First National Financial Corp

TSX:FN

Earnings Call Transcript 2020-Q3

[Operator]

Good morning, ladies and gentlemen, and welcome to the First National Third Quarter 2020 Analyst Call. [Operator Instructions] This call is being recorded for replay purposes on October 28, 2020, at 10:00 a.m. Eastern Time. It is now my pleasure to turn the call over to Stephen Smith, Chairman and Chief Executive Officer of First National. Please proceed, Mr. Smith.

[Stephen J. R. Smith, Co]

Good morning, everyone. Welcome to our call, and thank you for participating. Rob Inglis, our Chief Financial Officer; and Moray Tawse, Executive Vice President, are also on the line. 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. As you saw from our earnings release last night, Q3 was a record quarter for First National. Growth in volumes produced strong growth in our profitability metrics. To be precise, Q3 2020 pre-fair market value income was ahead of Q3 2019 by 25%. If you recall, Q3 2019 at that time was also a record quarter ahead of 2018 by 28%. As a result of the strong earnings over the past year, First National has generated capital in excess of what the company needs for our growth objectives. Accordingly, our Board of Directors announced a special dividend of $0.50 per share payable on December 15, 2020, to shareholders of record at the end of November. In addition, with some clarity now for our 2020 fiscal year, the Board also increased the regular monthly dividend with the dividend payable on December 15. The annual dividend rate will increase from $1.95 per share to $2.10 per share. We strive for consistency and sustainability in our performance. I'm pleased to say our nonbank business model has delivered both over many years. In fact, this is the fourth consecutive quarter -- I'm sorry, the fourth consecutive year the Board has authorized a special dividend and the 13th time since our 2006 IPO that our dividend or distribution has increased. The most recent increase moves our annualized dividend rate by almost 8% year-over-year. For those long-time shareholders who have stayed with us, inclusive of the payments we will make next month and in December, First National will pay a cumulative total of $25.80 in dividends or distributions per share since our IPO at $10 per share in 2006. We're proud of this track record and determined to build on it in future years. Turning to the highlights of Q3. MUA surpassed $117 billion as a result of 8% annualized growth in the quarter itself and growth of 6% annualized in September 2016 (sic) [ 2019 ]. As MUA is a significant driver of earnings, this growth is important. Looking at contributors. The contributors, both segments, residential and commercial, achieved very strong growth in new production and made the most mortgage renewal opportunities. Single-family mortgage originations were 42% or $1.7 billion higher than a year ago. All our regional offices achieved double-digit year-over-year production growth. The growth leaders were Québec and British Columbia with increases of 69% and 61%, respectively, over last year. We believe this growth...

[Operator]

Ladies and gentlemen, please...[Technical Difficulty]

[Stephen J. R. Smith, Co]

I would suggest the Canadians are much more inclined to favor physically distance technology-enabled solutions today as they search for a mortgage, and this is exactly what First National and our partners have always offered. Unlike the branch operations of the banks, which have been disrupted by the pandemic, our MERLIN underwriting system has continued to operate without fail to assist Canadians through their mortgage broker partners in getting the best combination of service, choice and value. Not to be ignored, of course, is the fact that home purchasing activity across the country was remarkably strong during the quarter. Supported by low interest rates, it became easier for home buyers to qualify for a mortgage. I think it's reasonable to say we were all surprised by the strength of the market given the pandemic conditions. While we knew from commitment activity in May and June, Q3 would be good, it exceeded our expectations. Through the first 9 months of 2020, total single-family production, including renewals, amounted to $18.2 billion, $4.2 billion or 30% above last year. For the quarter, single-family renewals were ahead of last year by about 14%. On the commercial side, new mortgage originations were $1.7 billion, $256 million or about 18% above last year. Unlike in Q2, we saw growth both in insured and conventional market production. As you may recall, we saw some investors in conventional mortgages pause their activities early this year to assess risks, which caused us to focus more heavily on CMHC-insured programs. Now some of these investors are returning. First National's ability to expertly fund a variety of different commercial mortgage types is a clear advantage that I believe our customers appreciate. While market share is difficult to calculate in commercial, I have to believe we have captured more of the market as we maintained our strong presence while some of our competitors step back. Once again, the vast majority of our commercial fundings were on multiunit residential properties, which continued to perform well for owners and developers. As much as technology is a driver of First National success, the most important ingredient is our people. Up and down the line in both single-family and commercial, our team has adjusted very well to working from home, and over these past 7 months has maintained a good level of efficiency and productivity. We are asking them to continue their fine efforts from home to protect everyone's health and safety. I'll now ask Rob to provide details on quarterly financial performance before Moray comments on our outlook.

[Robert A. Inglis, Chief Financial Officer]

Thanks, Stephen, and good morning, everyone. We're very pleased with third quarter performance. Even in a period without a pandemic, these results will be considered very strong. Looking first at revenue increased 3% over last year or 4% if we exclude the impact of changes in fair market value gain and losses related to interest rate movements between the quarters. Revenue growth was driven by higher placement fees. Placement fees increased 41% or almost $29 million compared to Q3 of last year, reflecting, in large part, the 48% growth in mortgage volume with institutional investors. Now looking deeper, placement volume in our commercial segment grew by 16% because mortgage spreads were twice what they were last year. Placement fees in this segment increased by 133%. There will come a time where mortgage spreads will normalize, but with continued uncertainty in the economy, these spreads seem to be lingering at least so far in the fourth quarter. This growth was partially offset by a decrease in placements of renewed mortgages as the company chose to securitize these instead. Mortgage servicing income also increased in the quarter by 5% over last year as reflected growth in revenue earned in the company's underwriting and fulfillment processing sources business as our third-party customers are also growing their market share and benefiting from the advantages provided by MERLIN. The growth was more than enough to offset decreases related to lower administration fees, particularly for mortgages on deferred payment plans and lower interest rates on escrow deposits. Growth was also registered in deferred placement fee revenue, which was ahead of last year by about $9 million. This reflected higher product originated for these programs, but the bigger driver were wider spreads on the mortgages. Not all sources of revenue grew. Net interest revenue earned on securitized mortgages decreased by 3% or about $1 million, largely due to the indirect consequences of the pandemic on securitization spreads, and the cost of indemnities payable to NHA-MBS debtholders when mortgages prepaid prior to their scheduled maturity dates. These indemnities are calculated to make whole NHA-MBS debtholders who are assumed to reinvest the prepayment principle at risk-free reinvestment rates. As was the case in Q2, the costing of indemnity rose as a result of a decrease in interest rates in March. This is reflected in a $3.4 million increase in securitized mortgage interest expense year-over-year. Growth in the Excalibur securitization program offset some of this negative variance and the growth in securitized commercial segment mortgages. Another effect of the lower interest rate environment was lower mortgage investment income, which decreased 31% year-over-year as mortgage rates earned in the warehouse period were lower than in 2019. Turning now to mortgage deferrals. And as you know, First National provided qualifying borrowers with a 3-month deferral payment to help them through the abrupt impact of the pandemic this past spring. By mid-May, the company had approved mortgage payment deferrals for 13.9% of eligible single-family MUA. By mid-July, this number had fallen to 4.2%, and as of October 23, had been reduced to 0.7%. While the majority of these borrowers have resumed making payments, the company estimates that 1% of the borrowers that took part in the deferral payment program will have some form of delinquency issues going forward. Deferred mortgages are not classified as delinquent or in arrear and will not be reported to mortgage default insurers or credit bureaus. First National's exposure is generally not to credit losses, but to the funding related to the mortgages that are insured. From an accounting perspective, deferred mortgages ceased to amortize and interest otherwise payable will be capitalized to the principal of the mortgage such that mortgage balances will increase during this period. However, when these mortgages are securitized, the related debt cannot be increased in step with the mortgage, in fact, must be repaid according to amortization. This is most significant for the company's NHA-MBS program. As the issuer, First National is required to make timely payments on the NHA-MBS securities as issued. The company must use its own resources to fund the increased mortgage balance as well as to fund the pay down of the securitized debt. At June 30, 2020, this obligation required investment for the company of $39 million compared to about $5 million at the end of March. At September 30, this investment was $65 million. Now moving to profitability metrics. Pre-fair market value income increased by 25% compared to last year as growth in the revenue flowed to the bottom line. Net income per share increased 20%. Strong profitability meant that the after-tax dividend payout ratio against pre-fair market value income was just 40%. All things considered, we believe there is good support to the latest dividend increase the Board announced commencing with the December 2020 payment. As a final observation, despite the investment in growing its market share and providing financial assistance to its borrowers, the company still managed to earn over 50% return on equity on normalized income in the quarter. And now here's Moray with our outlook.

[Moray Tawse, Co]

Good morning, everyone. Well, I would like to add my thanks to First National's employees for their performance under these challenging circumstances. It's one thing to adjust to work from home and another to address at the same time the demands that are created by such a significant increase in volumes. Hard work, dedication and great support from our IT team has made a world of difference. We've continued to hire this year to address the growth in our business, and our amazing team now numbers over 1,100 employees. It's certainly more difficult to hire in these times, and this speaks to the effort of our HR team. Now turning to our outlook. I am aware that the Bank of Canada has made a rate announcement this morning as we started our call, and we will be interested in their assessment of the current state of the economy. I think it's safe to say that Canada still faces much economic uncertainty. And with COVID-19 still present, and in some regions on the rise, it's difficult to look too far forward. That said, we feel very positive about the fourth quarter. Based on what we saw in Q3, we expect substantially higher seasonal residential originations to continue as well as ongoing commercial segment success with growing originations. Should this prove to be the case, we expect a good finish to the year and extending into the 2021 in a positive fashion as well. Conditions, of course, are quite dynamic. Some of our competitors in the commercial stepped back earlier this year, and we're now seeing more of them returning, however, wide spreads are still persisting. On the funding side, there continues to be strong demand for product from our institutional investors and as a result of substantial amount of liquidity in the financial system. Compared to the early days of the lockdown, securitization markets normalized in Q2 and continue that way into Q3.In some respects, we think that the current situation parallels the experience we had coming out of the 2008 credit crisis. Now as then, we are benefiting from wider mortgage coupons relative to funding costs on new originations. If the wider spreads persist, the company will continue to benefit. Overall, I believe that our long-standing approach to doing business through MERLIN is right for the times, and our results to date would certainly support this expectation. The ability to get business done virtually resonates with our partners and borrowers now more than ever. We suspect that one of the reasons our single-family team experienced substantial growth in Q3 is the disruption that COVID-19 created for traditional bank origination channels. To conclude, I would just remind you that it's far from business as usual, even though First National performed well. As much as we might like to, it's simply not possible for us to reliably estimate the length and severity of COVID-19-related developments or their impact on the financial results and conditions of the company in future periods. What we can say with confidence is that we continue to enjoy strong relationships with the mortgage brokers and diverse funding sources that set our company apart. As a result of our long-term progress, First National continue to generate income and cash flows from its $34 billion portfolio of mortgages pledged under securitization and $81 billion servicing portfolio and focus, as always, on the value inherent in our significant single-family renewal book. That concludes our prepared remarks. Now we will be pleased to take your questions. Operator, please open the line for questions.

[Operator]

[Operator Instructions] And your first question will come from Geoff Kwan with RBC Capital Markets.

[Geoffrey Kwan, Analyst]

My first question was just talking about the positive outlook that you guys have for Q4 and the start of 2021. Specifically on the residential side, do you have any thoughts on the year-over-year growth that you had in originations in Q3, whether or not you think you can kind of hold the line there for Q4? Or is it more of a comment that you expected, and it sounds like it should be up significantly, but maybe not quite as strong as what you saw in Q3 on the residential side?

[Stephen J. R. Smith, Co]

Well, Geoff, I guess, I don't think we have precise numbers. I think Q4 would be strong. Q3, October commitments are strong compared to last year, and this continues the trend of the rest of 2020. So we think it's going to be strong, but we don't -- we typically don't give forecasts on growth.

[Geoffrey Kwan, Analyst]

I guess maybe did you feel like it's strong, but because of either just seasonality or whether or not some of the pent-up demand or this surge that we've seen, I guess, for people that are wanting to live in bigger places has that kind of the acceleration? Has that started to show some signs of slowing? Or is it still remaining at the same pace?

[Stephen J. R. Smith, Co]

Well, I would -- if I had a sense, I'd say, in the last day or 2, I just mean yesterday, today, we've probably seen a little bit of moderation that we would just attribute to the fact we're getting into November -- we're getting in November, December. So you tend to get -- start to get a little bit of slowdown. But I think all the factors that contributed to the strength of the market in Q3, at the end of Q2 and Q3, are still around, which is low interest rates, demand for housing, the -- I think, a factor that home buyers to -- have not been affected by the pandemic to the same extent of renters. So it's a bit of a bifurcation in the market. But the factors that are contributing to strength in Q3, we see continuing into Q4. And I think on balance, we probably see them continuing into 2021.

[Robert A. Inglis, Chief Financial Officer]

And I think, Geoff, on the commercial side, we did see a severe slowdown in the processing of applications in the last quarter from CMHC, just because a number of them and shortage of staff at CMHC. They're starting to catch up now, so applications have already been submitted in the third quarter. We should see sort of a rapid pickup in the processing and funding of those into the fourth and first quarter.

[Geoffrey Kwan, Analyst]

Okay. Perfect. And just my other question was, do you have a view on how much market share you think the mortgage brokerage channel as a whole has increased during the pandemic? And then also specifically within the mortgage broker channel, how your market share has changed again since the pandemic started?

[Stephen J. R. Smith, Co]

We do not have any numbers on how much the mortgage broker market has increased relative to the overall market. I think those numbers will come out in time. We might get some visibility on that maybe at the end of the year or when the banks do their Q3 numbers, but we don't -- I guess for that, there will be the Q4 numbers. So we might get some visibility there. Our share has been strong. I know we are #2 at the end of Q2. There's that report. I'm sure you see the financial report, which shows mortgage brokers' closings. I think that's a pretty good indication. And I think you can see that our numbers were quite strong there. But it's probably the overall -- probably the overall share in the market that's been the issue. I think the other big factor is, I mean, we've had maybe 2 or 3 years of fairly tight spreads. So a big factor here is we're seeing in addition to -- so if you want to look at sector things that have happened, in 2016 about 4 years ago, there was a stress test for insured mortgages. So that had a definite effect in the year later, to put a stress test for commercial mortgages. So that had an effect. And then what 2020 starts to see and we saw that in February and March, was a big pop in mortgage demand. And so there were factors where the government was trying to take steps to, say, moderate the market in '16, '17. The government of Ontario, government of BC -- and then I think finally, the market was coming back. Our commitments for March 2020 notwithstanding that the pandemic started mid-March was the strongest month for commitments for 2020. And that's prepandemic. So there was very, very strong demand there. And I think that started to be reflected again in -- at the end of May, starting in May and June again. So I think those factors are still there. And then the other one is that we had a period, I think, in '18 and '19, where the price setters in our market are the D-SIBs mortgage spreads relative to government Canada Bonds or I guess, CMB and NHA-MBS were quite tight, and they've been an awful lot wider this year. So we've had a big impact. One can never predict where those are going, but they're maintaining the wides too. And also on the commercial side, spreads started to widen out at the end of '19. So we went into '20 with wider spreads. They widened out during the pandemic, in the last 4 or 5 months. They start to come back in again, but they're still wide relative to '19.

[Operator]

[Operator Instructions] The next question will come from Graham Ryding with TD Securities.

[Graham Ryding, Research Analyst of Financial Services]

Just maybe just a quick question on your net interest margin on the securitized side. Indemnity costs were a drag last quarter, I think, to the tune of almost $10 million in this quarter, it was about $3.4 million. So maybe just some color on what's driving the lower drag? Is it just less prepayment activity? And what is your expectation or outlook for that going forward?

[Stephen J. R. Smith, Co]

Yes. Well, I think what we started to do, we started to -- we're not a big buyers of first -- of 1-year mortgages, and I think we started to be more aggressive in that area. So as a result by being more aggressive in that area and putting some 1-year business on the books in a competitive way, it tended to reduce the prepayment spreads. I think we're comfortable -- we're probably going to be able to maintain these lower prepayment penalties or indemnity payments for the -- for going forward. So I think that sort of caught us unawares when we first thought the payments, and then we just took steps to address that. So we're comfortable that we're going to have lower indemnities going forward. The Q3 numbers will probably be more indicative of what we're going to see for the upcoming quarters.

[Graham Ryding, Research Analyst of Financial Services]

Okay. Understood. And then it sounds like the wider spreads that you're seeing this year are persisting as you move into Q4, largely. Is that an accurate description? And then are the economics similar for you, if you choose to fund versus institutional placements versus securitization on the residential side is -- are the economics similar right now?

[Stephen J. R. Smith, Co]

Yes. Well, this is a perennial question of split between securitization and institutional prices. Generally, we make more money doing securitization and institutional placements. We do a securitization. Generally, we get the entire spread, but we take on commitment risks. We take on prepayment risk. We take on indemnity payment risks. So there's a lot of risks to take on, but generally we get rewarded for that. So we try to securitize as much as we can so -- because the economics there are better. And in tight spread environments, the economics aren't a lot different. In wider spread environments, they are as they are -- as they were last quarter, I mean, Q2.

[Graham Ryding, Research Analyst of Financial Services]

Okay. And then last question, if I could. Just on the deferrals front. So pretty encouraging numbers in terms of the percentage of your residential book that is still deferred and sort of down from a peak in May. Your numbers seem to be a lot better than what we've seen coming from some of the big banks and the mortgage insurance company. So what would you attribute the difference to?

[Stephen J. R. Smith, Co]

My sense would be is I don't think our numbers are materially different than the rest of the industry. And what I would say is that the D-SIBs tend to do out of the box offer 6-month deferral. And so they're just coming through to the end of that. So you probably haven't seen them reporting. And I guess the mortgage -- the only mortgage -- the public mortgage insurer would be, I guess, that would be the general numbers coming through. They would tend to reflect the big banks because that would be more their customer. I would be very surprised if our numbers are materially different than the D-SIBs.

[Graham Ryding, Research Analyst of Financial Services]

Okay. Understood. And then the -- your estimate of 1% of the deferrals will have some form of delinquency going forward. Is that a reflection of what you're seeing...

[Stephen J. R. Smith, Co]

I'll give you a number -- let me give you a number, what we -- we have some visibility on what we see our 6-month deferrals on the arrears. And I think on the people -- of the people who took 6-month deferrals, not the people just in 3 months and came off, but the people who took the full 6 months. I think of those 6 month deferrals, there, it was 3.5% that were -- missed their payment by 1 day. So that's a very, very part or type of default. That translates into -- and Rob, correct me if I'm wrong here, I think it was 11 or 12 basis points in overall deferral for the portfolio. So I'm [indiscernible] memory. Let's put it this way. Deferrals, just not on our radar at this stage. Rather arrears from referrals are not on the radar. I have to say probably, if you want to be a little bit more getting into it, it's probably if you are going to see issue, you may not see it for a month or 2. Just might be enough cash it was if they can make a couple of payments. And I would think going forward -- I think, going forward, you may see an increase. It's just not some we're worried about. And I think I will remind you that our model was such that we don't really have significant credit risk on our balance sheet. So either that's borne by the insurance companies sort of buying our ultimate investors. So it's not an issue. I think the one thing I'd add -- and I read a report 2 weeks ago, and it dealt with the employment numbers for September. And as you may recall, there was a big increase in employment in September, exceeding expectations. And one of the analysts -- and I forget which bank it was, but one of the analysts or one of the economists in the bank pointed out that 99.5% of all people who are making $16 or more who were employed in February were still employed in -- employed in September. So I think among homeowners, most homeowner, the job losses have been among those employees in minimum wage, restaurants, parts, seasonal employment. Homeowners tend to be more steady, more permanent jobs, further along in their careers, have not experienced the same job loss. So I think we're not going to see the mortgage that may have been anticipated back at the beginning of the pandemic.

[Operator]

The next question is from Jaeme Gloyn National Bank Financials.

[Jaeme Gloyn, Analyst]

Just want to follow up on the deferral question. I was just curious, I'm not sure if you mentioned this. The mortgages that are still deferred, very small, but are they deferred because they've been given a second or third extension? Or are they just still haven't lapsed on their 6 months?

[Stephen J. R. Smith, Co]

Just haven't lapsed on their 6 months. I mean if -- technically, I think you could get a deferral as late as September. So I'd say most deferrals, people would have gotten their 3-month deferral in that period of about March 15 to April 15. And so that would have extended in June to July. So they would be coming -- most of them are coming June, September through October. But you could have come in and got in a 3-month deferral, let's say, May 1 or May 15. And then August 15, you could have asked for another 3 months of referral. So these are people on original referrals. We are not offering any further deferrals at this time. So if we -- our programs for [indiscernible] not unlike most people in the industry. You basically gave attestation that you had some income-related issue. We -- because of the huge numbers, we just weren't able to do the type of in-depth verification, we normally would on those circumstances. Now people who come and they ask for another deferral. [ That's in the deferral ], they have to provide fairly substantial documentation. And if there's not a path back to a medium employment, we're going to be taking the appropriate steps.

[Jaeme Gloyn, Analyst]

Okay. That sounds great. I wanted to dig into the Excalibur program, if I could. And hopefully, you can help us with a little bit more disclosure around how that program has been evolving recently. Are you seeing similar growth in originations in that business as the broader single-family business?

[Stephen J. R. Smith, Co]

The growth -- trying -- Excalibur has been strong. Actually, I don't know off the top of my head how growth in Excalibur was in Q3 compared to Q3 last year. Rob, do you recall?

[Robert A. Inglis, Chief Financial Officer]

About the growth?

[Stephen J. R. Smith, Co]

Yes, growth. Was Q3 Excalibur higher than Q3, Excalibur '19.

[Robert A. Inglis, Chief Financial Officer]

I think that was pretty flat. I think we sort of slowed down a bit on sort of our criteria for underwriting. But I think going forward, we're more comfortable with our program, and we hope to grow the program over the next year. I think I wrote in the MD&A this time that we had a small pilot project under the Vancouver office, which is a little bit of origination, but that's the next chapter for that program is to get out west and get a part there.

[Stephen J. R. Smith, Co]

Actually, that does remind me. I think in April and May, we tightened our criteria with respect to Excalibur. I think that will reflect close to Q3 to some extent. I think we're a lot more comfortable with the market again there, and we continue to see growth in that area for 2021.

[Jaeme Gloyn, Analyst]

Okay. Great. And moving to the placement fee margin. Obviously very solid in Q3 and up about 20 basis points year-over-year. Are you able to sort of disaggregate the drivers of that increase? Is it just the higher fee on the commercial mortgages that's driving the bulk of that? Is it something in the single-family space, maybe the Excalibur program? Can you sort of just break that expansion down for us, so we can understand how sustainable it is going forward?

[Robert A. Inglis, Chief Financial Officer]

Yes. Jaeme, I'll talk to that a little bit. It's probably all 3 of them, but the Excalibur part is very small, right? So it didn't have much impact. The multi-unit stuff, we'll have very wide spreads. In the extent that we sold that institution, there was a lot of extra spread in there that we got upfront in cash. In residential too, there was wide spreads in that segment as well. So we did do well by placing mortgages with various institutions. As I said in, I guess, previous disclosure, some of the stuff we sell on commitment at a fixed price, I think, gets affected by wide spreads. But some that we sell institutions on a funded basis, that does get us more placement fee. So I guess that's the extent of all 3 things, but I would say mostly the bigger prime mortgages in the residential space and the prime -- insured mortgages in the commercial segment.

[Operator]

[Operator Instructions] And at this time, there are no further questions. Mr. Smith, any closing comments, sir?

[Stephen J. R. Smith, Co]

Thank you very much, operator. We look forward to reporting Q4 results in late February '21. In the meantime, thanks for taking part in our call, and have a good day.

[Operator]

Ladies and gentlemen, thank you for participating in today's conference call. You may now disconnect.