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Gerry McCaughey, CEO of CIBC

The week before Christmas, a group of senior bankers gathered at the Toronto offices of Canadian Imperial Bank of Commerce to work out the details of an emergency funding effort.

For CIBC chief executive officer Gerry McCaughey, it had been both a miserable and taxing month, doubtless the most difficult of his 21/2-year reign atop the bank. The bank had taken $753-million in writedowns because of its entanglement with a spiralling subprime mortgage mess, and recently stunned investors with the acknowledgment that it had $10-billion worth of hedged exposure to that market.

What these investors didn't know was that CIBC was preparing to write down an additional $2-billion in a matter of weeks, enough to make it one of the costliest misadventures in Canadian banking history.

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Mr. McCaughey, whose entire tenure to this point had been geared toward erasing the taint of previous scandals, methodically stripping away risk and rehabilitating the bank's maverick reputation, knew that he would have to make senior management changes, and was already in secret negotiations to recruit his close friend Richard Nesbitt, who runs the Toronto Stock Exchange, as a replacement for Brian Shaw as head of the gaffe-prone investment bank, CIBC World Markets.

Mr. Shaw, who probably suspected at this time that his days were numbered, nevertheless remained in Toronto while his family went to Mexico on vacation, helping to carry out one of Mr. McCaughey's imperatives: Defusing potential bombs by exiting whatever remained of the bank's structured product businesses. About 40 consultants had also been brought in to help CIBC clean up the debris.

The most pressing issue was the bank's balance sheet. Given the grisly prognosis for the subprime market, it had become clear that CIBC would likely have to take billions of dollars in additional charges to mark down the value of its holdings, a scenario that would erode the bank's capital levels and could put them dangerously close to minimum regulatory limits.

At a board meeting in December, Mr. McCaughey and his fellow directors agreed that the bank would have to approach private and public investors to raise close to $3-billion, and that it should do so as fast as practicable: Any delay could make the effort more costly, if not impossible, given that conditions were deteriorating almost daily.

On Dec. 18, Mr. McCaughey hired UBS as a financial adviser, in part because of the firm's strength in the banking sector, and in part because of his respect for Oliver Sarkozy, UBS's joint global head of financial institutions - and, incidentally, the half-brother of French President Nicholas Sarkozy. The two bankers had met when CIBC purchased an additional stake in FirstCaribbean International Bank in 2006, and had remained close since that deal, keeping in touch with regular telephone conversations.

The initial meeting, in Toronto, was supposed to last a half hour, but went much longer, thanks to an extended conversation about history between Mr. McCaughey and Mr. Sarkozy - surely no surprise to the CIBC contingent, who are well acquainted with their boss's tendency to digress.

When they did get down to business, Mr. McCaughey insisted that he would not merely issue a chunk of stock in a private placement to large institutional investors - he wanted a sizable piece to be sold to the public as well. The deal would also have to be straight equity: CIBC couldn't issue preferred shares, as many of its U.S. peers have done to bail themselves out of similar trouble, because the bank was already up against a cap on these securities.

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Throughout the holidays - even on Christmas Day - the bankers finalized details of the plan, and kept in touch daily on 8 a.m. phone calls. As the New Year approached, they drew up a list of private parties who might be enticed to buy $1.5-billion worth of stock; an additional $1.25-billion would be sold in the market to regular investors.

The list included the Ontario Teacher's Pension Plan; Asian tycoon Li Ka-shing, once a major shareholder of the bank, and a customer dating back almost four decades; Canada Pension Plan Investment Board; insurer Manulife Financial Corp., once rumoured to be a possible merger partner for CIBC; the Caisse de dépôt et placement du Québec; and the Ontario Municipal Employees Retirement System.

On Monday, Jan. 7 - the first day back from holidays for many on Bay Street - the bank dropped the bombshell: Mr. Nesbitt would leave the TSX and replace Mr. Shaw as head of CIBC World Markets; Tom Woods, the chief financial officer, would be placed in charge of the faltering risk management operation, taking over from Ken Kilgour; David Williamson, a well-regarded former executive at life insurer Clarica, would be brought in as CFO; and Nick LePan, the past Superintendent of Financial Institutions, would join the board.

A few days prior to this announcement, CIBC had secretly begun to contact private investors, and initially the hope was to unveil the capital-raising effort in the second week of January. But there was a glitch. Teachers, which had contemplated taking a large piece of the deal, was demanding more stringent terms than CIBC was willing to offer. The bank balked, and Teachers left the table, forcing CIBC to bring in another investor.

Other than causing a small delay, however, this did little to upset the bank's plans; in fact, the participation was so strong - abetted by an offering price that was about 13 per cent lower than where CIBC's stock was trading - that another pension fund, the Public Sector Pension Investment Board, was refused a piece of the deal when it attempted to get in at the 11th hour.

But once news of the capital injection hit the markets, reaction was mixed. While some applauded Mr. McCaughey's prudence, and agreed that this would cushion the blow, others viewed it as a grim portent.

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The bank could have absorbed the $2-billion it planned to write down in the first quarter of this year, but adding more capital was tantamount to an expectation - if not an admission - that more was to come.

New and improved CIBC On the last day of May, 2007, a group of senior management at CIBC huddled in a boardroom and prepared to begin a conference call with analysts. It had been a good second quarter, for the most part. For more than a year, Mr. McCaughey had been painstakingly laying out his vision for the New and Improved CIBC: no more fumbling after Wall Street glory, no more over-the-top risk-taking.

This was a return to your grandmother's bank, a boring cash cow that catered to retail customers, lent money to Canadian corporate clients, managed financial wealth, and augmented this with a strong, but plain vanilla, investment bank.

So far, so good, investors seemed to be saying.

Of course, banks can't control the economy, and CIBC, like most in the industry, could see trouble on the horizon. In the previous few months, there were worrisome signs emanating from the U.S. housing market, which was suffering rising defaults among so-called "subprime" borrowers: that is, people with weak credit histories that had purchased a home at higher interest rates. Billions of dollars worth of these mortgages were bundled into complex securities known as collateralized debt obligations, or CDOs, and then sold off in chunks to large investors, including banks.

Smart investors were starting to ask questions. On the May conference call, a hedge fund manager, Mark Cicirelli, asked a seemingly arcane question about CIBC's exposure to a small CDO called Tricadia 2006-07, from which the bank had apparently purchased $330-million worth of securities backed by mortgages: How much money did the bank stand to lose if the mortgage market fell off a cliff, something that was now looking more and more likely?

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Not much, replied Brian Shaw, head of CIBC's investment bank. He explained that Tricadia pooled together a series of reasonably good-quality CDOs, and the result was a security that was highly rated by the credit rating agencies.

"I guess I would just conclude," he offered, "by saying in summary our risk in this space is not at all major."

Mr. Cicirelli wasn't altogether convinced by the explanation. Nor, for that matter, was Mr. McCaughey.

'De-risking the business' For the next few weeks after the call, Mr. McCaughey attempted to get the measure of CIBC's dealings with the worsening subprime market and, autodidact that he is, make himself an expert on the subject. Although he was not intimately aware of the bank's CDO activities, given they were such a small part of the bank's overall business, sources said the Tricadia question left him uneasy: History had long since taught him that if someone smelled smoke at CIBC, a fire was probably not far behind.

As June progressed, this smoke only thickened. A growing host of subprime casualties was appearing, headlined by a major blowup at a hedge fund operated by Bear Stearns, Wall Street's fifth-largest player.

Despite reassurances from some of his managers that the majority of these CDOs were not merely safe, but also insured, Mr. McCaughey began questioning everyone, from department heads to front-line traders. Often, sources said, he would request sheaves of information, take it home on the weekend, and arrive Monday morning armed with a series of questions.

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The answers, it soon became apparent, were of little comfort, either to Mr. McCaughey or the board, which received a debriefing on the issue during the middle of the month.

CIBC, a bank whose mantra had become "de-risking," was sitting on $1.7-billion worth of unhedged CDOs, much of which were backed by subprime mortgages - in other words, the bank had not bought protection from insurers to guard against the possibility of default on this portfolio.

A further $10-billion worth - a staggering amount - had indeed been hedged, but $3.5-billion of that amount was hedged with a single insurer. Normally, that kind of concentration would elicit concern, but Mr. McCaughey was told by some managers that there was little to worry about: These securities were rated triple-A - in other words, very safe and low-yielding - and on top of that, CIBC had purchased protection from an A-rated bond insurer.

"As we were de-risking the business, it was an area we didn't get to," conceded one director. "We didn't think of it as high risk."

By the time they did, it was all but too late - in the second week of July, the CDO market collapsed, leaving the bank with little means of offloading its holdings or buying further protection.

Two years after arriving as CEO, and working to overcome a $2.4-billion (U.S.) settlement with Enron Corp. investors, Mr. McCaughey was facing the possibility he might have to write down most of the value of his $1.7-billion worth of unhedged positions, leaving the bank with a punitive charge. Little did he know at the time, that that was the least of his worries.

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A triumph of alchemy It's logical to ask, given the bank's self-proclaimed focus on risk, just how CIBC could blunder into what one director described as "a catastrophe." To be fair, a good portion of the problem was systemic, and any investment bank that had the misfortune of playing in this game has been savaged, as the examples of Citigroup, Merrill Lynch, UBS, and Bear Stearns, among others, have made painfully clear. So far, global banks have written off more than $100-billion in subprime-related mishaps, and the toll continues to climb.

So how could some of the shrewdest minds in the financial world be so horribly gulled?

The explosion of CDOs in recent years is a triumph of alchemy; financial engineers, looking to create a more liquid market for asset-backed securities, devised a way to repackage questionable assets in a way that won top marks from credit rating agencies.

The process is notoriously complex, and has several permutations, but a basic scenario would look something like this. An investment bank pools together various forms of debt, like subprime mortgages, into a CDO structure. The structure is then divided into layers, or "tranches:" The top portion, the most highly rated, would have the least chance of default but would pay the lowest interest. As one descends through the layers, the risk climbs, and so do the premiums to investors.

The theory behind CDOs was that they could diversify risk by slicing it up and dispersing it widely throughout the financial system. Of course, the appetite for these securities fuelled the need for more and more product, which meant that many people who shouldn't have qualified for mortgages - or who were likely to default once their payments increased - were approved for homes they couldn't afford.

Once the mortgage market collapsed, it triggered a domino effect in the financial system, decimating the value of CDOs, forcing banks to take charges, and threatening the stability of the very insurers from whom banks like CIBC bought protection.

The glaring flaw in this meltdown was the ratings: In retrospect, these subprime-backed securities look nowhere near as safe as the triple-A paper issued by the world's bluest of blue-chip companies. Yet many were rated as such, thanks to clever financial manoeuvring by the originators of these products - and, many would say, sloppy procedures at some of the world's top credit rating agencies.

Which brings us back to CIBC. The important thing about ratings is how they affect a bank's capital position. Banks are required by regulators to backstop their investments with capital; the higher the rating, the less capital required, since the security is perceived as a relatively low-risk investment. That also means a bank can amass a much larger portfolio of triple-A securities than it could with lower-rated investments.

One of the first things Mr. McCaughey did when he arrived at CIBC was reduce the amount of economic capital at his investment bank by 50 per cent, in essence, drastically reducing its risk profile and tilting more of the bank toward predictable retail earnings.

In theory, that kind of move would force CIBC out of undesirable businesses by putting a chokehold on capital.

In practice, something rather different happened. CIBC migrated to more highly rated securities, in order to ease up on capital, and saw an opportunity in the burgeoning CDO market.

The bank accumulated much of its $12-billion worth of CDO exposure over the past 18 months. Sometimes it would act as guarantor. Sometimes it would actually help structure the deals. And sometimes it would simply be a buyer.

"They acted as sales agent, guarantor, underwriter," said one person familiar with the bank's involvement. "It was for information flow; you create a body of knowledge, and you become a player."

Picture this. An investment bank originates a CDO, and asks CIBC to guarantee - or essentially insure - a senior tranche of triple-A-rated notes. The bank says fine, since the capital requirements would be minimal, and then, for added caution, takes out the equivalent of a reinsurance policy with another bond insurer. The bank collects a premium as a guarantor, pays out a smaller premium to the insurer, and pockets the difference. In other cases, when the bank was trying to help a deal along, it would take a chunk of triple-A securities onto its own books without buying protection: The irony is that these securities were seen as having such low risk - and consequently, paid such meagre returns - that it wasn't easy to offload them.

Even so, as several executives and directors have privately pointed out, taking unprotected positions in complex derivatives was antithetical to the strategy that Mr. McCaughey had been preaching for the bank: Focusing on core areas of strength, and exiting some of the more exotic areas where the potential for damage far outstripped the possible rewards.

Other Canadian banks largely steered clear of this structured product market, but not CIBC, which has shown an almost genetic predisposition toward following whatever the pack is doing in New York or London, usually with abysmal consequences (Enron and the U.S. mutual fund trading scandal being two of the more recent examples).

"CIBC was not in the business of - and should not have been in the business of - investing in these things for their own account," said one senior source at the bank.

"Somebody on the business side, early in the year, should have seen that this was occurring. We ended up sitting on stuff we shouldn't have been sitting on. It's a management and accountability issue."

The hedged book bites Initially, CIBC appeared to emerge somewhat less scathed than had been expected. In August, the bank ended weeks of speculation by revealing publicly it would take a $290-million charge on $1.7-billion worth of unhedged exposure to CDOs underpinned by residential mortgages.

At this point, other than a few pockets of muttering, no one paid much attention to the hedged book. There was even some cautious optimism. In September, the U.S. Federal Reserve cut the benchmark interest rate by 0.5 percentage points, triggering a mini-rally that appeared to cauterize the bleeding in the subprime market.

But the optimism was short-lived.

By October, the indexes that measure the health of the subprime market were foundering again. At the end of the month, Merrill Lynch reported $8.4-billion (U.S.) in charges, and fired its CEO, Stan O'Neal. Citigroup, meanwhile, unleashed the first in a series of writedowns - $5.9-billion - and its embattled leader, Charles Prince, soon resigned.

On Nov. 5, CIBC parted ways with the head of its debt division, Phipps Lounsbery, who ultimately had responsibility for the CDO book (the same day, incidentally, that Mr. McCaughey unloaded his money-losing U.S. investment bank to Oppenheimer Holdings).

But the trouble was just beginning.

Two days after Mr. Lounsbery departed, ACA, the insurer with which CIBC had hedged $3.5-billion worth of subprime-backed securities, reported a massive loss, and cratered in the market. Standard & Poor's responded by placing ACA on credit watch negative, signalling a possible rating cut.

Such a move would be disastrous for CIBC: If ACA was pushed into default, and could no longer provide insurance, CIBC could be forced to write off billions of dollars. Suddenly, the $10-billion hedged book - up to this point regarded as relatively safe - was in serious jeopardy.

"You expect hedges to work," one director said. "We wished we didn't have one [large]single exposure … but most of our focus was on the unhedged."

From a risk-management perspective, the decision to hedge so heavily with a single insurer - and a shaky one at that - appears foolhardy. Sources said CIBC risk experts and traders would "work down the book," meaning they would hedge with a triple-A-rated insurer for what they could, and then migrate down through the ranks. Others have posited that ACA may have given them more favourable pricing terms for such a large chunk of business.

Regardless of how safe the underlying investments appeared, executives and directors at CIBC acknowledge it was a serious mistake to rely so heavily on one counterparty, and that the risk systems were flawed in that respect.

As ACA teetered, CIBC held a board meeting, and Mr. McCaughey and the directors ran through their options. In the short term, they would signal to the market an additional $463-million in charges on their unhedged securities, which had further declined in value throughout the fall. Longer term, however, they realized they faced more drastic measures.

"We had to keep the bank on the track of refocusing World Markets," explained one director. "And then there was the need to bring in new management. We felt we had to move quickly on that to restore confidence. When all is said and done, we needed a new management team to continue Gerry's strategy and execution."

Elsewhere, some investors have wondered why Mr. McCaughey's own job was not imperilled by this costly pratfall, seeing how similar mistakes sealed the fate of banking CEOs in the U.S.

But several directors at CIBC, who spoke on condition of anonymity, said Mr. McCaughey continues to have their full backing. For one thing, they noted, these securities had received the imprimatur of credit rating agencies, and their collapse gored just about everyone in this area of the market. Secondly, given CDOs were a small and esoteric part of the bank's overall business, the directors maintained the warning signs would not have naturally risen to the CEO's office.

"It's clear he got let down in one part of the business that no one expected to be a problem," a board member said. "This is a damn shame, because that strategy [of reducing risk]is a good one, and Gerry was well down the track."

The popular guessing game now is how much more pain CIBC will have to bear. The bank seems to believe the worst is over, but some analysts remain skeptical, especially in light of news this week surrounding bond insurers, the firms like ACA that provide hedges on the CDOs.

On Thursday, credit rating agency Moody's Investors Service put the ratings of bond insurer MBIA Insurance Corp. on review for a possible downgrade. That came just a day after Ambac Assurance Corp. reported record losses and was itself placed under review, along with all of the securities it guaranteed.

It's not known how much, if any, of CIBC's exposure might be hedged with Ambac or MBIA. In early December, the bank said it had five triple-A-rated counterparties and two double-A-rated counterparties.

Even if the worst of the storm has passed, CIBC still faces a difficult test, not only in recapturing the confidence of investors, who have seen this movie one too many times, but in fixing a risk-monitoring culture that clearly did not function properly.

"The changes that they've made - two very senior and respected board members, plus new members of their executive team - we looked at pretty favourably," said Peter Routledge, a senior credit officer with Moody's.

"But capital isn't a cure for risk-management shortcomings."

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