Bank of Montreal 2008 Annual Report Download - page 69

MD&A
BMO Financial Group 191st Annual Report 2008 | 65
Non-Bank-Sponsored Canadian Securitization Conduits
We hold ABCP of six non-bank-sponsored Canadian conduits with a
carrying value of $187 million as at October 31, 2008 ($308 million in
2007). We have not provided backstop liquidity commitments to
these conduits.
We recorded impairment charges of $70 million in the year
ended October 31, 2008 ($54 million in 2007) on our investments in the
conduits. Realization on our investment in the ABCP of the non-bank-
sponsored conduits will be affected by the terms of the agreement
reached among certain non-bank-sponsored Canadian ABCP conduits
and investors known as the Montreal Accord. BMO is fully supportive
of the Montreal Accord.
Structured Finance Vehicles
We facilitate development of investment products by third parties,
including mutual funds, unit investment trusts and other investment
funds that are sold to retail investors. We enter into derivative
contracts with these funds to help the funds provide investors with the
desired exposure and hedge our exposure related to these derivatives
by investing in other funds. In addition, we also sponsor certain vehicles
that provide investors with access to debt portfolios through the
issuance of commercial paper. We consolidate those vehicles where
our interests expose us to a majority of the expected losses or
residual returns, or both. Assets held by the vehicles in which we have
a significant variable interest but which are not consolidated totalled
$132 million as at October 31, 2008 ($353 million in 2007). Our exposure
to loss from vehicles related to this activity is limited to the amount
of our investment, which totalled $40 million as at October 31, 2008
($99 million in 2007). In the event we choose to or are required to
terminate our relationship with these vehicles, we would be required
to settle any associated derivative contracts at their fair value.
Credit Protection Vehicle
We also sponsor Apex Trust (Apex), a Canadian special purpose vehicle
that provides credit protection via credit default swaps through
12 investment-grade-rated leveraged super-senior tranches of diversified
pools of U.S. and European corporate credits. Apex has exposure to
approximately 450 corporate credits that are diversified by geographic
region and industry, of which 74% are rated investment grade.
On May 13, 2008, Apex was restructured and investors exchanged
their original holdings for mid-term notes issued by Apex with terms
of five and eight years (the Notes). Apex issued $2.2 billion of Notes,
to which BMO has an exposure of $815 million. Another party to the
restructuring has a $600 million exposure to the Notes through a total
return swap with BMO. The total return swap has a price reset in
September 2009 based on a reference index and BMO has the option
to terminate the swap at that time. If BMO chooses to extend the swap,
its cost may increase due to the price reset, depending on market
conditions at that time.
A senior funding facility of $1.13 billion (the Senior Facility) was
also put in place pursuant to the restructuring, with BMO providing
$1.03 billion of that facility. Advances under the Senior Facility rank ahead
of the Notes. As at October 31, 2008, $553 million had been drawn
against BMO’s committed share of the Senior Facility to fund collateral
calls arising from declining mark-to-market values of the underlying
credit default swaps. The Notes and the Senior Facility total approximately
$3.3 billion and represent 16% of the approximately $21 billion
of net notional credit positions held by the vehicle.
Under the terms of the restructuring, BMO also entered into credit
default swap contracts with the swap counterparties and into offsetting
swaps with Apex. BMO has exposure to the swap counterparties
for realized credit losses on the notional credit positions if those credit
losses exceed the aggregate $3.3 billion value of the Notes and the
Senior Facility.
In 2007, we recorded charges of $80 million related to our exposure
to Apex. In 2008, we recorded another $110 million of charges and,
at the end of 2008, had $815 million exposure to the Notes, with a
carrying value of $625 million. We also recorded $120 million of charges
in 2008 in relation to the total return swap transaction. The foregoing
charges largely related to deterioration in the credit quality of the
underlying portfolios and significant increases in credit spreads given
current market conditions.
Realized credit losses on the Apex Notes will only be incurred
should losses on defaults in the underlying credits exceed the first-loss
protection on a tranche. There were a number of credit events in
the underlying portfolios that resulted in a reduction in Apex’s first-loss
protection on nine of the tranches. The two tranches with lower levels
of first-loss protection experienced reductions in first-loss protection
from 12.0% to an estimated 11.2% on a tranche with a notional amount
of $342 million, and from 8.3% to an estimated 7.0% on a tranche
with a notional amount of $875 million. These two tranches were rated
A and A (high), respectively, by DBRS at October 31, 2008. Each of the
other 10 tranches has first-loss protection ranging from 14.4%
to 30.3%,
and each was rated AAA. This substantial first-loss protection from
future defaults is significantly higher than the historical credit loss expe-
rience of the corporate credits.
Based on the total notional amount of $1,217 million for the
two tranches with lower levels of first-loss protection, BMO’s exposure
to loss on the Notes in respect of these tranches would be $450 million,
as BMO owns 37% of the Notes.
BMO does not consider the May 2008 purchase of the Notes
described above to imply or indicate an intent to provide support to
other mid-term noteholders or provide additional subordinated support
to Apex. Instead, the purchase was a one-time, isolated event
related to the restructuring of Apex. We do not intend to purchase
additional mid-term notes of Apex nor do we intend to reimburse
any other mid-term noteholder for any loss they may incur.
Structured Investment Vehicles
Credit investment management vehicles provide investors with opportu-
nities to invest in customized, diversified debt portfolios in a variety of
asset and investment grade rating classes.
We hold subordinate capital notes of two BMO-managed London-
based Structured Investment Vehicles (SIVs), Links Finance Corporation
(Links) and Parkland Finance Corporation (Parkland), with a carrying
value of $nil. The investments are recorded as available-for-sale
securities in our Consolidated Balance Sheet. Our exposure to loss
relates to our investments in the vehicles, derivative contracts we have
entered into with the vehicles and senior funding we provide through a
liquidity facility in order to fund the repayment of the senior notes.
The assets held by Links and Parkland at October 31, 2008 totalled
US$6.8 billion and 698 million, respectively. The fair value of our
derivative contracts outstanding with the SIVs as at October 31, 2008
was recorded in our Consolidated Balance Sheet as a derivative
asset of $57 million (derivative liability of $11 million in 2007). We
earned investment
management fees of $5 million and $21 million in
2008 and 2007, respectively, for managing these portfolios.
In the event we choose to or are required to terminate our
relationship with these vehicles, any associated derivative contracts
would be settled at their fair value.
On March 3, 2008, we agreed to provide senior-ranked support
for the funding of Links and Parkland through BMO liquidity facilities.
The facilities backstop the repayment of senior note obligations
to facilitate the SIVs’ access to further senior funding, provide
supplemental funding and permit the SIVs to continue the strategy
of selling assets in an orderly manner.