Moody’s Investors Service has changed its rating outlook on the Bank of Montreal and its subsidiaries to “negative” from “stable”, citing the bank’s capital market exposure and rising loan losses.

“The outlook change is the product of several factors. First, BMO’s business mix has a material weighting towards capital markets activities in general, and structured credit activities specifically, which is likely to result in continued earnings volatility, in Moody’s view. Second, the bank has entered a prolonged period of higher loan losses which will pressure earnings for several quarters. Finally, these two factors will dampen BMO’s risk-adjusted profitability, which is already low relative to its current rating level,” said senior vice president, Peter Routledge. Moody’s noted that these concerns are partially offset by the bank’s strong capitalization and an improving risk management discipline.

However, in Moody’s view, BMO’s business mix has a moderately more pronounced weighting towards capital markets than its domestic peers. It says that the volatility from this business has strained the bank’s profitability materially since 2007, producing nearly $3 billion in pre-tax charges, including structured credit losses. “This volatility, which has been characterized by asymmetric losses in recent years, is an additional drag on BMO’s ratings,” said Routledge.

BMO’s structured credit exposures have produced approximately $2 billion in pre-tax losses since the turmoil in the credit markets began, the rating agency said. “Although the bank has bled much of the potential losses contained in these exposures into its earnings, additional losses could accelerate rapidly in a severe economic downturn,” it warned. As for loan losses, Moody’s said that BMO’s provisions will rise through 2010 and put additional pressure on the bank’s risk-adjusted profitability. Moody’s also notes that BMO has produced a net charge-off ratio on loans — the ultimate measure of a bank’s credit risk discipline — that was well below peer medians every year since at least 1992 and up until 2008. In 2008, Moody’s notes that BMO lagged all its peers on this ratio. “This was largely a consequence of its U.S. commercial and residential real estate exposures. Outside these exposures, Moody’s expects BMO to continue to outperform its peers in terms of credit costs,” it said.

“Nonetheless, BMO’s loan losses will rise and its risk-adjusted profitability will remain constrained,” said Routledge, “the challenge BMO faces is managing these two points of earnings pressure from a low level of risk-adjusted profitability, relative to its current ratings level.”

According to Routledge, “while Moody’s believes that BMO’s core earnings and capital are more than adequate to absorb prospective credit and capital markets losses, a deterioration in risk-adjusted profitability — a long-stated major ratings driver for the bank — could ultimately lead to a downgrade in BMO’s bank financial strength rating.”

Two positive credit trends partially offset these negative rating drivers, Moody’s noted. “First, the bank’s capitalization is very strong, with a Tier 1 ratio of 10.7%… Moreover, the bank has demonstrated the ability to access private capital sources since October 2008. In addition, BMO has made good progress in bolstering its risk management discipline which could, in Moody’s view, lead to lower earnings volatility and fewer asymmetric losses going forward,” it concluded.

IE