MCAN Mortgage Corporation
Annual Report 2012

Plain-text annual report

MC CAN MO ANN ORTGAG NUAL RE GE CORP EPORT 2 PORATI 2012 ION 2012 ANNUA AL REPORT / M MCAN MORTGA AGE CORPORAT TION DESCRIP PTION OF BU USINESS MCAN is a provinces an also qualifie public company nd territories in es as a mortgage y listed on the To Canada. MCAN e investment corp oronto Stock Ex N is a Loan Com poration (“MIC” xchange (“TSX”) mpany under the ”) under the Inco ) under the symb e Trust and Loan ome Tax Act (Ca bol MKP and is n Companies Ac anada) (the “Tax a reporting issue ct (the “Trust Ac x Act”). er in all ct”) and Our objectiv family resid investments Insurance C by the provi ve is to generat dential, residentia s, real estate and Corporation (“CD isions of the Tax te a reliable stre al construction, n securitization in DIC”) deposit ins x Act applicable eam of income non-residential c nvestments. We surance up to a m e to a MIC. by investing ou construction and e employ leverag maximum of fiv ur funds in a po d commercial loa ge by issuing ter ve times capital ( ortfolio of mortg ans), as well as o rm deposits eligi (on a non-consol gages (including other types of lo ible for Canada D lidated basis) as g single ans and Deposit limited The term de income for Such divide eposits are sour tax purposes 50 ends are received rced through a n 0% of capital ga d by our shareho network of indep ains dividends a lders as capital g pendent financia and 100% of non gains dividends al agents. As a n-capital gains d and interest inco a MIC, we are e dividends that w ome, respectivel entitled to dedu we pay to shareh y. ct from holders. TABLE O OF CONTEN NTS PRESIDEN MANAGEM CONSOLID NOTES TO DIRECTOR CORPORA NT AND CEO’S MENT’S DISCU DATED FINANC O CONSOLIDAT RS, OFFICERS A ATE INFORMAT MESSAGE TO USSION AND A CIAL STATEM TED FINANCIA AND MANAGE TION ................. SHAREHOLDE ANALYSIS OF O MENTS ............... AL STATEMEN EMENT ............. .......................... ERS .................. OPERATIONS . .......................... NTS .................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... .......................... ......... 2 ......... 3 ....... 42 ....... 48 ....... 81 ....... 82 2012 ANN NUAL REPORT / / MCAN MORTG GAGE CORPOR RATION MESSAG E TO SHARE EHOLDERS In 2012, MC $197 millio impaired co at Decembe 0.67% in th increased an CAN Mortgage C n in growth, rep orporate mortgag er 31, 2011. Imp he prior year. A nd we have impr Corporation (the presenting a 26% ges a percentage paired mortgage As a result of th roved our earnin e “Company”, “M % increase in the of the total corp s as a percentag he growth and r ngs stability and r MCAN” or “we” e corporate asse porate portfolio d ge of total mortg rebalancing of o risk profile. ”) continued to g et portfolio. Por decreased to 1.1 gages were 0.51 our corporate a grow its corpora rtfolio quality co 16% at Decembe 1% at December asset portfolio, o ate assets as it de ontinued to imp er 31, 2012 from r 31, 2012, dow our core earning elivered prove as m 2.24% wn from gs have Net income $1.68 in the capital raise (“MCAP”) the effects o the present p for 2012 of $21 e prior year due ed through the contributed sign of the dilution fr price level. 1.5 million decre to the reduced rights offering nificantly to MC rom the rights of eased from $27.1 earnings from s in August 2012 CAN’s operating ffering through t 1 million in the p securitization an 2. Equity inco results this year the gain in share prior year. Earn nd the dilution e ome from our in r. MCAN shareh e price from the nings per share w effects of the $2 nvestment in M holders were ab rights offering s were $1.22 comp 0 million of new MCAP Commerc le to recapture s share price of $1 pared to w share cial LP some of 11.85 to In 2012, we buyout of c purchase lef a consolida origination to produce administrati e saw significant certain partners ft MCAN and C ated MCAP. Fo capability and a improved resul ion at December t activity in our in MCAP Serv adcap Limited P ollowing the bu assets under adm ts in 2012, prod r 31, 2012. equity investme vice Corporation Partnership (a su uyout, MCAP p ministration. With ducing over $10 ent in MCAP. D n, resulting in a ubsidiary of the C purchased the i h a consolidated 0 billion in orig During the seco a $14 million in Caisse de dépôt interests of Re d leadership team gination for the ond quarter we p ncrease in our e et placement du esMor Trust Co m and refined str e year and $36 participated in M equity investmen u Québec) as par ompany, increas rategy, MCAP w billion in assets MCAP’s nt. This rtners in sing its went on s under While our securitizatio distributable portfolios, t investment in M on activities and e earnings to M o contribute to th MCAP produced d the tax effect MCAN for the y he future income d improved inc of expensing o year. We expect e and dividends come for accoun rigination and c t MCAP’s secur of MCAN. nting purposes closing costs re uritization activit in 2012, the gr sulted in MCAP ty, over the dur rowth in incom P producing neg ration of the m me from gligible mortgage On March 2 Xceed Mort specialized, mortgage m expected to under Sectio 26, 2013, MCAN tgage Corporatio single family market and, in re be funded with on 182 of the Bu N announced the on (“Xceed”) for insured and un ecent years, has h a combination usiness Corporat signing of a def r $1.75 per share ninsured residen been focused on of cash and com tions Act (Ontari finitive agreemen e, for a total con ntial mortgage le n winding down mmon shares, an io). nt to acquire all nsideration of ap ender, focused n its legacy secu and will be effec of the issued an pproximately $53 primarily on th uritization portfo cted pursuant to nd outstanding sh 3.0 million. Xce he insured area olio. The transa a plan of arran hares of eed is a of the action is ngement This transac platform tha liquid assets significant p basis, provid ction provides M at is expected to s, including Can proportion of Xc ding it with capa MCAN with a u o deliver increm nada Mortgage a ceed’s assets at c acity to achieve i unique opportun mental asset grow and Housing Co closing. In addit its growth objec nity to acquire a wth and potenti orporation (“CM tion, the acquisit ctives. an established m ial for increased MHC”) insured m tion provides new mortgage origina d income for M mortgages, are e w equity for MC ation and under CAN. Cash an expected to repr CAN on a cost ef rwriting nd other resent a ffective In 2013, w optimizing pipeline of n of the first q second half corporate as e plan to grow the yield perfor new and existing quarter of 2013. f of the year. W ssets, which we e the profitability rmance of corpo g unfunded mort The equity com We expect our co expect to have a y of the Compa orate assets as w tgage commitme mponent of the X orporate net inve a positive impact any by continui we utilize the re ents should resul Xceed transaction estment income t on our taxable i ing the growth emaining capaci lt in the full inve n is expected to to increase as a income. of the corporat ity from the 201 estment of the b provide capital a result of the in te balance shee 12 rights offerin alance sheet by for asset growth ncreased investm et while ng. Our the end h in the ment in Although re expect them residential c profitability egulatory change m to contribute t construction loa y which should e es are expected o a significant d ans. Market con nhance the over to result in som disruption to res ditions are expe all return of our me downward pr sidential markets ected to contribu corporate asset ressure on price s. We expect to ute to improved portfolio in 201 points in our co o see tighter und d credit spreads 3. ore markets, we derwriting stand s and constructio e do not dards on on loan William Jan President an ndrisits nd Chief Executi ive Officer - 2 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS This Management’s Discussion and Analysis of Operations (“MD&A”) should be read in conjunction with the consolidated balance sheets and accompanying notes as at December 31, 2012 and December 31, 2011 and the consolidated statements of income, changes in shareholders’ equity, comprehensive income and cash flows for the years then ended, which have been prepared in accordance with International Financial Reporting Standards (“IFRS”) and have been presented in Canadian currency. This MD&A has been prepared as at March 26, 2013. Additional information regarding MCAN Mortgage Corporation (the “Company”, “MCAN” or “we”), including copies of our continuous disclosure materials such as the Annual Information Form, is available on our website at www.mcanmortgage.com or through the System for Electronic Document Analysis and Retrieval (“SEDAR”) website at www.sedar.com. A CAUTION ABOUT FORWARD-LOOKING INFORMATION AND STATEMENTS This MD&A contains “forward-looking statements” within the meaning of applicable Canadian securities laws. The words “may,” “believe,” “will,” “anticipate,” “expect,” “planned,” “estimate,” “project,” “future,” and other expressions that are predictions of or indicate future events and trends and that do not relate to historical matters identify forward-looking statements. Such statements reflect management’s current beliefs and are based on information currently available to management. The forward-looking statements in this MD&A include, among others, statements and assumptions with respect to: the current business environment and outlook; • • possible or assumed future results; • ability to create shareholder value; • business goals and strategy; • the stability of home prices; • effect of challenging conditions on us; • • sufficiency of our access to capital resources; and • • factors affecting our competitive position within the housing markets; the timing of the effect of interest rate changes on our cash flows; and the completion of MCAN’s proposed acquisition of Xceed Mortgage Corporation (“Xceed”) (discussed below under “Recent Developments”) Reliance should not be placed on forward-looking statements because they involve known and unknown risks, uncertainties and other factors, which may cause the actual results to differ materially from the anticipated future results expressed or implied by such forward-looking statements. Factors that could cause actual results to differ materially from those set forth in the forward- looking statements include, but are not limited to: technology changes; • global market activity; • worldwide demand for and related impact on commodity prices; • changes in government and economic policy; • changes in general economic, real estate and other conditions; • changes in interest rates; • mortgage rate and availability changes; • adverse legislation or regulation; • • confidence levels of consumers; • ability to raise capital on favourable terms; • our debt and leverage; • competitive conditions in the homebuilding industry, including product and pricing pressures; • ability to retain our executive officers; • • • additional risks and uncertainties, many of which are beyond our control, referred to in this MD&A and our other public litigation risk; relationships with our mortgage originators; • filings with the applicable Canadian regulatory authorities; and the expected timing and completion of MCAN’s proposed acquisition of Xceed is subject to Xceed shareholder approval, court and regulatory approvals, and other customary closing conditions; accordingly, there can be no certainty that the transaction will be completed or that anticipated benefits will be realized Subject to applicable securities law requirements, we undertake no obligation to publicly update any forward-looking statements whether as a result of new information, future events or otherwise. However, any further disclosures made on related subjects in subsequent reports should be consulted. - 3 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION TABLE OF CONTENTS - MD&A SELECTED FINANCIAL INFORMATION ................................................................................................................................... 5 HIGHLIGHTS .................................................................................................................................................................................. 6 OUTLOOK ....................................................................................................................................................................................... 6 PERFORMANCE CHARTS ............................................................................................................................................................ 7 RESULTS OF OPERATIONS ......................................................................................................................................................... 9 FINANCIAL POSITION ................................................................................................................................................................ 16 SUMMARY OF FOURTH QUARTER RESULTS ....................................................................................................................... 21 SELECTED QUARTERLY FINANCIAL DATA ......................................................................................................................... 25 SECURITIZATION PROGRAMS ................................................................................................................................................. 26 DESCRIPTION OF CAPITAL STRUCTURE ............................................................................................................................... 28 RIGHTS OFFERING ..................................................................................................................................................................... 28 DIVIDEND POLICY AND RECORD ........................................................................................................................................... 28 OFF-BALANCE SHEET ARRANGEMENTS .............................................................................................................................. 29 CONTRACTUAL OBLIGATIONS ............................................................................................................................................... 29 TRANSACTIONS WITH RELATED PARTIES ........................................................................................................................... 29 RECENT DEVELOPMENTS ........................................................................................................................................................ 30 CAPITAL MANAGEMENT .......................................................................................................................................................... 30 FINANCIAL INSTRUMENTS AND OTHER INSTRUMENTS .................................................................................................. 32 LIQUIDITY .................................................................................................................................................................................... 32 RISK FACTORS ............................................................................................................................................................................ 33 RISK MANAGEMENT ................................................................................................................................................................. 36 PEOPLE ......................................................................................................................................................................................... 38 REGULATORY COMPLIANCE................................................................................................................................................... 38 INTERNAL AUDIT ....................................................................................................................................................................... 38 CRITICAL ACCOUNTING POLICIES AND ESTIMATES ........................................................................................................ 38 FUTURE CHANGES IN ACCOUNTING POLICY ..................................................................................................................... 40 DISCLOSURE CONTROLS AND PROCEDURES AND INTERNAL CONTROLS OVER FINANCIAL REPORTING ........ 41  - 4 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION SELECTED FINANCIAL INFORMATION Table 1: Income Statement Highlights (in thousands except for per share amounts and %) 2012 2011 2010 Change from 2011 (%) ($) Operating Results Net investment income - corporate assets Net investment income - securitization assets before market value adjustment Fair market value adjustment Net investment income - securitization assets Net investment income Operating expenses Income before income taxes Provision for (recovery of) income taxes Net income $ 31,135 $ 25,650 $ 27,380 $ 5,485 21.4% 2,778 (8,682) (5,904) 25,231 8,993 16,238 (5,255) 21,493 $ 5,830 228 6,058 31,708 6,860 24,848 (2,255) 27,103 $ 9,055 1,629 10,684 38,064 6,100 31,964 5,306 26,658 (3,052) (8,910) (11,962) (6,477) 2,133 (8,610) (3,000) (5,610) (52.3%) (3,907.9%) (197.5%) (20.4%) 31.1% (34.7%) 133.0% (20.7%) $ $ Average mortgage portfolio yield - corporate Term deposit average interest rate 5.81% 2.44% 6.53% 2.36% 7.59% 2.10% Average mortgage portfolio yield - securitized Financial liabilities from securitization - average interest rate 4.00% 4.23% 4.32% 3.54% 3.66% 3.64% Basic and diluted earnings per share Taxable income per share Dividends per share $ $ $ 1.22 1.17 1.42 $ $ $ 1.68 1.42 1.81 $ $ $ 1.85 1.79 1.19 $ $ $ (0.46) (0.25) (0.39) Return on average shareholders’ equity 13.03% 18.52% 21.97% (11.0%) 3.4% (5.4%) (3.3%) (27.4%) (17.6%) (21.5%) (29.6%) Table 2: Balance Sheet Highlights (in thousands except for per share amounts and %) December 31 2012 December 31 2011 December 31 2010 Change from 2011 (%) ($) Balance Sheet Highlights Assets Corporate Securitization Total assets Mortgages - corporate Mortgages - securitized Liabilities Corporate Securitization Total liabilities $ 950,686 2,035,935 $ 2,986,621 $ 753,799 3,140,359 $ 3,894,158 $ 538,118 3,147,907 $ 3,686,025 $ 196,887 (1,104,424) $ (907,537) $ $ 739,812 936,947 $ 640,351 $ 1,499,016 $ 420,322 $ 1,910,995 $ 99,641 $ (562,069) 790,526 $ 2,018,314 $ 2,808,840 618,277 $ 3,117,416 $ 3,735,693 438,732 $ 3,122,214 $ 3,560,946 172,249 $ (1,099,102) $ (926,853) 26.1% (35.2%) (23.3%) 15.5% (37.5%) 27.9% (35.3%) (24.8%) Shareholders’ equity $ 177,781 $ 158,465 $ 125,079 $ 19,316 12.2% Capital Ratios Tax Assets to Capital Ratio Tier 1 Capital Ratio Total Capital Ratio Credit Quality Impaired mortgage ratio Total mortgage arrears Share Information (end of period) Number of common shares outstanding at year-end Book value per common share Common share price - close Market capitalization 5.70 21.74% 21.84% 4.91 22.21% 22.26% 4.39 22.10% 22.06% 16.1% (2.1%) (1.9%) 0.51% 63,489 $ 0.67% 76,279 $ 0.63% 91,828 $ (8,833) (23.9%) (11.6%) 18,729 9.49 14.01 262,393 16,862 9.40 $ $ 13.40 $ 225,951 $ $ $ 14,448 8.66 13.86 200,249 $ $ $ 0.71 0.61 36,442 11.1% 7.6% 4.6% 16.1% $ $ $ $ - 5 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION HIGHLIGHTS  Corporate assets were $951 million at December 31, 2012, up $197 million from $754 million at December 31, 2011.  We completed a rights offering during 2012, issuing 1.7 million new common shares for net proceeds of $20 million. The rights offering created $115 million of new asset capacity based on our target assets to capital ratio of 5.75, which is measured on a tax basis.  As at December 31, 2012, we had $16 million of remaining asset capacity.  Impaired corporate mortgages as a percentage of the corporate portfolio were 1.16% at December 31, 2012, down from 2.24% at December 31, 2011. Impaired mortgages as a percentage of total mortgages were 0.51% at December 31, 2012, down from 0.67% in the prior year.  Net income was $21.5 million in 2012 ($1.22 per share), down from $27.1 million in 2011 ($1.68 per share). Our return on equity was 13.0% for the year compared to 18.5% in 2011.  Total mortgage arrears decreased to $63 million at December 31, 2012 from $76 million at December 31, 2011.  Dividends per share were $1.42 in 2012, down from $1.81 in 2011.  We declared a 2013 first quarter dividend of $0.31 per share to be paid on March 28, 2013 to shareholders of record as of March 15, 2013. This dividend comprises the regular quarterly dividend of $0.28 per share and an extra dividend of $0.03 per share.  We entered into a definitive agreement on March 26, 2013 to acquire all of the issued and outstanding shares of Xceed. The proposed transaction is expected to close on or about June 24, 2013. OUTLOOK Residential housing markets in Canada continue to benefit from stable economic conditions. The Canadian economy is supported by employment and economic growth that should support housing markets in 2013. Changes to mortgage underwriting standards that took effect in 2012 may reduce housing demand and prices in some markets; however, consumers continue to benefit from low residential mortgage rates that remain at attractive levels and contribute to housing affordability. The prospect of future increases in mortgage rates also provides incentive for potential home buyers to purchase in the near term. We expect housing markets to slow throughout 2013 as a result of adjusting market conditions, although we expect to take advantage of opportunities in mortgage markets during this transition. Regulatory changes to underwriting standards are expected to impact the number of eligible home buyers that are able to borrow under government-backed mortgage insurance programs. This reduction will create growth opportunities for MCAN in the uninsured mortgage market. We expect spreads to increase such that, on a risk-adjusted basis, we expect this asset class to provide superior returns. Although regulatory changes are expected to result in some downward pressure on price points in our core markets, we do not expect them to contribute to a significant disruption to residential markets. We expect to see tighter underwriting standards on residential construction loans and the cancellation of construction projects within our core markets as developers concentrate on managing inventory. We expect these market conditions to improve credit spreads and construction loan profitability. Furthermore, we expect to observe more opportunities for short-term bridge/mezzanine lending which will enhance the overall return of our corporate asset portfolio in 2013. Our investment in MCAP Commercial LP (“MCAP”) continues to provide a stable source of residential mortgage and construction origination. MCAP continues to strengthen its origination capability, providing support to MCAN. We continue to monitor mortgage markets for investment opportunities and will adjust our investment strategy accordingly. We concentrate our origination efforts on the entry-level/affordable segment within our core markets in an effort to minimize the potential impacts of any weakness in home values. We expect to be active in the uninsured single family mortgage market, and we expect this segment to improve its risk-adjusted returns as a result of recently announced regulatory changes. NON-GAAP MEASURES We prepare our consolidated financial statements in accordance with International Financial Reporting Standards (“IFRS”). We use a number of financial measures to assess our performance. Some of these measures are not calculated in accordance with IFRS, are not defined by IFRS, and do not have standardized meanings that would ensure consistency and comparability between companies using these measures. The non-GAAP measures used in this MD&A are defined as follows: - 6 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Return on Average Shareholders’ Equity Return on average shareholders’ equity is a profitability measure that presents the annualized net income available to shareholders’ equity as a percentage of the capital deployed to earn the income. We calculate return on equity using average shareholders’ equity, including all components of shareholders’ equity. Taxable Income Taxable income is a profitability measure that presents MCAN’s income for tax purposes. We typically pay out all taxable income to shareholders through dividends. Average Interest Rate The average interest rate is a profitability measure that presents the average annualized yield of an asset or liability. Tier 1 and Total Capital Ratios and Risk Weighted Assets These measures provided in this MD&A are in accordance with guidelines issued by the Office of the Superintendent of Financial Institutions (“OSFI”) and are located on Table 21 of this MD&A and Note 33 to the consolidated financial statements. PERFORMANCE CHARTS The following graph compares MCAN’s cumulative total shareholder return (assuming an investment of $100 on December 31, 2007) on its common shares during the period from January 1, 2008 to December 31, 2012, with the S&P/TSX Composite Index (Total Return) and the S&P/TSX Financial Services Index (Total Return), assuming reinvestment of all dividends. Figure 1: Shareholder Return $300.00 $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 31/12/2007 31/12/2008 31/12/2009 31/12/2010 31/12/2011 31/12/2012 MCAN S&P/TSX Composite Index S&P/TSX Financial Services Index MCAN S&P/TSX Composite Total Return Index S&P/TSX Capped Financial Index Jan 1 2008 100 100 100 Dec 31 2008 101.71 67.00 64.18 Dec 31 2009 172.69 90.48 93.55 Dec 31 2010 192.74 106.41 101.51 Dec 31 2011 210.17 97.14 97.61 Dec 31 2012 Compound Annual Growth 242.97 104.13 114.34 19.43% 0.81% 2.72% Note: Dividends declared on MCAN’s common shares are assumed to be reinvested at the closing price on the payment date. - 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Figure 2: Dividend Growth Regular Dividend Per Share Extra Dividend Per Share $1.81 $0.73 $1.42 $0.33 $1.44 $0.43 $1.19 $0.15 $1.18 $0.34 $1.00 $0.08 $0.96 $0.84 $0.92 $0.96 $1.01 $1.04 $1.08 $1.09 2006 2007 2008 2009 2010 2011 2012 Table 3: Ten Year Financial Summary (in thousands, except per share amounts) December 31 2012 (IFRS) 2011 (IFRS) 2010 (IFRS) 2009 (CGAAP) 2008 (CGAAP) 2007 (CGAAP) 2006 (CGAAP) 2005 (CGAAP) 2004 (CGAAP) 2003 (CGAAP) Net Income $ 21,493 27,103 26,658 24,742 30,348 14,843 15,211 14,116 11,601 8,247 Earnings Per Share 1.22 $ 1.68 1.85 1.73 2.14 1.12 1.23 1.18 1.12 0.84 Dividends Per Share 1.42 $ 1.81 1.19 1.44 0.96 1.00 1.18 0.97 1.11 0.68 Assets 1 $ 950,686 753,799 538,118 506,683 570,154 557,425 498,107 434,369 454,365 369,477 Shareholders’ Equity $ 177,781 158,465 125,079 122,879 116,609 103,007 84,611 81,164 74,965 61,741 Market Capitalization 262,393 $ 225,951 200,249 194,766 129,438 140,416 141,052 116,918 103,374 83,747 1 2012, 2011 and 2010 consist of corporate assets only as reported under IFRS. 2009 and earlier years consist of total assets under Canadian Generally Accepted Accounting Principles (“CGAAP”). - 8 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION RESULTS OF OPERATIONS MCAN reported net income of $21.5 million for the year ended December 31, 2012, down from $27.1 million in the prior year. Earnings per share were $1.22 compared to $1.68 in the prior year. The decrease was primarily due to higher provisions for credit losses, lower securitization income and higher operating expenses, partially offset by an increase in spread income, higher equity income from MCAP, and an increased recovery of income taxes. Table 4: Net Income - For the Years Ended December 31 (in thousands) 2012 2011 Net Investment Income - Corporate Assets Mortgage interest Equity income from MCAP Commercial LP Fees Marketable securities Interest on financial investments and other loans Interest on cash and cash equivalents Financial Expenses Term deposit interest and expenses Mortgage expenses Provision for credit losses Net Investment Income - Securitization Assets Mortgage interest Interest on financial investments Interest on short-term investments Other securitization income Interest on financial liabilities from securitization Mortgage expenses Net investment income before fair market value adjustment Fair market value adjustment - derivative financial instruments Net investment income Operating expenses Income before income taxes Provision for (recovery of) income taxes Net income Basic and diluted earnings per share Taxable income per share Dividends per share Net Investment Income - Corporate Assets $ $ $ $ $ 41,395 6,906 2,236 2,061 1,422 544 54,564 17,157 3,712 2,560 23,429 31,135 14,372 4,763 1,547 9,407 30,089 26,888 423 27,311 2,778 (8,682) (5,904) 25,231 8,993 16,238 (5,255) 21,493 1.22 1.17 1.42 $ $ $ $ $ 32,593 5,007 1,593 1,281 1,342 592 42,408 12,293 3,407 1,058 16,758 25,650 20,718 5,714 814 9,001 36,247 29,844 573 30,417 5,830 228 6,058 31,708 6,860 24,848 (2,255) 27,103 1.68 1.42 1.81 Mortgage interest income increased by $8.8 million from the prior year as a result of a $180 million increase in the average mortgage portfolio (from $511 million in 2011 to $691 million in 2012), partially offset by a decrease in the average mortgage yield to 5.81% in 2012 from 6.53% in 2011. The decrease in yield was a result of lower average yields in the uninsured single family and construction portfolios. The construction loan portfolio is primarily floating rate, however, certain loans carry a minimum interest rate. The proportion of minimum rate loans declined from 2011, which led to the decrease in yield. The decrease in the uninsured single family mortgage yield was a result of the maturity in the current year of certain high-yielding - 9 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION mortgages that contributed to the higher yield in 2011. Mortgage interest income includes $1.2 million of realized discount income from MCAN’s acquired mortgage portfolios compared to $2.0 million in 2011. Equity income from our ownership in MCAP increased by $1.9 million from the prior year, primarily due a significant volume of mortgage securitizations in the current year and increases to income resulting from mortgages measured at fair value. The prior year had significant gains from sales of mortgages. Fees consist of other mortgage fees of $2.0 million (2011- $1.3 million) and fee income from a profit sharing arrangement related to mortgage portfolios acquired by MCAP of $190,000 (2011 - $303,000). Other mortgage fees include extension, renewal and letter of credit fees earned on our corporate mortgage portfolio. Marketable securities income increased by $780,000 from the prior year, primarily due to $943,000 of gains from the sales of securities during 2012 compared to $nil in 2011. Term deposit interest and expenses increased by $4.9 million from 2011 as a result of a $171 million increase in the average term deposit balance (from $507 million in 2011 to $678 million in 2012) and an increase in the average term deposit rate to 2.44% in 2012 from 2.36% in 2011. Mortgage expenses, consisting primarily of mortgage servicing expenses, increased by $305,000 from 2011 as a result of a significantly larger average portfolio, although the average mortgage servicing rate decreased in 2012. Details of the provision for credit losses are discussed in “Credit Quality”. Net Investment Income - Securitization Assets Net investment income from securitization assets relates to MCAN’s participation in certain securitization programs, including the Canada Mortgage Bonds (“CMB”) program. As existing CMB issuances mature, we expect net investment income from securitization assets to decrease as the related mortgages and reinvestment assets are removed from our balance sheet. Net investment income from securitized assets before fair market value adjustments was $2.8 million in 2012 compared to $5.8 million in the prior year. Including fair market value adjustments on derivative financial instruments, net investment income on securitized assets was negative $5.9 million in 2012 compared to positive $6.1 million in the prior year. Mortgage interest income decreased by $6.3 million from the prior year, primarily due to a $518 million decrease in the average mortgage portfolio over 2011. In addition, the average yield decreased from 4.23% in 2011 to 4.00% in 2012. As the securitized mortgages repay, we reinvest the collected principal in certain permitted investments (which include financial investments and short-term investments) until the maturity of the CMB issuance. Interest on financial investments decreased by $951,000 from 2011 as a result of a decrease in the average portfolio, while interest on short-term investments increased by $733,000 from the prior year as a result of an increase in the average portfolio. Other securitization income was $9.4 million in 2012 compared to $9.0 million in the prior year, consisting primarily of interest rate swap receipts of $7.4 million (2011 - $8.6 million). As part of the CMB program, we enter into “pay floating, receive fixed” interest rate swaps to hedge interest rate risk. In addition, we earned $1.3 million of refinancing and renewal income (2011 - $132,000) and $978,000 from the sale of mortgage-backed securities (“MBS”) (2011 - $261,000). Interest on financial liabilities from securitization decreased by $3.0 million from 2011, primarily due to a lower average balance as a result of the maturity of certain CMB issuances in 2012. In addition, the average interest rate decreased to 3.54% in 2012 from 3.66% in 2011. The negative fair market value adjustment to derivative financial instruments of $8.7 million (2011 - positive $228,000) relates to the CMB interest rate swaps. The unrealized portion of this fair market value adjustment can be volatile as it is driven by changes in the forward interest rate curve. From an economic perspective, this adjustment is generally offset by changes in future expected income from securitized mortgages and principal reinvestment assets that have a floating interest rate. We regularly monitor our interest rate swap hedge position to minimize our exposure to interest rate risk. From an accounting perspective, changes in future expected income from these floating rate assets are not reflected in the consolidated statement of income, which can cause significant volatility to net income since there is no offset to the fair market value adjustment to derivative financial instruments. Our existing financial liabilities from securitization mature as follows: 2013 - $1.1 billion, 2014 - $872 million, 2015 - $45 million. - 10 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Net Interest Income Presented in the following tables is an analysis of average rates and net interest income. Net interest income is the difference between interest earned on certain assets and investments and the interest paid on liabilities to fund those assets. Table 5: Net Interest Income - For the Year Ended December 31, 2012 (in thousands except %) Corporate Securitized Total Corporate Securitized Total Average Balance1 Income/Expense Average Rate3 Corporate Securitized Assets Cash and cash equivalents Short-term investments Marketable securities Mortgages - corporate Mortgages - securitized Financial investments Other loans Total on interest earning assets Other assets Total assets $ 67,779 - 24,523 690,931 - 21,457 3,496 808,186 26,658 $ 834,844 $ - 582,187 - - 1,195,262 1,063,934 - 2,841,383 10,605 $ 2,851,988 $ 67,779 582,187 24,523 690,931 1,195,262 1,085,391 3,496 3,649,569 37,263 $ 3,686,832 $ 544 - 2,061 41,395 - 1,309 113 45,422 - $ 45,422 $ - 1,547 - - 14,372 4,763 - 20,682 - $ 20,682 $ 544 1,547 2,061 41,395 14,372 6,072 113 66,104 - $ 66,104 0.80% - 4.56% 5.81% - 6.90% 3.20% 5.69% - 5.50% - 0.89% - - 4.00% 1.77% - 2.59% - 2.55% $ 660,180 Liabilities and Shareholders’ Equity Term deposits Financial liabilities from securitization Other liabilities Shareholders’ equity Total liabilities and shareholders’ equity - 31,747 - $ 691,927 $ - $ 660,180 $ 17,157 $ - $ 17,799 2.44% - 2,824,402 5,597 - 2,824,402 37,344 164,906 - - - 26,888 - - 26,888 - - - - - 3.54% - - $ 2,829,999 $ 3,686,832 $ 17,157 $ 26,888 $ 44,687 2.44% 3.54% Net Interest Income2 $ 28,265 $ (6,206) Spread of Mortgages (Corporate Portfolio) over Term Deposits 3.37% 1The average balance is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2Net interest income is equal to net investment income less equity income from MCAP, other securitization income, fee income, mortgage expenses and provision for credit losses. 3The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Balance”, as non- recurring items are excluded from the calculation of the average rate. The income/expense associated with the securitized assets and liabilities in the tables above represents MCAN’s 30% weighted average share of CMB program economics. Although net interest income from securitization assets and liabilities shown above is presented as a negative amount, net interest income from securitization assets before negative fair market value adjustments remains positive due to the impact of the CMB interest rate swaps, which are “pay-floating, receive-fixed” swaps. Since interest rates have generally decreased since the original securitization dates, the positive interest rate swap income has offset lower than expected principal reinvestment income (since the majority of reinvested assets have a floating interest rate). Interest rate swap receipt income was $7.4 million in 2012. - 11 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Table 6: Net Interest Income - For the Year Ended December 31, 2011 (in thousands except %) Corporate Securitized Total Corporate Securitized Total Average Balance1 Income/Expense Average Rate3 Corporate Securitized Assets Cash and cash equivalents Short-term investments Marketable securities Mortgages - corporate Mortgages - securitized Financial investments Other loans Total on interest earning assets Other assets Total assets $ 72,892 - 22,146 511,345 - 10,939 2,975 620,297 36,999 $ 657,296 $ - 277,661 - - 1,713,674 1,133,824 - 3,125,159 4,456 $ 3,129,615 $ 72,892 277,661 22,146 511,345 1,713,674 1,144,763 2,975 3,745,456 41,455 $ 3,786,911 $ 592 - 1,281 32,593 - 1,182 160 35,808 - $ 35,808 $ - 814 - - 20,718 5,714 - 27,246 - $ 27,246 $ 592 814 1,281 32,593 20,718 6,896 160 63,054 - $ 63,054 0.81% - 5.78% 6.53% - 5.79% 5.38% 5.77% - 5.45% - 1.00% - - 4.23% 2.01% - 3.13% - 3.12% $ 507,225 Liabilities and Shareholders’ Equity Term deposits Financial liabilities from securitization Other liabilities Shareholders’ equity Total liabilities and shareholders’ equity - 11,294 - $ 518,519 $ - $ 507,225 $ 12,293 $ - $ 12,293 2.36% - 3,115,145 6,854 - 3,115,145 18,148 146,393 - - - 29,844 - - 29,844 - - - - - 3.66% - - $ 3,121,999 $ 3,786,911 $ 12,293 $ 29,844 $ 42,137 2.36% 3.66% Net Interest Income2 $ 23,515 $ (2,598) Spread of Mortgages (Corporate Portfolio) over Term Deposits 4.17% 1The average balance is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2Net interest income is equal to net investment income less equity income from MCAP, other securitization income, fee income, mortgage expenses and provision for credit losses. 3The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Balance”, as non- recurring items are excluded from the calculation of the average rate. The income/expense associated with the securitized assets and liabilities in the tables above represents MCAN’s 28% weighted average share of CMB program economics. Although net interest income from securitization assets and liabilities shown above is presented as a negative amount, net interest income from securitization assets before negative fair market value adjustments remains positive due to the impact of the CMB interest rate swaps, which are “pay-floating, receive-fixed” swaps. Since interest rates have generally decreased since the original securitization dates, the positive interest rate swap income has offset lower than expected principal reinvestment income (since the majority of reinvested assets have a floating interest rate). Interest rate swap receipt income was $8.6 million in 2011. Table 7: Interest Income and Average Rate by Mortgage Portfolio (Corporate) For the Years Ended December 31 (in thousands except %) Average Assets1 2012 Interest Income Average Rate2 Average Assets1 2011 Interest Income Average Rate2 Single family Construction and single family uninsured (completed inventory loans) Commercial Average mortgages - corporate portfolio $ 345,049 $ 21,509 5.74% $ 256,803 $ 16,616 6.52% 280,039 65,843 $ 690,931 15,826 4,060 $ 41,395 6.05% 5.96% 5.81% 228,826 25,716 $ 511,345 14,602 1,375 $ 32,593 6.66% 5.39% 6.53% 1The average is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Assets”, as non-recurring items are excluded from the calculation of the average rate. - 12 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Credit Quality Table 8: Provisions for Credit Losses and Write-offs (in thousands except basis points) For the Years Ended December 31 Individual provision (recovery) Single family uninsured Residential construction Commercial uninsured Collective provision Single family uninsured Residential construction Commercial Corporate mortgages - total Financial investments and other loans Other provisions Total provision for credit losses Corporate mortgage portfolio data: Provision for credit losses Net write-offs Net write-offs (basis points) 2012 195 300 58 553 185 583 359 1,127 (20) 900 2,007 2,560 1,680 1,323 19.1 $ $ $ $ $ $ $ 2011 (144) - 58 (86) 719 142 286 1,147 (3) - 1,144 1,058 1,061 275 5.4 $ $ $ $ $ $ $ The allowance for credit losses reduces the carrying value of mortgage assets to provide for an estimate of the principal amounts that borrowers may not repay in the future. In assessing the estimated realizable value of assets, we must rely on estimates and exercise judgment regarding matters for which the ultimate outcome is unknown. A number of factors can affect the amount that we ultimately collect, including the quality of our underwriting process and credit criteria, the diversification of the portfolio, the underlying security relating to the mortgages and the overall economic environment. Individual allowances include all of the accumulated provisions for losses on particular assets required to reduce the related assets to estimated realizable value. The collective allowance represents losses that we believe have been incurred but not yet specifically identified, and is calculated at each balance sheet date. Collective allowance rates depend on asset class, as different classes have varying underlying risks. Future changes in circumstances could materially affect our future provisions for credit losses from those provisions determined in the current period, and there could be a need to increase or decrease the allowance for credit losses. Collective provisions in both years are consistent with the growth in the respective corporate mortgage portfolio classes over those periods. During 2012, we recorded a $900,000 increase to a provision relating to our pro-rata share of estimated losses pursuant to an indemnity on the underlying assets of a residential construction loan securitization program. The provision, which was $1.1 million as at December 31, 2012, relates to an impaired residential construction loan that we have indemnified. This amount represents our estimated loss at this date based on property values given current market conditions. There are no other impaired mortgages associated with the indemnification of this securitization program. During the first quarter of 2012, MCAN and another participant lender foreclosed on one of MCAN’s impaired residential construction loans with a carrying value of $6.8 million (net of a $1 million individual allowance). The realization of the previously recorded individual allowance was recognized as a mortgage write-off upon foreclosure. The current year also had a $103,000 write-off related to a commercial loan, while the balance of write-offs in both years related to uninsured single family mortgages. Corporate mortgage arrears were $39 million as at December 31, 2012, up from $29 million as at December 31, 2011. The increase from the prior year includes a $13 million increase in single family mortgage arrears, partially offset by a $5 million decrease in construction loan arrears. Securitized mortgage arrears of $24 million decreased significantly from $48 million as at December 31, 2011, partly due to a decrease in the total portfolio balance. There were no other assets in arrears at year end. We continue to proactively monitor loan arrears and take prudent steps to collect overdue accounts. - 13 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Net Impaired Mortgages and Allowances Table 9: Net Impaired Mortgages and Allowances (in thousands except %) As at December 31 Corporate portfolio Residential construction Single family Commercial Securitized portfolio Single family Net impaired mortgages Total mortgages Net impaired as % of total mortgages (net of individual allowances) Net impaired as % of corporate mortgages (net of individual allowances) Collective allowance Individual allowance Total allowance 2012 2011 $ $ 1,760 6,856 - 8,616 - 8,616 $ $ 9,945 3,759 427 14,131 86 14,217 $ 1,676,759 $ 2,139,367 0.51% 1.17% 3,723 713 4,436 $ $ 0.67% 2.24% 2,919 1,160 4,079 $ $ The decrease in impaired mortgages during 2012 related primarily to the foreclosure of the impaired construction loan noted above. This was partially offset by an increase in impaired corporate single family mortgages. Operating Expenses (in thousands) For the Years Ended December 31 Salaries and benefits General and administrative 2012 3,953 5,040 8,993 $ $ 2011 3,234 3,626 6,860 $ $ Operating expenses increased by $2.1 million from the prior year, primarily due to higher salaries and benefits from an increase in the number of employees and increased corporate expenses. Income Taxes (in thousands) For the Years Ended December 31 Current tax provision (recovery) Deferred tax provision (recovery) 2012 (1,519) (3,736) (5,255) $ $ 2011 (2,072) (183) (2,255) $ $ The recovery of current taxes in both years was primarily due to the payment of the higher than usual dividends on March 31, 2011 and March 31, 2012 of $14.5 million and $10.1 million, respectively. These dividends were deductible from 2010 and 2011 taxable income due to MCAN’s status as a mortgage investment corporation (“MIC”) under the Income Tax Act (Canada) (the “Tax Act”), which allows us to deduct dividends paid within 90 days of year end from taxable income. However, these dividends were not deductible in the calculation of year-end current taxes payable for accounting purposes since they had not yet been paid as of that date. The payment of these dividends during the first quarters of 2011 and 2012 decreased current taxes payable significantly from the previous year end balances and, as a result of this decrease, created a recovery of current taxes. The substantial recovery of deferred taxes in 2012 was primarily due to the significant negative fair market value adjustment to derivative financial instruments during the year. MCAN’s taxable income was $21 million ($1.17 per share) in 2012 and $23 million ($1.42 per share) in 2011. As a MIC, we typically pay out all of our taxable income to shareholders through dividends. - 14 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION The key differences between taxable income and pre-tax net income include the non-deductibility of fair market value adjustments, collective provisions for credit losses and the amortization of upfront CMB costs for tax purposes, the treatment of capital gains income, and differences between equity income from MCAP for accounting and tax purposes. The table below provides a reconciliation between net income for accounting purposes and taxable income. The adjustments below represent the difference between the individual components for accounting and tax purposes. (in thousands) For the Years Ended December 31 Net income for accounting purposes Adjustments: Provision for (recovery of) income taxes Equity income from MCAP Provision for credit losses Fair market value adjustment - derivative financial instruments Capital gains Amortization of upfront CMB costs Securitization program cash outflows Other items Taxable income Cash Flows 2012 2011 $ 21,493 $ 27,103 (5,255) (6,739) 1,627 8,682 (1,085) 3,083 (1,013) (275) 20,518 $ (2,255) (3,734) 866 1,123 (1,438) 3,159 (1,320) (625) 22,879 $ Operating activities used cash flows of $444 million in 2012 and provided $389 million in 2011. We had substantial cash outflows in the current year from the repayment of financial liabilities from securitization, partially offset by net mortgage and term deposit inflows. In the prior year, significant net term deposit and mortgage inflows contributed to the balance. Investing activities provided cash flows of $518 million in 2012 and used $429 million in 2011. The current year net inflow was primarily due to the maturity of financial investments held as CMB reinvestment assets, while the prior year net outflow was a result of the acquisition of financial investments and short-term investments as CMB reinvestment assets. Financing activities used cash flows of $2 million in 2012 and provided $5 million in 2011. Inflows from the issuance of common shares decreased in the current year, partially offset by a decrease in outflows from the payment of dividends. Summary of Three Year Results of Operations In 2010 financial performance was solid, with earnings per share of $1.85. Discount income and income related to the CMB program remained strong, and we recognized income from the full reversal of a significant individual mortgage allowance without principal loss. Earnings per share of $1.68 in 2011 were down from 2010, although still solid by historical standards. We continued to earn income from the CMB program and discounted mortgages, although both were lower than 2010. Equity income from MCAP was significantly higher in 2011 than in recent years. In 2012, earnings per share decreased to $1.22, primarily due to significant negative fair market value adjustments. Income from the CMB program began to decline as a result of the maturity of certain CMB issuances. Income from corporate assets increased in line with the portfolio size, while equity income from MCAP remained strong. - 15 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION FINANCIAL POSITION Total assets were $2.99 billion as at December 31, 2012, consisting of $951 million of corporate assets and $2.04 billion of securitization assets. Corporate assets increased by $197 million during 2012, which included increases of $99 million in mortgages, $73 million in cash and cash equivalents and $21 million in our equity investment in MCAP. The decrease in securitization assets was a result of the maturity of certain CMB issuances throughout 2012, as the remaining mortgages and reinvestment assets were used to repay CMB financial liabilities from securitization at the time of maturity. Table 10: Assets (in thousands) As at December 31 Corporate Assets Cash and cash equivalents Marketable securities Mortgages Foreclosed real estate Financial investments Other loans Equity investment in MCAP Commercial LP Other assets Securitization Assets Short-term investments Mortgages Financial investments Derivative financial instruments Other assets Corporate Assets 2012 2011 $ 123,825 20,390 739,812 4,355 18,067 3,164 36,386 4,687 950,686 378,443 936,947 714,631 4,666 1,248 2,035,935 $ 2,986,621 $ 51,309 30,149 640,351 - 12,536 3,027 15,480 947 753,799 345,487 1,499,016 1,279,479 13,348 3,029 3,140,359 $ 3,894,158 Cash and cash equivalents, which include cash balances with banks and overnight term deposits, increased by $73 million during the year. These investments provide liquidity to meet maturing term deposit and new mortgage commitments and met our liquidity requirements at December 31, 2012, as discussed in the “Liquidity” section. Marketable securities, consisting of corporate bonds, real estate investment trusts and exchange-traded funds, decreased by $10 million during 2012. Marketable securities provide MCAN with additional liquidity at yields in excess of cash and cash equivalents. The corporate mortgage portfolio increased by $99 million during the year, which included increases of $91 million in construction loans and $16 million in commercial loans and a decrease of $6 million in uninsured single family mortgages. - 16 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Figure 3: Total Corporate Mortgage Portfolio (in thousands) $800,000 $700,000 $600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $- 2012 2011 TOTAL $739,812 $640,351 We invest in insured and uninsured single family mortgages in Canada. We believe that the Canadian residential property market continues to exhibit healthy fundamentals, but we expect to observe continuted moderation in sales volumes in 2013. We do not invest in the United States mortgage market. The uninsured mortgages that we invest in may not exceed 80% of the value of the real estate securing such loans at the time of funding. For the purposes of this ratio, value is the appraised value of the property as determined by a qualified appraiser at the time of funding. Residential mortgages insured by Canada Mortgage and Housing Corporation (“CMHC”) or Genworth Financial Mortgage Insurance Company Canada Inc. (“Genworth”) may exceed this ratio. Uninsured residential construction loans are made to homebuilders to finance residential construction projects. These loans generally have a floating rate of interest and terms of one to two years. Our limit on total conventional construction loans is 250% of regulatory capital. Non-residential construction loans may comprise up to one half of this limit. Per our internal limits, the maximum single conventional construction loan may not exceed the lesser of $15 million or 20% of regulatory capital. The composition of our corporate mortgage portfolio is as follows: Figure 4: Corporate Mortgage Portfolio Composition by Product Type (in thousands) $350,000 $300,000 $250,000 $200,000 $150,000 $100,000 $50,000 $- 2012 2011 - 17 - Single family uninsured $290,465 $296,695 (46.3%) (39.3%) Single family insured $76,104 $77,558 (12.1%) (10.3%) Construction $299,348 $208,151 (40.4%) (32.6%) Commercial $73,895 $57,947 (10.0%) (9.0%) MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Figure 5: Corporate Mortgage Portfolio Geographic Distribution (2012) Figure 6: Corporate Mortgage Portfolio Geographic Distribution (2011) Other: 13.4% BC: 15.5% Ontario: 44.5% Other: 11.6% BC: 17.8% Ontario: 39.6% Alberta: 26.6% Alberta: 31.0% As at December 31, 2012, we held discounted mortgages with a net discount of $5.9 million (December 31, 2011 - $9.1 million). We retain 50% of any recoveries of that amount, and we pay the remaining 50% to MCAP. The amount of the discount ultimately recovered is dependent on the value of the real estate securing the mortgage, as well as the financial capacity of the borrower. Additionally, these mortgages have maturity dates ranging from 2013 (for certain fixed rate mortgages) to 2032 (for certain floating rate mortgages). The realization of the discount is based on management’s expectations as to when cash will be received. Table 11: Mortgage Originations (in thousands except %) For the Periods Ended Single family uninsured Single family insured 1 Residential construction (advances) Commercial Quarters Ended December 31 2011 2012 Years Ended December 31 2011 2012 $ 32,679 439 104,800 13,068 $ 150,986 $ 70,729 - 101,972 19,133 $ 191,834 $ 141,457 19,740 330,454 38,957 $ 530,608 $ 249,641 - 226,280 42,523 $ 518,444 1 Single family insured originations, to the extent reflected above, consist only of mortgages that we intend to hold for investment purposes. Financial investments increased by $6 million during 2012, primarily due to advances on a commercial real estate equity investment and the acquisition of a retained interest. Our equity investment in MCAP, in which we hold a 23.4% equity interest, increased by $21 million during 2012. During the second quarter of 2012, we provided $14 million in additional capital to MCAP. MCAP is an originator and servicer of mortgage loans for third party investors in Canada. We outsource the majority of our mortgage and loan origination and servicing to MCAP, and the remainder to other third party servicers. As at December 31, 2012, MCAP had $36 billion of assets under administration. - 18 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Securitization Assets Short-term investments consist of treasury bills and commercial paper held as reinvestment assets for the CMB program, CMB cash held in trust and cash pledged as collateral. The $33 million increase in short-term investments during 2012 related primarily to commercial paper held in trust as CMB reinvestment assets. MCAN’s securitized mortgage portfolio consists of insured mortgages securitized through the CMB program and other securitization programs. All mortgages in the securitized portfolio are insured, therefore they do not have a collective allowance. The $562 million decrease in securitized mortgages is a result of the repayment of securitized mortgages (and subsequent reinvestment into short-term investments and financial investments) and the maturity of certain CMB issuances throughout 2012, as the remaining mortgages and reinvestment assets are used to repay CMB financial liabilities from securitization at the time of maturity. The composition of our securitized mortgage portfolio is as follows: Figure 7: Securitized Mortgage Portfolio Composition by Product Type (in thousands) $1,499,016 $47,941 $1,451,075 Commercial insured Single family insured $1,600,000 $1,400,000 $1,200,000 $1,000,000 $800,000 $600,000 $400,000 $200,000 $0 $936,947 $47,734 $889,213 2012 2011 Figure 8: Securitized Mortgage Portfolio Geographic Distribution (2012) Figure 9: Securitized Mortgage Portfolio Geographic Distribution (2011) Other: 13.9% BC: 14.2% Alberta: 23.7% Other: 12.2% Ontario: 48.2% BC: 14.5% Alberta: 23.3% Ontario: 50.0% Financial investments consist of insured MBS held as reinvestment assets for the CMB program and a receivable associated with MCAN’s participation in the Insured Mortgage Purchase Program (“IMPP”). For further information on the IMPP, refer to the “Securitization Programs” discussion. Financial investments decreased by $565 million during 2012, consisting of a decrease of $558 million in insured MBS held as reinvestment assets and a $7 million decrease in the IMPP receivable. The decrease in insured MBS held as reinvestment assets was primarily due to the maturity of certain CMB issuances throughout 2012, as the remaining mortgages and reinvestment assets were used to repay CMB financial liabilities from securitization at the time of maturity. - 19 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Derivative financial instruments at December 31, 2012 consisted of interest rate swaps relating to the CMB program. We have entered into “pay-floating, receive-fixed” swaps to hedge against interest rate risk on reinvested CMB principal collections. The decrease of $8.7 million to derivative financial instruments during 2012 consisted of net interest rate swap receipts of $7.4 million and an unrealized loss of $1.3 million. Table 12: Liabilities and Shareholders’ Equity (in thousands) As at December 31 Liabilities Corporate Liabilities Term deposits Current tax liabilities Deferred tax liabilities Other liabilities Securitization Liabilities Financial liabilities from securitization Other liabilities Shareholders’ Equity Share capital Contributed surplus Retained earnings Available for sale reserve 2012 2011 $ 777,077 2,114 1,842 9,493 790,526 $ 601,577 3,321 5,436 7,943 618,277 2,015,046 3,268 2,018,314 2,808,840 3,111,357 6,059 3,117,416 3,735,693 155,005 510 19,985 2,281 177,781 $ 2,986,621 132,817 510 23,491 1,647 158,465 $ 3,894,158 Term deposit liabilities increased by $176 million during the year. To fund our corporate operations, we issue term deposits that are eligible for Canada Deposit Insurance Corporation (“CDIC”) deposit insurance. We do not use capital markets (including asset-backed commercial paper) for liquidity. The decrease in financial liabilities from securitization related primarily to the maturity of $1.1 billion of CMB liabilities during 2012. In addition, there was a partial repayment of the liability associated with MCAN’s participation in the IMPP (refer to “Securitization Programs” discussion) during the year. The liabilities associated with the CMB program pay out in full at the time that a specific issuance matures. Financial liabilities from securitization as at December 31, 2012 mature as follows: 2013 - $1.1 billion, 2014 - $872 million, 2015 - $45 million. Share capital increased by $22 million during the year, which was primarily raised through the rights offering, in addition to the dividend reinvestment plan. The rights offering raised net proceeds of $20 million, with 1.7 million new common shares issued. For further information on share capital, refer to Note 22 to the consolidated financial statements. Retained earnings decreased by $3.5 million, consisting of net income of $22 million less dividends of $25 million. The available for sale reserve represents unrealized gains or losses (net of deferred taxes) on available for sale marketable securities and financial investments. - 20 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION SUMMARY OF FOURTH QUARTER RESULTS We reported net income for the quarter ended December 31, 2012 of $7.3 million ($0.40 per share), up from $5.2 million ($0.30 per share) in the prior year. Table 13: Net Income for the Quarters Ended December 31 (in thousands) 2012 2011 Net Investment Income - Corporate Assets Mortgage interest Equity income from MCAP Commercial LP Fees Marketable securities Interest on financial investments and other loans Interest on cash and cash equivalents Financial Expenses Term deposit interest and expenses Mortgage expenses Provision for credit losses Net Investment Income - Securitization Assets Mortgage interest Interest on financial investments Interest on short-term investments Other securitization income Interest on financial liabilities from securitization Mortgage expenses Net investment income before fair market value adjustment Fair market value adjustment - derivative financial instruments Net investment income Operating expenses Income before income taxes Provision for (recovery of) income taxes Net income Basic and diluted earnings per share Taxable income per share Dividends per share Net Investment Income - Corporate Assets $ $ $ $ $ 10,006 4,253 677 392 198 180 15,706 4,687 948 421 6,056 9,650 3,099 819 478 2,455 6,851 5,923 91 6,014 837 (2,115) (1,278) 8,372 2,470 5,902 (1,440) 7,342 0.40 0.06 0.28 $ $ $ $ $ 8,845 3,262 689 399 81 115 13,391 3,424 822 388 4,634 8,757 4,685 1,504 233 2,593 9,015 7,448 136 7,584 1,431 (3,190) (1,759) 6,998 1,769 5,229 6 5,223 0.30 0.51 0.27 Mortgage interest income increased by $1.2 million as a result of a $147 million increase in the average mortgage portfolio from $581 million to $728 million, partially offset by a 0.71% decrease in the average mortgage yield from 6.21% in 2011 to 5.50% in 2012. Mortgage interest income includes $19,000 (2011 - $600,000) of discount income on MCAN’s acquired mortgage portfolios, which contributed to the decrease in the mortgage yield over the prior year. Equity income from our ownership interest in MCAP increased by $1.0 million from 2011, primarily due to a significant volume of mortgage securitizations in the current year and increases to income resulting from mortgages measured at fair value. The prior year had significant gains from sales of mortgages. Fees were comparable to the prior year. Fees consist of fee income from a profit sharing arrangement relating to mortgage portfolios acquired by MCAP of $107,000 (2011 - $85,000) and other mortgage fees of $570,000 (2011 - $602,000). - 21 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Marketable securities income was comparable to the prior year. The average balance decreased in the current year, however there was a recovery of $159,000 in the current year on the sale of a security that had previously been written down. Term deposit interest and expenses increased by $1.3 million in 2012, primarily due to a $184 million increase in the average outstanding balance from $547 million in 2011 to $731 million in 2012. The average term deposit interest rate increased from 2.42% in 2011 to 2.44% in 2012. For details of the provision for credit losses, refer to Table 17. Net Investment Income - Securitization Assets Mortgage interest income decreased by $1.6 million as a result of a $573 million decrease in the average mortgage portfolio from 2011. Interest on financial investments decreased by $685,000 as a result of a decrease in the average portfolio from 2011. Interest on short-term investments increased by $245,000 in the current year as a result of an increase in the average portfolio from 2011. Other securitization income decreased by $138,000. Interest rate swap receipts decreased by $371,000, while we earned $261,000 from gains of sales of MBS in the prior year. In the current year, we earned $615,000 of refinancing and renewal gains. There was a negative fair market value adjustment to derivative financial instruments of $2.1 million (2011 - negative $3.2 million) for the quarter relating to the CMB interest rate swaps. Net Interest Income Presented in the following tables is an analysis of average rates and net interest income. Net interest income is the difference between interest earned on certain assets and investments and the interest paid on liabilities to fund those assets. Table 14: Net Interest Income - For the Quarter Ended December 31, 2012 (in thousands except %) Corporate Securitized Total Corporate Securitized Total Average Balance1 Income/Expense Average Rate3 Corporate Securitized Assets Cash and cash equivalents Short-term investments Marketable securities Mortgages - corporate Mortgages - securitized Financial investments Other loans Total on interest earning assets Other assets Total assets $ 89,379 - 19,740 727,834 - 24,217 3,397 864,567 55,441 $ 920,008 $ - 757,653 - - 986,676 836,755 - 2,581,084 7,293 $ 2,588,377 $ 89,379 757,653 19,740 727,834 986,676 860,972 3,397 3,445,651 62,734 $ 3,508,385 $ 180 - 392 10,006 - 177 21 10,776 - $ 10,776 $ $ - 819 - - 3,099 819 - 4,737 - 4,737 $ 180 819 392 10,006 3,099 996 21 15,513 - $ 15,513 0.80% - 4.69% 5.50% - 5.80% 2.45% 5.02% - 4.71% - 1.49% - - 3.72% 1.67% - 2.70% - 2.67% $ 731,117 Liabilities and Shareholders’ Equity Term deposits Financial liabilities from securitization Other liabilities Shareholders’ equity Total liabilities and shareholders’ equity - 28,075 - $ 759,192 $ - $ 731,117 $ 4,687 $ - $ 4,887 2.44% - 2,569,614 4,213 - 2,569,614 32,288 175,366 - - - 5,923 - - 5,923 - - - - - 3.37% - - $ 2,573,827 $ 3,508,385 $ 4,687 $ 5,923 $ 10,810 2.44% 3.37% Net Interest Income2 $ 6,089 $ (1,186) Spread of Mortgages (Corporate Portfolio) over Term Deposits 3.06% 1The average balance is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2Net interest income is equal to net investment income less equity income from MCAP, other securitization income, fee income, mortgage expenses and provision for credit losses. - 22 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION 3The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Balance”, as non- recurring items are excluded from the calculation of the average rate. The income/expense associated with the securitized assets and liabilities in the tables above represents MCAN’s 30% weighted average share of CMB program economics. Although net interest income from securitization assets and liabilities shown above is presented as a negative amount, net interest income from securitization assets before negative fair market value adjustments remains positive due to the impact of the CMB interest rate swaps, which are “pay-floating, receive-fixed” swaps. Since interest rates have generally decreased since the original securitization dates, the positive interest rate swap income has offset lower than expected principal reinvestment income (since the majority of reinvested assets have a floating interest rate). Interest rate swap receipt income was $1.9 million in the fourth quarter of 2012. Table 15: Net Interest Income - For the Quarter Ended December 31, 2011 (in thousands except %) Corporate Securitized Total Corporate Securitized Total Average Balance1 Income/Expense Average Rate3 Corporate Securitized Assets Cash and cash equivalents Short-term investments Marketable securities Mortgages - corporate Mortgages - securitized Financial investments Other loans Total on interest earning assets Other assets Total assets $ 57,647 - 29,567 580,844 - 11,739 2,838 682,635 30,480 $ 713,115 $ - 334,760 - - 1,559,890 1,225,961 - 3,120,611 3,357 $ 3,123,968 $ 57,647 334,760 29,567 580,844 1,559,890 1,237,700 2,838 3,803,246 33,837 $ 3,837,083 $ $ 115 - 399 8,845 - 43 38 9,440 - 9,440 $ $ - 233 - - 4,685 1,504 - 6,422 - 6,422 $ 115 233 399 8,845 4,685 1,547 38 15,862 - $ 15,862 0.79% - 5.35% 6.21% - 3.60% 5.31% 5.49% - 5.25% - 0.94% - - 4.17% 1.91% - 2.93% - 2.92% Liabilities and Shareholders’ Equity Term deposits $ 546,863 $ - $ 546,863 $ 3,424 $ - $ 3,424 2.42% - Financial liabilities from securitization Other liabilities Shareholders’ equity Total liabilities and shareholders’ equity Net Interest Income2 - 14,678 - 3,111,397 6,315 - 3,111,397 20,993 157,830 - - - - 7,448 - - 7,448 - - - - - 3.63% - - $ 561,541 $ 3,117,712 $ 3,837,083 $ 3,424 $ 7,448 $ 10,872 2.42% 3.63% $ 6,016 $ (1,026) Spread of Mortgages (Corporate Portfolio) over Term Deposits 3.79% 1The average balance is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2Net interest income is equal to net investment income less equity income from MCAP, other securitization income, fee income, mortgage expenses and provision for credit losses. 3The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Balance”, as non- recurring items are excluded from the calculation of the average rate. The income/expense associated with the securitized assets and liabilities in the tables above represents MCAN’s 28% weighted average share of CMB program economics. Although net interest income from securitization assets and liabilities shown above is presented as a negative amount, net interest income from securitization assets before negative fair market value adjustments remains positive due to the impact of the CMB interest rate swaps, which are “pay-floating, receive-fixed” swaps. Since interest rates have generally decreased since the original securitization dates, the positive interest rate swap income has offset lower than expected principal reinvestment income (since the majority of reinvested assets have a floating interest rate). Interest rate swap receipts were $2.3 million in the fourth quarter of 2011. - 23 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Table 16: Interest Income and Average Rate by Mortgage Portfolio (Corporate) For the Quarters Ended (in thousands except %) December 31, 2012 Interest Income Average Rate2 Average Assets1 December 31, 2011 Interest Income Average Rate2 Average Assets1 Single family Construction and single family uninsured (completed inventory loans) Commercial Average mortgages - corporate portfolio $ 351,602 $ 4,573 5.02% $ 304,932 $ 4,712 6.29% 311,188 65,044 $ 727,834 4,449 984 $ 10,006 6.00% 5.77% 5.50% 235,122 40,790 $ 580,844 $ 3,642 491 8,845 6.33% 4.88% 6.21% 1The average is calculated with reference to opening and closing monthly balances and as such may not be as precise if daily balances were used. 2The average rate as presented may not necessarily be equal to “Income/Expense” divided by “Average Assets”, as non-recurring items are excluded from the calculation of the average rate. Table 17: Provisions for Credit Losses and Write-Offs (in thousands except basis points) For the Quarters Ended December 31 2012 2011 Individual provision (recovery) Single family uninsured Residential construction Commercial uninsured Collective provision Single family uninsured Residential construction Commercial Corporate mortgages - total Financial investments and other loans $ $ $ $ 145 (150) 116 111 24 119 171 314 (4) 310 $ $ $ $ (138) - 58 (80) 119 147 197 463 5 468 Total provision for credit losses $ 421 $ 388 Corporate mortgage portfolio data: Provision for credit losses Net write-offs Annualized net write-offs (basis points) Operating Expenses (in thousands) For the Quarters Ended December 31 Salaries and benefits General and administrative $ $ 425 83 4.6 $ $ 383 2 0.1 2012 1,011 1,459 2,470 $ $ 2011 882 887 1,769 $ $ Operating expenses increased by $701,000 as a result of higher salaries and benefits from an increase in the number of employees and increased corporate expenses. - 24 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Income Taxes (in thousands) For the Quarters Ended December 31 Current tax provision (recovery) Deferred tax provision (recovery) 2012 2011 $ $ (1,604) 164 (1,440) $ $ 1,612 (1,606) 6 The current tax (recovery) provision in the respective years was consistent with the (deficiency) excess of taxable income versus dividends paid. The provision for deferred taxes in the current year related to our equity investment in MCAP, while the recovery of deferred taxes in the prior year related to negative fair market adjustments to derivative financial instruments. SELECTED QUARTERLY FINANCIAL DATA Table 18: Selected Quarterly Financial Data (in thousands, except per share amounts) Net investment income - corporate assets Net investment income - securitization assets before fair market value adjustment Fair market value adjustment Net investment income - securitization assets Net investment income Operating expenses Income before income taxes Provision for (recovery of) income taxes Net income Basic and diluted earnings per share Q1/12 Q2/12 Q3/12 Q4/12 Q1/11 Q2/11 Q3/11 Q4/11 $ 5,616 $ 9,997 $ 5,872 $ 9,650 $ 5,308 $ 6,165 $ 5,420 $ 8,757 1,026 457 458 837 1,469 1,844 1,086 1,431 (3,238) (1,460) (1,869) (2,115) (3,238) 1,722 4,934 (3,190) (2,212) (1,003) (1,411) (1,278) (1,769) 3,566 6,020 (1,759) 3,404 2,141 8,994 2,351 4,461 2,031 8,372 2,470 3,539 1,672 9,731 1,793 11,440 1,626 6,998 1,769 1,263 6,643 2,430 5,902 1,867 7,938 9,814 5,229 (3,104) $ 4,367 323 $ 6,320 (1,034) $ 3,464 (1,440) $ 7,342 (5,222) $ 7,089 733 $ 7,205 2,228 $ 7,586 6 $ 5,223 $ 0.26 $ 0.37 $ 0.19 $ 0.40 $ 0.49 $ 0.44 $ 0.45 $ 0.30 Taxable income Taxable income per share $ 6,116 0.36 $ $ 8,150 0.48 $ $ 4,809 0.27 $ $ 1,443 0.06 $ $ 4,389 0.30 $ $ 5,532 0.34 $ $ 4,495 0.27 $ $ 8,463 0.51 $ Dividends per share Regular Extra Total $ $ 0.27 0.33 0.60 $ $ 0.27 - 0.27 $ $ 0.27 - 0.27 $ $ 0.28 - 0.28 $ $ 0.27 0.73 1.00 $ $ 0.27 - 0.27 $ $ 0.27 - 0.27 $ $ 0.27 - 0.27 Net investment income from our corporate portfolio has been stable and consistent for the past eight quarters. The fourth quarters of 2011 and 2012 and the second quarter of 2012 were higher than usual as a result of significant equity income from MCAP. Net investment income before fair market value adjustments from our securitization portfolio declined during 2012 as a result of the maturity of CMB issuances during the year. The fair market value adjustment is driven by changes in the forward interest rate curve and accordingly may be volatile. We generally recover current taxes in the first quarter based on the magnitude of the extra dividend. We generally incur deferred tax expense on a positive fair market value adjustment, and vice versa. - 25 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION SECURITIZATION PROGRAMS We participate in the National Housing Act (“NHA”) MBS program, which involves the securitization of insured mortgages to create MBS. Pursuant to the NHA MBS program, investors of MBS receive monthly cash flows consisting of interest and scheduled and unscheduled principal payments. CMHC makes principal and interest payments in the event of any NHA MBS default by the issuer, thus fulfilling the timely payment obligation to investors. To date, we have sold MBS as part of the CMB program, the IMPP and a market MBS program, which are discussed below. CMB Program We participate in the CMB program, which involves the sale of MBS to the Canada Housing Trust (“CHT”). On the sale of MBS to CHT, we receive proceeds for the sale, incur a liability in the amount of such proceeds received and are obligated to pay interest on this liability, which does not amortize over the term of the issuance and is payable in full at maturity. The securitized mortgages and reinvestment assets are held as collateral against the CMB liabilities. During 2012, we repaid $1.1 billion of CMB issuance liabilities at their scheduled maturities, which represented MCAN’s first CMB liability repayments to date. As CMB issuance liabilities continue to mature, we expect net investment income from securitization assets prior to fair market value adjustments to decrease. Over the term of a CMB issuance, we are entitled to interest income received from the securitized mortgages. As the securitized mortgages repay, we reinvest the collected principal in certain permitted investments and are also entitled to interest income from the reinvested assets. We also recognize servicing expenses on the mortgages and pay certain upfront costs. We participate in the CMB program with MCAP. We participate in the economics of each CMB issuance in accordance with a pre-determined economic sharing percentage, which dictates the upfront and ongoing cash flow rights and obligations of the participants. MCAN’s weighted average economic participation for outstanding CMB issuances as at December 31, 2012 was 30% (December 31, 2011 - 28%). MCAP has indemnified MCAN for the remaining 70% of CMB program obligations (December 31, 2011 - 72%). The sales of MBS to CHT failed to meet derecognition criteria, since we did not transfer substantially all risks and rewards on sale. The primary risk retained was mortgage prepayment risk, while the primary reward retained was the excess of mortgage interest income and reinvestment asset interest over securitization liability interest. Interest rate risk is largely mitigated by the interest rate swaps discussed below, and credit risk is minimal as all mortgages securitized through the NHA MBS program are insured. We accounted for these transactions as collateralized borrowings and recorded cash received as a financial liability from securitization. As a result of the failure to meet derecognition criteria on the sale of the securitized mortgages to CHT, we recognize 100% of the mortgages, reinvestment assets and securitization liabilities on the consolidated balance sheets until the maturity of a CMB issuance. We recognize our 30% share of mortgage interest income, principal reinvestment income, interest expense on the securitization liabilities and certain other program expenses on the accrual basis. We enter into “pay floating, receive fixed” interest rate swaps as part of the CMB program. The purpose of the interest rate swaps is to hedge interest rate risk on both securitized mortgages and principal reinvestment assets that have a floating interest rate, as substantially all interest payments on the securitization liabilities are fixed rate. The interest rate swaps are classified as held for trading, where changes in fair value are recorded through the consolidated statements of income. From an economic perspective, these fair value changes are generally offset by changes in future expected income from securitized mortgages and principal reinvestment assets that have a floating interest rate. From an accounting perspective, changes in future expected income from these floating rate assets are not reflected in the consolidated statements of income, which can cause volatility to the consolidated statements of income since there is no offset to fair value changes in the interest rate swaps. In March 2010, OSFI released a final advisory with respect to the impact of IFRS rules regarding securitization on regulatory capital ratios, which require assets and liabilities that are subject to securitization to be reflected as on-balance sheet items. The advisory indicated that any on-balance sheet assets and liabilities recognized from securitization transactions (including insured mortgages that are securitized through the CMB program) were required to be included in the calculation of a regulated financial institution’s regulatory capital ratios. Pursuant to these guidelines, we are required to include any assets and liabilities recognized from securitization transactions undertaken after June 30, 2010 in the calculation of our regulatory capital ratios under IFRS. Consequently, our future participation in securitization transactions, namely through our participation in the CMB program, was significantly reduced at this time from historical participation levels in order for us to comply with our regulatory capital ratios. In late 2011, we commenced a market MBS program (discussed below under “Other MBS Programs”) to allow for our continued participation in securitization transactions. However, at this point, we have been unable to develop additional alternative structures and arrangements that may permit our continued participation in the CMB program. - 26 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Other MBS Programs Insured Mortgage Purchase Program We participated in the IMPP, which involved the sale of MBS to CMHC by MCAN. Although we have no continuing economic involvement in the IMPP, we earned an up-front fee for our participation. We participated in the IMPP on behalf of MCAP, who is entitled to 100% of the ongoing economics and cash flows of the IMPP. We purchased certain mortgages from MCAP that were subsequently securitized into MBS as part of the IMPP. These mortgage sales from MCAP to MCAN failed to meet derecognition criteria, since MCAP retained substantially all risks and rewards as part of the aforementioned entitlement to all economics and cash flows. As a result of this, at the time of sale we recognized a corresponding financial investment (representing a receivable from MCAP) and financial liability from securitization (representing the securitization proceeds received from CMHC). We are the counterparty for the ongoing cash flows between MCAP and CMHC in its role as the IMPP counterparty. Similar to the CMB program, we have no direct obligations relating to the renewals or refinances of the underlying IMPP mortgages. As the originator and servicer of these mortgages, MCAP has control over the direction of the renewed or refinanced mortgages. We do not have the right to create new MBS with these matured mortgages upon renewal, early renewal or refinance, however they may potentially be used to create new MBS as part of the market MBS program that we initiated in 2011 discussed below. Since the inception of the market MBS program, 0.2% ($524,000) of mortgages in new MBS pool issuances through this program have been renewed or refinanced mortgages from the IMPP. We do not rely on renewed or refinanced mortgages from the IMPP to create new MBS pools that are sold through the market MBS program. Market MBS Program In 2011, we commenced the market MBS program, under which we sell MBS into the market and the net economics and cash flows from the underlying mortgages (“interest-only strips”) to a third party. To date, all interest-only strip sales have been made to MCAP. We met derecognition criteria on the sale of the mortgages (i.e. upon creation of MBS and subsequent sales of MBS and interest-only strips to third parties) since we transferred substantially all risks and rewards on sale, and accordingly they were removed from the consolidated balance sheet at that time. The primary risk associated with the market MBS program is liquidity risk, specifically the obligation to fund 100% of any cash shortfall related to the Timely Payment Guarantee (discussed below) as part of the market MBS program. The primary reward associated with the market MBS program is the excess of mortgage interest income over MBS interest. The risks and rewards are both transferred to the purchaser of the interest-only strips pursuant to contractual agreements entered into with such purchaser. In 2012, we recognized $978,000 of income (2011 - $261,000) related to the sale of MBS and the interest-only strips associated with the underlying mortgages. We have no continuing economic involvement with the MBS and the interest-only strips on the underlying mortgages. We only earn income from this program at the time of sale of the MBS and interest-only strips. The market MBS program has provided MCAN with an opportunistic source of income. To December 31, 2012, we have not been required to include the securitized mortgages in the calculation of our regulatory assets, nor have we had to allocate any regulatory capital to this program. Our ability to continue to generate future income under this MBS program is dependent upon our ability to acquire insured mortgages from MCAP or other mortgage originators as well as our ability to sell the MBS and interest-only strips on a profitable basis. Recently announced regulatory changes that impact the Canadian mortgage market and potential interpretations being sought under existing guidance in respect of the capital treatment of securitization of mortgages may impact the extent of MCAN’s participation in the securitization of mortgages and its earnings from that business. We will continue to identify and assess alternatives and opportunities in this line of business in order to maximize returns for our shareholders. Timely Payment Guarantee Consistent with all issuers of MBS, we are required to remit a “timely payment” to MBS investors (representing scheduled principal and interest payments), even if these mortgage payments have not been collected from mortgagors. Similarly, at the maturity of the MBS pools that have been issued by MCAN, any outstanding principal must be paid to the MBS investors. If mortgage payments have not been collected from mortgagors or mortgagors are unable to renew their mortgages at their scheduled maturity, we will be required to use our own financial resources to fund our pro-rata share of these obligations until mortgage arrears are collected or proceeds are received from the mortgage insurers following the sale of the mortgaged properties. CMB Program As part of the CMB program, MCAP is responsible for its pro-rata share of the Timely Payment Guarantee obligations noted above based on its contracted economic participation. If MCAP is not able to provide funds to cover any cash shortfalls, we will be required to use our own financial resources to fund its pro-rata share of these obligations until mortgage arrears are collected or - 27 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION proceeds are received from the mortgage insurers following the sale of the mortgaged properties. To date, we have not had to use our own financial resources to fund any CMB program cash shortfalls from MCAP. Insured Mortgage Purchase Program As part of the IMPP, MCAP is obligated to fund 100% of any cash shortfalls associated with the Timely Payment Guarantee as noted above. If MCAP is not able to provide funds to cover any cash shortfalls, we will be required to use our own financial resources to fund its 100% share of this obligation until mortgage arrears are collected or proceeds are received from the mortgage insurers following the sale of the mortgaged properties. To date, we have not had to use our own financial resources to fund any IMPP cash shortfalls from MCAP. Market MBS Program As part of the market MBS program, the purchaser of the interest-only strip is obligated to fund 100% of any cash shortfalls associated with the Timely Payment Guarantee as noted above. If the interest-only strip purchaser is not able to provide funds to cover any cash shortfalls, we will be required to use our own financial resources to fund its 100% share of this obligation until mortgage arrears are collected or proceeds are received from the mortgage insurers following the sale of the mortgaged properties. To date, we have not had to use our own financial resources to fund any market MBS program cash shortfalls from interest-only strip purchasers. DESCRIPTION OF CAPITAL STRUCTURE Our authorized share capital consists of an unlimited number of common shares with no par value. At December 31, 2012, there were 18,728,500 common shares outstanding. At March 26, 2013, there were 18,766,567 common shares outstanding. For additional information related to share capital, refer to Note 22 to the consolidated financial statements. RIGHTS OFFERING We successfully completed a rights offering that expired on August 22, 2012. The rights offering was fully subscribed and raised net proceeds of $20 million, with 1,699,157 new common shares issued. This resulted in additional asset capacity of $115 million based on our target assets to capital ratio of 5.75 as measured on a tax basis. DIVIDEND POLICY AND RECORD Our dividend policy is to pay out substantially all of our taxable income to our shareholders. As a MIC under the Tax Act, we can deduct dividends paid to shareholders during the year and within 90 days thereafter from income for tax purposes. These dividends are taxable in the shareholders’ hands as interest income. In addition, as a MIC, we can pay certain capital gains dividends which are taxed as capital gains in the shareholders’ hands. We intend to continue to declare dividends on a quarterly basis. Dividends per share over the past three years are as follows: Table 19: Dividends Fiscal Period First Quarter - Regular Dividend First Quarter - Extra Dividend Second Quarter Third Quarter Fourth Quarter Taxable Dividends Capital Gains Dividends 2012 $ 0.27 0.33 0.27 0.27 0.28 $ 1.42 $ 1.37 0.05 $ 1.42 2011 $ 0.27 0.73 0.27 0.27 0.27 $ 1.81 $ 1.81 - $ 1.81 2010 0.26 0.15 0.26 0.26 0.26 1.19 1.19 - 1.19 $ $ $ $ The Board of Directors of the Company (the “Board”) declared a first quarter dividend of $0.31 per share to be paid March 28, 2013 to shareholders of record as of March 15, 2013. The dividend comprises the regular quarterly dividend of $0.28 per share and a $0.03 per share extra dividend, and consists of a $nil per share capital gains component and a $0.31 per share taxable component. - 28 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION OFF-BALANCE SHEET ARRANGEMENTS We commit to fund mortgages to borrowers in advance of funding at agreed upon interest rates. Substantially all of these commitments relate to floating rate construction loans. At December 31, 2012, outstanding commitments for future fundings of mortgages intended for our corporate portfolio were $248 million. Off-balance sheet arrangements relating to the CMB program are discussed in the “CMB Program” section above. CONTRACTUAL OBLIGATIONS We have contractual obligations to make principal and interest payments on term deposits and an operating lease. In addition, we have outstanding commitments for future fundings of mortgages intended for our own portfolio, as discussed above. As part of the CMB program, we are required to pay servicing expenses on the securitized mortgages and other ongoing costs. We outsource our mortgage and loan origination and servicing to MCAP and other third party servicers. We continue to pay servicing expenses as long as the mortgages and loans remain on our balance sheet. Table 20: Contractual Obligations As at December 31, 2012 Term deposits Operating lease Mortgage fundings CMB obligations Less than one year One to five years Over five years Total $ $ 467,957 277 198,336 473 667,043 $ $ 309,120 205 49,251 201 358,777 $ $ - - - - - $ 777,077 482 247,587 674 $ 1,025,820 TRANSACTIONS WITH RELATED PARTIES In 2012, we purchased certain corporate services from MCAP in the amount of $566,000 (2011 - $497,000). We also purchased certain mortgage origination and administration services from MCAP in the amount of $2.8 million (2011 - $2.9 million). During 2012, we received $3.0 million of mortgage fees from MCAP (2011 - $2.2 million). The fees received from MCAP include commitment, extension, renewal, and letter of credit fees. We use MCAP systems, including networks, subsystems and general ledger. We also receive technology support from MCAP. In 2012, we paid fees in the amount of $1.7 million to MCAP relating to a profit sharing arrangement on a portfolio of discounted mortgages (2011 - $2.7 million). We received $190,000 of fees from MCAP relating to a profit sharing arrangement on a portfolio of discounted mortgages (2011 - $303,000). In 2012, we earned $978,000 from the sale of interest-only strips to MCAP (2011 - $261,000), discussed above in “Securitization Programs.” We have established an Executive Share Purchase Plan (the “Share Purchase Plan”) whereby the Board can approve loans to key personnel for the purpose of purchasing MCAN’s common shares. The maximum amount of loans approved under the Share Purchase Plan is limited to 10% of the issued and outstanding common shares. During 2012, MCAN advanced $305,000 of new loans under the Share Purchase Plan (2011 - $299,000). As at December 31, 2012, $1.9 million of loans were outstanding (December 31, 2011 - $1.8 million). The loans under the Share Purchase Plan bear interest at prime plus 1%, and have a five- year term. In 2010, we established a Deferred Share Units Plan (the “DSU Plan”) whereby the Board granted units under the DSU Plan to the President and Chief Executive Officer (for the purposes of this paragraph, the “Participant”). Each unit is equivalent in value to one common share of MCAN. Following the Participant’s retirement/termination date, the Participant is entitled to receive cash for each unit. The individual unit value is based on the average market value of MCAN’s common shares for the five days preceding the retirement/termination date. The Participant was granted 30,000 units under the DSU Plan during 2010. In addition, the Participant is entitled to receive dividend distributions in the form of additional units. The underlying units follow a graded vesting schedule over three years. All dividends paid prior to July 6, 2014 vest as at July 6, 2014. All dividends paid after July 6, 2014 vest immediately. As at December 31, 2012, 20,000 units had vested (December 31, 2011 - 10,000). We recognize compensation expenses associated with the DSU Plan in line with the graded vesting schedule. The compensation expense recognized for the year ended December 31, 2012 related to the DSU Plan was $137,000 (2011 - $181,000). As at December 31, 2012, the accrued DSU Plan liability was $446,000 (December 31, 2011 - $309,000), included in accounts payable and accrued liabilities. - 29 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION RECENT DEVELOPMENTS On March 26, 2013, we announced the signing of a definitive agreement (the “Arrangement Agreement”) to acquire all of the issued and outstanding shares of Xceed for $1.75 per share, for a total consideration of approximately $53.0 million. Xceed is a specialized, single family insured and uninsured residential mortgage lender, focused primarily on the insured area of the mortgage market and, in recent years, has been focused on winding down its legacy securitization portfolio. The transaction is expected to be funded with a combination of cash and common shares of MCAN, and will be effected pursuant to a plan of arrangement under Section 182 of the Business Corporations Act (Ontario). Under the terms of the Arrangement Agreement, Xceed shareholders will, for each share held, receive at their election, subject to adjustment: (i) 0.118 Common Shares or (ii) $1.75 in cash, or a combination thereof, subject to a maximum of approximately $30.3 million in aggregate cash being paid. Assuming the maximum cash consideration is elected to be received by Xceed shareholders, upon completion of the transaction, existing Xceed shareholders will own approximately 7.54% of MCAN on a fully diluted basis. The expected timing and completion of the proposed acquisition is subject to Xceed shareholder approval, court and regulatory approvals, and other closing conditions. Xceed shareholders are expected to vote on the transaction at the end of May 2013. If all necessary approvals are obtained, we expect to complete the proposed transaction on or about June 24, 2013. The terms and conditions of the Arrangement Agreement will be summarized in Xceed’s management information circular and proxy circular delivered to Xceed shareholders. The Arrangement Agreement will be available under MCAN’s profile on SEDAR at www.sedar.com. Assuming all necessary approvals are obtained and the transaction is completed, the acquisition of Xceed is expected to provide multiple benefits to MCAN, including: (i) an established mortgage origination and underwriting platform from which to deliver incremental asset growth and potential for increased income; (ii) new equity on a cost effective basis which will provide MCAN with the capacity to achieve its growth objectives; (iii) opportunities for long-term and sustainable earnings derived from a combination of Xceed’s CMHC origination and underwriting capabilities and MCAN’s existing operations and superior access to capital; (iii) the ability to further lever MCAN’s single family residential capabilities; (iv) support for MCAN’s existing growth plans through Xceed’s origination and underwriting infrastructure and technology capabilities; (v) enhanced portfolio management resulting from Xceed’s database management and reporting capabilities; and (vi) CMHC approved lender status (subject to regulatory approval) which will provide MCAN with the opportunity to expand the scope of its operations. CAPITAL MANAGEMENT We derive our net investment income from the investment of our equity and the difference or spread between amounts earned on our assets and the cost of the term deposits that we issue to fund such assets. As a MIC under the Tax Act, we are limited to a liabilities to capital ratio of 5:1 (or an assets to capital ratio of 6:1), based on our non-consolidated balance sheet measured at its tax value. Securitization assets and liabilities are both excluded from the calculation of the Tax Act ratio. As a loan company under the Trust and Loan Companies Act (the “Trust Act”), OSFI regulates our consolidated regulatory assets to capital and has granted us a maximum consolidated regulatory assets to capital ratio. We borrow to the extent that we are satisfied that the borrowing and additional investments will increase our overall profitability. OSFI has issued guidelines to federally regulated companies for capital adequacy, which include meeting a minimum regulatory capital to risk-weighted assets ratio of 10% for Total capital and 7% for Tier 1 capital. Our internal target minimum Tier 1 and Total capital ratios are both 20%. Assets securitized through the CMB program prior to June 30, 2010 are excluded from the calculation of regulatory ratios. - 30 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Our Tax Act and regulatory ratios are as follows: Table 21: Regulatory Capital (amounts in thousands, except %) As at December 31 Tax Act Ratios Income tax assets Income tax capital Income tax assets to capital ratio Income tax liabilities to capital ratio Regulatory Ratios (OSFI) Tier 1 capital Share capital Contributed surplus Retained earnings Tier 1 capital deductions Tier 2 capital Unrealized gain on available for sale marketable securities Tier 2 capital deductions Total capital Total regulatory assets Total risk-weighted assets Capital ratios Tier 1 capital to risk-weighted assets ratio Total capital to risk-weighted assets ratio Assets to capital ratio 2012 2011 $ 953,235 168,477 5.66 4.66 $ 766,065 156,116 4.91 3.91 $ 155,005 510 19,985 (229) 175,271 1,032 (229) 803 $ 132,817 510 23,491 (229) 156,589 560 (229) 331 $ 176,074 $ 156,920 $ 1,002,759 806,140 $ $ $ 818,112 704,954 21.74% 21.84% 5.70 22.21% 22.26% 5.21 We are limited to the lowest maximum assets amount in the above two asset tests, and the maximum leverage permitted under the Tax Act is more constraining on MCAN than the regulatory assets to capital ratio mandated by OSFI. We manage our assets to a level of 5.75 times capital on a tax basis to provide a prudent cushion between the maximum and total actual assets. We fund the majority of our investments through the issue of term deposits eligible for CDIC deposit insurance with varying maturities in all provinces of Canada. We do not use capital markets (including asset-backed commercial paper) for liquidity. In order to promote a more resilient banking sector and strengthen global capital standards, the Basel Committee on Banking Supervision (“BCBS”) has issued a revised capital framework referred to as Basel III. The Basel III rules will be phased in from 2013 to 2019. In December 2012, OSFI released its final Capital Adequacy Requirements (“CAR”) guideline to reflect (and require Canadian financial institutions to adhere to) certain changes to the global capital rules represented by Basel III. Of particular relevance to the Company, under the CAR guideline:  OSFI requires all federally regulated financial institutions to meet the minimum Common Equity Tier 1 (“CET 1”), Total Tier 1 and Total Capital requirements set out therein. In 2013, those minimum capital ratios are 3.5% for CET 1, 4.5% for Total Tier 1 and 8% for Total Capital and by 2015 those minimum capital ratios increase to 4.5%, 6% and 8%, respectively (with the phase-in of certain regulatory adjustments and phase-out of non-qualifying capital instruments over a 10 year horizon). Those regulatory adjustments include the deduction of certain non-significant investments in the capital of banking, financial and insurance entities above a certain threshold. Those adjustments are expected to impact the Company’s capital calculations and, in particular, the inclusion of its equity investment in MCAP in such calculations.  Capital, for purposes of the assets-to-capital multiple, can be calculated on the transitional basis (phasing-in regulatory adjustments between 2013 and 2018 and phasing-out non-qualifying capital instruments over a 10 year horizon commencing in 2013). As at December 31, 2012, we did not have any non-qualifying capital instruments.  Commencing in 2016, OSFI will also require all federally regulated financial institutions to maintain a capital conservation buffer. The buffer will be phased-in over time and reach its final level of 2.5% in 2019. - 31 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION  In addition to the minimum capital requirements and capital conservation buffer to be maintained by all federally requlated institutions, OSFI expects all such institutions to attain target capital ratios equal to or greater than the 2019 minimum capital ratios and the 2019 capital conservation buffer well in advance of the phase-in period. Accordingly, OSFI expects all such institutions to achieve a CET 1 ratio of 7% by the first quarter of 2013, and a Total Tier 1 ratio of 8.5% and a Total Capital ratio of 10.5% by the first quarter of 2014 (in each case, calculated on an “all in” basis giving effect to all regulatory adjustments that will be required by 2019 and including the 2019 capital conservation buffer). Failure to achieve such targets will serve as triggers for supervisory intervention. We expect to be able to meet OSFI’s requirements and expectations under the CAR guideline without materially adversely affecting the Company’s business plan. We maintain prudent capital planning practices to ensure that we are adequately capitalized and continue to satisfy minimum standards and internal targets. In conjunction with the annual strategic planning and budgeting process, we complete an Internal Capital Adequacy Assessment Process (“ICAAP”) in order to ensure that we have the capital adequacy to support our business plan and risk appetite. The ICAAP assesses the capital available to support the various inherent risks that we face including credit, liquidity, interest rate, market, geographic concentration and reputational risks. The Company’s business plan is also stress tested under various adverse scenarios in order to determine the impact on our results from operations and financial condition. The ICAAP is reviewed by both management and the Board and is submitted to OSFI annually. In addition, we perform stress testing on our internal forecasts for capital adequacy on a quarterly basis and the results of such testing are reported to the Board. Based on our 2012 ICAAP and recent quarters’ stress testing, we have determined that the Company remains adequately capitalized. For additional information on our capital management, refer to Note 32 to the consolidated financial statements. FINANCIAL INSTRUMENTS AND OTHER INSTRUMENTS The majority of our consolidated balance sheet consists of financial instruments, and the majority of net income is derived from the related income, expenses, gains and losses. Financial instruments include cash and cash equivalents, short-term investments, marketable securities, mortgages, financial investments, other loans, financial liabilities from securitization, term deposits and derivative financial instruments, which are discussed throughout this MD&A. The use of financial instruments exposes us to interest rate, credit, liquidity and market risk. A discussion of these risks and how these risks are managed is found under “Risk Management” below. Information on the financial statement classification and amounts of income, expenses, gains and losses associated with the instruments are located in the “Results from Operations” and “Financial Position” sections of this MD&A. Information on the determination of the fair market value of financial instruments is located in the “Critical Accounting Policies and Estimates” section of this MD&A. LIQUIDITY Our liquidity management process includes a Liquidity Risk Management Framework that incorporates multi scenario stress testing. Results of the stress testing are reported to management on a monthly basis and to the Risk Committee of the Board (“RCB”) on a quarterly basis. The table below shows the composition of our liquidity ratios over the last two years. - 32 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Table 22: Liquidity Ratios (in thousands except %) As at December 31 Tier 1 liquidity Cash and cash equivalents Tier 2 liquidity Marketable securities Eligible mortgage-backed securities Tier 3 liquidity CMHC-insured single family mortgages less 25% Total liquidity 100 day term deposit maturities Tier 1 & 2 liquidity to 100 day term deposit maturities Total liquidity to 100 day term deposit maturities 2012 2011 $ 123,825 $ 51,309 20,390 7,137 27,527 19,458 30,149 - 30,149 19,001 $ 170,810 $ 100,459 $ 141,958 $ 88,953 107% 120% 92% 113% We have established and maintain liquidity policies which meet the standards set under the Trust Act and any regulations or guidelines issued by OSFI. For further analysis of our liquidity risks and how we manage them, refer to the “Risk Factors” and “Risk Management” sections below. RISK FACTORS The shaded areas of this MD&A represent a discussion of risk factors and risk management policies and procedures relating to credit, liquidity, interest rate and market risks as required under IFRS 7, Financial Instruments: Disclosures. The relevant MD&A sections are identified by shading within boxes and the content forms an integral part of the consolidated financial statements. We are exposed to a number of risks that can adversely affect our ability to achieve our business objectives or execute our business strategies, and which may result in a loss of earnings, capital and/or damage to our reputation. The risks that have been identified may not be the only risks faced by the Company. Other risks of which the Company is not aware of or which the Company currently deems to be immaterial may surface and have a material adverse impact on the Company’s business, results from operations and financial condition. The significant risks to which we are exposed are as follows: Credit Risk Credit risk is the risk of financial loss resulting from the failure of a counterparty, for any reason, to fully honour its financial or contractual obligations to the Company, primarily arising from our mortgage and lending activities. Fluctuations in real estate values may increase the risk of default and may also reduce the net realizable value of the collateral property to the Company. These risks may result in defaults and credit losses, which may result in a loss of earnings. Credit losses occur when a counter party fails to meet its obligations to the Company and the value realized on the sale of the underlying security deteriorates below the carrying amount of the exposure. Liquidity Risk Liquidity risk is the risk that cash inflows, supplemented by assets readily convertible to cash, will be insufficient to honour all cash outflow commitments (both on and off-balance sheet) as they come due. The failure of borrowers to make regular mortgage payments increases the uncertainties associated with liquidity management, notwithstanding that we may eventually collect the amounts outstanding, which may result in a loss of earnings or capital, or have an otherwise adverse effect on our financial condition and results of operations. - 33 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Reputational Risk Reputational risk is the exposure to negative consequences from the occurrence of other risks. The loss of reputation can greatly affect shareholder value. Reputation refers to the perception of the Company by various stakeholders, including investors, customers, employees, service providers and regulators. Perceptions may be impacted by various events including financial performance, specific adverse occurrences, unfavourable media coverage and changes or actions of the Company’s leadership. Reliance on Key Personnel Our future performance is dependent on the abilities, experience and efforts of our management team and other key personnel. There is no assurance that we will be able to continue to attract and retain key personnel, although it remains a key objective of the Company. Should any key personnel be unwilling or unable to continue their employment with MCAN, there may be an adverse effect on our financial condition and results of operations. Interest Rate Risk Interest rate risk is the potential impact of changes in interest rates on our earnings and capital. Interest rate risk arises when our assets and liabilities, both on and off-balance sheet, have mismatched repricing dates. Changes in interest rates where we have mismatched repricing dates may have an adverse effect on our financial condition and results of operations. In addition, interest rate risk may arise when changes in the underlying interest rates on assets do not match changes in the interest rates on liabilities. This potential mismatch may have an adverse effect on our financial condition and results of operations. Our exposure to interest rate risk is discussed further in Note 32 to the consolidated financial statements. Economic Conditions The Canadian economy experienced a slowdown in growth and employment levels in 2012, however it is expected to normalize in 2013. Low interest rates continue to support housing markets, however regulatory changes which occurred in the latter half of 2012 appear to have had a negative impact on housing markets. We expect to see a decline in housing activity (new home sales and re-sales) in the first half of 2013. Although fundamentals within the economy are expected to improve in the second half of 2013, we do not believe that the improvement will be sufficient to avoid an overall decline in housing activity in 2013. Interest rates are expected to remain low throughout 2013, however a decline in general economic conditions may result in an increase in default rates within the mortgage market. This potential decline in credit quality of borrowers and our mortgage portfolio may negatively impact our net income. Regulatory Risk Changes in laws and regulations, including interpretation or implementation, may affect the Company by limiting the products or services that we can provide and increasing the ability of competitors to compete with our products and services. Also, any failure by the Company to comply with applicable laws and regulations may result in sanctions and financial penalties which may adversely impact our earnings and damage our reputation. Increasing regulations and expectations as a result of the recent financial crisis, both globally and domestically, have increased the cost and resources necessary to meet regulatory expectations for the Company. Market Risk Market risk is the exposure to adverse changes in the value of financial assets. For the Company, market risk factors include price risk on marketable securities, interest rates, real estate values, commodity prices and foreign exchange rates, among others. Any changes in these market risk factors may negatively affect the value of our financial assets, which may have an adverse effect on our financial condition and results of operations. We do not undertake trading activities as part of our regular operations, and therefore are not exposed to risks associated with activities such as market making, arbitrage or proprietary trading. Operational and Infrastructure Risk We are exposed to many types of operational risks that affect all companies. Such risks include the risk of fraud by employees or others, unauthorized transactions by employees, and operational or human error. We are also exposed to the risk that computer or telecommunication systems could fail, despite efforts to maintain these systems in working order. Shortcomings or failures in internal processes, employees or systems, including any of our financial, accounting or other data processing systems, may lead to financial loss and damage to our reputation. In addition, despite our contingency plans in place, our ability to conduct business may be adversely affected by a disruption in the infrastructure that supports our operations. - 34 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Outsourcing Risk Outsourcing risk is the risk incurred when we contract out a business function to a service provider instead of performing the function ourselves, and the service provider performs at a lower standard than we would have under similar circumstances. We outsource all mortgage and loan origination, servicing and collections to MCAP and other third parties. Competition Risk Our operations and income are a function of the interest rate environment, the availability of mortgage products at reasonable yields and the availability of term deposits at reasonable cost. The availability of mortgage products for the Company and the yields thereon are dependent on market competition. In the event that we are unable to compete successfully against our current or future competitors or raise term deposits to fund our lending activities, there may be an adverse effect on our financial condition and results of operations. Monetary Policy Our earnings are affected by the monetary policies of the Bank of Canada. Changes in the supply and demand of money and the general level of interest rates could affect our earnings. Changes in the level of interest rates affect the interest spread between our mortgages, loans and investments, securitization investments and term deposits, and as a result may impact our net investment income. Changes to monetary policy and in financial markets in general are beyond our control and are difficult to predict or anticipate. Environmental Risk We recognize that environmental hazards are a potential liability. This risk exposure can result from non-compliance with environmental laws, either as principal or lender, which may negatively affect our financial condition and results of operations. We aim to mitigate this risk by complying with all environmental laws and by applying a rigorous environmental policy and procedures to our commercial and development lending activities. Changes in Laws and Regulations Changes to current laws, regulations, regulatory policies or guidelines (including changes in their interpretation, implementation or enforcement), the introduction of new laws, regulations, regulatory policies or guidelines or the exercise of discretionary oversight by regulatory or other competent authorities including OSFI, may adversely affect us, including by limiting the products or services that we provide, restricting the scope of our operations or business lines, increasing the ability of competitors to compete with our products and services or requiring us to cease carrying on business. In addition, delays in the receipt of any regulatory approvals and authorizations that may be necessary to the operation of our business may adversely affect our operations and financial condition. Our failure to comply with applicable laws and regulations may result in sanctions and financial penalties that could adversely impact our earnings and damage our reputation. Changes in Accounting Standards and Accounting Policies We may be subject to changes in the financial accounting and reporting standards that govern the preparation of our consolidated financial statements. These changes may materially impact how we record and report our financial condition and results of operations and, in certain circumstances, we may be required to retroactively apply a new or revised standard that results in our restating prior period financial statements. Please refer to the “Future Changes in Accounting Policy” section of this MD&A for further details. Accuracy and Completeness of Information on Customers and Counterparties In deciding whether to extend credit or enter into other transactions with customers and counterparties, we rely on information furnished by them, including financial statements and other information. We may also rely on the representations of customers and counterparties as to the accuracy and completeness of that information. Our financial condition and results of operations may be negatively affected to the extent that we rely on financial statements and other information that do not comply with IFRS, that are materially misleading or that do not fairly represent, in all material respects, the financial condition and results of operations of the customers and counterparties. Leverage Leverage increases our potential exposure to all risk factors described above. No Assurance of Achieving Investment Objectives or Payment of Dividends As a result of the risks discussed above, there is no assurance that the Company will be able to achieve its investment objectives or be able to pay dividends at targeted or historic levels. The funds available for the payment of dividends to our shareholders will vary according to, among other things, the principal and interest payments received in respect of the Company’s investments. - 35 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION There can be no assurance that the Company will generate any returns or be able to pay dividends to our shareholders in the future. RISK MANAGEMENT We operate in changing regulatory and economic environments. As a result, our management team and the Board are particularly diligent in their consideration of all identified risks. Our goal is not to eliminate risk, as this would result in significantly reduced earnings, but rather to be proactive in our assessment and management of risk, as a means to gain a strategic advantage and ultimately enhance shareholder value. Our senior management team is responsible for the quality of processes, policies, procedures and controls and for internal reporting on a day-to-day basis. The Board is actively involved in the risk management process, providing oversight and guidance on an ongoing basis and at least quarterly. Internal Audit is involved in the risk management process to provide validation of its effectiveness, with reports provided to senior management and the Board. As discussed above under “Risk Factors,” we are exposed to various inherent risks, particularly credit risk, liquidity risk and interest rate risk. We mitigate these risks through prudent credit limits, established lending policies and procedures, effective monitoring and reporting, investment diversification and by the diligent management of assets and liabilities. Credit Risk Credit and commitment exposure is closely monitored through a reporting process that includes a formal monthly review involving the Asset and Liability Committee (“ALCO”) which is comprised of management and a formal quarterly review involving the RCB. A Dashboard Report, which identifies, assesses, ranks and provides trending analysis on all material risks to the Company, is provided to the RCB on a quarterly basis. Weekly monitoring also takes place through our Capital Commitments Committee, which is comprised of management. Our exposure to credit risk is managed through prudent risk management policies and procedures that emphasize the quality and diversification of our investments. Credit limits, based on our risk appetite, which is approved by the Board at least annually, have been established for concentration by asset class, geographic region, dollar amount and borrower. These policies are amended on an ongoing basis to reflect changes in market conditions and our risk appetite. All members of management are subject to limits on their ability to commit the Company to credit risk. We identify potential risks in our mortgage portfolio by way of regular review of market metrics, which are a key component of quarterly market reports provided to the RCB. We also undertake site visits of active mortgage properties. Existing risks in our mortgage portfolio are identified by arrears reporting, portfolio diversification analysis, annual reviews of large loans and risk rating trends of the entire mortgage portfolio. The aforementioned reporting and analysis provides adequate monitoring of and control over our exposure to credit risk. In the current economic environment, we have increased our monitoring of real estate market values for single family mortgages, with independent assessments of value obtained as individual mortgages exceed 90 days in arrears. We assign a credit score and risk rating for all mortgages at the time of underwriting based on the quality of the borrower and the underlying real estate. Risk ratings are reviewed annually for large exposures, and whenever there is an amendment or a material adverse change such as a default or impairment. We have established a methodology for determining the adequacy of our collective allowances. The adequacy of collective allowances is assessed periodically, taking into consideration economic factors such as Gross Domestic Product, employment, housing market conditions as well as the current position in the economic cycle. We record an individual allowance to the extent that the estimated realizable value of a mortgage has decreased below its net book value. Individual allowances include all of the accumulated provisions for credit losses on a particular mortgage. At December 31, 2012, we had recorded $713,000 (December 31, 2011 - $1.2 million) of individual allowances on our mortgage portfolio (refer to Note 9 to the consolidated financial statements). Our maximum credit exposure on our individual financial assets is equal to the carrying value of the respective assets, except for our corporate mortgage portfolio, whose maximum credit exposure also includes outstanding commitments for future mortgage fundings. Liquidity Risk We closely monitor our liquidity position to ensure that we have sufficient cash to meet liability obligations as they become due. The RCB is responsible for the review and approval of liquidity policies. ALCO is responsible for liquidity management. We have an internal target of a standard level of liquid investments (cash and cash equivalents, marketable securities and 75% of CMHC-insured single family mortgages) of at least 100% of term deposits maturing within 100 days. In addition, all single family mortgages are readily marketable within a time frame of one to three months, providing us with added flexibility to meet unexpected liquidity needs. We have access to capital through our ability to issue term deposits eligible for CDIC deposit - 36 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION insurance. These term deposits also provide us with the ability to fund asset growth as needed. We also maintain an overdraft facility to fund asset growth or meet our short-term obligations as required. The overdraft facility is a component of a larger credit facility that also has a portion which guarantees letters of credit used to support the obligations of borrowers to municipalities in conjunction with construction loans. The total facility is $50 million, with sub-limits of $30 million for overdrafts and $30 million for letters of credit. We believe that our liquidity position and our access to capital markets in the form of term deposits and the banking facility support our ability to meet current and future commitments as they come due. Management has developed a Liquidity Risk Management Framework that is reviewed and approved annually by the Board. This framework details the daily, monthly and quarterly analysis that is performed by management. Management monitors changes in cash and cash requirements on a daily basis and formally reports to ALCO on a monthly basis. Management also completes monthly and quarterly stress testing which is reviewed by ALCO and the RCB. Management monitors trends in deposit concentration with significant term deposit brokers on a monthly basis. Our liquidity position and access to funding support our ability to meet current and expected future commitments. Our liquid investments were 120% of term deposits maturing within 100 days at December 31, 2012. For further details on our liquid assets and our ability to meet liability obligations, refer to Note 32 to the consolidated financial statements. We have established and maintain liquidity policies and procedures which meet the standards set under the Trust Act and any regulations or guidelines issued by OSFI. Our sources and uses of liquidity are outlined in the table below. We manage our net liquidity surplus/deficit by raising term deposits as mentioned above. Table 23: Liquidity Analysis (in thousands) Sources of liquidity Cash and cash equivalents Marketable securities Mortgages - corporate Foreclosed real estate Financial investments Other loans Uses of liquidity Term deposits Other liabilities Within 3 Months 3 Months To 1 Year 1 to 5 Years Over 5 Years December 31 2012 December 31 2011 $ 123,825 - 119,985 - 565 19 244,394 $ - $ - 307,611 - 2,480 - 310,091 230,981 9,493 240,474 236,976 - 236,976 - 7,092 302,307 - 779 1,240 311,418 309,120 - 309,120 $ - 13,298 9,909 4,355 14,243 1,905 43,710 $ 123,825 20,390 739,812 4,355 18,067 3,164 909,613 $ 51,309 30,149 640,351 - 12,536 3,027 737,372 - - - 777,077 9,493 786,570 601,577 7,943 609,520 Net liquidity surplus (deficit) $ 3,920 $ 73,115 $ 2,298 $ 43,710 $ 123,043 $ 127,852 Off-Balance Sheet Unfunded mortgage commitments $ 124,459 $ 73,877 $ 49,251 $ - $ 247,587 $ 296,666 The above table excludes securitized assets and liabilities and pledged assets as they are restricted. For a discussion regarding liquidity risk relating to the maturity of CMB program issuances and other MBS programs, refer to the “Timely Payment Guarantee” section of the “Securitization Programs” discussion. Interest Rate Risk We evaluate our exposure to a variety of changes in interest rates across the term spectrum of our assets and liabilities, including both parallel and non-parallel changes in interest rates. By managing and matching the terms of corporate assets and term deposits so that they offset each other, we seek to reduce the risks associated with interest rate changes, and in conjunction with liquidity management policies and procedures, we also manage cash flow mismatches. ALCO reviews our interest rate exposure on a monthly basis using interest rate spread and gap analysis as well as interest rate sensitivity analysis based on various scenarios. This information is also formally reviewed by the RCB each quarter. We do not currently use derivative financial instruments outside of the CMB program, however the potential use of such instruments for our on-balance sheet assets is analyzed and reported to ALCO on a monthly basis. We manage interest rate risk associated with securitization assets and liabilities through the use of “pay-floating, receive-fixed” interest rate swaps. For further details, refer to the “CMB Program” section of this MD&A. - 37 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION Ultimately, risk management is monitored and controlled at the highest level of the Company. ALCO reviews and manages these risks on a monthly basis. Our Board also reviews and approves all risk management policies and procedures at least annually. Management reports to the Board on the status of risk management at least quarterly. Market Risk Our marketable securities portfolio is susceptible to market price risk arising from uncertainties about future values of the securities. We manage the equity price risk through diversification and limits on both individual and total securities. Reports on the portfolio are submitted to the Company’s senior management on a regular basis and to the Board on a quarterly basis. General Litigation In the ordinary course of business, MCAN and its service providers (including MCAP), their subsidiaries and related parties may from time to time be party to legal proceedings that may result in unplanned payments to third parties. To the best of our knowledge, MCAN management does not expect the outcome of any of these proceedings to have a material adverse effect on the consolidated financial position or results of operations of MCAN. Currently, MCAP is one of several parties to a claim in respect of a development project in Alberta. Although a summary judgment in MCAP’s favour was rendered at trial, the Alberta Court of Appeal overturned the summary judgment in part and has directed that certain aspects of the claim be allowed to proceed to trial. MCAN management does not believe that the claim has any merit and believes the claim will ultimately be unsuccessful. In any event, management of MCAN believes that any monetary damages against MCAP would not have a material financial impact on MCAN. PEOPLE As at December 31, 2012, we had 23 employees. REGULATORY COMPLIANCE Our Chief Compliance Officer ensures that management understands the impact of all relevant legislation affecting the business, assesses compliance with current and pending legislation and works with management to address any gaps in policies and procedures. We use a Legislative Compliance Management System that ensures all managers assess their compliance with relevant legislation on a quarterly basis. Senior management liaises with regulators to keep them apprised of company progress and changes to our business. Our Chief Compliance Officer reports quarterly to the Conduct Review, Corporate Governance & Human Resources Committee of the Board. INTERNAL AUDIT The Internal Audit function, consisting of the Chief Audit Officer, has unrestricted access to our operations, records, property and personnel, including senior management and the Chairman of the Audit Committee of the Board (the “Audit Committee”). Internal Audit formulates an annual risk-based plan for approval by the Audit Committee and then undertakes internal audit reviews throughout the year with regular and direct reporting to both senior management and the Audit Committee. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Note 4 to the consolidated financial statements provides detailed information on our significant accounting policies, the method of applying those policies, and the material components of the amounts in the consolidated balance sheets and the statements of income, changes in shareholders’ equity, comprehensive income and cash flows. The policies discussed below are considered particularly important, as they require management to make judgments involving estimations, which are discussed in Note 6 to the consolidated financial statements. We have control procedures to ensure that these policies are applied consistently and that the policies are independently reviewed on at least an annual basis. Changes to accounting policies are made only after an appropriate amount of research and discussion has occurred and independent advice is obtained. Estimates are considered carefully and reviewed at an appropriate level within MCAN. We believe that our estimates of the value of our assets and liabilities are appropriate. Actual results may differ from those estimates. Financial Instruments All financial instruments are initially recognized on the trade date, and are classified based on management’s intentions. Financial assets are classified as held for trading, held to maturity, available for sale or loans and receivables, and financial liabilities are classified as held for trading or at amortized cost. Changes in the unrealized fair value of financial instruments classified as held for trading are recognized to income. Changes in the unrealized fair value of available for sale financial assets are recognized in the available for sale reserve, except for those considered to be changes attributable to impairment which are charged to income. Upon disposal, the cumulative change in fair value is transferred to income. Other classifications are subsequently measured at amortized cost. From time to time, we may use derivative and non-derivative financial instruments to - 38 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION manage interest rate risk as discussed above in the “Securitization Programs” section. Hedge accounting is optional, and where it can be applied, it requires MCAN to document the hedging relationship and to test the effectiveness of the hedging item to offset changes in value of the underlying hedged item on an ongoing basis. At December 31, 2012, we did not have any hedge accounting relationships. All financial instruments that are carried on the consolidated balance sheets at fair value are estimated using valuation techniques based on observable market data such as market interest rates currently charged for similar financial investments to expected maturity dates. For further details on financial instruments, refer to Notes 4, 5, 7, 8, 9, 11, 12, 15, 18, 21 and 22 to the consolidated financial statements. Allowance for Credit Losses The allowance for credit losses reduces the carrying value of mortgage assets to provide for an estimate of the principal amounts that borrowers may not repay in the future. In assessing the estimated realizable value of assets, we must rely on estimates and exercise judgment regarding matters for which the ultimate outcome is unknown. A number of factors can affect the amount that we ultimately collect, including the quality of our own underwriting process and credit criteria, the diversification of the portfolio, the underlying security relating to the loans and the overall economic environment. Individual allowances include all of the accumulated provisions for losses on particular assets required to reduce the related assets to estimated realizable value. The collective allowance represents losses that we believe have been incurred but not yet specifically identified. The collective allowance is established by considering historical loss trends during economic cycles, the risk profile of our current portfolio, estimated losses for the current phase of the economic cycle and historic industry experience. Allowance rates depend on asset class, as different classes have varying underlying risks. Future changes in circumstances could materially affect our future provisions for credit losses from those provisions determined in the current year, and there could be a need to increase or decrease the allowance for credit losses. We complete a review of all provisioning policies at least annually. We continue to monitor asset performance and current economic conditions, focusing on any regionally specific issues to assess the adequacy of the current provisioning policies. Provisioning rates are reviewed on a quarterly basis. In addition to considering current economic conditions, we assessed the probability of default, expected loss as a result of default and the mortgage exposure at the time of default when establishing our collective allowance. We continue to review our underwriting and credit requirements on a regular basis, and we have taken measures as warranted by changes in the market and economic conditions. We believe that we have established adequate provisioning rates given the current economic concerns. Our current provisioning rates consider the impact of a decline in real estate values and anticipated default/loss percentages that are sufficient to offset current and historical loss experiences. On an ongoing basis, we reassess the fair value of other loans and financial investments, determined on the basis of expected discounted cash flows. When a decline in value is identified as a result of impairment that is other than temporary, an allowance is recorded through the income statement. For further details on our accounting policies and balances of the allowances for credit losses, refer to Notes 4, 6, 10 and 12 to the consolidated financial statements. Discount Income Recognition We may acquire mortgage portfolios from third parties at fair market value. A mortgage discount will exist to the extent that the fair market value of a mortgage is less than its par value. The discount is allocated between a valuation reserve component and an accretion component. The valuation reserve component represents the risk of credit loss, while the accretion component represents the part of the discount to be recognized to income over time, thereby adjusting the yield on the mortgage from its face rate to an effective yield. The accretion component is amortized to income over the term of the related mortgage through the application of the effective interest rate method. The valuation reserve component is only recognized into income upon payout, less any realized credit loss. Income Taxes Current tax assets and liabilities are measured at the amount expected to be recovered from or paid to the taxation authorities. The tax rates and tax laws used to compute the amount are those that are enacted or substantively enacted at the consolidated financial statement date. Deferred tax is provided on temporary differences at the consolidated financial statement date between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. For further details on our accounting policies and balances relating to income taxes, refer to Notes 4 and 19 to the consolidated financial statements. We will continue to proactively monitor the appropriateness of our position on a quarterly basis. - 39 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION FUTURE CHANGES IN ACCOUNTING POLICY Standards issued but not yet effective up to the date of issuance of the Company’s consolidated financial statements are listed below. This listing is of standards and interpretations issued, which the Company reasonably expects to be applicable at a future date. The Company intends to adopt those standards when they become effective. IFRS 7, Financial Instruments: Disclosures - Offsetting Financial Assets and Financial Liabilities This standard will require entities to disclose gross amounts subject to right of set-off, amounts set off in accordance with the accounting standards followed, and the related net credit exposure. This standard is effective for periods beginning on or after January 1, 2013. Retrospective application will be required. The Company does not expect the adoption of this standard to have a material impact on its results as well as to the presentation of the Company’s financial statements. IAS 32, Financial Instruments: Presentation - Offsetting Financial Assets and Financial Liabilities (Amendments to IAS 32). These amendments clarify the offsetting criteria in IAS 32 to address inconsistencies in their application. These amendments clarify that an entity currently has a legally enforceable right to set-off if that right is not contingent on a future event and enforceable both in the normal course of business and in the event of default, insolvency or bankruptcy of the entity and all counterparties. The amendment also clarifies the application of the IAS 32 offsetting criteria to settlement systems. This amendment will be effective for annual periods beginning on or after January 1, 2014. The Company is in the process of assessing the impact of adopting this amendment. IFRS 10, Consolidated Financial Statements This standard is effective for annual periods beginning on or after January 1, 2013 and will replace portions of IAS 27, Consolidated and Separate Financial Statements and interpretation SIC-12, Consolidation - Special Purpose Entities. Under IFRS 10, consolidated financial statements include all controlled entities under a single control model that applies to all entities, including special purpose entities and structured entities. A group will still continue to consist of a parent and its subsidiaries; however IFRS 10 uses different terminology from IAS 27 in describing its control model. The changes introduced by IFRS 10 will require management to exercise significant judgment to determine which entities are controlled, and therefore are required to be consolidated by a parent, compared with the requirements that were in IAS 27. The Company does not anticipate any material changes to the financial position or operating results upon adoption of IFRS 10. IFRS 12, Disclosure of Interests in Other Entities This standard includes disclosure requirements about subsidiaries, joint ventures, and associates, as well as unconsolidated structured entities. Many of the disclosure requirements were previously included in IAS 27, IAS 1 and IAS 28 while others are new. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to result in material changes to the presentation of the Company’s financial statements. IFRS 13, Fair Value Measurement This standard provides guidance on how to measure the fair value of financial and non-financial assets and liabilities when fair value is required or permitted per IFRS. While many of the concepts in IFRS 13 are consistent with current practice, certain principles could have a significant effect on some entities adopting the standard. IFRS 13 is effective January 1, 2013 and will be adopted prospectively. The Company does not expect the adoption of this standard to have a material impact on its results. IAS 1, Presentation of Financial Statements This standard has a number of amendments regarding financial statement presentation and disclosure requirements. This standard is effective for annual periods beginning on or after July 1, 2012. The Company does not expect the adoption of this standard to result in material changes to the presentation of the Company’s financial statements. IAS 19, Revised Employee Benefits This standard prescribes the accounting and disclosure requirements for employee benefits. This standard shall be applied by an employer in accounting for all employee benefits, except those to which IFRS 2, Share-based Payment, applies. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to have a material impact on its results as well as to the presentation of the Company’s financial statements. IAS 28, Investments in Associates and Joint Ventures This amendment prescribes the accounting for investments in associates and to set out the requirements for the application of the equity method when accounting for investments in associates and joint ventures. This standard shall be applied by all entities that are investors with joint control of, or significant influence over, an investee. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to have a material impact on its results. - 40 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF OPERATIONS / 2012 ANNUAL REPORT MCAN MORTGAGE CORPORATION DISCLOSURE CONTROLS AND PROCEDURES AND INTERNAL CONTROLS OVER FINANCIAL REPORTING Disclosure Controls and Procedures (“DC&P”) A disclosure committee, comprised of members of our senior management (the “Disclosure Committee”) is responsible for establishing and maintaining adequate disclosure controls and procedures. As of December 31, 2012, we have evaluated the effectiveness of the design and operation of our DC&P in accordance with requirements of National Instrument 52-109 of the Canadian Securities Commission – Certification of Disclosure in Issuers’ Annual and Interim Filings (“NI 52-109”). Our Chief Executive Officer and Chief Financial Officer supervised and participated in this evaluation. Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective to ensure that information required to be disclosed by us in reports we file or submit is recorded, processed, summarized and reported within the time periods specified in securities legislation and is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Internal Controls over Financial Reporting (“ICFR”) The Disclosure Committee is responsible for establishing and maintaining adequate ICFR. Under the supervision and with the participation of the Disclosure Committee, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our ICFR based upon the framework issued by the Committee of Sponsoring Organizations of the Treadway Commission, a recognized control model, and the requirements of NI 52-109. Based on the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our ICFR were effective as of December 31, 2012. Ernst & Young LLP, our Independent Registered Chartered Accountants, have audited our consolidated financial statements for the year ended December 31, 2012. Changes in ICFR There were no changes in our ICFR that occurred during the period beginning on January 1 and ending on December 31, 2012 that have materially affected, or are reasonably likely to materially affect, our ICFR. Inherent Limitations of Controls and Procedures All internal control systems, no matter how well designed, have inherent limitations. As a result, even systems determined to be effective may not prevent or detect misstatements on a timely basis, as systems can provide only reasonable assurance that the objectives of the control system are met. In addition, projections of any evaluation of the effectiveness of ICFR to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may change. - 41 - 2012 A ANNUAL REPOR RT / MCAN MOR RTGAGE CORP PORATION STATEME ENT OF MANA AGEMENT’S R RESPONSIBILI ITY FOR FINA ANCIAL INFOR RMATION The accomp responsibilit representati all other sec Internationa Superintend panying consoli ty of manageme ons contained in ctions of the ann al Financial Rep dent of Financial idated financial ent and have been n these consolid nual report. The porting Standard l Institutions Can statements of n approved by th dated financial st consolidated fin ds (“IFRS”), inc nada. MCAN Mortga he Board of Dire tatements, the M nancial statemen cluding the acco age Corporation ectors. Managem Management’s D nts have been pre ounting requirem n (“MCAN” or ment is responsib Discussion and A epared by manag ments of our re the “Company ble for the inform Analysis of Oper gement in accor egulator, the Of y”) are the mation and rations and rdance with ffice of the The Compa reasonable a from unauth any’s accounting assurance that th horized use or di g system and re he Company’s f isposition. elated internal c financial record controls are des s are complete signed, and supp and accurate an porting procedu nd that assets ar ures maintained re safeguarded a to provide against loss The Office deemed nec depositors a of the Superinte cessary to be sati and that the Com endent of Financ isfied that the pr mpany is in sound cial Institutions C rovisions of the d financial condi Canada makes su Trust and Loan ition. uch examination Companies Act n and enquiry in t are being duly nto the affairs of observed for the f MCAN as e benefit of The Board o responsible through an A controls, con of Directors is r for reviewing Audit Committe ntrol systems an esponsible for e and approving e of unrelated di nd compliance m nsuring that man the consolidated irectors appointe matters and report nagement fulfils d financial state ed by the Board ts thereon to the s its responsibili ements. These of Directors. Th e Audit Committ ity for financial responsibilities he Chief Financi tee. reporting and is are carried out ial Officer review s ultimately t primarily ws internal The Audit C reporting p statements a Directors an Committee meet rocess, auditing and recommend nd Shareholders ts periodically w g matters and f s them to the B the appointment with managemen financial reporti oard of Director t of external aud nt and the extern ing issues. Th rs for approval. ditors and approv nal auditors to d he Audit Comm The Audit Com val of their fees. discuss internal mittee reviews t mmittee also rec controls over th the consolidated commends to th he financial d financial he Board of The consoli with Canadi idated financial ian generally acc statements have cepted auditing s e been audited b standards. Ernst by the Company t & Young LLP y’s external aud has full and free ditors, Ernst & Y e access to the A Young LLP, in a accordance e. Audit Committee William Jan President an ndrisits nd Chief Executi ive Officer T Tammy Oldenbu Vice President a V urg and Chief Financ cial Officer Toronto, Ca February 28 anada, 8, 2013 - 42 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION Independent auditors’ report To the Shareholders of MCAN Mortgage Corporation We have audited the accompanying consolidated financial statements of MCAN Mortgage Corporation, which comprise the consolidated balance sheets as at December 31, 2012 and December 31, 2011 and the consolidated statements of income, comprehensive income, changes in shareholders’ equity and cash flows for the years then ended, and a summary of significant accounting policies and other explanatory information. Management's responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditors' responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditors' judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditors consider internal control relevant to the entity's preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity's internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of MCAN Mortgage Corporation as at December 31, 2012 and December 31, 2011, and its financial performance and its cash flows for the years then ended in accordance with International Financial Reporting Standards. Chartered Accountants Chartered Accountants Licensed Public Accountants Licensed Public Accountants Toronto, Canada February 28, 2013 - 43 - 2012 ANN NUAL REPORT / CONSOLIDAT C (in thousand ED BALANCE ds of Canadian d E SHEETS dollars) MCAN MORTG GAGE CORPORA ATION As at Decem mber 31 Assets Not te 2012 20 011 Assets Corporate Cash and c s cash equivalents Marketabl le securities s Mortgages d real estate Foreclosed investments Financial i ns Other loan vestment in MCA Equity inv ets Other asse AP Commercial LP tion Assets Securitizat Short-term m investments s Mortgages investments Financial i e financial instru Derivative ets Other asse uments Liabilities and Shareholde ers’ Equity Liabilities Corporate Term depo Current tax Deferred t Other liabi Liabilities osits x liabilities tax liabilities ilities Securitizat Financial l Other liabi tion Liabilities liabilities from s ilities securitization Shareholde Share cap Contribut Retained Available ers’ Equity pital ted surplus earnings e e for sale reserve 7 8 9 10 0 11 1 12 2 13 3 4 14 15 5 6 16 11 1 17 7 4 14 18 8 19 9 9 19 0 20 1 21 0 20 22 2 2 22 4 24 $ $ $ 123,825 20,390 739,812 4,355 18,067 3,164 36,386 4,687 950,686 378,443 936,947 714,631 4,666 1,248 2,035,935 2,986,621 777,077 2,114 1,842 9,493 790,526 2,015,046 3,268 2,018,314 2,808,840 155,005 510 19,985 2,281 177,781 2,986,621 $ $ 51,3 30, 640,3 309 149 351 - 12,5 536 027 3,0 480 15,4 947 9 799 753,7 345,4 1,499,0 1,279,4 13,3 3,0 3,140,3 $ 3,894,1 487 016 479 348 029 359 158 $ 601,5 3,3 5,4 7,9 618,2 577 321 436 943 277 3,111,3 6,0 3,117,4 3,735,6 357 059 416 693 132,8 817 5 510 491 23,4 647 1,6 465 158,4 158 $ 3,894,1 The accompan Operations are nying notes and sh e an integral part haded areas of the of these consolida “Risk Factors” a ated financial state and “Risk Manage ements. ement” sections of f Management’s D Discussion and Ana alysis of On behalf of th he Board: William Jand President and drisits d Chief Executiv ve Officer David G. B Director, C Broadhurst Chairman of the Audit Committe ee - 44 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION CONSOLIDATED STATEMENTS OF INCOME (in thousands of Canadian dollars except for per share amounts) Years Ended December 31 Note 2012 2011 Net Investment Income - Corporate Assets Mortgage interest Equity income from MCAP Commercial LP Fees Marketable securities Interest on financial investments and other loans Interest on cash and cash equivalents Term deposit interest and expenses Mortgage expenses Provision for credit losses Net Investment Income - Securitization Assets Mortgage interest Interest on financial investments Interest on short-term investments Other securitization income Interest on financial liabilities from securitization Mortgage expenses Net investment income before fair market value adjustment Fair market value adjustment - derivative financial instruments Net Investment Income Operating Expenses Salaries and benefits General and administrative Income Before Income Taxes Provision for (recovery of) income taxes Current Deferred Net Income Basic and diluted earnings per share Dividends per share Weighted average number of basic and diluted shares (000’s) 13 25 26 27 28 26 17 19 19 $ $ $ $ 41,395 6,906 2,236 2,061 1,422 544 54,564 17,157 3,712 2,560 23,429 31,135 14,372 4,763 1,547 9,407 30,089 26,888 423 27,311 2,778 (8,682) (5,904) 25,231 3,953 5,040 8,993 16,238 (1,519) (3,736) (5,255) 21,493 1.22 1.42 17,579 $ $ $ $ 32,593 5,007 1,593 1,281 1,342 592 42,408 12,293 3,407 1,058 16,758 25,650 20,718 5,714 814 9,001 36,247 29,844 573 30,417 5,830 228 6,058 31,708 3,234 3,626 6,860 24,848 (2,072) (183) (2,255) 27,103 1.68 1.81 16,147 The accompanying notes and shaded areas of the “Risk Factors” and “Risk Management” sections of Management’s Discussion and Analysis of Operations are an integral part of these consolidated financial statements. - 45 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (in thousands of Canadian dollars) Years Ended December 31 Net income Other comprehensive income Change in unrealized gain on available for sale marketable securities Transfer of gains on sale of marketable securities to net income Change in unrealized gain on available for sale financial investments Less: deferred taxes 2012 2011 $ 21,493 $ 27,103 1,527 (943) 190 (140) 634 736 - 1,249 (306) 1,679 Comprehensive income $ 22,127 $ 28,782 CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY (in thousands of Canadian dollars) Years Ended December 31 Share capital Balance, beginning of year Common shares issued Balance, end of year Contributed surplus Balance, beginning of year Changes to contributed surplus Balance, end of year Retained earnings Balance, beginning of year Net income Dividends declared Balance, end of year Available for sale reserve Balance, beginning of year Other comprehensive income Balance, end of year Total shareholders’ equity Note 2012 2011 22 23 $ 132,817 22,188 155,005 $ 100,112 32,705 132,817 510 - 510 23,491 21,493 (24,999) 19,985 1,647 634 2,281 510 - 510 24,489 27,103 (28,101) 23,491 (32) 1,679 1,647 $ 177,781 $ 158,465 The accompanying notes and shaded areas of the “Risk Factors” and “Risk Management” sections of Management’s Discussion and Analysis of Operations are an integral part of these consolidated financial statements. - 46 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands of Canadian dollars) Years Ended December 31 2012 2011 Cash provided by (used for): Operating Activities Net income Adjusted for non-cash items: Current taxes Deferred taxes Equity income Provision for credit losses Fair market value adjustment - derivative financial instruments Amortization of securitized mortgage and liability transaction costs Amortization of other assets Amortization of mortgage discounts Amortization of premium on marketable securities Gain on sale of financial investment Mortgage advances Mortgage reductions Proceeds on sale of mortgages Issuance of term deposits Repayment of term deposits Repayment of financial liabilities from securitization Decrease (increase) in other assets Increase (decrease) in other liabilities Cash flows (for) from operating activities Investing Activities Decrease (increase) in marketable securities Increase in short-term investments Decrease (increase) in financial investments Increase in foreclosed real estate Increase in equity investment in MCAP Commercial LP Decrease (increase) in other loans Proceeds on sale of financial investment Distributions from MCAP Commercial LP Cash flows from (for) investing activities Financing Activities Issue of common shares Dividends paid Cash flows (for) from financing activities Increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplementary Information Interest received Interest paid Taxes paid $ 21,493 $ 27,103 (1,519) (3,736) (6,906) 2,560 8,682 3,083 127 (332) 154 - (1,704,120) 1,400,526 762,382 575,609 (400,109) (1,096,911) (2,085) (2,520) (443,622) 10,190 (32,956) 559,509 (4,355) (14,000) (130) - - 518,258 22,188 (24,308) (2,120) 72,516 51,309 123,825 2012 62,755 39,915 58 $ $ (2,072) (183) (5,007) 1,058 (228) 3,610 110 (116) - (876) (1,204,705) 893,692 499,054 607,643 (427,127) (8,886) 2,552 3,623 389,245 (22,803) (124,538) (284,285) - - 305 1,619 1,057 (428,645) 32,705 (27,305) 5,400 (34,000) 85,309 51,309 2011 57,309 36,342 323 $ $ The accompanying notes and shaded areas of the “Risk Factors” and “Risk Management” sections of Management’s Discussion and Analysis of Operations are an integral part of these consolidated financial statements. - 47 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS Note Page Corporate Information ........................................................................................................................................................... 49  1.  Basis of Preparation ............................................................................................................................................................... 49  2.  Basis of Consolidation ........................................................................................................................................................... 49  3.  Summary of Significant Accounting Policies ........................................................................................................................ 50  4.  Significant Accounting Judgments and Estimates ................................................................................................................. 56  5.  Securitization Activities ........................................................................................................................................................ 57  6.  7.  Cash and Cash Equivalents ................................................................................................................................................... 59  8.  Marketable Securities ............................................................................................................................................................ 59  9.  Mortgages - Corporate ........................................................................................................................................................... 60  10.  Foreclosed Real Estate .......................................................................................................................................................... 63  11.  Financial Investments ............................................................................................................................................................ 63  12.  Other Loans ........................................................................................................................................................................... 64  13.  Equity Investment in MCAP Commercial LP ....................................................................................................................... 64  14.  Other Assets .......................................................................................................................................................................... 65  15.  Short-Term Investments ........................................................................................................................................................ 65  16.  Mortgages - Securitized ......................................................................................................................................................... 65  17.  Derivative Financial Instruments ........................................................................................................................................... 66  18.  Term Deposits ....................................................................................................................................................................... 67  Income Taxes ........................................................................................................................................................................ 67  19.  20.  Other Liabilities ..................................................................................................................................................................... 68  21.  Financial Liabilities from Securitization ............................................................................................................................... 69  22.  Share Capital and Contributed Surplus .................................................................................................................................. 69  23.  Dividends .............................................................................................................................................................................. 70  24.  Available for Sale Reserve .................................................................................................................................................... 70  25.  Fees ....................................................................................................................................................................................... 70  26.  Mortgage Expenses ............................................................................................................................................................... 71  27.  Provision for Credit Losses ................................................................................................................................................... 71  28.  Other Securitization Income .................................................................................................................................................. 71  29.  Related Party Disclosures ...................................................................................................................................................... 71  30.  Commitments and Contingencies .......................................................................................................................................... 73  31.  Credit Facilities ..................................................................................................................................................................... 73  Interest Rate Sensitivity ......................................................................................................................................................... 74  32.  33.  Capital Management .............................................................................................................................................................. 76  34.  Financial Instruments ............................................................................................................................................................ 77  35.  Standards Issued But Not Effective ....................................................................................................................................... 78  36.  Comparative Amounts ........................................................................................................................................................... 80  - 48 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 1. Corporate Information MCAN Mortgage Corporation (the “Company” or “MCAN”) is a Loan Company under the Trust and Loan Companies Act (the “Trust Act”) and a Mortgage Investment Corporation (“MIC”) under the Income Tax Act (Canada) (the “Tax Act”). As a Loan Company under the Trust Act, the Company is subject to the guidelines and regulations set by the Office of the Superintendent of Financial Institutions Canada (“OSFI”). The Company’s primary objective is to generate a reliable stream of income by investing its corporate funds in a portfolio of mortgages (including single family residential, residential construction, non-residential construction and commercial loans), as well as other types of financial investments, loans and real estate investments. MCAN employs leverage by issuing term deposits eligible for Canada Deposit Insurance Corporation (“CDIC”) deposit insurance up to a maximum of five times capital (on a non-consolidated tax basis) as limited by the provisions of the Tax Act applicable to a MIC. The term deposits are sourced through a network of independent financial agents. As a MIC, MCAN is entitled to deduct from income for tax purposes 50% of capital gains dividends and 100% of other dividends paid. Such dividends are received by shareholders as capital gains dividends and interest income, respectively. MCAN also participates in the Canada Mortgage Bonds (“CMB”) program, and other securitizations of insured mortgages. For further details, refer to Note 6. MCAN is incorporated in Canada. Its head office is located at 200 King Street West, Suite 400, Toronto, Ontario, Canada. MCAN is listed on the Toronto Stock Exchange under the symbol MKP. The consolidated financial statements were approved in accordance with a resolution of the Board of Directors on February 28, 2013. 2. Basis of Preparation The consolidated financial statements of the Company have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). The consolidated financial statements have been prepared on a historical cost basis, except for marketable securities, foreclosed real estate, certain financial investments designated as available for sale and derivative financial instruments, which have been measured at fair value. The consolidated financial statements are presented in Canadian dollars. The disclosures that accompany the consolidated financial statements include the significant accounting policies applied (Note 4) and the significant judgments and estimates applicable to the preparation of the consolidated financial statements (Note 5). The Company separates its assets into its corporate and securitization portfolios for reporting purposes. Corporate assets represent the Company’s core strategic investments, and are funded by term deposits and share capital. Securitization assets consist primarily of mortgages securitized through the CMB program and reinvestment assets purchased with mortgage principal repayments, and are funded by financial liabilities from securitization. 3. Basis of Consolidation The consolidated financial statements include the balances of MCAN and its subsidiaries as at December 31, 2012. All intra-group balances, transactions, income and expenses are eliminated in full. Subsidiaries are fully consolidated from the date on which control is transferred to the Company. Control is achieved where the Company has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. - 49 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies The following are the significant accounting policies applied by the Company in the preparation of its consolidated financial statements: (1) Financial instruments - initial recognition and subsequent measurement (i) Date of recognition All financial assets and liabilities are initially recognized on the trade date, which is the date that the Company becomes a party to the contractual provisions of the instrument. This includes purchases or sales of financial assets that require delivery of assets within the time frame generally established by market convention. (ii) Initial measurement of financial instruments The classification of financial instruments at initial recognition depends on the purpose and management’s intention for which the financial instruments were acquired and their characteristics. All financial instruments are measured initially at their fair value plus, in the case of financial instruments not subsequently recorded at fair value through the consolidated statements of income, directly attributable transaction costs. (iii) Derivatives recorded at fair value through the consolidated statements of income Derivatives are recorded at fair value and carried as assets when their fair value is positive and as liabilities when their fair value is negative. Changes in the fair value of derivatives are included in the consolidated statements of income. The Company uses derivative financial instruments such as interest rate swaps to hedge its interest rate risk as part of its participation in the CMB program. No derivative financial instruments have been designated for hedge accounting. (iv) Financial assets or financial liabilities held for trading Financial assets or financial liabilities held for trading are recorded at fair value. Changes in fair value are recognized in the consolidated statements of income. Interest income or expense is recorded in the consolidated statements of income on the accrual basis. A financial asset or financial liability is classified as held for trading if: (a) it is acquired or incurred principally for the purpose of selling or repurchasing in the near term; (b) on initial recognition it is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or (c) it is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument). (v) Financial assets and financial liabilities designated at fair value through the consolidated statements of income Financial assets and financial liabilities classified in this category are those that have been designated by management on initial recognition. Management may only designate an instrument at fair value through the consolidated statements of income upon initial recognition when the following criteria are met, and designation is determined on an instrument by instrument basis:  The designation eliminates or significantly reduces the inconsistent treatment that would otherwise arise from measuring the assets or liabilities or recognizing gains or losses on them on a different basis; or  The assets and liabilities are part of a group of financial assets, financial liabilities or both which are managed and their performance evaluated on a fair value basis, in accordance with a documented risk management or investment strategy; or  The financial instrument contains one or more embedded derivatives, which significantly modify the cash flows that otherwise would be required by the contract. - 50 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) Financial assets and financial liabilities designated at fair value through the consolidated statements of income are recorded in the consolidated financial statements at fair value. Changes in fair value are recorded in the consolidated statements of income. Interest earned or incurred is accrued in interest income or interest expense, respectively, using the effective interest rate method (“EIRM”), while dividend income is recorded in income when the right to the payment has been established. (vi) “Day 1” profit or loss When the transaction price is different from the fair value of other observable current market transactions in the same instrument or based on a valuation technique whose variables include only data from observable markets, the Company immediately recognizes the difference between the transaction price and fair value (a “Day l” profit or loss). In cases where fair value is determined using data which is not observable, the difference between the transaction price and model value is only recognized in the consolidated statements of income when the inputs become observable, or when the instrument is derecognized. (vii) Available for sale financial investments Available for sale investments include marketable securities and an equity investment in commercial real estate. Equity investments classified as available for sale are those that are neither classified as held for trading nor designated at fair value through the consolidated statements of income. Certain marketable securities are intended to be held for an indefinite period of time but may be sold in response to needs for liquidity or in response to changes in the market conditions. (viii) Held to maturity financial investments Held to maturity financial investments are non-derivative financial assets with fixed or determinable payments and fixed maturities which the Company has the intention and ability to hold to maturity. After initial measurement at fair value, held to maturity financial investments are subsequently measured at amortized cost using the EIRM, less impairment. Amortized cost is calculated by taking into account any discount or premium on acquisition and fees that are an integral part of the EIRM. The amortization is included in interest on financial investments and other loans in the consolidated statements of income. The losses arising from impairment of such investments are recognized in the consolidated statements of income. The Company has not designated any financial assets as held to maturity. (ix) Loans and receivables Loans and receivables include mortgages, other loans, non-derivative financial assets and certain financial investments with fixed or determinable payments that are not quoted in an active market, other than:  Those that the Company intends to sell immediately or in the near term and those that the Company upon initial recognition designates at fair value;  Those that the Company, upon initial recognition, designates as available for sale; or  Those for which the Company may not recover substantially all of its initial investment, other than because of credit deterioration. After initial measurement, loans and receivables are subsequently measured at amortized cost using the EIRM, less allowance for impairment. Amortized cost is calculated by taking into account any discount or premium on acquisition and fees and costs that are an integral part of the EIRM. The amortization is included in mortgage interest income or interest on financial investments and other loans in the consolidated statements of income. The losses arising from impairment are recognized in the consolidated statements of income. (x) Financial liabilities After initial recognition, interest bearing financial liabilities are subsequently measured at amortized cost using the EIRM. Premiums and discounts on the liabilities are recognized in the consolidated statements of income when the liabilities are extinguished as well as through amortization using the EIRM. Amortized cost is calculated by taking into account any discount or premium on acquisition and fees or costs that are an integral part of the effective interest rate (“EIR”). The EIR amortization is included in the related line in the consolidated statements of income. - 51 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) (xi) Transaction costs Transaction costs are incremental costs that are directly attributable to the acquisition, issue or disposal of a financial asset or financial liability. These costs are defined as costs that would not have been incurred if the Company had not acquired, issued or disposed of the related financial instrument. Transaction costs are capitalized and amortized over the expected life of the instrument using the EIRM, except for transaction costs which are related to financial assets or financial liabilities classified as held for trading or designated at fair value, which are expensed. (2) Derecognition of financial assets and financial liabilities (i) Financial assets A financial asset (or, where applicable a part of a financial asset or part of a group of similar financial assets) is derecognized when:   The rights to receive cash flows from the asset have expired; or The Company has transferred its rights to receive cash flows from the asset or has assumed an obligation to pay the received cash flows in full without material delay to a third party under a “pass-through” arrangement; and either:   the Company has transferred substantially all the risks and rewards of the asset, or the Company has neither transferred nor retained substantially all the risks and rewards of the asset, but has transferred control of the asset. When the Company has transferred its rights to receive cash flows from an asset or has entered into a pass-through arrangement, and has neither transferred nor retained substantially all the risks and rewards of the asset nor transferred control of the asset, the asset is recognized to the extent of the Company’s continuing involvement in the asset. In that case, the Company also recognizes an associated liability. The transferred asset and the associated liability are measured on a basis that reflects the rights and obligations that the Company has retained. (ii) Financial liabilities A financial liability is derecognized when the obligation under the liability is discharged or cancelled or expires. Where an existing financial liability is replaced by another from the same lender on substantially different terms, or the terms of an existing liability are substantially modified, such an exchange or modification is treated as a derecognition of the original liability and the recognition of a new liability, and the difference in the respective carrying amounts is recognized in the consolidated statements of income. (3) Determination of fair value The fair value for financial instruments traded in active markets is based on their quoted market price or other trading data, without any deduction for transaction costs. For all other financial instruments not traded in an active market, the fair value is determined by using appropriate valuation techniques. Valuation techniques include the discounted cash flow method, comparison to similar instruments for which market observable prices may exist and other relevant valuation models. Certain financial instruments are recorded at fair value using valuation techniques in which current market transactions or observable market data are not available. Where available, their fair value is determined using a valuation model that has been tested against prices or inputs to actual market transactions and using the Company’s best estimate of the most appropriate model assumptions. The fair value of certain real estate assets is determined using independent appraisals. Models and valuations are adjusted to reflect counterparty credit and liquidity spread and limitations in the models. (4) Non-current assets held for sale Held-for-sale foreclosed assets in the settlement of an impaired mortgage are initially carried at fair market value less costs to sell. In subsequent measurements, the asset is carried at the lower of its carrying amount and fair market value less the estimated cost to sell at the date of foreclosure. Any difference between the carrying value of the asset before foreclosure and the initially estimated realizable amount of the asset is recorded in the provision for credit losses line of the consolidated statements of income. - 52 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) (5) Impairment of financial assets The Company assesses at each consolidated financial statement date whether there is any objective evidence that a financial asset or a group of financial assets is impaired. A financial asset or a group of financial assets is deemed to be impaired if, and only if, there is objective evidence of impairment as a result of one or more events that have occurred after the initial recognition of the asset (an incurred “loss event”) and that loss event (or events) has an impact on the estimated future cash flows of the financial asset or the group of financial assets that can be reliably estimated. Evidence of impairment may include indications that the borrower or a group of borrowers is experiencing significant financial difficulty, the probability that they will enter bankruptcy or other financial reorganization, default or delinquency in interest or principal payments and where observable data indicates that there is a measurable decrease in the estimated future cash flows, such as changes in arrears or economic conditions that correlate with defaults. (i) Financial assets carried at amortized cost For financial assets carried at amortized cost, the Company first assesses individually whether objective evidence of impairment exists for financial assets that are significant, or collectively for financial assets that are not individually significant. If the Company determines that no objective evidence of impairment exists for an individually assessed financial asset, it includes the asset in a group of financial assets with similar credit risk characteristics and collectively assesses them for impairment. Assets that are individually assessed for impairment and for which an impairment loss is, or continues to be, recognized are not included in a collective assessment of impairment. If there is objective evidence that an impairment loss has occurred, the amount of the loss is measured as the difference between the asset’s carrying amount and the present value of estimated future cash flows (excluding future expected credit losses that have not yet been incurred). The carrying amount of the asset is reduced through the use of an allowance account and the amount of the loss is recognized in the consolidated statements of income. Interest income continues to be accrued on the reduced carrying amount and is accrued using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss. The interest income is recorded as part of the related interest income component. Mortgages, together with the associated allowance, are written off when there is no realistic prospect of future recovery and all collateral has been realized or has been transferred to the Company. If, in a subsequent period, the amount of the estimated impairment loss increases or decreases because of an event occurring after the impairment was recognized, the previously recognized impairment loss is increased or reduced by adjusting the allowance account. If a future write-off is later recovered, the recovery is credited to the provision for credit losses. The present value of the estimated future cash flows is discounted at the financial asset’s original EIR. If a mortgage has a variable interest rate, the discount rate for measuring any impairment loss is the current EIR. The calculation of the present value of estimated future cash flows reflects the projected cash flows less costs to sell. For the purpose of a collective evaluation of impairment, financial assets are grouped on the basis of the Company’s internal system that considers credit risk characteristics such as asset type, industry, geographical location, collateral type, past-due status and other relevant factors. Future cash flows on a group of financial assets that are collectively evaluated for impairment are estimated on the basis of historical loss experience for assets with credit risk characteristics similar to those in the group. Historical loss experience is adjusted on the basis of current observable data to reflect the effects of current conditions on which the historical loss experience is based and to remove the effects of conditions in the historical period that do not exist currently. Estimates of changes in future cash flows reflect, and are directionally consistent with, changes in related observable data from year to year (such as changes in unemployment rates, property prices, payment status or other factors that are indicative of incurred losses in the group and their magnitude). The methodology and assumptions used for estimating future cash flows are reviewed regularly to reduce any differences between loss estimates and actual loss experience. (ii) Available for sale financial investments For available for sale financial investments, the Company assesses at the consolidated financial statement date whether there is objective evidence that an investment or a group of investments is impaired. - 53 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) In the case of equity investments classified as available for sale, one of the indications of impairment would include a significant or prolonged decline in the fair value of the investment below its cost. ‘Significant’ is evaluated against the original cost of the investment and ‘prolonged’ against the period in which the fair value has been below its original cost. Where there is evidence of impairment, the cumulative loss - measured as the difference between the acquisition cost and the current fair value, less any impairment loss on that investment previously recognized in the consolidated statements of income - is removed from other comprehensive income and recognized in the consolidated statements of income. Impairment losses on equity investments are not reversed through the consolidated statements of income; increases in their fair value after impairment are recognized directly in other comprehensive income. In the case of debt instruments classified as available for sale, impairment is assessed based on the same criteria as financial assets carried at amortized cost. However, the amount recorded for impairment is the cumulative loss measured as the difference between the amortized cost and the current fair value, less any impairment loss on that investment previously recognized in the consolidated statements of income. Future interest income continues to be accrued based on the reduced carrying amount of the asset, using the rate of interest used to discount the future cash flows for the purpose of measuring the impairment loss. The interest income is recorded to the related interest income component. If, in a subsequent year, the fair value of a debt instrument increases and the increase can be objectively related to an event occurring after the impairment loss was recognized in the consolidated statements of income, the impairment loss is reversed through the consolidated statements of income. (6) Offsetting financial instruments Financial assets and financial liabilities where MCAN is considered the principal to the underlying transactions are offset and the net amount reported in the consolidated financial statements if, and only if, there is a currently enforceable legal right to offset the recognized amounts and there is an intention to settle on a net basis, or to realize the asset and settle the liability simultaneously. (7) Taxes (i) Current tax Current tax assets and liabilities are measured at the amount expected to be recovered from or paid to the taxation authorities. The tax rates and tax laws used to compute the amount are those that are enacted or substantively enacted at the consolidated financial statement date. Current tax relating to items recognized directly to shareholders’ equity is recognized in equity and not in the consolidated statements of income. Management periodically evaluates positions taken in the Company’s tax returns with respect to situations in which applicable tax regulations are subject to interpretation, and establishes provisions where appropriate. (ii) Deferred tax Deferred tax is provided on temporary differences at the consolidated financial statement date between the tax bases of assets and liabilities and their carrying amounts for financial reporting purposes. Deferred tax liabilities are recognized for all taxable temporary differences, except:  In respect of taxable temporary differences associated with investments in subsidiaries or associates and interests in joint ventures where the timing of the reversal of the temporary differences can be controlled and it is probable that the temporary differences will not reverse in the foreseeable future. Deferred tax assets are recognized for all deductible temporary differences, carry forward of unused tax credits and unused tax losses, to the extent that it is probable that taxable income will be available against which the deductible temporary differences, and the carry forward of unused tax credits and unused tax losses can be used, except in the following instances:  Where the deferred tax asset relating to the deductible temporary difference arises from the initial recognition of an asset or liability in a transaction that is not a business combination and, at the time of the transaction, affects neither the accounting income nor taxable income; and  In respect of deductible temporary differences associated with investments in subsidiaries or associates and interests in joint ventures, deferred tax assets are recognized only to the extent that it is probable that the temporary differences will reverse in the foreseeable future and taxable income will be available against which the temporary differences can be utilized. - 54 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) The carrying amount of deferred tax assets is reviewed at each consolidated financial statement date and reduced to the extent that it is no longer probable that sufficient taxable income will be available to allow all or part of the deferred tax asset to be utilized. Unrecognized deferred tax assets are reassessed at each consolidated financial statement date and are recognized to the extent that it has become probable that future taxable income will allow the deferred tax asset to be recovered. Deferred tax assets and liabilities are measured at the tax rates that are expected to apply in the year when the asset is realized or the liability is settled, based on tax rates (and tax laws) that have been enacted or substantively enacted at the consolidated financial statement date. Deferred tax relating to items recognized directly in shareholders’ equity is recognized in shareholders’ equity and not in the consolidated statements of income. Deferred tax assets and deferred tax liabilities are offset if a legally enforceable right exists to set off current tax assets against current tax liabilities and the deferred taxes relate to the same taxable entity and the same taxation authority. (8) Dividends on common shares Dividends on common shares are deducted from shareholders’ equity in the quarter that they are approved. Dividends that are approved after the consolidated financial statement date are disclosed as an event after the consolidated financial statement date. (9) Investments in associates The Company’s investments in its associates are accounted for using the equity method. An associate is an entity in which the Company has significant influence. Under the equity method, the investment in the associate is carried on the consolidated balance sheets at cost plus post acquisition changes in the Company’s share of net assets of the associate. The consolidated statements of income reflect the share of the results of operations of the associate. Where there has been a change recognized directly in the equity of the associate, the Company recognizes its share of any changes and discloses this, when applicable, in the consolidated statements of changes in shareholders’ equity. Unrealized gains and losses resulting from transactions between the Company and the associate are eliminated to the extent of the interest in the associate. The most recent available financial statements of the associate are used by the investor in applying the equity method. When the financial statements of an associate used in applying the equity method are prepared as of a different date from that of the investor, adjustments shall be made for the effects of significant transactions or events that occur between that date and the date of the investor’s financial statements. Where necessary, adjustments are made to harmonize the accounting policies of the associate with those of the Company. After application of the equity method, the Company determines whether it is necessary to recognize an additional impairment loss on the Company’s investment in its associate. The Company determines at each consolidated financial statement date whether there is any objective evidence that the investment in the associate is impaired. If this is the case, the Company then calculates the amount of impairment as the difference between the recoverable amount of the associate and its carrying value and recognizes the amount in the consolidated statements of income. (10) Revenue recognition Revenue is recognized to the extent that it is probable that the economic benefits will flow to the Company and that the revenue can be reliably measured, regardless of when the payment is being made. Revenue is measured at the fair value of the consideration received or receivable, taking into account contractually defined terms of payment and excluding taxes and duty. The Company assesses its revenue arrangements against specific criteria in order to determine if it is acting as principal or agent. The Company has concluded that it is acting as a principal in all of its revenue arrangements. Interest income or expense For all financial investments measured at amortized cost and interest bearing financial assets classified as available for sale, interest income or expense is recorded using the EIRM, which reflects the rate that exactly discounts the estimated future cash payments or receipts through the expected life of the financial instrument or a shorter period, where appropriate, to the net carrying amount of the financial asset or liability. Interest income or expense is included in the appropriate component of the consolidated statements of income. - 55 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 4. Summary of Significant Accounting Policies (continued) (11) Cash and short-term investments Cash and short-term investments on the consolidated balance sheets comprise cash held at banks and short-term deposits with original maturity dates of less than 90 days. (12) Share-based payment transactions The cost of cash-settled transactions is measured initially at fair value at the grant date, further details of which are discussed in Note 29. The obligations are adjusted for fluctuations in the market price of the Company’s common shares. Changes in the obligations are recorded as salaries and benefits in the consolidated statements of income with a corresponding change to other liabilities. The liability is re-measured at fair value at each consolidated financial statement date up to and including the settlement date. 5. Significant Accounting Judgments and Estimates The preparation of the Company’s consolidated financial statements requires management to make judgments, estimates and assumptions that affect the reported amounts of revenues, expenses, assets and liabilities, and the disclosure of contingent liabilities, at the end of the reporting period. However, uncertainty about these assumptions and estimates could result in outcomes that require a material adjustment to the carrying amount of the asset or liability affected in future periods. Going concern The Company’s management has made an assessment of the Company’s ability to continue as a going concern and is satisfied that the Company has the resources to continue in business for the foreseeable future. Furthermore, management is not aware of any material uncertainties that may cast significant doubt upon the Company’s ability to continue as a going concern. Therefore, the consolidated financial statements continue to be prepared on the going concern basis. Fair value of financial instruments Where the fair values of financial assets and financial liabilities recorded in the consolidated financial statements cannot be derived from active markets, they are determined using a variety of valuation techniques that include the use of mathematical models. The inputs to these models are derived from observable market data where possible, but where observable market data are not available, judgment is required to establish fair values. The judgments include considerations of liquidity and model inputs such as discount rates, prepayment rates and default rate assumptions for certain investments. Impairment losses on mortgages The Company reviews its individually significant mortgage balances at each consolidated financial statement date to assess whether an impairment loss should be recorded in the consolidated statements of income. In particular, judgment by management is required in the estimation of the amount and timing of future cash flows when determining the impairment loss. In estimating these cash flows, the Company makes judgments about the borrower’s financial situation and the net realizable value of collateral. These estimates are based on assumptions about a number of factors and actual results may differ, resulting in future changes to the allowance. Mortgages that have been assessed individually and found not to be impaired and all individually insignificant mortgages are then assessed collectively, in groups of mortgages with similar risk characteristics, to determine whether a provision should be made due to incurred loss events for which there is objective evidence but whose effects are not yet evident. The collective assessment takes account of data from the mortgage portfolio (such as credit quality, levels of arrears, credit utilization, loan to value ratios, etc.), concentrations of risks and economic data (including levels of unemployment, real estate prices indices and the performance of different individual groups). Taxes Uncertainties exist with respect to the interpretation of complex tax regulations, changes in tax laws and the amount and timing of future taxable income. Differences arising between the actual results and the assumptions made, or future changes to such assumptions, could necessitate future adjustments to tax income and expense already recorded. The Company establishes provisions, based on reasonable estimates, for possible consequences of audits by relevant tax authorities. The amount of such provisions is based on various factors, such as experience of previous tax audits and interpretations of tax regulations by the responsible tax authority. As the Company assesses the probability for a litigation and subsequent cash outflow with respect to taxes as remote, no contingent liability has been recognized. - 56 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 5. Significant Accounting Judgments and Estimates (continued) Deferred tax assets are recognized for all unused tax losses to the extent that it is probable that taxable income will be available against which the losses can be used. Significant management judgment is required to determine the amount of deferred tax assets that can be recognized, based upon the likely timing and the level of future taxable income together with future tax planning strategies. Further details on taxes are disclosed in Note 19. 6. Securitization Activities The Company participates in the National Housing Act (“NHA”) mortgage-backed securities (“MBS”) program, which involves the securitization of insured mortgages to create MBS. Pursuant to the NHA MBS program, investors of MBS receive monthly cash flows consisting of interest and scheduled and unscheduled principal payments. Canada Mortgage and Housing Corporation (“CMHC”) makes principal and interest payments in the event of any NHA MBS default by the issuer, thus fulfilling the timely payment obligation to investors. To date, the Company has sold MBS as part of the CMB program, the Insured Mortgage Purchase Program (“IMPP”) and a market MBS program, which are discussed below. CMB Program MCAN participates in the CMB program, which involves the sale of MBS to the Canada Housing Trust (“CHT”). On the sale of MBS to CHT, MCAN receives proceeds for the sale, incurs a liability in the amount of such proceeds received and is obligated to pay interest on this liability, which does not amortize over the term of the issuance and is payable in full at maturity. The securitized mortgages and reinvestment assets are held as collateral against the CMB liabilities. Over the term of a CMB issuance, MCAN is entitled to interest income received from the securitized mortgages. As the securitized mortgages repay, MCAN reinvests the collected principal in certain permitted investments and is also entitled to interest income from the reinvested assets. MCAN also recognizes servicing expenses on the mortgages and pays certain upfront costs. MCAN participates in the CMB program with MCAP Commercial LP and its wholly owned subsidiaries including MCAP Service Corporation (collectively “MCAP”). MCAN participates in the economics of each CMB issuance in accordance with a pre-determined economic sharing percentage, which dictates the upfront and ongoing cash flow rights and obligations of the participants. MCAN’s weighted average economic participation for outstanding CMB issuances as at December 31, 2012 was 30% (December 31, 2011 - 28%). MCAP has indemnified MCAN for the remaining 70% of CMB program obligations (December 31, 2011 - 72%). The sales to CHT failed to meet derecognition criteria since MCAN did not transfer substantially all risks and rewards on sale. The primary risk retained was mortgage prepayment risk, while the primary reward retained was the excess of mortgage interest income and reinvestment asset interest over securitization liability interest. Interest rate risk is largely mitigated by the interest rate swaps discussed below, and credit risk is minimal as all mortgages securitized through the NHA MBS program are insured. MCAN accounted for these transactions as collateralized borrowings and recorded cash received as a financial liability from securitization. As a result of its failure to meet derecognition criteria on the sale of the securitized mortgages to CHT, MCAN recognizes 100% of the mortgages (Note 16), reinvestment assets (Notes 11 and 15) and securitization liabilities (Note 21) on the consolidated balance sheets until the maturity of the CMB issuance. MCAN recognizes its 30% share of mortgage interest income, principal reinvestment income, interest expense on the securitization liabilities and certain other program expenses on the accrual basis. MCAN has also capitalized certain costs associated with the securitized mortgages and securitization liabilities, both of which are amortized using the EIRM. The Company enters into “pay floating, receive fixed” interest rate swaps as part of the CMB program (Note 17). The purpose of the interest rate swaps is to hedge interest rate risk on both securitized mortgages and principal reinvestment assets that have a floating interest rate, as substantially all interest payments on the securitization liabilities are fixed rate. The interest rate swaps are classified as held for trading, where changes in fair value are recorded through the consolidated statements of income. From an economic perspective, these fair value changes are generally offset by changes in future expected income from securitized mortgages and principal reinvestment assets that have a floating interest rate. From an accounting perspective, changes in future expected income from these floating rate assets are not reflected in the consolidated statements of income, which can cause volatility to the consolidated statements of income since there is no offset to fair value changes in the interest rate swaps. - 57 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 6. Securitization Activities (continued) Other MBS Programs Insured Mortgage Purchase Program The Company participated in the IMPP, which involved the sale of MBS to CMHC by MCAN. Although MCAN has no continuing economic involvement in the IMPP, it earned an up-front fee for its participation. MCAN participated in the IMPP on behalf of MCAP, who is entitled to 100% of the ongoing economics and cash flows of the IMPP. MCAN purchased certain mortgages from MCAP that were subsequently securitized into MBS as part of the IMPP. These mortgage sales from MCAP to MCAN failed to meet derecognition criteria, since MCAP retained substantially all risks and rewards as part of the aforementioned entitlement to all economics and cash flows. As a result of this, at the time of sale MCAN recognized a corresponding financial investment representing a receivable from MCAP (Note 11) and financial liability from securitization representing the securitization proceeds received from CMHC (Note 21). MCAN is the counterparty for the ongoing cash flows between MCAP and CMHC in its role as the IMPP counterparty. Market MBS Program In 2011, the Company commenced the market MBS program, under which it sells MBS into the market and the net economics and cash flows from the underlying mortgages (“interest-only strips”) to a third party. To date, all interest-only strip sales have been made to MCAP. MCAN met derecognition criteria on the sale of the mortgages (i.e. upon creation of MBS and subsequent sales of MBS and interest-only strips to third parties) since it transferred substantially all risks and rewards on sale, and accordingly they were removed from the consolidated balance sheet at that time. The primary risk associated with the market MBS program is liquidity risk, specifically the obligation to fund 100% of any cash shortfall related to the Timely Payment Guarantee (discussed below) as part of the market MBS program. The primary reward associated with the market MBS program is the excess of mortgage interest income over the MBS interest. The risks and rewards are both transferred to the purchaser of the interest-only strips pursuant to contractual agreements entered into with such purchaser. In 2012, MCAN recognized $978 of income (2011 - $261) related to the sale of MBS and the interest-only strips associated with the underlying mortgages. The Company has no continuing economic involvement with the MBS and the interest- only strips on the underlying mortgages. The Company only earns income from this program at the time of sale of the MBS and interest-only strips. Timely Payment Guarantee Consistent with all issuers of MBS, the Company is required to remit a “timely payment” to MBS investors (representing scheduled principal and interest payments), even if these mortgage payments have not been collected from mortgagors. Similarly, at the maturity of the MBS pools that have been issued by MCAN, any outstanding principal must be paid to the MBS investors. As part of the CMB program, MCAP is responsible for its pro-rata share of the timely payment guarantee obligations noted above based on its respective contracted economic participation. As part of the IMPP, MCAP is obligated to fund 100% of any cash shortfall. As part of the market MBS program, the purchaser of the interest-only strip is obligated to fund 100% of any cash shortfall. During 2012, the Company adopted certain amendments to IFRS 7, Financial Instruments: Disclosures. The amendments require additional disclosure about financial assets that have been transferred but not derecognized to enable the user of the Company’s consolidated financial statements to understand the relationship with those assets that have not been derecognized and their associated liabilities. In addition, the amendments require disclosures about continuing involvement in derecognized assets to enable the user to evaluate the nature of, and risks associated with, the entity’s continuing involvement in those derecognized assets. The adoption of IFRS 7 had no impact on the Company’s financial position or net income. Transferred financial assets that are not derecognized in their entirety CMB Program As a result of the failure to meet derecognition criteria, the CMB mortgage sale transactions have resulted in MCAN recognizing the securitized mortgages, reinvestment assets and financial liabilities from securitization on its balance sheet. The remaining securitized mortgage balance as at December 31, 2012 was $936,947 (December 31, 2011 - $1,499,016) (Note 16). The reinvestment asset balance as at December 31, 2012 was $878,588 (December 31, 2011 - $1,402,050) (Notes 11 and 15). The financial liabilities from securitization balance as at December 31, 2012 was $1,855,051 (December 31, 2011 - $2,944,209) (Note 21). - 58 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 6. Securitization Activities (continued) Insured Mortgage Purchase Program As a result of the failure to meet derecognition criteria, the IMPP mortgage sale transactions have resulted in MCAN recognizing a loan receivable from MCAP and a loan payable to the IMPP counterparty on its consolidated balance sheet. The balance of both loans as at December 31, 2012 was $159,995 (December 31, 2011 - $167,148) (Notes 11 and 21). Transferred financial assets that are derecognized in their entirety but where the Company has a continuing involvement Market MBS Program The Company sold $284,143 of MBS through the market MBS program during 2012 (2011 - $26,132), and has sold $310,275 since the inception of the program. MCAN recognized $978 of income in 2012 (2011 - $261), and has recognized $1,239 of income since the inception of the program. MCAN met derecognition criteria on the sale of the mortgages (i.e. on creation and sale of MBS) and the interest-only strips as a result of the transfer of substantially all risks and rewards, and accordingly they were removed from the consolidated balance sheet at that time. MCAN’s continuing involvement relates to the Timely Payment Guarantee obligation noted above. Similarly, at the maturity of the MBS pools that have been issued by MCAN, any outstanding principal must be paid to the MBS investors. The total outstanding MBS balance related to the market MBS program as at December 31, 2012 was $295,948 (December 31, 2011 - $26,054), which was not reflected as an asset or liability on MCAN’s consolidated balance sheet at either date. The MBS mature as follows: 2016 - $48,378, 2017 - $247,570. 7. Cash and Cash Equivalents As at December 31 Cash balances with banks Bankers’ acceptances and term deposits 2012 $ $ 11,825 112,000 123,825 $ $ 2011 8,309 43,000 51,309 Cash and cash equivalents include balances with banks and short-term investments with original maturity dates of less than 90 days. Refer to Note 31 for an analysis of the Company’s available credit facilities. 8. Marketable Securities As at December 31 Corporate bonds Real estate investment trusts Exchange-traded funds 2012 8,491 7,825 4,074 20,390 $ $ 2011 15,819 11,283 3,047 30,149 $ $ Marketable securities are designated as available for sale. Corporate bonds mature between 2015 and 2022, while real estate investment trusts and exchange-traded funds have no specific maturity date. Fair values are based on bid prices quoted in active markets, and changes in fair value are recognized in the consolidated statements of comprehensive income. - 59 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 9. Mortgages - Corporate (a) Summary As at December 31, 2012 Corporate portfolio: Single family mortgages - Uninsured - Uninsured (completed inventory loans) - Insured Construction loans - Residential - Non-residential Commercial loans - Uninsured - Insured As at December 31, 2011 Corporate portfolio: Single family mortgages - Uninsured - Uninsured (completed inventory loans) - Insured Construction loans - Residential - Non-residential Commercial loans - Uninsured - Insured Gross Principal Collective Allowance Individual Total Net Principal $ $ 271,662 20,315 76,104 274,977 26,585 74,605 - $ 744,248 $ 1,135 80 - 1,748 166 594 - 3,723 $ $ 147 150 - 300 - 116 - 713 $ 1,282 230 - $ 270,380 20,085 76,104 2,048 166 272,929 26,419 710 - 4,436 73,895 - $ 739,812 $ Gross Principal Collective Allowance Individual Total Net Principal $ $ 261,724 36,270 77,558 191,628 18,861 54,645 3,744 $ 644,430 $ 1,031 166 - 1,219 119 384 - 2,919 $ $ 102 - - 1,133 166 - $ 260,591 36,104 77,558 1,000 - 58 - 1,160 $ 2,219 119 189,409 18,742 442 - 4,079 54,203 3,744 $ 640,351 $ Gross principal as presented in the tables above includes unamortized capitalized transaction costs. MCAN’s corporate mortgage portfolio includes insured and uninsured single family mortgages. The Company does not invest in the United States mortgage market. Uninsured mortgages may not exceed 80% of the value of the real estate securing such loans at the time of funding. Residential mortgages insured by CMHC or Genworth Financial Mortgage Insurance Company Canada Inc. (“Genworth”) may exceed this ratio. Uninsured completed inventory loans are credit facilities extended to provide interim mortgage financing on residential units (condominium or freehold), where all construction has been completed. Residential construction loans are made to homebuilders to finance residential construction projects. Non-residential construction loans provide construction financing for retail shopping developments, office buildings and industrial developments. Commercial loans include commercial term mortgages and high ratio mortgage loans. The weighted average yield of the Company’s corporate mortgage portfolio is as follows: As at December 31 Single family Construction Commercial Total 2012 4.63% 5.95% 6.94% 5.39% 2011 5.48% 6.49% 5.63% 5.82% - 60 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 9. Mortgages - Corporate (continued) Mortgages are classified as loans and receivables and are carried at amortized cost. The fair market value of the corporate mortgage portfolio as at December 31, 2012 was $742,779 (December 31, 2011 - $644,361). Fair market values are calculated on a discounted cash flow basis using the prevailing market rates for similar mortgages. Outside of the change during the periods shown in the above tables, there were no significant fluctuations in mortgage balances within the periods. For information regarding the maturity dates of the Company’s mortgages, refer to Note 32. As at December 31, 2012, the Company held $12,565 of second uninsured single family mortgages (December 31, 2011 - $969). As at December 31, 2012, the Company had $11,981 (December 31, 2011 - $nil) of insured single family mortgages pledged as collateral as part of the CMB program. Outstanding commitments for future fundings of mortgages intended for the Company’s corporate portfolio were $247,587 at December 31, 2012 (December 31, 2011 - $296,666). The majority of these commitments relate to floating rate construction loans. (b) Discounted mortgages Principal balances presented in section (a) are net of the unamortized discount on the Company’s portfolio of single family mortgages purchased at a discount. As at December 31, 2012, the Company held discounted mortgages with an aggregate discount of $5,874 (December 31, 2011 - $9,141). Upon the payout of a mortgage, the remaining unamortized discount is recognized in mortgage interest income. The Company retains 50% of any recoveries of the discount and pays the remaining 50% to MCAP (refer to Note 29 for profit sharing fees paid to/from MCAP). In addition, the Company amortizes the portion of the discount that it expects to recover into income over the remaining term of the mortgage on an EIRM basis. The amount of the discount ultimately recovered is dependent on the value of the real estate securing the mortgage, as well as the financial capacity of the borrower. Additionally, these mortgages have maturity dates ranging from 2013 (for certain fixed rate mortgages) to 2032 (for certain floating rate mortgages). The recognition of discount income is based on management’s expectations as to when cash will be received. The composition of the discount is as follows: As at December 31 Fixed rate Floating rate (c) Geographic Analysis 2012 3,648 2,226 5,874 $ $ 2011 2,310 6,831 9,141 $ $ As at December 31, 2012 Single Family Construction Commercial Total Ontario Alberta British Columbia Other $ $ 167,177 74,108 60,033 65,251 366,569 $ $ 135,627 101,181 50,678 11,862 299,348 $ $ 26,375 21,417 3,884 22,219 73,895 $ $ 329,179 196,706 114,595 99,332 739,812 As at December 31, 2011 Single Family Construction Commercial Total Ontario Alberta British Columbia Other $ $ 157,624 97,548 71,572 47,509 374,253 $ $ 71,710 86,500 37,970 11,971 208,151 $ $ 24,423 14,458 4,344 14,722 57,947 $ $ 253,757 198,506 113,886 74,202 640,351 44.5% 26.6 15.5 13.4 100.0% 39.6% 31.0 17.8 11.6 100.0% - 61 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 9. Mortgages - Corporate (continued) (d) Mortgage Allowances Details of the collective allowances for mortgage credit losses for the current and prior year are as follows: Collective Individual 2012 Total Collective Individual Balance, beginning of year Provisions (recoveries) Write-offs Balance, end of year $ $ 2,919 1,127 (323) 3,723 $ $ 1,160 553 (1,000) 713 $ $ 4,079 1,680 (1,323) 4,436 $ $ 2,047 1,147 (275) 2,919 $ $ 1,246 (86) - 1,160 $ $ The Company’s individual allowances for mortgage credit losses are as follows: As at December 31 Uninsured single family Residential construction Commercial - uninsured (e) Arrears and Impaired Mortgages Mortgages past due but not impaired are as follows: 2012 297 300 116 713 $ $ $ $ As at December 31, 2012 Single family - uninsured Single family - insured Residential construction Commercial As at December 31, 2011 Single family - uninsured Single family - insured Residential construction 1 to 30 days 14,064 330 $ 3,436 17,830 $ 31 to 60 days 61 to 90 days Over 90 days 8,378 385 2,743 - 11,506 $ $ 646 58 - - 704 $ $ - 627 - - 627 $ $ 1 to 30 days 31 to 60 days 61 to 90 days Over 90 days 7,839 422 - 8,261 $ $ 4,822 367 - 5,189 $ $ 433 - - 433 $ $ - 626 - 626 $ $ $ - $ $ $ Impaired mortgages (net of individual allowances) are as follows: As at December 31, 2012 Ontario Alberta British Columbia Other As at December 31, 2011 Ontario Alberta British Columbia Other Residential Single Family Construction Commercial $ $ 1,533 1,528 1,736 2,059 6,856 $ $ - 1,760 - - 1,760 $ $ - - - - - $ $ Single Family Residential Construction Commercial $ $ 2,055 769 393 542 3,759 $ $ 1,237 8,708 - - 9,945 $ $ 427 - - - 427 $ $ 2011 Total 3,293 1,061 (275) 4,079 2011 102 1,000 58 1,160 Total 23,088 1,400 2,743 3,436 30,667 Total 13,094 1,415 - 14,509 Total 1,533 3,288 1,736 2,059 8,616 Total 3,719 9,477 393 542 14,131 - 62 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 10. Foreclosed Real Estate In 2012, the Company foreclosed an impaired residential construction loan which is now held as real estate within a wholly owned subsidiary and is carried at the lower of carrying amount and fair market value less the estimated cost to sell. The investment was recorded at its fair value less estimated cost to sell at the time of foreclosure, and no gain or loss was recognized at this time as the fair market value was equal to the carrying value of the impaired loan net of its individual allowance. During the year, the Company’s share of the initial phase of this property was sold for $2,400, while the subsequent phases are subject to an option to purchase by the same party under the same contract. No gain or loss was recognized on the sale of the initial phase. 11. Financial Investments As at December 31 Corporate assets: Investment - commercial real estate Retained interest Other financial investments Asset-backed commercial paper Subordinated loan - residential mortgage securitization program Securitization assets: Insured mortgage-backed securities (in trust for CMB program) Receivables - IMPP Corporate Assets 2012 2011 13,792 3,084 734 457 - 18,067 $ $ 8,250 - 1,294 457 2,535 12,536 554,636 159,995 714,631 $ 1,112,331 167,148 $ 1,279,479 $ $ $ $ The Company holds an equity investment in a commercial real estate investment fund in which it has a fixed proportionate share. As acquisitions are made by the fund, the Company advances its proportionate share to finance the acquisitions. The investment is designated as available for sale, with changes in fair value recognized in the consolidated statements of comprehensive income. The Company holds a retained interest in insured single family mortgages that yields up to 8.75% depending on mortgage prepayment levels. During 2012, its average yield was 8.75% (2011 - n/a). The retained interest is designated as fair value through profit and loss, with changes in fair market value recognized in the consolidated statements of income. The Company held a subordinated loan - residential mortgage securitization program with an interest rate of 10% at December 31, 2011. The loan was rated BB high by Dominion Bond Rating Service (“DBRS”), was classified as loans and receivables and had no specific maturity date. The subordinated loan was receivable from a special purpose entity (“SPE”). The Company did not control the SPE and therefore did not consolidate it. Securitization Assets Insured MBS (held in trust for the CMB program) represent receivables from third party MBS issuers held as principal reinvestment assets as part of the Company’s participation in the CMB program. The weighted average yield was 1.74% at December 31, 2012 (December 31, 2011 - 1.77%). The fair market value of MBS held in trust for the CMB program as at December 31, 2012 was $556,620 (December 31, 2011 - $1,121,238). Receivables - IMPP represent the Company’s loan receivable from MCAP associated with the Company’s involvement in the IMPP (Note 6), although it has no economic interest and therefore recognizes no income. All financial investments are classified as loans and receivables and carried at amortized cost except for the investment - commercial real estate and retained interest, whose classifications are discussed above. The carrying value of all financial investments approximates fair value, except the insured MBS noted above. - 63 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 12. Other Loans As at December 31 Loans receivable - employees Loans receivable - MCAP Loans receivable - other Note 29 29 2012 1,924 1,240 - 3,164 $ $ 2011 1,831 - 1,196 3,027 $ $ The Company has loans receivable from MCAP bearing interest at 5% and maturing in 2015. A loan receivable as at December 31, 2011 had an interest rate of the greater of 7% and prime plus 4% (7% at December 31, 2011) and was payable on demand. All other loans are classified as loans and receivables. 13. Equity Investment in MCAP Commercial LP The Company has a 23.4% equity interest in MCAP as at December 31, 2012 (December 31, 2011 - 22.7%), consisting of 25% of voting class A units, 0% of non-voting class B units and 25% of non-voting class C units. During 2012, MCAN purchased $14,000 of non-voting class C units in MCAP. MCAP used these funds, in addition to equity capital from one of its other partners, to acquire the remaining 80% in MCAP Service Corporation that was not previously owned by MCAP. During 2012, MCAP also acquired the residential mortgage operations and certain related assets of ResMor Trust Company. Subsequent to MCAN’s purchase of class C units in MCAP, MCAP issued new class B units such that MCAN’s interest in MCAP decreased to 23.4%. Since MCAP’s fiscal year end is November 30th, MCAN records equity income from MCAP on a one-month lag. To the extent that MCAP has a material transaction during the one-month lag, MCAN is required to reflect the transaction in the month in which it occurred instead of the subsequent month. MCAN holds a 25% voting interest in MCAP through its class A units. The remaining 75% of the class A and class C units are held by Cadcap Limited Partnership, a subsidiary of the Caisse de dépôt et placement du Québec. Years Ended December 31 Balance, beginning of year Additional equity investment Equity income Distributions received Balance, end of year As at December 31 Share of MCAP’s balance sheet: Assets Liabilities Equity $ $ 2012 15,480 14,000 6,906 - 36,386 2012 $ 1,215,427 1,175,194 40,233 $ $ $ 2011 11,530 - 5,007 (1,057) 15,480 2011 109,533 90,063 19,470 Carrying amount - equity investment in MCAP $ 36,386 $ 15,480 The variance between MCAN’s share of MCAP’s equity and MCAN’s carrying amount of its equity investment in MCAP arose from a corporate reorganization that took place in 2004 in which MCAN reduced its partnership interest in MCAP from 50% to 25%. Years Ended December 31 2012 2011 Share of MCAP revenue and net income: Revenue Net income $ $ 33,392 6,906 $ $ 12,010 5,007 - 64 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 14. Other Assets Other corporate assets include receivables, capital assets and prepaid expenses. Other securitization assets, totalling $1,248 at December 31, 2012 (December 31, 2011 - $3,049), consist of miscellaneous assets relating to the Company’s participation in the CMB program. Other assets are carried at cost. As at December 31 Corporate assets: Receivables Related party receivables - MCAP Capital assets Other 15. Short-Term Investments As at December 31 Commercial paper (in trust for CMB program) Repo GOCs (in trust for CMB program) CMB cash held in trust Cash pledged as collateral - CMB program 2012 2011 952 2,757 565 413 4,687 $ $ 287 - 379 281 947 2012 2011 319,590 4,362 54,491 - 378,443 $ $ 289,719 - 52,964 2,804 345,487 $ $ $ $ Short-term investments consist primarily of commercial paper and Government of Canada Bonds for which MCAN has a repurchase agreement with a financial institution (“Repo GOCs”) held as reinvestment assets for the CMB program in addition to CMB cash held in trust and cash pledged as CMB program collateral. The weighted average yields of the CMB principal reinvestment assets listed above are as follows: commercial paper - 1.14% (December 31, 2011 - 1.10%) and Repo GOCs - 0.90% (December 31, 2011 - n/a). Short-term investments mature within 90 days. CMB cash held in trust represents securitized mortgage principal collections from borrowers to be used to acquire principal reinvestment assets in the following month. The carrying value of short-term investments approximates fair value. 16. Mortgages - Securitized MCAN’s securitized mortgage portfolio consists of insured mortgages securitized through the CMB program and other securitization programs. These mortgages are held as collateral against the CMB liability (Notes 6 and 21). (a) Summary As at December 31, 2012 Single family Commercial As at December 31, 2011 Single family Commercial Gross Principal Allowance Net Principal $ $ 889,213 47,734 936,947 $ $ - - - $ $ 889,213 47,734 936,947 Gross Principal Allowance Net Principal $ 1,451,075 47,941 $ 1,499,016 $ $ - - - $ 1,451,075 47,941 $ 1,499,016 Certain capitalized transaction costs are included in mortgages and are amortized using the EIRM. As at December 31, 2012, the unamortized capitalized cost balance was $1,636 (December 31, 2011 - $3,965). All mortgages in the securitized portfolio are insured, therefore they do not have a collective allowance. The fair market value of the securitized mortgage portfolio as at December 31, 2012 was $1,057,508 (December 31, 2011 - $1,672,958). - 65 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 16. Mortgages - Securitized (continued) The weighted average yield of the Company’s securitized mortgage portfolio is as follows: As at December 31 Single family Commercial Total (b) Geographic Analysis As at December 31 Ontario Alberta British Columbia Other 2012 3.34% 3.26% 3.34% 2011 4.00% 3.49% 3.99% 2012 2011 $ $ 451,569 221,606 133,095 130,677 936,947 48.2% 23.7% 14.2% 13.9% 100.0% $ 749,176 348,636 218,030 183,174 $ 1,499,016 50.0% 23.3 14.5 12.2 100.0% (c) Arrears and Impaired Mortgages Mortgages past due but not impaired are as follows: As at December 31, 2012 1 to 30 days 31 to 60 days 61 to 90 days Over 90 days Total Single family $ 16,665 $ 3,682 $ 1,538 $ 2,321 $ 24,206 As at December 31, 2011 1 to 30 days 31 to 60 days 61 to 90 days Over 90 days Total Single family $ 27,713 $ 12,776 $ 3,117 $ 3,947 $ 47,553 There were no impaired securitized mortgages as at December 31, 2012 (December 31, 2011 - $86). 17. Derivative Financial Instruments As part of its participation in the CMB program, the Company enters into “pay-floating, receive-fixed” interest rate swaps. The purpose of these swaps is to hedge interest rate risk on both securitized mortgages and principal reinvestment assets that have a floating interest rate. The interest rate swap notional is an accreting balance which approximates the sum of floating rate CMB mortgages and reinvestment assets. The interest rate swap counterparty is a Canadian chartered bank. The interest rate swaps are carried at fair value, which is calculated by discounting future net cash flows based on forward interest rates. The fair values displayed below represent only MCAN’s share of the fair value of the interest rate swaps. The following tables outline the Company’s pro-rata share of derivative financial instruments: As at December 31, 2012 Less than one year One to five years Over five years Total CMB interest rate swaps - fair value CMB interest rate swaps - outstanding notional $ $ 1,802 94,983 $ $ 2,864 102,690 $ $ - - $ $ 4,666 197,673 As at December 31, 2011 Less than one year One to five years Over five years Total CMB interest rate swaps - fair value CMB interest rate swaps - outstanding notional $ $ 4,165 113,413 $ $ 9,183 159,490 $ $ - - $ $ 13,348 272,903 - 66 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 17. Derivative Financial Instruments (continued) Derivative financial instrument activity was as follows: Years Ended December 31 Balance, beginning of year Net interest rate swap receipts Unrealized derivative financial instrument gain (loss) Balance, end of year 18. Term Deposits As at December 31 Term deposits Accrued interest Fair value 2012 2011 $ 13,348 $ 13,120 (7,408) (1,274) (8,682) (8,587) 8,815 228 $ 4,666 $ 13,348 2012 2011 $ $ $ 769,450 7,627 777,077 786,837 $ $ $ 595,747 5,830 601,577 610,944 Term deposits are issued to various individuals and institutions with original maturities ranging from 30 days to five years. The weighted average term deposit rate as at December 31, 2012 was 2.45% (December 31, 2011 - 2.44%). The Company’s term deposits are eligible for CDIC deposit insurance. Term deposits are classified as other financial liabilities and are recorded at amortized cost. The estimated fair value of term deposits as presented above is determined by discounting the contractual cash flows, using market interest rates currently offered for deposits of similar remaining maturities. 19. Income Taxes The composition of the provision for (recovery of) income taxes is as follows: Years Ended December 31 Income before income taxes Less: dividends Income subject to tax Statutory rate of tax Tax provision (recovery) before the following: Statutory rate difference in subsidiaries Rate changes and other differences Non-taxable portion of capital gains Temporary differences not previously recognized Deferred tax included in equity of associate Adjustments in respect of prior years Years Ended December 31 Current tax provision (recovery) Deferred tax provision (recovery) 2012 16,238 (24,999) (8,761) 39% (3,417) 66 (495) (428) (450) (452) (79) (5,255) 2012 (1,519) (3,736) (5,255) $ $ $ $ 2011 24,848 (28,101) (3,253) 40% (1,301) (225) (6) (569) - - (154) (2,255) 2011 (2,072) (183) (2,255) $ $ $ $ - 67 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 19. Income Taxes (continued) The composition of the deferred tax liabilities is as follows: As at December 31 Provision for credit losses Securitization-related items Equity investment in MCAP Commercial LP Financial investments Marketable securities Loss carry forward benefit Other Current Taxes Payable 2012 2011 $ $ (1,492) 2,454 931 191 253 (126) (369) 1,842 $ $ (1,198) 6,529 (157) 162 137 - (37) 5,436 As a MIC under the Tax Act, MCAN is able to deduct from income for tax purposes dividends paid within 90 days of year- end. However, for accounting purposes, dividends paid in the following quarter that have not been declared and accrued prior to quarter end are not deductible in the calculation of current taxes payable. 20. Other Liabilities As at December 31 Corporate liabilities: Accounts payable and accrued charges Related party payables - MCAP Dividends payable Securitization liabilities: Accrued charges Other CMB liabilities 2012 2011 $ $ $ $ 4,249 - 5,244 9,493 17 3,251 3,268 $ $ $ $ 2,602 789 4,552 7,943 28 6,031 6,059 The Company held investments in the senior position and first loss position of a residential construction loan securitization program that were both repaid in full in 2010 as part of the windup of the securitization program. The investments were replaced by an indemnity agreement whereby the investors of the securitization program are responsible for any incurred losses in the underlying loans in accordance with their pro-rata share of the first loss investment at the time that the securitization program was wound up. Since the Company previously held 25% of the first loss position, it is responsible for 25% of any losses incurred on the remaining loans in the securitization program. The Company participates in the indemnity agreement with a related party. During 2012, the Company increased its accrued liability representing estimated losses associated with this indemnity from $200 to $1,100 as a result of a decrease in the fair market value of an impaired residential construction loan that the Company has indemnified. This amount represents the Company’s estimated loss as at December 31, 2012 based on the underlying property value given market conditions at that date. There are no other impaired mortgages associated with the indemnification of this securitization program. As at December 31, 2012, the outstanding balance of the remaining loans was $25,226 (December 31, 2011 - $25,282). Due to the short-term nature of other liabilities, their carrying value approximates fair value. - 68 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 21. Financial Liabilities from Securitization Financial liabilities from securitization include financial liabilities relating to the Company’s participation in the CMB program and financial liabilities as a result of its involvement in the IMPP. As at December 31 Financial liabilities - CMB program Financial liabilities - IMPP Note 6 6 2012 2011 $ 1,855,051 159,995 $ 2,015,046 $ 2,944,209 167,148 $ 3,111,357 The financial liabilities - CMB program had a weighted average interest rate of 3.18% as at December 31, 2012 (December 31, 2011 - 3.66%). As financial liabilities from securitization mature, the securitization liability and related assets (securitized mortgages and principal reinvestment assets) are removed from the consolidated balance sheets. Financial liabilities from securitization as at December 31, 2012 mature as follows: 2013 2014 2015 CMB IMPP Total $ 965,885 844,359 44,807 $ 1,855,051 $ $ 132,433 27,562 - 159,995 $ 1,098,318 871,921 44,807 $ 2,015,046 MCAN does not participate in the economics of the IMPP (Note 6) and therefore pays no interest on this liability, nor does it recognize interest income from the associated receivable (Note 11). Certain capitalized transaction costs are included in financial liabilities from securitization and are amortized using the EIRM. As at December 31, 2012, the unamortized capitalized cost balance was $500 (December 31, 2011 - $1,099). 22. Share Capital and Contributed Surplus The authorized share capital of the Company is unlimited common shares with no par value. Issued Balance, January 1 Issued Share issuance Rights offering Dividend reinvestment plan Executive Share Purchase Plan Balance, December 31 Number of Shares 2012 Number of Shares 2011 16,861,575 $ 132,817 14,447,743 $ 100,112 - 1,699,157 167,768 - 18,728,500 - 19,913 2,275 - 155,005 2,300,000 - 93,532 20,300 16,861,575 31,024 - 1,382 299 132,817 $ $ During 2012, the Company successfully completed a fully subscribed rights offering of 1,699,157 common shares at a price of $11.85 per share, for net proceeds of $19,913 after deducting $222 of issuance costs. During 2011, the Company completed a public share offering of 2,300,000 common shares at a price of $14.50 per share, for net proceeds of $31,024 after deducting $2,326 of issuance costs. During 2012, the Company issued 167,768 (2011 - 93,532) shares under the dividend reinvestment plan out of treasury at the weighted average trading price for the 5 days preceding such issue (2011 - 20 days). In November 2011, the Company amended its dividend reinvestment plan to change the basis of the weighted average trading price to the five days preceding such issue less a discount of 2%. The January 3, 2012 dividend was the first dividend for which the revised basis was applicable. For details on the Executive Share Purchase Plan, refer to Note 29. The Company had no potentially dilutive instruments as at December 31, 2012 or December 31, 2011. Contributed surplus of $510 represents the discount on the repurchase of warrants in 2004. - 69 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 23. Dividends Dividends on common shares declared in the prior year and paid in the current year (recognized as a liability at December 31, 2011 and 2010) Fourth quarter dividend, 2011: $0.27 per share (2010: $0.26 per share) Dividends on common shares declared and paid during the year 2012: $1.14 per share (2011: $1.54 per share) Dividends on common shares declared during the year (recognized as a liability at December 31, 2012 and 2011) Fourth quarter dividend, 2012: $0.28 per share (2011: $0.27 per share) 2012 2011 $ 4,552 $ 3,756 $ 19,755 $ 23,549 $ 5,244 $ 4,552 Dividends on common shares approved in first quarter (not recognized as a liability at December 31, 2012 or 2011) First quarter dividend, 2013: $0.31 per share (2012: $0.60 per share) $ 5,819 $ 10,129 Dividends paid within 90 days after year end by a MIC are deductible for income tax purposes, however, where such dividends are not recognized as a liability at year-end the deduction is not taken into account in determining current taxes payable for accounting purposes. The payment of the approved 2013 first quarter dividend of $5,819 noted above (2012 - $10,129), which was not recognized as a liability as at December 31, 2012, is expected to reduce current taxes payable as at March 31, 2013 by $2,297 (March 31, 2012 - $4,017). Certain additional factors may impact current taxes payable between December 31, 2012 and March 31, 2013. 24. Available for Sale Reserve The available for sale reserve consists of unrealized gains and losses (net of deferred taxes) on available for sale marketable securities. As at December 31 Unrealized gain on available for sale marketable securities Less: deferred taxes $ Unrealized gain on available for sale financial investments Less: deferred taxes 2012 1,284 (252) 1,032 1,440 (191) 1,249 $ 2011 697 (137) 560 1,249 (162) 1,087 25. Fees Years Ended December 31 Mortgagor fees Fee income from profit sharing $ 2,281 $ 1,647 Note 29 2012 2,046 190 2,236 $ $ 2011 1,290 303 1,593 $ $ - 70 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 26. Mortgage Expenses Corporate Assets Years Ended December 31 Mortgage servicing expense Other mortgage expenses Securitization Assets 2012 2,401 1,311 3,712 $ $ Mortgage expenses associated with securitization assets consist primarily of mortgage servicing expenses. 27. Provision for Credit Losses Years Ended December 31 Mortgages - collective provisions Mortgages - individual recoveries Financial investments and other loans - collective recoveries Other provisions 28. Other Securitization Income Years Ended December 31 Net interest rate swap receipts Refinancing and renewal gains Income from sale of MBS Other securitization-related items 29. Related Party Disclosures 2012 1,127 553 (20) 900 2,560 2012 7,408 1,325 978 (304) 9,407 $ $ $ $ 2011 2,612 795 3,407 2011 1,147 (86) (3) - 1,058 2011 8,587 132 261 21 9,001 $ $ $ $ $ $ The consolidated financial statements include the financial statements of the Company and its equity accounted associates listed in the following table: Associate: MCAP Commercial LP % Equity Interest December 31 2012 December 31 2011 23.4% 22.7% The Company holds a 23.4% equity interest in MCAP, a non-public entity. During 2012, MCAN purchased $14,000 of non-voting class C units in MCAP. MCAP’s principal activities include the origination and servicing of mortgages. The Company holds one of five seats on MCAP’s Board of Directors. During 2012, the Company purchased certain corporate services from MCAP in the amount of $566 (2011 - $497) and purchased certain mortgage origination and administration services from MCAP in the amount of $2,766 (2011 - $2,859). Also, the Company received $3,038 (2011 - $2,201) of mortgage fees from MCAP. During 2012, the Company paid fees in the amount of $1,675 (2011 - $2,685) to MCAP relating to a profit sharing arrangement on a portfolio of discounted mortgages and received $190 (2011 - $303) of fees from MCAP relating to a profit sharing arrangement on a portfolio of discounted mortgages. - 71 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 29. Related Party Disclosures (continued) As part of the aforementioned profit sharing arrangements related to discounted mortgages, MCAP pays MCAN 50% of any recoveries of discounts on mortgages held on MCAP’s balance sheet. In addition, MCAN reimburses MCAP for 50% of any credit losses on discounted mortgages held on MCAP’s balance sheet (where MCAN participates in a profit sharing arrangement), and vice versa. During 2012, MCAN created certain MBS that were sold to a third party. MCAN subsequently entered into an economic arrangement with MCAP and sold the rights to all net economics associated with these MBS, consisting primarily of interest-only strips less upfront costs. MCAN earned $978 from these sales (2011 - $261), which are included in other securitization income. Derecognition was achieved on the sale of the mortgages. During 2012, MCAN purchased a retained interest in insured single family mortgages from MCAP that yields up to 8.75% depending on mortgage prepayment levels. The balance as at December 31, 2012 was $3,084 (December 31, 2011 - $nil) (Note 11). During 2012, MCAN advanced loans to MCAP bearing interest at 5%. At December 31, 2012, the outstanding loan balance was $1,240 (December 31, 2011 - $nil) (Note 12). All related party transactions noted above were in the normal course of business. Compensation of Executives of the Company, which include the President and Chief Executive Officer, Vice President and Chief Financial Officer, Vice President, Investments, Vice President and Chief Risk Officer and Vice President, Operations, is as follows: Years Ended December 31 Salaries and short term employee benefits Other long term benefits Executive Share Purchase Plan 2012 1,878 137 2,015 $ $ 2011 1,557 181 1,738 $ $ The Company has established an Executive Share Purchase Plan (the “Share Purchase Plan”) whereby the Board of Directors can approve loans to key personnel for the purpose of purchasing the Company’s common shares. During 2012, no common shares were issued out of treasury under the Share Purchase Plan (2011 - 20,300). The loans advanced in 2012 were provided to purchase shares issued through the rights offering. The maximum amount of loans approved under the Share Purchase Plan is limited to 10% of the issued and outstanding common shares. Dividend distributions on the common shares are used to reduce the principal balance of the loans as follows: 50% of regular distributions, and 75% of capital gain distributions. Common shares are issued out of treasury for the Share Purchase Plan at the weighted average trading price for the 20 days preceding such issue. MCAN advanced $305 of new loans under the Share Purchase Plan during 2012 (2011 - $299). As at December 31, 2012, $1,924 of loans were outstanding (December 31, 2011 - $1,831) (Note 12). The loans under the Share Purchase Plan bear interest at prime plus 1%, 4% at December 31, 2012 (December 31, 2011 - 4%) and have a five-year term. The shares are pledged as security for the loans and had a fair market value of $3,159 as at December 31, 2012 (December 31, 2011 - $2,749). During 2012, MCAN recognized $72 of interest income (2011 - $70) on the Share Purchase Plan loans. Deferred Share Units Plan In 2010, the Company established a Deferred Share Units Plan (the “DSU Plan”) whereby the Board of Directors granted units under the DSU Plan to the President and Chief Executive Officer (the “Participant”). Each unit is equivalent in value to one common share of the Company. Following his retirement/termination date, the Participant is entitled to receive cash for each unit. The individual unit value is based on the average market value of the Company’s common shares for the five days preceding the retirement/termination date. The Participant was granted 30,000 units under the DSU Plan during 2010. In addition, the Participant is entitled to receive dividend distributions in the form of additional units. The underlying units follow a graded vesting schedule over three years. All dividends paid prior to July 6, 2014 vest as at July 6, 2014. All dividends paid after July 6, 2014 vest immediately. As at December 31, 2012, 20,000 units had vested (December 31, 2011 - 10,000). The remaining 10,000 units vest on July 6, 2013. The Company recognizes compensation expenses associated with the DSU Plan in line with the graded vesting schedule. The compensation expense recognized related to the DSU Plan for the year ended was $137 (2011 - $181). As at December 31, 2012, the accrued DSU Plan liability was $446 (December 31, 2011 - $309). - 72 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 30. Commitments and Contingencies The Company has contractual obligations to make principal and interest payments on term deposits. The Company also has a monthly operating lease related to its premises, expiring in 2014 with monthly lease payments of $20. In addition, the Company has outstanding commitments for future fundings of mortgages intended for its corporate portfolio. As part of the CMB program, MCAN is required to pay servicing expenses on the securitized mortgages and other ongoing costs. These expenses are accounted for on the accrual basis. As at December 31, 2012 Term deposits Operating lease Mortgage fundings CMB obligations Less than one year One to five years Over five years Total $ $ 467,957 277 198,336 473 667,043 $ $ 309,120 205 49,251 201 358,777 $ $ - - - - - $ 777,077 482 247,587 674 $ 1,025,820 MCAN incurred $260 of operating lease expenses during the year (2011 - $238), included in general and administrative expenses. MCAN outsources its mortgage and loan origination and servicing. MCAN continues to pay servicing expenses as long as the mortgages and loans remain on its consolidated balance sheet. The Company guarantees certain of the credit and operating activities of MCAP. CDP Capital - Real Estate Advisory Inc. (“CDP Capital - Real Estate Advisory”) indemnifies the Company to the extent of 75% of the costs of any claim resulting from any claims on the guarantees. The effect of this indemnity is that the cost of any claim will be borne by the Company and CDP Capital - Real Estate Advisory pro rata to their respective voting interests in MCAP. The guarantees subject to the CDP Capital - Real Estate Advisory indemnity are as follows: (a) guarantee of the performance of MCAP with respect to the warehousing of residential construction loans related to MCAP’s residential construction loan securitization program; and (b) guarantee of the premises lease with respect to the premises occupied by MCAP and the Company at 200 King Street West, Toronto with a current monthly rent of $116 and expiring in September 2014. The Company is a party to an indemnity agreement relating to a residential construction loan securitization program, discussed in Note 20. In the ordinary course of business, MCAN and its service providers (including MCAP), their subsidiaries and related parties may from time to time be party to legal proceedings which may result in unplanned payments to third parties. To the best of the Company’s knowledge, MCAN management does not expect the outcome of any of these proceedings to have a material effect on the consolidated financial position or results of operations of MCAN. Currently, MCAP is one of several parties to a claim in respect of a development project in Alberta. Although a summary judgment in MCAP’s favour was rendered at trial, the Alberta Court of Appeal overturned the summary judgment in part and has directed that certain aspects of the claim be allowed to proceed to trial. MCAN management does not believe that the claim has any merit and believes the claim will ultimately be unsuccessful against MCAP at trial. In any event, management of MCAN believes that any monetary damages against MCAP would not have a material financial impact on MCAN. 31. Credit Facilities The Company has a line of credit from a Canadian chartered bank that is a $50,000 facility bearing interest at prime plus 1%, 4% at December 31, 2012 (December 31, 2011 - prime plus 1%, 4%). The facility has a sub limit of $30,000 for issued letters of credit and $30,000 for overdrafts, and is due and payable upon demand. As at December 31, 2012, the outstanding overdraft balance was $nil (December 31, 2011 - $nil). - 73 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 31. Credit Facilities (continued) The letters of credit have a term of up to one year from the date of issuance, plus a renewal clause providing for an automatic one-year extension at the maturity date subject to the bank’s option to cancel by written notice at least 30 days prior to the letters of credit expiry date. The letters of credit are for the purpose of supporting developer obligations to municipalities in conjunction with residential construction loans. As at December 31, 2012, there were letters of credit in the amount of $25,665 issued (December 31, 2011 - $26,666) and additional letters of credit in the amount of $16,082 committed but not issued (December 31, 2011 - $12,597). 32. Interest Rate Sensitivity Interest rate risk arises when principal and interest cash flows have mismatched repricing and maturity dates. Interest rate risk, or sensitivity, is the potential impact of changes in interest rates on financial assets and liabilities. An interest rate gap is a common measure of interest rate sensitivity. A positive gap occurs when more assets than liabilities reprice within a particular time period. A negative gap occurs when there is an excess of liabilities over assets repricing. The former provides a positive earnings impact in the event of an increase in interest rates during the time period. Conversely, negative gaps are positively positioned for decreases in interest rates during that particular time period. The determination of the interest rate sensitivity or gap position is based upon the earlier of the repricing or maturity date of each asset and liability, and includes numerous assumptions. The interest rate sensitivity analysis is based on the Company’s consolidated balance sheets as at December 31, 2012 and December 31, 2011 and does not incorporate mortgage and loan prepayments. The Company currently cannot reasonably estimate the impact of prepayments on its interest rate sensitivity analysis. The analysis is subject to significant change in subsequent periods based on changes in customer preferences and in the application of asset/liability management policies. Floating rate assets and liabilities are immediately sensitive to a change in interest rates while other assets are sensitive to changing interest rates periodically, either as they mature, as interest payments are collected or paid, or as contractual repricing events occur. Non-interest rate sensitive assets and liabilities are not directly affected by changes in interest rates. The Company manages interest rate risk by matching the terms of corporate assets and term deposits. To the extent that the two components offset each other, the risks associated with interest rate changes are reduced. The Asset and Liability Management Committee (“ALCO”) reviews the Company's interest rate exposure on a monthly basis using interest rate spread and gap analysis as well as interest rate sensitivity analysis based on various scenarios. This information is also formally reviewed by the Risk Committee of the Board each quarter. The Company does not currently use derivative financial instruments outside of the CMB program, however the potential use of such instruments is analyzed and reported to ALCO on a monthly basis. The interest rate risk associated with securitization assets (including short-term investments, mortgages - securitized and financial investments) and liabilities (financial liabilities from securitization) from the CMB program is managed through the use of “pay-floating, receive-fixed” interest rate swaps (included in derivative financial instruments). For further details on how the Company manages interest rate risk associated with the CMB program, refer to Notes 6 and 17. - 74 - Assets Corporate Securitization Liabilities Corporate Securitization Assets Corporate Securitization Liabilities Corporate Securitization NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 32. Interest Rate Sensitivity (continued) The following table presents the assets and liabilities of the Company by interest rate sensitivity: As at December 31, 2012 Floating Rate Within 3 Months 3 Months to 1 Year 1 to 5 Years Over 5 Years Non Interest Sensitive Total $ 378,655 410,198 788,853 $ 74,847 539,952 614,799 $ 216,912 460,824 677,736 $ 203,574 463,718 667,292 $ $ 5,588 - 5,588 71,110 161,243 232,353 $ 950,686 2,035,935 2,986,621 Shareholders’ Equity - - - - - 80,519 80,519 230,981 - 230,981 236,976 965,884 1,202,860 309,120 808,648 1,117,768 - - - - 13,449 163,263 176,712 790,526 2,018,314 2,808,840 177,781 177,781 GAP $ 708,334 $ 383,818 $ (525,124) $ (450,476) $ 5,588 $ (122,140) - YIELD SPREAD 1.01% 0.92% 1.90% 1.74% 5.61% As at December 31, 2011 Floating Rate Within 3 Months 3 Months to 1 Year 1 to 5 Years Over 5 Years Non Interest Sensitive Total $ 146,524 748,409 894,933 $ 91,866 375,588 467,454 $ 246,190 615,452 861,642 204,508 $ 1,226,768 1,431,276 $ 13,663 - 13,663 $ 51,048 174,142 225,190 $ 753,799 3,140,359 3,894,158 Shareholders’ Equity - - - - - 80,505 80,505 75,629 - 75,629 251,381 1,087,983 1,339,364 274,567 1,775,721 2,050,288 - - - - 16,700 173,207 189,907 618,277 3,117,416 3,735,693 158,465 158,465 GAP $ 814,428 $ 391,825 $ (477,722) $ (619,012) $ 13,663 $ (123,182) - YIELD SPREAD 0.62% 1.13% 1.55% 1.12% 6.63% Certain residential construction loans and single family uninsured completed inventory loans are subject to the greater of a minimum interest rate (ranging between 3% and 15%) or a prime based interest rate. To the extent that the minimum rate exceeds the prime based rate at December 31, 2012, these mortgages have been reflected in the table above as fixed rate mortgages, as follows: within 3 months - $65,024 (December 31, 2011 - $32,651), 3 months to 1 year - $57,580 (December 31, 2011 - $57,783) and 1 to 5 years - $28,330 (December 31, 2011 - $35,406). An immediate and sustained 1% increase (decrease) to market interest rates at December 31, 2012 would have a positive (adverse) effect of $2,608 (December 31, 2011 - $1,539) to net income over the following twelve month period. An immediate and sustained 1% increase (decrease) to market interest rates at December 31, 2012 would have an adverse (positive) effect to the available for sale reserve of $208 (December 31, 2011 - $494). When calculating the effect of an immediate and sustained 1% change in market interest rates on net investment income, the Company determines which assets and liabilities reprice over the following twelve months and applies a 1% change to their respective yields at the time of repricing to determine the change in net investment income for the duration of the twelve month period. - 75 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 33. Capital Management The Company's primary capital management objectives are to maintain sufficient capital for regulatory purposes and to earn acceptable and sustainable risk weighted returns for shareholders. Through its risk management and corporate governance framework, the Company assesses current and projected economic, housing market, interest rate and credit conditions to determine appropriate levels of capital. The Company typically pays out all of its taxable income by way of dividends. Capital growth is achieved through retained earnings, public share offerings, rights offerings and the dividend reinvestment plan. The Company's capital management is driven by the guidelines set out by the Tax Act and OSFI. As a MIC under the Tax Act, the Company is limited to a liabilities to capital ratio of 5:1 (or an assets to capital ratio of 6:1), based on the non- consolidated balance sheets measured at their tax values. As a Loan Company under the Trust Act, the Company has been granted a maximum consolidated regulatory assets to capital ratio by OSFI. The Company manages its assets to a level of 5.75 times capital on a non-consolidated tax basis to provide a prudent cushion between its limit and total actual assets. The Company manages its capital to comply with the requirements of the MIC test and OSFI regulations at all times. The Company has adopted the Basel II capital management framework. The Company has implemented the standardized approach to calculating risk-weighted assets for credit risk and the basic indicator approach for the calculation of operational risk. Tier 1 capital includes share capital, contributed surplus, retained earnings and certain components of accumulated other comprehensive income. Tier 1 and Tier 2 capital are both reduced by 50% of unrated securitization exposures. OSFI’s target minimum Tier 1 and Total capital ratios for the Company are 7% and 10%, respectively. The Company’s target minimum Tier 1 and Total capital ratios are both 20%. Both ratios were above this target as at December 31, 2012. Securitization assets and liabilities are both excluded from the calculation of the Tax Act ratio. Assets securitized through the CMB program prior to June 30, 2010 are excluded from the calculation of regulatory ratios. The Company’s Tax Act and regulatory ratios are as follows: As at December 31 Tax Act Ratios Income tax assets Income tax capital Income tax assets to capital ratio Income tax liabilities to capital ratio Regulatory Ratios (OSFI) Tier 1 capital Share capital Contributed surplus Retained earnings Tier 1 capital deductions Tier 2 capital Unrealized gain on available for sale marketable securities Tier 2 capital deductions Total capital Total regulatory assets Capital ratios Tier 1 capital to risk-weighted assets ratio Total capital to risk-weighted assets ratio Assets to capital ratio 2012 2011 $ 953,235 168,477 5.66 4.66 $ 766,065 156,116 4.91 3.91 $ $ 155,005 510 19,985 (229) 175,271 1,032 (229) 803 132,817 510 23,491 (229) 156,589 560 (229) 331 $ 176,074 $ 156,920 $ 1,002,759 $ 818,112 21.74% 21.84% 5.70 22.21% 22.26% 5.21 As at December 31, 2012 and December 31, 2011 the Company was in compliance with the capital guidelines issued by OSFI under Basel II. - 76 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 33. Capital Management (continued) The Company’s assets, analyzed on a risk-weighted basis, are as outlined in the table below. Assets securitized through the CMB program prior to June 30, 2010 are excluded from the calculation of risk-weighted assets. As at December 31 On-Balance Sheet Assets Cash and cash equivalents Short term investments Marketable securities Mortgages - corporate Financial investments Other loans Equity investment in MCAP Other assets Off-Balance Sheet Assets Letters of credit Mortgage funding commitments Derivative Financial Instruments CMB interest rate swaps Outstanding notional Add-on factor Potential credit exposure Positive replacement cost Credit equivalent Risk weighting Risk-weighted equivalent Charge for operational risk Total Risk-Weighted Assets 2012 2011 $ $ 25,396 - 20,390 494,935 21,966 3,164 36,386 5,933 608,170 12,832 123,794 136,626 197,673 0.5% 988 4,666 5,654 20% 1,131 10,813 561 30,149 402,632 18,414 3,027 15,480 3,976 485,052 13,333 137,526 150,859 272,903 0.5% 1,365 13,348 14,713 20% 2,943 60,213 66,100 $ 806,140 $ 704,954 The risk-weighting of all on-balance sheet assets (except derivative financial instruments) and all off-balance sheet assets is based on a prescribed percentage of the underlying asset position, in addition to adjustments for other items such as impaired mortgages and unrated securitization investments. The derivative financial instrument credit equivalent consists of the fair market value of the derivative and an amount representing the potential future credit exposure. Risk-weighted assets also include an operational risk charge, which is based on certain components of the Company’s net investment income over the past three years. In order to promote a more resilient banking sector and strengthen global capital standards, the Basel Committee on Banking Supervision (“BCBS”) proposed significant enhancements and capital reforms to the current framework. The revised framework, referred to as Basel III, will be effective January 1, 2013. Further details on Basel III are available in the Capital Management section of the Management’s Discussion and Analysis (“MD&A”). 34. Financial Instruments The majority of the Company’s consolidated balance sheet consists of financial instruments, and the majority of net income is derived from the related income, expenses, gains and losses. Financial instruments include cash and cash equivalents, short-term investments, marketable securities, mortgages, financial investments, other loans, financial liabilities from securitization, term deposits and derivative financial instruments. All financial instruments that are carried on the consolidated balance sheets at fair value (marketable securities, certain financial investments and derivative financial instruments) are estimated using valuation techniques based on observable market data such as market interest rates currently charged for similar financial investments to expected maturity dates. The following table summarizes financial assets reported at fair value. Financial assets and liabilities are classified into three levels, as follows: quoted prices in an active market (Level 1), fair value based on observable inputs other than quoted prices (Level 2) and fair value based on inputs that are not based on observable data (Level 3). - 77 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 34. Financial Instruments (continued) As at December 31, 2012 Level 1 Level 2 Level 3 Financial Assets Marketable securities Financial investments - commercial real estate Financial investments - retained interest Derivative financial instruments $ $ 11,899 - - - 11,899 $ $ 8,491 - - 4,666 13,157 $ $ - 13,792 3,084 - 16,876 As at December 31, 2011 Level 1 Level 2 Level 3 Financial Assets Marketable securities Financial investments - commercial real estate Derivative financial instruments $ $ 14,330 - - 14,330 $ $ 15,819 - 13,348 29,167 $ $ - 8,250 - 8,250 The following table shows the continuity of Level 3 financial assets recorded at fair value: Balance, December 31, 2011 Advances Repayments Changes in fair value, recognized in other comprehensive income Balance, December 31, 2012 $ $ 8,250 12,711 (4,275) 190 16,876 An increase of 0.25% to capitalization rates as at December 31, 2012 would result in a decrease to the fair value at Level 3 financial investments - commercial real estate by $1,015 (December 31, 2011 - $688). A decrease of 0.25% to capitalization rates as at December 31, 2012 would result in an increase to the fair value of Level 3 financial investments - commercial real estate by $1,084 (December 31, 2011 - $736). An increase of 1% to market interest rates as at December 31, 2012 would result in a decrease to the fair value at Level 3 financial investments - retained interest by $15 (December 31, 2011 - n/a). A decrease of 1% to capitalization rates as at December 31, 2012 would result in an increase to the fair value of Level 3 financial investments - retained interest by $15 (December 31, 2011 - n/a). There were no transfers between levels during the years ended December 31, 2012 or December 31, 2011. There were no financial liabilities reported at fair value as at December 31, 2012 or December 31, 2011. Risk Management The types of risks to which the Company is exposed include interest rate, credit, liquidity and market risk. The Company’s enterprise risk management framework includes policies, guidelines and procedures, with oversight by senior management and the Board of Directors. These policies are developed and implemented by management and reviewed and approved annually by the Board of Directors. The nature of these risks and how they are managed is provided in the Risk Management and Risk Factors section of the Management’s Discussion and Analysis of Operations (“MD&A”). Certain disclosures required under IFRS 7, Financial Instruments: Disclosures, related to the management of credit, interest rate, liquidity and market risks inherent with financial instruments are included in the MD&A. The relevant MD&A sections are identified by shading within boxes and the content forms an integral part of these consolidated financial statements. 35. Standards Issued But Not Effective Standards issued but not yet effective up to the date of issuance of the Company’s consolidated financial statements are listed below. This listing is of standards and interpretations issued, which the Company reasonably expects to be applicable at a future date. The Company intends to adopt those standards when they become effective. - 78 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 35. Standards Issued But Not Effective (continued) IFRS 7, Financial Instruments: Disclosures - Offsetting Financial Assets and Financial Liabilities This standard will require entities to disclose gross amounts subject to right of set-off, amounts set off in accordance with the accounting standards followed, and the related net credit exposure. This standard is effective for periods beginning on or after January 1, 2013. Retrospective application will be required. The Company does not expect the adoption of this standard to have a material impact on its results as well as to the presentation of the Company’s financial statements IAS 32, Financial Instruments: Presentation - Offsetting Financial Assets and Financial Liabilities (Amendments to IAS 32). These amendments clarify the offsetting criteria in IAS 32 to address inconsistencies in their application. These amendments clarify that an entity currently has a legally enforceable right to set-off if that right is not contingent on a future event and enforceable both in the normal course of business and in the event of default, insolvency or bankruptcy of the entity and all counterparties. The amendment also clarifies the application of the IAS 32 offsetting criteria to settlement systems. This amendment will be effective for annual periods beginning on or after January 1, 2014. The Company is in the process of assessing the impact of adopting this amendment. IFRS 10, Consolidated Financial Statements This standard is effective for annual periods beginning on or after January 1, 2013 and will replace portions of IAS 27, Consolidated and Separate Financial Statements and interpretation SIC-12, Consolidation - Special Purpose Entities. Under IFRS 10, consolidated financial statements include all controlled entities under a single control model that applies to all entities, including special purpose entities and structured entities. A group will still continue to consist of a parent and its subsidiaries; however IFRS 10 uses different terminology from IAS 27 in describing its control model. The changes introduced by IFRS 10 will require management to exercise significant judgment to determine which entities are controlled, and therefore are required to be consolidated by a parent, compared with the requirements that were in IAS 27. The Company does not anticipate any material changes to the financial position or operating results upon adoption of IFRS 10. IFRS 12, Disclosure of Interests in Other Entities This standard includes disclosure requirements about subsidiaries, joint ventures, and associates, as well as unconsolidated structured entities. Many of the disclosure requirements were previously included in IAS 27, IAS 1 and IAS 28 while others are new. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to result in material changes to the presentation of the Company’s financial statements. IFRS 13, Fair Value Measurement This standard provides guidance on how to measure the fair value of financial and non-financial assets and liabilities when fair value is required or permitted per IFRS. While many of the concepts in IFRS 13 are consistent with current practice, certain principles could have a significant effect on some entities adopting the standard. IFRS 13 is effective January 1, 2013 and will be adopted prospectively. The Company does not expect the adoption of this standard to have a material impact on its results. IAS 1, Presentation of Financial Statements This standard has a number of amendments regarding financial statement presentation and disclosure requirements. This standard is effective for annual periods beginning on or after July 1, 2012. The Company does not expect the adoption of this standard to result in material changes to the presentation of the Company’s financial statements. IAS 19, Revised Employee Benefits This standard prescribes the accounting and disclosure requirements for employee benefits. This standard shall be applied by an employer in accounting for all employee benefits, except those to which IFRS 2, Share-based Payment, applies. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to have a material impact on its results as well as to the presentation of the Company’s financial statements. IAS 28, Investments in Associates and Joint Ventures This amendment prescribes the accounting for investments in associates and to set out the requirements for the application of the equity method when accounting for investments in associates and joint ventures. This standard shall be applied by all entities that are investors with joint control of, or significant influence over, an investee. This standard is effective for annual periods beginning on or after January 1, 2013. The Company does not expect the adoption of this standard to have a material impact on its results. - 79 - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS / 2012 CONSOLIDATED FINANCIAL STATEMENTS MCAN MORTGAGE CORPORATION December 31, 2012 (Dollar amounts in thousands except for per share amounts) 36. Comparative Amounts Certain comparative amounts have been reclassified to conform to the presentation adopted in the current year. There was no impact to the financial position or net income as a result of these reclassifications. - 80 - 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION DIRECTORS David G. Broadhurst President, Poynton Investments Limited; Chair of the Audit Committee; Member of Conduct Review, Corporate Governance and Human Resources Committee; Director since May 1997. Brydon Cruise President and Managing Partner, Brookfield Financial; Member of Conduct Review, Corporate Governance and Human Resources Committee; Member of Risk Committee; Director since May 2010. Susan Doré Corporate Director; Chair of Information Technology Committee; Member of Audit Committee; Member of Conduct Review, Corporate Governance and Human Resources Committee; Director since May 2010. Brian A. Johnson Partner, Crown Capital Partners and Crown Realty Partners; Member of Risk Committee; Chair of Conduct Review, Corporate Governance and Human Resources Committee; Member of Information Technology Committee; Director since January 2001. Derek A. Norton President and CEO, MCAP Commercial LP; Member of Information Technology Committee; Director since July 2000. Jean C. Pinard Corporate Director; Member of Risk Committee; Director since November 2005. Robert A. Stuebing Corporate Director; Member of Audit Committee; Chair of Risk Committee; Director since April 2004. Ian Sutherland Chair, MCAN Mortgage Corporation; Director since January 1991. William Jandrisits President and Chief Executive Officer, MCAN Mortgage Corporation; Member of Information Technology Committee; Director since August 2010. Karen Weaver Executive Vice President & Chief Financial Officer First Capital Realty Inc.; Member of Audit Committee; Member of Information Technology Committee; Director since November 2011. OFFICERS AND MANAGEMENT William Jandrisits President and Chief Executive Officer Derek Sutherland Vice President and Chief Risk Officer Tammy Oldenburg Vice President and Chief Financial Officer Carl Brown Vice President, Operations Michael Misener Vice President, Investments Paco Lai Senior Manager, Cash Operations Sylvia Pinto Corporate Secretary Chief Compliance Officer Sal Jadavji Enterprise Risk Management Officer Chief Anti-Money Laundering Officer Privacy Officer Business Continuity/Disaster Recovery Coordinator Robert Horton Chief Audit Officer Hassan Shaikh Assistant Vice President, Investments Dipti Patel Senior Manager, Investments John Tyas Controller Eloise Goodwin Manager of Finance Murtuza Lakdawala Assistant Controller - 81 - CORPORATE INFORMATION Head Office 200 King Street West, Suite 400 Toronto, Ontario M5H 3T4 Tel: (416) 572-4880 Fax: (416) 598-4142 Corporate Counsel Goodmans LLP Toronto, Ontario Auditors Ernst & Young LLP Toronto, Ontario Public Listing Toronto Stock Exchange Exchange symbol MKP Bank Bank of Montreal First Canadian Place Toronto, Ontario Website www.mcanmortgage.com 2012 ANNUAL REPORT / MCAN MORTGAGE CORPORATION Corporate Information This MCAN Mortgage Corporation 2012 Annual Report is available for viewing/printing on our website at www.mcanmortgage.com, or additionally on SEDAR at www.sedar.com. To request a printed copy, please contact Ms. Sylvia Pinto, Corporate Secretary, 200 King Street West, Suite 400, Toronto, Ontario M5H 3T4, by phone 416-572-4880 or 1-855-213-6226, or e-mail spinto@mcanmortgage.com. Registrar and Transfer Agent For dividend information, change in share registration or address, lost certificates, estate transfers, or to advise of duplicate mailings, please call MCAN Mortgage Corporation’s Transfer Agent and Registrar at 1-800-564-6253, or write to Computershare Trust Company of Canada, 100 University Avenue, 9th Floor, Toronto, Ontario M5J 2Y1. Dividend Reinvestment Plan For information regarding MCAN’s Dividend Reinvestment Plan, please visit the Company’s website at www.mcanmortgage.com under Shareholders > Dividend Reinvestment Plan. An Enrolment Form may be obtained at any time upon written request addressed to the Plan Agent, Computershare. Registered Participants may at obtain www-us.computershare.com/investor/. Enrolment Forms online also General Information For general enquiries about MCAN Mortgage Corporation, please write to Ms. Sylvia Pinto, Corporate Secretary or e-mail mcanexecutive@mcanmortgage.com. Annual Meeting Tuesday, May 14, 2013 4:30 p.m. (Eastern Daylight Savings Time) St. Andrew’s Club & Conference Centre 150 King Street West 27th Floor Toronto, Ontario - 82 - 

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