First National Financial Corp

TSX:FN

Earnings Call Transcript 2022-Q1

[Operator]

Good morning, and welcome to First National's First Quarter Analyst Call. This call is being recorded on Wednesday, April 27, 2022. [Operator Instructions] Now it is my pleasure to turn the call over to Jason Ellis, President and Chief Executive Officer of First National. Please go ahead, sir.

[Jason Ellis, executive]

Thank you. Good morning, everyone. Welcome to our call, and thank you for participating. Before we begin, 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 risks and uncertainties and should be considered in conjunction with the risk factors detailed in our MD&A.

Joining me today is Rob Inglis, Chief Financial Officer. Typically, our call start with a discussion of quarterly progress and finish with context with the road ahead. Today, the agenda is a little different. I'll start by addressing our outlook, and Rob will then provide commentary on the first quarter. This seems appropriate as the market environment is changing rather quickly and this is likely on your mind as it is on ours as well.

We entered 2022 expecting to see a reset in Canadian housing activity brought on by rising interest rates and with this change, lower single-family production. After 4 months, we have seen some evidence that this expectation is playing out. There have been 2 Bank of Canada overnight rate increases and the Canadian Real Estate Association recently reported a 16.3% decline in activity in March when compared to the record activity recorded in the same month last year. The Real Estate Association's projection for transactions in all of 2022 is for a decline of 8.1% from last year. This is consistent with CMHC forecast. Given what we know today, including what we see in our commitment pipeline, our short-term expectation is also for moderately lower origination than last year. Downside risks to our forecast includes stronger-than-expected inflation pressures and accelerated interest rate increases.

Some commentators contend that the most recent rate increases will have little impact on the new applicants getting approved at current mortgage stress test rates. That's solid, but also an argument that could be tested depending on Bank of Canada action. A counterpoint is that record immigration levels in 2022 will contribute to both purchase and rental demand. The resulting rental demand could be particularly beneficial to the multifamily residential customers of our commercial division.

In terms of commercial mortgages, we anticipate that short-run originations will remain strong based on our CMHC pipeline. But here again, that may shift quickly depending on the magnitude of interest rate increases and the gulf that may develop between the perceptions of buyers and sellers with respect to commercial property values, which, of course, will affect borrowing activity in the market. This is a period of heightened uncertainty, but First National is prepared.

From a business model perspective, we gained competitive advantage in part because of our market reach as a leader in the mortgage broker channel. This channel gives us direct consumer intelligence and access to a broad spectrum of origination opportunities. Our suite of products includes both Prime and Excalibur branded mortgages. Our expanding share in the Alt-A market will be a valuable source of growth in this environment. Our Commercial segment also gains advantage because of the breadth of its product offering. CMHC and conventional mortgages provide choice for borrowers that is often lacking with other lenders. There are also funds flowing into the multiunit sector as the government promotes affordable housing. Current market dynamics will also have a bearing on refinancing, prepayment activity and renewals. To the degree we can project it, I would say that as we move through 2022, the advantages of refinancing for borrowers will lessen with the correspondingly favorable impact to the company and reduced prepayment speed on our portfolio. This should be supportive of net interest margin and ultimately create more renewal opportunities on scheduled maturity.

From a funding perspective, we continue to see robust demand for First National's mortgage with institutional investors and securitization markets remain strong. As you know, we are a mature user of CMHC securitization program. And as we move forward, we intend to continue leveraging those programs to their fullest extent. This can come at the expense of current quarter's earnings when compared to placing mortgages directly with investors. But through securitization, we maximize the economic value of the mortgages originated and create years of future securitization net interest margin and cash flow for shareholders. Our Canada mortgage bond expertise and the preferred allocation into the program available to affordable multifamily pools, the kind that First National has been originating in the past 2 years, stand us in good stead going forward as we add to future sustainability and profit.

I know there are a lot of moving parts in any outlook, but I will add one more, our cost structure. As you will have observed, we have given up some operating leverage by investing in the retention and growth of our workforce over the past year. This was entirely necessary given the much higher business volumes. As our new people gain their footing, leverage will improve. To ensure it does, we recruit great people and onboard them with effective training, job shadowing and career development program. I'm also pleased to note that First National opened its new headquarters late in the first quarter and is now operating with a hybrid work in office, work-from-home approach for our teams in all locations across Canada. This is a welcome return to what could be called a new normal. Now over to Rob for his report on the first quarter. Rob?

[Robert Inglis, executive]

Thanks, Jason. Against the changing and somewhat volatile market backdrop, First National performed as management expected in the first quarter. Zeroing in on key performance indicators, total originations are up 2% over last year, which is a good accomplishment given the impact of a slower housing market on single-family originations, which were down 3% from last year's elevated production levels.

MUA increased 4% year-over-year and at an annualized rate of about 3% in Q1 on origination and retention improvement. Revenue was higher by 4%, the same as MUA, largely due to the impact of $27.9 million of gains on financial instruments, or about 2% lower than last year, excluding this impact. Measures of profitability were satisfactory. Net income was $1 million higher while pre-fair market value income was $18.9 million lower on tighter mortgage spreads, which affected placement fee revenue and higher employee headcount and compensation expenses to support our organizational growth.

And lastly, First National sustained its reputation as a high-yielding company with a monthly dividend payments at the annualized equivalent of $2.35 per share and a Q1 payout ratio of 67% or 108% excluding gains and losses on financial instruments. Describing these results in detail is really the job of the MD&A, but I'll comment on some of the items of interest. Because we have a robust hedging program, the company continues to protect the value in mortgages originated for securitization. With increases in interest rates, this hedging program generated gains of about $150 million and holding short bonds against our committed pipeline and funded mortgages in the quarter. Because of effective hedging accounting, only over $28 million of this has affected the income statement. Hedge gains are the advantage of monetizing net interest margins upfront, therefore reducing the risk to future securitization cash flows.

Because you often ask, I will also highlight 3 expense items, starting with broker fees. In dollar terms, these increased 1% year-over-year on 5% growth in origination volumes funded with institutional investors. The increase in broker fees lagged the increase in placement activity due to product mix sold. Shorter-term Excalibur loans with lower broker fees made up a larger portion of mortgages placed. Generally, we do not see any structural change in broker expenses, which are tied to volumes and loyalty. We continue to enjoy strong market share in the broker channel and provide good compensation and good service. That brings me to staffing expenses.

Salaries and benefits increased 17% to $48 million year-over-year on a 22% growth in FTE. Most FTE growth occurred in the residential underwriting departments. This is understandable given the relatively high volumes we continue to process and the need to sustain our competitive edge and reputation for responsiveness among brokers, borrowers and our third-party clients. As Jason mentioned, we lose some operating leverage until newcomers are fully acclimatized, but it's a necessary cost to bear for the long-term sustainability of the business.

And finally, CapEx. We expect to spend about $10 million annually. In the first quarter, the run rate was temporarily higher than that because of our move to 16 New York Street in Toronto. This new environmentally friendly facility provides the room we never had at our whole headquarters for things like staff training and has a logical layout for the teams in each department. It is, in short, an asset for our long-term future.

In closing, we are satisfied with the performance in the first quarter as MUA, the source of most of First National's earnings, increased to a record high. Our market outlook takes into account rising interest rates and the possibility of further slowing in housing and mortgage activity. We are ready. Structurally, our mortgage broker partnerships are strong as is our channel share, giving us good access to available opportunities. Our funding sources are broad and deep. We continue to take steps to create value for shareholders over the long term through our securitization activities and have now created a $35 billion securitization portfolio. And we look forward to generating income and cash flow from over our $87 billion servicing portfolio while focusing, as always, on the value inherent in our significant single-family renewal book. That concludes our prepared remarks. Operator, please open the lines for questions. Thank you.

[Operator]

[Operator Instructions] And your first question will be from Etienne Ricard at BMO Capital Markets.

[Etienne Ricard, analyst]

On the commercial outlook, you're guiding for strong originations near term, a little more cautious view as interest rates rise. How sensitive do you expect both your insured multi-unit and conventional originations to perform in the rapidly rising rate environment?

[Jason Ellis, executive]

I think, Etienne, that probably is a really great question because it's very difficult to predict. I think at this stage, we are looking ahead to how quickly the Bank of Canada may actually accelerate or not, its increases to rates. I think that as we see rates rising the cap rates used to value commercial properties will be moving, which will probably create some disconnect between where buyers and sellers view the market. I think that the pipeline presently though, is encouraging. There still seems to be a great deal of activity, particularly in the CMHC multiunit space. I would say that perhaps sequentially the conventional part of our commercial business has moderated relative to the CMHC portion. But I would say we are still looking annually to grow commercial origination year-over-year.

[Etienne Ricard, analyst]

And what's the mix between CMHC and conventional?

[Jason Ellis, executive]

I would say we are still predominantly a CMHC lender, but the mix between conventional and CMHC has been shifting towards conventional not to suggest that conventional would be more than CMHC. But what I mean to say is that the overall diversification of the product suite has been moving to more balance. I'd have to get back to, Etienne, off the top of my head, I can't tell you the split between insured and conventional last quarter, predominantly insured.

[Robert Inglis, executive]

I have some number. Yes, like before the pandemic, it was maybe 65% CMHC and 35% conventional. And during the pandemic, it swung 90% CMHC because nobody wanted to do anything that was not insured by the government. Q1 of last year, I think we went back to sort of the norms of 65% insured and 35% conventional. In Q1 2022, I think we're at 85% insured because really, it's dropped off the conventional but people that are investing in that are kind of like I see rates going up, where are spreads? I don't know, uncertainty breeds in activity.

[Etienne Ricard, analyst]

Okay. So we're back at 65-35?

[Robert Inglis, executive]

No, 85-15 right now.

[Jason Ellis, executive]

For the first quarter, yes. So let me just -- so I'll clarify my statement earlier. We had -- last year, we introduced what we called our core conventional products in the commercial department on the strength of strong investor support and definitely saw very, very constructive growth in the conventional commercial space. However, I would say, most recently, specifically in the first quarter, conventional commercial lending moderated relative to CMHC, but we're still looking for growth this year overall in both our CMHC and conventional books.

[Etienne Ricard, analyst]

Understood. And shifting towards single-family. How do you expect the Excalibur program to perform in this environment? In other words, should we expect Excalibur to perform better given immigration activity and economic reopenings for the self-employed?

[Jason Ellis, executive]

So performance in terms of origination volumes or performance in terms of arrears performance?

[Etienne Ricard, analyst]

Originations.

[Jason Ellis, executive]

Yes. Well, I think we're still very much in a growth phase with the Excalibur program. And so we're looking forward to significant growth in those origination volumes throughout the year. We've already begun our expansion out west with sales and underwriting staff in our Vancouver office, and we're seeing good traction there. So I think that despite perhaps the overall market calling for moderation in origination volume, the Excalibur platform should be a source of growth for us this year.

[Operator]

Next question will be from Geoff Kwan at RBC Capital Markets.

[Geoffrey Kwan, analyst]

You -- on the institutional placement fee rates, are you seeing any changes even directionally on where they're going in? Also can you refresh the rates that your institutional funders pay, is that a fixed kind of basis points over the term of a contract? Or are they, say, potentially like influenced where interest rates are at?

[Jason Ellis, executive]

So it's a combination of both, Geoff. The overwhelming majority of what we place with investors from our single-family production is fixed. So at the time we originate the mortgage commitment, that commitment is allocated to a designated investor, and that investor bears the subsequent interest rate risk associated with the committed mortgage. And so to that end, those mortgages attract a fixed placement fee with the investor. A much smaller portion of the single family is sold as a portfolio of loans once they've been funded. And in that case, you would have a more variable placement fee. That was the dynamic we saw having a significant influence on earnings during 2020, especially as we originated mortgages interest rates fall and then sold those mortgages at significant premium to the investors. And on the commercial side, it is more of a variable concept where the spread available on the mortgages relative to the CMB execution will drive those placement fees. So it is a mix. To sum it up, I guess, single-family, mostly a fixed placement fee and on the commercial mortgages a little bit more variable based on the spreads available in the market.

[Geoffrey Kwan, analyst]

Okay. That's helpful. On the underwriting side, have there been any tweaks just given it seems like the market is starting to slow. But also, too, is -- has there been anything on the underwriting side that's changed just given where home prices are and the increased potential for fraud to be happening? I mean it was something that OSFI had flagged of some issues within the industry recently?

[Jason Ellis, executive]

No, we certainly haven't detected any kind of trend as it relates to any kind of fraud, whether it's fraud for shelter or otherwise. And we've made no explicit changes to our underwriting or eligibility criteria. I'd like to think that we've always underwritten cautiously, and we haven't made any specific adjustments, no.

[Geoffrey Kwan, analyst]

Okay. And then just my last question was on the other expenses line, it's increased noticeably in the last few quarters. You flagged, I think, kind of hedging expenses in Q1. But just wondering is this a reasonable run rate? Or how do you think that this line on expenses might evolve in the upcoming quarters?

[Jason Ellis, executive]

Yes. I'll touch on one major component of it, and then I'll see if Rob has anything else to add. But you mentioned hedging expenses. So with the growth of our origination and the scale with which we fund mortgages through securitization, we've been running a fairly large hedge book. And as the market started anticipating Bank of Canada rate hikes, obviously, we saw 5-year government bonds move out ahead of those increases. So what we had was a very, very low repo rate on our short bond position relative to an increasing short yield on those 5-year bond hedges and that just created a much higher cost to carry those hedges, and that definitely had a significant impact on that expense line. Going forward, as the Bank of Canada and overnight rates catch up, so to speak, with the 5-year yields, we should see that moderate. So a flatter curve between the overnight and 5-year yield will definitely help that. Rob, what were some of the other major contributors to that?

[Robert Inglis, executive]

Yes. I think when you have an increase of, say, 20% in head count, you have to buy them computers and stuff, right? So definitely, the depreciation of equipment, et cetera, has been higher than it was before. Moving to 16 York, our new facility, it's fantastic, but it costs more money than the old place at the 100 University, sort of brand-new leaseholds there, brand new equipment, you leave a lot of stuff behind. So that's sort of added to sort of that expense line. So $1.5 million maybe in the quarter that will be there ongoing, I think. And just generally with the pandemic, not over, but a little bit over, people are traveling more. I think we had our sales conference for commercial guys. They all got COVID, but they had a good time, that cost about $0.5 million. So it's kind of a onetime thing, but those things going to add up for all of the discretionary expenses dissolved in 2020 and now they're kind of coming back.

[Operator]

[Operator Instructions] Your next question will be from Graham Ryding at TD Securities.

[Graham Ryding, analyst]

Your comment around the -- you got a question around just sort of how the placement fees work. Just to make sure I understand your commentary there. When you say it's a fixed fee, are you referring to that being a fixed placement fee at commitment as opposed to it being a fixed fee for perhaps like a period of time like the next 6 to 12 months? I just want to clear that up.

[Jason Ellis, executive]

Yes, sure. So we have purchase and servicing agreements with an array of third-party investors. They're not very -- they don't change very often. So the fee they would pay to us is that fixed fee as a percentage of the mortgage principle is set in advance. It's pretty constant. It doesn't change very much. We allocate the commitment to them. They manage that risk, and we then earn that placement fee on any of those committed mortgages that do fund. And if not a very volatile number, it tends to be pretty constant. Does that answer the question?

[Graham Ryding, analyst]

Yes. Yes, that helps. And my second question would just be on the credit front. I know you guys don't have a lot of direct credit risk. But you do indirectly because obviously, your mortgages are going to people that are putting them on their balance sheet. Can you just talk to me about sort of maybe the level of the magnitude of your concern here that we're in a pretty high inflationary environment. And could the rising rate sort of outlook ultimately lead to a recession and a credit cycle. Where is your sort of barometer on that risk?

[Jason Ellis, executive]

Right. Well, I mean, the most obvious barometer is what we're observing right now in the moment, and of course, we're not in a recession yet. Our arrears rates are at absolute record lows. There's very little activity in terms of arrears on the book right now. Looking ahead, one of the advantages of the tremendous runoff we've had in housing prices is that even on our conventional book at most 80% loan-to-value in recent years, if you look at some of the statistics in the market, a lot of those borrowers have added material amounts of equity as a result of housing prices increasing. So directly or indirectly, I don't think we view the risk of losses as significant for First National in any respect.

As far as my view on overall economy, obviously, employment is the most critical thing when it comes to the performance of your mortgage book. We're at record low -- record high employment levels right now. And I'm not seeing anything on the horizon to suggest that that's going to change materially. One thing we did during the pandemic certainly was that the earlier impact or the most significant impact to employment seem to happen on individuals that were not homeowners. We'll see what that plays out like if we do face any headwinds going forward.

[Graham Ryding, analyst]

Okay. And then just my last question would just be there was some commentary about the market being competitive and now putting some pressure on margins in the quarter. Sort of when you think about what you originated in March and April, have you been able to maintain that level of margins for your securitization NIM and placement fees? Or are you seeing any further margin...

[Jason Ellis, executive]

Yes, I think that things have generally leveled off here. And I think most recently, as I observed, Canada rates and other benchmarks versus our mortgage coupons, we probably had the opportunity to catch up a little bit. One thing about rates going up is that mortgage coupons tend to be a little bit sticky, chasing them up. But I feel like the market overall has done a good job of closing that gap. I think that we're probably where we're going to be, I think, for the balance of the year.

[Operator]

Next question will be from Jaeme Gloyn at National Bank.

[Jaeme Gloyn, analyst]

I just wanted to first dig in a little bit more on the expense side. In terms of the hedging costs in the -- I think it was like a $7 million increase year-over-year. How -- could you break that down between the cost that's attributable to the steeper curve and the cost that's attributable to just running a larger hedge book?

[Robert Inglis, executive]

I think it's -- I can just go ahead a little bit here on sort of the steep curve. We've always had a large hedge book. I mean for the last 3 or 4 years doing $15 billion of stuff for both things. We always have like $3 billion of notional hedge on. It's just a steep rate curve. I mean I think recently, the repo gives you almost less than -- well, maybe they give a little bit of money for borrowing the bond. Before it used to be a sort of margin there, now with a steep yield curve, you're hamstrung there. But I would say, too, that we're getting higher coupons relative to the interest we're paying to the banks on the borrowing and that shows up in mortgage investment income. So you see it was up like $6 million. So it's sort of like, yes, we have higher hedge cost, but yes, we're making more money here, they kind of offset.

[Jaeme Gloyn, analyst]

Okay. Got it. And then with respect to the employee costs, headcount, obviously, the big driver, but are you seeing an increase in, let's say, like the average cost per employee are there actual salaries increasing? And what kind of rate would that be sort of running at?

[Jason Ellis, executive]

Yes. So I think the pressure on the salary and benefit line has been a combination of things. Certainly, with this labor market, there's been an investment in both retention and recruiting. In terms of putting a number on the sort of year-over-year compensation per head, I don't have that at the top, Graham, probably put that in the -- or Jaeme, pardon me, in the 5% to 6% range. But I'd have to circle back on that. The pressure has definitely been a function of increased headcount, but retention has contributed, I think, overall.

[Jaeme Gloyn, analyst]

Okay. Understood. Next question is on the securitization margins. The commentary this quarter seems to be fairly consistent with the commentary last quarter about future margins will face a little bit of pressure. That should alleviate as prepayment speeds slow down and return to normal. But am I reading that right? Like we should still continue to see maybe a couple of bps of securitization margin pressure here for a few quarters until everything sort of normalizes?

[Jason Ellis, executive]

Yes. I think we're still -- I mean we've -- like I said a moment ago, I think that we've seen a good catch-up on mortgage coupons in the last sort of 2 to 4 weeks. The challenge is the fact that mortgage coupons tend to move slow relative to the benchmark, right? So it's that problem of catching up over and over as rates continue to move, I feel like the biggest moves in the sort of 5-year part of the curve have been expressed. I think a lot of what the Bank of Canada is planning to do was already built in there. So my hope is that we're currently at a point where I think that those securitization margins will stabilize from here on out in terms of new originations. It's a question of the schedule of stuff running off, and I don't have it at my fingertips. But I think that I think it's fair to assume there may be a couple of basis points of pressure in the coming quarters, but I don't think it should be a material change going forward.

[Robert Inglis, executive]

I'll just add a couple of things on prepayment. So there's 2 things on prepayment. There's the aspect of penalties versus your penalties to the pool. And as we described back in the pandemic, it was highly negative because yields are so low. Well, now it's gone back to sort of regular, the payout pays us a penalty. We keep that, and there's no cost to pay to -- on the paydown of the MBS. But at the same time, prepayment effects the amortization of the capitalized cost, right? So we have to pay a broker to originate the loan, does get capitalized. If it runs off faster than we thought, it's going to run off, that amortization gets higher. What we've seen that all through 2021, and it started off in 2022, it's still high, but we feel that someone's going to stop here because people have mortgages at 1.8%, 2%. They can't move anywhere else for advantage and housing activity will slow down, prepayment will slow down, which means the amortization of those upfront costs will also slow down in terms of amortization, which should help us. So prepayment has the 2 aspects, one of which -- both of which should get better as we go.

[Jaeme Gloyn, analyst]

Okay. Good. That's good color there. Last question from me is tied to the dividend. Typically, I would have expected a dividend increase or a small dividend increase. At this stage, it looks like the April dividend is still in line with where it's been the last several quarters or months, I guess, the monthly dividend. Am I -- is there anything to read into the, I guess, the lack of a dividend increase at this point? Or is there -- maybe I'm missing something on the timing?

[Jason Ellis, executive]

No, nothing to read into it. I think we'll continue to characterize ourselves as a high dividend paying company. And I think at this stage, we're just letting this year play out and see how things look. But I think that our general feeling about our dividend policy hasn't changed.

[Jaeme Gloyn, analyst]

Okay. Just taking a little bit more of a conservative approach to start '22?

[Jason Ellis, executive]

Right.

[Robert Inglis, executive]

I think it was really difficult in 2021 to set the dividend rate. And I think we knew that 2021 wasn't going to continue forever and ever. It's going to slow down. So we wanted to make a sustainable rate for the next year or so, and we did that. And I think the $2.35 was like a huge increase over the previous rate. So maybe we overdid it a bit in terms of the increase, but we're still comfortable this year in covering that dividend rate, of course.

[Operator]

And at this time, Mr. Ellis, we have no other questions. Please proceed.

[Jason Ellis, executive]

Thank you. Just a moment. I'll be with you in 1 minute.

[Robert Inglis, executive]

Should I do it? Thanks, operator.

[Jason Ellis, executive]

No I'm good. I got it. Sorry, I logged out and lost track of my sign off here. Thank you, operator. As there are no further questions, I'll remind you that our Executive Chairman, Stephen Smith, will host our Annual Meeting of Shareholders on May 5 at 9:30. We look forward to that and to reporting our second quarter results this summer. Thank you for taking part in our call, and have a good day. Thank you.

[Operator]

Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. Once again, thank you for attending. And at this time, we do ask that you please disconnect your lines. Enjoy your day.