong absolute and relative share price performance in 2009 and increased regulatory/political risk. Bank stocks doubled off their 2009 lows and were up 59% in 2009, outperforming the TSX by 26% in 2009.

• Canadian bank stocks are expected to remain long-term outperformers, with some consolidation expected in the first half of 2010. We believe we are in a consolidation phase, with a stalled bank rally in the near term. Thus rapid appreciation from these levels is difficult to see given the magnitude of the 2009 rally and the fact that banks appear to have been placed on hold with respect to capital management pending clarity from the regulator. In addition, a sharp acceleration in earnings is not expected until the later part of 2010.

• We have 1-Sector Outperform ratings on RY and BMO, with 2-Sector Perform ratings on BNS, CWB, LB, TD, and NA, and a 3-Sector Underperform rating on CM. Our order of preference is RY, BMO, NA, CWB, LB, TD, BNS, and CM.

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BMO NB & Scotia Capital Prefer Insurance Cos.

Scotia Capital, 11 January 2010

TSX Insurance over TSX Banks. Insurance stocks have underperformed Banks by roughly 40% in the last 12-months. More recently, however, the Insurance sector has easily outperformed, posting a gain of 12.9% in the last month versus -1.2% for the TSX Banks index. We believe Insurance will continue to outperform Banks in coming months as LT yields move up and the yield curve eventually starts flattening. As highlighted in Exhibit 6, yield curve flattening is typically accompanied by Insurance outperformance (chart- Insurance outperforms when the blue line is going down). In our Strategic Edge portfolio (SEP), we are currently 3% overweight Insurance and 3% underweight banks. We reiterate our insurance over banks call.

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BMO Nesbitt Burns, 08 January 2010

We have trimmed our bank and utility weight in order to add a position in Manulife. Given almost $5 billion in new equity and a 50% dividend cut, Manulife has achieved ‘fortress’ levels of capital. With modestly higher equity markets and interest rates, and the absence of further valuation basis changes, Manulife’s earnings should be more predictable. John Reucassel is forecasting a recovery in earnings to $1.75 per share this year, and $2.00 per share next year.

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