Bank of Montreal (BMO) 2002 Q3 法說會逐字稿

Thank you for standing by. Welcome to the Bank of Montreal third quarter financial results conference call. During the presentation, all participants will be in a listen-only mode. Afterwards, we will conduct the question-and-answer session. If you have a question press 1-4 on the telephone. As a remind they are conference is being recorded today, Tuesday, August 27th, 2002. I would like now to turn the conference over to Susan Payne, Senior Vice President of Investor Relations. Please go ahead, Ma'am.

Thank you, Billy. Good afternoon, everyone, and welcome to the Bank of Montreal's third quarter fiscal 2002 conference call. Today's overview of our third quarter results will be provided by Tony Comper, our Chairman and CEO, Karen Maidment our CFO and Mike Maila at Risk Management. .

After Mike's presentation, we'll then go to a question-and-answer session. At that time, in addition to Tony, Karen and Mike, the following individuals will also be available to answer your questions. Bill Downe, deputy chair, Ron Roger, who heads up the Personal and Commercial Client Group, Frank Teacher who joins us from the Harrisbank, [Gilles Latch] from the Private Client Group and from the Investment Banking Group, Yvan Bourdeau. At this time, I would like to refer our listeners to the investor relations website at www.bmo.com for forward-looking statements and the risk factors pertaining to these statements. Now I'd like to hand the floor over to Tony.

Thanks, Susan. Good afternoon, everyone.

Our retail and business banking operations in Canada and the US generated strong earnings growth in the third quarter. However, overall performance was below our own and the market's expectation due to investment write-downs and weak revenues in market sensitive businesses. The single biggest impact came from our decision to write off the last our equity investment in collateralized bond obligations, or CBOs. That reduced earnings per share by 7 cents. Nonetheless it's important to note that earnings increased by 19 percent for the second quarter. These are encouraging signs of a performance lift in upcoming quarters as our perseverance in implementing our transnational growth strategy while continuing to contain costs positions as well for the future.

One sign is our credit picture. At a $160 million loan loss provisions for the quarter were half the amount we incurred in the previous quarter when we had an exceptional situation with respect to Teleglobe. Impaired loans and lost provisions tracked as anticipated during the quarter and we're maintaining the annual provisions guidance that we provided last April. Furthermore, let me repeat the message that I gave this audience 3 months ago. We continue to anticipate that our loan losses for 2002 will compare favorably with the peer group average.

Another positive sign is expense management. If you exclude acquisitions, we brought expenses down by $43 million, or 3 percent from the third quarter of last year. For example, the expense-to-revenue ratio of our Personal and Commercial Client Group, that's our retail and commercial operations in Canada, improved to 58.7 percent from 60 percent in the second quarter and 62.2 percent a year ago. I want to assure you that we're continuing to exercise hiring constraints and reduce discretionary expenses right across the Enterprise.

Let me turn now to our operating groups. The performance star this quarter and indeed this year is the Personal and Commercial Client Group. It is demonstrating the benefits of aggressive strategy implementation over the last couple of years. Earnings grew 22 percent from the third quarter of last year, or 20 percent so far this year.

In the US, retail and business banking net income grew 98 percent from a year ago, reflecting 7 percent organic deposit growth and 22 percent organic lending growth. If you [exclude] the acquisition of the First National Bank of Joliet, deposit growth rises to 16 percent and lending growth is 33 percent. Another positive trend is the improve loan-to-deposit ratio which enables us to fund loans through our own retail deposit base without relying on more expensive wholesale funding.

In Canada, personal commercial net income increased 13 percent reflecting revenue growth since the second quarter of 8 percent over a 12 month period ending in January 2001 as we have reported before, we introduced a thousand new salespeople into our Canadian branch system. And now we're gaining real sustainable benefits from this investment. Good growth in volumes and market share continued in the third quarter and we anticipate ongoing performance improvement.

Our sales efforts will benefit from the successful launch of Halfway Connect, that's our state-of-the-art sales and productivity technology platform. Rollout of the largest technology project in our corporate history of approximately 16,000 Canadian retail bankers is more than 50 percent implemented and we're on track for completion by the end of January 2003. While our Investment Banking Group recorded an investment write-downs in weak revenues from market-sensitive businesses, as I said, we have now completely written off the bank's investment of CBOs and we're continuing to reduce the capital allocated to low return, non-relationship corporate lending. Turning to the Private Client Group, where we have been investing heavily in expansion with an eye to long-term balance to short-term growth, revenues rose 20 percent from the third quarter of last year. That was due almost entirely to the effects of acquired businesses.

Otherwise, revenues were flat in this group with weak equity markets translating into lower customer trading volumes. However, having completed the acquisition of Morgan Stanley's online accounts on July 26, our 8th US acquisition since 1999, we now rank 6th in North America in direct investing based on number of accounts and we have an integrated wealth management platform that is poised for healthy returns when conditions improve. I think it's especially noteworthy that the successful integration of our largest acquisition, CSFBdirect into Harris Direct, were key measures are right on expectations in the midst of market conditions that are hardly conducive to growth.

Here's some pretty compelling evidence. As of the end of June, average assets per account, revenue per trade, and cost reductions were all ahead of plan. While annualized trades per account on account attrition were in line with peer group averages. We believe that this kind of performance in this kind of market bodes well for the future. And while on the subject of prospects for our direct investing business, I can't resist pointing out the top quality of our technology platform in Canada as well as the US. Yesterday, Gomez Canada once again named BMO investment line, Canada's top online broker, also ranking us best in customer service.

Overall the leadership team is cautiously optimistic about prospects for the balance of the year and for 2003 as we continue to implement our transnational growth strategy and manage expenses in an an unsettled economic environment.

We stand by our earnings per share and return on equity targets for 2002, fully aware that in order to achieve them, cash EPS, excluding non-recurring items, needs to move up from 72 cents in the third quarter to a minimum of 84 cents in the fourth quarter. We believe this goal is within our reach. Now that we have the CBO losses behind us and anticipate momentum in businesses across the enterprise.

Finally, let me remind you that three months ago, BMO Financial Group became one of the first companies on the continent to announce its intention to expense options and our determination to further this organization's well-established reputation for leadership in high quality financial disclosure, Karen and I have gone one step further. We have both signed a statement in this quarter's results confirming our accountability for financial information.

In addition, on August 14, the CEO and CFO of the Harris Bank certified the quarterly results of our US subsidiary under the new Sarbanes-Oxley Act, Bank of Montreal will file a similar certification on a voluntary basis following the release of third quarter results. To provide you with a closer look at these results, here's Karen.

Thanks Tony. As Tony indicated the third quarter was slightly below expectations, primarily for the level of investment write-downs, the largest component of which was the [CVO] equity investment representing 7 cents a share. This is now fully written down and excluding this writedown, cash EPS would be 79 cents compared to 70 cents per share. Aside from this commercial results were strong both North and South of the border. Our provision for credit losses is within guidance. And we're pleased with our cost containment initiatives. However, revenue was down as it was affected by the write-downs, although somewhat boosted by acquisitions.

Looking at our financial snapshot on slide 1, you can see that net income reported was 346. The difference between that and the net income excluding non-recurring items was 360, or $14 million. One time acquisition related cost associated with the CSFB related acquisition. Those costs were related to rebranding and systems replatforming. Further acquisition related costs are anticipated and will be categorized as non-recurring items in the fourth quarter. When we announced the deal, we estimated one-time costs at around 50 to 55 million US. And we expect to be within that range.

Effective tax rate for the quarter was 27.6 percent, down from 32.7 last year and up slightly from 25.9 in Q2 of this year. Tax rates benefited from the lower statutory rate, lower rates and such, loss carry forwards and other initiatives. We expect that the average tax rate for fiscal 2002 will be around 29 to 30 percent which is lower than the 32 to 34 that I had previously provided. Cash on [INAUDIBLE] of 14.4 for the quarter reflects the improvement over Q2. And as you can see, revenue was down 4.1 percent reflecting the losses on investment securities this quarter and expenses were higher due to acquisition.

There is more to that story and I'll get to that in a moment. Turning to slide three, you can see the group performance, as I indicated, personal commercial strong results both on a linked basis and year-over-year basis investment banking was impacted by the write-downs and private clients held well in the difficult operating environment.

Turning to Slide 6, we provided a reconciliation of the earnings per share on a linked and a year-over-year basis. So if we break down the changes that are reported, you look at the Q2 '02 number you saw 59 cents a share. Provisions for credit losses were lower. That gives a lift of 21 cents a share. The CBOs we have taken a writedown in the second quarter so it only affected the link comparison by one cent. Other net investment losses would be six. And with other of one cents a share, it brings us to the 72 cents that we have reported.

You look at it year-over-year base, provision for credit losses were higher than a year ago accounting for 6 cents. The CBOs were higher accountings for 7 cents and the other net investment losses an additional 7 cents. Underlying business growth was about 4 cents a share. Illustrating the reconciliation between the 88 and the 72 cents.

If we turn to Slide 8, we have shown you a breakdown of revenue growth. You can see that revenue is down 3.6 percent from Q2. That was due to the net investment security losses of approximately 116 million pre-tax. Mostly in investment banking which were partially offset by the strong volume growth in personal and commercial banking. In fact, if you factor out the write-downs this quarter, revenues actually increase quarter over quarter.

If you break down the components of revenue between net interest income or spread and other income, you can see that net interest income increased 17 million from the second quarter. That's because average assets went up about 3.6 billion and net interest margin actually zeroed slightly by about 7 basis points. Margins declined in Canadian and US retail banking and also in wholesale banking but the asset levels grew in all the groups. The other income is the area that was affected by the CBO writedown of 35 million pre-tax and the other net investment 35 million US pre-tax for Canadian 56 pre-tax. Also, it was affected by the other net investment security losses, lower securitization revenue than the previous quarter, where we had a gain on securitizations in our corporate loan portfolio. Offset by volume growth in personal commercial.

If you look at Slide 10, you can see the trend in our overall net interest margins and you can see a slight decline of 7 cents for the total bank. P&C down 4 basis points and IBG is down, as well. Those reflect the fact that wholesale spreads came down as the yield curve was more flat this quarter. P&C spreads were stable in Canada but in the US, they narrowed somewhat.

On Chart 11, we have broken down the investment writedown and you can see the impact of those write-downs on a pre-tax basis and the effect on the earnings per share. So the CBO write-downs of $56 million pre-tax was about 7 cents of the 20 cents of total writedown. And although the accounting rules do not require us to write this off, we decided it was prudent, given that the outlook was not improving. WorldCom bonds were written down and accounted for approximately 3 cents. And given the economic cycle, other write-downs take in accounted for approximately 10 cents and these write-downs were in our equity and fixed income portfolios as well as our merchant banking. The 20 cents of the total write-downs was offset by approximately 6 cents of gains bringing the net 14 cents.

On Slide 12, you can see components of our operating performance. And looking at the expense side, we have shown a comparison on a link basis and a year-over-year basis of the total expenses taking into consideration acquisitions. You can see consistent with Q2, the bank's core expenses continue to be successfully managed down. This is demonstrated notably in the slide for Q3 by the decline in ongoing growth from last quarter despite additional days.

Excluding acquisition expenses for the quarter, it decreased 43 million from Q3 of last year, mainly due to reduced variable compensations commensurate with the write-downs in investment banking. The expense to revenue ratio on Slide 13 was affected both by the acquisitions on the expense side as well as the write-downs on the revenue side and so they were at the level of 68.4 percent. If you factor out the write-downs and the acquisition, the productivity ratio of our core business is around 64 percent. Turning to the group performance on Slide 14, you can see the personal and commercial total Canada and US results and the strong growth in terms of revenue, net income.

On Slide 15, we have broken out the performance between the US and Canada and then illustrates the improved contributions from both franchises. You can see that, uhm, Chicagoland Banking results have improved almost double over last year of in quarter and on a link basis most of the improvement is related to Canada.

Slide 17 through 19 show the significant volume growth that we're experiencing in our personal and commercial business. The sales force has generated strong growth and market share and the momentum continues in Q3. Residential mortgage balances grew 13.5 percent over last year and continue to grow versus Q2 of this year. Personal loans and deposits on slides 18 and 19 exhibit similar favorable trends. In the US, we experienced strong loan growth and deposit growth coupled with the growth attributed to the Joliette acquisition. The market share related to those growths are shown on slide 20 where you can see improvements on almost all the major products.

Slide 21 shows the IBG performance on a quarterly basis and you can see that this declined considerably given the level of write-downs taken this quarter. Revenues fell 28 percent from Q3 of last year and much of the decline was due to the recognition of the losses on investment securities but it also reflected lower lending volumes in weak credit environments and the fact that we had a significant prior year dividend revenue in our [merchant] banks.

On the positive side, we saw improved equity origination volume, partially offsetting the effective decreased mergers and acquisition activity. Net interest margin narrowed from the third quarter due to the lower spreads and capital markets businesses and the effect of the prior year dividend. On a link basis revenues were down 16 percent driven by an increase in the investment security losses, lower interest income and reduced M&A activity. Expenses continue to decrease. Due to the lower revenue base compensation costs and other costs containment measures. Private client groups performance is shown on slide 23. And you can see that it was flat year-over-year at 25 million despite a weak economic environment.

As Tony indicated, CSFB is fully integrated and produced positive cash net income this quarter. The Morgan Stanley online was close and is not impacting these results this quarter. Turning to slide 25, we show the assets under management and the assets under administration for private client group and you can see that they're up modestly from the second quarter given the difficult market conditions. We were pleased with this result and it was really related to the acquisitions as well as the strategic initiatives.

We have shown on slides 26 and 27 a lot of the details related to the direct investing and the CSFB acquisition now Harris Direct and as Tony indicated active accounts have increased. We are on side with most of our targets with the exception of the revenue per cap which is really impacted by the challenging market environment.

Turning to slide 29, you can see that the capital position of the bank remains strong. Both the Tier 1 ratio and the total capital ratios increased from the second quarter primarily due to increased earnings and a small modest increase in risk weighted assets. The risk weighted assets are shown on slide 30 and only up slightly over the last quarter.

Slide 31 shows our annual targets for the year and as Tony's indicated, we continue to expect cash EPS growth of 8 to 12 percent for the full year, which will require minimum of 84 cents per share in the fourth quarter. This is achievable if you start with a base of 72 cents a share for the quarter and add back the 7 cents for the CBO and 3 cents for WorldCom, both of which have been written off. That brings to you 82 cents. Factoring in business growth, we believe it will push us into the target range. However, if there is a significant negative event, this could obviously be a challenge. Achievement of the cash EPS growth target will also ensure achievement of the cash ROE target and as mentioned earlier, PCL will remain within our revised guidance of 775 to 825. Now I'll turn it over to Mike.

Thank you, Karen and good afternoon, everyone. As Tony mentioned, [INAUDIBLE] quality in the third quarter was essentially in line with expectations.

Let me then walk you quickly through the main highlights of the quarter as slide 32 indicates, the third quarter has been yet another busy and productive quarter for our workout and restructuring teams. While formations of growth impaired loans declined 4 percent quarter over quarter, write-offs increased significantly in the third quarter, reflecting primarily recognition of the low recovery level on a number of telecom exposures.

Reductions in gross impaired loans were 210 million in the quarter, about a third lower than in the previous one as sales of [public] loans in the third quarter were less than 20 million versus approximately $300 million in the second quarter. However, successful restructurings of a number of impaired loans in manufacturing, transportation, service industry and retail trade, resulted in a significant level of repayments during the quarter primarily in the US, commercial and corporate portfolios.

Turning to the consumer and commercial portfolios shown on Slide 3, you can see that key asset quality indicators continue to be encouraging in both cases. As you know, the consumer portfolio and the Canadian commercial portfolio together represent about 70 percent of the overall loan portfolio. This plus the progress achieved in managing the impaired corporate portfolio over the past 2 quarters underpins our confidence that the loan loss provision guidance remains achievable.

Turning to trading -- slide 4, you can see that our activities were trending somewhat lower during the quarter. However, net trading revenue was strong and relatively consistent throughout the quarter with 64 out of 66 trading days showing a positive P&L. Before concluding, let me briefly outline the content of the index. On slides 6 and 7, data on communications and power sectors respectively. On slide 8, you'll find highlights to our exposure to Brazil, Argentina and Uruguay. Slide 9 contains a summary of our structural market risk exposures. And on slide 10 you'll find a chart showing the frequency distribution of our daily net revenue trading and underwriting activities in the third quarter. At this point, let me turn the conference over to Tony Comper. Tony.

Thanks, Mike. Just before we get into the questions, I just wanted to add a special item to today's agenda and that's to note that with regret that our colleague Al McNally will no longer be among us at these quarterly meetings. Al will continue to be with us. He is being kicked upstairs as Non-executive Chairman of [INAUDIBLE] Bank Corp and I wanted to acknowledge his significant contribution to this Enterprise over almost 3 decades. Thanks, Al and from a go forward basis Frank Teacher will be speaking to issues from the Harris Bank in Chicago. Okay, conference Operator, could we take the first question please?

If you would like to register a question, press 1 followed by a 4 on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and would you like to withdraw your registration, please press the 1 followed by the 3. If you are using a speaker phone, please lift your handset before entering your request. One moment, please, for the first question. And our first question comes from Heather Wolf from Goldman Sachs. Please proceed with your question.

Hi, good afternoon.

Good afternoon, Heather.

Two quick questions for you. First, Karen, I think you had indicated that you thought the minimum of 84 cents in the fourth quarter was possible but obviously a significant event. Could -- if it were to surface, could derail that. And I'm curious if you would be willing to elaborate on any kind of significant event that you think could derail the 84 cents and then the second question is probably for Mike with respect to Adelphia. You indicated in your press release that you had provisioned modestly for in a credit and I'm curious if you can give us any more color there.

This is Karen. What I said, first of all, I don't anticipate any significant event that would be negative. My only point was that when we set out our guidance of the year of 8 to 12 percent we did anticipate Teleglobe. We have absorbed Teleglobe within our current run rate. We have written off the PCL. So we have less margin for unexpected events. But I am not expecting anything at this point.

And the economic backdrop that you are using for that, can we assume that it's similar to this quarter?

Yeah. That's a fair assumption, Heather. The fact of the matter is that -- and I'll give to Mike quickly, is that the US economy, one, is recovering at a slower rate than anybody had anticipated, including ourselves. In fact, the recessionary trough while narrow was broader. It was three quarters, not one quarter. Canada's quite a different story. But we anticipate that that environment is going to persist throughout the fourth quarter at least. Mike?

Thank you, Tony. Heather, this is Mike. With respect to Adelphia, as we mentioned, we have six loans to operating subsidiaries which are adequately secured in our view. With respect to the provision we took, we looked at those six loans and found that two out of the six it would be prudent to place Prudential Provision against those two. Again, no loss is anticipated of any significance the number is $22 million against those two loans.

Perfect. Thanks very much.

The next question comes from Jamie Keating from Merrill Lynch. Please proceed with your question.

Thank you very much. I wonder if I could dig into the securities portfolio on losses a little bit if I may just for some color. I'm curious as to how you or could you describe to us, you know, where the sources of these were in terms of what else may be lurking. I was recalling that the CBO losses are or CDO losses that were put through in the past may have been towards the bottom of the barrel and I thought -- I didn't know we had anymore. And I wonder if you could also perhaps describe a little bit more about the other securities losses you described that they were equity fixed income. And a third category, I just wondered if you could just describe a bit more about that. And then if I may also follow up with a retail question about -- I'll just hold that.

Good afternoon, Jamie. I'll get Karen to give some more of the details. On the CBO business, this is a credit business we started in 1996 building upon some of the capabilities of managing our own loan portfolio. To start it off, we made an injection of capital. What has happened subsequently is that the high yield bond spreads have gone way out and after taking a successive series of write-downs which were -- was not good news, frankly, we're now of the view that we're not going to see a return of those spreads back in the foreseeable future and therefore our decision was, let's get done with it and get the residual equity written off. So that's the position that we took on that Karen, do you want to fill in Jamie's question on the residual securities?

Yes. I indicated in prior meetings that the book value of the equity was 35 million US. We wrote that off. That's 56 Canadian pre-tax. Or 7 cents a share. The WorldCom bonds, we wrote off 27 million, which is 3 cents a share. So that accounts for half of the total writedown. If you look at the other write-downs of 75 million, it was a variety of things, including mid grade bonds, preferred shares, some merchant banking, and some common stock. So really, looking again at the portfolio very carefully, and being prudent with our valuation.

Thanks. Maybe I can follow up on that a little bit. But maybe I'll swing over to retail for now. I just wanted to perhaps ask if Ron or one of the others could give us some commentary or color on the nature of the improvement in operating margin in the retail bank and specifically whether there is a structural improvement under way related to either perhaps some costs rolling off as it related to the technology installation peaking or if there is a sales productivity improvement. I wonder if I can just understand a bit more about why we're seeing the bounce in retail profitability.

The short answer is that some of all of the above but I'll get Ron to respond in more detail. Ron?

Good afternoon, Jamie. It's really a reflection of the story we have been telling for the last year or so. We have the people introduced into the system, the thousand people going back to that point in time. They have been augmented with new technology support. We're always reviewing processes to ensure that we can enable their jobs to be easier to be fulfilled as it pertains to dealing with customers. And we were very aggressive in growing all aspects of our balance sheet whether they be on the personal product side or the commercial product side. So it's a reflection of, I think, improved efficiency, continuing to supply the support to the people so that they can do the job. We're growing volumes and we're picking up market share and, uhm, think we've got a pretty good balance of the spend relative to the revenues that are flowing from them.

And Ron, are there any structural improvement in the costs related to the spend on technology or is that pretty flat?

It's basically tracking the way we would expect it. You know, we'll running up to connected. Tony indicated a little earlier we're about halfway there completed by end of this calendar year, beginning January next year. Those expenses are coming on. But we are always reviewing our overall cost structure to ensure that we can become as efficient as possible, taking out expenses to enable us to incur those incremental investments which ultimately turn into expenses. So it's basically on track. I just think we had of we have a better model than we had before.

Maybe coming at your question, trying to interpret what you were asking, Jamie, a good chunk of those costs for the technology rollout would be capital expenditure costs and they would be amortized over a period of time.

Thank you very much. Looks like a nice underlying quarter.

Thank you, Jamie.

The next question comes from Jack Dzierwa from Salomon Smith Barney. Please proceed with your question.

Thank you very much. Tony, in your introductory remark you mentioned about transnational expansion plans. Can you comment on what to anticipate from this front?

Yes, help me again with that Jack. I'll try to respond to what I think you're asking and then if I don't hit the nail on the head, then come back to me. Basically, what you have seen us do over the last two or three years is build out the platform of the operations of the Bank of Montreal in the US. As you know, our platform starts being bigger than some of our Canadian competitors by a couple of dimensions that we measure and it's focused a lot around the starting point which was the assets of the Harris Bank and the Chicagoland and Illinois area so we're -- the core of the franchise is in retail and commercial in Chicagoland.

The next piece of the puzzle is the investment banking business in the eight-state Midwest region which stems off the core commercial/corporate banking franchise of the Harris bank and more recently what we have been doing is augmenting the private client business that was predominantly a Chicago-based business and expanding that into other geographic locations and other client segments with the series of acquisitions that we have done. So we're quite pleased with the progress that we have made. It certainly shows up when you look at the fact that we have kind of tripled our base in the core retail and commercial franchise in Chicagoland. -- that we're doing very well in terms of building out the investment banking capability in the eight-state Midwest region and the building of the private client business continues apace. The one area that continues to be a bit of a lakuhna if I can put it that way in our investment banking business is that we still believe that we need an equity sales trading and research product capability and they kind of don't come walking along every day. But we keep our eyes open and it wouldn't surprise me at all if you saw us adding that residual product capability to our investment banking capability.

So basically, you see another Robinson Stevens that sort of boutique you would be looking for?

Excuse me? Robbie Stevens? I don't think so. But we need that equity sales trading and research platform. Unfortunately, as you know, they don't come kind of packaged that way, but we continue to look. But the fundamental thing is we're not about to do anything that isn't going to be shareholder-friendly, let me characterize it that way, as we look out for that opportunity.

Fair enough. Thank you very much.

Thanks, Jack.

The next question comes from Jim Bantos from Credit Suisse First Boston. Please proceed with your question.

Good afternoon. You have made some progress in terms of expense reductions on a year-over-year basis. And you're to be commended for that the other banks seem to be a little bit more aggressive and one of the areas that they have seemed to target is the incentive compensation. And there's been some modest reductions that you have shown to date. Can you talk about how you have been tracking in terms of this compensation relative to revenues and where do you see this number going forward? This is maybe an area where it could be the differential in the next quarter.

Well, the fundamental underpinnings of what we have been trying to do on the cost reduction with, I think, success is kind of a brute force approach. So we have been dramatically managing each element of expense. We have been containing our hiring programs except in the areas where we believe they are directly related to revenue growth. We have been controlling our overall salary cost and just managing each element of expense while we get on with some more fundamental process changes that are kind of under way but take a little bit longer period of time. I'm going to get Yvan Bourdeau to talk about the variable comp reductions that we saw this quarter. Yvan?

Thank you, Tony. I would like at the outset to mention overall the (indiscernible) your group in the enterprise, in addition to concentrating on the variable comp, we do spend a lot of effort trying to manage our other expenses and you will see from quarter to quarter and year-over-year some progress that we have made there by improving the productivity of the investment bank. Now, specifically, as we're say the variable comp, as you know, we do have some formula that drives revenue base on -- as to how much of a performance that is contributed by the investment bank.

If you were to look as of the end of the Q3, our variable comp would actually accrue in line with the performance that was contributed in the first three quarters by the investment bank. We are on the regular basis investigating whether or not our comp is competitive in the marketplace and that's one area that we have to pay a fair amount of attentions as you are probably familiar with and I have to say that at this point in time we are probably -- we are competitive, and by the same token I would say that we are probably a bit on the conservative side so. Looking forward, anticipating the type of result that Karen has outlined earlier I would expect that our variable comp will actually increase in Q4 because we anticipate the contribution from the investment bank to be greater than what you have seen in Q3.

That's great. Thank you. And in terms of the improvements on the investment banking side, from a revenue perspective in Q4, are there particular areas outside of the security gains that we should likely see some sort of rebound on that you can see -- you feel more confident in terms of improvement, say, Yvan?

I would say that obviously we were affected in Q3 by the investment security write-downs. Looking forward, there is no question that we're seeing some improvement in capital markets on the part of our clients. Given where the yield curve is at this point in time, we have seen in the third quarter and you've seen that in our results in Q3 on the trading front, improving substantially from Q2. And I was primarily driven by client -- and that was primarily driven by client business.

And I believe that given the volatility that we have experienced so far, our clients will be more prone in seeking our advice as to how they should hedge their interest rate risk or foreign exchange risk. So anticipate in Q4 ongoing demand for those products which would bode well for our capital markets unit. On the investment banking front, the M&A was relatively weak in Q3. And I was primarily driven because of the market condition that we were confronted w once again, we're seeing sign of improvement in the marketplace. And I'm anticipating that in Q4 we should have better result from an M&A point of view.

Thanks very much for the color. I appreciate it.

The next question comes from Melanie Ward from RBC Capital Markets. Please proceed with your question.

Great. Thanks very much. Could you tell us the size of your merchant banking portfolio right know?

I'll get -- thanks, Melanie. Good afternoon. I'll get Mike Maila to address that.

Melanie, this is Mike. In total, it's about 600 million of outstanding investment. Of which about 2/3rds are in the Investment Banking Group. And 200 million would be venture capital in Canada.

The Canada piece being relatively smaller ticket items. The US piece being relatively larger ticket items. But size-wise in the 10 to $15 million range of investment each.

Great. Thanks. And could you also elaborate a little bit on your airline exposure?

Mike?

Melanie, the airline sector have not been one we have focused on. At the moment, the exposure in terms of loans outstanding is about 100 million. -- about $100 million.

Great. Thanks very much.

The next question comes from Ian De Verteuil from BMO Nesbitt Burns. Please proceed with your questions.

Both my questions relate to page 9 of the narrative. The first one is on the expense line, there is a comment made about higher pension costs. I was wondering if Karen could comment, have you changed expected returns or maybe just sort of quantify how much the pension costs kicked in in the quarter and the second question related to the issue of the expensing of stock options. You have indicated that on an annual basis, sorry, looking out at fiscal '03 the impact of stock options would be about 2 to 4 cents a share. But then you say that if you had actually done it this year, the impact would have been 35 million year to date which is I think already 7 cents. Can you reconcile those two numbers for me?

Sure, Ian in terms of pension, we commented on the fact that the pension costs were up there year over last year. Last year the pension expense was zero. Because of the surplus physician. This year, we reduced the investment income assumption on the plan and the annual charge will be about 50 million pre-tax. As we look forward, I think the -- we will review it again and it's possible that it will come down. We'll have to consider that in the context of funding. But I would anticipate the pension expense will increase next year substantially.

Maybe you could flesh that out a little bit? What are your expected returns now?

7.5 percent is what's in our --

How much higher could your pension costs be next year if you, you know, sort of took it down another point?

Yeah. I guess would be around another 40 million. All in.

Thanks.

And that's rough.

Yup.

Give or take 10 on either side. In terms of the stock option, the accounting requirements that the CICA have adopted is that you will expense stock options as they are issued. And so we'll start expensing stock options and it will be about 2 to 4 cents. But each year, that will accumulate to the point that at some point that could reach around the 8-plus cents a share. And that's really the difference between the number we gave you, which is all the stock options that are issued right now. And the impact that would have and the approach that we'll take to adopting the new accounting policy.

Great. Clear answer. Thank you.

The next question comes from [Schleshin Jiwarimani] from Morgan Stanley. Please proceed with your question.

Hi. My question relates to your US strategy. Looks like some of the larger US brokers are exiting the online and direct brokerage market. Could you give us some color on how you might view this market differently and how this fits in with your broader US retail strategy?

Well, to start with and I'll get my colleague to respond but the -- we see this in several dimensions. The most important dimensions arguably is the acquisition of a significant client franchise which has a demographic characteristic which is precisely the target of our private client strategy in the US. And I always remind us that while there is the discussion around this business which had significant volume uplift in the '98, '99, 2000 period, this is quite a mature business.

I have been around long enough to remember when it started back in 1975, so the direct investing business has been with us for almost 30 years now and is a mature business in all aspects. What we like about the client franchise is that we acquired first from CSFB and subsequently from Morgan Stanley they have a profile -- it's not kind of a day trading kind of client profile. They have a profile that looks more like the target market of our private client franchise in the US. So that's encouraging and it was I think a unique opportunity at a point in time. And I couldn't comment frankly on the strategies of the brokers that were disvesting but obviously there is a different strategic view of businesses they wanted to be in versus businesses that we have targeted. Gilles, do you want to today that?

Yes, Tony. As you know, this quarter is when we integrated CSFBdirect and we renamed that Harris Direct. That was at the beginning of May. And at the end of July, it is that we closed on Morgan Stanley line and that was integrated on July 26th, so we're now operating all on the same [INAUDIBLE]. And what we've been able to accomplish, although our projections were less than when we bought CSFBdirect last November we have been able to draw out of that business much more cost than what we had anticipated.

So a combination of that and one-time costs probably coming in less than what we had anticipated we expect that in spite of lower revenues, that the bottom line is going to be roughly the same. You know, we have been able to operate this business on what -- at what we think a pretty slow time at an operating basis, it is making money. Which is quite a departure from last year when these businesses were not making money. We have been at this now for about I guess about 3 months and if anything else, if anything, we feel even more confident that this is going to work out extremely well. As Tony mentioned, the client base is very much an affluent client base. We have already started speaking to the clients. We have active cross-selling programs going on. And clearly they're very receptive to the other offerings which are, in our case, total service and private bank. And already, we have been -- we have seen clients migrate. So in the US now through this direct investing channel, we have 1.5 million clients. And we have only kind of begun with them. But certainly in the early stages, it looks very, very promising.

The added asset was the fact that I commented earlier in my remarks about the quality of the technology offering that we have in Canada. Ditto in the United States where the technology that we acquired with the acquisition is the leading technology in that business. And that's an attractive proposition.

Okay. Thank you.

The next question comes from Michael Goldberg from Dejardens Securities.

Thanks. I have a couple of number questions. One qualitative question. Let me start with the number question. I notice that your other asset category which I guess moves around quite a bit but it's up fairly dramatically this quarter, I presume that's related to derivative-related assets.

Right.

Can you just confirm that? And also, tell me what's the significance of the movement in these derivative-related assets and liabilities?

You're correct it does relate to hedging and derivative-related assets and the significance -- there is no significance to the timing. They're just done in accordance with the underlying business and the -- they turn over fairly quickly so they will move up and down and you'll see an increase in other assets and other liabilities.

Okay. Also, just rather than speaking in terms of the change from prior periods, could you give us the actual amount of revenue and expenses related to the acquisitions in each of the three quarters this year?

Yeah. Uhm, sorry. What -- Michael, can you ask that question again?

Right. Your supplementary has the -- the, uhm, the change number in revenue and expenses related to the acquisitions.

Right.

And a just want to make sure I'm not missing anything. Could you give us the actual amount of revenue and expenses from acquisitions in the each of the first three quarters?

You're looking at the quarter over quarter? So for instance, if you, uhm, look at the Q over Q expense growth in the acquired business, you would see an increase of $22 million.

Yes.

That would be all CSFBdirect. If we're looking at -- if, uhm, let me help you another way. The CSFB or the total acquisition revenue for Q2 would have been about $63 million.

This is for Q2 or for Q3?

For Q2. And then I'll give you the Q3 numbers.

Okay.

So 63 million for Q2. The expenses, 67 million for Q2.

Yes.

And bringing that to a net loss of $4 million. That would include all the amortization items there. CSFB was 33 million in revenue and 45 million in expenses.

Okay.

The Guardian Group of funds would have accounted for about 13 million in revenue. And 10 in expenses. And Joliet would have been the remainder.

Okay.

Now, if you looked at Q3, the big changes are for CSFB because CSFB, now Harris Direct, was only in for two months in Q2 and it's in three months in Q3

Yes.

And our revenue number for CSFB is 59 or 60 million and the mix related to that was 67 million.

So 59 and 67.

Right. And that's -- that as Gilles said on a cash basis, that was positive. It had a large amount of amortization in those expenses of $16 million.

Okay. All right. That's great. And the one other question that I had, was can you give us a little bit more color on what Halfway Connect is all about?

Okay. Let me -- I'll start off but the real pro on this is Ron Rogers. Basically, the -- there is two drivers on this one of which is we had a variety of technology generations if I can characterize it that way in our domestic retail system and this kind of is a comprehensive replacement of the front line technological support to all of our sales staff. So it includes user-friendly hardware and software making it easy to pull together comprehensive client information at point of sale driven by swipe card technology, making it dramatically easier for the sales staff to support the clients.

One of the more interesting benefits comes from the fact that with the older technology that this is replacing, there is a fairly significant up-front learning curve on the part of new tellers, new CSR's and others probably took them three to four weeks to kind of go up the learning curve on some of the more -- on some of the more archaic coding and software front end. This replaces it with icon-driven technology which makes the learning curve collapse to literally almost 24 hours and so they are kind of waxing enthusiastic about how this is helping them do their job and serving the clients. And the basic payoffs is reduced time to serve client and significantly enhanced cross-sell and marketing opportunities. Ron, do you want to add something to that?

I don't think the expert can add too much to that. [ Laughter ] I think you covered it pretty well. Michael, it's really getting a Cingular platform out there that makes it a lot easier for our people to access information about clients almost instantaneously, and it provides us with in essence the tracks to come along later on with additional software using customer value management which we're also investing in fairly rapidly, which will enable people to do an awful lot more in dealing with clients and understanding -- doing a lot more predictive modeling and the like and enabling themselves to do quickly -- to quickly come up with solutions that previously would take extended periods of time.

And from a RAS perspective where that is reliability, availability and security, it's significantly easier to maintain and to put in new copies of the software operating in the local servers and things of that nature so up time is going to increase marginally, not consequentially but we are going to have better up time as a result.

And just a couple of other questions about this. Michael, you had up until fairly recently, quite a bit of duplication as I understand in your client files. Has that pretty much been cleared up now?

Yes, it has, Michael.

Michael, just in the interests of time, I think we are going to move on to another question. Perhaps you can get back into the queue if you would like to ask a further question.

Thank you. The next question comes from Steve Cawley from TD Newcrest. Please proceed with your question.

The first question is for Mike. Mike, speaking to some of our telecom people who thought that you were being pretty optimistic with the 93 percent recovery rate on Adelphia, could you maybe talk a little bit more about that? Tell me where you are getting that level of confidence?

Yes. Steve, okay, as I mentioned, we have six separate loans to six operating subsidiaries. And it's difficult to generalize across the board unless you look at the numbers and cash flow for each subscriber base. So we have gone through that exercise on the loan-by-loan basis and as I said, we believe the loans are adequately secured, interest is current, and in effect, the Prudential provision we put against two of the loans was that we felt they were slightly less well secured than the other four.

And the fact that there is quite a bit of cable assets out for sale right now doesn't concern you that the value of Adelphia's assets may fall in value?

The values may well fall, as long as we have adequate protection and dedication of the cash flow to repay our loans obviously that's the first way out, Steve.

Okay. All right. Next question for Tony, Tony, I'm a little surprised to hear you talking about wanting to make a brokerage acquisition sales trading and research in the US. To me, it looks like Harris is doing pretty well right now. The retail platform is growing assets. And in this marketplace, people are more willing to pay a premium multiple for retail franchises than wholesale. Could you maybe just go back to that discussion and maybe talk about the preference of brokerage versus retail acquisitions in the US market?

It's not a preference of one versus the other. The fact of the matter is that we really have three businesses in the US. We have the retail and commercial business in Chicagoland and you are absolutely right, that's -- we're growing that. The second business is what we call our investment banking business Harris Nesbitt and that's more of the inheritance of the corporate bank client franchise of the Harris bank which is kind of an 8-state Midwest business. We are well positioned with lending and debt capability in the US right now. But we think the added product capability for the investment banking business would be to add an institutional equity sales and trading capability, part of which we're building right now, but if something that was within the crosshairs of meeting our financial expectations came along, we would add that to it. So that's independent, if you will, of the retail and commercial banking business, which is in Chicagoland. And the private client business I have already talked about is the third major business in the U.S.

To go back to the retail franchise for a second, given the positive experience you have had with Joliet, does it give you -- are you more inclined now to take a look at the limited franchises that are left in the Chicago market and say to yourself, maybe we can pay a little bit higher for these franchises because of the experience with Joliet and try to get investors to think a little bit more long term on this story?

Well, you know, we have -- we think it's important to maintain our expectations in terms of what we're going to get by way of return but we pretty well built out the major areas where we are but we will continue with a program of selective acquisition and de novo branching to the tune of we think we need about another 50 physical branches within that broader area and we'll get there by being opportunistically acquiring. If there is a bank where we want to go and they have a one or two branch outlet and that looks like it makes better economic sense than building out on our own -- but the broad program is we'll be bigger by about a third in about four to five years through a combination of selective acquisition, if that looks good, or de novo growth.

So finally, maybe I would ask it this way to go back to the initial point: If there was an optimal split between retail and wholesale, at Harris, let's say five years out, would it be much different than what we're seeing today?

It depends on the rate of growth and we will challenge each one of the businesses to kind of maintain their relative percentage of the pie by not slowing down in any of the areas. So but we don't have a view of the optimal growth rates. Clearly, the retail and commercial business is growing at a pace that's going to be pretty challenging for our colleagues in the Investment Banking Group to match for the guys in the private client which have also got pretty good growth prospects so we haven't put a pin into exactly what we would like the -- either the relative growth rates or the resting position to be in that but obviously some of the businesses have faster growth rates than others.

Thanks for your time.

The next question comes from Rob Wessel from National Bank Financial. Please proceed with your question.

Rob, before you start, I'm mindful of everyone's time and I know you have a conference call after this one here, so if we could keep the questions just to one and then if there is any further maybe as a follow-up or you could call us later, that would be helpful. Thank you.

Good afternoon, Rob.

Good afternoon. I'm sorry, one question? Is that what you said?

Just to make sure that everybody gets a chance, Rob.

I'll go as quick as I can. I just wanted to clarify something that Karen had said, uhm, with respect to the acquisition expenses which were classified as one time and then I may have misunderstood but I thought she had mentioned that they thought there were more coming. So does that make them recurring or did I misunderstand?

Rob, it's Karen and when we did the deal we said it would be about 50 to 55 million US and we think we'll be in that range. And the bulk of the remainder of the expenses will be in the fourth quarter as non-recurring.

Great. I have one more equally short question.

Okay.

With respect to the guidance for Q4 being 82 cents, I know that you did a reconciliation of 72 cents reported now plus 7 cents for the CBO and 3 cents for WorldCom got you to 82. Does that mean that by inference we should assume that there are more write-downs coming, another four or five cents next quarter?

No. That's just hypothetical.

Thank you.

The next question comes from Susan Cohen from Dundee Securities. Please proceed with your question. Ms. Cohen yours line is open. Please proceed with your question.

At this point, can you give us any guidance with respect to loan loss provision for 2003?

No, we can't at this point in time. It's a little bit early in the cycle. We're still in the phasing of -- phases of our planning and we would do that as is our normal course in November, when we communicate our final fourth quarter results, Susan.

Okay. Given that I didn't get a good answer -- well, the answer I wanted to that, could I ask one quick question?

Go ahead, Susan. [ Laughter ]

Just with respect to the power and power generation slide, can you just talk about the areas that you would highlight as being more risky than others within the categories that you have broken down?

Mike?

Yes, Susan. It's Mike here. Obviously, we've tried to show you the regulated utilities which tend to have cash flows that are more predictable. So that would be the first category on slide 7. Diversified generation, obviously benefits from a number of projects where some might do better than others and would compensate so I would say in terms of risk class, we would look to the diversification as a benefit. The third level, more or less, in the order in which we show it, would be generation projects that benefit from power purchase agreements where essentially the market price and volume risk possibly as well could be off taken and therefore we have covered that risk through acceptable third parties. And then finally, perhaps the one where you see the impairments is the merchant generation projects which are single projects, obviously not diversified, and don't benefit from the PTA, so I hope that helps you, Susan.

It does. Thank you.

Thanks, Susan

The next question comes from Quentin Broad from CIBC World Markets. Please proceed with your question.

Thank you. Good afternoon. I guess for Mike, two quick questions. Mike, is there a nuance in the trading revenue histogram that wasn't there in Q1 when you reflect trading and underwriting revenues versus there wasn't the underwriting component of that headline in Q1 of this year?

No. Quentin, typically, we have a broader definition perhaps than most and we have since Q1 taken the broadest possible definition of including trading and underwriting positions. In fact, it's broader than an accounting definition of mark-to-market. We include portfolios that may be on accrual but in fact are managed from a risk standpoint as mark-to-market.

Okay. And on page 34 of the sub pack, I believe it is, there is a note regarding the market value exposures. Could you just explain that, Mike, to me, with respect to having exposure to falling US rates and rising Canadian rates, which would seem to be perhaps in the offing?

Can you refer me specifically to what footnote, Quentin?

Page 34, I believe it is, footnote 2?

Yes. So as it happens, from an interest rate standpoint, we are positioned to have exposure to falling interest rates in the US and to rising interest rates in Canada. This measure is conservative as we do not recognize the benefit of any correlation between those two risks. And simply add them up. So it's a very conservative measure where we add up the risks even though they may be in opposite directions, Quentin.

But by definition that would suggest the bank is expecting a rising US rate environment and a falling Canadian rate environment?

You could possibly infer that. But it's a matter of balancing the risks over time to maintain stable high quality earnings. That's the purpose of our structural interest rate management. We do not take positions of that sort except in our trading and underwriting portfolios, Quentin, generally.

Okay. Thanks.

Our next question comes from Trevor Bateman from CIBC World Markets. Please proceed with your question.

Hi, good afternoon. Just ask -- posing a question with respect to the commitments to extend credit just in the context of an increase in the quarter, in relation to the overall general trend of the decline in that amount of extended. I was wondering could you provide color on that and how does the composition of the commitments compare to what's on your balance sheet?

Trevor, this is Mike. He think if you refer to page 23 of the supplementary package, you will see the evolution over time of our commitments and contingent liabilities. I believe you are focusing on commitments.

Yes.

And if you look at that, in effect, between October 30 1st and July 31st, the commitments with original maturity of a year and under have actually increased from 69.4 billion to 73.7, whereas those with maturity of more than one year have gone down slightly from 25 to 23. Is that what you were getting at?

Yeah, sorry about that. Yeah, on slide 23. I was trying to understand it in the context of the general industry decline in those commitments in the quarter.

Well, we have taken the view that essentially, these commitments would -- which come approximately to 9 percent of the loan outstandings in the risk-weighted asset terms are essentially a reflection of the various decisions we make on individual portfolios. So you can see that as part of our normal loan portfolio growth, Trevor.

Okay. Thanks.

Ms. Payne, there are no further questions at this time. I will turn the call back to you.

Thank you. Thanks for joining us today. And as always, if there are any further questions, please either call us at investor relations at 416-867-6656 or email us at BMO.com/investorrelations. Thank you and good afternoon.

Thanks, everyone.

Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your line. Have a good day, everyone.