Bank of Montreal 2010 Annual Report Download - page 68

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
accounts that were of lesser credit quality. These six accounts represented
commitments of US$240 million, of which US$223 million is outstanding.
Three of the accounts, representing exposure of US$140 million, have
been classified as impaired and we established a US$45 million provision
for credit losses in the year.
BMO is also a counterparty to derivative contracts with the vehicle
that are used to manage its exposure to interest rates. The fair value
of derivative contracts outstanding with the vehicle and recorded in our
Consolidated Balance Sheet was a derivative liability of $2.2 million at
October 31, 2010 ($1 million in 2009). BMO is not required to consolidate
the vehicle, as the vehicle has issued an expected-loss note to a third
party. The holder of the note consolidates the vehicle as the noteholder
is exposed to the majority of expected losses.
In the event we choose to or are required to terminate our relation-
ship with the vehicle, we would be required to settle any associated
derivative contracts at their fair value and would no longer receive fees
for the administration of the vehicle.
Credit Protection Vehicle
We also sponsor Apex Trust (Apex), a Canadian special purpose vehicle
that comprises 12 tranches of diversified corporate credits, each of which
has the benefit of first-loss protection. The 12 tranches in Apex have
exposure to approximately 440 corporate credits that are diversified by
geographic region and industry. Approximately 69% of the corporate
credits are rated investment grade (25.6% rated higher than BBB
and 43.7% rated BBB) and 30.6% are rated below investment grade.
The ratings of the majority of the corporate credits have stabilized
in 2010, with the number on review for downgrade decreasing and
the number on review for upgrade increasing.
Apex has issued $2.2 billion of notes (Apex Notes) with remaining
terms of three and six years.
A senior funding facility of $1.13 billion has been made available
to Apex, with BMO providing $1.03 billion of that facility.
BMO has entered into CDS contracts on the net notional positions
in the structure with the swap counterparties and into offsetting swaps
with the vehicle. BMO has exposure to losses on the notional amount
above the $3.33 billion total amount of Apex Notes and senior funding
facility. Based on their notional values, the contracts will expire in
2012 (24%), 2013 (40%), 2014 (6%) and 2016 (30%).
After giving effect to the hedges we have
entered into, BMO has
no net exposure through the Apex Notes to realized
credit losses in
the tranches. Realized credit losses in Apex would only be incurred
should losses on defaults on the underlying credits exceed the first-loss
protection on a tranche. As detailed below, a significant majority of
Apex’s positions benefit from substantial first-loss protection. There was
minimal change in the levels of first-loss protection in 2010. We have
hedged the first $515 million of loss exposure on our committed expo-
sure under the senior funding facility. As of October 31, 2010, $nil
($112 million in 2009) was advanced through BMO’s committed share
of the senior facility to fund collateral calls arising from changes in
mark-to-market values of the underlying CDSs.
Two of the 12 tranches have lower levels of first-loss protection
than the others. If losses were realized by Apex investors on the full
notional amounts of $1,217 million in the two weakest tranches, BMO’s
exposure would be $nil, given the hedges that are now in place. Each of
the other 10 tranches, which have a net notional amount of $20.1 billion,
is rated from A (low) to AAA and has significant first-loss protection,
ranging from 13% to 29% with a weighted average of 23.2%.
Structured Investment Vehicles
We hold subordinate capital notes of two BMO London-managed struc-
tured investment vehicles (SIVs), Links Finance Corporation (Links) and
Parkland Finance Corporation (Parkland), with a carrying value of $nil.
Our exposure to loss in the SIVs relates to our investments in the vehicles,
derivative contracts we have entered into with the vehicles and senior
funding we provide through a loan facility that was put in place in order
to fund the repayment of the SIVs’ senior notes.
The fair value of our derivative contracts outstanding with the SIVs
was recorded in our Consolidated Balance Sheet as a derivative asset
of $30 million ($12 million in 2009). We earned investment management
fees of $2 million and $3 million in 2010 and 2009, respectively, for
managing these portfolios.
In the event we choose to or are required to terminate our relation-
ship with these vehicles, any associated derivative contracts would be
settled at their fair value.
We provide senior-ranked support for the funding of Links and
Parkland through BMO loan facilities, permitting the SIVs to continue the
strategy of selling assets in an orderly and value-sensitive manner.
At October 31, 2010, amounts drawn on the facilities totalled
US$4.3 billion and €478 million (US$5.8 billion and €597 million in 2009).
The loan facilities totalled US$4.5 billion for Links and €508 million for
Parkland at October 31, 2010. Advances under the loan facilities rank
ahead of the SIVs’ subordinated capital notes. Consistent with
the strategy of selling assets in an orderly manner, the pace of asset
sales was measured throughout 2010 as a result of market conditions.
We anticipate that the SIVs will continue the strategy of selling assets
in an orderly manner based upon market conditions and that asset sales
in the near future will be modest. The total amount drawn under the
loan facilities is primarily affected by the pace and price of asset sales
and asset maturities. Amounts funded are expected to decrease from
current levels based on these factors. We expect asset maturities
of US$942 million and €116 million in 2011 and US$1,450 million and
€184 million in 2012. The remaining assets mature over time.
The par value of the assets held by Links and Parkland totalled
US$5.3 billion and €624 million, respectively (US$7.1 billion and
€752 million in 2009). The market value of the assets held by Links and
Parkland, including hedges and cash equivalents, totalled US$4.4 billion
and €551 million, respectively (US$5.5 billion and €631 million in 2009).
During 2010, there were maturities and repayments of assets totalling
US$1.1 billion in Links and €105 million in Parkland, as well as asset
sales of US$730 million in Links and €44 million in Parkland. The SIVs’
capital noteholders will continue to bear the economic risk from actual
losses up to the full amount of their investment. The book value of
the subordinated capital notes in Links and Parkland at October 31, 2010
was US$689 million and €141 million, respectively. Subsequent to year
end, the SIVs recorded impairment charges related to Irish bank and
insurance company subordinate debt of US$113 million and €19 million
on par values of US$158 million and €29 million in Links and Parkland,
respectively. These charges reduce the book value of the subordinated
capital notes. For both Links and Parkland, BMO believes that the
first-loss protection provided by the subordinate capital notes continues
to exceed future expected losses.
Links holds a portfolio of debt securities including subordinated
commercial bank debt (43%), CBOs and CLOs with under lying assets that
are primarily corporate obligations (14%), residential mortgage-backed
securities (16%) and commercial mortgage-backed securities (8%).
Links has 54% of its assets invested in the United States, 43% in Europe
and 3% in other countries. Approximately 45% of Links’ debt securities
are rated Aa3 or better by Moody’s (51% in 2009) with 88% rated invest-
ment grade (91% in 2009). Approximately 39% are rated AA– or better
by S&P (47% in 2009) with 90% rated investment grade (92% in 2009).
Parkland has a higher proportion of highly-rated assets than Links, and
has 64% of its assets invested in Europe, 30% in the United States and
the remainder in Australia and Canada. Certain debt securities are on
credit watch for a ratings downgrade.
66 BMO Financial Group 193rd Annual Report 2010