Moody’s has announced it has:
changed the rating outlook on the Bank of Montreal (BMO) and its subsidiaries to negative from stable. BMO is rated B for bank financial strength and Aa1 for deposits. The negative outlook applies to BMO’s Harris subsidiaries including Harris N.A. (bank financial strength rating of B-, long-term deposits of Aa3). Note that there already exists a negative outlook on Harris N.A.’s bank financial strength rating.
Senior vice president, Peter Routledge, stated that “the outlook change is the product of several factors. First, BMO’s business mix has a material weighting towards capital markets activities in general, and structured credit activities specifically, which is likely to result in continued earnings volatility, in Moody’s view. Second, the bank has entered a prolonged period of higher loan losses which will pressure earnings for several quarters. Finally, these two factors will dampen BMO’s risk-adjusted profitability, which is already low relative to its current rating level.” Partially offsetting these concerns is the bank’s strong level of capitalization and an improving risk management discipline.
BMO’s structured credit exposures have produced approximately C$2 billion in pre-tax losses since the turmoil in the credit markets began. Although the bank has bled much of the potential losses contained in these exposures into its earnings, additional losses could accelerate rapidly in a severe economic downturn. Moody’s primary focus is on two BMO exposures: (1) credit protection vehicle — known as Apex Trust; and (2) the structured investment vehicles, Links Finance Corporation / Links Finance LLC and Parkland Finance Corporation / Parkland (USA) LLC.
According to Mr. Routledge, “the challenge BMO faces is managing these two points of earnings pressure from a low level of risk-adjusted profitability, relative to its current ratings level.” BMO’s performance since 2007 is instructive. During that time, the bank’s capital markets charges have consumed approximately 25% of BMO’s pre-provision, pre-tax (core) earnings, and caused its already weak ratio of core earnings to risk-weighted assets to drop by 50 basis points on average (i.e., from approximately 2.2% to 1.7%). According to Mr. Routledge, “while Moody’s believes that BMO’s core earnings and capital are more than adequate to absorb prospective credit and capital markets losses, a deterioration in risk-adjusted profitability — a long-stated major ratings driver for the bank — could ultimately lead to a downgrade in BMO’s bank financial strength rating.”
As noted above, two positive credit trends offset partially the aforementioned negative rating drivers. First, the bank’s capitalization is very strong, with a Tier 1 ratio of 10.7% and a ratio of tangible common equity (adjusted for Moody’s hybrid credit) as a percent of risk-weighted assets at 9%.
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