U.S. Problems Weigh on our Banks

Bank stocks have struggled since late last year, due to fears that the problems with subprime mortgages in the United States will spread to Canada. Most of Canada’s big five banks have some exposure to these troubled loans, and writedowns have hurt their recent earnings. Despite the losses, Canada’s major banks have enough capital to continue making new loans.

We feel every Canadian investor should own at least two of these five banks. Bank of Nova Scotia is still our top choice for new buying.

Royal Bank of Canada $48 (Toronto symbol RY; Conservative Growth Portfolio, Finance sector; Shares outstanding: 1.3 billion; Market cap: $62.4 billion; SI Rating: Above average) is Canada’s largest bank, with total assets of $627.5 billion.

Royal is taking advantage of the slowing U.S. economy to expand its operations there. It recently agreed to pay an undisclosed sum for Houston-based Richardson Barr & Co., which advises oil and natural gas companies on acquisitions and divestitures. This purchase should help expand Royal’s earnings, as rising energy prices have spurred strong interest in privately held landholdings by exploration companies.

The bank has also completed its purchase of Washington D.C. -based investment firm Ferris, Baker Watts, Inc. for an undisclosed sum. The firm has 42 offices in eight states, and will strengthen Royal wealth management operations in the U.S.

In its second fiscal quarter ended April 30, 2008, Royal wrote down $430 million worth of U.S. subprime loans. It has about $2 billion in remaining subprime exposure. However, that’s just 3% of its market cap.

Strong growth at its Canadian retail banking operations should push up Royal’s fiscal 2008 earnings to $4.45 a share. The stock trades at 10.8 times that figure. The $2.00 dividend yields 4.2%.

Royal Bank is a buy.

Toronto-Dominion Bank $64 (Toronto symbol TD; Conservative Growth Portfolio, Finance sector; Shares outstanding: 802.9 million; Market cap: $51.4 billion; SI Rating: Above average) is Canada’s second-largest bank, with assets of $503.6 billion.

TD recently completed its acquisition of U.S.- based Commerce Bancorp for $8.5 billion in cash and stock. To put the purchase price in context, TD earned $973 million or $1.32 a share in its second fiscal quarter ended April 30, 2008. The acquisition doubled TD’s retail banking operations in the United States to around 1,100 branches. TD estimates that its larger U.S. operations will contribute $750 million to its earnings in fiscal 2008, and $1.2 billion in 2009.

The bank originally planned to re-brand all of its U.S. operations as “TD Commerce Bank”. However,a legal challenge from a smaller bank with a similar name prompted TD to make this change. It’s unlikely that dropping the Commerce name will force TD to writedown any of the $6.1 billion in goodwill it recorded on the purchase.

Concerns over rising mortgage defaults in the U.S. have weighed on TD’s stock price in the past few months. However, Commerce Bancorp’s conservative lending policies have limited its exposure to subprime mortgages.

TD now trades at 10.9 times its forecast earnings of $5.86 a share. The $2.36 dividend yields 3.7%.

TD Bank is a buy.

Bank of Nova Scotia $51 (Toronto symbol BNS; Conservative Growth Portfolio, Finance sector; Shares outstanding: 987.0 million; Market cap: $50.3 billion; SI Rating: Above average) is the third-largest bank Canadian bank, with $452.6 billion in assets.

The bank has few holdings in the U.S. It prefers to focus on developing regions where it can quickly expand its market share. International operations now supply 30% of its earnings.

For example, it recently increased its stake in Scotiabank Peru, that country’s third-largest bank, from 78% to 98%. The $230 million price is equal to 20% of the $980 million or $0.97 a share that Bank of Nova Scotia earned in the three months ended April 30, 2008.

Bank of Nova Scotia is also expanding its Canadian operations. It recently agreed to pay $442 million U.S. for the Canadian operations of E*Trade, a leading online discount broker.

The purchase will increase Bank of Nova Scotia’s share of Canada’s fast-growing online investing market, from 6% to 10%, based on the number of accounts.

The bank should earn $4.04 a share in fiscal 2008, which implies a p/e of 12.6. The $1.96 dividend yields 3.8%.

Bank of Nova Scotia is a buy.

Bank of Montreal $49 (Toronto symbol BMO; Conservative Growth Portfolio, Finance sector; Shares outstanding: 503.5 million; Market cap: $24.7 billion; SI Rating: Above average) is Canada’s fourth-largest bank, with assets of $375.2 billion.

The bank recently restructured two of its investment vehicles that hold asset-backed securities. The restructuring averted potential writedowns and costs of as much as $1.5 billion. To put that in context, Bank of Montreal earned $642 million or $1.25 a share in its second fiscal quarter ended April 30, 2008. The latest earnings included a $57 million after-tax gain from the restructuring of these two investment vehicles. The restructuring also reduces the likelihood that Bank of Montreal will have to issue new shares.

Bank of Montreal now aims to further cut its long-term risk by building up its retail operations, and shrinking its corporate and stock market businesses. It may also take advantage of the slowdown in the United States to expand its American operations. Bank of Montreal’s main U.S.asset is 100%-owned Harris Bank, which provides banking services in Chicago, Florida and Arizona.

The bank also continues to expand its operations in China. It recently became the first Canadian bank to offer fixed-term deposit products in that country. These products should increase Bank of Montreal’s appeal among clients who plan to immigrate to Canada, as well as Chinese citizens who wish to study at Canadian universities.

The bank should earn $4.95 a share in fiscal 2008, and the stock trades at 9.9 times that estimate. The $2.80 dividend yields 5.7%.

Bank of Montreal is a buy.

Canadian Imperial Bank of Commerce $63 (Toronto symbol CM; Conservative Growth Portfolio, Finance sector; Shares outstanding: 380.8 million; Market cap: $24.0 billion; SI Rating: Above average) is the fifth-largest bank in Canada with assets of $343.1 billion.

The problems with U.S. subprime mortgages have hurt CIBC more than the other big fiveCanadian banks. So far, CIBC has written off $6 billion worth of loans and illiquid securities.

CIBC could face a further $1 billion in writedowns due to concerns over the financial health of several major bond insurers. These insurers provide CIBC and other banks with guarantees on securities they hold, such as bonds backed by U.S. subprime mortgages. In the three months ended April 30, 2008, CIBC lost $1.1 billion or $3.00 a share, mainly due to $1.7 billion (after-tax) in writedowns.

Despite the possibility of more writedowns, CIBC still has enough capital to conduct its operations and satisfy regulatory requirements.

CIBC’s recent losses have now prompted a class-action lawsuit, which accuses its officers and directors of not disclosing the full extent of the bank’s exposure to troubled securities. CIBC has denied the allegations.

The stock now trades at just 8.8 times its forecast fiscal 2008 earnings of $7.20 a share. The $3.48 dividend yields 5.5%.

CIBC is a buy.