Friday, October 03, 2008

Cerberus to Invest $1.05 Billion in CIBC's US Real Estate Portfolio

  
Dow Jones Newswires, Monica Gutschi, 3 October 2008

Canadian Imperial Bank of Commerce, which has been badly hurt by its exposure to the U.S. residential real-estate market, announced a deal Friday that will reduce its remaining risk to that market but allow it to reap the benefits if the market rebounds.

The bank's shares are higher on the news.

Under the deal, Cerberus Capital Management will invest US$1.05 billion for senior notes tied to a portfolio of the bank's U.S. real estate assets. Cerberus will receive cash flow from the notes, while CIBC retains ownership of the underlying assets, principally residential mortgage-backed securities, or RMBS, and collateralized debt obligations, or CDOs.

The transaction protects CIBC's capital base while at the same time allows it to hold on to assets whose market value may increase substantially over time.

"We wanted to put a floor under our exposure but protect the potential upside, " McCaughey said in an interview. "The sharing of risk with them (Cerberus) was very important."

"Essentially, in this transaction CIBC has given away a portion of what appears to be the economic value of the underlying assets to protect the accounting (i.e. mark-to-market) downside," noted Robert Sedran, bank analyst with National Bank Financial.

Bruce Campbell, who owns CIBC stock as principal of Campbell-Lee Investment Management, agreed. "My sense of it is, you might be giving up some obvious upside if and when things recover," he said. In exchange, risk to shareholders is reduced.

But the deal will also likely reduce CIBC's earnings by about 30 Canadian cents annually until the notes are repaid, analysts said.

The deal also doesn't eliminate the possibility of future charges on CIBC's remaining US$1.75 billion in hedges with monolines. Given widening spreads on credit-default swaps, analysts believe the bank could take a charge of about US$ 1 billion in the fourth quarter.

However, the bank has increased its reserves related to those hedges, which would minimize the impact on its capital of any potential write-down. CIBC has already taken US$7.5 billion in charges related to its U.S. real estate exposure, and earlier this year raised C$2.9 billion in equity to shore up its capital base.

The bank's Tier 1 capital ratio at the end of July was 9.8%, but that number will rise to 10.1% following the completion of a C$300 million preferred-share issue. The deal with Cerberus will add another 13 basis points to that ratio.

New York-based Cerberus will effectively pay par for the portfolio, which held a fair value of US$1.186 billion at the end of June, but a month later was valued at US$1.075 billion. The notional value of the assets is US$6 billion, Sedran noted.

CIBC won't provide any financing or performance guarantees, and interest and principal payments on the senior notes will be paid only if the RMBS and CDOs of RMBS perform. Following the repayment of the notes, the bank will retain all future cash flows of the portfolio.

McCaughey said the transaction is beneficial for both sides.

Cerberus, a U.S.-based private equity firm, is expected to recover its investment plus a capped return of 20%. The notes are callable after three years, McCaughey said.

The transaction is a "signal to the marketplace" that the securities "may be stores of value beyond where they're being valued today," McCaughey says, adding that he believes the market for those real-estate securities could become "far more robust" in the future.

McCaughey said there were a number of catalysts that could signal a bottom in the declining U.S. residential real-estate market. At one point, it could reach a floor "where everybody is willing to do business." Another is that "large pools of capital" held by both private and public parties begin to realize the opportunities available and begin accumulating the assets. And still another could be a recovery of the North American economy.

McCaughey said there was substantial interest from a large number of counterparties in CIBC real-estate portfolio, but that the "symmetry of interests" was strongest with Cerberus.

"The amount of capital that is preparing to invest in both distressed assets and in the financial sector is extremely large," he noted, but added that many were waiting for "uncertainty to clear."

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The Globe and Mail, Tara Perkins, 3 October 2008

New York-based private equity giant Cerberus Capital Management LP is putting $1.05-billion (U.S.) into Canadian Imperial Bank of Commerce's troubled subprime mortgage portfolio, signalling a growing willingness among investors to gamble on these distressed securities.

A robust market for these securities is going to develop, “because we know how many inquiries we received on this portfolio and how close the pricing was,” CIBC chief executive officer Gerald McCaughey said in an interview.

In recent months, the bank approached a broad range of possible counterparties to do a deal on its mortgage portfolio, from investment banks to funds to private family institutions, predominantly in the United States. Mr. McCaughey said large pools of capital, such as foreign pension funds and sovereign wealth funds, are now entering the market through local intermediaries.

“They will invest directly, but the fact is that they are using the U.S.-based distressed debt players, private equity players, as well as large financial institutions, who are intermediaries,” he said.

CIBC got into serious talks with four potential investors, and each was relatively close on price.

The bank, which has taken $6.8-billion (Canadian) in writedowns over the past three quarters, wanted to limit its exposure to the subprime market. “We wanted to provide a floor, so there would be some certainty for our shareholders,” Mr. McCaughey said.

The deal will see the bank issue a note to Cerberus, which could earn a return of up to 20 per cent depending on the future value of the mortgage portfolio. The fair value of the mortgage portfolio was $1.075-billion (U.S.) at the end of July.

Cerberus is betting that the value of CIBC's subprime securities will rise above their current value on the bank's books. CIBC will keep any gains once the private equity firm's investment and interest have been paid.

The deal is made possible because CIBC is required to use fair value accounting to determine the value of its subprime exposure, while it and Cerberus believe the actual economic value is higher, Mr. McCaughey noted. “What we've done here is we've given away a portion of the upside that is in the economic models in our assets in order to be certain that we've protected the downside.”

Credit Suisse analyst Jim Bantis said in a note to clients it “is an expensive but pragmatic move made by CIBC, in our view, as it further reduces the risk of another capital raise.”

The bank tapped the market for a $2.9-billion (Canadian) equity injection this year to strengthen its balance sheet.

Since Mr. McCaughey realized the extent of CIBC's subprime problem last year, he has taken actions ranging from handing over the bulk of its U.S. investment banking operations to Oppenheimer Holdings Inc. to cutting its asset-backed commercial paper program in half.

Prior to Friday, CIBC's Tier 1 capital ratio was already a high 10.1 per cent, and it will now rise by 0.13 per cent.

RBC Dominion Securities Inc. analyst Andre-Philippe Hardy said CIBC has removed risk in one of its four structured finance exposures, but noted there are three left, including its exposure to bond insurers and its collateralized loan obligations.

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Bloomberg, Sean B. Pasternak, 3 October 2008

Canadian Imperial Bank of Commerce, which has taken more writedowns than any Canadian lender during the financial crisis, said Cerberus Capital Management LP will invest $1.05 billion in its U.S. real estate portfolio, helping the bank reduce risk.

The U.S. buyout fund will pay cash for senior notes linked to the residential real estate assets, the Toronto-based bank said today in a statement. Cerberus will receive cash flow from the notes, while CIBC will retain ownership of the underlying assets, the bank said.

CIBC, which wrote down its debt investments by about C$7.55 billion ($6.97 billion) since last year, said it's giving away "potential upside" in its portfolio to protect against any downside in the real estate market.

"We've been very clear that we've been looking to de-risk the bank, and I think this a pretty high profile example of finding a way to do that," Chief Administrative Officer Ron Lalonde said in a telephone interview.

Chief Executive Officer Gerald McCaughey has been trying to reduce risk at the bank's U.S. operations, selling most of its New York-based investment banking business to Oppenheimer Holdings Inc. in January.

Cerberus, the New York-based firm chaired by former U.S. Treasury Secretary John Snow, expects to recoup its investment plus a return of about 20 percent, McCaughey said. The notes mature in three to four years, he said.

"We believe the transaction benefits both sides," Cerberus spokesman Peter Duda said.

The investment by Cerberus will reduce CIBC's profit by about 30 cents a share annually until the notes are repaid, Blackmont Capital Inc. analyst Brad Smith wrote in a note to investors. CIBC is expected to have a net loss of C$3.80 a share for the year ending Oct. 31, according to the average estimate of seven analysts surveyed by Bloomberg News.

The real estate portfolio has a notional value of about $6.3 billion and consists of mortgage-backed securities and collateralized debt obligations. The assets have been written down "by a material amount," Lalonde said, with a fair value of $1.08 billion at July 31.

"Some of those notes are in significant distress and some of those notes will end up being liquidated and terminated for some amount of value," Lalonde said.

Canada's fifth-biggest bank spent almost two months talking to potential bidders, including investment banks and funds, Lalonde said. He declined to name specific bidders.

"CIBC has given away a portion of what appears to be the economic value of the underlying assets to protect the accounting (i.e. mark-to-market) downside,'' National Bank Financial analyst Robert Sedran said in a note to investors.

The transaction shows "there is capital out there to enter into these deals, but there hasn't been an avalanche of them yet," Lalonde said. He cited similar transactions at Merrill Lynch & Co. and UBS AG.

"There is a significant amount of hedge fund and private equity money that has been raised that stands ready to be deployed in the right types of investments in distressed assets,'' said Paul Jorissen, a partner at New York-based Mayer Brown LLP, which advised CIBC on the transaction. "The issues that I think challenge potential investors are trying to call the bottom of the market."

He declined to name which companies were looking. Schulte Roth & Zabel LLP, also of New York, acted as legal advisers to Cerberus.

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Financial Post, Jonathan Ratner, 3 Octber 2008

Cerberus Capital Management’s $1.05-billion investment in CIBC’s residential real estate portfolio comes in exchange for a capped return of approximately 20%. It appears that CIBC will retain any upside if the assets rise in value above that level.

Collateral supporting the notes Cerberus will receive include most of CIBC’s U.S. subprime residential mortgage-backed securities and collateralized debt obligation investments, which have a notional value estimated at $6-billion and a current fair value of $1.136-billion, according to Blackmont Capital analyst Brad Smith.

“The announced transaction with Cerberus effectively provides a second layer of fully funded insurance against further losses on the remaining subprime-related asset exposure,” he told clients.

Potential related future losses are reduced by $1.70 per share, while the 20% return should cut CIBC’s future earnings by 30¢ per share annually until the notes are repaid, the analyst added.

RBC Capital Markets analyst Andre-Philippe Hardy agreed that the negative EPS impact would be around 30¢ in the first year, but said this should fall as the notes get amortized.

While both analysts viewed the deal as positive, they noted that areas of risk remain for CIBC. These include $2.9-billion in fair value of hedges with financial guarantors, $22.2-billion in structured finance exposures mostly linked to corporate debt and collateralized loan obligations, and another $2.2-billion in other unhedged holdings of structured credit. CIBC’s non-residential credit exposure given its relative size to the bank’s $11.6-billion Tier 1 capital base also remains a concern.

CIBC’s conclusion that the additional insurance the Cerberus transaction provides was desirable suggests that management has lost confidence in the ability of its monoline insurance coverage to pay claims, Mr. Smith said.

“This in turn is consistent with market perceptions as reflected in the elevated level of CDS swaps spreads accorded most monoline debt obligations,” he said, adding that despite the bank’s discount valuation, its risk profile is too high to recommend it.

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Bloomberg, Sean B. Pasternak, 2 October 2008

Canadian banks and insurers are poised to benefit from a U.S. ``garage sale'' of financial- services assets, said Adam Waterous, head of global investment banking at Scotia Capital.

``This is going to be the biggest garage sale since the 1920s, and Canadian financials are well positioned,'' Waterous said today in an interview. ``This is a once-in-a-lifetime opportunity.''

The 24-member KBW Bank Index has dropped 19 percent this year as the U.S. government mulls a $700 billion rescue plan for beleaguered financial institutions. Banks and insurers including Lehman Brothers Holdings Inc. and American International Group Inc. have been forced to unload assets.

Canadian financial firms including Toronto-Dominion Bank and Manulife Financial Corp. had relatively few losses from the credit crunch that has resulted in $587.7 billion in losses and writedowns by financial companies worldwide.

Waterous, 47, said Canadian insurers may be in the best position to acquire assets abroad. Analysts including Andre- Philippe Hardy at RBC Capital Markets have said that Manulife, Sun Life Financial Inc. and others may look at assets sold by AIG.

AIG's price-to-book ratio, which compares a company's stock price to its book value per share, is currently 0.13 percent, compared with 1.68 percent at the end of 2007, according to Bloomberg data.

``Maybe we'll get lucky and we'll get a deal like in the United States, where these people are getting franchises for next to nothing,'' Manulife Chief Executive Officer Dominic D'Alessandro told investors on Sept. 29. ``It's truly unbelievable.''

In addition, the failure of Lehman Brothers and Merrill Lynch & Co.'s sale to Bank of America Corp. will create more opportunities for Canadian banks to lend to corporate clients in the U.S., Waterous said. Toronto-based Scotia Capital, a unit of Canada's third-biggest bank, plans to add more bankers in the U.S. after hiring three senior managing directors in its U.S. commodities business over the last 12 months, he said.

``This is a great time to build bench strength,'' said Waterous, who was promoted to the new position last month.

Waterous also heads the Scotia Waterous oil-and-gas advisory unit, acquired by Bank of Nova Scotia in 2005 to expand in Canada's commodity sector. Scotia Capital has announced 24 oil and gas deals in the 12 months ended Sept. 30, according to Bloomberg data, more than any other investment bank. The bank ranks second for merger value, trailing JP Morgan Chase & Co.

Waterous also expects ``record deal flow'' from the commodities sector over the next six months as oil prices decline and growth prospects for those companies weaken. Global mergers and acquisitions declined 28 percent this year to $2.37 trillion, according to Bloomberg data. The value of Canadian mergers has slumped by about two-thirds from the first nine months of 2007, to $105.6 billion.

``It was harder to do a deal at the prices four months ago,'' Waterous said. ``Prices are now at reasonable levels.''

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Dow Jones Newswires, 2 October 2008

Genuity Capital Markets still has plenty of questions about Bank of Montreal's Links SIV, which may get downgraded by Moody's. Firm says BMO hasn't said whether SIV holds debt securities of troubled US financial institutions. And Genuity says BMO's accounting for the SIV, the US trust Fairway Finance, and its conduits "remain too creative for our liking." BMO may end up having to consolidate some of the off-balance sheet vehicles and take charges, firm adds.

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Reuters, Lynne Olver, 30 September 2008

With European banks getting propped up almost daily, unimaginable U.S. bank and insurance failures and growing economic uncertainty, Canadian bank investors have a back seat on the global roller coaster.

Canadian banks are not likely to tap directly into a U.S. government bailout plan, assuming lawmakers can eventually agree to a rescue package. Even so, Bay Street institutions are likely to feel the fallout from widespread uncertainty about the global financial system that is expected to persist, no matter what Congress does to alleviate the stress.

The Canadian banks are caught up in severe swings in investor sentiment and rising concerns about their business prospects in a weakening North American economy. While some analysts think they have a rare opportunity to make U.S. acquisitions at bargain-basement prices, deals may not occur until some of the dust settles.

"There's a growing recognition of the impact of the credit crisis on the global economy. We've got some major economies on the verge of recession, if not in recession," said Patricia Croft, chief economist at money management firm Phillips, Hager & North in Toronto.

Canada is not expected to escape an economic downturn, meaning consumer and business demand for loans will slow and credit losses will rise.

Canadian financial stocks were hammered on Monday, led by a 9.3 percent drop in Bank of Montreal, which closed at $42.00 a share, and Canadian Imperial Bank of Commerce, which dropped 8.5 percent to C$56.90.

Some of those declines were reversed on Tuesday morning, with bank stocks springing back. The S&P/TSX financials index, composed of banks, insurance companies and asset managers, rose 3 percent.

"We are in uncharted territory, unprecedented events, and so I think volatility is going to continue until we get some sense of resolution around the credit crisis," Croft said.

Canadian banks are being tarred with the same brush as global financial companies, even though they have strong balance sheets and greater stability, she said.

"I think ultimately there will be some stratification in valuation and Canadian banks should do well," Croft said.

The fortunes of the big Canadian banks are connected in various ways to the U.S. markets, said Ohad Lederer, a bank analyst at Veritas Investment Research in Toronto.

Some of them, including Bank of Montreal and CIBC, hold complex debt securities tied to U.S. corporate credit, while Royal Bank of Canada and Toronto-Dominion Bank are large lenders in U.S. markets.

"There is no decoupling here, " Lederer said. "While the direct impact of the bailout attempt (on Canadian banks) is not large, I think people are now starting to fear for the indirect effects."

Those effects include pressure on the banks' wealth-management units if investors pull their money out of volatile markets, Lederer said.

Rob Sedran, a bank analyst at National Bank Financial, agreed that the "direct implications" of U.S. developments to ease the financial crisis may not be significant for Canadian banks, but economic instability is.

Three of them have significant operations in the United States: RBC in the Southeast, Bank of Montreal's Harris Bank in the Chicago area; and TD Bank's retail focus in the New England and Mid-Atlantic states.

"At the end of the day Royal Bank doesn't need a financial bailout, BMO doesn't need a financial bailout, TD doesn't need a financial bailout," Sedran said. "It's the indirect impact on the underlying economy that we're more concerned with."

Mario Mendonca, an analyst at Genuity Capital Markets, cut his 2009 earnings per share targets for the Canadian bank group early on Monday, citing fallout from the U.S. economic slowdown.

The Canadian economy will likely experience "a soft landing" in terms of unemployment, housing starts and housing prices, compared with steeper U.S. declines, Mendonca said in a research note.

But a soft landing "does entail some pain," Mendonca added. He raised his forecast for the Canadian banks' loan-loss provisions while cutting his retail loan growth forecast.

Mendonca said his 2009 bank earnings estimates are now "noticeably below consensus," particularly for Bank of Montreal and Bank of Nova Scotia.

Canadian banks have frequently been touted as being in a superb position to make U.S. bank acquisitions, as their conservative management styles, integrated investment and retail banking models and other differences have left them better capitalized.

This is reflected in their valuations. Shares of the largest five Canadian banks are trading at twice their book value, while U.S. large-cap regional banks are trading at less than book value, according to TD Newcrest.

But Canadian executives may wait for a more stable environment to do deals, National Bank Financial's Sedran said.

They might forgo some upside, but they'll also forgo some of the risk, Sedran said.

"They seem to be a lot more prudent in terms of allocating capital into this crisis, and would prefer to see the way clear a little bit before becoming more aggressive."

Even regional Canadian banks with no capital markets businesses, no U.S. operations and no complex debt holdings saw their stock prices get whacked on Monday.

Canadian Western Bank, the seventh largest Canadian bank by market value, dropped 8.3 percent to close at C$19.71, after touching a 52-week low, and was little changed on Tuesday morning

Despite Monday's plunge, Canadian bank stocks have done slightly better than the main index of the resource-heavy Toronto Stock Exchange this year.

As of Monday's close, the S&P/TSX banks index had fallen 13 percent in 2008, versus an 18 percent drop in the S&P/TSX composite index.
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