First National Financial Corp

TSX:FN

Earnings Call Transcript 2023-Q2

[Operator]

Good morning, and welcome to First National’s Second Quarter Analyst Call. This call is being recorded on Wednesday, August 2, 2023. [Operator Instructions]

Now it’s 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 CEO]

Thank you, operator. Good morning, everyone. Welcome to our call, and thank you for joining us. 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 management discussion and analysis. Second quarter results exceeded expectations. Pre-fair market value EBITDA of $89.8 million was 61% higher than the same quarter last year. Residential origination, including renewals, while modestly stronger than expected at $7.4 billion, was still down 12% when compared to the same period last year.

Commercial originations were down just 3% with relative strength in our CMHC-insured multifamily originations. Despite lower originations overall, our business model proved its resiliency. Recurring revenue from servicing and net interest earned on our portfolio of securitized mortgages delivered expected stability to our financial results. Key to maintaining these predictable and recurring revenues is the continued growth of mortgages under administration even during periods of reduced originations. Residential MUA grew 6.1% and to $92 billion, and commercial MUA grew 12.9% to $46 billion.

Our return to more traditional prepayment speeds has been an important factor in facilitating this growth. Higher mortgage rates have reduced the incentive to refinance midterm and more mortgages are reaching maturity, resulting in more renewal opportunities. For context, annualized liquidation rates on fixed-rate MBS in the second quarter as published by CMHC averaged approximately 25% in 2021 and 20% in 2022, but just 9% this year. Offsetting lower placement fees on lower origination and relatively fewer mortgages placed with institutional investors was growth in net interest income as both mortgages pledged under securitization, and net interest margin grew. Again, lower prepayment speeds contributed to this result.

Despite media headlines, residential mortgage arrears remain near historical lows. The 90-day arrears rate is virtually unchanged from last quarter at approximately 6 basis points. Of course, there continues to be a disproportionate amount of attention directed towards floating rate mortgages.

As a reminder, First National issues adjustable rate mortgages. Payments adjust with every change to the prime rate, and our borrowers remain on their amortization schedule. The arrears rate on the adjustable rate portfolio continues to track that of the broader portfolio, with no signs of stress from higher payments presenting itself yet. Not surprisingly, new originations are now skewed towards fixed rates. Just 8% of borrowers in the second quarter selected an adjustable rate compared to 62% in the same quarter last year.

New Excalibur originations were down consistent with the overall residential experience. Arrears in the Alt-A book are flat compared to last quarter, and there has been no meaningful change in any of the average portfolio metrics, like loan-to-value, credit scores or debt service ratios. On the commercial side of the business, we’re very pleased with origination volumes and with growth in MUA, especially against the backdrop of a commercial market that has broadly experienced reduced transaction activity. Looking ahead, in light of the last 2 rate hikes by the Bank of Canada and the marginal impact to affordability, we are reviewing our expectations for residential originations in the second half. We no longer anticipate that originations in the second half will exceed those from the same half last year.

We still believe, however, that on a relative basis, the second half will compare to last year more favorably than the first half did. Our outlook for commercial originations is more optimistic. In March, CMHC announced an increase in insurance premium rates for all multifamily residential products, taking effect on June 19. Advanced notice of that change caused a surge in activity as borrowers look to submit applications to CMHC ahead of the premium increase. This has created a strong pipeline of multifamily commitments to fund later in the year and into 2024.

Last quarter, we mentioned the announcement by the Department of Finance that it would be engaging the market in a consultation on possible changes to the Canada Mortgage Bond Program. We’ve since had a meeting with stakeholders from finance, CMHC and the Bank of Canada to share our views, and look forward to an update this fall. To sum up, the second quarter exceeded our expectations, supported by the work of our First National team. Higher rates may result in some moderation to housing activity in the second half of the year, but growth in mortgages under administration will continue to drive servicing and net interest income in support of ongoing profitability. Now over to Rob.

[Rob Inglis, CFO]

Thanks, Jason. As Jason mentioned, despite lower year-over-year origination volumes, MUA increased 8% to a record $137.8 billion at June 30 and 14% higher on an annualized basis during the second quarter itself. Growth in MUA has been supported by a return to a more normal prepayment speeds relative to those experienced during the pandemic. Based on these trends, we expect MUA to continue to grow this year. Moving now to our financial results.

Q2 revenue grew year-over-year. But excluding the impact of higher interest costs incurred to fund the securitization portfolio, net revenue was about $257 million including the changes in gains and losses of financial instruments, a 2% increase. Net interest income and net interest margin are also both higher than Q2 last year. This is a function of several factors, including slower prepayment rates, a larger Alt-A securization portfolio and a growing commercial segment portfolio. Going forward, we expect net interest income and margin to be relatively stable.

Second quarter featured large gains on financial instruments as bond yields increased, and the value of the company’s short bond position held against single-family commitments went up. Excluding these fair value-based revenues, net revenue was unchanged year-over-year as growth in securitization net interest margin offset a 30% reduction in placement fees. Placement fees were lower due to a 39% decrease in new residential origination, which was sold to institutions, and lower per unit fees earned for renewed mortgages. Generally, these per unit fees were lower as some customers chose shorter renewal terms due to the higher rate environment. However, gains on deferred placement fees, which we typically earn in originating and selling commercial mortgages to institutional investors, more than doubled year-over-year.

This reflected larger volumes sold into these programs than in 2022. Q2 mortgage investment income was 41% above last year as we earned more interest income on the portfolio and the mortgages accumulated for securitization. Mortgage servicing income increased 13% year-over-year on growth in MUA and strong performance by our third-party underwriting business. Generally, underwriting business revenues were similar to the second quarter of 2022. But after a slow first quarter as the entire market suffered, we are very pleased with this result.

Third-party underwriting remains a good adjunct to our business model and a valuable way to leverage our core competencies and assist our customers and mortgage brokers. Unlike Q1, when bond yields fell as the market priced in a possible recession, bond yields rose in the second quarter linked to large gains on the short bonds we used to hedge single-family commitments. This created a quarterly gain on short bonds of just over $36 million. A similar interest rate environment last year meant there were gains in Q2 2022 on short bonds of $31.7 million. Looking now at expenses.

Broker fees expense in the quarter were lower year-over-year on lower origination volume and relatively fewer placements with institutional investors. Per unit fees were similar between the periods. Salaries and benefit costs decreased 7% year-over-year in Q2 and were flat to Q1. FTE was lower year-over-year due to attrition and up modestly between the quarters. In context, the market for great talent remains tight.

Looking at our core measure of profitability, Q2 pre-fair market value income increased 61% year-over-year. This very positive performance reflected the cumulative effect of several components: growth in our securitized mortgage portfolio, superior results from servicing our institutional MUA and some operational efficiency throughout the organization. While higher interest rates negatively affect origination and the cost of board funds, the company benefited from high rates in 2 ways: the value of holding the escrow deposits for our borrowers; and two, favorable cost of carrying interest rate hedges, which has reduced interest expense in the quarter. Ongoing profitability supported ongoing dividend payments at an annualized rate of $2.40. Our payout ratio for the quarter against net income attributable to common shareholders was 41% and or 55%, excluding gains and losses on financial instruments.

We consider our pre-fair market value dividend payout ratio, the more relevant of the 2 measures as it reflects core operating performance. Either way, we have a good coverage for the dividend over the first half of the year, the pre-fair market value payout ratio was 67% for the first 6 months of 2023. As always, I would encourage you to review the full text of our MD&A for financial analysis and our outlook. In summary, second quarter results exceeded our expectations, which continue to be tempered by the ongoing impact of higher interest rates and real estate activity across the country. While origination declines were lower than anticipated in the quarter, recent Bank of Canada rate increases appear to be taking another bite out of market activity.

On the plus side, there are various ways in which we generate revenue through our business model continued to serve us well in the quarter and should benefit us in the final 6 months of the year as we earn income what is now a $38 billion securitization portfolio and a $97 billion servicing portfolio. Now we’ll be pleased to answer your questions.

Operator, please open the lines. Thank you.

[Operator]

[Operator Instructions] Your first question comes from the line of Nik Priebe from CIBC Capital Markets.

[Nik Priebe, CIBC Capital Markets]

I just wanted to drill into servicing fee revenue a little bit here. It looks like on a sequential basis, MUA was up very modestly quarter-over-quarter, but there was a much larger step-up in servicing fee revenue. Can you just talk about maybe the seasonality element there and the proportion of those fees that would be derived from interest earned on escrow deposits? Just trying to understand the pattern of revenue recognition for that line item a little bit better.

[Jason Ellis, President and CEO]

Yes. So that servicing line, Nik, includes the fees earned in providing third-party underwriting services. So sequentially, quarter 2 featured much higher volumes of mortgage originations relative to the first quarter, and that would explain the majority of the change in the servicing line sequentially. I would say, second to that, more year-over-year, certainly the interest earned on tax escrows and P&I collections held in trust contributed. But sequentially, that was not as significant a contributor.

[Nik Priebe, CIBC Capital Markets]

Understood. Okay. That makes sense.

[Jason Ellis, President and CEO]

And I guess for clarity, the sort of per unit servicing fee that we would earn on the servicing portfolio is unchanged.

[Nik Priebe, CIBC Capital Markets]

Okay. Okay. That’s good. And then as you I think alluded to in the prepared remarks, borrower preference has clearly shifted quite meaningfully towards fixed rate mortgages against a more uncertain interest rate environment. Does that dynamic have any direct impact on the economics of your business? Like I’d imagine it could entail somewhat higher hedging costs. But is there anything else that we should be aware of there?

[Jason Ellis, President and CEO]

No, I think the only material thing you actually touched on is, of course, there is a hedging aspect to committing on a fixed rate, which doesn’t exist on a commitment for an adjustable rate. Otherwise, our math to determine the appropriate rates on both products is similar and should result in similar outcomes for us.

[Operator]

Your next question comes from the line of Etienne Ricard from BMO Capital Markets.

[Etienne Ricard, BMO Capital Markets]

Well, first off, congrats on your partnership with BMO, clearly a sign of confidence in the mortgage broker channel. What’s interesting in my view is that with BMO’s return, there is now a majority of the banks present in the broker channel. I’m curious in your discussions with banking partners, such as BMO and TD, what do the banks value most in the broker channel that is more challenging to replicate in more traditional distribution channels?

[Jason Ellis, President and CEO]

I think, generally speaking, the banks recognize the scale and continued growth of the broker channel as a source of distribution for residential mortgages. I think it continues to be an increasingly relevant place to originate. And I think demographically, younger and newer borrowers are using the Internet and nontraditional channels to access financial services generally, including mortgages. So I feel as though it’s something they can’t ignore. And as a result, they’re turning their mind to it.

To the extent that BMO made the decision to outsource the activity of adjudication and fulfillment of the mortgage applications, I can’t speak to definitively. But I imagine having been absent from the channel for a period of time and perhaps viewing the success of TD by outsourcing that activity, may have turned their mind to the idea. We’re thrilled to have earned mandate. And I think you’re right. I think it’s a great endorsement for the channel, and we think it’s a great endorsement for the service we provide here at First National.

[Etienne Ricard, BMO Capital Markets]

Do you believe it’s only a matter of time before all of the banks operated in the broker channel? And I guess in that scenario, do you see the banks more as an opportunity to form partnerships or more as a threat to First National’s market share?

[Jason Ellis, President and CEO]

That’s a good question. I guess I could see it rubbing both ways. The opportunity to work alongside the banks as a service provider is a great diversification opportunity for revenue streams in a way to leverage our core competencies of underwriting and both servicing which we continue to provide as a third-party service as well. I guess there’s always a risk of having 1 share diluted as more and more participants enter the market. But I right now don’t have any clear indication that the other D-SIBs are on the verge of making any significant changes with respect to their view of how they access the market.

[Operator]

Your next question comes from the line of Geoff Kwan from RBC.

[Geoff Kwan, RBC]

I just wanted to follow up on the BMO arrangement that you have there. Then you kind of came out, if I remember correctly, right at the end of June, is that when they would have started up in the broker channel? Or is it going to take a bit of time for them to kind of get the products and everything all kind of lined up? So I’m just wondering when that starts up. And also two is, are the financial terms of the agreement how similar is it to the other 2 biddings that you’re [dealing] within the broker channel?

[Jason Ellis, President and CEO]

So BMO did disclose that the final work is still being completed to ready themselves for their reentry to the channel and are looking at a January time frame to begin receiving applications. So for First National, in terms of revenue generation, this will be a 2024 event. But a lot of the very, very heavy lifting has now been done, and we’re looking forward to getting started with them. As far as the financial terms, I really can’t speak to them, but I can say that the service we’re providing to the bank in support of their reentry to the broker channel, is very, very, very similar to the work that we provide to the other 2 counterparties.

[Geoff Kwan, RBC]

Okay. And just my second question was just on the placement -- institutional placement fee rates. I know -- I mean, it was a little bit lower than, I guess, what it typically is, and there was some reference to it in the MD&A. Is that just more of a little bit of a blip that can happen from at times quarter-to-quarter? Or is there something in the current environment with maybe where rates are at or whatnot that might see, even if it’s a near-term issue, some degree of movement in the placement fee rates you’re receiving?

[Jason Ellis, President and CEO]

No, I would say that the quarter featured an unusual thing in the selection by borrowers. Rob mentioned on renewals, but also through the quarter, there was an unusually large number of borrowers selecting 3-year terms. Again, I think some borrowers, perhaps advised by their brokers or on their own terms, viewed a shorter term, albeit at a higher rate, the better strategy as they looked ahead to an earlier renewal and an opportunity to access what they viewed perhaps lower rates in the near future. So the per unit placement fee was affected by the shorter-term mortgages originated in place.

[Operator]

Your next question comes from the line of Graham Ryding from TD Securities.

[Graham Ryding, TD Securities]

Just wanted to go back to the mortgage servicing income was a big lift quarter-over-quarter and year-over-year, and the new flag third-party underwriting fees were actually up year-over-year, which is a bit of a surprise just given the market was quieter. So can you talk about, like is that from your 2 partners that you’re servicing? And is that market share gains on their part? Or do you have more than -- do you have more institutions than maybe you did last year or something like that?

[Jason Ellis, President and CEO]

Yes. No, I’ll clarify. Third-party underwriting fees as a function of third-party volumes were up sequentially in Q2 versus Q1, but I would say largely comparable to Q2 of last year. And to the extent that they weren’t materially lower than the same quarter last year, it may speak to relative market share for our counterparties. Now I note that one of the most significant competitors in the channel traditionally has been Scotia Mortgage Authority. And through the end of last year and into this year, they have been less aggressive in their stance, and that may have contributed to some of that.

[Graham Ryding, TD Securities]

Okay. That makes sense. And then the other area in the quarter I thought was a contributor to the strong result was lower interest expense, and you flagged a couple of things. Lower amount of mortgages accumulated for sale, is that deliberate on your part? Or is that something that’s just volatile quarter-to-quarter and kind of out of your control?

[Jason Ellis, President and CEO]

I think that’s just the fact that originations were reduced relatively speaking. Now sequentially, of course, higher, but versus the same quarter last year, originations were lower. And by extension, mortgages accumulated for sale would be lower.

[Graham Ryding, TD Securities]

Okay. And then how material was the -- I think you mentioned hedging-related gains? I think interest expense was actually down both quarter-over-quarter and year-over-year.

[Jason Ellis, President and CEO]

Yes. So the change would be more pronounced year-over-year. But it is significant in that if you look back to the second quarter last year, we were still in a scenario where there would be negative carry being short a 5-year bond relative to the overnight repo rate that we would earn against covering those short positions flash forward to this quarter, and it’s quite an inverted curve between overnight repo rates and 5-year government bond yields. And so on a typical portfolio of $2 billion of short bonds, that transition from expense to net positive carry is a meaningful structural change and definitely a nice tailwind to our results that we expect to enjoy for the remainder of the year.

[Graham Ryding, TD Securities]

Okay. Understood. My last question, just on the mortgages or the MUA growth, up 8% year-over-year. That looks high for you relative to sort of your track record and your run rate, looking at years past, your originations are down double digits year-over-year. So can you just give me some color perhaps I missed at the beginning of the call, I got on late, but is it higher renewals and less runoff, or what’s sort of keeping -- driving the strong MUA growth?

[Jason Ellis, President and CEO]

There’s no question it is lower prepayment speeds resulting in more mortgages available to us -- or not only are they staying with us, we’re given the opportunity to retain them at renewal. Like you heard me mention during our prepared comments, prepayment speeds throughout the pandemic were extraordinarily high. So it really was a bit of a treadmill originating mortgages, as you saw, mortgages running off the book. With the rate environment we’re in, the utility to midterm refinancing is gone and the prepayment speeds have slowed to the point where we really are seeing the impact to MUA as mortgages are more sticky. With respect to the actual retention rate on the mortgages that reach maturity, it’s not materially different than it has been over the years.

Maybe a percentage point or 2 higher, which is great. Each percentage point actually really adds up on the renewal book. But generally speaking, it is the lower prepayment speed and the fact that mortgages are just not running off nearly as quickly.

[Graham Ryding, TD Securities]

Okay. So I got 1 more, if I could. Just you mentioned the CMB and the Department of Finance, not with you, including some others. Did they give you any indication of the options that they’re considering? And then what the potential impact on the business would be on those potential scenarios, or is it too early to discuss?

[Jason Ellis, President and CEO]

I think it’s too early. I mean they certainly said that they were keeping all manner of options open, if there was a positive outcome to that conversation, I was pleased that the recognized the utility of some of the key structural elements of the Canada mortgage bond as it exists now, the transparency around frequency of issue, the ability to access a bond like the CMB itself to hedge future issuances, allowing lenders like First National to communicate rates and rate commitments to commercial developers, and really to help communicate housing policy through the program as intended. So we weren’t the only ones that expressed interest in maintaining that kind of structural element of the program. And I was pleased with their response to that concern.

[Operator]

[Operator Instructions] Your next question comes from the line of Jaeme Gloyn from National Bank Financial.

[Jaeme Gloyn, National Bank Financial]

A question just on prepayment. Obviously, lower in the last couple of years than -- or last year or so than the years prior. Just wondering how it’s been trending more sequentially, let’s say, and how you’re thinking about it in Q3 or Q4 even just as housing activity kind of picked up here in the spring, would you anticipate a continued sequential increase in prepayment activity flowing into this quarter, maybe next?

[Jason Ellis, President and CEO]

I think we’re -- so if I were to pass my mind back over the long term, I would characterize prepayment anywhere between 8% and 12% is what we would expect and model in our amortization of investments in securitized mortgages. I think the 9% in Q2 that I referenced in our comments is based on all fixed rate NHA-MBS. I would say First National’s own experience was closer to about 7%. So low on a historical basis. I don’t see us trending much below that going forward.

There’s always going to be, regardless of the rate environment, people who move, people who change jobs, so on and so forth. So I think sequentially, we’re probably going to level off. But given the rate environment and given the limited opportunities to refinance for economic benefit, I don’t see that going higher in the near term. So I do think we’ll continue to benefit from the advantages that the slower prepayment speeds give us for the remainder of the year at least.

[Jaeme Gloyn, National Bank Financial]

Okay. Okay. And so of course, the read-through there is still some tailwinds on the securitization NIM. And then maybe the headwind, if I understand correctly, that these, let’s say, I guess, does lower prepayment help or hurt demand for mortgage loans. So like from an institutional investor perspective, just look -- read in that comment of lower opportunities after accelerated prepayment, sort of talking through the per unit fee rate and placement fees.

[Jason Ellis, President and CEO]

So per unit fees are unaffected by prepayment speeds. When we sell mortgages to institutional investors, we earn an upfront origination premium. The only piece that might be at risk is if mortgages are prepaying faster, they leave the book and we stop earning servicing income going forward. So again, stickiness of MUA helps in the continued generation of servicing revenues. And as it relates to the securitization book, obviously, it allows us to continue earning the NIM. One of the important contributors though, as it relates to the securitized portfolio and NIM, is when prepayment speeds were quite high, it wasn’t just that we were losing the principal balances from the securitized book, but we had to accelerate the amortization of the capitalized costs to originate and securitize those loans, the guarantee fees paid to CMHC, the fees paid to brokers who originate the deals and the like. So the tailwind is twofold. One, the mortgages stay on the book longer, which allows the actual principal balance in the portfolio to grow.

Similarly, Rob doesn’t need to accelerate any of those amortization of costs, which is -- which had been a headwind for NIM during the higher prepayment speed era. So I think that from here, prepayment speeds have stabilized. I think that the securitized portfolio will have an opportunity to continue to grow. But net interest margins will probably stabilize from here, all else being equal.

[Jaeme Gloyn, National Bank Financial]

Okay. Yes, that’s good on the NIM and then on the per unit. And then I guess my question was just getting to how institutional investors view the prepayment landscape, as in like the last couple of years of lower prepayment versus maybe accelerated prepayment prior to that. Like does that -- does the level of prepayment affect buyer demand and the rate they’re willing to pay for these mortgages?

[Jason Ellis, President and CEO]

Understood. Right. Well, I mean, to the extent that they’re seeing their assets run off faster than they may have planned, assuming they continue to have the liquidity and capital that they need to put to work, it may very well contribute to their go-forward demand for new originations. So you’re right, all else being equal, I think high prepayment speeds were constructive as they look to replace assets. Slower prepayment speeds, all else being equal, could moderate their demand. However, our experience over history is that demand for prime conventional and high ratio insured mortgages is virtually insatiable across the D-SIB landscape.

[Rob Inglis, CFO]

And what they’re paying for a fee is the same this year as it was, let’s say, 3 years ago. They haven’t changed the pricing.

[Jason Ellis, President and CEO]

Yes. I mean -- yes, if you want to drill right down to it, yes. Per unit fees to sell mortgages to our best institutional investors is unchanged, and we don’t anticipate any change to that going forward.

[Rob Inglis, CFO]

I think on the comments before, last year or last quarter, probably doing more 3-year term stuff, which would give us a lower price from the institutions, because they have a 3-year duration as opposed to a 5 year. We prefer to sell a 5-year, but a lot of 3 years going through the books this year.

[Jaeme Gloyn, National Bank Financial]

Okay. Great. And then last one, and maybe it’s a bit early at this stage, only halfway through the year. But payout ratio on pre-fair market value income is trending below. I think the target is like 70%, correct me if I’m wrong on that one.

And what we’ve seen in years past is maybe a little bit of a true-up or special divi payment to bring that payout ratio even closer to 100% as you’re sort of seeing stabilization in the market, potential for recovery next year, like what -- how are you thinking about dividend growth and maybe special dividends in the Q4 period, is that something that’s on the board topics these days?

[Jason Ellis, President and CEO]

So I’d say that our attitude to our dividend policy is unchanged. It’s the same as it’s ever been. You’re right, it’s probably early yet to suggest any expectation. As always, we will look as we move through the rest of the year at our opportunities to deploy any excess capital within the business to generate the kinds of high return on equities our shareholders have come to expect. If it came to pass that we saw no opportunity to do that, we would revisit our capital and make a decision at that point as to what we think the appropriate level would be to carry forward. So we’ll keep you posted.

[Operator]

There are no further questions at this time. I’d now like to turn the call back over to Mr. Ellis for any closing remarks.

[Jason Ellis, President and CEO]

All right. Thank you, operator. We look forward to reporting our Q3 results in October. Thank you for participating, and have a great day.

[Operator]

Thank you, sir. Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines. Have a lovely day.