First National Financial Corp

TSX:FN

Earnings Call Transcript 2023-Q1

[Operator]

Good morning, ladies and gentlemen, and welcome to First National's First Quarter Analyst Call. This call is being recorded today, Monday, May 01, 2023. At this time, all callers are in listen-only mode. Later, we will conduct a question-and-answer session and instructions will be provided at that time on how to queue up.

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, President and Chief Executive Officer]

Thank you, operator, and good morning, everyone. Welcome to our call and thank you for participating. Rob Inglis, our Chief Financial Officer, joins me and will provide his commentary shortly.

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.

I'll start with our short run expectations. In our last call, we indicated our expectation that mortgages under administration would grow this year, but that originations would be lower in the first half of 2023 than in the first half of 2022. Mortgages under administration have in fact grown to a record level despite lower origination in the quarter. We continue to expect that second quarter originations will fall short of the 12.2 billion we generated in last year's comparative period with year-over-year reductions in both residential and commercial volumes. That was not, however, the sum of our 2023 outlook. We also expressed our view that a more constructive housing market would emerge in the second half of this year. Our view in this respect is unchanged as well. We are already seeing signs of price stabilization and increased activity in the housing market. We still expect improvement in origination volumes in the second half. This constructive second half outlook assumes that the Bank of Canada will not raise interest rates again this year, that reduced uncertainty will encourage buyers to act and that employment levels will remain strong.

In general terms, we are expecting increased housing activity. But absent the incentive of extremely low interest rates, we're also expecting a reset to more traditional pre-pandemic origination volume.

As you know, originations including renewals are important in the maintenance and growth of mortgages under administration, and we can grow MUA in the short term even without growth in origination. Additionally, originations are not always material to earnings in the quarter in which they occur. Both points were illustrated in Q1 and form useful context for our Q2 outlook.

Thinking about sources of future business, we expect prime mortgages to dominate our single family lending, complemented by continued contributions from our Excalibur Alt-A business. Excalibur has not reached a point of maturity, so the portfolio has room for expansion. The recent edition of sales coverage in the prairies reflects our thinking. As a result of the market for this product and our expanded distribution, we think Excalibur volumes in 2023 will compare favorably to 2022. Despite the relatively small portfolio size, our limited credit exposure and the strong historical performance, there does seem to be a disproportionate amount of attention paid to the Excalibur program by some interested parties.

For those who worry about credit risk, some Excalibur facts may be of interest. The average credit score of borrowers is over 750. This is not a product defined by weak credit. The average loan to value of Excalibur mortgages is 68%, and Excalibur mortgage origination is limited to properties in primary and secondary centers where there is a high degree of housing liquidity. You may recall, out of an abundance of caution, we did not release any provisions related to this portfolio at year end given the uncertain economic outlook. However, the portfolio continues to exhibit strong credit performance with no realized losses in all of 2022 or year-to-date. We are not currently forecasting any change in the credit quality or performance of the Excalibur program. First National will always be known as a prime lender. But since relaunching Excalibur, it has been a valuable and risk managed source of business.

On single family prime, we continue to enjoy strong relationships with mortgage brokers and continue to offer competitive mortgage rates and broker incentives that reflect our position as a leading lender in the broker channel. We also continue to realize that our mortgage renewal opportunities, and in the first quarter we saw a modest increase in retention rate. Notable in the quarter was increased borrower interest in three and four-year term fixed rates. Typically, the preferred term for prime borrowers is five years. This shift in term may reflect borrowers' views that fixed rates will have declined by 2026, allowing them to renew sooner into a lower mortgage coupon.

Generally, new origination has shifted back to fixed rates regardless of term, with just 9% of new borrowers selecting an adjustable rate in Q1 compared to 56% in the same quarter last year. The portfolio of adjustable rate mortgages continues to perform well with no signs of stress from higher interest payments. 30 and 90 day arrears numbers remain low, and a test to portfolio resiliency and conservatism.

For our commercial mortgage business, we remain at the view that this year's volumes will be dominated by insured lending in the multi-unit residential space. CMHC programs, including MLI Select launched last year are very popular with borrowers. That said, CMHC recently announced an increase in premiums for all forms of multi-unit residential housing effective in June, their first increase in six years. It remains to be seen how borrowers will react, but even with the change which ranges from 85 basis points to 155 basis points, lengthy amortizations at high loan-to-value make insured mortgage products uniquely valuable and competitive in the multi-unit space. The preponderance of insured multi-unit mortgages in our commercial portfolio also creates risk management advantages for First National during times of stress for assets like offices and shopping malls.

As it relates to conventional commercial loans, they're funded by investing partners with no residual credit risk to First National. Thinking about profitability, our outlook assumes the tailwinds that push securitization NIM ahead in Q1 will continue in the second quarter. Specifically, we anticipate normalized spreads between prime and CDOR compared to last year, and a continued moderation of prepayment trends, allowing the securitized portfolio to grow and slow the amortization of capitalized upfront origination costs.

To put context to that comment, our fixed rate NHA-MBS was prepaying at about 14% annualized in Q1 last year. This year it’s 4%. In Q1, last year, our adjustable rate NHA-MBS portfolio was prepaying at a 22% annual rate. This year, it's down to 12%. Of that 12%, about 1/3 is attributable to conversion from floating to fixed rate, a trend that is also slowing. As a result, mortgages pledged against securitization have grown with a positive impact on net interest income. Given the way the yield curve has evolved, we're also now generating positive carry on our hedging activity, a reversal from much of last year, which is also something we anticipate will continue.

Before wrapping up, a comment on funding. We have a large and diversified pool of funding sources. And as an approved issuer of NHA-MBS and seller into the Canada Mortgage Bonds program, we use securitization to minimize our funding costs. So it is noteworthy that the recent federal budget included a paragraph on the CMB indicating that the government is reviewing the program in relation to its regular borrowing strategies with a view to capturing the credit spread on the CMB program and reinvesting this basis in affordable housing programs. The government has promised additional details in its fall 2023 economic statement. We would surmise from this announcement that some funding will continue to be available, and we hope that the government's new strategy will be as effective in providing stable and predictable funding as the CMB has been for the past 22 years.

To summarize, we expect originations in Q2 to be below last year's levels with improvements in the second half of 2023, net interest margin tailwinds to continue to support profitability and good performance by the First National team as we continue to capitalize on all available opportunities to serve our stakeholders.

Now over to Rob.

[Rob Inglis, Chief Financial Officer]

Thanks, Jason. Q1 performance tracked to the expectations we set on our last call. MUA grew 7% year-over-year to a new record $133 billion, despite a 21% decrease in total mortgage origination. We experienced that volume decline in both single family down about 25% or $1.4 billion, and commercial, which was down 12% or about [$288 million]. In context, single family volumes were still $1.7 billion above the level we generated in Q1 2019 before the pandemic led to extraordinary housing activity, and this year's commercial originations are $600 million higher than before the pandemic. In light of today's realities and perhaps return of traditional winter seasonality, we are very happy with Q1 2023 originations.

Since we issued Q1 results on Friday, I'm certain everyone took the weekend to analyze the results. Accordingly, I will be brief, starting with Q1 revenue. Continuing the trend of the last five quarters, it grew year-over-year. All of the 23% increase reflected higher mortgage coupons in our securitized portfolio, a result of rising rates over the past 12 months. Net of the impact of higher interest rates incurred to fund this portfolio, revenue was about $176 million, including changes in gains and losses on financial instruments. Because of the large moves interest rates, this revenue changed by $39 million year-over-year. Excluding fair value based revenues, net revenue grew 9% from the 2022 first quarter as the growth in securitization NIM and mortgage investment income offset lower placement fees.

Placement fees were lower by 13%, a result of lower origination over gains on deferred placement fees, which we earned in originating and selling multis to institutional investors more than doubled year-over-year. This reflects success in our commercial segment with a mix of insured versus conventional mortgages tilted as we expected to favor the insured business. Q1 mortgage investment income was 46% above last year as we earned more interest income on the portfolio and on mortgages accumulated for securitization. Mortgage servicing income was also almost the same year-over-year, reflecting two offsetting factors: First, servicing income grew in tandem with MUA and benefited from higher interest earned on escrow deposits. These positive gains are offset by reduced fees earned on activity in our third-party underwriting platform, which reflected the slower housing market.

Unlike Q1 last year when the inflationary environment drove bond yields higher, leading to large gains on the short bonds we used to hedge single family commitments, bond yields fell to open 2023 as the market priced in a possible recession. This created a quarterly loss on short bonds of about $11.1 million.

Looking now at expenses, we continued to operate with a much larger team than we did in 2019 before the pandemic. That's well justified given the origination volumes remain well ahead of 2019 levels. Even so, we have kept a sharp eye at expenses in the context of an inflationary environment. Brokerage fees increased 27% over last year on a similar -- decreased 27% over last year on a similar decrease in single family mortgages originated for institutional investors.

Generally per unit fees were comparable to the [2002] first quarter. Going forward, per unit broker fees will continue to reflect market dynamics, which is very competitive right now.

Looking at our core measure of profitability, Q1 pre-fair market value income increased 32% year-over-year. This change reflected a cumulative effect of growth in our securitized mortgage creating five and 10-year income streams. This net securitization income plus higher commercial mortgage placement fees with institutional investors in Q1 drove this core measure higher. Ongoing profitability, supported ongoing dividend payments, an annualized rate of $2.40 per share, as well as the company's reputation as a high yielding stock. Our payout ratio in the quarter was 103% or 84% excluding gains and losses on financial instruments.

Now in closing, given the market reset and our expectations entering 2023, the results of the first quarter were well in line with our expectations, projections, and reflect First National's resiliency, the benefit of diversification and revenue sources, and of course, the ongoing value of what is now a $133 billion of MUA. We expect Q2 will be another challenging period for the market and First National by extension, but our outlook for the first half of the year remains constructive.

Now we'll be pleased to answer your questions. Operator, please open the lines. Thank you.

[Operator]

[Operator Instructions] Your first question will come from Geoff Kwan at RBC.

[Geoff Kwan, RBC Capital Markets]

My first question was just, if there's any numbers you can give behind, say it, like the percentage of borrowers this year that have renewed, that have been able to renew with no problems, given high rates and everything going on? And also too, just if any sort of numbers, again, percentage of borrowers, whatever that have sought help as they've had any sort of difficulty making mortgage payments?

[Jason Ellis, President and Chief Executive Officer]

Hi, Geoff. So 0% is the answer, as it relates to our adjustable rate portfolio, so those mortgages where payments reset along with changes in the prime rate, we continue to see an arrears rate in that portion of the portfolio that is equal to or less than the entire portfolio. So we're not seeing any issues on that side. And as it relates to the fixed rate borrowers who are now renewing into a higher rate environment than they were five years ago, we're not seeing any issues.

In fact, we've noted that our retention rate has increased slightly overall on renewing mortgages. And we're not currently engaged in any programs to relieve borrowers who are having any problems, because we're not seeing it yet.

[Geoff Kwan, RBC Capital Markets]

Okay. That's helpful. And then just my second question was on Excalibur. Thanks for the data points that you gave in your opening remarks. But I'm just wondering if you can remind just what credit risk you might have given how you're funding it, but also to what the typical mortgage terms are on those mortgages and any exposure to variable rates within the Excalibur segment?

[Jason Ellis, President and Chief Executive Officer]

Sure. Well, as it relates to variable rates there is no exposure. The Excalibur program is a fixed rate program exclusively. We have no adjustable rate option. It tends to be, or it is one, two, and three year fixed rates. And I would say that probably skews towards the one and two year rates being the most popular. As it is with our prime book, we continue to renew and move forward with our Excalibur book without any signs or indication of stress from the borrowers through that renewal process.

[Geoff Kwan, RBC Capital Markets]

Okay. And on the credit risk.

[Jason Ellis, President and Chief Executive Officer]

Right, on the credit piece, yes. So, like all of our originations, we fund our Excalibur program through a combination of securitization and whole loan sales to third-party balance sheets. Rob might be able to check me on this, but I think we probably have in the context of $2 billion worth of Excalibur in our securitization programs, but I'm not sure if that's right.

Rob, does that sound right to you?

[Rob Inglis, Chief Financial Officer]

Yes, that's close enough. I think maybe a little bit more, but things happen, but around $2 billion.

[Jason Ellis, President and Chief Executive Officer]

Yes, so around $2 billion. And of that Geoff, our actual exposure from a credit perspective would represent 15% of that principal balance, 15% representing our credit enhancement in the program to achieve an R-1 High rating on the resulting commercial paper.

[Operator]

Your next question comes from Nik Priebe at CIBC Capital Markets.

[Nik Priebe, CIBC Capital Markets]

I'm just trying to understand the relationship between a pair of trend lines that seem a bit counterintuitive to me. So, over the past 12 months total originations and renewals are down 15%, but total mortgages under administration are up 7%. And if I were to compare that to 2021, which was a stronger housing market environment, originations and renewals were up by about the same magnitude. But MUA only grew 4%. So I guess in that context, my question is, what conditions are necessary for an acceleration of MUA growth? Like would you expect a recovery in the housing market activity later this year to translate to a higher level of MUA growth above and beyond 7%?

[Jason Ellis, President and Chief Executive Officer]

That's an interesting two point comparison there, Nik. So, can you just repeat for me again the two moments in time or the two data points you were referencing?

[Nik Priebe, CIBC Capital Markets]

Sure. I mean, if I just look at the past 12 months total originations and renewals are down 15% year-over-year, but total mortgages under administration are up 7%. And then I just compare that to 2021, as we would agree the stronger market environment, in that year, originations and renewals were up 14%, but MUA growth was comparatively slower at 4%.

[Jason Ellis, President and Chief Executive Officer]

I think the answer probably boils down to the extreme prepayment speeds that we saw. So, during the pandemic originations were extreme to be sure, but as I even mentioned during my comments, I think we were seeing prepayment speeds. And if we were to use our NHA-MBS portfolio as a reference point for the market, fixed rate portfolios were paying at something like 22% annualized. It was hard to keep up with the runoff in the portfolio. So, one of the benefits we've seen with this moderation in the market as a result of higher rates is the incentive and propensity for borrowers to prepay for the benefit of refinancing your mortgage perhaps away sooner has gone away. So, I think it's a prepayment speed thing, but you've peaked my curiosity, so I'll probably look at the various inputs and maybe send a note out if I can, but it's -- yes, originations versus renewals versus liquidations. And we'll see how those all fit together. But I think prepayment speed is the answer.

[Nik Priebe, CIBC Capital Markets]

Now that makes sense. That's kind of what I suspected. And I think last quarter you had signaled that securitization NIM could benefit from certain tailwinds in 2023 particularly on the floating rate component of that portfolio. Now that policy rates have stabilized at least temporarily, do you expect any further benefit beyond the level achieved in Q1? Or is that Q1 securitization NIM a pretty reasonable baseline expectation for the balance of the year?

[Jason Ellis, President and Chief Executive Officer]

I think it's a pretty good expectation. I mean, at the very margin, all else being equal, there's a little bit of room left on that basis between the prime rate on the mortgages and one month CDOR, which forms the coupon on our adjustable rate MBS. I think in the quarter that probably averaged in the context of 170 basis points. I think the longer run average between those two benchmarks should be 180 to 185. So there's a little bit of room there, yet.

[Operator]

Your next question comes from Etienne Ricard at BMO Capital Markets.

[Etienne Ricard, BMO Capital Markets]

On credit quality, the regulator noted extending amortization as a risk for financial institutions. The first part of my question is, what patterns are you seeing on amortization periods coming up for -- for mortgages coming up for refinancing? And the second part is, are you seeing more competitive pressures from lenders that might be more willing to take on risk via longer amortization periods?

[Jason Ellis, President and Chief Executive Officer]

Okay. So, the first part of the question would be pressure on amortizations, on renewals. So all of our mortgages amortize according to contract. So our -- the mortgages on our portfolios that have resetting coupons are adjustable rate mortgages. And so their payments change with every change in prime, which means those borrowers stay on AM. So when they come up to maturity, no adjustments are required, and there has been no extension or pressure on their amortization term. So that's not a thing we're dealing with at First National specifically, in terms of competition from peer lenders willing to offer longer amortizations. Our principal addressable market is the insured prime one as it relates to the single family space. And obviously there we have amortizations prescribed by CMHC.

And then on the conventional side, similarly, OSFI has limits of -- on amortization. So we're not seeing amortization as a point of competition. The only place we see that would be in the Alt-A space, and we do see some Alt-A lenders offering longer amortizations in the 35 to 40 year range perhaps. But it's not material in the context of our business.

[Etienne Ricard, BMO Capital Markets]

Understood. And as you noted, the government announced its intention to launch consultations on the structure of the Canada Mortgage Bond program. I recognize it is still early in the process and details have yet to be released. That being said, what would you say needs to be preserved in the current structure of the CMB in order to ensure continued liquidity in the securitization market?

[Jason Ellis, President and Chief Executive Officer]

I think, not -- I think liquidity will be maintained. I think the government, in what little it has said, made it clear that it's important that whatever path they follow, there will be continued liquidity for mortgage funding, especially mortgage funding that supports the mandate for creating rental stock and affordable housing generally. But I think structurally, for First National and lenders like us, the regular frequency and dependability of the CMB issuance allows us to communicate CMB funding effectively at commitment to the borrowers. So we're able to quote a spread over a hedgeable reference benchmark, so we can offer borrowers CMB plus, lock them in at a spread, that allows them to then hedge their underlying CMB interest rate risk and properly price out and proceed with their project. So I think that ability to see into the future and reference and hedge against a knowable execution is critical to the program. And we'll be communicating that to the Department of Finance as best as we can.

[Operator]

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

[Graham Ryding, TD Securities]

You touched on it a little bit, but I was just wondering, are there any sort of arrears numbers you could provide both on your single family prime and your Excalibur? Maybe just what sort of change you're seeing quarter-over-quarter, year over year on the arrears front?

[Jason Ellis, President and Chief Executive Officer]

Yes. So broadly speaking, unchanged. So 30 days plus, which would be, I guess, a much broader measure is unchanged period-over-period. So virtually record low, Graham.

On the Excalibur side, we had a small increase in absolute numbers, like, half a dozen mortgages in the 90 day plus increase quarter-over-quarter. But the total number of mortgages is like 11. So -- in a percentage term, it might look as though the Excalibur program changed materially in the 90 day plus in terms of -- it's just -- we started from such a low base that a couple of loans trickled into the 90 day plus. But those loans specifically have low loan to values, are in liquid centers, and actually don't present any risk of credit loss at this point.

[Graham Ryding, TD Securities]

The CMB, are there any sort of changes here that you're anticipating or is this situation still very fluid? And how much are you funding annually currently through the CMB program?

[Jason Ellis, President and Chief Executive Officer]

Yes, the situation is decidedly fluid. So I mean, there's really very, very little information other than this idea that they've presented in the budget. As far as our utilization of the CMB, I would say probably fair to say that we maximize our utilization every quarter. Changes to the CMB structure or the way funding related to the CMB is delivered should be manageable. Again, we don't really know what form that's going to take. And not forgetting that there's always just the direct secondary market for NHA-MBS issuance as well. So that may evolve to fill a gap if necessary.

[Graham Ryding, TD Securities]

And can you remind me, is the CMB primarily -- are you funding your multi-unit originations through that program or is it both single-family and multi?

[Jason Ellis, President and Chief Executive Officer]

Both. Yes, so we would leverage the Canada Mortgage Bond for both single family and multi-family. However, the 10-year for First National tends to be an exclusively multi-family strategy.

[Graham Ryding, TD Securities]

Okay, understood. And then just my last question, if I could, just broadly speaking, obviously there's been lots of pressure in the U.S. on the regional bank in front, just with funding and liquidity. Have you seen any impact on your business from a funding perspective?

[Jason Ellis, President and Chief Executive Officer]

No, none whatsoever. So fortunately, it would seem that the nature of our banking system in Canada has proven it's resilience in terms of just having big D-SIBs and national banking presence. By extension with the deposit taking institutions with whom we do business, we've seen absolutely zero change in their appetite to acquire mortgage assets. And anecdotally, I understand that OFSI has been speaking to some of the smaller and medium sized banks, and fortunately it wouldn't seem that there's been any impact on deposit levels here in Canada. So, so far, no impact.

[Operator]

Your next question comes from Jaeme Gloyn at National Bank Financial.

[Jaeme Gloyn, National Bank Financial]

Yes, thanks. Just wanted to dig into the expense side just a little bit. So, if I'm breaking it down using sort of stable commissions on commercial originations, obviously you talked about a spiker or jump in employee wages and benefits, expenses. Just wondering if you can frame that a little bit for us, what kind of wage increases are you seeing across the board? And is there -- is that more sort of in your, let's say, blue collar employees versus white collar employees? Maybe a little bit more color around that?

[Jason Ellis, President and Chief Executive Officer]

I don't know. Rob, do you have any insight there?

[Rob Inglis, Chief Financial Officer]

Yes, sure. We don't define employees like that, Jaeme. They're all good employees. I mean, in general, like there's across the board merit or inflationary increase that we provide to employees in January of every year. I think, this year it was higher just because inflation was higher, the cost of living was higher, right? So I think just in terms of Q1 versus Q1, flat sort of in terms of number, but up to 3% wherever it was because of higher wages.

[Jason Ellis, President and Chief Executive Officer]

I'd probably add to that too, that over the course of the pandemic, we definitely saw a lot of migration in terms of employees. And I think the housing market, especially given how active it was, we did see a lot of pressure on our residential underwriting team. So there may have been also some salary adjustments along the way there that have accumulated over the last 18 months.

[Jaeme Gloyn, National Bank Financial]

Okay. Fair enough. And then on the other operating expense line, what I've understood in the past is that lower interest rates would help in terms of lowering the cost of hedging, which is something that flows through there. But -- and we saw like a fairly low number in Q4. It spiked up quarter-over-quarter here in Q1. You identified some travel expenses as some of the drivers, I guess for a year-over-year increase. But what would be driving that Q4 to Q1 increase in other operating expenses?

[Jason Ellis, President and Chief Executive Officer]

Well, Jaeme, first I'd add that, I think we re-classed all the hedging, right? So the hedging could be a big number, if there was a change between CDOR and the Government of Canada rates, so that now shows up in interest expense, right? So we've re-presented the comparative numbers such that all those numbers are now in interest. So that won't have an impact on other operating expenses.

[Jaeme Gloyn, National Bank Financial]

And so what's driving the Q4 to Q1 specifically, and then like when thinking about Q1, it's about 18 million. Is that -- as we think about other operating expenses, is there something in Q1 that bumps that number higher versus Q4 and then it'll trickle down or move lower in Q4? How should you think about those other operating experiences?

[Jaeme Gloyn, National Bank Financial]

One thing is technology a little bit. I think at the end of that, sort of every year you have to pay for various things for crypto security, for example, just the licenses for Microsoft, which everybody in the whole office uses. And we tend to sort of we prepay those and amortize those on occasion, but sometimes we just say, you know what, we'll put it through in Q1 and be done with it. So I think Q1 is a bit heavy in terms of that expense. And we have a launch for commercial and residential. They have offsite team meetings to launch the year, which are a little bit expensive. We shouldn't have a big deal in terms of overall cost. But in terms of Q4 versus Q1, that'll pop up a little bit. Maybe less than $1 million.

[Jaeme Gloyn, National Bank Financial]

In that, I think you said crypto security, but I just want to confer, is that cybersecurity?

[Jason Ellis, President and Chief Executive Officer]

He meant cybersecurity. Yes, yes. No crypto activity. Many moneys on cyber.

[Operator]

There are no other questions on the phone lines, so I will turn the conference back to Mr. Jason Ellis for any closing remarks.

[Jason Ellis, President and Chief Executive Officer]

Okay, thank you again, operator. Before we depart, a reminder that First National will host our Annual Meeting of Shareholders on Tuesday, May 16, 2023 at the TMX Market Centre in Toronto, starting at 10:00 AM. We look forward to seeing you there and reporting on our Q2 results this summer. Thank you for participating and have a great day.

[Operator]

Ladies and gentlemen, this does conclude your conference call for this morning. Again, we would like to thank you for your participation and we ask you to please disconnect your lines.