Home Capital Group Inc

TSX:HCG

Earnings Call Transcript 2022-Q1

[Operator]

Good morning. My name is Chris, and I'll be your conference operator today. At this time, I'd like to welcome everyone to the Home Capital Group Q1 2022 Results Conference Call. [Operator Instructions] Jill MacRae, Vice President of Investor Relations.

[Jill MacRae, executive]

Our agenda for today's presentation is as follows: We'll begin the call with remarks from Yousry Bissada, who is the President and CEO; Brad Kotush, our CFO, will then review our financial performance, which will be followed by a question-and-answer period for participants. We have a few members of our senior management team with us on the call to help answer your questions. On behalf of those speaking today, I note that this call may contain forward-looking statements and that actual results could differ materially from forecasts, projections, or conclusions in these statements. Please refer to our advisory on forward-looking statements on Page 2 of the presentation. I would also remind listeners that Home uses non-GAAP financial measures to arrive with adjusted results and the management will be referring to both adjusted and reported results in their remarks. And now I'd like to welcome Yousry Bissada.

[Yousry Bissada, executive]

I'll start with some comments about our first quarter results, followed by a discussion of the current market conditions and conclude with a brief look ahead. Then, I'll turn the call over to Brad who will discuss our results in more detail. This was a strong quarter. The reported origination growth across all our lending business was $2.8 billion, including $2.3 billion in single-family residential mortgages. Of that, our alternative mortgage loans, which we refer to as our classic business, we beat last quarter's record originations with a new record of $2.1 billion in Q1. Our funded volume of alternative mortgages in the quarter increased by 90% year-over-year. We reported strong growth in our commercial originations as well of $463 million. This represents a year-over-year increase of 70%. Strong origination activity contributed to growth in our balance sheet. We added over $1 billion to our loans on balance sheet in the quarter and reported 11% year-over-year growth in our loans under administration. Let me pause from our results to discuss the market.

We delivered this growth in a market that is starting to show signs of slowing after the rapid growth of prices and volumes last year. Reports from the Canadian Real Estate Association indicate that sales volumes for the first 3 months of the year have moderated from the record levels of 2021. We believe this is healthy for the long-term sustainability of the housing market. We are also seeing upward pressure on interest rates for the first time since the start of the pandemic. The Bank of Canada began to increase the benchmark overnight rate with a move of 25 basis points in March and a further increase of 50 basis points in April. The bank has made it clear they will take necessary options to keep inflation in check and maintain price stability. The bond market reacts to these signals and has priced an expectation of an additional move up to 100 basis points by year-end. This has a direct impact on our cost of funds. Let me explain. The market for deposits and the market for mortgages are both competitive. In a rising rate environment, deposits tend to reprice faster than mortgages. Typically, price on term deposits will follow closely to prices of the equivalent term, Government of Canada bond. Bond prices have moved rapidly this quarter, not just in response to central bank moves, but in anticipation of future increases.

On the mortgage side, it takes some time for the spread between mortgage rates and deposit rates to revert to the mean. In the broker distribution channel, the first lender to raise rates may risk losing volumes until those rates are matched by other lenders. Eventually, rates will move up to bring margins back closer to historical NIM levels. We've taken the lead in setting rates for our alternative mortgage loans at levels that began to move back to historical leads. We will always balance considerations of growth, sustainability, and long-term value in our pricing strategy. However, as our rates on our assets increased more slowly than our cost of funds, the result is NIM compression. We expect spreads to normalize if, as, and when the pace of rate increases stabilizes. Importantly, we were able to grow our loan book and the other assets that will continue to produce income into future through refinance and renewal activity. We have found that retention improves in periods of rising rates because borrowers are less likely to switch due to having to qualify at higher rates than other institutions.

Now returning to our results and some of the other achievements this quarter. We were very pleased with the results from our Oaken channel. We had a good quarter in terms of deposits and relationship roles. As rates have moved up, we have been thoughtfully and proactively moving consumer rates to maximize long-term value to both customers and investors. We closed our first RMBS offering for 2022 during the quarter and added additional funding through a number of channels as part of our funding diversification initiatives. Brad will share more details in his presentation. Additionally, we received an upgrade to our credit rating from DBRS. This is a validation of the strength of our company and our sustainable risk culture. We believe this upgrade will open up more opportunities for additional funding options in the future.

On the credit side, our metrics are healthy. The biggest predictor of credit defaults is unemployment, and the outlook for employment in Canada is still quite robust. You will hear more about this from Brad a little later. On our internal Ignite Technology Transformation Project, we made lots of progress. This includes, we continue to develop best-in-class reporting to our mortgage broker partners to help them in their business. We added data analytics internally to better understand our customers, and we automated more internal processes using robotic processing automation (RBAs). We were also named "Great Place to Work Hybrid." This is particularly meaningful as our back at home team has put a lot of energy into developing a successful hybrid work model. We have continued to make progress towards our goal of reaching our target capital range. For a combination of growth in our risk-weighted assets and share repurchases in the quarter, we have brought down our CET1 ratio by 85 basis points. Our normal course issuer bid was approved on February 17 and commenced purchases in the market.

Now for a brief look ahead. We are continuing to see demand for both our residential and commercial loans. While rates are higher than they have been in the last few years, they are still low in a historical context. With our years of experience operating in all types of rate conditions, we are comfortable in our ability to manage profitability to this environment as well. Margins will be impacted by changes in rate expectations, but we expect they will revert to historical average levels in time. We will continue to diversify our funding sources and make progress towards our target capital range. We are committed to achieving an efficient capital structure to drive ROE and deliver shareholder value. Finally, I want to recognize the people of Home Capital Group for their work this quarter. It's great to see so many back in person. Thank you for your dedication to supporting our customers, our partners, and ultimately our shareholders, through a very busy quarter in all our business areas. I'll now invite Brad to discuss our financial results.

[Bradley Kotush, executive]

My presentation begins on Slide 6. This morning, we reported net income of $44.7 million and diluted earnings per share of $1.02. The earnings per share decreased by 18% from the comparable period 1 year ago. Book value per share grew by more than 10% year-over-year to $37.45 and our return on equity for the quarter was 11.3%, which is still impacted by a higher level of CET1 capital, which remains above our target range of 14% to 15%. Slide 7 shows the factors contributing to the $0.22 decrease in our net income per share compared with last year. $0.19 of the decrease is attributable to lower net interest income, another $0.17 resulted from a change in credit provisioning as Q1 of last year had a $12 million reversal of provisions. Offsetting these 2 items was a contribution of $0.16 from a 16% reduction in average shares outstanding compared with last year. Pretax, pre-provision income decreased by 20% year-over-year, largely due to net interest margin compression.

Slide 8 is a look at our net interest income. Net interest margin for the quarter was 2.18% compared with 2.61% last year. In our last conference call, we shared the expectation of margins for the full year would be below 2021 level and Yousry has given you a good picture of the elements that contributed to that decrease. It is still a competitive market for both mortgages and funding, but we expect spreads to normalize over time and that our net income will benefit over time from the growth in loan balances that we are achieving.

Slide 9 shows our noninterest expense and efficiency ratio. Noninterest expense has increased slightly over the prior year, primarily due to increased salaries and benefits expenses. This reflects an increase in the average number of employees for the period as well as increased compensation. As noted, our expenses increased by 1.5%, while our LUA grew by 11% over the same period, indicating that we have been able to increase our LUA without significantly increasing our noninterest costs. The negative impact on our efficiency ratio is primarily attributable to decreased net interest revenue compared to 2021.

Turning to our lending operations beginning on Slide 10, this quarter originations in our single-family residential portfolio grew by 73% over last year, led by our Classic portfolio. As Yousry mentioned, this was a record for Classic in a quarter when sales volumes in Canada actually decreased from last year. Commercial originations also increased by 70% with growth in both residential and nonresidential lending as we have added new origination partners and participated in more transactions. Altogether, originations increased by 72% compared with Q1 of last year. We reported strong asset growth this quarter. Our single-family loans on balance sheet increased by 15.5% over last year on the strength of our origination volumes and retention efforts. Commercial loans on balance sheet declined year-over-year through a combination of discharges during the period and sales of insured multi-residential loans into the CMHC pool, where they earned securitization income with no credit risk.

Commercial loans under administration grew by 2.3% over last year. We have a good pipeline of commercial opportunities and expect to see continued growth in LUA. If current trends continue, we believe we can achieve double-digit growth in LUA this year, subject to market conditions. Growth in our open channel continues to outpace our broker-sourced deposits. Deposits sourced through Open grew by 11% and now make up 31.5% of total deposits. We are seeing good engagement across all our open channels by delivering not just attractive rates but also service and value. We are investing in continuous improvement of our digital offering for customers to improve our ability to service them. Internally, there is a lot of enthusiasm about the potential of Oaken. We continue to move forward on our strategy of funding diversification. During the quarter, we closed an RMBS offering of $425 million. At the end of 2021, we initiated our participation in a $250 million committed securitization conduit in partnership with one of the major banks, backed by a pool of uninsured single-family residential mortgages.

In Q1, we increased the program limit to $500 million. Subsequent to the quarter end, we added an additional $500 million funding facility with another major bank partner. We entered into a committed secured warehouse facility for $250 million using uninsured single-family residential mortgages as part of our existing $400 million warehouse facility backed by insured mortgages. Post the end of the quarter, we increased this warehouse line by an additional $200 million secured by $100 million insured and $100 million uninsured residential mortgages. We currently have a total warehouse facility of $850 million, $500 million backed by insured mortgages and $350 million backed by uninsured mortgages.

Turning to Slide 13 for a review of credit during the quarter. During the quarter, we recognized a reversal of $138,000 in the provision for credit losses compared with a reversal of $12 million in the year ago quarter. The reversal was primarily attributable to the commercial mortgage portfolio, where we had lower Stage 3 balances combined with a favorable impact in our forward-looking models from the easing of health-related restrictions on businesses. We reported a $4 million increase in provision expense in our single-family residential mortgage portfolio to reflect the growth of the portfolio as well as changes to the inputs to our forward-looking economic models used to estimate future credit losses. Net write-offs during the quarter were less than $0.5 million or about 1 basis point on an annualized basis.

Slide 15 shows our allowance coverage. The total allowance for credit losses was $35.9 million at the end of the quarter, which is a 38% reduction from year ago levels. Nearly 85% of the allowance is attributable to Stage 1 and Stage 2 loans. Allowance coverage of nonperforming loans of over 20% is above the year ago level, and we consider this level of coverage to be proven.

Slide 16 demonstrates that the credit quality of our loan book is solid. Net nonperforming loans now represent only 11 basis points of our total loans outstanding. Gross nonperforming loans, designated as Stage 3, have declined on an absolute basis even as we are reporting significant loan growth. Gross nonperforming loans totaled $26.5 million at quarter end, a reduction from last quarter mainly due to lower stage fee balances in our commercial portfolio. Net nonperforming loans at the end of the quarter have continued their downward trend and now represent only 11 basis points of our total loans outstanding. This is a validation of our underwriting and risk management processes and also makes it clear that our borrowers are deeply committed to staying current with obligations related to their most significant asset.

Taking a look at our capital strategy on Slide 17, we concluded the quarter with a CET1 capital ratio of 17.58%. Our CET1 ratio declined by 85 basis points during the quarter through a combination of share repurchases and growth in our risk-weighted assets, offset by capital generated from operations. During the quarter, we bought back approximately 373,000 shares through our normal course issuer bid. We can repurchase up to another 3.3 million shares under the terms of the NCIB and subject to market conditions, we plan on repurchasing the maximum number of shares allowed.

Finally, the Board declared a quarterly dividend in the amount of $0.15 per share. The Board and management are committed to achieving its target capital range and regularly review all opportunities to meet this target by the end of the year. And now I'll ask the operator to pool for questions.

[Operator]

[Operator Instructions] Our first question is from Geoffrey Kwan with RBC Capital Markets.

[Geoffrey Kwan, analyst]

To start with the housing activity slowing and seeing some evidence of home prices starting to decline, have you been making any changes around underwriting, but also just in general, how you're thinking about underwriting in this environment, given I think you have a target of 20% loan growth this year?

[Yousry Bissada, executive]

Yes, we've seen it slowdown, but it's still quite robust. There is still a lot of activity. At this point, we're pretty prudent in our risk appetite and our underwriting guidelines. We have not made changes, but we have very fast, flexible underwriting, if we should see a situation change by region or nationally. We can move rapidly to make changes. But at this point, we're continuing down the path.

[Geoffrey Kwan, analyst]

My other question was, Brad, on the expense side, what we saw in the quarter, was this kind of a good run rate on expenses, or do you expect some variation the rest of the year versus what we saw in Q1?

[Bradley Kotush, executive]

We expect to see some variation over the course of the year. Again, a lot of the costs in the current quarter showing up in the G&A line were the results of activity-based expenses, so there will be some flux there, and based on our current forecast, there will be some variability around that, but again, it's going to be dependent on activity.

[Operator]

Our next question is from Etienne Ricard with BMO Capital Markets.

[Etienne Ricard, analyst]

The yield on the Alt-A loan book declined sequentially. You point out in the MD&A that this is due to maturing vintage homes that carry a higher yield. Now given that Alt-A mortgages typically carry the 1- to 2-year term, at what point would you expect the portfolio yield to start increasing?

[Bradley Kotush, executive]

As you noted, there is a portfolio yield, a renewal yield, and the origination yield. And we expect, as you noted, that over the course of 12 to 14 months, then we'll start to see an increase in that overall portfolio yield.

[Etienne Ricard, analyst]

On the growth outlook, I just want to confirm, are you still expecting up to 20% loan growth in 2022, considering the magnitude of interest rate increases and affordability issues. In other words, what gives you confidence that the Alt-A market will grow this year despite a softening of housing activity?

[Bradley Kotush, executive]

Just as a further color on that percentage, that was our overall LUA, so it's not predicated entirely on Classic, and we'll see in our prepared remarks, we do expect to see double-digit growth. We had seen very strong growth in the first quarter and based on what we saw in our pipeline, we were able to make the statement of 20% overall LUA. In our prepared remarks today, we stated that we still expect double-digit growth, but there is now more uncertainty in that prediction than we had at the end of what we reported in Q4. So it is possible, but it's more in terms of the uncertainty to be still double digits.

[Yousry Bissada, executive]

Just to add to that, in the remarks where I also talk about renewals, so even if originations slow down some, renewals could go up, which is obviously part of the formula of growth. As you go to another institution, it's a higher rate plus you have to qualify at 200 basis points over. So renewals tend to go up in a rising rate environment, so that's also part of our expectation.

[Bradley Kotush, executive]

Clearly, that target or the expectation that we set out in our February reporting is something that we're still working to achieve.

[Etienne Ricard, analyst]

On capital allocation, clearly you're seeing still strong mortgage growth to your point, albeit at a highly competitive spread. At the same time, your stock is trading below book. So I heard you earlier in your comments, you want to maximize use of the NCIB. That being said, at what point would it make sense for you to prioritize another SIB relative to growing the loan portfolio.

[Bradley Kotush, executive]

We're going to review the market conditions, the value of our stock, where we think the most effective utilization of that capital will be. We have been successful in previous SIBs. We've also been successful in our NCIBs and for the near term, our view is that an NCIB is more effective and that if there is a requirement for an SIB that will occur later in the year. Again, subject to market conditions and if any of those factors change, then we'll reconsider that approach. But certainly, we will be repurchasing shares when we are able to.

[Operator]

Our next question is from Nigel D'Souza with Veritas Investment Research.

[Nigel D'Souza, analyst]

I wanted to circle back on the conversation on net interest margin and the decline in asset yields. It looks like that contraction in NIM is most on the asset yield side, and I was wondering if you could provide some more color on what vintages are driving that decline in the rollover yield and even on loan category mix or the certain loan categories that were more critical or weighted in the decline in asset yield that you saw this quarter?

[Bradley Kotush, executive]

Well, primarily, it was our Classic portfolio, and that's going to continue through the course of the year as some of the originations that were made in previous months then become funded once the commitments are realized. So as I stated earlier, that's going to appear through the course of the next quarter until our rate increases start to appear in the overall book and the maturing loans get renewed. And as Yousry said, if rates continue to increase, we do expect to see an increase in our renewals.

[Nigel D'Souza, analyst]

When I look at your commercial mortgage portfolio, however, the asset yields quarter-over-quarter for that part of your book, the non-residential commercial mortgages, it's down 100 basis points quarter-over-quarter; residential commercial mortgages is down about 80 basis points. Any color on what's driving the decline in yields we're seeing in the commercial mortgage portfolio?

[Yousry Bissada, executive]

Yes, part of that, is in commercial, we're getting higher quality business and higher quality business has larger deals. They have more competitive rates associated with it. That's part of your answer.

[Nigel D'Souza, analyst]

That makes sense, because when I look at your non-residential commercial book, I think sequentially, we're seeing the first growth in our portfolio since the start of the pandemic. So any additional color on what you're seeing in the commercial mortgage space. Is it just, as you mentioned, higher credit quality borrowers in a rising rate environment and do you expect that trend to continue?

[Yousry Bissada, executive]

Yes, we do. The commercial market is very robust right now as there's a lot of pressure on building homes. The nuclear sort of beginning of that is on the commercial side, land becomes homes, condos, or houses. So we expect it to continue, we expect to see a lot of business, and we expect to see high-quality business.

[Nigel D'Souza, analyst]

Last question from me on your retention rates, the pickup in yields has accelerated over the last few weeks. So in the current quarter, have you seen an improvement in retention rates across your portfolio or any color on what you're seeing finally in the market?

[Bradley Kotush, executive]

Not as of yet. I think we've seen some increased housing sale activity, so that has a somewhat negative impact on retention, but it's slightly up.

[Operator]

Our next question is from Graham Ryding with TD Securities.

[Graham Ryding, analyst]

Just looking at your CET1 ratio, it is a fairly material drop quarter-over-quarter. Beyond the share buybacks that you did, was the majority of that drop attributed to the loan growth or perhaps the type of loan growth? I'm just wondering if there's anything else that was perhaps a factor, it was a bit larger than I expected.

[Bradley Kotush, executive]

It was due to loan growth.

[Graham Ryding, analyst]

Looking on the credit side, what were the factors that your single-family sort of credit model that led to the $4 million increase in PCLs? I'm just wondering if higher rates was a factor there?

[Yousry Bissada, executive]

No. It was all largely attributable to portfolio growth.

[Graham Ryding, analyst]

Sticking with credit, it sounds like you're still not making any changes to underwriting at this point, but we are seeing some early signs of activity slowing and some price changes in the market. What are you looking out for and what do you need to see before you would start to really consider making any changes to underwriting?

[Yousry Bissada, executive]

Yes. There are 2 markets for us. There's the Alt-A and the A. What has slowed down somewhat is the A. The alternating A continues to be quite robust. Key is the job market is very, very positive. Employment is a key driver in our underwriting. We have to believe that individuals will have their job and able to pay. So that's a big part of our underwriting and income variation. So that is very robust, so that's why our underwriting continues to be healthy, and as I mentioned, the Alt-A is not slowing down currently relative to the A.

[Graham Ryding, analyst]

My last question, Brad, this is for you. Thinking about NIM and how it progresses through the year. Are you expecting sort of next quarter to still see some NIM compression, or what's the timing here for mortgage spreads to catch up with funding costs? What's your expectation?

[Bradley Kotush, executive]

Well, my expectation was that I hope it will be sooner than it has been, but we're making some progress. For example, if we were to just look at the average spread between yield on our Classic portfolio and insured mortgages, so that's a much more broadly quoted product, we had at the beginning of the year, a variance of about 80 basis points between the usual spread that we would see, that's now narrowed to 42. So there's still a bit to go, and we will see some further NIM compression in Q2, subject to portfolio mix and how the market would behave in terms of funding costs. I know Yousry has some more color he'd like to add.

[Yousry Bissada, executive]

The key to NIM is steady rates or slow increase or slow decrease. What has happened is this fast increase. As I mentioned in my comments, fast increase sets deposits. Our cost of funds sets our other diverse funding, such as RMBS resets it immediately. And then a little bit slower on the mortgage side, as I explained in terms of competition. So we'll get an impact when rates flatten out or the rate of increase slows down. They went up very, very rapidly. So what Brad was referring to in the second quarter is a lot of the business that's coming in the second quarter, we've already written, so we know what it's under. So as long as that happens, we'll get it back. We're quite confident.

[Operator]

[Operator Instructions] Our next question is from Julia Gul with National Bank Financial.

[Julia Gul, analyst]

First question is on any color you can provide us on market share. Obviously, a really strong quarter from originations in the Alt-A book. What's your sense in terms of market share, competitiveness? Do you feel like you've got more flow than maybe otherwise anticipated given your competitive rates, just a little bit more color around what you're seeing in the market than last time?

[Yousry Bissada, executive]

It's very hard to know market share until everyone reports their results, and the reason for that is there's a couple of sources of market share, but it doesn't distinguish between A and Alt-A. One source is where mortgages are getting registered. Another source is Finastra or Filogix reports, but it doesn't break down between A and Alt-A. We're very pleased with our numbers. As we've said, it's a dramatic increase. We've had a very, very good high-quality business come in. So we're very pleased with our numbers, but very difficult to give you a market share until everyone else has reported.

[Julia Gul, analyst]

In terms of the RMBS, obviously, it's been a pretty successful program last year, what are the indications from your bankers, from investors? Do you see any issues on RMBS this year or is that steady as she goes, what's your thought on that?

[Yousry Bissada, executive]

We don't see any issues continuing to be a problematic issue in the RMBS market.

[Operator]

[Operator Instructions] And it appears so we have no further questions. I'll turn the call over to Yousry Bissada for any closing remarks.

[Yousry Bissada, executive]

Let me wrap up by saying this was a great quarter. We reported great results in all our business areas, the resulting NIM is a normal structural outcome of a fast-rising rate environment and experience tells us that spreads will rework to historical average levels over time. So please note that our Annual General Meeting will be held on May 18. We have announced 3 new directors, who have been nominated for election to the Board; David Court, Joseph Natale, and Edward Waitzer; in addition to Betty DeVita, who was appointed last fall. Each of the nominees brings a rich background and experience to our Board, and I'm excited to work with them. We look forward to welcoming shareholders in person as well as virtually. Thank you for your interest in Home Capital, and have a good day.