There was some good news, a bit of bad and plenty of ugly in the Canadian banks’ fiscal 2008 first-quarter financial results.

Earnings in the core banking businesses of Canada’s Big Six banks are holding up relatively well, but the credit market disruption is driving a deterioration in credit quality and crimping the wholesale and, to a lesser extent, the wealth-management segments.

The ugly came in the form of continued writedowns and the threat of more losses on securities directly affected by the credit crunch.

At a time when many large financial services firms are suffering the effects of tumultuous markets, the Canadian banks are no exception. The quarter ended Jan. 31 saw a variety of one-time charges at several of the Canadian big banks. More important, the turbulent market environment is disturbing business flows. Retail revenue is, more or less, holding up, but the wholesale side is taking a bit of a pounding.

According to research by the capital markets division of Royal Bank of Canada, aggregate wholesale revenue for the Big Six dipped by 3% on a core basis — to slightly more than $4 billion in the first quarter of fiscal 2008 from almost $4.2 billion in the same period a year earlier. But when using generally accepted accounting principles — which include the $4.5 billion in collective writedowns reported during the quarter — the wholesale segment produced a loss of $324 million for the period.

Meanwhile, aggregate domestic retail revenue grew by 3% in the quarter compared with a year earlier. Wealth-management revenue, however, was down 2% on both a year-over-year and quarter-over-quarter basis.

But earnings, up 6% in the quarter vs a year earlier, grew notably slower than in prior quarters. The RBC report, written by analyst André-Philippe Hardy, says that income growth was 9% in the fourth quarter ended Oct. 31, 2007, and 15% in the third quarter: “Margin compression and the impact of weaker equity markets offset continued strong loan growth.”

Looking ahead, Hardy expects earnings growth in domestic retail banking to accelerate to 10% for the 2008 fiscal year — powered by loan volumes, cost-cutting and improved margins, in contrast to weaker contributions from wealth management and higher loan losses. Although the U.S. is facing a drop in consumer borrowing, RBC sees Canada’s consumer loan market holding up, driven by record-low unemployment, rising incomes and a stronger housing market.

That said, credit quality is deteriorating in Canada. On that front, Bank of Montreal was probably the biggest bearer of bad news in the fiscal first quarter. Not only did BMO take writedowns for trading losses and structured-product exposure, but it also saw provisions for credit losses and gross impaired loan formations rise sharply from the prior quarter.

As a result of eroding credit quality and other issues, National Bank Financial Ltd. analyst Robert Sedran has downgraded BMO to “underperform” from “market perform” in a recent report. Sedran has increased his estimate for BMO’s credit-loss provisions to $680 million for fiscal 2008 and $760 million for fiscal 2009, sharply higher than the $303 million BMO experienced in fiscal 2007.

The NBF report notes that BMO’s results missed anticipated levels by a “wide margin,” owing to much higher loan-loss provisions, slightly weaker capital markets revenue, tighter interest margins and lower securities gains. The report also points out that BMO has admitted it doesn’t expect to meet its earnings growth or loan-loss targets for the year. Says the NBF report: “Given that these targets were established just three months ago, the trends are worrisome.”

Several other analysts also have lowered their earnings projections and price targets for BMO, citing its weaker than expected credit quality and an increase in risk from its exposure to various asset-backed commercial paper conduits and other structured products.

“The outlook for BMO is much weaker than it was at the end of the fourth quarter, both on an absolute and a relative basis,” says a report by Dundee Securities Corp. analyst John Aiken. “Although its structured-investment vehicle and energy trading exposures are not as critical as they once were, the burgeoning ABCP situation and heightened credit risk have created much more significant valuation overhangs.”

Of course, BMO was far from the only bank to take an earnings hit as a result of the ongoing fallout from the credit crunch. CIBCtook the biggest charge once again, accounting for $3.4 billion of the $4.5 billion in total industry writedowns reported in the first quarter. CIBC’s charges led to the bank reporting a $1.5-billion loss for the quarter. But, even excluding the impact of those charges, its results fell below consensus earnings expectations.

@page_break@Results in the retail banking segment at CIBC improved notably in the quarter year-over-year, but the wholesale side was weak, trading revenue plunged and the threat of still more subprime fallout has some analysts cautious. Blackmont Capital Inc. analyst Brad Smith rates CIBC’s stock as a “sell”: “The risk of future writedowns has, in our view, increased meaningfully.”

Among the Big Six, only TD Financial Group and National Bank of Canada didn’t have significant one-time charges to report in the first quarter. And, not surprising, they were also the only banks to report increased earnings per share.

National Bank took charges in an earlier quarter, leaving TD as the only bank skating through the credit crunch without taking a direct hit to its balance sheet — so far.

But TD is also a victim of the generally gloomier environment. It, too, saw its loan-loss provisions rise and its wholesale income get thumped. But TD enjoyed sustained earnings in its core retail businesses on both sides of the border, and higher wealth-management earnings as well.

In fact, UBS Securities Canada Inc. analyst Peter Rozenberg suggests in a report that capital markets fallout and net interest margins (NIMs) are bigger short-term risks facing TD than the evolution of credit quality.

“We expect provisions to continue to increase from cyclically low levels, moderating performance,” the UBS report says. “However, we think that capital markets and NIMs, not credit, are the key risks, [in the] short term.” The report adds that margins are expected to come under modest pressure due to lower interest rates and increased competition for deposits.

All of the banks face these pressures, although some have additional risks and vulnerabilities on their balance sheets, depending on their specific business mix.

After TD, the bank least affected by the subprime writedown parade is Bank of Nova Scotia. Scotiabank had the lowest reported writedown among the banks taking such charges in the first quarter, as it did in the prior quarter.

As with the other banks, Scotiabank’s domestic retail business remains a source of strength — and the wholesale side is a point of weakness. In the quarter, wholesale income was down on the heels of a notable drop in trading revenue.

Although Scotiabank’s international profile continues to differentiate it from the rest of the pack, it saw earnings in that segment decline slightly year-over-year due to weaker results in Mexico. However, outside of that weakness, the bank’s international operations remain a more powerful force for earnings growth than its domestic business, which has been merely steady for several quarters.

As a result, the NBF report raised the rating on Scotiabank to “outperform”: “Although the shares carry a premium vs the average, we believe a premium valuation is appropriate, given its favourable geographical footprint, strong profitability and the numerous available options for the profitable deployment of excess common equity being generated domestically.”

Scotiabank also remains the top pick among the banks for Desjardins Securities Inc. analyst Michael Goldberg. According to his report, “Scotiabank has not been immune to the problems in structured credit, but its exposures are relatively small. As a result, [the] impact has also been small. Instead of building a high-risk trading platform, Scotiabank has stuck to the basics. It has built lower-risk business platforms outside of Canada and now benefits from their high and more durable returns. It is also investing to strengthen its domestic platform.”

RBC finds itself somewhere in the middle, in terms of the hit it has taken from the credit crunch. In the first quarter, it saw earnings decline by just 2% from the same quarter a year earlier, as it took not only a further writedown but also increased loan-loss provisions. Moreover, analysts note, it got an unexpected boost in trading revenue, viewed as unsustainable in future quarters.

RBC’s results are consistent with the other Big Six banks: strength in the bread-and-butter domestic banking business, with wonky markets afflicting market-driven businesses and foreign business lines weakened by the subprime mess.

Earnings in RBC’s domestic banking segment rose by 4%, accounting for more than half of quarterly earnings. The banking line was even stronger than this, but notable weakness in the global insurance business was also reported.

Conversely, RBC’s U.S. and international banking division saw a significant decline in income because of faltering credit quality. The wealth-management area also saw earnings slide 14% year-over-year, as markets weakened. The surprise jump in trading revenue helped boost the capital markets division’s profits (excluding the impact of its writedowns) compared with the same period a year ago.

Overall, analysts’ reports are a bit cautious about RBC’s prospects. They note that the bank didn’t raise its dividend as expected; also, the reliance on notoriously unreliable trading revenue and possible further exposure to the credit crunch has some questioning the quality of RBC’s first-quarter earnings.

NBF’s report notes that RBC has been lumped in with TD and Scotiabank as the banks least affected by the credit crunch and deserving of higher multiples. But, given RBC’s latest results, says the report: “The rationale for [RBC’s] membership in the group of banks with a premium multiple is less obvious.” IE