DBRS Confirms First National Financial at BBB, Trend Stable

DBRS Limited (DBRS) has today confirmed the Senior Secured – Guaranteed Debt and Class A Preference Shares ratings of First National Financial Corporation (FNF) at BBB and Pfd-3, respectively, and the Issuer Rating of First National Financial LP (FNFLP) at BBB. The Global Methodology for Rating Finance Companies, published by DBRS on October 16, 2014, was the methodology applied for the confirmation. The trend is Stable on all ratings.

The ratings reflect FNF’s sound franchise, which is supported by its position as Canada’s largest non-bank mortgage originator, with about $83 billion in mortgages under administration (MUA) as of September 30, 2014; its strong asset quality profile, with all assets secured by real estate and a substantial portion insured; and its high-quality, low-cost servicing capabilities. These factors are partially offset by the high reliance on wholesale funding, a high dividend payout ratio that limits financial flexibility and a degree of cash flow/earnings volatility from hedging of interest rate risk.

DBRS views FNF’s risk profile as solid and an important factor in the ratings. Given FNF’s sizable mortgage origination and servicing operations, DBRS views the Company’s most notable risk as operational risk. However, DBRS sees this risk as well managed, given the Company’s long history of operating these businesses and low instances of losses. FNF’s overall risk profile benefits from the Company’s low credit risk exposure, which is minimal relative to the size of the portfolio being serviced. Indeed, only a couple hundred million of the $83 billion in MUA represent direct credit risk to FNF, according to management, while over 60% of MUA have been sold to institutional investors, with no residual credit risk to FNF. Meanwhile, most of the on-balance-sheet mortgages accumulated for sale do not represent credit risk to FNF, because they are either insured or have already been sold and are being warehoused prior to transfer. Mortgage and loan investments are primarily uninsured first and second mortgages. Most of this portfolio is bridge lending, typically used by borrowers to fund acquisitions and renovations over periods less than 18 months. While this may be higher-risk lending for FNF, the risk in this portfolio is moderated by security.

DBRS views FNF earnings generation ability as solid. While earnings are occasionally volatile because of timing differences in the way FNF hedges its interest rate risk, the servicing business provides stable revenue generation that can mitigate the variability of revenues generated from new origination business. Originations have the potential to fluctuate with market conditions, but the major costs of origination – broker commissions – are variable, resulting in less earnings volatility than would otherwise be the case. Thanks to its size, FNF’s efficiency, which is critical in the originating and servicing businesses, has been acceptable and is consistently better than its closest peer.

DBRS considers the Company’s reliance on wholesale funding as a rating constraint. While DBRS views positively the multiple funding sources utilized by FNF, there is also a material level of funding concentration risk within its institutional investor funding sources. As a result, FNF could be significantly challenged to replace funding sources in the event of a market disruption.

FNF’s capital levels are viewed as acceptable for the relatively low levels of direct credit risk being assumed, but the Company could be challenged in the event of large unexpected charges related to operational or other risks.

Like other Canadian mortgage originators and servicers, FNF is exposed to the Canadian residential mortgage market and other real estate lending. As a result, FNF’s earnings could come under pressure should housing sales decline, resulting in lower origination and other fee income generation, while a downturn in residential mortgage or commercial real estate markets could lead to weakening asset quality indicators and ultimately have a negative impact on FNF’s business.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The applicable methodologies are Global Methodology for Rating Finance Companies and Preferred Share and Hybrid Criteria for Corporate Issuers (Excluding Financial Institutions), which can be found on our website under Methodologies.

This rating is endorsed by DBRS Ratings Limited for use in the European Union.