DBRS Morningstar Assigns HomeEquity Bank Public Long-Term Issuer Credit Rating at BBB (low) with Stable Trend

DBRS Limited (DBRS Morningstar) assigned initial public credit ratings to HomeEquity Bank (HEB or the Bank), including a Long-Term Issuer Rating of BBB (low). The trend on all ratings is Stable. The Bank’s Intrinsic Assessment (IA) is BBB (low) with a Support Assessment of SA3. The SA3 designation, which reflects no expectation of timely external support, results in the final credit rating being equivalent to the Intrinsic Assessment.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings reflect the Bank’s leading franchise in the niche market of providing reverse mortgages in Canada. DBRS Morningstar considers HEB’s strong and stable profitability as a positive contributor to its credit ratings. Additionally, asset quality remains strong with minimal loan losses, while the Bank’s funding and liquidity profile has been resilient, and current capital buffers are sufficient to absorb loan losses in a stressed environment. Nevertheless, the Bank’s very limited revenue diversification could make it susceptible to potential losses under stressed conditions. The credit ratings also reflect DBRS Morningstar’s expectation that asset quality metrics may modestly deteriorate from their current levels given the challenging economic environment. DBRS Morningstar also views the Bank’s monoline product offering, the limited size of the reverse mortgage market, as well as a heavy reliance on brokered deposits as credit rating constraints.

The Bank’s IA is positioned below the Intrinsic Assessment Range (IAR), reflecting HEB’s monoline business model, which is a specific and material weakness of the Bank, making it susceptible to material adverse changes in the Canadian real estate market or other product-specific pressures that may arise.

CREDIT RATING DRIVERS
Over the longer term, a more diversified funding mix, including directly sourced client deposits, while maintaining sound asset quality, would lead to a credit ratings upgrade. Credit ratings would also be upgraded if the Bank were able to materially improve its product and revenue diversification.

Substantive funding pressure caused by limited access to the brokered deposit market would lead to a credit ratings downgrade. Significant losses in the loan portfolio, especially as a result of unforeseen weakness in underwriting and/or risk management would also lead to a credit ratings downgrade.

CREDIT RATING RATIONALE
Franchise Combined Building Block (BB) Assessment: Weak/Very Weak
As a Schedule 1 Canadian Chartered Bank, HEB is the biggest reverse mortgage provider in Canada. The Bank operates in a niche market segment, however, with a loan portfolio of $6.9 billion as of Q2 2023 that is composed exclusively of reverse mortgages with a variety of distinctive features. With no branch presence, HEB sources mortgages through multiple distribution channels, including advertising media and referral relationships with major Canadian banks and mortgage brokers. While HEB’s competitive position remains largely unchallenged and barriers to entry are higher compared with the traditional mortgage market, new potential entrants, including the larger Canadian banks, could significantly undermine its market position.

Earnings Combined Building Block (BB) Assessment: Good/Moderate
HEB generates good levels of earnings that can cover heightened levels of provisioning expenses. HEB compares favourably to most of its peers with its steady and strong net interest margin (NIM) performance over the past few years. Despite higher operating expenses, net earnings expanded by 5.8% year over year (YOY) to $77.1 million in F2022 on the back of stronger net interest income (NII). NII grew 22.3% year YOY to $183.2 million, supported by higher interest rates that bolstered the NIM by 9 basis points (bps), as well as strong growth in the loan portfolio. The Bank has one of the best efficiency ratios (estimated at 38% in 2022) among its peers, benefitting from not having a branch footprint. Nevertheless, HEB’s noninterest income accounted for only 1.5% of total operating revenue in F2022, putting the Bank at the bottom of its peer group average. Noninterest income includes mainly mortgage administration fees and net gains on sale of mortgages.

Risk Combined Building Block (BB) Assessment: Good/Moderate
HEB has seen robust loan growth averaging 18.5% over the past six years through F2022. The Bank has experienced very few loan losses with strong asset quality, reflecting its conservative lending policy and the historical appreciation of housing prices. As a result, gross impaired loans (GILs) formed only 0.50% of gross loans as at December 31, 2022, while the net charge-off ratio stood at just 2 bps. DBRS Morningstar notes that reverse mortgages with a loan-to-value ratio (LTV) greater than 83% are classified as GILs, and this approach is not directly comparable with GILs on conventional mortgages. Reflecting an uncertain economic outlook and growing loan balances, provision for credit losses (PCL) totalled $8.3 million in F2022 compared with $2.2 million in the prior year. DBRS Morningstar expects HEB's asset quality metrics to modestly deteriorate in F2023 amid economic challenges and elevated interest rates. Furthermore, given its monoline business model and elevated home prices, particularly in the Greater Toronto and Greater Vancouver areas, a potential real estate market downturn would adversely affect the Bank’s asset quality.

Funding and Liquidity Combined Building Block (BB) Assessment: Moderate
HEB is predominantly funded through broker-sourced deposits, which accounted for about 94% of the funding base in F2022. Overall, total deposits grew 28.2% YOY to about $5.5 billion in F2022. Although they are nonredeemable term deposits, DBRS Morningstar views these as having higher flight risk once the terms expire compared with directly sourced client deposits. The Bank has been diversifying its funding base through the opening of wholesale funding channels, including senior medium-term debt with an outstanding amount of $375 million in F2022, and potentially bank deposit notes. It also has access to the standing-term liquidity facility of the Bank of Canada and a committed, revolving credit facility with the large Canadian Banks. On balance sheet liquidity levels are sufficient given the Bank’s lending model.

Capitalization Combined Building Block (BB) Assessment: Good
DBRS Morningstar views HEB’s capital levels as good, with its CET1 ratio at 13.8% as at December 31, 2022. At this level, the Bank has a capital cushion over the minimum regulatory requirement to support growth and absorb potential losses in a stressed environment. HEB uses a standardized Basel III approach on an all-in basis. With the new Capital Adequacy Requirements (CAR) guideline, effective April 2023, the Bank’s risk weighted capital ratios will get a boost as the Bank’s reverse mortgages will qualify for a lower risk weighting. HEB has limited flexibility to raise external capital given its private ownership structure. However, DBRS Morningstar notes that the Ontario Teachers' Pension Plan Board (rated AAA with a Stable trend by DBRS Morningstar), the administrator of Canada's largest single-profession pension plan, acquired HomeQ Corporation, the parent company of HomeEquity Bank, from Birch Hill Equity Partners Management Inc. in July 2022.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/421319.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

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/416784 (July 4, 2023).

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 22, 2023; https://www.dbrsmorningstar.com/research/415978). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (July 4, 2023; https://www.dbrsmorningstar.com/research/416784), in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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.dbrsmorningstar.com.

The credit rating was initiated at the request of the rated entity.

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

DBRS Morningstar had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

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

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

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