BMO takes C$983m loss on Bank of the West merger hedges

Temporary inversion of yield curve hit swaps safeguarding target’s fair value

Bank of Montreal (BMO) was forced to swallow a C$983 million ($751 million) loss in the third fiscal quarter to keep its acquisition of Bank of the West on track, as interest rate volatility rocked hedges it put in place after the deal was announced in December.

BMO is buying the California-based lender from BNP Paribas for $16.3 billion, financed entirely through equity and representing a 50% premium to tangible book value (TBV) at the time. The difference between the purchase price and TBV is recorded as goodwill, which – as with most intangibles – banks need to filter out when translating assets into regulatory capital.

 

 

To offset hits to Bank of the West’s TBV from a rise in interest rates, BMO entered into fixed-to-floating swaps, which gain value as rates climb. The interest rate risk on the swaps was then hedged with a portfolio of US Treasuries and other government bonds of matching duration, accounted for at amortised cost.

After netting C$3.4 billion in mark-to-market gains in the three months to end-April, the swaps produced a C$983 million paper loss the following fiscal quarter, which the bank blamed on a drop in medium- and long-term rates. US Treasury yields rose across all maturities between January and April, but the curve had temporarily inverted by July, as yields on intermediate debt climbed down.

Over the quarter, the government bond hedges earned C$38 million in interest income, down from C$122 million the previous quarter.

The net result from the hedging package shaved 20 basis points off BMO’s Common Equity Tier 1 ratio, compared to a 90bp benefit the previous quarter. The ratio stood at 15.8% at end-July, down from 16% at end-April.

What is it?

In line with Basel Committee for Banking Supervision rules, Canada’s Office of the Superintendent of Financial Institutions requires banks to deduct goodwill and most other intangible assets when deriving regulatory capital from balance sheet assets.

The interest swaps put in place by BMO for the Bank of the West deal do not qualify for hedge accounting.

Why it matters

That a fixed-to-floating swap could drop in value – albeit only temporarily – even amid the current rate-tightening race is testament to how volatile the last few months have been. It’s hardly the easiest environment to steer through a bank merger, but BMO is proceeding steadily.

The gains to-date on the goodwill hedging package – almost C$3.2 billion in the nine months to end-July – make the strategy very much a winner, despite the latest loss. And though the interest rate swaps helped push total notional for such instruments up 26% compared with last October, associated risk-weighted assets actually fell 17% over the same period – hinting at the efficacy of the govies put in place as a second layer of protection.

BMO’s management expects the deal to formally close around December, a year after it was first announced. When this happens, executives can expect plaudits from shareholders – and from acquisition-oriented peers that may take a page out of BMO’s books.

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