DBRS Upgrades Ratings of Home Capital Group Inc. and Confirms Ratings of Home Trust Company, All Trends Stable

DBRS Limited (DBRS) upgraded the Long-Term Issuer Rating and Long-Term Senior Debt rating of Home Capital Group Inc. (HCG or the Group) to B from B (low) as well as confirmed the Group’s Short-Term Issuer Rating and Short-Term Instruments rating at R-5. DBRS also confirmed the Long-Term Issuer Rating, Long-Term Deposits rating and Long-Term Senior Debt rating of HCG’s primary operating subsidiary, Home Trust Company (HTC or the Trust Company), at BB (low) as well as confirmed HTC’s Short-Term Issuer Rating and Short-Term Instruments rating at R-4. The trends on all ratings are Stable. The Intrinsic Assessment for HTC is BB (low), while the Support Assessment for HCG is SA3, which implies no expected systemic support for the Group.

The narrowing of the notching between the ratings of the Group and the Trust Company is driven by the incremental progress made by the Group in returning to profitability and stabilizing funding. Given this progress, HCG’s new management team is now in a position to develop an articulated strategy for the future of the Group, which is expected in Q2 2018. Despite the progress, DBRS remains cognizant that HCG has lost market share and has higher-than-peer funding costs and that the new rules around mortgage underwriting might impede growth.

HCG, once Canada’s largest Alternative-A mortgage provider, lost its top position after facing a turbulent second and third quarter in 2017 due to a liquidity event that stemmed from a crisis of confidence. The Group’s loans under administration (LUA) shrunk by 15% during 2017 to $22.5 billion, as it sold $1.5 billion in residential and commercial assets, while originations totalled $4.7 billion, half the amount underwritten in 2016. In Q4 2017, the Group commenced various initiatives aimed at repairing and improving mortgage broker relationships with the impetus of driving stronger originations going forward while maintaining underwriting risk standards. DBRS will look to HCG to maintain a solid footing in the industry and ensure that LUA growth remains measured. Meanwhile, the Office of the Superintendent of Financial Institutions’ new B-20 mortgage underwriting guidelines, which went into effect on January 1, 2018, are expected to have an impact on HCG’s originations and renewals; however, management has yet to determine the consequences of the new rules, which include a higher stress test on uninsured mortgages as well as constraints on bundled mortgages.

Earnings suffered during 2017 as the Group’s elevated funding costs caused a significant quarterly loss in Q2 2017. Indeed, in order to entice depositors and stabilize its funding, HCG had to pay higher interest rates on its deposit products in comparison with peers for most of 2017. In addition, the Group sequentially obtained new line of credit facilities to resolve liquidity issues, which cost it $148 million in fees and interest during the year. As a result, net income was down to $7.5 million in 2017 versus $247.0 million in 2016. DBRS expects earnings to remain positive. Nonetheless, HCG must be able to bring down funding costs further in order to revert back to historical profitability levels and to recapture lost market share. Refinancing its liquidity backstop that comes due in Q2 2018 from a subsidiary of Berkshire Hathaway Inc. (BH) at considerably lower costs could positively affect the ratings.

Asset quality remained strong in 2017, with impaired loans-to-gross loans at 0.34% as at December 31, 2017. Management continues to invest in improving risk policies and procedures in order to maintain the Group’s reputation for good underwriting, which DBRS believes is crucial at this point as HCG attempts to regain its position in the mortgage market. Positively, the new B-20 guidelines will likely drive some of the large bank borrowers to HCG, as they would not qualify for mortgages at the larger institutions given the more stringent stress tests, thereby improving the overall credit profile of the Group’s clients.

With funding now stable, HCG is looking to enhance its direct-to-consumer product offering in order to reduce the Group’s dependence on broker deposits, which comprises 79% the $12.2 billion of total deposits as at December 31, 2017. During the year, the Group saw its brokered demand deposits fall to $139.0 million from $2.0 billion as it faced a crisis of confidence that started in Q2 2017. As such, management has indicated that it will now limit demand deposits to a level that is commensurate with its available liquidity, which DBRS views positively. Liquid assets totalled $1.7 billion as at YE2017, almost three times the amount of demand deposits on the balance sheet. Meanwhile, the $2.0 billion line of credit from BH remains undrawn as at December 31, 2017.

Capitalization levels remain strong, with HCG’s Common Equity Tier 1 ratio at 23.2% as at YE2017. No dividends were declared as the Group focuses on reigniting growth. In DBRS’s view, maintaining a healthy capital cushion is prudent at this juncture. Meanwhile, DBRS ran its Canadian residential mortgage-backed securities model (including home equity lines 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.

The Grid Summary Scores for HTC are as follows: Franchise Strength – Weak; Earnings Power – Moderate/Weak; Risk Profile – Moderate; Funding & Liquidity – Weak; and Capitalisation – Moderate/Weak.

RATING DRIVERS
A further buildup of the deposit base through stable direct channels, a decreased dependence on brokered deposits and a lowering of funding costs in line with peer levels could lead to positive rating actions. Moreover, regaining market share by improving originations while sustaining an appropriate level of profitability and maintaining sound asset quality would be viewed positively. Conversely, the ratings could come under pressure if HCG is unable to improve service levels in order to repair and solidify relationships with mortgage brokers. Furthermore, a change in the asset mix that leads the Group to underwrite a materially larger proportion of commercial loans, which, in turn, would shift its focus from its core franchise of underwriting residential mortgages, or significant losses in the loan book that arise from unforeseen weakness in underwriting and/or risk management processes could also lead to negative rating actions.

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 the Global Methodology for Rating Banks and Banking Organisations (May 2017) and Rating Canadian Residential Mortgages, Home Equity Lines of Credit and Reverse Mortgages (November 2017), which can be found on our website under Methodologies.

Lead Analyst: Maria-Gabriella Khoury, Vice President, Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG, Global FIG

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.

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