Agcapita UpdateOctober 22, 2012

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THE GREAT CANADIAN BANK BAIL-OUT

TheCanadianbankingsystemissound,wedidn’thavetobail-outourbanks-right?Certainlythat’swhatwearecontinuallytold:

“...we have not had to put any taxpayers’ money into our financial system in Canada, nor do I anticipate that we’ll be obliged to do so.”JimFlaherty,MinisterofFinance

“Without wanting to appear arrogant or vain, which would be quite un-Canadian...while our system is not perfect, it has worked during this difficult time, I don’t want the government to be in the banking business in Canada.”JimFlaherty,MinisterofFinance

Thenagainwewerealsoassured:

“We will not run a deficit.”JimFlaherty,MinisterofFinance(Oct.2008).

Sopoliticalremonstrancesnotwithstanding,isanyofthistrue?Doubtsdidbegintosurfaceearlyin2012butinterestintheissuequicklydiedout.Thestabilityofthebankingsectorisacriticalquestion.Itisworthmorethanthecursorycoverageithasreceivedtodatesolet’sspendabitoftimeonittoday.

Didwebail-outtheCanadianbankingsystemfollowingthe2008financialcrisisandmoreimportantlymightwehavetobailitoutinthefuture?TosetthestagehereissomequickbackgroundontheCanadianbanksthenwecanmoveontothe“no bail-out here”premise.

Agcapita Update

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Agcapita Update (continued)

Canadian Banking Sector 101 - Concentrated, Large & Levered: Networkswithhighlyconcentratednodesarenotrobust-thepresenceofsinglepointsoffailurecanhavehugeconsequences.TheCanadianbankingsectorresemblessuchanetworkinthatitisdominatedbyjustfivebanks.Thesebanksarecolloquiallyreferredtoasthe“BigFive”.GiventheirsizeandmarketpresenceIamsurethenameswillbefamiliartoyou:

(APPROX C$ BILLIONS DEC 2011) ASSETS

BankofMontreal $500

BankofNovaScotia $575

CIBC $360

RoyalBankofCanada $750

Toronto-DominionBank $690

NotonlydoesthissmallgroupdominatetheCanadianbankingsector,thesectoritselfisverylargeinrelationtodomesticGDP.Thelargerthesizeofthebankingsector,thegreatertherisktothedomesticeconomyormoreaccuratelythewalletsofthetaxpayersintheeventthatabailoutisrequired.Ofcourse,beyondacertainsizebanksaresimplytoolargetobebailedoutwithdomesticcapitalortoputitinmorecolourfulterms-domesticbanksrunoutofdomestictaxpayersubsidiesandthenusuallythegameisup-seeGreece,ItalyandSpaininthelistbelow.

BANK ASSETS AS A PERCENTAGE OF GDP

Ireland 872

UK 389

France 338

Spain 251

Australia 205

Canada 157

Italy 151

Greece 141

U.S. 82

Itisnosecretthatbanksuseleveragetogeneratereturns.Additionalleveragecreatesadditionalriskbutwiththehopeofsufficientlyoffsettingprofit.Thetrickistouseenoughleveragetogenerateanattractiverateofreturn,butonewhichdoesnotleavethebanksusceptibletobeingrenderedinsolventbyahighimpactevent(e.g.housingmarketcollapse).Thatisthetheory.Sadly,giventheexplicitgovernmentsupportfor“too-big-to-fail”financialinstitutionswhichremovestheconsequencesofsuchinsolvencies,inpracticelargebankswilltendtocarryexcessiveleverageandmis-pricedriskatalltimes.

AnacceptedmeasureforbankleverageistheTangibleCommonEquityratio-“the ratio used to determine how much losses a bank can take before shareholder equity is wiped out. The Tangible

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Agcapita Update (continued)

Common Equity (TCE) ratio is calculated by taking the value of the company’s total equity and subtracting intangible assets, goodwill and preferred stock equity and then dividing by the value of the company’s tangible assets. Tangible assets is the company’s total assets less goodwill and intangibles.”

AroughestimateisthattheBigFiveTCEratiohoversaround3-4%.ItgoesalmostwithoutsayingthatCanadianbankingexecutivesrejecttheTCEtestasameasureoftheirleverageandriskforpreciselythereasonthatTCEtendstoshowthattheyareover-leveragedandrisky.

Inordertoensureareliablesupplyofbail-outfundsitiscriticalthatbanksareabletoarguewithastraightfacethattheeventthatbankruptsthemwasentirelyunforeseeable-atleasttothem.SodespitewhatCanadianbankssayIwouldarguetheCanadianbankingsystemhasalltherawmaterialthathasmadeforcriseselsewhere-concentration,largesizeinrelationtodomesticGDP,highleverageandmis-pricedresidentialrealestaterisk.

No Bail-out in 2008-2010? TheCCPA’sstudy,”The Big Banks’ Big Secret: Estimating Government Support for Canadian Banks During the Financial Crisis”,convincinglyrefutesthebeliefthatCanadianbanksdidnotneedorreceiveabailoutduringthecrisis.Directlyfromthereport: “Canada’s banks received $114 billion in cash and loan support between September 2008 and August 2010... They were double-dipping in not only two but three separate support pro grams, one of them American....At its peak in March 2009, support for Canadian banks reached $114 bil lion. To put that into perspective, that would have made up 7% of the Can adian economy in 2009 and was worth $3,400 for every man, woman and child in Canada.”

Perhapstheydidnotneedthemoneyandjusttookitbecauseitwasoffered?Thatdoesnotappeartobethecase.TheCCPAstudyestimatesthatthreeofCanada’sbanks-CIBC,BMO,andScotiabank-receivedbailoutsthatexceededtheirmarketvalueatthetimewhichdoestendtosupporttheconclusionthattheywereunderextremefinancialstress.

ESTIMATED EXTRAORDINARY SUPPORT SUMMARY

Bank Peak Support Date Peak Support Value ($bil) Peak Support to Co. Value (Date of Peak)

CIBC2 March09 $21 148%(March2009)

BMO3 January09 $17 118%(Feb2009)

Scotiabank4 January09 $25 100%(Feb2009)

TDBank5 September09 $26 69%(Feb2009)

RoyalBank6 March09 $25 63%(Feb2009)

Source:CCPA

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Agcapita Update (continued)

Mortgagesweretheusualsuspectatthecentreofthe2008Canadianbankingbail-outandsomortgagesprovidedtheconduitforgovernmentassistance.Thedefaultriskonapproximately50%ofCanadianmortgagesisinpracticeback-stoppedbytheCanadiangovernmentviatheCanadianMortgageandHousingCorporation.BanksdopaytoinsuretheirmortgageswiththeCMHCbutatwhatcouldbe

arguedarefarbelowmarketratesgivenglobalrealestatevolatilityandtheescalationofpricingrisksintheCanadianmarket.

OfcoursewhentheBigFivegotintotroublethetaxpayerCHMC,theBankofCanadaandsurprisinglyeventheUSFederalReservesteppedintobreach:

Source:CCPA

120

100

80

60

40

20

0Aug

2008Oct

2008Dec

2008Feb

2009Apr

2009Jun

2009Aug

2009Oct

2009Dec

2009Feb

2010Apr

2010Jun

2010

TOTAL SUPPORT TO CANADIAN BANKS

$B

illion

s

BankofCanadaU.S.FederalReserveCMHC

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Agcapita Update (continued)

Clearly,nomatterhowmuchtheBigFivewouldlikeustobelieveotherwise,theyexperiencedasevereliquiditycrisisin2008-2010hencetheneedtosellperformingbutilliquidCMHCguaranteedmortgages.TofillthisliquiditygaptheyreceivedemergencyfundingontheorderofsizeonapercapitabasisofthatreceivedbytheUSbanks.Itisworthelaboratingonthisasitpointsthewaytosomeseriousconcernsinthefuture.Canadianbanksneededabailoutthatamountedtoapproximately7%ofGDPwhenthelargepartoftheirassetbase-Canadianmortgages-wasnotinanyapparentdistress.

WhatwouldhappentoCanadianbanksiftheCanadianresidentialrealestatemarketweretoexperienceaUSstylecorrectionandinsteadofaliquiditycrisistheBigFiveactuallyhadasolvencycrisis?ForthisthoughtexperimentwehavetoassumeasharpfallinCanadianresidentialreal-estateprices-basedoncurrentpricesversuslong-termhistoricalaverages,rentsandincomeallbeingathighsthatdoesnotseementirelyimplausible.

5.0

4.5

4.0

3.5

3.0

2.5

2.019901995200020052010

HOUSE PRICES VERSUS INCOME

160

140

120

100

80

60

1995200020052010

HOUSE PRICES VERSUS HISTORICAL AVERAGES

VancouverCanadaUSA(Case-Shiller)

30

25

20

15

10

0.5

0.0

-0.5

-1.0

-1.5

-2.08083868992959801040710

HOUSE PRICES VERSUS RENTAL COSTS

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Agcapita Update (continued)

AccordingtoresearchbyDemograhia:“Historically,theMedianMultiple has been remarkably similar in Australia, Canada, Ireland, New Zealand, the United Kingdom and the United States, with median house prices having generally been from 2.0 to 3.0 times median household incomes, with 3.0 being the outer bound of affordability. This affordability relationship continues in many housing markets of the United States and Canada. However, the Median Multiple has escalated sharply in the past decade in Australia, Ireland, New Zealand, and the United Kingdom and in some markets of Canada and the United States. Housing in Canada is moderately unaffordable with a Median Multiple of 4.6 in major metropolitan markets.”Emphasismine.

Insummary,hereistheveryapproximatestateoftheCanadianbankingsectoranditscoreholding,Canadianresidentialrealestate(“RE”)mortgages:

– HighlyconcentratedwiththeBigFivedominatingthesector

– TotalassetsheldbytheBigFivearemuchlargerthanthesizeoftheCanadianeconomy

– BigFiveareusinghighleveragebasedonaconservativemeasuresuchastheTangibleCommonEquityratio

– ResidentialREpriceshaveanaverageMedianMultipleof4.6inmajormarketsversusthehistoricaverageof2.0to3.0

– C$1.3trillioninresidentialREmortgages,50%heldbytheCMHC,50%byCanadianbanks

– ResidentialREmortgagesrepresentapproximately40%ofbankassets

I’llleavethefinalconclusiontoyouaboutwhetherCanadianbanksareasrobustastheyaremadeouttobe,butIbelievethatgiventhestructureoftheCanadianbankingsectorandthelevelofresidentialREpricesthereisahigherchanceofacrisisandafuturebail-outthaniscommonlyperceived.

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