Bank of Montreal 2012 Annual Report Download - page 69

MD&A
MANAGEMENT’S DISCUSSION AND ANALYSIS
The ratings outlook for the majority of the corporate credit exposures
remained stable in 2012.
Apex has issued $2.2 billion of notes (Apex Notes) with remaining
terms of one and four years. BMO has hedged its exposure to its hold-
ings of Apex Notes. After giving effect to these hedges, BMO has no net
exposure through the Apex Notes to realized credit losses in the
tranches. In addition, a senior funding facility of $572 million has been
made available to Apex to fund collateral calls arising from changes in
mark-to-market values of the underlying credit default swaps (CDS),
with BMO providing approximately $522 million of that facility. We have
hedged the first $515 million of loss exposure on our committed
$522 million exposure under the senior funding facility. The amount of
the facility was reduced in 2012 by approximately $559 million due to
the return of collateral to Apex following the maturation of three of its
tranches. As at October 31, 2012 and 2011, no amounts had been
advanced through BMO’s committed share of the senior 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. As a result of these contracts, BMO has exposure to
losses on the notional amount above the approximately $2.8 billion
total aggregate amount of the Apex Notes and senior funding facility.
Based on the notional values, approximately 14% matured in 2012, 50%
will mature in 2013, 6% will mature in 2014 and the remainder in 2016.
Apex would incur realized credit losses only if defaults on the
underlying corporate credits were to exceed the first-loss protection
on a tranche. As detailed below, Apex’s positions benefit from
substantial first-loss protection. There was minimal change in the levels
of first-loss protection in 2011 and 2012 and the likelihood of loss is
now considered low.
The nine tranches, which have a total net notional amount of
$16.2 billion, are rated from B to AAA and have significant first-loss
protection, ranging from 7.6% to 29.4% of the notional exposures, with
a weighted average of 23.7%. The longest-dated tranche matures in
2016 and has first-loss protection of 28%. Given the hedges that are in
place and the protection provided by third party noteholders, BMO has
exposure to losses on the total notional amount only if losses exceed
$2.8 billion.
The net notional exposure of Apex to issuers in Greece, Italy and
Spain represented 0.6%, 0.9% and 1.1%, respectively, of its total
notional exposure. There was net notional exposure to another seven of
the countries that share the Euro currency, representing 11.7% of total
notional exposure. The notional exposure to the remainder of Europe
was 13.6% of total notional exposure. The bank is well protected as a
result of both first-loss protection and hedges that are in place, as
described above.
Structured Investment Vehicle
We have provided senior funding through a loan facility to a London-
managed BMO structured investment vehicle (SIV), Links Finance Corpo-
ration (Links). We consolidate the SIV under IFRS and our exposure to
potential losses in the SIV relates to the loan facility that was put in
place in order to fund the repayment of its senior notes. In the second
quarter of 2012, our other SIV, Parkland Finance Corporation, sold its
remaining assets, fully repaid its BMO senior funding facility and dis-
tributed the remaining proceeds to its capital noteholders.
The senior-ranked support we provide for the funding of Links
through the BMO loan facility permits the SIV to continue the strategy of
selling assets in an orderly and value-sensitive manner. At October 31,
2012, amounts drawn on the facility totalled US$1.4 billion
(US$2.6 billion in 2011). The loan facility totalled US$1.5 billion.
Advances under the loan facility rank ahead of the SIV’s subordinated
capital notes. We anticipate that the SIV will continue the strategy of
selling assets in an orderly manner based upon market conditions and
regulatory requirements. The total amount drawn under the loan facility
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 and
redemptions of US$239 million in 2013 and US$162 million in 2014.
The par value of the assets held by Links totalled US$2.0 billion
(US$3.3 billion in 2011) at year end. The market value of the assets held
by Links, including hedges and cash equivalents, totalled US$1.6 billion
(US$2.6 billion in 2011) and those assets are included in our con-
solidated balance sheet along with the liability for the outstanding
capital notes. During 2012, there were maturities and repayments of
assets totalling US$383 million, as well as asset sales of US$955 million.
The SIV’s capital noteholders will continue to bear the economic risk
from actual losses up to the full amount of their investments. The book
value of the Links subordinated capital notes at October 31, 2012, was
US$365 million. During fiscal 2012, Links repurchased US$90 million of
capital notes at a discount to the par value of the notes funded by the
sale of a portion of Links underlying assets that were representative of
the credit quality of the portfolio as a whole. BMO believes that the first-
loss protection provided by the subordinated capital notes of the SIV
continues to exceed future expected losses.
Approximately 21% of Links’ debt securities are rated Aa3 or better
by Moody’s (35% in 2011), with 71% rated investment grade (87% in
2011). Approximately 15% are rated AA- or better by S&P (27% in
2011), with 81% rated investment grade (89% in 2011). Links holds a
portfolio of debt securities, including subordinated commercial bank
debt (48%), collateralized bond obligations and collateralized loan
obligations with underlying assets that are primarily corporate obliga-
tions (5%), residential mortgage-backed securities (18%) and commer-
cial mortgage-backed securities (7%).
Links has 61% of its assets invested in the United States and 39%
in Europe. Links has European exposures but has no direct credit
exposure to issuers in Greece, Ireland, Italy, Portugal or Spain. Indirect
exposure to issuers in these countries through the SIV’s collateralized
bond and collateralized loan investments was minimal at October 31,
2012. The SIV’s par value exposure to issuers in the Eurozone countries
was $275 million, of which 36% were in France, 62% in the Nether-
lands, and 2% in Germany, of which $269 million was in the form of
bank subordinated debt. Almost all of this debt was rated investment
grade by both Moody’s and S&P. The SIV’s par value exposure to issuers
in the remaining European countries was $414 million, of which 84%
was in the United Kingdom, 8% in Switzerland, and 8% in Denmark.
Approximately $262 million was in the form of bank subordinated debt,
of which approximately 20% was rated investment grade by both
Moody’s and S&P.
Exposure to Other Select Financial Instruments, including
Collateralized Debt Obligations (CDOs) and Collateralized
Loan Obligations (CLOs)
BMO’s trading and available-for-sale portfolios contain CLOs and CDOs,
all of which are in run-off mode. The underlying securities consist of a
wide range of corporate assets. Unhedged exposures to CLOs totalled
$347 million and had credit ratings of AA- to AAA at year end. Hedged
CLO exposures of $890 million had a carrying value of $862 million at
year end, with $28 million recoverable on associated hedges with a
monoline insurer that is rated AA+ by S&P. The unhedged interest held
in CDO exposures was minimal, with a $13 million carrying value. There
were no hedged CDO exposures at year end.
The portfolio also contains CDS transactions referencing CDO instru-
ments where we do not hold the underlying derivative asset. At
October 31, 2012, we had CDS protection outstanding on a notional
amount of $0.5 billion. In the first quarter of 2012, this contract was
terminated at an insignificant loss. We have purchased credit protection
on a notional amount of $1.5 billion, which had a carrying value of
$0.3 million at year end.
Caution
This Select Financial Instruments section contains forward-looking statements. Please see the Cau-
tion Regarding Forward Looking Statements.
66 BMO Financial Group 195th Annual Report 2012