Tuesday, September 16, 2008

Implications of Lehman's Bankruptcy Filing

  
Scotia Capital, 16 September 2008

• Sun life disclosed yesterday afternoon $334 million exposure to Lehman bonds, with about one-half the exposure to senior-ranked bonds (which trade at 40-50 cents on the dollar) and one-half to subordinate debt (which trade at 10 cents on the dollar). The company noted the exposure relates to bonds backing policy liabilities, and that a charge would be taken in Q3/08. SLF also disclosed $15 million in net value of Lehman derivatives.

• We estimate SLF's charge could be $0.20-$0.30. Assuming a 75% provision (half a 60% provision and half a 90% provision, based on where the bonds trade) translates into a $0.28 EPS charge.

• The 2007 year end NAIC filings (U.S. operating companies only) suggest MFC has $260 million in Lehman bond exposure and GWO has $50 million, both largely senior-ranked. Assuming a 60% provision suggests a $0.07 EPS hit for MFC and a $0.02 EPS hit for GWO.

• Per the NAIC statements Lehman counterparty/derivatives risk for all the Canadian lifecos is extremely insignificant.
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RBC Capital Markets, 15 September 2008

Insurance EPS estimates down across the board

We have lowered our Q3/08 earnings per share estimates on weakness in global equity markets. Since the end of June, global equity markets have declined between 9%-14%, as at 10:00 (ET). Our estimate revisions are 3%-6%: Great-West (from $0.64 to $0.62), Industrial Alliance ($0.85 to $0.80), Manulife ($0.70 to $0.67) and Sun Life ($0.97 to $0.93).

Credit weakness could accelerate following demise of LEH

Today's bankruptcy filing by Lehman Brothers will likely cause a ripple-effect throughout credit markets. The greatest near term risks to earnings related to credit are exposures to LEH and downgrades on financial services holdings (which likely represent between 25%-30% of bonds) and their impact on reserves, in our view. If bonds held by the lifecos start seeing more downgrades in ratings, it would force the lifecos to strengthen their reserves (which has an earnings impact) even if there is no default or impairment.

Manulife could benefit from potential AIG asset sales

According to newspaper reports, AIG is considering the sale of its U.S. variable annuity business (among others). AIG was the largest writer of U.S. VAs in 2007 (11.8% market share), while Manulife was second with 8.6% - according to SNL Financial (SLF was 15th with 1.9% and GWO 19th with 1.1%). Manulife is in a strong position to acquire these assets, in our view, given its existing expertise and scale in the market, and would likely be interested.

LEH's asset management division also likely of interest

The asset management business of Lehman Brothers (Neuberger Berman) is also likely for sale and the Canadian lifecos would likely be interested. We believe GWO's Putnam Investments or SLF's MFS Investment Management could benefit from the addition of these funds by leveraging their existing distribution capabilities. The bidding process would likely be more competitive than for AIG's VA business, and we believe there are many other potential suitors that would bring more synergies to the table.

We continue to prefer stocks of Canadian lifecos to Canadian banks

We believe that the stocks of Canadian lifecos should outperform those of banks. We also like the sector on an absolute basis as Canadian lifeco multiples should rise over time (although the near term catalyst is not obvious, especially with equity markets being weak).

• Canadian lifecos have not been public for as long as banks but, if excluding the period in which they were expected to merge, they have traded at 10.0-14.5 times earnings. They are currently trading at 11.5 times forward earnings.
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RBC Capital Markets, 15 September 2008

The direct impact of the weekend's announcements on Canadian banks is probably manageable, in our view, but the indirect impacts are material as any announcements that impact the health of financial markets and drive the share prices of global banks down are likely to drive Canadian bank shares down in the near term as well.

• At 2.0x book value (based on Friday's close) we had been arguing that it was too early to buy based on the weakened economic outlook in Canada and the U.S. Valuations are likely to decline near term based on (1) widening spreads on fixed income securities, (2) uncertainty related to the unwinding of LEH's derivatives trades; and (3) uncertainty surrounding the health of other players such as AIG.

Widening spreads to put pressure on fixed income securities – especially structured finance assets.

• Credit spreads are widening this morning (the widely followed IG-10 is out about 40 basis points to 185/195 basis points).

• Depending on how long these stay wide, this will put more pressure on banks that need to mark to market debt securities, in our view – particularly structured finance assets.

• All banks are exposed but CIBC is most exposed in Canada, followed by BMO, in our view.

Derivative trades need to be unwound, which creates uncertainty.

• LEH had $730 billion in notional derivatives outstanding as at Q2/08.

• LEH would have posted collateral on many of the positions that it was out of money on, but counterparties on the other side of those trades find themselves suddenly unhedged against future price movements.

• Dealers will scramble to rehedge positions that are all of a sudden unhedged.

• Yesterday afternoon, banks/dealers got together to try to net out positions where LEH was intermediary but that is not an easy process (contracts are not necessarily standardized/maturities can differ...)

• We cannot know which of the Canadian banks would be owed what amounts from LEH in derivatives transactions as that disclosure is not available. From an unsecured lender perspective, Scotiabank was the only Canadian bank named as one of the 30 largest unsecured creditors in LEH's bankruptcy filing (BNS' exposure was a relatively modest $93mm)

The U.S. Government's willingness to support bailouts appears to be running thin, which is negative for share prices near term.

• Media reports suggest that the U.S. Government did not want to provide financial support to help MER/LEH (it supported the restructuring process by expanding securities accepted under its collateralized lending facility to include all investment grade securities, as well as equities)

• If the U.S. Government will not be bailing firms that "are too big to fail," who will provide capital recapitalize other firms that are struggling – most notably AIG, but also Washington Mutual?.
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Financial Post, Eoin Callan, 15 September 2008

With leading Wall Street institutions caught in a death spiral,stock-pickers at Odlum Brown see hidden value in Canadian banks.

“It is easy to get the impression that the Canadian banks are struggling, with the stocks well off their highs” and a heightened focus on credit exposures, analysts at the firm said. But “the reality is that the Canadian banks continue to have core businesses that are extremely profitable, especially compared to the U.S. and European peers,” they say.

“Profits are simply down from exceptional levels experienced over the last couple of years,” the firm said in a research note to clients last week.

The analysts point towards the steady earnings Canada’s big banks enjoy from their near-exclusive access to the country’s mature retail market.

The firm acknowledges it is “expecting somewhat slower growth from Canadian operations due to the economic slowdown that is underway”. But say that: “Looking forward, overall bank earnings are expected to remain robust.”

When the blows from the credit crisis and one-off items are stripped out, the big six Canadian banks reported aggregate cash earnings last quarter of $5.1 billion. This was 7 per cent lower than the previous quarter, but down 6% compared to a year earlier.

The special charges taken by the industry also slipped below $1 billion after hitting $2.8 billion in the first quarter.

Despite the challenging environment, Canadian bank stocks have outperformed relative to the general market this year. The analysts calculate that bank stocks have lost value based on the “average total return” of the year-to-date, but not done as badly as the S&P/TSX Total Return Index, which has slid 8.0 per cent.

This makes Canadian banks a buy, in the analysts’ view.
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The Globe and Mail, Tara Perkins & Boyd Erman, 15 September 2008

Sun Life Financial Inc., one of Canada's biggest insurers, will take a hit on $334-million Lehman Brothers bonds its holds.

Toronto-based Sun Life said it holds Lehman bonds with a face value of $334-million and about $15-million of Lehman derivatives. The derivatives are not at issues, and, Sun Life said, the size of the charge will depend on factors such as the amount of cash it gets back from Lehman's liquidation.

RBC Capital Markets analyst Andre-Philippe Hardy said he expects Sun Life to take a pre-tax charge of $167-million, assuming a 50 per cent recovery rate on Lehman exposure.

A spokesman for Sun Life said “it's relevant to place this into its context, not to diminish the exposure at all, but Sun Life's investment portfolio is over $100-billion and Sun Life is very well capitalized and diversified.

“Despite the extraordinary events of this past weekend, Sun Life is well positioned to weather the storm,” he said.

Canadian financial institutions, like their global brethren, have been scouring their balance sheets for exposure to Lehman as it heads into liquidation. In a good news story for Canadian investors, with the exception of Sun Life they aren't finding much.

Canadian Imperial Bank of Commerce has $25-million of exposure. Toronto-Dominion Bank and Royal Bank of Canada described their exposure as nominal. A Bank of Montreal spokesman said BMO's exposure also was not significant.

Bank of Nova Scotia is listed as a creditor owed $93-million (U.S.) in Lehman's bankruptcy filing, but a person familiar with the bank's balance sheet said that relates to a credit line that was not drawn and was terminated, thus leaving no exposure.

Banks in Canada and around the globe have been scrambling as Lehman moved toward the brink to unwind or cancel out any derivatives trades involving Lehman, bank executives said. Because Lehman's demise played out over many days, there was enough time to get a lot done.

“This appears to be what the banks were working on over the weekend and currently,” Genuity Capital Markets analyst Mario Mendonca said in an e-mail Monday.

All of the banks have positions that were hedged with Lehman, the storied Wall Street investment bank that has filed for bankruptcy protection, he said.

A spokeswoman for Royal Bank of Canada said that the bank has been working to reduce its risk relative to Lehman wherever possible for several months.

“In terms of our business activities with Lehman, they are one of our trading and transactional counterparties, with the major areas being securities and financing activities and derivatives,” she said. “We are well within our single name limits and are well-collateralized.”

Speaking at an investor conference Monday, Canadian Imperial Bank of Commerce executives said the bank's exposure is small.

“Lehman Brothers, in relation to CIBC, was a collateral posting counterparty and we do not have large exposures,” CIBC chief executive Gerald McCaughey said. “Industry developments in the United States over the weekend are another reminder of the challenging market environment, particularly in the U.S.,” he said. “In the face of these cyclical challenges the Canadian banks continue to be strong and well positioned.”

CIBC is in the process of re-hedging its exposure with other counterparties, Mr. Mendonca noted. “This is the issue - can the banks (not just CIBC) re-hedge the exposures to avoid larger mark to market losses,” he wrote in an e-mail, adding that, “with credit spreads blowing out, how has the $25-million changed since the end of Friday.”

Whether banks are losing money or not on their exposure to Lehman cannot be determined at the moment because it's not known what side of the trades they were on, or whether they were short or long credit, Mr. Mendonca said.

In a note to clients Monday, Mr. Hardy said that the direct impact of the weekend's events on the Canadian banks is probably manageable, but the indirect impacts are material.

Widening spreads will put pressure on fixed income securities, especially structured finance assets, he said. Banks that hold some of these complicated investments might have to write down their value.

“Depending on how long these stay wide, this will put more pressure on banks that need to mark to market debt securities, in our view - particularly structured finance assets,” Mr. Hardy said.

While all banks have some such exposure, CIBC, followed by Bank of Montreal, would be the most exposed in Canada, he said.

In an interview Sunday night, ING Direct Canada chief executive Peter Aceto said that the events in the U.S. would certainly touch the Canadian banking community.

“When you see such catastrophic things happening so close to you ... you can't help but know that you're not totally immune to it,” he said.

However, he believes the Canadian banking system is fundamentally different from its southern counterpart and that should help to keep it in better shape.

“There is so much that differentiates Canada from the United States in the discipline around mortgage lending, the discipline around home ownership, the discipline around CMHC relative to Fannie and Freddie,” he said. “Even though we've got some issues with employment, even though we've got some issues possibly with the real estate markets, Canadians don't have as much leverage and the lenders aren't in the same situation.”

In a separate note to clients Monday, Mr. Hardy lowered his earnings estimates for the Canadian insurance industry as a result of this weekend's events and weakness in global equity markets.

He added that Lehman's bankruptcy protection filing will likely cause a ripple-effect throughout credit markets.

“If bonds held by the lifecos start seeing more downgrades in ratings, it would force the lifecos to strengthen their reserves even if there is no default or impairment,” he wrote.

Mr. Hardy also said that the Canadian life insurers would also likely be interested in taking a look at Lehman's asset management business, Neuberger Berman, and that Manulife could benefit from potential asset sales at AIG.

Manulife is in a strong position to acquire these assets, in our view, given its existing expertise and scale in the market, and would likely be interested,” Mr. Hardy wrote.
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The Globe and Mail, Tara Perkins & Boyd Erman, 15 September 2008

Canadian banks have been scouring their balance sheets for exposure to Lehman Brothers Holdings Inc. as it heads into liquidation, and in a good news story for investors, they aren't finding much.

Canadian Imperial Bank of Commerce has $25-million of exposure. Toronto-Dominion Bank and Royal Bank of Canada described their exposure as nominal. A Bank of Montreal spokesman said BMO's exposure also was not significant.

Bank of Nova Scotia is listed as a creditor owed $93-million (U.S.) in Lehman's bankruptcy filing, but a person familiar with the bank's balance sheet said that relates to a credit line that was not drawn and was terminated, thus leaving no exposure.

Banks in Canada and around the globe have been scrambling as Lehman moved toward the brink to unwind or cancel out any derivatives trades involving Lehman, bank executives said. Because Lehman's demise played out over many days, there was enough time to get a lot done.

“This appears to be what the banks were working on over the weekend and currently,” Genuity Capital Markets analyst Mario Mendonca said in an e-mail Monday.

All of the banks have positions that were hedged with Lehman, the storied Wall Street investment bank that has filed for bankruptcy protection, he said.

A spokeswoman for Royal Bank of Canada said that the bank has been working to reduce its risk relative to Lehman wherever possible for several months.

“In terms of our business activities with Lehman, they are one of our trading and transactional counterparties, with the major areas being securities and financing activities and derivatives,” she said. “We are well within our single name limits and are well-collateralized.”

Speaking at an investor conference Monday, Canadian Imperial Bank of Commerce executives said the bank's exposure is small.

“Lehman Brothers, in relation to CIBC, was a collateral posting counterparty and we do not have large exposures,” CIBC chief executive Gerald McCaughey said. “Industry developments in the United States over the weekend are another reminder of the challenging market environment, particularly in the U.S.,” he said. “In the face of these cyclical challenges the Canadian banks continue to be strong and well positioned.”

CIBC is in the process of re-hedging its exposure with other counterparties, Mr. Mendonca noted. “This is the issue - can the banks (not just CIBC) re-hedge the exposures to avoid larger mark to market losses,” he wrote in an e-mail, adding that, “with credit spreads blowing out, how has the $25-million changed since the end of Friday.”

Whether banks are losing money or not on their exposure to Lehman cannot be determined at the moment because it's not known what side of the trades they were on, or whether they were short or long credit, Mr. Mendonca said.

In a note to clients Monday, RBC Capital Markets analyst Andre-Philippe Hardy said that the direct impact of the weekend's events on the Canadian banks is probably manageable, but the indirect impacts are material.

Widening spreads will put pressure on fixed income securities, especially structured finance assets, he said. Banks that hold some of these complicated investments might have to write down their value.

“Depending on how long these stay wide, this will put more pressure on banks that need to mark to market debt securities, in our view - particularly structured finance assets,” Mr. Hardy said.

While all banks have some such exposure, CIBC, followed by Bank of Montreal, would be the most exposed in Canada, he said.

In an interview Sunday night, ING Direct Canada chief executive Peter Aceto said that the events in the U.S. would certainly touch the Canadian banking community.

“When you see such catastrophic things happening so close to you ... you can't help but know that you're not totally immune to it,” he said.

However, he believes the Canadian banking system is fundamentally different from its southern counterpart and that should help to keep it in better shape.

“There is so much that differentiates Canada from the United States in the discipline around mortgage lending, the discipline around home ownership, the discipline around CMHC relative to Fannie and Freddie,” he said. “Even though we've got some issues with employment, even though we've got some issues possibly with the real estate markets, Canadians don't have as much leverage and the lenders aren't in the same situation.”

In a separate note to clients Monday, Mr. Hardy lowered his earnings estimates for the Canadian insurance industry as a result of this weekend's events and weakness in global equity markets.

He added that Lehman's bankruptcy protection filing will likely cause a ripple- ffect throughout credit markets.

“If bonds held by the lifecos start seeing more downgrades in ratings, it would force the lifecos to strengthen their reserves even if there is no default or impairment,” he wrote.

Mr. Hardy also said that the Canadian life insurers would also likely be interested in taking a look at Lehman's asset management business, Neuberger Berman, and that Manulife could benefit from potential asset sales at AIG.

Manulife is in a strong position to acquire these assets, in our view, given its existing expertise and scale in the market, and would likely be interested,” Mr. Hardy wrote.
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The Globe and Mail, Tara Perkins, 15 September 2008

Suddenly, there's a fire sale among U.S. banks, but Canada's biggest bank isn't biting.

JPMorgan Chase & Co. acquired faltering Bear Stearns & Co. at the steepest of discounts. Lehman Brothers Holdings Inc. is in crisis. And Bank of America appears poised to merge with Merrill Lynch & Co. Inc.

Royal Bank of Canada's name keeps coming up when suitors are mentioned for troubled U.S. investments such as Lehman and Bear Stearns. But RBC chief executive officer Gordon Nixon isn't interested, at least at this point, and he's not worried about being labelled timid.

“From our perspective, it is absolutely a time to be very, very cautious,” Mr. Nixon said in an interview.

The market is focusing on the cheaper value of U.S. banks, but “when you buy a financial institution, you're buying the balance sheet,” he noted. “There are a lot of companies out there with potentially negative equity,” he said. “That's one of the reasons you're not seeing a lot of M&A activity in the United States.”

He said if he were to make an acquisition, he would rather pay more but be very comfortable with a bank's assets, and he believes most of the world's bank CEOs now look at the United States that way.

Toronto-Dominion Bank made an $8.5-billion (U.S.) gamble on the United States, acquiring New Jersey-based Commerce Bancorp this spring, and now bills itself as the first North American bank.

But Mr. Nixon has no regrets about the conservative approach he has taken. “Some analysts and media and market pundits have been encouraging the Canadian banks over the past three or four or five years to much more aggressively acquire in the United States.

“If I could show you the pitch books that we've received from investment banks, and the damage that we would have done to our franchise and to our shareholders had we actually executed on those transactions …” he trailed off.

Royal's U.S. bank, now named RBC Bank, has about 430 branches in six states in the Southeastern United States, and RBC has been gradually expanding through small acquisitions.

Mr. Nixon said analysts have a valid point when they say RBC has more work to do in terms of scale if it wants to establish a major presence in the U.S. consumer banking business. But now is not the time to be bulking up, he suggested.

RBC has made more than 20 acquisitions in a range of business lines over the past eight years. And “the toughest business from our standpoint, when you look at return on capital, has actually been the personal and commercial banking business in the United States,” he said.

The bank is staying on top of its options, “but I can assure you, as we sit today, there is absolutely nothing of significance that we are working on or looking at,” he said.

Mr. Nixon shook up RBC's executive ranks this spring, because U.S. banking performance missed expectations and because RBC was making a $2.2-billion (U.S.) acquisition in the Caribbean, of RBTT Financial Group, while looking for other opportunities. The shuffle saw Jim Westlake move from head of Canadian banking to head of international banking and insurance.

Mr. Westlake is comfortable with the size of RBC's U.S. banking operations at the moment, and is focused on getting them to run as smoothly as the Canadian operations do. Over time, the U.S. bank unit will want to grow, but the measured approach has served it well so far, he suggested.

“We get criticized for buying too small,” he said. “While we very much admit that we've been less than satisfied with our overall performance in our U.S. banking to date, we certainly have not blown our brains out by going in and doing anything foolish, and we think we've built an asset for the future that will pay off for us.”

Mr. Nixon has heard the speculation that RBC is a suitor for faltering U.S. investment banks. “I think the market intuitively says, ‘well, if you want to expand and grow your capital markets business, here's a once-in-a-lifetime opportunity to do it, because look at the valuations of these organizations,'” he said.

“We're going to grow the capital markets business through building businesses, hiring teams, making small acquisitions like the energy boutique we bought in Houston,” Mr. Nixon said.

He would never rule out the idea of RBC doing a major deal in one or more of its business lines. But “we're very comfortable with our strategy, as I say, of continuing to invest and build in our businesses, because we've been able to make very strong returns.

Meanwhile, he's avoided deals that he said would have proven “disastrous.”
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Financial Post, David Pett, 11 September 2008

The recent rally in Canadian bank stocks is unlikely to continue for long, says Dundee Securities analyst John Aiken.

"As with the previous financial sector rallies, global valuations will decline once negative headlines resume, most likely in conjunction with U.S. third quarter reporting," Mr. Aiken said in a note to clients.

"We do not believe that Canadian banks will be immune and investors who have benefited from an overweight stance should sell into this rally and return to a modest underweighting by month end,"

Mr. Aiken told clients that Canadian bank stocks have enjoyed a wave of optimism, brought on by third quarter earnings released at the end of August that included lower-than-feared capital markets write downs – much to the relief of investors.

As a result, since Aug 26, the S&P/TSX Financials index is up about 7% through Wednesday's close., compared with a loss of roughly 5% for the broader S&P/TSX Composite Index. The Financials index is down about 10 points to 1670 in morning trading on Thursday.

"Despite the fact that several of the banks missed consensus expectations, the sector as a whole benefited from both CIBC and Royal Bank reporting significantly lower writedowns than had been anticipated, the analyst said.

He added that the recent exit of short-sellers that is helping drive bank valuations higher can also be attributed to the bailout – and likely nationalization – of government sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac in the U.S.

While he expects this positive sentiment toward the banks to continue short term, Mr. Aiken said negative headwinds against future growth will return, when the next round of earnings likely come in below consensus expectations.

The analyst said he remains concerned about the potential for loan loss provisions given the effect on greater economies of the ongoing U.S. residential real estate slow down. He also wrote that capital markets revenues will likely be depressed over the next few quarters due to the lack of activity and that net interest margins remain under pressure. Meanwhile, dividends are likely to increase only modestly – if at all – representing dividend growth still well below past year's levels.

Mr. Aiken continues to rank TD Bank and Royal Bank at the top of his coverage, tagging both with "buy" ratings. He continues to rate Bank of Montreal his only "sell."

"In the current environment, we advocate looking for strength and taking a defensive stance for those looking to allocate or shift capital within the banking sector. We believe that TD Bank [with a price target of $71] and Royal Bank [with a price target of $54] are the safest bets."
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