DBRS Morningstar Confirms First National Financial LP at BBB and Pfd-3, Stable Trends

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

KEY RATING CONSIDERATIONS
The Company’s ratings and Stable trend reflect its limited exposure to credit risk, given that all mortgages are either sold to institutional investors or securitized through various government and bank-sponsored securitization vehicles. Additionally, FNF has generated solid operating efficiency due to its large volume of originations, reflecting its top-three market share and the scalability of its operations. The ratings also consider the Company’s dependence on wholesale funding and the mortgage broker channel for originations. DBRS remains concerned about the combination of highly leveraged consumers and elevated home prices in the Greater Toronto Area (GTA) and Greater Vancouver Area. As a result, DBRS views FNF as susceptible to any adverse changes in the Canadian real-estate market, given that single-family mortgages comprise the majority of the Company’s mortgages under administration (MUA). In addition, the ratings take into account FNF’s single-name client concentration in institutional investor funding pools as well as the Company’s relatively high dividend payout ratio, which may limit its future growth potential.

RATING DRIVERS
Although there is currently limited upside to the rating, over the longer term, DBRS sees the potential for positive rating pressure if FNF can generate significantly higher and sustainable returns on total assets in line with higher-rated issuers. A noticeable diversification of funding sources beyond existing securitization vehicles and bank lines of credit as well as a reduction in single-name client concentration in institutional investor funding pools could also benefit the rating. Conversely, DBRS sees negative rating pressure if the Company incurs substantially higher delinquency rates due to deficiencies in risk management or underwriting that could reduce investor appetite for First National originated mortgages. A sustained deterioration in operating results or a significant slowdown in capital generation due to a high dividend payout ratio could also result in negative rating pressure.

RATING RATIONALE
FNF has a strong franchise, which benefits from its scale as the largest non-bank mortgage finance company in Canada with over $106 billion in MUA, 75% of which comprises single-family residential mortgages while the remainder comprises multi-residential and commercial mortgages. Mortgage originations in 2018 increased 9% compared with last year, largely reflecting the relaunch of Excalibur, a program targeting alternative borrowers with good credit, as well as growth in Ontario and Québec. Positively, the Company achieved this growth despite the new mortgage underwriting rules introduced by the Office of the Superintendent of Financial Institutions (OSFI) effective January 1, 2018, which included a stress test for uninsured mortgages. In addition, the Company successfully renewed $7.4 billion in mortgages compared with $6.3 billion in the prior year, which supported growth in MUA.

FNF has consistently generated solid earnings and stable revenue from its mortgage servicing operations, which has provided the Company with stable cash flows. FNF’s earnings power is also supported by its top-three market share in the broker mortgage channel as well as solid operating efficiency. In 2018, the Company reported net income of $166.4 million, which declined 21% compared with last year, largely due to lower gains on financial instruments as well as tighter securitization margins and lower placement fee revenue, both of which reflected tightening mortgage spreads. DBRS notes that approximately 9.0% of revenue generated by FNF came from one major Canadian financial institution, which is down from 9.9% in 2017. The Company continues its efforts to reduce this concentration risk by adding additional institutional investors.

DBRS considers the Company’s low-risk balance sheet to be a key factor supporting the rating. While DBRS notes that FNF’s direct exposure to credit risk is limited since almost all the mortgages it originates are either securitized or sold to financial institutions, the Company does have some credit-risk exposure to a portfolio of mortgages accumulated for sale and a portfolio of commercial first and second mortgages held for investment purposes by FNF. Overall, the Company remains susceptible to adverse changes in the Canadian real estate market. Historically, mortgages originated by FNF have outperformed the industry with very low delinquency rates, which DBRS considers vital to the Company’s business model and franchise. A weakening in the credit performance of its mortgages, especially above industry averages, could result in reduced investor appetite for FNF-originated mortgages.

DBRS views the Company’s reliance on wholesale funding as a rating constraint. Nonetheless, DBRS notes that FNF does have access to diverse secured funding sources, such as the Canada Mortgage and Housing Corporation’s (CMHC; rated AAA with a Stable trend by DBRS) National Housing Act Mortgage-Backed Securities (NHA-MBS), Canada Mortgage Bonds (CMB) and commercial mortgage-backed securities and bank-sponsored asset-backed commercial paper. Overall, DBRS views FNF’s liquidity and funding as appropriately managed, reflecting the Company’s business model with originated mortgages only remaining on FNF’s balance sheet for a short period of time. As FNF is not regulated by OSFI and does not have the necessary charter, the Company cannot access deposit funding.

While FNF is not subject to any capital requirements since it is not regulated by OSFI, the CMHC requires FNF to maintain a certain level of capital, given its participation in the NHA-MBS and CMB programs. Overall, DBRS views the Company’s capitalization levels as adequate based on its business model of securitizing a majority of its loan portfolio, which limits its exposure to credit risk. Tangible common equity (TCE) as a proportion of tangible assets declined to 1.2% compared with 1.3% in 2017 and remains modestly below FNF’s peers; however, excluding securitizations, TCE would be a solid 8.0%. In 2018, the common shares dividend payout ratio was 105%, which includes a one-time special dividend of $60 million that represented the distribution of excess retained earnings generated over several years. Since FNF’s common shares dividend payout ratio has been historically high, DBRS considers this as limiting its future growth potential. DBRS would view FNF’s effort to improve capital retention positively.

DBRS notes that the above press release was amended on March 12, 2020, to remove the Support Assessment from First National Financial LP.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodologies are Global Methodology for Rating Non-Bank Financial Institutions (November 2018), DBRS Criteria: Preferred Share and Hybrid Security Criteria for Corporate Issuers (November 2018) and DBRS Criteria: Rating Corporate Holding Companies and their Subsidiaries (November 2018), which can be found on our website under Methodologies & Criteria.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at www.dbrs.com.

The rated entity or its related entities did participate in the rating process for this rating action. 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.

Lead Analyst: Robert Colangelo, Senior Vice President, Canadian Banking Financial Institutions, Global FIG
Rating Committee Chair: Michael Driscoll, Managing Director, Head of NA FIG, Global FIG

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

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