Bank of Montreal 2007 Annual Report Download - page 42

Management’s Discussion and Analysis
38 BMO Financial Group 190th Annual Report 2007
MD&A
Underwriting and advisory fees increased $121 million or 30%,
after having increased 14% in 2006. Merger and acquisition fees were
particularly robust, and equity underwriting was notably strong as
markets were particularly favourable in the first half of the year. Debt
underwriting fees experienced a solid increase. Revenues in each of
the three categories were sharply lower in the fourth quarter in a diffi-
cult capital markets environment.
Securities gains increased $101 million or 70%. The increase
was largely attributable to a gain on sale of MasterCard International
Inc. shares.
Income from foreign exchange, other than trading, increased
$30 million or 29% due to more active and volatile foreign exchange
markets and gains on hedging our U.S. dollar earnings, which is
explained on page 35.
Insurance income increased $26 million or 13%. The increase
was due to favourable claims experience, as growth slowed somewhat
from the high rates of the past three years.
Other revenue includes various sundry amounts and rose
$22 million or 9%. The increase was attributable to higher sundry
fees in P&C Canada.
Table 7 on page 80 provides further detail on revenue and
revenue growth.
Trading-Related Revenues
Trading-related revenues are dependent on, among other things, the
volume of activities undertaken for clients, who enter into transactions
with BMO to mitigate their risks or to invest. BMO earns a spread or
profit on the net sum of its client positions by profitably neutralizing,
within prescribed limits, the overall risk of the net positions. BMO also
assumes proprietary positions with the goal of earning trading profits.
On May 17, 2007, we announced that we would be recording sig-
nificant losses in our commodities trading business. In 2007, we recorded
$853 million of such losses, of which $841 million was recorded as a
charge to non-interest trading revenues, and which, net of a $120 mil-
lion reduction in performance-based compensation and reductions
in income taxes, lowered net income by $440 million or $0.86 per share.
The losses related in substantial part to the use of a more appropriate
market-based methodology in the valuation of our commodities port-
folio. The portfolio had previously been marked to market each day by
traders and the valuations confirmed independently on a monthly basis.
As our natural gas portfolio grew, we sought additional verification
of the valuations from independent sources in addition to our principal
external broker for natural gas options contracts. Management subse-
quently initiated an external review of the commodities trading activity,
which raised concerns related to the reliability of quotes received from
the principal external broker. At that time, we suspended our business
relationship with the broker, pending the results of the external review.
BMO’s commodities portfolio is now more appropriately marked-
to-market after a completed valuation review. We recorded further losses
of $149 million in the third quarter, approximately half of which related
to the elimination of certain large proprietary positions by entering
into offsetting contracts with a counterparty. Losses were lower in the
fourth quarter, totalling $24 million.
In the fourth quarter, BMO recorded $318 million ($211 million
after tax) of charges for certain trading activities and valuation adjust-
ments related to deterioration in capital markets. The charges included
$169 million in respect of trading and structured-credit related positions
and preferred shares; $134 million related to Canadian asset-backed
commercial paper (ABCP); and a $15 million charge recorded in invest-
ment securities gains that related to capital notes in the Links Finance
Corporation (Links) and Parkland Finance Corporation (Parkland)
structured investment vehicles (SIVs).
Trading-related revenues include net interest income and non-
interest revenue earned from on and off-balance sheet positions
undertaken for trading purposes. The management of these
positions typically includes marking them to market on a daily
basis. Trading revenues include income (expense) and gains
(losses) from both on-balance sheet instruments and off-balance
sheet interest rate, foreign exchange (including spot positions),
equity, commodity and credit contracts.
Interest and Non-Interest Trading-Related Revenues ($ millions)
Change from 2006
For the year ended October 31 2007 2006 2005 $%
Interest rates 43 204 247 (161) (79)
Foreign exchange 273 214 172 59 28
Equities 189 173 145 16 9
Commodities (853) 124 91 (977) (+100)
Other 15 35 16 (20) (57)
Total (333) 750 671 (1,083) (+100)
Reported as:
Net interest income 154 32 175 122 +100
Non-interest revenue –
trading revenues (487) 718 496 (1,205) (+100)
Total (333) 750 671 (1,083) (+100)
The Canadian ABCP charges reflect $80 million for our investment
in commercial paper issued by one of our BMO-sponsored conduits
and $54 million for our investment in commercial paper issued by
non-bank-sponsored conduits. Both write-downs were taken using an
estimated mark-to-market adjustment of 15%. BMO has not provided
backstop liquidity commitments to any of the preceding conduits.
The above noted BMO-sponsored conduit’s underlying positions
are super-senior AAA-rated with exposures to high-quality, diversified
corporate debt through collateralized debt obligations (CDOs). The conduit
has no direct exposure to U.S. subprime-related loans. We are in dis-
cussions with a number of counterparties on restructuring alternatives
regarding this conduit.
Realization of any gains or losses on the non-bank-sponsored
investments will be affected by the outcome of the agreement reached
among certain non-bank-sponsored Canadian ABCP conduits and
investors known as the Montreal Accord.
Our investments and commitments related to SIVs are discussed
in the BMO Capital Markets section on page 53.
Given the amount of our investments in ABCP and the SIVs,
and given the uncertainty in the capital markets environment, these
investments could experience subsequent valuation gains and losses
due to changes in market value.
Trading-related revenue declined by $1,083 million from the
particularly strong results in 2006 because of the commodities losses
and charges discussed above.
Excluding the $1,171 million of significant items included in
trading revenues, trading-related revenues rose $88 million. Foreign
exchange trading revenues were strong over the course of the year,
with particularly strong growth in the third and especially the fourth
quarters. Fixed income trading revenues were very strong through
the first three quarters, falling significantly in the fourth quarter in
the difficult capital markets environment. Equities trading revenues
followed a similar pattern.
The Market Risk section on page 68 provides other information
on trading-related revenues.