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HomeQ Annual Report - 2010

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2010 Annual Report for HomeQ (TSX: HEQ)

2010 Annual Report for HomeQ (TSX: HEQ)

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  • 1. HOMEQ Corporation45 St. Clair Avenue West, Suite 600Toronto, Ontario M4V 1K9T 416 925 4757F 416 925 9938www.homeq.ca OUR DIRECTION IS SET HOMEQ Corporation 2010 ANNUAL REPORT 2009 ANNUAL REPORT
  • 2. BOARD OF DIRECTORS OFFICERS CORPORATE INFORMATION Table of Contents Financial Highlights 1 Toronto, Ontario Senior Vice President, Letter from the CEO 2 Pierre Lebel, LL.B, MBA Steven Ranson, CA, MBA Greg Bandler Vancouver, British Columbia Mr. Ranson is the President Sales and Marketing Chairman of the Board Accelerated Growth 4 Mr. Lebel is Chairman of and Chief Executive Officer of Imperial Metals Corporation the Company and HomEquity Bank. Senior Vice President HomEquity Bank Taking Flight 6 Gary Krikler, CA and Chief Financial Officer 25 Years of Expertise 8 Toronto, Ontario Toronto, Ontario Heather Briant, MBA, ICD.D Paula Roberts, MA, ICD.D Management Discussion and Analysis 10 Ms. Briant is the Senior Vice President, Ms. Roberts is the Executive Vice President Vice President, Finance Scott Cameron, CA Human Resources of Cineplex of Plan International Canada Inc. and Deposit Services Management’s Responsibility Entertainment LP. for Financial Reporting 40 Toronto, Ontario Vice President, General Counsel Auditors’ Report 41 Gary Samuel, LL.B Celia Cuthbertson, LL.B Toronto, Ontario Mr. Samuel is a Co-founder and and Corporate Secretary Paul Damp, CA Consolidated Balance Sheets 42 Mr. Damp is the Managing Partner Partner of Crown Realty Partners of Kestrel Capital Partners Consolidated Statements of Operations 43 Vice President, Wendy Dryden Operations Consolidated Statements of Changes Toronto, Ontario in Shareholders’ Equity 44 Daniel Jauernig, CA, CMA Mr. Jauernig is the President and Vice President, Consolidated Statements of Cash Flows 45 Neil Sider, Ph.D. Chief Executive Officer of Information Technology Classified Ventures Inc. Notes to Consolidated Financial Statements 46 Vice President, Corporate Information 69 Lori Sone-Cooper, CHRP Human Resources HOMEQ Corporation opens trading on the Toronto Stock Exchange (TMX) November 26, 2010 celebrating its 25th year of providing Canadian seniors with reverse mortgage solutions.With 25 years of expertise in its products and markets, substantialaccess to capital, and proven distribution and marketing, HomEquity From left to right: Paula Roberts, Gary Samuel, Paul Damp, Heather Briant, Pierre Lebel, Daniel Jauernig, and Steven Ranson.Bank has bright prospects. Indeed, the Bank is meeting robust demand 2010 has been a record year of growth for HOMEQ Corporation and HomEquity Bank. The Bank’s mortgage portfolio surpassedfor reverse mortgages from across the country.With a national presence $1.0 billion and the last five consecutive quarters have set year-over-year records for new originations for the CHIP Home Income Plan. The combination of portfolio growth, efficient originations, spread management and overhead expense control should continue to be translated into steady increases in income, leading to significant increases in Return on Equity. 2010 has been aand efficient distribution channels, HomEquity Bank’s mortgage portfolio remarkable year in which the organization has been completely transformed while delivering new levels of service and value to seniors. Our direction is firmly set for the future.has exceeded $1.0 billion. Chairman of the Board Pierre Lebel Ernst & Young LLP Computershare The shares of HOMEQ Corporation are AUDITORS REGISTRAR AND TRANSFER AGENT STOCK LISTING P.O. Box 251 100 University Avenue listed on the Toronto Stock Exchange 222 Bay Street Toronto, Ontario M5J 2Y1 under the symbol HEQ Ernst & Young Tower For any inquiries or change of Toronto, Ontario M5K 1J7 address please call: Toll free: 1 800 663 9097 68_69 Annual Report 2010 For further information, please contact: Gary Krikler, CA Senior Vice President and Chief Financial Officer or Scott G. Cameron, CA Vice President, Finance
  • 3. Financial Highlights ($ thousands except per share and percentage amounts) Three months ended Twelve months ended December 31, December 31, 2010 2009 2010 2009 OPERATING RESULTS Net income (loss) 197 345 123 (1,827) Per share 0.01 0.02 0.01 (0.13) Adjusted net income (1) 1,881 1,814 7,074 7,385 Per share 0.13 0.13 0.49 0.52 Return on equity (annualized) 0.8% 1.4% 0.1% (1.7%) Adjusted return on equity (annualized) (2) 8.4% 8.4% 8.0% 8.4% Spread income (3) 6,533 6,627 26,856 25,315 Spread percentage 2.78% 3.15% 2.96% 3.12% Dividends per share 0.07 0.14 0.28 0.56 Mortgage originations 47,462 43,365 205,759 110,195 Trailing four quarter origination cost % 6.0% 9.5% 6.0% 9.5% Trailing four quarter administration expense % 0.75% 0.69% 0.75% 0.69% Efficiency ratio 64.3% 58.7% 58.2% 56.2% BALANCE SHEET HIGHLIGHTS Total assets 1,183,750 1,016,563 Mortgage principal plus accrued interest 1,016,383 865,659 Deposits 367,643 40,093 Medium-term debt 626,298 792,328 Subordinated debt 40,308 50,335 Unsecured subordinated debt 19,724 10,144 Bank term loan 9,726 – Book value per share 6.81 7.09 PORTFOLIO QUALITY Appraised value of underlying properties 2,825,410 2,413,923 Average loan-to-value 36.0% 35.9% Non-accrual mortgage value 3,263 1,492 Allowance for credit losses 2,547 2,149 (1) Adjusted net income (loss) is explained in the Financial Results section on page 15 of Annual Report (2) Adjusted return on equity is explained in the Financial Results section on page 15 of Annual Report (3) Spread income, a non-GAAP measure, as discussed on pages 21 and 22 of Annual ReportMortgage Principal Plus Accrued Interest$1,016 million at December 2010 Years 10 1,016 09 866 08 814 14% CAGR 07 708 06 612 $0 $200 $400 $600 $800 $1,000 $1,200 $ Millions 1 Annual Report 2010
  • 4. The CHIP Home Income Plan is being transformed from a niche product to a mainstream solutionSteven K. Ranson that will increasingly President & Chief Executive Officer be included in Canadian seniors’ financial plans. LETTER FROM THE CEO RECORD GROWTH, BRIGHT PROSPECTS We are pleased to report that our subsidiary, HomEquity Bank’s mortgage portfolio has now surpassed $1.0 billion. Over the last five consecutive quarters we have set year-over-year records for new originations so that originations exceeded $200 million in 2010. Our remarkable growth is based on the recognition of reverse mortgages as mainstream financial solutions.
  • 5. debt, the benefits of our progress should become evident in 2011 and in future years as a result of a combination of portfolio growth, efficient originations, spread management and overhead expense control. HomEquity Bank capitalizes on long-standing relationships with top tier referral partners, including allHomEquity Bank is meeting heightened demand the major chartered banks. The demand for our productsfor its reverse mortgages from across the country; is robust. Moreover, we have the expertise, infrastructureindeed, almost every region is functioning at or and capital resources to enhance our unique position inabove expectations. This growth is driven by a the marketplace. With 25 years of expertise in ournumber of factors including the ever increasing product and market, substantial access to capital, andnumber of seniors, Canada’s fastest growing proven distribution and marketing, our prospects aredemographic. In addition, competitive pricing, bright. The next few years will be exciting ones indeed.effective publicity and engaging marketingcampaigns are making the CHIP Home Income Central to our success is the burgeoning demographicPlan more accessible and attractive to seniors. of seniors, seeking to enjoy their retirement years.As well, HomEquity Bank’s evolving products offer HomEquity Bank is uniquely positioned to satisfy seniors’features that precisely address consumer needs. financial needs and enable them to stay in their home.As a Schedule I bank, HomEquity Bank has gained 2010 has been a remarkable year in which we haveaccess to sufficient and relatively low-cost funds completely transformed ourselves. I would like to taketo support our growth through the issuance of this opportunity to commend our hard-working andGuaranteed Investment Certificates. In addition, capable employees for their tireless efforts during thethe demand for our medium-term notes increased year, and for their dedication to the highest standardsduring the year resulting in an improvement in our of productivity and customer service. We are extremelycost of funds from our traditional source. excited by our prospects for future growth and success.Encouragingly, our growth has been achieved with Sincerely,significant improvement in operational efficienciesand without any compromise to our strict underwritingcriteria. Additional expenditures incurred as a result ofbeing a bank are substantially fixed in nature and havenow been fully absorbed. Steven K. Ranson President & ChiefIn the near term, shareholders should be rewarded with Executive Officersteady increases in net income performance. Althoughadjusted net income in Q1 2011 will be somewhatreduced as a result of the cost of redeeming existing 2_3 Annual Report 2010
  • 6. ACCELERATED GROWTH Record Portfolio and Mortgage Originations
  • 7. Miro Zgavc, Systems Administrator Heidi Pascucci, Marketing Manager Celia Cuthbertson, VP General CounselEsther Kim, Office Administrator Mohamed Gaye, Mortgage Administrator HomEquity Bank is growing its market penetration Strong Growth in Yearly Organization based on pricing, product and marketing initiatives. $ Millions The result is a portfolio of more than $1 billion and record originations. $250 Record Portfolio and Mortgage Originations 206 $200 HOMEQ Corporation’s subsidiary, HomEquity bank, originated a record volume of reverse mortgages of $150 $206 million in 2010. On an annual basis, this is an 127 130 increase of 87% over 2009 and an increase of 58% 105 110 over the previous record of $130 million set in 2008. $100 89 77 77 84 As at December 31, 2010 the reverse mortgage 64 64 53 portfolio surpassed $1 billion and was 17% higher $50 36 48 than at December 31, 2009. 19 22 $0 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 Years Growth in Portfolio and Total Mortgages Outstanding $ Millions Given demographic trends, a CHIP Home Income Plan that is widely accepted in the marketplace, $1,400 and substantial barriers-to-entry for competitors, 14% CAGR 17% CAGR the growth trend is forecast to continue. Indeed, new $1,200 annual origination volume in 2010 was $206 million. 1,016 1,016 Lowered Cost of Acquisitions $1,000 Origination Costs as a % of Originations – 866 866 814 Trailing 4 Quarters $800 708 612 12% $600 11% 10.6% 10.8% 10% 9.8% 9.6% 9.5% $400 9% 8% 7.7% $200 7% 6.6% 6.1% 6.0% 6% Q4 Q4 $0 06 07 08 09 10 09 10 Years 5% 4% 3% HomEquity Bank’s 5 year compound annual growth 2% rate has accelerated to 14% in the last year. Indeed, Q4/08 Q1/09 Q2/09 Q3/09 Q4/09 Q1/10 Q2/10 Q3/10 Q4/10 this growth has expanded the portfolio to over $1 billion from $533 million in 2005. Total Origination Costs Spreads have been maintained at around the 3% mark. With the growing demand for reverse mortgages Origination efficiency is significantly better as evidenced and expertise of the sales and marketing teams, by the improvement in our origination cost percentage. an increased volume of business has been attained The Bank’s expense structure, which increased in within the existing sales and marketing structure. becoming a corporation and a Bank, has now stabilized The rolling four quarter origination costs and will have less impact in subsequent years. As well, percentage improved to 6.0% during the the expanded size of the business has absorbed these quarter, significantly better than the 9.5% additional costs. 4_5 rate in 2009. Annual Report 2010
  • 8. HomEquity Bank TAKING FLIGHT HomEquity Bank is well positioned for continued market leadership and growth
  • 9. Kevin Watson, IT Manager Sandra Gustafsson, Senior Mortgage Administrator Neil Sider, VP Information Technology Niary Toodakian, Marketing Manager Sasha Salandy, Senior Sales Associate HOMEQ Corporation, through its wholly owned When HOMEQ went public in 2002, as HomEquity Income subsidiary, HomEquity Bank, is the only national Trust, the portfolio of outstanding mortgages was just provider of reverse mortgages to senior over $360 million. homeowners, Canada’s fastest-growing Since then, HomEquity Bank has continued to build its demographic segment. brand, distribution networks and hire excellent people. The result is an improved awareness and acceptance of HOMEQ Corporation Milestones: the solution by Canadian senior homeowners. 1986: William Turner, founder of Canadian Home Income HOMEQ endured the credit crisis of 2007/8 and emerged Plan (CHIP) Corporation, now known as HomEquity Bank, in a position of strength, as a Schedule I bank in 2009. pioneers the reverse mortgage concept in Canada. But our success is in its early phases. Indeed, HomEquity Bank has been steadily improving and enhancing its 1997: First major banking partner recommends the CHIP offerings, and growing its business. A positive reception solution to its clients. in the marketplace is a further indication that the CHIP 2001: With a national distribution network, the Home Income Plan has evolved from a niche product to CHIP Home Income Plan solution is now available a mainstream financial solution. HomEquity Bank marked in every province. its one-year anniversary with record originations of $206 million in the latest four quarters and a portfolio 2002: CHIP’s parent company, Home Equity Income Trust, that now exceeds $1 billion. begins publicly trading on the Toronto Stock Exchange under the symbol HEQ.UN. At this time, the portfolio With a seasoned management team, product expertise, of outstanding mortgages is $364.3 million. specially trained professionals who deal with seniors, and skillful marketing, HomEquity Bank is well positioned October 2009: Canadian Home Income Plan Corporation for continued market leadership and growth. The is granted letters of patent and begins operating as a demographics are favourable. In the next six years, for Schedule I bank under a new name, HomEquity Bank. instance, it is estimated that the number of Canadian 2010: HomEquity Bank passes its one-year anniversary seniors will grow by 20%. Increased numbers of seniors as a Schedule I Canadian bank and records originations will seek flexible and innovative financial solutions to of $206 million with a portfolio that exceeds $1 billion meet their needs. By addressing their financial objectives, for the year. HomEquity Bank will help seniors get the most out of their retirement years. The Originator and Sole Provider of Canada’s Since its inception, the CHIP Home Income Plan has Reverse Mortgages helped thousands of Canadian seniors achieve a more HOMEQ Corporation, through its wholly owned enjoyable retirement by unlocking up to 40% of value subsidiary, HomEquity Bank, is the only national provider in their homes. There’s more to come. In the near future, of reverse mortgages to senior homeowners, Canada’s HomEquity Bank will introduce product features to an fastest-growing demographic segment. With a quarter even broader segment of Canadian seniors and century of experience in the marketplace, HomEquity homeowners. Since launching the reverse mortgage Bank enjoys a strong financial position with access to offering in Canada, HomEquity Bank is proud to enhance diverse and cost-effective funding sources. its market position by meaningfully assisting Canadian seniors in their retirement years. Looking back, however, this success did not come in an instant. In fact, HomEquity Bank’s history dates back With a seasoned management 25 years ago when William Turner originated the reverse mortgage concept in Canada, and founded the Canadian team, product expertise, specially Home Income Plan Corporation. trained professionals who deal with seniors, and skillful marketing, A decade later, HomEquity Bank’s first major banking HomEquity Bank is well positioned partner recommended our solution to its clients, facilitating the expansion of a partner network that for continued market leadership now includes all major Canadian banks and credit unions, and growth. The Bank’s one-year mortgage brokers, and leading wealth management anniversary is marked by record financial planning providers across Canada. originations of $206 million in the 6_7 latest four quarters and a portfolio Annual Report 2010 that now exceeds $1 billion.
  • 10. 25 YEARS OF EXPERTISEThe CHIP Home IncomePlan helps seniors enjoytheir retirement years
  • 11. In their retirement years, there can bea financial shortfall between what manyseniors have, and what they need.TheCHIP Home Income Plan is a perfectsolution. It allows seniors to access asignificant portion of their home equityfor income purposes.By converting a portion of home equity into cash, the CHIP Home Income Plan generates additional cashflow, increases investment opportunities and can minimize taxes. Best of all, seniors can remain in theirhomes for as long as they wish with no interest payments. The CHIP Home Income Plan is uniquely positioned to address the lifestyle and financial needs of seniors.Since its inception, HOMEQ Corporation has analyzed It takes into account that 84% of seniors want to staythe demographic wave of Canadian seniors and how in their home and don’t want to move (Decima Research).our business can address these trends. The wave is Of note, for those seniors who own their own home,here, and the first baby boomers are now over 65 years 77% of their net worth is locked up in home equityold. Seniors are the fastest growing demographic: in six (Statistics Canada).years, they will number 8 million Canadians or 23% of Seniors depending on their homes for their financialthe population. needs face two significant challenges. First, assetsIn their retirement years, there can be a financial based on home equity don’t generate income. As well,shortfall between what many seniors have, and maintaining older homes or renovating them on a fixedwhat they need. That’s why many Canadian seniors income can drain limited resources. Without otherare working past retirement age. Indeed, 23% of options, seniors may be deprived from enjoying theirCanadians between 70 and 74 years of age have retirement years to the fullest.remained in the workforce (Statistics Canada). The CHIP Home Income plan is a perfect solution. ItWhile many seniors choose to work to stay active, allows seniors to access a significant portion of theirothers must work to maintain their lifestyle. home equity for income purposes. By converting aWith Canadians living longer, saving less, and spending portion of home equity into cash, it generates additionalmore, many Canadian seniors find that additional cash flow, increases investment opportunities and canmonthly income is needed to meet their needs. minimize taxes. Best of all, seniors can remain in theirEven their RRSPs may not make up the difference. cherished homes for as long as they wish with no interest payments. For all these reasons, the CHIP Home Income Plan is gaining recognition as an attractive solution for Canadian seniors seeking to enjoy their retirement years. 8_9 Annual Report 2010
  • 12. MANAGEMENT DISCUSSION AND ANALYSISThe following management discussion and analysis (MD&A) is provided in order to enable readers to assess thefinancial position and results of operations of HOMEQ Corporation (HOMEQ) for the three months and year endedDecember 31, 2010. This MD&A should be read in conjunction with the Consolidated Financial Statements and theaccompanying notes for the year ending December 31, 2010. The financial statements and additional informationabout HOMEQ, including its Annual Information Form are available on SEDAR at www.sedar.com. This MD&A hasbeen prepared based on information available as at March 7, 2011. Unless otherwise indicated, all amounts arestated in Canadian dollars and have been prepared in accordance with Canadian generally accepted accountingprinciples (GAAP). HOMEQʼs Audit Committee reviewed this document, and prior to its release, the Board ofDirectors approved this document, on the Audit Committeeʼs recommendation.The management discussion and analysis is dated March 7, 2011.CAUTION REGARDING FORWARD-LOOKING STATEMENTSHOMEQ Corporation from time to time makes written and verbal forward-looking statements about businessobjectives, operations, performance, and financial condition, including, in particular, the forecast of anticipateddividend policy and the likelihood of HOMEQ’s success in developing and expanding its business. These may beincluded in HOMEQ’s or its predecessor’s Annual Reports, quarterly reports, regulatory filings, reports toshareholders, press releases, presentations and other communications.These forward-looking statements are based upon a number of assumptions and estimates that are inherentlysubject to significant uncertainties and contingencies, many of which are beyond the control of HOMEQ. Actualresults may differ materially from those expressed or implied by such forward-looking statements including but notlimited to risks related to capital markets and additional funding requirements, fluctuating interest rates, assetquality and rates of default as well as those factors discussed under the heading “Business Risks” herein and inHOMEQ’s documents filed on SEDAR. HOMEQ does not undertake to update any forward-looking statement,whether written or verbal, that may be made from time to time.
  • 13. Management D iscussion and A nalysisNON-GAAP MEASURESHOMEQ uses a number of financial measures to assess its performance. Some measures are calculated inaccordance with Canadian generally accepted accounting principles (GAAP), such as net interest income. Othermeasures are not defined by GAAP and do not have standardized meanings or similar measures used by othercompanies. HOMEQ believes that the non-GAAP items provide the reader with additional understanding of howmanagement views HOMEQʼs performance.Non-GAAP measures used in the MD&A include the following:YieldYield is a measure that presents interest earned on the mortgage portfolio as a percentage of the mortgageportfolio value.Cost of fundsCost of funds is a measure that presents the interest incurred on the debt used to fund the mortgage portfolio as apercentage of the aggregate value of debt.Spread IncomeSpread income is the difference in dollars between interest earned on the mortgage portfolio and interest paid onthe debt used to fund the portfolio.Spread PercentageSpread percentage is a measure that presents spread income as a percentage calculated as the differencebetween the yield earned on the mortgage portfolio and the cost of funds of the debt funding the mortgages.Tier 1 and Total Capital RatiosThe capital ratios provided in this MD&A are those of the Companyʼs wholly owned subsidiary, HomEquity Bank.The calculations are in accordance with the guidelines issued by the Office of the Superintendent of FinancialInstitutions (OSFI).Adjusted Net IncomeTo arrive at adjusted net income, HOMEQ removes certain items from reported net income which, as described inthe MD&A, management believes are not indicative of the underlying business performance.Adjusted Shareholders’ EquityTo arrive at adjusted shareholdersʼ equity, HOMEQ removes certain items from reported equity which managementbelieves are not indicative of the underlying capital structure.Return on Equity (Annualized) and Adjusted Return on Equity (Annualized)Return on equity (annualized) is a measure that presents net income earned in the current quarter multiplied by afactor of four and reflected as a percentage of average shareholdersʼ equity. Adjusted return on equity is calculatedas adjusted net income divided by the average adjusted shareholdersʼ equity.Efficiency ratioThe efficiency ratio is derived by dividing non-interest expenses by the sum of net interest income and non-interestincome. In general, a lower efficiency ratio is associated with a more efficient cost structure.Loan-to-valueLoan-to-value (LTV) measures the outstanding mortgage balance as a percentage of the appraised value ofthe property. 10_11 Annual Report 2010
  • 14. Management Discussion and A nalysisCORPORATE OVERVIEW AND STRATEGYHOMEQ Corporation is the continuing company of Home Equity Income Trust (the Trust) subsequent to a courtapproved plan of arrangement where the Trust converted to a corporation on June 30, 2009 (the Conversion).HOMEQ Corporation and the Trust are together referred to as “HOMEQ” or the “Company”.Effective June 30, 2009, all of the outstanding trust units of the Trust were exchanged for common shares ofHOMEQ on a one-for-one basis. All references to “shares” refer collectively to the common shares subsequent tothe Conversion and to units prior to the Conversion. All references to “dividends” refer collectively to payments toshareholders subsequent to the Conversion and to payments to unitholders prior to the Conversion. Since theConversion, HOMEQ has ceased reporting on matters specifically relevant to income trusts.HOMEQ has the same financial year end, December 31, as the Trust and continues the business of the Trust.HOMEQ through its subsidiary HomEquity Bank provides reverse mortgages, under the CHIP Home Income Planbrand, to homeowners aged 60 and over, Canadaʼs fastest growing demographic segment. The objective ofHOMEQ is to increase net income and return on equity through the profitable growth of the mortgage portfolio.HOMEQ is publicly traded on the Toronto Stock Exchange (TSX) under the symbol HEQ and has the followingdirect and indirect subsidiaries: • HomEquity Bank originates and finances reverse mortgages and provides mortgage administration services on the reverse mortgage portfolio. HomEquity Bank has been the main underwriter of reverse mortgages in Canada since its predecessor, Canadian Home Income Plan Corporation (CHIP), pioneered the concept in Canada in 1986. CHIP received its Letters Patent and Order to Commence as a federally regulated Schedule I bank, HomEquity Bank, from the Minister of Finance on October 13, 2009. HomEquity Bank issues Guaranteed Investment Certificate deposits to fund its mortgage portfolio. Unless indicated otherwise, CHIP and HomEquity Bank are collectively referred to as HomEquity Bank. • CHIP Mortgage Trust (CMT), a wholly owned subsidiary of HomEquity Bank, finances a segment of the reverse mortgages originated by HomEquity Bank by issuing short-term and medium-term debt. Senior debt is rated ʻR1-highʼ and ʻAAAʼ and subordinated debt is rated ʻBBBʼ by DBRS Limited (DBRS).The discussion of HOMEQʼs operations in the MD&A and financial statements consolidates the activities ofthese subsidiaries.Reverse mortgages are a solution to the financial needs of Canadian seniors. A reverse mortgage is a type ofresidential mortgage that permits qualifying homeowners to convert a portion of their home equity into cash on atax-free basis while remaining in the home. The advantage of a reverse mortgage, particularly to homeowners whohave significant portions of their wealth invested in their home, is that they are not required to repay any principalor interest on such mortgage until the loan becomes due.Each reverse mortgage is secured by a specific residential property, is a registered first mortgage and containsstandard contractual mortgage terms, conditions and default remedies. The loan becomes due on the earlier of (i)the time the home is sold, (ii) the time the home is permanently vacated by the mortgagors (as both spouses aretypically mortgagors), (iii) 180 days following the death of the last surviving mortgagor, and (iv) demand forrepayment after the occurrence of an event of default (including failure to pay property taxes, maintain insuranceor keep the home in proper repair).No event of default will occur merely because the outstanding balance of the reverse mortgage exceeds theappraised value of the underlying property. Notwithstanding a demand for repayment in the event of default,homeowners may remain in the home as long as they wish or are able. When the loan becomes due, the reversemortgage is usually repaid from the proceeds of the sale of the home and any excess value of the home remainswith the homeowner or the homeownerʼs estate. The right of HOMEQ to receive principal and interest when dueunder the reverse mortgage is limited to the realized value of the property at such time and HOMEQ has noadditional recourse to the mortgagors or their estates.HOMEQ actively markets reverse mortgages through referral networks and on a direct-to-consumer basis. Itsnetwork of referral arrangements includes all of the national Schedule I chartered banks in Canada as well as creditunions, mortgage brokers, and investment and financial planning firms.
  • 15. Management D iscussion and A nalysisHOMEQ finances its portfolio of mortgages with deposits, medium-term notes (MTNs), subordinated debt, and tothe extent necessary to maintain its regulatory capital and debt rating, equity. By maintaining a diversified sourceof financing it is able to mitigate its liquidity risk. The mix of funding in place is based on several factors includingcost and availability at any point in time.StrategyHOMEQʼs strategy is to continue to capitalize on the strong growth potential of reverse mortgages as a viablesource of cash flow for Canadian senior homeowners, adding new mortgages to a growing and increasinglyprofitable portfolio. The growth HOMEQ is experiencing is driven by a confluence of several factors.Seniors are the fastest growing segment of Canadaʼs population. According to Statistics Canada estimates, in thenext five years, the number of seniors will grow by nearly 20%. The first wave of baby boomers are now turning 65and entering retirement with different attitudes about work, debt and health.Meanwhile, the need for dependable and predictable sources of income in retirement is growing. Todayʼs seniorsare expected to live longer, but they are saving less than their parents did. The average Canadian between 55 and65 has less than $125,000 in their RRSP, according to a Statistics Canada report published in 2007.While homes represent a substantial portion of seniorsʼ wealth, reverse mortgages are a simple and sensiblesolution designed to unlock the productive potential of home equity. By turning a portion of the equity locked up intheir homes into cash, senior homeowners can create additional cash flow by either supplementing their incomedirectly or by investing the proceeds for income.HOMEQ is benefiting from increased acceptance of reverse mortgages in the marketplace, driven by greaterawareness of the solution and its benefits. Focused public relations and marketing efforts combined with uniquesolution features and competitive pricing have contributed to a successful repositioning of reverse mortgages as amainstream retirement financing solution for Canadaʼs senior homeowners. As well, an expanded distributionnetwork that now includes all major national Schedule I Canadian chartered banks, numerous credit unions,mortgage brokers, wealth management and financial planning organizations further broadens the awareness andavailability of reverse mortgages.The significant sustained benefits to HOMEQʼs net income will become evident as a result of a larger asset baseon which spread is generated, significant efficiencies in generating originations, as well as from the economies ofscale in administration infrastructure.ANNUAL OVERVIEWDuring 2010 HOMEQ celebrated the first anniversary of HomEquity Bank and entered its 25th year of businessoperations with record mortgage originations of $205.8 million. Increased brand awareness and competitive pricinghas resulted in higher demand across the country, and has established reverse mortgages as a mainstream financialsolution in Canada. In addition, the volume of inquiries and applications grew in the year and the sales cyclecontinued to shorten, indicating the strong motivation of new customers to acquire a reverse mortgage. The highermortgage originations are being achieved at a reduced origination cost percentage indicating effective sales andmarketing activity. The origination cost percentage for the year improved to 6.0%, a decrease from 9.5% in 2009.HOMEQʼs mortgage portfolio surpassed $1.0 billion, increasing $150.7 million or 17.4% over the year, as a resultof a combination of the increased volume of new mortgages originated and accrued interest net of mortgagerepayments. The quality of the mortgage portfolio remains strong at 36% LTV and a low incidence of non-performing loans.The overhead structure has increased in accordance with operating a federally regulated entity. However, improvedoperational efficiency will have an offsetting effect in future years. The mortgage administration expensepercentage was 0.75% in 2010, an increase from 0.69% in 2009, due mainly to the additional expenses ofoperating as a bank. 12_13 Annual Report 2010
  • 16. Management Discussion and A nalysisMortgages originated in 2010 were funded with Guaranteed Investment Certificates (GICs), and the depositinfrastructure operated effectively during the year. HOMEQ issued a total of $343.3 million of GICs during the yearand began to repay GICs issued in 2009. GICs provide a reliable and stable source of funding. HOMEQ sourcesits GICs exclusively through leading deposit brokers.During the year, HOMEQ managed the maturities of MTNs by raising funds well in advance of the expected finalpayment dates and repurchasing MTNs that were available. The remaining maturing MTNs were repaid on therespective expected final payment dates in the fourth quarter. HOMEQ also repurchased $10.0 million ofsubordinated debt during the year. The sources of funds for these transactions were GICs and new MTNs issuedduring the year.To maintain a sound capital structure and to sustain its growth trajectory, HOMEQ borrowed $10.0 million as a non-revolving term loan, the proceeds of which were used to invest in unsecured subordinated debt of HomEquity Bank,qualifying as Tier 2B capital. In addition, HomEquity Bank issued $10.0 million of unsecured subordinated debt toa third party also qualifying as Tier 2B capital.FINANCIAL HIGHLIGHTSFinancial OverviewReverse mortgages are long-term assets and earn interest over a multi-year period. Under GAAP, interest incomeis recognized in the period it is earned despite not being received in cash. Other than sales commissions andorigination salaries and benefits, which are deferred and amortized over the period the mortgages are expected toearn interest, origination costs such as marketing and the share of overhead expenses applicable to new mortgageoriginations are expensed under GAAP in the period incurred. This can have the effect of reducing net incomeduring periods of growth, but benefiting HOMEQ in the longer term.In 2009 HOMEQ changed its corporate structure from an income trust to a taxable entity. The resulting changes infinancial presentation are not entirely comparative to periods prior to Q2 2009.The table below provides a summary of results of the past nine quarters of operations. 2008 2009 2010($ thousands, Full Full Fullexcept per share amounts) Q4 Year Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearInterest income (1) (2) 14,833 59,800 13,077 12,524 11,961 11,273 48,835 10,861 11,537 12,485 13,060 47,943Interest expense 9,473 39,470 8,492 7,201 6,268 5,694 27,655 5,555 5,728 6,573 7,649 25,505Net interest income 5,360 20,330 4,585 5,323 5,693 5,579 21,180 5,306 5,809 5,912 5,411 22,438Provision for credit losses (1) (174) (276) 23 (40) (1,784) (39) (1,840) (201) (150) (136) (287) (773)Non-interest income (2) 31 128 25 36 66 40 167 19 37 29 32 117Net interest incomeand other income 5,217 20,182 4,633 5,319 3,975 5,580 19,507 5,124 5,696 5,806 5,156 21,782Non-interest expenses (2) 2,913 11,770 2,903 2,893 2,904 3,300 12,000 3,055 3,186 3,395 3,498 13,134Income before undernoted items 2,304 8,412 1,730 2,426 1,071 2,280 7,507 2,069 2,510 2,411 1,658 8,648Less: Unrealized (gain) loss on derivative instruments (17,746) (27,363) (2,271) 5,384 1,595 3,819 8,527 1,971 3,816 1,372 2,275 9,434 Current income tax expense (recovery) (2) – – – 973 900 1,873 869 1,038 864 (1,465) 1,306 Future income tax expense (recovery) 4,277 6,242 910 2,108 (1,300) (2,784) (1,066) (850) (1,395) (621) 651 (2,215)Net income (loss) 15,775 29,533 3,091 (5,066) (197) 345 (1,827) 79 (949) 796 197 123Per share 1.12 2.10 0.22 (0.36) (0.01) 0.02 (0.13) 0.01 (0.07) 0.06 0.01 0.01Average numberof shares outstanding 14,122 14,069 14,153 14,213 14,229 14,239 14,209 14,260 14,308 14,348 14,385 14,327(1) For the periods Q3 2009 and prior, specific allowances have been reclassified from interest income to provision for credit losses.(2) For the periods 2009 and prior, mortgage closing fees, net of costs and mortgage origination salaries and benefits have been reclassified to interest income from non-interest income and non-interest expenses respectively.
  • 17. Management D iscussion and A nalysisAdjusted Net Income and Adjusted Return on EquityThe table below details the adjustments between net income and adjusted net income for the past nine quarters ofoperations. In calculating adjusted net income, HOMEQ removes certain items from reported net income as itbelieves that these items are not indicative of the underlying business performance. In particular, as furtherdiscussed under “Derivatives” later in the MD&A, derivatives are normally held to maturity and thus any unrealizedgains or losses are timing differences and will be zero at maturity. In addition, costs related to the Conversion, theadjustment to the provision for credit losses in Q3 2009 and changes in future income tax rates are not consideredrecurring items. HOMEQ has calculated notional taxes for prior quarters when it was an income trust using a taxrate of 33%. 2008 2009 2010($ thousands, Full Full Fullexcept per share amounts) Q4 Year Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearNet Income (loss) before tax 20,050 35,775 4,001 (2,958) (524) (1,539) (1,020) 98 (1,306) 1,039 (617) (786)Add (deduct) Unrealized (gain) loss on derivatives (17,746) (27,363) (2,271) 5,384 1,595 3,819 8,527 1,971 3,816 1,372 2,275 9,434 Conversion costs – – 522 524 65 – 1,111 – – – – – Adjustment to provision for credit losses – – – – 1,741 – 1,741 – – – – –Adjusted net income before tax 2,304 8,412 2,252 2,950 2,877 2,280 10,359 2,069 2,510 2,411 1,658 8,648Notional taxes (760) (2,776) (743) (974) – – (1,717) – – – – –Tax provision as reported less taxeffect of above items and changesin future income tax rates – – – – (791) (466) (1,257) (549) (646) (604) 224 (1,574)Adjusted net income 1,544 5,636 1,509 1,976 2,086 1,814 7,385 1,520 1,864 1,807 1,881 7,074Per share 0.11 0.40 0.11 0.14 0.15 0.13 0.52 0.11 0.13 0.13 0.13 0.49Average number ofshares outstanding 14,122 14,069 14,153 14,213 14,229 14,239 14,209 14,260 14,308 14,348 14,385 14,327Similarly, management adjusts shareholdersʼ equity for items it believes are not indicative of the underlying capitalstructure in order to arrive at adjusted shareholdersʼ equity used to determine adjusted return on equity. Adjustedreturn on equity is calculated as adjusted net income divided by the average adjusted shareholdersʼ equity. Thetable below details the adjustments between shareholdersʼ equity and adjusted shareholdersʼ equity for the pastnine quarters. 2008 2009 2010 Full Full Full($ thousands) Q4 Year Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearShareholders’ equity 110,724 110,724 110,890 102,547 102,486 100,982 100,982 100,196 98,480 98,654 98,068 98,068Add (deduct)Derivative instruments, net (22,119) (22,119) (23,231) (17,344) (16,271) (14,101) (14,101) (12,818) (10,001) (9,041) (7,387) (7,387)Adjusted shareholders’ equity 88,605 88,605 87,659 85,203 86,215 86,881 86,881 87,378 88,479 89,613 90,681 90,681Adjusted return onequity (annualized) 6.9% 6.2% 6.8% 9.1% 9.7% 8.4% 8.4% 7.0% 8.5% 8.1% 8.4% 8.0%A discussion of various elements impacting net income follows. Where applicable, further details are discussedlater in the MD&A. 14_15 Annual Report 2010
  • 18. Management Discussion and A nalysisNet Interest IncomeNet interest income is derived mainly from the spread between the interest earned on the mortgage portfolio andthe interest paid on the debt to fund the portfolio. In 2010, net interest income was $22.4 million, an increase of$1.3 million or 5.9% over 2009, in comparison to the 17.3% increase in the mortgage portfolio. The rate of growthof net interest income is lower than the portfolio growth due to the following reasons; interest income lags portfoliogrowth because portfolio growth occurs throughout the year; HOMEQ held increased levels of cash resourcesearning lower yields; credit spreads on MTNs have increased over the year; and HOMEQ issued $30.0 million ofhigher costing unsecured subordinated debt and bank term loan in late 2009 and during 2010.In Q4 2010, net interest income was $5.4 million, $0.2 million or 3.0% lower than Q4 2009 due mainly to the interestexpense on the unsecured subordinated debt and the bank term loan issued in Q3 of 2010.Net interest income in Q4 2010 was $0.5 million lower than Q3 2010 due to the gains realized in the third quarteron the MTN repurchases and derivative unwind transactions as well as a full quarter of interest expense on theunsecured subordinated debt and the bank term loan issued during the third quarter.Provision for Credit LossesThe provision for credit losses includes specific and general allowances determined in accordance with HOMEQʼsinternal policies.The specific allowance increased $0.4 million during the year to $0.6 million, 0.06% of the value of the mortgageportfolio. The general allowance for credit losses increased $0.4 million to $2.5 million, equivalent to 0.25% of thevalue of the mortgage portfolio. In 2009, HOMEQ increased its general allowance by $1.7 million following acomprehensive assessment of statistical and qualitative analyses of the underwriting performance of eachmortgage as well as changes in the characteristics of the portfolio. The assessment, which is discussed in detaillater in the MD&A, included a review of general real estate conditions and trends and their potential impact on theportfolio. It is expected that as the mortgage portfolio grows, the general allowances will increase proportionately.Non-Interest ExpensesNon-interest expenses in 2010 of $13.1 million were $1.1 million or 9.5% higher than 2009. The increase is mainlyfrom $0.7 million relating to operating as a bank and $0.4 million in marketing. HOMEQʼs efficiency ratio for 2010was 58.2% compared to 56.2% in 2009. In general, a lower efficiency ratio is associated with a more efficient coststructure, a primary objective of HOMEQ. The increase in the efficiency ratio is a result of the increased cost baseas discussed above.Non-interest expenses for Q4 2010 of $3.5 million were $0.2 million or 6.0% higher than Q4 2009. The increasewas due to capital taxes and increased incentive compensation. HOMEQʼs efficiency ratio for Q4 2010 was 64.3%compared to 58.7% in Q4 2009.DerivativesUnder GAAP, derivatives not designated for hedge accounting are valued at fair market value with changes in fairvalue recognized in the current periodʼs statement of income. HOMEQʼs derivative portfolio is substantially weightedto receive fixed rates. Therefore the fair market value of the derivatives will move in an opposite direction to changesin the underlying interest rates and the yield curve used to value the derivatives. As rates decrease or the yield curveflattens, the fair value of the derivative portfolio increases. As the rates increase or the yield curve steepens, the fairvalue will decrease. In addition, as the derivative contracts approach maturity, the fair value will reduce.As the derivative portfolio matures, the derivative asset will be amortized resulting in unrealized losses onderivative instruments being recorded in the statement of income. HOMEQ has been designating most of itsderivatives as effective hedges during the year and applying the hedge accounting rules which should reduce thefluctuations to net income.HOMEQʼs derivatives are generally neither held for resale nor traded. For derivatives that are not subject to hedgeaccounting, HOMEQ believes that there is an asymmetry in the recognition methods of derivatives at fair marketvalue, and assets and liabilities at amortized cost. This has resulted in net income volatility not indicative of thebusiness. As both derivatives and medium-term debt are normally held to maturity, any unrealized gains or lossesare timing differences and will be zero at maturity.
  • 19. Management D iscussion and A nalysisHOMEQ recorded $9.4 million of unrealized loss on its derivatives in 2010 primarily due to the amortization of prioryear unrealized gains as the remaining duration of the instruments diminishes.In Q4 2010 the fair value of the derivatives declined $2.3 million primarily due to the amortization of prior yearunrealized gains and an increase in unrealized losses due an upward movement in interest rates.Income TaxesWith the conversion to a corporate structure on June 30 2009, HOMEQ is subject to income tax on its taxable incomeand has recorded a current tax expense of $1.3 million in 2010 compared to $1.9 million in 2009. Prior to theConversion, HOMEQ distributed all of its taxable income to its unitholders and was not subject to corporate taxes.HOMEQ also recorded a future tax recovery of $2.2 million in 2010 mainly as a result of the reduction of mark-to-market of the derivatives. In 2009 HOMEQ recorded a $1.1 million future tax recovery. Future income taxes areaccounted for under the liability method. Under this method of tax allocation, future tax assets and liabilities aredetermined based on differences between the financial reporting and tax basis of assets and liabilities and aremeasured using the substantively enacted tax rates and laws that will be in effect when the differences areexpected to reverse. Future income tax assets are recorded in the consolidated financial statements to the extentthat realization of such benefits is more likely than not.Net Income (Loss) and Adjusted Net IncomeHOMEQ reported $0.1 million of net income for the year, or $0.01 per share compared to a net loss of $1.8 millionor $0.13 per share in 2009. Adjusted net income in 2010 was $7.1 million or $0.49 per share, compared to $7.4million or $0.52 per share in 2009.For the fourth quarter of 2010 HOMEQ reported a net loss of $0.6 million or $0.04 per share and adjusted netincome of $1.9 million or $0.13 per share. The adjusted net income was comparable to 2009.Return on Equity and Adjusted Return on EquityHOMEQ reported a return on equity of 0.1% for 2010 (2009 – negative 1.7%) and adjusted return on equity of 8.0%(2009 – 8.4%).For Q4 2010, return on equity (annualized) was 0.8% compared to 1.4% in Q4 2009. Adjusted return on equity(annualized) was 8.4% in Q4 2010 (Q4 2009 – 8.4%).Portfolio GrowthHOMEQʼs objective is to grow the size of its mortgage portfolio thus generating increased profits and cash flow. Themortgage portfolio exceeded $1.0 billion dollars at December 31, 2010, increasing $150.7 million or 17.4% over2009. The following table shows the growth in the mortgage portfolio on a quarterly basis for the past nine quarters. 2008 2009 2010($ millions) Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4Opening mortgage balance (1) 798.2 814.2 825.7 832.9 837.0 865.7 905.0 946.0 985.0Originations 24.6 14.7 22.7 29.5 43.4 47.3 59.0 52.0 47.5Accrued interest 15.2 14.1 13.6 12.9 12.4 12.0 12.6 13.5 14.2Repayments of principal (15.4) (11.2) (20.0) (26.1) (17.7) (13.8) (21.1) (18.3) (20.8)Repayments of accrued interest (8.4) (6.1) (9.1) (12.2) (9.7) (6.2) (9.5) (8.2) (9.5)Reclassification of specific allowance (2) – – – – 0.3 – – – –Ending mortgage balance (1) 814.2 825.7 832.9 837.0 865.7 905.0 946.0 985.0 1,016.4Loan-to-value of new originations 27% 28% 28% 29% 33% 34% 32% 31% 30%Total repayments as % of opening balance 3.0% 2.1% 3.5% 4.6% 3.3% 2.3% 3.4% 2.8% 3.1%Trailing 4 quarters: Originations 129.6 116.1 99.8 91.5 110.2 142.9 179.2 201.7 205.8 Total repayments (84.1) (87.9) (92.6) (108.5) (112.1) (114.8) (116.3) (104.6) (107.4)(1) Excluding unamortized purchase price premiums, origination fees, deferred commissions and allowance for credit losses. 16_17(2) Starting in 2010, specific allowances are reported separately from the mortgage balance. An adjustment has been made in Q4 2009 in the above table. Annual Report 2010
  • 20. Management Discussion and A nalysisNew mortgage originations of $205.8 million were 86.7% higher than 2009. Demand for reverse mortgagescontinues to increase throughout the country and HOMEQ is benefiting from the experience and skill set of its salesforce and referral partners. The graph below shows the quarterly originations for the last nine quarters. During theperiod between Q4 2008 and Q3 2009, in order to conserve cash during the application process for obtaining itsbank licence, HOMEQ took steps to reduce its volume of mortgage originations. Mortgage Originations $ Millions $60.0 $50.0 $40.0 $30.0 $20.0 $10.0 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 $0 08 09 09 09 09 10 10 10 10 YearsAccrued interest in 2010 totalled $52.4 million, a decrease of $0.6 million or 1.1% from $53.0 million in 2009 dueto the combination of the 84 basis point reduction in yield earned on the mortgage portfolio offset by the 13.9%increase in the average mortgage balance. For Q4 2010, accrued interest of $14.2 million increased 14.5% due tothe 17.8% increase in average mortgage balance offset by the 13 basis point reduction in yield from Q4 2009.Total repayments of principal and interest of $107.4 million in 2010 were $4.7 million lower than 2009. As apercentage of the opening mortgage balance, total repayments were 12.4% were within the historical range of11.5% to 12.5%. Short-term fluctuations in the level of originations and repayments will have an impact on the totalportfolio balance in the future. Repayments in Q4 2010 were 3.1% of the opening mortgage balance. Mortgage Principal plus Accrued Interest $ Millions 14% CAGR $1,200 $1,000The compound annual growth $800rate of the portfolio from 2006 to2010 was 14%. $600 $400 $200 $0 06 07 08 09 10 Years
  • 21. Management D iscussion and A nalysisPortfolio QualityThe LTV measures the outstanding mortgage balance as a percentage of the appraised value of the property. Alower LTV, together with information on the past performance of the mortgage, indicates a probability that theproceeds realized on the disposition of the home will be sufficient to pay out the outstanding mortgage balance onmaturity. Once a mortgage has been originated, typically its LTV increases over time. Each property in themortgage portfolio is reappraised at least every five years.The average LTV ratio of the $205.8 million of new mortgages originated in 2010 was 31% compared to 30% in2009. The average LTV ratio of the $47.4 million of new mortgages originated in Q4 2010 was 30% in comparisonto 33% in Q4 2009. For the entire mortgage portfolio, the most recently appraised value of the underlying propertieswas $2.8 billion, for a LTV ratio of 36% at December 31, 2010, unchanged from that of December 31, 2009. Mortgages by LTV Range $ Millions $300The graph details the mortgage portfolio by $250loan-to-value range based on the mortgagevalue at December 31, 2010 and the most $200recent appraisal on the underlying property.Ninety-three percent of the portfolio has aloan-to-value ratio below 60 percent. $150 $100 $50 $0 < 20% 20.01%– 30.01%– 40.01%– 50.01%– 60.01%– 70.01%– 80.01%+ Dec-09 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% Dec-10HOMEQʼs policy is to cease accruing interest income from any mortgage where the loan to value (LTV) exceeds83% by creating a specific allowance for the amount by which the LTV is higher than 83%. To ensure that theseloans are reported as accurately as possible, each mortgage with a LTV in excess of 80% is reappraised at leastonce per year. At December 31, 2010, there were 22 loans with a specific allowance, an increase from 13 loans atDecember 31, 2009. These properties were disbursed across the country with a minor concentration in southernOntario. The total principal and accrued interest of these files net of a $0.6 million specific allowance was $3.3million, equating to 0.3% of the total portfolio. The appraised value of the properties securing the mortgages is $4.0million before disposition costs.HOMEQ continually monitors and reassesses its underwriting policies, procedures and methodology, paying closeattention to, amongst others, real estate trends, interest rate environments and occupancy experience. Inparticular, during the underwriting process: • Every property is appraised by a certified appraiser with particular attention paid to the property type, location and days on market of each comparative property; • The initial appraised value is subsequently discounted, typically by 7.5% or more; • A rate of future property appreciation is assumed for the life of the mortgage in comparison with the Canadian 20 year average. The average rate of assumed appreciation used in the initial underwriting of the mortgages in the portfolio is approximately 1.2%; and • Each mortgage originated is limited in maximum dollar amount and to no more than 55% LTV ratio. 18_19 Annual Report 2010
  • 22. Management Discussion and A nalysisThere is an inherent risk that the expected occupancy term, interest rate and property appreciation experiencedover the life of a mortgage might vary from the assumed factors used in underwriting the mortgage. In addition, thevalue of a mortgage may increase unexpectedly as a result of charges being applied to the mortgage during thecourse of its life. Charges applied to the mortgage can include fire insurance, property taxes, property maintenanceand legal fees which the client has not paid. HOMEQ covers these charges in order to retain its registeredmortgage in first position.HOMEQʼs loan provisioning methodology is reviewed and assessed periodically and, if required, is updated to takeinto account both current circumstances and evolution of the portfolio and business. In 2009, following acomprehensive assessment of statistical and qualitative analyses of the underwriting performance of eachmortgage as well as changes in the characteristics of the portfolio, HOMEQ amended its loan provisioning policybased on a risk management process that: • Utilizes an anticipatory approach to measuring and reporting risk and the probability of loss; • Calculates a general allowance that estimates the potential loss within the portfolio in an amount closely approximating the present value of projected future cash flow shortfalls; and • Adequately discloses general allowances. Geographic Diversification $ MillionsThe geographic distribution of the portfolioreflects the population density and real $400estate value across Canada. At December 31,2010, 75% of the reverse mortgage portfolio $300was located in Ontario and British Columbia.The graph shows the geographic distributionof the portfolio based on mortgage balances $200at December 31, 2009 and 2010. $100 $0 ON BC AB QC Other Dec-09 Dec-10The general allowance for credit losses increased $0.4 million to $2.5 million, equivalent to 0.25% of the total valueof the mortgage portfolio during 2010. As the mortgage portfolio grows the general allowance will also increase. In2009, the general allowance increased by $1.7 million in accordance with the amended provisioning methodologyand is not expected to recur to that extent again in the future. The provision recorded in 2009 has therefore beenexcluded from adjusted net income. Mortgagor Age Analysis $ MillionsClients in the age group of 71–85 $250represent 60% of the portfolio basedon outstanding mortgage balance. $200The average age of new customers formortgages originated in 2010 was 72.The graph shows the age distribution $150of clients within the portfolio based onmortgage balances at December 31, $1002009 and 2010 and reflects the consistententry age and occupancy term. $50 $0 60–65 66–70 71–75 76–80 81–85 86–90 91+ Dec-09 Dec-10
  • 23. Management D iscussion and A nalysisSpreadHOMEQʼs net interest income is derived from the spread between the interest earned on the mortgage portfolioand the interest paid on the GICs and debt used to fund the portfolio. Within the mortgage portfolio, the interestrate on 62% of the mortgages is based on Prime or Government of Canada Treasury Bill (T-Bill) rates plus a fixedspread while the interest on 38% of the mortgages is based on the more recent method of HomEquity Bankʼsposted rates. Posted rates are determined based on, amongst other factors, HomEquity Bankʼs average cost ofborrowing and the cost of comparative products. Until the proportion of the mortgage portfolio based on the postedrate increases, the yield earned on the mortgage portfolio will continue to be primarily driven by the portion of theportfolio based on Prime and T-Bill rates.In the fourth quarter of 2009, HomEquity Bank reduced its posted rates on new mortgages by an average ofapproximately 1.00%. Over a period of time the lower interest rates earned on new originations will have adownward effect on spread percentage but this will be offset by the effect of increased portfolio size and improvedorigination and administration efficiencies. In addition, borrowing costs can be effectively managed by havingaccess to more than one source of funds.Interest income earned on the mortgage portfolio in 2010 was $52.4 million, a decrease of $0.6 million or 1.1% from2009. The average yield earned on the mortgage portfolio of 5.52% was 84 basis points lower than 2009. Thereduced yield was partially offset by the 13.9% increase in the average mortgage portfolio from December 31,2009.HOMEQ funds its mortgage portfolio with a combination of GICs (35%) and debt (65%) (the Funding Portfolio).Debt consists of senior and subordinated medium-term debt, unsecured subordinated debt and a bank term loan.During the year HOMEQ managed the maturities of medium-term debt by raising funds by way of GICs and a newMTN issue well in advance of the maturities, and repurchasing MTNs that were available on the market. The rateof interest paid on refinancing these maturities will affect the overall cost of funds of the Funding Portfolio.GICs totalled $370.0 million at December 31, 2010 having an average cost of funds of 2.44%, compared to 2.22%at December 31, 2009. The increase in interest is reflective of the increase in the rate environment over the year.On June 22, 2010, HOMEQ issued $125.0 million of five-year MTNs having an expected final repayment date ofAugust 4, 2015. The debt was swapped in accordance with HOMEQʼs interest rate matching policy, resulting in acost of funds of 155 basis points above the corresponding BA rate. HOMEQ used $66.1 million of the proceeds torepurchase MTNs with expected final payment dates in the fourth quarter of 2010, and $24.0 million to repurchaseMTNs with expected final repayment dates in future years. Throughout the year, to help manage the large debtmaturities in Q4 2010, HOMEQ repurchased $93.1 million of maturing senior MTNs. HOMEQ refinanced theremaining $100.8 million of debt maturing in the fourth quarter with funds raised through GICs. The credit spreadof the bonds that matured in the fourth quarter was 87 basis points. In addition, $10.0 million of subordinated noteswere repurchased in June 2010.The cost of funds of the senior medium-term debt portfolio, on a swapped basis, at the end of the year had an averagecredit spread of 121 basis points in comparison to 103 basis points at December 31, 2009. The wider credit spreadis the result of more expensive debt issued in recent years refinancing less expensive debt issued five years ago.Also during the year, HOMEQ issued $10.0 million of unsecured subordinated debt and entered into a non-revolving term loan for $10.0 million, having interest rates of 8.60% and 8.21% respectively. Each transaction wasswapped in accordance with HOMEQʼs interest rate matching policy, resulting in a cost of funds of 608 and 592basis points above the corresponding BA rate, respectively. The impact of this debt, combined with the $10.0 millionof unsecured subordinated debt issued in 2009, on the Funding Portfolio is an 11 basis point increase in the costof funds annually.HOMEQ, in accordance with its asset and liability matching policy, unwound $148.4 million of derivatives during theyear which reduced the cost of funds by 19 basis points for the year.HOMEQ recognized $0.3 million gain in the year, reducing interest expense on the MTN repurchases and derivative 20_21 Annual Report 2010
  • 24. Management Discussion and A nalysisunwind transactions.Interest expense on the Funding Portfolio in 2010 was $25.5 million, a decrease of $2.2 million or 7.8% from 2009due to the cost of funds being 64 basis points lower partially offset by a 16.0% increase in the average size of theFunding Portfolio. The increase in the Funding Portfolio is a result of the funding requirements of the growingmortgage portfolio and capital requirements. The cost of funds on the Funding Portfolio was 2.60% in 2010,compared to 3.24% in 2009. The lower cost of funds is due to a lower interest rate environment offset by the moreexpensive interest cost on debt issued during the year.The interest income and interest expense discussed above resulted in a spread of $26.9 million earned in 2010,$1.5 million or 6.1% higher than 2009. Spread income increase as the mortgage portfolio increases.The combination of lower interest rates charged on new mortgages, the higher credit spread on the senior MTNsand the interest cost on the new subordinated debt and bank term loan resulted in a lower spread percentageearned in 2010 of 2.96%, 16 basis points lower than 2009.For Q4 2010, spread percentage was 2.78%, 37 basis points lower than Q4 2009 largely as a result of the highercost of funds on refinancing the November maturity and the full quarter effect of the higher interest rates on theunsecured subordinated debt and bank term loan issued in Q3 2010. Spread income in Q4 2010 of $6.5 million,was $0.1 million lower than Q4 2009. The spread percentage is expected to be compressed through the firstquarter of 2011 until the May 2011 maturity is refinanced. The MTNs maturing in May 2011 have a credit spread of187 basis points and are expected to be refinanced with GICs and a MTN with a lower credit spread.Interest rate risk resulting from timing differences between the interest reset dates on the mortgages and interestreset dates on HOMEQʼs debt is managed through the use of derivative instruments such as interest rate swapsand forward rate agreements. Derivative instruments are entered into with Schedule I Canadian chartered banksto reduce counterparty risk. The objective of HOMEQʼs hedging practices is to maintain a relatively stable spreadbetween interest earned on the mortgages and interest paid on the highly rated debt used to fund them.HOMEQ has elected under CICAʼs Section 3865 – Hedges to apply hedge accounting for certain interest rateswaps in its derivative portfolio. The designated hedges are effective at December 31, 2010. The objective of thesehedges is to protect against changes in the fair value of the deposits and debt due to changes in the underlyingbenchmark interest rate.Spread income and spread percentage for the prior nine quarters are shown below. 2008 2009 2010 Full Full($ thousands) Q4 Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearMortgage interest income (1) 15,036 14,177 13,595 12,877 12,321 52,970 12,037 12,649 13,493 14,183 52,362Average mortgage balance (2) (3) 805,422 820,369 829,548 832,866 848,452 833,025 883,077 924,459 964,032 999,592 948,586Average mortgage yield– annualized (%) 7.41% 7.01% 6.57% 6.13% 5.76% 6.36% 5.53% 5.49% 5.55% 5.63% 5.52%Interest expense 9,474 8,492 7,201 6,268 5,694 27,655 5,555 5,728 6,573 7,649 25,505Average debt balance (3) (4) 850,102 848,448 847,809 846,418 864,221 852,823 900,225 944,874 1,025,044 1,064,201 988,968Cost of funds – annualized (%) 4.42% 4.06% 3.41% 2.94% 2.61% 3.24% 2.50% 2.43% 2.54% 2.85% 2.60%Spread ($) 5,562 5,685 6,394 6,609 6,627 25,315 6,482 6,921 6,920 6,533 26,856Spread (%) 2.99% 2.95% 3.17% 3.20% 3.15% 3.12% 3.03% 3.06% 3.01% 2.78% 2.96%(1) Net of specific allowances for 2008 and 2009, also excludes early repayment fees and amortization of purchase price premiums, deferred commissions and deferred mortgage fees and costs.(2) Excluding unamortized purchase price premiums, origination fees and commissions and deferred mortgage fees and costs.(3) Calculated on the average of the month end balances during the period.(4) Reflects the principal portion of deposits and debt.
  • 25. Management D iscussion and A nalysisMortgage Origination CostHOMEQʼs objective is to limit mortgage origination costs to no more than 6% of the value of mortgages originated,and to focus on improving sales and marketing efficiencies in order to reduce this percentage over time.Total origination costs of $12.3 million in the year were $1.9 million or 17.7% higher than 2009 in comparison toorigination growth of over 86.7%. The origination cost percentage for 2010 of 6.0% improved 3.5 percentage pointsover 2009 and is the lowest since HOMEQ went public in 2002. Marginal origination cost percentage of 4.3% was2.5 percentage points lower than 2009.In Q4 2010 total origination costs were $3.3 million, 3.8% lower than Q4 2009 while mortgage originationsincreased by 9.4%. Total origination cost percentage in the quarter was 7.0% compared to 8.0% in Q4 2009.Marginal origination cost percentage of 5.0% was 0.9% lower in Q4 2010 than in Q4 2009.A significant improvement in origination capacity and efficiency has been achieved in part by the increased sizeand experience of the sales force and support teams, and the management of overhead expenses. Theimprovement in efficiency will partially offset the impact of a reduction in spread which has resulted from lowerrates.The following table provides the details of the calculation for the past nine quarters. 2008 2009 2010 Full Full($ thousands) Q4 Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearMortgage originations 24,554 14,680 22,690 29,460 43,365 110,195 47,260 59,000 52,038 47,461 205,759 Origination expenses Commissions 1,230 856 943 1,166 1,681 4,646 1,279 1,389 1,418 1,557 5,643Direct origination expenses Origination salaries and benefits 189 201 193 191 197 782 185 190 168 170 713 Marketing 774 428 356 581 663 2,028 588 614 610 626 2,438Marginal origination costs 2,193 1,485 1,492 1,938 2,541 7,456 2,052 2,193 2,196 2,353 8,794Origination overhead expenses Salaries and benefits 1,233 1,082 1,077 1,106 1,502 4,767 1,233 1,322 1,431 1,610 5,596 Office 266 264 283 283 353 1,183 326 337 365 332 1,360 Subtotal 1,499 1,346 1,360 1,389 1,855 5,950 1,559 1,659 1,796 1,942 6,956 50% inclusion 749 673 680 695 927 2,975 779 830 898 971 3,478Total origination cost 2,942 2,158 2,172 2,633 3,468 10,431 2,831 3,023 3,094 3,324 12,272Origination cost (%) Marginal Origination cost Current quarter 8.9% 10.1% 6.6% 6.6% 5.9% 6.8% 4.3% 3.7% 4.2% 5.0% 4.3% Trailing four quarter 7.4% 7.5% 7.9% 7.8% 6.8% 6.8% 5.6% 4.8% 4.4% 4.3% 4.3% Total Origination cost Current quarter 12.0% 14.7% 9.6% 8.9% 8.0% 9.5% 6.0% 5.1% 5.9% 7.0% 6.0% Trailing four quarter 9.6% 9.8% 10.6% 10.8% 9.5% 9.5% 7.7% 6.6% 6.1% 6.0% 6.0%Origination overhead costs increased in 2010 due to increased costs relating to operating as a bank and incentivecompensation based on 2010 actual results versus targets.Commissions in Q4 2010 include annual quota incentives earned on the record $205.8 million mortgage originations. 22_23 Annual Report 2010
  • 26. Management Discussion and A nalysisMortgage Administration ExpenseCost effective administration of its mortgages is an important objective of HOMEQ. In 2010, mortgageadministration expenses were $7.1 million, $1.4 million or 24.1% higher than 2009, in comparison with growth inthe average mortgage portfolio of 13.9%. The increase is mainly due to the added cost related to operating as abank. As a percentage of the average mortgage portfolio, mortgage administration expenses were 0.75% in 2010,compared to 0.69% in 2009.In Q4 2010, administration costs were $1.9 million, $0.2 million or 12.0% higher than Q4 2009. The averagemortgage portfolio increased 17.8%. As a percentage of the average mortgage portfolio, mortgage administrationexpense percentage was 0.75% in Q4 2010, compared to 0.79% in Q4 2009.On a quarterly basis, mortgage administration expenses may fluctuate slightly, however, operational efficienciesand economies of scale are reducing administrative expenses as a percentage of the average mortgage portfolio.The following table provides the details of the calculation for the past nine quarters. 2007 2008 2009 Full Full($ thousands) Q4 Q1 Q2 Q3 Q4 Year Q1 Q2 Q3 Q4 YearAverage mortgage balance 805,422 820,369 829,548 832,866 848,452 833,025 883,077 924,459 964,032 999,592 948,586Administration expenses Mortgage administration 64 75 67 88 77 307 75 118 100 127 420 Origination overhead expenses 749 673 680 695 927 2,975 779 829 898 971 3,477 Professional services 417 878 981 502 478 2,839 508 549 640 424 2,121 Amortization of capital assets 69 60 64 66 91 281 102 88 86 89 365 Business and capital taxes – – – 215 45 260 72 63 56 160 351 Other 93 116 65 63 91 335 151 95 107 130 483Less: Conversion costs – (522) (524) (65) – (1,111) – – – – – Mortgage administration fees (31) (25) (36) (66) (39) (167) (20) (37) (30) (30) (117)Total administration expenses 1,361 1,255 1,297 1,498 1,670 5,720 1,667 1,705 1,857 1,871 7,100Administration expense (%) Annualized 0.67% 0.61% 0.63% 0.72% 0.79% 0.69% 0.76% 0.74% 0.77% 0.75% 0.75% Trailing four quarters 0.67% 0.63% 0.64% 0.66% 0.69% 0.69% 0.72% 0.75% 0.76% 0.75% 0.75%CASH FLOW AND LIQUIDITYThe objective of liquidity management is to ensure that the amount of liquidity available is sufficient to meetHOMEQʼs financial obligations when they are due in order to support the orderly continuation of operations. Seniormanagement is responsible for managing the various funding sources, and to ensure that adequate funds areavailable for future growth at an appropriate cost. Liquidity management ensures availability of funds to meetanticipated maturities of existing sources of funds and to finance growth in the asset portfolio. The liquiditymanagement process takes into account operating liquidity, uncertainties surrounding cash flows, the quality ofliquid assets and the availability of funding facilities.An intricacy of HOMEQ is the deferred nature of its income streams. HOMEQ earns and accrues interest on amonthly basis, yet interest income is not received in cash until mortgages are repaid. Whereas net accrual of intereston mortgages (accrual of interest on mortgages net of repayments of accrued interest) is deemed an operatingactivity in accordance with GAAP, it results in growth in the mortgage portfolio, equivalent to new originations, andis effectively an investing activity. Pursuant to the covenants in CMTʼs trust indenture and the capital treatment ofHomEquity Bankʼs assets, HOMEQ is able to finance substantially all of the growth in its mortgage portfolio (netaccrual of interest plus originations net of mortgage principal repayments) with GICs and debt.HOMEQ finances its portfolio of mortgages with GICs, MTNs, subordinated debt, and to the extent necessary tomaintain its regulatory capital and debt rating, unsecured subordinated debt and equity. By maintaining a diversifiedsource of financing it is able to mitigate its liquidity risk. The mix of funding in place is based on several factorsincluding cost and availability at any point in time.
  • 27. Management D iscussion and A nalysisPrimary sources of funding are as follows: • GIC Deposits – HomEquity Bank accepts deposits from the public by issuing GICs with terms up to five years. GICs provide a reliable and stable source of funding that can be matched against anticipated reverse mortgage cash flows. Payment of principal and interest on HomEquity Bankʼs GICs is eligible to be guaranteed to the holder by the Canadian Deposit Insurance Corporation in an amount up to $100,000. Deposits are sourced exclusively through deposit agents who are members of the Federation of Canadian Independent Deposit Brokers or the Investment Industry Regulatory Organization of Canada. HomEquity Bank has longstanding relationships with the largest Schedule I banks through the mortgage origination partnership agreements which have been in place for many years. The majority of its deposits come from affiliated deposit agents of some of these banks. • Medium-Term Notes – CMT has the option of raising funds through the issuance of medium-term debt. DBRS has issued a AAA rating on the senior medium-term debt and BBB rating on the subordinated debt. As a result of these superior ratings, CMT has historically had access to the capital markets to finance new mortgages on cost-effective terms. Pursuant to the terms of its indenture and with the consent of the rating agency rating its debt, CMT is permitted to operate with a maximum senior debt-to-mortgage ratio of 95% when its senior rated debt consists only of MTNs. Including senior and subordinated debt, it is permitted to operate with a maximum total debt-to-mortgage ratio of 98%. CMT must also maintain minimum cash on hand equivalent to at least 2% of the CMT mortgage portfolio value. During the period, CMT operated within these covenants. At December 31, 2010, the senior debt-to-mortgage ratio was 76.4% and the total debt-to-mortgage ratio was 82.8%. In order to mitigate the refinancing risk of existing MTNs, approximately 80% of these instruments can be extended from their expected final payment dates to their legal maturities which range from 2031 to 2035. We expect that any MTNs issued in the future will also have extended legal maturities.As discussed earlier in the MD&A, the portfolio of reverse mortgages has a LTV of 36% and is secured byresidential real estate. As a result, HOMEQ can reasonably expect to recover the full recorded value of mostmortgages. HOMEQʼs portfolio of approximately 8,000 reverse mortgages is diversified by location, property type,date of origination and age of borrower. As supported by prior experience, between 2% and 5% of the mortgageportfolio is repaid each quarter, providing a predictable source of cash flow.Historically HOMEQ has used cash flows from operating activities to fund its operations and dividends, and theexcess of those cash flows coupled with borrowings under its debt programs have been used to fund growth in themortgage portfolio.Liquid AssetsHOMEQ holds liquid assets determined in accordance with its liquidity management policy which are invested incompliance with its liquidity investment policy. The credit quality of these assets is such that they are easilymarketable. They can be readily converted to cash to fulfill cash requirements should the need arise.The table below summarizes the liquid assets held at December 31. December 31, December 31,($ thousands) 2010 2009Cash and non-interest bearing deposits with banks 48,881 8,218Treasury bills issued or guaranteed by Canada – –Treasury bills issued or guaranteed by Provinces 15,993 6,298Corporate notes 1,200 –Cash and cash equivalents 66,074 14,516Interest bearing deposits with banks 11,994 21,972Total liquid assets 78,068 36,488 24_25 Annual Report 2010
  • 28. Management Discussion and A nalysisDepositsHOMEQ commenced issuing GICs when HomEquity Bank received its letters patent from the Minister of Financeon October 13, 2009. During the year HomEquity Bank issued $343.3 million of GICs in terms ranging from one tofive years and had $370.0 million of GICs outstanding at December 31, 2010. GICs have been used to fund newmortgages and, to some extent, maturing MTNs.The table below summarizes the timing of maturities of principal amount of deposits issued as of December 31. Within 2 to 4 to December 31, December 31,($ thousands) 1 year 3 years 5 years 2010 2009Issued to individuals 127,326 127,995 114,650 369,971 40,177DebtDuring the year HOMEQ managed the cash flow requirements of maturities of MTNs by raising funds well inadvance and repurchasing MTNs that were available. The remaining principal of maturing MTNs was repaid on theexpected final payment dates.The total principal amount of debt outstanding at December 31, 2010 of $689.1 million was $155.0 million lowerthan at December 31, 2009. The debt balance decreased due to the maturity of two MTNs in the fourth quartertotalling $260.0 million, the repurchase of $24.0 million of MTNs and $10.0 million of subordinated debt maturingin future years and $6.0 million of payments on the amortizing debt, offset by issuing $145.0 million in new debt asdetailed below. The repurchases reduced the negative carry on it cash resources.On June 22, 2010, HOMEQ issued $125.0 million of five-year MTNs having an expected final repayment date ofAugust 4, 2015. The MTNs were swapped in accordance with HOMEQʼs interest rate matching policy, resulting ina cost of funds of 155 basis points above the corresponding BA rate.On August 3, 2010, HomEquity Bank concluded the sale of $10.0 million of unsecured subordinated MTNs dueMay 31, 2016 having a coupon of 8.60%. The MTNs were swapped in accordance with HOMEQʼs interest ratematching policy, resulting in a cost of funds of 608 basis points above the corresponding BA rate. The proceeds ofthe MTNs were used for regular operating purposes. The total of $20.0 million unsecured subordinated debtconstitutes subordinated indebtedness within the meaning of the Bank Act (Canada) and qualifies as Tier 2BCapital of HomEquity Bank.On September 24, 2010, HOMEQ entered into a non-revolving term loan for $10.0 million maturing on May 31,2016 having a coupon of 8.21%. The loan was swapped in accordance with HOMEQʼs interest rate matching policy,resulting in a cost of funds of 592 basis points above the corresponding BA rate. The proceeds of the loan wereused to invest in unsecured subordinated debt issued by HomEquity Bank, constituting subordinated indebtednesswithin the meaning of the Bank Act (Canada) and qualifying as Tier 2B Capital. HOMEQ has provided a promissorynote, a general security agreement and a pledge of all investments made in HomEquity Bank including theunsecured subordinated debt and all of the issued and outstanding shares in the capital of HomEquity Bank.HOMEQ continues to be satisfied with its ability to access the wholesale debt market.The table below summarizes the timing of the expected final payments of the debt at December 31, 2010.Approximately 76% of these instruments can be extended from their expected final payment dates to their legalmaturities which range from 2031 to 2035. The remaining debt has a bullet payment requirement at their respectiveexpected final payment dates. Within 2 to 4 to More than 5 December 31, December 31,($ thousands) 1 year 3 years 5 years years 2010 2009Medium-term debt 280,800 213,280 125,000 619,080 784,115Subordinated debt 40,000 40,000 50,000Unsecured subordinated debt 10,000 10,000 20,000 10,000Bank term loan 10,000 10,000 –Total 280,800 253,280 135,000 20,000 689,080 844,115
  • 29. Management D iscussion and A nalysisThe $280.8 million of MTNs due within one year of December 31, 2010 is made up of two series of MTNs; $119.0million has an expected final payment date of May 2, 2011 and a legal maturity date of May 2, 2033 and $161.8million has an expected final payment date of May 16, 2011 and a legal maturity date of May 16, 2033.Subsequent to the end of the year, HomEquity Bank issued $175.0 million of senior MTNs on February 1, 2011 witha coupon of 3.97% and an expected final payment date of February 1, 2016. The MTNs were swapped inaccordance with HOMEQʼs interest rate matching policy, resulting in a cost of funds of 138 basis points above thecorresponding BA rate. Proceeds from this issue were used to repay the remaining amount of the $161.8 millionbond in Q1 2011. In addition, funds from the debt issue will be used in part to repay a portion of the $119.0 millionof MTNs maturing on May 2, 2011.CAPITALEquityOn June 30, 2009 the Conversion of the trust structure was completed, whereby the Trust and its subsidiariesbecame subsidiaries of HOMEQ. The outstanding units of the Trust were exchanged for common shares ofHOMEQ on a one-for-one basis.HOMEQ has three long-term incentive plans; a Restricted Share Plan (RSP) for management, a Deferred SharePlan (DSP) for Directors and an Option and Share Appreciation Rights Plan for management.A restricted share granted through the RSP entitles the holder to receive, on the vesting date, a share plus theamount of dividends that would have been paid on the shares respectively if the share had been issued on the dateof grant. Subject to the achievement of performance conditions, if any, restricted shares vest equally over threeyears and the total cost of the grant is recognized over the vesting period.The DSP allows the Directors to defer a portion of their cash compensation and receive the equivalent amount inshares of the Company. On retiring from the Board, a Director will receive all deferred shares accumulated in the plan.HOMEQ intends to settle the restricted and deferred shares in voting shares of the Company upon vesting andretirement respectively. Until such time, restricted and deferred shares do not trade on the TSX, have no votingrights and cannot be sold or liquidated early.During Q1 2010, the Board of Directors approved the Option and Share Appreciation Rights Plan as a third long-term incentive plan. The plan was approved by shareholders at the annual general meeting on May 13, 2010. Underthe plan, 82,000 stock options were granted to senior management of HOMEQ. These stock options were valuedat $0.1 million, have a term of seven years and vest equally over three years.The table below summarizes HOMEQʼs share activity for the period ended December 31, 2010. Management Directors’ Total Restricted Deferred Number Voting Share Plan Share Plan of SharesBalance, December 31, 2009 14,006,839 81,449 150,753 14,239,041Restricted shares redeemed 35,750 (35,750) – –Restricted share grants, net – 29,700 – 29,700Deferred shares earned – – – –Shares issued under dividend reinvestment plan 75,203 – – 75,203Shares earned and granted under the long-term incentive plan – – 46,446 46,446Balance, December 31, 2010 14,117,792 75,399 197,199 14,390,390Periodically, as required, HOMEQ may issue additional shares to maintain its regulatory capital and debt rating asthe mortgage portfolio grows. 26_27 Annual Report 2010
  • 30. Management Discussion and A nalysisOn March 23, 2010 HOMEQ introduced an optional Dividend Reinvestment Plan (the Plan) for shareholders. Therehave been 75,203 shares issued under the Plan in 2010.Shareholders participating in the Plan will be able to use the cash dividends paid on their existing HOMEQ sharesto purchase additional shares. Under the Plan, HOMEQ determines whether the additional shares are purchasedon the secondary market or are newly issued by HOMEQ. Newly issued shares will be priced at the volume-weighted average trading price of the HOMEQ shares on the Toronto Stock Exchange on the five trading dayspreceding the dividend payment date, subject to a possible discount of up to 5%.HOMEQʼs Board of Directors has determined that, until otherwise decided and announced, shares purchasedunder the Plan will be newly issued and at a discount of 4%. Therefore, participating shareholders will receiveshares valued at 104% of the cash dividend being reinvested. Further details of the Plan can be found on theCompanyʼs website at www.homeq.ca.Capital ManagementCapital is the fundamental building block which enables HOMEQ to support its lending and borrowing operations.The amount of capital required in relation to the size of HOMEQʼs operations is determined by regulation and bythe judgement of senior management and the Board.The overall objective of capital management is to ensure that HOMEQ has sufficient capital to maintain itsoperations based on current activities and expected business developments in the future. At the same time,HOMEQ must invest its capital to provide a return to shareholders commensurate with the risk of the business andcomparable to other financial institutions.The regulatory capital requirements of HomEquity Bank are determined in accordance with OSFI Guideline A,Capital Adequacy Requirement (CAR) – Simpler Approaches. The Guideline specifies the types of items includedin capital and the measures OSFI will consider in reviewing capital adequacy. There are two capital standardsaddressed in HomEquity Bankʼs capital management policy. These are the risk based capital ratio and the Assets-to-Capital Multiple.In the determination of its capital levels, HomEquity Bank has implemented an Internal Capital AdequacyAssessment Process (ICAAP) based on HOMEQʼs assessment of the business risks of HomEquity Bank. As aresult of this process, HOMEQ has established the capital ratios of HomEquity Bank and has developed controls,mitigating actions and contingency plans to be enacted on the occurrence of pre-determined events.HOMEQ intends to maintain strong capital levels through the retention of earnings, the management of its risk-weighted asset mix and by maintaining effective access to a variety of sources of additional capital should the needarise.As a result of changes to the qualifying criteria for capital under the guidelines published by the Basel Committeeon Banking Supervision (BCBS) on December 16, 2010 and January 13, 2011 and subsequent OSFI guidanceregarding the treatment of non-qualifying capital instruments published on February 4, 2011, certain capitalinstruments may no longer qualify as capital beginning January 1, 2013. HOMEQʼs non-common capital instrumentswill be considered non-qualifying capital instruments under Basel III and will therefore be subject to a 10% phase-out per year beginning in 2013. These non-common capital instruments include subordinated debentures.HOMEQ pays quarterly dividends to shareholders. The amount of dividends paid is at the discretion of the Boardof Directors, is evaluated annually and may be revised subject to business circumstance and expected capitalrequirements depending on, among other things, HOMEQʼs earnings, financial requirements for future operations,the satisfaction of solvency tests imposed by the Ontario Business Corporation Act for the declaration and paymentof dividends and other conditions existing from time to time.Subsequent to the end of the year, the Board of Directors declared a quarterly dividend of $0.07 per share on theoutstanding common shares of the Company, which is equivalent to an annual dividend of $0.28 per share. Thedividend is payable to shareholders of record at the close of business on March 30, 2011 and is payable onApril 14, 2011.
  • 31. Management D iscussion and A nalysisThe table below summarizes HOMEQʼs capital measures (relating solely to HomEquity) as at December 31, 2010. December 31, December 31,($ thousands) 2010 2009Shareholders’ equity per HomEquity Bank Consolidated Balance Sheet 75,494 76,666Deductions 341 301Tier 1 capital 75,153 76,365Unsecured subordinated debt 30,000 10,000Less: accumulated amortization for capital adequacy purposes 4,000 2,000Tier 2 capital 26,000 8,000Total regulatory capital 101,153 84,365Credit risk 518,689 440,250Off balance sheet exposure 3,463 6,258Operational risk 41,001 40,331Total risk-weighted assets 563,153 486,839Capital ratiosTier 1 capital ratio 13.3% 15.7%Total capital ratio 18.0% 17.3%Assets-to-capital multiple 11.5x 11.8xProduction capacityGiven the nature of its business, HOMEQ does not require significant investment in infrastructure, facilities orequipment. Limited capital investment is made on an ongoing basis to upgrade the information technology platform,to maintain the office environment and to provide the sales force with appropriate tools and equipment to carry outtheir functions. In the near term, future capital expenditure on the existing business is expected to continue at alevel consistent with prior years.FINANCIAL INSTRUMENTSAs reflected in Note 2 to the consolidated financial statements commencing on page 8 of the 2010 Annual FinancialStatements, in the normal course of business, HOMEQ uses derivative instruments such as interest rate swaps andforward rate agreements effectively matching the interest term of its debt to the interest term of the mortgageportfolio to ensure a relatively stable interest rate spread. Derivatives are classified as held-for-trading and aremeasured at fair value. Unrealized gains or losses from changes in fair value are recognized in the consolidatedstatements of income and changes in shareholdersʼ equity. Fair market values of the derivative instruments aredetermined using the period end interest rate curves compared to the rates in the derivative contract. Realizedamounts receivable or payable on derivatives are accrued and recorded as adjustments to interest expense in theconsolidated statements of income and changes in shareholdersʼ equity.HOMEQ does not hold or use any derivative contracts for speculative trading purposes. The derivative contractsused are entered into with Schedule I Canadian chartered banks to reduce any counterparty risk associatedwith derivatives.HOMEQ has elected under CICAʼs Section 3865 – Hedges to apply hedge accounting for certain interest rateswaps in its derivative portfolio. 28_29 Annual Report 2010
  • 32. Management Discussion and A nalysisBUSINESS RISKSHOMEQʼs business strategies and operations expose it to a range of risks that could adversely affect its business,financial condition and operating results. HOMEQ has adopted a risk management framework (RMF) methodology.The RMF uses a systematic and proactive approach, identifying high priority risks which are continuously reviewedand assessed such that appropriate action can be taken to mitigate those risks over time.In accordance with the RMF, HOMEQ performs regular monitoring of its risks, assessments, and related actionplans. Senior management and the Board of Directors obtain information that allows them to keep informedregarding the effectiveness of their risk management processes and activities. HOMEQ has created a ConductReview and Risk Management Committee in order to satisfy the above and assist the Board of Directors in fulfillingits responsibilities.In addition to ongoing risk management processes, management regularly evaluates a range of extreme butplausible scenarios and stress tests to evaluate the potential impact that these events could have on its business.HOMEQʼs stress testing program is in accordance with OSFI Guideline E-18, Stress Testing.The stress testing program is an important part of the HOMEQʼs enterprise risk management framework. Resultsfrom the stress testing program are used in part: • To assess whether current portfolio exposures and policy limits remain consistent with the institutionʼs risk appetite under stressed scenarios. • To quantify the amount of additional capital required in stressed scenarios. Stress testing is an integral component of capital management. • To discover potential early warnings that would otherwise be overlooked allowing management to be more proactive in its decision making process.Detailed below are the areas of risk that HOMEQ has identified and deemed to be its primary areas of exposure.A more complete analysis of HOMEQʼs risk universe is included in the risk section of HOMEQʼs Annual InformationForm, which is available on SEDAR.Credit RiskCredit risk is the potential for financial loss if the assets as currently reflected on the balance sheet becomeimpaired and not fully recoverable as a result of the occurrence of a specific event. In particular, this can result froma significant drop in real estate values persisting for an extended period of time.Risks included in this category include underwriting risk, derivative related risk, and financial instrument risk.This risk is managed and mitigated in the underwriting and administrative processes. In addition, each mortgageoriginated is limited in maximum dollar amount and LTV ratio in accordance with internal guidelines. Credit risk ismitigated further by the geographic diversity and the collateralization of the portfolio by mortgages with a currentappraised value at December 31, 2010 of $2.8 billion.Spread Interest RiskHOMEQʼs operating margin is primarily derived from the spread between interest earned on the mortgage portfolio,and the interest paid on the deposits and debt used to fund the portfolio. Spread interest risk is the exposure orpotential impact to HOMEQʼs earnings and financial condition to changes in interest rates, resulting either fromchanges in the shape of the yield curve, absolute changes in interest rates across the yield curve or the quality ofthe assets on which interest is earned. The risk arises when assets and liabilities have mismatched re-pricingdates, are referenced to different underlying instruments or the long-term expectation of the quality of assetsdiminishes. Risks included in this category include basis risk, refinancing/cost of debt risk, underwriting risk andderivative related risk.
  • 33. Management D iscussion and A nalysisHOMEQʼs objective is to maintain a relatively stable spread between interest earned on the mortgages and interestpaid on the debt used to fund them. HOMEQ has internal policies (interest rate risk management policy) regardingthe extent of mismatch that it is prepared to accept and has quantified the potential risk involved.Operational RiskOperational risk involves breakdowns in internal controls and corporate governance which can lead to financial lossthrough a variety of means. Risks included in this category include but are not limited to fraud, security risk, processrisk, business disruption and system failures and loss of key personnel. HOMEQ has implemented policies andprocedures to manage and control business activity and specified risks.Liquidity RiskLiquidity risk is the potential that HOMEQ may not be capable of meeting its financial obligations when they aredue to support the orderly continuation of operations. This can occur as a result of not being able to liquidateassets, payments not being received as expected, or obtain funding within the period of time required.HOMEQ has a diversified range and proven sources of funding alternatives and has created policies andprocedures to ensure that cash flows are accurately predicted and monitored. Access to sufficient funding at theprecise moment it is required cannot however be guaranteed. HOMEQ must therefore maintain a sufficient amountof liquid assets to fund its anticipated loan commitments, operations, deposit maturities and interest paymentsshould a shortfall arise.Legal and Regulatory RiskLegal and regulatory risk is the risk of non-compliance with applicable legal and regulatory requirements. Thiscan be difficult to manage since there are multiple regulators to comply with. Risks considered within the broadercategory of legal and regulatory risk include capital risk and money laundering and terrorist financing risk.HOMEQ has developed and implemented a Legislative Compliance Management Framework in order to managethese risks.CONTROLS AND PROCEDURESDisclosure Controls and ProceduresHOMEQ maintains appropriate information systems, procedures and controls to ensure that information disclosedexternally is complete, reliable and timely. HOMEQʼs President and Chief Executive Officer (CEO) and the SeniorVice President and Chief Financial Officer (CFO), evaluated or caused an evaluation, under their direct supervisionand with the participation of management, of the design and operating effectiveness of HOMEQʼs disclosurecontrols and procedures (as defined in National Instrument 52-109, Certification of Disclosure in Issuersʼ Annualand Interim Filings, of the Canadian Securities Administrators) as at December 31, 2010. Based on this evaluation,the CEO and the CFO concluded that such disclosure controls and procedures were appropriately designed andwere operating effectively.Internal Controls over Financial ReportingHOMEQ also established adequate internal controls over financial reporting to provide reasonable assuranceregarding the reliability of HOMEQʼs financial reporting and the preparation of the financial statements for externalpurposes in accordance with Canadian GAAP. HOMEQʼs CEO and CFO, evaluated or caused an evaluation, undertheir direct supervision and with the participation of management, of the design and operating effectiveness ofHOMEQʼs internal controls over financial reporting (as defined in National Instrument 52-109, Certification ofDisclosure in Issuersʼ Annual and Interim Filings, of the Canadian Securities Administrators) as at December 31,2010, using the Committee of Sponsoring Organizations Internal Control – Integrated Framework. Based on thisevaluation, the CEO and the CFO concluded that such internal controls over financial reporting were appropriatelydesigned and were operating effectively. 30_31 Annual Report 2010
  • 34. Management Discussion and A nalysisIt should be noted that a control system, no matter how well conceived and operated, can provide only reasonable,not absolute, assurance that the objectives of the control system are met. Given the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance that all control issues, includinginstances of fraud, if any have been detected. These inherent limitations include, among other items: (i) thatmanagementʼs assumptions and judgments could ultimately prove to be incorrect under varying conditions andcircumstances; (ii) the impact of undetected errors; and (iii) controls may be circumvented by the unauthorized actsof individuals, by collusion of two or more people, or by management override.The design of any system of controls is also based in part upon certain assumptions about the likelihood of futureevents, and there can be no assurance that any design will succeed in achieving its stated goals under all potentialfuture conditions.Changes in Internal Controls over Financial ReportingThere have been no significant changes in HOMEQʼs internal controls over financial reporting during the yearended December 31, 2010, that have materially affected, or are reasonably likely to materially affect, HOMEQʼsinternal control over financial reporting.ACCOUNTING POLICIES AND ESTIMATESChanges in Significant Accounting PoliciesThe significant accounting policies are outlined in Note 2 of the consolidated financial statements commencing onpage 8 of the 2010 Annual Financial Statements. There have been no changes in significant accounting policiesduring year other than as described below.Share-based compensationHOMEQ has adopted the fair value-based method of accounting for stock options and recognizes compensationexpense based on the fair value of the options on the date of grant, which is determined using the Black-Scholesoption pricing model. The fair value of the options is recognized over the vesting period of the options granted ascompensation expense and an increase to contributed surplus. The contributed surplus balance is subsequentlyreduced as the options are exercised and the amount initially recorded for the options in contributed surplus iscredited to common shares. Compensation expense related to stock-based compensation is included in salariesand benefits in the consolidated statements of operations.Critical Accounting EstimatesThe estimates listed below are considered critical because they refer to material amounts and require managementto make estimates that involve uncertainty.The allowance for credit losses recorded in the balance sheet is maintained at a level which is considered adequateto absorb credit-related losses to the mortgage loan portfolio. A mortgage allowance is taken when, in the opinionof management, there is no longer reasonable assurance of the collection of the full amount of principal andinterest. Mortgage allowances, in an amount which approximates the present value of projected future cash flowshortfalls, are determined based on the mortgage loan outstanding and the most recently appraised value of theunderlying property. HOMEQ has both general and specific allowances as described below.HOMEQʼs specific allowance policy is to cease accruing interest income on a mortgage having a LTV greater than83%. Any increase or decrease in specific allowances is included with provision for credit losses on theconsolidated statements of income.General allowances are provided for losses inherent in the mortgage portfolio but not yet specifically identified andtherefore not yet captured in the determination of specific allowances. HOMEQ evaluates and monitors theunderwriting performance indicators of mortgages as well as changes in the characteristics of the portfolio. Theseindicators include a review of general real estate conditions and trends and their potential impact on the portfolio, theexpected occupancy term and interest rates experienced over the life of a mortgage compared to initial underwritingassumptions.
  • 35. Management D iscussion and A nalysis 32_33 Annual Report 2010
  • 36. Management Discussion and A nalysisHOMEQ also uses estimates to determine the amortization of the commissions, purchase price premiums andorigination fees paid on the acquisition of reverse mortgages. The estimates are based on the projected lives ofthe mortgages for which the premiums and fees were paid. The methodology attempts to match the amortizationof these amounts over the period that the mortgages earn interest income. The projected lives of the mortgagesare reassessed on an annual basis.Future Accounting and Reporting ChangesInternational Financial Reporting StandardsThe Canadian Accounting Standards Board has confirmed that International Financial Reporting Standards (IFRS)will replace current Canadian GAAP for publicly accountable enterprises, including HOMEQ, effective for fiscalyears beginning on or after January 1, 2011.Accordingly, HOMEQ will apply accounting policies consistent with IFRS beginning with its interim financialstatements for the quarter ended March 31, 2011. HOMEQʼs 2011 interim and annual financial statements willinclude comparative 2010 financial statements, adjusted to reflect any changes in accounting policies resultingfrom the adoption of IFRS.IFRS Transition PlanHOMEQʼs IFRS implementation team is progressing on schedule in accordance with its IFRS transition plan.HOMEQ has completed the following elements of its transition to IFRS: • Detailed analysis of the relevant IFRS requirements and identified the areas where accounting policy changes are required, and those for which accounting policy alternatives are available; • Assessment of the first-time adoption requirements and alternatives; • Determination of expected changes to significant accounting policies resulting from the adoption of IFRS; • Management and employee education on the relevant aspects of IFRS and the expected changes to accounting policies; • Determination of the expected quantitative impact on its consolidated balance sheet as at January 1, 2010 in accordance with IFRS 1 First-time Adoption of IFRS; • Resolution of the accounting policy change implications on information technology, internal controls and contractual arrangements; and • Training and education of management and employees.To complete its preparation for the transition to IFRS, HOMEQ is currently preparing pro forma Q1 2010 financialstatements consistent with IFRS presentation and disclosure requirements. HOMEQ is also completing itsassessment of any necessary changes to internal controls over financial reporting resulting from changes inaccounting policies and business processes.Impact of Adopting IFRS on the OrganizationThe Board of Directors and Audit Committee have been regularly updated on the progress of the IFRSimplementation plan and with information regarding the expected changes to significant accounting policies.As part of its analysis of the expected changes to significant accounting policies, the implementation teamassessed what changes are required to HOMEQʼs information technology and data systems and businessprocesses. HOMEQ identified some changes were required to the systems and documentation used to applyhedge accounting for its derivative contracts, and has completed the necessary work with its third party vendor toensure the appropriate changes are in place. The other changes to systems and processes identified were minimaland HOMEQ believes the systems and processes will accommodate the necessary changes.
  • 37. Management D iscussion and A nalysisHOMEQ is continuing its review of contractual arrangements to identify those that would be affected by theexpected changes to significant accounting policies. To date, HOMEQ has not identified any arrangements forwhich the expected changes will have a significant impact.Impact of Adopting IFRS on Internal Controls over Financial ReportingThe expected changes in accounting policies and business processes have the potential to affect HOMEQʼsinternal controls over financial reporting (ICFR). The implementation team has performed a preliminary assessmentas to whether changes to ICFR are required. Based on the assessment to date, HOMEQ does not currently expectthe adoption to IFRS to have a significant impact on ICFR.HOMEQ has augmented certain existing controls and procedures to include the ongoing activities of the IFRStransition plan.First-time adoption of IFRSThe adoption of IFRS requires the application of IFRS 1 First-time Adoption of International Financial ReportingStandards (IFRS 1), which provides guidance for an entityʼs initial adoption of IFRS. IFRS 1 generally requiresretrospective application of IFRS effective at the end of its first annual IFRS reporting period. However, IFRS 1 alsoprovides certain optional exemptions and mandatory exceptions to this retrospective treatment.HOMEQ expects to elect the following optional exemptions in the preparation of an opening IFRS statement offinancial position as at January 1, 2010, HOMEQʼs (Transition Date): • To apply IFRS 2 Share-based Payments only to equity instruments that were issued after November 7, 2002 and had not vested by the Transition Date; • To apply IFRS 3 Business Combinations prospectively from the Transition Date, therefore not restating business combinations that took place prior to the Transition Date; • To elect to designate certain existing financial instruments as available-for-sale as at the Transition Date; and • To apply the transition provisions of IFRIC 14 Determining whether an Arrangement Contains a Lease, therefore determining if arrangements existing at the Transition Date contain a lease based on the circumstances existing at that date.IFRS 1 does not permit changes to estimates that have been made previously. Accordingly, estimates used in theretrospective application of changes in accounting policies resulting from the adoption of IFRS must be consistentwith those made under current Canadian GAAP.Impact of Adopting IFRS on HOMEQ’s Significant Accounting PoliciesHOMEQ has finalized its determination of the expected changes to significant accounting policies resulting fromthe adoption of IFRS and quantified the expected impact on the consolidated balance sheet as at January 1, 2010.Included below are highlights of the areas where changes to significant accounting policies are expected. This isnot intended to be a complete list of areas where the adoption of IFRS will require a change in accounting policies,but to provide highlights of HOMEQʼs determination of expected changes to significant accounting policies resultingfrom the adoption of IFRS. 34_35 Annual Report 2010
  • 38. Management Discussion and A nalysisAccounting policies have been selected to be consistent with IFRS as it is expected to be effective for HOMEQ forits 2011 annual consolidated financial statements. Changes to IFRS in effect at December 31, 2011 may requireHOMEQ to revise its determination of expected changes in accounting policies resulting from the adoption of IFRS. • Financial Instruments: Recognition and Measurement IFRS includes certain restrictions on electing to designate financial assets and financial liabilities as at fair value through profit and loss. As a result of these restrictions, HOMEQ expects to elect to designate its interest bearing deposits with financial institutions and securities as available-for-sale financial assets. Accordingly, these financial assets will be measured at fair value with changes recognized in other comprehensive income. Upon sale or impairment, the accumulated fair value adjustments recognized in other comprehensive income will be recorded in the consolidated statements of operations. Under current Canadian GAAP, these financial assets were classified as held-for-trading, and measured at fair value with changes recognized in the consolidated statements of operations. The cumulative changes in fair value for interest bearing deposits with financial institutions and securities held at January 1, 2010 were not significant. As a result, this change in accounting policy is not expected to have a significant effect on the consolidated balance sheet at January 1, 2010. • Financial Instruments: Recognition and Measurement In accordance with current Canadian GAAP, certain revenue and expenses directly related to the origination of mortgages are included in the carrying value of the mortgage and recognized over the estimated period the mortgage will earn interest. While IFRS requires similar treatment, the description of costs that should be included in the carrying value of the mortgage, referred to as transaction costs, is different. HOMEQ expects that certain compensation costs related to the origination of mortgages will not qualify as transaction costs under IFRS and should not be included in the carrying value of the mortgages. Accordingly, HOMEQ expects to change its accounting policy so that these costs are expensed as incurred. Under current Canadian GAAP, the costs were included in the carrying value of the mortgages. The effect of applying this change in accounting policy retrospectively at January 1, 2010 is expected to be a decrease in the carrying value of the mortgages of approximately $4.6 million and a corresponding increase in the deficit. This change in the accounting values of the mortgage assets is expected to result in an increase in deferred tax assets of $1.2 million and a corresponding decrease in the deficit. • Financial Instruments: Impaired Loans The requirements of IFRS and current Canadian GAAP related to the measurement and recognition of impairment of financial assets carried at amortized cost are generally consistent. Both utilize an incurred loss model and allow general and specific allowances. HOMEQ does not expect that any significant changes will be required to its loan provisioning policy, or the measurement of its allowance for credit losses. Accordingly, no significant change is expected in the allowance for credit losses at January 1, 2010 as a result of adopting IFRS. • Financial Instruments: Hedge Accounting Certain methods of assessing hedge effectiveness that are permitted under current Canadian GAAP are not permitted under IFRS. In addition, there are some differences in the guidance provided for measuring hedge ineffectiveness. HOMEQ expects that its current method of assessing hedge effectiveness is appropriate under IFRS, and that the IFRS requirements will not have a significant impact on its measurement of hedge ineffectiveness. Accordingly, no significant change in the application of hedge accounting is expected in the consolidated balance sheet at January 1, 2010.
  • 39. Management D iscussion and A nalysis • Impairment of Goodwill Goodwill is tested annually for impairment under both current Canadian GAAP and IFRS. However, there are differences in the methods used to determine whether an impairment loss should be recognized, and the measurement of an impairment loss. Under current Canadian GAAP, goodwill is first tested for impairment by comparing the carrying amount of the goodwill and associated assets to their fair value. If the carrying amount of the goodwill and associated assets exceeds their fair value, an impairment loss is calculated by comparing the carrying amount of the goodwill to the implied fair value of the goodwill. Goodwill is tested for impairment under IFRS by comparing the carrying amount of the goodwill and associated assets to their recoverable amount. Recoverable amount is defined as the higher of the fair value less costs to sell and the value in use. Value in use is determined using discounted estimated future cash flows. HOMEQ expects to change its accounting policy related to impairment of goodwill to be consistent with IFRS. However, HOMEQ does not expect that application of the new accounting policy at January 1, 2010 will result in an impairment of assets. As a result, these changes in accounting policy are not expected to have a significant effect on the consolidated balance sheet at January 1, 2010. • Share-based Payments In certain circumstances, IFRS requires a different measurement of share-based compensation than current Canadian GAAP. In particular, HOMEQ expects to change its accounting policy to recognize the expense associated with the grants of restricted shares through its long-term incentive plans. Restricted shares issued vest equally over three years, and under IFRS each tranche (that vests separately) must be treated as a separate grant. Under current Canadian GAAP, HOMEQ was recognizing the total associated expense on a straight-line basis over the total vesting period. While the total compensation expense recognized over the total vesting period is not expected to be significantly different, the effect of the change in accounting policy is expected to be a higher compensation expense earlier in the vesting period, and a lower compensation expense later in the vesting period. The effect of applying this change in accounting policy to all restricted share grants which had not vested at January 1, 2010 is expected to be an increase in common shares of $0.1 million and a corresponding increase in the deficit. • Income Taxes In the past, a subsidiary of HOMEQ transferred mortgages to another subsidiary and charged a premium for originating the mortgage. The premium was taxable in the subsidiary transferring the mortgages when they were transferred, but not tax deductible in the subsidiary acquiring the mortgages until amortized over the life of the mortgages. As a result of these transactions, there is a temporary difference in the accounting value and tax basis of the related mortgages on the consolidated statement of financial position. Under current Canadian GAAP, deferred tax is not permitted to be recognized on temporary differences arising as a result of inter-group transfers of assets. Under IFRS, a deferred tax asset is required to be recognized on this type of temporary difference. HOMEQ expects this will result in a change in accounting policy on adoption of IFRS. The effect of changing the accounting policy to recognize deferred tax assets on inter-group transfers of assets is expected to be an increase in deferred tax assets of approximately $3.0 million and a corresponding decrease in the deficit. 36_37 Annual Report 2010
  • 40. Management Discussion and A nalysisSummary of Expected Impact on Shareholders’ Equity at January 1, 2010The following summarizes the expected impact of adopting IFRS, including the application of IFRS 1, onshareholdersʼ equity:($ thousands) January 1, 2010Shareholders’ equity under current Canadian GAAP 101,982Expected impact of changes in accounting policies: a) Change in transaction costs (4,556) b) Tax effect of change in transaction costs 1,198 c) Deferred income tax asset on inter-group transfers 2,982 d) Change in recognition of restricted shares –Expected shareholders’ equity on adoption of IFRS 101,606 a) The expected effect of retrospective application of the change in accounting policy so that certain compensation costs related to the origination of mortgages are no longer included in the carrying value of the mortgages, but expensed as incurred. b) The expected tax effect of the change in the accounting value of the mortgages resulting from the change in accounting policy described in (a). c) The expected effect of the change in accounting policy to recognize deferred tax assets related to temporary differences arising from inter-group transfers. d) The expected effect of the change in accounting policy to treat each tranche included in a grant of restricted shares as a separate grant. The increase in common shares is offset by a decrease in the deficit, resulting in no impact on total shareholdersʼ equity.Summary of Expected Impact on 2010 Annual Net IncomeHOMEQʼs 2011 interim and annual financial statements will include 2010 financial statements for the comparativeperiod, adjusted to comply with IFRS.HOMEQ has estimated the impact of the expected changes to accounting policies on its 2010 annual net incomereported under current Canadian GAAP. The reconciliation and the explanations included below are intended tohighlight the most significant areas and should not be regarded as complete or final:($ thousands) Year ended December 31, 2010Net income under current Canadian GAAP 123Expected impact of changes in accounting policies: a) Change in transaction costs (402) b) Tax effect of change in transaction costs 73 c) Deferred income tax asset on inter-group transfers (450) d) Change in recognition of restricted shares 8Expected 2010 annual net income (loss) under IFRS (648)
  • 41. Management D iscussion and A nalysisThe estimated impact of these changes in accounting policies on 2010 annual basic and diluted earnings per shareis a reduction of $0.05 per share. The impact on adjusted net income is also $0.05 per share. A similar reductionin net income and adjusted net income is expected to for 2011. a) The expected effect of the change in accounting policy to expense as incurred certain compensation costs related to the origination of mortgages. Under current Canadian GAAP, these costs were included in the carrying value of the mortgages and recognized over the expected mortgage term. b) The expected tax effect of the change in the accounting value of the mortgages resulting from the change in accounting policy described in (a). c) The expected reversal of deferred tax assets recognized on adoption of IFRS. The deferred tax assets relate to temporary differences arising from past inter-group transfers; these assets were not recognized under current Canadian GAAP. d) The expected effect of the change in accounting policy to treat each tranche included in a grant of restricted shares as a separate grant. The change in accounting policy changes the timing of recognizing compensation expense related to the restricted shares, but does not change the total amount of expense expected to be recognized over the vesting periods.Subsequent DisclosuresFurther disclosures of the IFRS transition process are expected as follows: • HOMEQʼs first financial statements prepared in accordance with IFRS will be the interim financial statements for the three months ending March 31, 2011, which will include notes disclosing transitional information and disclosure of new accounting policies consistent with IFRS. The interim financial statements for the three months ending March 31, 2011 will also include 2010 financial statements for the comparative period, adjusted to comply with IFRS, and HOMEQʼs transition date IFRS statement of financial position (as at January 1, 2010).OUTLOOKHOMEQʼs goal is to continue to be Canadaʼs leading provider of reverse mortgages. Market awareness of bothHOMEQ and its products has increased, and sources of referral cover a widening array of financial institutions. Inaddition, HOMEQ is benefiting from a preference of seniors to remain in their homes as long as possible, and fromthe demographic trend of an increasing seniors population.The introduction of lower interest rates on reverse mortgages in late 2009, coupled with growing demand, createda significant increase in customer inquiries and funded mortgages in 2010. This resulted in record originationvolume of $205.8 million in 2010 and the mortgage portfolio increased by 17% so that it now exceeds $1.0 billion.While both origination and portfolio growth have been exceptional, HOMEQʼs financial performance lags thefinancial services industry. Return on equity is a widely used measure of financial performance by financialinstitutions and HOMEQʼs adjusted ROE of 8.0% in 2010 is low in comparison to others. Having established a solidbase for portfolio growth and operational efficiency as a bank, management recognizes that profitability mustimprove and has set an objective to increase ROE to 15% in 2013.To achieve this goal, HOMEQ will focus on portfolio growth, interest rate spread, origination costs and overheadexpense control.HOMEQ expects that demand for reverse mortgages will remain firm in 2011. The Canadian real estate marketregained stability in early 2009 and indications are that it will remain stable during the year ahead. Stable realestate markets tend to give seniors more confidence to make significant financial decisions. With a continuedpositive impact coming from the increasing number of Canadians over 60 years of age, an increase in the size ofthe sales force and additional experience in the sales and marketing functions, HOMEQʼs objective is to increasenew originations by 25% per annum. Increased originations and compounding interest, offset by repaymentsexpected at historical levels, will increase the total mortgage portfolio. HOMEQʼs objective is to increase themortgage portfolio by between 15% and 20% per annum. 38_39 Annual Report 2010
  • 42. Management’s Responsibility for Financial ReportingThe consolidated financial statements of HOMEQ Corporation (the Company) have been prepared by and are theresponsibility of the management of the Company. The consolidated financial statements have been prepared inaccordance with Canadian generally accepted accounting principles, including the accounting requirementsspecified by the Office of the Superintendent of Financial Institutions Canada and reflect, where necessary,managementʼs best estimates and judgments.Management is also responsible for maintaining systems of internal and administrative controls to providereasonable assurance that the Companyʼs assets are safeguarded, that transactions are properly executed inaccordance with appropriate authorization, and that the accounting systems provide timely, accurate and reliablefinancial information. Controls include quality standards in hiring and training of employees, written policies, acorporate code of conduct and appropriate management information systems.The internal control systems are further supported by a legislative compliance framework, which ensures that theCompany and its employees comply with all regulatory requirements, as well as a risk management framework thatensures proper risk control, related documentation, and the measurement of the financial impact of risks. Inaddition, the internal audit function periodically evaluates various aspects of the Companyʼs operations and makesrecommendations to management for, among other things, improvements to the control systems.Every year, the Office of the Superintendent of Financial Institutions Canada makes such examinations andinquiries as deemed necessary to satisfy itself that the Companyʼs subsidiary, HomEquity Bank is in sound financialposition and that it complies with the provisions of the Bank Act (Canada).The financial statements have been audited on behalf of the shareholders by Ernst & Young LLP, CharteredAccountants, in accordance with Canadian generally accepted auditing standards. The Auditorsʼ Report outlinesthe scope of their examination and their independent professional opinion on the fairness of these consolidatedfinancial statements. Ernst & Young LLP has full and open access to the Audit Committee.The internal auditors, the external auditors and the Office of the Superintendent of Financial Institutions Canadameet periodically with the Audit Committee, with management either present or absent, to discuss all aspects oftheir duties and matters arising therefrom.The Board of Directors is responsible for assuring that management fulfils its responsibility for financial reportingand internal control. The directors perform this responsibility at meetings where significant accounting, reportingand internal control matters are discussed, and the consolidated financial statements, annual and quarterly reportsare reviewed and approved.The Boardʼs Audit Committee, consisting of independent directors, has reviewed these consolidated financialstatements with management and the auditors and has reported the results of this review to the Board of Directors,which has approved the consolidated financial statements.Steven K. Ranson, CA Gary Krikler, CAPresident & Chief Executive Officer Senior Vice President & Chief Financial Officer
  • 43. Auditors’ ReportTo the Shareholders ofHOMEQ CORPORATIONWe have audited the accompanying consolidated financial statements of HOMEQ Corporation, which comprise theconsolidated balance sheets as at December 31, 2010 and 2009 and the consolidated statements of operations,changes in shareholdersʼ equity and cash flows for the years then ended, and a summary of significant accountingpolicies and other explanatory information.Management’s Responsibility for the Consolidated Financial StatementsManagement is responsible for the preparation and fair presentation of these consolidated financial statements inaccordance with Canadian generally accepted accounting principles, and for such internal control as managementdetermines is necessary to enable the preparation of consolidated financial statements that are free from materialmisstatement, whether due to fraud or error.Auditors’ ResponsibilityOur responsibility is to express an opinion on these consolidated financial statements based on our audits. Weconducted our audits in accordance with Canadian generally accepted auditing standards. Those standards requirethat we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance aboutwhether the consolidated financial statements are free from material misstatement.An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in theconsolidated financial statements. The procedures selected depend on the auditorsʼ judgment, including theassessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud orerror. In making those risk assessments, the auditors consider internal control relevant to the entityʼs preparationand fair presentation of the consolidated financial statements in order to design audit procedures that areappropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of theentityʼs internal control. An audit also includes evaluating the appropriateness of accounting policies used and thereasonableness of accounting estimates made by management, as well as evaluating the overall presentation ofthe consolidated financial statements.We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basisfor our audit opinion.OpinionIn our opinion, the consolidated financial statements present fairly, in all material respects, the financial position ofHOMEQ Corporation as at December 31, 2010 and 2009 and the results of its operations and its cash flows for theyears then ended in accordance with Canadian generally accepted accounting principles. Chartered AccountantsToronto, Canada, Licensed Public AccountantsMarch 7, 2011 40_41 Annual Report 2010
  • 44. Consolidated Balance SheetsAs at December 31 2010 2009(in thousands of dollars) $ $ASSETSCash resources (note 4)Cash and cash equivalents 66,074 14,516Interest bearing deposits with banks 11,994 21,972 78,068 36,488Securities (note 5)Held-for-trading – 12,192Loans (note 6)Residential reverse mortgages 1,069,598 919,573Allowance for credit losses (3,185) (2,412) 1,066,413 917,161OtherDerivative instruments (note 18) 15,264 28,544Property and equipment, net of accumulated amortization (note 7) 540 659Goodwill and other intangible assets (note 8) 19,807 19,956Future income tax assets (note 9) 1,182 594Income taxes receivable 1,306 –Prepaid expenses and other assets 1,170 969 39,269 50,722 1,183,750 1,016,563LIABILITIES AND SHAREHOLDERS’ EQUITYLiabilitiesDeposits (notes 10 , 17 and 18)Payable on a fixed date 367,643 40,093 367,643 40,093OtherDerivative instruments (note 18) 2,093 3,347Future income tax liabilities (note 9) 10,914 12,542Income taxes payable – 1,873Dividends payable 988 980Accounts payable and accrued liabilities 7,988 3,939 21,983 22,681Medium-term debt (notes 11, 17 and 18) 626,298 792,328Subordinated debt (notes 12, 17 and 18) 40,308 50,335Unsecured subordinated debt (notes 13 and 17) 19,724 10,144Bank term loan (notes 14, 17 and 18) 9,726 – 696,056 852,807 1,085,682 915,581Shareholders’ equityCommon shares (notes 1 and 15) 103,754 102,794Contributed surplus (note 16) 18 –Deficit (5,704) (1,812) 98,068 100,982 1,183,750 1,016,563Commitments (note 21)The accompanying notes are an integral part of these consolidated financial statements.On behalf of the Board of Directors:Pierre B. Lebel Paul DampDirector Director
  • 45. Consolidated Statements of OperationsFor the years ended December 31 2010 2009(in thousands of dollars) $ $Interest incomeMortgage interest (note 6) 47,516 48,552Securities 80 178Deposits with banks 347 105 47,943 48,835Interest expenseDeposits 4,946 133Medium-term debt 17,059 24,149Subordinated debt 2,006 3,187Unsecured subordinated debt 1,273 186Bank term loan 221 – 25,505 27,655Net interest income 22,438 21,180Provision for credit losses (note 6) 773 1,840Net interest income after provision for credit losses 21,665 19,340Non-interest incomeMortgage administration fees 117 167 117 167Net interest income and non-interest income 21,782 19,507Non-interest expensesSalaries and benefits (note 22) 5,800 4,945Selling, general and administration (note 23) 6,969 6,774Amortization of intangible assets 164 96Amortization of property and equipment 201 185 13,134 12,000Income before under noted item 8,648 7,507Unrealized losses on derivative instruments (note 18) 9,434 8,527Income (loss) before income taxes (786) (1,020)Current income tax expense 1,306 1,873Future income tax recovery (2,215) (1,066)Provision for income taxes (recovery) (note 9) (909) 807Net income (loss) and total comprehensive income (loss) 123 (1,827)Average number of common shares outstanding 14,327 14,209Basic and diluted earnings (loss) per share (note 2) 0.01 (0.13)The accompanying notes are an integral part of these consolidated financial statements. 42_43 Annual Report 2010
  • 46. Consolidated Statements of Changes in Shareholders’ EquityFor the years ended December 31 2010 2009(in thousands of dollars) $ $Common sharesBalance at beginning of year 102,794 –Conversion from Trust Units (note 1) – 102,547Issued during the year 960 247Balance at end of year 103,754 102,794Contributed surplusBalance at beginning of period – –Amortization of fair value of employee stock options 18 –Employee stock options exercised – –Balance at end of year 18 –Shareholders’ / Unitholders’ equityBalance at beginning of year – 110,724Issued during the year – 238Transition adjustment on adoption of financial instruments standard – (484)Net income (loss) for the year – (1,975)Dividends declared – (5,956)Conversion to common shares (note 1) – (102,547)Balance at end of year – –DeficitBalance at beginning of year (1,812) –Net income for the year 123 148Dividends declared (4,015) (1,960)Balance at end of year (5,704) (1,812)Total Shareholders’ equity 98,068 100,982The accompanying notes are an integral part of these consolidated financial statements.
  • 47. Consolidated Statements of Cash FlowsFor the years ended December 31 2010 2009(in thousands of dollars) $ $OPERATING ACTIVITIESNet income (loss) 123 (1,827)Adjust for non-cash itemsAmortization Purchase price premiums and origination fees 3,407 3,500 Deferred origination commissions and mortgage fees and costs 2,457 1,960 Deferred deposit commissions 391 11 Debt issue costs 1,534 1,227 Intangible assets 164 96 Property and equipment 201 185Increase in provision for credit losses 773 1,840Compensation expense related to long-term incentive plans 498 488Future income tax recovery (2,215) (1,066)Unrealized losses on derivative instruments 9,434 8,527 16,767 14,941Changes in non-cash working capitalAccrual of interest payable on debt and derivatives 15 (5,016)Accrual of interest on mortgages (52,425) (53,068)Repayments of accrued interest on mortgages 33,447 36,819Other (note 24) 669 2,993 (18,294) (18,272)Cash used in operating activities (1,527) (3,331)INVESTING ACTIVITIESMortgages originated (205,759) (110,195)Mortgage principal repayments 74,013 75,144Origination commissions and deferred mortgage fees and costs (5,165) (4,598)Decrease in securities, net 12,192 12,310Decrease (increase) in interest bearing deposits with banks, net 9,978 (4,009)Purchase of intangible assets (15) (461)Purchase of property and equipment (82) (243)Cash used in investing activities (114,838) (32,052)FINANCING ACTIVITIESIncrease in deposits, net 327,534 40,166Gross proceeds from medium-term debt 125,000 150,000Repayment of medium-term debt (266,035) (155,071)Repurchase of medium-term debt (24,000) –Repurchase of subordinated debt (10,000) (10,000)Gross proceeds from unsecured subordinated debt 10,000 10,000Gross proceeds from bank term loan 10,000 –Increase in debt issue costs (1,049) (599)Proceeds from shares issued under dividend reinvestment plan 480 –Dividends (4,007) (8,166)Cash provided by financing activities 167,923 26,330Net increase (decrease) in cash and cash equivalents, during the year 51,558 (9,053)Cash and cash equivalents, beginning of year 14,516 23,569Cash and cash equivalents, end of year (note 4) 66,074 14,516Supplemental cash flow information:Interest paid 19,011 31,325Income taxes paid 5,096 –The accompanying notes are an integral part of these consolidated financial statements. 44_45 Annual Report 2010
  • 48. Notes to Consolidated Financial Statements(in thousands of dollars except per share amounts)December 31, 20010 and 20091. ORGANIZATION AND BASIS OF PRESENTATION HOMEQ Corporation (the Company) was incorporated on March 10, 2009 under the laws of the Province of Ontario. The Company is a holding company which invests in its wholly owned subsidiary, HomEquity Bank (formerly Canadian Home Income Plan Corporation), which originates and administers reverse mortgages. On June 30, 2009, Home Equity Income Trust (the Trust) converted to a corporation, by way of a Plan of Arrangement continuing its business operations as HOMEQ Corporation (the Conversion). The Company continues the business of the Trust. Under the Conversion, the unitholders of the Trust exchanged each of their trust units for common shares of the Company, on a one-for-one basis. All references to “shares” refer collectively to common shares subsequent to the Conversion and to trust units prior to the Conversion. All references to “dividends” refer collectively to payments to shareholders subsequent to Conversion and to payments to unitholders prior to the Conversion. These consolidated financial statements of the Company have been prepared using the continuity of interest method for the assets, liabilities and operations of the Trust.2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES These consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles. The significant accounting policies are summarized as follows: Basis of consolidation These consolidated financial statements reflect the financial position and results of operations of the Company consolidated with the financial position and results of operations of its subsidiaries. The Companyʼs principal subsidiary is HomEquity Bank (formerly Canadian Home Income Plan Corporation). Transactions and balances between the Company and its subsidiaries are eliminated on consolidation. Use of estimates The preparation of financial statements in accordance with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Allowance for credit losses, fair value of certain financial instruments, income taxes and valuation of goodwill and other intangible assets are areas where management makes significant estimates and assumptions in determining the amounts to be recorded in the consolidated financial statements. Financial assets and liabilities The Canadian Institute of Chartered Accountants (CICA) Section 3855, Financial Instruments – Recognition and Measurement establishes standards for recognizing and measuring financial assets, financial liabilities and derivatives. It requires that financial assets and financial liabilities (including derivatives) be recognized on the consolidated balance sheet when the Company becomes a party to a contract. All financial instruments are required to be measured at fair value on initial recognition except for certain related party transactions. Measurement in subsequent periods depends on whether the financial instrument has been classified as held- for-trading (based on an intent to sell for short-term profit taking or through an optional irrevocable management election), held-to-maturity, available for sale, loans and receivables or other liabilities. Financial instruments that are either designated as held-for-trading or available-for-sale are required to be measured at fair value at each consolidated balance sheet date.
  • 49. Notes to Consolidated Financial S tatem ents Under these standards, the Company classifies its mortgages as loans receivable and carries them at amortized cost. The Companyʼs liabilities continue to be classified as other liabilities. Financial instruments The CICAʼs Section 3862, Financial Instruments – Disclosures, and Section 3863, Financial Instruments – Presentation, establishes standards for the disclosure of the significance of financial instruments for the Companyʼs financial position, performance and cash flows and the nature and extent of risks arising from financial instruments to which the Company is exposed during the year and at the consolidated balance sheet date, and how the entity manages those risks. The Company is exposed to a variety of financial risks in the normal course of business. The financial risk management objectives are described in the Management Discussion and Analysis. The disclosures required under Section 3862 are included in note 19. Fair value of financial instruments The Company presents cash resources, held-for-trading securities and derivative instruments at fair value. Loans, deposits and certain other assets and certain other liabilities are recorded at amortized cost. Except as disclosed in note 20 to these consolidated financial statements, the carrying values of the Companyʼs financial instruments approximate their fair values. Capital disclosures The CICAʼs accounting standard, Section 1535, Capital Disclosures, establishes standards for the disclosure of both qualitative and quantitative information that enables users of financial statements to evaluate the entityʼs objectives, policies and processes for managing capital, quantitative data about what is considered capital and whether an entity has complied with any capital requirements and consequences of non-compliance with such capital requirements. The disclosures required under Section 1535 are included in note 17. Cash and cash equivalents Cash and cash equivalent balances have less than 90 days to maturity from the date of acquisition. Cash and cash equivalents consist of cash, Canadian and provincial securities, interest bearing deposits with banks and corporate notes. Cash and cash equivalents are designated as held-for-trading, and accordingly, are carried at fair value. Changes to fair value are recorded in the consolidated statements of operations. Investment interest is recognized on an accrual basis. Securities Securities balances have more than 90 days to maturity from the date of acquisition and consist of Canadian and provincial securities and corporate notes. Securities are accounted for at settlement date and designated as held-for-trading, and accordingly, are carried at fair value. Changes to fair value are recorded in the consolidated statements of operations. Investment interest is recognized on an accrual basis. Mortgages Mortgages are lifetime, interest accruing mortgages that are secured by residential real property. Interest income is recognized on an accrual basis on all mortgages and is due together with repayment of the principal at the time the property is vacated by the homeowner(s). Mortgage loans (including purchase price premiums, origination fees and commissions) are stated at amortized cost plus accrued interest. Purchase price premiums, origination fees and commissions are deferred and expensed over the estimated period that mortgages earn interest. The mortgage loans reprice frequently and changes in interest rates will have a minimal impact on fair value. On that basis, fair value is assumed to approximate carrying value. Mortgage early repayment fees are recorded as revenue when received. 46_47 Annual Report 2010
  • 50. Notes to Consolidated Financial S tatem ents 2. Summary of Significant Accounting Policies (cont’d) Allowance for credit losses The allowance for credit losses recorded in the consolidated balance sheets is maintained at a level which is considered adequate to absorb credit-related losses to the mortgage loan portfolio. A mortgage allowance is taken when, in the opinion of management, there is no longer reasonable assurance of the collection of the full amount of principal and interest. Mortgage allowances, in an amount which approximates the present value of projected future cash flow shortfalls, are determined based on the mortgage loan outstanding and the most recently appraised value of the underlying property. The Company has both specific and general allowances as described below. Specific allowances The Companyʼs policy is to cease recognizing interest income on a mortgage having a loan-to-value greater than 83%. Any increase or decrease in specific allowances is included with provision for credit losses on the consolidated statements of operations. General allowances General allowances are provided for losses inherent in the mortgage portfolio but not yet specifically identified and therefore not yet captured in the determination of specific allowances. The Company evaluates and monitors the underwriting performance indicators of mortgages as well as changes in the characteristics of the portfolio. These indicators include a review of general real estate conditions and trends and their potential impact on the portfolio, the expected occupancy term and interest rates experienced over the life of a mortgage compared to initial underwriting assumptions. Prepaid expenses Prepaid expenses are stated at cost and are amortized over their expected beneficial life. Income taxes Income taxes are determined using the liability method. Under this method of tax allocation, future tax assets and liabilities are determined based on differences between the financial reporting and tax bases of assets and liabilities and are measured using the substantively enacted tax rates and laws that will be in effect when the differences are expected to reverse. Future income tax assets are recognized to the extent that realization is considered more likely than not. Prior to the Conversion, the Trust qualified as a mutual fund trust under the Income Tax Act (Canada). The Trust distributed all or substantially all of its taxable income to the unitholders. Income tax obligations relating to the distributions are the obligations of the unitholders and accordingly, no current tax provision for income taxes on the income of the Trust was made. Property and equipment Computer hardware is recorded at cost and amortized on a straight-line basis over four years. Furniture and equipment are stated at cost and are amortized on a straight-line basis over a term of seven years. Leasehold improvements are recorded at cost and are amortized on a straight-line basis over the term of the related lease. The amortization expense is recognized in the consolidated statements of operations. Deposits Deposits are payable on a fixed date and consist of fixed-interest rate guaranteed investment certificates. The terms of these deposits range from one year to five years. Deposits are financial liabilities and are measured at cost using the effective interest rate method. Deposit broker commissions are included in deposits on the consolidated balance sheets and are amortized to interest expense over the term of the deposit.
  • 51. Notes to Consolidated Financial S tatem ents Derivative financial instruments The Company uses derivative instruments such as interest rate swaps and forward rate agreements, economically hedging the interest term of some of its medium-term, subordinated debt and deposit liabilities to the interest term of the mortgage portfolio to ensure a relatively stable interest rate spread. Derivatives are classified as held-for- trading and are measured at fair value. Unrealized gains or losses from changes in fair value are recognized in the consolidated statements of operations. Fair value of derivative instruments is determined using an internal valuation model with observable inputs. Realized amounts receivable or payable on derivatives are accrued and recorded as adjustments to interest expense in the consolidated statements of operations. The Company does not hold or use any derivative contracts for speculative trading purposes. Derivative instruments used are entered into with Schedule I Canadian chartered banks to reduce any counterparty risk associated with derivatives. Hedge accounting CICA Section 3865, Hedges, specifies the requirements for the use of hedge accounting. When the Company applies hedge accounting, at the inception of a hedging relationship, the Company documents the relationship between the hedging instrument and the hedged item, its risk management objective and its strategy for undertaking the hedge. In order to be deemed effective, the hedging instrument and the hedged item must be highly and inversely correlated such that the changes in fair value of the hedging instrument will substantially offset the effects of the hedged exposure to the Company throughout the term of the hedging relationship. If a hedging relationship becomes ineffective, it no longer qualifies for hedge accounting and any subsequent change in fair value of the hedging instrument is recognized in earnings. Comprehensive income CICA Section 1530, Comprehensive Income, requires the presentation of a consolidated statement of comprehensive income for certain revenues, expenses, gains and losses that are not recorded as part of net earnings but presented in other comprehensive income until it is considered appropriate to recognize it in net earnings. The Company does not have any income from this source and as such a consolidated statement of comprehensive income has not been included in these consolidated financial statements. Goodwill and other intangible assets Goodwill reflects the purchase price paid on acquisition of Canadian Home Income Plan Corporation, prior to its continuance as HomEquity Bank, in excess of the fair market value of net tangible assets and identifiable intangible assets acquired. Goodwill is not amortized but is tested for impairment annually. Costs incurred by HomEquity Bank in obtaining its bank license have been capitalized and are recorded at cost. Bank license costs are not amortized but are tested for impairment annually. Software is recorded at cost and amortized on a straight-line basis over three years. Amortization expense is recognized in amortization of intangible assets on the consolidated statements of operations. Transaction costs for debt liabilities Debt issue costs incurred by the Company are capitalized and are included in medium-term debt, subordinated debt and unsecured subordinated debt. These costs are amortized over the term of the debt on an effective interest rate method and are included in interest expense in the consolidated statements of operations. The Company does not incur any transaction costs related to financial instruments that are designated as held- for-trading. 48_49 Annual Report 2010
  • 52. Notes to Consolidated Financial S tatem ents 2. Summary of Significant Accounting Policies (cont’d) Long-term incentive plans Directors and senior executives participate in long-term incentive plans under which they are eligible to receive Company shares. The plans consist of a restricted share plan and an Option and Share Appreciation Rights plan for senior executives and a deferred share plan for Directors. The restricted shares vest equally over three years. The benefit resulting from the issue of shares under this plan is recorded as salaries and benefits expense in the consolidated statements of operations, on a straight- line basis over the vesting period, based on the market price of the Companyʼs shares on the date of grant. The Company has adopted the fair value-based method of accounting for stock options under the Option and Share Appreciation Rights plan and recognizes compensation expense based on the fair value of the options on the date of grant, which is determined using the Black-Scholes option pricing model. The fair value of the options is recognized over the vesting period of the options granted as compensation expense and an increase to contributed surplus. The contributed surplus balance is subsequently reduced as the options are exercised and the amount initially recorded for the options in contributed surplus is credited to common shares. Compensation expense related to stock-based compensation is included in salaries and benefits in the consolidated statements of operations. The deferred share plan allows the Directors to defer a portion of their compensation until they retire from the Board and receive the equivalent amount in shares of the Company. The amount deferred during the year is recorded as professional services expense in the consolidated statements of operations. As the Company intends to settle its obligations related to these plans by issuing shares, the Companyʼs obligations under these plans are presented within shareholdersʼ equity. Earnings per share Basic and diluted earnings per share are calculated by dividing net income by the average number of fully paid common shares outstanding during the year.3. INITIAL APPLICATION OF ACCOUNTING POLICIES Long-term incentive plans At the Annual General Meeting of Shareholders held on May 13, 2010, the Shareholders approved an Option and Share Appreciation Rights Plan. The Company has adopted the fair value-based method of accounting for stock options and recognizes compensation expense based on the fair value of the options on the date of grant, which is determined using the Black-Scholes option pricing model. The fair value of the options is recognized over the vesting period of the options granted as compensation expense and an increase to contributed surplus. The contributed surplus balance is subsequently reduced as the options are exercised and the amount initially recorded for the options in contributed surplus is credited to common shares. Compensation expense related to stock-based compensation is included in salaries and benefits in the consolidated statements of operations.
  • 53. Notes to Consolidated Financial S tatem ents4. CASH RESOURCES Included in cash and cash equivalents are securities with maturities of less than 90 days from the date of acquisition. For the year ended December 31, 2010 the yield earned on these investments ranged between 0.17% and 1.2% with a weighted average rate of 0.60% (December 31, 2009 – 0.80%). December 31, December 31, 2010 2009 $ $ Cash and non-interest bearing deposits with banks 48,881 8,218 Treasury bills issued or guaranteed by provinces 15,993 6,298 Corporate notes 1,200 – Cash and cash equivalents 66,074 14,516 Interest bearing deposits with banks 11,994 21,972 Total cash resources 78,068 36,4885. SECURITIES At December 31, 2010 the Company held no securities with maturities of more than 90 days from the date of acquisition. For the year ended December 31, 2010 the yield earned on investments that matured during the year ranged between 0.24% and 0.53% with a weighted average rate of 0.29% (December 31, 2009 – 0.27%). Remaining term to maturity Within 1 1 to 5 Over 5 December 31, December 31, year years years 2010 2009 $ $ $ $ $ Treasury bills issued or guaranteed by Canada – – – – 3,996 Treasury bills issued or guaranteed by provinces – – – – 6,499 Other debt securities – – – – 1,697 – – – – 12,1926. LOANS Residential reverse mortgages December 31, December 31, 2010 2009 $ $ Mortgage principal plus accrued interest 1,016,383 865,659 Mortgage purchase price premiums, net of accumulated amortization 30,398 33,572 Mortgage origination fees, net of accumulated amortization 2,072 2,305 Deferred commissions and mortgage fees and costs, net of accumulated amortization 20,745 18,037 1,069,598 919,573 50_51 Annual Report 2010
  • 54. Notes to Consolidated Financial S tatem ents 6. Loans (cont’d) Geographic region and loan-to-value The following tables show the composition of the residential reverse mortgage portfolio by geographic distribution and loan-to-value ratio range, which measures the outstanding mortgage balance as a percentage of the appraised value of the property: December 31, December 31, December 31, December 31, 2010 2009 2010 2009 Province $ $ % % Ontario 401,230 357,338 39.5 41.3 British Columbia 365,637 312,428 36.0 36.1 Alberta 123,560 105,770 12.1 12.2 Quebec 79,133 54,389 7.8 6.3 Other 46,823 35,734 4.6 4.1 1,016,383 865,659 100.0 100.0 December 31, December 31, December 31, December 31, 2010 2009 2010 2009 Loan-to-value $ $ % % Less than 30.0% 193,444 173,715 19.0 20.1 30.1% – 40.0% 287,219 242,436 28.3 28.0 40.1% – 50.0% 294,324 246,051 29.0 28.4 50.1% – 60.0% 165,976 135,881 16.3 15.7 60.1% – 70.0% 61,926 54,820 6.1 6.3 Greater than 70.1% 13,494 12,756 1.3 1.5 1,016,383 865,659 100.0 100.0 Impaired loans The following table shows residential reverse mortgages with a loan-to-value ratio of greater than 83%, which management considers impaired, and the appraised value of those underlying properties: December 31, December 31, 2010 2009 $ $ Mortgage principal plus accrued interest 3,901 1,755 Specific allowance (638) (263) 3,263 1,492 Appraised value of underlying properties 4,008 1,798 Allowance for credit losses December 31, December 31, 2010 2009 $ $ Specific allowances Balance, beginning of year (263) (164) Provision for credit losses (572) (171) Write-offs 88 70 Recoveries 109 2 Balance, end of year (638) (263) General allowances Balance, beginning of year (2,149) (408) Provision for credit losses (398) (1,741) Balance, end of year (2,547) (2,149) Total allowances (3,185) (2,412)
  • 55. Notes to Consolidated Financial S tatem ents Mortgage interest December 31, December 31, 2010 2009 $ $ Interest income 52,362 53,068 Early repayment fees 1,018 92 53,380 53,992 Less: Amortization of deferred commissions and mortgage fees and costs, net (2,457) (1,940) Amortization of purchase price premiums and origination costs (3,407) (3,500) (5,864) (5,440) 47,516 48,5527. PROPERTY AND EQUIPMENT December 31, December 31, Accumulated 2010 2009 Cost amortization Net book value Net book value $ $ $ $ Computer hardware 636 326 310 371 Furniture and equipment 108 56 52 46 Leasehold improvements 624 446 178 242 1,368 828 540 6598. GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets consist of the following: December 31, December 31, 2010 2009 $ $ Goodwill 19,109 19,109 Bank license costs 427 427 Software – amortized (1) 271 420 19,807 19,956 (1) Software had a cost of $510 and accumulated amortization of $239 (December 31, 2009 $183). 52_53 Annual Report 2010
  • 56. Notes to Consolidated Financial S tatem ents9. INCOME TAXES Reconciliation of income taxes The reconciliation of statutory and effective rates of tax is as follows: December 31, December 31, 2010 2009 $ $ Combined Canadian federal and provincial income tax rate applied to income (loss) before income taxes 31.0% 33.0% Tax recovery calculated at statutory rate (244) (337) Increase (decrease) in income taxes due to: Income distributed to unitholders – (340) Impact of tax rate changes (89) 1,732 Net change in valuation allowance (269) 269 Other (307) (517) Provision for income taxes (recovery) (909) 807 Components of future income tax balances The tax effects of temporary differences that give rise to the future income tax assets and liabilities are presented below: December 31, December 31, 2010 2009 $ $ Future income tax assets Property and equipment – 14 Non-capital losses 85 – Mortgages 117 – Allowance for credit losses 654 580 Debt issue and deferred costs 326 – 1,182 594 Future income tax liabilities Property and equipment 98 – Mortgages 8,276 7,367 Derivative instruments 2,536 5,172 Debt issue and deferred costs 4 3 10,914 12,542 At December 31, 2010, the Company had non-capital losses carried forward of $326. The non-capital losses expire as follows: 2029 – $157 and 2030 – $169.10. DEPOSITS All deposits are payable on a fixed date and are issued in Canada. Maturity term Within 1 2 to 3 4 to 5 December 31, December 31, year years years 2010 2009 $ $ $ $ $ Individuals 127,149 127,399 113,557 368,105 40,177 Adjustment in carrying value of hedged deposits (see note 18) – (440) (22) (462) (84) 127,149 126,959 113,535 367,643 40,093 Effective interest rate 1.66% 2.47% 3.29% 2.44% 2.22%
  • 57. Notes to Consolidated Financial S tatem ents11. MEDIUM-TERM DEBT Expected Fair December 31, December 31, final Interest value 2010 2009 Series payment Interest basis rate at $ $ $ 2009-1 Oct 26, 2010 Floating rate (1) – – – 150,000 2005-1 Nov 1, 2010 Fixed rate – – – 110,000 2007-3 May 2, 2011 Fixed rate 5.613% 120,493 119,000 125,000 2008-1 May 16, 2011 Fixed rate 5.764% 164,156 161,800 165,000 2006-3 Aug 1, 2012 Fixed rate 4.542% 103,133 100,200 115,000 2006-1 Feb 1, 2013 Fixed rate 4.637% 108,647 105,000 105,000 2007-2 Nov 30, 2012 Floating rate (2) 2.298% 8,082 8,080 14,115 2010-1 Aug 4, 2015 Fixed rate 4.490% 130,133 125,000 – 634,644 619,080 784,115 Interest payable 8,229 7,858 Interest receivable on derivative instruments (4,250) (3,954) Debt issue costs, net of accumulated amortization (1,072) (1,614) Adjustment in carrying value of hedged debt (see note 18) 4,311 5,923 626,298 792,328 (1) Rate reset on the 26th day of January, April and July 2010 based on the three-month bankers acceptance rate plus 1.40%. (2) Rate is reset each May 1st and November 1st based on the six-month Government of Canada Treasury Bill rate plus 1.283%. The Company has a best efforts obligation to refinance the series 2006-3, 2007-3, 2008-1 and 2010-1 notes on the respective expected final payment dates. If a note remains outstanding after the expected final payment date, the interest will become the one-month Bankersʼ Acceptance rate plus the following spreads calculated and payable monthly: 2006-3 – 1.25%, 2007-3 – 3.00%, 2008-1 – 4.00% and 2010-1 – 3.00% until legal maturity. The legal maturity dates of these notes range from August 1, 2031 to August 3, 2035. Fair value of medium-term debt is determined using average quoted market rates provided to the Company by capital markets dealers. During the year ended December 31, 2010, the Company repurchased $35,215 of series 2005-1 and $124,000 of series 2009-1 prior to their repayment in full on their expected final payment dates. The Company also repurchased the following medium-term notes: $6,000 of series 2007-3, $3,200 of series 2008-1 and $14,800 of series 2006-3. For the year ended December 31, 2010 included in medium-term debt interest expense is a net cost of $549 related to these transactions which consist of a loss of $1,508 on the repurchases, $216 of accelerated recognition of unamortized debt issue costs and a gain of $1,175 on the reduction of notional principal of related interest rate swaps. Subsequent to year end the Company redeemed all of the series 2008-1 senior medium-term notes which had an expected final payment of May 16, 2011. The Company also concluded the sale of $175,000 of senior medium- term notes. The notes have a coupon of 3.97% and have an expected final payment date of February 1, 2016 (note 26). 54_55 Annual Report 2010
  • 58. Notes to Consolidated Financial S tatem ents12. SUBORDINATED DEBT Expected Fair December 31, December 31, final value 2010 2009 Series payment Interest basis Interest rate $ $ $ 2007-1B Nov. 1, 2012 Fixed rate 6.663% 10,152 10,000 10,000 2007-2B Nov 30, 2012 Fixed rate 7.582% 20,737 20,000 20,000 2006-2B Aug. 1, 2013 Fixed rate 5.803% 9,885 10,000 20,000 40,774 40,000 50,000 Interest payable 477 719 Interest receivable on derivative instruments (57) (143) Debt issue costs, net of accumulated amortization (112) (241) 40,308 50,335 The Company has a best efforts obligation to refinance the series 2006-2B and 2007-1B notes on their respective expected final payment dates. If a note remains outstanding after the expected final payment date, the interest will become the one-month Bankersʼ Acceptance rate plus the following spreads calculated and payable monthly: 2006-2B – 1.75% and 2007-1B – 3.50% until legal maturity. The legal maturity dates of these notes range from August 1, 2031 to November 1, 2032. The series 2007-2B note is repayable after the 2007-2 medium-term note is repaid in full. Fair value of subordinated debt is determined using average quoted market rates provided to the Company by capital market dealers. During the year ended December 31, 2010, the Company repurchased $10,000 of the series 2006-2B subordinated notes. For the year ended December 31, 2010 included in subordinated debt interest expense is a net gain of $511 related to this transaction which consists of a loss of $57 on the purchase, $33 of accelerated recognition of unamortized debt issue costs and a gain of $601 on the reduction of notional principal of a related interest rate swap.13. UNSECURED SUBORDINATED DEBT Fair December 31, December 31, Interest value 2010 2009 Maturity Interest basis rate $ $ $ Oct 31, 2014 Fixed rate 9.713% 10,411 10,000 10,000 May 31, 2016 Fixed rate 8.600% 9,890 10,000 – 20,301 20,000 10,000 Interest payable 238 183 Interest receivable on derivative instruments (11) – Debt issue costs, net of accumulated amortization (225) (39) Adjustment in carrying value of hedged debt (note 18) (278) – 19,724 10,144 Fair value of the unsecured subordinated debt is determined using quoted market rates provided to the Company by a capital market dealer.14. BANK TERM LOAN Fair December 31, December 31, Interest value 2010 2009 Maturity Interest basis rate $ $ $ May 31, 2016 Fixed rate 8.210% 10,009 10,000 – Interest payable 71 – Interest receivable on derivative instruments (21) – Adjustment in carrying value of hedged debt (note 18) (324) – 9,726 –
  • 59. Notes to Consolidated Financial S tatem ents On September 24, 2010, the Company entered into a non-revolving term loan for $10,000 maturing on May 31, 2016 with a coupon of 8.21%. The proceeds of the loan were used to invest in unsecured subordinated debt issued by HomEquity Bank, constituting subordinated indebtedness within the meaning of the Bank Act (Canada) and qualifying as Tier 2B Capital. The Company has provided a promissory note, a general security agreement, and a pledge of all investments made in HomEquity Bank including the unsecured subordinated debt and all of the issued and outstanding shares in the capital of HomEquity Bank. The transaction was conducted on a private basis. Fair value of the term loan is determined using quoted market rates provided to the Company by a capital markets dealer.15. SHARE CAPITAL A summary of the changes to the Companyʼs share capital is as follows: Authorized: An unlimited number of common shares December 31, 2010 December 31, 2009 Number of Amount Number of Amount Common shares shares $ shares $ Balance, beginning of year 14,239,041 102,794 – – Conversion from Trust units – June 30, 2009 – – 14,215,433 – Shares issued under Dividend reinvestment plan 110,953 480 – 102,547 Shares earned and granted under the long-term incentive plans (1) 40,396 480 23,608 247 Balance, end of year (2) 14,390,390 103,754 14,239,041 102,794 (1) Includes vested, non-vested and cancelled shares. (2) Includes 75,399 restricted shares issued under the Restricted Share Plan and 197,199 deferred shares issued under the Deferred Share Plan. December 31, 2010 December 31, 2009 Number of Proceeds Number of Proceeds Trust units units $ units $ Balance, beginning of year – – 14,123,549 – Units issued under distribution reinvestment plan – – – – Units earned and granted under the long-term incentive plans (1) – – 91,884 238 Conversion to HOMEQ Corporation shares – – (14,215,433) – Balance, end of year – – – 238 The Company has three long-term incentive plans: a Restricted Share Plan (RSP) for management, a Deferred Share Plan (DSP) for Directors and an Option and Share Appreciation Rights Plan for management. A restricted share granted through the RSP entitles the holder to receive, on the vesting date, a share plus the amount of dividends that would have been paid on the shares respectively if the share had been issued on the date of grant. Subject to the achievement of performance conditions, if any, restricted shares vest equally over three years and the total cost of the grant is recognized over the vesting period. As at December 31, 2010, 221,620 restricted shares have been issued since the inception of the plan and 75,399 shares remain within the plan, none of which have vested. For the year ended December 31, 2010, 29,700 restricted shares have been issued (December 31, 2009 – 55,000). The non-employee Directors may elect to receive their compensation in whole or in part in the form of deferred shares under the DSP in lieu of cash compensation. On retiring from the Board, a Director will receive all deferred shares accumulated in the plan. The maximum number of shares that may be issued under the DSP is limited to 500,000. 56_57 Annual Report 2010
  • 60. Notes to Consolidated Financial S tatem ents 15. Share Capital (cont’d) As at December 31, 2010, the Directors have earned 197,199 shares under the DSP. For the year ended December 31, 2010, 46,446 deferred shares have been issued (December 31, 2009 – 60,492). For the year ending December 31, 2010, Directorsʼ fees and executive compensation expense under the long- term incentive plans was $480 (December 31, 2009 – $488). The Company intends to settle the restricted and deferred shares in shares of the Company upon vesting and retirement, respectively. Until such time, these shares do not trade on the Toronto Stock Exchange, have no voting rights and cannot be sold or liquidated early. At the Annual General Meeting of Shareholders held on May 13, 2010, the Shareholders approved a third long- term incentive plan. This new plan, the Option and Share Appreciation Rights Plan was established to reinforce the alignment of interests between key executives and shareholders, reward achievement of shareholder value creation and provide competitive compensation opportunities to enable the Company to attract, retain and motivate leaders that are critical to the long-term success of the Company. The options have a term of seven years and vest equally over three years. A summary of the Companyʼs Option and Share Appreciation Rights Plan and related information is described in note 16. On March 23, 2010 the Company introduced an optional Dividend Reinvestment Plan (the Plan) for shareholders. The Plan was available to shareholders beginning with cash dividends paid on April 13, 2010 to shareholders of record March 29, 2010. The Plan allows eligible Canadian shareholders to elect to have their cash dividends from the Company automatically reinvested in additional shares. Shareholders who participate in the Plan will receive a further bonus of shares equal in value to 4% of each dividend that was reinvested.16. OPTION AND SHARE APPRECIATION RIGHTS PLAN A summary of the Companyʼs Option and Share Appreciation Rights Plan and related information is as follows: December 31, 2010 December 31, 2009 Exercise Weighted average Number of price Number of Exercise price shares $ shares $ Outstanding at beginning of year – – – – Granted 82,000 7.21 – – Exercised – – – – Forfeited – – – – Outstanding at end of year 82,000 7.21 – – Exercisable, end of year – 7.21 – – Under the fair value-based method of accounting for stock options, for the year ended December 31, 2010 the Company has recorded compensation expense in the amount of $18 (December 31, 2009 – nil) related to grants of options under the Options and Share Appreciation Rights Plan. This amount is included in salaries and benefits in the consolidated statements of operations and in contributed surplus on the consolidated balance sheets. The fair value of options granted is estimated at the date of grant using the Black-Scholes valuation methodology, with the following assumptions: (i) risk-free rate of 3.07%; (ii) expected option life of 4.5 years; (iii) expected volatility of 20% and (iv) expected dividend yield of 4.12%.17. CAPITAL MANAGEMENT The overall objective of capital management is to ensure that the Company has sufficient capital to maintain its operations based on current activities and expected business developments in the future and to provide a return to shareholders commensurate with the risk of the business and comparable to other similar companies. The Companyʼs capital resources consist of deposits, medium-term notes, subordinated debt, unsecured subordinated debt, bank term loan and equity. Historically, the Company has used cash flows from operating activities to fund its operations and distributions, and the excess of those cash flows coupled with borrowings under its debt programs have been used to fund growth in the mortgage portfolio.
  • 61. Notes to Consolidated Financial S tatem ents The Companyʼs subsidiary, HomEquity Bank, received its Letters Patent and Order to Commence as a federally regulated Schedule I bank from the Minister of Finance on October 13, 2009. As a chartered bank, HomEquity Bank has access to retail deposits sourced through deposit brokers, which became part of capital resources. The regulatory capital requirements of HomEquity Bank are specified by the Office of the Superintendent of Financial Institutions (OSFI) in its Guideline A, Capital Adequacy Requirement (CAR) – Simpler Approaches. The Guideline specifies the types of items included in capital and the measures OSFI will consider in reviewing capital adequacy. There are two capital standards addressed in HomEquity Bankʼs capital management policy: risk based capital ratios and Assets-to-Capital multiple. The Company has implemented policies and procedures to monitor compliance with regulatory capital requirements. HomEquity Bank has implemented an Internal Capital Adequacy Assessment Process which is based on the Companyʼs assessment of the business risks of HomEquity Bank. The total regulatory capital of HomEquity Bank is comprised of Tier 1 and Tier 2 capital as follows: December 31 December 31, 2010 2009 $ $ Shareholders’ equity per HomEquity Bank’s consolidated balance sheet 75,494 76,666 Deductions 341 301 Tier 1 capital 75,153 76,365 Book value of unsecured subordinated debt 30,000 10,000 Less: accumulated amortization for capital adequacy purposes 4,000 2,000 Tier 2 capital 26,000 8,000 Total regulatory capital 101,153 84,365 Credit risk 518,689 440,250 Off-balance sheet exposure 3,463 6,258 Operational risk 41,001 40,331 Total risk-weighted assets 563,153 486,839 Capital ratios Tier 1 Capital Ratio (1) 13.3% 15.7% Total Capital Ratio (2) 18.0% 17.3% Assets-to-Capital Multiple (3) 11.5x 11.8x (1) The Tier 1 Capital Ratio is defined as Tier 1 capital divided by total risk-weighted assets. (2) The Total Capital Ratio is defined as total regulatory capital divided by total risk-weighted assets. (3) The Assets-to-Capital Multiple is calculated by dividing total assets, including specified off-balance sheet items net of other specified deductions, by total capital. During the year ended December 31, 2010, HomEquity Bank complied with the OSFI guideline related to capital ratios and the Assets-to-Capital multiple. Both the Tier 1 and Total Capital Ratios remain above OSFIʼs stated minimum capital ratios of 7% and 10%, respectively, for a well capitalized financial institution. HomEquity Bankʼs Assets-to-Capital Multiple remains below the maximum permitted by OSFI. HomEquity Bankʼs wholly owned subsidiary, CHIP Mortgage Trustʼs (“CMT”) borrowings are subject to debt- to-mortgage covenants. The covenants are: a maximum senior debt-to-mortgage ratio of 93% when it has commercial paper outstanding, a maximum of 95% when its senior rated debt consists only of medium-term notes and a maximum total debt-to-mortgage ratio of 98%. CMT is also required to maintain minimum cash on hand equivalent to 2% of its mortgage portfolio value. At December 31, 2010, the senior debt-to-mortgage ratio was 76.4% (December 31, 2009 90.4%), the total debt-to-mortgage ratio was 82.8% (December 31, 2009 97.5%) and CMT held more than the required amount of cash. The Company closely monitors business performance to manage compliance with these covenants. 58_59 Annual Report 2010
  • 62. Notes to Consolidated Financial S tatem ents18. DERIVATIVE INSTRUMENTS In the normal course of business, the Company enters into interest rate derivative contracts to manage interest rate risk. Derivative financial instruments are financial contracts that derive their value from underlying changes in interest rates or other financial measures. Interest rate swaps are contracts in which two counterparties agree to exchange cash flows over a period of time based on rates applied to a specified notional principal amount. A typical interest rate swap would require one counterparty to pay interest based on a fixed rate and receive interest based on a variable market interest rate determined from time to time with both calculated on a specified notional principal amount. No exchange of principal amount takes place. Forward rate agreements are contracts that effectively fix a future interest rate for a period of time. A typical forward rate agreement provides that at a pre-determined future date, a cash settlement will be made between counterparties based upon the difference between a contracted rate and a market rate to be determined in the future, calculated on a specified notional principal amount. No exchange of principal amount takes place. Fair values Fair values of the interest rate derivatives are determined using an internal valuation model with observable inputs. Changes in fair value resulting in unrealized gains or losses are recorded in the consolidated statements of operations. Notional amounts The notional value of derivative financial instruments represents an amount to which a rate or price is applied in order to calculate the exchange of cash flows. Notional principal amounts do not represent the potential gain or loss associated with market risk and is not indicative of the credit risk associated with derivative financial instruments. The notional amounts are not recorded as assets or liabilities on the consolidated balance sheets. The following table summarizes the fair values, notional principal and weighted average rates of the derivative instruments outstanding as at December 31, 2010. The floating rate for all instruments is based on the CDOR- BA rate for terms ranging from one to twelve months. Weighted average rate Notional principal Fair values December 31, December 31, December 31, December 31, December 31, December 31, 2010 2009 2010 2009 Interest rate contracts 2010 2009 $ $ $ $ Receive fixed Swaps 4.00% 4.14% 685,000 650,000 15,199 28,248 Forward rate agreements 1.69% – 30,000 – 24 – Pay fixed Swaps 1.45% 1.55% 75,000 25,000 41 288 Forward rate agreements – 0.33% – 60,000 – 8 ASSETS 790,000 735,000 15,264 28,544 Receive fixed Swaps 2.43% 2.22% 120,500 35,000 1,051 188 Pay fixed Swaps 2.79% 2.25% 64,500 211,000 1,039 3,146 Forward rate agreements 1.40% 1.17% 75,000 10,000 3 13 LIABILITIES 260,000 256,000 2,093 3,347 Maturity terms The following table summarizes the notional principal and fair value by term to maturity of derivative instruments outstanding as at December 31, 2010. Maturity dates range from May 2011 to May 2016.
  • 63. Notes to Consolidated Financial S tatem ents Remaining term to maturity Within 1 1 to 3 3 to 5 Over 5 December 31, December 31, year years years years 2010 2009 $ $ $ $ $ $ Notional principal Swaps 349,800 235,200 175,000 – 760,000 675,000 Forward rate agreements 30,000 – – – 30,000 60,000 Derivative assets 379,800 235,200 175,000 – 790,000 735,000 Swaps 28,000 93,000 44,000 20,000 185,000 246,000 Forward rate agreements 75,000 – – – 75,000 10,000 Derivative liabilities 103,000 93,000 44,000 20,000 260,000 256,000 Fair values Swaps 2,502 9,322 3,416 – 15,240 28,536 Forward rate agreements 24 – – – 24 8 Derivative assets 2,526 9,322 3,416 – 15,264 28,544 Swaps 275 1,021 611 183 2,090 3,334 Forward rate agreements 3 – – – 3 13 Derivative liabilities 278 1,021 611 183 2,093 3,347 Hedge accounting results The Companyʼs fair value hedges consist of interest rate swaps that are used to protect against changes in fair value of fixed-rate medium-term debt, deposits, unsecured subordinated debt and the bank term loan due to movements in market interest rates. Changes in the fair value of derivatives that are designated and qualify as fair value hedging instruments are recorded as unrealized losses (gains) on derivative instruments in the consolidated statements of operations, along with adjustments to the carrying value of the financial instruments that are attributable to the hedged risk. The Company elected under Section 3865 – Hedges, to apply hedge accounting to the interest rate swaps detailed below. Medium-term debt During the year ended December 31, 2010, the Company entered into interest rate swaps having a notional amount of $125,000 to hedge the series 2010-1 fixed-rate medium-term debt issued during the year. As at December 31, 2010 the Company has interest rate swaps having a notional amount of $284,000 that hedge series 2008-1 and series 2010-1. The fair value of these swaps is recorded as derivative instruments assets on the consolidated balance sheets. The hedges were effective on December 31, 2010. During year ended December 31, 2010, the Company recorded a hedge ineffectiveness gain of $144 (December 31, 2009 – loss of $805), which is included in unrealized losses on derivative instruments on the consolidated statements of operations. Deposits During the year ended December 31, 2010 the Company entered into interest rate swaps having a notional amount of $137,500 to hedge $137,500 of deposits issued during the year. As at December 31, 2010 the Company has interest rate swaps having a notional amount of $147,500 that hedge deposits. The fair value of these swaps is recorded as derivative instruments assets on the consolidated balance sheets. The hedges were effective on December 31, 2010. During the year ended December 31, 2010, the Company recorded a hedge ineffectiveness gain of $491 (December 31, 2009 – gain of $20), which is included in unrealized losses on derivative instruments on the consolidated statements of operations. 60_61 Annual Report 2010
  • 64. Notes to Consolidated Financial S tatem ents 18. Derivative Instruments (cont’d) Unsecured subordinated debt During the year ended December 31, 2010, the Company entered into interest rate swaps having a notional amount of $10,000, to hedge $10,000 of unsecured subordinated debt issued during the year. The fair value of these swaps is recorded as derivative instruments assets on the consolidated balance sheets. The hedges were effective on December 31, 2010. During the year ended December 31, 2010, the Company recorded a hedge ineffectiveness gain of $239 (December 31, 2009 – nil), which is included in unrealized losses on derivative instruments on the consolidated statements of operations. Bank term loan During the year ended December 31, 2010, the Company entered into an interest rate swap having a notional amount of $10,000, to hedge $10,000 of the bank term loan raised during the year. The fair value of this swap is recorded as derivative instruments assets on the consolidated balance sheets. The hedges were effective on December 31, 2010. During the year ended December 31, 2010, the Company recorded a hedge ineffectiveness gain of $180 (December 31, 2009 – nil), which is included in unrealized losses on derivative instruments on the consolidated statements of operations. Derivative – related risks Market risk Derivative instruments have either no or an insignificant market value at inception. They obtain value, increase or decrease, as relevant interest rates, foreign exchange rates or credit prices change, such that the previously contracted terms of the derivative transactions have become more or less favourable than what can be negotiated under current market conditions for contracts with the same terms and the same remaining period to expiry. The potential for derivatives to increase or decrease in value as a result of the foregoing factors is generally referred to as market risk. This market risk is mitigated as the Company does not hold or use any derivative contracts for speculative trading purposes. Credit risk Credit risk on derivative financial instruments is the risk of a financial loss occurring as a result of a default of a counterparty on its obligation to the Company. Credit risk is limited by dealing only with Schedule I Canadian chartered banks as counterparties. The maximum derivative credit exposure to the Company is the fair value of derivative contracts presented in the summary table above. The Companyʼs exposure to risks arising from other financial instruments is disclosed in note 19.
  • 65. Notes to Consolidated Financial S tatem ents December 31, 2010 National Replacement Credit risk Risk-weighted Fair Interest rate contracts principal cost (1) equivalent (2) assets (3) value $ $ $ $ $ Swaps Maturing within 1 year 349,800 2,502 2,502 500 2,502 Maturing in 1 to 3 years 235,200 9,322 10,498 2,100 9,322 Maturing in 3 to 5 years 175,000 3,416 4,291 858 3,416 Maturing over 5 years – – – – – Forward rate agreements Maturing within 1 year 30,000 24 24 5 24 790,000 15,264 17,315 3,463 15,264 December 31, 2009 National Replacement Credit risk Risk-weighted Fair Interest rate contracts principal cost (1) equivalent (2) assets (3) value $ $ $ $ $ Swaps Maturing within 1 year 110,000 3,076 3,076 615 3,076 Maturing in 1 to 3 years 455,000 19,201 21,476 4,295 19,201 Maturing in 3 to 5 years 110,000 6,259 6,809 1,362 6,259 Forward rate agreements Maturing within 1 year 60,000 8 – – 8 735,000 28,544 31,361 6,272 28,544 (1) Replacement costs represents the cost of replacing all contracts that have a positive fair value, using current market rates. (2) Credit risk equivalent represents the total replacement cost plus an amount representing the potential future credit exposure, as outlined in OSFI’s Capital Adequacy Guideline. (3) Risk-weighted assets represent the credit risk equivalent, weighted based on the creditworthiness of the counterparty, as prescribed by OSFI.19. FINANCIAL INSTRUMENTS – FINANCIAL RISKS The Company performs regular monitoring of its risks, assessments, and related action plans. Senior Management and the Board of Directors obtain information that allows them to keep informed regarding the effectiveness of their risk management process and activities. The Company has a Conduct Review and Risk Management Committee to assist the Board of Directors in fulfilling its responsibilities. Credit risk (non-derivative) Credit risk is the potential for financial loss if a borrower or counterparty in a transaction fails to meet its obligations in accordance with agreed terms. Credit risk on the Companyʼs cash and cash equivalents is mitigated by maintaining cash balances at Schedule I Canadian chartered banks. Credit risk on the mortgage loans is mitigated by following Board approved underwriting policies. In particular, during the underwriting process every property is appraised by a certified appraiser with particular attention paid to the property type, location and days on market of each comparative property. The initial appraised value is subsequently discounted, typically by between 7.5% and 30%. A rate of future property appreciation assumed for the life of the mortgage is low in comparison with the Canadian average of approximately 4.5% for the past 20 years. The average rate of assumed appreciation used in the initial underwriting of the existing mortgage portfolio is approximately 1.2%. Each mortgage originated is limited in maximum dollar amount and loan-to-value ratio in accordance with internal guidelines. The Company also obtains a first charge on the underlying property securing the mortgage. Credit risk is mitigated further by the geographic diversity and the collateralization of the portfolio. 62_63 Annual Report 2010
  • 66. Notes to Consolidated Financial S tatem ents 19. Financial Instruments – Financial Risks (cont’d) Interest rate risk The Companyʼs operating margin is primarily derived from the spread between interest earned on the mortgage portfolio, and the interest paid on the debt and deposits used to fund the portfolio. Mortgages have various interest rate reset terms, ranging from variable to five-year. Interest on the majority of the Companyʼs debt is fixed until maturity. The Company uses derivative contracts to move the fixed rate on the debt to match the rate reset terms of the mortgage portfolio, to mitigate any fluctuations that changes to the underlying benchmark rates may have on its operating margin at the time of the mortgage resets. Interest rates on approximately 62% of the mortgage portfolio are based on the Government of Canada Treasury Bill and bond rates whereas interest rates on the debt and derivative instruments are based on the Bankersʼ Acceptance rates. Historically, changes in interest rates do not impact each benchmark rate equally which may result in a reduction in spread. Liquidity risk Liquidity risk is the risk that the Company will not be able to meet its obligations when they are due. With respect to medium-term and subordinated debt, the Company mitigates these risks by issuing only highly rated debt, by using a syndicate of several dealers to issue debt, and by staggering the maturities of its debt obligations. With respect to deposits the Company mitigates risk by holding a required amount of cash and cash equivalents to meet maturing deposit liabilities. The following table summarizes the expected final payment dates of debt principal and interest payable, derivative instruments and deposit maturities on the consolidated balance sheets: December 31, Within 2 to 3 4 to 5 Over 5 2010 1 year years years years Total $ $ $ $ $ Deposits 127,149 126,959 113,535 – 367,643 Interest payable on medium-term debt 8,229 – – – 8,229 Interest payable on subordinated debt 477 – – – 477 Interest payable on unsecured subordinated debt 238 – – – 238 Interest payable on bank term loan 71 – – – 1 Derivative instruments 278 1,021 611 183 2,093 Debt principal (1) Medium-term debt 280,800 213,280 125,000 – 619,080 Subordinated debt – 40,000 – – 40,000 Unsecured subordinated debt – – 10,000 10,000 20,000 Bank term loan – – – 10,000 10,000 Total 417,242 381,260 249,146 20,183 1,067,831 December 31, Within 2 to 3 4 to 5 Over 5 2009 1 year years years years Total $ $ $ $ $ Deposits 13,609 15,416 11,068 – 40,093 Interest payable on medium-term debt 7,857 – – – 7,857 Interest payable on subordinated debt 719 – – – 719 Interest payable on unsecured subordinated debt 183 – – – 183 Derivative instruments 212 2,237 898 – 3,347 Debt principal (1) Medium-term debt 260,000 405,000 119,115 – 784,115 Subordinated debt – 10,000 40,000 – 50,000 Unsecured subordinated debt – – 10,000 – 10,000 Total 282,580 432,653 181,081 – 896,314 (1) Certain tranches of debt have refinancing terms upon their expected final payment dates. See notes 11 and 12.
  • 67. Notes to Consolidated Financial S tatem ents Interest rate sensitivity The Company is exposed to interest rate risk as a result of the mismatch, or gap, between the maturity or repricing date of interest sensitive assets and liabilities. The following table summarizes the gap position at December 31, 2010 for the selected period intervals. Figures in parentheses represent an excess of liabilities over assets or a negative gap position. The Company estimates that an annualized 100 basis point decrease in interest rates would increase net interest income after tax over the next twelve months by $463. A 100 basis point increase in interest rates would decrease net income after tax over the next twelve months by a similar amount. These sensitivities are hypothetical and should be used with caution. Non-interest 0 to 3 4 to 12 1 to 3 Over 3 rate Floating months months years years sensitive Total 2010 (in thousands except % amounts) $ $ $ $ $ $ $ Assets Cash resources 48,881 17,193 – – – – 66,074 Weighted average interest rate 1.00% 0.98% – – – – 1.00% Interest bearing deposits – 11,994 – – – – 11,994 Weighted average interest rate – 1.09% – – – – 1.09 Loans 192,721 156,227 470,716 143,829 52,890 50,030 1,066,413 Weighted average interest rate 5.00% 5.20% 5.78% 6.88% 6.44% – 5.46% Derivative instruments – – 2,526 9,322 3,416 – 15,264 Weighted average interest rate – – 3.19% 4.19% 4.00% – 3.67% Other assets – – – – – 24,005 24,005 Total 241,602 185,414 473,242 153,151 56,306 74,035 1,183,750 Liabilities and shareholders’ equity Deposits – 24,059 103,090 127,399 113,557 (462) 367,643 Weighted average interest rate – 1.24% 1.76% 2.47% 3.29% – 2.44% Medium-term debt – – 280,800 213,280 125,000 7,218 626,298 Weighted average interest rate – – 5.70% 4.50% 4.49% – 5.03% Subordinated debt – – – 40,000 – 308 40,308 Weighted average interest rate – – – 6.91% – – 6.85% Unsecured subordinated debt – – – – 20,000 (276) 19,724 Weighted average interest rate – – – – 9.16% – 9.28% Bank term loan – – – – 10,000 (274) 9,726 Weighted average interest rate – – – – 8.21% – 8.44% Derivative instruments – 1 277 1,021 794 – 2,093 Weighted average interest rate – 1.46% 1.88% 2.09% 3.11% – 2.22% Other – – – – – 19,890 19,890 Shareholders’ equity – – – – – 98,068 98,068 Total – 24,060 384,167 381,700 269,351 124,472 1,183,750 Derivative instruments – (415,000) (79,200) 255,200 239,000 – – Interest rate sensitivity gap 241,602 (253,646) 9,875 26,651 25.955 (50,437) – Cumulative gap 241,602 (12,044) (2,169) 24,482 50,437 – – 2009 Total assets 122,069 181,936 457,343 123,417 55,706 76,092 1,016,563 Total liabilities and shareholders’ equity – 2,160 288,911 430,450 166,118 128,924 1,016,563 Derivative instruments – (142,500) (321,000) 353,000 110,500 – – Interest rate sensitivity gap 122,069 37,276 (152,568) 45,967 88 (52,832) – Cumulative gap 122,069 159,345 6,777 52,744 52,832 – – 64_65 Annual Report 2010
  • 68. Notes to Consolidated Financial S tatem ents20. FAIR VALUE OF FINANCIAL INSTRUMENTS The following table summarizes the fair values of the Companyʼs financial instruments. The estimated fair value amounts are designed to approximate amounts at which financial instruments could be exchanged in a current transaction between willing parties who are under no compulsion to act. The Company uses a fair value hierarchy to categorize the inputs used in valuation techniques to measure fair value of financial instruments. The classifications are as follows: the use of quoted market prices for identical financial instruments (Level 1); internal models using observable market information as inputs (Level 2) and internal models without observable market information as inputs (Level 3). The Company had no Level 1 and Level 3 financial instruments at December 31, 2010 and there have been no transfers between levels. Due to the estimation process and the need to use judgement, the aggregate fair value amounts should not be interpreted as being necessarily realizable in an immediate settlement of the instruments. December 31, 2010 December 31, 2009 Fair value Fair value over over Carrying carrying Carrying carrying value Fair value value value Fair value value Assets Cash Resources (1) 78,068 78,068 – 36,488 36,488 – Securities (1) – – – 12,192 12,192 – Loans (2) 1,066,413 1,066,413 – 917,161 917,161 – Derivative instruments (3) 15,264 15,264 – 28,544 28,544 – Other (4) 24,005 24,005 – 22,178 22,178 – 1,183,750 1,183,750 – 1,016,563 1,016,563 – Liabilities Deposits (5) 367,643 373,759 6,116 40,093 40,549 456 Derivative instruments (3) 2,093 2,093 – 3,347 3,347 – Other (4) 19,890 19,890 – 19,334 19,334 – Medium-term debt (6) 626,298 641,862 15,564 792,328 812,628 20,300 Subordinated debt (6) 40,308 41,082 774 50,335 48,923 (1,412) Unsecured subordinated debt (6) 19,724 20,025 301 10,144 10,421 277 Bank term loan (6) 9,726 9,735 9 – – – Shareholders’ equity 98,068 98,068 – 100,982 100,982 – 1,183,750 1,206,514 22,764 1,016,563 1,036,184 19,621 The fair value amounts of the Companyʼs financial instruments have been determined using the following methods and assumptions: (1) Cash resources and securities are valued using internal models using observable market information as inputs (Level 2) (2) Loans are recorded at amortized cost. The mortgage loans reprice frequently and changes in interest rates will have a minimal impact on fair value. On that basis, fair value is assumed to approximate carrying value. (3) Fair value of derivative instruments is determined using an internal valuation model with observable inputs (Level 2) (4) Certain other assets and certain other liabilities are recorded at amortized cost. The carrying value of these other assets and other liabilities are assumed to approximate their fair value due to their short-term nature. (5) Fair value of deposits is determined by discounting the contractual cash flows using the market interest rates currently offered for deposits with similar terms. (6) Fair value of medium-term debt, subordinated debt, unsecured subordinated debt and bank term loan are determined using average quoted market rates provided to the Company by capital market dealers.
  • 69. Notes to Consolidated Financial S tatem ents21. COMMITMENTS The Company is committed to annual payments under operating leases for office premises. In addition to minimum lease payments for premises rental, the Company will pay its share of common area maintenance and realty taxes over the term of the leases. The Companyʼs annual lease obligations are as follows: $ 2011 482 2012 480 2013 477 2014 484 2015 49022. SALARIES AND BENEFITS December 31, December 31, 2010 2009 $ $ Mortgage administration 204 178 Overhead 5,596 4,767 5,800 4,94523. SELLING, GENERAL AND ADMINISTRATION December 31, December 31, 2010 2009 $ $ Marketing 2,438 2,028 Professional services 2,121 2,839 Office expenses 1,360 1,183 Other 483 335 Business and capital taxes 351 260 Mortgage administration 216 129 6,969 6,77424. CONSOLIDATED STATEMENTS OF CASH FLOW – OTHER December 31, December 31, 2010 2009 $ $ Prepaid expenses and other assets (201) (261) Intangible assets – (310) Income taxes payable (3,179) 1,873 Accounts payable and accrued liabilities 4,049 1,691 669 2,993 66_67 Annual Report 2010
  • 70. Notes to Consolidated Financial S tatem ents25. FUTURE ACCOUNTING CHANGES Transition to International Financial Reporting Standards The Canadian Accounting Standards Board has confirmed that International Financial Reporting Standards (IFRS) will replace current Canadian GAAP for publicly accountable enterprises, including the Company, effective for fiscal years beginning on or after January 1, 2011. Accordingly, the Company will apply accounting policies consistent with IFRS beginning with its interim financial statements for the quarter ended March 31, 2011. The Companyʼs 2011 interim and annual financial statements will include comparative 2010 financial statements, adjusted to reflect accounting policies that are consistent with IFRS.26. SUBSEQUENT EVENTS Subsequent to year end the Company redeemed all of the series 2008-1 senior medium-term notes which had an expected final payment date of May 16, 2011. The Company incurred an estimated net cost of $1,633 related to these transactions. These redemptions were funded from cash resources on hand, deposits raised and proceeds of the medium-term note issue described below. On January 25, 2011, the Company concluded the sale of $175,000 of senior medium-term notes. The notes have a coupon of 3.97% and have an expected final payment date of February 1, 2016. The Company also entered into an interest rate swap to hedge the interest rate on the notes. On a swapped basis, the interest rate of the notes is approximately 138 basis points over the corresponding Bankersʼ Acceptance rate. The Company incurred an estimated cost of $613 related to this transaction. Proceeds from this issue were used to redeem some of the series 2008-1 senior medium-term notes which had an expected final payment date of May 16, 2011. In addition, proceeds from this issue will be used to repay a portion of the Series 2007-3 senior medium-term notes, which have an expected final repayment date of May 2, 2011. On March 7, 2011 the Companyʼs Board of Directors approved the payment of a quarterly dividend of $0.07 per share on the outstanding common shares of the Company, which is equivalent to an annual dividend of $0.28 per share. The dividend was payable to shareholders of record at the close of business on March 30, 2011 and is payable on April 14, 2011.27. COMPARATIVE CONSOLIDATED FINANCIAL STATEMENTS The comparative consolidated financial statements have been reclassified from statements previously presented to conform to the presentation of the 2010 consolidated financial statements.
  • 71. BOARD OF DIRECTORS OFFICERS CORPORATE INFORMATION Table of Contents Financial Highlights 1 Toronto, Ontario Senior Vice President, Letter from the CEO 2 Pierre Lebel, LL.B, MBA Steven Ranson, CA, MBA Greg Bandler Vancouver, British Columbia Mr. Ranson is the President Sales and Marketing Chairman of the Board Accelerated Growth 4 Mr. Lebel is Chairman of and Chief Executive Officer of Imperial Metals Corporation the Company and HomEquity Bank. Senior Vice President HomEquity Bank Taking Flight 6 Gary Krikler, CA and Chief Financial Officer 25 Years of Expertise 8 Toronto, Ontario Toronto, Ontario Heather Briant, MBA, ICD.D Paula Roberts, MA, ICD.D Management Discussion and Analysis 10 Ms. Briant is the Senior Vice President, Ms. Roberts is the Executive Vice President Vice President, Finance Scott Cameron, CA Human Resources of Cineplex of Plan International Canada Inc. and Deposit Services Management’s Responsibility Entertainment LP. for Financial Reporting 40 Toronto, Ontario Vice President, General Counsel Auditors’ Report 41 Gary Samuel, LL.B Celia Cuthbertson, LL.B Toronto, Ontario Mr. Samuel is a Co-founder and and Corporate Secretary Paul Damp, CA Consolidated Balance Sheets 42 Mr. Damp is the Managing Partner Partner of Crown Realty Partners of Kestrel Capital Partners Consolidated Statements of Operations 43 Vice President, Wendy Dryden Operations Consolidated Statements of Changes Toronto, Ontario in Shareholders’ Equity 44 Daniel Jauernig, CA, CMA Mr. Jauernig is the President and Vice President, Consolidated Statements of Cash Flows 45 Neil Sider, Ph.D. Chief Executive Officer of Information Technology Classified Ventures Inc. Notes to Consolidated Financial Statements 46 Vice President, Corporate Information 69 Lori Sone-Cooper, CHRP Human Resources HOMEQ Corporation opens trading on the Toronto Stock Exchange (TMX) November 26, 2010 celebrating its 25th year of providing Canadian seniors with reverse mortgage solutions.With 25 years of expertise in its products and markets, substantialaccess to capital, and proven distribution and marketing, HomEquity From left to right: Paula Roberts, Gary Samuel, Paul Damp, Heather Briant, Pierre Lebel, Daniel Jauernig, and Steven Ranson.Bank has bright prospects. Indeed, the Bank is meeting robust demand 2010 has been a record year of growth for HOMEQ Corporation and HomEquity Bank. The Bank’s mortgage portfolio surpassedfor reverse mortgages from across the country.With a national presence $1.0 billion and the last five consecutive quarters have set year-over-year records for new originations for the CHIP Home Income Plan. The combination of portfolio growth, efficient originations, spread management and overhead expense control should continue to be translated into steady increases in income, leading to significant increases in Return on Equity. 2010 has been aand efficient distribution channels, HomEquity Bank’s mortgage portfolio remarkable year in which the organization has been completely transformed while delivering new levels of service and value to seniors. Our direction is firmly set for the future.has exceeded $1.0 billion. Chairman of the Board Pierre Lebel Ernst & Young LLP Computershare The shares of HOMEQ Corporation are AUDITORS REGISTRAR AND TRANSFER AGENT STOCK LISTING P.O. Box 251 100 University Avenue listed on the Toronto Stock Exchange 222 Bay Street Toronto, Ontario M5J 2Y1 under the symbol HEQ Ernst & Young Tower For any inquiries or change of Toronto, Ontario M5K 1J7 address please call: Toll free: 1 800 663 9097 68_69 Annual Report 2010 For further information, please contact: Gary Krikler, CA Senior Vice President and Chief Financial Officer or Scott G. Cameron, CA Vice President, Finance
  • 72. HOMEQ Corporation45 St. Clair Avenue West, Suite 600Toronto, Ontario M4V 1K9T 416 925 4757F 416 925 9938www.homeq.ca OUR DIRECTION IS SET HOMEQ Corporation 2010 ANNUAL REPORT 2009 ANNUAL REPORT

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