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TD Bank’s $20-billion question: Was a giant expansion bet on the United States worth it?



As the global financial system melted down in the fall of 2008, executives at Toronto-Dominion Bank had two choices: run for cover and pray, or stick their necks out and seize the moment.

At the time, Canada’s second-largest lender was fresh off nearly $20-billion worth of acquisitions in the United States. But with the prospect of a nasty recession growing, it looked increasingly likely that TD’s growth strategy, shepherded by then chief executive officer Ed Clark, could blow up overnight.

Sensing that he couldn’t let a good crisis go to waste, Mr. Clark went all-in, putting himself out there in the most American way possible: on cable television. Canadian banks were seen as beacons of stability amid global tragedy, and he started doing regular hits on business channels such as CNBC, talking up TD’s folksy retail banking strategy. “The simplest model you could possibly have is just open branches – we call them stores in the United States – in great locations, open them longer than everyone else … and then give just spectacular, friendly service,” he would boast.

It was a brilliant marketing tactic, and better yet, he meant it. TD really did excel in retail branch banking in Canada. And Mr. Clark, along with TD U.S. head Bharat Masrani, had studied the complex mortgage securities business in 2005, but couldn’t make sense of it, so TD exited it years before those securities blew up.

Mr. Clark projected a U.S. expansion built on a safe, boring business. For nearly two decades, the move played out that way. Yet, in an ironic twist, TD’s plain-vanilla banking strategy has come back to bite. In the wake of major anti-money-laundering (AML) breaches, including a prominent role in a US$653-million drug-trafficking ring, TD is now in the crosshairs of every major U.S. banking regulator, as well as the U.S. Department of Justice, potentially facing billions of dollars worth of fines.

Amid the fallout, TD’s U.S. strategy has come into question. Over several decades, scores of foreign banks eyed the massive American market, only to retreat from retail banking licking their wounds. European banks fled in droves, and even TD’s archrival, Royal Bank of Canada, walked away, booking a $1.3-billion writedown during its escape.

By no means has TD’s U.S. expansion been an outright disaster. Its U.S. retail bank is profitable, churning out roughly $4-billion in earnings per year, but TD paid hefty premiums to build a beachhead and that’s hurt its return on equity (ROE), which is the industry’s top measure of performance.

There are also questions about TD’s growth potential. Regulators have already blocked its US$13.4-billion acquisition of Memphis, Tenn.-based First Horizon Corp. because of TD’s AML deficiencies, and there are fears TD’s organic expansion could also be restrained for years. Investors aren’t sure what to make of it all. This week Bank of Nova Scotia analyst Meny Grauman noted they are currently ascribing negative value to TD’s entire U.S. retail division.

TD, for its part, is still enamoured by the U.S. “We are thrilled with our growth and sustained strong performance, and continue to be excited about the potential of our franchise and its opportunities ahead,” Leo Salom, president and CEO of the division, said in a statement to The Globe and Mail.

But TD’s executives have also learned that America is a very different beast from Canada. “The U.S. market is less profitable because there’s way more competition,” National Bank Financial analyst Gabriel Dechaine said in an interview. And a core tenet of TD’s strategy, to be a Main Street bank, hasn’t worked out as planned. “Replicating the Canadian business model is just not possible.”

TD kicked off its U.S. expansion in 2004 by buying 51 per cent of Banknorth, which was based in Portland, Me. At the time, Canadian lenders were grappling with how to grow because Ottawa had blocked two major bank mergers.

TD initially planned to dip its toes into U.S. retail banking, but the expansion rapidly accelerated. After TD bought the rest of Banknorth in 2006, it acquired New Jersey-based Commerce Bank a year later, because the lender unexpectedly came up for sale when its founder got into regulatory trouble. Much like TD, Commerce believed in retail banking, offering its branch customers dog treats and umbrellas if it rained. After the deal closed, TD trademarked the phrase “America’s Most Convenient Bank.”

Through it all, Mr. Clark was the architect of the expansion plan, but he orchestrated it with Mr. Masrani, who became head of the U.S. retail division. All in, they spent just shy of $20-billion from 2004 to 2007, paying an average of 3.2 times book value for the U.S. acquisitions. In banking, paying more than two times book value is seen as pricey. Coughing up more than three times constituted a huge premium.

Had the U.S. economy stayed hot, TD could have thrived and earned back those premiums, but the global financial crisis hit in 2008. Growth was anemic for years because the economy was so weak, and interest rates were slashed to near zero, decimating lending profit margins.

The premiums TD paid also hurt its ROE. When buying a bank, any premium has to be accounted for, dollar-for-dollar, in capital – essentially cash reserves that function as a cushion in hard times. The higher the premium, the more cash that must be set aside. This capital is counted as equity in the ROE calculation, which lowers the return by default.

The global financial crisis also pushed U.S. regulators to effectively double the amount of capital that banks needed to hold in a short period of time. “TD didn’t price their acquisitions anticipating the huge increase in postfinancial-crisis capital levels,” Rob Wessel, a top bank analyst during TD’s acquisition spree and now managing partner of Hamilton ETFs, said in an interview. “That makes it hard to meet their original ROE objectives.”

Inside TD, it took leaders five years from the onset of the crisis to feel as if they were finally entering a growth phase. In 2014, the same year Mr. Masrani succeeded Mr. Clark as CEO, chairman Brian Levitt told The Globe, “We’re no longer in a mode where we say, ‘Don’t look at the numbers, think about the future.’”

It wasn’t bluster. Over the next five years, TD’s annual U.S. earnings more than doubled. Then, during the COVID-19 pandemic, TD benefited from trillions of dollars in U.S. government stimulus sloshing through the American economy.

But below the surface, some things weren’t adding up. In the fall of 2021, TD replaced its U.S. retail banking head and installed Mr. Salom as leader. TD was sitting on billions of dollars of excess cash as well, and it wasn’t clear whether the bank’s leadership was timid to deploy it.

Any questions were put to rest in early 2022, when TD splurged on First Horizon. Strategically, it made a lot of sense. Not only would it push TD into the U.S. Southeast, where the population and economy have been booming – unlike the Northeast and the Mid-Atlantic – but it would make TD more of a commercial bank.

In the U.S., most regional banks are commercial lenders that also offer mortgages or some other retail products. For two decades, TD has tried to be the opposite, and in doing so, it has gone up against national giants such as JP Morgan Chase.

In theory, TD’s strategy was decent. Retail lenders are flush with core deposits, which are cheap sources of funding for a bank’s loans. But that model works better here because Canadians are loyal and happy to deal with a single institution for their mortgage, credit card, investments and day-to-day banking. Americans are built different. So, even though TD has more than 10 million customers along the eastern seaboard, many of them are monoline clients – they only have one product with the bank.

In that respect, First Horizon offered some promise, but the acquisition got blocked last May because of TD’s money laundering woes.

Over the year since, TD mostly treaded water, its hands tied by negotiations with regulators. Last week, the bank finally booked a US$450-million provision after settling with one of three U.S. regulators, but two more are likely to come – plus a Justice Department investigation.

Because TD’s U.S. retail arm earns around $4-billion annually, it can stomach the monetary pain. The big question is whether any non-monetary penalties will stifle growth.

In an extreme case, U.S. regulators could enforce an asset cap, which could prevent TD from growing, even organically, for a number of years. Even if that doesn’t materialize, TD clearly can’t do more U.S. deals for a while, and there could be a wave of consolidation in the banking sector if Republicans win power in elections this November.

At the same time, organic growth is currently hard to come by. Lending margins are shrinking because depositors are demanding higher interest rates, and TD is also spending to update its AML systems. Last year its U.S. banking division had negative 9 per cent operating leverage, which means its expenses grew much faster than its revenues.

There are some bright spots. Ironically, TD may have dodged a bullet with First Horizon, because it had agreed to pay US$25 per share, and the stock closed Friday at US$15.79.

TD is also co-operating with regulators and has taken responsibility for its AML flaws. “Law enforcement pays a lot of attention to co-operation,” said Dan Stipano, a lawyer at Davis Polk & Wardwell LLP in Washington and former deputy chief counsel at the Office of the Controller of the Currency (OCC), the main U.S. banking regulator. “If management is co-operative and deemed capable, they’re generally going to fare better.”

But there’s still so much uncertainty, and there’s nothing investors hate more. Before the AML issue exploded, TD commanded a premium valuation relative to most Canadian rivals, which meant investors weren’t so fussed about lower returns from the U.S. expansion. They wanted a growth story, and TD served one up.

That, at least, is how TD sees it, and it’s why the bank is still all-in on the U.S. “TD’s move into U.S. retail banking has been very successful, as evidenced by the fact America’s Most Convenient Bank has become a top-10 U.S. player in less than 20 years,” Mr. Salom wrote in his statement.

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