Wednesday, November 19, 2008

Scotiabank's $890 Million Writedown for Q4 2008

  
TD Securities, 19 November 2008

Event

Yesterday after market close, Scotiabank pre-announced Q4/08 write-downs totaling C$890 million pre-tax.

Impact

A disappointing (early) start to earnings season, given that Scotiabank has been relatively clean through the downturn. A portion of the mark is purely accounting, and none of the exposures reflect an excessive concentration or material breakdown in the bank's risk management discipline in our view. For the group, we continue to see heightened risk of Q4 surprises given the incredible volatility and we look for write-downs across the group.

Details

Not a breakdown in risk control. C$160 million pre-tax relates purely to hedge accounting issues (which occur every quarter although not on this magnitude) and C$170 million pre-tax relates to the failure of Lehman Brothers, while another C$410 million pre-tax represents MTM (mark to market) adjustments, which could conceivably come back over time. Scotia would like to have it back, but in the context of a C$462 billion balance sheet, the number does not suggest to us a systematic breakdown.

Ongoing exposures manageable. In our opinion, Scotiabank continues to have among the smallest exposure to problem assets of any Canadian bank. If challenging markets persist we expect to see losses across a range of exposures, but Scotia's positions remain manageable in our view. Likely more to come from peers. Visibility is extremely poor heading into Q4 given the tremendous volatility. Combined with year-end clean up, the risk of surprises remains high in our view. We expect more issues across the group, with write-downs on the order of a few hundred million each (except CIBC estimated at C$1.5-2.0 billion).

Little impact on Scotiabank's ongoing model. The hit to capital is in our view, manageable ($0.60 to BVPS and 30bp to Tier 1) and we expect Scotiabank to remain exceptionally well capitalized (Tier 1 estimate at 9.4%). Any silver lining to the announcement was the lack of any significant issues related to the International platform, where current investor concerns are focused.

There are three buckets of write-downs in total:

1. Lehman C$170 million pre-tax. Heading into the bankruptcy of Lehman Brothers, Scotia was in the process of re-hedging a position and became exposed to the underlying securities (blue chip Canadian equities). The bank subsequently decided to liquidate the portfolio given the deteriorating market conditions. The loss of C$170 million pre-tax represented a 10% decline in value. This resulting loss is permanent, but not a recurring item in our view. Scotiabank has submitted a bankruptcy claim for losses, but not reflected any expected recovery. Also, Scotia has no remaining exposure to Lehman.

2. Valuations adjustments. These include several positions.

a) U.S. Conduit (Liberty). This was a C$245 million pre-tax MTM adjustment with the potential for recovery.

The bank operates an ABCP conduit in the U.S. (Liberty). The conduit contained approximately C$400 million in CDO securities (as disclosed in Q3) and spreads widened dramatically on the securities during the quarter. Scotia bought the securities out of the conduit as a condition of their existing liquidity agreements (similar to actions taken by BMO in 1H08). The bank immediately marked the securities to 20 cents on the dollar. The securities remain highly rated and have not experienced any defaults. The remaining assets in the conduit (approximately US$7 billion) are credit receivables and the conduit continues to function normally. The bank does not own any of the Asset Backed Commercial Paper of the conduit (a strong signal that the existing paper continues to function).

b) Other CDOs. This was a C$165 million pre-tax MTM adjustment with the potential for recovery. The bank owns approximately C$700 million worth of direct exposures. During the quarter, CDO spreads widened dramatically on the securities and the bank has recognized a MTM loss. All the securities remain investment grade and have not experienced any defaults.

c) AFS (Available For Sale) Securities. This was an other than temporary impairment charge of C$150 million pre-tax.

The bank has a portfolio of approximately C$35 billion worth of AFS Securities. The charge reflects a range of smaller marks, the largest being in the C$30-40 million range. The securities are spread across the bank’s businesses and regions and we suspect they represent investments/securities in some of the fairly public corporate downfalls we have seen during the quarter.

3. ALM hedging. Scotiabank expects a MTM loss of C$160 million pre-tax, but this is 100% accounting related. The bank hedges fixed rate loans with interest rate swaps. The swaps are MTM while the loans are recorded on an accrual basis. When interest rates decline, the hedges reflect losses on the swaps, but the loans are unchanged (despite the obvious economic offset). This process occurs every quarter, across all the banks as normal business operations. However, it was notable this quarter given the strong movement in rates. This MTM reverses 100% over the life of the loan since it is a true economic hedge.

Outlook

We have made no changes to our estimates or Target Price.

Justification of Target Price

Using fair value estimates in a Gordon Growth model, our target price reflects 2.7x P/BV.

Key Risks to Target Price

1) The continued weakening of the U.S. dollar, 2) country and political risk in its international markets such as Mexico, 3) integration challenges associated with its recent and future acquisitions and 4) adverse changes in the credit markets, interest rates, economic growth or the competitive landscape.

Investment Conclusion

In our view, despite these write-downs being a disappointing start to earnings season, we see little impact on Scotia’s ongoing model and do not view the write-downs as a breakdown in the bank’s risk control. Scotiabank’s ongoing exposures look manageable. We continue to see heightened risk of Q4 surprises across the group given the volatility in markets.
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Financial Post, David Pett, 19 November 2008

Shares in the Bank of Nova Scotia were down more than 2% Wednesday as investors react poorly to the news that Scotia will take another writedown, this one worth $595-million after tax.

The remaining five big banks, including Royal Bank of Canada, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce, Bank of Montreal and National Bank of Canada, were also trading lower, on anticipation that more writedowns are in the cards. The latest rumour forecasts CIBC writing down another $1-billion or more in the very near future.

For those keeping count, here are the total after tax charges suffered by the banks since the third quarter of 2007:

• CIBC has written down $4.969-billion representing 46% of its common equity.
• Royal Bank has written down $1.086-billion representing 4% of its common equity.
• Scotiabank has written down $899-million representing 4.8% of its common equity.
• Bank of Montreal has written down $638-million representing 4.2% of its common equity.
• National Bank has written down $484-million representing 10.3% of its common equity.
• TD Bank has written down $65-million representing 0.2% of its common equity.
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Dow Jones Newswires, Monica Gutschi, 18 November 2008

The upheaval in the global financial system and the meltdown of equity markets in October have hurt Bank of Nova Scotia, which announced Tuesday it will take after-tax write-downs in the fourth quarter of C$595 million.

The write-downs are primarily related to trading activities, and the valuation adjustments on derivatives and structured credit instruments.

The charges arose "as a result of recent challenging market conditions and unprecedented volatility in global financial markets," the bank said in a press release.

Bank of Nova Scotia has already taken C$171 million in charges since the credit crisis began in August 2007, although it hadn't taken any in the past two quarters.

And even with the latest writedowns, its charges are only a small portion of the total C$12 billion in pre-tax write-downs taken by Canadian banks as a whole.

Banks globally have taken about US$500 billion in pre-tax charges since the crisis began.

Brad Smith at Blackmont Capital said Scotia's fourth-quarter write-downs were "a relatively small amount of money" that probably will shave about 60 Canadian cents a share off its earnings in the period. "If that's all there is, then there's nothing to worry about."

He said he wasn't surprised to see the write-downs, as he expects Canadian banks to view 2008 as a "lost year' and enter 2009 with a cleaner slate.

John Aiken at Dundee Securities said in a recent earnings preview report that the fourth quarter is likely to be a "kitchen sink" quarter for the banks.

"We believe the banks are likely to carry on the tradition of cleaning up their balance sheets with a myriad of write-downs in the fourth quarter," he wrote.

Aiken estimated Scotia could take a maximum write-down of C$3.1 billion without affecting its capital position. He estimated Scotia has about C$1.7 billion in excess common equity.

Aiken or an associate involved in writing the report owns Bank of Nova Scotia stock but his firm doesn't have an investment-banking relationship with the company.

Bank of Nova Scotia said a charge of about C$115 million in trading revenue is related to the bankruptcy of Lehman Brothers Holdings Inc. in September. It said this loss occurred mainly as a result of a failed settlement and the unwinding of trades in rapidly declining equity markets shortly after the bankruptcy. The bank said it has submitted a bankruptcy claim for losses.

It will also take valuation adjustments of about C$370 million. This includes writedowns of about C$105 million in available-for-sale securities based on current estimates of fair value, largely reflecting ongoing deterioration of economic conditions and volatility in debt and equity markets. It said the other C$265 million relates to mark-to-market adjustments on collateralized debt obligations.

Included in the C$265 million will be a net fair-value loss of about C$135 million on the purchase of certain CDOs from the bank's U.S. multi-seller conduit, pursuant to the terms of a liquidity asset-purchase agreement. It said the widening of credit spreads coupled with recent credit events in certain previously highly-rated reference assets have resulted in a substantial decline in the market value of structured instruments. If these spreads improve, a portion of the valuation adjustments would reverse and be recorded as income. The bank said its remaining exposure to CDOs will now be about US$348 million.

The bank said it will take a mark-to-market loss of about C$110 million relating to derivatives used for asset/liability management purposes that don't qualify for hedge accounting. This was driven by continuing declines in interest rates and is expected to reverse over the average three-year life of the hedges such that no economic loss should occur, it said.

The bank said about C$305 million relates to Scotia Capital, about C$90 million to International Banking and about C$200 million to the Other business segment, which includes Group Treasury and Executive Offices.

Bank of Nova Scotia will report its fourth-quarter earnings on Dec. 4.

In Toronto Tuesday, the bank's shares rose C$1.07 to C$37.17. They have declined 26% so far this year.
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