Preview of Banks' Q3 2009 Earnings

Scotia Capital, 18 August 2009

Banks Begin Reporting August 25

• Banks begin reporting third quarter earnings with Bank of Montreal (BMO) on August 25, followed by Canadian Imperial Bank of Commerce (CM) on August 26, National Bank (NA), Toronto Dominion (TD), and Royal Bank (RY) on August 27, Bank of Nova Scotia (BNS) on August 28, and Laurentian Bank (LB) and Canadian Western (CWB) closing out reporting on September 3. Scotia Capital’s earnings estimates are highlighted in Exhibit 1, consensus earnings estimates in Exhibit 2, and conference call information in Exhibit 3.

Earnings Nearing Cyclical Bottom?

• We expect third quarter operating earnings to decline 14% year over year and 2% sequentially. The year-over-year decline in earnings is due mainly to an 81% increase in loan loss provisions and a decline in net-interest margin, partially offset by strong wholesale banking earnings. The sequential decline in earnings is mainly due to lower expected trading and securitization revenue.

• Interestingly, bank operating earnings have handily beaten consensus estimates over the past several quarters; however, these beats have been generally discounted due to continued noise with respect to mark-to-market writedowns and the fact that trading and securitization revenue have been the main drivers in positive earnings surprises. There has also been a lot of uncertainty about what sustainable trading revenue levels are. At the same time, earnings have absorbed high loan losses and a fall-off in wealth management earnings. In terms of trading revenue, we 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. We suspect the market is attributing most of the trading gains as cyclical, with very little structural consideration. However, from a directional perspective, we see a structural expansion in trading revenue due to the expansion of bank trading platforms and activity, less market capacity and competition, and favourable market conditions that may persist for some time (it may take years to fully revert to the mean), which are all expected to lead to higher structural or sustainable trading revenue.

• We expect third quarter bank index operating earnings to be 410, which we believe is at or near the cyclical bottom, with bank operating earnings having retraced back to Q2/06 levels. We expect a modest pickup sequentially in earnings for Q4/09 to 432, which would be flat YOY; thus, Q3/09 would mark the bottom in bank operating earnings.

• We believe that post the spectacular bank stock rally, the market is now discounting that both loan loss provisions and mark-to-market writedowns are manageable. However, we do not believe the market is discounting the possibility that we may be nearing the peak in loan losses this cycle, or that mark-to-market losses could drop precipitously, or the potential positive impact of net-interest margin expansion.

• Operating return on equity is expected to be 16.5% for the third quarter, down slightly from 17.1% in Q2/09 and down more materially from 20.0% a year earlier.

• Loan loss provisions in Q3 are expected to increase to $2.6 billion or 0.83% of loans, slightly higher than the Q2 level of $2.5 billion or 0.83% of loans, but significantly higher than $1.4 billion or 47 basis points (bp) a year earlier. The growth rate in quarterly loan loss provisions is expected to be 4.6% in Q3/09, down from the peak growth in Q1/09 of 36%. We believe that the bank group is nearing peak sequential loan loss levels.

• We expect a substantial reduction in mark-to-market writedowns this quarter and actual gains in the AFS OCI account (although FX translation will be negative for OCI), due to a number of factors. The corporate bond spreads have improved dramatically to 248 bp from 429 bp in the previous quarter, with the LCDX Index (Corporate Debt/LBO Proxy) increasing 17% from the Q2 levels and the ABX-BBB flat at 3.0. In addition, CDS spreads have improved remarkably in the past quarter, narrowing by 50% to 60% for Citigroup, JP Morgan, Barclays, and Goldman Sachs. In terms of the two main monoline insurers, CDS spreads were somewhat stable, with MBIA narrowing (improving) by 3% and Ambac widening by 28% (there is not a linear relationship with respect to probability of default). The magnitude of potential mark-to-market writedowns has declined in general to a guesstimate of $100 to $300 million per bank, if any (except NA with negligible writedown potential).

• The banks’ overall net-interest margin has the potential to positively surprise due to the steep positive yield curve, loan repricing, deposit surge from money market funds, continuing wide wholesale margin, and easing of liquidity pressures. Personal deposits funded 96% of retail loans in Q2/09, up from the historical low of 81% in 2007 and 88% in 2008. The yield curve steepened 32 bp in Q3 to 322 bp (91-day vs. 10-year) and contracted slightly by 7 bp (2-year vs. 10-year), although it remained attractive at 204 bp.

• Bank prime rate averaged 2.25% in the third fiscal quarter versus 2.64% in Q2/09, potentially squeezing the margin; however, the banks have aggressively repriced their loan book to mitigate this pressure. The absolute low level of interest rates continues to be a major concern in terms of bank profitability. Thus, any signal that there will be no further rate reductions and there may perhaps be moderate, orderly incremental increases in interest rates would be viewed very favourably for bank profitability.

• We continue to forecast a 7% earnings decline in 2009 and a 9% increase in 2010. Return on equity is expected to be 17.0% in 2009 and 17.3% in 2010.

• The fear concerning whether Canadian bank dividends are safe has subsided, and the market is now more balanced in looking at underlying fundamentals, earnings power, and P/E multiples. However, the recent Manulife dividend cut did cause some slight extrapolation to Canadian banks and questioning of the safety of Canadian bank dividends, which we believe has no basis. We not only continue to believe that Canadian bank dividends are safe, but also believe that dividend increases are on the horizon. Canadian banks have a significant opportunity to elevate their status and receive a premium from the equity markets for the soundness of their operating platforms and business models.

• We believe that there is a major scarcity of reliable attractive yield in the marketplace. A number of global banks are no longer paying meaningful dividends. Canada’s largest insurance company cut its dividend by 50%; the high yield income trust market is drawing to a close in Canada, thus Canadian banks’ dividend track record stands out (see report titled “Four Decades of Dividend Growth,” March 2002). Further rewarding shareholders for holding their stock via early dividend increases would, we believe, drive this point home with investors and be supportive to higher (premium) valuations.

• Bank stocks have increased 44% year-to-date 2009, substantially outperforming the TSX, which has increased 21%. Despite the share price performance, we believe valuation remains attractive at 11.2x 2010 earnings estimates, especially if earnings are near their cyclical bottom. We continue to expect bank P/E multiple expansion through 2012, similar to that experienced post the 2002 cycle. We expect bank P/E multiples to expand back to 14x in the next few years and eventually reach 16x.

• Bank dividend yields also remain very attractive at 4.3% or 124% relative to the 10-year government bond yield, which is 3.0 standard deviations above the mean. Bank dividend yields are also attractive against equities at 0.8x the TSX Equity Index versus a 1.4x historical mean and a 1.1x level recorded from 1956 to 1978.

• The sustainability of bank dividends, scarcity of reliable yield, and the resumption of superior dividend growth are expected to be the catalysts for significantly higher bank share prices.

• We quoted Peter L. Bernstein and Robert D. Arnott’s research in our report titled, “Four Decades of Dividend Growth” (March 2002); they conclude that dividends have been the most significant contributor to total equity returns (dividends represented 63% of total equity returns from 1802 to 2001).

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

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

BNS – Scotiabank Mexico Contribution Improves Modestly QOQ

• Scotiabank Mexico reported Q2/09 consolidated net income of $32 million (P$372 million), a 60% decline from a year earlier and a 26% decline from the previous quarter. Earnings declined YOY due to higher loan loss provisions, a P$371 million before-tax loss on sale of a P$860 million credit card portfolio, and a gain on sale on the Mexican Stock Exchange IPO a year earlier. This was somewhat offset by a decline in the effective tax rate to 13% from 31% a year earlier and 38% in the previous quarter, due to lower earnings in the quarter and favourable timing differences.

• Scotiabank Mexico’s contribution to BNS, after adjustments for Canadian GAAP, is $61 million or $0.06 per share, versus $54 million or $0.05 per share in the previous quarter, and $104 million or $0.10 per share a year earlier. The adjustment to Canadian GAAP includes a reversal of the loss on partial sale of credit card portfolio, as the loss was recognized in the previous quarter.

TD – TD Ameritrade Earnings Improve Sequentially

• TD Ameritrade (AMTD) reported a 12% decline in earnings to US$0.30 per share from US$0.34 per share a year earlier due to the weak net interest margin and higher expenses, but increased 30% sequentially. Earnings were slightly above consensus. TD Bank estimates TD Ameritrade’s contribution this quarter to be $68 million or $0.08 per TD share versus $0.06 per share in the previous quarter and $0.09 per share a year earlier.

TD Pre-Announced an FDIC Special Assessment Charge for Q3/09

• On May 28, 2009, TD pre-announced a US$50 million FDIC special assessment charge based on 5 bp of total assets less Tier 1 Capital as at June 30, 2009. This charge translates into C$0.04 per share. We estimate that similar charges for BMO and RY would be approximately US$20 million (C$0.04 per share) and US$15 million (C$0.01 per share), respectively.

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Financial Post, Eric Lam, 18 August 2009

With Canadian banks reporting their results next week, analyst forecasts continue to roll in. Next up is James Bantis of Credit Suisse, who warns that the pendulum of investor sentiment has swung from too bearish in February to too bullish now.

"Earnings quality in the first half of 2009 was poor, relying on unusually high trading revenue to offset credit challenges," he said in a note to clients. "Looking ahead, credit provisions are expected to accelerate well into the first half of 2010 whereas trading revenue levels may be close to peaking."

Mr. Bantis expects operating earnings to be down 16% on average from the third quarter of 2008, with a considerable downside risk gross impaired loans are forecasted to rise by 10% to 15%.

Credit Suisse has also compiled a brief summary of what to expect from each bank:

•Bank of Montreal: Underperform, EPS 93 cents (in line with consensus), Target Price $36
•Bank of Nova Scotia: Neutral, EPS 84 cents (3 cents above consensus), Target Price $34
•CIBC: Underperform, EPS $1.35 (3 cents below consensus), Target Price $48
•National Bank: Neutral, EPS $1.32 (2 cents below consensus), Target Price $48
•Royal Bank: Neutral, EPS 93 cents (2 cents above consensus), Target Price $37
•TD Bank: Neutral, EPS $1.20 (1 cent below consensus), Target Price $44

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Financial Post, Eric Lam, 17 August 2009

With the Bank of Montreal set to announce its third quarter results next week, Blackmont takes a quick look at what to expect for the latest earnings season for Canada's Big Six.

Overall, Brad Smith, analyst, forecasts per share profits will be about 15% below 2008 levels, close to the median consensus forecast of 16%.

"As has been the case for much of the past 12-18 months, credit provisioning decisions will have a meaningful impact on reported profits," Mr. Smith said in a note Monday. "Moreover, it remains to be seen if the banks see fit to increase loss allowances relating to their domestic loan books that have migrated to a more consumer focus in recent years."

Consumer lending has always shown great resilience, but recent pressure on employment and income levels has seen a steep climb in consumer bankruptcies, he said.

Other than earnings, credit loss development and capital positioning are important factors to consider for investors, Mr. Smith said.

As for individual banks, the Bank of Nova Scotia has the best chance of posting a "positive surprise" given its stable credit profile in Mexico, while the Bank of Montreal's weak performance in its U.S. personal and commercial segment and lower-than-expected securitization revenue are likely to depress results.

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TD Securities, 13 August 2009

Canadian Banks: A Closer Look - Personal Loan Market

• Defining the credit risks. The third in a series of in-depth reports, we look at the Personal Loan books of the Canadian banks and the outlook for credit losses. We continue to expect credit costs to climb materially in 2009 and 2010, but we maintain our view that expenses will be manageable.

• Personal Loans - a significant driver of credit expense. Our outlook reflects some C$5.3 billion in PCLs relating to Personal Loans in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian banks. This is against our estimate of pre-tax, pre-provision profit of roughly C$35 billion.

• HELOCs - unlikely to be a source of credit stress. The Canadian HELOC exposures are of relatively high quality and should see minimal losses. U.S. exposures are higher risk but represent relatively small portfolios.

• Credit Cards - likely to see relatively intense losses. On a managed basis, trends have been deteriorating across the board with losses running 5-6%. We continue to expect loss rates to ultimately reach high single digits.

• Other Personal Loans - a mixed bag. Sub-prime auto loans and unsecured Lines of Credit, for example, should see elevated losses, but they are a smaller portion of the book. Overall, we expect low single digit losses here.

• CIBC dealing with cards; BMO looks thinly reserved. With the largest Cards book, CIBC is seeing significant credit deterioration, but the bank is well reserved and appears to be managing the downturn. Overall, BMO stands out as having relatively thin reserves. We do not see the Personal Loan portfolio as overly problematic, but it does have some pockets of lower quality U.S. exposures.

Executive Summary

The Personal Loan books of the Canadian banks have deteriorated, and are likely to continue to be a source of relatively intense credit losses. This should drive an estimated C$5.3 billion in PCLs in 2010. However, trends remain reasonably well controlled and the expected material uptick should be manageable.

In this, the third in a series of in-depth reports on the outlook for credit, we detail the industry’s credit exposure to the Personal Loan market (which we define as personal lending excluding traditional residential mortgages which we covered in a previous report - “A Closer Look – Canadian Residential Mortgage Market,” dated April 23, 2009).

Included in this portfolio are Home Equity Lines of Credit (HELOCs), Credit Cards and Other Personal Loans (i.e. unsecured loans/Lines of Credit, investment loans, auto loans etc). Importantly, we consider loan and credit exposure on a managed basis; that is including, where possible, direct securitization exposure. Overall, personal lending represents just below 25% of the managed loan books of the Large-Cap Canadian banks on average.

• HELOCs. A fairly significant portfolio for some banks of total managed loans (TD has a reported exposure of nearly 25%). The Canadian exposures are of relatively high quality, in our view, (helped by the existence of a robust mortgage insurance framework in Canada) and recent performance data continues to suggest minimal losses. Some select U.S. based exposures are likely to see elevated losses, but they are relatively small. Conditions are likely to continue to slip from current levels, but HELOCs are unlikely to be a material source of credit stress for the Canadian banks in our view.

• Credit Cards. Card exposure varies materially across the banks, but peaks at approximately 7% of managed loans at CIBC. Credit cards are likely to see some of the most intense loss rates of any portfolio and we have already seen significant deterioration. We expect losses to continue to track unemployment higher toward a high single digit pace. This will move the industry to levels at or slightly above historical peaks.

• Other Personal Loans. This segment represents a fairly large catch-all ranging from low risk personal investment loans to higher-risk sub-prime auto loans. Trends have been relatively muted to date, but losses are likely to continue to climb driven by higher risk categories. Historical data is particularly sparse for this segment, but we assume PCL rates will reach upwards of 250-300bp.

Overall, we see PCL rates relating to Personal Loans running on the order of 200bp over the coming year, driving some C$5.3 billion in PCL expense in 2010 out of our total estimate of C$9.8 billion for the Large-Cap Canadian Banks. This is against our roughly C$35 billion in pre-tax, pre-provision profits. In this context, we maintain that the current cycle will be manageable. We continue to expect to see losses peak in 1H10.

Looking across each of the names, while all should manage the downturn, there are a range of specific issues for each bank;

Our Take on the Names:

BMO. Overall, the bank is relatively thinly reserved (a function of a high quality book and aggressive charge-offs according to management). In our view, there are no grave issues in the Personal Loan book at BMO, but they do have a small book of lower quality U.S. HELOC loans which should continue to deteriorate.

Scotiabank. The key concern remains the bank’s international portfolio of credit card and consumer finance loans primarily in Mexico and Latin America respectively. Although credit costs have increased, trends have begun to show some signs of moderation over recent quarters.

CIBC. The key exposure at CIBC is clearly the bank’s outsized credit card portfolio. Conditions here have deteriorated in recent quarters and we expect them to get worse. However, the bank has been tightening underwriting standards, managing collection efforts, and increasing credit reserves in anticipation of higher losses. Furthermore, the most recent data points from the bank’s securitization trust suggests trends are moderating with delinquency and credit loss rates improving month over month in June 2009 (echoing similar comments from management in their Q2/09 conference call).

National Bank. In our view, National will likely continue to see above average credit performance with limited areas of concern. The Personal Loan portfolio benefits from an entirely domestic and largely Quebec focus as well as among the smallest concentrations of credit card lending.

Royal Bank. We do not believe the bank has material areas of concern within their Personal Loan book. Although Royal has a sizeable credit card portfolio, it is still relatively small at just 4% of the bank’s managed portfolio and the performance trends to date have been relatively good (although it is unclear how aggressive/conservative the bank has been in building reserves against future card losses).

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Financial Post, David Pett, 14 August 2009

With third quarter earnings results looming, BMO Capital Markets analyst Ian de Vertueil fine-tuned a couple of his Canadian bank recommendations this week, putting Bank Of Nova Scotia and Bank of Montreal back on the same playing field.

To start, the analyst upgraded Scotiabank from Underperform to Market Perform while increasing his 2009 cash earnings per share estimate for the bank from $2.90 to $3 and his 2010 cash EPS estimate from $2.55 to $2.65. Mr. Verteuil's price target on the stock climbs from $41 to $42.

"Since we downgraded Scotiabank six months ago, the shares have underperformed the bank group by 8%," he said in a note to clients. "We continue to believe the bank will feel more credit headwinds in the short term from its corporate loan book both in North America and internationally, but the underperformance highlights that much of this is reflected in the share price."

Mr. de Vertueil now also has a Market Perform rating on Bank Of Montreal shares, after downgrading the stock from Outperform and lowering his price target from $56 to $53. He noted that BMO is relatively expensive on earnings but still trades at a discount to the overall group on price to book.

"Since our upgrade a year ago, the shares have outperformed the group, up 9% versus the bank index, which is essentially flat," he said.

"At the time of our upgrade, we thought the concerns on the bank’s off-balance sheet exposure were overdone. We don’t expect any material surprises in the quarter, but we think that most of the sentiment shift on the stock has now occurred. Given the bank’s limited leverage to a more stable credit environment, we believe that a downgrade is warranted."

Overall, Mr. de Verteuil expects Canadian banks to report solid third quarter earnings.

"On a reported basis, we believe that results will be well up from a year earlier, but this entirely reflects the fact that CIBC is comparing with a very weak quarter of a year earlier. Exclusive of CIBC, the group’s reported earnings will be down about 4% versus a year earlier," he wrote.

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Financial Post, John Greenwood, 14 August 2009

The impact of rising loan losses at the Canadian banks will be cushioned by stronger trading and underwriting revenues in the third quarter, according to RBC Capital Markets analyst Andre-Philippe Hardy.

Over the past year the banks have been hammered by the credit crunch but as conditions start to stabilize and net interest margins move up the banks will feel the benefit when they post their results starting on August 25.

“We are positive on Canadian bank shares given that indicators of futureprofitability are trending in the right direction, and the banks have enough revenue and capital in our view to handle the impact of challenging economic conditions on loan losses over the next 6 - 12 months,” Mr. Hardy said.

He pointed to National Bank as the player facing the fewest headwinds since it has almost no exposure to the United States and limited operations in the hard-hit province of Ontario.

Meanwhile a report from Desjardins Securities analyst Michael Goldberg warns of a below normal quarter at the banks with continued credit issues.

“US banks have finished reporting their second quarter results, and we believe that the highlights are likely to be mirrored in Canadian third-quarter earnings on a much smaller scale,” Mr. Goldberg said.

Despite the gloomy economy, global financial markets have shown significant improvement since the dark days of March, with rising equity markets helping to buoy bank profits.

Mr. Goldberg said he expects stronger equity markets and narrowing credit spreads to drive higher trading revenue but at the same time warned of underlying concerns over credit quality both in the US and Canada.

“Although we do not believe that the problems in Canada will get near as bad as in the US, we believe that credit quality for the Canadian banks will get worse before it gets better,” he said.

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Gordon Nixon: Legacy at a Crossroads

The Globe and Mail, Tara Perkins, 14 August 2009

The good news: Royal Bank of Canada escaped the Big Red Blush. Canada's largest bank never fell head over heels for subprime mortgages, nor was it seduced into any of the other risky trysts that have been coming back to haunt banks around the world since the financial crisis began.

So why did RBC's latest quarter produce the bank's first loss in 15 years?

That would be the bad news. The loss reflects a $1-billion writedown in the value of Royal Bank's U.S. banking operations. It's an acknowledgment that the bank's stateside strategy is, as ever, stuck in neutral.

Unlike writedowns relating to toxic exposures, this charge didn't mar the bank's precious capital levels. But that doesn't make it any more palatable to chief executive officer Gordon Nixon, who has been sweating over the States since his first day on the job.

It was eight years ago that Mr. Nixon, then a wunderkind investment banker, took charge at Canada's biggest bank. His predecessor had just bought a U.S. bank, and it fell to Mr. Nixon to make the purchase work.

Less than two months after Mr. Nixon's ascension, 9/11 walloped the economy. The U.S. bank has been a headache for him ever since.

At 52, Mr. Nixon is one of the longest-serving chief executives among the world's top banks. He was named Canada's Outstanding CEO of the Year in 2007, and he has since cemented his reputation by keeping his company grounded while the financial crisis shook the foundation of world's banking system. Investors have rewarded him: By market value, Royal Bank is now the world's 12th-biggest bank. (The distinction, it must be said, is partly owed to the shrinking value of many major banks.)

But its U.S. bank, now called RBC Bank, could still make or break Mr. Nixon's legacy.

The U.S. market has always proven problematic for foreign banks, his included. But now, thanks to a crisis that has cast more than 300 institutions onto regulators' watch list of “problem banks,” a buyer's market beckons – and, arguably, a once-in-a-generation opportunity to build a major presence in U.S. banking.

Mr. Nixon has always been cautious – too cautious, many have said – about beefing up RBC Bank. When he has taken action, the record has been mixed. Royal Bank's most recent expansion attempt, a $1.6-billion (U.S.) takeover of Alabama National Bancorporation, has turned out to be what one analyst calls “a disaster.” Redeeming the U.S. banking strategy won't be easy.

“Up until now, it is the only strategy that everyone, even Royal probably, would admit has failed for the company,” says Darko Mihelic, an analyst at CIBC World Markets. “Other strategies within wealth management and capital markets have proven successful over time, and this one has failed.”

Mr. Nixon confronts a choice between exiting the U.S. consumer lending business, or growing it. “You're either admitting you made a mistake and you're exiting, or you are stubbornly refusing to admit that you made a mistake and you're going to plow more money into it,” Mr. Mihelic says. “Either way, it's not a great outcome.”

Mr. Nixon dismisses the exit option as “very unlikely.” He sees a third alternative: “Also very much on the table is that we continue to just build a smallish but very strong regional bank.”

But that's the strategy, observers point out, that got Royal Bank into its quandary in the first place.

“Focusing on [improving] returns is a good short-term strategy but not necessarily a good long-term strategy,” says Edward Jones analyst Craig Fehr. “I think growth is an important part of this puzzle, and I think that's largely going to come through acquisitions.”

Sumit Malhotra, an analyst at Macquarie Capital Markets, is skeptical. “Given the historically low rates of return associated with regional banking in the U.S., perhaps the bigger issue is whether [Royal Bank's] management wants to get bigger in this business,” he says.

Growth by necessity

While industry executives are loath to admit it, the Canadian banking market is so mature it's sprouting hair in its ears. With room for growth limited, market share changes among the big five are often just give-and-take skirmishes fought with fierce pricing incentives. Royal Bank is so tapped out in Canada that it's muscling up against the legal lines that prevent it from selling insurance, in some locations offering that service and banking in adjacent storefronts.

So RBC wants to increase the proportion of its business that's coming from abroad. Immediately to the south lies the world's biggest banking market, an elusive pot of gold that's led many banks over the rainbow.

As the financial crisis has illustrated, banking is a different game in the U.S. In contrast to the concentrated, orderly Canadian industry, more than 8,000 institutions are battling for customers in a market that is still tinted with cowboy capitalism: Mortgage rules are looser, capital requirements are lower, and many regional banks thrive simply by arbitraging the difference between short-term and long-term interest rates.

Canadian banks have pulled through the global crisis with high marks precisely because they didn't take many of the risks that were once so profitable for their counterparts in other countries. With regulators around the world moving to tighten and harmonize banking rules, Canadian banks might now find it easier to go head-to-head with incumbents in the American market.

Royal Bank made its first real foray into U.S. consumer and small-business banking (known as “retail” banking) just months before Mr. Nixon stepped into the CEO role in 2001. His predecessor, John Cleghorn, had just paid $2.3-billion (U.S.) for Centura Banks Inc. At that price, the mid-sized lender, with 241 branches and 3,600 employees in the Carolinas and Virginia, was the largest foreign acquisition that a Canadian bank had ever made.

But Centura's results disappointed right out of the gate, and Mr. Nixon inherited the challenge of making the gamble pay off. Mr. Nixon was careful – or timid, in critics' view – from the start. In the first year he took a look at, but passed up, batches of branches that were put up for sale by Wachovia Corp. and Huntington Bancshares Inc.

In 2005, Mr. Nixon presciently sold off Royal Bank's U.S. mortgage origination business, RBC Mortgage Co., which it had acquired (as Prism Mortgage Co.) in 2000. It was the type of operation that helped trigger the financial crisis with overaggressive mortgage sales tactics. Indeed, late last year, the U.S. government alleged that between 2001 and 2005, RBC Mortgage Co. falsified documentation in support of mortgage loan applications, leading to a $10.71-million settlement.

The decision to abandon RBC Mortgage likely saved Royal Bank's U.S. banking business from a much grimmer fate. Most of the mortgage company's assets were sold to New Century Mortgage Corp., the subprime mortgage lender whose 2007 bankruptcy was one of the pivotal events of the crisis.

Rather than play hot potato with risky mortgages, RBC decided to focus on bread-and-butter lending, the type of business it thrives on in Canada. With Centura's network limited largely to rural areas and small towns, RBC Bank aimed to add strength in cities.

During 2006 and 2007, the bank made three more modest acquisitions that expanded its southeastern footprint. First was the takeover of an Atlanta-based bank with 26 branches and offices. That was followed by a move into Alabama with the purchase of 39 AmSouth branches for roughly $400-millionUS or Canadian?. And then, also in Alabama, came a bigger role of the dice.

Alabama beckons

On a damp September day two years ago, Mr. Nixon met with John Holcomb III, the CEO of Alabama National Bancorporation. The encounter was the culmination of a dance that had begun the prior December, when Scott Custer, head of RBC's U.S. bank, phoned Mr. Holcomb and broached the idea of buying his company.

In the interim, Alabama National had become a more eager seller, as mortgage defaults and home foreclosures rose, and credit quality deteriorated in some of its key markets, such as Florida and Alabama itself. For its part, Royal Bank had become a more eager buyer as the prospective price of the acquisition dropped.

So, on a day when U.S. regulators put out an unusual notice urging financial institutions to cut some slack for borrowers who couldn't afford their mortgages any more, Mr. Nixon, Mr. Custer and Peter Armenio, then in charge of RBC's U.S. and international strategy, sat down with Alabama National's executive team in Toronto, and agreed to the final terms of a $1.6-billion (U.S.) takeover.

Thirty-six per cent of Alabama National's loan portfolio was in real estate construction, with a further 28 per cent in commercial mortgages – the very stuff that has since caused so much destruction on the balance sheets of some U.S. regional banks.

Since the deal, the value of U.S. banks have plummeted.

“Regret is a difficult word,” Mr. Nixon says when asked about the timing of the purchase. “If we had acquired Alabama National today, it would have been just as strategic, but we would have acquired it at a very different valuation. If you look at any investment that has been made in the last 15 years in the United States, there have been few dollars that have been good investments.”

About seven months after Royal Bank announced the purchase, Mr. Nixon unveiled a management shakeup, his second in four years. This one saw Mr. Armenio retire and Jim Westlake, who had previously run RBC's Canadian retail banking operation, named head of international banking and insurance.

“Our short-term financial performance has not been pleasant,” Mr. Westlake acknowledged in a July interview from Atlanta.

With its street strength now standing at 430 branches in six southeastern states, RBC Bank last year ranked 31st by deposits among U.S. banks, according to data from SNL Securities. (Larger rivals that compete in the region include SunTrust Banks Inc., Regions Financial Corp. and BB&T Corp., which ranked seventh, ninth and 10th nationally.)

The Southeast has been disproportionately hit by real estate pain, but Mr. Westlake says the region is still the country's strongest growth market for banks in the long term, thanks to favourable demographic trends. What's more, the U.S. “is still the largest banking market in the world, and one where we intend to do well in the future.”

This spring, Royal Bank drafted a three-phase turnaround plan for RBC Bank that it hopes to complete within two years.

A better record on lending is a key part of the fix. RBC Bank represents a mere $30-billion (Canadian) of Royal Bank's $680-billion in assets and, roughly in keeping with those numbers, its U.S. loans are only 15 per cent of the total. But in the latest quarter, the U.S. caused more than half of Royal Bank's loan losses.

U.S. acquisitions

If its stateside salvation is to be realized through acquisitions, RBC must figure out how to capitalize on the fire sale expected in the industry – and how to not get burned by it.

It won't be easy, as the record shows. While Mr. Nixon has been accused of thinking too small, buying big is no guarantee of success, either. Toronto-Dominion Bank has spent roughly $20-billion (U.S.) in recent years to build up a U.S. bank with roughly $73-billion in deposits – but its most recent major acquisition was done at near the top of the market and it's still unclear whether the strategy will pay off.

Canadian Imperial Bank of Commerce, which is now in early stage discussions about taking a stake in a troubled Irish bank, may be looking overseas in part because its own U.S. forays have been disastrous. A decade ago, the bank tried to build a U.S. retail bank by putting branches in grocery stores, but pulled the plug on the experiment after hundreds of millions of dollars in losses. And Bank of Montreal has had its own struggles with Harris Bank, despite the latter's well-established market position in the U.S. Midwest.

Still, there's no denying that the price of expansion is far more reasonable now than when RBC and TD made their earlier deals. For example, SunTrust Banks Inc., the regional rival that is a favourite of the analysts who are pushing Royal Bank to make an acquisition, has $116-billion of deposits and a market value of roughly $10.5-billion; not long ago, it was worth $30-billion.

Mr. Nixon subscribes to estimates that as many as 1,000 banks will fail as customers buckle under the weight of their debts.

“We think we can position our bank in the United States very well as the U.S. evolves and restructures,” he says during a July interview in his office in Toronto. “The $64,000 question is, what does that mean strategically?”

He figures he's got some time to answer the question. The U.S. government's capital infusions into the nation's 19 largest banks has alleviated the pressure to consolidate. Banks that have been bailed out by the government or refinanced have bought themselves some time, and “it's very unlikely you're going to see a significant amount of acquisition activity in the near future,” Mr. Nixon says.

When the opportunities do ripen, Mr. Nixon says it might result in an acquisition or a merger – or perhaps selling RBC Bank to a U.S. bank that Royal Bank takes a stake in. “We want to have the flexibility to have lots of options available to us,” Mr. Nixon says.

No sooner does he make that declaration than Mr. Nixon acknowledges that his position sounds a bit “wishy washy.” But he doesn't mind the rap. In his view, his patience and caution has served the bank well so far. Many Royal watchers agree.

“They faced a lot of pressure prior to the crunch to make a big splash in the U.S., and they chose not to,” says Peter Routledge, senior vice-president of financial institutions at Moody's. “Sometimes a good strategic decision is what you decide not to do.”

“If I were Gord, I would feel vindicated that I resisted pressure from analysts and investors to make an acquisition at what turned out to be the peak of the market,” says Rob Wessel, a former bank analyst and industry expert.

But the peak is ancient history now. And Royal Bank is well positioned to be an acquirer. Its capital ratio sits at 11.4 per cent, having risen from 9 per cent in just six months. (The regulatory minimum is 7 per cent.) “We are significantly overcapitalized,” Mr. Nixon says. “We can grow our businesses and our balance sheet over the next number of years. A lot of our international competitors are going to have to either raise a tremendous amount of equity or shrink their balance sheets.”

The majority of analysts who follow RBC say Mr. Nixon is wise to take a bit of time to see how U.S. prospects shake out. But, they add, he can't wait too long.

“My view is that, if your stock is performing this well anyways, take your time and make the right decision,” says Mr. Mihelic, the CIBC analyst. But if the recovery occurs more quickly than expected, opportunities will start to dry up, he adds. In this scenario, the bank's window of opportunity could be as short as six to 12 months.

Mr. Nixon believes that the financial crisis will be followed by a golden age for banks. It's a relatively rare view, and one that might make him inclined toward having a larger U.S. presence. But he will not be rushed.

“I'm not sure that everyone will see that," he says (of the coming golden era). “We want to make sure we participate in a very smart way.”

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Manulife Q2 2009 Earnings

Scotia Capital, 7 August 2009

Event

• MFC reported $1.09 EPS, versus our $0.45 estimate and consensus of $0.70. Dividend was cut 50% as part of MFC's plan to build "fortress" capital levels.

Implications

• 50% dividend cut was very disappointing - it's now up to MFC to prove it can service this capital better and that a reduced dividend is a better long-term value proposition. At least the dividend cut was done from a position of strength - MCCSR at 242% (likely 255% based on current markets, highest we've ever seen it) - and in no way suggests the company is in difficulty.

• We peg Q2/09 underlying EPS in the $0.48 range (lower than our $0.52 estimate), which would correspond to a 12% ROE for the quarter - credit risk profile remains excellent. Sales were weak over a strong Q2/08.

• We're lowering our 2010 EPS estimate to $2.35 from $2.58.

Recommendation

• With the dividend cut and weaker sales, MFC is becoming a show me story, but at 9.5x 2010E EPS there's excellent valuation support for what we believe is still a very strong global franchise.

Dividend Cut Was Disappointing

• 50% dividend cut was very disappointing - it's now up to MFC to prove it can service this capital better and that a reduced dividend is a better long term value proposition. Claiming to want to build "fortress" capital levels from a position of strength, the dividend was cut. And while talked about as being essentially last on the list of potential means of fortifying MFC's already high capital levels (outside of an equity raise), actually going ahead with it was unexpected and disappointing.

• At least the dividend cut was done from a position of strength - MCCSR at 242% (likely 255% based on current markets, highest we've ever seen it) - and in no way suggests company is in difficulty. This dividend cut was in no way a sign of weakness, and, if the objective is to build capital to record levels to provide a cushion larger than we've ever seen to protect from downside risk and support growth of what is likely now more capital intensive products, then certainly a dividend cut is the most cost effective means of achieving this objective. We estimate the current MCCSR (255% as of today's markets) can withstand a 27% decline in equity markets before the ratio hits 200%. The dividend cut adds 10 points annually to the MCCSR.

• We peg Q2/09 underlying EPS in the $0.48 range (lower than our $0.52 estimate), which would correspond to a 12% ROE for the quarter - credit risk profile remains excellent. Exhibit 1 details the development. MFC's credit risk profile remains impressive. With just $0.13 EPS in credit hits in Q2/09, the company did significantly better than SLF ($0.78 EPS) and GWO ($0.27). Gross unrealized losses on fixed income securities below 80% of amortized cost for more than six months are 2.5% of the bond portfolio, faring much better than SLF (5.8%) and GWO (4.3%).

• We're lowering our 2010 EPS estimate to $2.35 from $2.58, in part to reflect lower-than-expected underlying EPS in the quarter, and in part to reflect management's comments on "normalized earnings" (suggested to be $0.46 to $0.52). The "normalized earnings", which in no way should be construed as guidance, assume 2% market appreciation per quarter and include no experience gains/losses and no assumption changes, which, together have accounted for $0.65 in EPS on average annually since 2004 (largely experience gains over the company's conservative assumptions). We believe it is highly unlikely these will be eliminated in 2010, even a level of 1/2 or 1/4 the $0.65 average is possible, in our opinion. As well, our estimates assume the S&P 500 will end 2010 at 1,150, 10% higher than management's 2% per quarter appreciation from June 30, 2009 levels. 2010E ROE is 13.3%.

• More noise in Q3/09. A Q3/09 review of all assumptions, the most significant change being policyholder lapse as it relates to VA/seg fund guarantees, should result in an estimated charge not to exceed $0.30 EPS. We expect other reserve-related lapse and interest charges (but, because of a different methodology, not nearly to the same extent as SLF's expected $0.90 EPS hit), to result in an additional $0.30 EPS hit.

• Weak sales over a strong Q2/08. U.S. VA sales were down 31% as MFC de-risks this portfolio (it believes it is ahead of its peers) and U.S. individual insurance sales down 29% (but progressively improving month over month). Canadian sales were mixed. Asia was strong.

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Sun Life Q2 2009 Earnings

Scotia Capital, 7 August 2009

Event

• EPS was $1.05, beating our $0.95 estimate and consensus of $0.89.

Implications

• Credit hits continue to hurt EPS. SLF's track record in this regard has been extremely poor, in our opinion. Total credit hits in Q2/09 were $0.78 EPS, well above our $0.39 estimate.

• A very noisy Q2/09; we'd peg underlying EPS in line with our $0.72 estimate and underlying ROE at 10%. However, since credit hits are consistent and consistently high, we believe the likelihood of achieving this level in the near term is highly unlikely. We're lowering our 2010E EPS to $3.15 from $3.20, but credit remains a wildcard. We're forecasting just $0.18 in credit hits in EPS in 2010, but we remain very sceptical and uneasy.

• U.S. top-line starting to show some positive momentum,with Canada top-line mixed. MFS was strong, but at only 8% of underlying EPS, it's difficult for it to significantly move the needle.

Recommendation

• Positive momentum in U.S. sales is encouraging, but credit continues to be of concern. At 10.5x 2010E EPS, we believe SLF

Credit Woes Continue

• Noisy Q2/09 - but we'd peg underlying EPS in line with our $0.72 estimate. The details are outlined in Exhibit 1. Underlying EPS excludes the impact of credit hits. Since credit hits are consistent and consistently high, we believe the concept of underlying EPS and the likelihood of achieving this level in the near term is highly unlikely.

• Credit hits continue to hurt EPS. SLF's track record in this regard has been extremely poor, in our opinion. Total credit hits in Q2/09 were $0.78 EPS, well above our $0.39 estimate, and significantly higher than GWO's $0.27 and MFC's $0.13. SLF's total credit hits since Q3/08 (ex LEH/Wamu/AIG) have been $2.42 in EPS, well above MFC's $0.56 and GWO's $0.48. Included in the $0.78 in credit hits were $0.17 for CMBS and commercial mortgages, and $0.22 in impairment charges, including $0.12 for CIT.

• We're lowering our 2010E EPS to $3.15 from $3.20, but credit remains a wildcard - we're forecasting just $0.18 in credit hits in EPS in 2010, but we remain very sceptical and uneasy. We outline the details in Exhibit 2. As well, with Sun Life's gross unrealized losses on bonds trading below 80% of amortized cost for more than six months accounting for 5.8% of the company's bond portfolio, more than double that of MFC's (2.5%) and significantly higher than GWO (4.3%), we remain cautious. Our 2010E ROE is 10.4%. We expect the company will provide some form of core EPS potential for 2010 when it presents Q3/09 results.

• Q3/09 could be ugly. The company indicated it could take a $0.80-$0.98 EPS reserve-related hit in Q3/09, as it updates its actuarial methodology and assumptions related to interest rates and equity markets. More specifically, compliance with updated actuarial practice with regards to stochastic economic generators is driving the change. None of the other Canadian lifecos use a stochastic economic generator (they use deterministic), and therefore will not be affected. Combining this hit with likely $0.30 EPS in credit hits (a real wildcard once again) and about $0.25 in possible gains due to rebounding equity markets in Q3/09, we still arrive at an estimated $0.22 EPS loss.

• U.S. top-line starting to show some positive momentum. Sun Life's domestic U.S. variable annuity sales were up 63% YOY, and U.S. core (ex COLI/BOLI/PPVUL) individual insurance sales were up 33%, as company efforts to boost wholesaler productivity (reducing wholesaler count, but poaching some of the industry's best wholesalers from competitors) are beginning to bear fruit. The U.S. operations will embark on a rebranding campaign at the end of the year.

• MFS very strong - but at only 8% of underlying EPS it's difficult for it to significantly move the needle. Gross sales, including managed funds, were up 20% YOY and ex managed funds were up 8% YOY. Net sales were a very strong $4.9B, including retail net flows of $1.2B. While MFS is strong, it still accounts for only 8% of underlying EPS.

• Canada mixed. Ind. insurance sales were down 5% and wealth management sales fell 9%.

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Great-West Lifeco Q2 2009 Earnings

TD Securities, 7 August 2009

Impact – Neutral; Target Increases on Roll forward a Quarter

EPS ex an unusual item was $0.47 vs. our $0.50 estimate and consensus of $0.49. On a normalized basis (see Exhibit 1) we derive EPS of $0.57 vs. our $0.58 estimate. The focus going into Q2/09 was twofold: (1) credit, which was slightly worse than we expected; and (2) Putnam, which had another challenging quarter, but this was expected, and management indicated it’s close to being net flow positive. Our target price increases to $28 from $26, as we roll forward one quarter. We still have concerns with its credit exposure to U.K. banks, and Putnam, but we believe both are manageable.

EPS as Reported was impacted by a few macro themes (see Exhibit 1):

• Equity: -$0.07 from lower fee income, -$0.01 from higher reserves.

• Credit: less than -$0.01 from impairments, -$0.27 from increased provisions for future credit losses in actuarial liabilities.

• Other: +$0.21 from a release of excess interest rate mismatch reserves.

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Scotia Capital Changes Banks' Ratings

Scotia Capital, 5 August 2009

Banks - Rating Changes

• We have changed our ratings on a number of banks. We have changed BMO and CM and downgraded NA.

• Bank rating changes are: upgrading BMO to 1-Sector Outperform from 2-Sector Perform, upgrading CIBC to 2-Sector Perform from 3-Sector Underperform and downgrading NA to 3-Sector Underperform from 2-Sector Perform.

BMO - Upgrading to 1-Sector Outperform

• We have upgraded BMO to 1-Sector Outperform from 2-Sector Perform based on the continued strengthening of its operating platforms, leverage to a turn in the credit cycle given its industry high loan losses, and expected positive earnings surprises.

• BMO's Canadian retail operation is expected to continue to recover from years of underperformance based on the launch of new product initiatives, upgrade of retail facilities, and aggressive repricing of the loan book.

• BMO is also well positioned with its strong wholesale operating platform to benefit from the high profits being generated due to repricing of risk, improving capital markets, and reduced capacity and competition.

• We believe BMO's earnings are relatively high quality with negligible reliance on securitization revenue and security gains, despite a large unrealized surplus. BMO also stands to benefit from leverage to lower loan losses going forward as loan losses for the bank appeared to have peaked in Q3/08 on a quarterly basis. BMO loan loss provisions for 2009 YTD represented 35% of operating income (pre-tax, pre-provision earnings) versus NA at 9%.

• Our earnings estimate for Q3/09 for BMO is $1.16 per share versus consensus of $0.93 per share, thus we are expecting a positive earnings surprise this quarter.

• BMO valuation is attractive using normalized earnings. Based on normalized earnings, 2009 YTD excluding security gains/securitization revenue and normalized loan losses, BMO is trading at only 10.2x earnings versus 14.9x for NA using the same basis.

CM - Upgrading to 2-Sector Perform

• We have upgraded CM to 2-Sector Perform from 3-Sector Underperform due to significant share price underperformance trailing NA by an astonishing 57% year-to-date and the bank group by 14%.

• CM underperformance has certainly been warranted given the level of market-to-market writedowns, weak retail banking earnings, lack of revenue growth, reliance on security gains and the puzzling decline in its net interest margin especially relative to the bank group. CIBC loan loss provisions for 2009 YTD represented 25% of pre-tax, pre-provision earnings, in line with the bank group.

• However, given the improvement in credit spreads we expect market-to-market losses to moderate with some potential for recovery over the next year. In addition, the stock would likely react favourably to a reversal in its net interest margin (perhaps some bad hedges roll off?). An improved net interest margin may help the very weak earnings profile of the retail bank.

• Earnings expectations for CIBC remain low with a high degree of uncertainty but the probability of a positive earnings surprise is increasing and given the share price underperformance we believe an upgrade is warranted.

NA - Downgraded to 3-Sector Underperform

• We have downgraded NA to 3-Sector Underperform from 2-Sector Perform based on 90% increase in its share price year-to-date versus CIBC's gain of only 33% and the bank group's 47%.

• NA's strong share price performance has been warranted given its consistent earnings production through the credit cycle (with the exception of non-bank ABCP) and its negligible exposure to the U.S. NA's consistent earnings have been driven by its strong and relatively large wholesale platform, superior credit performance, continued strong trading revenue, high security gains and strong earnings from securitization. We also believe NA share price has benefitted from not being listed in New York.

• However going forward we believe NA will likely give back some of its superior share price performance. If we look at estimated normalized earnings for 2009 YTD adjusting for security gains, securitization revenue, and loan losses, NA is trading at a significant P/E premium to the bank group at 14.9x. NA loan loss provisions 2009 YTD represent only 9% of pre-tax, pre-provision earnings versus the bank group at 24% and BMO at 35%.

Recommendation

• We remain overweight the bank group and expect the P/E recovery to continue. We believe bank fundamentals remain strong including high capital levels, strong underlying profitability with earnings near the cyclical bottom. Dividend yields remain extremely attractive and dividend increases, we believe, are on the horizon.

• Our order of preference is now: RY, BMO, BNS, CM, CWB, LB, TD and NA.

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Reuters, 4 August 2009

Canadian banks face a substantial risk to future credit performance from the stressed job markets in the United States, and to a lesser extent domestically, and their loan-loss provisioning levels appear ill-equipped to absorb it, Blackmont Capital said.

Toronto-Dominion Bank and Bank of Montreal may deliver double-digit negative total returns as their above-average U.S. credit exposures will weigh on valuation for the foreseeable future, analysts Brad Smith and Richard McCormick said in a note.

They, however, raised their price targets on six Canadian banks, including Royal Bank of Canada , and said RBC and Bank of Nova Scotia offer the most appealing combination of future growth and current capital stability.

Despite their price target increases, the analysts maintained their cautious outlook for credit in the near term, and for bank equity valuations in the medium term.

"Our cautious stance reflects the continuing high level of uncertainty with respect to the timing of a recessionary bottom and the elevated risk of an extended period of lethargic economic activity," the analysts said.

Beyond the credit-related challenges, they see the need for a substantial rethink of domestic bank business models to reflect and better align future activities with a more stringent regulatory capital regime and a lower acceptable financial leverage environment going forward.

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Financial Post, Jonathan Ratner, 4 August 2009

Since touching all-time lows early in the year, the price-to-earnings (P/E) ratio for Canadian banks stocks has made substantial gains. The S&P 500’s relative P/E is currently around 0.78, which means the bank sector multiple is quickly closing in on historical highs, according to Blackmont Capital analyst Brad Smith.

He raised his one-year target P/E for the Canadian bank sector to 11.5 times from 8.0x previously. As a result, the analyst’s median return expectations for the sector move to roughly flat, up from an anticipated decline of nearly 30% reflected in previous future valuation estimates.

Mr. Smith highlighted Royal Bank and Bank of Nova Scotia as the names that offer “the most appealing combination of future growth and current capital stability.” This is reflected in his premium valuation expectation for both.

“Toronto-Dominion Bank and Bank of Montreal are expected to deliver double-digit negative total returns, reflecting our continuing view that their above-average U.S. credit exposures will weigh on valuation for the foreseeable future,” the analyst said.

But despite making substantial increases to his price targets on each of Canada’s Big Six banks, the uncertainty linked to timing the bottom of a recession and the risk of an extended economic slowdown, has Mr. Smith cautious on the near-term outlook for credit and the medium-term outlook for bank equity valuations.

“In the near term, we continue to view stressed labour market conditions in the US and to a lesser extent domestically, as representing a substantial risk to future credit performance, a risk for which current bank loan loss provisioning levels appear to be ill-equipped to absorb,” he said.

And beyond these credit-related challenges, Mr. Smith thinks domestic banks need to rethink their business models to better align future plans with what is likely to be a more stringent regulatory capital regime and an environment where the acceptable level of financial leverage is lower.

Summary of Blackmont’s ratings:

Bank, new target, rating, old target
BMO, $43, underperform, $32
BNS, $46, sector perform, $36
CIBC, $64, sector perform, $46
National, $58, sector perform, $37
RBC, $53, outperform, $42
TD, $53, underperform, $38

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Desmarias Dynasty

Bloomberg, Lisa Kassenaar, 31 July 2009

Deep among the pine forests of rural Quebec lies a private estate the size of Manhattan, a refuge where French President Nicolas Sarkozy has gone to relax.

Former U. S. presidents George H. W. Bush and Bill Clinton have played golf here, on 18 meticulously groomed holes with a bright-yellow cottage for respite at the 13th tee. Pheasant shoots are orchestrated from the hunting lodge; opera is performed in the music pavilion. An original of Auguste Rodin's The Thinker and a statue of Thomas Jefferson adorn the rough, granite hills.

At the heart of the property is a grand residence surrounded by formal gardens called Cherlieu -- which means beloved place -- that's modeled on a 16th-century Palladian villa. This is the home of Paul Desmarais Sr., a white-haired, Canadian billionaire whose obscurity outside Quebec masks his family's vast connections and influence in global business and politics.

"They keep a very low profile," says Brian Mulroney, who met Mr. Desmarais in 1965 and, as Canada's prime minister from 1984 to 1993, introduced him to president Ronald Reagan and Bush. "That's the way they like it."

Mr. Desmarais, 82, started out with a backwoods Ontario bus line in 1951. Now, he and his family control Power Corporation of Canada, a holding company headquartered in an unmarked, eight-story building on Montreal's leafy Victoria Square. Paul Sr.'s sons, Paul Jr., 54, and Andre, 52, are co-chief executives. Together, the brothers govern a labyrinthine business empire that extends from Denver to Geneva to Hong Kong, with seats on 38 related corporate boards.

Power Corp. owns 66% of Power Financial Corp., a web of North American insurance and asset management companies with 2008 revenue of $36.5-billion. In 2007, the Desmarais bought Putnam Investments, a once mighty, Bostonbased mutual fund company that had been wounded by a trading scandal and weak fund performance.

The US$3.9-billion deal closed two months before the Standard & Poor's 500 Index peaked in October 2007. Power Financial's biggest challenge is to make good on plans to renovate Putnam into a flagship for U. S. expansion, after the mutual fund manager's assets were almost halved by the 2008 plunge in global markets.

In Europe, the Desmarais have been partners with Albert Frere, one of Belgium's richest men, for almost two decades. Together, they hold stakes in Total SA, Europe's third-biggest oil and gas company, based in Courbevoie, France; Paris-based Lafarge SA, the world's biggest cement maker; and Paris-based GDF Suez SA, the world's second-biggest utility. Paul Desmarais Jr. is a director of all three.

In China, the Desmarais own 4.3% of Hong Kong-based Citic Pacific Ltd., a steel, mining and real estate development company with a market value of US$7.2-billion as of July 13. Andre Desmarais joined the board in 1997. His father first ventured into China in the 1970s.

"Power Corp. is like an iceberg -- large and largely invisible," says David Beatty, a professor of strategic management at the University of Toronto.

Those who bet on Power Corp. in the 15 years from 1993 to 2008 earned slightly more than investors in Omaha, Neb.-based Berkshire Hathaway, according to data compiled by Bloomberg. Power Corp.'s average annual return in the period, including reinvested dividends, was 14.5%. Berkshire, which pays no dividend, returned an average of 14.1%.

The Desmarais also run a US$1.6-billion, Paris-based private equity firm called Sagard Private Equity Partners. Investors include companies managed by the Frere family; Bernard Arnault, CEO of luxury goods giant LVMH Moet Hennessy Louis Vuitton SA; and Laurent Dassault of the French aviation family, who's on Power Corp.'s board.

The unit is named for Sagard, Que., a French Canadian hamlet of 260 people that's about 480 kilometres from Montreal and adjacent to Mr. Desmarais's 6,070-hectare estate.

Four years ago, Paul Sr. built the villagers a yellow, wooden Roman Catholic church. In December, he attended Christmas services there with the maids, cooks and gardeners who work on his property.

Some visitors to the estate arrive by helicopter. They come for quiet weekends or for enormous costume parties. Cirque de Soleil has performed there. Guests have included King Juan Carlos of Spain and assorted National Hockey League stars.

"They rank with the best and most generous hosts in the world," says Mr. Mulroney, 70, in an interview the morning after a four-day visit to Sagard. "The only thing they don't do is tuck you in at night."

Paul Sr. also owns a home in Palm Beach, Fla., and another in New York. He was Canada's eighth-richest man in 2008, worth $4.1-billion, according to Canadian Business magazine. That was a slide from fourth in 2007 -- partly reflecting a plunge of 44% in the shares of Power Corp. as the global economy shuddered. Profit fell 41% to $868-million in 2008, the lowest amount since 2002.

At Power Financial, where shares declined 44% last year, net income dropped 35% to $1.34-billion, hurt by lower fee income from its prime holding, Winnipeg-based insurance firm Great-West Lifeco Inc., and $983-million in writedowns and other costs related to Putnam.

Power Corp. and Power Financial's stocks, which trade in Toronto, have rebounded in 2009. Power Corp. stock traded at $29.53 this week, up 26.4% for the year. Power Financial was at $29.98, up 21%.

The family's mystique is fed by its policy of avoiding the press. "No one really knows the full extent of their power," says John Aiken, an analyst at Dundee Securities Corp. in Toronto who covers Canadian banks and insurers. "They are an enigma, and I think they like perpetuating that." The father and sons all declined to comment for this story.

Like Berkshire Hathaway, Power Corp. relies on the insurance business for steady returns. Power Financial's core companies have been built up with numerous small acquisitions. The Desmarais keep cash high and borrowing low. Power Corp. had $5.3-billion in cash on its balance sheet at the end of 2008 and just $6.4-billion in long-term debt, according to Bloomberg data.

Power Corp.'s dividend payout in 2008 was $1.11 a share, up from 91¢ in 2007. That put the Desmarais' dividend cheque at more than $130-million. Paul Sr., directly and through holding companies, controls 48.6 million participating preferred shares of Power Corp., which carry 10 votes each. He also holds 72 million common shares, according to the company.

He doesn't collect dividends from Power Corp.'s other publicly traded units: Power Financial; Great-West; IGM Financial Inc., Canada's biggest mutual fund company; and Geneva-based Pargesa Holding SA, home of Power's European investments.

Power Financial CEO Jeffry Orr sits for an interview in a third floor boardroom of Power Corp.'s Montreal head office. The walls are lined with paintings by Jean-Paul Riopelle, a Quebec-born abstract expressionist. Elsewhere in the building is a collection of 18th-century neoclassical French antiques and a filing cabinet said to have been used by Talleyrand, Napoleon's foreign minister.

While earnings declined in 2008, Power Financial's $36.5-billion in revenue represented a jump of 27%, as receipts from Europe doubled, the company reported. "Our fundamental strategy hasn't changed," Mr. Orr says. He aims to grab market share in life insurance, retirement products and asset management as millions of households in North America and Europe, hurt by falling home and equity prices, set more money aside. "They are going to need to save," he says.

The brothers, who took over as co-CEOs in 1996, go into deep detail at dozens of board meetings a year, Mr. Orr says. "They're very active shareholders with active oversight, but they aren't running the businesses themselves," he says. "It's a very fine line."

Paul Jr. is Power Corp.'s chairman; Andre is deputy chairman and president. The father's only official title is chairman of Power Corp.'s executive committee.

A third generation is in training. Paul Desmarais III, 27, is a banker in the special situations group at Goldman Sachs Group Inc. in New York. His brother Nicolas, 23, has worked at consulting firm Bain & Co. in San Francisco. Both are members of Young Canadians in Finance, which sponsored discussions at a Montreal conference.

Paul Sr., in his ninth decade, now spends most of his time on his estate. He helped design the Sagard mansion, which was finished in 2003. The library is filled with architecture books, says Tom McBroom, the Toronto golf course designer who spent six years working with Desmarais on the meandering loop of fairways and greens strung out through the woods.

"I would stay over, and he would be up late at night in his housecoat going over the plans for the house," Mr. Mc-Broom says. Sometimes in the evenings, he says, Paul Sr. and Jacqueline would sit and talk about the old days -- when they had no high-powered friends and Paul, to save money, would drive one of his buses.

Yet the dynasty was already in the making. Sitting in the back as the bus bumped along were Paul Jr. and Andre, who would grow up to inherit their parents' business empire.

• Power Corp. and the Desmarias Family, 25 May 2006

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Scotia Capital Increases Banks' Target Prices

Scotia Capital, 29 July 2009

P/E Recovery to Continue

• Canadian banks are turning in a spectacular year thus far in terms of share price performance with the bank index up 42% year-to-date and up 90% from the late February lows. The P/E multiple has recovered from the low 6.0x (valuation contagion U.S. pricing of Canadian bank stocks) in late February to the current 11.6x on LTM operating earnings.

• The major bank rally has happened at breathtaking speed and it is natural to expect some retracement in bank share prices or at least a consolidation phase. However, given the attractive dividend yield of 4.4% that is now viewed as safe, the low return from Treasuries, and bank underlying earnings power with operating earnings nearing the bottom for the cycle, we believe the P/E multiple will continue to expand at the same time the earnings outlook is improving. We are therefore increasing our share price targets based on a target multiple of 13.3x our 2010 earnings estimates versus our previous target of 12.6x on 2009E EPS. We expect the P/E multiple to expand into the 13x to 14x range before consolidating similar to post the tech meltdown in 2002.

• We would expect further P/E multiple expansion to the 14x to 16x range after a six to twelve month period of consolidation as the market would likely need further confirmation of the longer term level of profitability and strength of underlying fundamentals. We continue to use the Graham & Dodd P/E Matrix as guide with a 5% long term growth rate and bond yields of 5% to 6% equating to our 14x to 16x target P/E multiple range.

• In the near to medium term we expect bank valuations to be given a boost as the earnings outlook improves based on net interest margin expansion (loan book repricing, steep yield curve) as well as the realization that loan losses are peaking and the descent will be played out over the next several years through the economic recovery.

Increasing Target Prices

• Thus our new 12 month target for the bank index increases 16% to 25,000 based on a 13.3x P/E multiple on our 2010 earnings estimates for total expected one year return of 25%. We are increasing our target prices on BMO, BNS, CM, NA, RY, TD and CWB to $60, $55, $75, $70, $65, $70 and $20, respectively, with LB unchanged. Our revised target prices are highlighted in Exhibit 1.

Earnings Power and ROE Momentum Favours RY and BNS

• In terms of bank fundamentals earnings power has remained strong and capital levels are robust. The bank group return on equity on a fully loaded basis after all mark to market writedowns is 11% year-to-date in 2009 with operating return on equity very solid at 17.7% despite near peak loan loss provisions.

• If we exclude the impact of security gains and the entire positive income statement impact of securization the operating ROE for 2009 YTD slips to 16.3% from 17.7%. If we further adjust the loan loss provisions ratio to an average or normalized loss ratio of 43 bp from 83 bp, the underlying or core ROE would be 18.5% for 2009 YTD for the bank group led by RY and BNS at 21.3% and 18.9% respectively. Thus we believe the level of bank profitability and earnings power is supportive to higher P/E multiples especially given the level of interest rates and supportive dividend yield.

Minimal Regulatory Changes Required

• In addition capital levels are high with Tier 1 ratio of 10.8%, CE/RWA of 11.1% and TCE/RWA of 7.6%. We estimate net earnings after dividends represent a capital build of 90 basis points per annum with Canadian banks continuing to have full access to the capital markets for capital and funding.

• The Canadian banking system is now generally viewed as being among the strongest in the world with no major changes needed in terms of regulation and structure. However Canadian banks will likely be modestly impacted by the global push for lower leverage, higher liquidity, increased amount and quality of capital, pro-cyclicality requirements, and higher capital allocated to various activities.

• Canadian banks profitability or return on equity would be reduced if higher capital requirements were introduced beyond the high levels they already have. The impact of profitability of an immediate 200 bp increase in Tier 1 via common equity bringing the Tier 1 ratio up to 13% (funds held in liquid Treasuries - improving liquidity) would be to reduce ROE by 2% to 3%, thus ROE downside is to the 15% to 16% range (assumes no repricing of products and activities impacted). Thus we believe the highly profitable, low risk Canadian model will continue post the global financial markets reformation.

• Bank valuation remains very attractive on a dividend yield basis, although dividend yields are down from their lofty heights to a still very attractive 4.4% and remain in the strong buy range against government bonds or the equity markets. Bank dividend yield relative to 10 year bonds is 2.9 standard deviations above the mean. If this ratio was to revert to one and two standard deviations, bank stocks would need to increase 55% and 21%, respectively, assuming no dividend increases and a constant bond yield.

Recommendation - Remain Overweight the Group

• In conclusion, Canadian banks are well capitalized with high quality balance sheets, a diversified revenue mix, a solid long term earnings growth outlook, low exposure to high risk assets and compelling valuation on both a yield and P/E multiple basis. We remain Overweight the bank group.

• Our order of preference continues to be biased towards strong wholesale banks with wealth management earnings momentum expected to improve. Our order of preference is RY, BMO, BNS, CWB, NA, LB, TD and CM.

Bank Significant Outperformance

• Thus far in 2009 the bank index has increased 42%, outperforming the S&P/TSX by 24%. This compares to slight outperformance in 2008 of 3% and underperformance of 15% in 2007 (commodity bubble), the third worst year for bank stocks. The other major years of bank underperformance were in 1979 (commodity bubble) and 1999 (Nortel/tech bubble). If bank share price performance remains intact for the remainder of the year this will be the fourth highest outperformance in 50 years on a total return basis.

Third Quarter Update

• Banks begin reporting third quarter earnings with BMO on August 25, followed by CIBC on August 26, NA, TD and RY on August 27, BNS on August 28, and LB and CWB closing out reporting on September 3.

• We are looking for a 14% decline in earnings year over year and 2%, sequentially. Return on equity for the bank group is expected to be 16.5% with mark-to-market writedowns moderating.

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TD Securities, 28 July 2009

U.S. banking results provided some relief for the market relative to mixed expectations heading into earnings season. However, broadly speaking underwriting activity and trading were key sources of strength, while credit and core P&C banking trends continue to reflect ongoing challenges. Issues around troubled assets and related write-downs have moved to the background.

• There remains an inordinate amount of noise in reported results. However, in this report we do our best to summarize the key trends in the U.S. results and draw out some implications for the Canadian banks.

• Credit remains a key focus and we review the U.S. loan books of the Canadian banks. U.S. results appear to support our view that credit conditions are likely to continue to deteriorate (albeit potentially at a slower pace). To date the biggest concerns have been around some specific exposures (largely related to U.S. housing construction). To us, focus will shift to broader deterioration across commercial portfolios going forward.

• We expect U.S. loan books to continue to account for a disproportionate amount of credit costs (up to 50% of PCLs in some cases). All that said, we continue to view aggregate credit costs as manageable for the industry.

• Looking to capital markets, the U.S. results seem to confirm that market conditions remain very favorable for certain trading and investment banking activities. We expect this to continue to carry through the Canadian results and we expect another strong quarter. However, we note that a stellar equity underwriting quarter (driven by recapitalizing the U.S. banking sector) was a key contributor to the U.S. experience.

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Preview of Insurance Cos Q2 2009 Earnings

Scotia Capital, 20 July 2009

Canadian Lifecos – A Noisy Quarter Expected – Focus Remains on Credit – Capital Positions Very Strong

• Lots of moving parts this quarter. A sharp increase in equity markets quarter over quarter (QOQ) combined with continued uncertainty in credit conditions could lead to a noisy Q2/09 for the lifecos. Manulife has suggested that all of the gains from the rebound in equity markets, gains that arise predominantly from the mark-to-marketing mechanics of segregated fund/variable annuity reserving, may not all fall to the bottom line; variable annuity reserves need to be boosted for lower corporate bond rates and increasing persistency, and long-term care reserves need to be boosted for lower interest rates and a few swaps that went offside. While we don’t know what others will do, there could very well be similar reserve adjustments, although not to the same extent as the $1.00 in EPS we expect in the case of MFC. We’re also expecting some “guidance” if any as to what “underlying” EPS is for the quarter. We put underlying EPS in Q1/09 at $0.52 for GWO, $0.57 for IAG, $0.52 for MFC, and $0.72 for SLF. Exhibit 1 outlines the development of our Q2/09 estimates.

• We’ve modestly cut our 2009 and 2010 estimates – largely due to currency. For 2010 we took $0.09 in EPS off each of GWO and SLF and $0.17 off MFC, as we revised our FX assumptions to address what looks to be an increasing Canadian dollar versus foreign currencies. Scotia Economics now forecasts the Canadian dollar will average US$0.86 in 2009 and US$0.96 in 2010, £0.55 in 2009 and £0.56 in 2010, and ¥84 in 2009 and ¥87 in 2009. MFC is the most sensitive to changes in currencies. These revised forecasts also led to a $0.04 EPS reduction in 2H/09 for GWO, a $0.07 reduction for MFC, and a $0.06 reduction for SLF.

• A more measured view on long-term interest rates results in a reduction in EPS for IAG (by far the most sensitive), with little impact on others, apart from MFC interest rate reserve strengthening in Q2/09. After increasing steadily since the start of the year, new money rates have fallen since mid-June, with a 25 bp decline in long-term provincial bond yields (a good proxy, especially Quebec bonds, for IAG’s initial reinvestment rate for reserving or IRR), and a 40 bp decline in Moody’s AA corporate bond yields. For IAG, each 10 bp decline in the IRR results in a $0.30 EPS hit. We’ve decreased our 2009 and 2010 EPS estimates by $0.21 and $0.30, respectively, to reflect a more measured view of long-term interest rates. As MFC has suggested, a drop in corporate interest rates used to discount seg fund/VA liabilities, largely in the U.S., will result in a reserve hit in Q2/09. We suspect that given the recent volatility we’ve seen in these rates, MFC will significantly pad its assumption, and look for a total EPS hit in Q2/09 for interest rates that could be as high as $0.50. While we don’t forecast any reserve hits for interest rates for SLF, there certainly is a chance, and each 10 bp drop in new money rates across the yield curve results in a $0.05 EPS hit for SLF. GWO is the least affected by swings in interest rates, with a 10 bp decline hurting EPS by only $0.01.

• We suspect the lifecos will continue to increase reserves for asset default throughout 2009 as credit conditions remain uncertain. We forecast increases in assumption for credit default, largely given rating agency downgrades, as well as increases in reserves for lapse assumptions (we suspect policyholders will hold onto “lapse-supported policies” longer than expected, to the detriment of lifeco earnings) will translate into EPS hits in the second half of 2009. We estimate these “hits” will be just $0.03 for GWO and $0.01 for IAG, given their limited exposure to both U.S. commercial real estate (CRE) and U.S. commercial mortgages, as well as their modest segregated fund exposure. With relatively higher exposure to U.S. CRE and U.S. commercial mortgages, we expect these hits for MFC and SLF to be slightly higher (although exposures are still significantly below those of the U.S. lifecos) and expect these EPS hits in the second half of 2009 to be $0.17 for MFC and $0.15 for SLF. We must admit that we have a degree of cautiousness around SLF’s estimate, given its less-than-stellar history in terms of credit hits.

• Sun Life most likely to suffer as credit continues to weigh. SLF’s track record in this regard speaks for itself, with a total of $1.64 EPS in credit hits in the past three quarters (excluding LEH/Wamu and AIG) versus $0.21 for GWO, $0.22 for IAG, and $0.43 for MFC. As well, gross unrealized losses on fixed income securities trading below 80% of acquisition cost for more than six months represent 4.9% of fixed income assets for SLF, 5.7% for GWO, 1.5% for MFC, and 1.3% for IAG.

• We see healthy Q2/09 capital ratios. We peg MCCSR ratios at 213% for GWO, 230% for IAG, 255% for MFC, and 230% for SLF, all well above regulatory minimums (120%), regulatory watch-list levels (150%), and comfortably above target ranges (175% or 180% to 200%), although we do expect target ranges to be reset to levels above 200%. IAG can withstand a 32% drop in equity markets from current levels (i.e., S&P/TSX of 7,100) before its MCCSR ratio hits 175%, and a 45% drop (i.e., S&P/TSX of 5,450) before it hits 150% levels. We estimate MFC (on a “do nothing” basis, and without utilizing the $1.0 billion currently sitting at the holdco) can withstand a 30% drop in equity markets from current levels (i.e., to an S&P 500 level of 640) before its ratio hits 185%, and a 40% drop in equity markets (i.e., to an S&P 500 level of 525) before it hits regulatory watch-list 150% levels.

Great-West Lifeco Inc.

1-Sector Outperform – $27 one-year target, based on 1.9x 6/30/10E BVPS and 11.0x 2010E EPS

• We’re looking for EPS of $0.49 for Q2/09, $0.01 above consensus.

• Credit hits could be around $0.07 EPS, some related to U.K. hybrids and some related to other general provisions.

• Cautious on Putnam. We look for net sales of around negative $2 billion. Margins are expected to remain very weak as they have in the past.

Industrial-Alliance Insurance and Financial Services Inc.

2-Sector Perform – $31 one-year target, based on 1.4x 6/30/10E BVPS and 9.5x 2010E EPS

• We’re looking for EPS of $0.62 in Q2/09, $0.02 below consensus.

• "Canada only" likely leads to very modest credit hits - we expect just $0.02 in EPS.

• Keeping a cautious eye on long-term corporate interest rates – particularly Quebec long-term provincials where yields have declined 30 bp in the last seven weeks – IAG is by far the most sensitive.

• Sales will likely remain weak.

Manulife Financial Corporation

1-Sector Outperform – $30 one-year target, based on 1.7x 6/30/10E BVPS and 11.0x 2010E EPS

• We are looking for EPS of $0.45 for Q2/09, $0.25 below consensus.

• A lot of moving parts. We are expecting a noisy quarter, with $1.38 EPS due to the QOQ appreciation in the market (17% weighted average for MFC) offset by $1.22 EPS in reserve hits.

• Focus will be on “core” or underlying EPS. We look for some assistance from management in this regard. We believe core EPS could be in the $0.53 range.

• Update on capital plan - dividend cut unlikely, but remains an option (albeit at the bottom of the pecking order).

• MCCSR we expect to be 255%, well above its 180%-200% target

Sun Life Financial Inc.

2-Sector Perform – $33 one-year target, based on 1.3x 6/30/10E BVPS and 10.0x 2010E EPS

• We are looking for EPS of $0.95, $0.09 above consensus.

• Significant gains from rebound in equity markets should add an additional $0.55-$0.60 to EPS.

• Company track record makes us a little nervous with respect to credit - expect $0.32 in credits, significantly lower than prior run rate.

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Bloomberg, Sean B. Pasternak and Doug Alexander, 21 July 2009

Canadian banks, facing the biggest profit decline in seven years, are expanding their insurance businesses, using the Internet and stand-alone outlets to get around restrictions dating from at least 1923 on insurance sales in bank branches.

Royal Bank of Canada, Bank of Montreal and other lenders are increasing sales online and making acquisitions to skirt the rules and take a bigger slice of the country’s C$115 billion ($104 billion) insurance market.

“Banks are definitely trying to prod areas where there’s not a strict distinction between what a bricks-and-mortar branch is,” said John Aiken, an analyst at Dundee Securities Corp. in Toronto.

With insurance revenue rising by 53 percent last quarter at Royal Bank alone, the business is helping counter the biggest profit decline since 2002 for Canadian lenders. Profit before one-time items at Canada’s six main banks will fall an average of 9.5 percent for the year that ends Oct. 31 on higher loan losses, according to Aiken.

Royal Bank, the country’s largest lender, opened 43 insurance offices adjacent to their bank branches over the last four years to bypass the restrictions, and plans to open more. Bank of Montreal, the No. 4 bank, bought the Canadian life insurance arm of American International Group Inc. in April for C$329.5 million. The purchase may increase the bank’s earnings within a year.

Bank of Nova Scotia, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce and Canadian Western Bank have followed suit, getting around government restrictions by offering life, health and property insurance on their Web sites.

Canada is “the only civilized country in the world that doesn’t allow our banks to sell insurance” through branches, said Larry Pollock, chief executive officer of Canadian Western Bank in Edmonton, Alberta.

The banks’ expansion into insurance is leading to a showdown with the country’s insurance brokers, who say the lenders are violating rules set up by the federal government in 1991. The guidelines state that banks can only promote insurance “outside of a branch.” They previously had been restricted from selling most types of insurance since at least 1923, according to the Department of Finance.

The banks’ insurance outlets should be “separate and distinct” from their branches, and not next door, says Dan Danyluk, CEO of the Insurance Brokers Association of Canada, which represents 33,000 brokers. Bank clients may feel “tied” to an institution that can package insurance together with mortgages and other bank products, he said.

“It’s not about the competitive disadvantage to insurance brokers,” Danyluk said. “The fundamental principle is that consumers are in a very vulnerable position when they’re seeking credit. If banks control that money, consumers aren’t in a strong position.”

Danyluk said that adjacent branches, along with Internet advertising and insurance pamphlets on display in branches, violate the spirit of the Bank Act.

Canada’s financial services regulator gave the banks a boost last month when it clarified that a bank Web site “is not a bank branch.”

“This was exactly what we were waiting for,” said Pollock, 62, who added that Canada’s eighth-biggest bank plans to ramp up its online insurance promotions.

Manulife Financial Corp., the country’s largest insurer, has lost little share to the country’s banks, said Paul Rooney, senior executive vice president for Canada.

Manulife supports the ban on insurance sales in branches because it ensures that clients have more options than just the bank’s own insurance products. The Toronto-based insurer uses a network of 10,000 brokers to sell its policies.

“If you have in-branch selling of insurance, I think it would be difficult for you to see a TD product being sold in a Bank of Montreal branch,” Rooney said in a telephone interview. Independent brokers “are so critically important in ensuring that the consumer gets the right product from the right company at the right price.”

Even with the ban, insurance sales at the banks are growing.

Insurance accounted for 19 percent of Royal Bank’s revenue in the first half of 2009, up from 15 percent a year ago. Premiums and deposits increased 38 percent in the second quarter to C$1.24 billion, helped by higher revenue from annuities and other products.

Royal Bank “cannot provide the value that we believe we bring to the marketplace in the current Bank Act until we do it on the Internet, over the phone and somewhere near the branch,” said Neil Skelding, the bank’s head of insurance.

Bank of Montreal says its purchase of the AIG unit, announced in January, makes it the largest bank-owned seller of life insurance in the country behind Royal Bank, based on direct premiums written. The Toronto-based bank plans to sell insurance through its existing network of brokers and the Internet.

Bank of Montreal had C$222 million in insurance income in fiscal 2008, a 37 percent increase since 2005. The figure excludes the AIG acquisition.

“This is really about accelerating our strategy,” Gordon Henderson, senior vice president of insurance, said in a telephone interview. “We have viewed insurance as a strategic priority for the enterprise for a number of years.”

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Scotia Capital's Analyst Meeting with Manulife CEO

Scotia Capital, 10 July 2009

• Following yesterday's MFC lunch, we met with CEO Don Guloien.

• In our opinion, the lunch did a good job of clearing the air. Guloien mentioned to us in our subsequent meeting he was amazed that a sell-side only meeting held June 25 "produced" everything from a dividend cut to an equity raise when nothing suggesting anything of the sort was ever mentioned (in our opinion, broad market dissemination of a message is a much better way to go).

• What he did say in our meeting yesterday is that nothing has essentially changed over the last couple of months in terms of the company's capital plan, even though the market has rebounded. Priorities remain to build capital through, in order of preference, preferreds, innovative tier 1, medium term notes, reinsurance, and lastly dividend cuts/common equity. In effect, everything is on the table, just as it was a couple of months ago. They're looking at more debt/prefs/innovatives, and with a debt+prefs+innovatives/total capital ratio of 27%, vs. SLF at 29% and GWO at 41%, they still have ample room, possibly another $1.5B to reach 30%. Housing the recent $1B in innovative Tier 1 at the holdco provides lots of flexibility as well.

• With respect to all this dividend talk, Guloien said essentially said nothing has changed. It's a Board decision, it remains the last item in the pecking order in the capital plan, he's very cognisant of investor sentiment (acknowledging though that lifecos are different than banks), and it's not his job to say it will never happen. The payout ratio is a function of "core earnings" (which will be elaborated on when the company reports Q2/09 Aug 6) over the long run and he has suggested growing into the target payout ratio could be a more likely scenario. The target payout ratio is 25%-35%, our 2010 estimate puts them at 38%, and consensus puts them at 41%, which is lower than consensus for SLF of 44% (above their 30%-40% target) and consensus for GWO of 50% (above their 30%-40% target).

• Unlike other CEOs Guloien is very open. He's blatantly honest and will explain both sides of any idea freely and openly with the Street. His style will likely take a bit of getting used to.

• MFC sees plenty of acquisition opportunities down the road and believes that these volatile markets will separate the strong from the weak.

• At 7x 2010E EPS, we believe MFC is good value for an excellent franchise.

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Financial Post, David Pett, 3 July 2009

Manulife Financial Corp. was one of the biggest gainers on markets over the past three months, but thanks to a late June slump, the life insurance giant still remains one of the better buying opportunities heading into the third quarter, says Desjardins Securities analyst Michael Goldberg.

"We believe that the recent decline in Manulife's stock price has been an overreaction by investors, Mr. Goldberg said in a note to clients.

For the second quarter, Manulife shares were up 42%, compared to 19% for the broader TSX benchmark. However, since June 19, the stock has dropped 14%.

The sell off followed news that the OSC is investigating the company's disclosure to investors regarding its segregated funds and annuity business, but Mr. Goldberg believes the real culprit behind the drop was a Manulife statement saying it may need to strengthen its reserves .

"As we have said in the past, we expect any reserve strengthening next quarter to be minimal on a net basis and any expectation of a net reserve release following the buildup of those reserves at a cost of $7-billlion over the past few quarters, would be naive," he said.

He said Manulife is now trading at 7.6x his projected 2010 EPS forecast of $2.80, which compares favourably to his $26.50 price target based on 9.5x 2010 EPS.

"It is time to lessen exposure to Canadian bank positions and start accumulating Canadian lifecos," Mr. Goldberg added.

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U.S. Regulators Could Learn from Canada's Banks

USA Today, David J. Lynch, 5 July 2009

Our northern neighbor sometimes seems so similar to the United States that it's hard to tell where the USA ends and Canada begins. Here's one way: Canada is the place with healthy banks, taxpayers unscathed by megabillion-dollar bailouts and no need to overhaul financial regulation because it was done right the first time.

As U.S. officials scramble to prevent a crisis sequel, the ability of Canadian banks to navigate the current financial storm is earning global plaudits. The World Economic Forum in October ranked the country's financial institutions No. 1 in the world for solvency. U.S. banks came in 40th, two rungs behind Botswana.

Praise for the Canadian regulatory approach has come from former Federal Reserve Board chairman Paul Volcker as well as the head of the National Economic Council, Larry Summers. "Canada has come through this period with much less financial damage than we suffered. ... I think there are some lessons in financial regulation to be gained from what's happened in Canada," Summers told USA Today in a recent interview.

Indeed, Canada's experience is reflected in elements of the Obama administration's proposed revamp of financial industry regulation, the most sweeping set of changes since the 1930s. One example is an increase in the capital buffer required of financial institutions, especially those whose failure would threaten the entire system. Canadian banks must maintain high-quality capital reserves beyond international standards, thus limiting the banks' use of borrowed funds for investments. (Such leveraged financial bets magnify gains if they pay off — or losses if they don't.)

"The proposals the Obama administration have come up with are certainly along the lines of our thinking," says Mark Carney, governor of the Bank of Canada.

But the prospect of congressional turf battles prompted the administration to shy from tackling the fragmented U.S. regulatory system, meaning perhaps the greatest Canadian lesson is being ignored. The administration opted to leave in place multiple financial regulatory agencies rather than mimic Canada's most distinctive feature: a single powerful regulator, the Office of the Superintendent of Financial Institutions, with a mandate to roam across banks, insurance companies and pension plans.

"We see everything. ... If we see something that concerns us, we tell them to fix it," says Julie Dickson, OSFI superintendent.

Along with a consolidated regulatory system, Canada also boasts a more conservative executive-suite culture. Canadian bankers act less like Wall Street's masters of the universe and more like sedate, green-eyeshade types. Regulators aren't the enemy; they're an early-warning system that signals financial problems before they blossom into catastrophe.

In the U.S., some blame the financial debacle on the 1999 repeal of a Depression-era law that prohibited commercial banks from owning investment banks. But Canada notably allowed such mergers for more than a decade without incident before the U.S. scrapped its Glass-Steagall law. Conservative management made the difference.

In 2005, for example, Ed Clark, CEO of TD Bank Financial Group, which operates a U.S. retail subsidiary, grew increasingly worried about the complexity of some of the securities in the bank's portfolio.

Clark didn't fully understand how the derivatives would behave in different market environments, and he suspected no one else did either.

So he did something almost no one on Wall Street had the foresight to do: He ordered his traders to ditch the risky but highly profitable positions. Over the next nine months, TD gradually unwound its derivatives holdings at a cost of more than $200 million in write-offs, which looks like a bargain compared with the $2.2 trillion in losses that U.S.-originated derivatives are expected to incur this year and next, according to the International Monetary Fund.

Still, at the time it was a controversial move, even within TD's own ranks. "I actually said internally, 'I'm not going to be proven right in my career,' " Clark recalled. "I didn't see it blowing up that fast."

Clark is happy to take a little credit for getting a big call right. But he says far less dramatic factors at the core of financial industry operations also explain Canada's stability. Canada's Big 5 banks, which account for about 85% of industry assets, didn't make subprime loans to customers with weak or non-existent credit ratings. And rather than package their mortgages into securities for sale to other investors, as U.S. banks did, Canadian banks held onto the loans. Limits on the banks' use of borrowed money to goose their investment returns further insulated them from the woes suffered by their American counterparts.

While Canada has avoided the more than $1 trillion the U.S. has at risk in its financial industry rescue, it hasn't been able to dodge the economic fallout. Thanks to its close links to the U.S., unemployment is 8.4% and total output in April was 3% less than one year ago.

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