First National Financial Corp

TSX:FN

Earnings Call Transcript 2024-Q3

[Operator]

Good morning, and welcome to First National's Third Quarter Earnings Call. This call is being recorded on Wednesday, October 30, [Operator Instructions] Now, it is my pleasure to turn the call over to Jason Ellis, President and Chief Executive Officer of First National. Please go ahead, sir.

[Jason Ellis, executive]

Thank you. Good morning. Welcome to our call, and thank you for participating. Rob Inglis, our Chief Financial Officer, joins me and will provide his commentary shortly. I 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's discussion and analysis. For the third quarter, pre-fair market value income of $75.3 million was 21% below last year. This was largely the result of lower residential origination, together with our decision to increase direct securitization in our Commercial segment relative to placing mortgages with investors. 

As you know from our previous calls, direct securitization means we incur associated costs in the current quarter while deferring the revenues to future periods. In developing our 2024 financial plan a year ago, we assumed that single-family originations would be lower than the prior year.

In practice, as discussed previously, the impact of the largest lender in the broker channel actively reengaging was significant. The effect of this has been evident in the year-over-year comparisons in every quarter of 2024 so far.

The 20% year-over-year reduction in our single-family residential originations in Q3 should be viewed in this context. Essentially, we are comparing to a period when the largest lender was absent from the broker channel. 

Notably, despite the lower origination volumes in absolute terms, First National's relative standing in the channel is unchanged year-to-date. In fact, there is evidence to suggest that First National actually improved its relative standing to rank second in both funding and new commitment activity in the third quarter. We look forward to more normalized year-over-year comparisons going forward.

Excalibur mortgage volumes were also lower than last year, but only marginally. We believe that the Alt-A market has been comparatively unaffected by the recent competitive dynamics observed in the prime space. From a credit perspective, the Excalibur program continues to outperform relative to expectations. 

Based on recent Canadian real estate Association data, the housing market itself is stable with year-to-date seasonally adjusted sales activity up 3.6%. In terms of prices, the TerraNet National House Price Index rose 1% from September 2023 and is now just 3% below the peak index set in May of 2022.

Looking forward in stark contrast to the year-over-year decline in funded mortgages, new residential commitments issued in the quarter were 50% higher compared to the same period in 2023. This augurs well for year-over-year new origination growth in Q4 as these new commitments transform into fundings.

Notably, First National did not alter our sales or service strategies to bolster commitment levels during the quarter. Between Bank of Canada actions and new homeownership incentives announced by the federal government, it seems that the housing market is setting up well for the quarters ahead.

In our commercial mortgage business, where our focus is multiunit residential housing, total originations were 18% lower than last year, largely a function of lower renewal business on fewer renewal opportunities. New origination volumes, as you've seen from renewals were just 5% lower than Q3 last year.

Through the first 9 months of 2024, commercial origination is 17% higher than last year despite the impact of interest rates on transactions and new development activity. CMHC incentives to build multiunit rental stock and create affordable housing have kept our clients active.

The availability of funding through a larger CMB has provided an efficient source of liquidity for lenders in the space, including First National. The larger CMB with funding dedicated to multifamily housing has attracted new lenders to the market and has had a tightening effect on margins. Our value proposition to borrowers, however, continues to make us the leading lender in the multiunit residential sector in the country and will serve us well going forward.

Fourth quarter commercial originations will likely moderate slightly compared to especially strong quarter last year, but we expect to close 2024 with record annual commercial mortgage volumes. 

Now, before I turn the call over to Rob for his analysis, a couple of final observations. First, the Board has approved a special dividend of $0.50 per common share. The Board authorizes specials when First National has generated retained earnings in excess of what is needed for near-term growth. And this happens frequently, 7 times in the past 8 years because of the capital-efficient nature of our business and purpose-driven management of equity.

We're also pleased to note that in the quarter, First National surpassed $150 billion in mortgages under administration. Now, as a result of the extraordinary volumes of new originations during the pandemic years, we are moving toward a period of significant renewal opportunities in our single-family mortgage book, positioning ourselves to service our borrowers for a second mortgage term is always a priority, and we look forward to increased renewal volumes in the next few years.

To sum up, results on a year-to-date basis unfolded largely as we anticipated when we set out our 2024 plan with lower originations and higher investment in securitization. We believe this investment will pay off with future net interest income.

Looking ahead, the arrival of tailwinds in the form of interest rate reductions and a growing residential commitment pipeline should deliver higher year-over-year originations in Q4 and a strong start to 2025. Rob?

[Robert Inglis, executive]

Thanks, Jason, and good morning, everyone. Before jumping to my quarterly commentary, another key highlight of yesterday's announcement was our Board's decision to increase the common share dividend effective with the payment in December. This is the 18th such increase in the 18 years since First National's IPO and will bring the annualized payment to $2.50 per share.

Now, turning to our results. Mortgage under administration grew by 6% on both a year-over-year and annualized basis during the third quarter to a record $150.6 billion. We've often spoken about the importance of MUA to franchise value. This is not just a milestone, but the foundation of profitability for several years to come.



Also of note, while down on a year-over-year basis, single-family originations did grow sequentially between Q2 and Q3 of this year by close to 10%, perhaps an indicator that Canadian borrowers responded favorably to the first 2 Bank of Canada rate reductions in June and late July.

Turning to third quarter revenue. It was down 1% from last year due to the impact of changing interest rates on our residential commitment hedging program. Excluding fair value losses on that program in Q3 this year versus what it gained last year, revenues grew by about 8% on a 14% increase in our securitization portfolio and higher coupon rates. 

Moving briefly to the largest components parts of revenue. Net interest income on mortgages pledged under securitization increased 4% over last year to $60.2 million. Measured against the average size of the securitized portfolio, NIM was lower in Q3 at 55.3 basis points versus 59.5% last year.

The most significant factor in this change is the relative growth of our prime asset-backed commercial paper programs, which traditionally deliver one of the lower net interest margins of our various securitization platforms. 



In Q3 last year, we also received prepayment penalties from borrowers, but given where rates were at the time, no penalties were due to MBS pools. This meant we received large net inflows into last year's net interest margin, but in the last few months, we've seen that phenomenon disappear with the resumption of interest penalty to those pools, an outcome of lower interest rates. 

By segment, commercial NII was higher by $3.3 million due to portfolio growth of 17% as well as a margin increase in our insured construction mortgage program. Q3 single-family residential net interest income was lower by $800,000 despite a 13% increase in related programs. Here, the favorable results from our Excalibur securitization program were offset by narrower prime mortgage net interest margin.

Q3 mortgage servicing income was down 7% year-over-year at $71.1 million. Here, a 2% growth in administration revenue from higher MUA was offset by lower third-party underwriting revenues, reflecting a competitive market. Our third-party business continues to perform as planned as we ramp up to support the staged expansion of our newest customer. 



This necessitates adding fixed costs in advance of the growth. Placement fee revenue declined 25% year-over-year to $57.1 million on a 29% reduction in placement activity and a relative increase in renewed mortgages. Per unit placement fees on renewals are lower than a new origination.

However, in the 2024 quarter, the per unit value of the placement of renewed mortgages was greater than it was in the 2023 quarter. This is the result of falling interest rates. The company committed to these mortgages when interest rates were higher and subsequently sold to investors when rates had fallen later in the quarter to create these higher margins.



All in, including Prime, Excalibur and renewals, residential per unit fees were about 7% higher year-over-year. Third quarter mortgage investment income was 3% lower year-over-year to $40.9 million, a function of our decision to reduce the size of our commercial bridge lending portfolio and place more of this part with our institutional customers. Lower rates on the mortgages accumulated for sale also had an impact. 

Now, moving to costs. Third quarter broker fee expense declined 35% to $29.9 million on a 38% decrease in single-family origination placed with institutional customers, even though per unit broker fees were about 3% higher year-over-year.

Salaries and benefit expense increased 7% or $3.3 million year-over-year, primarily due to a 9% increase in full-time employees, some of it to support the ramp-up of our services for our new third-party underwriting customer. Offsetting some of this increase was a $1.4 million reduction in incentive compensation paid to our commercial division due to lower production volume. 

Turning to profitability, we consider approximately 40% of the $20.2 year-over-year reduction in pre-fair market value income was due to the higher direct securitization of multifamily mortgages. The other part of the decrease is related to lower single-family origination, including our third-party underwriting department.

For the quarter, the common share payout ratio against after-tax pre-fair market value income was 104%. If gains and losses on financial instruments are excluded, the payout ratio would have been 68%.

On an IFRS and non-IFRS basis, First National remains solidly profitable and we look forward to generating income and cash flow from securitized mortgages and our servicing portfolio, which are both at record levels. Now, we'll be pleased to answer your questions. Operator, please open the lines.

[Operator]

[Operator Instructions] Your first question comes from Nik Priebe at CIBC Capital Markets.

[Nikolaus Priebe, analyst]

I wanted to start with a question on the recently announced mortgage reform and just better understand your view on the impact of First National. My basic understanding is that longer amortization periods will only be a marginal benefit, whereas a higher cap on mortgage insurance is a net positive because you're more active on insured mortgages in the broker channel. But you do offer both an insured and uninsured mortgage product.

So, I was just wondering if you can elaborate on why you might be a bit over-indexed on the insured side. I'm just trying to understand that dynamic a bit better.

[Jason Ellis, executive]

Sure. I think traditionally, as a mortgage finance company that tends to leverage mortgage default insurance and the related CMHC-sponsored securitization programs, we have typically originated a higher percentage of high-ratio mortgages than perhaps the traditional bank channels have. I'm not sure how significant that is, but it is to a degree. And I think it's just a function of being a mortgage finance company as opposed to a bank where their access to CDIC-insured deposits perhaps makes them especially competitive on conventional loans.

With respect to the recent changes in mortgage regulations, the availability of a 30-year amortization to all first-time homebuyers and for all first-time homebuyers and for all buyers of newly constructed homes will be actually somewhat constructive at the margin. 

I don't think it's a game changer, but it is definitely constructive and probably increases the addressable market of borrowers for us. The increase in the cap on the purchase price of mortgages that are eligible for mortgage default insurance from $1 million to $1.5 million, I think in practice, Nik, will have a very small effect on the market because in reality, when you reflect on the size of a mortgage that you might take in order to purchase a home for $1.5 million on a high ratio basis, the payments required would suggest that you would need an income approaching $300,000, which is definitely getting into rarefied air. 

I'm not sure if I answered all or some of the questions.

[Nikolaus Priebe, analyst]

No, that's good. And I guess on another theme, you've been vocal about the changing competitive dynamics in the broker channel with certain lenders more aggressively asserting themselves in a bid to recapture share.

Your commitment pipeline is now building on the single-family side. Have you noticed any discernible change to that posture from your competitors? Or do you feel that the growth that you're seeing in single-family commitments is more related to improving market conditions as opposed to an easing of that competitive pressure?

[Jason Ellis, executive]

I think it's a combination of the 2. It's actually very difficult to put a finger on it. But given the significant increase that we have seen in recent months, I think it is a combination of increased activity on the back of monetary policy, and I think a slight easing off in terms of the amount of aggressive discounting on rates we may have seen from some participants in the market.

I think another factor to consider is, it was the third quarter last year where I think that large participant in the channel started their return. And so, when I look at my commitments issued in this year, I'm comparing it to a quarter last year where I may have first started to see the effect of that lender reentering the market.

So, there may be a little bit of a year-over-year comparison effect coming on. But I think also the market has shown some tailwinds. And I think 1 or 2 of the large lenders in the channel may have taken their foot off the gas a little bit. So, a number of things, I think, happening at the same time.

[Nikolaus Priebe, analyst]

And then just last one for me. Salaries and benefits expense stepped down sequentially. Is there anything specific you'd attribute that to? The obvious one could be lower commercial volumes and the related incentive comp, but I just wanted to confirm there.

[Jason Ellis, executive]

Yes, Nik, I think you're right about that. I think in the comparative quarter, actually, it was a higher number than it should have been. There was a little bit of under accrual in Q2 2023, which kind of bled into Q3. So, in Q3 2023 was higher, but definitely with lower production, that sort of reduced the salaries line this period.

[Operator]

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

[Etienne Ricard, analyst]

Single-family mortgage activity appears to be picking up. Two questions for me. The first is, what upside in new originations do you see to the extent housing market activity normalizes closer to long-term levels? And second point, how do you expect renewal metrics to trend in a 4% to 5% mortgage rate environment?

[Jason Ellis, executive]

I'll answer the second half first. From a renewal and retention perspective, I would say that throughout this year, we have had a retention rate on single-family renewals that is comparable to our long-term average. We haven't seen any measurable change up or down in that respect and certainly have no reason to believe that as we roll forward into next year that, that would change.

With respect to the rate environment, if that was a question at all about the ability or any stress of our borrowers being able to renew at the new higher rates, that has not materialized in any respect whatsoever.

As I said, I think, in previous quarters, from 5 years ago, where, of course, the natural habitat of Canadian borrowers is in a 5-year term, household incomes are up significantly and housing prices are significantly higher, if even off the peak from May of 2022, such that in the worst case that a borrower was unable to meet their new payment obligations, they have significant equity in the property, and they've been able to sell it. But that has not been happening in any significant way as we're not seeing our retention levels fall as a result of that kind of activity.

So, the good news is the stories in the media and the concern around this great cliff of renewals in a higher rate environment is not materializing into any stress for our book of borrowers. What was the first half of the question again?

[Etienne Ricard, analyst]

Well, housing market activity in Toronto and Vancouver has been slower relative to historical averages. So, if activity normalizes closer to historical levels, what upside do you see to new originations?

[Jason Ellis, executive]

It's tough to say a big part of what we do is refinancing of existing mortgages in addition to funding purchases. So, purchases and housing activity in that respect are only part of the equation. But I imagine, all else being equal, it should be a pretty straight correlation. More housing activity means more mortgage origination.

And as a company that is highly operationally leveraged with very little variable cost compared to our fixed costs, I think that we would enjoy a disproportionate improvement in our pre-fair market value earnings with growing activity in the housing market.

[Etienne Ricard, analyst]

And lastly, to the extent this competitive pressure eases a little bit, do you see also easing pressure on broker fees?

[Jason Ellis, executive]

Yes. So, I should be clear, competitive pressure isn't easing and never will ease. The idea that we even refer to the competitive nature of the market is almost unnecessary. If there's ever a quarter where it isn't competitive, I will be surprised. What is changing specifically is that dynamic that we had a very material lender in the channel absent for the better part of the year and then return, which has created a very specific dynamic, which has made the year-over-year comparisons quite difficult.

I would say, going forward, that has stabilized. The normal participants in the channel are all there and active. And so, going forward, I think year-over-year comparisons are going to be more normalized. But make no mistake, it will continue to be and will always be a very competitive market.

[Operator]

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

[Jaeme Gloyn, analyst]

I wanted to touch on another one of the mortgage rule changes coming, and that's the no-stress test on a mortgage switch. Can you sort of talk through some of the puts and takes that you expect First National to experience as a result of that change? And any sort of financials around that, I guess, would be and would be appreciated. But maybe just talk through some of the impacts and what you're doing from a strategy perspective.

[Jason Ellis, executive]

Yes. I think that it probably doesn't amount to a measurable change, anything that would be worth forecasting the future results. I would say, like any lender, we win some switches and we lose some switches.

Practically speaking, the change to allow a conventional borrower to switch lenders without requalifying actually hasn't been the barrier to movement that, again, may have been perceived because household income has gone up and because borrowers five years ago were qualifying at the minimum qualifying rate of at least 5.25% and we're now in an environment where conventional mortgages are around 4.5%, there actually has been very little barrier in practice to them moving lenders at maturity if they chose to.

So, I don't think the policy change is going to have a significant effect on what we see happening in the market. I think it's a great change, at least from the optics perspective that now all borrowers can equally access the entire market and choose to move wherever they like.

[Jaeme Gloyn, analyst]

On the NIM, we had securitization NIM had a little bit of a bump back higher this quarter. It seems like it was commercial driven and commercial volumes have been in a bigger slice of the origination profile this year. Is this something that we can expect to see over the coming quarters? And maybe frame that within maybe a more general securitization NIM guidance?

[Jason Ellis, executive]

Yes. So, like we've said in previous quarters, the net interest margin is made up of a lot of different moving parts. But I would say there's 2 things that I see factoring in as we move forward the next several quarters. One of them will be, as Rob mentioned, as we move into an environment now where as rates fall, we once again start seeing rate indemnity penalties payable to NHA-MBS pools on liquidations.

I would say that over the course of the next year will probably result in an opportunity cost, let's call it, of about 2 to 3 basis points compared to what we enjoyed for most of this year and the year before when we were not paying indemnity penalties to the pools. So, I'd say headwind in the context of 2, maybe 2.5 basis points to overall NIM as we stop enjoying those net indemnity flows.

On the flip side, you'll note the higher losses on our hedging program on mortgage commitments. As you know, we adjust for those in pre-fair market value income because they reflect interest rate changes, not changes in core business. But because you can't treat the hedge losses during the commitment period as hedges and capitalize them to the securitized portfolio, what we do end up with is recognizing some of those losses in the current periods of origination and then securitizing the pools at wider net interest margins without the offsetting amortization of those commitment losses.

So, I think that, that may have a benefit in terms of a couple of basis points wider as we move forward. So, I would say probably stable net interest margin as we move forward from here. I'm not anticipating any significant changes in either direction.

[Jaeme Gloyn, analyst]

So, safe to say that rate impacts are some of the drivers you're watching more so than mix shift, I guess.

[Jason Ellis, executive]

Yes, I think that's right. I mean, Rob did mention something that is worth perhaps highlighting. We have been using asset-backed commercial paper to fund conventional residential mortgages a little bit more actively this year than we have in the past. And, as a result, that has had a small negative effect on NIM just because those prime conventional mortgages carry relatively narrow spreads.

I think how much we continue doing that may factor a little bit in terms of, again, basis points here and there. But it's a $35 billion portfolio of 5- and 10-year mortgages. So, it would be very difficult to imagine a scenario where that net interest margin moves significantly over the course of a number of quarters.

[Operator]

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

[Graham Ryding, analyst]

Maybe I could just touch on the recent announcement around lower immigration targets for both permanent and non-permanent residents. How material do you think that could be for the mortgage or housing sales activity over the near or medium term? Or is this something that's more likely to be sort of impacting the demand for the rental market? How are you viewing that change?

[Jason Ellis, executive]

Yes. It's probably order of operations, more immediately an impact to the rental market and only subsequently perhaps purchases on homes. We have such a supply issue here in Canada that I think a moderation in immigration is not likely to have a profoundly negative effect on housing activity.

Here at First National, we don't have a significant focus on new to Canada-type products. So, I don't imagine that shift in policy having a significant effect or a measurable effect on our results. But to your question, I think it is a more immediate impact into the rental market.

[Graham Ryding, analyst]

The other question I wanted to ask is just on your securitization I guess, capacity. It looks like you've done $11.2 billion of originations renewals this year that have been funded through securitization. Does that suggest that you've got some constraints for securitization volume in Q4 of this year and your funding mix may be a bit more weighted towards institutional placements? Or how much visibility do you have on securitization capacity?

[Jason Ellis, executive]

Well, as we've mentioned before, we are mature users of CMHC programs, specifically the NHA-MBS. And we will, as we move through the fourth quarter, use all of the available MBS guarantee fees that we receive access to. Fortunately, that is relatively balanced. And I think that, that securitization number also includes, of course, sales into our ABCP conduits.

Those conduits are also quite mature platforms. We see mortgages running off of those as quickly as we add them in some cases. So, no immediate constraints there. And it would seem that in recent quarters, our bank sponsors of those ABCP conduits have renewed enthusiasm for growth, and we're seeing very constructive reverse inquiries from those bank sponsors around growing the commitments we have for those programs.

So, I don't see an immediate constraint or misalignment with our projected fundings and our ability to fund those mortgages via securitization. That said, we always have a significant bid from our investors to place mortgages on balance sheet. It just boils down to best execution sometimes.

[Graham Ryding, analyst]

And so, it looks like you've sort of averaged in terms of your funding mix, roughly around 40% of it has gone to securitization year-to-date. So, it sounds like there's no reason why it couldn't potentially remain that sort of mix in Q4?

[Jason Ellis, executive]

That's right. There's no immediate reason why it would change for the fourth quarter relative to year-to-date. It's this way, there's dry powder, if that's what you're asking.

[Graham Ryding, analyst]

Yes, yes. That's basically what I'm asking, because I guess you've done a lot of volume year-to-date compared to years past. So, I'm just trying to get a feel for how much capacity you feel like you have.

And then my last question, if I could, is just you noted that your commitments in Q3 on the single-family side were up 50% year-over-year. How should we think about that translating into originations? Like do you have a typical conversion rate of commitments that would actually fund into mortgages?

[Jason Ellis, executive]

Yes. Yes, so I'm trying to think about the math here, like if commitments are up 50% fundings too should be up a similar percentage because the conversion ratio on -- I think that a 50% commitment growth should roughly translate into a 50% funded growth. That doesn't suggest that every commitment is a funded mortgage, but if commitments are growing, so are fundings.

[Operator]

Thank you. Mr. Ellis, there are no other questions. Back to you for closing comments.

[Jason Ellis, executive]

Okay. Thank you, operator. We look forward to our fourth quarter results in March. Thank you for participating, and have a great day.

[Operator]

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