DBRS Confirms Ratings of First National Financial at BBB and Pfd-3, Stable Trends, Discontinues Rating on Senior Secured Guaranteed Debt

DBRS Limited (DBRS) has today confirmed the Issuer Rating of First National Financial LP (FNFLP) at BBB, and the ratings for the Senior Unsecured Debt and Class A Preference Shares of First National Financial Corporation (FNFC; DBRS refers to FNFLP and FNFC together as First National or the Company) at BBB (low) and Pfd-3, respectively. The trend on these ratings is Stable. The rating actions follow a detailed review of the Company’s operating results, financial fundamentals and future prospects.

In addition, DBRS has today discontinued the ratings on FNFC’s Senior Secured – Guaranteed Debt as the debentures were paid in full on May 7, 2015.

The confirmation of the ratings reflect First National’s strong franchise as Canada’s largest non-bank mortgage originator and servicer, with almost $94 billion in mortgages under administration (MUA). DBRS also considers the low risk balance sheet of the Company with nearly all mortgages being sold to either institutional investors or securitized with minimal residual risk to the Company. All mortgages are secured by real estate and around 98% of the mortgages on the balance sheet are insured. First National’s operating leverage is better than that of its peer group and allows for profitability to reach the bottom line; however, high dividend payouts limit organic capital generation. Furthermore, the Company’s reliance on wholesale funding and the broker channel for new originations constrains the ratings.

Although the economic environment in Canada remains challenging, the Stable trend reflects DBRS’s view that First National’s low exposure to credit risk and the Company’s diversification of its revenue streams should afford First National the ability to successfully navigate the environment. While it is unlikely given the current environment, ratings could be positively impacted over the medium term by further diversification of funding, with additional third-party underwriting business accretive to earnings. Conversely, ratings could come under pressure should the Company incur material operational risk-related losses, MUAs experience a prolonged contraction indicating a deterioration in the strength of the franchise, and/or should First National’s access to liquidity become strained.

First National’s business model relies on generating stable underlying cash flows over the life of each loan from the servicing business (the Company retains servicing rights on virtually all originated mortgages) and from the spread between securitized assets and the corresponding funding. Furthermore, the Company launched a third-party underwriting and fulfillment services business with a major Canadian Financial Institution at the beginning of 2015. Although the venture resulted in a 30% increase to First National’s head count, the business has proven successful, turning profitable in Q3 2015 with actual serviced volumes surpassing the initial budget by 50%. As a result, mortgage servicing income increased by 26% to $117 million in 2015, while placement fees grew by 30% to $166 million. Importantly, despite the expansion related to the venture, First National’s efficiency, which is critical in the originating and servicing businesses, remains acceptable, and consistently outpaces its peer group.

DBRS considers First National’s low risk balance sheet as a key factor supporting the ratings. DBRS notes that the Company’s direct credit exposure is limited to a $246 million mortgage investment portfolio (0.9% of total assets as of YE15) it holds on its balance sheet, mostly in commercial bridge lending. Historically, mortgages originated by First National have outperformed the industry with very low delinquency rates. DBRS sees sustaining this performance as critical to the Company’s business model and franchise. While low energy prices continue to be a headwind for the Canadian economy, the impact on the Canadian housing market has largely been regional to date, with some weakening of credit metrics in the western provinces.

DBRS considers First National’s liquidity and funding to be appropriately managed and aligned with its assets. First National funds most of its MUA either through sales to institutional investors (63%) or by securitization (26%), with the remaining MUA mostly warehoused temporarily, awaiting sale or securitization. However, FNF does have some concentration risk, with 13.7% of placement fees and mortgage income being originated from one Canadian financial institution in 2015.

In 2015, the Canada Mortgage and Housing Corporation (CMHC) changed the limits of the amount of mortgage-backed securities it will guarantee and increased the price on the guarantee stamping fee; however, this did not limit First National’s originations for the year, but is expected to have a marginal effect in 2016. On the other hand, the Canadian government’s intention to prohibit the use of insured mortgages as collateral in non-CMHC securitizations, which is effective as of July 1, 2016, may have a modest effect on the Company’s future ability to use bank-sponsored asset-backed commercial paper (ABCP). However, DBRS expects that First National will be looking to expand its use of private securitization pools to fund these products.

DBRS considers First National’s capital levels to be acceptable given the relatively low level of credit risk. At December 31, 2015, the Company’s tangible partner equity-to-tangible assets (excluding securitized mortgages) was 8.8%. However, given the high dividend payout ratio, organic capital generation has been constrained. DBRS would view improved capital retention favourably.

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.

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

The applicable methodology is the Global Methodology for Rating Finance Companies (October 2015). Other applicable methodologies include DBRS Criteria: Preferred Share and Hybrid Criteria for Corporate Issuers (January 2016), DBRS Criteria: Rating Holding Companies and Their Subsidiaries (January 2016) and DBRS Criteria: Guarantees and Other Forms of Explicit Support (February 2016). These documents can be found on DBRS’s website at www.dbrs.com.