A N N U A L R E P O RT 2 0 0 6
First National Financial Income Fund (TSX: FN.UN) owns a 19.97% interest in First National
Financial LP, a Canadian-based originator, underwriter and servicer of predominantly prime
residential (single-family and multi-unit) and commercial mortgages. With more than
$24 billion in mortgages under administration, First National is Canada’s largest non-bank
originator and underwriter of residential mortgages and is among the top three in market
share in the growing mortgage broker distribution channel.
www.firstnational.ca
Montréal
Toronto
Halifax
Vancouver
Calgary
TABLE OF CONTENTS
Investment Highlights
Our Business Model
Our Revenue Model
Letter From the President
Corporate Governance
Board Members
Management’s Discussion and Analysis
First National Financial Income Fund
Financial Statements
First National Financial LP
Financial Statements
1
2
3
4
6
8
10
27
34
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
INVESTMENT HIGHLIGHTS
First National’s strength is based on our commitment to service,
product development, and prudent risk management.
Our long-term growth strategy is focused on four key objectives:
•
•
•
•
providing a complete range of mortgage products;
increasing mortgages under administration;
lowering costs through efficient processes; and
maintaining a conservative risk profile.
We are achieving this by leveraging our leadership position
with mortgage brokers and by continually innovating our
products and operations.
Canada’s largest non-bank originator and underwriter of
residential mortgages
Leader in high growth mortgage broker distribution channel
Mortgages under administration increased 3%
year over year
Revenue increased 46%*
Adjusted EBITDA increased 24%*
Diversified revenue and funding sources
Experienced management with 80% retained interest
*
Year-to-date results for the period ended December 31, 2006 represent a combined nine-month period,
which includes the activities of First National Financial Income Fund and First National Financial LP (FNLP) from
June 15 through December 31, 2006, together with the activities of First National Financial Corporation (FNFC) from
April 1 through June 14, 2006.
FUNDING
(As at December 3, 2006)
REVENUE
(As at December 3, 2006)
CMBS 5%
NHA-MBS %
ABCP 8%
INSTITUTIONAL PLACEMENTS 76%
NET PLACEMENT 30%
MORTGAGE SERVICING 32%
RESIDUAL SECURITIZATION 6%
NET GAIN ON SECURITIZATION 20%
MORTGAGE INVESTMENT 2%
2
FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
Our Business Model
MORTGAGES
SOURCES OF FUNDING
Single-family Residential
Prime
Alt-A
Multi-Unit Residential
& Commercial
Large Conventional
CMHC Insured
Small Conventional
Bridge Lending
Underwriting
Placement
Securitization
Servicing
Institutional Placement
Banks
Life Insurers
Trust Companies
Pension Funds
Securitization Conduits
ABCP
CMBS
NHA-MBS
Canada Mortgage Bond
First National’s business
model is simple: we originate,
underwrite and service
mortgages.
We offer a full range of mortgage products for both the
residential and commercial markets. Our service process
offers a complete end-to-end solution for the client. Most
of our single-family mortgages are originated through the
residential mortgage broker channel while our multi-unit
and commercial mortgages are originated through an
experienced group of in-house underwriters.
Our mortgages are funded through a diversified mix of both
institutional placements and securitization conduits. This
gives us flexibility to finance and manage our mortgages in
a low risk and cost effective manner.
We service virtually all the mortgages we originate which
creates stable, consistent and predictable cash flows.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
3
Our Revenue Model
MORTGAGES
Origination
Servicing &
Administration
•
•
•
•
Placement Fees
Gain on Securitization
Mortgage Servicing Income
Residual Securitization Income
BRIDGE LOANS
& OTHER
Interest Income
•
Mortgage Investment Income
First National has three
revenue sources: origination,
servicing & administration, and
investment.
Mortgage originations generate revenues at the time
they are placed with institutional investors or sold to
securitization conduits. This revenue is recorded as either
placement fees or gain on securitization. Additional revenue
earned on our securitization conduits is recognized as
residual securitization income over the term of the mortgage.
Recurring revenue is also earned from servicing our
mortgage portfolio.
Another important source is mortgage investment income
derived from interest earned on securitization receivables
and other mortgage-related assets such as mortgage
and loan investments, servicing rights and mortgages
accumulated for sale.
4
FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
LE T TER FROM THE PRESIDENT
Fellow Unitholders,
On behalf of management and the Board of Directors, I am
pleased to report First National Financial Income Fund’s
results for fiscal 2006.
The Fund commenced operations upon completion of its
initial public offering (IPO) on June 15, 2006 and has a 19.97%
indirect interest in First National Financial LP (FNLP).
Moray Tawse and I co-founded First National in 1988 and
are very proud of its success. The value of mortgages
under administration has grown steadily to more than
$24 billion at the end of fiscal 2006 from $835 million in
1997. This represents a 10-year compound annual growth
rate of 41%. FNLP is currently Canada’s largest non-bank
originator and underwriter of residential mortgages and is
among the top three in market share in the high-growth
mortgage broker distribution channel.
In 2006, we continued to build on our success and enjoyed
one of the busiest and most rewarding years in the history
of First National.
Key Events of 2006
Our IPO, the most significant event of the year, marked an
important step in our strategic evolution. This has created
a strong public platform that will provide us with greater
opportunities for growth.
In keeping with our strategy of expanding our breadth of
mortgage products, FNLP became one of the first Canadian
lenders to offer the Canada Mortgage and Housing
Corporation (CMHC) insured Interest Only Mortgage, a
new mortgage concept that helps qualified homebuyers
lower their monthly mortgage payments and improve their
cash flow flexibility.
First National’s Alt-A product evolution strategy also
progressed well in 2006. Alt-A mortgage products are
ideal for customers with strong credit histories, who may
not be able to verify income in the traditional manner, and
those who require more flexible underwriting. We recently
completed a multi-city seminar series to build broker
awareness for Excalibur, the First National Alt-A mortgage
solution, and the opportunities within the Alt-A market.
Our marketing efforts have been very well-received,
positioning us to capture market share gains in this high
growth segment.
We, like you, were surprised by the government’s
October 31, 2006 announcement regarding proposed tax
changes for income trusts. More clarity was provided on
this matter in December, and we continue to review the
proposed changes to assess their potential impact on the
Fund. While we were pleased with the guidance from the
government on income trust expansion restrictions, we are
still awaiting the passing of the proposed changes into
legislation. Until then, we expect to continue to operate as
an income trust for the next four years. With a favourable
business environment and sound business strategy, we are
confident that we can enhance long-term unitholder value.
Evidence of Success
Growth in First National’s key metrics provide sound evidence
of the strength of our business model.
•
•
•
Mortgages under administration (MUA) were $24.4
billion as at December 31, 2006, an increase of 31%
over 2005.
Revenue for the nine-month period was up 46% to
$156.4 million.*
Adjusted EBITDA for the nine-month period increased
24% to $51.3 million.*
These excellent results were driven by a combination of
successful strategies.
Growth in Single-family Mortgage Origination
Prime single-family residential originations for the nine-
month period, which accounted for the majority of the
origination volume, were $4.7 billion, up 37% compared to
the same period in 2005. This significant growth was
primarily due to two factors: the posting of very competitive
prime single-family mortgage rates, and our growing market
share in the mortgage broker distribution channel. We
originate virtually all of our residential mortgages through
independent mortgage brokers — the fastest growing
distribution channel in Canada.
* Year-to-date results for the period ended December 31, 2006 represent a combined nine-month period,
which includes the activities of First National Financial Income Fund and FNLP from June 15 through
December 31, 2006, together with the activities of First National Financial Corporation (FNFC) from April
1 through June 14, 2006.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
5
Growth in Higher Margin Mortgage Origination
While our main focus has historically been on the prime
single-family mortgage market, First National has been
pursuing strategies to increase volumes in both the Alt-A
and commercial mortgage backed securities (CMBS)
markets by leveraging on existing infrastructure and
distribution channels. These markets are typically more
profitable than conventional mortgage lending markets and
add to economies of scale by further increasing MUA. We
have been successful in increasing volume for both of these
products this year, originating $432 million of Alt-A
mortgages and $285 million of CMBS mortgages, compared
to $151 million and $224 million respectively in 2005.
Canada Mortgage Bond: Revenue Enhancing Initiative
Another revenue enhancing initiative involves the Canada
Mortgage Bond (CMB). The CMB is an initiative of the
Canada Housing Trust, a trust created by CMHC which
is designed to offer mortgage backed securities to
the investment community in the form of semi-annual
interest yielding five year bonds. This agreement has
given us access to lower costs of funds on single-family
mortgage securitizations.
As a result of this exceptional performance, we have
consistently delivered on our commitment to paying stable
distributions to unitholders. The Fund’s distributable cash
for the period June 15 (the IPO date) to December 31,
2006 was $7.9 million or $0.68 per unit. Since the IPO,
distributions declared have totalled $6.1 million or $0.52
per unit which translates to a payout ratio of 76%. These
monthly distributions represent an annualized distribution
of $0.95 per unit, which is consistent with management’s
expectation at the time of the IPO.
Outlook
Based on the strength of our fundamentals and the current
market conditions, we are optimistic about the year ahead.
The Canadian economy as a whole, the principal driver of
the single-family residential housing market, continues to
show strength despite some weakness in Ontario.
From an interest rate perspective, housing continues to be
affordable by historical standards. We see numerous
opportunities arising in Western Canada due to the strong
regional economy. The mortgage broker market should
continue to grow rapidly as the distribution channel of
choice in the mortgage industry.
Growth Strategy
Moray Tawse and I have retained an 80% interest in FNLP
and, along with you, we are committed to its long-term
growth and success.
There are four primary goals that form the basis for our
growth strategy:
•
•
•
•
providing a complete range of mortgage products;
increasing mortgages under administration;
lowering costs through efficient processes; and
maintaining a conservative risk profile.
To realize these goals, we will leverage our leadership
position with mortgage brokers and continue to innovate our
operations and products to create efficiencies. One
particular growth initiative for 2007 is the launch of
single-family mortgages in Quebec.
Acknowledgements
I would like to recognize all the key players in First National’s
success this year. To our employees, I thank you for your
ongoing commitment. I acknowledge my fellow board
members for providing valued guidance and dedication to
our unitholders. I extend gratitude to our mortgage
brokers and customers for your support and feedback,
which helps us develop innovative products to serve your
evolving needs.
Finally, I offer a sincere thank you to our unitholders for
entrusting us with your investment. We look forward to
earning your trust again in the years ahead.
Yours truly,
Stephen Smith
President and Chairman
6
FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
CORPORATE GOVERNANCE
Board of Directors 2006
BACK ROW: Stanley Beck, Robert Mitchell, Stephen Smith, Robert Courteau, John Harris
FRONT ROW: John Brough, Moray Tawse, Duncan Jackman
First National believes that
investor trust and confidence
comes from straightforward
and transparent governance
from its Board of Directors.
To properly guide the Fund towards ongoing success,
management and the Board are committed to the highest
standards of integrity. As such, the Board of Directors’ role
is clear and focused: to serve the long-term interests of
our unitholders.
Policies
The Board has adopted several policies which reflect
best practices in governance and disclosure. These include
a Disclosure Policy, a Code of Business Conduct, a
Whistleblower Policy and an Insider Trading Policy.
As a newly listed public company, the Board continues to
develop and implement appropriate governance policies
and practices.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
7
Committees
Upon the closing of First National’s IPO, the Board
of Directors created an Audit Committee and a
Compensation, Governance and Nominating Committee
to further the effective functioning of the Fund’s corporate
governance strategy.
Audit Committee
The Audit Committee’s responsibilities include:
•
•
•
•
•
the oversight and supervision of the audit of the Fund’s
financial statements;
the management of the relationship with the auditor of
the Fund’s financial statements;
the oversight and supervision of the accounting and
financial reporting practices and procedures of the Fund;
the oversight and supervision of the adequacy of
the
and
procedures; and
accounting
controls
internal
Fund’s
the oversight and supervision of the quality and integrity
of the Fund’s financial statements.
All of the Audit Committee members are independent
directors and deemed financially literate for the purposes
of the Canadian Securities Administrators’ Multilateral
Instrument 52–110 — Audit Committees.
Committee Members: John Brough (Chair),
Duncan Jackman and Robert Mitchell
Compensation, Governance and
Nominating Committee
The Compensation, Governance and Nominating
Committee’s responsibilities include:
•
•
•
•
•
•
annually reviewing the President’s goals and objectives
for the coming year and providing an appraisal of the
President’s performance;
making recommendations concerning compensation
of the Fund’s senior executive officers and the
remuneration of the Board of Directors;
the Fund’s approach
to corporate
developing
governance issues and compliance with applicable laws,
regulations, rules, policies and orders with respect to
such issues;
advising the Board of Directors on filling director vacancies;
periodically reviewing the composition and effectiveness
of the directors and the contributions of individual
directors; and
adopting and periodically reviewing and updating the
Fund’s written disclosure policy.
All of the Compensation, Governance and Nominating
Committee members are independent directors for the
purposes of the Canadian Securities Administrators’
Multilateral Instrument 58 – 101 — Disclosure of Corporate
Governance Practices.
Committee Members: Stanley Beck (Chair),
Robert Courteau and John Harris
8
FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
BOARD MEMBERS
Stephen Smith, Chairman, is President and Co-Founder of First National. Mr. Smith has been an
innovator in the development and utilization of various securitization techniques to finance mortgage
assets and is a regular speaker at securitization and financial services conferences. Mr. Smith holds a
Master of Science (Economics) from the London School of Economics and Political Science, a
Bachelor of Science (Honours) in Electrical Engineering from Queen’s University, and is a member
of the Association of Professional Engineers of Ontario. He is also Vice-Chairman of the Greater
Toronto Transit Authority (Go Transit).
Moray Tawse is Vice President, Mortgage Investments. He directs the operations of all commercial
mortgage origination activities and is Co-Founder of First National. Mr. Tawse is one of Canada’s
leading experts on commercial real estate and is often called upon to deliver keynote addresses
at national real estate symposiums. Prior to co-founding First National, Mr. Tawse was Manager
of Mortgages for the Guaranty Trust Company of Canada from 1983 until 1988.
Stanley Beck, Q.C. has been President of Granville Arbitrations Limited (an arbitration and
mediation firm) for more than five years. He was previously a Professor of Law and Dean at
Osgoode Hall Law School in Toronto. From 1985 to 1990, Mr. Beck served as Chairman of the
Ontario Securities Commission. Mr. Beck acts as a consultant on securities and corporate matters.
In addition, Mr. Beck is the chairman of 407 International Inc. and GMP Capital Trust and serves on
the board as a director of Scotia Utility Corp., Scotia NewGrowth Corp., Canadian Tire Bank Inc.,
Hollinger Inc. and Hollinger International.
John Brough is President of both Wittington Properties Limited (Canada) and Torwest, Inc.
(United States) real estate investment companies. He has held these positions since 1998. From
1974 until 1996, he was with Markborough Properties Inc., where he was Senior Vice President and
Chief Financial Officer from 1986 until 1996. From 1996 to 1998, Mr. Brough was Executive Vice
President and Chief Financial Officer of iStar Internet, Inc. Mr. Brough is a director of Kinross Gold
Corporation, Silver Wheaton Corp., Livingstone International Inc. and Rockwater Capital Corp.
Mr. Brough holds a Bachelor of Arts (Political Science and Economics) from the University of Toronto
and is a Chartered Accountant.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
The Board of Directors consists of eight
members, six of whom are independent.
Robert Courteau is the President and Managing Director of SAP Canada (an enterprise software
company) and is responsible for all of SAP’s business activities in Canada. Prior to joining SAP Canada
in January 2004, Mr. Courteau served as the Executive Vice President responsible for Canadian sales
and consulting services for EDS Corporation. Mr. Courteau graduated from Concordia University with
a Bachelor of Commerce degree.
John Harris is the Chairman and Chief Executive Officer of Harris Steel Group Inc. Employed
by Harris Steel Inc. since 1974, Mr. Harris was appointed President and Chief Operating Officer
of Harris Steel Group Inc. in 1994 and was named Chairman and Chief Executive Officer in
2005. Mr. Harris has a Bachelor of Arts degree from Trent University and a Master of Business
Administration degree from the University of Toronto.
Duncan Jackman has been the Chairman and Chief Executive Officer of E-L Financial Corporation
Limited (an insurance holding company) since 2003 and the Chairman and Chief Executive Officer
of both Economic Investment Corporation (a closed end investment trust) and United Corporations
Limited (a closed end investment trust) since 2001. Prior to this, Mr. Jackman held a variety of
positions, including portfolio manager at Cassels Blaikie and investment analyst at RBC Dominion
Securities. Mr. Jackman holds a Bachelor of Arts (Honours) in Literature from McGill University.
Robert Mitchell has been President of Dixon Mitchell Investment Counsel Inc., a Vancouver-
based investment management company since 2000. Prior to that, Mr. Mitchell was Vice President,
Investments at Seaboard Life Insurance Company. Mr. Mitchell is a director and chairman of the
audit committee for Discovery Parks Holdings Ltd., trustee for Discovery Parks Trust. Discovery
Parks Trust was established to support the high technology and research industries in British
Columbia through the development of its real estate assets. Mr. Mitchell has a Master of Business
Administration from the University of Western Ontario, a Bachelor of Commerce (Finance) from
the University of Calgary, and is a CFA charterholder.
0 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
MANAGEMENT’S DISCUSSION AND ANALYSIS
The following management’s discussion and analysis of financial condition
and results of operations is prepared as of February 28, 2007. This discussion
should be read in conjunction with the consolidated financial statements of
First National Financial Income Fund (the “Fund”) and First National
Financial LP (“FNLP”) as at and for the nine-months ended December 31,
2006 (as applicable) and the notes thereto. This discussion should also be
read in conjunction with the audited financial statements and notes thereto
of First National Financial Corporation (as predecessor to First National LP –
“FNFC”) for the year ended March 31, 2006. The consolidated financial
statements of the Fund and FNLP have been prepared in accordance with
Canadian generally accepted accounting principles (“GAAP”).
The Fund earns income from its 19.97% interest in FNLP. The Fund accounts
for its investment in FNLP using the equity method and therefore does not
consolidate the results of operations of FNLP. As a result, financial statements
with accompanying notes thereon have been presented for both the Fund
and FNLP. In addition, the following management’s discussion and analysis
(“MD&A”) presents a discussion of the financial condition and results of
operations for both the Fund and FNLP.
Information for the nine-month period ended December 31, 2006 for FNLP
includes information from FNLP and its predecessor, FNFC. Historical
comparative information refers to FNFC.
This MD&A contains forward-looking statements. Please see “Forward-
Looking Statements” for a discussion of the risks, uncertainties and
assumptions relating to these statements. The selected financial information
and discussion below also refers to certain measures to assist in assessing
financial performance. These “non-GAAP measures” such as “EBITDA”,
“Adjusted Net Income”, “Distributable Cash”, and “Distributable Cash per
Unit” should not be construed as alternatives to net income or loss or other
comparable measures determined in accordance with GAAP as an indicator
of performance or as a measure of liquidity and cash flow. Non-GAAP
measures do not have standard meanings prescribed by GAAP and therefore
may not be comparable to similar measures presented by other issuers.
The Fund is entirely dependent upon the operations and financial condition
of FNLP. The earnings and cash flows of FNLP are affected by certain risks.
For a description of those risks, please refer to the “Risk and Uncertainties
Affecting the Business” section.
Unless otherwise noted, monetary amounts are
Canadian dollars.
in
thousands of
General Description Of The Fund And First National Financial LP
Pursuant to an underwriting agreement dated June 6, 2006 and initial
public offering (“IPO”), the Fund sold 10,600,000 units of the Fund
(“Fund Units”, “Units”, or “Unit”), at a price of $10.00 per Unit for
proceeds totaling $106 million. The proceeds of the offering were
used to partially fund the indirect acquisition (through the Fund’s
wholly-owned subsidiary, First National Financial Operating Trust) by
the Fund of a 17.94% interest in First National Financial LP (“FNLP”).
The underwriters were also granted an over-allotment option to
purchase 1,200,000 Units at $10.00 per Unit. The option was exercised
in full on July 11, 2006. Accordingly, the Fund indirectly holds a 19.97%
interest in FNLP and First National Financial Corporation holds an
80.03% controlling interest in FNLP.
Concurrent with the initial public offering and as part of the acquisition
agreement between FNLP and FNFC on June 15, 2006, FNLP purchased
all of FNFC’s assets and assumed its liabilities, except for future income
tax liabilities, which are payable by FNFC. The consideration for this
purchase was:
•
•
•
the issuance of 48,486,316 exchangeable Class B LP units to FNFC
an acquisition promissory note of $10.94 million, which has been
accounted for as a distribution in FNLP’s financial statements;
a working capital note in the amount of $6.4 million, representing
the difference between the net assets, except future income tax
liabilities, of FNFC as at March 31, 2006 and the net assets
transferred to FNLP as at June 14, 2006. The issuance of this
note has also been accounted for as a distribution in FNLP’s
financial statements.
First National Financial Income Fund
The Fund is an unincorporated, open-ended trust established under the
laws of the Province of Ontario on April 19, 2006, pursuant to a
Declaration of Trust. The Fund has been established to acquire and
hold, through a newly constituted wholly owned trust, First National
Financial Operating Trust (the “Trust”), investments in the outstanding
limited partnership units of FNLP. Each unitholder participates pro rata
in any distribution from the Fund. Income tax obligations related to the
distributions of the Fund are the obligations of the unitholders.
Additional information relating to the Fund and FNLP is available on the
Fund’s profile on the System for Electronic Data Analysis and Retrieval
(“SEDAR”) website at www.sedar.com.
The Fund effectively commenced operations through its indirect
investment in FNLP on June 15, 2006, and the income reported by the
Fund commenced on that date.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
Selected Quarterly Information
Quarterly Results (in $000s except per unit amounts)
2006
Fourth Quarter
Third Quarter
Second Quarter
Investments
Net Income
Revenue
Net Income
for the period
($/Unit)
Total Assets
$ 1,602
$ 1,825
$
488
$ 1,596
$ 1,819
$
487
Distributions
0.14
0.16
0.05
$ 110,417
$ 111,617
$ 100,128
At December 31, 2006 the Fund has an investment in 11,800,000 units
(19.97%) of First National Financial LP at a cost of $111.6 million. Under
Canadian GAAP, the Fund is required to account for this investment
using the equity method. During the period June 15, 2006 to December
31, 2006, the Fund’s earnings from FNLP were $3.9 million and the
carrying value of this investment at December 31, 2006 was $109.5
million. During the period from October 1, 2006 to December 31, 2006,
the Fund’s earnings from FNLP were $1.6 million.
Expenses
Trust administration expenses include trustees’ fees and travel costs.
Statement of Distributable Cash
(in $000s except per unit amounts)
The initial public offering described above closed on June 15, 2006. The
Fund made its first distribution of $0.11875 per Unit, representing a
monthly distribution of $0.07917 per Unit plus the stub period of June
15, 2006 to June 30, 2006, on August 15, 2006. Beginning on September
15, 2006, the Fund made monthly distributions of $0.07917 per unit on
or around the 15th of each month. On December 14, 2006, the Fund
declared its sixth distribution in the amount of $0.07917 per unit payable
January 15, 2007. These distributions of approximately $6.1 million are
equivalent to the distributions that the Fund receives from FNLP.
Consistent with management’s expectation at the time of the IPO, these
distributions represent an annualized distribution rate of $0.95 per unit.
As shown in the following table, the Fund’s payout ratio based on
distributable cash is approximately 76% since the IPO.
For the three-months ended
December 31, 2006
For the Period June 15
to December 31, 2006
First National Financial LP
Net Income
Amortization
EBITDA (1)
Maintenance Capital Expenditures
Distributable Cash from First National Financial LP
First National Financial Income Fund
Weighted Average Share of Distributable Cash from First National Financial LP
Trust Administration Expenses
Distributable Cash from First National Financial Income Fund (2)
Distributable Cash per Unit ($/Unit) (2)
Distributions Declared
Distributions Declared per Unit ($/Unit)
18,038
290
18,328
124
18,204
3,635
6
3,629
0.31
2,803
0.24
40,148
589
40,737
341
40,396
7,957
13
7,944
0.68
6,072
0.52
(1) EBITDA is a non-GAAP measure that represents earnings generated to fund capital investment, meet
financial obligations and fund distributions. It is considered a key measure as it demonstrates the ability of
the business to meet its capital and financing commitments.
(2) Distributable cash and distributable cash per unit are non-GAAP measures generally used by Canadian
open-ended trusts as an indicator of financial performance. They are considered key measures as they
demonstrate the cash available for distributions to unit holders.
2 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
Income Taxes
The Fund is a mutual fund trust for income tax purposes. As such, the
Fund is only taxed on any amount not allocated to unitholders. The
Fund intends to distribute substantially all of its taxable income to its
unitholders and the Fund intends to comply with the provisions of
the Income Tax Act (Canada) that permit, amongst other items,
the deduction of distributions to unitholders from the Fund’s
taxable income.
Outstanding Securities of the Fund
At December 31, 2006 and at February 28, 2007, the Fund had
11,800,000 units outstanding.
First National Financial Corporation holds 47,286,316 exchangeable
Class B LP units of FNLP, each of which is exchangeable into one Fund
Unit at no cost at any time at the option of First National Financial
Corporation, and each of which carries a Special Voting Right that
entitles the holder to receive notice of, attend and vote at all meetings
of unitholders of the Fund.
Critical Accounting Estimates
Management makes estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the Consolidated Financial Statements, and
revenues and expenses during the reporting period. Management
reviews these estimates on an ongoing basis, including those related to
securitization accounting. Changes in facts and circumstances may result
in revised estimates and actual results may differ from these estimates.
Business Risks
The Fund is entirely dependent upon the operations and financial
condition of FNLP. The earnings and cash flows of FNLP are affected by
certain risks. For a description of those risks, please refer to the Risk and
Uncertainties Affecting the Business section in the First National Financial
LP portion of this analysis.
Guarantee
The Fund’s wholly-owned subsidiary, First National Financial Operating
Trust has provided guarantees to and subordinated their rights to receive
payments from FNLP in respect of FNLP’s bank credit facility.
First National Financial LP
Basis of Presentation
The financial statements of First National Financial LP (“FNLP” or the
“Company”) are prepared in accordance with Canadian Generally
Accepted Accounting Principles (“GAAP”).
FNLP is considered to be a continuation of First National Financial
Corporation’s (“FNFC’s” or the “Company’s”) business following the
continuity of interest method of accounting. Under the continuity of
interest method of accounting, FNLP’s acquisition of the FNFC business
is recorded at the net book value of FNFC’s business assets and liabilities
on June 14, 2006 and the equity of FNLP represents the equity of the
FNFC business at that date.
The consolidated statements of income and cash flows for the nine-
months ended December 31, 2006 reflect the activities of the FNFC
business from April 1, 2006 to June 14, 2006 and the activities of FNLP
for the period June 15, 2006 to December 31, 2006. The comparative
figures represent the historic activities of FNFC.
Executive Summary
The recent quarter and year-to-date performance is fully consistent with
management’s expectations. The Company continues to have growth in
mortgages under administration from increasing mortgage origination
volumes, especially in the prime single-family and Alt–A markets.
Highlights
•
•
•
Mortgages under administration grew to $24.4 billion at December
31, 2006 from $22.7 billion at September 30, 2006, an increase of
7.5%; the growth from December 31, 2005, when mortgages under
administration were $18.6 billion, was 31.2%;
Revenue for the nine-months ended December 31, 2006 grew by
46% over the comparative period;
Adjusted EBITDA increased by 24% for the nine-month period
ended December 31, 2006 in comparison to the same period in
the prior year. This increase has resulted from higher volumes
experienced in many aspects of the company’s business including
placement fees on higher origination volumes, servicing income
derived from the larger portfolio of mortgages under administration,
and gains on securitization earned from higher Alt-A and commercial
mortgage origination.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
3
Selected Annual Financial Information for the Company’s fiscal year ends
(in $000s except per unit amounts)
December 31, 2006 (1)
March 31, 2006
March 31, 2006
For the Period
Income Statement Highlights
Revenue
Brokerage fees
Other operating expenses
EBITDA (2)
Amortization of capital assets
Interest paid to shareholders
Provision for income taxes
Net Income
Distributions declared
Per Unit Highlights
Net Income per unit (3)
Distributions declared per unit
At Period End
Balance Sheet Highlights
Total assets
Total long-term financial liabilities
156,427
(67,891)
(37,007)
51,529
(803)
–
(3,312)
47,414
30,406
0.80
0.51
528,116
–
144,643
(47,915)
(37,796)
58,932
(895)
(1,711)
(19,994)
36,332
–
0.61
N/A
279,751
–
102,226
(37,971)
(36,298)
27,957
(708)
(1,695)
(9,290)
16,264
–
0.28
N/A
253,190
13,700
(in $000s except where noted)
December 31, 2006 (1)
March 31, 2006
March 31, 2005
Reconciliation of EBITDA to Adjusted EBITDA
EBITDA(2)
Historic management compensation expenses (4)
Revised management compensation (5)
Adjusted EBITDA (2)
51,529
917
(1,125)
51,321
58,932
700
(1,500)
58,132
27,957
8,500
(1,500)
34,957
(1) December 31, 2006 figures are for the nine-month period ended December 31, 2006.
(2) EBITDA and Adjusted EBITDA are not recognized earnings measures under GAAP and do not have
standardized meanings prescribed by GAAP. Therefore, EBITDA and Adjusted EBITDA may not be
comparable to similar measures presented by other issuers. Investors are cautioned that EBITDA should
not be construed as an alternative to net income or loss determined in accordance with GAAP as
indicators of the Company’s performance or as an alternative to cash flows from operating, investing and
financing activities as a measure of liquidity and cash flows.
(3) Per unit amounts calculated as if the Company converted to a partnership on April 1, 2004 and issued
59,086,316 partnership units so that these measures are comparable among the periods show. Prior to
June 15, 2006, the Company had two shares outstanding.
(4) Management compensation for each of the two senior management executives while FNFC operated as
a private company.
(5) Normalized compensation for each of the two senior management executives consistent with
compensation policies that have been implemented on closing of the IPO.
4 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
Vision
The Company provides mortgage financing solutions to virtually the
entire mortgage market in Canada. By offering a full range of mortgage
products with a focus on customer service and superior technology, the
Company views itself as one of the leading “non-bank” mortgage lenders
in the industry. Growth has been achieved while maintaining a relatively
conservative risk profile. The Company sees itself levering on these
strengths to continue to lead the “non-bank” mortgage lending industry
in Canada, managing risk appropriately.
Strategy
The Company’s strategy is built on four cornerstones: providing a full
range of mortgage products; growing assets under administration;
employing leading edge technology to lower costs and rationalize
business processes; and maintaining a conservative risk profile. An
important consequence of the Company’s strategy is the direct
relationship with the mortgage borrower. Although the Company places
most of its originations with third parties, FNLP is perceived by all of its
borrowers as the mortgage lender. This is a critical distinction. It allows
the Company to communicate with each borrower directly throughout
the term of the related mortgage and negotiate new transactions and
pursue marketing initiatives. Management believes this strategy will
provide long-term profitability and branding for the Company.
Key Performance Drivers
The Company’s success is driven by the following factors:
•
•
•
Growth in portfolio of mortgages under administration;
Growth in origination of higher margin mortgages; and
Lowering the costs of operations through the innovation of systems
and technology.
Growth in Portfolio of Mortgages under Administration
Management considers the growth in mortgages under administration a
key element of the Company’s performance. The portfolio grows in two
ways: through mortgages originated by the Company and mortgage
servicing portfolios purchased from third parties. Mortgage originations
not only drive placement fee and gain on securitization revenues, but
perhaps more importantly, longer term values such as servicing fees,
mortgage administration fees, renewal opportunities and a customer
base for marketing initiatives. For the nine-months ended December 31,
2006, mortgages under administration grew to $24.4 billion from $19.6
billion as at March 31, 2006, an annualized rate of increase of 33%.
During the current quarter, mortgages under administration grew to
$24.4 billion from $22.7 billion as at September 30, 2006. This is an
annualized increase of 30%. This growth is primarily organic, created
from new originations of $6.0 billion in the nine-month period net of
normal run-off. This compares favorably with the nine-month period
ended December 31, 2005 when originations totaled $4.7 billion. For
the nine-months ended December 31, 2006, non-originated servicing
business increased mortgages under administration by $1.3 billion.
Growth in Origination of Higher Margin Mortgages
While the Company’s main focus is on the Prime single-family mortgage
market, during 2006 FNLP has launched strategies to increase volumes
in both the Alt-A and CMBS markets by leveraging on existing
infrastructure and distribution channels. Alt-A describes single-family
residential mortgages that are originated using broader underwriting
criteria than those applied in originating prime mortgages. Alt-A
borrowers are generally considered “A” quality borrowers in terms of
their credit histories, but do not qualify for a prime mortgage because of
non-conformities, such as the degree of income disclosure and
verification required. These markets are relatively more profitable than
conventional mortgage lending markets and add to economies of scale
in the Company’s operations by further increasing mortgages under
administration. The Company has been successful in increasing volume
for both of these products. For the nine-month period ended December
31, 2006, the Company originated $432 million of Alt-A mortgages and
$285 million of CMBS mortgages. These volumes contrast the prior
year’s comparative period ended December 31, 2005 when the
Company originated $151 million of Alt-A mortgages and $224 million
of CMBS mortgages. For the current quarter the comparative volumes
are $155 million versus $55 million for Alt-A and $115 million versus
$123 million for CMBS. At December 31, 2006, the Company’s
securitized Alt-A mortgages under administration totaled $569 million.
Lowering Costs of Operations through Innovation of Systems
and Technology
The Company has always used technology to provide for efficient and
effective operations. This is particularly true for its MERLIN underwriting
system, Canada’s only web-based real time broker information system.
By creating a paperless, 24/7 available commitment management
platform for mortgage brokers, the Company has reached a place
among the top three ranked lenders in market share in the broker
channel. This has translated into increased single-family origination
volumes and higher closing ratios (the percentage of mortgage
commitments that the Company issues that actually become closed
mortgages). The nine-months ended December 31, 2006 showed
single-family origination volumes of $4.7 billion, which compares to $3.4
billion for the same period ended on December 31, 2005.
Canada Mortgage Bond as a New Funding Source
The Canada Mortgage Bond (“CMB”) is an initiative introduced by
Canada Mortgage and Housing Corporation whereby the Canada
Housing Trust issues securities to investors in the form of semi-annual
interest yielding five year bonds the proceeds of which are used to buy
NHA mortgage backed securities. In the quarter ended September 30,
2006, the Company entered into an agreement with a Canadian bank
which allowed the Company to indirectly sell a portion of the Company’s
single-family mortgage origination into the September issue of the CMB.
Pursuant to the same agreement, the Company indirectly sold a smaller
amount into the December 2006 CMB issue. Because of the similarities
to a traditional Government of Canada bond (both have five year
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
5
unamortizing terms with a government guarantee), the CMB trades in
the capital markets at only a modest premium to the yields on
Government of Canada bonds. For the Company, this agreement has
given the Company access to lower costs of funds on single-family
mortgage securitizations.
First National Mortgage Trust as Special Purpose Vehicle
In another initiative to increase gain on securitization revenue, the
Company created a special purpose vehicle, First National Mortgage
Trust, in March 2006 for the purpose of financing its mortgages through
the issuance of R-1(High) and R-1(Mid) rated ABCP directly in the
Canadian public debt markets. The Company uses both this vehicle and
bank sponsored conduits to access the CP markets; however the cost
of funding through First National Mortgage Trust is considerably cheaper.
The amount of commercial paper notes issued by this trust grew from
Nil at March 31, 2006 to over $478 million as at December 31, 2006.
Key Performance Indicators
The principal indicators used to measure the Fund’s performance are:
•
Earnings before income taxes, depreciation and amortization after
normalizing management compensation while the Company was a
private entity (“Adjusted EBITDA”)
•
Distributable cash.
Adjusted EBITDA is not a recognized measure under Canadian generally
accepted accounting principles (“GAAP”). However, management
believes that Adjusted EBITDA is a useful measure to provide investors
with an indication of cash available for distribution prior to capital
expenditures and income taxes. Adjusted EBITDA should not be
construed as an alternative to net earnings determined in accordance
with GAAP or to cash flows from operating, investing and financing
activities. The Fund’s method of calculating Adjusted EBITDA may differ
from other issuers and, accordingly, Adjusted EBITDA may not be
comparable to measures used by other issuers. Management believes
that the cash generation performance of the operations is better
monitored by Adjusted EBITDA and provides a better comparative to
the operations of the Company while it was a private entity.
Distributable cash is not a defined term under GAAP. It is determined
by the Fund as earnings before income taxes adjusted for non-cash
expenses, including depreciation and amortization, and reduced by
maintenance capital expenditures and current income taxes. Management
believes that net cash generated by the Fund prior to distribution is an
important measure for investors to monitor. Some consider this measure
to be more important than actual cash distributions. Any distribution in
excess of the distributable cash means a depletion of the cash reserve,
while any distribution below the distributable cash means that the
reserves are being built for future investments, to serve as a buffer for
operations over economic cycles or to reimburse outstanding debt.
(in $000s except where noted)
Three-months ended
Nine-months ended
December 31,
2006
December 31,
2005
December 31,
2006
December 31,
2005
For the Period
Revenue
Net income
Adjusted EBITDA (1)
Less:
Public company expenses
Maintenance capital expenditures
Distributable cash (2)
At Period end
Total assets
Mortgages under administration
49,551
18,038
18,328
–
124
18,204
34,899
8,080
13,014
250
117
12,647
156,427
47,414
51,321
250
539
50,532
107,140
25,848
41,295
750
462
40,083
528,116
24,359,481
393,016
18,607,866
528,116
24,359,481
393,016
18,607,866
(1) This Non-GAAP measure adjusts income before income taxes by adding back expenses for management
compensation and interest expense on shareholder loans which consist primarily of distributions to
shareholders while First National operated as a private company. This measure also includes a deduction
of $1,500,000 for normalized compensation for each of the two senior management executives based on
compensation policies that will take effect on closing of the initial public offering.
(2) This Non-GAAP measure adjusts Adjusted EBITDA by deducting public company expenses and
maintenance capital expenditures. The comparative figures assume the Company incurred public company
expenses in the prior period as described in the initial public offering prospectus.
6 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
Reconciliation of distributable cash to cash provided by (used in) operations
(in $000s except where noted)
Three-months ended
Nine-months ended
For the Period
Cash provided by (used in) operating activities
37,222
51,516
(36,086)
23,372
December 31,
2006
December 31,
2005
December 31,
2006
December 31,
2005
Add:
Provision for income taxes - current
Interest on shareholder loans
Funding of increase
in securitization receivable (1)
Net change in non-cash working
capital balances related to operations (2)
Less:
Normalized management compensation
Amortization of purchased mortgage
servicing rights
Public company expenses (3)
Maintenance capital expenditures
–
–
10,752
3,862
432
870
4,239
–
9,108
1,300
20,100
12,411
(29,491)
(43,480)
63,778
(3,928)
–
155
N/A
124
50
136
250
117
208
502
250
539
550
418
750
462
Distributable cash (4)
18,204
12,647
50,532
40,083
(1) Funding of the increase in securitization receivable represents the difference between gains
on securitization recorded on the sale of mortgages to securitization vehicles in a period and the cash
received from prior periods’ securitizations.
(2) The Company’s working capital balances consist of: “Accounts
sundry”,
“Mortgages accumulated for sale”, Accounts payable and accrued liabilities”, “Management bonuses payable”,
“Shareholder loan”, and “Current taxes payable”. “Mortgages accumulated for sale” represents mortgages
held temporarily until settlement, usually for a period not exceeding seven days, with institutional investors
or securitization vehicles.
receivable and
(3) For the quarter and nine-months ended December 31, 2005, these figures are pro-forma
amounts to provide a suitable comparative to the current quarter’s actual figures.
(4) This Non-GAAP measure adjusts Adjusted EBITDA by deducting public company expenses
and maintenance capital expenditures. The comparative figures assume the Company incurred public
company expenses in the prior period as described in the initial public offering prospectus.
Revenues and Funding Sources
Mortgage Origination
The Company derives a significant amount of its revenue from mortgage
origination activities. The majority of mortgages originated are funded by
either placement with institutional investors or sale to securitization
conduits, in each case with retained servicing. Depending upon market
conditions, either an institutional placement or a securitization conduit
may be the most cost-effective means for the Company to fund
individual mortgages. In general, originations are allocated from one
funding source to another depending on market conditions and strategic
considerations related to maintaining diversified funding sources. The
Company retains servicing rights on virtually all of the mortgages it
originates, which provides the Company with servicing fees to
complement revenue earned through originations. For the nine-months
ended December 31, 2006, origination volume grew from $4.7 billion
to $6.0 billion or 28% over the same period in the prior year. For the
quarter ended December 31, 2006, origination volume grew from $1.6
billion to $1.7 billion or 6% over the same quarter in the prior year.
Placement Fees and Gain on Securitization
The Company recognizes revenue at the time that the mortgage is
placed with the institutional investor or sold to the securitization conduit.
Cash amounts received in excess of the mortgage principal at the time
of sale are recognized in revenue as “Placement fees”. The present value
of additional amounts (excess spread) expected to be received over the
remaining life of the mortgages sold (net of servicing and other costs)
are recognized as a “Gain on securitization”.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
7
recognition of revenue and the receipt of cash is effectively equal to the
“Gain on securitization” less “Amortization of securitization receivable”
(net of “Amortization of servicing liability”) in any given year. For the
fiscal year ended March 31, 2006, the timing difference required working
capital funding of approximately $10.6 million. For the nine-months
ended December 31, 2006, the volume of mortgages funded through
ABCP programs has increased and the Company funded approximately
$10.6 million in upfront fees to support purchases of mortgages from
institutions. This timing difference required working capital funding of
approximately $20.1 million. To the extent that gains on securitization
do not increase for a number of years, the effects of the timing difference
would be neutralized as new securitization receivables would be offset
by collections of existing securitization receivables.
Mortgage Servicing and Administration
The Company services virtually all mortgages generated through its
mortgage origination activities on behalf of a wide range of institutional
investors. Mortgage servicing and administration is a key component of
the Company’s overall business strategy and a significant source of
continuing income and cash flow. In addition to pure servicing revenues,
fees related to mortgage administration are earned by the Company
throughout the mortgage term. Another aspect of servicing is the
administration of funds held in trust including: borrower’s property tax
escrow, reserve escrows, and mortgage payments. As acknowledged in
the Company’s agreements, any interest earned on these funds accrues
to the Company as partial compensation for administration services.
The Company has negotiated favorable interest rates on these funds
with the chartered bank which maintains the deposit account and earns
significant interest revenue.
In addition to the interest income earned on securitization receivables,
the Company also earns interest income on mortgage related assets,
including mortgages accumulated for sale, mortgage and loan investments
and purchased mortgage servicing rights.
The excess spread on a mortgage is the difference between the interest
rate on the mortgage and the yield earned by the investor after
accounting for all anticipated prepayment provisions, servicing obligations
and other costs. For Alt-A and small conventional multi-unit residential
and commercial mortgages, the excess spread also includes assumptions
for credit losses.
Upon the recognition of the “Gain on securitization”, the Company
establishes a “Securitization receivable” which is amortized as spread
income is received by the Company. In addition, the Company is also
required to establish a “servicing liability”, which represents the future
cost of servicing the securitized mortgages. As spread income
is received by the Company, both the securitization receivable and the
servicing liability are amortized accordingly. Residual securitization
income consists of two components, the difference between a) the
spread income received over time and the spread income assumed in
the Company’s derivation of securitization receivable at the time of sale;
and b) the amortization of the servicing liability. The excess is attributable
to better than expected cash flows being earned by the securitization
than those anticipated when gain on sale assumptions regarding
prepayments, cost of funds, and credit losses are originally forecasted.
For all institutional placements and loans securitized through NHA-MBS
and CMBS, the Company earns “Placement fees”. In addition, under
certain circumstances, additional revenue from institutional placements
and NHA-MBS may be recognized as a “Gain on securitization”.
Revenues based on these originations are equal to either (1) the present
value of the excess spread, or (2) an origination fee based of the
outstanding principal amount of the mortgage. This revenue is received
in cash at the time of placement. Of the Company’s $6.0 billion of
originations for the nine-months ended December 31, 2006, $4.5
billion was placed with institutional investors, $87 million was sold under
the NHA-MBS program and $285 million was originated for sale to
CMBS conduits.
All loans securitized through the Company’s ABCP program are
recognized as a “Gain on securitization”, as is a portion of the spread
earned from NHA-MBS. Of the Company’s $6.0 billion of originations
for the quarter ended December 31, 2006, $1.1 million was sold to
ABCP conduits, generating “Gain on securitization” revenue. The
Company also acquires other significant amounts of mortgages for sale
to its ABCP programs from other institutions. For the nine-months
ended December 31, 2006, the Company acquired approximately $675
million of such mortgages.
In the past several years, the Company has experienced significant
growth in mortgages funded through its ABCP securitization programs.
As a result, revenue from “Gain on securitization” has increased
accordingly. Since cash flows received from securitized assets are
received over the life of the mortgage, and the revenue is recognized
upon origination, there will be a timing difference between the
recognition of revenue and the receipt of cash. This is not unlike most
companies that record the revenue from sales at the time that goods
are sold or shipped and set up a receivable until the cash is actually
received. The financial effect of the timing difference between the
8 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
Results of Operations
The following table sets forth information on the volume of mortgages originated by First National and the mortgages under administration for the
periods indicated:
(in $ millions)
Quarter ended
Nine-months ended
December 31,
2006
December 31,
2005
December 31,
2006
December 31,
2005
Mortgage Originations By Asset Class
Single-family residential
Multi-unit residential and commercial
Total originations
Funding of Mortgage Originations by Source
Institutional investors
CMBS
NHA-MBS
ABCP and Company internal resources
Total
Mortgages Under Administration
Single-family residential
Multi-unit residential and commercial
Total
1,138
580
1,718
1,161
115
22
420
1,718
14,145
10,214
24,359
1,076
551
1,627
1,148
123
40
316
1,627
10,157
8,451
18,608
4,669
1,306
5,975
4,518
285
87
1,085
5,975
14,145
10,214
24,359
3,406
1,250
4,656
2,938
224
148
1,346
4,656
10,157
8,451
18,608
The Company experienced steady growth in the nine-month period
ended December 31, 2006. Total mortgage origination increased from
$4.7 billion in the nine-month period of 2005 to $6.0 billion for the
period ended December 31, 2006, representing an increase of 28%.
Total mortgage origination for the three-month period ended December
31 increased from $1.63 billion in the corresponding quarter of 2005 to
$1.72 billion for the quarter ended in 2006, representing an increase of
6%. Overall the 28% growth reflects the Company’s growing market
share in the single-family residential mortgage broker channel and
competitive rates posted in Q3 of this year. For the quarter, the year
over year origination growth was slower relative to the significant
growth in originations experienced in the third quarter. Total revenues
for the nine-months ended December 31, 2006 compared to the same
period ended December 31, 2005, increased by 46% from $107 million
to $156 million. Total revenues for the fourth quarter were $50 million
compared to the $35 million for the corresponding period in the prior
year, representing an increase of 43%. This growth results primarily from
increased origination volume as well as securitization activities. The
Company purchased and securitized $675 million of insured single-family
mortgages in the nine-month period and recorded gains on securitization
of $12.4 million as well as significant increases in Alt-A securitization
gains due to increased origination. Mortgage servicing revenue has also
increased due to the substantial increase in the mortgages under
administration between 2005 and 2006.
The timing of revenues recognized on CMBS securitization also had a
small impact. These revenues are recognized at the time CMBS
mortgages are sold into securitization vehicles. In the nine-months
ended December 31, 2005, the Company went to market with two
pools of mortgages and recorded placement fee revenues of $6.2
million regarding CMBS mortgages. For the nine-months ended
December 31, 2006, the company securitized one normal sized pool as
well as contributing $23 million of CMBS mortgages to a Merrill Lynch
issue and recognized $3.0 million of revenue in placement fees. This
decrease is also reflective of tighter spreads in the CMBS market. At
December 31, 2006, First National has $173 million under administration
awaiting CMBS placement in early 2007.
Placement Fee Revenue
Comparing the nine-months ended December 31, 2006 to the same
period ended December 31, 2005, placement fee revenue increased by
46%, to $73.1 million from $50.0 million. This is largely due to the
growth of mortgages originated for institutional placement which
increased by 53% period over period. The timing of CMBS securitization
as described above offset this growth by approximately 6%.
Gain on Securitization Revenue
Gain on securitization revenue increased by 49%, to $37.8 million from
$25.4 million. The increase is primarily due to two securitizations,
through the Company’s commercial paper conduit. In the current
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
quarter, the Company purchased two portfolios totaling $265 million of
single-family mortgages which were securitized for a gain of $5.0 million.
Second, as a consequence of a securitization of the Company’s
mortgages indirectly through the CMB distribution channel, the Company
recorded gains on securitization of $7.4 million. Although the volume of
mortgages originated for ABCP conduits has decreased from the nine-
month period ended December 31, 2005 to the current period by 19%,
gain on securitization revenue has not been affected greatly. This is a
result of the significant growth in Alt-A origination which is securitized
by the Company. Alt-A securitization is more profitable than the
securitization of prime mortgages. In the nine-months ended December
31, 2006, the company securitized $432.6 million of Alt-A mortgages. In
the comparable period of the prior year, the securitized volume was
$152.3 million, an increase of 184% accounting for a $7.5 million increase
in gain on securitization revenue.
Mortgage Servicing Revenue
Mortgage servicing income increased by 51%, to $29.2 million from
$19.3 million which is primarily due to the growth in the portfolio of
mortgages under administration which grew by 31% from period to
period, in particular the residential component which grew by 39%. The
higher servicing rates associated with residential and a greater portion of
origination being placed as opposed to securitized for much of the year,
has also lead to revenue increases for mortgage servicing. Another
aspect of this revenue is interest earned on funds held in trust. These
funds are administered by the Company and include borrowers’
property tax escrow. This income was $7.0 million for the 2006 nine-
month end and $3.6 million for the 2005 comparative. The dramatic
increase is due to the increase in short-term interest rates and the
amount of funds held in trust. At December 31, 2006 the amount of
funds held in trust were $289 million (2005 - $236 million) and the
average 30 day Canadian Deposit Offer Rate (“CDOR”), which is a
benchmark for short-term interest rates increased from 3.15% for the
2005 quarter end to 4.33% for the December 31, 2006 quarter end, an
increase of 37.5%.
Mortgage Investment Income Revenue
Mortgage investment income increased by 34%, to $11.4 million from
$8.5 million. This increase is due to increased investment in mortgage
assets held on balance sheet, including mortgages accumulated for sale,
securitization receivable, mortgage and loan investments and purchased
mortgage servicing rights. Together these assets, excluding mortgages
accumulated for sale which turnover daily, have increased by 42% from
March 31, 2006 to December 31, 2006. While short-term interest rates
have risen (prime lending rate averaged 5.93% for the nine-months
ended December 2006 and was 4.44% for the comparative period), this
variable only affects mortgage and loan investments interest revenue. In
comparison, residential five year posted mortgage rates remained steady,
fluctuating between 5.90% on April 11, 2005 to 6.00% on December 12,
2006. These increases are offset by lower rates earned on securitization
receivables. The average discount rates implicit in the securitization
receivables have decreased as mortgages securitized at 10% rates in the
periods prior to April 1, 2005 run off. These have been replaced by new
assets being discounted at 7%.
Residual Securitization Income Revenue
Residual securitization income increased by 28%, to $5.0 million from
$3.9 million. The primary source of this revenue is the amortization of
the servicing liability, which represents the servicing portion of the
spread received from securitization conduits. It also includes the excess
cash flows received over the expected cash flows received from
securitization vehicles. The increase from the prior year’s quarter is a
function of the growth of the securitization receivable which grew by
44% from the comparative quarter. The growth has been offset by a
reduction of gains related to “lock-in” transactions. This revenue is
earned when borrowers elect to change the terms of their mortgage
from floating rate to fixed rate. The December 2005 period featured a
significant amount of lock-in revenue as the Company sold these
mortgages to institutional investors at going placement fee rates. Because
of the conservatism of the Company’s assumptions in recording the
securitization receivable associated with these mortgages, the placement
fees normally exceeded the carrying value of the securitization revenue.
In the current nine-month period ended December 31, 2006 quarter,
there has been a significant reduction in such lock-in transactions due in
part to the stability of short-term interest rates such that borrowers do
not have the same incentive to change their mortgage terms.
Brokerage Fees Expense
Brokerage fees expense increased by 78%, to $67.9 million from $38.2
million. The increase is due primarily to the increased single-family
residential origination between the periods of 37%. As virtually all single-
family mortgage originations are sourced through brokers these
percentage changes should be comparable. Additional increases are
attributable to $10.6 million of costs incurred to purchase $675 million
of mortgages for securitization as described previously in the gain on
securitization section above. These expenses accounted for 28% of the
increase over and above origination volumes. The remaining increase
of 13% pertains to three factors: increased volume bonus costs, the
increase of Alt-A volume which has higher broker fees and new
insurance costs to support the Company’s home warranty program
launched in September 2005. Because of the Company’s success in
single-family origination, more brokers qualify for the Company’s volume
bonus incentives this period than in the comparative period. Alt-A
origination requires higher broker fees due to the increased credit
adjudication information needed from brokers. Because Alt-A volume
increased by 184% between the periods, this had an effect on overall
brokerage fees expense.
Salaries and Benefits Expense
Salaries and benefits expense increased by 31%, to $21.3 million from
$16.2 million. To support the increase in mortgage origination and
servicing a larger mortgage portfolio under administration, the Company
has added to its head count. As at December 31, 2006 the Company
had 352 employees and 292 as at December 31, 2005. The 30% overall
20 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
increase in salaries is consistent with the increase in mortgages under
administration of 30%. The Company also introduced an RRSP
matching program in March 2006 which accounted for approximately
3% of the increase. Management salaries are paid to the two senior
executives who are indirectly the Class B LP unitholders. The current
period’s expense includes an increase to this expense as a result of the
revised compensation arrangement executed on closing of the initial
public offering.
Interest Expense
Interest expense increased by 89%, to $7.0 million from $3.7 million.
This has been primarily driven by rising interest rates and increased use
of the Company’s credit facility for commercial mortgage investments
and CMBS warehousing. As described in the “Liquidity and cash
resources” section of this analysis, the Company warehouses a portion
of the mortgages it originates prior to settlement with the ultimate
investor. The Company uses the credit facility with its banking syndicate
to fund the mortgages in this period. First National’s average investment
in commercial mortgages and CMBS warehoused mortgages for the
quarter ended December 31, 2006 increased by 62% from the
comparative period’s amount. As described above regarding mortgage
investment income, short-term interest rates also increased about 33%
between comparative quarters. Interest on shareholders’ loans is $nil in
the current quarter as the related shareholder loans were repaid prior
to March 31, 2006.
Other Operating Expense
Other operating expense increased by 18%, to $8.6 million from $7.3
million. The increase in these expenses is primarily due to the increase
in the amount of mortgages under administration of 30% from period
end to period end. The increase trails this growth, evidencing the
economies of scale built into the Company’s business model. A large
amount of these costs are fixed and do not increase in the same
proportion as revenues.
Provision for Income Taxes
Because the Company converted to a limited partnership from a
corporation, the income before income taxes earned subsequent to the
conversion date of June 15, 2006 does not attract tax at the partnership
level. Accordingly, there is no provision for income taxes for the period
June 15 through December 31, 2006.
Net Income
Net income increased by 87%, to $47.4 million from $25.3 million,
primarily as a result of the change in the taxability of the income of the
Company as described above and the growth of mortgages under
administration which has driven servicing income and Alt A origination
which has lead to higher gains on securitization.
Adjusted EBITDA
Adjusted EBITDA increased by 24%, to $51.3 million from $41.3 million.
The increase was largely due to the increase of mortgages under
administration of 31% and increased Alt A origination.
Operating Segment Review
The Company aggregates its business from two segments for financial reporting purposes: (i) Residential (which includes single-family residential
mortgages) and (ii) Commercial (which includes multi-unit and commercial mortgages), as summarized below.
(in $000s except percent amounts)
Operating Business Segments
Nine-months ended
Originations
Percentage change
Revenue
Percentage change
Income before income taxes
Percentage change
Period ended
Identifiable assets
Mortgages under administration
Residential
Commercial
December 31,
2006
4,669,000
December 31,
2005
December 31,
2006
December 31,
2005
3,406,000
1,306,000
1,250,000
37.1%
119,040
49.6%
29,073
22.4%
December 31,
2006
188,001
14,145,311
79,569
23,762
4.5%
37,387
35.6%
22,570
39.7%
27,571
16,161
December 31,
2005
107,402
10,670,000
December 31,
2006
December 31,
2005
340,115
10,214,170
172,349
8,953,000
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
2
Residential Segment
Liquidity and Capital Resources
Residential revenues have increased by 49.6% from the prior nine-month
period primarily due to the 37.1% increase in origination of single-family
mortgages. These revenues have also been bolstered by growth in
mortgage servicing revenue which has been increased through the
growth of the residential mortgage portfolio and higher amounts of
interest earned on fund held in trust. Income before income taxes
increased by 20.4% to reflect the growth in Alt-A origination and
mortgage servicing. Because prime single-family mortgage origination is
not a high margin business, the increase of revenues shown above does
not generate bottom line profitability in the period of origination.
Identifiable assets have increased due to increased single-family
origination volumes which affect mortgages accumulated for sale,
mortgage and loan investments and securities purchased under resale
agreements and owned. These securities are used by the Company to
hedge outstanding Alt-A fixed mortgage rate commitments in
the residential sector.
Commercial Segment
Commercial revenues have increased by 35.6% from the prior nine-
month period due primarily to the increase in securitization of small
multi-family and commercial loans offset by the timing of the recognition
of CMBS placement fees. The Company increased origination of smaller
commercial mortgages in the current period and recorded greater gains
on their securitization. For CMBS, in the nine-months ended December
31, 2006, the Company earned placement fees of $3.0 million from
CMBS securitizations. In the comparative period in 2005 the Company
earned $6.2 million from CMBS securitizations. Higher short-term
interest rates have also led to increased interest income on trust funds
and mortgage investment income. The growth in the mortgage portfolio
under administration has driven mortgage servicing revenues higher.
Income before income taxes grew at a higher rate due to the high
margin nature of commercial origination.
Identifiable assets for the commercial sector increased primarily due to
the CMBS securitization timing. Not only did the Company have $30
million more CMBS mortgages accumulated for sale at the end of
December 2006 than March 2006, but because of hedging requirements,
the Company had $96 million more securities held for resale for its
CMBS program at the end of December compared to March 2006.
Review of Fourth Quarter Results
Revenue in the fourth quarter increased from the prior year’s comparative
quarter due to increased growth of originations and in particular, Alt-A
and small commercial loan originations on which the Company earns
higher gains on securitization. The current year’s quarterly revenue
has also benefited from the growth in the portfolio of mortgages under
administration during the year which has caused 38% increases in
mortgage servicing income, mortgage investment income, and residual
securitization income. Net income and distributable cash for the fourth
quarter increased by $9.9 million from the same period in 2005 due to
increased revenues and the change in taxability of the Company.
The Company’s liquidity strategy has been to use bank credit to fund
working capital requirements and to use cash flow from operations to
fund longer term assets, providing a relatively low leveraged balance
sheet. The Company’s credit facilities are typically drawn to fund:
(1) mortgages accumulated for sale, (2) securitization receivables, and
(3) mortgage and loan investments. The Company entered into a credit
facility on closing of the initial public offering which provides for a total
of $200 million in financing. Subsequent to December 31, 2006, this
facility was increased to $250 million.
At December 31, 2006, outstanding bank indebtedness was $169.6
million (March 31, 2006 – $60.6 million) of which $90.7 million (March
31, 2006 – $44.7 million) was drawn to fund mortgages accumulated for
sale. At December 31, 2006, the Company’s other interest-yielding
assets included: (1) securitization receivables of $78.0 million (March 31,
2006 – $54.1 million) and (2) mortgage and loan investments of $53.2
million (March 31, 2006 – $36.8 million). The difference between bank
indebtedness and mortgages accumulated for sale, which the Company
considers a proxy for true leverage, has grown between March and
December 2006 and now stands at $78.9 million. This represents a debt
to equity ratio of 0.82 to 1 which the Company believes is still at a
conservative level. This ratio has increased as the Company has taken
advantage of opportunities to purchase mortgages for securitization, in
particular its CMB initiative started in September. As these investments
return cash, it will be used to pay down the bank indebtedness.
The Company funds a portion of its mortgage originations with
institutional placements and sales to securitization vehicles on the same
day as the advance of the related mortgage. The remaining originations,
primarily residential, are funded by the Company on behalf of institutional
investors or securitization vehicles on the day of the advance of the
mortgage. On specified days, typically weekly, the Company aggregates
all mortgages “warehoused” to date for an institutional investor and
transacts a settlement with that institutional investor. A similar process
occurs for sales to securitization vehicles, although the Company can
dictate the date of sale into the vehicle at its discretion. The Company
uses a portion of the committed credit facility with the banking syndicate
to fund the mortgages during this “warehouse” period. The credit facility
is designed to be able to fund the highest balance of warehoused
mortgages in a month and is normally only partially drawn.
The Company also invests in short-term mortgages, usually six to
eighteen months, to bridge existing borrowers in the interim period
between long-term financing solutions. The banking syndicate has
provided credit facilities to partially fund these investments. The
syndicate has also provided credit to finance a portion of the
Company’s securitization receivables and other miscellaneous long term
financing needs.
Capital Expenditures
First National’s business is not a capital intensive business. Historically,
capital expenditures have included technology software and hardware,
facility improvements and office furniture. In the nine-months ended
22 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
December 31, 2006, the Company purchased new computers, office
equipment and leaseholds to support the growth of its single-family
residential business, in particular the outfitting of new premises for its
Calgary residential sales office.
Going forward, the Company expects maintenance capital expenditures
will be approximately $1,000,000 annually and primarily relate to
technology software and hardware maintenance. Maintenance capital
expenditures are expected to be funded from operating cash flow.
Critical Accounting Policies and Estimates
FNLP prepares its financial statements in accordance with GAAP, which
requires management to make estimates, judgements and assumptions
that management believes are reasonable based upon the information
available. These estimates, judgements and assumptions affect the
reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements, and the
reported amounts of revenue and expenses during the reporting period.
Management bases its estimates on historical experience and other
assumptions, which it believes to be reasonable under the circumstances.
Management also evaluates its estimates on an ongoing basis.
The significant accounting policies of First National are described in
Note 2 to the audited financial statements. The policies which First
National believes are the most critical to aid in fully understanding and
evaluating its reported financial results include the determination of the
gain on securitization revenue.
The Company uses estimates in valuing its gain or loss on the sale of its
mortgages to special purpose entities (“Trusts”) through securitizations.
Under GAAP, valuing a gain on sale requires the use of estimates to
determine the fair value of the retained interest (derived from the
present value of expected future net cash flows) in the mortgages. The
retained interest is reflected on the Company’s balance sheet as
securitization receivable.
On a quarterly basis, the Company reviews the estimates used to ensure
their appropriateness and monitors the performance statistics of the
relevant mortgage portfolios to adjust and improve these estimates. The
estimates used reflect the expected performance of the mortgage
portfolio over the life of the mortgages. The assumptions underlying the
estimates used for the nine-months and quarter ended December 31,
2006 continue to be consistent with those used for the year ended
March 31, 2006.
The key assumptions used in the valuation of gain on sale are prepayment
rates, the annual expected credit losses, and the discount rate used to
present value future expected residual cash flows. The annual rate of
unscheduled principal payments is determined by reviewing portfolio
prepayment experience on a monthly basis. The Company uses a rate
of 16% for residential adjustable mortgages, 13% for residential fixed
rate mortgages and 32% for commercial floating rate mortgages. The
Company assumes there is no prepayment on commercial fixed rate
mortgages. Credit losses are also reviewed on a monthly basis, in the
context of the type of mortgages securitized. For the largest portion of
the Company’s securitizations, the mortgages are either insured or low
ratio mortgages for which the Company does not provide for the event
of a credit loss. For the securitization of Alt-A mortgages, the Company
uses a credit loss rate of 0.35% per annum which is greater than the rate
experienced by theCompany to-date, but which management feels is
an appropriate estimate of losses that will average over the life of
mortgages being securitized. For the securitization of small multi-unit
residential and commercial mortgages, the Company uses a credit loss
rate of 0.25% per annum which is greater than the rate experienced
by the Company to-date, but which management feels is an appropriate
estimate of losses that will average over the life of mortgages
being securitized.
Changes During 2006: Consolidation of Variable Interest Entities
Effective April 1, 2005, the Company adopted the recommendations of
CICA Accounting Guideline 15 — Consolidation of Variable Interest
Entities (“AcG-15”). The adoption of AcG-15 has had no effect on the
financial statements of the Company for the nine-months and quarter
ended December 31, 2006 and the comparatives presented therein.
Future Changes: Financial Instruments, Hedges and
Comprehensive Income
The CICA has issued three new accounting standards — Financial
Instruments — Recognition and Measurement, Hedges, and
Comprehensive Income. These standards are effective for the Company
beginning with the first quarter of the 2007 fiscal year. The principal
impacts of the standards are detailed below:
•
•
•
Comprehensive income will be a new component of shareholders’
equity and a new statement entitled Statement of Comprehensive
Income will be added to the Company’s primary financial statements.
Financial assets and liabilities will be required to be classified as
available for sale, held to maturity, trading or loans and receivables.
Such classification may affect their carrying value and timing of
recognition of unrecognized gains and losses.
For fair value hedges, where the Company is hedging changes in
the fair value of assets and liabilities or firm commitments, the
change in the value of derivatives and hedged items will be recorded
through income. Adoption is not expected to have a significant
impact on the financial statements of the Company since
the new standard is in harmony with CICA Accounting Guideline
13 – Hedging Relationships (“Acg-13”), which the standard replaces
and which the Company has previously adopted.
Summary of Contractual Obligations
The Company’s long-term obligations include, among other things, its
five year operating lease for its head office, and its obligations for the
ongoing servicing of mortgages sold to Trusts and mortgages related
to servicing rights purchased. The Company sells it mortgages to
Trusts and purchases servicing rights on a fully-serviced basis, and is
responsible for the collection of the principal and interest payments on
behalf of the Trusts, including the management and collection of
mortgages in arrears.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
23
(in $000s)
Lease Obligations
Servicing Liability
Total Contractual Obligations
Payments Due By Period
Total
9,082
15,038
24,120
0-1 Years
1-3 Years
4-5 Years
After 5 Years
2,104
4,967
7,071
3,947
7,746
11,693
3,031
2,160
5,191
–
165
165
Guarantees
First National Financial Operating Trust (the “Trust”) and First National
Financial GP Corporation (FNLP’s general partner, the “GP”) have
entered into postponement of claim and guarantees with respect to
FNLP’s borrowings under its credit facility. The guarantee is supported
by first ranking security over all the present and future assets of the
Trust, including a first ranking pledge of all securities held by the Trust in
FNLP and the GP.
Financial Instruments
The Company uses bond forwards (consisting of bonds sold short and
bonds purchased under resale agreements) to manage interest rate
exposure between the time a mortgage rate is committed to borrowers
and the time the mortgage is sold to the Trusts and the underlying cost
of funding is fixed. As interest rates change, the value of these interest
rate derivatives varies inversely with the value of the mortgage contract.
As interest rates increase, a gain will be recorded on the hedge which
will be offset by the loss on the sale of the mortgage to the Trusts as
the mortgage rate committed to the borrower is fixed at the point of
commitment. For residential mortgages, primarily mortgages for the Alt-
A program, only a portion of the mortgage commitments issued by the
Company eventually fund. The Company must assign a probability of
funding to each mortgage in the pipeline and estimate how that
probability changes as mortgages move through the various stages of
the pipeline. The amount that is actually hedged is the expected value
of mortgage fundings within the next 60 days (60 days being the standard
maximum rate hold period available). For the period ended December
31, 2006, the Company had entered into $29.0 million in notional value
forward bond sales. The current contracts were purchased in the period
November 1, 2006 to December 18, 2006. The mark-to-market value
of the hedges as at December 31, 2006 was insignificantly different from
the carrying value to the Company.
For multi-unit residential and commercial mortgages, the Company
assumes all mortgages committed will fund and hedges each mortgage
individually. This includes mortgages committed for the CMBS program
as well as mortgages for sale to the Company’s own securitization
vehicles. As at December 31, 2006, the Company had entered into
$198.0 million in notional value forward bond sales. The current
contracts were purchased during the period from November 24, 2005
to December 28, 2006. The mark-to-market value of the hedges as at
December 31, 2006 was a $0.9 million loss to the Company.
The Company is considering using a derivative based hedging program
comprising bond futures instead of the current practice of selling bonds
short and offsetting with resale agreements. This will ease the
administration of the hedging program and consequently, reduce the
amount of hedging securities disclosed on the balance sheet.
The Company has also entered into interest rate swaps to immunize the
Company’s exposure to changing interest rates related to cash flows
receivable from servicing rights. When the Company bids for servicing
rights, particularly from CMBS issuances, it estimates the interest to be
earned from receiving mortgage payments and holding them in trust
until payable to the ultimate investor/ transfer agent. This estimate
requires the Company to use current short-term interest rates as a
proxy for rates over a long term period (typically ten years for CMBS).
In order to lock in this rate and ensure the purchase price for the rights
is not impaired in the future, the Company enters into interest rate
swaps to remove the variability of changing short-term interest rates.
As at December 31, 2006, the notional value of these swaps is $5.7
million and the mark-to market value of the swaps was $0.1 million in
favour of the Company. The amortizing swaps mature between April
2015 and October 2016.
Related Party Transactions
Concurrent with the initial public offering and as part of the acquisition
agreement between FNLP and FNFC on June 15, 2006, FNLP incurred
a working capital note payable in the amount of $6,339, representing
the difference between the net assets of FNFC as at March 31, 2006
and the net assets transferred to FNLP as at June 14, 2006. The issuance
of this non-interest bearing note has been accounted for as a distribution
in FNLP’s financial statements. This note was paid in full prior to August
31, 2006 by FNLP to FNFC.
Risk and Uncertainties Affecting the Business
The business, financial condition and results of operations of the
Company are subject to a number of risks and uncertainties, and are
affected by a number of factors outside the control of management of
the Company including: reliance on sources of funding, concentration of
institutional investors, reliance on independent mortgage brokers,
changes in interest rates, repurchase obligations and breach of
representations and warranties on mortgage sales, risk of servicer
termination events and trigger events, cash collateral and retained
interest, reliance on multi-unit residential and commercial mortgages,
24 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
general economic conditions, government regulation, competition,
reliance on mortgage insurers, reliance on key personnel, conduct and
compensation of independent mortgage brokers, failure or unavailability
of computer and data processing systems and software, insufficient
insurance coverage, change in or loss of ratings, impact of natural
disasters and other events, environmental liability, alt-a mortgages
employ broad underwriting criteria and ability to sustain performance
and growth. In addition, risks associated with the structure of the Fund
include those related to the dependence on FNLP, leverage and
restrictive covenants, cash distributions which are not guaranteed and
will fluctuate with FNLP’s performance, the nature of Units, distribution
of securities on redemption or termination of the Fund, restrictions on
potential growth, unitholder liability, undiversified and illiquid holding in
the Trust, the market price of Units, dilution of existing unitholders and
FNLP unitholders, statutory remedies, control of the Company and
contractual restrictions and income tax matters. Risk and risk exposure
are managed through a combination of insurance, a system of internal
controls, and sound operating practices. For a more complete discussion
of the risks affecting the Fund’s business, reference should be made to
the prospectus of the Fund dated June 7, 2006.
Income Tax Matters
On December 21, 2006, the Department of Finance (Canada) released
draft legislation to implement proposals originally announced on October
31, 2006 pertaining to the taxation of certain income distributed by
publicly traded trusts and the tax treatment of such distributions to
unitholders (the SIFT Proposals). If the SIFT Proposals are enacted as
currently proposed, commencing in January 2011 (provided the Fund
experiences only normal growth and no undue expansion before then)
the Fund will be liable for tax at a rate comparable to the combined
federal and provincial corporate tax rate on all or a significant portion of
its income distributed to unitholders, and unitholders will receive Fund
income distributions as taxable dividends. There can be no assurance
that the final rules will not differ from the current draft legislation.
If the SIFT Proposals are enacted as announced the Fund will be required
to account for future income taxes under the asset and liability method,
whereby future income tax assets and liabilities are recognized for the
future tax consequences attributable to differences between the financial
statement carrying amounts of existing assets and liabilities and their
respective tax bases. Future income tax assets and liabilities are measured
using enacted or substantively enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are
expected to be recovered or settled. The effect on future income tax
assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date. Future income tax assets
are recorded in the consolidated financial statements to the extent that
realization of such benefits is more likely than not.
If enacted as proposed, the SIFT Proposals will apply a tax at the trust
level on distributions of certain income from publicly traded trusts at
rate of tax comparable to the combined federal and provincial corporate
tax and to treat such distributions as dividends to unitholders. Generally,
existing trusts will have a four-year transition period and will not be
subject to the new rules until 2011. However, assuming the SIFT
Proposals are ultimately enacted
form proposed, the
implementation of such proposals would be expected to result in
adverse tax consequences to the Fund and certain unitholders, may
impact the future level of distributions made by the Fund, and may
reduce the value of Fund units and hence the cost to the Fund of raising
capital in the public capital markets.
in the
Further, the Department of Finance (Canada) has indicated that, while
there is no intention to prevent normal growth of existing trusts during
the transition period, any undue expansion of a particular trust could
result in loss of the benefit of the transitional period. On December 15,
2006, the Department of Finance (Canada) issued guidelines with
respect to what will be considered normal growth in this context. While
the Fund does not intend to raise capital in excess of the safe harbour
limits outlined in these guidelines, there is a risk that the adverse tax
consequences resulting from the SIFT Proposals could be realized
sooner than 2011.
Management’s Annual Report on Disclosure Controls and
Procedures and Internal Control over Financial Reporting
Disclosure Controls and Procedures
Disclosure controls and procedures are designed to provide reasonable
assurance that all relevant information is gathered and reported to
senior management, including the President & Chief Executive Officer
(CEO) and the Chief Financial Officer (CFO), on a timely basis so that
appropriate decisions can be made regarding public disclosure.
An evaluation of the effectiveness of the design and operation of First
National’s disclosure controls and procedures was conducted as of
December 31, 2006, by and under the supervision of First National’s
management, including the CEO and the CFO. Based on this evaluation,
the CEO and the CFO have concluded that the Company’s disclosure
controls and procedures, as defined in Canada by Multilateral Instrument
52-109, Certification of Disclosure in Issuers’ Annual and Interim Filings,
are effective to ensure that information required to be disclosed in
reports that the Company files or submits under Canadian securities
legislation is recorded, processed, summarized and reported within the
time periods specified in those rules and forms.
Internal Control over Financial Reporting
Internal control over financial reporting is designed to provide
reasonable assurance regarding the reliability of financial reporting and
the preparation of financial statements in accordance with Canadian
generally accepted accounting principles. Management is responsible
for establishing and maintaining adequate internal control over financial
reporting for First National Financial LP and First National Financial
Income Fund.
First National’s management, including the CEO and the CFO, has
evaluated the effectiveness of the internal control over financial reporting
using the framework and criteria established in Internal Control –
Integrated Framework, issued by the Committee of Sponsoring
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
25
Outlook
The Company achieved excellent financial results in the nine-month
period ended December 31, 2006 and the outlook for the next fiscal
year is favourable. Nonetheless, market conditions can change quickly,
making future conditions difficult to predict.
After a period of rising interest rates, rates have been stable for the past
six months, such that housing continues to be affordable by historical
standards. The economy, which is the principal driver of the single-family
residential housing market, continues to be strong across the country,
particularly in Western Canada. In addition, the mortgage broker
distribution channel continues to grow.
Although more difficult to predict, management anticipates overall
commercial mortgage originations for the next fiscal year, including all
classes of commercial lending and bridge loans, will exceed the levels of
the previous year. Originations destined for CMBS conduits are also
likely to exceed prior year levels.
Mortgage assets under administration are expected to grow strongly in
fiscal 2007 with double-digit growth anticipated. The Company’s own
originations, third party institutional mortgage growth and increases in
CMBS master servicing will all contribute to increases in mortgage assets
under administration.
Organizations of the Treadway Commission. Based on this evaluation,
management has concluded that internal control over financial reporting
was effective as of December 31, 2006.
Changes in Internal Control over Financial Reporting
There were no changes in internal control over financial reporting that
have materially affected, or are reasonably likely to materially affect, First
National’s internal control over financial reporting.
Forward-Looking Statements
Forward-looking statements are included in this MD&A. In some cases,
forward-looking information can be identified by the use of terms such
as ‘‘may’’, ‘‘will, ‘‘should’’, ‘‘expect’’, ‘‘plan’’, ‘‘anticipate’’, ‘‘believe’’, ‘‘intend’’,
‘‘estimate’’, ‘‘predict’’, ‘‘potential’’, ‘‘continue’’ or other similar expressions
concerning matters that are not historical facts. Forward-looking
information may relate to management’s future outlook and anticipated
events or results, and may include statements or information regarding
the future financial position, business strategy and strategic goals, product
development activities, projected costs and capital expenditures, financial
results, risk management strategies, hedging activities, geographic
expansion, licensing plans, taxes and other plans and objectives of or
involving the Company. Particularly, information regarding growth
objectives, any increase in mortgages under administration, future use of
securitization vehicles, industry trends and future revenues is forward-
looking information. Forward-looking information is based on certain
factors and assumptions regarding, among other things, interest rate
changes and responses to such changes, the demand for institutionally
placed and securitized mortgages, the status of the applicable regulatory
regime and the use of mortgage brokers for single-family residential
mortgages. These forward-looking statements should not be read as
guarantees of future performance or results, and will not necessarily be
accurate indications of whether or not, or the times by which, those
results will be achieved. While management considers these assumptions
to be reasonable based on information currently available to it, they may
prove to be incorrect. Forward looking-information is subject to certain
factors, including risks and uncertainties, which could cause actual results
to differ materially from what management currently expects. These
factors include reliance on sources of funding, concentration of
institutional investors, reliance on independent mortgage brokers’ and
changes in interest rates under ‘‘Risk and Uncertainties Affecting the
Business’’. In evaluating these statements, the reader should specifically
consider various factors, including the risks outlined under ‘‘Risk and
Uncertainties Affecting the Business’’, which may cause actual events or
results to differ materially from any forward-looking statement. The
forward-looking statements contained in this discussion represent
management’s expectations as of February 28, 2007, and are subject to
change after such date. However, management and the Fund disclaim
any intention or obligation to update or revise any forward-looking
statements whether as a result of new information, future events or
otherwise, except as required under applicable securities regulations.
26 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
MANAGEMENT’S
RESPONSIBILITY FOR
FINANCIAL REPORTING
AUDITORS’ REPORT
The accompanying consolidated financial statements of First National
Financial Income Fund for the period from June 15, 2006 to December
31, 2006 and the financial statements of First National Financial LP for
the period April 1, 2006 to December 31, 2006 and all information in
this annual report are the responsibility of management.
The financial statements have been prepared by management in
accordance with Canadian generally accepted accounting principles. The
preparation of these financial statements requires management to make
estimates and assumptions that affect certain reported amounts which
management believes are reasonable.
The Audit Committee of the Board of Directors has reviewed in detail
the financial statements with management and the independent auditor.
The Board of Directors has approved the financial statements on the
recommendation of the Audit Committee.
Ernst & Young LLP, an independent auditing firm, has audited First
National Financial Income Fund’s 2006 consolidated financial statements
and First National Financial LP’s 2006 financial statements in accordance
with Canadian generally accepted auditing standards and has provided
independent audit opinions. The auditors have full and unrestricted
access to the Audit Committee to discuss the results of their audits.
To the Unitholders of
First National Financial Income Fund
We have audited the consolidated balance sheet of First National
Financial Income Fund as at December 31, 2006 and the consolidated
statements of income and unitholders’ equity and cash flows for the
period from April 19, 2006, the date of Declaration of Trust, to
December 31, 2006. These financial statements are the responsibility of
the Fund’s management. Our responsibility is to express an opinion on
these financial statements based on our audit.
We conducted our audit in accordance with Canadian generally accepted
auditing standards. Those standards require that we plan and perform an
audit to obtain reasonable assurance whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles
used and significant estimates made by management, as well as evaluating
the overall financial statement presentation.
In our opinion, these consolidated financial statements present fairly, in
all material respects, the financial position of the Fund as at December
31, 2006 and the results of its operations and its cash flows for the
period from April 19, 2006, the date of Declaration of Trust, to
December 31, 2006 in accordance with Canadian generally accepted
accounting principles.
Stephen J. R. Smith
President & Chairman
Robert A. Inglis
Vice President, Finance
Toronto, Canada
February 27, 2007
Chartered Accountants
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
27
CONSOLIDATED BALANCE SHEET
(in $000s of dollars, as at December 31, 2006)
2006
$
934
109,483
110,417
934
13
947
109,470
$
110,417
ASSETS
Distributions receivable
Investment in First National Financial LP [note 4]
LIABILITIES AND EQUITY
Liabilities
Distributions payable
Accounts payable and accrued liabilities
Total liabilities
Equity
Unitholders’ equity
See accompanying notes
Approved by the Trustees:
Trustee
John Brough
Trustee
Robert Mitchell
28 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
CONSOLIDATED STATEMENT OF INCOME AND
UNITHOLDERS’ EQUITY
(in $000s of dollars, period from April 19 to December 31, 2006)
REVENUE
Equity income from investment in First National Financial LP
$
3,915
EXPENSES
Trust administration expenses
Net income for period
Unitholders’ equity, beginning of the period
Unitholders’ equity, initial amount
Redemption
Issued pursuant to initial public offering on June 15, 2006
Issued pursuant to over-allotment option
Distributions [note 5]
Unitholders’ equity, end of period
Average number of units outstanding during the period
Earnings per unit/share
Basic
See accompanying notes
13
3,902
–
1
(1)
99,640
12,000
(6,072)
109,470
11,643,216
$
0.34
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
2
CONSOLIDATED STATEMENT OF C ASH FLOWS
(in $000s of dollars, period from April 19 to December 31, 2006)
OPERATING ACTIVITIES
Net income for the period
Add (deduct) items not affecting cash
Equity income from investment in First National Financial LP
Distributions received from First National Financial LP
Net change in non-cash working capital balances
related to operations
Cash provided by operating activities
INVESTING ACTIVITIES
Investment in First National Financial LP
Cash used in investing activities
FINANCING ACTIVITIES
Issuance of Fund Units
Distributions paid
Cash provided by financing activities
Net change in cash during the period and cash equivalents end of period
See accompanying notes
$
3,902
(3,915)
5,138
5,125
13
5,138
(111,640)
(111,640)
111,640
(5,138)
$
106,502
–
30 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(December 31, 2006, in $000s of dollars, except per unit amounts)
1. Organization And Business Of The Fund
First National Financial Income Fund (the “Fund”) is an unincorporated,
open-ended trust established under the laws of the Province of
Ontario on April 19, 2006, pursuant to a Declaration of Trust. The
Fund was established to acquire and hold, through a newly
constituted wholly owned trust, First National Financial Operating
Trust (the “Trust”), investments in the outstanding limited partnership
units of First National Financial LP (“FNLP”). Pursuant to an
underwriting agreement dated June 6, 2006 and initial public offering
dated June 15, 2006, the Fund sold 10,600,000 units of the Fund
[“Fund Units”, “Units” or “Unit”], at a price of $10.00 per Unit
for proceeds totalling $106,000. The proceeds of the offering, net
of underwriters fees of $6,360, were used to partially fund the
indirect acquisition [through the Trust] by the Fund of a 17.94%
interest in FNLP, through the issuance of 10,600,000 Class A LP
Units by FNLP.
Concurrent with the initial public offering and as part of the
acquisition agreement between the Fund, FNLP and First National
Financial Corporation [“FNFC” or the “predecessor”], on June
15, 2006, FNLP purchased all of FNFC’s assets and assumed its
liabilities, except for income tax liabilities. The consideration for this
purchase was:
•
•
•
the issuance of 48,486,316 exchangeable Class B LP Units;
an acquisition promissory note of $97,140, of which $10,940
has been accounted
in FNLP’s
financial statements;
for as a distribution
a working capital note in the amount of $6,339, representing the
difference between the net assets of FNFC as at March 31, 2006,
excluding tax liabilities, and the net assets transferred to FNLP as
at June 14, 2006. The issuance of this note has also been
accounted for as a distribution in FNLP’s financial statements.
The exchangeable Class B LP units retained by FNFC are
exchangeable on a one-for-one basis for units of the Fund at any
time at the option of FNFC. FNLP is managed by First National
Financial GP Corporation, the general partner, which holds a 0.01%
interest in FNLP. The Fund initially owned 17.94% of the shares of
First National Financial GP Corporation and FNFC wholly owned
the remaining 82.06%. The ownership of the general partner will
change pro rata as the exchangeable Class B LP units are exchanged
for units in the Fund.
On July 11, 2006, the underwriters exercised an over-allotment
option to purchase 1,200,000 Units of the Fund at $10.00 per Unit
from FNFC. Accordingly, as at December 31, 2006, the Fund
indirectly holds a 19.97% interest in FNLP and FNFC holds an
80.03% controlling interest in FNLP.
The Class A LP unitholders and the exchangeable Class B LP
unitholders of FNLP are entitled to one vote for each unit held at all
meetings of holders of the LP Units and have economic rights that
are equivalent in all material respects, except that exchangeable
Class B LP units are exchangeable, directly or indirectly, on a one-for-
one basis [subject to customary anti-dilution provisions] for Fund
Units at the option of the holder at any time. Additionally,
exchangeable Class B LP units have special voting rights that entitle
the holder to receive notice of, attend and to vote at all meetings of
unitholders of the Fund.
The Fund effectively commenced operations through its indirect
investment in FNLP on June 15, 2006. The excess of the Fund’s cost
of its investments in units of FNLP over the carrying value of the
underlying net assets has been assigned to goodwill and finite life
intangible assets. Income reported by the Fund commenced on the
acquisition date.
Pursuant to the Limited Partnership Agreement between FNLP, the
Trust and FNFC dated June 15, 2006, a subsidiary of FNFC, First
National Financial GP Corporation, as general partner of FNLP, has
full power and exclusive authority to employ all persons necessary
for the conduct of the partnership, to enter into an agreement and
to incur any obligation related to the affairs of the partnership and
is entitled to full reimbursement of all costs and expenses incurred
on behalf of the partnership. As general and administrative costs
incurred by First National Financial GP Corporation are on behalf of
the partnership, these costs have been reflected in the financial
statements of FNLP.
2. Basis Of Presentation And Significant Accounting Policies
Basis of presentation
These consolidated financial statements have been prepared in
accordance with Canadian generally accepted accounting principles.
These consolidated financial statements should be read in conjunction
with the audited March 31, 2006 financial statements of FNFC
included in the Fund’s initial public offering prospectus dated
June 6, 2006.
Income taxes
The Fund qualifies as a “mutual fund trust” as defined in the Income
Tax Act (Canada) [“the Tax Act”], including its establishment and
maintenance as a Trust for the benefit of Canadian residents.
Consequently, these consolidated financial statements do not reflect
any provision for income taxes as the Fund intends to distribute to
its unitholders substantially all of its taxable income and the Fund
intends to comply with the provisions of the Tax Act that permit,
amongst other items, the deduction of distributions to unitholders,
from the Fund’s taxable income.
On October 31, 2006, the Minister of Finance (Canada) announced
proposed tax legislation rendering income trusts taxable commencing
in 2011. In the event the Fund becomes a taxable entity, income
taxes payable will reduce net earnings and will affect distributable
cash by an equivalent amount.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL INCOME FUND
3
Investments in FNLP and First National Financial GP Corporation
The Fund accounts for its investments in FNLP and First
National Financial GP Corporation using the equity method. Under
this method, the cost of the investment is increased by the
Fund’s proportionate share of FNLP’s earnings and reduced by
any distribution paid to the Fund by FNLP and amortization of
the portion of the purchase price discrepancy, consisting of
intangible assets.
Excess of purchase price over the carrying values of assets
The excess of the Fund’s cost of its investment in units over the
carrying value of the underlying net assets has been allocated to
servicing rights, FNLP’s broker and borrower relationships and
goodwill. The excess related to servicing rights is being amortized
over the average term of the related mortgages and the excess
related to broker and borrower relationships over the estimated
useful term of 5 and 10 years of the relationships. The goodwill
component of the purchase price discrepancy will not be amortized
The value of the assets will be tested annually for impairment.
3. Fund Units
The Fund may issue an unlimited number of Units for consideration
and on the terms and conditions as determined by the Fund’s
trustees. Each Fund Unit is transferable and represents an equal
undivided beneficial interest in any distribution from the Fund.
All Fund Units are of the same class and have equal rights
and privileges.
In connection with the initial public offering, the Fund issued
10,600,000 Fund Units on June 15, 2006 for $10 per Unit. On July
11, 2006, subject to the over-allotment option, the Fund issued
1,200,000 additional Fund Units for $10.00 per Unit.
4. Investment In First National Financial LP
Investment in First National Financial LP consists of the following:
Initial investment, June 15, 2006
Additional purchase pursuant to over-allotment option
Equity in earnings of First National Financial LP
since initial investment
Amortization of purchase price discrepancy
Distributions received
Under the terms of the Exchange, Voting and Registration Rights
Agreement dated June 15, 2006, the exchangeable Class B LP units
held by FNFC are exchangeable for Fund Units on a one-for-one
basis. After exercise of the over-allotment options, the Fund has
reserved 47,286,316 Units for the exchange of the exchangeable
Class B LP units.
Fund Units are redeemable at any time on demand by the unitholder.
The redemption price per Unit is equal to the lesser of:
•
90% of the weighted average trading price per Unit during the
last 10 days on the principal exchange on which the Units are
listed; or
•
An amount equal to:
-
-
-
the closing price of the Units on the date on which the Units
were tendered for redemption on the principal stock
exchange on which the Units are listed, if there was a trade
on the specified date and the applicable market or exchange
provides a closing price; or
the average of the highest and lowest prices of the Units on
the date on which the Units were tendered for redemption
on the principal stock exchange on which the Units are listed,
if there was trading on the date on which the Units were
tendered for redemption and the exchange or other market
provides only the highest and lowest trade prices of the Units
traded on a particular day; or
the average of the last bid and ask prices quoted in respect of
the Units on the principal stock exchange on which the Units
are listed if there was no trading on the date on which the
Units were tendered for redemption.
$
99,640
12,000
7,915
(4,000)
(6,072)
$ 109,483
32 FIRST NATIONAL FINANCIAL INCOME FUND
Annual Report 2006
5. Distributions To Unitholders
The Fund is entirely dependent on distributions from FNLP to make its own distributions. The Fund pays monthly distributions to its unitholders
of record on the last business day of each month approximately 15 days after the end of each month. The table below outlines the cumulative
distributions to unitholders:
Period ended
Distributions paid
July 31, 20061
August 31, 2006
September 30, 2006
October 31, 2006
November 30, 2006
Distributions payable
December 31, 2006
Total distributions
1 Distribution for unitholders of record on this date was for the period June 15, 2006 to July 31, 2006.
6. Guarantee
The Fund’s wholly-owned subsidiary, First National Financial
Operating Trust, has provided guarantees to and subordinated its
rights to receive payments from FNLP in respect of FNLP’s bank
credit facility that had an outstanding amount at December 31, 2006
of $116,900 and an authorized limit of $200,000.
Per unit
Amount
$ 0.11875
$
1,401.3
0.07917
0.07917
0.07917
0.07917
0.07917
934.2
934.2
934.2
934.2
934.2
$ 0.51460
$
6,072.3
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
33
AUDITORS’ REPORT
To the Partners of
First National Financial LP
We have audited the balance sheets of First National Financial LP as at
December 31, 2006 and March 31, 2006 and the statements of income,
cash flows and changes in equity for the nine-month period ended
December 31, 2006 and the year ended March 31, 2006. These financial
statements are the responsibility of the Company’s management. Our
responsibility is to express an opinion on these financial statements
based on our audits.
We conducted our audits in accordance with Canadian generally
accepted auditing standards. Those standards require that we plan and
perform an audit to obtain reasonable assurance whether the financial
statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial
statement presentation.
In our opinion, these financial statements present fairly, in all material
respects, the financial position of the Company as at December 31,
2006 and March 31, 2006 and the results of its operations and its cash
flows for the nine-month period ended December 31, 2006 and the
year ended March 31, 2006 in accordance with Canadian generally
accepted accounting principles.
Toronto, Canada
February 27, 2007
Chartered Accountants
34 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
BALANCE SHEETS
(in $000s of dollars)
December 31, 2006
March 31, 2006
As at
As at
ASSETS
Accounts receivable and sundry
Mortgages accumulated for sale
Securitization receivable [note 3]
Cash collateral and short-term notes held by securitization trusts [note 3]
Mortgage and loan investments [note 4]
Purchased mortgage servicing rights [note 5]
Securities purchased under resale agreements and owned [note 11]
Capital assets, net [note 6]
Total assets
LIABILITIES AND EQUITY
Liabilities
Bank indebtedness [note 7]
Accounts payable and accrued liabilities
Income taxes payable [note 9]
Future income tax liabilities [note 9]
Servicing liability [note 3]
Securities sold under repurchase agreements and sold short [note 11]
Total liabilities
Commitments and guarantees [note 10]
Equity
GP units [note 1]
Class A LP units [note 1]
Exchangeable Class B LP units [note 1]
Shareholders’ equity — predecessor [note 1]
Retained earnings
Total equity
Total liabilities and equity
See accompanying notes
On behalf of the Board:
Director
Stephen Smith
Director
Moray Tawse
$
16,846
$
90,669
77,949
45,489
53,230
7,267
232,952
3,714
528,116
$
169,638
$
14,487
–
–
15,038
232,952
432,115
$
59
$
109,140
(22,940)
–
9,742
96,001
10,315
44,688
54,126
23,389
36,771
6,378
100,603
3,481
279,751
60,558
8,593
12,482
17,882
11,315
100,603
211,433
–
–
–
68,318
–
68,318
$
528,116
$
279,751
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
35
STATEMENTS OF INCOME
(in $000s of dollars, except earnings per share/unit)
Nine-month period ended
December 31, 2006 March 31, 2006
Year ended
REVENUE
Placement fees
Gains on securitization [note 3]
Mortgage investment income
Mortgage servicing income
Residual securitization income
EXPENSES
Brokerage fees
Salaries and benefits
Interest
Interest on shareholders’ loans
Management salaries
Other operating
Income before income taxes
Provision for (recovery of) income taxes [note 9]
Current
Future
Net income for the period
Earnings per unit/share [note 16]
Basic
See accompanying notes
$
$
$
$
73,069
37,804
11,444
29,154
4,956
156,427
67,891
21,317
7,022
–
917
8,554
105,701
50,726
4,239
(927)
3,312
47,414
0.80
$
$
67,108
29,998
12,578
27,401
7,558
144,643
47,915
22,914
5,260
1,711
700
9,817
88,317
56,326
$
14,950
$
5,044
19,994
36,332
0.61
36 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
STATEMENTS OF C ASH FLOWS
(in $000s of dollars)
Nine-month period ended Year ended
December 31, 2006 March 31, 2006
OPERATING ACTIVITIES
Net income for the period
Add (deduct) items not affecting cash
Gains on securitization
Amortization of securitization receivable
Amortization of purchased mortgage servicing rights
Amortization of capital assets
Amortization of servicing liability
Future income taxes
Net change in non-cash working capital balances
related to operations [note 12]
Cash provided by (used in) operating activities
INVESTING ACTIVITIES
Additions to capital assets
Acquisition FNFC business
Investment in cash collateral and short-term notes, net
Investment in mortgage and loan investments
Repayment of mortgage and loan investments
Investment in purchased mortgage servicing rights
Cash used in investing activities
FINANCING ACTIVITIES
Repayment in shareholders’ loans
Issuance of Class A LP Units [note 1]
Issuance of GP Units [note 1]
Distributions paid
Exercise of over-allotment option
Distribution related to working capital adjustment
Securities purchased under resale agreements and owned
Securities sold under repurchase agreements and sold short
Cash provided by (used in) financing activities
Net increase in bank indebtedness during the period
Bank indebtedness, beginning of period
Bank indebtedness, end of period
Supplemental cash flow information
Income taxes paid
Interest paid
See accompanying notes
$
47,414
$
36,332
(37,804)
21,839
502
803
(4,135)
(927)
27,692
(63,778)
(36,086)
(1,036)
(97,140)
(22,100)
(46,428)
29,969
(1,391)
$
(29,998)
23,141
574
895
(3,797)
5,044
32,191
3,574
35,765
$
(1,699)
–
(7,685)
(59,687)
49,965
(3,454)
$
(138,126)
$
(22,560)
–
109,140
59
(25,728)
(12,000)
(6,339)
(132,349)
132,349
65,132
(109,080)
(60,558)
(169,638)
(13,700)
–
–
–
–
–
9,992
(9,992)
(13,700)
(495)
(60,063)
(60,558)
$
15,794
7,022
$
3,004
6,971
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
37
STATEMENTS OF CHANGES IN EQUITY
(in $000s of dollars)
Number of Nine-month period ended Year ended
Units December 31, 2006 March 31, 2006
GP units
Balance, beginning of period
Issued upon formation [note 1]
Balance, end of period
Class A LP units
Balance, beginning of period
Issued upon acquisition of FNFC business [note 1]
Issued upon exercise of over-allotment option [note 1]
Balance, end of period
Exchangeable Class B LP units
Balance, beginning of period
Transfer of excess of purchase price over net book
value to exchangeable Class B LP Units upon
acquisition of FNFC business [note 1]
Repurchased upon exercise of over-allotment
option [note 1]
Balance, end of period
Shareholders’ equity — predecessor
Balance, beginning of period
Net income for the period [note 18]
Distribution related to working capital adjustment
Paid to FNFC on acquisition of FNFC business [note 18]
Future income tax liabilities applicable to predecessor
not assumed by the partnership on acquisition [note 1]
Transfer of excess of purchase price over net book
value to exchangeable Class B LP Units upon
acquisition of FNFC business [note 1]
Balance, end of period
Retained earnings
Balance, beginning of period
Net income for the period [note 18]
Less distributions declared
Balance, end of period
Equity
See accompanying notes
–
59,092
59,092
10,600,000
1,200,000
11,800,000
48,486,316
(1,200,000)
47,286,316
2
(2)
–
$
$
–
59
59
–
97,140
12,000
$
109,140
$
–
(10,940)
(12,000)
$
(22,940)
$
–
–
–
–
–
–
–
–
–
–
–
68,318
7,266
(6,339)
(97,140)
16,955
10,940
–
–
40,148
(30,406)
9,742
96,001
$
$
$
31,986
36,332
–
–
–
–
$
68,318
–
–
–
–
68,318
$
$
38 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
NOTES TO FINANCIAL STATEMENTS
(December 31, 2006, in $000s of dollars)
1. General Organization And Business Of First National
•
Financial LP
First National Financial LP [the “Company” or “FNLP”], a limited
partnership established under
is a
Canadian-based originator, underwriter and servicer of predominantly
prime single-family residential and multi-unit residential and
commercial mortgages.
laws of Ontario,
the
As a Canada Mortgage and Housing Corporation approved lender,
the Company is active in the single-family residential and commercial
mortgage markets. As at December 31, 2006, the Company
had mortgages under administration of $24,359,481 [March 31,
2006 – $19,622,960] and cash held in trust of $287,382 [March
31, 2006 – $236,392]. Mortgages under administration are serviced
for financial institutions such as insurance companies, pension funds,
mutual funds, trust companies, credit unions and special purpose
entities [including trusts], also referred to as securitization vehicles.
As at December 31, 2006, the Company administered 83,098
mortgages [March 31, 2006 – 66,846] for 106 institutional investors
[March 31, 2006 – 105] with an average remaining term to maturity
of 60 months [March 31, 2006 – 61 months].
First National Financial Income Fund [the “Fund”] owns an indirect
interest in FNLP of 19.97% and First National Financial Corporation
[“FNFC” or the “predecessor”] holds indirectly the controlling
interest of 80.03%. The Fund is an unincorporated, open-ended
trust established under the laws of the Province of Ontario on April
19, 2006, pursuant to a Declaration of Trust. The Fund was
established to acquire and hold, through a newly constituted wholly-
owned trust, First National Financial Operating Trust [the “Trust”],
investments in the outstanding limited partnership units of FNLP.
Pursuant to an underwriting agreement dated June 6, 2006 and an
initial public offering dated June 15, 2006 and the exercise of an
over-allotment option by the underwriters on July 11, 2006, in
aggregate the Fund sold 11,800,000 units of the Fund [“Fund Units”,
“Units” or “Unit”] at a price of $10.00 per Unit for proceeds totalling
$118,000. The proceeds of the offering, net of underwriters fees of
$6,360 and other offering costs of $2,500 were used to partially
fund the indirect acquisition [through the Trust] of FNLP by the
Fund through the issuance of Class A LP Units by FNLP.
Concurrent with the initial public offering and as part of the
acquisition agreement between the Fund, FNLP and FNFC, FNLP
purchased all of FNFC’s assets and assumed its liabilities, except for
income tax liabilities. The consideration for this purchase was:
•
•
the issuance of 48,486,316 Class B exchangeable partnership units;
an acquisition promissory note of $97,140, of which $10,940
has been accounted
in FNLP’s
financial statements;
for as a distribution
a working capital note of $6,339, representing the difference
between the net assets of FNFC as at March 31, 2006, excluding
future income tax liabilities, and the net assets transferred to
FNLP as at June 14, 2006. The issuance of this note has also
been accounted for as a distribution in FNLP’s financial statements.
FNLP is considered to be a continuation of FNFC business following
the continuity of interest method of accounting. Under the continuity
of interest method of accounting, FNLP’s acquisition of the FNFC
business is recorded at the net book value of FNFC business assets
and liabilities on June 14, 2006 and the equity of FNLP represents
the equity of the FNFC business at that date.
Pursuant to the Limited Partnership Agreement between FNLP, the
Trust and FNFC dated June 15, 2006, First National Financial GP
Corporation, as general partner, has full power and exclusive
authority to employ all persons necessary for the conduct of the
partnership, to enter into an agreement and to incur any obligation
related to the affairs of the partnership and is entitled to full
reimbursement of all costs and expenses incurred on behalf of the
partnership. As general and administrative costs incurred by First
National Financial GP Corporation are on behalf of the partnership,
these costs have been reflected in the financial statements of FNLP.
On August 17, 2006, the acquisition promissory note and the
working capital note were paid in full.
2. Significant Accounting Policies
Use of estimates
The preparation of financial statements in conformity with Canadian
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities, including contingencies, at the date of the
financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results may differ from
those estimates. Major areas requiring use of estimates by
management are the securitization receivable and the fair values of
financial assets and liabilities.
Change in fiscal year end
Upon the reorganization of the Company going public, the
shareholders/partners changed the Company’s fiscal year end from
March 31 to December 31. Consequently, the comparative numbers
are as at and for the year ended March 31, 2006.
Revenue recognition
The Company earns revenue from placement, securitization and
servicing activities related to its mortgage business. The majority
of originated mortgages are funded either by placement of
mortgages with institutional investors or the sale of mortgages to
securitization conduits. The Company retains servicing rights on
substantially all of the mortgages it originates, providing the Company
with servicing fees.
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
3
Placement fees are earned by the Company for its origination and
underwriting activities on a completed transaction basis when the
mortgage is with the institutional investor or securitized. Amounts
collected in excess of the mortgage principal are recognized as
placement fees.
Securitization revenue consists of gain on securitization and residual
securitization income. The Company complies with The Canadian
Institute of Chartered Accountants’ [“CICA”] Accounting Guideline
12, “Transfers of Receivables”. Accordingly, gains on securitization
are recognized in income at such time as the Company transfers
mortgages to securitization vehicles and surrenders control whereby
the transferred assets have been isolated presumptively beyond the
reach of the Company and its creditors, even in bankruptcy or other
receivership. When the Company securitizes mortgages, it generally
retains a residual interest, presented in the balance sheet as
securitization receivable, and the rights and obligations associated
with servicing the mortgages. The measurement of gains or losses
recognized on the sale of mortgages depends in part on the previous
carrying amount of the transferred mortgages, as allocated between
the assets sold and the interests that are retained by the Company
as the seller, based on the relative fair value of the assets and the
retained interest at the date of transfer. To obtain fair values, quoted
market prices are used where available. Since quoted prices are
generally not available for retained interests, the Company estimates
fair value based on the net present value of future expected
cash flows, calculated using management’s best estimates of key
assumptions related to expected credit loss experience, prepayment
rates and discount rates commensurate with the risks involved.
Residual securitization income represents the difference between
the actual cash flows received on securitized mortgages and the
assumed cash flows, recognized in income as received. Further,
subsequent to securitization, the fair value of retained interests is
measured quarterly and compared to the securitization receivable
at the balance sheet date. Should the securitization receivable
exceed the fair value of the retained interests determined by
reference to underlying remaining expected cash flows, an
impairment charge is included in residual securitization income to
reduce the carrying value of the securitization receivable.
The Company services substantially all of the mortgages that it
originates whether the mortgage is placed with institutional investors
or transferred to a securitization vehicle. In addition, mortgages are
serviced on behalf of third-party institutional investors and
securitization structures. Servicing revenue is recognized in income
on an accrual basis and is collected on a monthly basis from
institutional investors. For securitized mortgages, the Company
retains the rights and obligations to service mortgages and records a
liability for future servicing and a reduction of gain on securitization
at the time of transfer. Servicing income related to securitized
mortgages is accreted to income over the life of the servicing
obligation and included in residual securitization income. Interest
income earned by the Company related to servicing activities is
classified as mortgage servicing income.
In addition to the foregoing sources of revenue, the Company
earns interest income which is recorded on an accrual basis from its
interest bearing assets including securitization receivable, mortgage
and loan investments and mortgages accumulated for sale. Prior to
placement or transfer, funded mortgages are presented in the
balance sheet as mortgages accumulated for sale which are typically
held for a period of less than 180 days and are carried at cost.
Brokerage fees
Brokerage fees incurred to originate mortgages are deferred and
amortized to income over the term of the underlying mortgage.
Upon placement or securitization of the related mortgages,
brokerage fees are recorded as an expense.
Mortgage and loan investments
Mortgage and loan investments are carried at outstanding principal
balances adjusted for unamortized premiums or discounts and are
net of specific provisions for credit losses, if any.
Mortgage and loan investments are recognized as being impaired
when the Company is no longer reasonably assured of the timely
collection of the full amount of principal and interest. An allowance
for loan losses is established only for mortgages and loans that are
known to be uncollectible.
Mortgages accumulated for sale
Mortgages accumulated for sale are mortgages funded on behalf of
the Company’s investors. These mortgages are carried at cost and
held for terms of less than 90 days.
Purchased mortgage servicing rights
The Company purchases the rights to service mortgages from third
parties. Purchased mortgage servicing rights are initially recorded at
cost and charged to income over the life of the underlying mortgage
servicing obligation. The fair value of such rights is determined on a
periodic basis to assess the continued recoverability of the
unamortized cost in relation to estimated future cash flows
associated with the underlying serviced assets. Any loss arising from
an excess of the unamortized cost over the fair value is immediately
recorded as a charge to income.
Other financial instruments
To meet the criteria for hedge accounting, a financial instrument
must be effective at reducing the risk associated with the exposure
being hedged, and must be designated at the inception of the
instrument. Accordingly, changes in the market value of the
instrument must substantially offset the changes in the market value
of the underlying hedged item, both at inception of the hedge and
throughout the hedge period. If the hedging relationship is found to
no longer be effective, the derivative is reclassified as a trading item
and is marked to market. Upon reclassification to trading, any gain or
loss associated with the derivative would be amortized over the
remaining term of the hedged instrument.
40 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
When applying hedge accounting the Company complies with
Accounting Guideline 13 [“AcG 13”], “Hedging Relationships”,
as issued and amended by the CICA. AcG 13 addresses the
identification, designation, documentation and effectiveness of
hedging relationships for the purpose of applying hedge accounting.
AcG-13 establishes certain conditions for applying hedge accounting
and the discontinuance of hedge accounting. The Emerging Issues
Committee abstract [EIC] 128, “Accounting for Trading, Speculative
or Non-Hedging Derivative Financial Instruments”, requires that
any derivative financial instrument not designated within an AcG-
13-compliant hedging relationship be measured at fair value with
changes in fair value recorded in current income. The Company
applies hedge accounting for its hedging related to commercial
mortgage securitization.
Bonds sold short and bonds purchased under resale agreements
Bonds sold short consist of the short sale of a bond. Bonds purchased
under resale agreements consist of the purchase of a bond with
the commitment by the Company to resell the bond to the original
seller at a specified price. The Company uses combinations of bonds
sold short and bonds purchased under resale agreements to create
synthetic forward interest rate contracts that it uses to hedge the
mortgage commitments and on balance sheet mortgages of the
Company. Accordingly bonds sold short are carried at the proceeds
from sale plus accrued interest less accrued coupon. The accrued
coupon on bonds sold short is recorded as interest expense. Bonds
purchased under resale agreements are carried at cost plus accrued
interest, which approximates market value. The difference between
the cost of the purchase and the predetermined proceeds to be
received on a resale agreement is recorded over the term of the
hedged mortgages as an offset to interest expense. Transactions are
recorded on a settlement date basis.
Bonds owned and bonds sold under repurchase agreements
The Company purchases bonds and enters into bond repurchase
agreements to close out hedging positions when mortgages are sold
to special purpose entities or securitization vehicles.
These transactions are accounted for in a similar manner as the
transactions described for bonds sold short and bonds purchased
under resale agreements.
Income taxes
These financial statements are those of the partnership and do
not reflect the assets, liabilities, revenues and expenses of its
partners. FNLP is a partnership carrying on business in Canada, and
consequently, is not directly subject to federal or provincial income
taxes. The income or loss for income tax purposes of the partnership
is required to be allocated to FNLP’s partners. Accordingly, the tax
provision recorded represents income taxes accrued on earnings
while FNFC operated the Company’s business from April 1, 2006 to
June 14, 2006.
Cash and cash equivalents
Cash and cash equivalents consist of cash balances with banks and
bank indebtedness.
Capital assets
Capital assets are recorded at cost, less accumulated amortization, at
the following annual rates and bases:
Computer equipment
Office equipment
Leasehold improvements
Computer software
30% declining balance
20% declining balance
straight-line over the term of the lease
30% declining balance except for
computer licence, which is straight-
line over 10 years
Variable interest entities
The partnership adopted CICA Accounting Guideline 15 [“AcG-
15”], “Consolidation of Variable Interest Entities” in the current year.
AcG-15 provides a framework for identifying a variable interest
entity [“VIE”] and requires a primary beneficiary to consolidate a VIE.
A primary beneficiary is the enterprise that absorbs the majority
of the VIE’s expected losses or receives a majority of the VIE’s
residual returns, or both. The Company has interests in VIEs that
are not consolidated because the Company is not considered the
primary beneficiary.
Future changes: financial instruments, hedges and
comprehensive income
The CICA has issued three new accounting standards - “Financial
Instruments — Recognition and Measurement”, “Hedges” and
“Comprehensive Income”. These standards are effective for the
Company beginning with the first quarter of fiscal 2007. The principal
impacts of the standards are detailed below:
Comprehensive income will be a new component of equity and a
new statement entitled statement of comprehensive income will be
added to the Company’s primary financial statements.
Financial assets and liabilities will be required to be classified as
available for sale, held to maturity, trading or loans and receivables.
Such classification may affect their carrying value and timing of
recognition of unrecognized gains and losses.
For fair value hedges, where the Company is hedging changes in
the fair value of assets and liabilities or firm commitments, the
change in the value of derivatives and hedged items will be recorded
through income.
3. Securitization
The Company securitizes residential and commercial mortgage
loans. In all of those securitizations, the Company retains servicing
responsibilities and subordinate interests. In approximately 26%
[March 31, 2006 – 46%] of current-period securitizations, the
Company securitized fixed-term mortgage loans through the
NHA-MBS program and with institutional investors and received a
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
4
fixed servicing fee for its servicing responsibilities. The remaining
74% [March 31, 2006 – 54%] of those securitizations consisted of
sales of fixed and floating rate mortgages to special purpose entities.
In these cases, the Company does not receive an explicit servicing
fee; instead, the Company receives subordinated interests consisting
of rights to future cash flows arising after the investors in the special
purpose entities have received the return for which they contracted,
and provides credit enhancement to the special purpose entity in
the form of cash collateral accounts and short-term notes. The
investors and the special purpose entities have no recourse to the
Company’s other assets for failure of debtors to pay when due. The
Company’s retained interests are subject to credit, prepayment and
interest rate risks on the transferred receivables.
During the nine-month period ended December 31, 2006, the
Company securitized $2,152,161 [year ended March 31, 2006 –
$1,892,484] of mortgage loans to special purpose entities, recognizing
gains on securitization of $37,379 [year ended March 31, 2006 –
$27,940]. The Company also recognized gains on securitization
of $425 [year ended March 31, 2006 – $2,058], in addition to
placement fees, from the placement with institutional investors of
$762,534 mortgage loans during the period [year ended March 31,
2006 – $1,167,232].
The liability for implicit servicing on securitization was $15,038 as at
December 31, 2006 [March 31, 2006 – $11,315]. In the absence of
quoted market rates for servicing securitized assets, management
has estimated, based on industry expertise, that the fair market
value of this liability approximates its carrying value. Amortization of
the servicing liability during the period ended December 31, 2006
amounted to $4,135 [year ended March 31, 2006 – $3,797] and is
included in residual securitization income.
As part of the securitization activities the Company is required to
provide cash collateral and invest in subordinate short-term notes
for credit enhancement purposes as required by the rating agency.
Credit exposure to securitized mortgages is limited to the
securitization receivable, cash collateral and amounts invested in the
notes. The securitization receivable is paid to the Company by the
special purpose entity over the term of the mortgages, as monthly
net spread income. The full amount of the cash collateral and the
notes held by the securitization trusts, and accrued interest thereon,
is also recorded as a receivable and the Company anticipates full
recovery of these amounts. As at December 31, 2006, the cash
collateral was $37,726 [March 31, 2006 – $20,698] and the
subordinate short-term notes were $7,763 [March 31, 2006 – $2,691].
The key weighted average assumptions used in determining the securitization gains were as follows:
Prepayment rate
Discount rate
December 31,
2006
%
12.1
%
6.8
March 31,
2006
12.0
6.8
There was no credit loss assumption used for insured mortgages as no loss is expected. For uninsured mortgages, the expected weighted average
credit loss assumption used was 0.33% [March 31, 2006 – 0.32%].
Cash flows received from securitization vehicles for the nine-month period ended December 31, 2006 and the year ended March 31, 2006 are
as follows:
Proceeds from new securitizations
Receipts on securitization receivable
Nine-month period ended
December 31, 2006
Year ended
March 31, 2006
$ 2,887,222
$ 3,043,980
24,591
30,699
42 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
The Company uses various assumptions to value the securitization receivable [excluding cash collateral and subordinate short-term notes held by
the securitization trusts], which are set out below in the table, including the rate of unscheduled prepayments. Accordingly, the securitization
receivable is subject to measurement uncertainty. The effect of variations between actual experience and assumptions will be recorded in future
statements of income. Key economic weighted average assumptions and the sensitivity of the current carrying value of residual cash flows to
immediate 10% and 20% adverse changes in those assumptions are as follows:
December 31, 2006
Commercial mortgage loans Residential mortgage loans
Adjustable
Fixed rate
Fixed rate
Adjustable
Carrying value of retained interests
Average life [in months] [1]
Prepayment speed assumption [annual rate]
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
Residual cash flows discount rate [annual]
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
Expected credit losses
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
$ 18,628
$ 2,550
$ 23,110
$ 33,661
38
0.9%
14
27
6.0%
282
556
$
$
$
$
0.07%
107
$
214
$
14
31.7%
82
$
161
$
8.0%
19
37
$
$
0.07%
13
$
26
$
35
12.6%
644
$
$ 1,266
7.0%
275
545
$
$
0.24%
366
$
732
$
34
16.5%
896
$
$ 1,759
7.0%
360
713
0.05%
111
221
$
$
$
$
March 31, 2006
Commercial mortgage loans Residential mortgage loans
Adjustable
Adjustable
Fixed rate
Fixed rate
Carrying value of retained interests
Average life [in months] [1]
Prepayment speed assumption [annual rate]
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
Residual cash flows discount rate [annual]
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
Expected credit losses
Impact on fair value of 10% adverse change
Impact on fair value of 20% adverse change
$ 16,041
40
0.04%
3
$
$
6
6.88%
249
$
493
$
0.05%
58
$
115
$
$ 3,574
16
34.5%
192
$
369
$
8.2%
30
$
59
$
0.06%
15
$
30
$
(1)
The weighted average life of prepayable assets in periods [for example, months or years] can be
calculated by multiplying the principal collections expected in each future period by the number
of periods until that future period, summing those products, and dividing the sum by the initial
principal balance.
$ 4,298
36
$ 30,213
33
12.6%
75
$
138
$
7.2%
48
95
0.3%
83
166
$
$
$
$
16%
733
$
$ 1,439
8.2%
384
760
0.04%
71
143
$
$
$
$
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
43
These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in carrying value based on a 10% or 20%
variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may
not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without
changing any other assumption; in reality, changes in one factor may result in changes in another [for example, increases in market interest rates
may result in lower prepayments and increased credit losses], which might magnify or counteract the sensitivities.
The Company estimates that the expected cash flows of the securitization receivable will be as follows:
2007
2008
2009
2010
2011
Thereafter
Mortgages under administration are serviced as follows:
Institutional investors
Securitization vehicles
CMBS conduits
$
25,738
21,381
18,753
8,172
3,017
888
$
77,949
December 31, 2006
March 31, 2006
$
15,116,636
$ 12,206,363
5,309,532
3,933,313
4,459,951
2,956,646
$
24,359,481
$ 19,622,960
The Company’s exposure to credit losses is limited to mortgages under administration totalling $1,026,876 [March 31, 2006 – $518,029].
The Company incurred actual credit losses, net of recoveries, of $185 during the nine-month period ended December 31, 2006 [year ended
March 31, 2006 – $265].
4. Mortgage And Loan Investments
As at December 31, 2006, mortgage and loan investments consist primarily of commercial first and second mortgages held for various terms up
to 19 years. Due to the short-term, floating rate and bridging nature of most of these mortgages, management believes that fair value
approximates carrying value.
The contractual repricing on the table below is based on the earlier of contractual repricing or maturity dates.
December 3, 2006 March 3, 2006
Within 1 year Over 1 to 3 years Over 3 to 5 years Over 5 years Book value Book value
Residential
Commercial
$
3,417
$
–
46,823
2,183
$ 50,240
$
2,183
$
–
172
$ 172
$
14
$
3,431
$
4,951
621
49,799
31,820
$
635
$
53,230
$
36,771
44 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
The Company has not experienced any credit losses or impairment on these items in the nine-month period ended December 31, 2006 or in
the year ended March 31, 2006.
The maturity profile of mortgage and loan investments is as follows:
2007
2008
2009
2010
2011
Thereafter
$
$
46,512
5,575
336
–
172
635
53,230
5. Purchased Mortgage Servicing Rights
As at period end, the balance consists of the following components:
December 3, 2006
March 3, 2006
Cost
Accumulated amortization Net Book Value Cost Accumulated amortization Net Book Value
Third-party commercial
mortgage servicing rights $ 3,614
$ 1,445
$ 2,169
$ 3,614
$ 1,157
$ 2,457
CMBS primary and master
servicing rights
5,492
$ 9,106
394
5,098
4,101
180
$ 1,839
$ 7,267
$ 7,715
$ 1,337
3,921
$ 6,378
During the nine-month period ended December 31, 2006, the Company purchased servicing rights valued at $1,391 [year ended
March 31, 2006 – $3,454]. Amortization charged to income for the nine-month period ended December 31, 2006 was $502 [year ended March
31, 2006 – $574].
During the nine-month period ended December 31, 2006 and the year ended March 31, 2006, management determined that the estimated
fair market value of this asset at any time was not less than the Company’s unamortized cost; accordingly, no write downs were recorded
during the periods.
6. Capital Assets
Capital assets consist of the following:
December 3, 2006
March 3, 2006
Cost
Accumulated amortization Net Book Value
Cost Accumulated amortization Net Book Value
Computer equipment
$ 2,790
$ 1,453
$ 1,337
$ 2,740
$
1,530
$ 1,210
Office equipment
2,392
Leasehold improvements
1,293
Computer software
1,198
$ 7,673
1,272
721
513
1,120
572
685
2,048
1,166
1,082
1,105
542
378
943
624
704
$ 3,959
$ 3,714
$ 7,036
$
3,555
$ 3,481
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
45
7. Bank Indebtedness
8. Swap Contracts
Bank indebtedness includes a one year revolving line of credit of
$200,000 [March 31, 2006 – $150,000], of which $163,900 [March
31, 2006 – $56,100] was drawn at December 31, 2006 and against
which the following have been pledged as collateral:
a) a general security agreement over all assets, other than real property,
of the Company; and
b) a general assignment of all mortgages owned by the Company.
The revolving line of credit bears variable rate interest based on
prime or bankers’ acceptance rates.
Swaps are over-the-counter contracts in which two counterparties
exchange a series of cash flows based on agreed upon rates to
a notional amount. The Company uses interest rate swaps to
manage interest rate exposure relating to variability of interest
earned on Commercial Mortgage Backed Securities [“CMBS”]
payments held in trust as the master servicer. The swap agreements
that the Company entered into are interest rate swaps where two
counterparties exchange a series of payments based on different
interest rates applied to a notional amount in a single currency.
The following table presents the notional amounts and fair value of
swap contracts as at December 31, 2006 and March 31, 2006 by
remaining term to maturity:
Interest rate swap contracts
$
–
$ 5,665
$
5,665
3 to 5 years
December 31, 2006
>5 years
Total notional amount
Fair value
$
81
Interest rate swap contracts
$
–
$ 4,056
$
4,056
$ (42)
March 31, 2006
3 to 5 years >5 years Total notional amount Fair value
9. Income Taxes
Reconciliation of income taxes consists of the following:
Income before income taxes [while a taxable entity]
Statutory income tax rate
Income taxes at statutory rate
Increase (decrease) resulting from
Effect of future tax rate changes
Other non-deductible amounts for tax purposes
Nine-month period ended
December 31, 2006
$ 10,578
35.64%
3,770
(477)
19
Year ended
March 31, 2006
$
56,326
35.87%
20,204
(322)
112
$
3,312
$
19,994
46 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
Future income taxes
Future income taxes reflect the net tax effect of temporary differences between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Future income tax liabilities are comprised of the following:
Purchased mortgage servicing rights
Retained interest in securitized assets and related benefits
Servicing liability
Other temporary differences
Total future income tax liabilities
10. Commitments And Guarantees
As at December 31, 2006, the Company has the following operating
lease commitments for its office premises:
2007
2008
2009
2010
2011
$ 2,104
2,066
1,882
1,912
1,119
$ 9,083
Outstanding commitments for future advances on mortgages with
terms of one to 10 years amounted to $1,346,659 as at
December 31, 2006 [March 31, 2006 – $1,457,279]. The
commitments generally remain open for a period of up to 90
days. These commitments have credit and interest rate risk profiles
similar to those mortgages which are currently under administration.
Certain of these commitments will expire before being drawn down.
Therefore, these amounts do not represent the Company’s future
cash requirements.
Accounts receivable and sundry
Mortgages accumulated for sale, net
Accounts payable and accrued liabilities
Management bonus payable
Distributions payable
Shareholders’ loans
Income taxes payable
December 31, 2006
March 31, 2006
$
$
–
–
–
–
–
$
2,296
19,485
(4,073)
174
$
17,882
In the normal course of business, the Company enters into a variety
of guarantees. Guarantees include contracts where the Company
may be required to make payments to a party, based on changes in
the value of an asset or liability that the party holds. In addition,
contracts under which the Company may be required to make
payments if a third party fails to perform under the terms of the
contract [such as mortgage servicing contracts] are considered
guarantees. The Company has determined that the estimated
potential loss from these guarantees is insignificant.
11. Securities Owned And Sold Short Under Resale And
Repurchase Agreements
The Company’s outstanding securities transactions under resale and
repurchase agreements have a remaining term to maturity of less
than one month.
12. Net Change In Non-cash Working Capital Balances
Related To Operations
Net change in non-cash working capital balances related to
operations consists of the following:
Nine-month period ended
December 31, 2006
$
(6,531)
Year ended
March 31, 2006
$
(3,117)
(45,981)
5,894
–
(4,678)
–
(12,482)
2,017
2,873
(8,000)
–
(2,144)
11,945
$
(63,778)
$
3,574
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
47
13. Financial Instruments
Fair value
The estimated fair value of the securitization receivable is
determined using a discounted cash flow calculation and the market
interest rates currently charged for CMBS with similar terms and
credit risks.
The carrying values of accounts receivable and sundry, mortgages
accumulated for sale and accounts payable and accrued liabilities
are assumed to approximate their fair values due to their short-term
nature or underlying interest rate repricing. Any assets that are
not financial instruments have been excluded from the estimate
of fair values.
Market risk
Market risk refers to the risk that a change in the level of one or
more of market prices, interest rates, indices, volatilities, correlations
or other market factors, such as liquidity, will result in losses. As
certain financial instruments and investments held are recognized at
fair value or net recoverable amount, these changes could affect
reported earnings as they occur. The Company manages market risk
on a divisional level and on an individual product basis.
Credit risk
The Company incurs credit risk when entering into, settling and
financing various transactions. Credit risk arises from the potential
that investors or counterparties fail to satisfy their obligations. Credit
risk is managed by dealing with counterparties the Company believes
to be creditworthy and by actively monitoring credit and margin
exposure and the financial health of the counterparties.
Interest rate risk
Interest rate risk arises from the possibility that changes in interest
rates will affect the value of financial instruments. The Company
manages interest rate risk by entering into hedging activities.
14. Related Party Transaction
During the period, the Company loaned a total of nil [year ended
March 31, 2006 – $3,942] by way of a promissory note, bearing
interest at prime rate, to a company wholly owned by a shareholder
of the Company. No amounts were outstanding in the note at
March 31, 2006 or at any time subsequent to that date.
15. Information About Major Customers
Placement fees and mortgage servicing income from two Canadian
chartered banks represent approximately 37% of the Company’s
total revenue. During the nine-month period ended December 31,
2006, the Company placed 54% of all mortgages it originated with
two institutional investors, who are Canadian chartered banks.
16. Earnings Per Unit
Earnings per unit are calculated as follows:
Net income available to unitholders
Number of unitholders [Class A and B]
Basic earnings per unit (1)
[1] For comparative purposes, the number of units reflects the reorganization of capital as if it had occurred
on April 1, 2005.
Nine-month period ended
December 31, 2006
Year ended
March 31, 2006
$
47,414
59,086
$
0.80
$
36,332
59,086
$
0.61
17. Earnings By Business Segment
The Company operates principally in two segments, being Residential
and Commercial. These segments are organized by mortgage
type and contain revenues and expenses related to origination,
underwriting, securitization and servicing activities. Expenses not
allocated to segments relate to compensation paid to senior
management. Identifiable assets are those used in the operations
of the segments.
48 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
REVENUE
Placement, securitization and servicing
$
113,982
$
31,001
$
144,983
Nine-month period ended December 31, 2006
Residential
Commercial
Total
Mortgage investment income
EXPENSES
Amortization
Interest
Other operating
Corporate non allocated expenses
Income before income taxes
Identifiable assets
Capital expenditures
5,058
119,040
619
2,948
86,400
–
89,967
29,073
188,001
6,386
37,387
184
4,074
10,559
–
14,817
22,570
340,115
11,444
156,427
803
7,022
96,959
917
105,701
50,726
528,116
$
898
$
138
$
1,036
Year ended March 31, 2006
Residential
Commercial
Total
REVENUE
Placement, securitization and servicing
$
Mortgage investment income
EXPENSES
Amortization
Interest on shareholders’ loans
Other interest
Other operating expenses
Corporate non allocated expenses
Income before income taxes
Identifiable assets
Capital expenditures
92,676
4,699
97,375
647
855
2,530
66,917
–
70,949
26,426
107,402
$
1,399
$
39,389
$
132,065
7,879
47,268
248
856
2,730
12,834
–
16,668
30,600
12,578
144,643
895
1,711
5,260
79,751
700
88,317
56,326
172,349
$
300
279,751
$
1,699
Annual Repor t 2006
FIRST NATIONAL FINANCIAL LP
4
18. Results Of FNLP
To provide information to the Fund’s unitholders, management has prepared the following statements of income and cash flows, which reflect
the activities of FNLP for the nine-month period ended December 31, 2006. The tables below show the results of the FNFC business prior to
June 15, 2006 and the results of FNLP subsequent to June 14, 2006:
Statements of income
REVENUE
Placement fees
Gain on securitization
Mortgage investment income
Mortgage servicing income
Residual securitization income
EXPENSES
Brokerage fees
Salaries and benefits
Interest
Management salaries
Other operating
Income before income taxes
Provision for (recovery of) income taxes
Current
Future
April 1, 2006 to
June 14, 2006
[unaudited]
June 15, 2006 to
December 31, 2006
[unaudited]
Nine-month
period ended
December 31, 2006
$ 18,923
$
54,146
$
73,069
4,349
2,783
7,475
1,209
33,455
8,661
21,679
3,747
37,804
11,444
29,154
4,956
34,739
121,688
156,427
14,837
5,637
1,435
105
2,147
24,161
10,578
4,239
(927)
3,312
53,054
15,680
5,587
812
6,407
81,540
40,148
–
–
–
67,891
21,317
7,022
917
8,554
105,701
50,726
4,239
(927)
3,312
Net income for the period
$
7,266
$
40,148
$
47,414
50 FIRST NATIONAL FINANCIAL LP
Annual Report 2006
Statements of Cash Flows
OPERATING ACTIVITIES
Net income for the period
Add (deduct) items not affecting cash
Gain on securitization
Amortization of securitization receivable
Amortization of purchased mortgage servicing rights
Amortization of capital assets
Amortization of servicing liability
Future income taxes
Net change in non-cash working capital
balances related to operations
Cash provided by (used in) operating activities
INVESTING ACTIVITIES
Additions to capital assets
Investment in cash collateral and subordinate
short-term notes
Investment in mortgage and loan investments
Repayment of mortgage and loan investments
Acquisition of FNFC business
Investment in purchased mortgage servicing rights
April 1, 2006 to
June 14, 2006
June 15, 2006 to
December 31, 2006
[unaudited]
[unaudited]
Nine-month
period ended
December 31, 2006
$
7,266
$
40,148
$
47,414
(4,349)
7,665
125
214
(1,516)
(927)
8,478
(68,644)
(60,166)
(33,455)
14,174
377
589
(2,619)
––
19,214
4,866
24,080
(418)
(618)
(3,057)
(13,811)
3,338
—
—
(19,043)
(32,617)
26,631
(97,140)
(1,391)
(37,804)
21,839
502
803
(4,135)
(927)
27,692
(63,778)
(36,086)
(1,036)
(22,100)
(46,428)
29,969
(97,140)
(1,391)
Cash used in investing activities
$ (13,948)
$ (124,178)
$
(138,126)
FINANCING ACTIVITIES
Issuance of Class A LP Units
Issuance of GP Units
Distribution related to working capital adjustment
Distribution paid
Exercise over-allotment option
Securities purchased under resale agreements and owned
Securities sold under repurchase agreements and sold short
Cash provided by financing activities
Net increase in bank indebtedness during the period
Bank indebtedness, beginning of period
Bank indebtedness, end of period
19. Comparative Financial Statements
—
—
—
—
—
(71,750)
71,750
—
(74,114)
(60,558)
109,140
59
(6,339)
(25,728)
(12,000)
(60,599)
60,599
65,132
(34,966)
––
109,140
59
(6,339)
(25,728)
(12,000)
(132,349)
132,349
65,132
(109,080)
(60,558)
$ (134,672)
$
(34,966)
$
(169,638)
The comparative financial statements have been reclassified from statements previously presented to conform to the presentation of the
December 31, 2006 financial statements.
INVESTOR INFORMATION
Registrar and Transfer Agent
Computershare Investor Services Inc.
P: 1-800-564-6253
Investor Relations Contacts
Rob Inglis
Vice President, Finance
rob.inglis@firstnational.ca
Danna Broadworth
Account Executive
BarnesMcInerney Inc.
dbroadworth@barnesmcinerney.com
Exchange Listing and Symbol
TSX: FN.UN
Investor Relations Website
www.firstnational.ca
Annual Meeting
April 25, 2007, 2 p.m. ET
TSX Broadcast & Conference Centre
The Gallery
The Exchange Tower
130 King Street West
Toronto, Ontario
Company Address
First National Financial Income Fund
100 University Avenue
North Tower, Suite 700
Toronto, Ontario M5J 1V6
P: 416-593-1100
F: 416-593-1900
Senior Executives of
First National Financial LP
Stephen Smith
Co-Founder, President & Chairman
Moray Tawse
Co-Founder
& Vice President, Mortgage Investments
Rob Inglis
Vice President, Finance
Scott McKenzie
Vice President, Residential Mortgages
Jeremy Wedgbury
Managing Director, Mortgage Originations
Stephen Craine
Managing Director, Mortgage Servicing
Legal Counsel
Stikeman Elliott LP
Toronto, Ontario
Auditor
Ernst & Young LLP
Toronto, Ontario
.
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