Bank of Montreal 2008 Annual Report Download - page 72

MANAGEMENT’S DISCUSSION AND ANALYSIS
MD&A
68 | BMO Financial Group 191st Annual Report 2008
Off-Balance Sheet Arrangements
BMO enters into a number of off-balance sheet arrangements
in the normal course of operations. Our arrangements with certain
variable interest entities have been addressed on pages 63 to 66 and
69 to 70 of Management’s Discussion and Analysis. The discussion
that follows addresses our remaining off-balance sheet arrangements.
Credit Instruments
In order to meet the financial needs of our clients, we use a variety
of off-balance sheet credit instruments. These include guarantees
and standby letters of credit, which represent our obligation to make
payments to third parties on behalf of a customer if the customer is
unable to make the required payments or meet other contractual
requirements. We also engage in securities lending where we lend either
our securities or our customers’ securities to third parties. This exposes
us to credit risk, as a third party may not return the securities as agreed.
We also write documentary and commercial letters of credit, which
represent our agreement to honour drafts presented by a third party
upon completion of specified activities. Commitments to extend
credit are off-balance sheet arrangements that represent our commit-
ment to customers to grant them credit in the form of loans or other
financings for specific amounts and maturities, subject to meeting
certain conditions.
There are a large number of credit instruments outstanding at
any time. Our customers are broadly diversified and we do not anticipate
events or conditions that would lead a significant number of our
customers to fail to perform in accordance with the terms of the contracts.
We use our credit adjudication process in deciding whether to enter
into these arrangements just as we do when extending credit in the form
of a loan. We monitor off-balance sheet instruments to ensure that
there are no undue concentrations in any geographic region or industry.
The maximum amount payable by BMO in relation to these
credit instruments was approximately $99 billion at October 31, 2008
($110 billion in 2007). However, this amount is not representative of
our likely credit exposure or liquidity requirements for these instruments
as it does not take into account any amounts that could possibly
be recovered under recourse or collateralization provisions. In addition,
a large majority of these commitments expire without being drawn
upon. Further information on these instruments can be found in Note 5
on page 115 of the financial statements.
Securities lending commitments are generally short-term in nature
and subject to recall on a demand basis. For all other credit commit-
ments outlined above, in the absence of an event that triggers a
default, early termination by BMO may result in breach of contract.
Variable Interest Entities (VIEs)
Our interests in VIEs are discussed primarily on pages 63 to 66 and
69 to 70. Capital and Funding Trusts are discussed below.
Capital and Funding Trusts
BMO Subordinated Notes Trust (SN Trust) issued $800 million of BMO
Trust Subordinated Notes (the Notes) in 2007, the proceeds of which
were used to purchase a senior deposit note from BMO. We hold
all of the outstanding voting trust units in SN Trust and will do so at all
times while the Notes are outstanding. We are not required to consoli-
date SN Trust. BMO will not terminate SN Trust while the Notes are
outstanding, unless SN Trust has sufficient funds to pay the redemption
price on the Notes and only with the approval of the Office of the
Superintendent of Financial Institutions. We also provide a $30 million
credit facility to SN Trust, of which
$5 million had been drawn at
October 31, 2008 ($5 million in 2007).
We guarantee payment of the
principal, interest, redemption price, if any, and any other amounts on
the Notes on a subordinated basis.
BMO Covered Bond Trust (the CB Trust) was created to guarantee
1 billion of bonds issued by BMO in 2008. BMO sold assets to the
CB Trust in exchange for a promissory note. The assets of the CB Trust
have been pledged to secure payment of the bonds issued by BMO.
This program is referred to as our covered bond program. We are
required to consolidate the CB Trust as we are exposed to the majority
of the expected losses and residual returns.
Guarantees
Guarantees include contracts where we may be required to make
payments to a counterparty based on changes in the value of an asset,
liability or equity security that the counterparty holds. Contracts under
which we may be required to make payments if a third party does
not perform according to the terms of a contract and contracts under
which we provide indirect guarantees of indebtedness are also
considered guarantees. In the normal course of business, we enter
into a variety of guarantees, including standby letters of credit, backstop
and other liquidity facilities and derivatives (including but not limited
to credit default swaps and written options), along with indemnification
agreements.
The maximum amount payable, without consideration of recovery
through our recourse and collateral provisions, was $120 billion as at
October 31, 2008 ($93 billion in 2007).
For a more detailed discussion of these agreements, please see
Note 7 on page 118 of the financial statements.
Financial Instruments
As a financial institution, most of BMO’s balance sheet is comprised
of financial instruments and the majority of our net income results from
gains, losses, income and expenses related to financial instruments.
Financial instrument assets include cash resources, securities,
loans, customers’ liabilities under acceptances and derivative instruments.
Financial instrument liabilities include deposits, derivative instruments,
acceptances, securities sold but not yet purchased, securities lent or
sold under repurchase agreements, subordinated debt, preferred share
liability and capital trust securities.
Financial instruments are used for both trading and non-trading
activities. Non-trading activities generally include the business of lending,
long-term investing, funding and asset-liability management.
Our use of financial instruments exposes us to credit and counter-
party risk and various market risks, including equity price risk, commodity
price risk, interest rate risk and foreign currency risk. A discussion
of how we manage these and other risks as well as structural interest
rate sensitivities can be found in the Enterprise-Wide Risk Management
section on pages 73 to 84 of this MD&A. Further information on how
we determine the fair value of financial instruments is included in the
Financial Instruments Measured at Fair Value discussion in the Critical
Accounting Estimates section of the MD&A that follows.