Bank of Montreal 2010 Annual Report Download - page 71

MD&A
This ratio varies with changes in the economy and credit conditions.
If we were to apply these high and low ratios to average net loans and
acceptances in 2010, our provision for credit losses would range from
$2,127 million to $292 million. Our provision for credit losses in 2010
was $1,049 million.
Additional information on the process and methodology for
determining the allowance for credit losses can be found in the discus-
sion of credit risk on page 80 as well as in Note 4 on page 120 of the
financial statements.
Financial Instruments Measured at Fair Value
BMO records securities and derivatives at their fair value. Fair value
represents our estimate of the amount we would receive, or would
have to pay in the case of a derivative liability, in a current transaction
between willing parties. We employ a fair value hierarchy to categorize
the inputs we use in valuation techniques to measure fair value.
The extent of our use of quoted market prices (Level 1), internal models
using observable market information (Level 2) and internal models
without observable market information (Level 3) in the valuation of
securities, derivative assets and derivative liabilities as at October 31, 2010,
as well as a sensitivity analysis of our Level 3 assets, is disclosed in
Note 29 on page 160 of the financial statements.
Valuation models use general assumptions and market data, and
therefore do not reflect the specific risks and other factors that would
affect a particular instrument’s fair value. As a result, we incorporate
certain adjustments when using internal models to establish fair values.
These fair value adjustments take into account the estimated impact
of credit risk, liquidity risk, valuation considerations, administrative costs
and closeout costs. For example, the credit risk adjustment for derivative
financial instruments incorporates credit risk into our determination of
fair values by taking into account factors such as the counterparty’s credit
rating, the duration of the instrument and changes in credit spreads.
Valuation Product Control (VPC), a group independent of the trading
lines of business, verifies the fair values at which financial instruments
are recorded. For instruments that are valued using models, VPC identifies
situations where valuation adjustments must be made to the model
estimates to arrive at fair value.
The methodologies used for calculating these adjustments are
reviewed on an ongoing basis to ensure that they remain appropriate.
Significant changes in methodologies are rare and are made only when
we believe that the change will result in better estimates of fair value.
Valuation Adjustments ($ millions)
As at October 31 2010 2009
Credit risk 109 135
Liquidity risk 51 39
Administrative costs 9 8
Other 43 41
212 223
Valuation adjustments made to model estimates to arrive at fair value
were lower in 2010. The decrease in the adjustment for credit risk
was due to narrower relative credit spreads between our counterparties
and BMO.
Accounting for Securitizations
When loans are securitized, we record a gain or loss on sale. In deter-
mining the gain or loss, management must estimate the net present
value of expected future cash flows by relying on estimates of the
amount of interest and fees that will be collected on the securitized
assets, the yield to be paid to investors, the portion of the securitized
assets that will be repaid before their scheduled maturity, credit losses,
the fair value cost of servicing and the rate at which to discount these
estimated future cash flows. Actual cash flows may differ significantly
from those estimated by management. If management’s estimate of
future cash flows were different, our gain on securitization recognized
in income would also be different.
Additional information concerning accounting for securitizations,
including a sensitivity analysis for key assumptions, is included in Note 8
on page 126 of the financial statements.
Accounting for Variable Interest Entities
In the normal course of business, BMO enters into arrangements with
variable interest entities (VIEs). VIEs include entities where the equity is
considered insufficient to finance the entity’s activities or for which
the equityholders do not have a controlling financial interest. We are
required to consolidate VIEs if the investments we hold in these entities
and/or the relationships we have with them result in us being exposed
to a majority of their expected losses and/or being able to benefit from
a majority of their expected residual returns.
We determine whether an entity is a VIE and whether BMO holds
a variable interest in that VIE based primarily on quantitative analysis.
We perform a variety of complex estimation processes involving qualita-
tive and quantitative factors to calculate and analyze a VIE’s expected
losses and expected residual returns. These processes involve estimating
the future cash flows and performance of the VIE, analyzing the variability
of those cash flows and allocating the expected losses and expected
residual returns among the identified parties holding variable interests.
The analysis enables us to identify the party that is exposed to a majority
of the VIE’s expected losses and/or expected residual returns, and thus
determine which party should consolidate the entity.
We are required to reconsider if consolidation is required when our
obligation to absorb expected losses or right to receive expected residual
returns increases. If there is a change in events that leads to BMO
absorbing the majority of the expected losses or residual returns, BMO
would be required to consolidate the VIE as of the date of the change.
With respect to the credit protection vehicle Apex, reconsideration
events include BMO purchasing additional Notes, granting additional
liquidity facilities, increasing the amount of the loan extended by BMO
beyond what is contemplated under the existing credit lending facilities,
or guaranteeing repayment of Apex Notes held by third parties. Each of
these reconsideration events could result in BMO absorbing additional
expected losses or residual returns. We do not expect that such reconsid-
eration events will occur in the near future.
With respect to the structured investment vehicles Links and
Parkland, reconsideration events include a purchase or sale by BMO
of capital notes, provision of additional lending facilities, renegotiation
of the loan facility provided by BMO, asset for capital note exchanges
and provision of a guarantee by BMO to compensate noteholders for
realized losses. The reconsideration event that is most likely to occur
is a renegotiation of certain terms in our lending facilities. If we were to
renegotiate certain terms of our lending facilities, we would not expect
to consolidate the vehicles based on our current assessment of our
exposure to expected losses.
Reconsideration events for our Canadian multi-seller conduits
include the purchase or sale by BMO of ABCP issued by the vehicles and
the granting of additional liquidity facilities or credit enhancement. Since
BMO regularly purchases and sells ABCP issued by our Canadian multi-
seller conduits, we continually monitor our exposure to expected losses
to ensure they do not approach consolidation thresholds.
Reconsideration events for our U.S. multi-seller conduit include
the granting of additional liquidity facilities or credit enhancement
and a change in the size of the expected loss note. Repayment of the
expected loss note would also be a reconsideration event and a third
party would have to agree to absorb the exposure to the majority
of the expected losses. Otherwise, BMO would be required to consolidate
the vehicle. We monitor BMO’s exposure to expected losses as recon-
sideration events occur and increase the expected loss note so that
consolidation is not required.
BMO Financial Group 193rd Annual Report 2010 69