Butterfield Bank may have to make further write-downs on its investments, while high expense levels and adverse lending conditions are added challenges facing the Bermuda-based bank in the future.

That is the view of LOM's Equity Research report, which claims that the bank is set to encounter a difficult operating environment during the rest of the year and into 2009.

The study, which was published by Jeremy Dyck, a research analyst at LOM, also said the bank's capital position remained strong and that it had confidence in the management and its ability to turn things around following a disappointing second quarter in which the bank made its first quarterly loss in more than a decade.

LOM said it expected the bank's profitability and productivity measures to gradually move higher, towards historical levels, as the company progressed into next year.

Mr. Dyck said: "The second quarter was obviously a very difficult one for Butterfield. Not only did they report significant one-time losses totalling more than $50 million, but expense growth and a difficult capital markets environment have served to undermine the bank's level of profitability.

"While the near-term environment is indeed challenging, Butterfield is in a strong capital position and we are confident that things will start to improve towards the end of this year and into 2009."

The report said that the bank's significant second-quarter losses of $50.7 million underline its main concerns with its investment book, specifically the bank's $959 million purchase of predominantly long-term collateralised mortgage obligations and asset-backed securities investments during 2007.

Butterfield Bank reported a net loss of $16.5 million in the second quarter of 2008 compared to a profit of $35.9 million during the same period last year, as a result of a one-time operating loss of $50.7 million - $23 million of which came from the permanent impairment of a held-to-maturity investment, and $27.7 million from credit support agreements provided by Butterfield's Money Market Fund.

The report also pointed to the $23 million permanent impairment loss as a "sign of things to come" for near-term earnings reports.

These losses were partially offset by $6.9 million in gain related to holdings in credit card companies, including $2.8 million realised and $4.1 million unrealised.

The bank also entered into an agreement to merge its international fund services businesses with those of Fulcrum Group to form an international fund services provider with operations in nine countries and assets under administration of approximately $100 billion. Butterfield Bank will have a 40-percent ownership stake in the new company, called the Butterfield Fulcrum Group, and expects to realise an extraordinary gain in excess of $110 million in the second half of this year as a result of the merger.

LOM said that Butterfield's loan book rose almost 10 percent, with customer deposits up only 1.2 percent, while its loan-to-customer deposits ratio increased to 40.3 percent at the end of the quarter, meaning that higher leverage could be problematic if Bermuda's economy were to falter substantially and loan defaults advanced correspondingly.

It believes that the bank's move to merge its fund operations with Fulcrum could be an effort to reduce costs through synergies, elimination of redundancies, lay-offs, etc., and would result in a gain of more than $110 million later in the year, which it could use to write off future credit-related losses, should they occur.