Xceed Mortgage Corporation. Management s Discussion and Analysis for the First Quarter ended January 31, 2009

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1 Xceed Mortgage Corporation Management s Discussion and Analysis for the First Quarter ended January 31, 2009

2 Forward-Looking Statements Statements contained in this report that address activities, events or developments that management or Xceed Mortgage Corporation ( Xceed or the Company ) believes, expects or anticipates will or may occur in the future, including the Company s future growth, results of operations, performance and business prospects and opportunities, other than statements of historical fact, are forward looking statements. These forward looking statements reflect the current internal projections, expectations or beliefs of the Company, based on information currently available to the Company. Actual results and developments may differ materially from results and developments discussed in the forward looking statements as they are subject to a number of risks and uncertainties including risks relating to inflation levels and general economic conditions, changes in interest rates, the securitization of mortgages, the nature of the Company s borrowers, changes in government regulations and competition. Consequently, any forward looking statements made in this report are qualified by this caution. Investors and others should consider the aforementioned and other uncertainties and not place undue reliance on forward-looking statements when making decisions since there can be no assurance that actual results or developments will be realized as intended or expected, and even if substantially realized, that they will have the expected consequences to, or effects on, the Company. These forward looking statements are made as of the date of this report and the Company assumes no obligation to update or revise them to reflect new events or circumstances. Financial Highlights ($000 s, except per share amounts and ratios) At period end: Mortgage and other assets under administration (1) Deferred net mortgage interest receivable Total assets Total liabilities Shareholders equity January 31, 2009 October 31, 2008 January 31, ,083,931 28, ,270 74,225 86,045 2,139,363 34, ,300 74,674 82,626 2,523,155 55, , ,138 96,159 For the three month period: Total revenues Cash flow from operations (2) Net income 8,512 8,003 3,341 6,448 2,434 1,594 5,738 1,630 1,518 Earnings per Share Basic Diluted Cash flow from operations per share (2) Basic Diluted Ratios Return on average shareholders equity Average mortgage default (90 Days+) (3) 15.92% 3.09% 7.72% 3.55% 6.44% 3.33% Non-GAAP and Other Measures: (1) Mortgage assets (in thousands of dollars) included in this balance were $1,986,846 (October 31, 2008 $2,042,290). (2) Cash flow from operations is presented before net change in non-cash net asset balances related to operations. For fiscal 2008, this has been calculated after removing the one-time after-tax cash-based expense effects of $1.5 million related to severance, and $0.4 million related to refinancing costs for Xceed Mortgage Trust. (3) Ratios are presented on a combined securitized and non-securitized portfolio basis. 2 XCEED Mortgage Corporation First Quarter 2009 Report

3 Management s Discussion and Analysis The following discussion is intended to provide review and analysis of the results of operations and financial position of Xceed Mortgage Corporation ( Xceed or the Company ) for the three months (the quarter ) ended January 31, This analysis should be read in conjunction with the corresponding unaudited interim financial statements and accompanying notes for the period then ended and management discussion and analysis and audited financial statements (including accompanying notes) for the fiscal year ended October 31, This report and information set out herein is dated as at March 11, Additional information can be found at and in the Company s Annual Information Form. Description of Business Xceed is a mortgage lender, with mortgage and other assets under administration of $2.1 billion as at January 31, Xceed delivers residential mortgage financing solutions to the Canadian borrowing public through a national network of mortgage brokers. Selected Quarterly Information The following table provides selected unaudited quarterly financial information for the last eight quarters: For the quarter ended ($000 s, except per share amounts) Three months ended: Total revenues Net income (loss) January 31, ,512 3,341 (1) October 31, ,448 1,594 (2) July 31, ,497 1,587 April 30, ,619 (16,671) (3) January 31, ,738 1,518 October 31, ,347 (22,524) (4) July 31, ,687 6,472 April 30, ,369 4,744 Earnings (loss) per Share Basic Diluted (0.60) (0.60) (0.81) (0.79) (1) Includes a number of one-time accounting adjustments related to positive adjustment resulted from the implementation of the third-party asset back commercial paper restructuring plan, and valuation write-downs discussed below. (2) Includes a pre-tax adjustment for the reversal of $2.0 million ($1.3 million after-tax) in servicing liabilities on whole loan sales made during the fourth quarter of (3) Includes restructuring charges and severance costs of $6.5 million ($9.9 million pre-tax). (4) Includes $18.5 million ($28.1 million pre-tax) valuation write-down. Business Environment Overview Capital markets, both nationally and internationally, have suffered from turbulence, and these difficult conditions persist. The Company s revenue, operations and financial results have been and continue to be, materially and adversely affected by the continued illiquidity in the whole sale funding markets. The impact of these conditions to the Company were partially offset by the successful implementation of the third-party asset backed commercial paper ( ABCP ) restructuring plan during the first quarter of Strategy and Risk Management In light of the economic uncertainties and difficult capital market conditions, the Company s strategy remains focused on protecting its liquidity and funding needs, including the preservation of its residual interest cash flows from the existing securitization programs. The Company continues to concentrate on originating and renewing insured mortgages that qualify for sale under the Canada Mortgage Bond Program. Benefiting from the successful implementation of the third-party ABCP restructuring plan, the Company can now offer renewals to certain qualified uninsured mortgages under the affected securitization vehicle ( QSPE-XCD ). Implementation of the third-party ABCP restructuring plan does not, however, mean that the Company will be able to resume offering uninsured high-ratio mortgages since sufficient financing for securitizing these at an economically viable and profitable cost is still not available. On the closing of the third-party ABCP restructuring plan during January 2009, the Company received a one-time payment of $4.8 million for the retroactive adjustment in funding costs. The Company was entitled to receive an additional $0.9 million for interest earned on the illiquid ABCPs XCEED Mortgage Corporation First Quarter 2009 Report 3

4 through its residual interest in QSPE-XCD which the Company had previously written off at the end of the second quarter of The Company recorded $5.7 million ($3.8 million after-tax) for the above items in the first quarter of 2009 under securitization income. The Company also recorded a fair value increase of $8.8 million ($5.9 million after-tax) to its deferred net mortgage interest receivable for QSPE-XCD. Liquidity and Funding The Company is the financial services agent for Xceed Mortgage Trust ( XMT ), its term funding securitization vehicle. The Company estimates that XMT will need to raise approximately $225 to $235 million in A-C Notes to retire $305 million of Series 2007-T2 and Series 2006-T1 Class A2 Senior Notes maturing on March 17 and April 17, 2009 respectively. Given that there has been no success to date after exploring all available viable alternative to raise funds for XMT to retire the Class A-2 Senior Notes, the Company had notified the Indenture Trustee on March 9, 2009 of the likelihood of an amortization event occurring on March 17, 2009 if Series 2007-T2 Class A-2 Notes were not fully repaid on that date. Upon the occurrence of an amortization event, XMT s operations will continue unchanged. However, all outstanding notes in the series will started to be repaid with principal and coupon interest (converted to the corresponding monthly equivalent rate), on a monthly basis in sequential order, with the most senior tranche being paid with priority over the subordinate tranches. The amounts due to the Company, the residual interest holder, will be distributed last. The Company recorded a pre-tax valuation write-down of $2.0 million ($1.4 million after-tax) to its deferred net mortgage interest receivable at the first quarter ended January 31, 2009 as a result. XMT has total outstanding principal of $439.3 million as at January 31, The Company s mortgage securitization facility provided by the Canadian branch of an international bank through Okanagan Funding Trust ( OFT ) was adjusted with less favourable pricing terms subsequent to January 31, As a result of higher funding costs and increase in market spreads, the Company recorded a pre-tax valuation write-down of $4.5 million ($3.0 million after-tax) to its deferred net mortgage interest receivable at the first quarter ended January 31, The facility has total outstanding mortgage principal of $199.8 million as at January 31, The Company s revolving warehouse credit facility was renewed subsequent to January 31, 2009 for another term with less favorable pricing terms. The facility limit was reduced by the Company during the fourth quarter of 2008 from $250 million to $150 million on anticipated lower volume and to reduce the standby fees. The next renewal date of the warehouse credit facility is December 31, The Company believes that, based on the current origination activities and the reduced size of its operating structure and costs, the cash flow from operations and existing resources will enable it to meet its short- and intermediate-term liquidity requirements, and its objectives to maximize shareholders value. Business Volumes and Trends For the three months ended January 31, 2009, the Company funded $86.9 million in mortgages, compared with $65.7 million in the corresponding period of The Company sold mortgages valued at $86.0 million during the first quarter of fiscal 2009, the majority were insured mortgages sold on a whole loan basis. This compared with $131.1 million for the same period in fiscal 2008, of which $98.2 million were mortgages sold on a whole loan basis, and the balance were uninsured mortgages sold to off-balance sheet securitization entities with deferred purchase price. The Company continues to fund new insured mortgages through its revolving warehouse credit facility. 100% of the Company s new origination pipeline is insured mortgage product. As at January 31, 2009 and the date of this report, 27,742,557 common shares were issued and options for 68,049 voting common shares were granted and are outstanding. The Company has no preferred shares outstanding. The average numbers of shares outstanding during the period ended January 31, 2009 on an undiluted and diluted basis were 27,742,557. Results of Operations Net income for the three months ended January 31, 2009 was $3.3 million, as compared with net income of $1.5 million for the corresponding period of the prior year. Results for the three months ended January 31, 2009 were materially affected by the implementation of the third-party ABCP restructuring plan, as well as a number of related accounting and fair value adjustments to the Company s deferred net mortgage interest receivable discussed above necessary to reflect the ongoing nature of the Company s business and management s expectation of future performance of the securitization vehicles which the Company utilizes. These items totaled $5.3 million ($8.0 million pre-tax) in favor of the Company s fiscal first quarter results. Results for the corresponding period of the prior year included one-time reversal of $1.3 million ($2.0 million pre-tax) related to the Company s employee long-term incentive plan and an executive long term compensation plan. Ignoring the effects of the one-time items, results for the three 4 XCEED Mortgage Corporation First Quarter 2009 Report

5 months ended January 31, 2009 would have been a net loss of ($2.0) million, compared to net income of $0.2 million for the corresponding period of fiscal The loss mainly reflects the dramatic decline in the Bankers Acceptance (BA) rate that took place during the quarter, which led to a decline in fair value of the deferred net mortgage receivable of $1.5 million ($1.0 million after-tax) on anticipated lower reinvestment income from the Company s securitized portfolios. Basic and diluted earnings per share for the first quarter of fiscal 2009 amounted to $0.12 compared to basic and diluted earnings of $0.05 for the corresponding period of fiscal The aforementioned one-time items caused an increase of $0.19 for both basic and diluted earnings per share for the three months ended January 31, Return on average shareholders equity ( ROE ) for the three months ended January 31, 2009 was 15.9% compared to 6.4% in the corresponding quarter of the previous year. Ignoring the effects of the aforementioned one-time items, ROE for the three months ended January 31, 2009 would have been negative 9.5%. Cash Flow from Operations The Company defines cash flow from operations as the cash generated by its operating activities, before taking into consideration the net change in other non-cash net asset balances which are related to operating activities. This can be calculated by removing the effects of amortization and other items not affecting operating cash from net income, as per the subtotalled amount reported within the Operating Activities section of the Company s Statements of Cash Flows. However, this can also be calculated by subtracting expenses that are operating cash outflows from the revenues that generate operating cash inflows, as shown in the non-gaap calculation below. ($000 s, except per share amounts) For the quarter ended: Cash securitization income Interest earned Cash-based revenues Three Months Ended January 31, 2009 January 31, ,155 1,077 17,232 9,700 3,373 13,073 Net origination income (costs) Less: Other cash-based expenses Cash flow from operations Cash flow from operations per share Basic Diluted (1,411) (7,818) 8, (419) (11,024) 1,630 The Company has sold mortgages which it has originated to various entities ( Trusts ) either as part of a securitization program or on a whole loan sale basis. Once sold to the Trusts, mortgages sold as part of a securitization program begin to generate cash flows over the duration of their term, which primarily represent the interest earned on the transferred mortgages less funding costs. Mortgages that are sold on a whole loan sale basis generate a one-time cash flow for the Company consisting of the full cash value of the mortgage principal plus a premium. The premium is the present value of excess cash flows between the mortgage interest rate and the Trust s required returns, after taking into account the costs to secure the loans. Usually the most significant generator of cash flow from operations is the premium proceeds from the sale of insured mortgages on a whole loan basis which the Company receives upfront cash premium and the securitization programs monthly spread income received over time, both of which are a major subcomponent of residual securitization income. The magnitude of this source of cash income is driven by the size of the Company s portfolio of mortgages under administration and the net spreads generated by this portfolio. The cash securitization income includes the one-time amount of $4.8 million received upon the implementation of the third-party ABCP restructuring plan, as well as the $0.9 million on the interest earned on the illiquid ABCPs which the Company had written-off in the second quarter of XCEED Mortgage Corporation First Quarter 2009 Report 5

6 Cash flow from operations for the quarter ended January 31, 2009 was $8.0 million or $0.29 per basic and diluted share, as compared to $1.6 million or $ per basic and diluted share in fiscal Ignoring the effect of one-time receipts resulted from the implementation of the third-party ABCP restructuring plan, cash flow from operations for the quarter ended January 31, 2009 would have been $2.3 million or $0.08 per basic and diluted share. Revenue For the period ended: Net gain on sale of mortgages (1) Residual securitization income Securitization income Interest earned Net origination income (costs) Total revenues 2,963 5,883 8,846 1,077 (1,411) 8,512 ($000 s) Three Months Ended January 31, 2009 January 31, ,141 (357) 2,784 3,373 (419) 5,738 (1) Net gain on sale of mortgages is total gain on sale of mortgage loans less hedging costs. The Company derives its primary sources of revenue from the premium proceeds it receives from whole loan sales as well as the gains it recognizes through securitization to off-balance sheet securitization entities, and the residual securitization income from the securitized mortgages. The Company also earns interest income on mortgages that temporary reside on the Company s balance sheet pending sale. The Company sold an aggregate of $ 86.0 million of mortgages for the three months ended January 31, 2009, with the vast majority of which were insured mortgages sold on whole loan basis. This compares with $131.1 million for the corresponding period of 2008, of which $98.2 million were insured mortgages sold on whole loan basis. Gain on sale was $ 3.0 million in the first quarter of 2009, compared with $3.1 million for the corresponding period of Gain on sale for the first quarter of 2008 included $1.0 million from the sale of uninsured mortgages to OFT, and insurance premium costs of $2.3 million to insure the mortgages prior to the sale. The Company received premium proceeds of $4.9 million from whole loan sale for the three months ended January 31, 2009, compared with $6.1 million for the corresponding period of The magnitude of the net gain recognized is predicated on the Company s mortgage funding volumes and the subsequent sales to Trusts. Changes in net gain as a percentage of mortgages sold for the first quarter ended January 31, 2009 compared to the previous quarters were primarily caused by changes in average sales mix trends between insured and uninsured mortgage products. Insured mortgages normally have better credit profile borrowers are arranged on fixed-rate terms and entail lower mortgage spread margins. These effects resulted in a gain recognized in first fiscal quarter of 2009 which was 3.4% of the amount of mortgages sold, as compared to 2.4% for the same period of fiscal Ignoring the effects of insurance costs, net gain as a percentage to sale for the same period of the prior year would have been 4.2%. Other factors affecting gain as a percentage of sales relate to the overall mix of business securitized, including the length of the average mortgage duration, the average risk profile and the costs of the respective credit enhancement or collateralization levels required as well as market factors such as the discount rate used for valuation and pricing. The Company s history of sales to Trusts including whole-loan sales, for the last eight quarters, along with the corresponding gain, is as follows: ($000 s, except percentages) For the quarter ended: January 31, 2009 October 31, 2008 July 31, 2008 (1) April 30, 2008 (2) January 31, 2008 (3) October 31, 2007 July 31, 2007 April 30, 2007 (4) Sales of Mortgages Historical Gain Recognized Gain as % of Sale 85, , ,132 78, , , , ,839 2,963 5,326 3,405 2,126 3,141 (677) 9,513 13, % 4.3% 2.0% 2.7% 2.4% (0.3%) 3.3% 4.1% (1) Sales of mortgages included $24.4 million that were previously sold to OFT, which were then purchased back from OFT during the quarter, and resold to an aggregator of insured mortgages on a whole-loan basis. (2) During this quarter, all of the mortgages were sold on a whole-loan basis. (3) Sale of mortgages included $57.1 million that were previously sold to OFT, with an original gain as a percentage of sales that was negative 0.3%, which were then purchased back from OFT and resold to an aggregator of insured mortgages on a whole-loan basis. (4) Historical gain recognized does not include the negative one-time effects of the $0.6 million loss recognized related to the XMT term transaction completed during that period. 6 XCEED Mortgage Corporation First Quarter 2009 Report

7 Residual securitization income is the monthly spread income received over time, in excess of the amortization of the deferred net mortgage interest receivable recorded at the time of sale. This excess or residual amount is attributable to better than expected cash flows being earned by the Trusts than those anticipated when gain on sale assumptions regarding prepayments, loan losses and the cost of funds were originally forecast and set. Once this residual securitization income is added to the net gain on sale of mortgages, combined income from securitized assets becomes $8.8 million for the three months ended January 31, 2009, compared with $2.8 million for the corresponding period of fiscal 2008, an increase of 214.3%. Ignoring the aforementioned one-time items related to the implementation of the third-party ABCP restructuring plan, residual combined securitization income for the three months ended January 31, 2009 would have been $3.1 million, an increase of $0.3 million or 10.7% over the same period of Interest earned decreased by $2.3 million, when comparing the three months ended January 31, 2009 to the corresponding period of fiscal Interest income is the result of the Company s temporary investment in mortgages held by Xceed prior to their sale to the Trusts, as well as the Company s investments in the subordinated notes issued by the Trusts. There was also a corresponding decrease in interest expense (see below) of $1.3 million, when comparing the three months ended January 31, 2009 to the corresponding period in fiscal Both interest income and expense are subject to variation depending on the volume of mortgages funded during the period, the going market interest rates, as well as the length of time these mortgages are held on the Company s consolidated balance sheet prior to being securitized or sold as whole loans. In general, as the volume of mortgages funded increases, both interest earned and interest expensed will increase. Similarly, interest earned and interest expense, in general, increase when mortgages are held by the Company for longer periods of time prior to securitization or sale as whole loans. Net origination expense consists of origination commissions and volume reward incentives paid to mortgage brokers or financial institution mortgage specialists that refer mortgages to Xceed and commissions paid to the Company s internal salespeople. In prior periods when originating uninsured mortgages, the Company earned application and origination fees which offset the origination expenses in first quarter The Company did not originate uninsured mortgages in first quarter Net origination expense are driven by origination volume and product mix. Net origination expense for the three months ended January 31, 2009 was $1.4 million (2008 $0.4 million). Operating Expenses and Taxes For the quarter ended: Compensation and other operating expenses Deferred charge amortization Interest expense ($000 s, except number of employees and ratios) Three Months Ended January 31, 2009 January 31, , , ,057 Provision for (recovery of) income taxes Total expenses and taxes Average number of employees Productivity index (1) Compensation and other operating expenses as % of total mortgages funded (2) 1,419 4, % 2.6% (477) 5, % 6.2% (1) Calculated by dividing the sum of compensation and other operating expenses and deferred charge amortization by securitization income. (2) Calculated by dividing compensation and other operating expenses over total amount of mortgages funded. Compensation and other operating expenses decreased by $1.1 million, for the three months ended January 31, 2009 as compared to the corresponding period of fiscal The decreases were primarily a result of cost reduction measures taken during the first and second quarter of 2008 that included the severance of approximately 100 employees from the Company s workforce. In the first quarter of fiscal 2008, management reassessed and reversed $2.0 million in previously accrued balances associated with the Company s employee long-term incentive plan and an executive long term compensation plan. In addition, as a result of reduced origination volumes experienced by the Company, employee and internal sales force incentive compensation costs related to mortgage originations were significantly reduced. The Company employed an average of 42 full-time staff during the first quarter of fiscal 2009, compared to an average of 145 employees for the corresponding period for fiscal Approximately 44 employees comprised the core workforce of Xceed at the quarter end January 31, Management believes that this is the appropriate and adequate level of staffing required to achieve the Company s short to medium term plans. Deferred charge amortization decreased by $0.7 million for the three months ended January 31, 2009 as compared to the corresponding period of fiscal 2008 due to the write-off of $5.3 million in deferred charges relating to infrastructure costs it no longer expects to receive future benefits. The write-off was recorded as an unusual item during the second quarter of XCEED Mortgage Corporation First Quarter 2009 Report 7

8 Interest expense decreased by $1.3 million for the three months ended January 31, 2009 compared to the corresponding period of fiscal 2008, due to lower origination volume, declining market interest rate as well as shorter holding period for the mortgages held in the warehouse prior to sale. The productivity index was 26.0% for the three months ended January 31, 2009, compared with 146.9% for the corresponding period of fiscal The productivity index for the three months ended January 31, 2009 reflected the results of a number of cost reduction measures taken during the first two quarters of fiscal 2008, and the aforementioned one-time positive impact from the implementation of the third-party ABCP restructuring plan during the first quarter of 2009 which rendered the comparison not meaningful. The productivity index for the third and fourth quarters of 2008 were 45.2% and 48.8% respectively. Ignoring the effects of the one-time positive adjustments resulted from the implementation of the third-party ABCP restructuring plan, the productivity index for the three months ended January 31, 2009 would have been 61.4%, a decline of 25.8% from the previous quarter. In general, a lower productivity ratio is associated with a more efficient cost structure. Critical Accounting Estimates Securitization The Company uses estimates in valuing its gain or loss on the sale of its mortgages to qualified special purpose entities. Under GAAP, valuing a gain on sale requires the use of estimates to determine the fair value of the retained interest (derived from the present value of expected future net cash flows) in the mortgages. The retained interest is reflected on the Company s balance sheet as deferred net mortgage interest receivable. On a quarterly basis, the Company reviews the estimates used to ensure their appropriateness and monitors the performance of the securitized portfolio using actual performance statistics to adjust and improve these estimates. The estimates used reflect the expected performance of the mortgage portfolio over the life of the mortgages. The basis on which the Company analyzed and determined its estimates for fiscal first quarter of 2009 was consistent with that used during fiscal Under the terms of agreements with the mortgage sub-servicing agent and the securitization agent of the Company s securitization program, per unit servicing and securitization program fee costs fall when certain milestones are reached. The Company believes that the estimates used in the calculation of the gain on sale are prudent based on all available information. Management s estimates are reviewed and approved by the Company s Audit Committee. The key assumptions used in the valuation of gain on sale are prepayment rates, the annual expected credit losses, and the discount rate used to net present value future expected residual cash flows. The annual rate of unscheduled principal payments is determined by reviewing portfolio prepayment experience on a monthly basis. The Company uses a rate of 12% for uninsured business and a rate of 20% for insured business. Credit losses are reviewed on a monthly basis, in the context of the life cycle of the mortgages. As a prudent estimate of credit losses, the estimates used for credit loss assumptions for uninsured mortgages that entail loan-to-value of up to 90% is 0.20%, whereas the credit loss assumptions for loan-to-value of greater than to 90% is 0.65%. The discount rate and cost of funding are adjusted to reflect the current market conditions. However, due to unprecedented developments in the capital markets which contributed to the dramatic declines in interest rates since September 30, 2008, the Company decided to maintain its discount rate unchanged from September 30, 2008 at 4.64% compared to 3.51% for January 31, Financial Instruments The Company uses interest rate swaps to manage interest rate exposure between the time a mortgage rate is committed to borrowers and the time the underlying cost of funding the mortgage on sale to the Trusts is fixed. As interest rates change, the value of these interest rate derivatives varies inversely with the value of the mortgage contract. As interest rates increase, the gain that would be recorded on the sale of the mortgage decreases because the mortgage rate promised to the borrower is fixed at the point of commitment. However, the commitment or liability implicit in an interest rate swap to pay at a fixed rate also decreases in value, thereby offsetting the change in the value of the mortgage contract. Changes in the value of the swap contract are recorded separately as a gain or loss on the Company s statement of income and retained earnings. Because not all committed mortgages actually fund, a probability of funding is assigned to each mortgage in the pipeline and that probability changes as mortgages move through the various stages of the pipeline. The amount that is actually hedged is the expected value of fundings within the next 60 days (60 days being the standard maximum rate hold period available). As at January 31, 2009, the Company had entered into $100.6 million (October 31, 2008 $68.4 million) in notional value interest rate swaps. The current contracts were purchased on January 6, 2009 and January 28, The fair value of the swaps at the end of fiscal first quarter 2009 was $0.1 million in favor of the Company ( $0.1 million, in favor of the Company). In the first quarter of fiscal 2009, the Company recognized a $0.7 million gain compared to a $0.4 million gain during the fourth quarter of fiscal Some of the gains and losses recognized on hedging activities are offset by interest rate movements on mortgage commitments that the Company funds and sells to securitization vehicles. 8 XCEED Mortgage Corporation First Quarter 2009 Report

9 Realized and Unrealized Gains on Financial Instruments When implementing CICA Section 3855 in fiscal 2007, management elected to designate the deferred net mortgage interest receivable ( deferred purchase price ) as held-for-trading. As a result, the Company is required to record its deferred purchase price receivable at fair value at each reporting date, based on current management assumptions that reflect the cost structure that is related to each securitization sale. In the case of net mortgage interest receivable and cash collateral, adjustments in fair value can also result from changing market conditions and volatility. Changing interest rate spreads that increase basis risk or the costs of funds of the various Trust vehicles are reflected in the realized and unrealized gains on financial instruments. Also reflected are gains and losses including movements in the value of the hedges associated with mortgages, and mortgage commitments on the balance sheet during the period. Realized and unrealized losses of ($0.7) million were recognized during the three months ended January 31, 2009 (2008 gain of $1.4 million). Realized and unrealized losses on financial instruments for the prior year were largely attributable to hedge cash settlements during that period, whereas realized and unrealized losses for the first quarter 2009 were largely attributable to the net valuation write-up of the Company s deferred net mortgage interest receivable in QSPE-XCD during the quarter resulted from the implementation of the restructuring plan, offset by continued decline in reinvestment interest, increasing funding costs for the OFT securitization program, and the one-time valuation charge for XMT related to early amortization. Risk Management The various risks to which the Company is exposed and the Company s policies and processes to measure and manage them individually are set out below: Credit risk Credit risk relates to the potential for financial loss resulting from the failure of a borrower or counterparty to fully honour its financial or contractual obligations, such as the failure to repay principal and/or interest on a mortgage. The Company is exposed to the risk that, in the event of a counterparty default, prevailing market conditions are such that the Company would incur a loss in replacing the defaulted transaction. The Company s objective is to continuously monitor the credit risk it is exposed to and create risk-based assessments using methodical approaches that allow it to maintain defaults and credit losses within acceptable limits to deliver consistent results. The Company s approach to managing credit risk is based on the consistent application of a detailed set of credit policies and prudent arrears management and by dealing with counterparties that are deemed creditworthy. The Company has established credit guidelines that are reviewed by its Credit Risk Committee. Reporting of key parameters includes, but is not limited to, the concentration of the portfolio by geographical region, credit grade, loan-to-value, loan size, and product distribution. Reporting of arrears by these parameters is also reviewed and monitored on a regular basis by the Company s executive team and the Credit Risk Committee such that adjustments to the Company s product suite or credit guidelines are to be made for its new originations. The Company s exposure to credit risk is mitigated by mortgage insurance, the diversification of its portfolio, product offering, and through its first ranking interest in properties for which the Company lends funds to its borrowers as well as the short period over which a mortgage is held by the Company prior to securitization. The Company s maximum exposure to credit risk in respect of all financial assets is their carrying value as reflected on the consolidated balance sheets. Interest rate risk Interest rate risk is defined as the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market interest rates. Interest rate risk arises for the Company as a result of changes in market interest rates from the time the Company issues a mortgage commitment to the sale of the mortgage receivable to a qualified special purpose entity. It is the Company s policy to keep its asset and liability mismatches at stable and acceptable levels to maintain steady net interest income. The Company measures and monitors interest rate risk based on gap/duration limits and dollar tolerances that are reviewed daily by its capital markets group and financial position reports reviewed by its executive team. Given the uncertainty and time between the issuance of a mortgage commitment to funding of a mortgage, Xceed assigns probabilities associated to the likelihood of funding based on the stage of the commitment and the number of days to expected funding. These probabilities are based on historical information and are reviewed and adjusted weekly by the Company s Asset Liability Management Committee ( ALCO ). The Company mitigates interest rate risk by entering into interest rate swaps to hedge potential interest rate exposure. The Company s accounts receivable and accounts payable and accrued liabilities have no exposure to interest rate risk. Cash collateral and other deposits receivable from Trusts and the Company s B-Note Facility carry a variable rate of interest and are subject to interest rate cash flow risk. With the exception of cash collateral and other deposits receivable from Trusts, the other financial assets and liabilities that the Company classifies as held-for-trading are exposed to interest rate risk. XCEED Mortgage Corporation First Quarter 2009 Report 9

10 Liquidity risk Liquidity risk is the risk that the Company will be unable to meet its financial obligations as and when they fall due as a result of funding mismatches. The Company s liquidity risk arises from mortgage commitments and settlement of interest rate swap positions. Liquidity risk can also arise from changes in critical terms for the Company s warehouse line of credit or credit enhancement level for certain securitization program. The Company s objective is to ensure sufficient liquid financial resources to cover financial obligations as they come due and sustain operations both under normal and adverse conditions. The Company measures and monitors liquidity risk by regularly evaluating its cash inflows and outflows under expected and adverse conditions through cash flow reporting such that it anticipates certain funding mismatches and ensures the cash management of the business within certain tolerable levels. These cash flow forecasts are reviewed weekly by the Company s ALCO. Xceed mitigates liquidity risk through continuous monitoring of its debt covenants and the diversification of its funding sources, both in the short-term as well as the long term. Liquidity and Capital Resources ($000 s, except percentages) January 31, 2009 October 31, 2008 At period end: Mortgage warehouse line of credit facility drawn Other credit facility Shareholders equity Total capitalization Debt to equity percentage 47,336 9,494 86, , % 47,818 9,564 82, , % Xceed is focused on managing its liquidity and capital requirements. The Company earns interest income on mortgages that remain on the Company s consolidated balance sheet for a period of time pending sale to Trusts. The Company finances the on-balance sheet mortgages through a combination of its own working capital and external credit facilities. On October , the Company established Xceed Asset Trust ( XAT ) for the purpose of entering into a warehouse credit facility with the Canadian branch of an international bank. The facility is secured against a first ranking interest that allows the Company to sell originated mortgages to XAT (a variable interest entity) and draw from this facility, at its discretion, at preset drawdown rates as a percentage of the principal balance of the related eligible mortgage loans. In the event of default, the credit facility may be suspended or terminated and all amounts outstanding would immediately become due and payable. Given the reduced origination volumes and a desire to reduce standby charges, the facility limit was reduced from $350.0 million to the current limit of $150 million during Under the terms of the facility, the Company is required to maintain a ratio of liabilities to tangible net worth of not more than 5.00 to There is also a requirement that the Company not experience two consecutive quarters where net income, before consideration of income tax and dividends is less than $1. The Company must also maintain its cash and borrowing capacity greater than $10.0 million or the sum of its cash, borrowing capacity and securitization receivables greater than $40.0 million. In the event of default, the facility may be suspended or terminated and all amounts outstanding would immediately become due and payable. The Company was in compliance with the financial and operating covenants which the facility requires it to maintain as at January 31, 2009 and as at the date of this report. The warehouse credit facility was renewed subsequent to January 31, 2009 for another term with less favorable pricing terms. The next renewal date of the warehouse credit facility is December 31, During the second quarter of fiscal 2007, the Company incorporated Xceed Capital Corporation ( XCC ), a wholly-owned subsidiary, and entered into an agreement with the Canadian branch of a European bank to establish a new $25.0 million credit facility (the B-Note Facility ) intended to finance the Company s investment in B notes, within its securitizations. XCC has been consolidated with the Company as at January 31, 2009 and as at October 31, In October of 2007, the Company established a $300.0 million mortgage securitization facility. This facility is provided through Okanagan Funding Trust ( OFT ), which is sponsored by a Canadian branch of an international bank. OFT issues commercial paper rated by Standard and Poor s and is supported by a global-style liquidity arrangement. This facility allowed the Company to sell Xceed originated mortgages from the Company or XAT and to draw from this facility, based on predetermined drawdown rates that were applied to the principal balance of the related eligible mortgage assets. The facility is secured against a first ranking security interest in the mortgages sold to OFT. As the Company no longer originates uninsured mortgages and to reduce the cost of standby fees, this facility is no longer committed. The facility was adjusted with less favourable 10 XCEED Mortgage Corporation First Quarter 2009 Report

11 pricing terms subsequent to January 31, The Company supplies the cash collateral credit enhancement requirements associated with this facility. The outstanding mortgage principal balance as of January 31, 2009 is $199.8 million. At the end of the first quarter of 2008, the Company signed a master mortgage purchase agreement with Residential Mortgage Funding Trust ( RMFT ), a conduit that is an aggregator of insured mortgages destined for sale to the Canada Mortgage Bond Program, which allowed the Company to fund new insured originations by selling them to RMFT. Mortgages are sold to RMFT as whole loan sales which generate a one-time cash flow for the Company consisting of the full cash value of the mortgage principal plus a premium. The premium is the present value of excess cash flows between the mortgage interest rate and the Trust s required returns, after taking into account the costs to secure the loans. As at January 31, 2009, Xceed had cash and cash equivalents in the form of cash and short-term deposits of $15.8 million (October 31, 2008 $9.9 million). Cash invested in mortgages not sold to Trusts totaled $64.9 million (October 31, $63.2 million). The Company provided $20.0 million (October 31, 2008 $17.9 million) in credit enhancement for the senior notes issued by OFT and $1.2 million (October 31, 2008 $0.9 million) was held in cash collateral for the benefit of the hedge and other counterparties. The Company invested $9.5 million (October 31, 2008 $9.6 million) in the medium term subordinated notes ( B notes ) issued by QSPE-XCD through its subsidiary XCC. The Company also invested $11.6 million (October 31, 2008 $12.0 million) in cash deposits with XMT as per XMT s requirements. The Company s indebtedness as at January 31, 2009 was related to its warehouse credit facility of $47.3 million (October 31, 2008 $47.8 million), and its B-Note Facility of $9.5 million (October 31, $9.6 million). The total debt to equity ratio of the Company was 66.0% at the fiscal quarter ended January 31, 2009 (October 31, %). Mortgages originated by the Company have been sold to Trusts on a fully-serviced basis. The Company has assigned responsibility for the servicing of its mortgages to the largest Canadian third-party servicer of mortgages. It works in conjunction with this servicer to effect the collection of principal and interest payments on behalf of the Trusts, as well as the management and collection of mortgages in arrears. The market disruption and the extension of extendible asset backed commercial paper (ABCP) since August 2007, has been restructured. Given that a portion of the Company s portfolio was funded by such ABCP, these circumstances had negatively impacted the Company s retained interest in this securitization program and its profitability and cash flows for the prior quarters. Xceed has reached an agreement with the committee restructuring the third-party ABCP as to the financial terms of the Company s affected securitization program. Xceed expects, on implementation of the restructuring plan, an improvement in the cash flow from the portfolio due to the decrease in cost of funds. Further, the Company received $4.8 million in cash proceeds upon closing of the plan. The successful implementation of the plan does not mean that the Company will be able to resume offering uninsured high-ratio mortgages for some time, if ever, since sufficient financing for securitizing these at an economic cost is still not available. Mortgage payments collected by a commercial paper securitization vehicle which holds approximately $752.2 million of Xceed-originated mortgages are accumulated in that Trust s collection account. The Trust also holds cash in a cash collateral account intended to provide security and collateralization to the structure. A combined $36.7 million of the cash proceeds otherwise held in the collection and cash collateral accounts had been invested in ABCP issued by other securitization trusts which are also affected by the market turbulence. Upon closing of the ABCP restructuring plan, $36.7 million in affected ABCP had been exchanged for notes issued under the new plan. Approximately $18.0 million will be distributed in-kind to the issuing vehicles in each exchange for returning future cash distribution. Any effect on the value of the investments retained when they are ultimately liquidated entails a risk that Xceed s retained interest may eventually be disrupted or impaired. Management does not anticipate any significant impact on the timing of residual interest cash flows related to this specific potential risk on the basis that it expects that the Trust will have the ability to hold these investments for over two years prior to having to liquidate them. However, there is no certainty associated with this outcome. Management continues to believe that the disruption in the Canadian ABCP market which occurred in August 2007 was a consequence of liquidity issues facing the ABCP market rather than concerns over the quality of Xceed-originated assets. It is important to note fundamental differences between the U.S. and the Canadian housing markets, as the Canadian housing market which has remained relatively resilient, if less robust in recent months, over its U.S. counter parts. Mortgages originated and administered within the Company s portfolios have performed within the expectations communicated to investors when these were sold to the Trusts, and, as such, the Trust s continue to be rated in accordance with the ratings provided by Standard and Poor s and/or DBRS as applicable based on its analysis in rating those assets. These mortgages are all first-charge residential mortgages. Since the Company has been an alternative lender in the non-traditional mortgage market, diligent management of the mortgage portfolio is crucial to the Company s future success. Average default ratios (90 or more days in arrears) on the Company s securitized and non-securitized portfolio of mortgages decreased from 3.55% in fiscal 2008 to 3.09% in fiscal quarter ended XCEED Mortgage Corporation First Quarter 2009 Report 11

12 Certain of the Company s securitization structures require the Company to maintain default ratios that are lower than prescribed limits. A failure to maintain the ratios within these limits may prevent the Company from securitizing mortgages using these structures and can result in disruption in the flow of its residual securitization income to the Company. There can be no assurance that the historical performance of the uninsured mortgage portfolio at maturity will be indicative of future performances. All of the uninsured mortgages provide for balloon payments to be due at their respective mortgage maturity dates unless prepaid prior thereto. Mortgages with balloon payments expose a lender to greater risk than fully amortizing loans because the ability of an obligor to make a balloon payment is typically dependent upon the ability either to fully refinance the mortgage or to sell the related collateral at a price sufficient to permit the obligor to make the balloon payment. The ability of an obligor to effect a refinancing or sale will be affected by a number of factors, including the value of the collateral, the level of available mortgage rates at the time of sale or refinancing, the obligor s equity in the collateral, the financial condition of the obligor, the condition of the collateral and the prevailing general economic conditions. Xceed is not required to refinance any mortgage loan. The Company s ability to fund any refinancing of a mortgage loan is dependent on the obligor s and property s ability to meet the underwriting standards in place at the maturity date. The Company is the financial services agent for Xceed Mortgage Trust ( XMT ), its term funding securitization vehicle. The Company estimates that XMT will need to raise approximately $225 to $235 million in A-C Notes to retire $305 million of Series 2007-T2 and Series 2006-T1 Class A2 Senior Notes maturing on March 17 and April 17, 2009 respectively. Given that there has been no success to date after exploring all available viable alternative to raise funds for XMT to retire the Class A-2 Senior Notes, the Company had notified the Indenture Trustee on March 9, 2009 of the likelihood of an amortization event occurring on March 17, 2009 if Series 2007-T2 Class A-2 Notes were not fully repaid on that date. Upon the occurrence of an amortization event, XMT s operations will continue unchanged. However, all outstanding notes in the series will started to be repaid with principal and coupon interest (converted to the corresponding monthly equivalent rate), on a monthly basis in sequential order, with the most senior tranche being paid with priority over the subordinate tranches. The amounts due to the Company, the residual interest holder, will be distributed last. The Company recorded a pre-tax valuation write-down of $2.0 million ($1.4 million after-tax) to its deferred net mortgage interest receivable at the first quarter ended January 31, 2009 as a result. XMT has total outstanding principal of $439.3 million as at January 31, Management is not aware of any other trends or expected fluctuations in its liquidity. Given its initiatives to control origination volumes and resize infrastructure, the Company believes that cash flow from continuing operations and existing cash resources will be sufficient to meet the Company s short-term and long-term requirements, allowing it to manage its ability to collect its residual interest from its securitized portfolios, currently valued at $28.4 million. Dividends The Company reviews its dividend distribution policy on a quarterly basis, taking into consideration its financial position, profitability, cash flow and other factors considered relevant by its Board of Directors. No dividends may be declared in the event that there is a default of a condition of the Company s warehouse credit facility or where such payment would create a default. Despite the Company s positive cash flows during fiscal quarter ended January 31, 2009, in view of the current market turbulence and its expected impact on Xceed s performance for an extended period, the Company s Board of Directors determined that it would be prudent to conserve cash and continue to suspend dividends for the current fiscal year. Capital Expenditures During first fiscal quarter, as a result of the financial crisis impacting the economy, the Company decided to undertake only those capital expenditures which were essential to smoothly run the Company s operations. There were no capital expenditures incurred during the quarter. Accounting Policy and Reporting Changes Understanding the Company s significant accounting policies is essential to understanding the Company s reported results of operations and financial position. The significant accounting policies used by Xceed are the same accounting policies as for the year ended October 31, 2008, except for those described below. Effective November 1, 2008, the Company adopted CICA Emerging Issues Committee Abstract EIC-173, Credit Risk and the Fair Value of Financial Assets and Financial Liabilities. The abstract clarifies how the Company s own credit risk and the credit risk of the counterparty should be taken into account in determining the fair value of financial assets and financial liabilities, including derivatives. The new guidance did not have a material effect on the financial position or earnings of the Company. 12 XCEED Mortgage Corporation First Quarter 2009 Report

13 Management s Discussion and Analysis (concluded) Future Accounting and Reporting Changes The CICA Accounting Standards Board requires that all Canadian publicly accountable enterprises adopt International Financial Reporting Standards (IFRS) for years beginning on or after January 1, IFRS uses a conceptual framework similar to Canadian GAAP, but there are some differences in recognition, measurement and disclosures. IFRS will be effective for the Company for its fiscal 2012, beginning on November 1, This would include restatement of prior year comparative fiscal 2011 financial results for interim and annual periods. Currently, the Company is in the planning phase of converting to IFRS. It is not yet possible to fully determine the impact to the financial statements, as accounting standards and their interpretations are changing. The conversion to IFRS is a significant initiative for the Company, for which adequate resources are being dedicated to ensure proper implementation. Disclosure Controls and Procedures Management has designed disclosure controls and procedures to provide reasonable assurance that material information relating to the Company has been appropriately disclosed. There have been no changes during the quarter ended January 31, 2009 that in management s view, would have materially affected or that are reasonably likely to materially affect, the Company s disclosure controls and procedures. Internal Controls over Financial Reporting Management has designed internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with Canadian generally accepted accounting principles. There have been no changes during the quarter ended January 31, 2009 that in management s view, would have materially affected, or that are reasonably likely to materially affect, the Company s internal controls over financial reporting. Transactions with Related Parties The Company did not enter into any related party transactions in either fiscal 2009 or XCEED Mortgage Corporation First Quarter 2009 Report 13