DBRS Downgrades Home Capital Group Inc. to BBB (low), Maintains Negative Trend

DBRS Limited (DBRS) has today downgraded Home Capital Group’s (HCG or the Group) Senior Debt rating to BBB (low) from BBB and its Short-Term Instruments rating to R-2 (low) from R-2 (middle). Additionally, DBRS has downgraded the Issuer Rating as well as the Deposit and Senior Debt ratings of Home Trust Company (HTC or the Trust Company), HCG’s primary operating subsidiary, to BBB from BBB (high). DBRS has also downgraded the Trust Company’s Short-Term Instruments rating to R-2 (middle) from R-2 (high). Concurrently, DBRS has maintained the Negative trend on all ratings. The Support Assessment for HTC remains SA3, which implies no expected support for the Trust Company because DBRS has lowered HTC’s Intrinsic Assessment (IA) to BBB from BBB (high).

The downgrades reflect DBRS’s increasing concern over internal pressures at HCG caused by recent changes in the executive management team. On March 27, 2017, HCG announced the immediate departure of Chief Executive Officer (CEO), Mr. Martin Reid, and named independent director, Ms. Bonita J. Then, as interim President and CEO while the Group searches for a full-time replacement. DBRS considers the announcement as indicating weaker strategic leadership and operational risk management at HCG than is commensurate with the prior rating level. Moreover, DBRS expects HCG’s process of improving operational efficiency, strengthening internal controls and enhancing operating performance to take time. Furthermore, DBRS believes that there is high execution risk in implementing these initiatives, especially during periods of change in senior management, which could further stress the Group’s relationships with the mortgage broker community, thereby affecting revenue generation.

The rating actions also consider recent regulatory actions related to HCG and the potential for these enforcement actions to pressure the Group’s operating results. On February 10, 2017, HCG disclosed that it received an enforcement notice from the Ontario Securities Commission (OSC) regarding the Group’s 2014 and 2015 disclosures with respect to the impact of HCG’s findings that income information submitted on some loan applications had been falsified and the subsequent remedial steps taken, including the suspension of brokers and brokerages. The OSC notice stated that its preliminary conclusion is that the Group failed to meet its continuous disclosure obligations in 2014 and 2015. Subsequently, on March 14, 2017, the Group disclosed that the OSC had issued enforcement notices to several current and former officers and directors of HCG regarding the 2014 and 2015 disclosures and, in some instances, trades in the Group’s shares. DBRS notes that both HCG and the individuals can respond to the notices prior to the OSC determining whether to commence proceedings. DBRS considers that the potential OSC enforcement could increase reputational risk and negatively affect broker deposits.

The continuation of the Negative trend reflects DBRS’s view that the Department of Finance Canada’s new mortgage rules, which took effect in October 2016, may have a negative impact on the Group’s and industry’s origination volumes as well as on loans under administration, which may represent a headwind to profitability. DBRS would like to see a prolonged period of stable positive operating performance in light of these rules. In addition, the trend reflects potential legal repercussions from the OSC’s enforcement notice and the uncertainty regarding their impact on the Group.

Furthermore, the Negative trend reflects DBRS’s concern that HCG’s franchise could be weakened by the changes in management because of potential regulatory action by the OSC or because of changes in risk management and operational processes. DBRS considers that such changes may ultimately lead to a loss of market share and could have an impact on relationships with deposit brokers, which could in turn affect HCG’s main source of funding.

RATING DRIVERS

Ratings could be lowered if HCG’s legal reserves are affected by any potential legal action stemming from an OSC investigation that results in a meaningful monetary settlement or judgement. Further uncertainty caused by OSC actions could also lead to downward pressure on the Group’s ratings. If HCG is unable to restore positive operating leverage and successfully execute upcoming initiatives aimed at stopping leakage from the existing mortgage portfolio and improving broker customer service on the front end, the ratings could come under further pressure. Significant losses in the loan portfolio as a result of unforeseen weakness in the underwriting and/or risk-management process, a material loss of market share or substantially lower originations because of the new Department of Finance Canada mortgage rules could also have a negative impact on the ratings.

Although unlikely, given the Negative trend, HCG’s ratings could be positively affected over the medium term by a meaningful increase in funding through direct deposits and less dependence on confidence-sensitive broker-sourced deposits. In addition, a noticeable diversification of income driven by the introduction of more fee-based revenue and a sustained improvement in operating efficiency would be viewed 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.

The principal 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 2017), 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.

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