DBRS Morningstar Confirms Ratings on Home Capital Group Inc. at BB (high) and Home Trust Company at BBB (low), Changes Trends to Stable

DBRS Limited (DBRS Morningstar) confirmed the long-term ratings of Home Capital Group Inc. (HCG or the Group) at BB (high) and the Group’s short-term ratings at R-3. DBRS Morningstar also confirmed the long-term ratings of HCG’s primary operating subsidiary, Home Trust Company (HTC or the Trust Company), at BBB (low) and the Trust Company’s short-term ratings at R-2 (middle). Additionally, DBRS Morningstar changed the trends on all ratings to Stable from Negative. The Intrinsic Assessment (IA) for HTC is BBB (low), while its Support Assessment is SA1. HCG’s Support Assessment is SA3, and its Long-Term Issuer Rating is positioned one notch below HTC’s IA.

KEY RATING CONSIDERATIONS
The trend change to Stable reflects DBRS Morningstar’s view that the considerable uncertainties facing financial institutions, particularly those with more limited business models, because of the Coronavirus Disease (COVID-19) pandemic have begun to abate. At the onset, DBRS Morningstar expected the economic impact of the various lockdowns on businesses across Canada, particularly for smaller firms and entrepreneurs, many of whom represent HCG’s core Alternative-A (Alt-A) borrowers, to disrupt the Group. However, HCG performed well and was able to maintain origination volumes as it utilized deferral programs and helped clients navigate through the various government aid initiatives.

In confirming the ratings, DBRS Morningstar recognizes the continued positive momentum in HCG’s franchise and earnings. The Group is in the process of implementing its strategic plan, which includes investments in technology to launch new products while enhancing efficiencies. Over the past few years, HCG has made significant strides in regaining its position in the mortgage finance industry all while maintaining strong asset quality. Furthermore, HCG continues to diversify its funding sources and improve its liquidity position. However, DBRS Morningstar remains concerned about the combination of highly leveraged consumers and elevated home prices, particularly in the greater Toronto and Vancouver areas, and believes that housing prices remain vulnerable. As a result, we view HCG as susceptible to any adverse changes in the Canadian real estate market.

RATING DRIVERS
Sustained improvement in franchise and profitability while maintaining a similar risk profile would lead to a ratings upgrade. Moreover, an increase in the proportion of stable termed direct deposits and further diversification of funding away from dependence on brokered deposits would also lead to a ratings upgrade.

Conversely, a ratings downgrade would occur should there be significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management. Furthermore, disproportionate growth in commercial originations that weaken HCG’s risk profile would also lead to a ratings downgrade, as would substantive funding pressure caused by deposit outflows.

RATING RATIONALE
HCG is one of Canada’s leading Alt-A mortgage providers for borrowers who are either self-employed, new immigrants, or recovering from bruised credit. Residential Alt-A mortgages formed around 63% of the Group’s $17.5 billion loan portfolio as of December 31, 2020. At the onset of the coronavirus pandemic, DBRS Morningstar was concerned that the various lockdowns would have a disproportionately negative impact on small businesses and those who are self-employed, and as a result, the demand for Alt-A mortgages and the performance of those mortgages would be materially affected. However, government aid programs and an easing of restrictions during the summer and autumn helped cushion some of the economic impact. In addition, in 2019, HCG had launched a multiyear strategic plan aimed at defending its core market position while enhancing its various technology systems to streamline operations and introduce new products and revenue streams. These factors helped the Group maintain its loans under administration in 2020 at $23.0 billion and drive stronger originations, primarily insured residential and commercial mortgages, which reached $7.0 billion in F2020, up 23% from F2019.

The Group recorded strong performance in F2020 as the lower interest rate environment reduced funding costs at a faster rate than at which HCG’s mortgages were being repriced. As a result, F2020 net income was 23% higher year over year at $176 million. Furthermore, the Office of the Superintendent of Financial Institutions (OSFI) instructed Canadian banks to take proactive provisions for performing loans that could turn delinquent because of the economic uncertainty from the pandemic. Consequently, HCG recorded provision for credit losses (PCL) of $30.2 million in Q1 2020, which later started being released as it expects PCL levels to normalize in 2021. Meanwhile, the Group continues to spend on its Ignite Program, an investment to upgrade the Group’s core banking system and to add new digital tools. As such, HCG expects the efficiency ratio, which improved to 49% in F2020 from 55% in F2019, to vary over the near term.

Meanwhile, as DBRS Morningstar expected, the economic impact of lockdowns has taken its toll and loan impairments have begun to rise, which, although higher at 0.68% in F2020 versus 0.58% in F2019, remain manageable. Like other financial institutions, HCG offered its clients a chance to apply for mortgage payment deferrals, which reached a peak of 23% of loans outstanding as of April 30, 2020. The Group worked closely with its clients through the crisis and there are currently no deferrals outstanding. However, restrictions on real estate transactions because of the social distancing measures, in addition to court closures, posed a challenge for HCG in cases where it needed to efficiently foreclose on a property, thus driving up impaired loans on the Group’s balance sheet. Furthermore, HCG’s uninsured commercial loans of $1.9 billion represented 11% of its on-balance sheet portfolio at the end of 2020. We note this portfolio could face challenges if businesses continue to face intermittent lockdowns.

We view HCG’s funding and liquidity positions as stable. Although unused, the Trust Company provided further funding and liquidity flexibility with the ability to access some of the Canadian federal government liquidity programs. Even though on a downward trend, the Group continues to be highly dependent on broker-sourced deposits, which comprise 71% of its $13.9 billion total deposits at December 31, 2020. Positively, HCG is growing its direct-to-consumer channel through its Oaken Financial offering and diversifying its funding sources through various securitization programs.

With OSFI’s moratorium on dividend increases, HTC was able to retain all of its earnings, which translated into a higher Common Equity Tier 1 ratio of 19.8% as at YE2020, up from 17.6% in the prior year. This implies a capital cushion of $983 million, which is more than adequate to cover loan losses in a moderately stressed economic environment, in DBRS Morningstar’s opinion.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 8, 2020; https://www.dbrsmorningstar.com/research/362170). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

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 under Related Documents or by contacting us at [email protected].

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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