DBRS Confirms Ratings of First National Financial at BBB and Pfd-3, Stable Trend

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; FNFLP and FNFC together, First National or the Company) at BBB (low) and Pfd-3, respectively. The trend on all ratings is Stable. The Intrinsic Assessment (IA) for FNFLP is BBB, while its Support Assessment remains SA3. The Company’s Support Assessment is also SA3 and its Senior Unsecured Debt rating is positioned one notch below FNFLP’s IA.

The ratings reflect First National’s low-risk balance sheet, with nearly all mortgages being sold to either institutional investors or securitized, resulting in minimal credit risk to the Company. DBRS also considers the Company’s large volume and scalability, which create operating efficiency. These positive factors are tempered by the Company’s reliance on wholesale funding and mortgage brokers for asset origination, as well as its relatively high dividend payout, which makes for lower retention of earnings to organically increase capital. Furthermore, DBRS sees a degree of key man risk with FNF, given the importance of the founders, and would view a more developed succession plan for the co-founders and executive management favourably.

First National’s franchise benefits from its scale as Canada’s largest non-bank mortgage originator and servicer, with more than $99 billion in mortgages under administration (MUA) as of December 31, 2016. The Company has a dominant market share in insured single-family residential mortgage lending, which makes up 78% of MUA, in addition to multi-unit residential and commercial mortgages, which form 22% of MUA. For 2016, First National’s single-family residential mortgage originations were down 4% to $12.4 billion due to lower originations from the Calgary office and increased competition from smaller lenders. In 2016, the Department of Finance put into place several new rules related to mortgage lending, including higher qualifying rates for five-year borrowers and more restrictive criteria around eligibility for portfolio insurance. DBRS notes that the last of these new regulations came into effect on November 30, 2016. As such, the ultimate impact of these new rules on the Company’s origination volumes and franchise have yet to be determined and likely will not be so until the higher volume spring selling season is complete. That said, the Company expects the new rules on qualifying rates to affect Canada’s industry-wide insured mortgage originations by 5% to 10%.

The Company’s net income almost doubled to $202 million, primarily benefiting from gains on financial instruments of $28 million, as well as higher administration income from MUA growth of 6%. Furthermore, the Company’s third-party underwriting and fulfillment services business with a major Canadian financial institution had its first full year of operation. As a result, mortgage servicing income increased by 12% to $131 million in 2016, while placement fees grew by 7% to $177 million as the company increased institutional placement year over year. Benefiting from growing revenues, First National’s efficiency ratio (excluding gains on financial instruments) improved from 58% in 2015 to 52% in 2016. Nevertheless, DBRS is cautious that there is some concentration risk, with 8.3% of placement fees and mortgage income being earned from one Canadian financial institution in 2016, a decrease from 13.7% in 2015.

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 largely limited to a $255 million mortgage investment portfolio, which primarily consists of commercial bridge lending and represents less than 1% of on balance sheet assets. 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, as any weakening in performance, especially if outside industry averages, could result in reduced investor demand for Company originated mortgages. However, with rising housing prices in the greater Toronto and Vancouver areas, a real estate market correction in Canada could see a rise in delinquency rates, especially on the commercial side, which could affect the Company’s origination volumes and funding as well as increase servicing costs, offset by higher servicing-related revenue.

First National is reliant on secured forms of wholesale funding, especially securitization vehicles, to fund its assets. However, DBRS notes that the Company does benefit from a diversity of secured funding sources including Canadian Mortgage Housing Corporation (CMHC)’s National Housing Authority Mortgage Backed Securities (NHA-MBS), Canada Mortgage Bonds (CMB), Commercial Mortgage Backed Securities (CMBS) and bank-sponsored asset backed commercial paper (ABCP). DBRS considers First National’s liquidity and funding as appropriately managed and aligned with its assets.

In DBRS’s opinion, First National’s capital levels are low, but in line with other mortgage lenders. At December 31, 2016, the Company’s tangible shareholder equity-to-tangible assets increased modestly to 1.3% versus 1.1% in 2015, reflecting an increase in retained earnings, offset by asset growth. First National’s common dividend payout ratio decreased in 2016 to 50% due to higher net income; however, given the high level of historical payouts, organic capital generation has been constrained. DBRS would view improved capital retention favourably.

RATING DRIVERS
Although unlikely given the current environment, ratings could be positively affected over the medium term through less single-name concentration within the Company’s funding sources, or due to significantly higher and sustainable net interest margins and returns on total assets in line with higher rated issuers. Conversely, ratings could come under pressure should First National lose market share due to lower originations on the back of the new Department of Finance mortgage rules or increased competition, or if the Company shows sustained deterioration in operating results due to its inability to respond to competitive or regulatory changes. Furthermore, any changes in government-sponsored securitization programmes that constrain the Company’s funding or low capital generation due to a high dividend payout could also negatively affect the ratings.

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 principal methodologies are Global Methodology for Rating Finance Companies (October 2016), DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (December 2016) and DBRS Criteria: Rating Corporate Holding Companies and their Subsidiaries (December 2016), which can be found on dbrs.com under Methodologies.

Lead Analyst: Maria-Gabriella Khoury, Vice President – Global FIG
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG & Sovereign Ratings

The rated entity or its related entities did participate in the rating process. DBRS had access to the accounts and other relevant internal documents of the rated entity or its related entities.