Browsing the blog archives for October, 2009.

Bank of Montreal Credit Rating Slips

Financial Crisis

Credit Downgrade

Moody’s announced that they were reviewing the BoM’s credit rating in anticipation of downgrading it this week.  They are concerned over the health of BoM’s US-based Harris banking unit but otherwise do not appear to be concerned over the BoM’s asset quality.

That is not a view shared by the DBRS rating agency whose most recent credit ratingreport indicates that they are very concerned over the BoM’s continuing exposure to $6 B in loans to prop-up off-balance sheet Structured Investment Vehicles.

In fact the DBRS report bluntly states that they rate the BOM’s debt as high as AA(low) only because they believe that the Canadian government will offer “systematic and timely external support” to BoM.

Other analysts are also concerned over the continuing SIV exposure.  This is due to the  fact that:

  • the market value of these derivatives is significantly less than the bailout loans provided by BoM and
  • the BoM continues to publicly deny that they have a problem here.

SIV Exposure

So how much of a problem does the BoM have with SIVs?  It’s on the same scale as the Israeli problem with Iran’s nuclear program.

According to the BOM’s published Q3 Supplementary Financial Information, the total Regulatory Capital of the bank is $24 B.  That’s the amount of real investor capital put into the BoM.  As previously described in earlier posts, banks inflate this asset by also counting the loans that they have made as “assets” since those loans generate interest revenue.

The total BoM’s “asset” base of $334 B includes $65 B of derivatives of which $49 B are securitized assets.  According to the Q3 Supplementary Report, 90% of the $49 B is impaired and a full $37 B is rated as having a high risk of default ( Risk weight >7%).

Prudently the BoM has reserved $735 M of capital against this risk, however, that provision will be about as effective as a fart in a thunderstorm should these derivatives prove worthless.

Given the recent signs of economic recovery, it is likely that not all of the $37 B will tank.  A risk weight of >7% means that roughly 1/2 of these loans will likely default in 5 years (1.07^6 = 1.50).  Many analysts believe that the $6 B in SIV loans made to support Link SIV and Parkland SIV are at greatest risk however.

To put the danger posed by $6 B in bad loans in perspective, the BoM’s entire quarterly revenue in Q3 was $3 B and its net income is currently approximately $1 B / quarter.

Hence, a $6 B default can cause a life-threatening liquidity crisis that would require a government bailout to prevent outright bank failure.

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BMO Q3 Update

Financial Crisis

Interest Rate Exposure

Banks are experts at  financial obfuscation when reporting their results.  The latest Q3 reports from the Bank of Montreal are a great example of this.

On page 11 they describe their exposure to risk in interest rates in a reasonably positive light: for each negative change in interest rates by 100 basis points they lose $231 M on their loan book, but if interest rates go down the same amount (highly unlikely by the way), they make $204 M.

What they don’t tell you is that due to the structure of their interest rate gap position (which you can see if you dig into BMO’s Q3 supplementary statistics) the actual exposure is $333 M decrease in asset value for the first 100 basis point increase and a whopping $706 M decrease for a 200 basis point increase.

But asset value is only part of the story when it comes to Banks.  The real question is how is the bank making money on those loan “assets”?  After all it doesn’t matter if the asset is more valuable if the bank loses liquidity by carrying it.

So what is really revealing in the supplementary statistics is the fact that the Bank’s interest earnings will go down no matter which way interest rates move!!

A 100 basis point increase causes earnings to drop $27 M while a 100 basis point decrease causes earnings to drop by $51 M!!  Heads you lose and tails you lose.

So How Is BMO Doing?

BMO’s Q3 results are not encouraging.  At best, the bank is treading water.

For example, despite having $413 B in assets, it’s cash position of $10.7 B is basically flat compared to the previous quarter.  Although liquidity improved by about $500 M, 80% of this was due to the fact that BMO issued $400 M in preferred shares during the 3rd quarter.

Thin liquidity is very dangerous for a bank.  A bank may crow about Tier 1 capital ratios, but it is liquidity that determines whether they stay in business or not.

BMO’s loan book is still toxic.   The sum of PCL+GIL (sick and sicker loans) is 3.3 B largely unchanged from Q2 to Q3.  PCL is Provision for Credit Losses (loans the bank admits are dead) and GIL is Gross Impaired Loans (loans that are not being paid back).  And of the loans that BMO has yet to admit are bad, according to the BMO’s own risk weights, $37 B (nearly 10% of the entire loan book) are so risky that they are statistically likely to default within 5 years.

To put this in perspective, BMO’s non-investment grade loans  is 10x higher than the amount (in total dollars) the Royal Bank has in the same risk categories.

Looking at BMO’s Canadian delinquency ratios, Q3 personal loan and mortgage delinquency ratios are unimproved in Q3 over the past 3 quarters, and credit card delinquency ratio has increased quarter over quarter for the past 4 quarters.  BMO’s US delinquency ratios have deteriorated in all categories quarter over quarter for the past 4 quarters.

Meanwhile BMO’s market share is slipping with quarter over quarter declines in Canadian personal loans, mortgages, retail deposits and commercial loans.

Overall Moody’s rates the BMO’s financial strength as B-grade risk with a negative outlook.  For the most part, BMO’s ratings by S&P, Moody’s,  DBRS and Fitch are generally one notch less than the Royal Bank’s ratings.

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