On November 25th Bank of Montreal (TSE: BMO) reported their Q4 results and the numbers weren’t all that bad, on the surface anyway. They reported EPS of $1.18, slightly ahead of analyst expectations and ahead of last year’s earnings. Revenue was also ahead of expectations, the tier 1 capital ratio was a solid 9.77% and there was no sign of a big write-down. So, low and behold, everything looks pretty good… could this possibly be the bottom?
Well, not so fast. First of all, BMO’s positive earnings surprise was driven primarily by one-time items that are likely not sustainable. One-time items included: a very low effective income tax rate for the quarter, gains in trading revenue, and a higher than normal net interest margin. In addition, BMO avoided taking a $123 million loss to its bottom line because of a recent accounting rule change – the rule change allowed BMO to reclassify $2.0 billion of assets and make them exempt from the mark to market rule. Regardless, that’s not what’s important here. What is important is what the future holds – that’s what will drive the stock price.
Credit markets haven’t improved one bit and BMO’s exposure to the US will certainly result is further losses in the loan books. Loan loss provisions grew to $465 million this quarter, up 360% year-over-year and well ahead of expectations. That brings the year’s total provisions for bad loans to $1.33 billion vs. $353 million for 2007. After what’s happened this year in the markets, bad loans (particularly US loans) will plague banks for years to come. Further losses will continue to eat away at the bank’s capital and put pressure on the tier 1 ratio (the ratio of a bank’s tier 1 capital (equity, retained earnings and cash) to its risk weighted assets (loans adjusted for credit risk)).
BMO’s tier 1 ratio currently stands at a healthy 9.77%. Regulations stipulate that banks must maintain capital levels such that the tier 1 ratio stays above 8%. If the ratio drops below 8%, the bank must replenish its tier 1 capital by issuing common stock or preferred shares. However, given current market conditions, there’s speculation that this threshold level may be raised. Accordingly, Canadian banks have been aiming to keep these ratios above 9%. With earnings deteriorating and more write-downs always a possibility, the current 9.77% ratio could be at risk.
On to the sacred dividend – the bread and butter for any Canadian bank stock. Is it safe? I’ll wager a guess and say no, it’s not. In Tuesday’s earning’s release, the company announced they would be freezing the dividend at $0.70 per share and will not be increasing it until the market calms down, which could be for quite a while. Understandable, but there go most of the dividend based investors who hope for steady dividend growth that’s typical for a Canadian bank. But that’s not where the story ends.
