DBRS Confirms First National Financial at BBB and Pfd-3, Trends Stable

DBRS has today confirmed the Senior Secured – Guaranteed Debt rating of First National Financial Corporation (FNFC or the Company) at BBB, its Class A Preference Shares rating at Pfd-3 and the Issuer Rating of First National Financial LP (FNFLP) at BBB; all trends remain stable. (FNF refers to FNFLP and FNFC collectively.) The rating and trend reflect FNFC’s status as Canada’s largest non-bank mortgage originator ($53 billion in mortgages under administration (MUA)); its strong asset quality profile, with all assets secured by real estate and a substantial portion insured; and its high-quality and low-cost servicing capabilities.

Unlike most financial institutions, the Company funds most of its mortgage originations either through sales to institutional investors (70%) or off balance sheet in securitization vehicles. On-balance-sheet exposures are limited to a warehouse facility and a small portfolio of mortgage and loan investments, which are primarily multi-unit residential and commercial (MUR&C) bridge loans. The business model focuses on generating stable underlying cash flows from the servicing business (the Company retains servicing rights on virtually all originated mortgages) over the life of each loan.

While origination revenues have the potential to be more volatile, depending on market conditions, the major costs of origination are variable (broker commissions), leading to less earnings volatility than would otherwise be the case. Efficiency is critical in the originating and servicing businesses, and FNF has gradually reduced operating expenses, excluding broker commissions, from 19 basis points (bps) of MUA in 2006 to 13 bps in 2010.

While FNF is not exposed to credit risk with the majority of its MUA because they are sold or insured, it is exposed to credit risk on about $702 million of (primarily) securitized assets, although there is security backing this exposure. Although the Company has been successful in the past in placing its originated mortgages with institutional investors or in securitization conduits, there is a material level of funding concentration risk.

Limited earnings visibility has been due to the nature of securitization accounting; revenues have the potential to be volatile, depending on changes in assumptions, including discount rates, prepayment rates, credit loss estimates and spreads. The upcoming adoption of International Financial Reporting Standards (IFRS) will address some of these issues. Although the financial statements will be radically altered by the new accounting standards, there is little change in the underlying economics.

FNF is not regulated by the Office of the Superintendent of Financial Institutions (OSFI), resulting in funding and liquidity limitations as well as less stringent compliance requirements and oversight in a wide variety of areas, including capital, liquidity and risk management.

The Company implemented a common dividend payout that represents a very high proportion of earnings (DBRS estimates in the order of 70%). Although this is an improvement from the level of distributions paid when it was an income trust, the high payout continues to limit capital flexibility.

The rating on FNFC’s Senior Secured – Guaranteed Debt is based on a guarantee from FNFLP and an Intercreditor Agreement between Computershare Trust Company of Canada as the debenture trustee and the lenders under a credit facility among four Canadian chartered banks as lenders and FNFC, as borrower and affiliates of FNFC as guarantors (FNFLP’s Credit Facility). The Intercreditor Agreement ranks the indebtedness created under the debentures equally and ratably with the indebtedness created under FNFLP’s Credit Facility.

On January 1, 2011, First National Financial Income Fund (FNFIF) completed its conversion and amalgamation and became First National Financial Corporation. As a corporation, FNFC will begin paying taxes in 2011. The amalgamation resulted in the two co-founders owning 40.087% of FNFC through their holding companies and the remaining 19.826% being owned by the former third-party unitholders of First National Financial Income Fund. There were no rating implications related to the amalgamation and conversion. Subsequent to the conversion, FNFC issued $100 million in preferred shares, the proceeds of which were used to repay current indebtedness.

In 2010, FNF reported net income of $161.4 million, virtually unchanged from 2009. However, earnings would have been down materially if not for unrealized gains on financial instruments, particularly one generated by an assumption change related to the anticipated spread between prime rates and 30-day banker’s acceptances.

FNFC has adopted IFRS beginning in the first quarter of 2011, resulting in material changes to the financial statements, including an increase in assets from about $1.1 billion to about $8.3 billion as previously securitized assets and their related liabilities come back on the balance sheet. Retained earnings are expected to be reduced from $164 million to approximately $76 million, primarily as a result of a reversal of previously booked securitization gains, partially offset by the capitalization of origination costs associated with securitized mortgages. Under IFRS, earnings from securitized assets will be recorded as net interest income rather than the securitization gains that were booked under previous Canadian Generally Accepted Accounting Principles (GAAP).

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Global Methodology for Rating Banks and Banking Organisations, which can be found on the DBRS website under methodologies. In applying this methodology, DBRS has allowed for the fact that the credit in question is not a bank.