Canadian banks have withstood the turmoil whipped up by the financial crisis better than their US and European peers, maintaining strong Tier 1 capital ratios and keeping their heads well above water–without a government bailout.

The recently tabled federal budget does include a provision that would allow the government to buy equity in the banks, although it seems more an effort to provide the appearance of a level international playing field. Canada’s Big Five haven’t yet required government assistance, but their ability to compete with US and European banks is increased if their costs of capital are similarly limited, or at least appear to be.

It’s also noteworthy amid the current uncertainty that none of the major banks has cut a dividend since the Great Depression.

But the current economic situation will challenge all financial institutions. Canadian banks have handled the first wave–the financial crisis–relatively well. The second wave–a serious economic downturn–will hit both capital and profits, but the Canadian banking system is probably better positioned than most others to ride it out.

Nevertheless, the market appears to be telling the financial sector that bigger is better these days, and all the Canadian banks are boosting their Tier 1 Capital with equity sales, partly in anticipation of rising loan losses as the economy slows in 2009.

The concept of Tier 1 capital was established by the Basel Committee on Banking Supervision in its 1988 report on The International Convergence of Capital Measurement and Capital Standards. This report presented the outcome of an effort to consolidate rules about capital adequacy of international banks with a view to strengthening the soundness and stability of the international banking system.

A second objective was that the framework should be fair and have a high degree of consistency in its application to banks in different countries. The Basel Committee wanted to preserve as much as possible a level international playing field.

The Basel Committee concluded that the key element of capital is equity capital and disclosed reserves. This was the only element common to all countries’ banking systems and was wholly visible in public filings.

It further concluded that capital, for supervisory purposes, should be defined in two tiers in a way which required at least 50 percent of a bank’s capital base should be a core element comprised of equity capital and published reserves from post-tax retained capital (Tier 1). Other elements of capital were admitted into Tier 2 up to an amount equal to the core capital. The elements of capital as established by the Basel Committee, are as follows:

Tier 1 Capital

• common stock
• non-cumulative preferred stock
• share premium reserve
• disclosed reserves, including retained earnings
• minority interests
• fund for general banking risks (if stated as a separate item)

Tier 2 Capital

• cumulative preferred stock
• revaluation reserves (made up of either asset revaluation or unrealized gains/losses on securities)
• subordinated debt
• undisclosed or hidden reserves
• hybrid (debt/equity) capital instruments.

Many banks that ran aground in 2008 had capital ratios well above the required minimum set by regulators; had their capital ratios been a few percentage points higher it’s unlikely they could have weathered the evaporating market confidence.

Consider that Washington Mutual had a Tier 1 capital ratio of 8.4 percent on Sept. 30, well above the 6 percent threshold that regulators use to classify a bank as well capitalized. JPMorgan Chase (NYSE: JPM), which purchased WaMu had a similar ratio of 8.9 percent. Wachovia, which agreed to sell to Wells Fargo (NYSE: WFC) in October, had a capital ratio of 7.5 percent as of Sept. 30, compared to Wells Fargo’s 8.6 percent. And National City had an 11 percent capital ratio, and yet had to sell out to PNC Financial Services (NYSE: PNC). By comparison, Bank of America (NYSE: BAC), considered one of the bedrock financial institutions, had a capital ratio at the end of the third quarter of 7.6 percent.

These numbers show that capital ratios aren’t a certainty in measuring health, and imposing a blanket increase won’t instantly stabilize financial institutions. But as their international peers soak up USD500 billion in government money, Canada’s Big Five banks have been able to raise private funds.

Canadian Imperial Bank of Commerce (TSX: CM, NYSE: CM) recently completed a CAD325 million preferred share issue with a yield of 6.5 percent. The CIBC issue was originally set at CAD275 million when it was announced Jan. 26, but was expanded the following day “as a result of strong investor demand.”

Toronto-Dominion Bank (TSX: TD, NYSE: TD) sold CAD375 million in preferred stock yielding 6.25 percent last week, after increasing the issue from CAD275 million.

Bank of Nova Scotia (TSX: BNS, NYSE: BNS) completed a CAD325 million issue of 6.25 percent preferreds on Jan. 21, and on the same day announced an additional issue of CAD250 million, which it increased later in the day to CAD275 million.

Scotiabank, which recently raised CAD1 billion from debentures yielding 6.65 percent, recently deployed CAD270 million to increase its stake in Thailand-based Thanachart Bank to 49 percent from 25 percent.

Royal Bank of Canada (TSX: RY, NYSE: RY), after raising CAD3.2 billion in common equity late in 2008, issued CAD275 million in 6.25 percent preferreds in early January, then later in the month presented another CAD275 million issue, which almost immediately swelled to CAD350 million.

In December, Bank of Montreal (TSX: BMO, NYSE: BMO) sold CAD1 billion of new common shares and CAD450 million of notes yielding 10.2 percent that qualify as Tier 1 capital.

Canada’s banks remain well capitalized, and the Office of the Superintendent of Financial Institutions has no plans to increase current capital requirements; markets have been driving capital levels up, not regulators.

Determining capital adequacy involves assessing many factors beyond Tier 1 ratios. But Canada’s conservative, deposit-based banking model has put it in good position to negotiate the current turmoil.

Their dividends have remained intact and their capital ratios are still comfortably above the regulatory minimum. And the Bank of Canada has estimated American and European banks would need to raise USD1.2 trillion to bring their leverage down to Canadian levels.

A weaker economy could push provisions for credit losses higher than expected, and an extended period of very low earnings or unexpected government intervention could clearly have a negative impact on dividends. But current payout rates combined with a collective 10.1 percent Tier 1 capital ratio suggest lower dividends aren’t on the horizon.

Fourteen Steps to Recovery

Interesting times when the most concise description of the present state of the ongoing rescue of the US financial system comes from a guy who made his bones crunching baseball stats and found fame and glory during an historic political season.

Here’s the heart of Nate Silver’s order:

5. However, with Geithner having backed off some of the plans that would have entailed greater political risks while at the same time the Republican tolerance for “nationalization” is increasing, the politics are looking substantially less complicated than they did a week ago.
6. Not all banks are in the same boat. Most everyone thinks that Citibank is toast. Most everyone thinks that Wells-Fargo is solvent. (Although even there, concerns exist about its real estate portfolio in California). There is a lot of room between these two goalposts.
7. The Fed probably has some idea about which banks are in which boats, but it probably also needs to have better than some idea before it can plan effectively. Hence, the “stress test”.
8. What is commonly being referred to as “nationalization” might be better described as bankruptcy, reorganization, or receivership.

As to No. 5, former Fed Chairman Alan Greenspan provided even more cover for the administration in the Financial Times today. “It may be necessary to temporarily nationalise some banks in order to facilitate a swift and orderly restructuring,” said Maestro. “I understand that once in a hundred years this is what you do.”

Moral Hazard v. Systemic Risk

For some it will be reliving a nightmare; for others, Frontline’s “Inside the Meltdown” will connect the dramatic dots–Bear Stearns…Fannie and Freddie…Lehman Brothers…AIG–that together trace the financial aspect (sort of like a homicide-scene chalk outline) of our trouble.

Does the credit crunch and financial crisis all boil down to “this one decision” former Treasury Secretary Henry Paulson made in mid-September 2008?

Watch it the old fashioned way on your local PBS station, or the way the kids are doing it here. (That oxygen was “literally sucked from the room” and Chris Dodd and his colleagues could survive is also rather amazing; must have been a lot of gasbags in that meeting.)

Speaking Engagements

There are few better places to combine work and play than Sin City: Join Canadian Edge, Editor Roger Conrad and The Energy Strategist Editor Elliott Gue for The Money Show Las Vegas, May 11-14, 2009, at The Mandalay Bay Resort & Casino.

With Elliott’s and Roger’s sage advice, this is one trip to Vegas that won’t make a wreck out of you.
To attend as Roger’s guest, click here or call 800-970-4355 and refer to promotion code 012649.

And make plans to join Roger, Elliott, Gregg Early and Benjamin Shepherd at the 18th Atlanta Investment Conference. Sponsored by Friends for Autism, the conference is held in a mountain setting north of Atlanta from Thursday, April 23, to Saturday, April 25.

Roger, a steady hand through many market events such as the one we’re dealing with now, will talk about Canadian income and royalty trusts as well as his new service focused on exploiting the greatest spending boom in history, New World 3.0.

Elliott will detail the new direction for Personal Finance and provide insight into his approach to stock selection and portfolio management. What’s required now amid these difficult times are clarity and focus, qualities Elliott has demonstrated in these pages and through The Energy Strategist for years.

Gregg, a constant at PF for nearly two decades, will be there to address recent developments with the publication. He’ll also discuss the Smart Grid, an endeavor he’s exploring as part of his role with New World 3.0.

Ben, editor of Louis Rukeyser’s Mutual Funds and Louis Rukeyser’s Wall Street, the in-house mutual fund expert, will discuss efficient, cost effective ways to simplify the investing process.

Be sure to bring your questions. These guys love to talk markets and everything that impacts them.

Attendance is limited to 175 of the most enlightened, savvy individual investors. Go to http://www.aicatchota.com/ for more information. Meals are included for the Canadian Edge discounted price of $459 for a single and $599 for couples. Call 770-952-7861 or e-mail altinvestconf@mindspring.com to register.

The Roundup

Conservative Holdings

RioCan REIT (TSX: REI-U, OTC: RIOCF) took a CAD24.3 million writedown during the fourth quarter, the hole that explains its 53 percent decline in net income. Fund from operations (FFO), the key measure for REITs, registered a more modest decline, to CAD87.3 million (CAD0.39 per unit) from CAD87.5 million (CAD0.42 per unit).

 For the year, RioCan reported net income of CAD146.9 million (CAD0.67 per unit), up from CAD32.4 million (CAD0.16 per unit) in 2007. FFO for 2008 was CAD322.6 million (CAD1.48 per unit), basically flat with the CAD314.6 million (CAD1.51 per unit) in 2007. The REIT reported an occupancy rate of 97 percent as at Dec. 31, 2008.

RioCan also announced its February distribution would be unchanged from the previous month. Steady, stable RioCan REIT is a buy up to USD18.

Yellow Pages Income Fund (TSX: YLO-U, OTC: YLWPF) continues to rebut analyst predictions of its imminent demise: Canada’s dominant directory business reported a 7.2 percent rise in distributable cash flow (DCF) for 2008 to CAD750.9 million (CAD1.43 per unit). Fourth quarter DCF per unit was up 9.1 percent to CAD0.36 on CAD425.6 million in revenue.

Yellow’s transition from print to the Internet seems to be going well, as online revenue grew by 43.5 percent; total revenue was up to CAD1.7 billion from CAD1.62 billion a year ago. Unfairly lopped with US directory companies Idearc (OTC: IDAR) and RH Donnelly (OTC: RHDC), Yellow Pages Income Fund remains a buy up to USD10 for those without a position.

Conservative Holdings’ Reporting Dates

·          AltaGas Income Trust (TSX: ALA-U, OTC: ATGFF) Feb. 27, 2009 (Estimated)

·          Artis REIT (TSX: AX-U, OTC: ARESF) Mar. 18, 2009 (Confirmed)

·          Atlantic Power Corp (TSX: ATP-U, OTC: ATPWF) March 30, 2009 (Confirmed)

·          Bird Construction Income Fund (TSX: BDT-U, OTC: BIRDF) Feb. 13, 2009 (Estimated)

·          Canadian Apartment REIT (TSX: CAR-U, OTC: CDPYF) Feb. 26, 2009 (Confirmed)

·          CML Healthcare Income Fund (TSX: CLC-U, OTC: CMHIF) Feb. 13, 2009 (Estimated)

·          Consumers’ Waterheater (TSX: CWI-U, OTC: CSUWF) Feb. 19, 2009 (Confirmed)

·          Innergex Power Income Fund (TSX: IEF-U, OTC: INRGF) Mar. 11, 2009 (Estimated)

·          Keyera Facilities (TSX: KEY-U, OTC: KEYUF) Feb. 24, 2009 (Confirmed)

·          Macquarie Power & Infrastructure (TSX: MPT-U, OTC: MCQPF) Feb. 19, 2009 (Confirmed)

·          Northern Property REIT (TSX: NPR-U, OTC: NPRUF) Mar. 2, 2009 (Confirmed)

·          Pembina Pipeline Income Fund (TSX: PIF-U, OTC: PMBIF) Mar. 5, 2009 (Confirmed)

·          TransForce (TSX: TFI, OTC: TFIFF) Mar. 12, 2009 (Confirmed)

Aggressive Holdings

Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV), as was widely anticipated, cut its distribution in half, a move, like so many others, to strengthen the balance sheet. The fund continues to pay down debt, and its Montney assets are promising. Balance-sheet strength now positions it to exploit opportunities in the future. Advantage Energy Income Fund is a buy up to USD10.

ARC Energy Trust (TSX: AET-U, OTC: AETUF) reported a 34 percent increase in cash flow from operating activities, a 4 percent increase in production volumes and funded 91 percent of its 2008 capital program with cash flow and its (Canadians-only) dividend reinvestment program. It, too, however, has responded to the economic downturn with distribution cuts.

ARC cut its full-year payout ratio by 15 percent during 2008, from 71 to 60. And it continues to manage costs well. That type of discipline is why the trust is worthy of patience is it positions itself to exploit development opportunities and sustain its distribution well into the future. ARC Energy Trust is a buy up to USD25.

Provident Energy Trust (TSX: PVE-U, NYSE: PVX) cut its distribution by 33 percent to CAD0.06 per unit from CAD0.09 per unit effective with the February payment due in March. The trust also announced a CAD50 million reduction in its 2009 capital program, from CAD165 million to CAD115 million. Provident will defer development of certain projects until market conditions improve.

The distribution cut, combined with reductions to Provident’s capital spending program, are designed to make it sustainable as a dividend-paying investment. Provident Energy Trust remains a buy up to USD6.

Trinidad Drilling (TSX: TDG, OTC: TDGCF) renewed its revolving credit facility with a reduced amount available of CAD225 million (from CAD250 million).

Trinidad had drawn CAD65 million of its renewed CAD225 million facility as of Dec. 31, 2008. The next renewal scheduled for April 2010. Trinidad expects its effective interest rate to 2009 to remain in the 2008 neighborhood of approximately 7.5 percent.

Trinidad Drilling is a buy up to USD5.

Aggressive Holdings’ Reporting Dates

·          Advantage Energy Income Fund (TSX: AVN-U, NYSE: AAV) Mar. 6, 2009 (Estimated)

·          Ag Growth Income Fund (TSX: AFN-U, OTC: AGGRF) Mar. 13, 2009 (Confirmed)

·          Boralex Power Income Fund (TSX: BPT-U, OTC: BLXJF) Feb. 26, 2009 (Confirmed)

·          Daylight Resources Trust (TSX: DAY-U, OTC: DAYYF) Mar. 5, 2009 (Estimated)

·          Enerplus Resources (TSX: ERF-U, NYSE: ERF) Feb. 27, 2009 (Estimated)

·          GMP Capital Trust (TSX: GMP-U, OTC: GMCPF) Feb. 27, 2009 (Confirmed)

·          Newalta Income Fund (TSX: NAL-U, OTC: NALUF) Mar. 4, 2009 (Confirmed)

·          Paramount Energy Trust (TSX: PMT-U, OTC: PMGYF) Mar. 11, 2009 (Estimated)

·          Penn West Energy Trust (TSX: PWT-U, NYSE: PWE) Feb. 18, 2009 (Confirmed)

·          Peyto Energy Trust (TSX: PEY-U, OTC: PEYUF) Mar. 5, 2009 (Estimated)

·          Provident Energy Trust (TSX: PVE-U, NYSE: PVX) Feb. 13, 2009 (Estimated)

·          Trinidad Drilling (TSX: TDG, OTC: TDGCF) Feb. 26, 2009 (Confirmed)

·          Vermilion Energy Trust (TSX: VET-U, OTC: VETMF) Mar. 2, 2009 (Confirmed)