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Annual Report 2014

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2014 Annual Report 2014 At a Glance $85.9 Billion Mortgages Under Administration (“MUA”) grew 14% in 2014 to a record $85.9 billion. MUA has grown every year since First National placed its first mortgage in the early 1990s. 40% I 2014 Annual Report 2014 at a glance Pre-FMV1 return on shareholders’ equity of 40% in 2014 and three-year average of 46% demonstrates the Company’s efficient use of capital. 1 Pre Fair Market Return is a non-IFRS Measure, see page 8 In 2014, First National increased its common share dividend for the seventh time since its initial public offering. The Company now pays at an annualized rate per common share of $1.50. First National paid out 87% of its earnings available to common shareholders in dividends in 2014, despite the increased investment in securitization transactions. # 7 87% 2014 at a glance 2014 Annual Report II Stephen Smith Chairman and Chief Executive Officer Letter from the CEO Fellow Shareholders: First National produced solid financial results in 2014 while also starting a new business that will create value in future years. Looking first at annual performance, activity levels in Canadian real estate and mortgage markets allowed the Company to set new annual records for Mortgages under Administration ($85.9 billion), mortgage originations ($16.2 billion) and revenues ($803.1 million). Compared to 2013, these three metrics grew Net income was $104.5 million ($1.62 per com- 14%, 15% and 3% respectively and marked the mon share) compared to $172.1 million ($2.75 continuation of a long-term growth trend in per common share) in 2013; the income before the business that shows the results of our on- taxes was $140.3 million compared to $233.5 going efforts to use our resources to deliver million in 2013 and Pre-Fair Market Value responsive service to mortgage brokers and EBITDA, a non-IFRS measure, was $183.1 borrowers. Indeed, since the business funded million compared to $197.6 million in 2013. its first mortgage back in the early 1990s, Pre-Fair Market Value EBITDA is calculated Mortgages under Administration (MUA) have by removing gains and losses on financial grown every year. As most of the Company’s instruments, which accounted for approximately earnings come from MUA, either in the form three quarters of the 41% year-over-year decline of net interest margin or servicing income, in earnings per share. this ongoing growth bodes well for the future. Although much lower than last year, 2014 We are particularly pleased that both segments earnings provided good support for First of our business — residential and commercial — National’s common share dividend payments captured strong new origination volumes. First which, for the year, amounted to $1.48 per National’s single family residential originations share, up 10 cents or 7% from 2013. The Board outpaced 2013 volumes by $1.6 billion or 15%, of Directors raised the dividend, starting while commercial outperformed 2013 by $600 with the April 2014 payment, to a $1.50 per million or 18%. Although we had less business common share annualized, or 12.5 cents per to renew in 2014 than in 2013 on the residential month. This marked the seventh increase side, total mortgage renewals were a healthy since the Company’s Initial Public Offering $4.7 billion as we sustained our high rates of in 2006. At its current level, First National’s retention. dividend is attractive for shareholders and is sustainable for the Company — representing Annual earnings were also solid, although vol- 87% of 2014 earnings available to common atility in the bond market (which affected our shareholders — even when factoring in our interest rate hedges) and tighter mortgage strategy of investing increasingly more cash spreads led to unfavourable year-over-year in mortgage securitization. comparisons. 1 Letter from the CEO First National Financial CorporationLetter from the CEO Securitized mortgages are one of First National’s to serve us well, providing increased transpar- future value creators, offering the potential for ency in underwriting for mortgage brokers. This solid, long-term income. For that reason, we are proprietary platform will feature prominently in pleased to note that the securitized portfolio our future including serving as the framework grew to a record $22 billion dollars, up $4 billion for a customized technology solution for a from 2013. Securitizations completed in 2014 new business venture which I will describe will produce future cash flows to enhance earn- later in this letter. ings over the next five and 10-year terms. Underscoring Our Commitment to Mortgage Brokers and Borrowers First National’s success in 2014 and indeed We also use technology to assist out bor- rowers to manage their mortgages with us. Borrowers responded positively to our efforts in 2014 on both the commercial and single over the past quarter century is not ours family residential sides of the business. We alone: it is shared with mortgage brokers with use technology to enable responsive service. whom we partner on a daily basis to bring My Mortgage, First National’s online personal competitive mortgage choices to Canadian mortgage management tool, was particularly home owners. well received: in 2014, it was used more than 632,000 times by over 81,635 borrowers. The Our long-term commitment to the broker online functionality to chat with our customer channel, which now accounts for approximately service representatives (a new feature added $70 billion of new Canadian mortgage origi- in 2014), view current mortgage balances, nations annually, and the work First National change payment dates, and calculate interest has done to remain responsive to mortgage savings from increased payment frequencies broker needs, paid off during the year as the has made My Mortgage an indispensable part Company’s market share in the channel of our service offering. Going forward, we increased to record levels. will strive to continuously improve service to borrowers. We sincerely thank our mortgage broker partners for entrusting more business with First National. We pledge to continue to sup- port the growth of the channel and to live by Keeping Funding Sources Well Diversified The Company continued to enjoy the advan- our high standards for application turnaround tages of funding diversification. Cost-effective time and funding execution. We track the funding is provided by various sources including performance of each of our offices against institutional partners, National Housing Act these standards and it is a source of great Mortgage Backed Securities, Canada Mortgage pride for our team that First National achieved Bond dealers, asset-backed commercial paper its responsiveness goals again in 2014 even and internal resources. with the record volumes. In the fourth quarter of 2014, we added an- Technology, in particular First National’s other source by returning to the Commercial MERLIN system, will continue to support the Mortgage Backed Securities (CMBS) market achievement of our service goals. When it and contributing $102 million of mortgages to was introduced 14 years ago, MERLIN became a CMBS pool. This is the first CMBS pool we Canada’s first online mortgage approval and have participated in since the global financial tracking system and since then has continued crisis. Letter from the CEO 2 2014 Annual ReportMortgages Under Administration ($ Billions) 100 80 60 40 20 0 85.9 14% Year-Over-Year Growth 2013 To 2014 2009 2010 2011 2012 2013 2014 Mortgage Originations ($ Billions) 20 15 10 5 0 16.2 15% Year-Over-Year Growth 2013 To 2014 2009 2010 2011 2012 2013 2014 Revenue ($ Millions) 1000 800 600 400 200 0 803.1 2009 2010 2011 2012 2013 2014 PRE-FMV EBITDA ($ Millions) 1 183.1 2009 2010 2011 2012 2013 2014 200 150 100 50 0 3 3% Year-Over-Year Growth 2013 To 2014 7% Year-Over-Year Decline 2013 To 2014 We view the potential reawakening of CMBS demand as a welcome event as it adds another dimension to First National’s funding opportunities. Building a New Business Line One of the highlights of the year was the agreement First National entered into with one of Canada’s major banks to provide underwriting and fulfillment processing services for mortgages originated by the Bank through the residential mortgage broker distribution channel. Starting in 2015, this agreement leverages the capabilities and strengths of both parties. For First National, it provides an opportunity to showcase our operations and service-oriented technology as we accept mortgage applications and underwrite mortgages in accordance with the Bank’s credit policies and compliance standards. To ensure success, First National created and started to staff a separate division, which will operate across Canada. The division began operations in late January 2015 in Ontario with the planned roll out to Western Canada and Quebec scheduled later in the year. As is customary with new ventures, we have invested in this business in advance of realizing returns, but over time, we expect it will contribute to our earnings. Looking Ahead First National’s financial resources, leadership in technolo- gy and dedication to service should enable the Company to respond well to opportunities in both residential and commercial markets in 2015. Looking ahead, the Company anticipates continuing strength in Canadian real estate and the continuation of its leadership position in the mortgage broker distribution channel. While the recent downturn in the price of oil may affect real estate values and demand for mortgages in Alberta and Saskatchewan this year, the national reach of First National’s lending platform and the fact that we do not have significant residual credit exposure to mortgages should help us to offset the impact of this development. 1 Pre-Fair Market Value EBITDA is a non-IFRS measure, see page 8 Letter from the CEO First National Financial CorporationOverall, by realizing the significant renewal opportunities available this year and managing its partnerships with in- stitutional customers, First National will continue to focus on sustainable profitability. Giving Credit Where It Is Due First National is a strong, stable business with many ad- vantages: the most important is its workforce. Today, we employ over 770 talented, hard-working Canadians who care deeply about our customers. We have steadily increased our talent base over the years including in 2014 when we supported the start-up of our new business venture. Bringing new talent on board and acclimatizing these professionals takes time but makes us a more resourceful and dynamic institution. What gives First National strength, however, is the ability to retain our talent. For example, our senior leaders have been C with First National for an average of over 15 years. Their business experience, connections and ongoing commitment make a significant difference for us in the marketplace. To all First National employees, new recruits and veterans alike, I offer my gratitude for your outstanding performance. In summary, 2014 was another good year for the Company. With the ongoing support of our customers, shareholders and our Board of Directors, we look forward to realizing the full potential of First National’s market leadership in the C B coming years. Yours sincerely, Stephen Smith Chairman and Chief Executive Officer E F D A Funding Sources (for the year ended December 31, 2014) C B D A Institutional Placements CMB Dealers 2% A 45% B C 44% NHA MBS D 2% E 6% 1% F Internal Resources ABCP CMBS Revenue Sources Prior to Fair Value Gains/Losses (for the year ended December 31, 2014) A 34% B 29% Net Interest – Institutional Placements B Securitized Mortgages C D 23% Mortgage Servicing Investment Income 14% A Mortgages Under Administration (as at December 31, 2014) A 80% B Insured 7% Multi-unit Residential and Commercial C 13% Conventional Single Family Residential Letter from the CEO 4 2014 Annual Report Our Management Team From left to right Rick Votano, Vice President, Information Technology Lisa White, Vice President, Mortgage Administration Scott McKenzie, Senior Vice President, Residential Mortgages Stephen Smith, Co-founder, Chairman and Chief Executive Officer Moray Tawse, Co-founder and Executive Vice President Jeremy Wedgbury, Senior Vice President, Commercial Mortgages Robert Inglis, Chief Financial Officer Jason Ellis, Managing Director, Capital Markets Hilda Wong, Vice President and General Counsel Corporate Profile First National Financial Corporation (TSX: FN, TSX: FN.PR.A) is the parent company of First National Financial LP, a Canadian-based originator, underwriter and servicer of pre- dominantly prime residential (single-family and multi-unit) and commercial mortgages. With $86 billion in mortgages under administration, First National is Canada’s largest non-bank originator and underwriter of mortgages and is among the top three in market share in the mortgage broker distribution channel. For more information, please visit www.firstnational.ca. 5 Letter from the CEO First National Financial CorporationTable of Contents Management’s Discussion and Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Management’s Responsibility for Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 General Description of the Company . . . . . . . . . . . . . . . . . . . . . . . . 8 Independent Auditors’ Report . . . . . . . . . . . . . . . . . . . . . . . . . 38 2014 Results Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Outstanding Securities of the Corporation . . . . . . . . . . . . . . . . . . 10 Selected Quarterly Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 Selected Annual Financial Information for the Company’s Fiscal Year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Vision and Strategy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Key Performance Drivers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Consolidated Statements of Financial Position . . . . . . . . . . . . . .39 Consolidated Statements of Comprehensive Income . . . . . . . . 40 Consolidated Statements of Changes in Equity . . . . . . . . . . . . . . 41 Consolidated Statements of Cash Flows . . . . . . . . . . . . . . . . . . . .42 Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . .43 Corporate Governance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .80 Growth in Origination of Mortgages . . . . . . . . . . . . . . . . . . . . . . . 13 Shareholder Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 Mortgage Underwriting and Fulfillment Processing Services . . 14 Lowering Costs of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Employing Securitization Transactions to Minimize Funding Costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Key Performance Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Determination of Common Share Dividend Payout Ratio . . . . . 17 Revenues and Funding Sources . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18 Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .20 Operating Segment Review . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Residential Segment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Commercial Segment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Liquidity and Capital Resources . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Financial Instruments and Risk Management . . . . . . . . . . . . . . . .28 Capital Expenditures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .30 Summary of Contractual Obligations . . . . . . . . . . . . . . . . . . . . . . . 31 Critical Accounting Policies and Estimates . . . . . . . . . . . . . . . . . . 31 Future Accounting Changes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Disclosure Controls and Internal Controls over Financial Reporting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .33 Risks and Uncertainties Affecting the Business . . . . . . . . . . . . . .34 Forward-Looking Information . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Outlook . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .35 Table of Contents 6 2014 Annual Report2014 Financial Report 7 Financial Report First National Financial CorporationManagement’s Discussion and Analysis The following management’s discussion and Additional information relating to the Company analysis (“MD&A”) of financial condition and is available in First National Financial Corpora- results of operations is prepared as of February tion’s profile on the System for Electronic Data 24, 2015. This discussion should be read in con- Analysis and Retrieval (“SEDAR”) website at junction with the audited consolidated financial www.sedar.com. statements of First National Financial Corpo- ration (the “Company” or “Corporation” or “First National”) as at and for the year ended December 31, 2014 and the notes thereto. This General Description of the Company discussion should also be read in conjunction First National Financial Corporation is the with the audited consolidated financial state- parent company of First National Financial ments and notes thereto of the Company LP (“FNFLP”), a Canadian-based originator, for the year ended December 31, 2014. The underwriter and servicer of predominantly audited consolidated financial statements of prime residential (single-family and multi-unit) the Company have been prepared in accor- and commercial mortgages. With $86 billion dance with International Financial Reporting in Mortgages under Administration (“MUA”), Standards (“IFRS”). First National is Canada’s largest non-bank originator and underwriter of mortgages and This MD&A contains forward-looking informa- is among the top three in market share in the tion. Please see “Forward-Looking Information” mortgage broker distribution channel. for a discussion of the risks, uncertainties and assumptions relating to such information. The Commencing in 2013, First National has also selected financial information and discussion consolidated its interest in First National below also refer to certain measures to assist Mortgage Investment Fund (the “Fund”), in assessing financial performance. These mea- which it launched in late 2012. Although the sures, such as “Pre-FMV EBITDA”, “Adjusted Company owns about 16% of the units issued Cash Flow”, and “Adjusted Cash Flow per Share”, by the Fund, because of its status as sole seller should not be construed as alternatives to net to the Fund and its rights as promoter, the income or loss or other comparable measures application of IFRS suggests that First National determined in accordance with IFRS as an exercises control over the Fund. The Fund indicator of performance or as measures of was created to obtain economic exposure to liquidity and cash flow. These measures do a diversified portfolio of primarily commercial not have standard meanings prescribed by mezzanine mortgages. Through the Fund’s IFRS and therefore may not be comparable to consolidation, the Company has effectively similar measures presented by other issuers. taken on a portfolio of about $55 million (De- cember 31, 2013 - $69 million) of mortgages. Unless otherwise noted, tabular amounts are in thousands of Canadian dollars. 8 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Because of the Company’s small proportionate • The Company also took advantage of its interest in the Fund’s units, it has also recorded renewal opportunities in the quarter, a $39 million (December 31, 2013 - $45 million) renewing $3.4 billion of single-family non-controlling interest in equity which offsets mortgages. Although retention rates were these assets. 2014 Results Summary similar in each year, in 2013 the Company renewed $4.4 billion of single-family mort- gages on more renewal opportunities. For the commercial segment in 2014, The Company is pleased with 2014 results. renewals increased to $1.3 billion from $1.2 In the single-family segment, First National’s billion in 2013; origination was up almost 15% compared to • During 2014, the Company used the Can- 2013. New commercial origination increased ada Mortgage Bonds (“CMB”) program to by 18%. These volumes and consistent renewal successfully securitize about $563 million rates enabled the Company to grow its MUA of mortgages in the 10-year program and and build the value of its portfolio of securi- $1.1 billion of mortgages in the five-year tized mortgages. term program. First National also securi- tized $263 million of mortgages for CMB • MUA grew to $85.9 billion at December replacement purposes in the year; 31, 2014 from $75.6 billion at December • Revenue for 2014 increased to $803.1 31, 2013, an increase of 14%; the growth million from $776.5 million in 2013. The 3% from September 30, 2014, when MUA was increase is attributable to more interest $83.2 billion, represented an annualized revenue from the Company’s growing increase of 13%; portfolio of securitized mortgages which • The Canadian single-family real estate increased from $17.7 billion at December market started slowly in 2014 but quickly 31, 2013 to $22.3 billion at December 31, gained momentum such that all told, 2014 2014; was another strong year. The Company • Income before income taxes for the year took advantage of market conditions and decreased by 40% from $233.5 million in originated record levels of new mortgages. 2013 to $140.3 million in 2014. The decrease Single-family mortgage originations for was due, in large part, to volatility in the the Company increased by 15% to $12.5 bond market, which negatively affected the billion in 2014 from $10.9 billion in 2013. Company’s interest rate hedges. Because The commercial segment had a strong of the unfavourable mark to market on year as volumes increased by 18%, from these hedges, large losses on financial $3.1 billion in 2013 to $3.7 billion in 2014. instruments were recorded in 2014. The Together, overall origination increased by net change in gains and losses on finan- 15% year over year; cial instruments between 2014 and 2013 reduced income before income taxes between the years by $78.8 million. 9 First National Financial CorporationManagement’s Discussion and Analysis• Without the impact of gains and losses on The Company’s decision to securitize more financial instruments, the Company’s earn- of its origination in 2014 instead of placing ings before income taxes, depreciation it with institutional investors also reduced and amortization (“Pre-FMV EBITDA”) for profitability. However, by securitizing about 2014 decreased by 7%, from $197.6 million $1.5 billion more of its origination, the Com- in 2013 to $183.1 million in 2014. This de- pany will earn future net interest revenue as crease is due to tighter mortgage spreads opposed to current period placement fees. Management’s Discussion and Analysis in 2014 which reduced revenue from net interest – securitized mortgages, gains on deferred placement fees and mortgage investment income. Outstanding Securities of the Corporation At December 31, 2014 and February 24, 2015, the Corporation had 59,967,429 common shares, 4,000,000 Class A preference shares, Series 1 and 175,000 debentures outstanding. Selected Quarterly Information Quarterly Results of First National Financial Corporation ($000s, except per share amounts) Revenue Net Income for the period Pre-FMV EBITDA for the period(1) Net Income per Common Share Total Assets 2014 Fourth Quarter $ 198,254 $ 17,856 $ 43,229 $ 0.27 $ 25,953,914 Third Quarter $ 230,552 $ 35,331 $ 50,121 $ 0.56 $ 25,077,361 Second Quarter $ 201,596 $ 28,217 $ 48,392 $ 0.44 $ 23,902,513 First Quarter $ 172,705 $ 23,061 $ 41,388 $ 0.35 $ 21,683,307 2013 Fourth Quarter $ 200,928 $ 41,821 $ 53,401 $ 0.66 $ 20,569,217 Third Quarter $ 200,522 $ 39,399 $ 56,124 $ 0.63 $ 19,930,780 Second Quarter $ 229,830 $ 67,845 $ 51,193 $ 1.10 $ 18,793,683 First Quarter $ 145,228 $ 23,036 $ 36,864 $ 0.36 $ 17,163,697 (1) This non-IFRS measure adjusts income before income taxes by adding back expenses for amortization of intangible and capital assets but it also eliminates the impact of changes in fair value by adding back losses on the valuation of financial instruments and deducting gains on the valuation of financial instruments. 10 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Given First National’s large amount of MUA Generally, in the last eight quarters the Company and portfolio of mortgages pledged under has endeavoured to grow its origination vol- securitization, quarterly revenue under IFRS is umes in order to build its servicing portfolio driven primarily by mortgage servicing revenue and to enable it to securitize larger amounts growth and the gross interest earned on the of mortgages in the NHA-MBS market. This mortgages pledged under securitization. longer-term strategy has been successful and Servicing revenue will change as the third-party Pre-FMV EBITDA grew steadily to over $197 portfolio of mortgages grows or contracts million in 2013. Despite continued success in The gross interest on the mortgage portfolio growing MUA and mortgage origination volume, is dependent both on the size of the portfolio tighter spreads in 2014 have reduced the of mortgages pledged under securitization profitability of mortgages pledged for secu- as well as weighted average mortgage rates. ritization and deferred placements fees. The All of these factors have increased over the table above shows a trend of growing income last 24 months as the Company has steadily reflecting typical Canadian seasonality: slower increased MUA and its portfolio of securitized first and fourth quarters and stronger mid-year mortgages. Net income is also dependent on quarters. conditions in the debt markets, which affect the value of gains and losses on financial Although the Company recorded growth in instruments arising from the Company’s inter- origination volumes and grew its MUA, the est rate hedging program. Accordingly, the fourth quarter of 2014 featured large losses movement of this measurement between on the fair value of financial instruments as quarters is related to factors external to the bond yields fell and negatively affected the business of the Company (primarily condi- Company’s economic hedges. This decreased tions in the bond markets). By removing this net income from the amount earned in the volatility and analyzing Pre-FMV EBITDA, 2013 comparative quarter. Tighter spreads management believes a more appropriate on deferred placement fees and pre-launch measurement of the Company’s performance operating expenses incurred for the new un- can be assessed. derwriting business reduced pre-FMV EBITDA between the fourth quarters. 11 First National Financial CorporationManagement’s Discussion and AnalysisSelected Annual Financial Information for the Company’s Fiscal Year Management’s Discussion and Analysis ($000s, except per share amounts) FOR THE YEAR ENDED DECEMBER 31 Income Statement Highlights Revenue 2014 2013 2012 $ 803,107 $ 776,508 $ 628,613 Interest expense – securitized mortgages (434,726) (323,236) (246,736) Brokerage fees (77,105) (84,420) (115,978) Salaries, interest and other operating expenses (143,062) (127,404) (106,547) Add (deduct): realized and unrealized (gains) losses on financial instruments Pre-FMV EBITDA(1) 34,916 (43,866) (6,153) 183,130 197,582 153,199 Amortization of capital assets (2,909) (2,374) (2,059) Amortization of intangible assets (5,000) (5,563) (6,468) Add (deduct): realized and unrealized gains (losses) on financial instruments (34,916) 43,866 6,153 Provision for income taxes (35,840) (61,410) (40,500) Net Income Dividends declared Per Share Highlights Net income per common share Dividends per common share AT YEAR END Balance Sheet Highlights Total assets 104,465 172,101 110,325 93,602 90,294 80,859 1.62 1.48 2.75 1.38 1.76 1.27 25,953,914 20,569,217 15,022,236 Total long-term financial liabilities $ 176,418 $ 179,195 $ 181,275 Notes: (1) Pre-FMV EBITDA is not a recognized earnings measure under IFRS and does not have a standardized meaning prescribed by IFRS. Therefore, Pre-FMV EBITDA may not be comparable to similar measures presented by other issuers. Investors are cautioned that Pre-FMV EBITDA should not be construed as an alternative to net income or loss determined in accordance with IFRS as an indicator of the Compa- ny’s performance or as an alternative to cash flows from operating, investing and financing activities as a measure of liquidity and cash flows. 12 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Vision and Strategy Key Performance Drivers The Company provides mortgage financing The Company’s success is driven by the solutions to virtually the entire mortgage following factors: market in Canada. By offering a full range of • Growth in the portfolio of mortgages under mortgage products, with a focus on customer administration; service and superior technology, the Company • Growth in the origination of mortgages; believes that it is the leading non-bank mort- • Lowering the costs of operations through gage lender in the industry. Growth has been the innovation of systems and technology; achieved while maintaining a relatively con- and servative risk profile. The Company intends to • Employing innovative securitization trans- continue leveraging these strengths to lead actions to minimize funding costs. the “non-bank” mortgage lending industry in Canada, while appropriately managing risk. The Company’s strategy is built on four cor- Growth in Portfolio of Mortgages under Administration nerstones: providing a full range of mortgage Management considers the growth in MUA to solutions; growing assets under administration; be a key element of the Company’s perfor- employing leading-edge technology to lower mance. The portfolio grows in two ways: costs and rationalize business processes; and through mortgages originated by the Company maintaining a conservative risk profile. An and through third-party mortgage servicing important element of the Company’s strategy contracts. Mortgage originations not only is its direct relationship with the mortgage drive revenues from placement and interest borrower. Although the Company places most from securitized mortgages, but perhaps of its originations with third parties, FNFLP more importantly, longer-term value from is perceived by most of its borrowers as the servicing fees, mortgage administration fees, mortgage lender. This is a critical distinction. renewals and the growth of the customer It allows the Company to communicate with base for marketing initiatives. As at December each borrower directly throughout the term 31, 2014, MUA totalled $85.9 billion, up from of the related mortgage. Through this rela- $75.6 billion at December 31, 2013, an increase tionship, the Company can negotiate new of 14%. This compares to $83.2 billion at Sep- transactions and pursue marketing initiatives. tember 30, 2014, representing an annualized Management believes this strategy will provide increase of about 13%. long-term profitability and sustainable brand recognition for the Company. Growth in Origination of Mortgages The origination of mortgages not only drives the growth of MUA as described above, but leverages the Company’s origination platform, which has a large fixed-cost component. As more mortgages are originated, the marginal costs of underwriting decrease. The Company can also decide to securitize more mortgages and take advantage of its origination in peri- ods of wider mortgage spreads. 13 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Prior to 2008, when the capital markets Funding spreads have also narrowed in recent experienced significant turbulence, the prime periods such that the spread between insured mortgages that the Company originated 5-year mortgages and the NHA-MBS related had tight spreads such that the Company’s costs of funds is approximately 1.57%. At this strategy was to sell these mortgages on com- level, it is still profitable for the Company to mitment to institutional investors and retain securitize. In 2014, the Company originated and the servicing. This strategy changed with renewed for securitization purposes approxi- the challenges in the credit environment. The mately $7.6 billion of single-family mortgages Company elected to invest in more mortgages and $1.3 billion of multi-unit residential mort- directly and earn the mortgage spread for itself gages in order to take advantage of these through securitization. Mortgage spreads can spreads. In 2014, the Company securitized be illustrated by comparing posted five-year through NHA-MBS approximately $1.9 billion fixed single-family mortgage rates to a of floating rate single-family mortgages, $4.1 similar-term Government of Canada bond as billion of fixed rate single-family mortgages listed in the table below. and $0.8 billion of fixed rate multi-unit residential Period 2006 2007 2008 2009 2010 2011 2012 2013 2014 Average five year Mortgage Spread for the Period 1.12% 1.50% mortgages. Mortgage Underwriting and Fulfillment Processing Services Early in the third quarter, the Company entered 2.68% into an agreement with a large Canadian 1.76% 1.75% 1.76% 1.92% schedule I bank (“Bank”) to provide under- writing and fulfillment processing services for mortgages originated by the Bank through the single-family residential mortgage broker channel. Under the strategic agreement, First 1.75% National will employ a customized software 1.57% solution based on its industry leading MERLIN technology to accept mortgage applications from the Bank in the mortgage broker channel The table shows an average spread of 1.12% in and underwrite these mortgages in accordance 2006. With the credit crisis, this spread bal- with the Bank’s underwriting guidelines. The looned to as high as 3.46% in 2008. Between Bank will fund all the mortgages underwritten 2009 and 2011, liquidity issues at financial under the agreement and retain full respon- institutions diminished and the competition sibility for mortgage servicing and the client for mortgages increased such that spreads relationship. The Company believes it can remained consistently higher than pre-crisis operate this distinct division profitably after levels. In mid 2011, the United States credit the start up period and expects to launch the rating was downgraded and interest rates fell new business in Ontario in early 2015 with a full significantly, accounting for wider mortgage national roll out by the middle of 2015. spreads in 2012 which tightened again in 2013. However in 2014, more competitive pressures took mortgage rates lower and compressed mortgage spreads to 2007 levels. 14 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Management considers the agreement a way Preferred Share Issuance to leverage the capabilities and strengths of On January 25, 2011, the Company issued First National in the mortgage broker chan- 4,000,000 1 Class A preference shares, Series nel and add some diversity to the Company’s 1 for gross proceeds of $100 million. These service offerings. shares are rate reset preferred shares having a stated 4.65% annual dividend rate, subject Lowering Costs of Operations to Board of Director approval, and a par value of $25 per share. The rate reset feature is Innovations in Systems and Technology at the discretion of the Company such that The Company has always used technology after the initial five-year term, the Company to provide for efficient and effective opera- can choose to extend the shares for another tions. This is particularly true for its MERLIN five-year term at a fixed spread (2.07%) over underwriting system, Canada’s only web- the yield of the then-relevant Government based, real-time broker information system. of Canada bond. While the investors in these By creating a paperless, 24/7 commitment shares have some rights to convert into a management platform for mortgage brokers, floating rate dividend upon reset, there are no the Company is now ranked among the top redemption options for these shareholders. As three lenders by market share in the broker such, the Company considers these shares to channel. This has translated into increased represent a permanent source of capital and single-family origination volumes and higher classifies the shares as equity on its balance closing ratios (the percentage of mortgage sheet. This capital has given the Company commitments the Company issues that actually the opportunity to pursue its strategy of in- become closed mortgages). creased securitization, which requires upfront Increase of Bank Credit Facility The Company uses a $1 billion revolving line of credit with a syndicate of banks. This facility enables the Company to fund the increasing investment. Employing Securitization Transac- tions to Minimize Funding Costs amount of mortgages accumulated for secu- Approval as both an Issuer of NHA-MBS and ritization. The entire facility is floating rate Seller to the Canada Mortgage Bonds Program and has a four-year term. The Company has The Company has been involved in the issu- elected to undertake this debt for a number ance of NHA-MBS since 1995. This program of reasons: (1) the transaction increases the has been very successful, with over $10 billion amount of debt available to fund mortgages of NHA-MBS issued. In December 2007, the originated for securitization purposes; (2) the Company was approved by Canada Mortgage debt is revolving and can be used and repaid and Housing Corporation (“CMHC”) as an as the Company requires, providing more issuer of NHA-MBS and as a seller into the flexibility than the debenture debt, which is CMB program. Issuer status has provided the always fully drawn; (3) the four-year term Company with a funding source that it can extension gives the Company a committed access independently. Perhaps more impor- facility that strategically extends the maturity tantly, seller status gives the Company direct of this debt beyond that of the debenture in access to the CMB. Generally, the demand 2015; and (4) the cost of borrowing reflects for high-quality fixed and floating rate in- the Company’s BBB issuer rating. vestments increased significantly with the economic turmoil in 2009. This demand has 15 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis continued into 2014 and allowed the Company CHT has indicated that it will not unduly to issue more than $6.7 billion of mortgages increase the size of its issuances and has through the NHA-MBS and CMB programs created guidelines through CMHC that limit during the year. In August 2013, CMHC an- the amount that can be sold by each seller nounced that it would be limiting the amount into the CMB each quarter. The Company is of guarantees it would issue on NHA-MBS subject to these limitations. pools created for sale to the “market”. CMHC indicated that the amount of guarantees it Key Performance Indicators was providing for such market pools (generally any pool not sold to the Canada Housing The principal indicators used to measure the Trust (“CHT”) for the CMB) was growing Company’s performance are: significantly. In order to better control the • Earnings before income taxes, depreci- absolute amount of risk that it takes on in this ation and amortization, and losses and respect, CMHC has implemented policies to gains on financial instruments (“Pre-FMV allocate the amount of guarantees to issuers. EBITDA”(1)) ; and The current amount being allocated to each • Dividend payout ratio. issuer is approximately the amount that First National used in 2014. These rules are similar (1) Pre-FMV EBITDA is not a recognized measure to the CMB allocation rules described below, under IFRS. However, management believes which have been in place since 2008 and are that Pre-FMV EBITDA is a useful measure that subject to change each year. provides investors with an indication of income normalized for capital market fluctuations and Canada Mortgage Bonds Program prior to capital expenditures. Pre-FMV EBITDA The CMB program is an initiative sponsored should not be construed as an alternative to by CMHC whereby the CHT issues securities net income determined in accordance with to investors in the form of semi-annual IFRS or to cash flows from operating, investing interest-yielding five- and 10-year bonds. and financing activities. The Company’s meth- Pursuant to the Company’s approval as a od of calculating Pre-FMV EBITDA may differ seller into the CMB, the Company is able to from other issuers and, accordingly, Pre-FMV make direct sales into the program. Because EBITDA may not be comparable to measures of the similarities to a traditional Govern- used by other issuers. ment 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 premium 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 mortgage securitizations. The Company also enjoys de- mand 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 sellers for larger issuances. 16 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis ($ 000s) QUARTER ENDED YEAR ENDED December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 FOR THE PERIOD Revenue Income before income taxes Pre-FMV EBITDA (1) AT PERIOD END Total assets $ 198,254 $ 200,928 $ 803,107 $ 776,508 23,206 43,229 57,531 53,401 140,305 183,130 233,511 197,582 25,953,914 20,569,217 25,953,914 20,569,217 Mortgages under administration 85,889,561 75,619,003 85,889,561 75,619,003 (1)This non-IFRS measure adjusts income before income taxes by adding back expenses for amortization of intangible and capital assets but it also eliminates the impact of changes in fair value by adding back losses on the valuation of financial instruments and deducting gains on the valuation of financial instruments. Since going public in 2006, First National has of its earnings. The Company calculates the been portrayed as a high-yielding dividend dividend payout ratio as dividends declared paying company. With a large MUA which on common shares over net income attribut- generates continuing income and cash flow able to common shareholders. This measure and a business model which is designed to is useful to shareholders as it indicates the make an efficient use of capital, the Company percentage of earnings which have been paid has been able to pay distributions to its share- out in dividends. holders which represent a relatively large ratio Determination of Common Share Dividend Payout Ratio ($ 000s) QUARTER ENDED YEAR ENDED December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 FOR THE PERIOD Net income attributable to common shareholders $ 17,180 $ 41,066 $ 101,710 $ 1 6 9 , 7 2 6 Dividends paid or declared on common shares 22,488 20,988 88,952 82,955 Common Share Dividend Payout Ratio After tax Pre-FMV Dividend Payout Ratio (1) 131% 74% 51% 57% 87% 70% 49% 60% (1) This non-IFRS measure adjusts the net income used in the calculation of the dividend payout ratio to after tax Pre-FMV earnings so as to eliminate the impact of changes in fair value by adding back losses on the valuation of financial instruments and deducting gains on the valuation of financial instruments. 17 First National Financial CorporationManagement’s Discussion and Analysis Management’s Discussion and Analysis For the year ended December 31, 2014, the In general, originations are allocated from one common share payout ratio was over 87%, funding source to another depending on market higher than the 49% ratio calculated for 2013. conditions and strategic considerations related A significant portion of this change is due to to maintaining diversified funding sources. The volatility in the bond market, which negatively Company retains servicing rights on virtually affected the Company’s interest rate hedges all of the mortgages it originates, which in 2014. In contrast there was a large favour- provide the Company with servicing fees to able impact in the 2013 results. These gains or complement revenue earned through origina- losses are recorded in the period in which the tions. For the year ended December 31, 2014, bond yields change; however, the offsetting new origination volume increased from $14.1 economic gains or losses are not recorded billion to $16.2 billion, or about 15%, compared in the same period. Instead, the resulting to 2013. economic gain (or loss) will be reflected in wider or narrower spreads on the mortgages Securitization pledged for securitization and will be gener- The Company securitizes a portion of its ally realized in net interest margin over the origination through various vehicles, including terms of the mortgages. If these amounts are NHA-MBS, CMB and Asset-backed Commercial excluded from the above calculations, the Paper (“ABCP”). Although legally these dividend payout ratio for 2014 would have transactions represent sales of mortgages, for been 70% versus 60% in 2013. For the quarter accounting purposes they do not meet the ended December 31, 2014, $18 million of such requirements for sale recognition and instead losses were incurred. Without the tax-effected are accounted for as secured financings. These losses, the fourth quarter would have had a mortgages remain as mortgage assets of the dividend payout ratio of 74% compared to an Company for the full term and are funded with adjusted ratio of 57% in 2013. securitization-related debt. Of the Company’s The Company also paid $4.65 million of for the year ended December 31, 2014, $8.9 dividends on its preferred shares in 2014. billion was originated for its own securitization $20.9 billion of new originations and renewals Revenues and Funding Sources programs. Mortgage Origination The Company derives a significant amount of its revenue from mortgage origination activi- ties. Most mortgages originated are funded either by placement with institutional investors or through securitization conduits, in each case with retained servicing. Depending upon market conditions, either an institutional placement or a securitization conduit may be the most cost-effective means for the Company to fund individual mortgages. 18 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Placement Fees and Gain on Deferred Mortgage Servicing and Administration Placement Fees The Company services virtually all mortgages The Company recognizes revenue at the time generated through its mortgage origination that a mortgage is placed with an institutional activities on behalf of a wide range of insti- investor. Cash amounts received in excess tutional investors. Mortgage servicing and of the mortgage principal at the time of place- administration is a key component of the ment are recognized in revenue as “placement Company’s overall business strategy and a fees”. The present value of additional amounts significant source of continuing income and expected to be received over the remaining cash flow. In addition to pure servicing reve- life of the mortgage sold (excluding normal nues, fees related to mortgage administration market-based servicing fees) is recorded as a are earned by the Company throughout the “deferred placement fee”. mortgage term. Another aspect of servicing is the administration of funds held in trust, A deferred placement fee arises when mort- including borrowers’ property tax escrows, gages with spreads in excess of a base spread reserve escrows and mortgage payments. As are sold. Normally the Company would earn acknowledged in the Company’s agreements, an upfront cash placement fee, but investors any interest earned on these funds accrues prefer paying the Company over time as they to the Company as partial compensation for earn net interest margin on such transactions. administration services provided. The Com- Upon the recognition of a deferred placement pany has negotiated favourable interest rates fee, the Company establishes a “deferred on these funds with the chartered banks that placement fee receivable” that is amortized as maintain the deposit accounts, which has the fees are received by the Company. Of the resulted in significant additional servicing Company's $20.9 billion of new originations revenue. and renewals in 2014, $11.4 billion was placed with institutional investors. In addition to the interest income earned on securitized mortgages and deferred placement For all institutional placements and mortgages fees receivable, the Company also earns sold to institutional investors for the NHA-MBS interest income on mortgage-related assets, market, the Company earns placement fees. including mortgages accumulated for sale or Revenues based on these originations are securitization, mortgage and loan investments equal to either (1) the present value of the and purchased mortgage servicing rights. excess spread, or (2) an origination fee based on the outstanding principal amount of the mortgage. This revenue is received in cash at the time of placement. In addition, under cer- tain circumstances, additional revenue from institutional placements and NHA-MBS may be recognized as “gain on deferred placement fees” as described above. 19 First National Financial CorporationManagement’s Discussion and AnalysisResults of Operations The following table shows the volume of mortgages originated by First National and mortgages under administration for the periods indicated: Management’s Discussion and Analysis QUARTER ENDED YEAR ENDED December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 ($ millions) MORTGAGE ORIGINATIONS BY SEGMENT New Single-family residential New Multi-unit and commercial Sub-total Single-family residential renewals Multi-unit and commercial renewals 2,860 1,195 4,055 823 328 2,496 887 3,383 824 392 12,525 3,701 16,226 3,365 1,306 Total origination and renewals 5,206 4,599 20,897 MORTGAGE ORIGINATIONS BY FUNDING SOURCE Institutional investors – new residential Institutional investors – renew residential Institutional investors – multi/commercial NHA-MBS/ CMB/ ABCP securitization CMBS Internal Company resources 1,434 372 1,091 2,095 102 112 1,704 403 967 1,428 — 97 6,323 1,700 3,343 8,942 102 487 10,925 3,133 14,058 4,404 1,174 19,636 7,131 1,621 2,952 7,476 — 456 Total 5,206 4,599 20,897 19,636 MORTGAGES UNDER ADMINISTRATION Single-family residential Multi-unit residential and commercial 66,992 18,898 57,652 17,967 66,992 18,898 57,652 17,967 Total $ 85,890 $ 75,619 $ 85,890 $ 75,619 Total new mortgage origination volumes single-family volumes increased by 15% and increased in 2014 compared to 2013 by 15%. commercial volume grew 35% compared to Single-family volumes increased by 15% and the 2013 quarter. When combined with re- commercial segment volumes increased by newals, total production increased from $19.6 18% year over year as demand for housing billion in 2013 to almost $20.9 billion in 2014, and commercial real estate continued and the or by 7%. Company increased its share in the mortgage broker channel. The fourth quarter of 2014 was consistent with the full year results as 20 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis The low interest rate environment which ex- The decrease is also a result of marginally isted for most of 2013 continued throughout lower per unit pricing on placement fees for 2014. Low mortgage rates, which stimulate both residential and commercial segment increased real estate transactions, together origination. The Company earned over $13.0 with the Company’s expertise in underwriting million of placement fees from mortgage CMHC mortgages, drove higher origination renewals sold to institutional investors in 2014 volumes. Origination for direct securitization compared to $9.4 million in 2013. into NHA-MBS, CMB and ABCP programs re- mained a large part of the Company’s strategy Gains on Deferred Placement Fees with volumes increasing from $7.5 billion in Gains on deferred placement fees revenue 2013 to $8.9 billion in 2014. decreased 5% in 2014 to $10.5 million from $11.0 million in 2013. The gains relate to multi- Net Interest - Securitized Mortgages unit residential mortgages originated and sold Comparing the year ended December 31, 2014 to institutional NHA-MBS issuers. Although to the year ended December 31, 2013, “net volumes for these transactions increased by interest – securitized mortgages” increased 23% from the 2013 to 2014, spreads on these by 9% to $115.5 million from $106.0 million. transactions tightened in 2014 so that the The increase was due to a larger portfolio Company realized lower per unit gains. of securitized mortgages offset by tighter weighted-average spreads on the portfolio Mortgage Servicing Income year over year. The portfolio of mortgages Mortgage servicing income increased by less funded through securitization increased from than 1% to $93.1 million from $92.8 million. This $17.7 billion as at December 31, 2013 to $22.3 increase was due to increased securitization by billion as at December 31, 2014; however, the Company and lower administration fees. the market for prime mortgages became more Although the growth in the amount of total competitive as the Company grew this portfolio. MUA was 14% year over year, the third-party Between December 31, 2013 and December 31, MUA only grew by 7% between 2013 and 2014. 2014, tighter mortgage spreads and mar- The majority of growth in MUA was for securi- ginally higher origination costs decreased tized mortgages. At December 31, 2014, there margins by approximately 0.11%. Generally as were approximately $23.7 billion of mortgages higher-spread securitizations have amortized in MUA on which the Company earned net inter- down, new securitizations have been entered est spread as opposed to servicing revenue. into at tighter spreads. Net interest is also This has grown from $18.2 billion in 2013, or affected by the amortization of deferred orig- by 31%. As the securitized portfolio has grown ination and other costs that are capitalized on and become a larger part of MUA, mortgage securitized mortgages. Placement Fees servicing income has been sacrificed for interest spread as recorded in “net interest — securitized mortgages” revenue. The Company’s average Placement fee revenue decreased by 13% in rate of servicing has also dropped as volume 2014 to $127.1 million from $145.4 million in discount thresholds for some residential in- 2013. New single-family origination volume for vestors were reached in late 2013. institutional customers, excluding renewals, decreased from $7.1 billion in 2013 to $6.3 billion in 2014 or by 11%. 21 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Mortgage Investment Income (1) gains and losses related to the Company’s Mortgage investment income increased 5% to economic hedging activities, and (2) gains $57.1 million from $54.2 million. The change and losses related to holding term assets is largely due to the Company’s securitization derived using discounted cash flow meth- program. As the Company elects to securitize odology. Much like the short bonds that the more of its origination, mortgages accumu- Company uses for hedging, the term assets lated for securitization increase and earn the are affected by changes in credit markets and Company higher interest income in the ware- Government of Canada bond yields (which housing period prior to securitization. form the risk-free benchmarks used to price Realized and Unrealized Gains (Losses) on ceivable, and mortgages designated as held Financial Instruments for trading). The following table summarizes For First National, this financial statement line these gains and losses by category in the item typically consists of two components: periods indicated: the Company’s deferred placement fees re- Summary of realized and unrealized gains (losses) on financial instruments ($ 000s) QUARTER ENDED YEAR ENDED December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 Gains (losses) on short bonds used for the economic hedging program Gains (losses) related to the mortgages designated at fair value net of interest rate swaps Gains (losses) on deferred placement fees receivable Other gains (16,550) 3,945 (41,486) 28,688 (1,620) 1,618 6,337 226 (44) 65 110 307 (74) 15,141 (297) 354 Total gains (losses) on financial instruments $ (17,988) $ 5,738 $ (34,916) $ 43,866 For most of 2013, Canadian capital markets For the Company, this meant the value of were relatively upbeat. The impact of an holding short bond positions as a hedge improving global economy and recovery in against its mortgages pending securitization Canada meant that bond yields increased decreased in the year and it recorded net and prices fell. This momentum faltered in losses related to the valuation of these financial early 2014 and 5-year bond yields dropped instruments. by 0.43% in the first six months of the year. Despite a slight rebound in the third quarter of 2014, bond yields finished the year lower at about 1.34%, down about 0.29% in the quarter and down 0.60% for the year. 22 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis The Company uses short Government of The net fair value of the gains and losses on all Canada bonds (including CHT-issued bonds) mortgages held at fair value and the related together with repurchase agreements to cre- swaps was a $6.3 million net gain for the year. ate forward interest rate contracts to hedge the interest rate risk associated with fixed Brokerage Fees Expense rate mortgages originated for its own securi- Brokerage fees expense decreased 9% to tization programs. For accounting purposes, $77.1 million from $84.4 million. This decrease these do not qualify as interest rate hedges as is explained almost entirely by lower origina- the bonds used are not derivatives but simple tion volumes of single-family mortgages for cash-based financial instruments. These gains institutional investors, which decreased by or losses are recorded in the period in which 11%. The remainder of the difference is ex- the bond yields change; however, the offsetting plained by a higher allocation to capitalized economic gains or losses are not recorded mortgage broker fees in 2013 in comparison in the same period. Instead, the resulting to 2014. economic gain (or loss) will be reflected in wider or narrower spreads on the mortgages Salaries and Benefits Expense pledged for securitization and will be realized Salaries and benefits expense increased 9% to in net interest margin over the terms of the $67.6 million from $62.0 million. The increase mortgages and the related debts. In 2014, the is due primarily to an increase in headcount Company recorded losses on these hedges of and higher employee costs associated with $41.5 million (2013 – gains of $28.7 million). commercial segment origination. The Company While these losses decreased 2014’s net compensates its commercial sales staff with income, the gross spread on the related port- commissions based on originated mortgages. folio of securitized mortgages going forward Commercial origination including renewals will be proportionally wider as the Company increased by 16% between 2014 and 2013, and issued securitization-related debt at lower sales compensation increased by $1.0 million relative interest rates than it would have prior year over year. As at December 31, 2014, the to the movement in bond yields. In order to Company had 770 employees, compared to adequately hedge its interest rate exposure, 663 as at December 31, 2013. The growth in the Company had more than $1.3 billion of head count also includes 49 employees hired bonds sold short at the end of the 2014 year. in the fourth quarter of 2014 for the new third-party underwriting processing business. The portion of the Company’s mortgages The Company expensed $0.9 million of em- which is held at fair value (primarily those ployee costs in the fourth quarter related to funded through ABCP), was affected posi- these hires. These employees were added in tively by the change in yields; however, these 2014 so that appropriate training, regulatory gains were offset by losses on the value of the registration and other initiatives could take interest rate swaps, which were used to hedge place prior to the 2015 launch dates. Without all fixed-rate mortgages in this portfolio. The these employees, headcount increased by 9% mortgages were favourably affected by lower largely to meet the administrative demand as- rates of prepayment and the tightening of sociated with the increased MUA, which grew mortgage funding spreads experienced within by 14% year over year. the quarter, which made existing mortgages comparatively more valuable. 23 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Management salaries were paid to the two Income before Income Taxes and Pre-FMV senior executives (Co-founders) who together EBITDA control about 77% of the Company’s common Income before income taxes decreased 40% shares. The current period expense is a result to $140.3 million from $233.5 million. The of the compensation arrangement executed decrease was due in large part to volatility in on the closing of the initial public offering the bond market, which negatively affected (“IPO”). Interest Expense the Company’s interest rate hedges. Income before income taxes was comparatively lower in 2014 than 2013 by $78.8 million because of Interest expense increased 24% to $36.3 million the unfavourable change in gains and losses in 2014 from $29.2 million in 2013. As discussed on financial instruments. Pre-FMV EBITDA, in the “Liquidity and Capital Resources” section which eliminates the impact of gains and of this analysis, the Company warehouses losses on financial instruments, decreased a portion of the mortgages it originates prior 7% to $183.1 million from $197.6 million. The to settlement with the ultimate investor or decrease was due to the increasing compet- funding with a securitization vehicle. The itiveness in the market for mortgages. As Company used the debenture together with mortgage spreads have tightened as a result a $1 billion credit facility with a syndicate of of competition, the Company’s net interest banks and 30-day repurchase facilities to fund margin has not grown as rapidly as the vol- the mortgages during this period. The overall ume of mortgages it has originated for this interest expense has increased from the prior business. The competitive landscape has also period due to increased use of these facilities led to lower pricing on placement and mort- to warehouse the larger amounts of mortgages gage servicing fees as institutional investors originated for the Company’s securitization sought to increase the return they derive from programs. the mortgages purchased from the Company. Other Operating and Amortization of Provision for Income Taxes Intangibles Expenses The provision for taxes decreased by 42% to Other operating and amortization of intangibles $35.8 million from $61.4 million. The provision is expenses increased 7% to $47.1 million from lower due primarily to the decreased earnings $44.1 million. The amortization of intangible recorded in 2014 compared to those in 2013. assets recognized on the IPO was $5.0 million in 2014 compared to $5.6 million in 2013 as some of these assets became fully amortized in 2013. Other operating expenses increased by $3.6 million as the costs saved on lower hedging and mortgage servicing were offset by about $0.7 million of expenses related to the third party underwriting and fulfillment pro- cessing services business which the Company entered into early in the third quarter of 2014. 24 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis Operating Segment Review The Company aggregates its business from two segments for financial reporting purposes: (1) Residential (which includes single-family residential mortgages); and (2) Commercial (which includes multi-unit residential and commercial mortgages), as summarized below: Operating Business Segments ($000s except percent amounts) RESIDENTIAL COMMERCIAL Year ended December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 Originations and renewals $ 15,889,345 $ 15,328,929 $ 5,007,918 $ 4,306,626 Percentage change 4% 16% Revenue $ 608,471 $ 590,976 $ 194,636 $ 185,532 Percentage change 3% 5% Income before income taxes $ 95,631 $ 175,049 $ 44,674 $ 58,462 Percentage change (45%) (24%) Period ended December 31, 2014 December 31, 2013 December 31, 2014 December 31, 2013 Identifiable assets $ 21,112,421 $ 16,282,131 $ 4,811,717 $ 4,257,310 Mortgages under administration $ 66,991,706 $ 57,652,258 $ 18,897,855 $ 17,966,745 Residential Segment Without the impact of this large unfavourable fair value change, net income before income Overall residential origination including re- taxes for the residential segment would have newals increased by 4% between 2014 and decreased by 13% year over year, indicative 2013 while residential revenues increased of lower mortgage servicing and net place- by about 3%. Part of the change in revenue ment fee revenue as the Company elected to is due to the change in gains and losses on securitize a greater portion of its origination. financial instruments. Excluding these changes, Identifiable assets increased since December revenue increased by 14% as the securitized 31, 2013, as the Company added about $3.8 mortgage portfolio grew and produced higher billion of net single-family mortgages to interest revenue. The net change in gains and mortgages pledged under securitization, $325 losses on financial instruments of $60.5 million million of mortgages accumulated for securitiza- also affected net income before income taxes. tion and more than $300 million of government bonds purchased for hedging purposes. 25 First National Financial CorporationManagement’s Discussion and AnalysisCommercial Segment This aggregate indebtedness is typically used to fund: (1) mortgages accumulated for sale or Management’s Discussion and Analysis Commercial revenues increased by almost securitization, (2) the origination costs asso- 5% from the prior year, and increased by 16% ciated with securitization, and (3) mortgage if the impact of changes in gains and losses and loan investments. The Company has a on the fair value of financial instruments are credit facility with a syndicate of eleven finan- excluded. This growth is due to a larger secu- cial institutions for a total credit of $1 billion. ritized mortgage portfolio in the Company’s This facility was closed in January 2014 for a commercial segment offset by tighter spreads four-year term. Bank indebtedness may also on the securitized mortgages and deferred include borrowings obtained through overdraft placement fees as the multi-unit residential facilities. At December 31, 2014, the Company mortgage market became more competitive. entered into repurchase transactions with Without fair value amounts, net income before financial institutions to borrow $660 million tax increased by 9% year over year, as higher related to $680 million of mortgages held in placement fees in 2014 offset lower income “mortgages accumulated for sale or securiti- from deferred placement. Identifiable assets zation” on the balance sheet. increased since December 31, 2013, as the Company increased its securitized portfolio At December 31, 2014, outstanding bank in- of multi-unit residential mortgages through debtedness (excluding bank indebtedness at NHA-MBS by about $600 million. the Fund level) was $601.9 million (December Liquidity and Capital Resources debenture financing of $175 million (December 31, 2013 - $260.3 million). Together with the 31, 2013 - $175 million), this “combined debt” The Company’s fundamental liquidity strategy was used to fund $690.2 million (December has been to invest in prime Canadian mort- 31, 2013 - $454.8 million) of mortgages gages. Management’s belief has always been accumulated for sale or securitization. At that these mortgages are considered “AAA” December 31, 2014, the Company’s other by investors and will always be well bid and interest-yielding assets included: (1) deferred highly liquid. This strategy proved effective placement fees receivable of $34.6 million during the turmoil experienced in 2007 through (December 31, 2013 – $33.6 million) and (2) 2009, when capital markets retreated and only mortgage and loan investments of $230.4 the highest-quality assets were bid. As the million (December 31, 2013 - $184.6 million). Company’s results in those years showed, The difference between “combined debt” First National had little, if any, trouble finding and the mortgages accumulated for sale or investors to purchase its mortgage origination securitization funded by it, which the Com- at profitable margins. Originating prime mort- pany considers a proxy for true leverage, has gages also allows the Company to securitize increased between December 31, 2013 and in the capital markets; however, this activity December 31, 2014, and now stands at $86.7 requires significant cash resources to purchase million (December 31, 2013 – $Nil). This rep- and hold mortgages prior to arranging for resents a debt-to-equity ratio of approximately term debt through the securitization markets. 0.21 to 1, which the Company believes is very For this purpose, the Company uses the conservative. combination of the $175 million debenture loan and the Company’s revolving bank credit facility. 26 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis This ratio increased from December 31, 2013 In June 2011, CMHC issued new regulations when there was no “true leverage” as the regarding the timing of mortgage title trans- Company invested $52 million in net new fer to its custodian. The notice requires that mortgage securitizations and $40 million in cash collateral be posted immediately on new mortgage and loan investments. pool settlement with the custodian on a dollar-for-dollar basis for all mortgages not The Company funds a large portion of its mort- registered with the custodian. Due to the diffi- gage originations for institutional placement culty in obtaining evidence from land registry on the same day as the advance of the related offices on a timely basis, the Company has mortgage. The remaining originations are been required to post cash collateral for the funded by the Company on behalf of institu- pending title transfers. At December 31, 2014, tional investors or pending securitization on $Nil million (December 31, 2013 - $4.8 million) the day of the advance of the mortgage. On of this collateral was held by the custodian. specified days, sometimes daily, the Company When this collateral is required, it is repaid to aggregates all mortgages warehoused to date the Company, as registration is subsequently for an institutional investor and transacts a evidenced to the custodian on these mortgages. settlement with that institutional investor. The other significant portion of cash collateral is A similar process occurs prior to arranging the investment made on behalf of the Compa- for term funding through securitization. The ny’s ABCP programs. As at December 31, 2014, Company uses a portion of the committed the investment in cash collateral was $19.0 credit facility with the banking syndicate to million (December 31, 2013 - $20.0 million). fund the mortgages during this warehouse period. The credit facility is designed to be able As demonstrated previously, the Company to fund the highest balance of warehoused continues to see strong demand for its mort- mortgages in a month and is normally only gage product from institutional investors and partially drawn. liquidity from bank-sponsored commercial paper conduits. By focusing on the prime The Company also invests in short-term mortgage market, the Company believes it mortgages, usually for six- to 18-month terms, will continue to attract bids for mortgages as to bridge existing borrowers in the interim its institutional customers seek government- period between long-term financing solutions. insured assets for investment purposes. The The banking syndicate has provided credit fa- Company also believes it can manage any cilities to partially fund these investments. As liquidity issues that would arise from a year- these investments return cash, it will be used long slowdown in origination volumes. Based to pay down this bank indebtedness. The syn- on cash flow received in 2014, the Company dicate has also provided credit to finance a will receive approximately $80 million of portion of the Company’s deferred placement cash, annually, from its servicing operations fees receivable and the origination costs and $123 million of annually cash flow from associated with securitization as well as other securitization transaction spread and deferred miscellaneous longer-term financing needs. placement fees receivables. A portion of the Company’s capital has been employed to support its ABCP and NHA-MBS programs, primarily to provide credit enhance- ments as required by rating agencies. 27 First National Financial CorporationManagement’s Discussion and AnalysisTogether, on an after-tax basis, this $150 mil- lion of annual cash flow would be more than Financial Instruments and Risk Management Management’s Discussion and Analysis sufficient to support the annual dividends of $90 million on the common shares and The Company has elected to treat deferred the $4.65 million on the preference shares. placement fees receivable, certain mortgages Although this is a simplified analysis, it does pledged under securitization that have been highlight the sustainability of the Company’s funded with ABCP and NHA-MBS debt and business model and dividend policy through several mortgages within mortgage and loan periods of economic weakness. investments, as financial assets measured at “fair value through profit or loss” such that As described earlier, the Company issued changes in market value are recorded in 4,000,000 Class A preference shares, Series the statement of income. Effectively, these 1 at a price of $25.00 per share for gross pro- assets are treated much like bonds earning ceeds of $100 million, before issue expenses. the Company a coupon at the discount rates The net proceeds of $96.7 million were invest- used by the Company. The discount rates ed in FNFLP as partners’ capital. The issuance used represent the interest rate associated gives the Company additional capital, which with a risk-free bond of the same duration will allow it to undertake greater volumes of plus a premium for the risk/uncertainty of securitization transactions directly and reduce the asset’s residual cash flows. As rates in the reliance on institutional investors as a funding bond market change, the carrying values of source. these assets will change. These changes may be significant (favourable and unfavourable) The Company’s Board of Directors has elected from quarter to quarter. The Company enters to pay dividends, when declared, on a monthly into fixed-for-float swaps to manage the in- basis on the outstanding common shares and terest rate exposure of fixed mortgages sold on a quarterly basis on the outstanding pref- to ABCP conduits. These instruments will also erence shares. For purposes of the enhanced be treated as fair value through profit or loss. dividend tax credit rules contained in the While the Company has attempted to exact- Income Tax Act (Canada) and any correspond- ly match the principal balances of the fixed ing provincial and territorial tax legislation, all mortgages over the next five-year period to dividends (and deemed dividends) paid by the the notional swap values for the same period, Company to Canadian residents on both com- there will be differences in these amounts. mon and preference shares after December 31, Any favourable or unfavourable amounts will 2010, are designated as "eligible dividends". be recorded in the statement of earnings each Unless stated otherwise, all dividends (and quarter. deemed dividends) paid by the Company hereafter are designated as "eligible dividends" for the purposes of such rules. For the prefer- ence 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 Part VI.1 of the Income Tax Act on dividends received on such shares. 28 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis The Company believes its hedging policies are Company’s other securitization vehicles. As at suitably designed such that the interest rate December 31, 2014, the Company had entered risk of holding mortgages prior to securitization into $86 million of notional value forward is mitigated. From an accounting perspective, bond sales for this segment. The total net val- any gains or losses on these instruments are re- ue of realized and unrealized gains and losses corded in the current period, as the Company’s on account of all notional hedges pertaining economic hedging strategy does not qualify to the period January 1, 2014 to December 31, as hedging for accounting purposes. The 2014 was a $41.5 million loss. This amount has Company uses bond forwards (consisting of been included in revenue in the statement of bonds sold short and bonds purchased under comprehensive income. resale agreements) to manage interest rate exposure between the time a mortgage rate is Upon settlement of the debenture issuance, committed to the borrower and the time the the Company entered into a float-for-fix mortgage is transferred to the securitization swap. The swap requires the Company to pay vehicle and the matched term debt is ar- CDOR+2.134% on a notional amount of $175 ranged. As interest rates change, the value of million and to receive the debenture interest these short bonds will vary inversely with the coupon (5.07%) semi-annually. This effectively value of the related mortgages. As interest converts the fixed rate semi-annual debenture- rates increase, a gain will be recorded on the based loan payable into a floating rate monthly bonds, which should be offset by a tighter in- resetting note payable. Since the date when terest rate spread between the interest rates this swap was entered into, five-year interest on mortgages and the securitization debt. rates have decreased pursuant to global This spread will be earned over the term economic issues and the value of this swap of the related mortgages. For single-family was $1.4 million as at December 31, 2014. The mortgages, primarily mortgages for the Company has documented this swap as a Company’s own securitization programs, only hedge for accounting purposes, as the fixed some of the mortgage commitments issued leg of the swap exactly matches the cash flow by the Company eventually fund. The Com- obligations under the debenture. Effectively, pany must assign a probability of funding to the unrealized gain of $1.4 million on the swap each mortgage in the pipeline and estimate has been excluded from earnings and been how that probability changes as mortgages applied to increase the carrying value of the move through the various stages of the pipe- debenture note payable. The Company is also line. The amount that is actually hedged is the a party to three amortizing fix-for-float rate expected value of mortgages funding within swaps that economically hedge the interest the next 120 days (120 days being the stan- rate exposure related to certain mortgages dard maximum rate hold period available for held on the balance sheet that the Company the mortgages). As at December 31, 2014, the has originated as replacement assets for its Company had $974 million of notional forward CMB activities. As at December 31, 2014, the bond positions related to its single-family aggregate notional value of these swaps was programs. For multi-unit residential and com- $28.9 million. During the year the value of mercial mortgages, the Company assumes all these swaps decreased by about $0.1 million. mortgages committed will fund and hedges The amortizing swaps mature between July each mortgage individually. This includes 2015 and June 2021. mortgages committed for the CMB program as well as mortgages for transfer to the 29 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis As described above, the Company employs In 2008, 30-day ABCP traded at approximately various strategies to reduce interest rate risk. 1.10 percentage points over BAs; but by the In the normal course of business, the Company end of March 2011 and continuing until the cur- takes some credit spread risk. This is the risk rent period, it was priced at a discount to BAs. that the credit spread at which a mortgage At the same time the Company has leveraged is originated changes between the date of on changing credit spreads. The success of this commitment of that mortgage and the date approach has been demonstrated through of sale or securitization. This can be illustrated the increase in volume and profitability of the by the Company’s experience with commercial NHA-MBS program and significant increases mortgages originated for the CMBS market in gains on deferred placement fees from the in the spring of 2007. These mortgages were sale of prime insured mortgages. As at De- originated at credit spreads designed to be cember 31, 2014, the Company had various profitable to the Company when sold to a exposures to changing credit spreads. In bank-sponsored CMBS conduit. Unfortunate- particular, in mortgages accumulated for sale ly for the Company, when these mortgages or securitization, there were almost $1.4 billion funded, the CMBS market had shut down. of mortgages that are susceptible to some The alternative to this channel was more degree of changing credit spreads. expensive as credit spreads elsewhere in the marketplace for this type of mortgage had Capital Expenditures widened. The Company adjusted for market- suggested increases in credit spreads in 2007 A significant portion of First National’s busi- and 2008, adjusting the value of the mortgages ness model consists of the origination and downward. In 2009, the economic environment placement or securitization of financial assets. remained weak but did not worsen from what Generally, placement activities do not require it was at the end of 2008. Overall credit spreads much capital investment as the Company acts stopped widening such that the Company ap- primarily in the capacity of a broker. On the plied the same spreads to these mortgages and other hand, the undertaking of securitization the Company did not record any additional transactions may require significant amounts unrealized losses or gains related to credit of the Company’s own capital. This capital is spread movement. Despite entering into effective provided in the form of cash collateral, credit economic interest rate hedges, the Company’s enhancements, and the upfront funding of exposure to credit spreads remained. This risk broker fees and other origination costs. These is inherent in the Company’s business model are described more fully in the “Liquidity and and cannot be economically hedged. Capital Resources” section above. The same exposure to risk is inherent in the Company’s securitization 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, the Company 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. 30 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis For fixed assets, the business requires capital expenditures on technology (both software and hardware), leasehold improvements and Summary of Contractual Obligations office furniture. The Company’s long-term obligations include five- to 10-year premises leases for its five During the year ended December 31, 2014, offices across Canada, and its obligations for the Company equipped a new floor at its head the ongoing servicing of mortgages sold to office for growth of its administration depart- securitization conduits and mortgages related ment and purchased new computers and office to purchased servicing rights. The Company and communications equipment primarily to sells its mortgages to securitization conduits support its single-family residential business. on a fully-serviced basis, and is responsible In the long term, the Company expects capital for the collection of the principal and interest expenditures on fixed assets will be approxi- payments on behalf of the conduits, including mately $4.0 million annually; however, in the the management and collection of mortgages next year, there will be greater expenditures in arrears. required to support the new third-party underwriting business. ($000s) PAYMENTS DUE BY PERIOD Lease Obligations $ 25,998 $ 5,966 $ 12,160 $ 4,989 $ 2,883 Total 0-1 Years 1-3 Years 4-5 Years After 5 Years Critical Accounting Policies and Estimates The significant accounting policies of First National are described in Note 2 to the Company’s audited financial statements as at The Company prepares its financial statements December 31, 2014. The policies which First in accordance with IFRS, which requires National believes are the most critical to aid in management to make estimates, judgments fully understanding and evaluating its reported and assumptions that management believes financial results include the determination of are reasonable based upon the information the gains on deferred placement fees and the available. These estimates, judgments and impact of fair value accounting on financial assumptions affect the reported amounts of instruments. assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial The Company uses estimates in valuing its statements, and the reported amounts of gain or loss on the sale of its mortgages revenue and expenses during the reporting placed with institutions earning a deferred period. Management bases its estimates on placement fee. Under IFRS, valuing a gain on historical experience and other assumptions deferred placement fees requires the use of that it believes to be reasonable under the estimates to determine the fair value of the circumstances. Management also evaluates its retained interest (derived from the present estimates on an ongoing basis. value of expected future cash flows) in the mortgages. 31 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis These retained interests are reflected on the the Company’s method of determining the Company’s balance sheet as deferred place- fair value of its securitized mortgages has a ment fees receivable. The key assumptions significant impact on earnings. The Company used in the valuation of gains on deferred uses different prepayment rates for its various placement fees are prepayment rates and the programs, which average approximately 10% discount rate used to present value future for single-family mortgages. The Company expected cash flows. The annual rate of un- assumes there is virtually no prepayment on scheduled principal payments is determined by multi-unit residential fixed rate mortgages. reviewing portfolio prepayment experience on Actual prepayment experience has been con- a monthly basis. The Company uses different sistent with these assumptions. The Company rates for its various programs, which average has also assumed discount rates based on approximately 11% for single-family mortgages. Government of Canada bond yields plus a The Company assumes there is virtually no spread that the Company believes would en- prepayment on multi-unit residential fixed rate able a third party to purchase the mortgages mortgages. and make a normal profit margin for the risk involved. On a quarterly basis, the Company reviews the estimates used to ensure their appropriate- Future Accounting Changes ness and monitors the performance statistics of the relevant mortgage portfolios to adjust and In July 2014, the IASB issued the final version improve these estimates. The estimates used of IFRS 9 – Financial Instrument, replacing IAS reflect the expected performance of the mort- 39 and all previous versions of IFRS 9. This fi- gage portfolio over the lives of the mortgages. nal version of IFRS 9 includes a logical model The assumptions underlying the estimates for classification and measurement, a single, used for the year ended December 31, 2014 forward-looking ‘expected loss’ impairment continue to be consistent with those used for model and a substantially-reformed approach the year ended December 31, 2013 and the to hedge accounting. Under this standard, quarters ended September 30, June 30 and financial assets are classified and measured March 31, 2014. based on the business model in which they are held and the characteristics of their con- The Company has elected to treat its financial tractual cash flows. The accounting model for assets and liabilities, including deferred financial liabilities is largely unchanged from placement fees receivable, specific mortgages IAS 39 except for the presentation of the pledged under securitization, some mortgage impact of own credit risk on financial liabilities and loan investments and bonds sold short, which will be recognized in OCI, rather than in at fair value through profit or loss. Essentially, profit and loss as under IAS 39. The new gen- this policy requires the Company to record eral hedge accounting principles under IFRS changes in the fair value of these instruments in 9 are aimed to align hedge accounting more the current period’s earnings. The Company’s closely with risk management. assets and liabilities are such that the Com- pany 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, 32 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis This new standard does not fundamentally disclosed by the Company in reports filed change the types of hedging relationships or under Canadian securities laws is recorded, the requirement to measure and recognize processed, summarized and reported within ineffectiveness; however it is expected to pro- the time periods specified under those laws, vide more hedging strategies that are used for and include controls and procedures that are risk management to qualify for hedge accounting designed to ensure that information is accu- and introduce more judgment to assess the mulated and communicated to management, effectiveness of a hedging relationship. including the Chief Executive Officer and Chief IFRS 9 is mandatorily effective for annual regarding required disclosure. periods beginning on or after January 1, 2018. The Company is in process of evaluating the As of December 31, 2014, management eval- impact of IFRS 9 on the Company’s financial uated, under the supervision of and with the Financial Officer, to allow timely decisions statements. participation of the Chief Executive Officer and Chief Financial Officer, the effectiveness of In May 2014, the IASB issued IFRS 15 Revenue the Company’s disclosure controls and proce- from Contracts with Customers, replacing IAS 11 dures. Based on this evaluation, management - Construction Contracts, IAS 18 - Revenue, concluded that the Company’s disclosure con- IFRIC 13 - Customer Loyalty Programs, IFRIC trols and procedures, as defined by National 15 - Agreements for the Construction of Real Instrument 52-109, Certification of Disclosure Estate, IFRIC 18 - Transfer of Assets from in Issuers’ Annual and Interim Filings, were Customers, and SIC 31 Revenue – Barter effective as of December 31, 2014. Transactions Involving Advertising Services. The standard contains a single model that Management is responsible for establishing applies to contracts with customers and two and maintaining adequate internal control approaches to recognizing revenue: at a point over financial reporting. Internal control over in time or over time. The model features a financial reporting is designed to provide contract-based five-step revenue recognition reasonable assurance regarding the reliability process to determine the nature, amount, of financial reporting and the preparation of timing and uncertainty of revenue and cash financial statements for external purposes in flows from the contracts with customers. accordance with reporting standards; however, IFRS 15 is effective for fiscal years ending on or trol over financial reporting may not prevent or after December 31, 2017. The Company intends detect misstatements on a timely basis. because of its inherent limitations, internal con- to adopt IFRS 15 in its financial statements for the annual period beginning on January 1, Management evaluated, under the supervision 2017 and is currently analyzing the impact on of and with the participation of the Chief Ex- the Company’s financial statements. ecutive Officer and Chief Financial Officer, the Disclosure Controls and Internal Controls over Financial Reporting effectiveness of the Company’s internal control over financial reporting based on the criteria set forth in Internal Control – Integrated Framework (2013) issued by the Committee The Company’s disclosure controls and pro- of Sponsoring Organizations of the Treadway cedures are designed to provide reasonable Commission (“COSO”) and, based on that assurance that information required to be evaluation, concluded that the Company’s 33 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Discussion and Analysis internal control over financial reporting was associated with the structure of the Company effective as of December 31, 2014 and that no include those related to the dependence on material weaknesses have been identified in FNFLP, leverage and restrictive covenants, the Company’s internal control over financial dividends which are not guaranteed and reporting as of December 31, 2014. No changes could fluctuate with FNFLP’s performance, were made in the Company’s internal controls restrictions on potential growth, the market over financial reporting during the year ended price of the Company’s shares, statutory rem- December 31, 2014 that have materially affected, edies, control of the Company and contractual or are reasonably likely to materially affect, restrictions, and income tax matters. Risk and the Company’s internal controls over financial risk exposure are managed through a com- reporting. Risks and Uncertainties Affecting the Business bination 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 ser- The business, financial condition and results vicing or spread income. For the single-family of operations of the Company are subject to residential segment, the Company relies on a number of risks and uncertainties, and are independent mortgage brokers for origination affected by a number of factors outside the and several large institutional investors for control of management of the Company. In sources of funding. These relationships are addition to the risks addressed elsewhere in critical to the Company’s success. For a more this discussion and the financial statements, complete discussion of the risks affecting the these risks include: ability to sustain perfor- Company, reference should be made to the mance and growth, reliance on sources of Company’s Annual Information Form. funding, concentration of institutional investors, reliance on independent mortgage brokers, Forward-Looking Information changes in interest rates, repurchase obli- gations and breach of representations and Forward-looking information is included in warranties on mortgage sales, risk of servicer this MD&A. In some cases, forward-looking termination events and trigger events on cash information can be identified by the use of collateral and retained interests, reliance on terms such as ‘‘may’’, ‘‘will”, ‘‘should’’, ‘‘expect’’, multi-unit residential and commercial mortgages, ‘‘plan’’, ‘‘anticipate’’, ‘‘believe’’, ‘‘intend’’, ‘‘es- general economic conditions, legislation timate’’, ‘‘predict’’, ‘‘potential’’, ‘‘continue’’ or and government regulation (including the other similar expressions concerning matters policies set for mortgage default insurance that are not historical facts. companies), competition, reliance on mort- gage insurers, reliance on key personnel and Forward-looking information may relate to the ability to attract and retain employees management’s future outlook and anticipated and executives, conduct and compensation events or results, and may include statements of independent mortgage brokers, failure or or information regarding the future financial unavailability of computer and data processing position, business strategy and strategic goals, systems and software, insufficient insurance product development activities, projected coverage, change in or loss of ratings, im- costs and capital expenditures, financial pact of natural disasters and other events, results, risk management strategies, hedging and environmental liability. In addition, risks activities, geographic expansion, licensing 34 2014 Annual ReportManagement’s Discussion and AnalysisManagement’s Discussion and Analysis plans, taxes and other plans and objectives future events or otherwise, except as required of or involving the Company. Particularly, under applicable securities regulations. information regarding growth objectives, any increase in mortgages under administration, Outlook future use of securitization vehicles, industry trends and future revenues is forward-looking Management is pleased with the results of information. Forward-looking information is 2014 particularly with the record origination based on certain factors and assumptions volumes realized as the Company took advan- regarding, among other things, interest rate tage of a strong real estate market. Looking changes and responses to such changes, the ahead, the Company anticipates continuing demand for institutionally placed and securi- strength in Canadian real estate and the tized mortgages, the status of the applicable continuation of its leadership position in the regulatory regime, and the use of mortgage mortgage broker distribution channel. With brokers for single-family residential mortgages. the cut in the Bank of Canada overnight rate This forward-looking information should not be announced in January 2015 the Company’s read as providing guarantees of future perfor- expectation of a low interest rate environment mance or results, and will not necessarily for 2015 has been reinforced. Low rates will be an accurate indication of whether or not, continue to keep mortgage affordability at or the times by which, those results will be favourable levels and allay refinancing risk. achieved. While management considers these During the fourth quarter of 2014, the Company assumptions to be reasonable based on infor- incurred employee costs, training, recruiting mation currently available to it, they may prove and other start-up costs in conjunction with to be incorrect. Forward-looking information is the mortgage underwriting and fulfillment subject to certain factors, including risks and processing services agreement it announced uncertainties, which could cause actual results on July 16, 2014. Although operations from to differ materially from what management this agreement commenced in January 2015, currently expects. These factors include reli- revenue will not be earned until the mortgag- ance on sources of funding, concentration of es underwritten fund later in the first quarter. institutional investors, reliance on independent Accordingly to start 2015, this new business mortgage brokers, and changes in interest may produce little if any marginal earnings for rates as outlined under ‘‘Risk and Uncertainties the Company’s bottom line. Affecting the Business’’. In evaluating this infor- mation, the reader should specifically consider By realizing the significant renewal oppor- various factors, including the risks outlined tunities available in the upcoming year and under ‘‘Risk and Uncertainties Affecting the managing its partnerships with institutional Business’’, which may cause actual events or customers, the Company will continue to fo- results to differ materially from any forward- cus on sustainable profitability. Management looking information. The forward-looking expects the Company to continue to generate information contained in this discussion the cash flow from its $22 billion portfolio of represents management’s expectations as of mortgages pledged under securitization and February 24, 2015, and is subject to change $64 billion servicing portfolio that will maximize after such date. However, management and the financial performance. Company disclaim any intention or obligation to update or revise any forward-looking informa- tion, whether as a result of new information, 35 First National Financial CorporationManagement’s Discussion and AnalysisManagement’s Responsibility for Financial Reporting The management of First National Financial In meeting our responsibility for the integrity Corporation (the “Company”) is responsible and fairness of the annual consolidated financial for the preparation and fair presentation of the statements and MD&A and for the accounting accompanying annual consolidated financial systems from which they are derived, manage- statements and Management’s Discussion and ment has established the necessary internal Analysis (“MD&A”). The consolidated financial controls designed to ensure that the Company’s statements have been prepared in accordance financial records are reliable for preparing with International Financial Reporting Standards financial statements and other financial infor- (“IFRS”). mation, transactions are properly authorized and recorded, and assets are safeguarded The consolidated financial statements and against unauthorized use or disposition. information in the MD&A necessarily include amounts based on the best estimates and As at December 31, 2014, the Chairman, Pres- judgments by management of the expected ident and Chief Executive Office and Chief effects of current events and transactions with Financial Officer evaluated, or caused an eval- the appropriate consideration to materiality. In uation under their direct supervision, of the addition, in preparing this financial information design and operation of our internal controls the Company must make determinations about over financial reporting (as defined in National the relevancy of information to be included, Instrument 52-109, Certificate of Disclosure and estimates and assumptions that affect the in Issuers’ Annual and Interim Filings) and, reported information. The MD&A also includes based on that assessment, determined that information regarding the impact of current the Company’s internal controls over financial transactions and events, sources of liquidity reporting were appropriately designed and and capital resources, operating trends, risks operating effectively. and uncertainties. Actual results in the future may differ materially from our present as- sessment of this information because future events and circumstances may not occur as expected. Management’s Responsibility for Financial Reporting 36 2014 Annual ReportManagement’s Responsibility for Financial Reporting The Board of Directors oversees through an Ernst & Young LLP, independent auditors Audit Committee, which is composed entirely appointed by the shareholders of First National of independent directors. This committee Financial Corporation upon the recommendation reviews the Company’s annual consolidated of the Board of Directors, have examined the financial statements and MD&A with both Company’s 2014 and 2013 annual consolidated management and the independent auditors financial statements and have expressed their before such statements are approved by the opinion upon the completion of such examina- Board of Directors. Other key responsibilities tion in the following report to the shareholders. of the Audit Committee include selecting the The auditors have full and free access to, Company’s auditors, approving the Company’s and meet at least quarterly with, the Audit interim unaudited condensed consolidated fi- Committee to discuss their audit and related nancial statements and MD&A, and monitoring matters. the Company’s existing systems of internal controls. Stephen J.R. Smith Chairman and Chief Executive Officer Robert A. Inglis Chief Financial Officer 37 Management’s Responsibility for Financial Reporting First National Financial CorporationIndependent Auditors’ Report To the Shareholders of First National Financial Corporation We have audited the accompanying consol- The procedures selected depend on the auditors’ judgment, including the assessment of the risks of material misstatement of the idated financial statements of First National consolidated financial statements, whether Financial Corporation, which comprise the due to fraud or error. consolidated statements of financial position as at December 31, 2014 and 2013, and the In making those risk assessments, the auditors consolidated statements of comprehensive consider internal control relevant to the entity’s income, changes in equity and cash flows preparation and fair presentation of the for the years then ended, and a summary consolidated financial statements in order to of significant accounting policies and other design audit procedures that are appropriate explanatory information. in the circumstances, but not for the purpose of expressing an opinion on the effectiveness Management’s responsibility for the consolidated financial statements Management is responsible for the preparation of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reason- ableness of accounting estimates made by and fair presentation of these consolidated management, as well as evaluating the overall financial statements in accordance with presentation of the consolidated financial International Financial Reporting Standards, statements. We believe that the audit evidence and for such internal control as management we have obtained in our audits is sufficient and determines is necessary to enable the prepa- appropriate to provide a basis for our audit ration of consolidated financial statements opinion. that are free from material misstatement, whether due to fraud or error. Opinion In our opinion, the consolidated financial Auditors’ responsibility Our responsibility is to express an opinion on statements present fairly, in all material respects, the financial position of First National Financial these consolidated financial statements based Corporation as at December 31, 2014 and on our audits. We conducted our audits in 2013, and its financial performance and its accordance with Canadian generally accepted cash flows for the years then ended in accor- auditing standards. Those standards require dance with International Financial Reporting that we comply with ethical requirements and Standards. plan and perform the audits to obtain reason- able assurance about whether the consolidated Toronto, Canada financial statements are free from material February 24, 2015 misstatement. An audit involves performing procedures to obtain audit evidence about the amounts Chartered Professional Accountants and disclosures in the consolidated financial Licensed Public Accountants statements. Independent Auditors’ Report 38 2014 Annual ReportConsolidated Statements of Financial Position As at December 31 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 ATTRIBUTABLE TO SHAREHOLDERS Common shares Preferred shares Retained earnings Non-controlling interests Total equity Total liabilities and equity See accompanying notes On behalf of the Board: Notes 2014 $ ($000s) 2013 $ 3 $ 496,733 $ 431,111 71,160 60,110 15 5 3 4 3 8 6 19 7 10 16 17 15 11 13 19 19 18 18 1,331,615 1,055,443 1,369,778 1,074,825 22,337,378 17,651,644 34,644 18,973 2,230 33,580 24,804 3,079 230,388 184,584 10,539 50,476 — 50,037 $ 25,953,914 $ 20,569,217 609,870 274,484 660,360 609,292 94,524 66,426 1,330,699 1,050,199 22,573,362 17,884,303 176,418 — 57,400 179,195 4,207 51,200 $ 25,502,633 $ 20,119,306 $ 122,671 97,394 192,669 122,671 97,394 184,561 412,734 404,626 38,547 451,281 45,285 449,911 $ 25,953,914 $ 20,569,217 John Brough Robert Mitchell 39 Consolidated Statements of Financial Position First National Financial Corporation Consolidated Statements of Comprehensive Income As at December 31 ($000s, except earnings per share) REVENUE Interest revenue – securitized mortgages $ 550,216 $ 429,223 Notes 2014 2013 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 3 4 (434,726) (323,236) 115,490 105,987 127,129 145,407 10,520 57,076 93,082 11,021 54,166 92,825 (34,916) 43,866 368,381 453,272 77,105 67,551 36,275 42,145 5,000 84,420 62,029 29,170 38,579 5,563 228,076 219,761 140,305 233,511 19 35,840 61,410 172,101 Net income and comprehensive income for the year 104,465 Net income and comprehensive income attributable to: Shareholders Non-controlling interests Earnings per share Basic See accompanying notes 101,710 169,726 2,755 2,375 $ 104,465 $ 172,101 18 $ 1.62 $ 2.75 Consolidated Statements of Comprehensive Income 40 2014 Annual ReportConsolidated Statements of Changes in Equity Years ended December 31 ($000s) Common shares Preferred shares Retained earnings Non- controlling interest Total equity Balance at January 1, 2014 $ 122,671 $ 97,394 $ 184,561 $ 45,285 $ 449,911 Comprehensive income Dividends paid or declared Non-controlling interests redemption — — — — — — 101,710 2,755 104,465 (93,602) (2,714) (96,316) — (6,779) (6,779) Balance at December 31, 2014 $ 122,671 $ 97,394 $ 192,669 $ 38,547 $ 451,281 Common shares Preferred shares Retained earnings Non- controlling interest Total equity Balance at January 1, 2013 $ 122,671 $ 97,394 $ 102,440 $ 42,895 $ 365,400 Comprehensive income Dividends paid or declared Non-controlling interests redemption — — — — — — 169,726 2,375 172,101 (87,605) (2,689) (90,294) — 2,704 2,704 Balance at December 31, 2013 $ 122,671 $ 97,394 $ 184,561 $ 45,285 $ 449,911 See accompanying notes 41 Consolidated Statements of Changes in Equity First National Financial CorporationConsolidated Statements of Cash Flows 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 losses (gains) on financial instruments ($000s) 2014 2013 $ 104,465 $ 172,101 6,200 (9,785) 18,300 (9,912) (65,622) (96,149) (4,670,001) (4,600,694) 4,683,052 4,630,915 9,028 849 2,909 5,000 8,590 17,955 802 2,374 5,563 (19,286) 74,685 121,969 Net change in non-cash working capital balances related to operations (305,398) (272,641) Cash used in operating activities INVESTING ACTIVITIES Additions to property, plant and equipment Repayment of cash held as collateral for securitization Investment in mortgage and loan investments Repayment of mortgage and loan investments Cash provided by (used in) investing activities FINANCING ACTIVITIES Dividends paid Obligations related to securities and mortgages sold under repurchase agreements Debt related to participation mortgages Securities purchased under resale agreements and owned, net Securities sold under repurchase agreements and sold short, net Non-controlling interest Cash provided by (used in) financing activities Net 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 $ (230,713) $ (150,672) (8,348) 5,831 (3,428) 44,689 (223,962) (142,353) 178,158 130,803 $ (48,321) $ 29,711 $ (93,102) $ (87,106) 51,068 6,007 108,684 (19,422) (276,172) (602,909) 265,340 602,412 (9,493) 15 $ (56,352) $ 1,674 (335,386) (274,484) (119,287) (155,197) $ (609,870) $ (274,484) $ 655,018 $ 536,524 449,287 44,386 335,516 40,693 Consolidated Statements of Cash Flows 42 2014 Annual ReportNotes to Consolidated Financial Statements December 31, 2014 and 2013 Note 1. General organization and business of first national financial corporation The carrying values of recognized assets and liabilities that are hedged items in fair value hedges, and otherwise carried at amortized cost, are adjusted to record changes in fair value attributable to the risks that are being hedged. The consolidated financial statements First National Financial Corporation (the “Cor- are presented in Canadian dollars and all poration” or “Company”) is the parent company values are rounded to the nearest thousand of First National Financial LP (“FNFLP)”, a except when otherwise indicated. The consoli- Canadian-based originator, underwriter and dated financial statements were authorized for servicer of predominantly prime residential issue by the Board of Directors on February 24, (single family and multi unit) and commercial 2015. mortgages. With almost $86 billion in mort- gages under administration as at December 31, 2.2 Basis of consolidation 2014, FNFLP is an originator and underwriter The consolidated financial statements comprise of mortgages and a significant participant in the financial statements of the Company and the mortgage broker distribution channel. its subsidiaries, including FNFLP, First National Financial GP Corporation (the general partner The Corporation is incorporated under the of FNFLP), FNFC Trust, a special purpose entity laws of the Province of Ontario, Canada and (“SPE”) which is used to manage undivided has its registered office and principal place co-ownership interests in mortgage assets of business located at 100 University Avenue, funded with Asset-Backed Commercial Paper Toronto, Ontario. The Corporation’s common (“ABCP”), First National Asset Management and preferred shares are listed on the Toronto Inc., First National Mortgage Corporation, Stock Exchange under the symbols FN and First National Mortgage Investment Fund (the FN.PR.A, respectively. “Fund”), and FN Mortgage Investment Trust (the “Trust”). Note 2. Significant accounting policies 2.1 Basis of preparation The Fund and Trust were created in 2012 as special purpose vehicles (“SPE”) to obtain exposure to a diversified portfolio of high The consolidated financial statements have yielding mortgages. While the Company has been prepared in accordance with International legal ownership of approximately 16% of the Financial Reporting Standards (“IFRS”). The units issued by the Fund, because of its status consolidated financial statements have been as the sole seller of assets to the Fund and its prepared on a historical cost basis, except for rights as promoter, the Company determined derivative financial instruments and financial that it had de facto control of the both the Fund assets and financial liabilities that are recorded and Trust, and therefore, had consolidated the at fair value through profit or loss (“FVTPL”) operations and net assets of the Fund and Trust. and measured at fair value. 43 First National Financial CorporationNotes to Consolidated Financial Statements Non-controlling interests in the Fund and Trust Major areas requiring use of estimates by are shown as a separate component of equity management are those that require reporting on the consolidated statements of financial of financial assets and financial liabilities at Notes to Consolidated Financial Statements position to distinguish them from the equity of fair value. the Company’s shareholders. The net income attributable to non-controlling interest is also 2.4 Significant accounting policies separately disclosed on the consolidated REVENUE RECOGNITION statement of comprehensive income. The Company earns revenue from placement, securitization and servicing activities related The Company did not consolidate, in its to its mortgage business. The majority of financial statements, an SPE over which the originated mortgages are sold to institutional Company does not have control. The SPE is investors through the placement of mortgages sponsored by a third-party financial institu- or funded through securitization conduits. The tion and acquires assets from various sellers Company retains servicing rights on substantially including mortgages from the Company. all of the mortgages it originates, providing the The Company earns interest income from the Company with servicing fees. retained interest related to these mortgages. As at December 31, 2014, the Company INTEREST REVENUE AND EXPENSE recorded, on its consolidated statements of FROM MORTGAGES PLEDGED UNDER financial position, its portion of assets of an SECURITIZATION SPE amounting to $242 million (2013 – $424 The Company enters into securitization million). The Company also recorded, on its transactions to fund a portion of its originated Consolidated Statements of Comprehensive mortgages. Upon transfer of these mortgag- Income, interest revenue – securitized mort- es to securitization vehicles, the Company gages of $8.6 million (2013 – $10.7 million) receives cash proceeds from the transaction. and interest expense – securitized mortgages These proceeds are accounted for as debt of $6.7 million (2013 – $7.6 million). related to securitized mortgages and the The consolidated financial statements have on its consolidated statements of financial Company continues to hold the mortgages been prepared using consistent accounting position, unless: policies for like transactions and other events in similar circumstances. All intercompany (i) substantially all of the risks and rewards balances and revenues and expenses have associated with the financial instruments been eliminated on consolidation. have been transferred, in which case the assets are derecognized in full; or 2.3 Use of estimates The preparation of financial statements in (ii) a significant portion, but not all, of the conformity with IFRS requires management to risks and rewards have been transferred. make estimates and assumptions that affect The asset is derecognized entirely if the the reported amounts of assets and liabilities, transferee has the ability to sell the financial including contingencies, at the date of the asset; otherwise the asset continues to be consolidated financial statements and the recognized to the extent of the Company’s reported amounts of revenue and expenses continuing involvement. during the reporting period. Actual results may differ from those estimates. Notes to Consolidated Financial Statements 44 2014 Annual ReportWhere (i) or (ii) above applies to a fully pro- all of the risks and rewards of the asset nor portionate share of all or specifically identified transferred control of the asset, the asset is cash flows, the relevant accounting treatment recognized to the extent of the Company’s is applied to that proportion of the mortgage. continuing involvement in the asset. In that case, the Company also recognizes an For securitized mortgages that do not meet associated liability. the criteria for derecognition, no gain or loss is recognized at the time of the transaction. PLACEMENT FEES AND DEFERRED Instead, net interest revenue is recognized PLACEMENT FEES RECEIVABLE over the term of the mortgages. Interest The Company enters into placement agreements revenue — securitized mortgages represents with institutional investors to purchase the interest received and accrued on mortgage mortgages that it originates. When mortgages payments by borrowers and is net of the are placed with institutional investors, the amortization of capitalized origination fees. Company transfers the contractual right to Interest expense — securitized mortgages receive mortgage cash flows to the investors. represents financing costs to fund these mort- Because it has transferred substantially all gages, net of the amortization of debt discounts the risks and rewards of these mortgages, it or premiums. has derecognized these assets. The Company retains a residual interest representing the Capitalized origination fees and debt discounts rights and obligations associated with servicing or premiums are respectively amortized on an the mortgages. Placement fees are earned by effective yield basis over the term of the related the Company for its origination and under- mortgages or debt. DERECOGNITION writing activities on a completed transaction basis when the mortgage is funded. Amounts immediately collected or collectible in excess A financial asset is derecognized when: of the mortgage principal are recognized as • The right to receive cash flows from the placement fees. When placement fees and asset has expired; associated servicing fees are earned over the • The Company has transferred its rights to term of the related mortgages, the Company receive cash flows from the assets or has determines the present value of the future assumed an obligation to pay the cash stream of placement fees and records a gain flows, received in full without material on deferred placement fees and a deferred delay to a third party under a “pass- placement fees receivable. Since quoted through” arrangement; and either (a) the prices are generally not available for retained Company has transferred substantially all interests, the Company estimates its value the risks and rewards of the asset or (b) based on the net present value of future the Company has neither transferred nor expected cash flows, calculated using man- retained substantially all of the risks and agement’s best estimates of key assumptions rewards of the asset, but has transferred related to expected prepayment rates and control of the asset. discount rates commensurate with the risks involved. 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 Notes to Consolidated Financial Statements 45 First National Financial CorporationNotes to Consolidated Financial StatementsMORTGAGE SERVICING INCOME Financial assets and financial The Company services substantially all of liabilities the mortgages that it originates whether the The Company classifies its financial assets mortgage is placed with an institutional investor as either at FVTPL or loans and receivables. or transferred to a securitization vehicle. In Financial liabilities are classified as either at addition, mortgages are serviced on behalf FVTPL or at amortized cost. Management de- of third-party institutional investors and termines the classification of financial assets securitization structures. For all mortgages and financial liabilities at initial recognition. administered for investors or third parties, the Company recognizes servicing income when Financial assets and financial services are rendered. For mortgages placed liabilities at FVTPL under deferred placement arrangements, the Financial instruments are classified in this Company retains the rights and obligations to category if they are held for trading or if they service the mortgages. The deferred placement are designated by management at FVTPL at fees receivable is the present value of the inception. excess retained cash flows over normal ser- vicing fee rates and is reported as deferred Financial instruments are classified as FVTPL placement revenue at the time of placement. if they are acquired principally for the pur- Servicing income related to mortgages placed pose of selling in the short term. Financial as- with institutional investors is recognized in sets and financial liabilities may be designated income over the life of the servicing obligation at FVTPL when: as payments are received from mortgagors. Interest income earned by the Company (i) the designation eliminates or significantly from holding cash in trust related to servicing reduces a measurement or recognition activities is classified as mortgage servicing inconsistency that would otherwise arise income. The amortization of the servicing from measuring assets or liabilities or rec- liability is recorded as mortgage servicing ognizing the gains and losses on them on income. a different basis; or MORTGAGE INVESTMENT INCOME (ii) a group of financial assets and/or financial The Company earns interest income from its liabilities is managed and its performance interest-bearing assets including deferred evaluated on a fair value basis. placement fees receivable, mortgage and loan investments and mortgages accumulated for The Company has elected to measure certain sale or securitization. Mortgage investment of its assets at FVTPL. The most significant of income is recognized on an accrual basis. these assets include: a large portion of mort- Brokerage Fees gages pledged under securitization and funded with ABCP related debt, certain mortgages Brokerage fees relating to the mortgages re- funded with MBS debt, deferred placement corded at fair value are expensed as incurred. fees receivable, and mortgages held by the Brokerage fees relating to mortgages recorded Trust. at amortized cost are deferred and amortized over the term of the mortgages. Notes to Consolidated Financial Statements 46 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The mortgages funded with MBS debt were category, where they are no longer held for previously funded by ABCP debt and as such the purpose of selling or repurchasing in have retained their classification as held for the near term and they would have met the trading (together with other ABCP funded definition of a loan and receivable at the date mortgages, “FVTPL mortgages”). For the of reclassification and the Company has the large portion of mortgages pledged under intent and ability to hold the assets for the securitization and funded with ABCP related foreseeable future or until maturity. debt, the Company has entered into swaps to convert the mortgages from fixed rate to Loans and receivables floating rate in order to match the mortgages Loans and receivables are non-derivative finan- with the 30-day floating rate funding provided cial assets with fixed or determinable payments by the ABCP notes. The swaps are derivatives that are not quoted in an active market and it and are required by IFRS to be accounted for is expected that substantially all of the initial at fair value. This value can change signifi- investment will be recovered, other than be- cantly with the passage of time as the interest cause of credit deterioration. rate environment changes. In order to avoid a significant accounting mismatch, the Company Loans and receivables are initially recognized has measured the swapped mortgages at fair at cost, including direct and incremental trans- value as well so that the asset and related action costs. They are subsequently valued at liability values will move inversely as interest amortized cost. rates change. The cash flows related to de- ferred placement fees receivable are typically DERIVATIVE FINANCIAL INSTRUMENTS received over five-to-ten-year terms. These Derivatives are categorized as trading unless cash flows are subject to prepayment volatility they are designated as hedging instruments. as the mortgages underlying the deferred Derivative contracts are initially recognized placement fees receivable can experience un- at fair value on the date on which a derivative scheduled prepayments. As well, the Company contract is entered into and are subsequently pledges these assets under the bank credit re-measured at their fair value with the changes facility. Accordingly, the Company manages in fair value recognized in income as they these assets on a fair value basis. occur. Positive values are recorded as assets and negative values are recorded as liabilities. Financial assets and financial liabilities at FVTPL are initially recognized at fair value. The Company enters into interest rate swaps Subsequent gains and losses arising from to manage its interest rate exposures associ- changes in fair value are recognized directly ated with funding fixed-rate receivables with in the Consolidated Statements of Compre- floating rate debt and to convert the fixed-rate hensive Income. debenture into floating rate debt. These contracts are negotiated over-the-counter. Held for trading non-derivative financial as- Interest rate swaps require the periodic ex- sets can only be transferred out of the held at change of payments without the exchange FVTPL category in the following circumstances: of the notional principal amount on which to the available-for-sale category, where, in the payments are based. rare circumstances, they are no longer held for the purpose of selling or repurchasing in the near term; or to the loans and receivables 47 First National Financial CorporationNotes to Consolidated Financial StatementsThe Company’s policy is not to utilize de- These mortgages are subject to participation rivative financial instruments for trading or agreements with other financial institutions speculative purposes. such that the Company’s investment is sub- ordinate to the other institutions’ investment. Mortgages pledged under securitization The Company has retained various rights to Mortgages pledged under securitization are the mortgages and a proportionately larger mortgages that the Company has originat- share of the interest earned on these mort- ed and funded with debt raised through the gages, such that the full mortgage has been securitization markets. The Company has a recorded on the Company’s consolidated continuous involvement in these mortgages, statements of financial position with an offset- including the right to receive future cash flows ting debt. This debt is recorded at face value arising from these mortgages. Mortgages and measured at its amortized cost. pledged under securitization (except for mortgages designated as FVTPL, primarily Mortgages accumulated for sale or mortgages funded with bank-sponsored securitization ABCP programs) have been classified as loans Mortgages accumulated for sale are mortgages and receivables and are measured at their funded for the purpose of placing with in- amortized cost using the effective yield method. vestors and are classified as FVTPL and are Origination costs, such as brokerage fees, recorded at fair value. These mortgages are bulk insurance premiums and timely payment held for terms usually not exceeding 90 days. guarantee fees that are directly attributable to the acquisition of such assets, are deferred Mortgages accumulated for securitization are and amortized over the term of the mortgages mortgages funded pending securitization in on an effective yield basis. Certain mortgages the Company’s various programs and are (primarily those funded under bank-sponsored classified as loans and receivables. These ABCP programs) are classified as FVTPL and mortgages are recorded at amortized cost. recorded at fair value. Securities sold short and securities purchased Debt related to securitized and under resale agreements participation mortgages Securities sold short consist of the short sale Debt related to securitized mortgages rep- of a bond. Bonds purchased under resale resents obligations related to the financing of agreements consist of the purchase of a bond mortgages pledged under securitization. This with the commitment by the Company to re- debt is measured at its amortized cost using sell the bond to the original seller at a specified the effective yield method. Any discount/ price. The Company uses the combination of premium on raising these debts that is directly bonds sold short and bonds purchased under attributable to obtaining such liabilities is resale agreements to economically hedge its deferred and amortized over the term of the mortgage commitments and the portion of debt obligations. funded mortgages that it intends to securitize Debt related to participation mortgages rep- resents obligations related to the financing of Bonds sold short are classified as FVTPL and a portion of commercial mortgages included are recorded at fair value. The accrued coupon in mortgage and loan investments. on bonds sold short is recorded as hedge in subsequent periods. expense. Notes to Consolidated Financial Statements 48 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements Bonds purchased under resale agreements Offering (“IPO”) in 2006. Intangible assets are carried at cost plus accrued interest, are subject to annual impairment review if which approximates their market value. The there are events or changes in circumstances difference between the cost of the purchase that indicate the carrying amount may not be and the predetermined proceeds to be recoverable. received on a resale agreement is recorded over the term of the hedged mortgages as Intangible assets with finite useful lives are an offset to hedge expense. Transactions are amortized on a straight-line basis over their recorded on a settlement date basis. estimated useful lives as follows: Securities owned and securities sold under Broker relationships Straight-line over repurchase agreements The Company purchases bonds and enters into bond repurchase agreements to close out economic hedging positions when mortgages Goodwill 10 years are sold to securitization vehicles or institutional Goodwill represents the price paid for the investors. Corporation’s business in excess of the fair value of the net tangible assets and identifiable These transactions are accounted for in a similar intangible assets acquired in connection with manner as the transactions described for the IPO. Goodwill is reviewed annually for securities sold short and securities purchased impairment or more frequently when an event under resale agreements. or change in circumstances indicates that the asset might be impaired. Mortgage and loan investments Mortgage and loan investments are carried at Property, plant and equipment their outstanding principal balances adjusted Property, plant and equipment are recorded for unamortized premiums or discounts and at cost, less accumulated amortization, at the are net of specific provisions for credit losses, following annual rates and bases: if any. Mortgage and loan investments are classified as loans and receivables, and 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 es- tablished for mortgages and loans that are known to be uncollectible. When management Computer equipment 30% declining balance Office equipment 20% declining balance Leasehold improvements straight-line over the term of the lease Computer software 30% declining balance except for a computer license, which is straight-line over 10 years considers there to be no probability of collection, Property, plant and equipment are subject to the investments are written off. an impairment review if there are events or Intangible assets Intangible assets consist of broker relation- ships and customer service contracts and arose in connection with the Initial Public changes in circumstances that indicate the carrying amount may not be recoverable. 49 First National Financial CorporationNotes to Consolidated Financial StatementsPurchased mortgage servicing rights liability based on the net present value of the The Company purchases the rights to service future expected cost of servicing these mortgages from third parties. Purchased mortgages. This is similar to the method the mortgage servicing rights are initially re- Company uses to calculate deferred placement corded at cost and charged to income over fees. Since quoted prices are generally not the life of the underlying mortgage servicing available for retained interests, the Company obligation. The fair value of such rights is estimates its value based on the net present determined on a periodic basis to assess the value of future expected cash flows, calculated continued recoverability of the unamortized using management’s best estimates of key cost in relation to estimated future cash assumptions related to expected prepayment flows associated with the underlying serviced rates and discount rates commensurate with assets. Any loss arising from an excess of the the risks involved. The Company earns the unamortized cost over the fair value is imme- related servicing fees over the term of the diately recorded as a charge to income. mortgages on an effective yield basis. Restricted cash Income taxes Restricted cash represents principal and in- The Company accounts for income taxes in terest collected on mortgages pledged under accordance with the liability method of tax al- securitization that is held in trust until the re- location. Under this method, the provision for payment of debt related to these mortgages income taxes is calculated based on income can be made in a subsequent period. tax laws and income tax rates substantively Bank indebtedness enacted as at the dates of the consolidated statements of financial position. The income Bank indebtedness consists of bank indebted- tax provision consists of current income taxes ness net of cash balances with banks. and deferred income taxes. Current and de- ferred taxes relating to items in the Company’s Cash held as collateral for securitization equity are recorded directly against equity. Cash held as collateral for securitization rep- resents cash-based credit enhancements held Current income taxes are amounts expected by various securitization vehicles, including to be payable or recoverable as the result of FNFC Trust and a Canadian Trust Company operations in the current year and any adjust- acting as the title custodian for the Company’s ment to tax payable/recoverable recorded in NHA-MBS program. previous years. Servicing liability Deferred income taxes arise on temporary The Company places mortgages with differences between the carrying amounts third-party institutional clients, and retains the of assets and liabilities on the consolidated rights and obligations to service these mort- statements of financial position and their tax gages. When the service related fees are paid bases. Deferred tax liabilities are generally upfront by a third party, the Company records recognized for all taxable temporary differ- a servicing liability for the additional future ences and deferred tax assets are recognized servicing cost as compared to the market to the extent that future realization of the tax rate, and a corresponding reduction of place- benefit is probable. ment fees at the time of sales. The Company determines the present value of servicing Notes to Consolidated Financial Statements 50 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements Deferred tax is calculated using the tax rates New accounting policies adopted expected to apply in the periods in which the On January 1, 2014, the Company adopted IFRIC assets will be realized or the liabilities settled. 21 Levies, issued by the IASB. The adoption of Deferred tax assets and liabilities are offset the standard did not have a significant impact when they arise in the same tax reporting on the Company’s consolidated financial group and relate to income taxes levied by statements. 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 Note 3. Mortgages Pledged Under Securitization (“EPS”) amounts for its common shares. EPS The Company securitizes residential and is calculated by dividing the net earnings commercial mortgages in order to raise debt attributable to common shareholders of the to fund these mortgages. Most of these secu- Company by the weighted average number of ritizations consist of the transfer of fixed and common shares outstanding during the year. floating rate mortgages into securitization Hedge accounting programs, such as ABCP, NHA-MBS, and the Canada Mortgage Bonds (“CMB”) program. At the inception of a hedging relationship, In these securitizations, the Company trans- the Company documents the relationship fers the assets to SPEs for cash, and incurs between the hedging instruments and the interest-bearing obligations typically matched hedged items, its risk management objective, to the term of the mortgages. These secu- its strategy for undertaking the hedge, and ritizations do not qualify for derecognition, its assessment of whether or not the hedging although the SPEs and other securitization instruments are highly effective in offsetting vehicles have no recourse to the Company’s the changes attributable to the hedged risks other assets for failure of the mortgages to in the hedged items. make payments when due. For fair value hedges, changes in the fair As part of the ABCP transactions, the Company value of derivatives that are designated and provides cash collateral for credit enhancement qualify as fair value hedging instruments are purposes as required by the rating agencies. recorded in the consolidated statements of Credit exposure to securitized mortgages comprehensive income, together with any is generally limited to this cash collateral. The changes in the fair value of the hedged asset principal and interest payments on the securi- or liability that are attributable to the hedged tized mortgages are paid to the Company by risk. The changes in fair value attributable to the SPEs monthly over the term of the mort- the hedged risk are accounted for as basis ad- gages. The full amount of the cash collateral justment to the hedged item. If the hedge no is recorded as an asset and the Company longer meets the criteria for hedge accounting, anticipates full recovery of these amounts. the adjustment to the carrying amount of a NHA-MBS securitizations may also require hedged item for which the effective interest cash collateral in some circumstances. As at method is used is amortized to the consoli- December 31, 2014, the cash held as collateral dated statements of comprehensive income for securitization was $18,973 over the period to maturity or derecognition. (2013 – $24,804). 51 First National Financial CorporationNotes to Consolidated Financial Statements The following table compares the carrying amount of mortgages pledged for securitization and the associated debt: Notes to Consolidated Financial Statements Securitized mortgages at face value $ 22,170,195 $ 22,612,160 2014 Carrying amount of securitized mortgages Carrying amount of associated liabilities Mark-to-market adjustment Capitalized origination costs Debt discounts Add: Principal portion of payments held in restricted cash Participation debt 41,859 125,324 — 22,337,378 455,003 — — — (56,481) 22,555,679 — 17,683 $ 22,792,381 $ 22,573,362 2013 Carrying amount of securitized mortgages Carrying amount of associated liabilities Securitized mortgages at face value $ 17,532,693 $ 17,919,788 Mark-to-market adjustment Capitalized origination costs Debt discounts Add Principal portion of payments held in restricted cash Participation debt 37,956 80,995 — 17,651,644 398,285 — — — (47,161) 17,872,627 — 11,676 $ 18,049,929 $ 17,884,303 The principal portion of payments held in re- In order to compare the components of stricted cash represents payments on account mortgages pledged under securitization to of mortgages pledged under securitization securitization debt, this amount is added to which has been received at year end but has the carrying value of mortgages pledged under not yet been applied to reduce the associated securitization in the above table. debt. This cash is applied to pay down the debt in the month subsequent to year end. 52 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The changes in capitalized origination costs for the year ended December 31 are summarized as follows: Opening balance, January 1 $ 80,995 $ 55,130 Add: new origination costs capitalized in the year Less: amortization in the year Ending balance, December 31 86,449 56,542 (42,120) (30,677) $ 125,324 $ 80,995 2014 2013 During the year ended December 31, 2014, the The following table summarizes the mortgages Company invested in mortgages that were pledged under securitization that are past due transferred into the securitization vehicles of as at December 31: $7,094,528 (2013 – $6,532,494). As at December 31, 2014, mortgages pledged under securitization include $21,985,346 (2013 – $17,440,211) of insured mortgages and $184,849 (2013 – $92,482) of uninsured mortgages. The contractual maturity profile of the mort- Arrears days 2014 2013 31 to 60 61 to 90 $ 71,170 $ 71,634 11,353 15,388 Greater than 90 53,389 30,284 $ 135,912 $ 117,306 gages pledged under securitization programs The Company did not set up allowance for is summarized as follows: mortgages past due over 90 days, as almost 2015 2016 2017 2018 2019 and thereafter 100% of the mortgages are insured. $ 2,760,503 2,977,333 3,597,619 4,499,764 8,334,976 Interest revenue — securitized mortgages con- sists of $105,130 (2013 – $100,160) of interest revenue related to ABCP funded mortgages, which are mostly measured at fair value and $445,086 (2013 – $329,063) of interest rev- $ 22,170,195 enue related to mortgages pledged under securitization and securitized mortgages included in FVTPL mortgages. The mortgages securitized through NHA-MBS and CMB programs have been classified as loans and receivables, except for approximately $1.2 billion (2013 – $1.1 billon) of mortgages included in FVTPL mortgages. These mort- gages are carried at par plus an adjustment for unamortized origination costs. Most mortgages in bank-sponsored ABCP programs have been classified as FVTPL. 53 First National Financial CorporationNotes to Consolidated Financial StatementsThe Company uses various assumptions to recorded in future statements of comprehensive value the FVTPL mortgages, which are set out income. Key economic weighted average as- in the tables below, including the rate of un- sumptions and the sensitivities of the current scheduled prepayment. Accordingly, FVTPL carrying values to immediate 10% and 20% mortgages are subject to measurement adverse changes in those assumptions as at uncertainty. The effect of variations between December 31 are as follows: actual experience and assumptions will be Notes to Consolidated Financial Statements FVTPL 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 FVTPL 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 2014 Commercial mortgages Residential mortgages $ 152,542 $ 3,249,160 $ $ $ $ 23 11.5% 477 951 2.0% 10,152 20,248 30 0.4% 1 1 2.2% 819 1,626 $ $ $ $ 2013 Commercial mortgages Residential mortgages $ 190,939 $ 3,097,341 24 8.2% $4 $8 2.3% 968 1,914 $ $ 27 11.6% $517 $ 1,028 2.1% 12,156 24,230 $ $ (1) The weighted-average life of prepayable assets in periods (for example, months or years) can be calculated by multiplying the principal collections expected in each future period by the number of periods until that future period, summing those products, and dividing the sum by the initial principal balance. 54 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements These sensitivities are hypothetical and should During the year ended December 31, 2014, be used with caution. As the figures indicate, $2,088,783 (2013 – $1,881,030) of mortgages changes in carrying value based on a 10% or were placed with institutional investors, 20% variation in assumptions generally cannot which created gains on deferred placement be extrapolated because the relationship of the fees of $10,520 (2013 – $11,021). Cash receipts change in assumption to the change in fair val- on deferred placement fees receivable for ue may not be linear. Also, in these tables, the the year ended December 31, 2014 were effect of a variation in a particular assumption $9,718 (2013 – $18,919). on the fair value is calculated without changing any other assumption; in reality, changes in The Company uses various assumptions to one factor may result in changes in another value the deferred placement fees receivable, (for example, increases in market interest rates which are set out in the table below, including may result in lower prepayments), which might the rate of unscheduled prepayments. magnify or counteract the sensitivities. Accordingly, the deferred placement fees Note 4. Deferred Placement Fees Receivable receivable are subject to measurement un- certainty. As at December 31, 2014, the fair value of deferred placement fees receivable is $34,644 (2013 – $33,580). An assumption of no credit losses was used, commensurate The Company enters into transactions with with the credit quality of the investors. The institutional investors to sell primarily fixed- effect of variations between actual experience rate mortgages in which placement fees are and assumptions will be recorded in future received over time as well as at the time of statements of comprehensive income. Key the mortgage placement. These mortgages economic weighted average assumptions and are derecognized when substantially all of the the sensitivity of the current carrying value risks and rewards of ownership are transferred of residual cash flows to immediate 10% and and the Company has minimal exposure to 20% adverse changes in those assumptions the variability of future cash flows from these are summarized as at December 31 as follows: mortgages. The investors have no recourse to the Company’s other assets for failure of mortgagors to pay when due. 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 2014 Commercial mortgages Residential mortgages 60 — — — 4.4% 380 752 $ $ $ $ 26 15.0% $2 $5 4.0% 1 1 55 First National Financial CorporationNotes to Consolidated Financial Statements 2013 Commercial mortgages Residential mortgages Notes to Consolidated Financial Statements 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 54 — — — 4.8% 393 778 $ 24 15.0% $1 $2 4.8% — 1 $ $ (1)The weighted-average life of prepayable assets in periods (for example, months or years) can be calculated by multiplying the principal collections expected in each future period by the number of periods until that future period, summing those products, and dividing the sum by the initial principal balance. These sensitivities are hypothetical and The Company estimates that the expected should be used with caution. As the figures cash flows from the receipt of payments on indicate, changes in carrying value based on a the deferred placement fees receivable will be 10% or 20% variation in assumptions generally as follows: cannot be extrapolated because the rela- tionship 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 of the retained interest is calculated without changing 2015 2016 2017 2018 any other assumption; in reality, changes in 2019 and thereafter 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. $ 9,117 8,165 7,053 5,643 8,904 $ 38,882 56 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements Note 5. Mortgages Accumulated for Sale Or Securitization Note 6. Mortgage and Loan Investments As at December 31, 2014, mortgage and loan Mortgages accumulated for sale or securi- investments consist primarily of commercial tization consist of mortgages the Company first and second mortgages held for various has originated for its own securitization pro- terms, the majority of which mature within grams together with mortgages funded for one year. placement with institutional investors. Mortgages originated for the Company’s own following: Mortgage and loan investments consist of the securitization programs are classified as loans and receivables and are recorded at amortized cost. Mortgages funded for placement with in- stitutional investors are designated as FVTPL, and are recorded at fair value. The fair values of mortgages held for trading approximate their carrying values due to their short-term nature. The following table summarizes the components of mortgages according to their classification: Mortgage loans, classified as loans and receivables Mortgage loans, designated as FVTPL 2014 2013 $ 175,570 $ 115,630 54,818 68,954 $ 230,388 $ 184,584 Mortgages accumulated for securitization Mortgages accumulated for sale 2014 2013 loans and receivables are carried at outstanding Mortgage and loan investments classified as principal balances adjusted for unamortized premiums or discounts and are net of specific $ 1,354,572 $ 1,063,068 provisions for credit losses, if any. 15,206 11,757 $ 1,369,778 $ 1,074,825 57 First National Financial CorporationNotes to Consolidated Financial Statements The following table discloses the composition of the Company’s portfolio of mortgage and loan investments by geographic region as at December 31, 2014: Notes to Consolidated Financial Statements Province/Territory Alberta British Columbia Manitoba New Brunswick Newfoundland and Labrador Nova Scotia Ontario Quebec Saskatchewan Yukon Portfolio balance Percentage of portfolio $ 24,336 % 6,594 43,199 2,361 3,179 4,323 111,336 30,255 3,966 839 10.56 2.86 18.75 1.02 1.38 1.88 48.34 13.13 1.72 0.36 $ 230,388 % 100.00 The following table discloses the mortgages The portfolio contains $5,050 (2013 – $3,900) that are past due as at December 31: of insured mortgages and $225,338 (2013 – Arrears days 2014 31 to 60 61 to 90 $ 4,596 $ — 2013 278 409 Greater than 90 34,453 15,216 $180,684) of uninsured mortgage and loan investments as at December 31, 2014. Of the above total amount, the Company considers $5,116 (2013 – $4,914) as impaired, for which it has provided an allowance for potential loss of $4,041 (2013 – $4,041) as at December $ 39,049 $ 15,903 31, 2014. 58 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The maturity profile in the table below is based on the earlier of contractual renewal or maturity dates. 2015 2016 2017 2018 2019 and thereafter Book value Book value 2014 2013 Residential $ 14,055 $ 249 $ 1,004 $ 742 $ 6,734 $ 22,784 $ 18,357 Commercial 146,479 43,300 13,191 3,795 839 207,604 166,227 $ 160,534 $ 43,549 $ 14,195 $ 4,537 $ 7,573 $ 230,388 $ 184,584 Interest income for the year was $13,607 (2013 – The intangible assets have a remaining $9,420) and is included in mortgage investment amortization period of less than two years. income on the consolidated statements of comprehensive income. For the purpose of testing goodwill for impair- Note 7. Other Assets ment, the cash-generating unit is considered to be the Corporation as a whole, since the good- will relates to the excess purchase price paid for the Corporation’s business in connection The components of other assets are as follows with the IPO. The recoverable amount of the as at December 31: Corporation is calculated by reference to the Corporation’s market capitalization, mortgages Property, plant and equipment, net 2014 2013 under administration, origination volume, and profitability. These factors indicate that the $ 13,200 $ 7,761 Corporation’s recoverable amount exceeds the Intangible assets, net 7,500 12,500 carrying value of its net assets and accordingly, Goodwill 29,776 29,776 goodwill is not impaired. $ 50,476 $ 50,037 59 First National Financial CorporationNotes to Consolidated Financial Statements Note 8. Purchased Mortgage Servicing Rights Purchased mortgage servicing rights consist of the following components: Notes to Consolidated Financial Statements 2014 2013 Cost Accumulated amortization Net book value Cost Accumulated amortization Net book value Third-party commercial mortgage servicing rights $ 3,614 $ 3,287 $ 327 $ 3,614 $ 3,183 $ 431 Commercial mortgage-backed secu- rities primary and master servicing rights 8,705 6,802 1,903 8,705 6,057 2,648 $ 12,319 $ 10,089 $ 2,230 $ 12,319 $ 9,240 $ 3,079 Amortization charged to income for the year ended December 31, 2014 was $849 (2013 – $802). Note 9. Mortgages under Administration mutual funds, trustcompanies, credit unions and securitization vehicles. As at December 31, 2014, As at December 31, 2014, the Company had the Company administered 274,674 mortgages mortgages under administration of $85,889,561 (2013 – 245,291) for 92 institutional investors (2013 – $75,619,003), including mortgages held (2013 – 91) with an average remaining term to on the Company’s consolidated statements of maturity of 42 months (2013 – 42 months). financial position. Mortgages under administra- tion are serviced for financial institutions such Mortgages under administration are serviced as banks, insurance companies, pension funds, as follows: Institutional investors 2014 2013 $ 53,625,460 $ 48,245,957 Mortgages accumulated for sale or securitization and mortgage and loan investments 1,593,103 1,255,267 Securitization vehicles, deferred placement investors 5,197,507 5,075,254 Mortgages pledged under securitization CMBS conduits 22,170,195 17,532,693 3,303,296 3,509,832 $ 85,889,561 $ 75,619,003 60 2014 Annual ReportNotes to Consolidated Financial Statements Notes to Consolidated Financial Statements The Company’s exposure to credit loss is limited to mortgages under administration totalling $336,998 (2013 – $201,271), of which $1,328 of mortgages have principal and inter- Note 11. Debt Related To Securitized and Participation Mortgages est payments in arrears as at December 31, Debt related to securitized mortgages rep- 2014 (2013 – $4,971). The Company incurred resents the funding for mortgages pledged actual credit losses, net of recoveries, of $625 under the NHA-MBS, CMB and ABCP programs. during the year ended December 31, 2014 (2013 As at December 31, 2014, debt related to – $3,752). As at December 31, 2014, the Com- securitized mortgages was $22,555,678 (2013 pany has $17,462 (2013 – $7,687) of uninsured – $17,872,627), net of unamortized discounts of non-performing mortgages (net of provisions $56,482 (2013 – $47,161). A comparison of the for credit losses) included in accounts receiv- carrying amounts of the pledged mortgages able and sundry. and the related debt is summarized in note 3. The Company maintains trust accounts on As at December 31, 2014, debt related to behalf of the investors it represents. The Com- participation mortgages was $17,684 (2013 pany also holds municipal tax funds in escrow – $11,676). for mortgagors. Since the Company does not hold a beneficial interest in these funds, they Debt related to securitized and participation are not presented on the consolidated state- mortgages is reduced on a monthly basis when ments of financial position. The aggregate of the principal payments received from the mort- these accounts as at December 31, 2014 was gages are applied. Debt discounts and premiums $537,524 (2013 – $405,426). are amortized over the term of each debt on an effective yield basis. Debt related to secu- ritization mortgages had a similar contractual maturity profile as the associated mortgages in mortgages pledged under securitization. Note 10. Bank Indebtedness Bank indebtedness includes a revolving credit facility of $1,000,000 (2013 – $570,000) maturing in January 2018, of which $609,639 (2013 – $258,421) was drawn as at December 31, 2014 and against which the following have been pledged as collateral: (a) a general security agreement over all assets, other than real property, of the Company; and (b) a general assignment of all mortgages owned by the Company. The credit facility bears a variable rate of interest based on prime and bankers’ acceptance rates. 61 First National Financial CorporationNotes to Consolidated Financial Statements Note 12. Swap Contracts The swap agreement that the Company en- tered into was an interest rate swap where two counterparties exchange a series of payments Notes to Consolidated Financial Statements Swaps are over-the-counter contracts in based on different interest rates applied to a which two counterparties exchange a series notional amount in a single currency. of cash flows based on agreed upon rates to a notional amount. The Company used interest The following tables present, by remaining rate swaps to manage interest rate exposure term to maturity, the notional amounts and relating to variability of interest earned on a fair values of the swap contract that do not portion of mortgages accumulated for sale qualify for hedge accounting as at December  and mortgages pledged under securitization 31, 2014 and 2013: held on the consolidated statements of financial position. 2014 Less than 3 years 3 to 5 years 6 to 10 years Total notional amount Fair value Interest rate swap contract $ 261,395 $ 2,960,335 $ 11,770 $ 3,233,500 $ 8,148 2013 Less than 3 years 3 to 5 years 6 to 10 years Total notional amount Fair value Interest rate swap contract $ 923,959 $ 1,678,567 $ 13,283 $ 2,615,809 $ 2,987 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 statements of financial position. Note 13. Debenture Loan Payable On the same date, the Company entered into a swap agreement to receive a 5.07% fixed coupon and pay monthly CDOR+2.134%, The $175 million of five-year term senior effectively protecting the Company against secured debentures, with an interest rate of changes in fair value due to changes in in- 5.07%, maturing on May 7, 2015, are secured terest rates. The swap agreement has been on a pari-passu basis with the security under designated as a fair value hedge and matures the credit facility described in bank indebt- on the due date of the debenture loan. edness. The net proceeds of the issuance were invested in FNFLP. FNFLP used the proceeds of the debenture loan to repay a portion of the bank indebtedness under its existing bank credit facility. 62 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The Company is a full guarantor on the deben- In the normal course of business, the Company tures and the costs relating to the debenture enters into a variety of guarantees. Guarantees issue have been borne by the Company. include contracts where the Company may be Note 14. Commitments, Guarantees and Contingencies 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 addition, contracts under which the Company may be required to make payments if a third party As at December 31, 2014, the Company has fails to perform under the terms of the contract the following operating lease commitments (such as mortgage servicing contracts) are for its office premises: considered guarantees. 2015 2016 2017 2018 2019 and thereafter $ 5,965 The Company has determined that the esti- 6,079 6,082 4,989 2,883 $ 25,998 mated potential loss from these guarantees is insignificant. Note 15. Securities Transactions Under Repurchase And Resale Agreements Outstanding commitments for future advances The Company’s outstanding securities pur- on mortgages with terms of one to 10 years chased under resale agreements and securities amounted to $889,294 as at December 31, sold under repurchase agreements have a 2014 (2013 – $803,991). The commitments remaining term to maturity of less than three generally remain open for a period of up to months. 90 days. These commitments have credit and interest rate risk profiles similar to those mort- gages that are currently under administration. Certain of these commitments have been sold to institutional investors while others will Note 16. Obligations Related to Securities and Mortgages Sold Under Repurchase Agreements expire before being drawn down. Accordingly, The Company uses repurchase agreements to these amounts do not necessarily represent fund specific mortgages included in mortgages future cash requirements of the Company. accumulated for sale or securitization. The current contracts are with financial institutions, are based on bankers’ acceptance rates and matured on or before January 30, 2015. 63 First National Financial CorporationNotes to Consolidated Financial StatementsNote 17. Accounts Payable and Accrued Liabilities Accrued interest on securitization debt is the interest due on securitization related debt subsequent to year end. Notes to Consolidated Financial Statements The major components of accounts payable and accrued liabilities are as follows as at Note 18. Shareholders’ Equity December 31: (a) Authorized 2014 2013 Unlimited number of common shares Accounts payable $ 47,138 $ 36,251 Unlimited number of cumulative 5-year rate reset preferred shares, Class A Series 1 Accrued interest on securitization debt 38,380 30,175 Unlimited number of cumulative 5-year rate Servicing liability 9,006 — reset preferred shares, Class A Series 2 $ 94,524 $ 66,426 (b) Capital stock Balance, December 31, 2014 and 2013 # 59,967,429 $ 122,671 # 4,000,000 $ 97,394 Common shares Preferred shares (c) Preferred shares Holders of Class A Series 1 Preferred Shares On January 25, 2011, the Company issued 4 have the right, at their option, to convert their million Class A Series 1 Preferred Shares at a shares into cumulative, floating rate Class A price of $25.00 per share for gross proceeds Preferred Shares, Series 2 (“Series 2 Preferred of $100,000 before issue expenses. Shares”), subject to certain conditions, on March 31, 2016 and on March 31 every five Holders of the Class A Series 1 Preferred years thereafter. Holders of the Series 2 Shares are entitled to receive a cumulative Preferred Shares will be entitled to receive quarterly fixed dividend yielding 4.65% an- cumulative quarterly floating dividends at a nually for the initial period ending March 31, rate equal to the three-month Government of 2016. Thereafter, the dividend rate may be Canada treasury bill yield plus 2.07% as and reset every five years at a rate equal to the when declared by the Board of Directors. five-year Government of Canada yield plus 2.07%, as and when approved by the Board Preferred shares do not have voting rights. of Directors. The par value per preferred share is $25. 64 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements (d) Earnings per share 2014 2013 Net income attributable to shareholders $ 101,710 $ 169,726 Less: dividends declared on preferred shares Net earnings attributable to common shareholders (4,650) 97,060 (4,650) 165,076 Number of common shares outstanding 59,967,429 59,967,429 Basic earnings per common share $ 1.62 $ 2.75 Note 19. Income Taxes The major components of current income tax ex- pense (recovery) for the year ended December The major components of deferred tax expense 31 consists of the following: for the year ended December 31 consists of the following: Income taxes relating to the prior year $ (560) $ (260) 2014 2013 Related to origination and reversal of timing differences $ 6,200 $ 18,300 2014 2013 Income taxes relating to the year 30,200 43,370 29,640 43,110 65 First National Financial CorporationNotes to Consolidated Financial StatementsThe effective income tax rate reported in the consolidated statements of comprehensive income varies from the Canadian tax rate of 26.37% for the year ended December 31, 2014 (2013 – 26.37%) Notes to Consolidated Financial Statements for the following reasons: Company’s statutory tax rate Income before income taxes Income tax at statutory tax rate Increase (decrease) resulting from Prior year adjustments Income not subject to tax Permanent differences Differences in current and future tax rates Other Income tax expense 2014 26.37% 2013 26.37% $ 140,305 $ 233,511 36,998 61,577 (560) (998) 277 (15) 138 (260) (610) 254 14 435 $ 35,840 $ 61,410 Significant components of the Company’s deferred tax liabilities for the year ended December 31 are as follows: Deferred placement fees receivable $ 9,136 $ 2014 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 Gains (losses) on interest rate swaps Servicing liability Loan loss reserves not deducted for tax purposes Debenture issuance costs Share issuance costs Other Deferred tax liabilities 33,048 11,038 1,978 14,894 (5,639) (5,316) (2,375) (684) (18) (198) 1,536 2013 8,855 21,358 10,009 3,296 12,436 (6,063) 978 — (845) (67) (422) 1,665 $ 57,400 $ 51,200 66 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The movement in significant components of the Company’s deferred tax liabilities and assets for the years ended December 31, 2014 and 2013 are as follows: As at January 1, 2014 Recognized in income As at December  31, 2014 DEFERRED INCOME TAX LIABILITIES Deferred placement fees receivable $ 8,855 $ 281 $ Capitalized broker fees 21,358 11,690 Carrying values of mortgages pledged under securitization in excess of tax values Gains on interest rate swaps Intangible assets Unamortized discount on debt related to securitized mortgages Other 10,009 978 3,296 12,436 1,665 1,029 (978) (1,318) 2,458 (129) Total deferred income tax liabilities $ 58,597 $ 13,033 $ DEFERRED INCOME TAX ASSETS Cumulative eligible capital property (6,063) 424 Servicing liability — (2,375) 9,136 33,048 11,038 — 1,978 14,894 1,536 71,630 (5,639) (2,375) (684) (5,316) (18) (198) (845) — (67) (422) 161 (5,316) 49 224 $ $ (7,397) $ (6,833) $ (14,230) 51,200 $ 6,200 $ 57,400 Loan loss reserves not deducted for tax pur- poses Losses on interest rate swaps Debenture issuance costs Share issuance costs Total deferred income tax assets Net deferred income tax liabilities 67 First National Financial CorporationNotes to Consolidated Financial StatementsAs at January 1, 2013 Recognized in income As at December  31, 2013 Notes to Consolidated Financial Statements DEFERRED INCOME TAX LIABILITIES Deferred placement fees receivable $ 11,025 $ (2,170) $ Capitalized broker fees 14,499 6,859 Carrying values of mortgages pledged under securitization in excess of tax values Gains on interest rate swaps Intangible assets Unamortized discount on debt related to securitized mortgages Other 8,168 — 4,751 2,122 2,232 1,841 978 (1,455) 10,314 (567) Total deferred income tax liabilities $ 42,797 $ 15,800 $ DEFERRED INCOME TAX ASSETS Cumulative eligible capital property Loan loss reserves not deducted for tax purposes Losses on interest rate swaps Debenture issuance costs Share issuance costs Total deferred income tax assets Net deferred income tax liabilities (6,502) (1,583) (1,051) (117) (644) 439 738 1,051 50 222 $ $ (9,897) $ 2,500 32,900 $ 18,300 $ $ 8,855 21,358 10,009 978 3,296 12,436 1,665 58,597 (6,063) (845) — (67) (422) (7,397) 51,200 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 man- agement, the Company may be required to change its provision for income taxes or deferred tax balances and the change could be significant. 68 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements Note 20. Financial Instruments and Risk Management Risk management and the time the mortgage is sold to a se- curitization vehicle and the underlying cost of funding is fixed. As interest rates change, the values of these interest rate dependent financial instruments vary inversely with the The various risks to which the Company is ex- values of the mortgage contracts. As interest posed and the Company’s policies and processes rates increase, a gain will be recorded on the to measure and manage them individually are economic hedge which will be offset by the set out below: reduced future spread on mortgages pledged Interest rate risk under securitization as the mortgage rate committed to the borrower is fixed at the Interest rate risk arises when changes in interest point of commitment. rates will affect the fair value of financial instruments. For single-family mortgages, only a portion of the commitments issued by the Company The Company uses various strategies to eventually fund. The Company must assign reduce interest rate risk. The Company’s risk a probability of funding to each mortgage in management objective is to maintain inter- the pipeline and estimate how that probability est rate spreads from the point that a mort- changes as mortgages move through the var- gage commitment is issued to the transfer ious stages of the pipeline. The amount that is of the mortgage to the related securitization actually economically hedged is the expected vehicle or sale to an institutional investor. value of the mortgages funding within the Primary among these strategies is the Com- future commitment period. pany’s decision to sell mortgages at the time of commitment, passing on interest rate risk The table below provides the financial impact that exists prior to funding to institutional that an immediate and sustained 100 basis investors. The Company uses bond forwards point and 200 basis point increase and de- (consisting of bonds sold short and bonds crease in short-term interest rates would have purchased under resale agreements) to man- had on the net income of the Company in age interest rate exposure between the time a 2014 and 2013. mortgage rate is committed to the borrower 100 BASIS POINT SHIFT Impact on net income and equity attributable to shareholders 200 BASIS POINT SHIFT Impact on net income and equity attributable to shareholders Decrease in interest rate Increase in interest rate(1) 2014 2013 2014 2013 $ 2,205 $ 1,414 $ (2,205) $ (1,414) $ 9,448 $ 7,157 $ (4,410) $ (2,828) (1) Interest rate is not to be decreased to below 0%. 69 First National Financial CorporationNotes to Consolidated Financial StatementsThe Company’s accounts receivable and sundry, Securities transacted are all Government of accounts payable and accrued liabilities, and Canada bonds and, as such, have virtually no Notes to Consolidated Financial Statements purchased mortgage servicing rights are not risk of credit loss. exposed to interest rate risk. Credit risk Liquidity risk and capital resources Liquidity risk is the risk that the Company will Credit risk is the risk of loss associated with be unable to meet its financial obligations as a counterparty’s inability or unwillingness to they come due. fulfill its payment obligations. The Company’s credit risk is mainly lending related in the The Company’s liquidity strategy has been form of mortgage default. The Company uses to use bank credit to fund working capital stringent underwriting criteria and experi- requirements and to use cash flow from enced adjudicators to mitigate this risk. The operations to fund longer-term assets. The Company’s approach to managing credit risk Company’s credit facilities are typically drawn is based on the consistent application of a to fund: (i) mortgages accumulated for sale or detailed set of credit policies and prudent ar- securitization, (ii) origination costs associated rears management. As at December 31, 2014, with mortgages pledged under securitization, 99% (2013 – 99%) of the pledged mortgages (iii) cash held as collateral for securitization, were insured mortgages. See details in note 3. (iv) costs associated with deferred placement The Company’s exposure is further mitigated fees receivable and (v) mortgage and loan in- by the relatively short period over which a vestments. The Company has a credit facility mortgage is held by the Company prior to with a syndicate of eleven financial institutions, securitization. which provides for a total of $1,000,000 in financing. Bank indebtedness also includes The maximum credit exposures of the financial borrowings obtained through outstanding assets are their carrying values as reflected on cheques and overdraft facilities. the consolidated statements of financial position. The Company does not have significant con- centration 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 individu- al mortgages that underlies these assets is diverse in terms of geographical location, borrower exposure and the underlying type of real estate. This diversity and the priority ranking of the Company’s rights mitigate the potential size of any single credit loss. Se- curities purchased under resale agreements are transacted with large regulated Canadian institutions such that the risk of credit loss is very remote. 70 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The Company finances the majority of its Fair value measurement mortgages with debt derived from the secu- The Company uses the following hierarchy ritization markets, primarily NHA-MBS, ABCP for determining and disclosing the fair value and CMB. Debt related to NHA MBS and of financial instruments recorded at fair value ABCP securitizations reset monthly such that in the consolidated statements of financial the receipts of principal on the mortgages position: are used to pay down the related debt within a 30-day period. Accordingly, these sources Level 1 – quoted market price observed in of financing amortize at the same rate as the active markets for identical mortgages pledged thereunder, providing an instruments; almost perfectly matched asset and liability Level 2 – quoted market price observed in ac- relationship. Market risk tive markets for similar instruments or other valuation techniques for which all significant inputs are based Market risk is the risk of loss that may arise from on observable market data; and changes in market factors such as interest rates and credit spreads. The level of market risk to Level 3 – valuation techniques in which one which the Company is exposed varies depending or more significant inputs are on market conditions, expectations of future unobservable. interest rates and credit spreads. Valuation methods and assumptions Customer concentration risk The Company uses valuation techniques Placement fees and mortgage servicing in- to estimate fair values, including reference come from one (2013 – one) Canadian financial to third-party valuation service providers institution represent approximately 20% (2013 using proprietary pricing models and internal – 16%) of the Company’s total revenue. During valuation models such as discounted cash the year ended December 31, 2014, the Company flow analysis. The valuation methods and key placed 29% (2013 – 31%) of all mortgages it assumptions used in determining fair values originated with that institutional investor. for the financial assets and financial liabilities are as follows: 71 First National Financial CorporationNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements (a) FVTPL mortgages in mortgages under (e) Other financial assets and financial securitization and certain mortgage and liabilities loan investments The fair value of mortgage and loan investments The fair value of these mortgages is determined classified as loans and receivables, mortgages by discounting projected cash flows using accumulated for sale or securitization, cash market industry pricing practices. Discount held as collateral for securitization, restricted rates used are determined by comparison to cash and bank indebtedness correspond to similar term loans made to borrowers with the respective outstanding amounts due to similar credit. This methodology will reflect their short-term maturity profiles. changes in interest rates which have occurred since the mortgages were originated. Impaired Carrying value and fair value of selected mortgages are recorded at net realizable value. financial instruments The fair value of the financial assets and (b) Deferred placement fees receivable financial liabilities of the Company approx- The fair value of deferred placement fees imates its carrying value, except for mort- receivable is determined by internal valuation gages pledged under securitization, which models using market data inputs, where has a carrying value of $22,337,378 (2013 possible. The fair value is determined by – $17,651,644) and a fair value of $22,734,523 discounting the expected future cash flows (2013 – $17,729,958), and debt related to se- related to the placed mortgages at market curitized and participation mortgages, which interest rates. The expected future cash flows has a carrying value of $22,573,362 (2013 – are estimated based on certain assumptions $17,884,303), and a fair value of $22,802,804 which are not supported by observable market (2013 – $17,911,851). data. Refer to note 4 “Deferred placement fees receivable” for the key assumptions used and sensitivity analysis. (c) Securities owned and sold short The fair values of securities owned and sold short used by the Company to hedge its inter- est rate exposure are determined by quoted prices. (d) Servicing liability The fair value of the servicing liability is de- termined by internal valuation models using market data inputs, where possible. The fair value is determined by discounting the ex- pected future cost related to the servicing of explicit mortgages at market interest rates. The expected future cash flows are estimated based on certain assumptions which are not supported by observable market data. 72 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements The following tables represent the Company’s financial instruments measured at fair value on a recurring basis at December 31: 2014 Level 1 Level 2 Level 3 Total FINANCIAL ASSETS Mortgages accumulated for sale $ — $ 15,206 $ — $ 15,206 FVTPL mortgages Deferred placement fees receivable Mortgage and loan investments Interest rate swaps Total financial assets Financial liabilities Securities sold under repurchase agree- ments and sold short Interest rate swaps Debenture loan payable — — — — — — — — 1,432 3,983,793 3,983,793 34,644 34,644 54,818 — 54,818 1,432 16,638 4,073,255 4,089,893 1,330,699 — — — 9,580 176,418 — — — 1,330,699 9,580 176,418 Total financial liabilities $ 1,330,699 $ 185,998 $ — $ 1,516,697 2013 Level 1 Level 2 Level 3 Total FINANCIAL ASSETS Mortgages accumulated for sale $ — $ 11,757 $ — $ 11,757 FVTPL mortgages Deferred placement fees receivable Mortgage and loan investments Interest rate swaps — — — — — — — 6,976 3,969,524 3,969,524 33,580 68,954 — 33,580 68,954 6,976 Total financial assets $ — $ 18,733 $ 4,072,058 $ 4,090,791 FINANCIAL LIABILITIES Securities sold under repurchase agreements and sold short Interest rate swaps Debenture loan payable $ 1,050,199 $ — — $ 1,050,199 — — 3,639 179,195 — — 3,639 179,195 Total financial liabilities $ 1,050,199 $ 182,834 $ — $ 1,233,033 73 First National Financial CorporationNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements In estimating the fair value of financial assets Transfers between levels in the fair value and financial liabilities using valuation tech- hierarchy are deemed to have occurred at the niques or pricing models, certain assumptions beginning of the period in which the transfer are used, including those that are not fully occurred. Transfers between levels can occur supported by observable market prices or as a result of additional or new information re- rates (Level 3). The amount of the change garding valuation inputs and changes in their in fair value recognized by the Company in observability. During the year, the Company net income for the year ended December 31, did not have any transfers between levels. 2014 that was estimated using a valuation technique based on assumptions that are not The following table presents changes in fully supported by observable market prices or the fair values, including realized losses of rates was approximately a loss of $8,590 (2013 $26,326 (2013 – realized gain of $24,580) of – gain of $19,286). Although the Company’s the Company’s financial assets and financial management believes that the estimated fair liabilities for the years ended December 31, values are appropriate as at the date of the 2014 and 2013, all of which have been classified consolidated statements of financial position, as FVTPL: those fair values may differ if other reasonably possible alternative assumptions are used. FVTPL mortgages Deferred placement fees receivable Securities owned and sold short Interest rate swaps 2014 $ 6,337 $ 307 (41,486) (74) 2013 15,141 (296) 28,667 354 $ (34,916) $ 43,866 The Company does not have any assets or liabilities that are measured at fair value on a non-recurring basis. 74 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated 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, 2014 and 2013. 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 FVTPL mortgages Deferred placement fees receivable Mortgage and loan investments Fair value as at January 1, 2014 Investments Unrealized gain recorded in income Payment and amortization Fair value as at December  31, 2014 $ 3,969,524 $ 3,110,849 $ 15,733 $ (3,112,313) $ 3,983,793 33,580 9,785 307 (9,028) 34,644 68,954 — — (14,136) 54,818 $ 4,072,058 $ 3,120,634 $ 16,040 $ (3,135,477) $ 4,073,255 Fair value as at January 1,2013 Investments Unrealized gain (loss) recorded in income Payment and amortization Fair value as at December  31, 2013 FINANCIAL ASSETS FVTPL mortgages $ 3,118,827 $ 3,546,819 $ 18,907 $ (2,715,029) $ 3,969,524 Deferred placement fees receivable Mortgage and loan investments 41,919 9,912 (296) (17,955) 33,580 25,021 46,117 — (2,184) 68,954 Total financial assets $ 3,185,767 $ 3,602,848 $ 18,611 $ (2,735,168) $ 4,072,058 Derivative financial instrument and The swap agreement is recorded at fair value hedge accounting with the changes in fair value recognized in The Company entered into a swap agreement income. Changes in fair value attributed to the to hedge the debenture loan payable against hedged risk are accounted for as basis adjust- changes in fair value by converting the fixed- ments to the debenture loan payable and are rate debt into a variable-rate debt. The swap recognized in income. agreement has been designated as a fair value hedge and the hedging relationship is formally Accordingly, as at December 31, 2014, accounts documented, including the risk management receivable and sundry have been increased by objective and measurement of effectiveness. $1,418 (2013 – $4,195) to account for the swap derivative, and the debenture loan payable has been increased by the same amount. 75 First National Financial CorporationNotes to Consolidated Financial StatementsNote 21. 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. Manage- The Company was in compliance with the bank covenant throughout the year. Notes to Consolidated Financial Statements Note 22. Earnings By Business Segment ment defines capital as the Company’s equity, The Company operates principally in two busi- debenture loan payable and retained earnings. ness segments, Residential and Commercial. The Company has a minimum capital require- These segments are organized by mortgage ment as stipulated by its bank credit facility. type and contain revenue and expenses related The agreement limits the debt under bank to origination, underwriting, securitization and indebtedness together with the debentures to servicing activities. Identifiable assets are four times FNFLP’s equity. As at December 31, those used in the operations of the segments. 2014, the ratio was 1.85:1 (2013 – 1.1:1). 2014 Residential Commercial Total REVENUE Interest revenue – securitized mortgages $ 413,629 $ 136,587 $ 550,216 Interest expense – securitized mortgages (322,930) (111,796) (434,726) Net interest – securitized mortgages 90,699 24,791 115,490 Placement and servicing Mortgage investment income EXPENSES Amortization Interest Other operating 158,644 36,198 285,541 5,257 33,795 150,858 189,910 37,171 20,878 82,840 2,652 2,480 33,034 38,166 195,815 57,076 368,381 7,909 36,275 183,892 228,076 Income before income taxes $ 95,631 $ 44,674 $ 140,305 Identifiable assets Goodwill Total assets Capital expenditures 21,112,421 4,811,717 25,924,138 — — 29,776 $ $ 21,112,421 5,845 $ $ 4,811,717 $ 25,953,914 2,503 $ 8,348 76 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements REVENUE 2013 Residential Commercial Total Interest revenue – securitized mortgages $ 315,512 $ 113,711 $ 429,223 Interest expense – securitized mortgages (232,626) (90,610) (323,236) Net interest – securitized mortgages 82,886 23,101 105,987 Placement and servicing Mortgage investment income EXPENSES Amortization Interest Other operating 241,427 34,037 358,350 5,176 26,663 151,462 183,301 51,692 20,129 94,922 2,761 2,507 31,192 36,460 293,119 54,166 453,272 7,937 29,170 182,654 219,761 Income before income taxes $ 175,049 $ 58,462 $ 233,511 Identifiable assets Goodwill Total assets Capital expenditures 16,282,131 4,257,310 20,539,441 — — 29,776 16,282,131 $ 4,257,310 $ 20,569,217 2,400 $ 1,028 $ 3,428 $ $ Related Party and Other Transactions A senior executive and shareholder of the Company has a significant investment in a mortgage default insurance company. The Company has referred several commercial mezzanine mortgage opportunities to a In the ordinary course of business, the insurance business controlled by a senior executive and company provides insurance policies to the shareholder of the Company. The Company Company’s borrowers at market rates. In addi- services these mortgages during their terms tion, the insurance company has also provided at market commercial servicing rates. The the Company with portfolio insurance at mar- mortgages which are administered by the ket premiums. The total bulk insurance premium Company have a balance of $24,765 as at paid in 2014 was $2,494 (2013 – $2,348), net December 31, 2014 (2013 – $31,245). of third-party investor reimbursement. 77 First National Financial CorporationNotes to Consolidated Financial StatementsThe insurance company has also engaged the IAS 39 except for the presentation of the Company to service a portfolio of mortgages impact of own credit risk on financial liabilities at market commercial servicing rates. As at which will be recognized in Other Compre- December 31, 2014, the portfolio had a balance hensive Income, rather than in profit and loss of $8.7 million (2013 – $9.0 million). as under IAS 39. Notes to Consolidated Financial Statements In the third quarter of 2014, an entity con- The new general hedge accounting principles trolled by a senior executive and shareholder under IFRS 9 are aimed to align hedge ac- of the Company purchased a 75% interest in a counting more closely with risk management. property on which the Company is the lender. This new standard does not fundamentally The related entity effectively assumed 75% of change the types of hedging relationships the mortgage upon the purchase. At Decem- or the requirement to measure and recog- ber 31, 2014, the mortgage had a principal nize ineffectiveness; however, it is expected balance of $17.5 million. to provide more hedging strategies that are used for risk management to qualify for Management compensation hedge accounting and introduce more judg- During the year ended December 31, 2014, the ment to assess the effectiveness of a hedging Company paid a total annual compensation of relationship. $3,757 (2013 – $3,657) to six senior managers. Senior managers are defined as those persons IFRS 9 is mandatorily effective for annual having authority and responsibility for planning, periods beginning on or after January 1, 2018. directing and controlling the activities of the The Company is in process of evaluating the Company. impact of IFRS 9 on the Company’s consoli- dated financial statements. Note 23. Future Accounting Changes The following accounting pronouncements issued by the IASB, although not yet effective, may have a future impact on the Company: IFRS 9 - Financial Instruments In July 2014, the IASB issued the final version of IFRS 9 – Financial Instruments, replacing IAS 39 and all previous versions of IFRS 9. This final version of IFRS 9 includes a model for classification and measurement, a single, forward-looking ‘expected loss’ impairment model and a substantially-reformed approach to hedge accounting. Under this standard, financial assets are classified and measured based on the business model in which they are held and the characteristics of their con- tractual cash flows. The accounting model for financial liabilities is largely unchanged from 78 2014 Annual ReportNotes to Consolidated Financial StatementsNotes to Consolidated Financial Statements IFRS 15 – Revenue from Contracts with IAS 1 Amendments – Presentation of Customers Financial Statements In May 2014, the IASB issued IFRS 15 Revenue The IAS 1 amendment was issued on December from Contracts with Customers, replacing 2014, effective for annual periods beginning on IAS 11 - Construction Contracts, IAS 18 - Rev- or after January 1, 2016, with earlier application enue, IFRIC 13 - Customer Loyalty Programs, being permitted. The amendment clarifies IFRIC 15 - Agreements for the Construction IAS 1 to address perceived impediments to of Real Estate, IFRIC 18 - Transfer of Assets preparers exercising their judgement in pre- from Customers, and SIC 31 Revenue – Barter senting their financial reports. The Company Transactions Involving Advertising Services. is in process of evaluating the impact of the The standard contains a single model that amendment on the Company’s consolidated applies to contracts with customers and two financial statements. approaches to recognizing revenue: at a point in time or over time. The model features a IFRS 10, 12 and IAS 28 Amendments – Investment contract-based five-step revenue recognition Entities: Applying the Consolidation Exception process to determine the nature, amount, tim- The amendments were issued on December ing and uncertainty of revenue and cash flows 18, 2014, addressing issues that have arisen in from the contracts with customers. the context of applying the consolidation ex- ception for investment entities. The Company IFRS 15 is effective for fiscal years ending on is in process of evaluating the impact of the or after December 31, 2017. The Company amendment on the Company’s consolidated intends to adopt IFRS 15 in its consolidated financial statements. financial statements for the annual period beginning on January 1, 2017 and is currently analyzing the impact on the Company’s con- solidated financial statements. 79 First National Financial CorporationNotes to Consolidated Financial Statements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 to maintaining the confidence of investors and Committees The Board of Directors has established an increasing shareholder value. As such, First Audit Committee and a Compensation, Gov- National is committed to the highest standards ernance and Nominating Committee to assist of integrity, transparency, compliance and in the efficient functioning of the Company’s discipline. corporate governance strategy. These standards define the relationships among all of our stakeholders — Board, Audit Committee The Audit Committee’s responsibilities include: management and shareholders — and are the basis for building these values and nurturing • Management of the relationship with the a culture of accountability and responsibility external auditor including the oversight across the organization. and supervision of the audit of the Com- pany’s financial statements; Policies The Board supervises and evaluates the man- • Oversight and supervision of the quality and integrity of the Company’s financial agement of the Company, oversees matters statements, and; related to our strategic direction and assesses • Oversight and supervision of the adequa- results relative to our goals and objectives. cy of the Company’s internal accounting As such, the Board has adopted several pol- controls and procedures, as well as its icies that reflect recommended practices in financial reporting practices. governance and disclosure. These include a The Audit Committee consists of three inde- Disclosure Policy, a Code of Business Conduct, pendent directors, all of whom are considered a Whistleblower Policy and an Insider Trading financially literate for the purposes of the Ca- Policy. These policies follow the corporate nadian Securities Administrators’ Multilateral governance guidelines of the Canadian Securi- Instrument 52-110 – Audit Committees. ties Administrators. As a public company, First National’s Board continues to update, develop Committee Members and implement appropriate governance policies John Brough (Chair), Peter Copestake and and practices as it sees fit. Robert Mitchell Corporate Governance 80 2014 Annual ReportCorporate Governance Compensation, Governance and Nominating Committee The Compensation, Governance and Nominating • Periodically reviewing the composition and effectiveness of the directors and the contributions of individual directors; and Committee’s responsibilities include: • Adopting and periodically reviewing and updating the Company’s written Disclo- • Making recommendations concerning the sure Policy. compensation of the Company’s senior The Compensation, Governance and Nominat- executive officers; ing Committee consists of three independent • Developing the Company’s approach to directors for the purposes of the Canadian Se- corporate governance issues and com- curities Administrators’ Multilateral Instrument pliance with applicable laws, regulations, 58-101 – Disclosure of Corporate Governance rules, policies and orders with respect to Practices. such issues; • Advising the Board of Directors on filling Committee Members director vacancies; Peter Copestake (Chair), Duncan Jackman and Barbara Palk 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. Stephen Smith the C.D. Howe Institute, a Governor of the Is President and Chief Executive Officer of the Royal Ontario Museum and Chair of Historica Corporation, President of First National and Canada. Mr. Smith has a Bachelor of Science co-founder of First National. Mr. Smith, one of (Honours) in electrical engineering from Canada’s leading financial services entrepreneurs, Queen’s University and a Master of Science has been an innovator in the development and (Economics) from the London School of Eco- utilization of various securitization techniques nomics and Political Science. Mr. Smith is a to finance mortgage assets. He is Chairman graduate of the Directors Education Program of the Canada Guaranty Mortgage Insurance at the University of Toronto, Rotman School Company as well as a director of The Empire of Management. In 2012, he was awarded The Life Insurance Company. He is also Vice-Chair Queen’s Diamond Jubilee Medal for contribu- of Metrolinx Inc. (GO Transit), a director of tions to Canada. 81 Corporate Governance First National Financial CorporationCorporate Governance John Brough Peter Copestake Served as President of both Wittington Serves as the Executive in Residence at the Properties Limited (Canada) and Torwest, Queen’s University School of Business and as Inc. (United States) real estate development a corporate director and business consultant. companies from 1998 to 2007. From 1974 Over the past 30 years he has held senior until 1996 he was with Markborough Proper- financial and executive management positions ties, Inc, where he was Senior Vice President at federally regulated financial institutions and Chief Financial Officer from 1986 until and in the federal government. Other current 1996. Mr. Brough is a Director of Kinross Gold directorships include membership on the Corporation, Silver Wheaton Corp. and Cana- Finance and Pension committees of Queen’s dian Real Estate Investment Trust. Mr. Brough University and directorships at Royal and Sun has a Bachelor of Arts (Economics) degree Alliance Insurance Company of Canada and from the University of Toronto, as well as a Canadian Derivatives Clearing Corporation. Chartered Accountant degree. Mr. Brough is a He additionally serves on the Independent graduate of the Directors Education Program Review Committees at First Trust Portfolios at the University of Toronto, Rotman School Canada and at PIMCO Canada and as Chair of of Management, is a member of the Institute the South East Ontario Medical and Academic of Corporate Directors and holds the designation Organization. Chartered Professional Accountant. Duncan Jackman Moray Tawse Is the Chairman, President and Chief Executive Is Executive Vice President and Secretary of Officer of E L Financial Corporation Limited, the Corporation, Executive Vice President of an investment holding company and has First National and co-founder of First National. held similar positions with E-L Financial since Mr. Tawse directs the operations of all of First 2003. Mr. Jackman is also the Chairman and National’s commercial mortgage origination President of Economic Investment Trust Lim- activities. With over 30 years of experience ited and United Corporations Limited, both in the real estate finance industry, Mr. Tawse closed-end investment corporations, and has is one of Canada’s leading experts on com- acted in a similar capacity with these corpora- mercial real estate and is often called upon tions since 2001. Mr. Jackman sits on a num- to deliver keynote addresses at national real ber of public and private company boards. estate symposiums. In addition, Mr. Tawse is Prior to 2001, Mr. Jackman held a variety also an independent director of Regal Lifestyle of positions including portfolio manager at Communities Inc., a TSX listed company that Cassels Blaikie and investment analyst at RBC owns and operates retirement properties Dominion Securities Inc. Mr. Jackman holds a across Canada. Bachelor of Arts from McGill University. Corporate Governance 82 2014 Annual ReportBarbara Palk Robert Mitchell Retired as President of TD Asset Management Has been President of Dixon Mitchell Investment Inc. in 2010 following a 30 year career in institu- Counsel Inc., a Vancouver-based investment tional investment and investment management. management company since 2000. Prior to She currently serves on the Boards of TD As- that, Mr. Mitchell was Vice President, Invest- set Management USA Funds Inc. in New York, ments at Seaboard Life Insurance Company. Ontario Teachers’ Pension Plan and Queen’s Mr. Mitchell is a director of, and chairs, the University where she is Chair. Her previous audit committee for Discovery Parks Holdings board experience includes the Canadian Coali- Ltd., and serves as a trustee for Discovery Parks tion for Good Governance, whose Governance Trust. Discovery Parks Trust was established Committee she chaired, Greenwood College to support the high technology and research School, the Investment Counselling Associ- industries in British Columbia through the de- ation of Canada, the Perimeter Institute, the velopment of its real estate assets. Mr. Mitchell Shaw Festival and UNICEF Canada. Ms. Palk has an MBA from the University of Western is a member of the Institute of Corporate Ontario, a Bachelor of Commerce (Finance) Directors, a Fellow of the Canadian Securities from the University of Calgary, and is a CFA Institute and a CFA charterholder. She holds charterholder. a Bachelor of Arts (Honours, Economics) degree from Queen’s University, and has been named one of Canada’s Top 100 Most Powerful Women (2004). 83 Corporate Governance First National Financial CorporationShareholder Information Corporate Address First National Financial Corporation 100 University Avenue North Tower, Suite 700 Toronto, Ontario M5J 1V6 Phone: 416.593.1100 Fax: 416.593.1900 Annual Meeting May 6, 2015, 10 a.m. EDT TMX Broadcast Centre The Gallery The Exchange Tower 130 King Street West Toronto, Ontario Senior Executives of First National Financial LP Stephen Smith Co-founder, Chairman and Chief Executive Officer Moray Tawse Co-founder and Executive Vice President Robert Inglis Chief Financial Officer Scott McKenzie Legal Counsel Stikeman Elliott LLP, Toronto, Ontario Auditors Ernst & Young LLP, Toronto, Ontario Investor Relations Contacts Robert Inglis Chief Financial Officer rob.inglis@firstnational.ca Ernie Stapleton President, Fundamental Senior Vice President, Residential Mortgages ernie@fundamental.ca Jeremy Wedgbury Senior Vice President, Commercial Mortgages Investor Relations Website www.firstnational.ca Lisa White Vice President, Mortgage Administration Registrar And Transfer Agent Computershare Investor Services Inc., Hilda Wong Vice President and General Counsel Jason Ellis Toronto, Ontario 1.800.564.6253 Exchange Listing And Symbols Common shares: (TSX) FN Managing Director, Capital Markets Preferred shares: (TSX) FN.PR.A Rick Votano Vice President, Information Technology Shareholder Information 84 2014 Annual ReportVANCOUVER CALGARY TORONTO MONTREAL HALIFAX 

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