As most are aware, Bank of Montreal (TSX—BMO; NYSE—BMO) has agreed to acquire Bank of the West (BOTW) and Toronto-Dominion Bank (TSX—TD; NYSE—TD) has reached an agreement to acquire First Horizon Bank (FHN). Both deals are expected to close in the first quarter of fiscal 2023 (period starting Nov. 1, 2022), subject to various approvals. This report delves into how bank purchase accounting works, how acquisitions impact CET1 (Common Equity Tier 1) ratios and how the impact changes in a rising interest rate environment.
The basic mechanics go as follows: When a bank acquires another bank, the target’s balance sheet gets “fair-valued” at close to derive essentially goodwill (and intangibles), a concept everyone is familiar with.
This is important because goodwill is removed from the acquiring bank’s available capital, the numerator in the CET1 ratio calculation (which compares capital to assets). Most of the accounting fair-value adjustment relates to the target bank’s loan book, and more specifically from what is called an interest rate mark and a credit mark. While these cause an upfront hit to the acquiring bank’s CET1 ratio, the vast majority of these marks are accreted back into earnings over the duration of the loan book.
Simply put, in most cases higher interest rates cause higher interest rate marks, more goodwill, a bigger drag on the CET1 ratio at close and higher earnings accretion after closing for the acquiring bank.
But things aren’t always so simple. BMO hedged its BOTW acquisition-related exposure to higher interest rates; TD has not, which is an important distinction.
Assuming BMO’s hedge works as intended, the rise in interest rates post-deal announcement has no incremental impact on its CET1 ratio or earnings accretion. For TD, the drag on its CET1 ratio at close will be higher versus the announcement day, but the earnings accretion will also be higher from the larger interest rate mark.
By our math, BMO’s and TD’s pro forma CET1 ratios were about 10.2 per cent and 10.6 per cent, respectively, as of the second quarter of fiscal 2022 (period ended April 30, 2022). Both are targeting a CET1 ratio at close in excess of 11 per cent. Both banks and their targets have roughly three quarters to organically generate capital; both could take action to manage risk-weighted assets (RWA) and we believe both will achieve the 11 per cent-plus target. That said, many items can impact CET1 ratios.
TD and BMO approach CET1 differently
We will break down our accounting discussion into two components—day 1, which relates to adjustments that happen at close, and day 2, which occurs after the transactions have closed.
Day 1: When an acquisition closes, the acquirer fair values the target’s balance sheet—and there are various complexities that go with this, but we will keep our discussion at a high level.
Assets and liabilities are revalued to derive a fair value for net assets being acquired, which compared with the purchase price derives goodwill. Most of the fair value calculation impacts the loan books and falls into two buckets:
-Credit fair value mark (credit mark). The loans being acquired are marked down based on expected credit losses over the lifetime of the portfolio. There is typically a gross mark, which includes impaired and performing loans, and a mark for performing loans.
This matters because what is put aside for impaired loans does not accrete back to future earnings. Because the fair value of loans includes an estimate for future credit losses, allowances for credit losses (ACL) at the acquired bank are released/recorded at zero.
-Interest rate fair-value mark (interest rate mark). Assume a fixed-rate loan originated last year paid five per cent annually; however, a similar loan originated today pays 5.5 per cent; therefore, the value of the first loan has arguably declined.
Both the credit mark on performing loans and all of the interest rate marks are accreted back into earnings over the expected duration of the loan book or related assets and liabilities. To be clear, if the fair value causes a negative mark, the accretion positively impacts earnings and vice versa.
Why does the accounting work like this? Take a bond analogy. Say you buy a bond for $100, interest rates go up and the value of the bond declines to $95. However, if you hold that bond to maturity, you get the entire $100 back. A similar thought process applies in bank purchase accounting.
Let’s walk through an example. Here are the parameters:
-There are two banks—Bank A (the acquirer) and Bank B (the target)
-We assume Bank A acquires Bank B for $80 cash, or twice Bank B’s book value
-We look at two scenarios:
-Scenario 1—assumes only a credit mark but no interest rate mark
-Scenario 2—assumes both a credit mark and an interest rate mark
-We assume there is a credit mark of $8 and an interest rate mark of $9
-For this example, we assume no other assets or liabilities are fair valued
-We use this example to demonstrate all the moving pieces
As noted earlier, the credit mark ($8 of the $17) is based on what Bank A expects credit losses to be over the lifetime of the loan portfolio, and there is no good way to show this in a math example.
However, we can show the math for the interest rate mark of $9. Let’s say Bank B has a $400 loan book that earns a five per cent fixed rate of interest annually ($20), and the duration is five years.
The total present value is $400 assuming no change in rates and no marks.
Under scenario 2, discounting the $20 interest payment and $400 repayment cash flows at 5.5 per cent, the total present value falls to $391. The difference between the two, or (A) – (B), equates to $9.
Now consider the pro forma EPS accretion for Bank A under both scenarios. In scenario 1, EPS accretion is eight per cent and in scenario 2 EPS accretion is 12 per cent. So, the accretion from the added interest rate mark in scenario 2 added $0.04 or four percentage points to EPS for Bank A on a pro forma basis.
Recall that BMO and TD are not backing out the accretion of fair value marks from cash EPS.
Day 2: After the acquisition closes, on the second day, the acquiring bank sets up ACLs for the acquired performing loans based on its IFRS 9 assumptions.
In IFRS 9 parlance, all of Bank B’s performing loans are put in stage 1, with ACLs equal to the expected credit losses over the next 12 months. Any negative loan migration (for example, from stage 1 to 2) over time may cause ACLs to ebb and flow in future periods as the book seasons. With the day 1 credit mark and day 2 ACL, credit protection doubles.
For BMO and TD, the day 2 ACL builds are in reported EPS but excluded from cash EPS. Point being that day 2 ACL build has no impact on cash EPS accretion.
Doug Young and Richard Huang are equity analysts at Desjardins Capital Markets in Toronto.
This is an edited version of an article that was originally published for subscribers in the July 15, 2022, issue of Investor’s Digest of Canada. You can profit from the award-winning advice subscribers receive regularly in Investor’s Digest of Canada.
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Investor's Digest of Canada •9/18/22 •