Inter-office Finance Department briefing memo

Memorandum

To: Assistant Deputy Minister (Policy), Dept. of Finance

From: Deputy Minister, Dept. of Finance

Re: Briefing book for Minister
______________________________________________

It appears that Minister Flaherty will handily win his riding, and that the Conservatives will be returned to office. What we can’t be sure of, however, is who our Minister will be. PM may want to put Min. Flaherty in Industry or DFA portfolio, so let’s update the current transition briefing book with the following cover memo:

Welcome to the new role, Minister:

The purpose of this memo is to focus you on the key challenge facing the Minister of Finance in the coming weeks; the state of our banking system. (You might have thought the domestic economy was your key priority but, privately, there is little we can do to stem the tide if the U.S. is already in recession.)

As you will recall, the large five Canadian banks have written off approximately $10 billion of shareholder capital over the past 12 months as a result of the global challenges in the subprime, CDS and structured credit markets. Considering that 15 of the world’s largest financial institutions have destroyed almost US$600 billion of capital, it must be said that the Canadian system has fared very well.

That is not to say that the Canadian voter hasn’t felt the pain of the stock market crash of last week, nor that parts of the domestic economy are not hurting, as they definitely are. A U.S.-led recession is certainly possible, if not likely, and the complaints you heard on the campaign trail had more to do with the 40-ish% drop in global stock markets this year than anything else.

The decision last week to provide $25 billion of relief to Canadian banks may have been seen to be “the government doing something”, and they definitely were. By applying a CMHC “wrapper” to these low risk mortgage securities, Canadian banks can now use them as collateral should they choose to tap the Bank of Canada for overnight funding. Historically, Canadian banks, like all banks, fund each other on a day by day basis. Our Canadian banks have built up hundreds of relationships around the world for this sole purpose. Starting in the summer of 2007 (see prior memo “‘Panic’ sets in to the debt markets
” July 29-07), this became a more difficult method to fund the daily activities of banking.

In recent months, fewer banks have had the comfort or capital to lend much longer than on an “overnight” basis. This is why overnight LIBOR is about 200 bps lower than 3 month LIBOR. By giving the Canadian banks “relief” via this $25 billion of CMHC backing, the media took this to mean that Canadian banks would now be able “to turn the lending taps on again” to kick-start the domestic economy.

The reality is different. The nature of the $25 billion of mortgages is such that the Canadian banks would have had to apply a capital allocation of approximately 20% against these loans. As such, banks had only $5 billion of capital applied against this pool; the types of new loan opportunities that might be available to a commerical lender today would be expected to have perhaps a 30% risk-weighting given the nature of the economy. If this “freed-up” capital were to be applied to new loans, one could see banks lending an additional $2.5 billion into the marketplace. With more than $200 billion of loans outstanding to existing corporate loan clients, and no expectation that they are inclined to add to that portfolio, we do not anticipate that the Canadian banks will add to their loan portfolios this year, at least on a net basis. If they were, this program would only allow them to increase their loan books by 1% in aggregate…bupkis in the context of our economy.

The change to loan loss provisions could swamp the amount of incremental lending capital that was hoped to flood the streets by the arm chair quarterbacks.

By allowing the banks to put these assets up as collateral, the goal was to give them incremental liquidity to replace much of the capital that is no longer being offered by other banks. Although the $25 billion CMHC announcement appeared to be a step by the government to alleviate the credit / stock /economic crisis all in one fell swoop, all that really happened was that the Bank of Canada made it easier for the Canadian banking fraternity to finance their current lines of business.

As for the U.S. Treasury’s US$250 billion bank preferred share acquisition announcement, we recognize that many Canadian observers may claim that “the playing field is not level”. We see no evidence at the present time that this will be the case. With a 5% pref coupon in year one, escalating at a rate of 1% for each subsequent year until reaching 9% rate in year five, U.S. banks will now have access to capital at rates that are well above what many Canadian banks are paying for their own recent new pref share issues. And that is before the dilutive impact of the 15% warrant coveraege

– TD Bank issued $250 million of prefs paying 5% on September 10th;

– ScotiaBank issued $300 million of prefs paying 5% for the first five years on September 9th; and

– RBC issued $350 million of prefs paying 5% for the first five years on September 8th.

In light of the fact that Canadian banks have written off modest amounts of capital of late, we do not anticipate that the government will be asked to emulate the U.S. Treasury’s program. But that doesn’t mean that you won’t be asked to consider same by the pundits. It should also be noted that the U.S. banks that utilize these new pref share facilities will not be able to deduct for tax purposes executive salaries that exceed $500,000/annum. Each Canadian bank currently pays several executives in excess of that figure.

We have quietly advised the Canadian banks that this recent $25 billion announcement was not meant to be taken as an indication that the federal government was interested in “bailing out” either bank investors or senior executives who suffer from decisions of the past. It was clear, however, that the public was unfairly blaming the sitting Prime Minister for losses in the stock market generated by nervousness in the global capital markets.

Going forward, we stress that our policy options are limited beyond what has already been announced. You may ask what role the Business Development Bank of Canada is playing during these difficult times, but our anecdotal evidence is that they are actually putting out less capital to early stage companies in calendar 2008 than 2007, despite the obvious increased need for their “complementary” services. An issue we can discuss further as you get your feet wet in the new portfolio.

Again, welcome to your new role at 110 O’Connor Street.

MRM