In the normal course of operations, the Bank engages in a variety of financial transactions that, under generally accepted accounting principles, are either not recorded on the Consolidated Balance Sheet or are recorded in amounts that differ from the full contract or notional amounts. These off-balance sheet arrangements involve, among other risks, varying elements of market, credit and liquidity risk which are discussed in the Managing risk section on pages 33 to 41 of this Annual Report. Off-balance sheet arrangements are generally undertaken for risk management, capital management and/or funding management purposes and include securitizations, commitments, guarantees and contractual obligations.
Securitizations are an important part of the financial markets, providing liquidity by facilitating investor access to specific portfolios of assets and risks. In a typical securitization structure, the Bank sells assets to a special purpose entity (SPE) and the SPE funds the purchase of those assets by issuing securities to investors. SPEs are typically set up for a single, discrete purpose, are not operating entities and usually have no employees. The legal documents that govern the transaction describe how the cash earned on the assets held in the SPE must be allocated to the investors and other parties that have rights to these cash flows. The Bank is involved in SPEs through the securitization of its own assets, securitization of third party assets and other financial transactions.
Securitization of bank-originated assets
The Bank securitizes residential mortgages, personal loans, credit card loans and commercial mortgages to enhance its liquidity position, diversify its sources of funding and to optimize the management of its balance sheet. Details of these securitizations are discussed below.
The Bank securitizes residential mortgages through the creation of mortgage-backed securities and transfers to SPEs. The Bank continues to service the securitized mortgages and may be exposed to the risks of the transferred loans through retained interests. There are no expected credit losses on the retained interests of the securitized residential mortgages that are government guaranteed (approximately 94% of all securitized residential mortgages). As at October 31, 2003, the Bank had outstanding securitized residential mortgages of $11.3 billion as compared with $8.1 billion in fiscal 2002.
The Bank securitizes real estate secured personal loans through sales to SPEs. The Bank provides credit enhancement through its retained interest in the excess spread of the SPEs and by funding cash collateral accounts. The Bank’s interest in the excess spread of the SPEs and the cash collateral account is subordinate to the SPEs’ obligations to the holders of its asset-backed securities and absorbs losses with respect to the personal loans before payments to noteholders are affected. As at October 31, 2003, the Bank had outstanding securitized personal loans of $4.6 billion as compared with $5.0 billion in fiscal 2002.
The Bank securitizes credit card loans through sales to SPEs. The Bank’s credit card securitizations are revolving securitizations, with new credit card receivables transferred to the SPEs each period to replenish receivable amounts as they are repaid. The Bank provides credit enhancement to the SPEs through its retained interest in the excess spread. The Bank’s interest in the excess spread of the SPEs is subordinate to the SPEs’ obligations to the holders of its asset-backed securities and absorbs losses with respect to the credit card receivables before payments to the noteholders are affected. As at October 31, 2003, the Bank had outstanding securitized credit card receivables of $1.5 billion as compared with $1.5 billion in fiscal 2002.
The Bank also securitizes commercial mortgages, which in addition to providing a source of liquidity and capital efficient funding, may reduce the Bank’s credit exposure. As at October 31, 2003, the Bank had outstanding securitized commerical mortgages of $1.0 billion as compared with $.3 billion in fiscal 2002.
Total bank-originated securitized assets not included on the Consolidated Balance Sheet amounted to $18.4 billion compared with $14.9 billion a year ago. Further details are provided in Note 4 of the Bank’s Consolidated Financial Statements.
Securitization of third party originated assets
The Bank assists its clients in securitizing their financial assets through SPEs administered by the Bank. The Bank may provide credit enhancement or liquidity facilities to the resulting SPEs as well as securities distribution services. The Bank does not provide employees to the SPEs, nor does it have ownership interests in these SPEs and all fees earned in respect of these activities are on a market basis.
Other financial transactions
The Bank sells trading securities to SPEs in conjunction with its balance sheet management strategies. The Bank does not retain effective control over the assets sold. Assets sold under such arrangements at October 31, 2003 amounted to $5.0 billion as compared with $5.0 billion in fiscal 2002. The Bank enters into total return swaps with the sale counterparties in respect of the assets sold. Market risk for all such transactions is tracked and monitored, and market risk capital is required.
In addition, the Bank also offers financial products, including mutual funds, structured notes and other financial instruments to clients, including SPEs as counterparties. These financial products are, on occasion, created using a SPE as issuer or obligor of the financial products. The Bank may provide certain administrative services and other financial facilities to the SPEs in exchange for market rate compensation.
Commitments and guarantees
Details of the Bank’s commitments and guarantees are provided in Note 19 of the Bank’s Consolidated Financial Statements.
The Bank has contractual obligations to make future payments on subordinated notes and debentures, operating lease commitments, capital trust securities and certain purchase obligations. Subordinated notes and debentures and capital trust securities are reflected on the Bank’s Consolidated Balance Sheets, while operating lease commitments and purchase obligations are not. Details of these contractual obligations as at October 31, 2003 are disclosed by remaining maturity in supplementary table 17 on page 53 of this Annual Report.