On December 15, the Bank of Montreal successfully issued a round of new common and preferred shares to raise $1 Billion in shareholder equity. This pushed the BMO’s Tier 1 ratio to 10.4%.
However, to sell this equity the BMO had to price the common shares at a 9.5% yield! Danger Signal #1 is a yield that is significantly above the rate that investment grade securities are priced. For example, Enbridge is priced to yield 3.8%, Transcanada Pipelines at 4.4%, Manulife at 5.5%.
Danger Signal #2 is that other peer banks have yields that are priced considerably lower. For example, the Royal Bank is priced to yield 5.8%, TD is at 6%, Scotiabank at 6.5%, CIBC at 7.3%. They average 6.4% , or 1/3 lower than the BMO.
Danger Signal #3 is that the total BMO market capitalization ($14.9 B) is now less than shareholder equity ($17.9 B). In other words, the BMO is worth less than the amount that shareholders invested in it and regardless of the high Tier 1 ratio, the Bank is worth considerably less than its Tier 1 equity.
When this happened to Wachovia in July 2008, the bank failed in Sept. When Wachovia failed, its total shareholder equity was $73 B – almost 5x that of BMO. Wachovia failed quickly – within 90 days. On Oct 28, the BMO’s market capitalization was $33 B. Today the BMO is worth half that amount.
According to the BMO’s 2008 Financial Report, the BMO is carrying about $8.7 B in bad assets – fully half of its market capitalization:
- Bad loans total $3.7 B. Of significant concern is that $2 B of this amount is so-called “formation of new impaired loans” – i.e. was suddenly added in 2008 alone. Half of these new impaired loans are attributable to losses in the manufacturing sector and in US real estate.
- Collateralized debt and loan obligations total $4.5 B. Most of this is hedged with other banks which is great in theory as long as there is no counter-party risk. However, in October inter-bank lending actually dried up due to fear of counter-party risk!
- Subprime mortgages and asset backed securities total another $0.5 B.
The BMO also has $99 B in off-balance sheet credit loaned to its clients. If only 10% of these default, then the total bad loans of the bank will double. Remember Enron?
The final straw that broke Wachovia’s back was when bad debts equalled more than the paid in equity of the bank. When that happens, the bank is insolvent. The BMO is halfway there! If its market capitalization falls by another half in another month, or if 10% of its off-balance-sheet lending defaults, or if some combination of these two events occur, the First Canadian Bank will be history.
A quick health test of the other Candian banks shows that they are in much better shape than the BMO:
- Royal Bank has a
- market cap of $45.5 B which is almost 2x shareholder equity at $24.4 B.
- yield of 5.5% which is below the peer group average for Canadian banks
- Scotiabank has a
- market cap of $29 B which is 1.5x shareholder equity at $18.8 B
- yield of 6.5% which is roughly equal to the peer group average
- CIBC has a
- market cap of $18.5 B which is 1.3x shareholder equity at 13.8 B
- yield of 7.3% which is above the peer group average (suggesting risk)
- TD has a
- market cap of $33.4 B which is slightly more than shareholder equity at $31.6 B
- yield of 6% which is below the peer group average.