DBRS Confirms Equitable Bank at BBB, Stable Trend

DBRS Limited (DBRS) has today confirmed and renamed the Long-Term Issuer Rating and Long-Term Senior Debt rating of Equitable Bank (the Bank) at BBB and confirmed its Subordinated Debt rating at BBB (low). The Long-Term Senior Debt rating of the Bank’s parent, Equitable Group Inc. (the Group; together with the Bank, Equitable or the Company), has also been confirmed at BBB (low) and renamed. In addition, DBRS has assigned to the Bank a Long-Term Deposits rating of BBB and to the Group a Long-Term Issuer Rating of BBB (low). The Bank’s Intrinsic Assessment of BBB and the Group's Support Assessment of SA3 are unchanged. All trends are Stable. DBRS further notes that the separation of the Long-Term Senior Debt and Long-Term Deposits ratings reflects the fact that these liabilities could be rated at different levels in the future. At this stage, DBRS is not changing its ratings of bank deposits.

In confirming the ratings, DBRS recognizes Equitable’s sound franchise strength as the second-largest mortgage lender in the niche Alt-A market and position as the ninth-largest independent Schedule I bank by assets in Canada. Furthermore, with the successful launch of its online bank, EQ Bank, in January 2016, Equitable has managed to capture over $1.2 billion in direct deposits, adding some diversification to its sources of funding. The rating confirmations also consider Equitable’s satisfactory asset quality and history of low impairments and charge-offs. These positive factors are tempered by the Company’s large exposure to single-family uninsured mortgages, which could face challenges in an economic downturn, as well as the potential impact of recent regulatory changes on new mortgage originations. In addition, the Company faced deposit outflows during Q2 2017, as its main competitor suffered a liquidity and funding crisis that drove Equitable to take several pre-emptive measures to bolster market confidence.

The Company has solidified its position in the Canadian mortgage market, as evidenced by the double-digit growth of its mortgages under management (MUMs) over the last few years. In Q1 2017, MUMs rose by 21% year over year (YOY) to $21.7 billion as Equitable continued to diversify the asset mix by adding a larger portion of prime insured mortgages, a portion of which it sources from third-party distribution agents for the purpose of securitization. At the same time, on balance sheet commercial and construction loans grew by 30% YOY to $3.0 billion in Q1 2017 as the Company continued to strengthen relationships with business partners through which it sources these loans. Equitable remains heavily reliant on external brokers for the origination of both mortgages and deposits.

As Equitable faced a deposit market disruption at the end of April 2017 because of contagion from its main rival, the Company took several successful actions to shore up its liquidity and funding. Equitable obtained a committed two-year $2.0 billion secured backstop funding facility from a syndicate of the six large Canadian banks; in addition, it raised rates on fixed-term deposits and obtained portfolio insurance on existing residential mortgages for securitization. These steps helped Equitable regain market confidence fairly quickly. DBRS expects Equitable to further diversify and reinforce its funding and liquidity.

DBRS considers Equitable’s stable profitability as a positive contributor to the ratings. Despite the low interest rate environment, Equitable has managed to maintain a net interest margin of 1.66% in Q1 2017 as it grew its loan book. Furthermore, in October 2016, the Company became the successor issuer on $3.1 billion of outstanding National Housing Act Mortgage-Backed Security pools originally issued by Maple Bank GmbH’s Toronto Branch. As such, Equitable’s non-interest income as a percentage of operating revenues increased to 8.7% and 12.3% in 2016 and Q1 2017, respectively, from 6.5% in 2015. With its branchless business model, Equitable has one of the strongest efficiency ratios among its peers at 33% in Q1 2017, while pre-provision income remains sufficient to absorb loan losses at current loss rates, which are relatively low.

The Company has successfully managed its uninsured Alt-A portfolio, which makes up over half of its on balance sheet loans. In addition, the Company has historically had low loan impairments and implements prudent risk-management practices. However, Equitable could be more susceptible to a real estate market correction than its bank peers that have a diversified business model, as the bulk of the Company’s retail credit risk lies with the riskier non-prime-mortgage market segment. This view is somewhat tempered by proposed changes by the Office of the Superintendent of Financial Institutions to its B-20 – Residential Mortgage Underwriting Practices and Procedures guidelines, which would have banks test uninsured mortgages at higher borrowing rates. In consequence, newly originated mortgages would have to qualify at a higher threshold, thereby improving the quality of the loans, although this could temper the volume of new originations going forward.

In DBRS’s opinion, Equitable maintains good capitalization levels, with the Common Equity Tier 1 ratio at 13.9% as at Q1 2017 and with relatively high earnings retention. However, given the Bank’s uninsured core lending portfolio, which is mainly composed of Alt-A mortgages, as well as the growth of the overall portfolio, there is limited buffer to absorb potential losses.

The Grid Summary Grades for Equitable are as follows: Franchise Strength – Good/Moderate; Earnings Power – Good; Risk Profile – Good/Moderate; Funding and Liquidity – Moderate; and Capitalisation – Good.

RATING DRIVERS
Given Equitable’s business model, which relies on broker deposits, there is limited upside to the ratings in the medium term. An improvement in its funding and liquidity profile, especially by directly sourcing more stable term deposits, could positively influence the ratings. In addition, the ratings could experience upside through earnings diversification from growth in fee-based income. In addition, the removal of a larger portion of securitizations off balance sheet would also be viewed favourably. The ratings could come under pressure should there be significant losses in the loan portfolio as a result of unforeseen weakness in the underwriting and/or risk-management process. Furthermore, material loss of market share or substantially lower originations because of regulatory changes to mortgage lending rules would have a negative impact on the ratings, as would substantive funding pressure caused by deposit outflows or insufficient liquidity to meet redemptions.

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 (May 2017); Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages (November 2016); and North American CMBS Multi-borrower Rating Methodology (March 2017), which can be found on dbrs.com under Methodologies.

Lead Analyst: Maria-Gabriella Khoury
Rating Committee Chair: Michael Driscoll

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.