Seven months after Amaranth was caught on the wrong side of the natural gas market with devastating effect, history has been repeated, although on a smaller scale, as the Bank of Montreal reported Friday that it has lost between C$350 million and C$450 million (US$313.70 million to US$403.33 million) in similar wrong-way trades in natural gas, specifically "out-of-the-money options." The bank also warned investors that more related losses could be coming, but that they would be "substantially lower" than the losses announced Friday.
Toronto-based BMO Financial Group, which is part of the fourth largest Canadian bank, said that mark-to-market commodity trading losses will be recorded in the second quarter of its 2007 fiscal year. The company said the impact to its second quarter earnings, which will be announced on May 23, is estimated in the range of C45-55 cents per share. Moody's Investors Service affirmed the bank's financial strength and ratings, saying the loss is easily absorbed by the bank's quarterly earnings and tangible common equity.
In a conference call, CEO Bill Downe said "The loss that we announced today is outside our tolerance." He added that most of the trading occurred in the United States and that the BMO traders involved remain with the bank. "It's really in the last eight weeks that we have seen the move in the market and it's outside the range of what we have experienced."
The bank said that during the quarter, positions held by BMO Financial Group in the energy market, primarily for natural gas, were negatively impacted by changes in "market conditions." In particular, the market became "increasingly illiquid and volatility dropped to historically low levels." In conjunction with this, BMO said there was a refinement in its approach to estimating the market value of this portfolio.
"The commodity trading losses were the result of decisions that did not adequately recognize the vulnerability of the portfolio to changes in market volatility," said Downe. "We are conducting a thorough review, and actions have been taken to address the current situation and reduce the likelihood of a recurrence. The commodity trading losses are particularly disappointing as our company continues to experience good operating momentum. We remain committed to providing the high level of service that our clients in the energy sector have come to expect from BMO Capital Markets."
On Friday, BMO stock dropped 1.78%, or C$1.27 to C$70/share. Most of the fall-off occurred in heavy trading at the opening and the stock price hovered around C$70 during the day. There was also talk that the news affected natural gas futures prices Friday, but traders were mixed on its impact (see related story). In its first regular session as front month, June natural gas climbed 22.9 cents to close at $7.831.
While significant, BMO's losses are in a completely different class than the losses incurred by Amaranth. Last September, the hedge fund collapsed following more than $6 billion in losses from wrong-way bets in the natural gas futures arena (see Daily GPI, Sept. 19, 2006; Sept. 27, 2006). Amaranth's downfall sparked widespread calls for investigations into energy trading and markets (see Daily GPI, Feb. 14; April 17). Amaranth was one of BMO's clients and the bank was the hedge fund's prime broker in Canada, but not in the United States.
Downe explained to analysts that following Hurricane Katrina, the volatility in the natural gas market increased significantly and natural gas prices increased as well. "Clients wanted to lock in prices and the bank increased its book of business related to this market," Downe told analysts. "As the banks' energy trading business continued to grow, so did our position in out-of-the-money natural gas options. At the same time, while natural gas positions continued to decline, the market became increasingly illiquid, and volatility dropped to historic lows."
BMO said it will continue to reposition the portfolio to a lower and sustainable level, consistent with maintaining its core business of serving its energy client franchise. Going forward, the value of the portfolio will be subject to market conditions. The company noted that it is possible that as the portfolio is repositioned it could experience subsequent gains or losses depending on future market conditions. However, BMO's expectation is that, even using adverse assumptions, any losses would be in a "substantially lower range" than those announced Friday.
Following the news, Moody's Investors Service affirmed the ratings and outlook of the Bank of Montreal ('Aa1' for deposits, 'B' bank financial strength, stable outlook) and its subsidiaries.
"The loss does highlight the fact that maintaining sizable trading portfolios, as BMO does, exposes a bank to low-frequency, high severity events that far exceed its value-at-risk and tolerance levels for maximum quarterly trading losses," said Peter Routledge, Moody's senior credit officer. "BMO has historically had a fairly prudent market risk appetite and thus we expect the bank to respond to this event by augmenting the bank's measurement, monitoring, and control systems to prevent other malignant exposures from developing in the future."
BMO also said that its Tier 1 capital ratio at the end of the first quarter was 9.90% and the impact of these losses will be less than 20 basis points on that ratio. As a result this loss does not impair the ability of the company to pursue its strategic agenda.
"Energy is a key sector for the bank where we provide hedging services to our clients," the bank said Friday. "In order to do this we are market makers in this segment. The large position was a result of active market making in the period during which there were fewer client transactions as prices declined and a significant reduction in volatility and liquidity."
The bank noted that risk positions were approved and in place according to bank policies. However, the bank noted that its limit structure is being tightened for this aspect of its business.
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