Friday, January 23, 2009

Another reason to worry about Royal Bank

By Andrew Willis at the Globe & Mail's Streetwise:

The more stones are turned over at the big banks, the more unattractive holdings emerge.

Royal Bank of Canada's U.S. credit portfolio is back in the spotlight Friday, as analysts seized on the bank's exposure to what's known as “stable value products.” These innocuous-sounding products spring out of the U.S. retirement savings industry. (And remember how innocuous “credit default swaps” sounded when first mentioned?)

Stable value products are purchased by corporations or financial institutions that run pension plans, and need to structure these portfolios in a conservative, tax-efficient fashion. As BMO Nesbitt Burns analyst Ian de Verteuil explained Friday, corporations and banks often buy “stable value wrappers” on various elements of the investments held in these plans. He said: “The basic idea is that a third party, in this case Royal Bank, will sell a stable value wrapper to protect against unexpected withdrawals from that policy when the value of the fund is below notional value.”

Now, this all sounds tame. But as Mr. de Verteuil noted: “Our focus on this area was highlighted by the release of year-end results for State Street, in which the bank took a $450-million (U.S.) charge against its stable value fund protection.”

If straight-laced State Street is suddenly setting aside provisions for these holdings, what's coming at Royal Bank?

The only Canadian player in this space, Royal Bank has total exposure to stable value products of $24.8-billion. That's a large number, but Mr. de Verteuil quickly pointed out that the amount “certainly far exceeds the potential loss that Royal Bank could incur from these products.”

However, Royal Bank disclosed that the accounting shortfall on one flavour of stable value products in its portfolio - known as bank-owned life insurance, or BOLI - exceeded $2-billion at the end of October.

“It is quite likely that the shortfall... will approach $3-billion at the end of Royal's first quarter,” said Mr. de Verteuil. “This amount is well less than the $24.8 billion notional amount, but it is still a large number. We have no idea about the likelihood or the potential size of a Royal charge in the coming quarters, but we believe the odds are rising.”

Now, let's be clear: Mr. de Verteuil doesn't expect BOLI to be ebola - the exposure is not a major threat to Royal Bank's financial health. It's just another potentially nasty surprise in a U.S. credit market that's been full of landmines for all the banks. Mr. de Verteuil said: “There will certainly be questions raised on why the bank had any involvement in stable value products in the U.S. at all.”

The top-ranked BMO analyst has a "market perform" rating on Royal Bank.

No comments: