Bank of Montreal 2008 Annual Report Download - page 70

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
66 | BMO Financial Group 191st Annual Report 2008
Consistent with the strategy of selling assets in an orderly manner,
the pace of asset sales slowed during the fourth quarter as a result of
market conditions. The amount drawn under the facilities is expected to
be less than the current maximum committed amount for both SIVs and
is expected to be at its highest level in July 2009. It is currently antici-
pated that the SIVs will continue the strategy of selling assets in an
orderly
manner based upon market conditions. However, for illustrative
purposes:
if there were no further asset sales and assets were repaid as
we anticipate given their terms, by July 2009, we would expect that
draws under the Links facility would be US$3.0 billion higher than
at October 31, 2008 and draws under the Parkland facility would
be 160 million higher. At October 31, 2008, amounts drawn on the
facilities totalled US$3.7 billion and 477 million, respectively. The
liquidity facilities total a maximum of approximately US$7.7 billion for
Links and 672 million for Parkland at October 31, 2008. Advances
under the liquidity facilities rank ahead of the SIVs’ subordinated capital
notes. The total amount drawn under the liquidity facilities is impacted
by a number of factors, including the pace and price of asset sales,
the maturity profile of the senior notes and asset maturities. While
the assets of the SIVs mature over time, the majority of the assets
are anticipated to be repaid in the period between 2010 and 2012.
The SIVs’ capital noteholders will continue to bear the economic
risk from actual losses up to the full amount of their investment.
The par value of the subordinate capital notes less realized losses
in Links and Parkland at October 31, 2008 was US$1.17 billion and
158 million, respectively, and BMO holds a nominal amount of capital
notes with a carrying value of $nil. While the market value of the SIVs’
assets is currently lower than the amount of senior debt outstanding,
BMO believes that the first-loss protection provided by the subordinate
capital notes exceeds future expected losses.
Although the credit quality of the assets in the SIVs has weakened
due to market conditions and some of the debt securities in the
SIVs were downgraded during the fourth quarter, the asset quality of
Links and Parkland remains high, with approximately 84% of debt
securities rated Aa or better by Moody’s, 73% rated AA or better by S&P
and 98% rated investment grade. Certain of the debt security ratings
are on credit watch, for downgrade. The senior notes of the SIVs are
rated AA– by S&P and Aaa by Moody’s (on review for downgrade).
The SIVs hold no direct exposure to U.S. subprime mortgages.
Links holds a diversified mix of debt securities, including senior and
subordinated commercial bank debt (33.4%), collateralized bond
obligations and collateralized loan obligations whose underlying assets
are primarily corporate obligations (19.3%), debt securities wrapped
by monolines (Ambac, FGIC, FSA and MBIA) (10.0%), residential
mortgage-backed securities (RMBS) (13.7%) and commercial mortgage-
backed securities (6.4%). Collateralized bond obligations include
US$83 million (1.2% of assets) backed primarily by U.S. subprime and
Alt-A RMBS collateral. Parkland’s asset diversification is broadly in line
with that of Links.
Auction-Rate Securities
Auction-rate securities (ARS) are typically short-term notes issued by
trusts in the United States to fund long-term, fixed-rate debt instruments
(corporate or municipal bonds issued primarily by municipalities,
student loan authorities and other sponsors). The interest rate on ARS
is regularly reset every 7 to 35 days through auctions managed by
financial institutions. A disruption in the market for ARS occurred in
the early part of 2008.
There are no BMO-sponsored ARS programs in the market and
BMO does not own any ARS in its trading portfolios. However, in
the fourth quarter of 2008, BMO offered to purchase from client accounts
US$143 million of ARS at par value plus accrued interest. During the
fourth quarter, BMO recorded a charge of $12 million ($8 million
after
tax) in respect of the valuation of ARS expected to be tendered
to our offer.
Exposure to Major Financial Institutions
In recent months, there have been significant developments affecting
U.S. and European based financial institutions, causing governments
in many jurisdictions around the world to take steps to support their
financial systems. During the year, BMO did not incur any significant
losses related to exposure to financial institutions. BMO had closed all
positions with Lehman Brothers, which sought bankruptcy protection
in the fourth quarter, and recorded a $32 million charge. It consisted
of a $19 million charge in PCG in respect of actions taken to support
U.S. clients and, in BMO Capital Markets, a $13 million charge net
of recoveries on credit default swap hedges. We also recorded a specific
provision of US$31 million on a US$62 million loan to the European
subsidiary of an Icelandic bank.
In addition, given the current international economic environment,
we are monitoring exposures to financial institution counterparties
in certain countries. At October 31, 2008, BMO’s direct exposure to these
financial institutions amounted to a modest $73 million in respect of
the uncollateralized mark-to-market value of counterparty derivatives,
after deduction of $8 million of collateral received in respect of
our $81 million gross exposure. There were no such exposures in respect
of the mark-to-market value of traded credits. A nominal adjustment
for counterparty credit risk was recorded against these exposures.
Collateralized Debt Obligations (CDOs)
CDOs are obligations of a special purpose vehicle (SPV) that is created
for a specific financing transaction. The SPV typically holds a nominal
amount of equity. The SPV issues various tranches of rated and unrated
debt securities (usually AAA to BB) that have well-defined rights to
cash generated from the operation and liquidation of the vehicle’s assets.
The risk of loss on the SPV’s portfolio varies by tranche. Losses will
first affect the equity tranche, next the mezzanine tranches and finally
the senior tranche. Super-senior is generally the most secure of all
tranches. The SPV uses the cash raised through the issuance of the CDOs
to invest in one or more different types of assets, including bonds, loans
and mortgages. The corresponding obligations of the SPV would be,
respectively, collateralized bond obligations (CBOs), collateralized loan
obligations (CLOs) and collateralized mortgage obligations (CMOs).
CMOs for which the underlying assets are residential properties are
referred to as residential mortgage-backed securities (RMBS); CMOs
for which the underlying assets are commercial properties are
referred to as commercial mortgage-backed securities (CMBS).