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

DBRS Limited (DBRS) confirmed the Long-Term Issuer Rating of First National Financial LP (FNF LP) at BBB and the ratings for Senior Unsecured Debt and Class A Preference Shares of First National Financial Corporation (FNFC; together with FNF LP, First National, FNF or the Company) at BBB (low) and Pfd-3, respectively. The trend on all ratings is Stable. The Intrinsic Assessment (IA) for FNF LP is BBB, while its Support Assessment remains SA3. FNFC’s Support Assessment is also SA3, and its Senior Unsecured Debt rating is positioned at BBB (low), one notch below FNF LP’s IA.

The ratings reflect the limited credit risk exposure of First National, as all mortgages are either sold to institutional investors or are securitized through various government-sponsored securitization vehicles. DBRS views the operating efficiency generated by FNF due to its large volume of originations and the scalability of its operations as a positive. The ratings also consider First National’s dependence on wholesale funding and mortgage brokers for originations, as well as the Company’s single-name client concentration in institutional investor funding pools. In addition, the Company’s relatively high dividend payout ratio limits capital retention. Lastly, DBRS would view a more developed succession plan to help mitigate key man risk as a positive.

DBRS remains concerned with rising housing prices, particularly in the greater Toronto and Vancouver areas, which could lead to a real estate market correction in Canada. As a result, First National may be susceptible to any adverse changes in the Canadian real estate market, given that single-family mortgages represent the majority of its mortgages under administration (MUA). In addition, the new more stringent underwriting rules that came into effect on January 1, 2018, in combination with rising interest rates could materially dampen mortgage originations. Furthermore, the Company increased its commercial mortgage originations by 20% in 2017 and plans on growing this business segment further. DBRS views commercial mortgages as higher risk, particularly in the event of a real estate market downturn.

First National’s franchise benefits from its scale as Canada’s largest mortgage finance company with $101.6 billion in MUA, 76% of which comprises single-family residential, with the remaining amount comprising multi-residential and commercial mortgages. In 2017, originations declined 2% to $16.9 billion, which largely reflects a 10% decline in single-family residential mortgage originations due to the new mortgage insurance rules that were announced in October 2016. This decline was partially offset by the 20% increase in commercial mortgage originations. Overall, MUA were up 2% year over year. Effective January 1, 2018, new mortgage underwriting rules were introduced by the Office of the Superintendent of Financial Institutions (OSFI), which includes a higher stress test for uninsured mortgages. Despite First National’s not being regulated by OSFI, the Company is adhering to these new underwriting rules. DBRS notes that while a further slowdown in single-family mortgage originations is expected to continue in 2018, borrowers are less likely to move to another lender at the time of renewal, since they would have to requalify for the mortgage under these new more stringent rules. As a result, DBRS considers that this should lower the run-off rate of MUA and help strengthen FNF’s servicing and administration revenue.

The Company’s net income was up a modest 4% to $210 million in 2017 compared with last year, largely due to higher gains on financial instruments and lower expenses. FNF has solid earnings power, which is supported by its leading market position in the broker-originated mortgage channel, its scale and its operating efficiency. The Company has generated consistent revenue from its mortgage servicing operations, which underpins FNF’s stable cash flows. In DBRS’s view, origination activities can fluctuate year over year depending on market demand. However, these fluctuations can be appropriately managed, since many of the expenses incurred on originations, such as broker commissions and compensation for in-house underwriters, are also variable in nature. Thus, alignment of expenses with revenue can reduce earnings volatility. DBRS notes that there is concentration risk, as 9.9% of revenue generated by FNF comes from one Canadian financial institution, which is up from 8.3% last year.

DBRS considers the low-risk balance sheet of First National to be a key factor supporting the rating. DBRS notes that the Company’s direct exposure to credit risk is limited, as almost all the mortgages it originates are either securitized or sold to financial institutions. Historically, mortgages originated by FNF have outperformed the industry with very low delinquency rates. For DBRS, sustaining this performance is vital to the Company’s business model and franchise. Any weakening in performance, especially above industry averages, could reduce investor appetite for FNF-originated mortgages. While currently small, the retained commercial real estate loan portfolio does pose direct credit risk. Overall, First National is susceptible to adverse changes in the Canadian real estate market and new more stringent underwriting rules that dampen mortgage originations.

First National is dependent on wholesale funding, which DBRS views as a rating constraint. Nevertheless, DBRS notes that the Company does benefit from diverse secured funding sources, including Canada Mortgage and Housing Corporation’s (CMHC) National Housing Act Mortgage-Backed Securities (NHA-MBS), Canada Mortgage Bonds (CMB) and Commercial Mortgage-Backed Securities (CMBS), and bank-sponsored asset-backed commercial paper (ABCP). Overall, DBRS views First National’s liquidity and funding as being appropriately managed and aligned with its business model, as originated mortgages are on FNF’s balance sheet for a short period of time. Since First National is not regulated by OSFI, it cannot access deposit funding.

DBRS views First National’s capitalization levels as adequate, given that FNF’s exposure to credit risk is limited to a commercial mortgage investment portfolio of approximately $380 million, as it securitizes a majority of its loan portfolio. As First National is not regulated by OSFI, it is not subject to any minimum capital requirements. However, FNF is required by CMHC to maintain a certain level of capital as a result of First National’s participation in the NHA-MBS and CMB programs. Tangible Common Equity as a proportion of Tangible Assets held steady at 1.3%. At 89.1% in 2017, FNF’s dividend payout ratio is high, although it does include a one-time special dividend. DBRS considers this as limiting First National’s future growth potential and would view improved capital retention positively.

RATING DRIVERS
Although there is limited upside potential in the short term, less single-name client concentration in institutional-investor funding pools would have positive implications on the rating. In addition, positive ratings pressure could arise if First National had a noticeable diversification of funding sources beyond the existing bank lines of credit and securitization vehicles, or if FNF achieved significantly higher and sustainable returns on total assets that were in line with higher-rated issuers. Conversely, the ratings could come under pressure if the Company were to suffer a material loss of market share, were unable to adapt products to new mortgage rules in order to sustain origination levels commensurate with peers, or were unable to adapt to changes in government-sponsored securitization programs that would constrain FNF’s ability to fund mortgage originations. Furthermore, substantially higher delinquency rates that would reduce investor appetite for First National-originated mortgages, an inability to reduce client concentration risk, a sustained deterioration in operating results or a significant slowdown in capital generation due to a high dividend payout ratio could lead to negative rating pressure.

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 Finance Companies (November 2017), DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (December 2017) and DBRS Criteria: Rating Corporate Holding Companies and Their Subsidiaries (December 2017), which can be found on dbrs.com under Methodologies.

Lead Analyst: Robert Colangelo, Senior Vice President, Canadian Banking Financial Institutions
Rating Committee Chair: Michael Driscoll, Managing Director – Head of North American 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 in connection with this rating action.

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