Short Interest in Banks Near All Time Highs

Scotia Capital, 13 February 2008

Short Interest in Canadian Banks Near All Time Highs

• Short interest in Canadian Banks has risen significantly from the extremely low levels during the 2001/2002 credit crunch where Canadian Banks had very high absolute and relative exposure to the troubled Telco/Cable and Power/Power Generation sectors (Exhibit 1).

• The short interest in Canadian banks began to rise (Exhibit 8) from extremely benign levels during 2006 peaking in late 2007 with the exception of CIBC whose short position reached an all time high as at January 31, 2008.

• The short interest ratio for Canadian banks has increased from 1.0 to 2.0 in 2002 to levels ranging from 3.3 to 8.5.

CIBC - Highest Short Interest

• The short interest in Canadian Banks has been focused on CIBC with a short interest ratio of 8.5 followed by RY at 5.5, BNS 5.2 and TD at 4.9. BMO and NA short interest ratios have dropped from previous peaks to 3.3 and 3.8. In the past cycle short interest was not meaningful with the respective short interest ratios for BMO, BNS, CM, NA, RY and TD being 1.0, 1.0, 2.8, 1.0, 1.7 and 1.8, respectively.

• It is difficult to derive the share price impact as a result of these relatively aggressive short positions. However we believe it has contributed meaningfully to the share price declines of Canadian Banks. The R squared in the past six months (Exhibits 15-20) between CIBC share price and the Short Interest Ratio is 92%, followed by NA at 63% and BMO at 61%. The banks that have the least exposure to high risk assets have been less affected with RY at 40%, TD 39% and BNS a low of 19%.

Low Exposure to High Risk Assets

• We continue to believe Canadian banks' exposure to high risk assets/loans is at a historical low on an absolute and relative basis compared to past cycles such as 1982 (LDC), 1990s (CRE) and 2002 (Telco/Cable/Power/Power Generation). We expect the bank P/E multiple to rebound significantly in the next few years as it did subsequent to weathering the Telco/Cable/Power sector problems (trough ROE 15%). We expect the stress testing of bank earnings in fiscal 2008 will again lead to higher multiples.

Compelling Valuations - Recommend Aggressively Buying

• Bank Valuations Best in Decades or Ever? The bank dividend yields relative to bonds and equities (Exhibits 4 and 5) are at unheard of levels at 5.2 and 2.0 standard deviations above their historical means. Bank P/E multiples have retraced to 10.9x trailing similar to 2001/2002 bottom.

• The resolution of the U.S. monoline problems is expected to be a key positive inflection point for bank stocks. As well we expect Canadian banks' solid earnings, profitability and dividend increases in 2008 to buoy bank stocks as we move through the year.

• We continue to recommend aggressively buying bank stocks at these levels. Reiterate 1-Sector Outperform ratings on Toronto-Dominion and Royal Bank with 8% dividend increases expected at the end of this month.

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New Hitches In Markets May Widen Credit Woes

The Wall Street Journal, Liz Rappaport, Carrick Mollenkamp, Karen Richardson, 10 February 2008

A widening array of financial-market problems threatens to trigger a new phase in the global credit crunch, extending it beyond the risky mortgages that have cost banks and investors more than $100 billion in losses and helped push the U.S. economy toward recession.

In the past few days, low-rated corporate loans -- the kind that fueled the buyout boom of recent years -- have plummeted in value. As a result, banks are expected to try to unload some of those loans this week at fire-sale prices.

Nervous buyers also have retreated in recent days from the market for securities backed by student loans and municipal bonds, roiling some corners of the short-term money markets. Similarly, investors have recoiled from debt backed by commercial real estate, such as office buildings.

Over the weekend, the world's top banking authorities warned that the U.S.-led economic slowdown and continued uncertainty about securities could lead banks to further reduce their lending, and choke off economic activity. (Please see related article.)

One sign of investors' anxiety: Standard & Poor's said its index of the prices on high-risk corporate loans fell to a record low of 86.28 cents on the dollar at the end of last week.

Few market participants expect defaults on any of this debt to match the elevated levels seen in last year's rout in the market for risky, or subprime, mortgages. But collectively, they threaten to deepen the financial system's wounds and create a growing pileup of shaky assets on the books of banks.

Behind the latest problems are some common themes: Investors bought some of these debt securities with borrowed money, or leverage. As prices have declined, lenders have forced the sale of some of these securities. The cash being pulled out of the market by these sales has magnified the losses from rising defaults.

Meanwhile, the Federal Reserve's interest-rate cuts, which were designed to reinvigorate the slowing U.S. economy, may be having unintended consequences in some quarters: sending investors fleeing from investments that do poorly when interest rates fall.

After years in which banks and investors have lent money on especially easy terms, "You've had the biggest credit bubble -- probably the biggest credit bubble we have ever had," says Jim Reid, credit strategist at Deutsche Bank AG in London. Part of the bubble has already been unwound, he says. The problem is, "nobody quite knows where that ends."

Especially hard hit: the market for loans to big U.S. companies with low credit ratings. Problems in this market have been percolating for months. These loans, known as leveraged loans, were a popular way to finance the multibillion-dollar private-equity buyouts of recent years that have wound down amid the credit crunch, like the takeovers of Freescale Semiconductor Inc. in 2006 and TXU Corp. last year. Investors started to shun buyout loans last summer, causing a buildup of the debt on bank's balance sheets.

During the past two weeks, prices on many of these loans have fallen to levels that in a normal environment would indicate that the market expected the corporate borrower to restructure or seek bankruptcy protection. But, though they are creeping up from record lows in 2007, the default rate on leveraged loans is still very low, at around 1% in January, out of the more than half-trillion dollars of these loans outstanding.

Investors are also fleeing leveraged loans because the payments they make to investors are tied to short-term interest rates. With short-term rates falling, thanks to the Fed's rate cuts, those payments are shrinking.

"The yields are just not all that attractive especially if you fear that [interest rates are] going to fall further," says Christian Stracke of debt-research firm CreditSights in London. "That just means that the yield you are going to be receiving is going to fall further."

The loans to Freescale and TXU are trading at around 80 and 90 cents on the dollar, respectively, after being issued at about face value -- large declines for these kinds of instruments.

Many types of investors have left the market for such loans, including individuals. According to AMG Data Services, investors pulled their money out of bank-loan mutual funds for the 18th straight week as of last Wednesday, an exodus that has withdrawn $4.26 billion from the market.

This, in turn, has created problems for securities called collateralized loan obligations, which are pools of bank loans bundled together and sold to investors in pieces. Like the mortgage market's collateralized debt obligations, these instruments were assigned high credit ratings and were touted as spreading the risk of default on the underlying debt.

This week, UBS Securities and Wachovia Securities will be trying to sell portfolios of loans that may be held by a class of collateralized loan obligations called market-value CLOs. Both investment firms were lenders to these CLOs, which depend heavily on borrowed money. Now, with the market value of the loans behind these securities falling, the firms are liquidating a total face value of more than $700 million of them.

Fitch Ratings last week cut the credit rating on pieces of 24 CLOs, putting several of them deeply into junk territory, with ratings in the triple-C or double-C range. Fitch also says it is reviewing its methodologies for rating market-value CLOs. These investments have triggers in place that force banks to liquidate loans being used as collateral when their prices fall by a certain amount.

Having to liquidate portfolios of collateral is an added burden for banks, which already had $152 billion of loans they were trying to sell from buyouts of recent years. As the values of the loans they are holding decline, they could need to take additional write-offs. Market-value CLOs account for about 10% of the estimated $300 billion market for CLOs, according to research by J.P. Morgan Chase & Co.

Related investments called total return swaps have also been hurt. These instruments are set up by banks for hedge-fund clients or other investors to buy loans with borrowed money. The loans serve as collateral, and when the values of the loans decline, the banks' clients can be driven into forced sales.

Citigroup Inc. is one of several banks affected by the upheaval. The bank structured nine of the 24 CLOs Fitch downgraded, amounting to about $4.5 billion of loans, according to a person familiar with the matter. Citigroup issued a statement Thursday saying the bank hasn't liquidated any loan collateral associated with its total return swap program.

Problems are cropping up elsewhere in credit markets. Money-market investors in the past have been large buyers of short-term instruments backed by tax-free municipal bonds and student loans. But they have been shunning these instruments -- known by such names as auction-rate securities and tender-option bonds -- because they fear the debt used to back the instruments will default or get downgraded by rating services.

Thursday and Friday, Goldman Sachs Group Inc. held auctions of hundreds of millions of dollars in securities backed by student loans, all of which failed to drum up enough demand at their asking prices.

More than half of the nation's $2.6 trillion of municipal debt, meanwhile, is guaranteed by bond insurers like Ambac Financial Group Inc., MBIA Inc., and Financial Guaranty Insurance Co. Because these insurers are also on the hook for billions of dollars in troubled subprime-mortgage-related bonds, their guarantees are no longer worth as much. Concerns about the credit ratings of the bond insurers are filtering into muni markets.

Several sales of auction-rate securities have failed to draw sufficient interest from investors in the past two weeks. These include auctions held by Georgetown University and Sierra Pacific Resources Inc. The failures leave investors paying a premium to lenders who would rather let go of the debt.

Big banks are now working to pour new money into the bond insurers, which could help relieve some stress in the financial system. But the spreading turmoil suggests that might not be enough to benefit banks and investors.

Commercial real estate is another segment of the market that is showing cracks. There were no new offerings of commercial mortgage-backed securities in January, and the cost of protection against default on such securities issued in 2005 and early 2006 has more than tripled, according to Market Group's CMBX index. Goldman Sachs estimates banks could write down $23 billion from CMBS losses this year.

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CIBC's Stock Price Influenced by Health of Monolines

Financial Post, Duncan Mavin, 8 February 2008

Canadian Imperial Bank of Commerce has about $2.6-billion exposed to the latest monoline insurer to find itself in trouble, reckons Blackmont Capital analyst Brad Smith.

SCA Ltd — which saw its credit ratings slashed by Moody’s Investors Service on Thursday — is one of a number of monolines that have provided financial guarantees to CIBC’s book of credit derivatives.

If he is correct about the size of CIBC’s exposure to SCA, “the downgrade will greatly increase the likelihood CIBC will need to record a further material loss provision in the first quarter of 2008.

The bank is due to report its first quarter results on February 28. The bank has already taken about $3.3-billion in writedowns related to its book of credit derivatives, including about $2-billion that was hedged with a single monoline insurer.

If the bank takes further massive writedowns, capital ratios will be under pressure despite last month’s $2.9-billion injection of emergency capital at CIBC.
Mr. Smith has a “sell” rating on CIBC, and a twelve-month target price of $66

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RBC Capital Markets, 7 February 2008

We believe that CIBC's stock price will be heavily influenced by the health of the financial guarantee industry. A successful resolution of financial guarantors' capital issues would be positive for CIBC, but the timing and chances of success are still uncertain.

• We believe that the market is pricing in approximately $3.5 billion in mark downs over and above the cumulative $3.3 billion that has been announced so far. For CIBC to have writedowns that large, further deterioration in the value of hedged assets and counterparty ratings is required.

• The most optimistic scenario for CIBC would be that hedged assets turn out to be worth more than current values, and/or financial guarantors maintain strong ratings. In that scenario, the bank's Tier 1 capital would increase from a pro-forma 11.4% to 12.5%, book value would increase by 11% and we believe fair value for the stock could be up to $86 per share. This scenario seems overly optimistic to us in the near term.

• The worst case scenario would lead to CIBC raising equity again, in our view, and the stock could see the low $50s. That scenario would imply severe pressure on CDO/CLO valuations and a valuation allowance of 100% on all hedges with financial guarantors. It is important to point out that we believe all banks' share prices would be weak in such a scenario, which would require a very dire recession.

We maintain our Sector Perform rating and 12-month price target of $73.

Our target valuation implies a P/E multiple among the lowest of the large Canadian banks, reflecting more exposure to sub-prime CDOs and financial guarantors, below average retail banking trends, our concerns over wholesale revenues and lower confidence about unknown exposures.

In general, we believe the turn in bank stock prices will come when the economic outlook improves, with potential specific upside at CIBC if:

• AAA-rated financial guarantors are able to secure enough capital to convince rating agencies and capital markets participants that their capital strength is unaffected by the prospects of losses on insured CDOs, and/or

• CIBC can improve its relative performance in domestic retail banking, an area where results have lagged peers.

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Banks Back ABCP Rescue Plan

The Globe and Mail, Paul Waldie, 5 February 2008

Toronto-Dominion Bank has declined to join other major Canadian and foreign banks in a financial support agreement to aid the restructuring of a troubled portion of the asset-backed commercial paper market.

The committee overseeing the restructuring of the $33-billion of frozen non-bank-sponsored ABCP said yesterday four Canadian banks agreed in principle to contribute to a fund that will help stabilize the market.

A key part of the restructuring involves the creation of a $14-billion margin facility that would protect against the threat of liquidation by funding margin calls on assets that underlie new notes.

Bank of Montreal, Canadian Imperial Bank of Commerce, Royal Bank of Canada and Bank of Nova Scotia will take part, National Bank of Canada having already been on board. But a TD spokesman reiterated his bank's position, saying in a statement that "we're supportive of a solution and willing to play a role, as long as that doesn't involve us taking on incremental risk."

On a conference call with reporters, committee chairman Purdy Crawford would not provide details about the amount each bank will contribute, but it is understood the Canadian banks will kick in about $2-billion in total.

TD does not want to take part because it did not sell the so-called third-party paper. Mr. Crawford would not say whether the committee is continuing negotiations with TD.

"That's a very co-operative bank and I have no other comment," he said.

The non-bank ABCP market has been frozen since August.

Mr. Crawford's committee consists of major investors in short-term paper and it has spent months working out a plan to replace the paper with longer-dated notes.

The committee also said it hopes to have information available for investors by the end of this month.

The information is expected to include the value of the assets underlying the existing ABCP as well as details about the replacement bonds.

Mr. Crawford said the committee is sticking by its deadline of March 31 to have investors vote on a restructuring. If new notes are approved, most investors can expect to receive full par value of their investment if they hold on to maturity, he added.

He also confirmed the committee has extended a standstill agreement, which effectively froze the market, until Feb. 22.

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Reuters, Nicole Mordant, 4 February 2008

Four of Canada's five biggest banks have conditionally agreed to put up funding to repair a damaged segment of Canada's commercial paper market, the group handling the drawn-out and complicated task said on Monday.

The committee also said major market players have agreed to extend a trading and margin call halt until February 22 and that enough information on the fix-it plan will be available toward the end of this month for investors to make informed decisions on what to do with their holdings.

The committee, made up of the largest investors in the C$33 billion market for Canadian asset-backed commercial paper not issued by the country's big banks, said it still expects the restructuring to be finished by the end of March.

The so-called nonbank ABCP sector seized up in August last year when investors started to worry about the debt investments' exposure to troubled U.S. subprime mortgages.

A committee of the largest investors and players, including Canadian pension funds and foreign banks, was quickly formed and on December 23 announced an agreement in principle on a broad plan to convert the frozen notes into longer-term paper.

The involvement of Canada's banks, which the media has speculated about since December, was confirmed on Monday by the committee, which is led by veteran Toronto lawyer Purdy Crawford.

Bank of Montreal , Canadian Imperial Bank of Commerce , Royal Bank of Canada and Bank of Nova Scotia have agreed in principle, subject to certain unspecified conditions, to join National Bank of Canada and others as lenders in a C$14 billion funding facility in the event of margin calls on the paper or the threat of default.

Such a financial underpin is crucial in getting the troubled market back on its feet and the banks' involvement was welcomed by Canada's finance minister in a statement.

Toronto-Dominion Bank , Canada's second biggest bank, was noticeably absent from the list. TD has said it did not believe it should have to put up money to fix a problem it had no hand in.

"The support of the major Canadian banks is an important component of the plan, and we are pleased to confirm their participation, which further reflects the spirit of compromise and goodwill that has prevailed throughout this process," Crawford said in a statement, which was overdue by three days.

Crawford declined to say on a conference call how much the banks will put in collectively, or individually, or what conditions they want met, leaving some in the market discomfited. He also declined to comment on TD's position.

"Until I see a number I don't think there is an agreement," said Daryl Ching, founder of Clarity Financial Strategy, a company set up to advise investors on the ABCP debacle.

The four banks also declined to comment further. The Globe and Mail newspaper said in December the committee had asked each bank to pony up C$500 million.

Under the restructuring plan, most noteholders can expect to receive full principal repayment if they hold the new restructured notes to maturity, which is on average seven years, the committee said on Monday.

Such a long wait is a tough request for some smaller corporate investors that need the money for day-to-day operations, and originally invested in the paper because it would pay out every one to three months.

Ching questioned whether the committee would finish its work by the end of March as there was still a lot to be done and given its propensity to miss its self-imposed deadlines.

The group, which is being advised by JP Morgan, said there has been active discussions on the restructuring of Devonshire Trust, which was not part of the plan announced in December.

The committee also said that BlackRock Inc had been appointed administrator and asset manager of the restructured trusts. BlackRock is the largest publicly-traded asset manager in the United States.

Toronto-based Coventree Inc , the biggest issuer of nonbank ABCP and the firm at the center of the market storm, said on Friday it is likely to wind up its business after its bid to administer the assets failed. Its stock dropped 35 percent to close at 55 Canadian cents on Monday.

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Scotiabank Expands in Guatemala & Dominican Republic

Dow Jones Newswires, Monica Gutschi, 4 February 2008

Bank of Nova Scotia hopes to add to its consumer finance portfolio through its purchase of bank assets in Guatemala and the Dominican Republic from Grupo Altas Cumbres of Chile.

"One of the things that we have found is that the consumer finance market is a great market in Latin America," said Frank Switzer, a spokesman for Toronto-based Bank of Nova Scotia.

Under the terms of the deal, Scotiabank will purchase Altas Cumbres' Banco de Antigua in Guatemala and select assets of Banco de Ahorro y Credito Altas Cumbres in Dominican Republic. It also has an option to purchase GAC's bank in Peru, Banco del Trabajo.

Scotiabank already operates in all three countries, but the Altas Cumbres purchase will be its first foray into consumer finance in Guatemala.

Scotiabank entered the Guatemala market in 2006 through the purchase of Costa Rica-based Corporacion Interfin, which offered leasing products.

GAC's Banco de Antigua specializes in consumer finance and remittances. It has 47 branches and 98 special service "Rapidito" kiosks in the country. It serves 160,000 clients and had US$82 million in assets at the end of June, according to Scotiabank.

The bank's focus on consumer finance was a point of attraction for Scotiabank, which has been building out its consumer finance assets in Latin over the past year. Last August it purchased a major stake in Chile's Banco de Desarrollo, which had a large consumer finance portfolio.

Switzer said the bank was hoping to leverage its expertise in the consumer finance market in Peru to other countries throughout Latin America.

Consumer finance involves granting small, short-term loans to consumers, often for a specific household purchase such as a refrigerator, motorcycle, or television. The potential market in Latin America is huge, since the majority of the population there remains unbanked. Banking penetration rates in many countries is still only 20-30%.

In the Dominican Republic, Scotiabank will purchase select GAC assets. GAC operates six branches in the country and 35 additional points of sale. Scotiabank has long been active in the Dominican Republic, and offers commercial and personal banking as well as trade finance and wealth management.

Terms weren't disclosed. Closing is expected within days.

Michael Goldberg, an analyst with Desjardins Securities, said in a note that these "in-market transactions are more valuable than planting the flag in a new market" because they expand on established operations. He said the acquisition was likely accretive but not material to earnings.

It wasn't immediately clear whether Goldberg owns Scotiabank shares nor whether his firm has an investment-banking relationship with the company.

Switzer said Scotiabank continued to look for bolt-on acquisition opportunities in countries where it already has a presence, with a focus on retail banking, wealth management, commercial banking and consumer finance.

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Financial Post, Jonathan Ratner, 4 February 2008

Scotiabank has announced that is expanding its operations in Guatemala and the Dominican Republic by buying banks from Chile’s Grupo Altas Cumbres, as well as an option to buy another in Peru. Terms of the deal were not disclosed.

Desjardins Securities analyst Michael Goldberg expects that the acquisition is accretive, but noted that it is not material to earnings in itself.

“What is notable is that these are all markets in which Scotia has established operations, so these in-market transactions are more valuable than planting the flag in a new market,” he told clients in a note, adding that these reasons should lead to a positive reaction on the news.

Mr. Goldberg has a “top pick” rating and $60 price target for Bank of Nova Scotia.

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The Globe and Mail, John Partridge, 4 February 2008

Bank of Nova Scotia is again bulking up its Latin American presence with acquisitions in Guatemala and the Dominican Republic, where it already operates.

The bank said Monday that it is buying Banco de Antigua in Guatemala and “select assets” of Banco de Ahorro y Credito Altas Cumbres in the D.R. from Chile's Grupo Altas Cumbres (GAC), with which it confirmed it was in negotiations last fall.

Under the deal, it said in a news release, it also has an option to buy GAC's Banco del Trabajo (BT) in Peru, the ninth largest commercial bank in that country, where Scotiabank Peru is already the third-largest lender.

A Scotiabank spokesman said the bank is still in negotiations with GAC about BT.

Scotiabank did not provide financial details of the transactions, which have received regulatory approval and are expected to close within days.

However, when it confirmed late last November that it was in talks with GAC — primarily, it appeared at the time, about BT — there were news reports in Chile that it was looking at a price of about $200-million (U.S.) for all three of the GAC operations.

The Peruvian bank likely would almost certainly represent the lion's share of this. It accounts for about $385-million or 77 per cent of the three banks' combined total assets of about $500-million.

Scotiabank first entered Guatemala in 2006 when it bought Costa Rican leasing company Corporacion Interfin, which sold its products in Guatemala. The acquisition of 10-year-old Banco de Antigua brings with it 47 branches and 98 special service “Rapidito” kiosks, about 160,000 clients and total assets of $82-million as of the end of last June.

As for Banco de Ahorro y Credito, it has been in the D.R. since 2002 and currently has six branches, 35 “additional points of sale,” 39,000 customers and $29-million in total assets as of last June, Scotiabank said. The Canadian bank said it is buying a “selected portion of those assets.”

It also said it would be re-branding these locations and services as “Soluciones-Scotiabank,” but the spokesman said later that this part of the announcement was premature and no decision had yet been taken.

Scotiabank currently operates the fifth largest private bank by assets on the Caribbean island.

Analyst Michael Goldberg at Desjardins Securities told clients in a note Monday that he expects the acquisitions are “accretive, although not material to earnings.”

What is “notable” about the deals, he said, is that they are in countries where the Canadian bank already operates, and “in-market transactions are more valuable than planting the flag in a new market. For these reasons, the news is likely to be seen as positive.”

Scotiabank, which bills itself as Canada's most international lender, has operations in more than 40 countries, with particular emphasis on Mexico, the Caribbean and Central and South America.

International operations accounted for 31 per cent of the $3.9-billion (Canadian) in profit the bank reported in fiscal 2007, up from 27 per cent of $2.6-billion in 2004.

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Bloomberg, Sean B Pasternak, 4 February 2008

Bank of Nova Scotia, Canada's third- biggest bank, agreed to buy lenders in Guatemala and the Dominican Republic from Chile's Grupo Altas Cumbres (GAC), adding 53 branches to its Latin American business.

The purchase includes Banco de Antigua in Guatemala and parts of Banco de Ahorro y Credito Altas Cumbres in the Dominican Republic, Toronto-based Scotiabank said today in a statement. The price wasn't disclosed.

Scotiabank gets about a third of its profit from operations outside of Canada, and has agreed to spend about C$2.1 billion ($2.1 billion) in foreign acquisitions over the past two years on banks in Peru, Chile and Costa Rica.

``What is notable is that these are all markets in which Scotia has established operations, so these in-market transactions are more valuable than planting the flag in a new market,'' Desjardins Securities analyst Michael Goldberg wrote today in a note to investors.

Bank of Nova Scotia also has an option to buy Altas Cumbres's Banco del Trabajo in Peru. Scotiabank said in November it had entered talks to buy the Peruvian lender, which has about $386 million in assets and 83 branches.

Banco de Antigua in Guatemala was created in 1997 and has 47 branches and 98 kiosks, with $82 million in assets as of June. Banco de Ahorro y Credito in the Dominican Republic has six branches and $29 million in assets.

Scotiabank fell 54 cents to C$48.29 in 4:10 p.m. trading on the Toronto Stock Exchange today, and has fallen 4 percent this year.

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Preview of Life Insurance Cos Q4 2007 Earnings

RBC Capital Markets, 4 February 2008

Macro environment poor for lifecos in Q4/07

• We expect currency translation to negatively impact the big 3 lifecos' YoY earnings growth by 7% on average with Manulife being the most impacted (8%). The Canadian dollar strengthened against the US Dollar (16%), the Japanese Yen (12%), and the British Pound. Industrial Alliance is not impacted by currency movements.

• Canadian, US and Japanese long-term interest rates were down QoQ and YoY. Lower long-term interest rates negatively impact all lifecos, but Industrial Alliance and Manulife most so. If Canadian interest rates remain at current levels, we believe lifecos may have to increase reserves in upcoming quarters.

• North American equity markets were down during the quarter, which is negative for reserves, but their average level was up YoY and QoQ, which benefits all lifecos' fee based businesses. Great-West's earnings have historically been less sensitive to equity markets but the acquisition of Putnam will increase the sensitivity.

• There were no widespread losses in corporate bonds, which benefits Manulife and Sun Life the most since they have more exposure to lower quality classes of bonds. The widening of credit spreads during the quarter (the CDX North American Investment Grade Index rose from 56 bps to 78 bps during the quarter and is now 109 bps) are positive for yields on new money but, if they are accurate predictors of future credit losses, a negative indication for 2008.

• Holdings of CDO of RMBS are not large and, to the extent that they have not been downgraded and that they match policy liabilities, they are unlikely to cause losses in Q4/07. If we are wrong, Great-West is more at risk in our view.

• We have slightly lowered our Q4/07 EPS estimates to reflect the difficult macro environment. We are still expecting aggregate YoY growth in EPS of 10% as we believe that the size of the lifecos' actuarial reserves is such that reserve releases in some areas may offset macro pressures. The earnings growth profile of the Canadian lifecos in 2001 and 2002 give us comfort that earnings targets can be met, as earnings grew in what was then a difficult macro setting. Multiples should decline, however, as the perceived quality of earnings is likely to be negatively impacted by the current macro environment.

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Financial Post, Duncan Mavin, 4 February 2008

Canadian life insurance stocks outperformed banks throughout 2007 and will likely do better than the banks in 2008 too, said Desjardins Securities
analyst Michael Goldberg in a note to clients Monday.

The big Lifecos, which begin report annual earnings for 2007 next week, were largely untouched by financial sector turmoil that started in the
United States and spread around the world last year.

But the life insurers have slipped against the banks of late, especially because of softening equity markets, lower government bond yields, and the sky-high loonie that is taking a bite out of earnings from extensive operations in the U.S. and overseas.

However, the lifecos will see a return to form and their stocks will do better than those of the banks this year, said Desjardins Mr. Goldberg.

"They have similar price/earnings valuations as banks despite superior earnings and dividend growth prospects in 2008," he said. "Business
platforms outside Canada are also superior to the banks and demographics remain favourable."

Desjardins¹ top pick is Manulife Financial Corp, with a target price of $48.50.

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Scotia Capital, 28 January 2008

Insurers – an excellent safe haven in times of recession

• Insurers have traditionally outperformed in recessions – an excellent safe haven. Not only has the group been relatively immune to the credit crunch, it has also historically done well in recessions. Over the last two recessions (2001, mid-1990 to early 1991) the lifecos and the P&C insurers have each, on average, outperformed the index in terms of both share price performance and EPS growth, as outlined in Exhibit 1. As the probability of a recession in the ensuing quarters continues to increase, we believe the group, traditionally recession-proof, with very strong balance sheets untarnished by subprime and other credit woes, is a safe haven, not to mention compelling value. Canadian Lifecos - Likely won't beat - 2009 should see 11% EPS growth

• Little chance of beating estimates this quarter as negative year-over-year (YOY) impact of currency (14%) outweighs a more moderate 9% year-over-year increase in average equity markets. Q2/07 (especially) and Q3/07 (to some extent) results for the lifecos beat consensus, largely due to the fact that the YOY increase in equity markets, averaging 17%, significantly offset the negative impact of a 5% YOY appreciation, on average, in the Canadian dollar. This is not expected to be the case for the upcoming Q4/07 results. The tailwind of buoyant equity markets, up just 9% YOY on average in Q4/07, is significantly less than what we have seen for the bulk of 2007, and the negative impact of the 14% YOY increase in the Canadian dollar is significantly higher than the 5% levels it has averaged for the bulk of 2007. Add to the mix the potentially negative impact of low long term interest rates and the end result is a Q4/07 that has little chance of beating estimates, and could in fact modestly miss.

• Even smaller chance of lifting estimates coming out of the quarter. With Scotia Capital’s strategist expecting the average levels of equity markets to increase just 2% in the case of the S&P 500 and 4% in the case of the S&P/TSX, we certainly do not expect equity market gains to help EPS growth to the same extent as they did in 2007, when equity markets were up on average 14%. And the negative impact of an increasing Canadian dollar will be felt much more in 2008, where average YOY appreciation in the Canadian dollar versus the U.S. dollar is expected to be 7%-8% (assuming the Canadian dollar averages US$0.99 in 2008), versus the 4%-5% change we had on average in 2007. EPS growth in the last several quarters has benefited from the fact that the YOY growth in equity markets was significantly higher than the negative impact of currency. This will simply not be the case going forward. And it certainly won’t be the case for Q1/08E and Q2/08E, where extremely sluggish YOY growth in equity markets (expected to be 2%) will be far outweighed by the negative impact of an 11%, on average, YOY appreciation in the Canadian dollar.

• We see 11% average EPS growth for the Canadian lifecos in 2009. Assuming equity markets appreciate 8% YOY on average in 2009, and the Canadian dollar remains at US$0.99 in 2009 on average, the same level we’re assuming for 2008, we see 11% EPS growth for Great-West Lifeco, 9% for Industrial-Alliance, 13% for Manulife, and 12% for Sun Life. While these growth rates are greater than the 2008 estimated EPS growth rates, they are slightly less than 2008E EPS growth rates excluding the impact of currency, reflecting the cumulative impact of a deceleration in equity market growth, the negative impact of lower bond yields, and tougher credit markets, offset to some extent by continued aggressive share buyback activity. Manulife’s growth rate is modestly higher than the group (13% versus the group average of 11%), due primarily to more aggressive share buybacks, and Industrial-Alliance’s growth rate is the lowest, primarily due to the fact that it is the most sensitive to declining interest rates and equity markets, and is by far the most exposed to what we deem to be the slower-growth Canadian market. Exhibit 2 outlines our estimates.

• Long-term bond yields continue to slide – probably the biggest risk for the lifecos. Yields on long-term bonds have fallen over 65 bp in Canada and over 130 bp in the United States in just over six months. Recently, the yields on both Canada and U.S. 10-year government bonds were well below 4%, with 10-year Government of Canada bonds at 3.86% and the U.S. 10-year Treasury yield at 3.58%. Scotia Economics currently forecasts the Government of Canada 10-year bond yield will climb 25 bp by the end of 2008 to 4.10%, and the U.S. 10-year treasury yield will climb 65 bp to 4.25%. If the current low long-term yields hold, though, we could see some EPS “pain” for the lifecos.

• If long-term interest rates remain at these levels, we could see a significant reduction in EPS for our Canadian lifecos. With liabilities longer than assets, a declining long-term interest rate scenario can pose significant reinvestment risk. The earnings impact comes not only in terms of lower investment yield, and hence lower investment income, but more so in terms of reserve increases on long-term insurance business. The long-term interest rate assumption used by actuaries in reserving for this business, referred to as the “ultimate reinvestment rate,” is a function of the 10-year moving average in long-term interest rates. And this keeps going down, which translates into reserve increases and thus lower EPS growth. If current rates remain through year-end 2008, we could see a 25 basis point (bp) YOY reduction in the ultimate reinvestment rate in 2007 (down to 4.45%) and a further 30 bp reduction in 2008 (down to 4.15%). We estimate this could translate into as much as a 3%-4% 2008E EPS hit for Manulife, a 2%-3% hit for Great-West Lifeco, a 1%-2% hit for Sun Life, and a significant 10%+ hit for Industrial-Alliance. Simply said, a long-term interest rate scenario below 4% causes pain, and we believe this is currently the biggest risk for the lifecos. As per the 2006 year-end annual reports, the last time these sensitivities were disclosed, the most sensitive of the lifecos to a 100 bp drop in long term interest rates is Industrial-Alliance (a 35% drop in EPS), with Manulife at a 9% drop in EPS, and Great-West Lifeco and Sun Life at an 8% drop in EPS.

Great-West Lifeco Inc.

1-Sector Outperform – $42 one-year target, based on 3.5x 12/31/08E BV and 14.5x 2008E EPS
• We are looking for EPS of $0.65 for Q4/07, $0.02 above consensus. Our 2008 EPS estimate is $2.68, $0.01 below consensus.
• Another steady quarter – Europe should continue to drive growth.
• Putnam should continue to show margin improvement. We assume margins will go to 24 bp from the current 20 bp (or 16 bp the way Great-West would look at them, where intercompany capital is removed), which should continue to propel earnings growth for Putnam through 2008. We look for net sales to be flat in the quarter. While we expect Putnam to still be small relative to Great-West’s earnings base in 2008 (we estimate it will amount to just 7% of the bottom line), we expect the company will continue to be an active acquirer, with more U.S. mutual fund acquisitions likely now that the Putnam financing is squared away.
• Earnings momentum from recent 401(k) tuck-in acquisitions in the United States should continue to propel bottom line – any more tuck-ins?
• Expect a 6%-8% dividend increase.

Industrial-Alliance Insurance and Financial Services Inc.

2-Sector Perform – $43 one-year target, based on 1.8x 12/31/08E BV and 12.8x 2008E EPS
• We are looking for EPS of $0.78 in Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $3.38 is $0.01 below consensus.
• We do not expect another charge for ABCP, like the $0.09 EPS charge the company took in Q3/07.
• A reduction in new business strain is likely to continue to drive results in Q4/07.
• Individual segfund sales should get a boost from the December 1 launch of new guaranteed minimum withdrawal benefit (GMWB) product.
• Unless another acquisition is made, we see 2009 EPS growth returning to the 9% range.
• Industrial-Alliance is the most sensitive of the Canadian lifecos to declining interest rates and declining equity markets – this makes us somewhat cautious.
• Could get a 5% dividend increase.

Manulife Financial Corporation

2-Sector Perform – $45 one-year target, based on 3.1x 12/31/08E BV and 14.3x 2008E EPS
• We are looking for EPS of $0.71 for Q4/07, in line with consensus. Our 2008 EPS estimate of $3.05 is $0.06 below consensus.
• Continued earnings growth momentum in Canada and Hong Kong/Other Asian Territories should offset continued weakness in U.S. and Japan segments.
• U.S. variable annuity sales and U.S. individual insurance sales expected to continue to gain momentum – Japan sales expected to rebound – any update on the prospect of a Bank of Tokyo Mitsubishi distribution arrangement in Japan for individual insurance?
• Why has it slowed its buyback activity? We don’t believe the company is up to anything special, and we anticipate the buyback activity to pick up again very soon.
• Update on variable annuity hedging – is the company still unhedged? The company is expected to embark on a strategy to hedge the guarantees for its variable annuity/segregated fund businesses, mitigating to some extent the volatility in this sizeable book of business. We expect to get an update on the cost (at least $0.02 per share), which we anticipate to have increased significantly in these volatile markets.

Sun Life Financial Inc.

1-Sector Outperform – $60 one-year target, based on 2.1x 9/30/08E BV and 13.3x 2008E EPS
• We are looking for EPS of $1.05 for Q4/07, $0.01 above consensus. Our 2008 EPS estimate of $4.41 is $0.03 below consensus.
• Could beat on the strength of the funding arrangement put in place two quarters ago. This arrangement is successfully mitigating the strain on U.S. no-lapse guarantee universal life individual sales. But Q4/07 will likely include at least $0.01 to $0.02 in EPS from the recovery of strain from business written in Q4/06 and Q1/07 as well, thus increasing the likelihood this company could beat in the quarter. Also, assuming the pace of U.S. variable annuity sales continues at the exceptional clip of Q2/07 (up 96%) and Q3/07 (up 91%), we could see further EPS benefit.
• U.S should continue to drive earnings growth. We believe the company’s ability to turn around this all-important segment and increase its scale will continue to help increase its multiple relative to the group.
• Excellent risk management helps to mitigate earnings volatility in these uncertain markets, and increase multiple.
• We expect a 6%-8% dividend increase.

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National Bank - Investor Day

National Bank Investor Day Summary

• National Bank (NA) held an Investor Day in Toronto on January 30, 2008. Presentations were made by Louis Vachon, CEO, as well as the head of each of National Bank's business segments, namely Personal and Commercial Banking, Wealth Management and Financial Markets. Risk Management was also addressed in a separate presentation.

• Listed below are key takeaways from the presentation.

New Client Centric Strategy - Focus on Cross-Selling

• National Bank unveiled its new bank-wide strategy of becoming a more client centric bank. Management plans to shift the focus from selling products to servicing its clients and taking advantage of cross-selling activities across segments for a bigger share of wallet.

• NA has outlined four key areas where it will focus its efforts to ensure the change in strategy is successful: technology, culture, organization and market and client knowledge.

• Some of the initiatives that have already been taken include adjusting compensation and outlining expectations to take cross-selling goals into account, changing the bank's motto to "One client, One bank" to help create a new culture within the bank, and attempting to better integrate technology platforms across different business segments.

NA Addresses Recession Concerns - Believes Quebec Economy is Solid

• NA attempted to address concerns of a U.S. recession by assessing the risk-profile of the Quebec economy. Management identified that the industries with heavy exposure to the U.S. economy such as manufacturing and transportation & warehousing have declined as a percentage of the overall economy by 6% to 18% in 2007 from 24% in 2000. Also, exports as of 2006 were more concentrated in high-tech sectors and less in automotive and Quebec manufacturing insolvencies have been declining despite a sharp increase in the Canadian dollar.

ABCP Update - More Granularity

• Mr. Vachon indicated that he believed the level of the non-bank ABCP provision taken in Q4/07 was extremely conservative and only two scenarios would cause the bank to take additional charges; if the U.S. were to go into a severe recession or if there was a disorderly sale of non-bank ABCP conduits. Neither scenario is believed to be extremely likely.

• NA reaffirmed that there are fewer than 100 clients holding the non-bank ABCP and that liquidity lines of $580 million have been extended to these clients but only 1/5th of the value has been drawn down.

• NA confirmed that its holdings of non-bank ABCP with U.S. sub-prime exposure are not disproportionately higher than the industry which is less than 10%.

NA Maintains Positive Outlook for 2008

• NA remains comfortable with its previous earnings growth estimate of 3%-8% for 2008; however, management recognizes that the majority of growth may occur in the second half of the year. NA also outlined a longer term three to five year growth rate of 5%-10%. Our 2008 earnings estimate of $5.60 per share represents a 1% decline in earnings from 2007. We remain concerned about NA's high reliance on high risk wholesale banking and its concentration in Central Canada.

• Maintain 2-Sector Perform.

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2008 Citi Financial Services Conference

Reuters, 29 January 2008

Royal Bank of Canada will write down its exposure to a troubled bond insurer in its first-quarter results, the bank's chief financial officer said on Tuesday.

Janice Fukakusa said Royal, Canada's biggest bank, has already revealed it is exposed to one A-rated monoline bond insurer and had taken a provision against this exposure.

"The current mark-to-market (value of that exposure) as of October 31 was C$104 million ($104 million)," Fukakusa told a Citi Financial Services Conference in New York.

"That monoline subsequently is in difficulty so we have written off the balance of our exposure in our first-quarter results," she said.

Royal's first quarter ends on January 31 and the results are due to be reported on February 29.

Fukakusa did not specify the exact writedown nor name the bond insurer, but Blackmont Capital analyst Brad Smith said the only such firm with a single A-rating at the end of October was ACA Capital Holdings .

ACA is the same insurer causing headaches for Canadian Imperial Bank of Commerce

Some businesses that invested in subprime securities hedged these instruments with counterparties like monoline bond insurer ACA in case their value dropped, which has happened along with surging defaults on subprime mortgages.

But several monolines, which are insurers that only operate in one business line, are now at risk of failing themselves, meaning investors who purchased protection from them may not get their money back.

Royal has already taken a hit from the subprime turmoil in the United States, although it is small compared to that felt by CIBC. In the fourth quarter, Royal took a C$360 million pre-tax writedown for its exposure to structured products with subprime content.

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Canadian Press, David Friend, 29 January 2008

Royal Bank of Canada will write down the full amount of its exposure to a U.S. bond insurer that was valued at $104 million months ago, the bank's chief financial officer said Tuesday.

The blue-chip bank's exposure to the monoline bond insurer was disclosed in its last quarterly report on Nov. 30. At that time, the bank took a writedown of $357 million pre-tax, or $160 million after tax and employee bonus reductions.

Since then, the monoline – not formally identified but assumed to be ACA Capital Holdings – has run into further trouble which forced Royal Bank to write down the remainder of its insurance value, CFO Janice Fukakusa said in a financial services conference call.

Fukakusa said that the mark-to-market value of the exposure was $104 million when the bank's financial year closed at the end of October.

The problems at the monoline insurer, whose business is to guarantee payment of principal and interest when a debt-security issuer defaults, are not regarded as significant for Canada's largest bank, which has a stock-market valuation of almost $64 billion.

RBC shares were ahead 34 cents to $50.04 on the Toronto Stock Exchange at midafternoon.

"If it was $104 million at the end of October it may have grown somewhat since then, and the ultimate charge-off of that amount would be something less than 10 cents a share," said Brad Smith of Blackmont Capital.

"If it was a material amount they would be pre-releasing it. I suspect from the way it's coming out . . . you're not even going to see this in the results."

Royal Bank spokeswoman Beja Rodeck said the bank will not issue a news release on the matter because it's not considered material.

The bank will report its first-quarter results Feb. 29.

Investors have braced themselves for ongoing Canadian bank writedowns connected to the crumbling U.S. subprime mortgage market, and Royal Bank's stock is off about 20 per cent from its highs of the past year.

The monoline Wall Street bond insurers have become a major focus of anxiety in anticipation that they will be unable to pay claims.

ACA Capital has fallen in danger of going bankrupt, though it has extended a waiver from its counterparties until Feb. 19.

New York insurance regulators met with a dozen banks last week to discuss ways to shore up MBIA Inc. and Ambac Financial Group Inc., two other players in the monoline industry which is estimated to have promised coverage on $2.3 trillion in debt.

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Reuters, 29 January 2008

Toronto-Dominion Bank may struggle to meet its baseline 7 percent earnings-per-share growth target in 2008 due to the deepening turmoil in financial markets and a weakening economic outlook, the bank's chief executive said on Tuesday.

Speaking at a financial services conference in New York, CEO Ed Clark said he was more pessimistic than he was late last year, when he said TD's 2008 growth would likely be at the low end of its 7-10 percent target.

He said the bank's securities wing has suffered from falling asset prices, while the weakening U.S. economy and strong Canadian dollar have combined to pinch growth in the Canadian province of Ontario, particularly among manufacturers.

"If the markets stay this flat and (Ontario's economy grows at) 1 percent, we're going to have to work hard to stay in that range," he said.

Clark, who has remodeled TD as a low-risk retail-focused bank, while at the same time establishing a growing U.S. presence, reiterated the bank has no exposure to the U.S. subprime mortgage market.

He also said he was not worried about the bank's role in helping finance a $34.8 billion leveraged buyout of Bell Canada owner BCE Inc., which some investors have worried may be re-priced or abandoned. TD is providing $3.8 billion in financing for the deal.

"I don't think that the fundamentals of Bell Canada have changed in the last six months. The only thing that has changed is the capital market," he said.

"Our view is that if you underwrite something, you ought to be prepared to hold it."

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The Globe and Mail, Tara Perkins, 29 January 2008

Toronto-Dominion Bank chief executive Ed Clark says a significant slowdown is coming, and the Canadian economy will not decouple from the United States.

Speaking to a financial services conference in New York, Mr. Clark spoke positively of the domestic banking environment.

“I always say to people if you don't buy me, buy one of the Canadian banks,” he told the room of investors. “It's been a terrific story in Canada.”

But he added Canada's economy will not likely escape troubles south of the border.

“Our outlook is that Canada will not decouple itself from the United States,” he said, adding there will be an impact on the bank's business.

“We're sitting here, the guns of August, waiting for the war to begin and anticipating it,” he said. “... Over a year ago, I announced it was coming, and all I did was end up cutting expenses probably a year in advance. But I do think this time it really is coming, and we are going to have a significant slowdown.”

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Implications on Banks of Basel II Capital Standards

RBC Capital Markets, 28 January 2008

The process that determines Canadian banks' regulatory capital will change beginning Q1/08.

• Regulators are introducing new capital standards that should better reflect individual banks' risk profiles and the banking world of today, than do the existing capital guidelines, which were initially established in 1988.

• We expect that the banks will hold less regulatory capital for credit risk, similar capital for market risk and more capital for operational risk. We do not expect overall regulatory capital to change materially for the industry in general.

• Large global banks' capital could decline by about 5%, which is made up of a 11% decline in capital allocated to credit risk and a 6% increase in capital coming from the introduction of capital requirements for operational risk.

• Regulatory capital requirements will be lower for retail exposures than for wholesale exposures, all else being equal. The lower capital requirements for retail exposures reflect lower and less volatile loan losses historically.

• Areas that will have higher capital charges include low rated corporate lending, bank and sovereign exposures, undrawn commitments and equity holdings.

• Banks will likely disclose significantly more details about their risk exposures than today. We expect enhanced disclosure on loan book composition, credit migration, and counterparty risk.

• The variability of capital ratios will increase under Basel II, with expected increases in risk weightings in tougher times and the opposite in good environments.

• The calculations of regulatory capital will incorporate some changes, with the most significant impact expected to be around general reserves and, for TD, its investment in TD Ameritrade.

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Analysts' Outlook on CIBC

Financial Post, Duncan Mavin, 28 January 2008

Investors wondering when the steady stream of bad news out of Canadian Imperial Bank of Commerce will dry up should not expect to wait too much longer, according to TD Newcrest analyst Jason Bilodeau.

CIBC — which has revealed a stunning capacity to shock investors even when it seems the bank can sink no lower — has seen its stock price plummet of late.

The bank’s subprime-related writedowns have soared to $3.3-billion and it is likely there is more to come. Last week, it also emerged the bank has an additional exposure to the ill winds blowing through the U.S. economy in the form of as much as $25-billion in credit derivatives — this book of securities is not linked to subprime, but it has already suffered a decline in value of at least $750-million, and it is backed by guarantees from under-pressure monoline insurers.

But with so much negativity around the bank already, there is “limited room for additional disappointment,” said Mr. Bilodeau in a note to clients.

“Negative headlines are likely to be confined to confirmation of what is already largely expected; including BIG write-offs. Importantly, the bank’s capital strength appears sufficient to withstand our near worst case scenario.”

CIBC raised $2.9-billion in new equity to stiffen its balance sheet last week. The new capital includes $1.5-billion from sophisticated investors Manulife Financial Corp., Caisse de dépôt et placement du Québec, Cheung Kong (Holdings) Ltd. and OMERS Administration Corp., who all presumably took a long, hard look at the bank’s books before parting with their cash.

Looking forward, Mr. Bilodeau picks two important themes — “we believe management will put a choke hold on its risk culture,” while “CIBC is transforming into one of the purest plays on Canadian retail and wealth management.”

The TD analyst rates CIBC a “buy” with an $80 target price.

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Financial Post, Duncan Mavin, 26 January 2008

Analysts are calling for yet more disclosure from Canadian Imperial Bank of Commerce about its book of credit derivatives, after it emerged yesterday the bank likely has as much as another $25-billion of securities that are partly tied to the uncertain U.S. economy.

The investments -- which the bank says are not subprime-related -- are already in the hole for $750-million, though CIBC has taken no writedown on this book so far.

The bank has not confirmed the size of its non-subprime book of credit derivatives, but it has said the securities are backed by 11 financial guarantors --a term that has recently been used in reference to the much-maligned monoline-insurance industry.

It is believed the underlying assets are mostly in North America and include collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBSs) and corporate loans.

There was frustration among analysts that more information about all of CIBC's credit derivatives has not been forthcoming, after CIBC provided details of its book of subprime derivatives in December and this month.

"We do not have a handle on exactly what CIBC owns," said Andre-Philippe Hardy, RBC Capital Markets analyst, in a note to clients. The "inability to estimate losses" will continue to weigh on CIBC's stock price, he said.

"We do not adequately understand the nature and extent of CIBC's credit derivative exposure," added Mario Mendonca, Genuity Capital Markets analyst, in a note. "Still not sure we have the whole story."

CIBC has taken $3.3-billion in writedowns from its portfolio of subprime investments -- that number is expected to rise by at least another $1-billion, possibly by the end of the current quarter -- and the latest revelations have raised fears of more writedowns to come.

"The good news is that the underlying assets are not subprime-related and the value, to Dec. 31, had only declined by 3.5%," Mr. Mendonca said. The bad news is that most of the decline in the underlying assets occurred in the last two months of 2007 and things may have worsened since then, he added. The Genuity analyst estimates the fall in the value of the non-subprime derivatives could have reached $1.4-billion.

The information about the CIBC's book of non-subprime credit derivatives also raised concerns about the bank's exposure to troubled monoline insurers.

Most observers agree monolines are key to the global financial crisis because they have provided insurance to many of the banks that are embroiled in the subprime mess, including CIBC.

The near-collapse of one of the monolines -- ACA Financial Guaranty Corp. -- has forced CIBC to writedown $2-billion this quarter related to its subprime investments.

A bailout plan for the monoline industry led by U.S. regulators is apparently in the works, but there are few signs of anything concrete so far.

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RBC Capital Markets, 25 January 2008

• In our January 24th report on CIBC, we highlighted the health of the financial guarantors as a key driver for the bank's future stock price.

• The outlook for financial guarantors is deteriorating, with today's downgrade of Security Capital from AAA to A by Fitch as the latest illustration of this point. However, there were media reports on January 23 that New York State's insurance regulators met with US banks to discuss a plan to raise capital for the bond insurers. At this stage, we do not know whether a government led bailout would succeed.

• CIBC's exposure to financial guarantors via hedged CDOs of RMBS is well known. CIBC has US$3.9 billion hedged with four AAA-rated guarantors, and US$551 million hedged with Ambac. CIBC also has US$1.5 billion (after writedowns of US$2.0 billion pre-tax) hedged with ACA.

• CIBC also disclosed on January 14 that it "has exposure to 11 financial guarantors where the underlying assets are unrelated to US residential real estate. The fair value of this exposure is approximately $750 million as at December 31, 2007."

• The fair value of the hedge represents how much CIBC was theoretically owed by financial guarantors at that time. It does not represent how much notional exposure CIBC has to financial guarantors.

• Based on conversations with the bank, we believe that, when the hedge was fair valued at $750 million, it implied markdowns of 3-4%, which would mean the notional exposure is $18-25 billion.

• We understand that the assets that are hedged are mostly Collateralized Loan Obligations and baskets of investment grade loans, with some Commercial Mortgage Backed Securities as well.

• We do not have a handle on exactly what CIBC owns; we know that CLOs and CMBS have not seen the same price declines as CDOs of sub-prime RMBS but, we also know that spreads have widened further since December 31, 2007.

• We believe that the inability to estimate losses will keep CIBC's multiple low as risk to profitability and book value estimates are high, in our view. A successful resolution of financial guarantors' capital issues would be positive for CIBC, but the timing and chances of success is still uncertain.

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Financial Post, David Pett, 25 January 2008

It seems even $2.9-billion of new equity can not dispel the clouds gathered around Canadian Imperial Bank of Commerce.

For now, the new capital boosts the bank’s key capital adequacy ratio — the regulated amount of capital the bank must set aside. But with more subprime-related losses to come at CIBC, the pressure is not off the bank’s balance sheet yet, says Blackmont Capital analyst Brad Smith in a note to clients.

“A distinct negative” for the bank was Thursday’s news that U.S. monoline insurer Security Capital Assurance has been downgraded by ratings agency Fitch. CIBC has hedged much of its exposure to subprime investments with monoline insurers, a number of which are struggling.

“Based on CIBC’s recently updated monoline hedge exposures and our thorough analysis of key monoline insurers, we believe there is an increased probability that the bank has a $2.6-billion subprime hedge exposure to SCA,” Mr. Smith said in his note.

“If this proves correct, the announced Fitch downgrade and rising probability of [other ratings agencies] following suit could strain CIBC’s Tier 1 ratio and accelerate loss emergence,” he added.

Blackmont has a “sell” rating on CIBC. Mr. Smith lowered his target price for the bank from $68 to $66.

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TD Bank's Commerce Buy Remains Unsure Bet

Financial Post, Duncan Mavin, 26 January 2008

Amid all the turmoil in global banking, Ed Clark has looked pretty smart of late.

The Toronto-Dominion Bank chief executive has steered his bank clear of subprime securities and asset-backed commercial paper. Mr. Clark perhaps also stood in the way of a merger between TD subsidiary TD Ameritrade and E*Trade Financial -- a role for which he was vilified by hedge funds last year, but which looks wise now that E*Trade is embroiled in its own subprime mess.

But there is a big outstanding question about Mr. Clark's otherwise glowing reputation: Has the TD chief struck gold or struck out with last year's transformational deal to buy New Jersey-based Commerce Bancorp?

Since TD announced the US$8.5-billion acquisition of Commerce in October, the U.S. bank has not put in a convincing performance.

Yesterday, Commerce reported its fourth-quarter results were only half what they were a year earlier.

Profit in the final quarter was US$33.4-million, compared with US$62.8-million in the same period of 2006.

The year-over-year comparison looks even worse after excluding a US$13.7-million gain this quarter on the sale of the company's insurance-brokerage business and a one-off hit of US$15.8-million related to certain legal settlements.

Take those two one-time items out of the equation and Commerce's results fell by 75%.

Commerce said part of the blame lies with rising loan losses in "residential real estate and related real estate development exposures, and exposures in the leveraged loan portion of the company's commercial loan portfolio."

The bank recorded a provision for credit losses of US$55.0-million, compared with US$26.0-million in the third quarter of 2007 and US$10.2-million in the fourth quarter of 2006.

Under founder Vernon Hill, Commerce was one of the fastest growing banks in the United States, expanding quickly, with a strong emphasis on customer service.

However, Mr. Hill left the bank last year when regulators began investigating dealings between the bank and members of his family, leaving Commerce without its charismatic figurehead.

Despite the pressures on U.S. banks and the problems specific to Commerce, TD did not get a cheap deal. The Canadian bank paid US$42 a share for Commerce, about 6% higher than its closing price of US$39.74 before the deal was announced.

Since then, U.S. bank stocks have been in meltdown mode.

Investors might be tempted to draw a link between Mr. Clark's previous big venture into the United States -- the acquisition of TD Banknorth. The Portland, Me.-based bank had grown quickly -- in contrast to Commerce, Banknorth's growth was via acquisitions -- before TD bought in.

But Banknorth has struggled to deliver in recent quarters, weighed down by yet more acquisitions that have taken more time than expected to bed in, as well as a tough banking environment in the United States.

Still, it is far too early to put the Commerce deal down as a mistake by TD's Mr. Clark.

A spokesman for TD declined to comment on the Commerce results yesterday, but the bank has made it clear the Commerce acquisition is one for the long term.

"I don't think they decided to buy Commerce Bancorp for what it would do to 2008 or 2009 earnings," said Rob Sedran, National Bank analyst.

"Even when they announced the deal, the U.S. economy was softening. When they bought it, it was part of a longer-term strategy to become a North American retail bank."

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Scotia Capital Recommends Aggressively Buying Bank Stocks

Scotia Capital, 25 January 2008

Banks Rebound Sharply From Underperforms

• Bank stocks, after declining 10% in 2007, have started the new year off declining a further 3%, representing one of the largest share price declines in decades and perhaps the only one not led by major earnings collapses. Bank relative performance in 2007 was the third worst in the past 40 or 50 years with only 1979 and 1999 being worse, despite the banks recording operating earnings growth of 10% and return on equity of 21% in fiscal 2007.

• Bank stocks have very rarely ever underperformed the market two years in a row. In fact the bank index typically rebounds very sharply. In 1980 and 2000 following the very weak relative performance in 1979 and 1999 the bank index appreciated more than 30% in each of those years. It is very early in the year but thus far in 2008 the bank index is outperforming the market by 4%.

Bank Earnings & Profitability Solid

• Bank investors remain nervous despite the release of fourth quarter earnings where the banks’ total writedowns represented a very modest 1.3% of common equity. The two banks (BNS and NA) that were due to increase dividends in the fourth quarter did so, although increases were modest. The bank group reported return on equity in the fourth quarter of 20% with a fully loaded ROE of 16%. Canadian bank writedowns pale by comparison to a number of global players. Banks’ return on equity for fiscal 2007 was 21%, which compares very favorably with the 11% recorded by the six major U.S. banks.

• Negative sentiment from headline news and troubled U.S. Financials has more than offset any comfort investors may have received from the release of solid fourth quarter results by the Canadian banks and the confirmation of their low exposure to high-risk assets.

• Bank share prices have continued under pressure early in 2008, driven by fears of monoline insurance companies defaulting, recession fears, and concerns about overall financial market instability. The insurance monolines Ambac and MBIA may fall under the category “Too Big to Fail.” Also they may be able to manage their commitments in a run-off scenario.

Bank Dividend Yields Relative to Bonds - Levels Never Seen Before

• Despite Canadian banks’ low exposure to high-risk assets (Exhibit 6) including monolines (except for CIBC), high capital levels, high profitability, resilient earnings base and a very stable residential mortgage market, Canadian bank stock price declines have pushed up dividend yields relative to long Canada bonds to levels never seen before. The bank dividend yield at 4.2% or 1.05x relative to long bonds is 5.0 standard deviations above the mean (Exhibit 15). This is the highest relative yield by a wide margin. Even if we look at a chart back to 1956, bank dividend yields would be 3.8 standard deviations above the mean, much higher than the 1958 peak of 3.3 standard deviations above the mean.

• This is astonishing especially if you believe, as we do, that the probability of dividend cuts is negligible; in fact we continue to look for dividend growth of at least 8%-10% per annum over the next five years. Hence the Best Buying Opportunity in Decades.

Stress Testing Earnings for a Recession - Payout Ratio 52%

• We are stress testing bank earnings (Exhibits 7-10) for a recession again this year following our fiscal 2006 analysis. In this year’s stress testing we have become more aggressive in haircutting earnings, with similar results and conclusion. Banks can weather a recession with return on equity troughing in the 17%-18% range. If we cut 2008 earnings to recession levels, banks would be trading at a P/E multiple of 12.4x with a dividend payout ratio of 52%. Thus the current dividend levels are totally maintainable and defensible.

• Canadian banks are not, however, immune to the turmoil in financial markets, and we expect earnings growth will be very challenging in the first half of 2008 as the higher funding costs and cost of carry on the banks’ excess liquidity and capital puts pressure on interest margins. The prime BA spread declined 22 basis points (bp) in the fourth quarter to 139 bp, with partial recovery in the first fiscal quarter by an estimated 15 bp.

Trimming Earnings Estimates

• We are trimming our 2008 operating earnings estimates by 5% due to expected margin pressure in the first half of 2008 because of an increase in bank funding costs and a lag in repricing assets, as well as negative carry on the banks’ excess liquidity and capital. Our earnings and share price target adjustments are highlighted in Exhibit 1.

• The operating earnings decline excludes the CIBC pre-announced special first quarter charge of $1.6 billion after tax or $4.75 per share comprised of $1.3 billion on hedged CDO/RMBS (ACA) and $0.3 billion on unhedged CDO/RMBS portfolio.

Resilient Earnings - Dividend Increases to Continue

• The potential further writedowns for the Canadian banks are expected to be modest, with Exhibit 13 highlighting possible future writedowns that are readily absorbable in operating earnings, except for CIBC.

• Our overall earnings outlook remains solid, with earnings growth of 3% expected in 2008 and earnings growth expected to rebound to 15% in 2009. Return on equity for 2008 and 2009 is forecast at the 22% level, with Tier 1 capital ratios remaining extremely high in the 9.5%-10.0% range.

• We expect earnings in the first half of 2008 (Exhibit 12) to be weak, with first quarter earnings declining 5% year over year and return on equity remaining stellar at 21.2%. We expect the four banks that are due to increase their common dividends to do so this quarter, with BMO and CM dividend increases expected in the 4% range and TD and RY increases expected in the 8%-9% range. There is some uncertainty with respect to a CIBC dividend increase given the recent equity issue. Earnings momentum is expected to pick up in the second half as credit markets and funding costs stabilize. We expect the banks’ very high trough ROEs to be supportive of higher share prices and higher valuation.

Bank Share Prices Expected to Double

• On an absolute return basis we have no sells in the bank group and, as fear subsides in the market, we expect significant appreciation in bank stocks over the next few years. Bank stocks, we believe, can easily double in the next three, four, or five years at the outside. We remain overweight the banks.

P/E Multiple to Recover

• In terms of bank P/E multiples, we expect the stress testing of bank earnings in fiscal 2008 will result in P/E expansion and higher multiples, as they did in 2002 (Telco & Cable) and 1998 (Asia Crisis), and that the longer-term trend of expanding P/Es will continue.

• Bank P/E multiples declined in 2007 (Exhibit 18) from 14.5x at the beginning of the year, closing the year out at a low of 11.1x with a further decline to the panic bottom of 10.8x trailing earnings in early 2008 (January 21, 2008). We have been searching for the illusive bottom since the 11.5x trailing range, with the panic selling on January 21, 2008 (bank stocks down 4%-5%) perhaps being the bottom.

• The P/E bottom in the Telco & Cable debacle was 10.9x, with the Asia Crisis being 9.0x. It seems that P/E multiples have bottomed in early 2008 at a similar level to Telco & Cable. Following this bottoming in 2002, the P/E multiples ran up to 15.1x. We are looking for a repeat.

• Banks are trading at a compelling 10.9x trailing earnings and 10.6x and 9.2x our 2008 and 2009 earnings estimates. Our target P/E multiples are 15.6x and 13.5x our 2008 and 2009 earnings estimates, respectively. The P/E multiple has significantly diverged from the trend line (Exhibit 17).

• Bank valuations on a yield basis relative to bonds, Pipelines & Utilities, Income Trusts, and the S&P/TSX Composite are all at unheard of levels.

• Reversion to the mean versus 10-year bond yields implies a 7.8% bond yield or 97% increase in the bank index. Bank dividend yields relative to TSX, Pipes & Utilities, and Income Trusts on reversion to the mean basis implies a bank index increase of 62%, 63%, and 38% respectively.

Recommend Aggressively Buying Bank Stocks

• We would be very aggressive buyers of bank stocks at these levels with the weakest Canadian banks having extremely strong fundamentals.

• We continue to believe the best long-term value and shareholder returns will be derived from the high revenue growth banks TD, RY, and BNS. These banks have high profitability, superior operating platforms, and solid growth prospects.

• It is no coincidence that the revenue-challenged banks CIBC, BMO, and NA got caught in 2007 as a result of going out of the risk curve in search of revenue and earnings. CIBC’s exposure to CDO/RMBS, BMO’s to SIVs and Commodity Trading, and NA’s involvement in non-bank ABCP were all divergent from the mainstream.

• A year ago we had all banks essentially trading at the same multiple, regardless of profitability, business mix, revenue growth, or strength of operating platforms, which was not normal. P/E convergence of this magnitude has occurred only half a dozen times in the past 40 years. However, the relative share price performance among the banks varied considerably in 2007, and we now have some divergence in P/E multiples, slightly greater than the historical means with severe overshoots possible.

• We are reinstating coverage of CIBC and maintaining our pre-restriction rating of 2-Sector Perform. CIBC is a trading buy (with some disclosure risk) based on a 35% share price decline from its high, deep P/E discount of 22% to the group, strong capital position post the equity issue, and potential resolution of the U.S. monoline debacle. If the U.S. regulators are able to help resolve the concerns surrounding Ambac and MBIA, no significant further writedowns would be likely, with some of this we believe currently priced in. In terms of the ACA-related writedown, we believe the risk is priced in, with some possibility that losses could be lower than expected depending on the ultimate fate of ACA and improvement in value of the underlying securities aided by significant Federal Reserve rate cuts.

• The retail bank (includes wealth management) of CIBC earned $7.31 per share in 2007, which would equate to $6.65 per share on a pro forma basis after the dilution from the recent equity issue. Thus CIBC is currently trading at an attractive 10.2x the diluted 2007 retail banking earnings, with no value attributable to the wholesale business.

TD and RY Remain 1-Sector Outperforms

• CIBC continues to be a higher risk bank than TD and RY, our long term core holding banks that we have 1-Sector Outperform ratings on.

• Our bank stock selection in order of preference is TD and RY with 1-Sector Outperform ratings, followed by, BNS 2-Sector Perform, CM 2-Sector Perform, and NA 2-Sector Perform and BMO as 3-Sector Underperform.

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Financial Post, David Pett, 25 January 2008

Two analysts have weighed in with somewhat pallid outlooks for Canadian banks this morning.

Desjardins Securities analyst Michael Goldberg expects earnings to be flat (at least on a collective basis) this year, and for dividend growth to slow appreciably.

With banks tightening their purse strings and being restricted in access to structured credit, he believes further credit crunching is unavoidable, no matter how much central banks grease the wheel.

Mr. Goldberg expects more modest top line growth and worsening loan quality as a result. However, he expects things to improve in 2009, and sees upside, both in terms of stock prices and dividend growth.

"We continue to view bank stocks as a foundation for any Canadian equity portfolio for the dividend growth potential they provide over time," wrote Mr. Goldberg.

His top picks are TD, because it "has avoided the pitfalls of sub-prime mortgages and structured products in Canada and the US, while continuing to successfully build its Canadian and US franchises," and Scotiabank, because "in the current uncertain environment, steady performance is a good thing."

Over at RBC Dominion Securities, Andre-Philippe Hardy and his team write that they are "increasingly concerned over the economy and equity markets" because "these two factors could be material negative earnings drivers for all financial services stocks in Canada."

Like Mr. Goldberg, however, Mr. Hardy tempers his pessimistic short-term outlook with longer term optimism, saying Canadian banks and insurance companies should navigate choppy economic waters better than their global peers and that "the return from holding these stocks over the next two or three years could be attractive as a result."

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Countrywide Fraud Suit Expands To 26 More Financial Services Firms

Dow Jones Newswires, 25 January 2008

The New York City Comptroller, New York State Comptroller and New York City Pension Funds expanded the consolidated class-action lawsuit against Countrywide Financial Corp. (CFC) and others to include 26 financial services companies that underwrote Countrywide's stock and bond offerings.

The expanded suit also named two global accounting firms and additional Countrywide officers and directors who signed Securities and Exchange Commission filings that allegedly contained false and misleading information about Countrywide's business and finances.

"As borrowers lost their homes and investors held onto artificially inflated securities, Countrywide executives cashed out to the tune of almost $700 million," said state comptroller Thomas P. DiNapoli. "We will pursue every avenue to ensure that those who defrauded investors are held accountable for their actions."

The class-action suit alleges that Countrywide, Calabasas, Calif., misstated and omitted information regarding its lending practices and other business information, resulting in the artificial inflation of its stock price. The suit also claims the company issued stock and bonds based on SEC filings that contained false information.

The expanded suit includes ABN Amro Inc., A.G. Edwards & Sons Inc., Banc of America Securities LLC, Barclays Capital Inc., BNP Paribas Securities Corp., BNY Capital Markets Inc., Citigroup Global Markets Inc., Deutsche Bank Securities Inc., Dresdner Kleinwort Wasserstein Securities Inc., Goldman Sachs & Co., Greenwich Capital Markets Inc., HSBC Securities (USA) Inc., J.P. Morgan Securities Inc., Lehman Brothers Inc., Merrill Lynch & Co., Morgan Stanley & Co., RBC Capital Markets Corp., RBC Dominion Securities Inc., RBC Dain Rauscher Inc., Scotia Capital Inc., SG Americas Securities, TD Securities Inc., UBS Securities LLC., Wachovia Capital Markets LLC, Wachovia Securities Inc., Grant Thornton LLP and KPMG LLP.

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National Bank Bails Out Insiders of Their ABCP Holdings

The Globe and Mail, Janet McFarland, 25 January 2008

Executives, directors and other insiders at National Bank of Canada had $7.8-million worth of asset-backed commercial paper investments bought back from them by the bank after markets collapsed in August, the bank has revealed.

In a shareholder proxy circular issued Friday, National Bank said a previously announced program to buy back $2.1-billion of ABCP investments from clients also included buybacks from 48 bank insiders.

They included five members of the board of directors, including chief executive officer Louis Vachon, as well as three other senior executives: Ricardo Pascoe, who is co-CEO of National Bank Financial; Luc Paiement, the other co-CEO of National Bank Financial; and Michel Tremblay, who was chief operating officer of personal and commercial banking but has since left the bank.

Mr. Vachon had the largest personal holding of ABCP investments at $2.54-million. Mr. Tremblay held $1.44-million.

Most of the insiders, including Mr. Vachon and Mr. Tremblay, held their ABCP investments through the bank's mutual funds.

The bank said the decision to include the insiders in the buyback was made by a committee of independent directors who had no interest in the ACBP buyback. André Caillé, who chaired the independent committee, said the insiders “had to be included in the transaction” which covered all individual retail clients.

“They, too, are clients who entrust the bank with their savings,” he said in a statement. “They could not be treated differently from other retail clients and penalized for doing business with their bank.”

Montreal-based National Bank, which is Canada's sixth-largest bank, has been at the forefront of the turmoil in Canada's ABCP market, which has been frozen since August. It was the lead dealer for commercial paper issued by Coventree Inc. that was sold to National Bank clients.

The bank was forced to take a writedown of 25 per cent of its $2.25-billion worth of paper in the fourth quarter last year, leading to its first quarterly loss in 15 years.

National Bank announced in August that it would repurchase ABCP holdings from individual retail clients and from corporate clients with total holdings of $2-million or less who were not considered accredited investors under regulations.

That means, however, that many corporate clients are still holding their ABCP investments, which have declined significantly in value.

The proxy circular said five directors and three executives accounted for $7.13-million of the total repurchased from insiders, while 32 other employees held another $704,031. The directors who held ABCP investments were Gérard Coulombe, Nicole Diamond-Gélinas, Paul Gobeil and Jean Douville, who is also chairman of the board.

Another board member who held ABCP investments was not covered by the transaction because his holdings did not fall within the parameters for the buyback.

The board said the three executives who had their ABCP repurchased put the money into a trust account so they could work on the issue “without any appearance of conflict of interest.”

Also Friday, the bank reported Mr. Vachon did not receive a bonus last year because financial results “fell short of the objectives set at the beginning of the year.”

He did, however, receive a mid-term compensation payment of 22,284 stock units valued at $1.2-million. They will only vest after three years if he remains in the job and will be based on the value of the bank's shares at that time.

He was also granted 196,464 stock options estimated to be worth about $2-million based on a calculation of their potential future value.

The bank's proxy circular also includes 20 shareholder resolutions proposed for a vote at the bank's annual meeting on Feb. 29.

They include four resolutions related to the bank's ABCP problems. One asks the bank to review the performance of the CEO and another executive in light of the ABCP losses the bank has suffered, questioning why the bank was allowed to hold such large positions in the financial instruments. Another calls on the bank to hire an independent investigator to review the decision to buy back $2-billion in ABCP holdings.

The bank has recommended shareholders vote against those proposals.

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Banks Will Disclose More Details on Risk Practices

Bloomberg, Sean B. Pasternak, 25 January 2008

Canadian banks including Royal Bank of Canada and Toronto-Dominion Bank will begin disclosing more information on their risk management starting as early as next month when they release first-quarter results.

Under new rules set by Basel II, a global standard for capital and risk practices, banks will be required to disclose 14 measures to investors, said Vivek Wadhwa, a principal at consulting firm McKinsey & Co. Some of these measurements will be disclosed quarterly, while others will be annually.

The measures are ``to increase transparency and enable market participants to obtain and assess important information,'' Wadhwa, a Basel II expert, told a conference in Toronto today. ``You'll see a significantly higher level of disclosure in Basel II compared to what was in Basel I.''

The disclosures will include credit adequacy and investments related to counter-party risk, he said. Banks globally have spent as much as hundreds of millions of dollars to address operational risk under the new accounting standard, said Wadhwa.

Societe Generale SA reported the largest trading loss in banking history yesterday after the French bank said a rogue trader placed bets on stock-index futures.

The events are an ``example of a failure perhaps in internal processes,'' Wadhwa said.

Canadian banks have also taken losses in the past year, including Canadian Imperial Bank of Commerce, which has announced writedowns of about $3.2 billion on investments linked to the U.S. subprime mortgage market. Bank of Montreal took writedowns of C$440 million last year on losses from natural gas trading.

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Analysts Lower Earnings Estimates & Target Prices

RBC Capital Markets, 24 January 2008

Our investment strategy team has been increasingly concerned over the economy and equity markets. If proven right, as they have so far in 2008, these two factors could be material negative earnings drivers for all financial services stocks in Canada, which would add to existing pressure on the conversion of foreign earnings back into Canadian dollars and, for life insurers, low long-term interest rates.

We are lowering our 12-month target prices and earnings estimates to reflect what is fast becoming a difficult macro environment for financial services companies.

We believe that investors in financial services stocks can afford to be patient. We believe that credit quality will deteriorate, uncertainty surrounding the North American economy has risen, equity markets may not be as strong as they have been for the last five years and the potential for negative headlines remains.

We continue to think that Canadian banks and lifecos should manage through a slower economy better than many global peers, that they are financially solid companies, and that they are unlikely to cut dividends. The return from holding these stocks over the next two to three years could be attractive as a result.

We prefer lifecos over banks although our preference is not as strong as it was given declines in long-term bond yields. We believe that the life insurers are less exposed to deteriorating credit quality, and we feel that their exposure to capital markets is lower than for banks. We are less bullish on lifecos versus banks than we were, however, as the significant declines in interest rates and the high Canadian dollar are more negative for them than for banks.

We believe the potential variability around our forecast returns is higher for banks than lifecos. If the US economic issues lead to a Canadian recession, our target prices would likely decline to levels that would suggest negative returns from holding bank shares over the next 12 months. On the other hand, there is more upside to earnings estimates and valuation multiples on banks if the macro environment proves more accommodating than our strategy team expects.

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Financial Post, David Pett, 24 January 2008

BMO Capital reduced its earnings forecasts for the bank by 7% Wednesday, telling investors to expect lower trading and capital markets revenues this year alongside higher loan losses.

Analyst Ian de Verteuil said lower expenses will cushion some of the impact but after removing all "unusual items" from his calculations he expects the sector to essentially have no earnings growth in 2008 when compared with 2007. He also said share buybacks are unlikely this year and broadly speaking, all banks are equally affected by his revised forecasts.

"To date, we believe the bulk of the market's concerns have been focused on liquidity pressures and securities valuation," Mr. de Verteuil wrote in a research note.

"There are more challenges ahead, includiing a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks.

That said, the analyst believes investors can take comfort in the fact that dividends appear very safe and bank business models remain very defendable.

He maintained his "market perform" rating on the overall sector and reiterated his "outperform" ratings on both TD Bank and National Bank of Canada.

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BMO Capital Markets, 23 January 2008

No banker makes a loan if he thinks it will go bad, and no trader puts in a trade that she expects will lose money. That is why bankers, investment bankers and traders aren’t terribly good at predicting loan losses or trading and capital markets revenues. Against this backdrop, and despite the recently stated view by various bank CEOs (that we have little to worry about), we are reducing our earnings forecasts for Canadian banks by 7%.

This incorporates lower trading and capital markets revenues and higher loan losses. Some of the impact of this will be mitigated by lower expenses. We are also assuming that buybacks are virtually non-existent in 2008. All in, after removing “unusual items”, we expect the Canadian bank sector to have essentially no earnings growth in 2008 when compared to 2007.

Our revised forecasts for each bank are shown below. Broadly, all banks are equally affected. As one would expect, the smaller banks, which have less capital markets exposure, have a minor impact. Note we are restricted on CM shares.

We are maintaining our Market Perform rating on the Canadian bank sector. After an extended period of underperformance, the group is certainly more attractive on a relative basis. To date, we believe the bulk of the market’s concerns have been focused on liquidity pressures and securities valuation. There are more challenges ahead, including a need for more realistic earnings forecasts (as we have done today), the risk of counterparty failures and the reality of more modest dividend increases and share buybacks. However, investors should take comfort, as bank dividends appear to be very safe and the business models of Canadian banks remain very defendable.

Profits

We are lowering our forecasted bank earnings by $1.6 billion after tax. This reflects $2.5 billion in lower revenues than we had originally forecast and $800 million of higher loan losses. The impact of these two negative headwinds will be offset by $1 billion of lower expenses. We have assumed a 32% tax rate, which also mitigates the impact. Our basic assumption is a material slowdown in economic activity in North America, but no recession in Canada. We are effectively pushing our earnings growth out 12 months (our 2009 forecast is essentially our previous 2008 expectation).

Loan Losses

We are raising our 2008 forecast for loan losses by $800 million from $3.6 billion to $4.4 billion. Our 2009 forecast is increased by $1 billion from $4.4 billion to $5.4 billion. We have assumed the deterioration is principally in the business loan book (about $400 billion) and the non-residential consumer book (about $275 billion) but not in residential mortgages. All in, we note that even with these increases, we are not assuming “recession-type” loan losses. If we did, we would expect a further $2-3 billion of losses, i.e., a further 7% reduction in our earnings forecasts.

This more cautious view appears to be at odds with many bankers who still believe that the environment remains benign and that the specific issues that are developing (e.g., Quebecor World, Ambac, etc.) are isolated. We are simply assuming that the traditional leading indicators (economic activity, unemployment, default rates, etc.) are a relatively good reflection of what happens next. The issue, as we see it, is one of timing – and it is likely that the higher losses are skewed to the second half of 2008.

Trading Revenues

We are cutting our trading revenues forecast for the Canadian banking system to $5 billion from $6 billion. As we show in Chart 1 below, Canadian bank trading revenues have been relatively stable through most of the past six years at about $5.5 billion despite additional capital that has been committed to the business. The reality is that trading revenues today have become more a reflection of the benefits of structuring off-balance sheet vehicles rather than gains or losses on the “good old” swap books.

The relatively poor performance in 2007 included numerous CDO writedowns, so we expect some improvement in 2008. However, we believe with the market volatility (and the general decline in most markets), the odds of a disappointing first half are high. Furthermore, we believe most banks are scaling back capital committed to the business as value-at-risk (VaR) and volatility rise. On a more optimistic point, we note that trading is still a very modest part of overall revenues.

We believe the majority of bank trading operations remain high quality with good diversification and solid profit dynamics. However, volatility is an important element of the business and this has not gone away. Even at revenues of $5 billion annually, the business of facilitating client needs and creating and managing some structure will remain an important part of Canadian banks.

Capital Markets

We have been impressed (and amazed) by the ability of the major players in the Canadian securities marketplace to show consistent growth in profits. The members of the IDA have achieved record profits for the sixth year in a row – an unprecedented performance.

We believe the IDA data excludes most of the trading books of Canadian banks (which are often held in off-shore banking subsidiaries for tax and other reasons) and the traditional corporate loan books. We are assuming that weaker activity in M&A, equity and fixed income underwriting will shave about 20% off of these revenues – down $1 billion off of a base of $6.5 billion.

Wealth Management

The management of Canadians’ wealth (or rather the provision of advice to Canadians to help them manage their own wealth) remains an excellent business for Canadian banks. And banks will likely continue to be relative winners. However, and after several years of strong equity market gains and very strong flows, we believe revenues will be weaker in 2008 than we had previously assumed. We estimate that bank revenues from mutual fund, brokerage (full-service and on-line), private banking and discretionary investment management activities generate about $10 billion of revenues for Canadian banks. All in, we are assuming that revenues will be down 5%, or about $500 million. We note that the effect is less than one might think because many client holdings are not simply equity based, and we are not forecasting net withdrawals.

Bye-Bye Buybacks

We had previously assumed share buybacks of about 1–2% of outstanding stock in 2008 and 2–3% in 2009. We are now assuming no buybacks in 2008 and 1–2% in 2009. Buybacks are additive to EPS because of the low P/E afforded to bank shares. Note that we are considering buybacks not issuance, which is already up meaningfully because of deal activity – TD buying Commerce Bancorp, and Royal’s purchase of RBTT and Alabama National.

What is particularly interesting is that despite comments of confidence in the future by bank CEOs, banks have all but turned off their buyback programs. Specifically, Canadian banks bought back virtually no stock in November and December. A more balanced approach to analyzing buybacks is by considering the six-month rolling average.

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