TD Buys Commerce Bancorp: Is Bigger Necessarily Better?

Includes: CBH-OLD, TD
by: Christopher Whalen

Readers of The IRA know that we have been critical of Toronto Dominion Bank (NYSE:TD) as it invested in Bank North and other US assets, in large part because of poor financial performance. So now TD buys Commerce Bancorp (NASDAQ:CBH), which in a sense represents an improvement for the Canadian bank's US portfolio, but we're still not sure that the TD management team knows how to deliver value with a US franchise that now totals over $100 billion in assets.

As of the end of June 2007, TD's US bank units reported ROA of 0.53% and ROE of 3.17%, in both cases 1.5 standard deviations below the asset peers selected by The IRA Bank Monitor. Of the $59 billion in assets of the two US bank units, TD Bank North and TD Bank USA NA, only 87% are tangible, illustrating the purchase premium TD historically has paid to buy into the US market. Post-CBH, tangible assets may be close to 80% of total.

If you are among the growing number of analysts using "as filed" FDIC financial statement data for business model profiling, then you would know that the $43 billion asset TD Bank North unit has decent lending returns and default experience, and strong core funding at 65% of total assets. With 721bp of lending yield and an Exposure at Default of just 43%, TD Bank North actually appears more conservative than many of its asset peers.

TD Bank USA, however, is not such a pretty picture. With just $16.8 billion in total assets at the end of June 2007, the smaller US unit of TD carries a disproportionate share of the risk in the US, at least looking at its regulatory disclosure. With 50% of loans in real estate and an equal amount in C&I, TD Bank USA reported an ROA of 0.24% and ROE of 4.59% in its latest call report to the FDIC. But the bank's tiny banking book is not the problem.

In fact, TD Bank USA has a profile that looks an awful lot like CBH, the $48 billion asset two-bank holding company which we last profiled in July ("What Does Jim Cramer See in Commerce Bancorp?"). Why is this significant? Because the biggest single item on balance sheets of CBH and TD Bank USA is MBS.

News reports have cited the MBS-heavy approach by CBH as something that TD intends to change, but what about the MBS portfolio at TD Bank USA? The Toronto Globe & Mail quotes Nesbitt Burns analyst Steve Theriault saying that the high level of MBS on the CBH balance sheet is "is well above TD's comfort level."

Well, what about TD's New York-based national bank subsidiary?

At the end of June 2007, over 90% of TD Bank USA's assets were deployed in MBS, this funded with the bank's 90% core deposits. That allocation of MBS vs. total assets is more than 2 SDs above peer. As we have noted in past missives, the combination of MBS and retail funding is not a winning strategy in the current interest rate environment. And this is the same issue that is weighing down the performance of CBH.

As you probably know, TD is paying over 2.5x book in cash and stock for CBH, which reported a "bank only" ROA of 0.66% and ROE of 11.16% at the end of June 2007. CBH reported just 20bps of defaults in Q2 2007 with an LGD of "only" 81.2% vs 69% for the peer group calculated by the IRA Bank Monitor. Remember, though, that CBH's loan book is quite small and that 60% of the bank's assets are tied up in MBS -- 3x the level of MBS to assets for its peers.

Indeed, as we noted in our July comment, because of the preponderance of MBS on CBH's balance sheet, it has the highest ratio of Economic Capital to Tier One Risk Based Capital ("RBC") of any large institution in our Basel II simulation, leading the outliers at a ratio 7.3:1. This is significantly higher than the 4.8:1 ratio of Economic Capital to Tier One RBC for JPMorgan Chase (NYSE:JPM). But of course most residents of the Buy Side, including Jim "Do Your Homework" Cramer, think CBH is just a fast-growing retail banking franchise, not a hedge fund with FDIC insurance.

In our view, one of the first things that TD need decide upon closing the CBH transaction is how and when to rebalance the bank's asset allocation. The same should be said about TD Bank USA, however. Observers who have missed this little nuance of TD's US bank unit asset allocation strategy are looking up the wrong tree, in our opinion.

Next, regarding the whole US portfolio, TD needs to decide when it intends to start making money in the US market instead of shoveling money into the proverbial furnace. With an efficiency ratio for TD's two US banks of 68%, TD is not quite as aggressive as CBH at 71%, but cost reduction has clearly got to figure in the immediate future

With Bank of America (NYSE:BAC) at 41%, JPM at 59%, Citigroup (NYSE:C) at 58% and Wachovia (NYSE:WB) at 54%, TD's efficiency ratio looks about 10-15 points too rich-- unless TD management can figure out a way to boost asset returns pronto.

Oh, just over the wire, Miami Valley Bank, with $86.7 million in total assets and $76 million in total deposits as of October 1, 2007, was closed today by Ohio's Superintendent of Financial Institutions. The FDIC was named receiver. More on this next week.