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RBC charges fuelled by liquidity squeeze

Royal Bank of Canada said yesterday that its second-quarter profit will be slashed by $855-million in writedowns, but made a point of noting that a significant portion of those stem from a lack of liquidity rather than an actual deterioration of the assets.

Bank chief executive officers, including RBC's Gordon Nixon, have been speaking out recently about accounting rules that force them to regularly put a value on investments that they might plan to hold for years. This produces volatile financial results that many executives think are exacerbating the current financial crisis.

Analysts said yesterday that they would not be surprised to see some of RBC's writedowns reversed if markets improve.

If credit spreads improve and some bond insurers get a bit stronger, "I can see a lot of the $855-million coming back into earnings, probably in 2009," Genuity Capital Markets analyst Mario Mendonca said in an e-mail, noting that the same goes for charges Canadian Imperial Bank of Commerce has taken.

Edward Jones analyst Craig Fehr said yesterday there's no question RBC will reverse some of its writedowns, "given that their holding period for some of these securities is certainly going to be long enough to make it through this credit turmoil."

"I don't necessarily think that all of this gets reversed; some of these writedowns will stick," he added.

But the value of some securities is being ratcheted down because there isn't an active, or liquid, trading market for them, even though the credit quality of their underlying assets is fine, Mr. Fehr said.

"So you just have to mark them down based on whatever the best estimate would be at this point."

Accounting rules essentially require the banks to mark their holdings of some risky securities to whatever value the market would place on them at the end of the quarter. If the market pricing is too unclear, banks sometimes use financial models instead.

"It's mark-to-market, mark-to-model, mark-to-imagination, whatever it may be," Mr. Fehr said.

Mr. Nixon has recently been speaking about the trouble accounting rules cause by forcing banks to write down what might be good long-term assets. During a presentation to analysts a couple of weeks ago, he said that "one of the big questions is how much of the writedowns are mark-to-market issues - rather than permanent impairments - and therefore will eventually be brought back into earnings."

Bank of Nova Scotia CEO Rick Waugh has also been vocal on the issue. He co-chairs an international banking committee that's hoping to see changes to the accounting rules. Banks are being obligated to put a price on their holdings, "but the fair value may be much different than the market value," he said recently. The resulting continual revaluation of bank portfolios is "quite worrisome," he added.

Analysts believe the investment community will soon turn back to focusing on how the Canadian banks' operations are performing, rather than on writedowns, although those aren't over yet.

Analysts expect CIBC to writedown somewhere between $1-billion and $1.8-billion this quarter, and Mr. Mendonca noted that RBC could be facing further charges as a result of its exposure to bond insurers and auction rate securities.

Some analysts were disappointed by the size of RBC's writedowns yesterday, which came in at the high end of expectations. Credit rating agencies DBRS and Moody's both said that the losses are manageable. "Capital ratios remain strong and provide a further cushion should further writedowns occur," said DBRS managing director Brenda Lum.

RBC is due to report its quarterly results on May 29, but one of the changes that regulators have been pushing for amid the financial crisis is early disclosure of any writedowns.

Charges breakdown

$200-million in valuation adjustments related to the bank's exposure to a unit of U.S. monoline mortgage insurer MBIA Inc.

$90-million in net writedowns related to its positions in U.S. subprime collateralized debt obligations and other structured credit trading positions.

$325-million in writedowns on U.S. auction rate securities and municipal GIC businesses.

$175-million in writedowns on other trading portfolios.

$65-million in writedowns against certain direct holdings the bank has classified as available for sale.

The losses will be offset by lower taxes and employee bonuses, bringing the total amount down to $420-million.

Royal Bank (RY)

Close: $49.85, up $1.23

© The Globe and Mail

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