First National Financial Corp

TSX:FN

Earnings Call Transcript 2021-Q2

[Operator]

Good morning, and welcome to First National's Second quarter Analyst call. This call is being recorded on Wednesday, July 28, 2021. [Operator Instructions] Now it's my pleasure to turn the call over to Stephen Smith, Chairman and Chief Executive Officer of First National. Please go ahead.

[Stephen J. R. Smith, Co]

Thank you, operator. Good morning, everyone. Welcome to our call, and thank you for participating. Also on the line with me are Rob Inglis, Chief Financial Officer, who will provide quarterly performance highlights; Jason Ellis, our President and Chief Operating Officer, will discuss our outlook. Since the MD&A provides full details, our prepared remarks will be brief. Before we begin, I'll 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.First National results in Q2 were very positive and reflected the strong and resilient housing market. Mortgages under administration, the source of most of our earnings increased 6% over last year to $121.5 billion. This is the 60th consecutive quarter of MUA growth since we went public in 2006, which is a testament to our vision 15 years ago and reflects the effectiveness of our business model.Looking at some of the factors that drove performance this quarter origination was up significantly in both segments of the business. Single-family originations increased 71% to $7.6 billion, not only was this a new quarterly record, it was ahead of the previous record by more than $1.5 billion. We continue to benefit from a strong share of the mortgage broker distribution channel, which is our exclusive source for single-family production. Technology-enabled service through Nolan continues to be a differentiator. Not only is Nolan a long-time driver of our brokerage partnerships, it has been the foundation of our strong results during the pandemic.While prime mortgages are our core offering in single-family, we continue to build our all-day presence with the originations for our Excalibur program. Growth in the B.C. market now complements our activities in Ontario, where the majority of production takes place. For our commercial business, Q2 originations increased 25% to almost $2.7 billion, including renewals, Commercial segment business was up 34% over the 2020 quarter.This growth reflects a strong property market, particularly money -- multiunit departments and renewed the bank for conventional loans that augmented our overall growth. As you may recall, commercial originations were lower in Q1 than the prior year, which was partly a function of timing and partly the fact that Q1 last year was unusually strong. Both business segments, these base year effects may continue to skew results over the course of the next two quarters. What's important is the longer-term trendline, which is positive.Another driver of performance was first National's third-party underwriting and fulfillment processing business. Our bank customers had great success in the marketplace and First National contributed by adjudicating mortgages originated through the broker channel in accordance with our customers' underwriting policy. This business leverages our technology and adds another revenue source. Rob will talk about other influences on performance, including changes in capital market conditions.On all sides of the business, the people of First national were very busy. We want to take this opportunity to publicly thank them for their diligent efforts in addressing record production. For shareholders a key takeaway is that earnings were steady, as we benefited from higher origination and wider mortgage spreads.Earnings in turn supported the Board's decision taken in May, and effective in June, to increase the regular monthly dividend to an annualized rate of $2.35 per share. This is the 14th increase in shareholder payouts since First National's IPO in 2006 and cements the company's reputation as a high-yielding dividend paying company. For the quarter, the common share payout was 66% or 65% if we exclude gains and losses on financial instruments. We consider this a healthy and sustainable level.Overall, we're very pleased with First National results to-date. Like you, we follow Bank of Canada announcements closely and take comfort from their economic projections for 2022. While the pandemic isn't behind us yet, it would appear that a return to a more predictable, healthy economy lies just ahead. With that, I'll turn the call over to Rob.

[Robert A. Inglis, Chief Financial Officer]

Thanks, Stephen, and good morning, everyone. Stephen mentioned some of the key drivers of performance, including MUA, which is up 6% year-over-year and 6% on an annualized basis in the quarter itself. Revenue also grew at the same rate, although, the increase was affected by changes in fair market value of financial instruments these changes are driven by interest rate movements. If we exclude that effect, revenue was 4% higher than last year, still a good showing.Biggest driver revenue growth was the 82% or $17.3 million increase in net interest from securitized mortgages. There are a number of moving parts in this number. One is from the comparison to Q2 2020, which was a period of financial turmoil. Last year, the Bank of Canada cut overnight rates by 1.5%, and First National followed suit by cutting our prime mortgage rate. However, the reduction in interest rates in our funding sources, namely NHA-MBS and asset-backed commercial paper conduits was slower to take effect. This reduced securitization margin last year by $6 million. In 2021, spreads on floating rate mortgages have been pretty normal.The decrease in interest rates also significantly increased the cost of indemnities payable to NBS debt holders last year, as our single-family borrowers increased mortgage prepayment to take advantage of the lower rate opportunities. Repayment still influences revenue, but not to the same degree. We estimate a more stable interest rate environment, save the company about $8.1 million in such indemnities. Of course, the 6% growth of mortgages pledged at securitization had a positive impact we shifted our funding strategy to allocate more origination volume to securitization, which is economically more favorable for long-term results, even though it does delay the recognition of earnings to future periods under current IFRS.Mortgage servicing income was another strong contributor for the company this quarter, and it's driven by growth in our third-party business that Stephen mentioned. Placement fees were consistent year-over-year despite lower revenue per unit. Increased residential origination volumes sold to third-parties were offset by a shift in allocation to First National's own securitization programs for the Commercial segment. Expenses in the quarter were generally higher, reflecting growth in capacity expansions brokerage expenses increased by 71% or $25 million year-over-year, largely due to a 78% increase in single-family originations for institutional investors.Commercial segment broker fees and portfolio insurance costs, which are included here, were lower than in 2020. Wage costs increased 26% on 40% growth in full-time employees to keep pace with the record volumes of underwritten mortgages and the higher MUA. Interest expense, much like investment income decreased 10% due to the decline in short-term lending rates. And as a footnote, during the quarter, we extended the term of our syndicated bank facility by 2 years and increased the commitment amount by $250 million.This gives us now $1.5 billion of liquidity price to reflect our BBB issuer credit rating. Now over to Jason.

[Jason Ellis, President & COO]

Thanks, Rob, and good morning, everyone. The second quarter was very successful for First National, delivered by a team still largely working from home. As much as we enjoy the benefits of our business model and technology advantages it still takes significant effort by people to make these results happen. My sincere thanks to all members of the company for your hard work and perseverance. In light of business volumes, we have added materially to our workforce and First National now employs over 1,500 people, 40% more than a year ago.People power gives us the ability to do more for our customers and partners, but it also requires careful attention to onboarding, training and advancement. We've had to be creative over the past year to foster our entrepreneurial culture while remote work has been the order of the day. We do see an end to the worst effects of the pandemic on the horizon. And as Stephen said, the Bank of Canada did send some positive signals about GDP next year. And as a result of the substantial amount of liquidity in the financial system, there continues to be strong mortgage demand from institutional investors. And as you saw from Q2 results, securitization markets are robust and continue to provide consistent and reliable funding for First National.From a housing market perspective, including single and multifamily residential, the reopening of the border to immigration when it happens, should create a tailwind. However, we share the Central Bank's view that the housing market activity is likely to ease back from historical highs. With the strong results of the second quarter, our outlook remains positive for the remainder of 2021. In the short term, the expectation for the next quarter includes continued strength in originations and employee productivity from the company's work-from-home strategy.The second quarter of 2020 was the start of the economic recovery following the pandemic-related economic turmoil experienced in the first quarter of 2020. Accordingly, growth rates in the first 6 months of 2021 reflected a 2020 comparative period highlighted by significant economic uncertainty and financial disruption. In the remaining 6 months of 2021, comparisons will be made to the last two quarters of 2020 that featured an exceptionally strong housing market.From a business plan perspective, we are well positioned to execute on our objectives. Throughout the pandemic, and as we prepare for a post pandemic world, our strategy will continue to rest on our 4 cornerstones. First, to provide a full range of mortgage solutions for Canadian single-family and commercial customers, a range that has increased recently with the regional expansion of Excalibur and greater institutional appetite for conventional commercial loans.Second, to grow mortgages under administration, the source of most of our earnings. Third, to employ technology to enhance our service to mortgage brokers and borrowers alike, and fourth, to lower costs and rationalize business processes while maintaining a conservative risk profile. We believe consistency of approach will provide long-term profitability and sustainable brand recognition for First National in a competitive marketplace.I'll conclude by reminding you of a fundamental advantage of being a mortgage lender with our business model, and that is the ability to continually generate income and cash flow from our $33 billion portfolio of mortgages pledged under securitization and $86 billion servicing portfolio. We will also focus, as always, on realizing the value inherent in our significant single-family renewal book. This concludes our prepared remarks. Now we will be pleased to take your questions. Operator, will you please open the line for questions.

[Operator]

[Operator Instructions] Your first question comes from Etienne Ricard from BMO Capital Markets.

[Etienne Ricard, Analyst]

So good momentum on single-family originations, given the strong real estate activity. Could you update us on market share gains, both for the broker channel and First National's on market share in the broker channel? And how would that compare relative to last year?

[Jason Ellis, President & COO]

Etienne, it's Jason here. I don't -- we don't yet have full visibility on the second quarter market share within the broker channel. There's usually a bit of a lag in that reporting coming to the market. In terms of the broker channels share of overall new mortgage origination, difficult to say. I think early on in the pandemic we imagined that given the traditional bank channels were closed or had reduced services that perhaps there would have been some modest increase in overall market share for the broker channel. Difficult to put a number on that, but it seems reasonable to expect that there may have been some transition of volume to the broker channel, and some of that should be sticky going forward. As far as First National's own performance, our market share, I think, continues to put us consistently in second or third position in the broker channel. And I think all indications are that we should continue to expect that kind of success.

[Etienne Ricard, Analyst]

And on the commercial front, it's great to see the increased allocations from CMH-C for affordability link housing. How meaningful are those allocations? And can you provide any guidance, as to how the spreads on those new securitizations that would compare to your existing portfolio?

[Jason Ellis, President & COO]

So first national has traditionally maximized its utility of CMH-C securitization programs. In addition, First National for a long time has been a leading lender in the CMH-C insured multifamily space. So the ability to leverage the affordable linked cooling, resulting in additional capacity into the 10-year CMB program has been a great advantage to First National, which we've taken advantage of. Generally speaking, the spreads on pools containing affordable linked, multifamily mortgages are comparable to those of the non-affordable linked pools. However, with the advent of these new allocation rules, there has been some enhanced competition, as you can imagine, in that space. So perhaps a modest compression of spreads going forward could be expected.

[Etienne Ricard, Analyst]

And last question for me. Maybe a more thematic question on the housing market. I mean, how are you seeing the second half of 2021? I mean, mortgage rates remain low, high household savings rates. If we are in the new normal of sub 2%, sub 3% mortgage rates, do you believe mortgage credit growth could remain at elevated levels relative to history?

[Stephen J. R. Smith, Co]

No. I think we're going to see in the second half of a relative moderation compared to Q1 and also, they'll be strong. In Q2 of 2020 was really quite exceptional, as was Q1 of 2021. I think some of the numbers we're getting out of sales for June, and also we have some visibility in July would indicate that growth in mortgage sales, while strong in historical terms have moderated a little bit relative to the dramatic activity of the past 12 months. I'm a believer that I'm not a bigger believer in interest rates being the determining factor. I think one has to take into account. It's an interesting number, but commitment by First National in March 2020 were the highest for the entire year. So we had actually pent-up demand independent with the interest rates. Certainly, lowest interest rates help, but it was, I think, lack of supply in major markets, such as Vancouver and Toronto tends to drive sales. I think that's continuing, but not quite at the same level as before.

[Operator]

Your next question comes from Graham Ryding from TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

I just wanted to ask you about the placement fee revenue yield. Your comments said that there was lower spreads in the market so that had some impact, I think, in the quarter, but also higher commercial volumes that you chose to securitize instead of play. So do you have any sort of visibility? Or could you provide any color, perhaps? Just is this -- should we consider this a long quarter for that placement fee yield? Or is this potentially like a reasonable run rate when we're looking out for the rest of this year and into 2020?

[Robert A. Inglis, Chief Financial Officer]

Yes. Graham, it's Rob. A number of issues there. The biggest thing is comparing to a very unusual quarter in Q2 2020. So if you remember, in Q1, we hedged a lot of our commitments, and we came out on the wrong side of those hedges, so we had a huge fair market valuable loss. On the other side of the equation though, those commitments had a lot of value. So when they funded in Q2 2020, we sold them on a sort of whole loan basis or kind of a placement of funded mortgages and got the value out of those mortgages in placement fees. So that was sort of an unusual situation because we kind of wrote off a huge loss in Q1 and made the money back partially in Q2. In Q2 of this year, that didn't happen. We just had regular sort of placement fees that sort of pre-pandemic spreads, prices. And I think I wrote that was worth maybe a $90 million change year-over-year in the single-family. And then in commercial, we have securitized a lot more because we can, and it's economically a better decision for us, but we don't get a placement fee for that stuff. So even though we have the product, that was worth, I think, a $10 million change in placement fee. So for going forward, I think maybe for commercial would be the same unless CMH-C changes their mind and says, you know what, we're going to ratchet back the affordability allocation scheme we've done.

[Stephen J. R. Smith, Co]

I guess the principal difference, Graham, under the affordability allocation you can sell a lot more into the Canada mortgage bond. So as a result, rather than selling them to third parties getting the gain on sale, we gain the income over time. So this is a case where the overall economic value to the corporation is enhanced by securitizing mortgages ourselves as oppose to selling it to institutional investors getting gain on sale.

[Jason Ellis, President & COO]

So I would say Q2 2021 placement fee per unit is more sort of consistent, and that will be appropriate for going forward. Q2 last year was sort of a different sort of accounting and to rely on our value like kind of stuff, so we're preparing a very turbulent quarter to a period of back to regular sort of business.

[Graham Ryding, Research Analyst of Financial Services]

So it sounds like you're going to -- as long as the allocation and the competition allowance, you're going to continue to fund some of those 10-year commercial margins via securitization going forward. It sounds like that's the plan?

[Jason Ellis, President & COO]

Yes.

[Graham Ryding, Research Analyst of Financial Services]

And when I think about your -- historically around $11 billion is what you would securitize annually, but I just look at your sort of funding mix. Has that number -- like has your capacity now increased with that, what did you call it like affordability program that has that capacity on the securitization front increased materially?

[Jason Ellis, President & COO]

It has increased perhaps modestly as opposed to materially, but one of the additional factors is those affordable linked pools do not count against the $9 billion securitization cap that lenders are faced with. So it allows you to issue greater than $9 billion of NHA-MBS without incurring the higher NHA-MBS guarantee fees that might otherwise be attributable to the volumes, about $9 billion. So it does give us a little bit of extra flexibility.

[Graham Ryding, Research Analyst of Financial Services]

And just my last question, that your mortgages under administration. It seems like the run-off rate has picked up a little bit relative to sort of historical levels. Is that just a reflection of the low interest rate environment and then just being more people sort of looking to perhaps opportunistically refinance some more activity?

[Jason Ellis, President & COO]

Yes, that's it exactly. We've seen that prepayment speed accelerate across the industry. It should be in relative terms temporary.

[Stephen J. R. Smith, Co]

I don't know whether that is low interest rates because you could -- you can refinance, but generally, you pay an interest rate differential. It's more just the heightened activity in the housing market with people buying in housing.

[Operator]

[Operator Instructions] Your next question comes from James Gloyn from National Bank Financial.

[Jaeme Gloyn, Analyst]

Yes. My question is just on the broker fee expenses and the rate there around loyalty incentive payments. And I'm just curious as to like the mechanics of those payments. Are they paid based on volume in that quarter and incurred in that quarter? Or is this something that sort of accrues throughout the year, and we could expect to see higher brokerage fee rates for the rest of this year? Or is that -- will that move lower as volumes move lower as well?

[Robert A. Inglis, Chief Financial Officer]

James, it's Rob here. A number of things, the number of loyalty things we have, some of it is a volume based. And typically, it's pay at the end of the year, but we accrue it monthly as we go. Some of it is, I think, an efficiency bonus, saying if you send a lot of your deals to First National as opposed to other lenders, we will give you some money for that. There's also a specific broker-by-broker loyalty. It's like a travel program that we -- we do a lot of deals with First National, and you're on [ wizer ], which means you're a good customer, you get more basis points for that. So I think it's really normalized now. It's not like we're increasing those programs. I think with a little bit of consolidation in the industry, it used to be 80% of our brokers got those rewards, now it's about 99% of the borrowers get those rewards. That's a little bit of timing. I think when we accrued last year based on our best guess about volume. But of course, last year, volumes were 50% ahead of plan, so we had to pay out a lot more than we bought for individual broker incentives. But I think going forward, it's sort of -- it's going to be steady now.

[Jaeme Gloyn, Analyst]

And so would the brokerage fee rate then stay elevated at these levels for the remainder of the year? Is that the takeaway on that front?

[Robert A. Inglis, Chief Financial Officer]

Well, I'm sure we elevated. I think it's just sort of sort of as expected. I mean, a lot of different things go into that line. There's commercial brokerage, which could be the 0 or a big number, there's portfolio management. And also there is -- we take some of those broker fees and we capitalize them to our balance sheet when we securitize, that's a bit of an allocation game. Sometimes, you leave a little bit behind in the income statement, as opposed to capitalize it because our capitalization program is a little bit conservative. A whole bunch of issues like that, but I think it's pretty well sale. Not growing a lot.

[Stephen J. R. Smith, Co]

Are you thinking there elevated?

[Jaeme Gloyn, Analyst]

Well, just compared to some previous years where I look at the brokerage fee rate more in sort of like the 60 basis points range, and it's been sort of running at about the low to mid-70s basis points range here over the last few quarters and even last year, I guess, given the stronger mortgage production.

[Robert A. Inglis, Chief Financial Officer]

Well, I'll tell you that, typically, as we pay a broker all in, including sort of the delivery cost about 1.2%. So I'm not sure what ratio you're calculating. So typically, this year, I think it's 1.22%, which is very similar to last year. So maybe just the numbers you're using aren't the right numbers to use?

[Jaeme Gloyn, Analyst]

Yes, maybe we'll take this off-line then.

[Operator]

So there are no further questions at this time. I'll turn it back to Mr. Smith for closing remarks.

[Stephen J. R. Smith, Co]

Thanks, operator. We look forward to hosting our third quarter results in October and thanks for taking part in our call. And have a good day, everyone.

[Operator]

Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your line.