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Annual Report 2011

Plain-text annual report

Delivering Service. Creating Solutions. Building Success. 2011 ANNUAL REPORT Corporate Profile First National Financial Corporation (TSX: FN) wholly owns First National Financial LP, a Canadian-based originator, underwriter and servicer of predominantly prime residential (single-family and multi-unit) and commercial mortgages. With almost $60 billion in mortgages under administration, First National is Canada’s largest non-bank originator and underwriter of mortgages, and ranks among the top three in market share in the growing mortgage broker distribution channel. 2011 Performance at a Glance FUNDING SOURCES (for the year ended December 31, 2011) REVENUE SOURCES PRIOR TO FAIR VALUE LOSSES (for the year ended December 31, 2011) MORTGAGES UNDER ADMINISTRATION (for the year ended December 31, 2011) B B A C A C A DE D B CD A 45% Institutional placements A 39% Institutional placements A 79% Insured B 13% CMB dealers C 32% NHA–MBS D 8% ABCP E 2% Internal company resources B 23% Net interest – securitized mortgages C 28% Mortgage servicing B 13% Multi-unit and commercial C 7% Conventional single-family residential D 10% Investment income D 1% Bridge loans/Alt-A 92% Insured or conventional single-family residential Investment Highlights > Canada’s largest non-bank mortgage originator > Leader in high-growth mortgage broker distribution channel > High-quality mortgage portfolio > Diverse revenue and funding sources MORTGAGES UNDER ADMINISTRATION (in $ billions) MORTGAGE ORIGINATIONS (in $ billions) REVENUE (in $ millions) EBITDA (in $ millions) . 6 9 5 3 . 3 5 8 . 7 4 . 9 1 1 . 9 0 1 8 . 1 51 . 0 1 . 8 1 1 . 6 0 4 . 1 3 3 . 0 4 6 4 3 . 4 9 3 7 . 1 4 3 . 0 4 9 2 . 0 9 3 2 2 . 5 6 21 . 1 3 1 . 6 6 0 1 . 0 0 1 1 . 1 4 7 2007 2008 2009 2010 2011 2007 2008 2009 2010 2011 2007 2008 2009 2010 2011 2007 2008 2009 2010 2011 12% Year-over-year growth 2010 to 2011 12% Year-over-year growth 2010 to 2011 18% Year-over-year growth 2010 to 2011 19% Year-over-year decline 2010 to 2011 Note: 2007–2009 under Canadian GAAP; 2010–2011 under IFRS FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 1 Message from the President Fellow Shareholders For First National Financial Corporation, 2011 was a year characterized by solid financial and operational performance across all of our divisional segments. The Company continued to increase its value with strategic investments in future growth throughout the year. In 2011, we fully leveraged our distribution channels as our volume of originations and mortgages under administration hit record levels. The Company also transitioned to International Financial Reporting Standards (IFRS). Throughout the year, the Canadian real estate market remained Since First National was formed in 1988, the Company has strong and First National was able to capitalize on these robust earned a reputation as a high-quality ser vice provider and conditions to originate and ser vice near-record levels of market leader in the residential and commercial mor tgage new mortgages in our residential, multi-unit and commercial lending sectors. For more than 23 years, we have met the segments. With a greater capital base resulting from our mortgage needs of a growing number of Canadian property preferred share issue early in the year, we took advantage of owners by building strong relationships within the commercial these increased origination levels by securitizing more than real estate and residential broker communities. These strategic $4 billion in mor tgages, which will continue to benefit the relationships allow us to build our customer base, drive our Company for the five- and 10-year terms of these transactions. growth and profitability and further strengthen our leadership The Company’s improved financial performance in 2011 was due to our consistent growth-oriented strategy, a high- performing team and commitment to operational excellence. position in this increasingly competitive marketplace. Record Financial Performance In 2011, First National achieved strong financial and operational results in the following key performance metrics: • Mortgages under administration increased 12% year-over- year to $59.6 billion; • Revenue grew to $464.0 million from $394.3 million in 2010, reflecting the increased interest revenue on securitized mortgages; • Income before income taxes decreased 19% to $96.8 million from $120.0 million in 2010; 2 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT • EBITDA decreased to $106.6 million in 2011 from We are very pleased with origination volumes and mortgages $131.2 million compared to the previous year; and under administration levels reached in 2011, and anticipate overall • The Company paid out dividends at $1.25 per share volumes to remain at comparable levels in 2012 and beyond. during the year, which represents an increase of 16% over the tax-effected regular distribution of the Corporation’s With a solid capital base and a strong balance sheet, First predecessor (First National Financial Income Fund) in 2010. National is well positioned to grow our market share and Together with payments on account of income tax, the increase profitability, allowing us to deliver solid and reliable Company paid out $108.0 million in 2011, or $18.1 million returns to our shareholders. We will continue to enhance more than in 2010, on a tax-equivalent basis. our operations, products and services while leveraging our The First National Management Team Left to right: Susan Biggar, General Counsel; Jason Ellis, Managing Director, Capital Markets; Jeremy Wedgbury, Managing Director, Commercial Mortgage Origination; Stephen Smith, Chairman and President; Moray Tawse, Vice President, Mortgage Investments; Robert Inglis, Chief Financial Officer; Lisa White, Vice President, Mortgage Administration; Scott McKenzie, Vice President, Residential Mortgages FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 3 Message from the President leadership position within the mor tgage broker distribution Looking back over the history of our Company, a great deal channel to better meet the needs of all of our stakeholders. of our success can be attributed to the experience and A Passion for Growth First National’s success has been building for 23 years, and our effectiveness of the management team. Each member is committed to contributing to First National’s strong business performance and future growth. Over the past several years, focus is still on growth. The Company was founded in 1988 our team has played a key role in propelling us forward to by Moray Tawse and myself when the securitization market realize our vision and consolidate our position as the leading was just developing. At that time, the mortgage broker channel non-bank mortgage lender in the industry. accounted for just 3% of the market. Today, brokers account for approximately 30% of the mortgage financing in Canada. We are most fortunate to have a dedicated group of employees From the very beginning, we placed a high priority on service building on its success and growing in the future. A number of and a commitment to assist brokers in efficiently meeting the our staff members have been part of the First National family needs of clients. This was coupled with our strongly held belief since we started this business more than 20 years ago, and both that investing in leading-edge technology would enable us to Moray and I take great pride in that they have remained with us. who believe in this Company and who are committed to deliver on this commitment. These two objectives were realized together through the development of MERLIN, a proprietary mortgage approval and tracking system. Industry Developments As a result of the market turmoil in 2011, the large Canadian banks increased mortgage spreads in order to raise profitability With the growth of Canada’s real estate markets and the on these assets. This was most evident in the fourth quarter, as accompanying need for mor tgages, First National expanded floating-rate single-family mortgages that had been priced at a its operations to meet the growing demand. The Company 0.70% discount to the prime rate in the summer were offered opened an office in Vancouver in 1991, and subsequent offices at no discount to prime. Similarly, fixed-rate mortgages were in Calgary and Montreal, to establish a presence in Canada’s key priced so as to increase spreads to a range of 1.75% to 2.00%. regional markets. With our conservative, disciplined approach to These increases enabled First National’s securitization activities underwriting, our record of superior service and administrative to be more profitable. capabilities, large institutions started looking to us to originate mortgage product. First National’s consistent year-over-year growth has consolidated our position as the market leader in non-bank mortgage lending. 4 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT In addition, Canada’s large banks also made the transition These proven strategies will continue to deliver strong results to IFRS this year. Together with increased capital requirements and business growth, allowing First National to further extend from Basel 3, there will be little incentive for the banks to our solid record of returns to our shareholders as the Company decrease spreads. First National has seen competitors exit builds on its strengths and consolidates its position as a leading the market or slow down origination in the face of higher mortgage lender. capital requirements for securitization, a direct consequence of these changes. Outlook As we proceed through 2012, the Company forecasts that I am proud of the financial and operational achievements we recorded in 2011, and look forward to the further growth of our business in 2012 and beyond. I’d like to thank our Board members for their guidance throughout the year, our shareholders for their mor tgages under administration will continue to grow and continued support, the management team and our employees produce higher income and cash flow. The wider mor tgage once again for their hard work and contributions, as well as spreads on our core products – prime mortgages – will give First our customers for their loyalty and support. Going forward, National the oppor tunity to continue to securitize directly, First National will continue to grow our established brand and retaining a large part of the economics of origination. outperform the market by doing what we do best – delivering service, creating solutions and building success. With our large investment in the portfolio of mortgages under securitization and servicing por tfolio at the end of this past Sincerely, year, First National expects increased cash flow and profitability going forward. Looking Ahead First National will continue to operate according to our four key strategies for ongoing success, including: • Providing a full range of mortgage solutions; • Growing assets under administration; • Employing leading-edge technology to lower costs and rationalize business processes; and • Maintaining a conservative risk profile. Stephen Smith Chairman and President FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 5 Our philosophy is unique in its simplicity: we deliver service, create solutions and build success. Through a combination of our innovative mortgage solutions, MERLIN – our industry-leading mortgage approval and tracking system – and our team of experts, First National has earned the trust of mortgage brokers, commercial clients as well as residential customers. These strong relationships are thanks to our unwavering commitment to delivering excellent service – a commitment shared by senior management and every member of the First National team. Delivering Service. We are committed to providing industry-leading service across all areas of our business. First National offers fast turnaround times for mortgage applications. Commercial clients often receive their mortgage commitment documents in as little as seven days, while mortgage brokers often receive responses to their submissions within four hours. In independent surveys, First National is continually ranked #1 by mortgage brokers for exceptional service. “First National has a very flexible approach. They look at each deal with a ‘can-do’ attitude and creative thinking.” – A.K., Senior Vice President, Finance Additionally, homeowners have access to our experienced team of customer care agents and their own personalized mortgage management tool, My Mortgage, online or by phone. “My needs have been met with awesome, courteous, and seamless service. I received the best customer service that I have had for as long as I can remember.” – K.P., Dartmouth, NS 6 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Creating Solutions. Building Success. At First National, we put all of our resources and expertise behind the development, administration and servicing of mortgage solutions. Each commercial mortgage inquiry starts with a professional mortgage consultation and analysis. A First National commercial mortgage expert will analyze the client’s needs and develop a customized proposal detailing the loan strategy, preferred terms, best rate solution and optimum financing recommendation. “First National’s product line-up provides us with flexible financing solutions that allow us to focus on the enhancement of our properties.” – B.D., President and CEO Residential mortgage brokers have access to a wide range of mortgage solutions, flexible payment terms and prepayment privileges to suit just about any lifestyle. MERLIN, First National’s exclusive industry-leading online mortgage approval and tracking system, ensures mortgage brokers stay connected to the status of their deal, so they can exceed customers’ expectations and maximize their operational efficiencies. “First National continues to be the industry standard with their customer-driven technology – MERLIN.” – J.S., Winnipeg, MB For many Canadians, buying their first home is a dream. Whether our homebuyers are new to Canada, self-employed or making their first purchase, together with their mortgage broker, we are all committed to helping them make this dream come true as easily and worry-free as possible. “I appreciate speaking with a real person. I also find your staff courteous and helpful. You took the time to explain my options, allowing me to choose the best plan.” – S.B., Ottawa, ON Time and time again, mortgage brokers tell us that a key component of excellent service is fast turnaround times so that they can differentiate themselves from the competition. First National responds to 90% of mortgage broker submissions in less than four hours. “Anyone looking to become a leader in the broker industry should consider First National as their lender of choice.” – D.I., Toronto, ON FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 7 Financial Reporting Table of Contents Management’s Discussion and Analysis Financial Statements 9 General Description of the Company 29 Management’s Responsibility for Financial Reporting 9 Basis of Presentation 30 Independent Auditors’ Report 10 Restatement of Comparative Figures 31 Consolidated Statements of Financial Position 13 2011 Results Summary 32 Consolidated Statements of Comprehensive Income 13 Outstanding Securities of the Corporation and Retained Earnings 13 Selected Quarterly Information 33 Consolidated Statements of Changes in Shareholders’ Equity 14 Selected Annual Financial Information 34 Consolidated Statements of Cash Flows for the Company’s Fiscal Year 35 Notes to Consolidated Financial Statements 15 Vision and Strategy 15 Key Performance Drivers Growth in Portfolio of Mortgages under Administration Growth in Origination of Higher Margin Mortgages Lowering Costs of Operations 16 Employing Innovative Securitization Transactions to Minimize Funding Costs 16 Key Performance Indicators 17 Determination of Adjusted Cash Flow and Payout Ratio 18 Revenues and Funding Sources 19 Results of Operations 22 Operating Segment Review Residential Segment Commercial Segment 23 Liquidity and Capital Resources 24 Financial Instruments and Risk Management 25 Capital Expenditures 25 Summary of Contractual Obligations 26 Critical Accounting Policies and Estimates 26 Future Accounting Changes 27 Risk and Uncertainties Affecting the Business 28 Forward-Looking Information 28 Outlook 8 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 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, 2012. This discus- sion should be read in conjunction with the audited consolidated financial statements of First National Financial Corporation (the “Company” or “Cor- poration” or “First National”) as at and for the year ended December 31, 2011 and the notes thereto. This discussion should also be read in conjunc- tion with the audited consolidated financial statements and notes thereto of the Company’s predecessor, First National Financial Income Fund, and First National Financial LP (“FNFLP”) for the year ended Decem ber 31, 2010. The audited consolidated financial statements of the Company have been prepared in accordance with International Financial Reporting Standards (“IFRS”). This MD&A contains forward-looking information. Please see “Forward-Looking Information” for a discussion of the risks, uncertainties and assumptions relating to these statements. The selected financial infor- mation and discussion below also refer to certain measures to assist in assessing financial performance. These other measures such as “EBITDA”, “Adjusted Cash Flow”, and “Adjusted Cash Flow per Unit” should not be construed as alternatives to net income or loss or other comparable mea- sures determined in accordance with IFRS as an indicator of performance or as a measure of liquidity and cash flow. These measures do not have standard meanings prescribed by IFRS and therefore may not be compa- rable to similar measures presented by other issuers. Unless otherwise noted, tabular amounts are in thousands of Canadian dollars. Additional information relating to the Corporation and FNFLP is avail- able in the Corporation’s profile on the System for Electronic Data Analysis and Retrieval (“SEDAR”) website at www.sedar.com. General Description of the Company First National Financial Corporation is the parent company of First National Financial LP, a Canadian-based originator, underwriter and servicer of predominantly prime residential (single family and multi- unit) and commercial mortgages. With over $59 billion in mortgages under administration (“MUA”), First National is Canada’s largest non- bank originator and underwriter of mortgages and is among the top three in market share in the growing mor tgage broker distribution channel. Pursuant to a Plan of Arrangement (the “Arrangement”) and an amalgamation (the “Amalgamation”) effective January 1, 2011, First National Financial Corporation succeeded First National Financial Income Fund (the “Fund”) as the public holding company invested in FNFLP. The Arrangement and Amalgamation (together, the “Con- version”) were used to convert the Fund into a corporate structure. The most significant steps involved in the Conversion were: • A new company, First National Financial Inc. (“FNFI”) was formed; • Unitholders of the Fund exchanged their 12,681,113 units in the Fund for shares in FNFI on a one-for-one basis; • The pre-Arrangement shareholders of the Corporation (the “Co-founders”) exchanged 47,286,316 shares in the Corporation for 47,286,316 shares of FNFI with the result that the Corporation became a wholly-owned subsidiary of FNFI; • The Fund and First National Financial Operating Trust were wound up; and • The Corporation and FNFI were amalgamated and continued under the name “First National Financial Corporation”. Basis of Presentation The financial statements of the Corporation are prepared in accor- dance with IFRS. Effectively, the Conversion reorganized the ownership interests in FNFLP such that all such interests are now consolidated and held through the Corporation in the same ratio as previously held by the Fund and by the Co-founders. Prior to the initial public offering of the Fund (the “IPO”) in June 2006, the Corporation owned and operated the business of First National. Concurrent with the IPO, the business of First National was transferred from the Corporation to FNFLP such that the Corporation then operated as a privately held holding company which owned a direct interest of 80.03% in FNFLP. At that time, the Fund indirectly held a 19.97% non-controlling inter- est in FNFLP. Given that the Conversion does not involve any arm’s- length transactions at fair market value, the Corporation has accounted for these transactions under the concept of a pooling of interests under common control. Accordingly, the Corporation’s finan- cial statements reflect the combined activities of the Fund and the Corporation prior to the Arrangement (including the consolidation of FNFLP). Immediately prior to the Arrangement, residual assets and lia- bilities of the Corporation were distributed and settled so that as of the Arrangement date, the consolidated balance sheet of the Corpo- ration substantially reflects the assets and liabilities of FNFLP at carry- ing value, plus the intangible assets represented by the excess of the purchase price paid by the Fund over the carrying value of its share of the net assets of FNFLP at the IPO date and the deferred tax liabilities related to temporary differences between the book and tax basis of the carrying value of the Fund’s investment in FNFLP. In effect this accounting treatment assumes, for comparative financial repor ting purposes, that the Conversion occurred at the time of the IPO. As all significant revenue earned by the Corporation in 2010 came from its investment in FNFLP, the effect on the comparative earnings is minimal; however, to the extent the Corporation earned revenue and incurred expenses, these are recorded in the 2010 comparative fig- ures. The Co-founders have provided indemnities to the Corporation to protect the current shareholders of the Corporation from any unrecorded liabilities incurred and unpaid by the Corporation in the period between the IPO and January 1, 2011. Accordingly, the prior year’s comparative figures have been restated to account for both the Conversion and IFRS. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 9 Restatement of Comparative Figures Conversion to a corporation Prior to the Conversion, the Fund was the public entity with an invest- ment in FNFLP, the operating entity. It accounted for its investment in FNFLP using the equity method, effectively consolidating the results of FNFLP in one line of equity pick up. Because of the limited usefulness of this financial reporting, the Company made public the results of FNFLP on a stand-alone basis ever y repor ting period. Now that FNFLP is wholly-owned by the publicly traded corporation, its assets, liabilities and results will be consolidated at the reporting issuer level, and pre- sentation of separate financial information for FNFLP will no longer be necessary. In order to present appropriate comparative information, the Company will restate the 2010 results and year end balances for FNFLP and the Fund as if FNFLP had been consolidated with the Fund and the Corporation since the IPO. This restatement is summarized below. The table takes the historical balance sheet of FNFLP as at December 31, 2010 and the income statement for the year ended December 31, 2010, and adjusts for values historically accounted for at the Fund level and the financial position and results of operations of the Corporation for the same periods. In particular, these adjustments per tain to $65.0 million of intangible assets (ser vicing rights and broker relationships) and $29.8 million of goodwill which the Fund re- corded on the IPO, and deferred tax liabilities of $57.8 million related to tax temporary differences embedded in the carrying value of the Fund’s investment in FNFLP. As at December 31, 2010, the net book value of the intangible assets was $32.5 million as these assets have been amortized since the IPO. Restatement of FNFLP’s 2010 financial results pursuant to the Conversion ($000s) First National Financial LP as previously presented December 31 2010 $ 1,149,082 – – $ 1,149,082 $ 887,722 – 887,722 261,360 As restated for First National Financial Corporation pursuant to the Conversion December 31 2010 $ 1,149,083 32,499 29,776 $ 1,211,358 $ 848,929 43,661 892,590 318,768 Conversion adjustments $ $ $ 1 32,499 29,776 62,276 (38,793) 43,661 4,868 57,408 $ 1,149,082 $ 62,276 $ 1,211,358 Year ended December 31 2010 $ 343,214 (181,787) – 161,427 – Year ended December 31 2010 $ 343,316 (183,230) (9,468) 150,618 (30,040) $ 102 (1,443) (9,468) (10,809) (30,040) $ 161,427 $ (40,849) $ 120,578 Balance sheet Operating assets Intangible assets Goodwill Total assets Operating liabilities Tax liabilities Total liabilities Equity Total liabilities and equity Income statement Revenue Expenses – operating – amortization Income before taxes Provision for taxes Net income for the period 10 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS Transition to IFRS In January 2006, the Canadian Accounting Standards Board announced its decision requiring all publicly accountable entities to report under IFRS. This decision established standards for financial reporting with in- creased clarity and consistency in the global marketplace. These stan- dards are effective for interim and annual financial statements relating to fiscal years beginning on or after January 1, 2011 and are applicable beginning with the Company’s first quarter of 2011. For the Company, this has meant a significant change in its accounting policy regarding revenue recognition, particularly in accounting for securitization trans- actions. Under Canadian GAAP, the Company’s securitizations were considered “true sales” for accounting purposes such that the Com- pany recorded gains on securitization when these mor tgages were sold to various securitization conduits. Under IFRS, these securitiza- tions do not meet the definition of a “true sale” and instead are accounted for as secured financings. Accordingly, the Company’s secu- ritizations (through ABCP conduits, National Housing Act – Mortgage Backed Securities (“NHA–MBS”) and direct Canada Mortgage Bonds (“CMB”) issuance) do not qualify for sale accounting. Its deferred placement transactions will continue to meet the criteria for off- balance sheet treatment as the risks and rewards associated with the ownership of these mor tgages have been transferred to an arm’s- length institution. The Company has restated its comparative 2010 financial state- ments as if IFRS accounting standards had been applied retroactively. This restatement eliminates all securitization receivables as at Decem- ber 31, 2009, and puts these mortgages back on the Company’s bal- ance sheet together with securitization debt related to these transactions. The restated balance sheet under IFRS as at Decem- ber 31, 2010 has a number of significant changes. As well as the rever- sal of the securitization receivables, the balance sheet also features: 1) An increase in the amount of the Company’s mortgage assets by approximately $7.2 billion; 2) An increase of $0.2 billion in restricted cash representing principal received on these mortgages in December 2010 and held in trust until the subsequent month; 3) An increase of the Company’s liabilities by an amount of $7.3 billion for notes payable associated with the securitized assets; 4) A decrease in deferred tax liabilities of $23.1 million, as the net tax-related temporary difference associated with securitization receivables has been reduced; and 5) A decrease in opening equity of $61.6 million, primarily reflecting the after-tax effect of reversing previously recognized securitization gains. The increase in mortgage assets also includes the addition of approxi- mately $47 million of unamortized deferred origination costs, primarily broker fees, which had been expensed under Canadian GAAP. The deferred origination costs will be amortized against interest revenue on the securitized mortgage portfolio over the term of the mortgages on an effective yield basis. The Company has also disclosed a restated statement of income under IFRS for the third quarter of 2010. Generally this quarter fea- tured large volumes of securitized mortgages and, accordingly, under Canadian GAAP large gains on securitization were recorded. These rev- enues are reversed under IFRS and are replaced with the net interest margin from previously recorded securitization transactions. In July 2010, the IFRS Interpretations Committee issued a staff paper which described their discussion of cer tain transition issues for “derecognition” accounting under IFRS. In particular, the extent of retroactive application of these standards for new adopters was debated. Currently the standard requires retroactive treatment for application of this accounting change, but only for transactions occur- ring after January 1, 2004. The Committee recommended that instead of this fixed date, the date should be defined as the date of transition to IFRS (or January 1, 2010 for Canadian issuers). The Committee’s recommendation has now been adopted into IFRS with an effective date of June 2011. The Company has chosen not to early adopt this standard and has accounted for the transition with retroactive applica- tion to January 1, 2004. The Company believes that to adopt this new standard would result in inconsistent financial information being presented, particularly on the balance sheet. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 11 MANAGEMENT’S DISCUSSION AND ANALYSIS The table below restates the 2010 results, as restated above for the Conversion, under IFRS. Restatement of FNFC’s 2010 financial results pursuant to IFRS ($000s) Balance sheet Mortgages pledged under securitization Securitization receivable Other operating assets Intangible assets Goodwill Total assets Debt related to securitized mortgages Operating liabilities Tax liabilities Total liabilities Equity Total liabilities and equity Income statement Revenue – gain on securitization – other Expenses – operating – amortization Income before taxes Provision for taxes Net income for the period As restated for First National Financial Corporation pursuant to the Conversion December 31 2010 $ – 157,443 991,640 32,499 29,776 $ 1,211,358 $ – 848,929 43,661 892,590 318,768 IFRS adjustments $ 7,193,961 (157,443) 156,117 – – $ 7,192,635 $ 7,274,482 2,745 – 7,277,227 (84,592) $ 1,211,358 $ 7,192,635 Year ended December 31 2010 $ 60,227 283,089 (183,230) (9,468) 150,618 (30,040) $ (60,227) 111,170 (81,604) – (30,661) – As restated for First National Financial Corporation pursuant to IFRS December 31 2010 $ 7,193,961 – 1,147,757 32,499 29,776 $ 8,403,993 $ 7,274,482 851,674 43,661 8,169,817 234,176 $ 8,403,993 Year ended December 31 2010 $ – 394,259 (264,834) (9,468) 119,957 (30,040) $ 120,578 $ (30,661) $ 89,917 12 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS 2011 Results Summary The Company was pleased with its operational results for 2011, includ- ing its transformation from an income trust to a dividend-paying cor- poration and the adoption of IFRS. Although its financial results were not as strong as the comparative results from 2010, the decrease in profitability pertains primarily to adverse capital markets conditions experienced in the third and fourth quarters. In 2011 First National continued to build its portfolio of mortgages pledged under securitiza- tion, increased overall origination volumes, and grew both net interest margin and mortgage servicing revenue. Mortgages under administra- tion continued to grow and the Company financed more mortgages directly with the CMB program. • MUA grew to $59.6 billion at December 31, 2011 from $53.3 bil- lion at December 31, 2010, an annualized increase of 12%; the growth from September 30, 2011, when mortgages under adminis- tration were $58.0 billion, was 2.8%, an annualized increase of 11%; • The Canadian single-family real estate market proved resilient despite continued economic concerns and volatile capital markets. In 2011 single-family mortgage originations for the Company in- creased by 9% to $9.1 billion from $8.3 billion in 2010. The com- mercial segment recorded even greater growth as volumes increased by 23% to $2.7 billion from $2.2 billion in 2010; • The Company securitized a significant por tion of its mor tgage origination in the CMB program in the year : $498 million in the 10-year program and $1.2 billion in the five-year term programs; • Revenue for the year ended December 31, 2011 increased to $464.0 million from $394.3 million in 2010. The growth of 18% is reflective of the increased interest revenue on securitized mort- gages, particularly floating rate mortgages indexed to the prime rate, which increased by 16% from an average of 2.58% in 2010 to 3.00% for 2011. Higher mor tgage servicing revenue, placement fees and mor tgage investment income offset the large negative charge recorded for losses on financial instruments; • The Company’s hedging program, while appropriate, accounted for $31.0 million of the net losses on financial instruments of $18.5 million. From an economic perspective, these losses are largely offset by higher values attributable to the hedged mortgages, which will be recognized in earnings over the five- and 10-year terms of the mortgages; • Income before income taxes decreased by 19.3% from $120.0 mil- lion in 2010 to $96.8 million in 2011. This decrease is due to vola- tile debt markets in the year which negatively affected the Company’s interest rate hedges. Despite this charge, the year pro- duced steady and growing income from the Company’s securitized mortgage and servicing portfolios; • EBITDA decreased by 18.8% from $131.2 million in 2010 to $106.6 million in 2011 due to the same factors cited above for income before income taxes; and • Dividends declared to common shareholders in 2011 increased 16% compared to tax-equivalent regular monthly distributions declared by the Fund in 2010. The Company celebrated its five-year anniversary as a public entity after listing on the Toronto Stock Exchange (“TSX”) on June 15, 2006. During those five and a half years to December 31, 2011, the Com- pany paid out $459 million in distributions and dividends to unithold- ers and shareholders. This represents a pre-tax return of 77% on the IPO price of $10 per unit. With the appreciation of the value of the Company since the IPO, original unitholders have earned a total pre- tax return of over 150% (at the year-end share price) on the IPO investment. Outstanding Securities of the Corporation At December 31, 2011 and February 28, 2012, the Corporation had 59,967,429 common shares, 4,000,000 Series 1, Class A preference shares and 175,000 debentures outstanding. Selected Quarterly Information Quarterly results of First National Financial Corporation ($000s, except per share amounts) Net income per common share (unit) Net income for the period Revenue Total assets 2011 $ 118,121 $ 17,687 $ 0.27 $ 11,927,270 Fourth quarter Third quarter $ 115,522 $ 12,107 $ 0.18 $ 10,754,813 Second quarter $ 121,579 $ 20,197 $ 0.32 $ 9,948,118 $ 108,798 $ 20,500 $ 0.33 $ 9,261,178 First quarter 2010 (1) Fourth quarter Third quarter Second quarter First quarter $ 116,011 $ 25,580 $ 0.43 $ 8,404,005 $ 105,238 $ 22,161 $ 0.37 $ 8,330,026 $ 90,411 $ 19,537 $ 0.32 $ 7,975,198 $ 82,599 $ 22,639 $ 0.38 $ 7,338,226 (1) 2010 figures have been restated to present comparative information to account for the Conversion and IFRS. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 13 MANAGEMENT’S DISCUSSION AND ANALYSIS Given First National’s large amount of MUA and portfolio of mort- gages pledged under securitization, quar terly revenue under IFRS is driven primarily by mortgage servicing revenue growth, and changing mortgage interest rates on mortgages pledged under securitization. Servicing will change as the portfolio of mortgages grows or contracts; however, the gross interest on the mortgage portfolio is significantly linked to the prime lending rate as the Company has pledged several billion dollars of floating rate mortgages to the NHA–MBS program. Prior to IFRS, revenue was more dependent on quarterly origination volumes and one-time securitization gains. Revenue beginning in the first quarter of 2010 onwards reflects the trend of the growing MUA and prime lending rate hikes experienced throughout 2010. The prime rate averaged 2.58% in 2010 but was 3.00% for all of 2011, an increase of 16%. In the third quar ter of 2011, and to a lesser extent in the four th quar ter, the Company was affected by volatile conditions in the debt markets and its revenue was reduced by $17.4 million and $8.4 million respectively, attributable to losses in the market value of financial instruments related to its interest rate hedging program. This issue also affected net income, which was decreased in aggregate for the quarters by approximately $15.9 million on an after-tax basis. During the eight quarters described above, except for the third and fourth quarters of 2011, mortgage spreads tightened steadily as Cana- dian capital markets returned to historical norms following the credit turmoil of 2008. This trend is evident in net income figures except for the fourth quarter of 2010, when the Company reduced the amount of mor tgages originated for its securitization program and earned increased upfront placement fee revenue, and in the third and fourth quarters of 2011, when large mark-to-market adjustments on financial instruments reduced earnings. Total assets have grown steadily as the Company has taken advantage of securitization opportunities in order to grow its mortgage assets pledged under securitization. Selected Annual Financial Information for the Company’s Fiscal Year ($000s, except per share/unit amounts) For the year then ended Income statement highlights Revenue Interest expense – securitized mortgages Brokerage fees Other operating expenses EBITDA (1) Amortization of capital assets Amortization of intangible assets Provision for income taxes Net Income Dividends/distributions declared Per share/unit highlights Net income per unit/common share Dividends/distributions declared per common share/unit At year end Balance sheet highlights Total assets Total long-term financial liabilities December 31 2011 December 31 2010 (2) December 31 2009 (2) $ 464,020 (184,291) (81,480) (91,642) 106,607 (1,856) (7,968) (26,292) 70,491 109,022 1.10 1.25 $ 394,259 (112,530) (70,718) (81,586) 131,221 (1,796) (9,468) (30,040) 89,917 89,623 1.50 1.49 $ 341,716 – (98,677) (77,807) 165,232 (1,749) – – 163,483 86,953 2.73 1.45 11,927,270 8,403,993 $ 184,689 $ 178,849 1,067,690 $ – (1) EBITDA is not a recognized earnings measure under IFRS and does not have a standardized meaning prescribed by IFRS. Therefore, 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 IFRS as an indicator 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. (2) Information for 2010 has been restated to conform to presentation under IFRS and for the Conversion. Information for 2009 has been presented using historical figures for FNFLP under Canadian GAAP. 14 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS Vision and Strategy Growth in Origination of Higher Margin Mortgages The Company provides mortgage financing solutions to virtually the entire mortgage market in Canada. By offering a full range of mort- gage products, with a focus on customer service and superior technol- ogy, the Company believes that it is the leading non-bank mortgage lender in the industry. Growth has been achieved while maintaining a relatively conservative risk profile. The Company intends to continue leveraging these strengths to lead the “non-bank” mortgage lending industry in Canada, while appropriately managing risk. The Company’s strategy is built on four cornerstones: providing a full range of mortgage solutions; growing assets under administration; employing leading-edge technology to lower costs and rationalize business processes; and maintaining a conservative risk profile. An im- portant element of the Company’s strategy is its direct relationship with the mortgage borrower. Although the Company places most of its originations with third parties, FNFLP is perceived by all of its bor- rowers 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. Through this relationship, the Com- pany can negotiate new transactions and pursue marketing initiatives. Management believes this strategy will provide long-term profitability and sustainable brand recognition for the Company. Key Performance Drivers The Company’s success is driven by the following factors: • Growth in the portfolio of mortgages under administration; • Growth in the origination of higher margin mortgages; • Lowering the costs of operations through the innovation of systems and technology; and • Employing innovative securitization transactions to minimize funding costs. The Company’s main focus has always been on the prime single-family mor tgage market. Prior to 2008, when the capital markets experi- enced some significant turbulence, these mortgages had tight spreads such that the Company’s strategy was to sell these mor tgages on commitment to institutional investors and retain the servicing. This strategy changed with the challenges in the credit environment and the Company was able to take a larger portion of the spread for itself. By the end of 2010, much of the turmoil in the capital markets had waned and mor tgage spreads returned to modest premiums over pre-crisis levels. This is most evident for five-year fixed rate single-family mor tgage rates compared to similar-term Government of Canada bonds. Prior to 2008, this comparison showed spreads of approxi- mately 1.25%. With the credit crisis, these spreads reached as high as 3.00% in 2008. Between 2009 and mid 2011, spreads gradually tight- ened as liquidity issues at financial institutions diminished and the com- petition for mor tgages increased such that at June 30, 2011, these mortgage spreads were at 1.46%. This changed with the United States credit rating downgrade and continuing global economic turmoil. Risk- free interest rates plummeted in the third quarter of 2011 and much like 2008, as bond yields dropped, mortgage rates remained constant such that the spread widened significantly. By the end of December 2011, the five-year spread was approximately 2.10%. In 2011, the Company has chosen to securitize a larger portion of its originations, both in the single-family and multi-family segments, to take advantage of these higher spreads. For all of 2011, the Company originated for securitization approximately $2.8 billion of single-family mortgages and $1.2 billion of fixed multi-residential mor tgages in order to take advantage of these wider spreads. In the year, the Company securi- tized approximately $1.1 billion of floating rate single-family mortgages, $833 million of fixed single-family mortgages and over $1 billion of fixed multi-residential mortgages. Growth in Portfolio of Mortgages under Administration Lowering Costs of Operations Management considers the growth in MUA to be a key element of the Company’s performance. The por tfolio grows in two ways: through mortgages originated by the Company and through mortgage servicing portfolios purchased from third parties. Mortgage origina- tions not only drive placement and securitization revenues, but, perhaps more importantly, longer term values such as servicing fees, mortgage administration fees, renewal opportunities and growth in customer base for marketing initiatives. As at December 31, 2011, MUA totalled $59.6 billion, up from $53.3 billion at December 31, 2010, a rate of increase of 12%. This compares to $58.0 billion at September 30, 2011, representing a quarter-over-quarter increase of 2.8% and an annualized increase of 11%. 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 underwrit- ing system, Canada’s only web-based real-time broker information sys- tem. By creating a paperless, 24/7-available commitment management platform for mortgage brokers, the Company is now ranked among the top three lenders by market share in the broker channel. This has translated into increased single-family origination volumes and higher closing ratios (the percentage of mortgage commitments the Com- pany issues that actually become closed mortgages). FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 15 MANAGEMENT’S DISCUSSION AND ANALYSIS Preferred share issuance On January 25, 2011, the Company issued 4,000,000 Series 1 Class A preference shares for gross proceeds of $100 million. The Company received net proceeds of $97.4 million after issuance costs net of de- ferred tax assets of $0.9 million. These shares are rate reset preferred shares having a stated 4.65% annual dividend rate, subject to Board of Director approval, and a par of $25 per share. The rate reset feature is at the discretion of the Company such that after the initial five-year term, the Company can choose to extend the shares for another five- year term at a fixed spread (2.07%) over the yield of the then relevant Government of Canada bond. While the investors in these shares have an option on each five-year anniversary to convert their Series 1 holdings into Series 2 preference shares (which pay floating rate divi- dends), there are no redemption options for these shareholders. As such, the Company considers these shares to represent a perma- nent source of capital and classifies the shares as equity on its balance sheet. Management believes this capital will give the Company the opportunity to pursue its strategy of increased securitization, which requires upfront investment. Employing Innovative Securitization Transactions to Minimize Funding Costs Approval as both an issuer of NHA–MBS and seller to the Canada Mortgage Bonds program The Company has been involved in the issuance of NHA–MBS since 1995. This program has been very successful, with over $5 billion of NHA–MBS issued. In December 2007, the Company was approved by Canada Mortgage and Housing Corporation (“CMHC”) as an issuer of NHA–MBS and as a seller into the CMB program. Issuer status has provided the Company with a funding source that it can access inde- pendently. Perhaps more importantly, seller status for the CMB gives the Company direct access to the CMB. Generally, the demand for high-quality fixed and floating rate investments increased significantly with the turmoil in 2009. This demand has continued into 2011 and allowed the Company to securitize almost $3 billion of mor tgages through the NHA–MBS program during the year, including $872 million in the fourth quarter. Canada Mortgage Bonds program The CMB program is an initiative sponsored by CMHC whereby the Canada Housing Trust (“CHT”) issues securities to investors in the form of semi-annual interest-yielding five- and 10-year bonds. The pro- ceeds of these bonds are used to buy NHA–MBS. In previous years, the Company entered into an agreement with a Canadian bank that allowed the Company to indirectly sell a portion of the Com pany’s residential mortgage origination into several CMB issuances. Subse- quently, pursuant to the Company’s approval as a seller into the CMB, the Company was able to make direct sales into the program. Because of the similarities to a traditional Government of Canada bond (both have five- and 10-year unamortizing terms and a federal government guarantee), the CMB trades in the capital markets at a modest premi- um to the yields on Government of Canada bonds. The ability to sell into the CMB has given the Company access to lower costs of funds on both single-family and multi-family mor tgage securitizations. Because these funding structures do not amortize, the Company can fund future mortgages through this channel as the original mortgages amortize or pay out. The Company also enjoys significant demand for mortgages from investment dealers who sell directly into the CMB. Because of the effectiveness of the CMB, there have been requests from approved CMB seller s for lar ger issuances. CHT has indicated that it will not unduly increase the size of its issuances and has created guidelines through CMHC that limit the amount that can be sold by each seller into the CMB each quar ter. The Company is also subject to these limitations. Key Performance Indicators The principal indicators used to measure the Company’s perfor- mance are: • Earnings before income taxes, depreciation and amor tization (“EBITDA”); and • Adjusted cash flow from operations (“Adjusted Cash Flow”). EBITDA is not a recognized measure under IFRS. However, manage- ment believes that EBITDA is a useful measure that provides investors with an indication of cash income prior to capital expenditures. EBITDA should not be construed as an alternative to net income de- termined in accordance with IFRS or to cash flows from operating, investing and financing activities. The Company’s method of calculating EBITDA may differ from other issuers and, accordingly, EBITDA may not be comparable to measures used by other issuers. 16 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS($000s) For the period Revenue Income before income taxes EBITDA (1) At period end Total assets Mortgages under administration Quarter ended Year ended December 31 2011 December 31 2010 (2) December 31 2011 December 31 2010 (2) $ 118,121 24,287 26,347 $ 116,011 33,029 35,938 $ 464,020 96,783 106,607 $ 394,259 119,957 131,221 11,927,270 59,598,596 8,403,993 53,293,132 11,927,270 59,598,596 8,403,993 53,293,132 (1) This non-IFRS measure adjusts income before income taxes by adding back expenses for amortization of intangible and capital assets. (2) December 2010 figures have been restated for the Conversion and transition to IFRS. Adjusted Cash Flow is not a defined term under IFRS. Management believes that net cash generated by the Company prior to investing and financing activities is an important measure for investors to moni- tor. Management cautions investors that, due to the Company’s nature as a mortgage seller and securitizer, there will be significant variations in this measure from quarter to quarter as the Company collects and invests cash from mortgage transactions. Adjusted Cash Flow is deter- mined by the Company as cash provided from operating activities in- creased/decreased by the change in mortgages accumulated for sale or securitization in the period. Mortgages accumulated for sale or se- curitization consist primarily of mortgages that the Company funds ahead of securitization transactions. Normally during the month after funding, the Company aggregates all relevant mortgages “warehoused” to date and creates a pool to sell to the NHA–MBS market. As the Company typically raises term debt through the securitization markets on these mortgages in the months subsequent to the month of fund- ing, there are large amounts of cash invested at quar ter ends. The Company’s credit facilities provide full financing for the majority of these mortgage loans. Accordingly, management believes the measure of Adjusted Cash Flow is only meaningful if the change in mortgages accumulated for sale between reporting periods is accounted for. Determination of Adjusted Cash Flow and Payout Ratio ($000s) Quarter ended Year ended For the period Cash provided by (used in) operating activities Add (deduct): Cash provided (used) related to pre-amalgamation shareholders of FNFC Change in mortgages accumulated for sale or securitization between periods Adjusted cash flow (1) Less: cash dividends on preference shares December 31 2011 December 31 2010 December 31 2011 December 31 2010 $ (124,025) $ 77,834 $ (456,358) $ 165,323 – 412 – 29,746 129,256 (36,293) 532,802 5,231 (1,163) 41,953 – 76,444 (3,154) (64,723) 130,346 – Adjusted cash flow available for common shareholders $ 4,068 $ 41,953 $ 73,290 $ 130,346 Adjusted cash flow per common share ($/share) (1) Dividends/distributions declared on common shares/units Dividends/distributions declared per common share/unit ($/share)/($/unit) Payout ratio 0.07 18,740 0.31 443% 0.70 34,303 0.57 81% 1.22 74,960 1.25 102% 2.17 114,444 1.91 88% (1) These non-IFRS measures adjust cash provided by (used in) operating activities by accounting for changes between periods in mortgages accumulated for sale or securitization and mortgage securitization activity. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 17 MANAGEMENT’S DISCUSSION AND ANALYSIS For the year ended December 31, 2011, the payout ratio was 102%. For the year ended December 31, 2010, the payout ratio was 88%. The increase in the payout ratio is a result of the higher dividend declared in 2011 compared to the tax-adjusted distributions made in 2010. The Company paid dividends in 2011 based on an annual rate of $1.25 per share. This rate is after provision for corporate income taxes and can only be compared to the distributions of the Fund if the distributions are adjusted on the same tax basis. The $1.50 annual distribution rate of the Fund in 2010 represents approximately $1.08 on an after-tax basis. Accordingly, the current dividend rate of $1.25 per share represents an increase of 16% from the prior year. Together with payments on account of income tax, the Company distributed $108.0 million in 2011 or $18.1 million more than in 2010, on a tax equivalent basis. If the Company had chosen to distribute the same after-tax equivalent as in 2010, the payout ratio in 2011 would have been approximately 89%. For the fourth quarter of 2011, the payout ratio was 443%. This large ratio is reflective of the large unrealized losses on account of the Company’s hedging progr am incur red in the third quar ter. Although accrued for accounting purposes in the third quarter, these losses became cash losses in the fourth quarter when the Company closed out its hedge positions. Without these items, the payout ratio for the quarter would have been 132%. The increase in the ratio from the full year’s ratio of 102% is due to the Company’s increased invest- ment in its prime ABCP program in the quarter. Note that in the year, the Company reclassified its cash flow activi- ties related to mortgage securitization. The reclassification effectively increased cash used in investing activities by $1,752,800 for the year ended December 31, 2010. The cash provided by financing activities decreased by $1,857,460 for the year ended December 31, 2010. This effected a decrease in operating cash flows of $14,712 for the year ended December 31, 2010. Revenues and Funding Sources Mortgage origination The Company derives a significant amount of its revenue from mort- gage origination activities. The majority of mortgages originated are funded by either placement with institutional investors or securitiza- tion 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 year ended December 31, 2011, origination volume increased from $10.5 billion to $11.8 billion, or 12%, compared to 2010. revenue recognition and instead are accounted for as secured financ- ings. These mortgages remain as mortgage assets of the Company for the full term and are funded with securitization-related debt. Of the Company’s $11.8 billion of originations for the year ended Decem ber 31, 2011, $4.0 billion was originated for securitization through the NHA–MBS or ABCP markets. Approximately $980 million of this origination is currently funded with ABCP-related debt. Placement fees and gain on deferred placement fees The Company recognizes revenue at the time that a mortgage is placed with an institutional investor. Cash amounts received in excess of the mortgage principal at the time of placement are recognized in revenue as “placement fees”. The present value of additional amounts expected to be received over the remaining life of the mortgage sold (excluding normal market based servicing fees) is recorded as a “deferred place- ment fee”. A deferred placement fee arises when mor tgages with spreads in excess of “normalized” spreads are sold. Investors prefer paying the Company over time as they earn net interest margin on such transactions. Upon the recognition of a “deferred placement fee”, the Company establishes a “deferred placement fee receivable” that is amor tized as the fees are received by the Company. Of the Company’s $11.8 billion of originations for the year ended Decem- ber 31, 2011, $6.8 billion was placed with institutional investors and $710 million was originated for institutional investors involved in the issuance of NHA–MBS. For all institutional placements and mortgages sold to institutional investors for the NHA–MBS market, the Company earns placement fees. Revenues based on these originations are equal to either (1) the present value of the excess spread, or (2) an origination fee based on the outstanding principal amount of the mor tgage. This revenue is received in cash at the time of placement. In addition, under certain circumstances, additional revenue from institutional placements and NHA–MBS may be recognized as “Gain on deferred placement fees” as described above. Mortgage servicing and administration The Company services virtually all mortgages generated through its mortgage origination activities on behalf of a wide range of institution- al 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 reve- nues, fees related to mortgage administration are earned by the Com- pany throughout the mortgage term. Another aspect of servicing is the administration of funds held in trust, including borrower’s property tax escrow, reserve escrow 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 provided. The Company has negotiated favourable interest rates on these funds with the chartered banks that maintain the de- posit accounts, which has resulted in significant interest revenue. Securitization The Company securitizes a portion of its origination through various vehicles, including NHA–MBS, CMB and asset-backed commercial paper. Although legally these transactions represent sales of mortgages, for accounting purposes, they do not meet the requirements for In addition to the interest income earned on securitized mortgages and deferred placement fees receivable, the Company also earns inter- est income on mortgage-related assets, including mortgages accumulat- ed for sale or securitization, mor tgage and loan investments and purchased mortgage servicing rights. 18 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSISResults of Operations The following table shows the volume of mortgages originated by First National and mortgages under administration for the periods indicated: ($ millions) Mortgage originations by asset class Single-family residential Multi-unit residential and commercial Total Funding of mortgage originations by source Institutional investors – residential Institutional investors – multi-unit/commercial NHA–MBS for institutional investors NHA–MBS / CMB / ABCP securitization Internal Company resources Total Mortgages under administration Single-family residential Multi-unit residential and commercial Total Total mortgage origination volumes increased in the year by 12% as both multi-unit residential and single-family origination experienced a strong year despite some unfavourable economic indicators. Total com- mercial segment originations increased by 24% from 2010 as historically low interest rates spurred real estate owners to enter into purchase and refinance transactions, particularly for 10-year terms. Similar incen- tives affected the single-family segment where volumes increased by 9% over 2010. Single-family volumes have also increased as some smaller lenders have exited the market as tighter spreads and in- creased capital requirements have made the returns from investing in prime mortgages lower than in the previous three years. Origination for direct securitization in the NHA–MBS, CMB and ABCP programs increased from $3.0 billion in 2010 to about $4.0 billion in 2011. The change represents an increase in multi-family origination of approxi- mately $678 million and an increase of approximately $348 million in single-family origination. This was the result of the Company’s decision to securitize more of its own origination directly and use its capital base efficiently. For the fourth quarter of 2011 overall origination in- creased by 6% to $2.9 billion from $2.75 billion in 2010. This increase reflects a 1% increase in single-family origination figures between the periods and a 23% increase in the multi-unit residential and commer- cial segment and is consistent with the trends experienced throughout the year. Quarter ended Year ended December 31 2011 December 31 2010 December 31 2011 December 31 2010 $ $ $ 2,121 796 $ 2,106 645 $ 9,083 2,719 $ 8,324 2,187 2,917 $ 2,751 $ 11,802 $ 10,511 $ $ 1,158 255 68 1,354 82 1,758 154 351 442 46 $ 6,099 696 710 4,047 250 5,713 531 1,081 3,021 165 $ 2,917 $ 2,751 $ 11,802 $ 10,511 $ 42,251 17,348 $ 36,948 16,345 $ 42,251 17,348 $ 36,948 16,345 $ 59,599 $ 53,293 $ 59,599 $ 53,293 For the latter part of 2011, Canadian capital markets were volatile. Continued global economic issues and a slowing recovery have meant a movement of capital from the equity markets to bond markets, such that bond prices were bid up and yields fell. The mor tgage market moved in step with these indicators. For the Company, these condi- tions had some significant impacts on its third quar ter 2011 results. As an originator of mor tgages, the uncer tain economic conditions made for a low rate environment, making it marginally easier for the Company to originate mortgages. However, declining bond yields had a negative impact on the Company’s hedging programs. The Company puts interest rate hedges on the fixed rate mortgages that it intends to finance through securitization. Those hedges are unwound as securiti- zation-related debt is raised. Because bond yields decreased through the quarter, the Company realized lower interest rates on these debts compared to the related mortgage interest rates but incurred losses on the hedges. Although these hedges were effective for the Company, IFRS accounting requires such hedge losses to be recognized in the period while the additional interest rate spread earned on the better funding execution will be recognized over the five- and 10-year terms of the mor tgages. As such the current year’s net income has been negatively affected by such accounting. Total revenues for the year ended December 31, 2011 increased by about 18% compared to 2010, from $394.3 million to $464.0 million. This increase resulted from the larger portfolio of mortgages pledged under securitization and higher mortgage rates thereon. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 19 MANAGEMENT’S DISCUSSION AND ANALYSIS Net interest – securitized mortgages Comparing the year ended December 31, 2011 to the year ended December 31, 2010, net interest – securitized mortgages increased 18% to $69.8 million from $59.0 million. The increase is due to a larger portfolio of securitized mortgages offset by tighter weighted-average spreads on the portfolio compared to those spreads a year ago. The portfolio of mortgages funded by securitization grew from $5.5 billion as at Januar y 1, 2010 to $7.2 billion as at December 31, 2010 to $9.8 billion as at December 31, 2011. However, the market for prime mortgages became more competitive during this period. At Decem- ber 31, 2010, the Company’s securitized mortgage portfolio earned gross spreads of approximately 1.37%. By December 31, 2011, as higher- spread securitizations amortized down and new securitizations were entered into at tighter spreads, the weighted average gross spread decreased to 1.11%. Net interest is also affected by the amortization of deferred origination costs that are capitalized on these mortgages and the provision for credit losses. Credit losses were minimal in the quarter as the Company’s exposure to uninsured mortgages is declin- ing, par ticularly as the Alt-A and small conventional mor tgages programs run off. Placement fees Placement fee revenue increased 3% to $110.0 million from $107.3 mil- lion. This increase is due to the growth in origination volumes for insti- tutional placement and the value of renewed mor tgages sold to institutional investors. Total origination volumes which drive placement fees, consisting of multi-unit residential mortgages for the third-party MBS program together with mor tgages originated for institutional investors, increased by 2% from 2010 to 2011. The Company also earned $9.6 million of placement fees related to renewals in the year, an increase of $6.2 million from 2010, accounting for an increase in placement fees. Gains on deferred placement fees Gains on deferred placement fees revenue decreased 49% to $6.7 million from $13.1 million. The decrease was due to lower vol- umes and tighter mortgage spreads on multi-unit residential mortgages originated for institutional MBS issuers. Volumes decreased from $1.1 billion in 2010 to $710 million, or by 34%, and the margins on these transactions narrowed from those realized in 2010. Mortgage servicing income Mor tgage ser vicing income increased 12% to $82.4 million from $73.8 million. This was primarily due to the growth in the amount of the mor tgage por tfolio under administration, which grew by 12% year-over-year. A significant portion of this growth in the past year has been for mortgages pledged under securitization, particularly for the Company’s NHA–MBS program. These mortgages earn net interest spread for the Company such that there are no servicing fees earned on these mor tgages. Despite the growth of this component of the mortgage portfolio, the Company continued to earn administration fees on these mortgages and comparatively more net interest income on the trust funds it administers. These components of overall servic- ing income have offset the slower growth experienced in the third- party portfolio of mortgages under administration. 20 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Mortgage investment income Mor tgage investment income increased 38% to $29.3 million from $21.2 million. The change is due primarily to the Company’s larger se- curitization program. As the Company elects to securitize more of its origination, mortgages accumulated for sale or securitization increase and earn the Company higher interest income in the warehouse period prior to securitization. This is particularly true for the CMB, for which the warehousing period is as long as four months. The remaining change is a combination of offsetting factors, including different bond yields than in the comparative quar ter (which affect the interest earned on deferred placement fees receivable), rising prime lending rates (which affect gross revenues on mortgage and loan investments), and increased amounts of mortgage and loan investments held during the comparative quarters. Realized and unrealized gains (losses) on financial instruments For First National, this line item typically consists of two components: (1) gains and losses related to the Company’s economic hedging activ- ities, and (2) gains and losses related to holding term assets derived using discounted cash flow methodology. Much like the short bonds which the Company uses for hedging, the term assets are affected by changes in credit markets and Government of Canada bond yields (which form the risk-free benchmarks used to price the Company’s deferred placement fees receivable, mortgages designated as held for trading (primarily those funded through ABCP) and some of its mort- gage and loan investments). The Company uses shor t Government of Canada bonds (pri- marily CHT-issued bonds) together with repurchase agreements to create forward interest rate contracts to hedge interest rate risk associated with fixed rate mortgages originated for its own securitiza- tion purposes. For accounting purposes, these do not qualify as valid in- terest rate hedges as the bonds used are not “derivatives” but simple cash-based financial instruments. In 2010 and prior periods, gains and losses on such hedges were offset by higher or lower securitization gains as both were recognized in the same period. Under IFRS, hedging gains or losses are still recorded in the period in which the securitization debt is taken on; however, the offsetting securitization gains are not recorded. Instead, the resulting economic gain will be reflected in wider or narrower spreads on the mortgages pledged for securitization and will be realized in net interest margin over the terms of the mortgages and the related debts. In the first quarter of 2011, the Company recorded gains on these hedges of $2.3 million. In the second quar ter of 2011, the Company recorded losses of $7.5 million on these hedges. Because of the significant decline in bond yields, in the third quarter of 2011 the Company recorded losses of $17.4 million on these hedges. Bond yields continued downward in the fourth quarter as issues on sovereign European debt chased Canadian investors from the equity markets into the bond markets. Although not as severe as experienced in the third quarter of 2011, the Company recorded losses of $8.4 million on its hedging activity in the four th quarter of 2011. Accordingly, the gross spread on the related portfolio of securitized mortgages going forward will be relatively higher as the Company’s testing indicates that the hedges were appropriate. MANAGEMENT’S DISCUSSION AND ANALYSISUncer tainty about the global economy, par ticularly in the Euro- pean Union and the US, led to a significant decrease in bond yields in the year. Generally, five-year Government of Canada bond yields declined significantly from approximately 2.6% at the beginning of the year to 1.3% at the end of the year. Accordingly, the Company’s deferred placement fees receivable and approximately $5 million of mortgages in mortgage and loan investments are more valuable on a comparative basis at year-end than at the end of 2010. The Company recorded gains related to holding these assets of $2.2 million in the year. Those portions of the Company’s mortgages which are held at fair value (primarily those funded through ABCP), also benefited from this change in yields. The fair value of these mortgages increased as market mortgage rates decreased for similar term mortgages. Imbed- ded credit losses in the Company’s pricing model improved and expo- sures to credit losses lessened as the Alt-A program continued to run off. In total for the year, the Company recorded gains in respect of ABCP funded mortgages (net of unrealized losses on related interest rate swaps) of $11.2 million. The changes in fair value related to the Company’s interest rate swaps, excluding those on the Company’s ABCP-funded mortgages, had a negative impact on the Company’s results. The Company re- corded net losses of about $0.8 million in the year. Generally, these losses resulted from lower bond yields, which made the value of the Company’s pay-fix swap positions less valuable than their market value at the end of the previous year. Brokerage fees expense Brokerage fees expense increased 15% to $81.5 million from $70.7 million. This increase is largely explained by the increase in sin- gle-family origination between the years, which increased by 9%. The Company’s securitization policy has also affected the increase of these fees. In 2011, the Company capitalized $30.6 million of single-family bro- ker fees to securitized mortgages. In 2010 this amount was $32.6 mil- lion. By adding these amounts back to the amounts expensed above, the Company’s total expenditure on broker fees grew by approxi- mately 8.4% from 2010 to 2011 in line with the expected 9% growth in origination volumes. Salaries and benefits expense Salaries and benefits expense increased 9% to $48.8 million from $44.7 million. The increase is due primarily to employee costs associ- ated with residential mortgage origination. The Company compensates its sales staff with commissions based on origination volumes com- pared to quotas. Because of the increased residential origination in the year of 9%, this compensation increased by $2.6 million year-over-year. The remaining increase is for increased requirements to administer a larger portfolio of mortgages. As at December 31, 2011, the Company had 574 employees, compared to 536 as at December 31, 2010. Man- agement salaries were paid to the two senior executives (Co-found- ers) who indirectly each own about 40% of FNFC’s common shares. The current period’s expense is as a result of the compensation arrangement executed on the closing of the initial public offering. Interest expense Interest expense increased 18% to $16.0 million from $13.6 million. As discussed in the “Liquidity and cash resources” section of this analy- sis, the Company warehouses a portion of the mortgages it originates prior to settlement with the ultimate investor or funding with a securi- tization vehicle. The Company uses a por tion of the debenture to- gether with a credit facility with a syndicate of banks and 30-day repurchase facilities to fund the mor tgages during this period. The Company renewed the credit facility in May 2011 for a three-year term and a total commitment of $125 million. The overall interest ex- pense has increased from the prior period due to the increased use of repurchase facilities to warehouse the larger amounts of mortgages originated for the CMB. As at December 31, 2011, the Company borrowed $664 million using these facilities, compared to $174 million as at December 31, 2010. Generally, interest expenses would have been greater but for the increased use of 30-day repurchase agree- ments instead of bank debt, which has saved the Company approxi- mately 0.95% in marginal interest rates. This expense has increased by 18% despite the increased use of warehouse borrowing facilities and the increase of overnight base borrowing rates, which have risen from an average of 0.71% for 2010 to 1.20% for 2011. Other operating and amortization of intangibles expenses These expenses increased 12% to $36.7 million from $32.8 million. During 2011, the Company expensed $8.1 million of hedging costs associated with the direct securitization of multi-unit residential and single-family mor tgages into the NHA–MBS market. In 2010, these costs amounted to $1.8 million as the Company securitized primarily floating rate mortgages which do not require such hedging. In 2011 operating expenses include $8.0 million (2010 – $9.5 million) for the amortization of intangible assets. In periods prior to 2011, this expense was incurred at the Fund level. During 2010, the Company incurred some one-time expenses totalling approximately $1.0 million related to the issuance of the debenture and the conversion to a corporation. The remaining change in these expenses represents the cost of additional servicing requirements for a larger portfolio of mortgages under administration. Income before income taxes and EBITDA Income before income taxes decreased 19% to $96.8 million from $120.0 million. The decrease in earnings was mainly the result of the $22.9 million of unfavourable losses related to the Company’s eco- nomic hedging program. Without the impact of all gains and losses on financial instruments, the Company’s financial results are approximate- ly 2% better than those recorded in 2010. EBITDA decreased 19% to $106.6 million from $131.2 million. The decrease was due to the same factors described for income before income taxes. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 21 MANAGEMENT’S DISCUSSION AND ANALYSIS Provision for income taxes The provision for taxes decreased 12% to $26.3 million from $30.0 million. The 2010 tax provision relates to deferred taxes which the Company accrued while it operated as an income trust plus cur- rent and deferred taxes accrued at the First National level, which are included in the comparative figures. The Fund was a mutual fund trust for income tax purposes. As such, the Fund was only taxed on any amount of taxable income not distributed to unitholders. While it existed, the Fund distributed substantially all of its taxable income to its unit holders such that it did not have any current tax liabilities. To the extent that the Fund’s accounting income earned from FNFLP was greater than the taxable income allocated to it by FNFLP, a deferred tax provision was recorded. No deferred tax provision was recorded for timing differences in accounting and taxable income scheduled to reverse prior to January 1, 2011; however, First National was liable for full tax on the portion of the par tnership’s income that would ulti- mately be earned by it. Generally the tax provision is lower due to the lower earnings recorded in 2011. 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 residential and commercial mortgages), as summarized below. Operating business segments ($000s, except percent amounts) Quarter ended Originations Percentage change Revenue Percentage change Income before income taxes Percentage change Period ended Identifiable assets Mortgages under administration Residential Commercial December 31 2011 December 31 2010 December 31 2011 December 31 2010 $ $ 9,083,331 9.1% 351,497 17.9% 82,896 (7.4%) $ $ 8,323,373 $ 298,011 $ 89,559 $ $ 2,719,100 24.3% 112,523 16.6% 13,887 (54.3%) $ $ 2,187,410 $ $ 96,248 30,398 December 31 2011 December 31 2010 December 31 2011 December 31 2010 $ 9,010,099 $ 42,251,220 $ 6,475,641 $ 36,948,100 $ 2,887,395 $ 17,347,376 $ 1,898,576 $ 16,345,032 Residential Segment Commercial Segment Residential revenues increased by about 18% although origination increased by about 9% between 2011 and 2010. The higher revenue relative to origination is attributable to higher interest revenue on securitized mor tgages, which increased with the prime rate, which increased by 16% over 2010. The decrease in net income before income taxes is par tially due to gains in fair value of $6.6 million earned in 2010. In 2011 the Company incurred $5.0 million of losses in fair value. Eliminating the effect of such revenue, net income before tax would have increased in 2011 by 6% from 2010, similar to the growth in origination. Identifiable assets have increased from those at December 31, 2010, as the Company added almost $2.0 billion of net single-family mor tgages to mor tgages pledged under securitization. The Company also increased the amount of securities purchased under resale agreements by approximately $300 million to hedge the larger pipeline of single-family fixed rate mortgages. Commercial revenues increased by 17% from the prior year despite the unfavourable mark to market on the Company’s hedging program on the multi-unit residential CMB program, which reduced revenue by approximately $13.5 million for the year. Eliminating the effect of such gains, revenue would have increased in 2011 by 32% from 2010, in line with the growth of origination volumes plus higher interest income on securitized mor tgages, increased amounts from mor tgage servicing and mortgage and loan investment interest revenue, which offset tighter margins on placement activities. Net income before tax, excluding the impact of fair value adjustments, fell by 8% or about $2.3 million from 2010 to 2011. The decrease was a result of the Company undertaking to securitize more of its origination directly. Not only was revenue off- set by larger interest expenses on higher amounts of securitization debt, but hedging expenses increased by $3.9 million and warehouse interest expense increased by almost $1 million. Identifiable assets 22 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSIS have increased from those at December 31, 2010, as the Company securitized approximately $1.0 million of multi-unit residential mort- gages through the NHA–MBS market in 2011 and increased mortgages pledged under securitization. Liquidity and Capital Resources The Company’s fundamental liquidity strategy has been to invest pri- marily in prime Canadian mortgages. Management’s belief has always been that these mortgages are considered “AAA” by investors and will always be well bid and highly liquid. This strategy proved effective during the turmoil experienced in 2007 through 2009 when capital markets retreated and only the highest-quality assets were traded. As the Company’s results have shown, First National had little, if any, trouble finding investors to purchase its mortgage origination at prof- itable margins. As a mortgage originator and securitizer, the Company requires significant cash resources to purchase and hold mortgages prior to selling to institutional investors or prior to arranging for term debt through the securitization markets. For this purpose, the Com- pany uses the combination of the $175 million debenture financing and the Company’s revolving bank credit facility. This aggregate indebt- edness is typically used to fund: (1) mortgages accumulated for sale or securitization, (2) deferred placement fees receivable, (3) the origina- tion costs associated with securitization, and (4) mortgage and loan in- vestments. The Company has a credit facility with a syndicate of four banks for a total credit of $125.0 million. This facility was renewed in May 2011 for a three-year term. Bank indebtedness may also include borrowings obtained through overdraft facilities. At December 31, 2011, the Company has entered into repurchase transactions with fi- nancial institutions to borrow $664.4 million related to $688.3 million of mortgages held in mortgages accumulated for sale or securitization on the balance sheet. At December 31, 2011, outstanding bank indebtedness at FNFLP was $80.6 million (December 31, 2010 – $23.8 million). Together with the debenture financing of $175 million (December 31, 2010 – $175 million), this “combined debt” was used to fund $162.6 million (December 31, 2010 – $139.5 million) of mortgages accumulated for sale or securitization. At December 31, 2011, the Company’s other interest-yielding assets included: (1) deferred placement fee receivable of $58.5 million (December 31, 2010 – $77.4 million); and (2) mort- gage and loan investments of $111.7 million (December 31, 2010 – $70.9 million). The difference between “combined debt” and the mortgages accumulated for sale or securitization funded by it, which the Company considers a proxy for true leverage, has increased between December 2010 and December 2011, and now stands at $93.0 million (December 31, 2010 – $65.7 million). This represents a debt-to-equity ratio of approximately 0.31 to 1, which the Company believes is at a conservative level. This ratio has increased from 0.25 to 1.00 as at December 31, 2010 as the Company has fully invested the proceeds of the preferred shares in $40.8 million in mor tgage and loan investments, $19.2 million in cash held as collateral under secu- ritization and approximately $30 million in net mor tgages pledged under securitization. The Company funds a large portion of its mortgage originations for institutional placement on the same day as the advance of the re- lated mortgage. The remaining originations are funded by the Com- pany on behalf of institutional investors or pending securitization on the day of the advance of the mortgage. On specified days, sometimes daily, the Company aggregates all mortgages warehoused to date for an institutional investor and transacts a settlement with that institu- tional investor. A similar process occurs prior to arranging for term funding through securitization. The Company uses a por tion of the committed credit facility with the banking syndicate to fund the mort- gages during this warehouse period. The credit facility is designed to be able to fund the highest balance of warehoused mor tgages in a month and is normally only partially drawn. The Company also invests in short-term mortgages, usually for six- to 18-month terms, 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. As these investments return cash, it will be used to pay down this bank indebt- edness. The syndicate has also provided credit to finance a portion of the Company’s deferred placement fees receivable and the origination costs associated with securitization as well as other miscellaneous longer-term financing needs. A portion of the Company’s capital has been employed to support its ABCP and NHA–MBS programs, primarily to provide credit en- hancements as required by rating agencies. In June 2011, CMHC issued new regulations regarding the timing of mortgage title transfer to its custodian. The notice requires that cash collateral be posted immedi- ately on pool settlement with the custodian for all mortgages not regis- tered with the custodian on a dollar-for-dollar basis. Due to the difficulty in obtaining evidence from land registry offices on a timely basis, the Company has posted collateral for the missing registrations. At Decem- ber 31, 2011, $9.3 million (December 31, 2011 – $nil) of this collateral was held by the custodian. The collateral will be repaid to the Company as registration is subsequently evidenced to the custodian on these mortgages. The other significant portion of cash collateral is the invest- ment made on behalf of the Company’s ABCP programs. As at Decem- ber 31, 2011, the investment in cash collateral was $47.6 million. Although both the Alt-A and small commercial loan programs have been discontinued, no further portion of the cash collateral for these programs will be recovered by the Company until these programs ter- minate fully in approximately two years, as the programs are subject to minimum enhancement levels. As the Alt-A program has paid down, the ratio of defaulted mortgages to the total mortgages in the program has become skewed. In order to keep these ratios at an acceptable level for rating agencies, the Company repaid face value debt from the Trust in 2011 of approximately $10.6 million related to defaulted mortgages. The Company received $15.6 million (face value) on the liquidation of previously repurchased mor tgages during the same period, experi- encing credit losses at expected levels. At December 31, 2011, the Company employs an assumption for the fair value of credit losses in the Alt-A program of 0.70% per annum. To date, this assumption has been more than enough to absorb all actual losses experienced in the program. The Company believes that prudent management of this pro- gram will continue to require some level of liquidity from the Company throughout its remaining term. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 23 MANAGEMENT’S DISCUSSION AND ANALYSIS As demonstrated previously, the Company continues to see strong demand for its mor tgage product from institutional investors and liquidity from bank-sponsored commercial paper conduits. The Com- pany’s strategy of using diverse funding sources has allowed the Company to thrive, producing record profitability in 2009 and 2010. By focusing on the prime mortgage market, the Company believes it will continue to attract bids for mortgages as its institutional custom- ers seek government-insured assets for investment purposes. The Company also believes it can manage any liquidity issues that would arise from a year-long slowdown in origination volumes. Based on cash flow received in the fourth quarter of 2011, the Company will receive approximately $66 million of cash, on an annualized basis, from its ser- vicing operations and $100 million of annualized cash flow from secu- ritization transaction spread and deferred placement fees receivable. Together, on an after-tax basis, this $120 million of annual cash flow would be more than sufficient to support the indicated annual divi- dends of $75 million on the common shares and the $4.65 million on the preferred shares. Although this is a simplified analysis, it does high- light the sustainability of the Company’s business model and dividend policy through periods of economic weakness. As described earlier, the Company issued 4,000,000 Series 1 pre- ferred shares at a price of $25.00 per share for gross proceeds of $100 million, before issue expenses. The net proceeds of $96.7 million were invested in FNFLP as par tners’ capital. The issuance gives the Company additional capital which will allow it to undertake greater volumes of securitization transactions directly and reduce reliance on institutional investors as a funding source. The Company’s Board of Directors has elected to pay dividends, when declared, on a monthly basis for the outstanding common shares and on a quarterly basis for the outstanding preferred shares. For purposes of the enhanced dividend tax credit rules contained in the Income Tax Act (Canada) and any corresponding provincial and territorial tax legislation, all dividends (and deemed dividends) paid by us to Canadian residents on our common and preferred shares after December 31, 2010 are designated as “eligible dividends”. Unless stated otherwise, all dividends (and deemed dividends) paid by us hereafter are designated as “eligible dividends” for the purposes of such rules. For the preferred shares, the Company has elected to pay any tax under Part VI.1 of the Income Tax Act, such that corporate holders of the shares will not be required to pay tax under Par t VI.1 of the Income Tax Act on dividends received on such shares. Financial Instruments and Risk Management The Company has elected to treat deferred placement fees receiv- able, the portion of mortgages pledged under securitization sold to ABCP conduits, and several mortgages within mortgage and loan in- vestments as financial assets at “fair value through profit or loss” such that changes in market value are recorded in the statement of income. Effectively, these assets are treated much like bonds, earning the Com- pany a coupon at the discount rates used by the Company. The dis- count rates used represent the interest rate associated with a risk-free bond of the same duration plus a premium for the risk/uncertainty of the asset’s residual cash flows. Accordingly, as rates in the bond market change, so will the carrying value of these assets. These changes may be significant (favourable and unfavourable) from quarter to quarter. The Company enters into fixed for float swaps to manage the interest rate exposure of fixed mortgages sold to ABCP conduits. These in- struments will also be treated as fair value through profit or loss. While the Company has attempted to exactly match the principal bal- ances of the fixed mortgages over the next five-year period to the notional swap values for the same period, there will be differences in these amounts. Any favourable or unfavourable amounts will be recorded in the statement of earnings each quarter. The Company believes its hedging policies are suitably disciplined such that the interest rate risk of holding mortgages prior to securiti- zation is mitigated. From an accounting perspective, any gains or losses on these instruments are recorded in the current period as the Com- pany’s “hedging” strategy does not qualify as hedging for accounting purposes. The Company uses bond forwards (consisting of bonds sold short and bonds purchased under resale agreements) to manage in- terest rate exposure between the time a mortgage rate is committed to the borrower and the time the mortgage is transferred to the se- curitization vehicle and the matched term debt is arranged. As interest rates change, the value of these short bonds will vary inversely with the value of the related mortgages. As interest rates increase, a gain will be recorded on the bonds which should be offset by a tighter interest rate spread between the interest rates on mor tgage and the securitization debt. This spread will be earned over the term of the related mortgages. For single-family mortgages, primarily mortgages for the Company’s own securitization programs, only a portion of the mortgage commitments issued by the Com pany eventually fund. The Company must assign a probability of funding to each mortgage in the pipeline and estimate how that probability changes as mor tgages move through the various stages of the pipeline. The amount that is actually hedged is the expected value of mortgages funding within the next 120 days (120 days being the standard maximum rate hold period available for the mortgages). As at December 31, 2011, the Company has $380.3 million of notional forward bond positions related to its single-family programs. For multi-unit residential and commercial mortgages, the Company assumes all mortgages committed will fund and hedges each mortgage individually. This includes mortgages com- mitted for the CMB program as well as mortgages for transfer to the Company’s other securitization vehicles. As at December 31, 2011, the Company had entered into $245.8 million in notional value forward bond sales for this segment. The change in mark-to-market value to- gether with realized losses totalled $31.0 million on the notional hedg- es transacted in the period January 1, 2011 to December 31, 2011. This amount has been expensed through the statement of income. Upon the settlement of the debenture issuance, the Company entered into a float-for-fix swap. The swap requires the Company to pay CDOR+2.134% on a notional amount of $175 million and to receive the debenture interest coupon (5.07%) semi-annually. This effectively converts the fixed rate semi-annual debenture-based loan payable into a floating rate monthly resetting note payable. Since the date when this swap was entered into, five-year interest rates have decreased pursuant to global economic issues and the value of this swap has increased to $9.7 million as at December 31, 2011. The 24 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSISCompany has documented this swap as a hedge for accounting pur- poses as the fixed leg of the swap exactly matches the cash flow obliga- tions under the debenture. Effectively, the unrealized gain of $9.7 million on the swap has been excluded from earnings and been applied to increase the carrying value of the debenture note payable. The Com- pany is also a party to four amortizing fix-for-float rate swaps that eco- nomically hedge the interest rate exposure related to cer tain mortgages held on the balance sheet that the Company has originated as replacement assets for its CMB activities. As at December 31, 2011, the aggregate notional value of these swaps was $48.6 million. Market swap rates decreased during the year so the value of these swaps decreased by approximately $0.8 million. The amortizing swaps mature between September 2013 and December 2021. As described above, the Company employs various strategies to reduce interest rate risk. In the normal course of business, the Com- pany takes some credit spread risk. This is the risk that the credit spread at which a mortgage is originated changes between the date of commitment of that mortgage and the date of sale or securitization. This can be illustrated by the Company’s experience with commercial mor tgages originated for the CMBS market in the spring of 2007. These mor tgages were originated at credit spreads designed to be profitable to the Company when sold to a bank-sponsored CMBS conduit. Unfortunately for the Company, when these mortgages fund- ed, the CMBS market had shut down. The alternative to this channel was more expensive as credit spreads elsewhere in the marketplace for this type of mortgage had moved wider. The Company adjusted for market-suggested increases in credit spreads in 2007 and 2008, ad- justing the value of the mortgages downward. In 2009, the economic environment remained weak but did not worsen from what it was at the end of 2008. Overall credit spreads stopped widening such that the Company applied the same spreads to these mortgages and the Company did not record any additional unrealized loss or gains relat- ed to credit spread movement. Despite entering into effective eco- nomic interest rate hedges, the Company’s exposure to credit spreads remained. This risk is inherent in the Company’s business model and cannot be economically hedged. The same exposure to risk is inherent in the Company’s securitiza- tion through ABCP. The Company is exposed to the risk that 30-day ABCP rates are greater than 30-day BA rates. Prior to the financial crisis, it considered this a low risk given the quality of the assets securitized, the amount of credit enhancements provided by the Company and the strong covenant of the bank-sponsored conduits with which the Company transacted. In 2008, 30-day ABCP traded at approximately 1.10 percentage points over BAs but by the end of De- cember 2011, it was priced at a discount to BAs. At the same time the Company has leveraged on changing credit spreads. This has been demonstrated through the increase in volume and profitability of the NHA–MBS program and significant increases in gains on deferred placement fees from the sale of prime insured mortgages. As at December 31, 2011, the Company has various exposures to changing credit spreads. The Company has $21 million of exposure re- lated to commercial mor tgages originated originally for the CMBS market. In mortgages accumulated for sale or securitization there are $847 million of mor tgages that are susceptible to some degree of changing credit spreads. Capital Expenditures A significant portion of First National’s business model consists of the origination and placement or securitization of financial assets. General- ly placement activities do not require much capital investment as the Company acts primarily in the capacity of a broker. On the other hand, the under taking of securitization transactions requires some- times significant amounts of the Company’s own capital. This capital is provided in the form of cash collateral, credit enhancements, and the upfront funding of broker fees and other origination costs. These are described more fully in the Liquidity and Capital Resources section above. For fixed assets, the business requires capital expenditures on technology (both software and hardware), leasehold improvements and office furniture. During the year ended December 31, 2011, the Company purchased new computers and office and communication equipment to support primarily its single-family residential business. Going forward, the Company expects capital expenditures on fixed assets will be approximately $2.0 million annually. Summary of Contractual Obligations The Company’s long-term obligations include five- to 10-year premises leases for its four offices across Canada, and its obligations for the on- going ser vicing of mor tgages sold to securitization conduits and mortgages related to purchased servicing rights. The Company sells its mortgages to securitization conduits on a fully-serviced basis, and is responsible for the collection of the principal and interest payments on behalf of the conduits, including the management and collection of mortgages in arrears. ($000s) Payments due by period Total 0–1 year 2–3 years 4–5 years After 5 years Lease obligations Total contractual obligations $ 17,552 $ 17,552 $ 3,758 $ 3,758 $ 6,661 $ 6,661 $ 5,894 $ 5,894 $ 1,239 $ 1,239 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 25 MANAGEMENT’S DISCUSSION AND ANALYSIS Critical Accounting Policies and Estimates The Company prepares its financial statements in accordance with IFRS, which requires management to make estimates, judgments and assumptions that management believes are reasonable based upon the information available. These estimates, judgments 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 repor ted amounts of revenue and expenses during the reporting period. Management bases its estimates on historical experi- ence 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 Company’s audited financial statements as at De- cember 31, 2011. 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 gains on deferred placement fees and the impact of fair value accounting on financial instruments. The Company uses estimates in valuing its gain or loss on the sale of its mortgages placed with institutions earning a deferred placement fee. Under IFRS, valuing a gain on deferred placement requires the use of estimates to determine the fair value of the retained interest (de- rived from the present value of expected future cash flows) in the mortgages. These retained interests are reflected on the Com pany’s balance sheet as deferred placement fees receivable. The key assump- tions used in the valuation of gains on deferred placement fees are prepayment rates and the discount rate used to present value future expected cash flows. The annual rate of unscheduled principal payments is determined by reviewing portfolio prepayment experience on a monthly basis. The Company uses different rates for its various programs that average approximately 15% for single-family mortgages. The Company assumes there is virtually no prepayment on multi-resi- dential fixed rate mortgages. Actual prepayment experience has been consistent with these assumptions. 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 esti- mates. The estimates used reflect the expected performance of the mortgage portfolio over the lives of the mortgages. The assumptions underlying the estimates used for the year ended December 31, 2011, continue to be consistent with those used for the year ended Decem- ber 31, 2010 and the quarters ended September 30, 2011, June 30, 2011 and March 31, 2011. The Company has elected to treat its financial assets and liabilities, including deferred placement fees receivable, ABCP-funded mortgages, some mortgage and loan investments and bonds sold short at fair value through profit or loss. Essentially, this policy requires the Company to record changes in the fair value of these instruments in the current period’s earnings. The Company’s assets and liabilities are such that the Company must use valuation techniques based on assumptions that are not fully supported by observable market prices or rates in most cases. Much like the valuation of deferred placement fees receivable described above, the Company’s method of determining the fair value of its mortgages funded by ABCP has a significant impact on earnings. The Company uses different prepayment rates for its various programs that average approximately 15% for single-family mortgages. The Com- pany assumes there is vir tually no prepayment on multi-residential fixed rate mortgages. Actual prepayment experience has been consis- tent with these assumptions. It has also assumed discount rates based on Government of Canada bond yields plus a spread that the Com- pany believes would enable a third party to purchase the mortgages and make a normal profit margin for the risk involved. Future Accounting Changes The Company has adopted IFRS as at January 1, 2010. The following new IFRS pronouncements have been issued and although not yet ef- fective, may have a future impact on the Company. IFRS 9 – Financial Instruments As of January 1, 2015, the Company will be required to adopt this standard, which is the first phase of the International Accounting Stan- dard Board’s (“IASB”) project to replace IAS 39 – Financial Instruments: Recognition and Measurement. IFRS 9 provides new requirements for how an entity should classify and measure financial assets and liabilities that are in the scope of IAS 39. Management is currently evaluating the potential impact that the adoption of IFRS 9 will have on the Com- pany’s consolidated financial statements. Of potential relevance to the Company is a revised section on hedge accounting designed to make the reporting of hedging activity more straightforward. Among other changes, the hedging standard will permit the use of a financial asset or liability as a hedging instrument. The current standard requires that only a derivative can be identified as a hedging instrument. As the Company has historically used shor t bonds (a financial liability) as a hedging instrument, the change could affect the nature of the Company’s reporting in this respect. IFRS 10 – Consolidated Financial Statements As of January 1, 2013, the IASB introduced a single model for consoli- dating subsidiaries using a control model. This standard addresses in particular the control of special purpose entities. There will be little impact to the Company as it currently consolidates its special purpose entities fully. IFRS 11 – Joint Arrangements As of January 1, 2013, the IASB has expanded the definition of a joint venture. The Company would be required to account for joint ventures by the equity method as opposed to proportionate consolidation. 26 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSISIFRS 12 – Disclosure of Interests in Other Entities As of January 1, 2013, the Company will be required to make new dis- closures on its off-balance sheet activities including those with special purpose entities. IFRS 13 – Fair Value Measurement As of January 1, 2013, the Company will be required to adopt this standard, which provides a framework for the application of fair value to those assets and liabilities qualifying or permitted to be carried at fair value. The Company believes its current measurement of fair value is appropriate and there will be little impact. IAS 27 – Separate Financial Statements As of January 1, 2013, this standard will only prescribe the accounting and disclosure requirements for investments in subsidiaries, joint ventures and associates when an entity prepares separate financial statements, and thus will have limited impact for the Company. IAS 28 – Investments in Associates As of January 1, 2013, this standard has been amended to correspond to changes in IFRS 10, 11 and 12, listed above, providing guidance for investments in associates. As described above, there should be little effect on the Company. Controls over financial reporting Management is responsible for establishing and maintaining adequate 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 state- ments for external purposes in accordance with reporting standards; however, because of its inherent limitations, internal control over financial repor ting may not prevent or detect misstatements on a timely basis. During the Company’s transition to IFRS and the Conversion to a corporation, management identified and subsequently implemented certain changes to accounting processes and procedures in order to comply with IFRS. These changes were most significant for the follow- ing financial statement components: reporting for mortgages pledged under securitization; reporting for debt related to securitized mortgages; reporting for both interest revenue – securitized mortgages and inter- est expense – securitized mortgages; reporting for deferred income taxes; reporting for consolidation of special purpose entities; and the restatement of 2010 comparative figures to incorporate IFRS and the conversion from an income trust structure. Because of these changes, management revised existing internal controls and designed and imple- mented new internal controls over financial reporting to provide rea- sonable assurance that the risk of material misstatements in the Company’s financial reporting has been mitigated. There were no other changes made in the Company’s internal controls over financial report- ing during the year ended December 31, 2011 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Management evaluated, under the supervision of and with the par- ticipation of the Chairman and President, and Chief Financial Officer, the effectiveness of the Company’s internal control over financial re- porting based on the criteria set forth in Internal Control over Financial Reporting – Guidance for Smaller Public Companies issued by the Com- mittee of Sponsoring Organizations of the Treadway Commission and, based on that evaluation, concluded that the Company’s internal con- trol over financial reporting was effective as of December 31, 2011 and that there were no material weaknesses that have been identified in the Company’s internal control over financial reporting as of Decem- ber 31, 2011. No changes were made in the Company’s internal con- trols over financial repor ting during the year ended December 31, 2011, except as described above related to IFRS and the Conversion, that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting. Risk and Uncertainties Affecting the Business The business, financial condition and results of operations of the Com- pany are subject to a number of risks and uncertainties, and are affect- ed by a number of factors outside the control of management of the Company including: ability to sustain performance and growth, reliance on sources of funding, concentration of institutional investors, reliance on independent mor tgage brokers, changes in interest rates, repur- chase obligations and breach of representations and warranties on mortgage sales, risk of servicer termination events and trigger events on cash collateral and retained interests, reliance on multi-unit residen- tial and commercial mortgages, general economic conditions, govern- ment regulation, competition, reliance on mortgage insurers, reliance on key personnel, conduct and compensation of independent mort- gage 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, and risk related to Alt-A mortgages, which experience higher arrears rates and credit losses than prime mortgages. In addition, risks associated with the structure of FNFC include those related to the de- pendence on FNFLP, leverage and restrictive covenants, dividends which are not guaranteed and could fluctuate with FNFLP’s perfor- mance, restrictions on potential growth, the market price of FNFC shares, statutory remedies, control of the Company and contractual re- strictions, and income tax matters. Risk and risk exposure are managed through a combination of insurance, a system of internal controls and sound operating practices. The Company’s key business model is to originate primarily prime mortgages and find funding through various channels to earn ongoing servicing or spread income. For the single- family residential segment, the Company relies on independent mort- gage brokers for origination and several large institutional investors for sources of funding. These relationships are critical to the Company’s success. For a more complete discussion of the risks affecting the Company’s business, reference should be made to the Annual Informa- tion Form of the Company. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 27 MANAGEMENT’S DISCUSSION AND ANALYSIS Forward-Looking Information Outlook Forward-looking information is 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 informa- tion regarding the future financial position, business strategy and stra- tegic 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 adminis- tration, 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. This forward-looking informa- tion should not be read as providing guarantees of future perfor- mance or results, and will not necessarily be an accurate indication 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 fac- tors include reliance on sources of funding, concentration of institu- tional investors, reliance on independent mor tgage brokers and changes in interest rates outlined under ‘‘Risk and Uncer tainties Affecting the Business’’. In evaluating this information, 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 information. The forward-looking information contained in this discus- sion represents management’s expectations as of February 28, 2012, and is subject to change after such date. However, management and the Company disclaim any intention or obligation to update or revise any forward-looking information, whether as a result of new informa- tion, future events or otherwise, except as required under applicable securities regulations. The global economic outlook turned negative during 2011. Epito- mized perhaps by Standard & Poor’s downgrade of the United States government’s credit rating in August, the latter half of the year fea- tured increased recessionary pressures, global financial turmoil and volatile equity markets. The interest rate environment, which began to rise in the first quarter of 2011, reversed course in the second quar- ter and then fell sharply in the third quarter as investors fled to the safety of the bond markets, driving down bond yields. Yet the Canadi- an real estate market remained strong throughout the year and the Company was able to originate near record levels of new mortgages. First National took advantage of this origination and its greater capital base by securitizing more than $4 billion of mor tgages. Although most of the origination costs for these mor tgages have been capi- talized, the costs of internal underwriting, large hedge losses, and significant fees paid to register the mortgages with the title custodian, have all been expensed. The spread from this increased securitization activity will benefit the Company for the five- and 10-year terms of these transactions going forward. Given the recent market turmoil, the large Canadian banks have acted to increase mortgage spreads in order to maintain profitability on these assets. This has been evidenced over the past quar ter as floating-rate single-family mortgages that had been priced at a 0.70% discount to prime in the summer are now being offered at no dis- count to prime. Similarly, fixed-rate mor tgages have recently been priced so as to increase spreads to a range of 1.75% to 2.00%. These increases will enable the Company’s securitization activities to be more profitable. The five large banks are also making the transition to IFRS this year. While this may not have a large impact on their mort- gage business, the Company has seen smaller competitors exit the market or slow down origination in the face of higher capital require- ments for securitization, which is a consequence of IFRS. Management is very pleased with its volume of originations for 2011. For 2012, management sees overall origination volumes remain- ing at levels comparable or slightly lower than 2011 origination as mar- ket activity slows down. The Company forecasts that MUA, currently at $59.6 billion, will continue to grow and produce higher income and cash flow. The wider mortgage spreads on the Company’s core prod- ucts, prime mortgages, will give the Company the opportunity to con- tinue to pursue more direct securitization. Together with the large investment in the portfolio of mortgages under securitization at the end of December 31, 2011, First National expects increased cash flow profitability in 2012. 28 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT MANAGEMENT’S DISCUSSION AND ANALYSISManagement’s Responsibility for Financial Reporting The accompanying consolidated financial statements of First National Financial Corporation for the period from January 1, 2011 to December 31, 2011 and all information in this annual report are the responsibility of management. The financial statements have been prepared by management in accordance with International Financial Reporting Standards. 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 audi- tors. 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 Corporation’s 2011 consolidated financial statements in accordance with International Financial Repor ting Standards and has provided an independent audit opinion. The auditors have full and unrestricted access to the Audit Committee to discuss the results of their audit. Stephen J. R. Smith Chairman and President Robert A. Inglis Chief Financial Officer FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 29 Independent Auditors’ Report To the Shareholders of First National Financial Corporation We have audited the accompanying consolidated financial statements of First National Financial Corporation, which comprise the consolidated statements of financial position as at December 31, 2011 and 2010, and January 1, 2010, and the consolidated statements of comprehensive income and retained earnings, changes in shareholders’ equity and cash flows for the years ended December 31, 2011 and 2010, and a summary of significant accounting policies and other explanatory information. Management’s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors’ responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accor- dance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circum- stances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of First National Financial Corpora- tion as at December 31, 2011 and 2010, and January 1, 2010, and its financial performance and its cash flows for the years ended December 31, 2011 and 2010 in accordance with International Financial Reporting Standards. Toronto, Canada, February 28, 2012 Chartered Accountants Licensed Public Accountants 30 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT First National Financial Corporation Consolidated Statements of Financial Position ($000s) As at ASSETS Restricted cash Accounts receivable and sundry Securities purchased under resale agreements and owned Mortgages accumulated for sale or securitization Mortgages pledged under securitization Deferred placement fees receivable Cash held as collateral for securitization Purchased mortgage servicing rights Mortgage and loan investments Income taxes recoverable Other assets Total assets LIABILITIES AND EQUITY Liabilities Bank indebtedness Obligations related to securities and mortgages sold under repurchase agreements Accounts payable and accrued liabilities Securities sold under repurchase agreements and sold short Debt related to securitized and participation mortgages Debenture loan payable Income taxes payable Deferred tax liabilities Total liabilities Equity Common shares Preferred shares Retained earnings Total equity Total liabilities and equity See accompanying notes Notes December 31 2011 December 31 2010 [1] January 1 2010 [1] 3 15 5 3 4 3 8 6 18 7 10 16 15 11 13 18 18 17 17 $ 230,519 61,558 657,626 850,938 9,761,921 58,509 56,882 4,771 180,872 3,556 60,118 $ 156,198 50,787 426,336 318,136 7,193,961 77,410 37,730 5,766 70,911 – 66,758 $ 73,440 46,972 333,705 382,859 5,540,794 90,268 43,709 6,607 54,737 – 76,769 $ 11,927,270 $ 8,403,993 6,649,860 $ 80,608 $ 9,896 $ 203,758 664,424 57,692 659,299 9,957,219 184,689 – 30,300 174,258 63,998 424,673 7,274,482 178,849 8,940 34,721 221,937 76,712 332,427 5,536,394 – 14,231 30,519 $ 11,634,231 $ 8,169,817 $ 6,415,978 $ 122,671 97,394 72,974 293,039 $ 122,671 – 111,505 234,176 $ 122,671 – 111,211 233,882 $ 11,927,270 $ 8,403,993 $ 6,649,860 [1] The 2010 comparative figures have been restated to account for the Conversion. See notes 1 and 23. John Brough Robert Mitchell FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 31 First National Financial Corporation Consolidated Statements of Comprehensive Income and Retained Earnings ($000s, except earnings per unit) Years ended December 31 REVENUE Interest revenue – securitized mortgages Interest expense – securitized mortgages Net interest – securitized mortgages Placement fees Gains on deferred placement fees Mortgage investment income Mortgage servicing income Realized and unrealized gains (losses) on financial instruments EXPENSES Brokerage fees Salaries and benefits Interest Other operating Amortization of intangible assets Income before income taxes Income tax expense Net income and comprehensive income for the year Retained earnings, beginning of year Less: dividends/distributions declared Retained earnings, end of year Earnings per share Basic See accompanying notes Notes 2011 2010 [1] 3 4 18 $ 254,118 (184,291) $ 171,526 (112,530) 69,827 58,996 110,041 6,663 29,311 82,372 (18,485) 279,729 81,480 48,808 15,998 28,692 7,968 107,292 13,123 21,192 73,846 7,280 281,729 70,718 44,653 13,613 23,320 9,468 182,946 161,772 96,783 26,292 70,491 111,505 (109,022) 119,957 30,040 89,917 111,211 (89,623) $ 72,974 $ 111,505 17 $ 1.10 $ 1.50 [1] The 2010 comparative figures have been restated to account for the Conversion. See notes 1 and 23. 32 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT First National Financial Corporation Consolidated Statements of Changes in Shareholders’ Equity ($000s) Balance at January 1, 2011 [1] Comprehensive income Issuance of preferred shares Dividends paid or declared Common shares Preferred shares Retained earnings Total shareholders’ equity $ 122,671 – – – $ – – 97,394 – $ 111,505 70,491 – (109,022) $ 234,176 70,491 97,394 (109,022) Balance at December 31, 2011 $ 122,671 $ 97,394 $ 72,974 $ 293,039 Balance at January 1, 2010 [1] Comprehensive income Distributions paid or declared Balance at December 31, 2010 See accompanying notes Common shares Preferred shares Retained earnings Total shareholders’ equity $ 122,671 – – $ $ 122,671 $ – – – – $ 111,211 89,917 (89,623) $ 233,882 89,917 (89,623) $ 111,505 $ 234,176 [1] The 2010 comparative figures have been restated to account for the Conversion. See notes 1 and 23. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 33 First National Financial Corporation Consolidated Statements of Cash Flows ($000s) Years ended December 31 OPERATING ACTIVITIES Net income for the year Add (deduct) items not affecting cash: Deferred income tax expense Non-cash portion of gains on deferred placement fees Increase in restricted cash Net investment in mortgages pledged under securitization Net increase in debt related to securitized mortgages Amortization of deferred placement fees receivable Amortization of purchased mortgage servicing rights Amortization of property, plant and equipment Amortization of intangible assets Unrealized gains on financial instruments Net change in non-cash working capital balances related to operations 2011 2010 [1] $ 70,491 $ 89,917 (3,508) (4,720) (74,321) (2,569,632) 2,613,535 24,771 995 1,856 7,968 (3,846) 63,589 (519,947) 4,202 (9,566) (82,758) (1,670,042) 1,738,088 23,355 841 1,796 9,468 (6,698) 98,603 66,720 Cash provided by (used in) operating activities $ (456,358) $ 165,323 INVESTING ACTIVITIES Additions to property, plant and equipment Investment of cash held as collateral under securitization Investment in mortgage and loan investments Repayment of mortgage and loan investments Cash used in investing activities FINANCING ACTIVITIES Dividends/distributions paid Issuance of preferred shares Obligations related to securities and mortgages sold under repurchase agreements Proceeds from debenture loan Debt related to participation mortgages Securities purchased under resale agreements and owned, net Securities sold under repurchase agreements and sold short, net Cash provided by financing activities Net decrease (increase) in bank indebtedness during the year Bank indebtedness, beginning of year Bank indebtedness, end of year Supplemental cash flow information Interest received Interest paid Income taxes paid See accompanying notes [1] The 2010 comparative figures have been restated to account for the Conversion. See notes 1 and 23. 34 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT $ (3,184) (19,152) (238,476) 129,580 $ (1,253) 5,979 (67,170) 53,642 $ (131,232) $ (8,802) $ (133,600) 96,481 490,166 – 69,202 (231,290) 225,919 $ (89,623) – (47,679) 175,000 – (92,631) 92,274 $ 516,878 $ 37,341 $ (70,712) (9,896) $ (80,608) $ 261,027 187,933 33,356 $ $ $ 193,862 (203,758) (9,896) 220,349 116,782 33,387 First National Financial Corporation Notes to Consolidated Financial Statements December 31, 2011 and 2010 ($000s, except per unit amounts or unless otherwise noted) Note 1 General Organization and Business of First National Financial Corporation First National Financial Corporation [the “Corporation” or “Com- pany”] is the parent company of First National Financial LP [“FNFLP”], a Canadian-based originator, underwriter and servicer of predomi- nantly prime residential [single-family and multi-unit] and commercial mortgages. With over $59 billion in mortgages under administration, FNFLP is an originator and underwriter of mortgages and a significant participant in the mortgage broker distribution channel. Pursuant to a Plan of Arrangement [the “Arrangement”] and an amalgamation [the “Amalgamation”] effective Januar y 1, 2011, the Corporation succeeded First National Financial Income Fund [the “Fund”] as the public holding company invested in FNFLP. The Arrangement and Amalgamation [together the “Conversion”] were used to convert the Fund into a corporate structure. The most significant steps involved in the Conversion were: • A new company, First National Financial Inc. [“FNFI”], was formed; • Unitholders of the Fund exchanged their 12,681,113 Class A units in the Fund for shares in FNFI on a one-for-one basis; • The pre-Arrangement shareholders of the Corporation [the “Co-founders”] exchanged 47,286,316 shares in the Corporation for 47,286,316 shares of FNFI with the result that the Corporation became a wholly-owned subsidiary of FNFI; • The Fund and First National Financial Operating Trust were wound up; and • The Corporation and FNFI were amalgamated and continued under the name “First National Financial Corporation”. Effectively, the Conversion reorganized the ownership interests in FNFLP such that all such interests are now consolidated and held through the Corporation in the same ratio as previously held by the Fund and by the Co-founders. Prior to the initial public offering of the Fund [the “IPO”] in June 2006, the Corporation owned and operated the business. Concurrent with the IPO, the business was transferred from the Corporation to FNFLP such that the Corporation then operated as a privately held holding company which owned a direct interest of 80.03% in FNFLP. At that time, the Fund indirectly held the non-controlling interest in FNFLP of 19.97%. Given the history of the Corporation’s relationship with FNFLP and the non-arm’s length nature of the Conversion, the Corporation has accounted for these transactions as a business combination under common control using the pooling of interests method. Accordingly, the Corporation’s con- solidated financial statements reflect the combined activities of the Fund and the Corporation prior to the Conversion [including the con- solidation of FNFLP]. Immediately prior to the Conversion, residual assets and liabilities of the Corporation were distributed and settled so that as of the Conversion date, the consolidated statement of financial position of the Corporation substantially reflects the assets and liabilities of FNFLP at book value, plus the intangible assets repre- sented by the excess of the purchase price paid by the Fund over the carrying value of its share of the net assets of FNFLP at the IPO date and deferred tax liabilities related to temporary differences between the book value and tax basis of the carrying value of the Fund’s invest- ment in FNFLP. In effect this accounting treatment assumes, for com- parative financial reporting purposes, that the Conversion occurred at the time of the IPO. The Co-founders have provided indemnities to the Corporation to protect the current shareholders of the Corpora- tion from any unrecorded liabilities incurred by the Corporation in the period between the IPO and January 1, 2011. The Corporation is incorporated under the laws of the Province of Ontario, Canada and has its registered office and principal place of busi- ness located at 100 University Avenue, Toronto, Ontario. The Corpora- tion’s common and preferred shares are listed on the Toronto Stock Exchange [“TSX”] under the symbols FN and FN.PR.A, respectively. Note 2 Significant Accounting Policies 2.1 Basis of preparation The consolidated financial statements have been prepared in accor- dance with International Financial Repor ting Standards [“IFRS”] as issued by the International Accounting Standards Board [the “IASB”] [see note 23 for IFRS transition disclosures]. The consolidated financial statements have been prepared on a historical cost basis, except for derivative financial instruments and financial assets and financial liabili- ties, which are recorded at fair value through profit or loss and mea- sured at fair value. The carr ying values of recognized assets and liabilities, that are hedged items in fair value hedges, and otherwise car- ried at amor tized cost, are adjusted to record changes in fair value attributable to the risks that are being hedged. The consolidated finan- cial statements are presented in Canadian dollars and all values are rounded to the nearest thousands, except when otherwise indicated. The consolidated financial statements were authorized for issue by the Board of Directors on February 28, 2012. 2.2 Basis of consolidation The consolidated financial statements comprise the financial state- ments of the Company and its subsidiaries, including FNFLP, First National Financial GP Corporation [the general partner of FNFLP] and FNFC Trust, a special purpose entity [“SPE”] which is used to manage undivided co-ownership interests in mortgage assets and fund these with Asset-Backed Commercial Paper [“ABCP”]. The consolidated FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 35 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS financial statements have been prepared using consistent accounting policies for like transactions and other events in similar circumstances. All inter-company balances and revenues and expenses have been eliminated on consolidation. 2.3 Use of estimates The preparation of financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, including contingencies, at the date of the consolidated 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 those that require reporting of financial assets and liabilities at fair value. 2.4 First-time application of IFRS The Company has applied IFRS to its financial repor ting with effect from January 1, 2010, the date of transition, in accordance with the transitional provisions set out in IFRS 1, “First-time Adoption of Interna- tional Financial Reporting Standards” [“IFRS 1”]. Previously, the Com- pany had prepared its financial statements in conformity with Canadian generally accepted accounting principles [“GAAP”]. The Company’s consolidated financial statements for the year ended December 31, 2011 are the first annual financial statements that comply with IFRS. IFRS 1 requires first-time adopters to retrospectively apply all effective IFRS as of the first annual reporting date. IFRS 1 also provides certain optional and mandatory exemptions for the first-time IFRS adopters. The mandatory exemptions are as follows: Mandatory exemptions Derecognition of financial assets and financial liabilities The Company has elected not to re-recognize any financial assets and financial liabili- ties derecognized before January 1, 2004. Hedge accounting Hedge accounting can only be applied prospectively from the transition date of January 1, 2010 to transactions that satisfy the hedge accounting criteria in IAS 39 at that date. Hedging relation- ships cannot be designated retrospectively and the supporting docu- mentation cannot be created retrospectively. As a result, only hedging relationships that satisfied the hedge accounting criteria as of the tran- sition date are reflected as hedges in the Company’s results under IFRS. Estimates The estimates at January 1, 2010 and at December 31, 2010 are consistent with those made for the same dates in accordance with Canadian GAAP, after adjustments to reflect any differences in accounting policies. 2.5 Significant accounting policies Revenue recognition The Company earns revenue from placement, securitization and ser- vicing activities related to its mortgage business. The majority of origi- nated mor tgages are sold to institutional investors through the placement of mor tgages or funded through securitization conduits. The Company retains servicing rights on substantially all of the mort- gages it originates, providing the Company with servicing fees. Interest revenue and expense from mortgages pledged under securitiza- tion The Company enters into securitization transactions to fund a por- tion of its originated mortgages. Upon transfer of these mortgages to securitization vehicles, the Company receives cash proceeds from the transaction. These proceeds are accounted for as debt related to securi- tized mortgages and the Company continues to hold the mortgages on its consolidated statement of financial position, unless: [i] substantially all the risks and rewards associated with the financial instruments have been transferred, in which case the assets are derecognized in full; or [ii] a significant portion, but not all, of the risks and rewards have been transferred. The asset is derecognized entirely if the transferee has the ability to sell the financial asset; otherwise the asset continues to be recognized to the extent of the Company’s continuing involvement. Where [i] or [ii] above applies to a fully proportionate share of all or specifically identified cash flows, the relevant accounting treatment is applied to that proportion of the mortgage. For securitized mor tgages that do not meet the criteria for derecognition, no gain or loss is recognized at the time of the transac- tion. Instead, net interest revenue is recognized over the term of the mortgages. Interest revenue – securitized mor tgages represents interest received and accrued on mortgage payments by borrowers and is net of the amortization of capitalized origination fees. Interest expense – securitized mor tgages represents financing costs to fund these mortgages, net of the amortization of debt dis- counts or premiums. Both capitalized origination fees and debt dis- counts or premiums are amortized on an effective yield basis over the term of the related mortgages/debt. Derecognition A financial asset is derecognized when: • The right to receive cash flows from the asset has expired; • The Company has transferred its rights to receive cash flows from the assets or has assumed an obligation to pay the received cash flows in full without material delay to a third party under a “pass- through” arrangement; and either [a] the Company has transferred substantially all the risks and rewards of the asset or [b] the Com- pany has neither transferred nor retained substantially all of the risks and rewards of the asset, but has transferred control of the asset. 36 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS When the Company has transferred its rights to receive cash flows from an asset or has entered into a pass-through arrangement, and has neither transferred nor retained substantially all of the risks and rewards of the asset nor transferred control of the asset, the asset is recognized to the extent of the Company’s continuing involvement in the asset. In that case, the Company also recognizes an associated liability. Brokerage fees Brokerage fees relating to the mortgages recorded at fair value are expensed as incurred and brokerage fees relating to mor tgages recorded at amortized cost are deferred and amortized over the term of the mortgages. Placement fees and deferred placement fees receivable The Company enters into placement agreements with institutional investors to pur- chase the mortgages it originates. When mortgages are placed with institutional investors, the Company transfers the contractual right to receive mortgage cash flows to the investors. Because it has transferred substantially all of the risks and rewards of ownership of these mort- gages, it has derecognized these assets. The Company retains a residual interest, representing the rights and obligations associated with servic- ing the mortgages. Placement fees are earned by the Company for its origination and underwriting activities on a completed transaction basis when the mortgage is funded. Amounts immediately collected or col- lectible in excess of the mortgage principal are recognized as placement fees. When placement fees and associated servicing fees are earned over the term of the related mortgages, the Company determines the pres- ent value of the future stream of placement fees and records a gain on deferred placement fees and a deferred placement fees receivable. 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 prepayment rates and discount rates commensurate with the risks involved. Mortgage servicing income The Company services substantially all of the mortgages that it originates whether the mortgage is placed with an institutional investor or transferred to a securitization vehicle. In addition, mortgages are serviced on behalf of third-party institutional investors and securitization structures. For mortgages pledged under securitizations, mortgages administered for investors or third parties, the Company recognizes servicing income when services are rendered. For mortgages placed under deferred placement arrangements, the Com- pany retains the rights and obligations to service the mortgages. The deferred placement fees receivable is the present value of the excess retained cash flows over normal servicing fee rates and is reported as deferred placement revenue at the time of placement. Servicing income related to mortgages placed with institutional investors is recognized in income over the life of the servicing obligation as payments are received from mortgagors. Interest income earned by the Company from hold- ing cash in trust related to servicing activities is classified as mortgage servicing income. Mortgage investment income The Company earns interest income from its interest-bearing assets including deferred placement fees receiv- able, mortgage and loan investments and mortgages accumulated for sale or securitization. Mortgage investment income is recognized on an accrual basis. Mortgages pledged under securitization Mortgages pledged under securitization are mortgages that the Com- pany has originated and funded with debt raised through the securiti- zation markets. The Company has a continuous involvement in these mortgages, including the right to receive future cash flows arising from these mortgages. Mortgages pledged under securitization [except for mortgages funded with bank-sponsored ABCP programs] have been classified as loans and receivables and are measured at their amortized cost using the effective yield method. Mortgages funded under bank- sponsored ABCP programs are classified as fair value through profit or loss and recorded at fair value. Origination costs, such as brokerage fees and timely payment guarantee fees that are directly attributable to the acquisition of such assets, are deferred and amortized over the term of the mortgages on an effective yield basis. Debt related to securitized and participation mortgages Debt related to securitized mortgages represents obligations related to the financing of mortgages pledged under securitization. This debt is measured at its amortized cost using the effective yield method. Any discount/premium on the raising of these debts that is directly attribut- able to the acquisition of such liabilities is deferred and amortized over the term of the debt obligations. Debt related to par ticipation mor tgages represents obligations related to the financing of a portion of commercial mortgages included in mor tgage and loan investments. These mor tgages are subject to participation agreements with other financial institutions such that the Company’s investment is subordinate to the other institution’s invest- ment. The Company has retained various rights to the mortgages and a proportionately larger share of the interest earned on these mort- gages, such that the full mor tgage has been recorded on the Com- pany’s statement of financial position with an offsetting debt. This debt is recorded at face value and measured at its amortized cost. Mortgages accumulated for sale or securitization Mortgages accumulated for sale are mortgages funded for the pur- pose of placing with investors and are classified as fair value through profit or loss and are recorded at fair value. These mortgages are held for terms usually not exceeding 90 days. The Company classifies mor tgages that are funded for its own securitization programs as loans and receivables and carries these mortgages at amortized cost. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 37 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Securities sold short and securities purchased under resale agreements Securities sold short consist of the short sale of a bond. Bonds pur- chased under resale agreements consist of the purchase of a bond with the commitment by the Company to resell the bond to the origi- nal seller at a specified price. The Company uses the combination of bonds sold short and bonds purchased under resale agreements to economically hedge its mor tgage commitments and the por tion of mortgages that it intends to securitize. Bonds sold short are classified as fair value through profit or loss and are recorded at fair value. The accrued coupon on bonds sold short is recorded as hedge expense. Bonds purchased under resale agreements are carried at cost plus accrued interest, which approxi- mates their market value. The difference between the cost of the pur- chase and the predetermined proceeds to be received on a resale agreement is recorded over the term of the hedged mortgages as an offset to hedge expense. Transactions are recorded on a settlement date basis. Securities owned and securities sold under repurchase agreements The Company purchases bonds and enters into bond repurchase agreements to close out economic hedging positions when mortgages are sold to securitization vehicles or institutional investors. These transactions are accounted for in a similar manner as the transactions described for securities sold shor t and securities pur- chased under resale agreements. Mortgage and loan investments Mortgage and loan investments are carried at their outstanding princi- pal 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 col- lection of the full amount of principal and interest. An allowance for loan losses is established for mortgages and loans that are known to be uncollectible. When management considers there to be no probability of collection, the investments are written off. Mortgage and loan investments are classified as loans and receiv- ables, except for a por tfolio of long-term commercial mor tgages which is designated as fair value through profit or loss and is recorded at fair value. Intangible assets Intangible assets are comprised of broker relationships and customer service contracts and arose in connection with the IPO in 2006. Intan- gible assets are subject to annual impairment review if there are events or changes in circumstances that indicate that the carrying amount may not be recoverable. Intangible assets with finite useful lives are amortized on a straight- line basis over their estimated useful lives as follows: Broker relationships Investor servicing contracts straight-line over 10 years straight-line over 5 years 38 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Goodwill Goodwill represents the price paid for the Corporation’s business in excess of the fair value of the net tangible assets and identifiable intan- gible assets acquired in connection with the IPO. Goodwill is reviewed annually for impairment or more frequently when an event or change in circumstance indicates that the asset might be impaired. Property, plant and equipment Property, plant and equipment 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 a computer license, which is straight-line over 10 years Property, plant and equipment are subject to an impairment review if there are events or changes in circumstance which indicate that the carrying amount may not be recoverable. 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 unamor- tized cost in relation to estimated future cash flows associated with the underlying serviced assets. Any loss arising from an excess of the unamor tized cost over the fair value is immediately recorded as a charge to income. Restricted cash Restricted cash represents principal and interest for mor tgages pledged under securitization held in trust awaiting the repayment of debt related to these mortgages. Bank indebtedness Bank indebtedness consists of cash balances with banks and bank indebtedness. Cash held as collateral under securitization Cash held as collateral under securitization is a cash-based credit enhancement held by FNFC Trust. Income taxes The Company accounts for income taxes in accordance with the lia- bility method of tax allocation. Under this method, the provision for income taxes is calculated based on income tax laws and income tax rates substantively enacted as at the date of the consolidated state- ment of financial position. The income tax provision consists of cur- rent income taxes and deferred income taxes. Current and deferred taxes relating to items recognized directly in equity are recognized directly in equity. FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Current income taxes are amounts expected to be payable or recoverable as the result of operations in the current year and any adjustment to tax payable/recoverable recorded in previous years. Deferred income taxes arise on temporary differences between the carrying amounts of assets and liabilities on the consolidated state- ment of financial position and their tax bases. Deferred tax liabilities are generally recognized for all taxable temporary differences and deferred tax assets are recognized to the extent that future realization of the tax benefit is probable. Deferred tax is calculated using the tax rates expected to apply in the periods in which the assets will be real- ized or the liabilities settled. Deferred tax assets and liabilities are offset when they arise in the same tax reporting group and relate to income taxes levied by the same taxation authority, and when a legal right to offset exists in the entity. Earnings per common share The Company presents earnings per share [“EPS”] amounts for its common shares. EPS is calculated by dividing the net earnings attribut- able to common shareholders of the Company by the weighted aver- age number of common shares outstanding during the year. Financial assets and liabilities The Company classifies its financial assets as either financial instru- ments at fair value through profit or loss or loans and receivables. Financial liabilities are classified as either held at fair value through profit or loss or at amortized cost. Management determines the classi- fication of financial assets and liabilities at initial recognition. Financial assets and financial liabilities held at fair value through profit or loss Financial instruments are classified in this category if they are held for trading, or if they are designated by management at fair value through profit or loss at inception. Financial instruments are classified as held for trading if they are acquired principally for the purpose of selling in the short term. Finan- cial assets and financial liabilities may be designated at fair value through profit or loss when: [i] the designation eliminates or significantly reduces a measurement or recognition inconsistency that would otherwise arise from mea- suring assets or liabilities or recognizing the gains and losses on them on a different basis; or [ii] a group of financial assets and/or financial liabilities is managed and its performance evaluated on a fair value basis. The Company has elected to measure certain of its assets at fair value through profit or loss. Most significant of these assets are: mortgages pledged under securitization and funded with ABCP-related debt, deferred placement fees receivable, cer tain long-term commercial mortgages within mortgage and loan investments, and certain mort- gages funded with MBS debt. The mortgages funded with MBS debt were previously funded by ABCP debt and as such have retained their classification as held for trading [together with ABCP-funded mort- gages, “HFT mortgages”]. For the HFT mortgages, the Company has entered into swaps to convert the mortgages from fixed rate to float- ing rate in order to match the mortgages with the 30-day floating rate funding provided by the ABCP notes. The swaps are derivatives and are required by IFRS to be accounted for at fair value. This value can change significantly with the passage of time as the interest rate envi- ronment changes. In order to avoid a significant accounting mismatch, the Company has measured the swapped mortgages at fair value as well so that the asset and related liability values will move inversely as interest rates change. The cash flows related to deferred placement fees receivable are typically received over five- to 10-year terms. These cash flows are subject to prepayment volatility as the mor t- gages underlying the deferred placement fees receivable can experi- ence unscheduled prepayments. As well, the bank syndicate bases a portion of its loans to the Company on the carrying value of these assets. Accordingly, the Company must manage these assets on a fair value basis. The long-term commercial mor tgage investments are being actively offered for sale by the Company. These mortgages are priced off of benchmark Government of Canada bonds, such that fair value is the most appropriate measurement in the circumstances. Financial assets and financial liabilities held at fair value through profit or loss are initially recognized at fair value. Subsequent gains and losses arising from changes in fair value are recognized directly in the consoli- dated statement of comprehensive income and retained earnings. Held-for-trading non-derivative financial assets can only be trans- ferred out of the held at fair value through profit or loss category in the following circumstances: to the available-for-sale category, when, in rare circumstances, they are no longer held for the purpose of selling or repurchasing in the near term; or to the loans and receivables cate- gor y, when they are no longer held for the purpose of selling or repurchasing in the near term, would have met the definition of a loan and receivable at the date of reclassification, and the Company has the intent and ability to hold the assets for the foreseeable future or until maturity. Loans and receivables Loans and receivables are non-derivative financial assets with fixed or determinable payments that are not quoted in an active market and it is expected that substantially all of the initial invest- ment will be recovered, other than because of credit deterioration. Loans and receivables are initially recognized at cost, including direct and incremental transaction costs. They are subsequently valued at amortized cost. Held-to-maturity Held-to-maturity assets are non-derivative financial assets with fixed or determinable payments and fixed maturities that the Company’s management has the positive intention and ability to hold to maturity. These assets are initially recognized at cost, including direct and incremental transaction costs. They are subsequently valued at amortized cost using the effective interest method. Held-to-maturity assets can be reclassified to the available-for- sale category if the portfolio becomes tainted following the sale of other than an insignificant amount of held-to-maturity assets prior to their maturity. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 39 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Derivative financial instruments Derivatives are categorized as trading unless they are designated as hedging instruments. Derivative contracts are initially recognized at fair value on the date on which a derivative contract is entered into and are subsequently re-measured at their fair value with the changes in fair value recognized in income as they occur. Positive values are recorded as assets and negative values are recorded as liabilities. The Company enters into interest rate swaps to manage its inter- est rate exposures associated with funding fixed rate receivables with floating rate debt and to convert the fixed rate debenture into float- ing rate debt. These contracts are negotiated over-the-counter. Inter- est rate swaps require the periodic exchange of payments without the exchange of the notional principal amount on which the payments are based. The Company’s policy is not to utilize derivative financial instru- ments for trading or speculative purposes. Hedge accounting At the inception of a hedging relationship, the Company documents the relationship between the hedging instruments and the hedged items, its risk management objective, its strategy for undertaking the hedge, and its assessment of whether or not the hedging instruments are highly effective in offsetting the changes attributable to the hedged risks in the hedged items. For fair value hedges, changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded in the consolidated statement of comprehensive income and retained earnings, together with any changes in the fair value of the hedged asset or liability that are attributable to the hedged risk. The changes in fair value attributable to the hedged risk are accounted for as basis adjustment to the hedged item. If the hedge no longer meets the crite- ria for hedge accounting, the adjustment to the carrying amount of a hedged item for which the effective interest method is used is amor- tized to the consolidated statement of comprehensive income and retained earnings over the period to maturity or derecognition. Note 3 Mortgages Pledged under Securitization The Company securitizes residential and commercial mor tgages in order to raise debt to fund these mortgages. Most of these securitiza- tions consist of the transfer of fixed and floating rate mortgages into securitization programs, such as ABCP, National Housing Act – Mort- gage Backed Securities (“NHA–MBS”), and the Canada Mor tgage Bonds [“CMB”] program. In these securitizations, the Company trans- fers the assets to special purpose entities [“SPEs”] for cash, and incurs interest-bearing obligations typically matched to the term of the mort- gages. These securitizations do not qualify for derecognition, although the SPEs and other securitization vehicles have no recourse to the Company’s other assets for failure of the mor tgages to make pay- ments when due. As part of the ABCP transactions, the Company provides cash col- lateral for credit enhancement purposes as required by the rating agencies. Credit exposure to securitized mortgages is generally limited to this cash collateral. The principal and interest payments on the 40 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT securitized mortgages are paid to the Company by the SPEs monthly over the term of the mortgages. The full amount of the cash collateral is recorded as an asset and the Company anticipates full recovery of these amounts. NHA–MBS financings may also require cash collateral in some circumstances. As at December 31, 2011, the cash held as collateral under securitization was $56,882 [December 31, 2010 – $37,730; January 1, 2010 – $43,709]. The following table compares the carrying amount of mortgages pledged for securitization and the associated debt: NHA–MBS and CMB programs Bank-sponsored ABCP Capitalized origination costs Debt discounts December 31, 2011 Carrying amount of securitized mortgages Carrying amount of associated liabilities $ 7,560,583 2,151,556 49,782 – $ 7,634,173 2,258,368 – (4,524) 9,761,921 9,888,017 Add: principal portion of payments held in restricted cash 225,707 – $ 9,987,628 $ 9,888,017 December 31, 2010 Carrying amount of securitized mortgages Carrying amount of associated liabilities $ 5,885,249 1,261,522 47,190 – $ 6,008,854 1,271,262 – (5,634) 7,193,961 7,274,482 NHA–MBS and CMB programs Bank-sponsored ABCP Capitalized origination costs Debt discounts Add: principal portion of payments held in restricted cash 152,445 – $ 7,346,406 $ 7,274,482 January 1, 2010 Carrying amount of securitized mortgages Carrying amount of associated liabilities $ 3,980,382 1,527,758 32,654 – $ 3,995,080 1,554,248 – (12,934) 5,540,794 5,536,394 NHA–MBS and CMB programs Bank-sponsored ABCP Capitalized origination costs Debt discounts Add: principal portion of payments held in restricted cash 73,440 – $ 5,614,234 $ 5,536,394 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The principal portion of payments held in restricted cash represents payments on account of mor tgages pledged under securitization which have been received at year end but have not been applied to reduce the associated debt. This cash is applied to pay down the debt in the month subsequent to year end. In order to compare all assets funded by each category of securitization debt, this amount is added to the carrying value of mortgages pledged under securitization in the above table. Except for approximately $521 million of securitized mor tgages included in HFT mortgages, the mortgages securitized through NHA– MBS and CMB programs have been classified as loans and receivables. These mortgages are carried at par plus adjustment for unamortized origination costs. Mor tgages in bank-sponsored ABCP programs have been classified as fair value through profit or loss and are net of specific provisions for credit losses. The following table summarizes the mor tgages pledged under Bank-sponsored ABCP mor tgages are net of valuation reserves securitization that are past due: Arrears days 31 to 60 61 to 90 Greater than 90 December 31 2011 December 31 2010 $ 45,801 6,465 38,306 $ 37,696 7,292 28,706 $ 90,572 $ 73,694 Interest revenue-securitized mortgages consists of $43,728 [2010 – $38,244] of interest revenue related to ABCP funded mor tgages, which are measured at fair value, and $210,390 [2010 – $133,282] of interest revenue related to mortgages pledged under securitization and securitized mortgages included in HFT mortgages. related to credit losses of $5,293 [December 31, 2010 – $5,599]. The changes in capitalized origination costs for the year ended December 31 are as follows: 2011 2010 Opening balance, January 1 Add: new origination costs in the year Less: amortization in the year $ 47,190 $ 32,654 25,152 (22,560) 40,185 (25,649) Ending balance, December 31 $ 49,782 $ 47,190 During the year ended December 31, 2011, the Company advanced funds and transferred into the securitization vehicles $4,004,716 [2010 – $3,651,937] of new mortgages. As at December 31, 2011, mortgages pledged under securitization include $9,220,847 [December 31, 2010 – $6,556,644] of insured mortgages and $496,584 [December 31, 2010 – $595,726] of unin- sured mortgages. The contractual maturity profile of the mortgages pledged under securitization programs is as follows: 2012 2013 2014 2015 2016 and thereafter Add: capitalized origination costs fair value premium – HFT mortgages $ 1,102,626 1,108,018 1,528,490 2,519,102 3,421,514 9,679,750 49,782 32,389 9,761,921 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 41 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 these tables, the effect of a variation in a particular assumption on the fair value 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], which might magnify or counteract the sensitivities. Note 4 Deferred Placement Fees Receivable The Company enters into transactions with institutional investors to sell primarily fixed rate mor tgages in which placement fees are received over time as well as at the time of the mortgage placement. These mortgages are derecognized when substantially all of the risks and rewards of ownership are transferred and the Company has mini- mal exposure to the variability of future cash flows from these mort- gages. The investors have no recourse to the Company’s other assets for failure of mortgagors to pay when due. During the year ended December 31, 2011, $1,012,743 [2010 – $1,749,715] of mor tgages were placed with institutional investors, which created gains on deferred placement fees of $6,663 [2010 – $13,123]. Cash receipts on deferred placement fees receivable for the year ended December 31, 2011 were $28,261 [2010 – $91,464]. The Company uses various assumptions to value the deferred placement fees receivable, which are set out in the table below, includ- ing the rate of unscheduled prepayments. Accordingly, the deferred placement fees receivable are subject to measurement uncer tainty. No assumption for credit loss was used, commensurate with the credit quality of the investors. The effect of variations between actual experience and assumptions will be recorded in future statements of comprehensive income and retained earnings. 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: FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The Company uses various assumptions to value the HFT mort- gages, which are set out in the tables below, including the rate of unscheduled prepayment. Accordingly, HFT mortgages are subject to measurement uncer tainty. The effect of variations between actual experience and assumptions will be recorded in future statements of comprehensive income. Key economic weighted average assumptions and the sensitivities of the current carrying values to immediate 10% and 20% adverse changes in those assumptions are as follows: HFT mortgages 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 Discount rate [annual rate] Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change HFT mortgages 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 Discount rate [annual rate] Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change December 31, 2011 Commercial mortgages Residential mortgages $ 487,959 14 $ 2,161,550 44 12.7% 15.0% $ $ 74 145 2.3% 649 1,280 2.4% 2,011 $ 10,867 4,005 $ 21,629 $ $ $ $ December 31, 2010 Commercial mortgages Residential mortgages $ 523,477 14 $ 738,045 20 10.9% 15.1% 32 63 2.7% 1,786 3,560 $ $ $ $ 191 381 3.4% 3,093 6,160 $ $ $ $ [1] The weighted-average life of prepayable assets in periods [for exam- ple, months or years] can be calculated by multiplying the principal collec- tions 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. 42 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS 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 these tables, the effect of a varia- tion 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], which might magnify or counteract the sensitivities. The Company estimates that the expected cash flows from the receipt of payments on the deferred placement fees receivable will be as follows: 2012 2013 2014 2015 2016 and thereafter $ 23,882 16,045 6,639 3,430 8,513 $ 58,509 Fair value of deferred placement fees receivable 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 rate] Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change Fair value of deferred placement fees receivable 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 rate] Impact on fair value of 10% adverse change Impact on fair value of 20% adverse change December 31, 2011 Commercial mortgages Residential mortgages $ 44,124 50 $ 14,385 20 0.6% 15.0% 26 51 $ $ 172 340 4.4% 4.1% 427 845 $ $ 48 95 $ $ $ $ December 31, 2010 Commercial mortgages Residential mortgages $ 51,468 56 $ 25,942 30 0.7% 15.0% $ $ $ $ 52 102 5.3% 775 1,531 $ $ $ $ 472 932 4.8% 144 287 [1] The weighted-average life of prepayable assets in periods [for exam- ple, months or years] can be calculated by multiplying the principal collec- tions 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. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 43 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Note 5 Mortgages Accumulated for Sale or Securitization Mortgages accumulated for sale or securitization consist of mortgages the Company has originated for its own securitization programs or mortgages funded for placement with other investors. Mortgages accumulated for securitization Mortgages accumulated for sale Note 6 Mortgage and Loan Investments Mortgages originated for the Company’s own securitization pro- grams are classified as loans and receivables and are recorded at amortized cost. Mortgages funded for placement with other investors are designated as held for trading and recorded at fair value. The fair values of mortgages held for trading approximate their carrying value due to their short-term nature. The following table summarizes the components of mortgages according to their classification: December 31 2011 December 31 2010 January 1 2010 $ 846,694 4,244 $ 300,309 17,827 $ 374,695 8,164 $ 850,938 $ 318,136 $ 382,859 As at December 31, 2011, mortgage and loan investments consist primarily of commercial first and second mortgages held for various terms, the majority of which mature within one year. Mortgage and loan investments consist of the following: Mortgage loans, classified as loans and receivables Mortgage loans, designated as fair value through profit or loss December 31 2011 December 31 2010 January 1 2010 $ 175,071 5,801 $ 60,555 10,356 $ 45,133 9,604 $ 180,872 $ 70,911 $ 54,737 Mortgage and loan investments classified as loans and receivables are carried at outstanding principal balances adjusted for unamortized premiums or discounts and are net of specific provisions for credit losses, if any. The following table discloses the composition of the Company’s port- folio of mor tgage and loan investments by geographic region as at December 31, 2011: [2010 – $70,388] of uninsured mortgage and loan investments as at December 31, 2011. The following table discloses the mortgages that are past due as at Province Alberta British Columbia Manitoba New Brunswick Newfoundland Nova Scotia Ontario Quebec Saskatchewan Yukon Portfolio balance Percentage of portfolio $ 2,716 2,265 16,778 1,048 645 23,867 76,232 55,289 1,031 1,001 1.50 1.25 9.28 0.58 0.36 13.20 42.14 30.57 0.57 0.55 $ 180,872 100.00 These balances are net of discounts of $121 [2010 – $296] and pro- visions for credit losses of $4,831 [2010 – $4,831]. The por tfolio contains $1,001 [2010 – $523] of insured mortgages and $184,298 44 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT December 31: Arrears days 31 to 60 61 to 90 Greater than 90 2011 2010 $ $ 7,470 221 7,266 2,122 1,694 7,739 $ 14,957 $ 11,555 Of the above total amount, the Company considers $6,121 [2010 – $5,968] as impaired, for which it has provided an allowance for poten- tial loss of $4,831 [2010 – $4,831] as at December 31, 2011. Due to loan-specific issues, the Company recorded credit losses of $525 for the year ended December 31, 2010. These losses were included in other operating expenses in the consolidated statement of comprehensive income and retained earnings. The Company re-assessed the credit risk of the mortgages at December 31, 2011, and concluded that no additional accrual is required for 2011. FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The contractual repricing in the table below is based on the earlier of contractual repricing or maturity dates. 2012 2013 2014 2015 2016 and thereafter Book value 2011 2010 Book value Residential Commercial $ 3,904 130,301 $ – 30,242 $ – 6,660 $ $ 134,205 $ 30,242 $ 6,660 $ 100 – 100 $ 1,178 8,487 $ 5,182 175,690 $ 3,039 67,872 $ 9,665 $ 180,872 $ 70,911 Interest income for the year was $8,643 [2010 – $8,722] and is included in mortgage investment income on the consolidated statement of comprehensive income and retained earnings. Note 7 Other Assets The components of other assets are as follows: Property, plant and equipment, net Intangible assets, net Goodwill December 31 2011 December 31 2010 January 1 2010 $ 5,811 24,531 29,776 $ 4,483 32,499 29,776 $ 5,026 41,967 29,776 $ 60,118 $ 66,758 $ 76,769 The intangible assets have a remaining amor tization period of less than five years. For the purpose of testing goodwill for impairment, the cash-gen- erating unit is considered to be the Corporation as a whole, since the goodwill relates to the excess purchase price paid for the Corpora- tion’s business in connection with the IPO. The recoverable amount of the Corporation is calculated by reference to the Corporation’s market capitalization, mor tgages under administration, origination volume, and profitability. These factors indicate that the Corporation’s recoverable amount exceeds the carrying value of its net assets and, accordingly, goodwill is not impaired. Note 8 Purchased Mortgage Servicing Rights Purchased mortgage servicing rights consist of the following components: 2011 2010 Cost Accumulated amortization Net book value Cost Accumulated amortization Net book value Third-party commercial mortgage servicing rights Commercial mortgage-backed securities primary $ 3,614 $ 2,913 $ 701 $ 3,614 $ 2,620 $ 994 and master servicing rights 8,705 4,635 4,070 8,705 3,933 4,772 $ 12,319 $ 7,548 $ 4,771 $ 12,319 $ 6,553 $ 5,766 The Company did not purchase any new servicing rights during the years ended December 31, 2011 and 2010. Amortization charged to income for the year ended December 31, 2011 was $995 [2010 – $841]. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 45 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Note 9 Mortgages under Administration As at December 31, 2011, the Company had mortgages under admin- istration of $59,598,596 [December 31, 2010 – $53,293,132], including mortgages held on the Company’s consolidated statement of financial position. Mor tgages under administration are serviced for financial institutions such as banks, insurance companies, pension funds, mutual funds, trust companies, credit unions and securitization vehicles. As at December 31, 2011, the Company administered 193,250 mortgages [December 31, 2010 – 174,483] for 92 institutional investors [Decem- ber 31, 2010 – 95] with an average remaining term to maturity of 41 months [December 31, 2010 – 44 months]. Mortgages under administration are serviced as follows: December 31 2011 December 31 2010 January 1 2010 Institutional investors Mortgages accumulated for sale or securitization and mortgage and loan investments Securitization vehicles, deferred placement investors Mortgages pledged under securitization CMBS conduits $ 39,562,867 $ 36,678,521 $ 32,879,103 437,596 3,904,347 5,540,794 5,031,205 1,031,720 4,920,105 9,761,921 4,321,983 389,047 4,366,884 7,193,961 4,664,719 The Company’s exposure to credit loss is limited to mortgages under administration totaling $619,165 [December 31, 2010 – $694,781], of which $25,378 of mortgages have principal and interest payments out- standing as at December 31, 2011 [December 31, 2010 – $38,435]. The Company incurred actual credit losses, net of recoveries, of $1,854 during the year ended December 31, 2011 [2010 – $3,689]. As at December 31, 2011, the Company has $3,995 [December 31, 2010 – $6,990] of uninsured non-performing mortgages [net of provisions for credit losses] included in accounts receivable and sundry. Note 10 Bank Indebtedness Bank indebtedness includes a revolving line of credit of $125,000 [December 31, 2010 – $125,000] maturing in May 2014, of which $66,403 [December 31, 2010 – $23,239] was drawn at December 31, 2011 and against which the following have been pledged as collateral: [a] a general security agreement over all assets, other than real prop- erty, of the Company; and [b] a general assignment of all mortgages owned by the Company. The revolving line of credit bears a variable rate of interest based on prime and bankers’ acceptance rates. The terms of the revolving line of credit include negative cove- nants customary for transactions of this kind. In February 2012, FNFLP and its lenders amended the financial covenants associated with the line of credit. The amendments are effective for the Corporation’s fourth quarter 2011 reporting. The amendments resulted in changes to the calculation of “Distributable Cash”. As a result, the Corporation is in compliance with all revised financial covenants as amended and restated as at December 31, 2011. $ 59,598,596 $ 53,293,132 $ 47,793,045 Note 11 Debt Related to Securitized and Participation Mortgages Debt related to securitized mor tgages represents the funding for mortgages pledged under the NHA–MBS, CMB and ABCP programs. As at December 31, 2011, debt related to securitized mortgages was $9,888,017 [December 31, 2010 – $7,274,482], net of unamortized discounts of $4,524 [December 31, 2010 – $5,634]. A comparison of the carrying amounts of the pledged mortgages and the related debt is summarized in note 3. As at December 31, 2011, debt related to participation mortgages was $69,202 [December 31, 2010 – nil]. Debt related to securitized and participation mortgages is reduced on a monthly basis when the principal payments received from the mortgages are applied. Debt discounts and premiums are amortized over the term of each debt on an effective yield basis. Note 12 Swap Contracts Swaps are over-the-counter contracts in which two counterpar ties exchange a series of cash flows based on agreed upon rates to a notional amount. The Company used an interest rate swap to manage interest rate exposure relating to variability of interest earned on a portion of mortgages accumulated for sale held on the consolidated statement of financial position. The swap agreement that the Com- pany entered into was an interest rate swap where two counterpar- ties exchange a series of payments based on different interest rates applied to a notional amount in a single currency. 46 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The following tables present, by remaining term to maturity, the notional amounts and fair values of the swap contract that do not qualify for hedge accounting as at December 31, 2011 and 2010: 2011 Less than 3 years 3 to 5 years 6 to 10 years Total notional amount Fair value Interest rate swap contract $ 369,852 $ 915,712 $ 16,112 $ 1,301,676 $ (1,009) 2010 Less than 3 years 3 to 5 years 6 to 10 years Total notional amount Fair value Interest rate swap contract $ 783,183 $ 292,255 $ – $ 1,075,438 $ (15,263) Positive fair values of the interest rate swap contracts are included in accounts receivable and sundry and negative fair values are included in accounts payable and accrued liabilities on the consolidated statement of financial position. Note 13 Debenture Loan Payable Note 14 Commitments, Guarantees and Contingencies On May 7, 2010, the Fund issued $175 million of five-year term senior secured debentures with an interest rate of 5.07% maturing on May 7, 2015. Pursuant to the Conversion, the Corporation assumed all liabili- ties related to the debentures. The debentures are secured on a pari- passu basis with the security under the one-year revolving line of credit described in bank indebtedness on advance. The net proceeds of the issuance were loaned to FNFLP at an interest rate of 5.1025% per annum. The Company used the proceeds of the debenture loan to repay a por tion of its bank indebtedness under its existing bank credit facility. On the same date, the Company entered into a swap agreement to receive a 5.07% fixed coupon and pay monthly CDOR+2.134%, effectively protecting the Company against changes in fair value due to changes in interest rates. The swap agreement has been designated as a fair value hedge and matures on the due date of the debenture loan. The Company has a full guarantee on the deben- tures and the costs relating to the debenture issue have been borne by the Company. As at December 31, 2011, the Company has the following operating lease commitments for its office premises: 2012 2013 2014 2015 2016 and after $ 3,758 3,398 3,263 3,164 3,969 $ 17,552 Outstanding commitments for future advances on mor tgages with terms of one to 10 years amounted to $1,814,084 as at Decem- ber 31, 2011 [2010 – $2,166,166]. 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 have been sold to institutional investors while others will expire before being drawn down. Accordingly, these amounts do not necessarily represent future cash requirements of the Company. In the normal course of business, the Company enters into a vari- ety of guarantees. Guarantees include contracts where the Company may be required to make payments to a third party, based on changes in the value of an asset or liability that the third party holds. In addi- tion, contracts under which the Company may be required to make payments if a third party fails to perform under the terms of the con- tract [such as mortgage servicing contracts] are considered guaran- tees. The Company has determined that the estimated potential loss from these guarantees is insignificant. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 47 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Note 15 Securities Transactions under Repurchase and Resale Transactions Note 16 Obligations Related to Securities and Mortgages Sold under Repurchase Agreements The Company’s outstanding securities purchased under resale agree- ments and securities sold under repurchase agreements have a remaining term to maturity of less than one month. The Company uses repurchase agreements to fund specific mor t- gages included in mor tgages accumulated for sale or securitization. The current contracts are with financial institutions based on bankers’ acceptance rates and mature on or before January 16, 2012. The sale is entered into concurrently with a total return swap which, with the mortgage sale, is the economic equivalent of a repurchase agreement. Note 17 Shareholders’ Equity [a] Authorized Unlimited number of common shares Unlimited number of cumulative five-year rate reset preferred shares, Class A Series 1 Unlimited number of cumulative five-year rate reset preferred shares, Class A Series 2 [b] Capital stock activities Balance, December 31, 2010 Issuance of preferred shares Balance, December 31, 2011 [c] Preferred shares On January 25, 2011, the Company issued 4 million Class A Series 1 Preferred Shares at a price of $25.00 per share for gross proceeds of $100,000 before issue expenses. Expenses of $3,519 related to the issuance have been recorded against capital stock, net of deferred income taxes recoverable of $913. The net proceeds of $96.5 million from the issuance were paid down to FNFLP as a contribution of partner capital. Subject to declaration by the Board of Directors, holders of the Series 1 Preferred Shares are entitled to receive a cumulative quar- terly fixed dividend yielding 4.65% annually for the initial period ending March 31, 2016. Thereafter, the dividend rate may be reset every five years at a rate equal to the five-year Government of Canada yield plus 2.07%, as and when approved by the Board of Directors. Holders of Class A Series 1 Preferred Shares have the right, at their option, to convert their shares into cumulative, floating rate Class A Preferred Shares, Series 2 [“Series 2 Preferred Shares”], subject to cer tain conditions, on March 31, 2016 and on March 31 every five years thereafter. Holders of the Series 2 Preferred Shares will be enti- tled to receive cumulative quarterly floating dividends at a rate equal to the three-month Government of Canada treasury bill yield plus 2.07% as and when declared by the Board of Directors. Preferred shares do not have voting rights. The par value per preferred share is $25. Common shares Preferred shares 59,967,429 $ – 122,671 – – $ 4,000,000 59,967,429 $ 122,671 4,000,000 $ – 97,394 97,394 [d] Common shares Pursuant to the Conversion as described in note 1, on January 1, 2011, unitholders of the Fund exchanged 12,681,113 Class A units in the Fund for common shares in the Company on a one-for-one basis. On the same date, the pre-Arrangement shareholders of FNFC exchanged their shares in FNFLP for 47,286,316 common shares of the Company. Common shares have voting rights and do not have par value per share. [e] Earnings per share Net income Less: dividends declared on preferred shares Net earnings attributable to common shareholders 2011 2010 $ 70,491 $ 89,917 (4,316) – $ 66,175 $ 89,917 Number of common shares outstanding Basic earnings per common share 59,967,429 1.10 $ 59,967,429 1.50 $ 48 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Note 18 Income Taxes Prior to the Conversion on Januar y 1, 2011, 21.15% of FNFLP’s income was allocated to the Fund and was not subject to current income tax to the extent the Fund distributed its taxable income to its unitholders. Following the Conversion, 100% of FNFLP’s income is allocated to the Company and is subject to current income taxes in the hands of the Company. For comparative reporting purposes, tax provisions and balances reflect those of the Company’s predecessor entities, the Fund and the Corporation. The major components of deferred tax expense (recovery) for the year ended December 31 are as follows: 2011 2010 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The effective income tax rate reported in the consolidated statements of comprehensive income and retained earnings varies from the Canadian tax rate of 28% for the year ended December 31, 2011 [2010 – 32%] for the following reasons: Company’s statutory tax rate Income before income taxes Income tax at statutory tax rate Increase (decrease) resulting from: Tax obligation assumed by unitholders of the Fund Permanent differences Differences in current and future tax rates Other 2011 2010 $ 28.00% 96,783 27,099 32.00% $ 119,957 38,386 – 585 (1,320) (72) (7,737) – (694) 85 Relates to origination and reversal of timing differences $ (3,508) $ 4,202 Income tax expense $ 26,292 $ 30,040 The major components of current income tax expense for the year ended December 31 are as follows: Significant components of the Company’s deferred tax liabilities for the year ended December 31 are as follows: Income taxes relating to the year $ 29,800 $ 25,838 2011 2010 Deferred placement fees receivable Capitalized broker fees Carrying values of mortgages pledged under securitization in excess of tax values Intangible assets Unamortized discount on debt related to securitized mortgages Cumulative eligible capital property Losses on interest rate swaps Loan loss reserves not deducted for tax purposes Debenture issuance costs Share issuance costs Other 2011 2010 $ 15,008 12,704 $ 20,809 12,746 8,391 6,257 1,156 (6,711) (4,988) (2,543) (162) (840) 2,028 5,352 8,492 1,522 (7,076) (5,133) (2,933) – (150) 1,092 Deferred tax liabilities $ 30,300 $ 34,721 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 49 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The movement in significant components of the Company’s deferred tax liabilities and assets for the year ended December 31, 2011 is as follows: As at January 1 2011 Recognized in income Recognized in equity Deferred income tax liabilities Deferred placement fees Capitalized broker fees Carrying values of mortgages pledged under securitization in excess of tax values Intangible assets Unamortized discount on debt related to securitized mortgages Other $ 20,809 12,746 $ (5,801) (42) $ 5,352 8,492 1,522 1,092 3,039 (2,235) (366) 936 Total deferred income tax liabilities $ 50,013 $ (4,469) $ – – – – – – – As at January 1 2011 Recognized in income Recognized in equity As at December 31 2011 $ 15,008 12,704 8,391 6,257 1,156 2,028 $ 45,544 As at December 31 2011 Deferred income tax assets Cumulative eligible capital property Losses on interest rate swaps Loan loss reserves not deducted for tax purposes Debenture issuance costs Share issuance costs Total deferred income tax assets $ $ (7,076) (5,133) (2,933) – (150) $ 365 145 390 (162) 223 $ – – – – (913) (6,711) (4,988) (2,543) (162) (840) $ (15,292) $ 961 $ (913) $ (15,244) Net deferred income tax liabilities $ 34,721 $ (3,508) $ (913) $ 30,300 The calculation of taxable income of the Company is based on estimates and the interpretation of complex tax legislation. In the event that the tax authorities take a different view from management, the Company may be required to change its provision for income taxes or deferred tax balances and the change could be significant. Note 19 Financial Instruments and Risk Management Risk management The various risks to which the Company is exposed and the Compa- ny’s policies and processes to measure and manage them individually are set out below: Interest rate risk Interest rate risk arises when changes in interest rates will affect the fair value of financial instruments. The Company uses various strategies to reduce interest rate risk. The Company’s risk management objective is to maintain interest rate spreads from the point that a mortgage commitment is issued to the transfer of the mortgage to the related securitization vehicle or sale to an institutional investor. Primary among these strategies is the Com- pany’s decision to sell mortgages at the time of commitment, passing on interest rate risk that exists prior to funding to institutional investors. 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 mor tgage rate is committed to bor- rowers and the time the mortgage is sold to a securitization vehicle and the underlying cost of funding is fixed. As interest rates change, the val- ues of these interest rate-dependent financial instruments vary inversely with the values of the mortgage contracts. As interest rates increase, a gain will be recorded on the economic hedge which will be offset by the reduced future spread on mortgages pledged under securitization as the mortgage rate committed to the borrower is fixed at the point of commitment. 50 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS For single-family mortgages, only a portion of the 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 economically hedged is the expected value of the mor tgages funding within the future commitment period. The Company also hedges against interest rate fluctuations by offsetting the exposure of the Company’s bank indebtedness and funds held in trust. Bank indebtedness, obligations related to debt and the debenture loan payable [after the effect of the interest rate swap] are all floating rate obligations indexed to 30-day CDOR; the funds held in trust earn the Company interest based on the same floating rate basis. Because both the indebtedness and funds held in trust have comparable values, with the liabilities at $745,032 [2010 – $363,003] at December 31, 2011 and the funds held in trust at $503,294 [2010 – $527,624] on the same date, the Company con- siders the arrangement to be a natural hedge against shor t-term interest rate fluctuations. The table below provides the financial impact that an immediate and sustained 100 basis point and 200 basis point increase and decrease in shor t-term interest rates would have had on the net income of the Company in 2011 and 2010. 100 basis point shift Impact on net income and shareholders’ equity 200 basis point shift Impact on net income and shareholders’ equity Increase in interest rate Decrease in interest rate 2011 2010 2011 2010 $ 450 $ 947 $ (449) $ 707 901 1,895 2,751 3,430 As at December 31, 2011, the Company administered $21,144 [2010 – $50,553] of fixed rate commercial mortgages, of which it has a direct face value interest of $5,281 [2010 – $10,903] included in mortgage and loan investments. The other interests in these mor tgages are owned by an arm’s-length investor and are subject to par ticipation agreements such that this investor receives a floating rate of return on its portion of these mortgages. The Company has exposure to the risk that short-term interest rates increase, and credit losses as the Com- pany has a first loss position. Accordingly, these mortgages are much more sensitive to changes in interest rates and credit loss than the Company’s typical mortgage and loan investments. The Company’s accounts receivable and sundry, accounts payable and accrued liabilities, and purchased mortgage servicing rights are not exposed to interest rate risk. The maximum credit exposures of the financial assets are their car- rying values as reflected on the consolidated statement of financial posi- tion. The Company does not have significant concentration of credit risk within any particular geographic region or group of customers. The Company is at risk that the underlying mortgages default and the servicing cash flows cease. The large portfolio of individual mort- gages that underlies these assets is diverse in terms of geographical location, borrower exposure and the underlying type of real estate. This and the priority ranking of the Company’s rights mitigate the potential size of any single credit loss. Securities purchased under resale agreements are transacted with large regulated Canadian insti- tutions such that the risk of credit loss is very remote. Securities trans- acted are all Government of Canada bonds and, as such, have virtually no risk of credit loss. Credit risk Credit risk is the risk of loss associated with a counterparty’s inability or unwillingness to fulfill its payment obligations. The Company’s credit risk is mainly lending-related in the form of mor tgage default. The Company uses stringent underwriting criteria and experienced adjudi- cators to mitigate this risk. The Company’s approach to managing credit risk is based on the consistent application of a detailed set of credit policies and prudent arrears management. As at December 31, 2011, 94% [December 31, 2010 – 92%] of the pledged mor tgages were insured mortgages. See details in note 3. The Company’s expo- sure is fur ther mitigated by the relatively shor t period over which a mortgage is held by the Company prior to securitization. Liquidity risk and capital resources Liquidity risk is the risk that the Company will be unable to meet its financial obligations as they come due. The Company’s liquidity strategy has been to use bank credit to fund working capital requirements and to use cash flow from opera- tions to fund longer-term assets. The Company’s credit facilities are typically drawn to fund: [i] mortgages accumulated for sale or securiti- zation, [ii] origination costs associated with mortgages pledged under securitization, [iii] cash held as collateral under securitization, [iv] costs associated with deferred placement fees receivable and [v] mortgage and loan investments. The Company has a credit facility with a syndi- cate of four banks which provides for a total of $125,000 in financing. Bank indebtedness also includes borrowings obtained through out- standing cheques and overdraft facilities. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 51 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The Company finances the majority of its mor tgages with debt derived from the securitization markets, primarily NHA–MBS and ABCP. These obligations reset monthly such that the receipts of princi- pal on the mortgages are used to pay down the related debt within a 30-day period. Accordingly, these sources of financing amortize at the same rate as the mortgages pledged thereunder, providing an almost perfectly matched asset and liability relationship. Valuation methods and assumptions The Company uses valuation techniques to estimate fair values, includ- ing reference to third-party valuation service providers, using proprie- tary pricing models and internal valuation models such as discounted cash flow analysis. The valuation methods and key assumptions used in determining fair values for the financial assets and financial liabilities are as follows: Market risk Market risk is the risk of loss that may arise from changes in market factors such as interest rates and credit spreads. The level of market risk to which the Company is exposed varies depending on market conditions, expectations of future interest rates and credit spreads. Customer concentration risk Placement fees, mor tgage servicing income and gains on deferred placement fees revenue from three Canadian financial institutions rep- resent approximately 47% [2010 – 43%] of the Company’s total reve- nue. During the year ended December 31, 2011, the Company placed 51% [2010 – 54%] of all mortgages it originated with the same three institutional investors. Fair value measurement The Company uses the following hierarchy for determining and dis- closing fair value of financial instruments recorded at fair value in the consolidated statement of financial position: [a] HFT mortgages and certain mortgage and loan investments The fair value of these mortgages is determined by discounting projected cash flows using market industry pricing practices. Dis- count rates used are determined by comparison to similar term loans made to borrowers with similar credit. This methodology will reflect changes in interest rates which have occurred since the mortgages were originated. Impaired mortgages are recorded at net realizable value. [b] Deferred placement fees receivable The fair value of deferred placement fees receivable is deter- mined by internal valuation models consistent with industry prac- tice using market data inputs, where possible. The fair value is determined by discounting the expected future cash flows related to the placed mortgages at market interest rates. The expected future cash flows are estimated based on cer tain assumptions which are not suppor ted by observable market data. Refer to note 4, “Deferred placement fees receivable” for the key assump- tions used and a sensitivity analysis. Level 1 – quoted market price observed in active markets for identi- cal instruments; [c] Securities owned and sold short Level 2 – quoted market price observed in active markets for similar instruments or other valuation techniques for which all significant inputs are based on observable market data; and Level 3 – valuation techniques in which one or more significant inputs are unobservable. The fair values of securities owned and sold shor t used by the Company to hedge its interest rate exposure are determined by quoted prices. [d] Other financial assets and financial liabilities The fair value of mortgage and loan investments classified as loans and receivables, mortgages accumulated for sale or securitization, cash held as collateral for securitization, restricted cash and bank indebtedness corresponds to the respective outstanding amounts due to their short-term maturity profiles. 52 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT The following table represents the Company’s financial instruments measured at fair value on a recurring basis: FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Financial assets Mortgages accumulated for sale HFT mortgages Deferred placement fees receivable Mortgage and loan investments Interest rate swaps Total financial assets Financial liabilities Securities sold under repurchase agreements and sold short Interest rate swaps Total financial liabilities Financial assets Mortgages accumulated for sale HFT mortgages Deferred placement fees receivable Mortgage and loan investments Interest rate swaps Total financial assets Financial liabilities Securities sold under repurchase agreements and sold short Interest rate swaps December 31, 2011 Level 1 Level 2 Level 3 Total $ $ – $ – – – – – $ 4,244 $ – – – 9,689 – $ 2,672,163 58,509 5,801 – 4,244 2,672,163 58,509 5,801 9,689 13,933 $ 2,736,473 $ 2,750,406 $ 659,299 $ – $ – 10,698 – $ – 659,299 10,698 $ 659,299 $ 10,698 $ – $ 669,997 December 31, 2010 Level 1 Level 2 Level 3 Total $ $ $ – $ – – – – – $ 17,827 $ – – – 3,849 – $ 1,261,522 77,410 10,356 – 17,827 1,261,522 [1] 77,410 10,356 3,849 21,676 $ 1,349,288 $ 1,370,964 424,673 $ – – $ 19,112 – $ – 424,673 19,112 Total financial liabilities $ 424,673 $ 19,112 $ – $ 443,785 The following adjustments have been made to restate the December 31, 2010 comparatives under IFRS: [1] Under IFRS, mortgages funded with bank-sponsored ABCP programs do not meet the derecognition criteria; the Company has chosen to classify these as fair value through profit or loss and recorded at fair value. Cash held as collateral under securitization related to these mortgages is held at cost. In estimating the fair value of financial assets and financial liabilities using valuation techniques or pricing models, certain assumptions are used including those that are not fully supported by observable mar- ket prices or rates [level 3]. The amount of the change in fair value recognized by the Company in net income for the year ended December 31, 2011 that was estimated using a valuation technique based on assumptions that are not fully suppor ted by observable market prices or rates was a gain of approximately $3,846 [2010 – $6,698]. Although the Company’s management believes that the esti- mated fair values are appropriate as at the date of the consolidated statement of financial position, those fair values may differ if other reasonably possible alternative assumptions are used. The following table presents changes in the fair values [including realized losses of $16,824 [2010 – gains of $582]] of the Company’s financial assets and financial liabilities for the years ended Decem- ber 31, 2011 and 2010, all of which have been classified as fair value through profit or loss: HFT mortgages Deferred placement fees receivable Mortgage and loan investments Securities owned and sold short Interest rate swaps 2011 2010 $ $ (5,694) 1,150 1,066 (8,707) (792) $ (12,977) $ 2,978 931 3,229 27 115 7,280 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 53 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Movement in level 3 financial instruments measured at fair value The following tables show the movement in level 3 financial instruments in the fair value hierarchy for the years ended December 31, 2011 and 2010. The Company classifies financial instruments to level 3 when there is reliance on at least one significant unobservable input in the valuation models. Financial assets HFT mortgages Deferred placement fees receivable Mortgage and loan investments Total financial assets Financial assets Bank-sponsored ABCP mortgages Deferred placement fees receivable Mortgage and loan investments Total financial assets Fair value as at January 1 2011 Investments Unrealized gain (loss) recorded in income Payment and amortization Fair value as at December 31 2011 $ 1,261,522 $ 1,863,838 $ 77,410 10,356 4,720 – 1,738 $ 1,150 1,066 (454,935) $ 2,672,163 58,509 (24,771) 5,801 (5,621) $ 1,349,288 $ 1,868,558 $ 3,954 $ (485,327) $ 2,736,473 Fair value as at January 1 2010 Investments Unrealized gain (loss) recorded in income Payment and amortization Fair value as at December 31 2010 $ 1,558,290 $ 90,268 9,604 461,914 $ 9,566 – (16,875) $ 931 3,230 (741,807) $ 1,261,522 77,410 (23,355) 10,356 (2,478) $ 1,658,162 $ 471,480 $ (12,714) $ (767,640) $ 1,349,288 Derivative financial instrument and hedge accounting The Company entered into a swap agreement to hedge the deben- ture loan payable against changes in fair value by converting the fixed rate debt into a variable rate debt. The swap agreement has been designated as a fair value hedge and the hedging relationship is for- mally documented, including the risk management objective and mea- surement of effectiveness. The swap agreement is recorded at fair value with the changes in fair value recognized in income. Changes in fair value attributed to the hedged risk are accounted for as basis adjustments to the debenture loan payable and are recognized in income. Accordingly, as at December 31, 2011, accounts receivable and sundry have been increased by $9,689 [December 31, 2010 – $3,849] to account for the swap derivative, and the debenture loan payable has been increased by the same amount. 54 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Note 20 Capital Management The Company’s objective is to maintain a strong capital base so as to maintain investor, creditor and market confidence and sustain future development of the business. Management defines capital as the Note 21 Earnings by Business Segment FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Company’s equity, long-term debt and retained earnings. The Company has a minimum capital requirement as stipulated by its bank credit facility. The agreement limits the debt under bank indebtedness together with the debentures to four times FNFLP’s equity. As at December 31, 2011, the ratio was 1.00:1.00 [December 31, 2010 – 0.80:1.00]. The Com- pany was in compliance with the bank covenant throughout the year. The Company operates principally in two business segments, Residential and Commercial. These segments are organized by mortgage type and contain revenue and expenses related to origination, underwriting, securitization and servicing activities. Identifiable assets are those used in the operations of the segments. REVENUE Interest revenue – securitized mortgages Interest expense – securitized mortgages Net interest – securitized mortgages Placement and servicing Mortgage investment income EXPENSES Amortization Interest Other operating 2011 Residential Commercial Total $ 172,511 $ (119,199) 81,607 $ (65,092) 254,118 (184,291) 53,312 16,515 69,827 165,566 13,421 232,299 6,203 12,989 130,210 149,402 15,025 15,890 47,430 3,621 3,009 26,914 33,544 180,591 29,311 279,729 9,824 15,998 157,124 182,946 Income before income taxes $ 82,897 $ 13,886 $ 96,783 Identifiable assets Goodwill Total assets Capital expenditures $ 9,010,099 $ 2,887,395 $ 11,897,494 29,776 – – $ 11,927,270 $ 2,228 $ 956 $ 3,184 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 55 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS REVENUE Interest revenue – securitized mortgages Interest expense – securitized mortgages Net interest – securitized mortgages Placement and servicing Mortgage investment income EXPENSES Amortization Interest Other operating 2010 Residential Commercial Total $ 119,986 $ (78,106) 51,540 $ (34,424) 171,526 (112,530) 41,880 17,116 58,996 170,054 7,971 219,905 7,048 11,081 112,217 130,346 31,487 13,221 61,824 4,217 2,532 24,677 31,426 201,541 21,192 281,729 11,265 13,613 136,894 161,772 Income before income taxes $ 89,559 $ 30,398 $ 119,957 Identifiable assets Goodwill Total assets Capital expenditures $ 6,656,143 $ 1,718,074 $ 8,374,217 29,776 – – $ 8,403,993 $ 877 $ 376 $ 1,253 Note 22 Related Party Transactions For the past three years, several of the Company’s commercial bor- rowers applied to the Company for mezzanine mortgage financing. The amounts of the mor tgages requested were in excess of the Company’s internal investment policies for investments of that nature; however, a business controlled by a senior executive and shareholder of the Company entered into agreements with the borrowers to fund the mortgages. The Company serviced these mortgages during their terms at market commercial servicing rates. The mortgages, which are administered by the Company, have a balance of $33,781 as at December 31, 2011 [December 31, 2010 – $21,627]. Company financed $15 million each of the mortgage while the Com- pany financed $30 million. The Company is the servicer of the mort- gage during the term. As at December 31, 2011, the mortgage had a balance of $15 million, each party holding the same percentage as the original funding. The mortgage was fully repaid in January 2012. A senior executive and shareholder of the Company has a signifi- cant investment in a mortgage default insurance company. In the ordi- nary course of business, the insurance company provides insurance policies to the Company’s borrowers at market rates. During the year, the Company was engaged by the insurance company to service a portfolio of $13.6 million of mortgages at market commercial servic- ing rates. As at December 31, 2011, the por tfolio had a balance of $13.4 million. In April 2011, the Company syndicated a $60 million mezzanine mortgage funding. As the full amount of the loan was in excess of the Company’s internal investment policies, two senior executives of the During the year ended December 31, 2011, the Company paid a total compensation of $2,910 [2010 – $2,882] to senior management and $216 [2010 – $195] to independent directors. 56 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Note 23 Transition to IFRS and the Conversion Effective January 1, 2011, the Company adopted IFRS. The Company retroactively applied IFRS to prior period financial reporting as if the transition to IFRS occurred effective January 1, 2010. Accordingly, the comparative financial results for 2010 have been presented to con- form to the same accounting policies used in 2011 under IFRS. As described in note 1, the comparative financial results have also been restated pursuant to the Conversion. The presentation in these con- solidated financial statements assumes that the Conversion occurred immediately prior to the transition to IFRS. In order for users of the financial statements to better understand all of these changes, FNFLP’s consolidated statement of financial posi- tion, consolidated statement of comprehensive income and retained earnings and consolidated statement of cash flows have been recon- ciled to the consolidated financial statements prepared under IFRS, assuming the Conversion occurred at the date of the IPO. The follow- ing reconciliations outline the impact of both IFRS and the Conversion: [i] Reconciliation of the changes in equity as at: • January 1, 2010 • December 31, 2010 [ii] Reconciliation of consolidated statement of comprehensive income and retained earnings for: • Year ended December 31, 2010 [iii] Reconciliation of consolidated statement of cash flows for: • Year ended December 31, 2010 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Reconciliation of the changes in equity The following table reconciles opening equity as at January 1, 2010 and December 31, 2010 to the comparative figures presented for FNFLP to account for the Conversion and the transition to IFRS. The largest adjustment relates to the purchase price discrepancies from the proceeds of the IPO and the subsequent Distribution Re-Invest- ment Plan [“DRIP”] in excess of the net book value of the net assets of FNFLP. The following reconciliations provide details of the impact of the Conversion on equity at January 1, 2010 and December 31, 2010: Equity as at January 1 2010 Equity as at December 31 2010 Amounts as originally stated for FNFLP $ 214,377 $ 261,360 Add: fair value of capital raised on IPO and DRIP in excess of net book value [note [c]] Less: amortization of intangible assets [note [c]] Less: deferred taxes related to intangible assets [note [c]] Less: deferred taxes related to timing differences inherent in FNFLP’s net assets [note [c]] Less: adjustments related to transition to IAS 39 and consolidation of the Trust [note [b]i and ii] Elimination of inter-company distributions and administration expenses [note [c]] Add: equity related to the 102,122 102,122 (30,379) (39,847) (8,600) (8,600) (21,919) (26,121) (47,408) (84,591) (37) 107 amalgamation of FNFC [note [c]] 25,726 29,746 As restated $ 233,882 $ 234,176 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 57 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Reconciliation of consolidated statement of comprehensive income for the year ended December 31, 2010 Previous GAAP FNFLP FNFC Trust [note [b]i] MBS [note [b]ii] IFRS B/S prior to Conversion Fund/FNFC [note [c]] IFRS REVENUE Interest revenue – securitized mortgages Interest expense – securitized mortgages Net interest – securitized mortgages $ – $ – – – $ (2,637) (2,637) – 3,557 (4,514) (512) – 6,315 2,809 5,018 – – – (2,637) – (2,637) 7,655 – 171,526 $ (109,893) 61,633 171,526 $ (112,530) 58,996 – $ – – 171,526 (112,530) 58,996 3,703 – (55,713) (5,370) – (41,889) (28,969) (66,605) (32,302) – (195) 4,208 – (28,289) (38,316) – 107,292 13,123 – 21,090 73,846 – 7,280 281,627 70,718 44,653 13,613 21,877 – – – – 102 – – – 102 – – – 1,443 9,468 107,292 13,123 – 21,192 73,846 – 7,280 281,729 70,718 44,653 13,613 23,320 9,468 150,861 10,911 161,772 130,766 – (10,809) 30,040 119,957 30,040 103,589 9,566 60,227 26,972 73,846 35,574 33,440 343,214 103,020 44,653 13,808 20,306 – 181,787 161,427 – Placement fees Gains on deferred placement fees Gain on securitization Mortgage investment income Mortgage servicing income Residual securities income Realized and unrealized gains (losses) on financial instruments EXPENSES Brokerage fees Salaries and benefits Interest Other operating Amortization of intangible assets Income before income taxes Income tax expenses – current Net income and comprehensive income for the year 161,427 7,655 (38,316) 130,766 (40,849) 89,917 Retained earnings, beginning of year Less distributions declared 117,087 (114,444) 42,966 – – – 160,053 (114,444) (48,842) 24,821 111,211 (89,623) Retained earnings, end of year $ 164,070 $ 50,621 $ (38,316) $ 176,375 $ (64,870) $ 111,505 Earnings per share Basic $ 2.69 $ 0.13 $ (0.64) $ 2.18 $ (0.34) $ 1.50 58 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Reconciliation of consolidated statement of cash flows for the year ended December 31, 2010 OPERATING ACTIVITIES Net income for the year Add (deduct) items not affecting cash: Deferred income taxes Non-cash portion of gains on securitization and gains on deferred placement fees Non-cash portion of gains on deferred placement fees Increase in restricted cash Net investment in mortgages pledged under securitization Net increase in debt related to securitized mortgages Amortization of securitization receivable and deferred placement fees receivable Amortization of deferred placement fees receivable Amortization of purchased mortgage servicing rights Amortization of property, plant and equipment Amortization of intangible assets Unrealized (gains) losses on financial instruments Amortization of servicing liability Net change in non-cash working capital balances related to operations Previous MBS and other adjustments [note [b]i and ii] GAAP FNFLP Fund/FNFC [note [c]] IFRS $ 161,427 $ (30,661) $ (40,849) $ 89,917 – – 4,202 4,202 (80,868) – – – – 81,517 – 841 1,796 – (32,857) (7,024) 124,832 70,000 80,868 (9,566) (82,758) (1,670,042) 1,738,088 (81,517) 23,355 – – – 26,159 7,024 950 (3,736) – – – – – – (9,566) (82,758) (1,670,042) 1,738,088 – – – – 9,468 – – (27,179) 456 – 23,355 841 1,796 9,468 (6,698) – 98,603 66,720 Cash provided by (used in) operating activities $ 194,832 $ (2,786) $ (26,723) $ 165,323 INVESTING ACTIVITIES Additions to property, plant and equipment Repayment of cash collateral and short-term notes, net Investment in mortgage and loan investments Repayment of mortgage and loan investments (1,253) 5,118 (74,082) 60,554 – 861 6,912 (6,912) – – – – (1,253) 5,979 (67,170) 53,642 Cash used in investing activities $ (9,663) $ 861 $ – $ (8,802) FINANCING ACTIVITIES Distributions paid Obligations related to securities and mortgages sold under repurchase agreements Proceeds from debentures loan Securities purchased under resale agreements and owned, net Securities sold under repurchase agreements and sold short, net $ (92,950) $ (4,118) $ 7,445 $ (89,623) (47,679) 175,000 (92,631) 92,274 – – – – – – – – (47,679) 175,000 (92,631) 92,274 Cash provided by financing activities $ 34,014 $ (4,118) $ 7,445 $ 37,341 Net decrease in bank indebtedness during the year Bank indebtedness, beginning of year $ 219,183 $ (249,336) (6,043) $ 7,147 (19,278) $ 38,431 193,862 (203,758) Bank indebtedness, end of year $ (30,153) $ 1,104 $ 19,153 $ (9,896) Supplemental cash flow information Interest received Interest paid Income taxes paid $ – $ 14,408 – 220,349 $ 102,374 – – $ – 33,387 220,349 116,782 33,387 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 59 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Notes to the reconciliations: [a] Elections under IFRS 1 i. ii. iii. The following exemptions are applicable to and have been adopted by the Company at its transition date to IFRS, which is January 1, 2010: Estimates IFRS 1 requires estimates made under IFRS at the date of transition to IFRS to be consistent with estimates made for the same date under previous Canadian GAAP. The estimates previously made by the Company under Canadian GAAP were not revised for application of IFRS except where necessary to reflect any differ- ences in accounting policies between Canadian GAAP and IFRS. Designation of previously recognized financial instruments Financial instrument designations are made on initial recognition. IFRS 1 per- mits an “available for sale” designation or a “fair value through profit or loss” designation to be made at the date of transition to IFRS. The Company has elected to designate mortgages pledged under secu- ritization in NHA–MBS and CMB programs as loans and receivables, and for mortgages pledged under securitization in bank-sponsored ABCP programs as fair value through profit or loss. Derecognition of financial assets and financial liabilities This exemp- tion allows IFRS first-time adopters to apply the IAS 39 derecogni- tion requirements prospectively for transactions occurring on or after January 1, 2004. The Company has elected to adopt this ex- emption for mortgages pledged under securitization. As a result, only gains on securitization recorded after 2003 which had been recognized in the past under Canadian GAAP have been reversed against opening equity. Previously reported securitization receiv- ables and related servicing liability have been derecognized. Ac- cordingly, both the mortgages and associated notes funding these mortgages, which were off-balance sheet under Canadian GAAP, are shown on the consolidated statement of financial position under IFRS. [b] IFRS revenue recognition – mortgages pledged under securitization Under previous Canadian GAAP, the Company’s securitizations were considered “transfers of receivables” for accounting pur- poses and were treated off-balance sheet. Gains on securitization were recognized in income at such time as the Company trans- ferred mor tgages to securitization vehicles and surrendered control whereby the transferred assets had been isolated pre- sumptively beyond the reach of the Company and its creditors. When the Company securitized mortgages, it generally retained a residual interest, presented in the balance sheets as a securitiza- tion receivable, and the obligations associated with servicing the mortgages as a servicing liability. Under IAS 39, these securitized mortgages do not meet the derecognition criteria, and instead are accounted for as a secured financing and remain on the Company’s consolidated statement of financial position. The proceeds from the securitization process are recorded as interest-bearing notes under which the mor t- gages act as collateral security. i. ii. Mor tgages issued through bank-sponsored ABCP programs are managed through FNFC Trust, a single-seller conduit, which includes three siloed portfolios: small commercial loans, Alt-A mortgages and prime mortgages. These mortgages are classified as fair value through profit or loss and recorded at fair value. As well, the mark- to-market adjustment on cash held as collateral under securitiza- tion that serves as credit enhancement for these mortgages is no longer required. The impact of these adjustments is shown on the above reconciliations under the FNFC Trust column. The FNFC Trust column is a direct reflection of the reported financial state- ments of FNFC Trust, plus the elimination of inter-company trans- actions and balances when consolidating with FNFLP. For mortgages that were issued through NHA–MBS or CMB pro- grams, the mor tgages were legally sold to funding vehicles and cannot be traded at the Company’s discretion; as such, the Com- pany classifies these mor tgages as loans and receivables, and records them at amortized cost. Origination fees associated with these mortgages have been capitalized and are amortized over the terms of the mortgages on an effective yield basis. The impact of these adjustments is shown in the above reconciliations under the MBS/other adjustments column. 60 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT [c] Conversion As described in note 1, the Company went through a series of transactions on Januar y 1, 2011 and established First National Financial Corporation [“FNFC”] as the repor ting entity. In sub- stance, these transactions represent a combination of FNFLP, FNFC and the Fund. In order for readers of the financial state- ments to have meaningful comparative information, the 2010 con- solidated financial statements have been restated as if the combined entity reported the same way in 2010. Significant adjust- ments related to the consolidation of the Fund and FNFC with FNFLP are: the addition of goodwill and intangible assets from the Fund, cash, current income taxes payable and equity from FNFC, as well as the deferred tax liabilities that were previously recorded on the financial statements of the Fund and FNFC. Under the new laws enacted by the government in 2007 for taxation of “specified investment flow-through”, the Fund accrued deferred tax liabilities related to the differences between the carrying values and tax base of its assets and liabilities star ting in 2007. The Fund also accrued for its portion of the deferred tax liabilities for its 21.15% ownership of FNFLP. As FNFLP is now wholly controlled by the Corporation, the 2010 comparative numbers have been adjusted for the full amount of deferred tax liabilities related to FNFLP. The impact of these adjustments is shown in the above reconciliations under the Fund/FNFC column. [d] Impact of converting to IFRS For the Company, this has meant a significant change in its accounting policy regarding revenue recognition, par ticularly in accounting for securitization transactions. Under Canadian GAAP, the Company’s securitizations were considered “true sales” for accounting purposes, such that the Company recorded gains on securitization when these mortgages were sold to various securi- tization conduits. Under current IFRS standards, these securitiza- tions do not meet the criteria for derecognition and instead are accounted for as a secured financing. Accordingly, the Company’s securitizations [through ABCP conduits, NHA–MBS and direct CMB issuance] do not qualify for sale accounting. FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS The Company has restated its comparative 2010 consolidated financial statements as if IFRS accounting standards had been applied for the past six years. This restatement eliminates all secu- ritization receivables as at January 1, 2010, and puts these mort- gages back on the Company’s balance sheet together with securitization debt related to these transactions. The restated con- solidated statements of financial position under IFRS as at Decem- ber 31, 2010 have a number of significant changes. In addition to the reversal of the securitization receivable of $157 million, the consolidated statements of financial position also include these changes: [1] an increase in the amount of the Company’s assets by approximately $7.3 billion of mor tgages; [2] an increase of $0.2 billion in restricted cash representing principal received on these mor tgages in December 2010 and held in trust until the subsequent month; [3] an increase in the Company’s liabilities by an amount of $7.3 billion of debt related to securitized mortgages; and [4] a decrease in opening equity of $19.5 million. The reconciliations of equity balances from Canadian GAAP to IFRS feature significant decreases representing the reversal of previously recorded net securitization receivables. At January 1, 2010, these decreased equity by $104.0 million [December 31, 2010 – $157.4 million]. These decreases were offset by increases resulting from the deferral of mortgage origination costs related to mortgages pledged under securitization which the Company had expensed under Canadian GAAP. These deferred costs totaled $32.7 million at January 1, 2010 [December 31, 2010 – $47.2 million]. The reconciliations of the consolidated statements of com- prehensive income both show decreased gains on securitization revenue as under IFRS these transactions do not meet the derecognition tests. In their place, the Company will earn net inter- est margin over the term of the pledged mortgages and related debts. In both periods presented, income before income taxes has decreased as gains on securitization exceeded the net interest income for the periods. The Company’s consolidated statement of cash flows is similarly affected by the inflation of the Company’s assets under IFRS. The investing in mortgages pledged under securitization and the net increase in debt related to securitized mortgages are new significant cash flows under IFRS that were not disclosed under Canadian GAAP. In prior year disclosures, these cash flows were effectively described on a net basis in operating activities related to securitization. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 61 FIRST NATIONAL FINANCIAL CORPORATION NOTES TO FINANCIAL STATEMENTS Note 24 Future Accounting Changes The Company has adopted IFRS as at January 1, 2010. The following new IFRS pronouncements have been issued and, although not yet effective, may have a future impact on the Company: IFRS 9 – Financial Instruments As of January 1, 2013, the Company will be required to adopt this standard, which is the first phase of the IASB project to replace IAS 39, “Financial Instruments: Recognition and Measurement”. IFRS 9 provides new requirements for how an entity should classify and measure finan- cial assets and financial liabilities that are in the scope of IAS 39. Man- agement is currently evaluating the potential impact that the adoption of IFRS 9 will have on the Company’s consolidated financial statements. IFRS 10 – Consolidated Financial Statements As of January 1, 2013, IFRS 10 – “Consolidated Financial Statements” will replace portions of IAS 27, “Consolidated and Separate Financial Statements” and interpretation SIC – 12, “Consolidation – Special Pur- pose Entities”. The IASB introduced a single model for consolidating subsidiaries using a control model. In particular this standard addresses the control of SPEs. There will be little impact to the Company as it currently consolidates its SPEs fully. IFRS 11 – Joint Arrangements As of January 1, 2013, the IASB will expand the definition of a joint ven- ture. The Company would be required to account for joint ventures by the equity method as opposed to proportionate consolidation. IFRS 12 – Disclosure of Interests in Other Entities As of January 1, 2013, the Company will be required to make new dis- closures on its off-balance sheet activities including those with SPEs. IFRS 13 – Fair Value Measurements As of January 1, 2013, the Company will be required to adopt this standard, which provides a framework for the application of fair value to those assets and liabilities qualifying or permitted to be carried at fair value. The Company believes its current measurement of fair value is appropriate and there will be little impact. IAS 27 – Separate Financial Statements As of January 1, 2013, this standard will only prescribe the accounting and disclosure requirements for investments in subsidiaries, joint ventures and associates when an entity prepares separate financial statements, and thus will have limited impact for the Company. IAS 28 – Investments in Associates As of January 1, 2013, this standard has been amended to correspond to changes in IFRS 10, 11 and 12 listed above, providing guidance for investments in associates. As described above, there should be little effect on the Company. 62 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Corporate Governance First National’s Board of Directors and management team fully acknowledge the importance of their duty to serve the long-term interests of shareholders. Sound corporate governance is fundamental for maintaining the confidence of investors and increasing shareholder value. As such, First National is committed to the highest standards of integrity, transparency, compliance and discipline. These standards define the relationships among all of our stakeholders – Board, management and shareholders – and are the basis for building these values and nur turing a culture of accountability and responsibility across the organization. Policies The Board super vises and evaluates the management of the Company and oversees matters related to our strategic direction and assesses results relative to our goals and objectives. As such, the Board has adopted several policies that 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. These policies are compliant with the corporate governance guidelines of the Canadian Securities Administrators. As a public company, First National’s Board continues to update, develop and implement appropriate governance policies and practices as it sees fit. The Audit Committee consists of three independent directors, all of whom are considered financially literate for the purposes of the Canadian Securities Administrators’ Multilateral Instrument 52 -110 – Audit Committees. Committee Members: John Brough (Chair), Peter Copestake and Robert Mitchell Compensation, Governance and Nominating Committee The Compensation, Governance and Nominating Committee’s responsibilities include: • Making recommendations concerning the compensation of the Company’s senior executive officers and the remuneration of the Board of Directors; • Developing the Company’s approach to corporate 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 Company’s written Disclosure Policy. Committees The Board of Directors has established an Audit Committee and a Compensation, Governance and Nominating Committee to assist in the efficient functioning of the Company’s corporate governance strategy. The Compensation, Governance and Nominating Committee consists of three independent directors for the purposes of the Canadian Securities Administrators’ Multilateral Instrument 58 -10 – Disclosure of Corporate Governance Practices. Committee Members: Stanley Beck (Chair), Duncan Jackman and Peter Copestake Audit Committee The Audit Committee’s responsibilities include: • Management of the relationship with the external auditor including the oversight and super vision of the audit of the Company’s financial statements; • Oversight and super vision of the quality and integrity of the Company’s financial statements; and • Oversight and super vision of the adequacy of the Company’s internal accounting controls and procedures, as well as its financial reporting practices. FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT 63 Board Members Collectively, the Board of Directors has extensive experience in mortgage lending, real estate, strategic planning, law and finance. The Board consists of seven members, five of whom are independent. 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 chairs the audit committee for Discovery Parks Holdings Ltd., trustee for Dis- covery Parks Trust. Discovery Parks Trust was established to suppor t the high technology and research industries in British Columbia through the development of its real estate assets. Mr. Mitchell has a MBA from University of Western Ontario, a Bachelor of Commerce (Finance) from University of Calgary, and is a CFA charterholder. Peter Copestake currently serves as a cor- porate director and as a consultant to business, academic and government organizations. Over the past 30 years he has held senior financial and management positions at federally regu- lated financial institutions and in the federal government. From 1999 to 2007 he was Se- nior Vice President and Treasurer of Manulife Financial Corporation. He currently serves as the Chairman Emeritus of the Association for Financial Professionals of Canada, Chair Emeri- tus of the Society of Canadian Treasurers, as a member of the Investment Committee of the Board of Trustees of Queen’s University, as a member of the Board of Directors of the Canadian Derivatives Clearing Corpora- tion, the Chairman of the Independent Review Committee of First Trust Por tfolios Canada and member of the Board of Directors of Manulife Bank. He is also currently serving as the Executive in Residence at the Queen’s University School of Business. Stephen Smith is President of the Corpo- ration, President of First National Financial LP and co-founder of First National. Mr. Smith has been an innovator in the development and utilization of various securitization tech- niques to finance mor tgage assets and is a regular speaker at securitization conferences. Prior to co-founding First National in 1988, Mr. Smith held various positions including Assistant Director, Corporate Planning, Hawker Siddeley Canada and Research Ana- lyst, Canadian Pacific Limited. Mr. Smith has a Master of Science (Economics) from the London School of Economics and Political Science, a Bachelor of Science (Honours) in Electrical Engineering, Queen’s University, and is a member of the Association of Profes- sional Engineers of Ontario. He is currently the vice-chairman of Metrolinx, a director of The Dominion of Canada General Insurance Company, the Empire Life Insurance Com- pany and is Chair of The Historica-Dominion Institute. Mr. Smith is a graduate of the Di- rectors Education Program at the University of Toronto, Rotman School of Management. Moray Tawse is Vice President and Secre- tary of the Corporation, Vice President, Mort- gage Investments of First National Financial LP and co-founder of First National. In addition to directing the operations of all of First National’s commercial mortgage origination activities, he is one of Canada’s leading ex- perts 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 arbi- tration and mediation firm) for more than five years. He was previously a Professor of Law and Dean at Osgoode Hall Law School, Toronto. From 1985 to 1990, Mr. Beck served as Chairman of the Ontario Securities Com- mission. 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 ser ves on the board as a director of Scotia Utility Corp. and Scotia NewGrowth Corp. John Brough served as President of both Wittington Proper ties Limited (Canada) and Torwest, Inc. (United States) real es- tate development companies from 1998 to 2007. From 1974 until 1996 he was with Markborough Properties, Inc., where he was Senior Vice President and Chief Financial Officer from 1986 until 1996. Mr. Brough is a Director of Kinross Gold Corporation, Silver Wheaton Corp., Canadian Real Estate Investment Trust and Transglobe Apartment Real Estate Investment Trust. Mr. Brough has a Bachelor of Arts (Economics) degree from the University of Toronto, as well as a Chartered Accountant degree. Mr. Brough is a graduate of the Directors Education Pro- gram at the University of Toronto, Rotman School of Management, and a member of the Institute of Corporate Directors. Duncan Jackman is the Chairman, Presi- dent and Chief Executive Officer of E-L Financial Corporation Limited, an invest- ment holding company and has held simi- lar positions with E-L Financial since 2003. Mr. Jackman is the Chairman and President of Economic Investment Trust Limited and United Corporations Limited, both closed- end investment corporations, and has acted in a similar capacity with these corporations since 2001. Prior to this, Mr. Jackman held a variety of positions including portfolio man- ager at Cassels Blaikie and investment analyst at RBC Dominion Securities Inc. Mr. Jackman holds a Bachelor of Ar ts in Literature from McGill University. 64 FIRST NATIONAL FINANCIAL CORPORATION 2011 ANNUAL REPORT Shareholder Information Corporate Address Senior Executives of First National Financial LP Investor Relations Contacts First National Financial Corporation 100 University Avenue North Tower, Suite 700 Toronto, Ontario M5J 1V6 Phone: 416.593.1100 416.593.1900 Fax: Stephen Smith Co-founder, Chairman and President Moray Tawse Co-founder and Vice President, Mortgage Investments Robert Inglis Chief Financial Officer Robert Inglis Chief Financial Officer rob.inglis@firstnational.ca Steve Wallace Vice President Barnes Communications Inc. swallace@barnesir.com Scott McKenzie Vice President, Residential Mortgages Investor Relations Website www.firstnational.ca Jason Ellis Managing Director, Capital Markets Jeremy Wedgbury Managing Director, Commercial Mortgage Origination Registrar and Transfer Agent Computershare Investor Services Inc. Toronto, Ontario 1.800.564.6253 Lisa White Vice President, Mortgage Administration Exchange Listing and Symbol TSX: FN Susan Biggar General Counsel Legal Counsel Stikeman Elliott LLP Toronto, Ontario Auditors Ernst & Young LLP Toronto, Ontario Annual Meeting May 3, 2012, 10 a.m. EDT TMX Broadcast Centre The Gallery The Exchange Tower 130 King Street West Toronto, Ontario VANCOUVER • CALGARY • TORONTO • MONTREAL • HALIFAX 

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