DBRS Confirms Home Capital Group Inc. at BBB; Revises Trend to Negative

DBRS Limited (DBRS) has today confirmed Home Trust Company’s (HTC or the Company) Issuer Rating and Deposits and Senior Debt rating at BBB (high) and Short-Term Instruments rating at R-2 (high). HTC is the primary operating subsidiary of Home Capital Group Inc. (HCG or the Group). DBRS has also confirmed the Group’s Senior Debt rating at BBB and Short-Term Instruments rating at R-2 (middle). Concurrently, the trend on all ratings has been revised to Negative from Stable. Under DBRS’s “Global Methodology for Rating Banks and Banking Organisations,” HTC has an intrinsic assessment of BBB (high) and a support assessment of SA3. The SA3 rating, which reflects the expectation of no timely external support, results in the final rating being equivalent to the intrinsic assessment. The rating action follows a detailed review of the Group’s operating results, financial fundamentals and future prospects.

The Negative trend reflects DBRS’s view that the Department of Finance Canada’s new mortgage rules, which took effect October 2016, will likely have a negative impact on the Group’s origination volumes as well as loans under administration (LUA) and, as a result, be a headwind to profitability. Moreover, these rules come at a time when the Group is already challenged by some loss of market share in its core broker channels because of (1) customer service issues with its mortgage broker customers and (2) customer-retention issues on the back end of its portfolio. These challenges combined with actions taken to enhance its risk-management capabilities have caused operating efficiency to deteriorate, creating a headwind to earnings growth. DBRS expects HCG to announce in early 2017 details on initiatives designed to restore the Company to positive operating leverage but expects the execution of these initiatives to take time.

In confirming the ratings, DBRS acknowledges HCG’s leading position in the niche non-prime single-family mortgage market, which enjoys higher margins, and historically strong profitability. In addition, the Company’s strong regulatory capital ratios and consistent ability to generate internal capital are considered in the ratings. These positive attributes are offset by geographic concentration in the loan portfolio and past exposure to fraudulent mortgage applications, increased operating costs as a result of the enhancement of risk processes to prevent future fraud and dependence on brokers for both mortgage and deposit generation.

HCG has $26.0 billion in LUA, $17.9 billion of which is on balance sheet, excluding loans held for sale. The Group has a significant focus on the niche Canadian Alt-A market where it is the largest market player. As at Q3 2016, the Group had $11.4 billion of non-prime uninsured residential mortgages in its portfolio. HCG specializes in underwriting such mortgages, where the difficulty lies in income verification (generally because of the borrower being self-employed or a new immigrant) rather than in the borrower’s creditworthiness. At the same time, the Group also originates insured mortgages that are generally securitized after origination through the Canada Mortgage and Housing Corporation’s National Housing Act Mortgage-Backed Securities and Canada Mortgage Bond programs. As at Q3 2016, on balance sheet insured residential mortgages, including residential commercial, stood at $3.9 billion. In addition, HCG has around $1.9 billion in commercial mortgages and $0.7 billion in credit card and small consumer loans.

Revenue generation remains solid despite the challenges noted above with net interest income increasing by 3% year over year (YOY) to $365 million in 9M 2016 from $354 million in 9M 2015. However, recent risk-improvement initiatives have resulted in non-interest expense outpacing revenue growth and negatively affecting HCG’s relatively good operating efficiency metrics. Indeed, non-interest expense increased by 23% YOY to $168 million in 9M 2016 from $136 million in 9M 2015, mainly because of increased headcount, ongoing investment in information technology security platforms and initiatives to strengthen risk management and compliance. As a result, net income fell by 9% during the same period to $197 million in 9M 2016. Although HCG is focusing on improving its operating leverage through higher revenue growth and reducing costs, DBRS expects the latter will be difficult to achieve in the short term as some of the risk-management initiatives the Group has invested in are labour intensive.

Despite the suspension of approximately 45 brokers who have been identified as being associated with falsified mortgage applications in 2014, HCG has been successfully managing its uninsured Alt-A portfolio, which makes up 44% of loans under administration, as evidenced by the Group’s low loan impairments and losses. However, DBRS is being cautious, as HCG is more susceptible to a real estate market correction than peers because of the nature of its portfolio. Furthermore, a 24% increase in its commercial mortgage loans during the year, which reached $1.9 billion in Q3 2016, in DBRS’s view, exposes HCG to wholesale risk at a time when the Group is concentrating on anchoring its enhanced retail risk-management processes.

The Group is highly dependent on brokers for both its mortgage and deposit origination. To improve funding, HCG is growing its direct deposit channel through its Oaken Financial offering as well as through its subsidiary, Home Bank (formerly CFF Bank, which it acquired in October 2015). With a limited buffer of unencumbered assets, DBRS views further growth in directly sourced deposits positively, as it would further enhance liquidity and funding. In addition, the Group initiated an asset-backed commercial paper funding program in April 2016 for its uninsured near-prime residential mortgages. While this program adds diversity, the short-term nature of such programs does introduce refinancing risk; however, DBRS expects the program to remain a very modest component of the Group’s overall funding.

HTC is regulated by the Office of the Superintendent of Financial Institutions and thus is subject to Basel III capitalization requirements. As at Q3 2016, HTC reported a CET1 ratio of 16.54%, one of the highest ratios among peers, giving HTC a buffer to contain potential loan losses. In addition, DBRS ran its Canadian residential mortgage-backed securities model (including home equity line of credit) on the uninsured residential mortgage portfolio using static loan-level data to gain an understanding of how the portfolio might act in the event of material market declines. The analysis showed that the expected loss in the mortgage portfolio during a significant real estate market correction is manageable. However, given the share buybacks that HCG undertook in 2016, DBRS also notes that the Group has to be cognizant of maintaining capital ratios at their currently high levels relative to regulatory minimums to maintain a sufficient cushion for the underwriting risk HCG undertakes relative to peers.

RATING DRIVERS
The ratings could come under pressure should HCG be unable to restore positive operating leverage — that is, if the Group cannot successfully execute upcoming initiatives aimed at stemming leakage from the existing portfolio — and improve broker customer service on the front end. Furthermore, significant losses in the loan portfolio as a result of unforeseen weakness in the underwriting and/or risk-management process, material loss of market share or substantially lower originations because of new Department of Finance Canada mortgage rules would also have a negative impact on the rating. Although unlikely given the Negative trend, ratings could be positively affected over the medium term by a meaningful increase in funding through direct deposits and less dependence on brokers, in addition to noticeable diversification of income and the introduction of more fee-based and non-interest income.

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 Banks and Banking Organisations (July 2016); Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages (November 2016); and DBRS Criteria: Support Assessments for Banks and Banking Organisations (March 2016), which can be found on the DBRS website under Methodologies.

Lead Analyst: Maria-Gabriella Khoury
Rating Committee Chair: Roger Lister

For more information on this credit or on this industry, visit www.dbrs.com.