Friday, May 18, 2007

BMO Raises Trading Losses to $680 Million

  
Scotia Capital, 18 May 2007

BMO - Trading Losses Larger Than Previously Announced

• BMO announced that trading losses are estimated to be $680 million pre-tax versus the previously announced range of $350 million to $450 million pre-tax. The loss of $680 million represents $327 million after-tax or $0.64 per share, larger than the previous range of $0.45 per share to $0.55 per share.

• First quarter earnings will be restated to reflect losses of $237 million after-tax or $0.46 per share and the remaining loss of $90 million after-tax or $0.18 per share will be recorded in Q2/F07.

S&P Places BMO on Credit Watch with Negative Implications

• In addition, S&P announced that it has placed BMO on Credit Watch with Negative Implications and is conducting a review of trading risk over the next 30 days.

Recommendation

• This trading loss reflects poor risk management and control; at the same time, the market has been paying a premium for BMO's risk management. We estimate that BMO is overvalued by 10% relative to the bank group based on fundamentals.

• We are adjusting our Q2/F07 earnings estimate to $1.15 per share from $0.83 per share in order to accurately reflect trading losses recorded in the second quarter. In addition, we are reducing our 2007 earnings estimate to $4.75 per share from $4.90 per share to reflect the increased estimate for trading losses.

• Our 2008 earnings estimate remains unchanged at $5.80 per share. Our 12-month share price target remains unchanged at $80 per share representing 16.8x and 13.8x our 2007 and 2008 earnings estimates.

• Maintain 3-Sector Underperform.
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Financial Post, Sean Silcoff, 18 May 2007

If someone out there has invented a time machine, give Bill Downe a call. The new chief executive of Bank of Montreal likely wishes he could travel back three weeks and try a different strategy for handling the bank's mounting PR disaster over growing losses in its commodities trading business.

The bank initially offered up a pretty lame explanation as to how it lost what was then estimated to be between $350-million and $450-million in the natural gas market. Changing market conditions, illiquidity and historically low volatility were to blame, it said on April 27. It was almost as if the bank thought nobody would notice.

It quickly emerged there was more to the story than BMO offered up. Liquidity in the market was fine. Something else was amiss in a business BMO had highlighted as a key contributor to profits. Two weeks before its announcement, it turned out, BMO's forensic auditors had handed it a report questioning the reliability of quotes from its New York natural gas trading broker, Optionable Inc. "Was it intentional, was it a mathematical model that blew up and no one caught it?" one energy trading industry insider told the Financial Post's Duncan Mavin. "It's definitely a lapse in risk management." Soon, the bank's star natural gas trader, David Lee, was gone, and its relationship ended with Optionable.

Yesterday, BMO confirmed what the market had anticipated: The situation is worse than originally explained. The losses are now valued at $680-million and could be higher. BMO is investigating "potential irregularities in trading and valuation." More heads are bound to roll.

This is not life-threatening for a bank that earned $2.7-billion in profit last year, but its credibility is on life support. The crisis exposes a disconnect between its reputation as the safe, cautious bank among Canada's Big Five and internal practices. And it happened in the division Mr. Downe used to head, capital markets. Given the size of the losses, some believe they built up over many months. "The absolute size of the estimated commodity trading losses far exceeds the bank's average market value exposure to commodities risk, is disproportionate to its total trading revenues, and does not reflect BMO's stated strategy of being a low-risk bank," credit rating agency Standard & Poor's said in a note.

Trading operations are a black box at all the banks, but nobody thought problems would emerge at BMO, of all places. If this destroys its reputation as the cautious bank, there is another myth that needs to be debunked as well.

For years, the accepted wisdom has been that you could throw a dart at a list of the big banks, invest in the one the dart hits, and it would do as well as any of the others.

Take a closer look at BMO and you'll find that hasn't been true, for a decade. Since May, 1997, its stock has lagged well behind the other four. Its net income, profit and dividends growth lagged three of the other four. Return on equity lags the pack.

And it is falling farther behind the leader, Royal Bank: In fiscal 1997, BMO had $208-billion in assets, or 87% the size of Royal. Last year it was down to 64%.

BMO made its bet a long time ago. "The bank built its strategy around doing everything to make a merger happen and to maximize the price that would be receive in the event it happened," said Desjardins Securities analyst Michael Goldberg. It didn't.

BMO will get past the commodities trading crisis, but it now has a crisis of a different sort: an identity crisis. If the bank decides the lesson from this experience is to become more cautious, it will continue to drift away from its peers in importance and size. The longer that happens, the more BMO will be at risk of becoming the bank nobody wants or needs to merge with.
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Financial Post, Duncan Mavin, 18 May 2007

Sources say the New York-based brokerage linked to Bank of Montreal's soaring natural-gas trading losses offered incentives to traders from other companies for their business in order to pump up its trading volumes --a practice considered highly unethical by many in the industry and which may be illegal.

The incentives are "shady," said one U.S. lawyer, a former senior executive at the Commodity Futures Trading Commission.

"Offering warrants to individual traders in return for those traders funnelling their company's business to Optionable is plain wrong," said an executive with another commodity brokerage.

Yesterday, BMO hiked the estimate for its natural-gas trading losses by 50% to $680-million. It also said it is "investigating potential trading irregularities" and has suspended its relationship with Valhalla, N.Y.-based Optionable Inc.

BMO first revealed its trading debacle three weeks ago, blaming historically low levels of natural- gas price volatility and low levels of demand for gas options.

However, as first reported in the Financial Post last week, the bank publicized the losses only after a report from forensic auditors Deloitte & Touche LLP said BMO's book of natural-gas trades was valued inaccurately based on information from Optionable.

A BMO spokesman declined to comment on whether incentives were offered by Optionable to David Lee or Bob Moore, the only BMO employees who have lost their jobs in the wake of the record trading losses.

However, Doug Kline at San Diego-based Sempra Energy said one of its traders, Jeff Bussan, was offered warrants that could be exchanged for Optionable stock by Kevin Cassidy, the brokerage's former chief executive.

In return for the warrants, Mr. Bussan was asked to funnel Sempra's business to Optionable without his employer's consent, Mr. Kline said. "Mr. Bussan said that would be a conflict of interest and would not accept the warrants."

Based on the allegations, someone making that kind of offer could face prosecution under New York state and U.S. federal laws concerned with commercial bribery, said Michael Miller, a partner specializing in white-collar crime with U.S. law firm Piliero Goldstein Kogan and Miller LLP.

Similar allegations to those made by the Sempra executives are expected to be revealed in a well-respected energy-trading publication today.

The Desk, a weekly newsletter circulated among energy-trading executives, will reveal the name of at least one other trader who was also offered warrants that could be exchanged for Optionable stock if he favoured the broker for his trades, said John Sodergreen, the publication's editor.

Optionable's revenue rose by more than 400% in the past year on the back of its rising trading volumes with BMO's Mr. Lee, who is regarded as a personal friend of Mr. Cassidy by other traders.

A BMO insider said the bank's internal code of conduct requires that all dealings with external parties are "fair, right and legal."

Optionable made 30% of its revenue directly from BMO's trading volumes. It is alleged in a class-action lawsuit filed against the brokerage this week that business with BMO was indirectly responsible for a much higher proportion of Optionable's revenue because each BMO trade would also have had a counter-party.

Mr. Cassidy resigned this week after it was revealed that he served time for fraud and tax evasion.
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The Globe and Mail, Sinclair Stewart & Tara Perkins, 18 May 2007

The way former colleagues see it, David Lee is the sort of guy any bank would love to hire: intelligent, hard-working, loyal and - a rarity in the brutally competitive trading world - downright modest.

Certainly, none of them envisaged this father of two would be ousted from his senior trading post at the brokerage arm of Bank of Montreal amid a spiralling scandal that has dented the company's reputation, resulted in more than half a billion dollars in losses, and prompted a wide-ranging internal investigation.

"It's completely against what I ever would have guessed," said one former co-worker, who was clearly dumbfounded by the controversy. "He's smart and cautious, so I can't imagine him setting himself up for such a loss."

No one has accused Mr. Lee of any wrongdoing, and he could not be reached for comment. An acquaintance said last week Mr. Lee was in Florida with his family.

Yet questions about his possible role in BMO's trading problem intensified yesterday, after the bank reported that the losses it suffered would be much greater than anticipated - $680-million before tax. BMO also said it would have to restate its first-quarter results. The bank confirmed that Mr. Lee and his boss, Bob Moore, were no longer with the company, and that it had hired a legal firm to help investigate potential "irregularities" in its trading book. Mr. Moore declined to comment.

Mr. Lee, by most accounts, earned his position as BMO's top natural gas trader. Born into a middle-class Italian-American family in New Jersey, he began his career at the Bank of New York.

In 1997, when he was in his mid-20s, he caught a break. BMO, eager to get into the lucrative U.S. commodities business, decided to build its own team from scratch. The bank hired nine for its New York office, including Mr. Lee, who came aboard as an analyst.

Those who worked there said it wasn't long before he distinguished himself. He was made a "backup trader" before becoming a junior trader covering crude oil.

He also became very close friends with Mr. Moore, a former official at Reliant Resources who was brought in to run the commodities operation in 2000 and to help "clean up" another gas options trading mess, according to one former BMO employee. The sources said Mr. Moore and Mr. Lee soon became "buddies," working closely together and often socializing with clients over drinks.

One of the reasons Mr. Lee was hand-picked to take over the scaled-down natural gas trading was because he was seen as smart, devoted, and relatively inexperienced: someone not likely to take chances and create another headache for the bank.

"He was a very nice kid, kind of quiet, and very likeable. I never saw him not work hard," this source said, adding he was a "solid" and skilled trader, though perhaps not the dominant sort that some have made him out to be.

Some co-workers acknowledged that Mr. Lee developed more of a cocksure attitude as his career progressed. It was not uncommon for brokers to take him to concerts, or invite him golfing, say those who worked for BMO.

Yet the soft-spoken trader, who one former co-worked described as "nondescript," cut a contrasting figure to that of his mentor.

"Bob was the boss," one former BMO official said. "He is a loud talker, a my-way-or-the-highway guy."

When Mr. Lee was handed control of the gas business, he began working with Kevin Cassidy, a senior executive at New York-based Optionable Inc., an energy broker. Mr. Cassidy had worked closely with Mr. Lee's predecessor.

The two men quickly became good friends, as did their families, and BMO became, over time, Optionable's most valued client, accounting for some 30 per cent of its trading volume last year. Mr. Moore also had a close relationship with Mr. Cassidy, said people familiar with the matter.

Mr. Cassidy was a "guy's guy - a stereotypical American broker," said someone who knew both Mr. Cassidy and Mr. Lee.

Until recently, Optionable's business prospects looked glowing. Nymex, the commodities exchange, had agreed to invest, and placed a representative on the company's board. When volumes soared, the stock did too - up from about $1 last fall to more than $8 before plunging to less than $1.

Last week, Mr. Cassidy stepped down as Optionable's chief executive officer, amid news reports that he had received jail sentences for fraud and tax evasion.

BMO, which is still trying to unravel what went wrong, has not levelled any accusations at its former traders or at Optionable, but sources within the bank said investigators can't reconcile the books kept daily by BMO traders with the quotes delivered by Optionable at the end of each month. That is an about-face from last month, when the bank pinned the losses on market factors.

"I think you're looking at a pattern of irregularities that doesn't make sense," said one person with knowledge of the probe. "Something is wrong."
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The Globe and Mail, Derek DeCloet, 18 May 2007

That 140-kilo chunk of marble that fell off First Canadian Place in downtown Toronto on Wednesday morning landed outside the window of the research department at Bank of Montreal's brokerage arm. Analysts being analysts, they immediately began engaging in wild speculation as to the cause of the loud thud.

Had someone just tossed trader David Lee from the 54th floor? Or was it simply the sound of Bill Downe's credibility hitting the ground at terminal velocity?

BMO's new top executive has been in the job for exactly 78 days and has 680 million reasons why it feels like much longer. The bank's trading losses are embarrassing, though not exactly devastating. Once Mr. Downe has extracted his pound of flesh from his traders, their bosses, their bosses' bosses and his shoeshine boy - no bonuses for them this Christmas - the estimated cost is $327-million, after tax (so far).

That represents less than 1 per cent of the bank's market capitalization and about 10 days' worth of revenue, a small fraction of the charge CIBC took to settle Enron lawsuits two years ago. So why all the fuss? That's easy: Because in a couple of ways, BMO's blunder is worse than CIBC's, not because of what happened on BMO's trading floor but why and how and who was involved.

Starting with the last one first: To whom were the traders accountable? On Bay Street, talk is rampant that they reported directly to Mr. Downe - not since he became CEO, but in the recent past. A BMO spokesman says that was never the case. Even so, he had run BMO Nesbitt Burns since 2001 and had been responsible for all of the bank's U.S. operations since 2002. When CIBC took its Enron hit, CEO Gerry McCaughey could plausibly claim that John Hunkin and David Kassie were responsible for it. Mr. Downe has no such luxury.

Moving on to the question of how, as in, how did they manage to blow $680-million? When BMO first revealed on April 27 it had a problem, management either didn't have a grasp of what had happened, or it was being less than forthright about it.

The official explanation at the time, from Mr. Downe himself, was that the market for natural gas derivatives became less volatile and less liquid - therefore, BMO's options to buy gas lost value. Now it's about "potential irregularities" in how those derivatives were traded and valued. The implication is that BMO management was given a false view of how its commodities portfolio was performing.

How could that happen? Here's an analogy. Suppose you were thinking of selling your home and called three agents to get an estimate of what it would sell for. One says $500,000, one says $550,000, one says $700,000. So, what's the value? You don't really know, because none of the agents has an obligation to pay that price. They're just numbers. For "your home," insert "BMO's derivatives book"; for "agents," insert "Optionable," the broker that handled much of BMO's commodities trading. But if "irregularities" were the problem, why tell everyone three weeks ago that it was a matter of poor liquidity and low volatility?

CIBC's Enron hit was painful, but at least it was quick and clean and over with in one shot. BMO's changing story leaves the impression the bank went deeply into a business that its top executives didn't understand.

That brings us to the matter of why. BMO's aggressiveness in commodities was no secret. It's the major reason BMO's trading revenue - $665-million last year - is more volatile than any other major bank's, according to Steve Cawley, TD Newcrest's financial services analyst. Why would a supposedly low-risk bank dive into a business known for occasional catastrophes (see Long-Term Capital, Amaranth, et al.)?

That decision can't be viewed without looking at what else is going on. A decade ago, BMO was solidly No. 3 among Canadian banks. Now it is fourth or fifth by most measures. In 2002 it had almost 15 per cent of the market for residential mortgages; now it's 13.4 per cent. Its share of personal deposits and loans has fallen. BMO is losing ground to Toronto-Dominion and Royal Bank in retail banking - and that's part of the explanation for why revenue growth was just 1.5 per cent last year.

It's not hard to conclude that BMO's management gave more leeway to Mr. Lee, and exercised a little less caution, in the hope that boffo trading numbers would mask some of these other problems. Since the flaws in the trading operation go back to last year, it also stands to reason profits were overstated in 2006. While Mr. Downe takes the heat, we'll all wait breathlessly to see whether ex-CEO Tony Comper refunds some of the $9.6-million he was paid last year for doing such a swell job.
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RBC Capital Markets, 17 May 2007

Event

BMO increases estimated commodities trading losses

Investment Opinion

BMO announced higher estimated commodities trading losses than previously disclosed on April 27th, which management had warned could happen as it continued to investigate matters.

The estimated losses now total $680 million pre-tax ($327 million after tax and incentive compensation, or $0.64/share) from earlier guidance of $350 to $450 million pre-tax. Most of this is expected to be recorded in Q1 (will be restated).

• Q1/07: $509 million pre-tax ($237 million after tax and incentive compensation, or $0.46 per share)

• Q2/07: $171 million pre-tax ($90 million after tax and incentive compensation, or $0.18 per share)

Management has taken numerous actions following its investigations, including:

• terminated employment of 2 commodities traders and suspending its relationship with Optionable Inc., the brokerage firm that provided derivatives trading and valuation services;

• reduced the natural gas portfolio by a third from its peak (and plans to continue reducing it);

• changed reporting lines and implemented additional risk measures and reduction of limits;

• now marking-to-market its commodities portfolio using a new independent source (the portfolio was previously marked-to-market by the traders and confirmed by its principal broker, Optionable Inc.).

Tax and incentive compensation offset the loss by approximately half the pre-tax amount. We believe there is a risk to employee morale if bonuses are affected by what appears to be actions of a few individuals.

We have updated our model to account for this announcement. Our valuation is unchanged. We continue to believe BMO will underperform the financial services stocks that we cover.

This event further validates our belief that there is more risk at BMO than other banks such as CIBC and TD, and more than people appreciate.

BMO's dividend yield of 3.9% (the highest of the banks which average 3.2%) may provide some support, but in our view BMO's yield should be higher because of its slower EPS growth and higher dividend payout ratio.
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Dow Jones Newswires, Kevin Kingsbury, 17 May 2007

BMO Financial Group on Thursday sharply raised its estimate of how much money it lost betting on natural gas markets and said it is investigating possible "irregularities" in trading and valuation.

The company, also known as the Bank of Montreal, now believes it lost C$680 million ($616 million), up from the C$350 million to C$450 million it disclosed April 27, after concluding that the earlier estimate was based on information provided by its principal broker that may have been inaccurate.

The greater losses still aren't enough to seriously shake the bank's all-important Tier 1 capital ratio - which will fall by about 0.2 percentage point as a result - but the new disclosures raise further questions about exactly what led to the losses, when the bank became aware of the trouble and why it wasn't able to come up with a timely assessment of its exposure.

Observers say it appears the problem may have more to do with the actions of a few employees rather than a lack of control by the bank.

In a note this week in which he upgraded Bank of Montreal to hold from sell, Genuity Capital markets analyst Mario Mendonca said: "We are coming to believe that the loss has as much to do with a rogue trader as a failure of the bank's risk-evaluation processes. We acknowledge that even a strong risk-monitoring system can be circumvented if an employee intentionally seeks to do so."

Bruce Campbell of Campbell-Lee Investment Management said Thursday he also suspects that was the problem, but added concerns remain that there could be more "skeletons in the closet."

Additionally, he said, the latest news reflects poorly on the bank, already considered to be the worst performer among its Canadian peers.

"Already it's quasi-out-of-favor, so it's easy to dump on it," Campbell said.

Standard & Poor's Ratings Services Thursday said it placed BMO's AA- long-term counterparty credit rating on watch with negative implications.

The watch "reflects our heightened concerns over the risk associated with the underlying strength of its enterprise risk management framework, management oversight, and the bank's trading operations" after the losses increased, S&P credit analyst Donald Chu said in a statement.

Moody's Investors Service retained its current rating but said the increase in the loss estimate and restatement of future earnings "indicate that the risk profile of BMO's natural gas portfolio was not well understood throughout the bank."

Bank of Montreal shares closed down 3 cents, or 0.03%, at $63.09. Shares were recently down 46 cents, or 0.7%, at $62.63 in late trading.

Bank of Montreal said last week it has suspended its relationship with brokerage firm Optionable Inc. (OPBL) - part-owned by Nymex Holdings Inc. (NMX) - pending the results of an investigation into the trading activity that led to the losses.

Natural gas trader David Lee and Bob Moore, executive managing director of commodity products, have been placed on leave and are no longer with the company.

A new team of traders has been assigned to the portfolio, and its risks have been reduced by one-third, the bank said.

"BMO is continuing its investigation of the facts and circumstances surrounding these mark-to-market commodities trading losses, including a review to determine whether any potential irregularities in trading and valuation took place," the bank said in a prepared statement.

The Bank of Montreal's trading position grew in late 2006 and early 2007, and was marked to market each day by its traders, with valuations confirmed by the bank's principal broker, the bank said in Thursday's release.

Earlier this year, the bank sought independent verification of the portfolio's value. It hired an outside firm in mid-February to review the bank's valuation, risk management and controls. The results were delivered in mid-April and led in part to the disclosure of the trading losses, the bank said in the release.

Bank of Montreal didn't say why it sought the independent verification. The bank's principal broker was Optionable, which said last week it only provides brokerage and execution services for trades it is instructed to make.

"After April 27, new information was obtained and BMO determined that a more appropriate market-based methodology should be used for this portfolio," the bank said in a prepared statement. "This change, together with increased concerns with the reliability of quotes received from its principal broker, used in its first-quarter valuation, led BMO to conclude that losses should be recognized partially in both the first quarter and second quarter of Fiscal 2007."

An Optionable spokesman Thursday declined to comment further on BMO's losses or statements. Lawrence R. Gelber, a lawyer representing Kevin Cassidy, the former Optionable chief executive who resigned over the weekend, said Optionable and Cassidy aren't responsible for BMO's losses.

"If BMO sustained losses, those losses resulted from knowing choices made by BMO and not by Optionable or Mr. Cassidy," Gelber said.

The Canadian bank's newly assessed losses come to C$327 million after taxes and incentive compensation adjustment and will be booked in the first and second quarters. Bank of Montreal said C$237 million of those losses will be recorded in its fiscal first quarter, cutting net income by 46 Canadian cents a share. The remainder will be recorded in the just-concluded second quarter and reduce net income by 18 Canadian cents a share. The company is set to release its second-quarter results Wednesday, at which time the firm also will provide restated first-quarter results.

Chief Executive Bill Downe said the commodity portfolio's risk is down by nearly one-third from its peak. Last month, he said the natural-gas market "moved very quickly," and the company was unable to sell its positions in order to avoid the losses because of market illiquidity and historically low volatility.

Nymex, the big U.S. energy futures exchange, paid $27.7 million for 19% of Optionable in April. Cassidy resigned Saturday after a discovery by the Nymex that he had spent time in prison. Cassidy was sentenced in August 1997 to 30 months in prison for credit card fraud, according to Florida Southern District court documents. Cassidy was also sentenced to six months in jail in 1993 for tax evasion.
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Bloomberg, Doug Alexander, 17 May 2007

Bank of Montreal's record trading losses won't just reduce earnings at Canada's fourth-biggest bank: They may cut bonuses paid to investment bankers by about C$115 million ($105 million) this year.

Bank of Montreal said today it will have pretax losses of C$680 million from trading natural gas, higher than its April 27 forecast of C$350 million to C$450 million.

The loss after tax and bonuses is C$327 million, the Toronto-based bank said. Assuming a 35 percent tax rate, the loss means a C$115 million hit to the ``incentive compensation'' pool, analysts said. The reduced bonuses would be largely borne by the BMO Capital Markets investment banking unit, whose staff receive pay and bonuses based largely on performance.

``We believe there is a risk to employee morale if bonuses are affected by what appears to be the actions of a few individuals,'' RBC Capital Markets analyst Andre-Philippe Hardy said today in a research note to clients. He rates the bank ``underperform.''

The two New York-based bankers involved in the trades are no longer with the firm. They are Bob Moore, the executive managing director of commodities products, and trader David Lee, who did natural-gas trades for the bank through Valhalla, New York-based broker Optionable Inc.

Bank spokesman Paul Deegan declined to comment on the impact of trading losses on compensation.

``Across the organization, the allocation of bonuses this year, as every year, will reflect our results, individually and collectively, and will be based upon the principle of fairness,'' Deegan said in an interview.

Bank of Montreal gave employees about C$1.32 billion for performance-based compensation in fiscal 2006, or about 35 percent of total compensation paid by the bank.

Bank of Montreal shares fell 30 cents to C$69.40 at the 4:10 p.m. close of trading on the Toronto Stock Exchange.
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Bloomberg, Sean B. Pasternak, 17 May 2007

Bank of Montreal, stung by the biggest trading loss in Canadian history, said the debacle will cost at least 50 percent more than originally forecast and started an investigation into potential ``irregularities.''

Canada's fourth-biggest bank will record pretax losses of C$680 million ($618 million) from trading natural gas, compared with an April 27 forecast of C$350 million to C$450 million, according to a statement today. Two New York-based bankers involved in the trades have left the firm.

The revised loss underscores the risks of a deposit-taking bank making bets in the natural gas market just seven months after the collapse of hedge fund Amaranth Advisors LLC. The bank said it may post additional gains or losses as its scales back the natural gas trades.

``BMO needs to take the time to get the story straight once and for all,'' said Pat McHugh, who helps manage about $218 billion at MFC Global Investment Management in Toronto, including Bank of Montreal shares. ``This is not Harry Potter. We don't want any more installments.''

Shares of Bank of Montreal fell 30 cents to C$69.40 in 4:10 p.m. trading on the Toronto Stock Exchange, and have dropped 2.6 percent since the day before the April 27 announcement.

The bank said the losses were bigger than it originally forecast after it adopted a different pricing model to better assess the value of its natural gas options contracts. The revision also reflects ``increased concerns'' about the reliability of quotes from its main broker, Optionable Inc. The loss dwarfs other trading losses by Canadian banks, such as the C$100 million after-tax loss reported by Canadian Imperial Bank of Commerce in 1998.

``I can't remember seeing anything that large,'' said Ian Nakamoto, director of research at MacDougall, MacDougall and MacTier Inc. in Toronto, which manages the equivalent of about $3.9 billion, including Bank of Montreal shares. ``Obviously they had to push the goalposts out further on the higher end.''

Of the C$680 million, about C$509 million will be reported in restated first-quarter results, and C$171 million will be in the fiscal second quarter, which ended April 30. The after-tax losses, which include adjustments in compensation, will be about C$327 million over the two quarters. The bank reports second- quarter earnings on May 23.

The trading loss represents about half of Bank of Montreal's earnings in a quarter, Standard & Poor's Rating Services said today in a statement. The ratings firm indicated for the first time since December 2001 it may cut the company's AA- credit rating to reflect ``heightened concerns'' about risk management and its trading operations.

``We're doing a full review of their trading risk management functions,'' S&P analyst Donald Chu said in a telephone interview. ``We have the responsibility to put the market on notice that we are concerned and that we're going out to see them and are doing a more thorough review.''

Bank of Montreal increased its dealings with Optionable as it expanded trading in natural gas options after prices rose following Hurricane Katrina in 2005.

The bets began to sour last year after the energy trading market, particularly natural gas, became ``increasingly illiquid'' and price swings, or volatility, dropped to historically low levels. That reduced the value of the bank's natural gas options and made it harder to trade them.

``BMO had a reputation of having strong risk control,'' said McHugh. ``It looks like we were misguided.''

The bank said it hired outside auditors in February to study the natural gas trades, and they reported to the bank in mid-April. Bank of Montreal suspended its relationship this month with Optionable, which counted the bank as its biggest customer.

Shares of Valhalla, New York-based Optionable have plunged more than 90 percent since Bank of Montreal first disclosed its trading loss, and two of its executives have left, including former Chief Executive Officer Kevin Cassidy, who stepped down May 12. Optionable shares rose 20 cents to 71 cents, for a market value of about $37 million.

``BMO is continuing its investigation of the facts and circumstances surrounding these mark-to-market commodities trading losses including a review to determine whether any potential irregularities in trading and valuation took place,'' the bank said.

Chief Executive Officer William Downe, who took over the top spot on March 1, said the bank has taken steps to reduce the risk of the commodities portfolio by a third from its peak, according to the statement. The bank said that New York traders David Lee and Bob Moore are no longer with the company, after being placed on leave following the losses.

The New York Mercantile Exchange, the biggest investor in Optionable, removed its representative from the energy broker's board of directors after learning Cassidy served time in prison, said a person with knowledge of Nymex's decision.

Lee, who worked in the New York office, was among Bank of Montreal's traders who carried out transactions with Optionable. Moore was executive managing director of commodities products.

Lee, a New Jersey native, was considered a star energy trader for the bank, and developed a ``strong relationship'' with Optionable's Cassidy, the National Post reported May 5. Bank of Montreal accounted for 30 percent of Optionable's $9.1 million first-quarter revenue, compared with 24 percent last year and 18 percent in 2005.

The announcement adds to the challenges facing Downe, 55, who replaced Anthony Comper. The bank, which owns the Harris Bank in Chicago, lost out on the takeover of larger competitor LaSalle Bank, after ABN Amro Holding NV agreed to sell the company to Bank of America Corp. for $21 billion.

Bank of Montreal also announced 1,000 job cuts in the first quarter to pare costs as profit growth slowed. Downe declined to comment today through spokesman Ralph Marranca.

The bank's trading losses could prompt an investigation from Canada's Office of the Superintendent of Financial Institutions, CIBC World Markets analyst Darko Mihelic wrote today in a note to investors. Jason LaMontagne, a spokesman for the regulator in Ottawa, declined to comment.

Laurie Gillett, a spokeswoman from the Ontario Securities Commission, declined to comment on Bank of Montreal.

David Gary, a spokesman for the U.S. Commodity Futures Trading Commission said he can't confirm or deny any investigation as it relates to trading at Bank of Montreal.
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Financial Post, Jonathan Ratner, 17 May 2007

The update from the Bank of Montreal’s that its natural gas commodities trading losses will be an estimated $680-million (pre-tax) as opposed to $350-million to US$450-million, will definitely hurt the bank’s earnings and could also lead to even less investor confidence.

Of this $680-million, $509-million will be recorded in BMO’s restated first quarter 2007 results, while the remaining $171-million will be recorded in the second quarter. Both will be reported on May 23, 2007.

Desjardins Securities analyst Michael Goldberg says that no matter the size of the loss, hopefully the days of trading as a black box in banks are coming to an end.

"Banks are big believers in the concept that you can’t manage what you don’t measure," he told clients in a note. "Therefore, it seems inconceivable that they do not have a multitude of metrics used internally to benchmark trading revenue and to explain variances from expected amounts."

But if this information is not shared with investors, they have no way of getting a handle on the activity and associated risks, he added.

While Mr. Goldberg considers BMO 'dead money' in the near term, he continues to rate the stock a 'buy' with a $75 price target, saying the impact of the trading losses should blow over in a year or so.
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The Globe and Mail, Tavia Grant & Tara Perkins, 17 May 2007

Canada's fourth-biggest bank had said April 27 natural gas bets resulted in losses of between $350-million and $450-million. On May 1 it acknowledged there could be further gains or losses on the portfolio.

Now, it appears those losses are larger than first estimated. More “significant” losses or gains could still follow, BMO said Thursday.

“Given the size and complexity of the portfolio, it could experience subsequent significant gains and losses due to repositioning of the portfolio and market volatility,” the company said.

The losses will affect both first- and second-quarter earnings.

BMO shares slipped 1 per cent to $69.03 on Thursday.

The bank made the adjustment to its loss estimate based on new information and a change to the bank's accounting methodology in the portfolio.

“This change, together with increased concerns with the reliability of quotes received from its principal broker, used in its first-quarter valuation, led BMO to conclude that losses should be recognized partially in both the first quarter and second quarter of fiscal 2007,” BMO said.

The change won't affect periods prior to the first quarter of this year. The bank now sees trading losses of 64 cents a share from its previous estimate of between 45 and 55 cents a share. Of this new amount, it will record 46 cents a share in the first quarter and 18 cents a share in the second quarter.

“Since our initial announcement on April 27, BMO and our external advisers have continued to investigate this matter,” said Bill Downe, president and chief executive, in a release.

“This has provided additional insight into the current circumstances, helped guide the actions we have taken and those we will take going forward. BMO has reduced the risk in this portfolio by approximately a third from its peak.”

Standard & Poor's placed the bank and its subsidiaries on “credit watch with negative implications” Thursday, reflecting heightened concerns over the risk associated with the strength of its risk management framework, management oversight, and trading operations.

S&P said it will be conducting a full review of BMO's trading risk management and trading operations within the next 30 days. If the bank's trading risk and enterprise risk management do not meet expectations, its short and long-term ratings could be lowered a notch.

Moody's Investors Service, meantime, affirmed its ratings and outlook for the bank.

BMO's losses are linked to Optionable Inc., an obscure New York commodities trading firm. Nearly one-third of Optionable's revenue came from BMO.

BMO said it's still investigating its mark-to-market commodities trading losses “including a review to determine whether any potential irregularities in trading and valuation took place.” Mark-to-market means the losses exist on paper but haven't been realized yet as BMO has not fully unwound its positions.

The bank confirmed its New York commodity traders had been valuing the portfolio on a daily basis, and the valuation confirmed independently by its principal broker.

BMO has assigned a new team of traders to the portfolio, “who continue to manage risk out of this portfolio.”

BMO releases its second-quarter results on May 23. It said Thursday that the impact of the losses on its Tier 1 capital ratio will be about 20 basis points.

Canada's banking regulator, the Office of the Superintendent of Financial Institutions, met recently with BMO and will “monitor the bank's actions going forward,” it said earlier this month.

The past month has been a rocky ride for Mr. Downe, who moved in to BMO's chief executive office when former CEO Tony Comper retired March 1.

Mr. Downe had been the bank's chief operating office since February of last year, after spending four years at the helm of BMO Nesbitt Burns, where he oversaw BMO's investment banking group as well as the bank's operations in the United States.

Now in his mid-50s, he has worked at BMO since 1983. He started as a credit analyst and lender in the bank's Houston office, which deals largely with energy, and has since worked in cities including Denver, Chicago, and Toronto.

About a month before officially assuming the top executive role at the bank, Mr. Downe made the decision to trim 1,000 back office jobs at BMO and take a $135-million restructuring charge, to cut costs in a way that banking customers would not notice. Some observers expected him to be more of a risk taker than his predecessor. The Bank of Montreal has had a reputation as a conservative, low risk, bank.

Mr. Downe has a B.A. from Wilfrid Laurier University, and graduated with an MBA from the University of Toronto in 1978. He has three adult sons.
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• Click here to read more about BMO's relationship with Optionable Inc.

• Click here to read more about the initial reports on BMO's commodity losses.
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