Overview

The Canadian securitization market has continued to mature in 2004. Evidence of the further development of the market included a number of new entrants into the marketplace as well as a couple of firsts from a transaction standpoint. In 2004, Broadway Credit Card Trust completed three separate public issuances of credit card receivables-backed notes to fund co-ownership interests in credit card receivables originated by Citibank Canada. The issuances by Broadway Credit Card Trust are worth noting based on Citibank's involvement and the fact that one of the issuances involved ten-year notes and another involved $500 million of floating-rate notes issued for a period of three years.

In June 2004, GMAC Residential Funding of Canada, Ltd. completed its first Canadian public term transaction, which involved the issuance by Canada Mortgage Acceptance Corp. of certificates evidencing co-ownership interests in a pool of residential mortgages. This was the first Canadian public securitization of non-conventional "Alt-A" residential mortgages.

In October 2004, Real Estate Asset Liquidity Trust ("Real-T") entered the commercial mortgage-backed securities market with the filing of a prospectus in respect of a $385 million issuance. The offering closed in October 2004 and involved certificates evidencing co-ownership interests in a pool of commercial mortgages, the majority of which were originated by Royal Bank of Canada and its affiliates. The addition of Real-T as a CMBS issuer further supports the development of the CMBS market in Canada. For the first ten months of 2004, there were six CMBS public transactions involving approximately $2.5 billion dollars of CMBSs.

Outstanding asset-backed commercial paper of Canadian securitization vehicles was in excess of $65 billion as of the end of October 2004. Canadian public term securities outstanding as of the end of October 2004 was approximately $30 billion, resulting in the Canadian securitization market consisting of over $95 billion of asset-backed securities outstanding (as reported by Dominion Bond rating Service Limited).

There were also a number of regulatory, accounting, legal and other developments during 2004, as highlighted below.

Capital Adequacy Guideline

In November 2004, the Office of the Superintendent of Financial Institutions Canada ("OSFI") released a new guideline B-5 covering the capital treatment applicable to federally regulated financial institutions ("FRFIs") participating in securitization transactions. FRFIs include all of the Canadian banks and many of the largest insurance and trust companies in Canada. The new guideline replaces the B-5 guideline issued in July 1994. The new guideline applies to all FRFIs on a consolidated basis, effective the beginning of fiscal year 2005. Changes have been kept to a minimum in recognition of the fact that further changes will be required before 2007 to align the guideline more closely with the new Basel II framework requirements. It introduces a number of changes and clarifies several issues and practices.

Among the changes introduced in the new B-5 guideline are the following:

• In order to qualify as a liquidity facility and obtain a 0% weighting for risk-based capital adequacy purposes, Canadian liquidity facilities include a requirement that draws only be made in circumstances where a "general market disruption" exists. This term is not defined in the current guideline and has been generally interpreted as meaning that the entire commercial paper market must be disrupted before a draw can be made under the facility. Failure to include this condition in a liquidity facility results in its being treated as a deduction from capital for capital adequacy purposes. The guideline now states that general market disruption can be defined as a disruption in the Canadian commercial paper market resulting in the inability of Canadian commercial paper issuers, including the applicable special purpose entity ("SPE"), to issue any commercial paper, and where the inability does not result from a diminution in the creditworthiness of the SPE or any originator or from a deterioration in the performance of the assets of the SPE, which supports the conclusion that it is not necessary for the entire commercial paper market to be disrupted. The current interpretation of general market disruption has meant that Canadian commercial paper conduits have typically not been rated by the major international rating agencies, as the liquidity protection has been viewed as inadequate to support a senior rating. It has been suggested that an asset-backed commercial paper program could now be structured to receive the highest rating from one of those agencies.
• Introduction of a 10% credit conversion factor charge for eligible liquidity facilities that are under a year or unconditionally cancellable.
• For enhancement facilities (other than first loss facilities) and senior tranche investments, the new guideline would permit the determination of capital requirements using a ratings-based approach to the applicable exposure. This change could result in more favourable capital treatment for enhancement facilities that achieve an investment-grade rating.
• The ability to provide liquidity support to an SPE through a liquidity asset purchase agreement (more typically found in U.S. securitization transactions) is now a contemplated subject, and there has been a removal of the distinction between liquidity support and liquidity asset purchase agreements.
• The prohibition on an FRFI making servicer advances has been relaxed in circumstances where the payments from the underlying assets have not been received due to temporary timing differences. While helpful in certain circumstances, such a facility would not meet the conditions typically required in CMBS transactions.
• OFSI has specifically reserved the right to adopt a look-through approach to determine the originator of the assets. The look-through approach may also be used to ensure appropriate capital is maintained by a FRFI in a securitization transaction.
• The requirement that all transactions between an FRFI and an SPE be approved by an FRFI's conduct review committee has been relaxed to provide that those approvals may be provided by the credit committee or an equally independent committee of the FRFI.

Further, OFSI has issued the following two advisory notices:

• An interim advisory effective from November 1, 2004 to April 30, 2005 in respect of OFSI assigning a zero percent risk weight to consolidated third-party assets from asset-backed commercial paper conduits that previously had not been on the FRFIs' balance sheets or would not be in the absence of Canadian accounting guideline AcG-15. AcG-15 addresses the consolidation of variable interest entities and became effective for the fiscal years beginning on or after November 1, 2004.
• An advisory effective January, 2005 regarding large exposure issues pertaining to certain liquidity support facilities (those with market disruption clauses and those which are liquidity asset purchase facilities) provided by FRFIs to SPEs.

CMBS

It is generally estimated that between $13 billion and $15 billion of commercial mortgages were underwritten in Canada in 2004, and that at least $2.5 billion of commercial mortgages were securitized in the capital markets by the end of 2004.

The CMBS market has matured to the point that roughly 20% of all commercial mortgages underwritten in the Canadian market will be securitized in one form or another. In most instances, the mortgages are originated by a financial institution or are warehoused in a warehousing facility to be later sold to fixed-income investors, once the required critical mass has been assembled.

Generally, securitizations of commercial mortgages have taken the form of commercial mortgage-backed securities ("CMBSs"), which are term securities (i.e., with a term greater than one year, five to ten years), which may take various forms, usually issued under a prospectus but also sometimes pursuant to an offering memorandum in the context of a private placement. Sometimes, also, it takes the form of asset-backed commercial paper ("ABCP"), with a term shorter than a year. Fewer ABCP deals are being done to finance term mortgages, since ABCP is usually seen as more efficient to finance shorter-term assets or floating rate loans (derivatives are required to securitize longer fixed-term mortgages through ABCP transactions).

CMBSs first made their appearance in Canada in December 1998. Prior to that, ABCP conduits had been involved in securitizing small-ticket commercial mortgages on a smaller scale. CMBSs issued since the inception of the market in 1998 have exceeded the $11.5 billion threshold.

The market has moreover consistently grown since 1998. For instance, the number of institutions contributing to pools of securitized mortgages has consistently increased and so has the size of the respective offerings. CMBSs are now part of the overall debt strategy of a large number of financial institutions and other investors.

The appearance in the market of a number of CMBS conduits with a large appetite for commercial mortgages to satisfy their need for products to securitize has brought increased competition among mortgage lenders. It is no longer exceptional to see mortgage lenders competing for a mortgage loan by utilizing A/B Loan, mezzanine financing and other techniques in order to offer the borrower a substantially larger loan amount, in which case only the less-leveraged A component of the financing will be securitized in a CMBS pool, with the more risky B component being placed with private investors. It is expected that further U.S. CMBS innovations will be introduced into Canada over the next year.

Rating agencies rating the CMBS have been actively involved by establishing criteria for the loans to be securitized. Rating agencies' criteria for CMBS loans have in certain circumstances included the following: (i) the obligation for the borrower and the owner to be organized as a special purpose entity (an "SPE"), with its constating documents providing for objects limited to owning, administering and financing the subject property, and prohibiting certain actions to be taken without the affirmative vote of an independent director; (ii) more extensive representations and warranties and covenants, including in respect of leasing matters, environmental matters, property management, etc.; (iii) the obligation for the borrower to provide the lender from time to time, throughout the term of the loan, with much more financial information regarding the borrower, the owner, the mortgage property and the tenants thereof; (iv) due-on-sale and due-on-further-encumbrances provisions; (v) a prohibition imposed upon the borrower and the owner to incur additional indebtedness, (vi) a prohibition to prepay, even with a yield maintenance fee (though loan defeasance with government of Canada bonds is usually permitted); and (vii) the requirement for various reserve accounts, such as for realty taxes, capital expenditures, tenants' improvements and leasing commissions, insurance, etc., and cash management arrangements. Also, although rating agencies allow limited recourse loans in a CMBS pool, the rating agencies usually require full recourse to an entity of substance for specific matters, such as: (i) failure to provide information; (ii) failure of the borrower and/or the owner to comply with its constating documents, including in respect of SPE requirements; (iii) resort to bankruptcy and insolvency legislation; (iv) failure to comply with prohibition to alienate and/or to further encumber the mortgage property; and (v) certain environmental matters, etc.

It is expected that the CMBS market will continue to mature and grow in the upcoming years.

Accounting Developments

In September 2004, the Canadian accounting guideline AcG-15 was finalized in respect of the consolidation of variable interest entities (each a "VIE"). The variable interest entity concept in this standard includes entities known as special purpose entities but is much broader and potentially includes partnerships, joint ventures, trusts and consolidated subsidiaries. The guideline is the same in a number of key respects to the U.S. FASB Interpretation No. 46. AcG-15 has been implemented effective for financial periods beginning on or after November 1, 2004.

Under AcG-15, a business enterprise may be recognized as the "primary beneficiary" of a variable interest entity and required to consolidate the assets, liabilities and results of the VIE if: (i) the business enterprise holds debt, equity or other interests (such as guarantees, management contracts, etc.) in the VIE ("variable interests"); and (ii) the variable interests will absorb a majority of the VIE's expected losses and/or entitle the business enterprise to receive a majority of the VIE's expected residual returns. Expected losses are specifically defined in the standard and require complex calculations as they are not simply negative investment returns. One of the key implementation issues that remain is on what basis the variability of the variable interests is to be calculated, such as on a fair value basis or a cash flow basis. One exception to the consolidation rules is in respect of a VIE that is recognized as a qualifying special purpose entity ("QSPE") under Canadian accounting guideline AcG-12, which is the equivalent of U.S. FASB 140. AcG-12 and FASB 140 are accounting guidelines relating to sale treatment for financial assets. Exposure drafts are expected to be released by FASB and the CICA in the second and third quarters of 2005 regarding AcG-12 and U.S. FASB 140. The exposure drafts are expected to affect the criteria for QSPEs.

Income Tax Developments

The Department of Finance (Canada ) has proposed technical amendments to the Income Tax Act (Canada ) that are helpful to the Canadian ABS and CMBS securitization markets. The proposed amendments, which, once enacted, will have effect from February 27, 2004, relate to the foreign property status and qualified investment status for deferred income plans of securities issued pursuant to Canadian securitizations. As a result, certain recent prospectuses for Canadian public securitization issuances, based on such proposed amendments and officer's certificates in respect of the applicable tests, have been able to state that the notes of the securitization trust or the CMBS pass-through certificates, as applicable, are, at the time of issue, not foreign property and are qualified investments for deferred income plans.

Personal Privacy Laws

One of the ongoing considerations for parties involved in securitizations of consumer receivables is the personal privacy provisions of the federal Personal Information Protection and Electronic Documents Act ("PIPEDA") and substantially similar provincial legislation. Since January 1, 2004, PIPEDA has had application to all commercial activities in Canada, subject, in certain circumstances, to applicable provincial legislation being enacted (as of October 2004, Alberta, British Columbia and Quebec have enacted personal privacy legislation). The federal legislation prohibits the collection, use or disclosure of personal information without an individual's knowledge and consent, subject to certain limited exceptions. Personal information is defined in a broad manner in the legislation and, as a result, a determination of whether there is appropriate consent to the assignment of the receivables becomes necessary.

Credit Derivatives and CDOs

The growing use of credit derivative and CDO technology in Canadian public structured finance transactions is perhaps one of the most interesting developments of 2004. The primary attraction of these transactions to investors is the ability to obtain extra yield linked to credit exposure to a large diversified basket of international companies without the need to acquire any debt securities of those companies.

Credit derivatives are an investment product pursuant to which one party (the "credit protection buyer") pays a second party (the "credit protection seller") to obtain credit protection against defaults by a reference entity in respect of a particular reference obligation (for example, a given amount of a particular bond issued by a public company). Credit derivatives are typically drafted based on terminology and documentation developed by the International Swaps and Derivatives Association.

Credit derivatives typically contain net loss thresholds below which the credit protection seller is not required to make a payment to the credit protection buyer. Once the net loss threshold has been exceeded, the credit protection seller is obliged to make a cash payment to the credit protection buyer equal to the excess of the net loss over the threshold.

The payment made by a credit protection buyer to a credit protection seller is usually a fixed number of basis points per annum applied to the maximum amount of default protection provided by the credit protection seller from time to time. This fixed amount (the "Fixed Amount") can be viewed as the risk premium that the credit protection seller receives in exchange for assuming credit exposure to the underlying reference entity. In very general terms, the sum of the (i) fixed amount payable for assuming credit exposure to a given reference obligation of a reference entity and (ii) the rate of return on a risk-free investment having the same term as the credit derivative should over time tend to be equal to the rate of return that would be earned by an investor investing directly in such reference obligation. Accordingly, credit derivatives can be used as a tool to de-couple the decision to assume credit exposure to a particular entity from the need to advance credit to such entity. In other words, spread attributable to credit risk can be obtained synthetically through the use of derivatives.

The concepts underlying credit derivatives are the basis of a type of structured finance transaction that is commonly referred to as a "CDO" or "collateralized debt obligation." CDO technology has been used in at least five public structured product offerings this year in Canada. These include ROC Pref Corp., ROC Pref II Corp., Global DiSCS Trust 2004-1, Global Diversified Investment Grade Income Trust and Global Diversified Investment Grade Income Trust II. The essential feature of all of these transactions is to provide investors with credit exposure and the related higher yield associated with a large portfolio of reference obligations of international reference entities. The amount of credit risk can be controlled by the level of the net loss threshold or "attachment point" that must be exceeded before an investor will lose money on its investment. Accordingly, a higher attachment point will generally lead to (i) a higher rating on the securities issued and (ii) lower risk and yield on the investment.

In the five transactions referred to above, investors were offered either preferred shares of a corporation or units of a trust. In all cases, the securities provided exposure to a credit derivative or a credit-linked note (a "CLN"). In structures involving a credit derivative, the proceeds of the offering are invested in low-risk investments, which are then pledged to the credit protection buyer as security for the obligation of the credit protection seller to make a payment following a default or other credit event in respect of a reference entity. In structures involving a CLN, the proceeds of the offering are advanced to a bank or a bankruptcy remote special purpose entity. Following the occurrence of defaults or other credit events in respect of one or more reference entities, the amount of principal that is to be repaid in respect of the CLN will be reduced to the extent that net losses on the underlying reference obligations have exceeded the attachment point.

The use of credit derivative and CDO technology in public structured finance transactions has been an exciting development this year that has followed closely on the heels of many such offerings made privately to accredited investors in 2002 and 2003. Some commentators have referred to credit risk as a new asset class. The five public transactions referred to above may be an example of how the Canadian retail market is beginning to adopt this view.