First National Financial Corp

TSX:FN

Earnings Call Transcript 2018-Q1

[Operator]

Good day, and welcome to the First National Financial Q1 2018 Analyst Conference. As a reminder, this call is being recorded on May 2, 2018, for replay purposes.At this time, I'd like to turn the conference over to Stephen Smith, Chairman and Chief Executive Officer. Please go ahead, Mr. Smith.

[Stephen J. R. Smith, Co]

Thank you. Good morning, everyone. Welcome to our call, and thank you for participating. I'm joined by Rob Inglis, our Chief Financial Officer; and Moray Tawse, Executive Vice President. I will remind you that our remarks and answers may contain forward-looking information about future events or the company's future performance. This information is subject to risk and uncertainties, and should be considered in conjunction with the risk factors detailed in our MD&A.First half will open 2018 as of end of 2017, with solid earnings performance. With steady growth in MUA, which reached another all-time high of $102.2 billion, the company generated solid metrics; $256 million of revenue, a 11% higher than a year ago; $36.9 million in net income, just slightly below Q1 of last year, and earnings per share of $0.59 per share, a $0.01 above last year. This performance provided good support for common share dividend payments, which amounted to $27.7 million with the annual equivalent of $1.85 per share.As a percentage of net income, attributable common shares to payout ratio was 79%. We are very pleased with these results, especially in light of government policy interventions since October 2016, and the curbing risk in the housing market. The latest and the largest policy intervention occurred, as you know on January 1 of this year with the introduction of a new guideline B-20 underwriting standards. First National adopted these rules in January 1, 2018, but still experienced growth in new single-family originations of 12% compared to last year. There were several reasons for that growth, including accelerated home buying activity seen in 2017 as consumers moved to qualify before B-20 became effective. Some of these commitments closed in the first quarter of 2018, as well, we believe First National has picked up some market share in the mortgage broker distribution channel.On the commercial side, new originations were up 27%, which we attribute to strong activity levels and First National's success in growing, both its conventional and CMHC-insured lending businesses. Our renewals in both segments were solid on available opportunities. And single-family renewals were unchanged from last year at $1.2 billion. At $152 million commercial renewals were lower than last year, when a particularly large mortgage flowed through the renewal line.I would say the results of the quarter were generally positive. While earnings adjusted for fair value considerations were 5% lower than a year ago, a large part of this reduction reflected our choice to shift mortgages to securitization programs, which had the effect of delay in the earnings process. Stepping back, first quarter marked our 30th anniversary in business. We're proud of our accomplishment, but proud still with strong and lasting relationships developed with our mortgage broker and funding partners as a result of the work we do collectively to help our owners achieve their real estate ownership goals. We look forward to building on the company legacy a good service, good products and good performance.I'll now ask Rob to provide details of our most recent performance before Moray comments on our outlook. Rob?

[Robert A. Inglis, Chief Financial Officer]

Good morning, everyone. As Stephen alluded to, mortgage under administration increased 3% year-over-year to $102.2 billion at March 31. During the quarter itself, MUA increased by $600 million from year-end 2017 or about 2% on an annualized basis. Growth in MUA, we experienced 11% growth in first quarter revenue, which increased to $256 million, compared to just over $232 million a year ago. Revenue growth primarily reflected the rising rate environment, 14% increase in interest revenue earned on securitized mortgages and a 36% increase in mortgage investment income with both resulting in adding new higher interest rate mortgages which replaced lower rate mortgages. Accordingly mortgages were also directly affected as both prime and BA rates increased by 75 basis points year-over-year. A 2% growth in mortgage servicing revenue was due primarily to the growth in MUA. These increases were partially offset by a 26% or $6.9 million decline in placement fees due to lower residential origination volume for institutional customers and a 5% decrease in gains on deferred placement fees, reflecting tighter spreads.Revenues still include gains or losses for financial instruments. Over 2018, the company adopted new hedging provisions led under IFRS 9. By documenting its hedging relationships, the company's gains or losses can now be recorded in other comprehensive income or deferred on our balance sheet than the contrast in the past where these gains or losses were recognized immediately in earnings. In first quarter of 2018, our hedging was very successful and most of the volatility was removed from the income statement. Looking at the outcome. We recorded gains on short bonds used for the economic hedging program of just $800,000 in the first quarter. Generally speaking, the company gained an additional $4.8 million on its hedging program, which was able to record in OCI and defer the balance sheet. This amount will be recognized in income over time, and as well as in a more appropriate revenue account. Instead of gains or losses on financial instruments, the company's securitization income and placement fees will be affected, much more reflective of the economics of these transactions.While we hope IFRS 9 will continue to remove the volatility from the income statement, we will continue to provide the pre-fair market value EBITDA measure and supplementary performance measure as is made relevant into our significant and sudden movements in interest rates and as needed to provide comparison to 2017 results.Pre-fair market value EBITDA in Q1 was down 5% or by $2.7 million compared to Q1 year ago, as a result of tighter mortgage spreads and increased securitization, which as Stephen said, delays the earnings process in comparison to placement fees. Placement fees are earned in the same period of origination. At $35.9 million, net income was just below Q1 of last year, while EPS was higher by $0.01 at $0.59 per share. Solid quarter earnings, the board declared common dividend -- share dividends in the first quarter of $0.462, which is the quarterly equivalent of $1.85 per annum. That's higher than a year ago, because as you'll recall, the board announced an increase in the dividend in April of 2017. The percentage of net income available for common shareholders through dividend payout ratio was 79% versus 75% a year ago, or stated as a ratio to after-tax pre-fair market value EBITDA, the dividend payout ratio was 79% compared to 71% in the first quarter of 2017.All things considered, First National opened 2018 with solid results. Now here is Moray with our closing comments.

[Moray Tawse, Co]

Thanks, Rob. Good morning, everyone. Well, I think this is an interesting reflection point in the market, because as Stephen said, all regulated lenders are required to adopt updated guideline B-20 underwriting practice at the beginning of this year. Since many of First National's institutional investors are OSFI regulated, we adopted these guidelines as well. Our early thinking was that B-20 will reduce the size, the addressable residential market, lead to increased competition, and have adapting effect on new single-family originations. The first quarter did not play out quite the way for First National as we saw strong residential originations pretty well across the country. The only exception was Alberta. Does this change our thinking on the impact of B-20? I think the jury is still out on the ultimate effect. With B-20 on the horizon, some buyers accelerated their decision to purchase a home and entered into commitment at the end of 2017. A portion of these commitments closed in the first quarter of 2018.Before drawing conclusions about B-20, it's important to acknowledge the spillover effect on quarter 1 originations. In our view, it will likely be the second quarter of 2018, because we see the full impact from the B-20 policy-driven adjustments. That said, we are cautiously optimistic the trend established in the first quarter will continue in the second. The 12% year-over-year increase in single-family origination quarter 1, represents we believe, a return to more normalized markets after the disruption of 2017 caused by new mortgage insurance rules. So despite feeling the full impact of both new qualifying mortgage rules under B-20 and higher interest rates in Q2, we are confident that our strong relationships with mortgage brokers and our diverse funding sources will set First National above the competition and lead to growth in originations.We unfortunately also expect to continue tightening interest rate environment similar to what we experienced in the first quarter of 2018 . Overall, we believe our position is strong and that we will benefit from the income and cash flow generated from what is now a $28 billion portfolio of mortgages pledged under securitization and, of course, $74 billion of servicing portfolio, while we focus on the value inherent in our significant single-family renewal book.Well, that concludes our prepared remarks. Now we will be pleased to take your questions. Operator, could you please open the line?

[Operator]

[Operator Instructions] We'll go first to Nik Priebe from BMO Capital Markets.Okay, and we'll go next to Victor Dri from National Bank Financial.

[Victor Dri, Associate]

It's Victor here, just in for Jaeme. Just a question here on the securitization funding. So it looked like it was elevated again in the quarter in all 56% according to our calculation here. Just wondering can First Nat sustain this fees-based securitization or does the CMHC fee threshold kind of bring FN back to more normal levels for the rest of the year?

[Stephen J. R. Smith, Co]

We can sustain that level for the rest of the year without any trouble.

[Victor Dri, Associate]

Okay. And is it still profitable for First National to kind of extend beyond that fee threshold, if they -- if you guys end up doing that?

[Stephen J. R. Smith, Co]

Yes. I think the pressure on profitability is not the volume, it's more just -- right now, we're experiencing tight spreads. So we got a tight spread environment for over a year. So we just securitize and set the problems in next period in the mortgage. So it is profitable, but not as profitable as we'd like.

[Robert A. Inglis, Chief Financial Officer]

I will say too that we are securitizing conventional loans as well. We are still part of the allocation of the [indiscernible].

[Victor Dri, Associate]

The other question was, so that -- you started talking about this in the more -- in beginning comments there, but with the B-20 impacts now we're kind of 4 months in those rate holds and commitments, and probably going to roll off soon. So just wondering what kind of gives you guys the confidence to provide kind of what appears to be a fairly optimistic guidance for Q2 and the rest of the year, given our kind of slowdown we've seen in the housing activity so far?

[Stephen J. R. Smith, Co]

Well, I guess, you've seen -- we still have a couple of months left in Q2. We've seen commitments fee fairly strong in April, up quite a bit over last year, although I have to say the last week has been slower. I think we're just feeling a little bit better, but it still remains to be seen. I think for a bunch of reasons we are picking up -- we've picked up share to some extent, and I guess it's a general feeling, but the market can change quite suddenly as we all know.

[Operator]

[Operator Instructions] And we'll go next to Marko Kais from TD Securities.

[Marko Kais, Associate]

My question is around the hedge accounting change under the IFRS 9. It sounds like there will be a lot less volatility in booking realized and unrealized gains. Just wondering if you can give us a sense of what kind of figure we can expect on a quarterly basis here. Is this quarter a representative run rate in your view?

[Robert A. Inglis, Chief Financial Officer]

Let's say, this quarter was, well very unusual and that the bond market started off of the year, sort of selling off, and then sort of humped in the middle of February and came back down. So if you go to the end of the 2017, towards the end of -- end of Q1 2018, rates were very flat. So it wasn't like a rising rate environment, but I would say that, generally speaking, we're going to see a lot less volatility. But where things spike, who knows what happens. We have a huge commitment for that and we don't hedge for accounting and that's still at risk of volatility. So I think definitely lower than in the past year, so I can't really [ tell us ] anything.

[Stephen J. R. Smith, Co]

The IFRS 9 eliminates a portion of the variability, but it doesn't eliminate it all. And so for that reason we're still keeping the pre-fair market value EBITDA measure, because we would use that as the longer-term measure or the real measure of our businesses going. So we would think that's going to be less volatile. I think 2 years ago, we had to turn one quarter where -- when the bank lowered rates 50 basis points, we think we had [ $40 million ] charge. We probably won't see that anymore because a portion of that would've already been fully bashed and hedged and it would go into OCI, but it won't eliminate it entirely.

[Marko Kais, Associate]

Just -- I think a note in your financials that refers to $1.2 billion credit exposure on the mortgages that are pledged under securitization. Just wondering are you exposed to all of this, $1.2 billion or just a certain residual piece of this?

[Robert A. Inglis, Chief Financial Officer]

All I am saying is in that note is that, we have in mortgages accumulated for sale, $1.2 billion of mortgages that we are going to securitize if NHA and their spreads change or ABCP spreads change, we could be a threat, because we hedge interest rates, we don't really hedge the spread to our funding source. So [indiscernible] said that the same goes in there for probably 10 years. I just said that credit spreads are part of the puzzle and those get changed as well.

[Marko Kais, Associate]

So it sounds like [ the direct ] was on the spreads, not the actual credit performance of the mortgages themselves?

[Robert A. Inglis, Chief Financial Officer]

Sorry, I didn't hear the question.

[Marko Kais, Associate]

What I am getting is that the [ risk heater ] is really on the spreads and the rates rather than the actual credit performance of the mortgages themselves because…

[Robert A. Inglis, Chief Financial Officer]

It's about the credit spread on interest. So the mortgage themselves primarily are insured by some loan to value conventional. Just saying, the credit spread between the mortgages and the ultimate funding source has all been set and could change between a time that we securitize those mortgages. In today's environment, I think unlikely that's going to have an impact, but 2017 had huge impact, when spreads [indiscernible].

[Stephen J. R. Smith, Co]

Yes, it also depends how you hedge. If you are using CMB and you short CMBs, you'll probably eliminate the basis risk, but if you're going into NHA MBS, it will still pick up the potential spread was between CMB and NHA MBS.

[Moray Tawse, Co]

Yes, I would agree that risk is like a 2007, 2008, sort of risk that could happen. In a regular environment like today, it's not material.

[Marko Kais, Associate]

And just my last question is, just if you could provide us an update on the commercial mortgage loans that are in arrears, and just trying to get a sense of what this quarter's $1 million provision reflects, specifically?

[Moray Tawse, Co]

We continue to work through sort of the legal process in Winnipeg, which we find very, very frustrating. And so it's just taking us longer I think to be able to clear that off our book.

[Operator]

[Operator Instructions] We'll go next to Geoff Kwan from RBC Capital Markets.

[Geoffrey Kwan, Analyst]

Just had one question. With where the housing market and it's been slowing down, and that employment, unemployment and economic growth has still remained constructive, can you talk to what would be some of the metrics or whatever that you track that you would say, hey, you know what, in this market or even on a national basis we need to pull back on the underwriting in terms of the new business that we're writing because we're not liking what we see in the market, like what would be some of those things that you look at?

[Stephen J. R. Smith, Co]

Well, I guess there is 2 areas, we have the commercial area and then we have the single-family area. I think fundamentally, our business is where our securitization market is. Really the tightening the underwriting has been occurring for about a decade now starting 2008. And so 2008, there has been a concern about an elevated real estate values and we have probably the tightest underwriting standards I have seen in the 30 years that I've been -- 40 years I've been in the industry, Geoff. So I think it's not also how we are going to make a change now, we've been making continuous changes with underwriters and writing standards. And that would be at the insurers and then that was again what we do. But again, our balance sheet is insured. So we don't have a direct credit risk we have on the insured mortgages. And a stat that I always quote is in 2007, 2008, the percentage of mortgage was [ 6%,16%, and under were 21%, 22% ] now, it's 5% or under. The average FICO score in 2008 was 705, now it's 771 or something like that. So I think it's an ongoing continuous process.

[Geoffrey Kwan, Analyst]

And I mean, you talked about the securitized insured market, but what about on the uninsured side?

[Stephen J. R. Smith, Co]

Well, again on uninsured side, I think, it's -- we have been dealing with that on the same basis. Of course, we have the residual credit risk on our insurance -- on our securitization program that we securitized. Similarly though that we sell a lot of those to Investors and we set a credit standard jointly with them, I'd say you mitigate real-estate risk by focusing on covenants. So our covenant requirements, we've been dealing with that for quite a period of time where the requirements for covenants are just not at all stronger. On single-family, fundamentally it's a -- I think too much of single-family business is what is a real estate story. In fact, a single-family loan is covenant loan on the borrower's ability to repay based on their employment secured by real state. But even we have a drop in real estate values. As long as that's mitigated by strong covenant, a person's ability to repay doesn't mean because real estate values go down that we are going to have a loss.

[Geoffrey Kwan, Analyst]

I mean I understand what you're saying in terms of on the covenant side, but I mean, are there certain things like, I mean if you saw -- started to see x percent or some sort of I guess, other metric where, let's say, for example, debt service ratios were creeping up across a particular region or whatever else like that, or other metric like -- I'm just trying to understand like, are there those types of metrics? I am just trying to see how you look at it as to what you would want to do to be a bit more careful, even though you do securitize yourself through your institutional partners?

[Stephen J. R. Smith, Co]

Again, what I would say is that something we've been doing now or probably the past 10 years is that we would intend to -- we continue to see improved quality of loans. So I think there is a focus from the external, they say, oh, well, this time you are going to change. Well no, we've been changing now for 10 years. And again, all [indiscernible] we have now, so a lot stronger, but that reflects the concern of the value of collateral that we've had for a number of years. So if you think that values are relatively low, you might be a little bit less picky about the covenant. If you start to be concerned with elevated collateral values since you are in Vancouver and in Toronto, we deal with that by making insured covenants, this is now a lot stronger. So I don't think [indiscernible] this is what we look at. We were going to make that change, I think it's been -- it's tended to be a continuous process that we have engaged and we've seen hike in real estate values, but we have been seeing that for quite a period of time and for that reason, we've tended to take our overall covenants.

[Operator]

We'll go next to Victor Dri from National Bank Financial.

[Victor Dri, Associate]

Yes, just a quick follow-up on the securitization. We were just wondering, is there a target level that you guys look for on the leverage side, like a target level of leverage for securitization? We have it at about on a roughly 41x just by our estimate here. So just wondering if you guys will think about like from a sort of target level of leverage there?

[Moray Tawse, Co]

No, leverage is something that we thought about quite a bit and I think leverage that's appropriate or not appropriate, depends on the nature of the asset. If we securitize an NHA MBS, for example, that's a complete pass-through. So on the balance, so we get the mortgage payments saying we take a spread on the way through and pass it through the investors. So the risk that we have on that is, you don't have a funding risk, it's totally matched. So for that reason, we're comfortable with the insurance. So we don't think that there is a big risk associated with being highly levered there. So we don't sit down if there is a metric that we could do too much of that. That's not a particular worry that we would have. So we don't sit and -- so I often get this question, it's well, you are highly levered. So it's -- on one hand, you've got entirely insured book back for the credit, the Government of Canada on the other hand, you've matched funding. That's almost like a servicing business which is taking the payments in, taking that into strip and passing through when we're almost like an administrator. Now for example, we do sort of a mezzanine books where we're at higher loan to values than the commercial loans and we haven't default our view on that would be much less levered on that even in the case [ 2 or 3 to 1 ] that type of thing. So the amount of leverage you have is more of -- it depends on the type of assets. So we don't -- we think of it more on business line, but we are -- it doesn't concern us that the leverage is at that level.

[Operator]

We'll go next to Nik Priebe from BMO Capital Markets.

[Nikolaus Priebe, Analyst]

I was disconnected earlier, so apologies. My question's been answered, but I just wanted to touch on the funding mix in the quarter. Obviously a high proportion [ will fund your ] securitization programs and I can certainly appreciate that -- I think that channel tends to be the more profitable offtake. But just wanted to ask -- wondering if that shift has also been partly reflected of evolving demand from institutional buyers? Is there anything you've seen or heard from institutional partners that might have contributed to lower placement activity in the first quarter?

[Stephen J. R. Smith, Co]

No, we [ don't have anything to do with ] institutional partners that change our outlook.

[Nikolaus Priebe, Analyst]

Okay and then just jumping to spreads, it certainly remained tight in the quarter. Just wondered if you could give us a sense of what the greater influence on that would be, whether it's the impact of some of the hedging gains recognized last year with the offsetting negative effect being recognized in lower margins this year, or whether it's just the result of a more competitive mortgage market more generally?

[Stephen J. R. Smith, Co]

It's result of a competitive market more generally and it's been -- our market, we are a price-taker. We compete with the Sched I banks, [indiscernible] they go through periodic periods where they compete very fiercely. And then they ducked back to the norm. It's been a very competitive period before over a long period of time. I hope that ends, but you never know for sure. We're still competitive. We make money, but not as much as money as I would like to.

[Operator]

And at this time, I'll turn it back to Mr. Smith for any additional or closing remarks.

[Stephen J. R. Smith, Co]

Thank you very much, operator. That concludes today's event. Thanks everyone for joining us. We look forward to host our annual meeting on May 7, which is next Monday at the TSX Gallery in Toronto beginning at 9 a.m. I know, I'll see every one of you there. Thanks for taking part in our call, and have a good day.

[Operator]

That does conclude today's conference. Thank you for your participation.