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Good day, and welcome to the First National Financial Q2 2018 Analyst Conference.As a reminder, this call is being recorded on July 25, 2018, for replay purposes. At this time I would like to turn the conference over to Stephen Smith, Chairman and Chief Executive Officer. Please go ahead, Mr. Smith.
Thank you, operator. Good morning, everyone. Welcome to our call, and thank you for participating. I'm joined by Rob Inglis, our Chief Financial Officer, and Moray Tawse, Executive Vice President.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 MD&A.The second quarter was broadly productive for First National, as originations and renewals increased in both single-family and commercial mortgage lending. Despite various changes in residential mortgage rules over the past 18 months aimed at reducing housing market risk, single-family originations increased 5%, or $100 million, compared to last year. Montreal office led our national single-family growth with an increase of 24%. As you know, Montreal's economy has performed well in recent periods, and this has increased our opportunity. In 2017 there was also very strong competition for market share in Quebec, with competitors having less regard for profitability. In Q2 2018 these competitors reverted to a more sustainable business model and First National's products were once again competitive.Most other markets also grew, including Ontario, our largest market, with originations up 4% year over year, and Vancouver office, with a growth of 5%. This more than offset a 9% decline in originations in Alberta. Economic indicators are pointing up in that province, and we are hopeful that this translates into better housing and mortgage market activity in future periods.First National's market share performance and to a lesser degree the relaunch of our Excalibur program were also uplifting factors. A couple of thoughts on Excalibur, you may recall that we had good success with this Alt-A product prior to the 2008 credit crisis, and in 2007 we originated more than $700 million with this program. After reviewing market conditions and consulting our mortgage broker and funding partners we decided to reintroduce it this year, beginning in Ontario. To start, Excalibur mortgages will be originated for placement with our institutional funding partners so that First National will earn a one-time placement fee and servicing income over the terms of these mortgages. So Excalibur's a national fit with our business model.Beyond new originations, single-family also executed well on our large renewal book, with renewals up 45% year over year, or by almost $600 million. In commercial new originations were 17% higher than a year ago, or up by $200 million, while commercial renewals were ahead 33%. First National is finding good success in both the conventional and insured commercial markets with positive results, particularly in the multi-family sector, where we are the largest apartment lender in Canada. Of note, the commercial segment surpassed $25 billion in mortgages under administration during the quarter, a key milestone in First National's long-term growth and performance.As a result of these diversified drivers, MUA reached $103.6 billion, an all-time high. Rob will walk us through the financial metrics of the quarter, which were affected by securitization activity and the adoption of a new accounting standard, IFRS 9.Looking at the bottom line for shareholders, second quarter net income was $0.76 per share, and the dividend payout ratio as a percentage of net income attributable to common shareholders was 61%, or 70% if we exclude gains on financial instruments. We are pleased with this performance and what it says about First National's durable and diverse business model.Now here's Rob.
Thanks, Stephen. I'll begin with some comments on revenue, which stood at $291 million for the quarter. That's about 1% lower than last year, [indiscernible] the fact that MUA grew year over year by about 4%, and about 5% on an annualized basis during the quarter itself. The reason is that we recorded lower revenue from gains on financial instruments. Due to changing interest rates and the impact and introduction of hedge accounting under IFRS 9 this year, this revenue was $17.7 million lower year over year. Under IFRS 9 we can now designate our shortfalls as hedges for accounting purposes. In 2017 such a choice was not available to the company. By choosing to use hedge accounting some of the volatility in the income statement is reduced, but it does not eliminate all of it. In the past we also recorded gains or losses related to holding mortgages which were deemed to be held for trading. In 2018 the mortgages on First National's balance sheet have been reclassified, and there should be much lower amounts of gains and losses related to these mortgages going forward. Also in 2018 Q2 we recorded gains on financial instruments of $7.3 million, compared to about $26 million in Q2 last year. Excluding such gains, normalized Q2 revenue would've been about 6% higher year over year, which is generally the result of rising interest rates.Corporate servicing income increased 4% year over year, the result of higher MUA and growth in the company's third-party underwriting business. Mortgage investment income increased 31%, due primarily to an increase in the company's commercial bridge loan program. Interest revenue on securitized mortgages increased 20%, due to our larger portfolio and higher average mortgage coupon on the mortgages within that portfolio, and the deferred placement fees were flat year over year at $2.4 million. Placement fees were the outlier, down 43% due to lower new residential origination volume meant for institutional customers. As you've seen, we're using securitization funding into HMBS, CMB, and ABCP programs to a greater degree in 2018 than in 2017. Although the impact from revenue was felt immediately, by securitizing we are putting in place a match-funded mortgage portfolio which provides revenue, cash flow, and earnings over the 5- and 10-year term of these mortgages.Moving now to our earnings performance, our decision to retain more mortgages, both newly originated and renewed, for our securitization program, which delays the earnings process until the securitization cash flows come in over a 5- and 10-year period, as well as tighter mortgage spreads, resulted in a year-over-year decline in net earnings pre-fair market value EBITDA. Even so, as Stephen said, earnings provided good coverage for our common share dividends. On solid core earnings the board declared common share dividends for the second quarter of $0.462, which is equivalent quarterly or per year of $1.85.Now here's Moray with our closing comments.
Thanks, Rob, and good morning, everyone. I know many of you are trying to get a fix on how B-20 is affecting originations and renewals for First National. In this regard, the first quarter was largely unhelpful, because there was a one-time impact of commitments made in December, before the rules changed, that may have inflated our originations in quarter one. Now that quarter two is in the books we can draw some conclusions, one of which is that origination increased to 5% for our single-family department, which speaks to the success and the durability of First National's business model. Another is that the recent CREA stat shows that June home sales growth of 4.1% nationally over May demonstrates that Canadians are still pursuing the dream of home ownership, despite the new rules of B-20 and rising interest rates.While B-20 has perhaps slowed the mortgage market, those same CREA stats show sales down 10% year over year. First National has always underwritten conservatively. As such, B-20 was not a big adjustment for us.Another point of conjecture about B-20 was that the new rules would make it more difficult for borrowers to move to a new lender. Perhaps some of the 45% growth in our single-family renewals in Q2 of this year can be attributed to B-20, but we believe that the real driver is the business we did in 2013 and the fact that our borrowers are renewing with First National for their second and third terms of their mortgages.The relaunch of our Excalibur added some incremental volume in the quarter that was not present last year. This had a modest impact on originations, given that the launch was confined to Ontario, but positive one, nonetheless. We're not going to state our specific Excalibur targets or expectations at this point, but I would say that we have every confidence that this product can be productive for First National as it was prior to 2008 once it fully ramps up.As an aside, I think the ease with which we relaunched Excalibur demonstrates that there's still a large market for buyers who can't prove income but are otherwise solid credits. Our relationships with our mortgage broker partners are strong, such that the product offering got immediate uptake. Our technology platform is flexible, as it accommodated the additional product seamlessly, and we were able to staff the underwriting group appropriately to ensure Excalibur is underwritten to First National standards.As for our overall outlook, we are optimistic that the trends and originations established in the second quarter will continue in the third, but we also expect tight interest rate spread environment, similar to what existed in the second quarter of 2018, to continue in the short term.Overall our positioning is strong, and we expect to continue to benefit from the income and capital generated from our $29 billion portfolio of mortgages placed under securitization, and over $74 billion of servicing portfolio, while we focus 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 lines for questions.
[Operator Instructions] Our first question today comes from Geoff Kwan of RBC Capital Markets.
The first question I had was I know when you have your funding, I mean, there's call it a straight institutional sale. You have some with a bit of a deferred placement fee, and then on the securitization side it could be ABCP or CMHC. But because your funding mix can change quarter to quarter, are you able to say for Q2 if you simplified the funding mix to being just either a straight, pure institutional sale versus CMHC securitization what, say, every 1 percentage point change in the funding mix one towards the other would've had an impact on earnings?
No.
Okay.
No, we don't -- I think that's always a little bit of an issue in our business compared to last year. I'd say last year this quarter probably income of pre-fair market value EBITDA was stronger because of a lot of institutional sales, and this quarter it probably [errs] on the other side where it's a lot weaker because of huge amounts of securitization. But we just don't -- we don't do that type of analysis.
Okay. On the Excalibur, I know you're not willing yet to kind of talk about targets or growth, but in terms of the actual fee you're receiving from the institutional investor or investors, I'm assuming that that fee would be higher than what you would get on a prime institutional sale, or was it actually the same?
Well, it's a little bit different type of model. We get a combination of a fee from the originator. We pay -- or from the purchaser. We actually get a fee from the borrower. But we still pay a fee to the broker, which maybe not be -- might be quite as much. I'd say the economics of it are slightly better than they are for prime.
Okay. Okay. And on the revolver, you talked about the term and the size increasing. When you signed the papers on that, and I know it's a floating rate, did the rate itself go up from what it was beforehand, and if so like how many basis points would it have gone up, if it did?
Do we -- I think we can answer that. No, the spread on the rate did not change. Generally our credit we're a Triple B rating, so that's sort of market determined, and those spreads haven't materially moved in the last number of years.
Okay. And then if I can sneak in one last question, you talked about your expectations on originations essentially being up year over year in Q3. There's been some people in the industry have talked about Q4, thinking that there's going to be a rebound in the market activity. Are you seeing anything to suggest that that may play out, or is it maybe more of a hope and expectation more than anything concrete from what some of the other market observers have been talking about?
Well, I don't know about the rebound. I think one would feel that a little bit. One of the reasons I think we had a strong Q1 and Q2 is because we had a very weak Q1 and Q2 last year in 2017. What people don't fully understand with B-20 is that there was the equivalent of B-20 in the insurance space with regulations that came in in the latter part of 2016, so that about 50% of our business is insured. So we took a bit of the beating in Q1 and Q2 last year because of those changes. That got no press, and everyone's talking about B-20 now, but B-20 only affects 50% of our originations. So we got a nice rebound back on the insured business this year, and I think just generally there's been a bit of a reallocation in the monoline space where we still have a full range of products, and I think that's helped us gain a little bit of market share relative to our competitors. We're actually seeing originations not so bad now, and I think I would support that, that we might see a good rebound. But it's tied to heavy sales, and there's no doubt B-20 and then [indiscernible].
Okay. Great. Thank you.
We'll go next to Graham Ryding, of TD Securities.
I'll just start with the Excalibur product. What was the rationale for launching the product now? Did you see a market opportunity because of B-20, or why now?
Well, I think we were -- I don't know if it's the B-20 thing. That's a little bit of a factor. It's interesting, the Alt-A business that we do now in that space and that we're selling to institutional investors is equivalent to the prime product of 5 and 10 years ago. It's a very high-quality product. People have good FICOs and they also have -- they tend to have good income that, while not traditional employment income, self-employed income, which is very strong. But we just looked at it as another -- we've been debating about it for a while, and I think we finally decided that there was, oh, enough liquidity. I think the biggest issue would be is I think we've got enough reverse inquiries or institutional investors wanting to purchase the product and that we could launch it and do it in some scale. I think in previous years when we looked about it we were not too sure that the size of the opportunity was particularly that large, and now we're comfortable there is that liquidity.
Got it. So it sounds like it's more than one institutional buyer, so it's several buyers for this product. Is that fair?
Well, I'm not going to get into the number of different buyers, but there's certainly an awful lot of interest.
Okay, got it. And would you elaborate on whether it's -- credit unions are interested in this product, or is it across the [indiscernible]?
Good try. I'm not going to get into -- as you know, we have a range of institutional buyers, be they credit unions, life insurance companies, federally regulated institutions, domestic, foreign, we have a lot of different institutional buyers.
Sure. And then just on the setting up the underwriting team for this product relative to your prime product, do you need a separate underwriting team, or did you take existing underwriters and move them into this space? How did you go about that?
So, our experience would be that underwriting Alt-A product is an entirely different mindset from doing prime product. Generally you can't do the -- you just can't do the same thing, and it's a little bit sort of similar so that we set up a separate team, and they look at the deal as if it's a prime -- as if it's a near-prime type of transaction. So we would take underwriters and perhaps retrain them. In this case we ended up hiring an underwriting manager from another institution, and also we set up a separate sales team, too, so that the people underwriting and the sales team are entirely separate. And this would be based on our experience on Excalibur. You can't really multitask this product, either from a sales point of view and an underwriting point of view or from a credit risk management point of view.
Got it. And my last question, if I could, how long do you think it would take before you fully ramp up across the country for this product?
Oh, we -- I think we've been surprised is how quickly we have ramped up. We thought it would be a quite slower ramp-up. I think we could be fully -- we would -- I don't know that we've turned our mind to it to, Graham, when we would expand. Our next step would be expanding to Vancouver. That's what we did 10 years ago. We went to Vancouver and underwrote. And I don't think we've turned to mind when we would go there yet. I think we'd probably want at least a few more months here, maybe put some more emphasis here before we went to Vancouver.
Okay. That's it for me. Thank you.
We'll go next to Nik Priebe, of BMO Capital Markets.
Just one follow-on question on the Excalibur product. Could you maybe explain how you're thinking about the potential contribution from that mortgage product? I know it's still early days and it sounds like it was a bit of a modest contribution in the first half of this year, but recognizing the offering was just relaunched and confined to Ontario, are you planning to sort of staff that business sufficiently to support an eventual return to sort of the volumes that you alluded to in 2007 after a ramp? Just trying to get a sense of how that business might scale.
Right. Oh, I think we can certainly see over time that we could easily get back up to $700 million a year, if maybe not a billion. I would think we would hope that we would get -- could originate a billion dollars a year in that over time within the next year to two years.
Okay. Okay, that's helpful.
Backing's not an issue. We just -- it's easy to get the people to do that in terms of we find there's enough salespeople available to do that and also underwriters.
Okay. You also alluded to pretty strong growth in the Quebec market last year. Just wondering, what in your estimation is driving that. Sounds like there were some competitive dynamics at play. Do you see evidence of the credit unions pulling back a bit on activity, or is there anything specific you'd point to there?
No, I think last year we found the credit union market, Desjardins, has just been very competitive. They were very competitive last year. Haven't been quite as competitive this year. The interest rates we were seeing in Quebec last year are crazy, and they're not quite as crazy this year so we were able to get back share. I think we were just seeing if one wants to look at the Canadian mortgage market in general over the past year to 18 months we are seeing a tightness of spreads that I haven't seen in a long time. Usually you'd see 6 months and people -- things would go back to normal. I don't think I've seen such a prolonged period of where all the DCIPS have been so competitive. I think it's a combination, if I had to speculate, it's huge pressure on share, on mortgage share, so people are pricing very, very competitively. But these are very tight spreads.
Okay. Okay, that's it for me. Thanks very much.
[Operator Instructions]And we'll go next to Jaeme Gloyn, of National Bank Financial.
First question, of course, on the Excalibur product. The one thing I'm thinking about is in terms of in ramping up and the volumes you were able to get, let's say, in the first half of 2018, how much did rate play a factor, and is that something that you would categorize as aggressive on the rate side, or is it really just relationship based?
Well, that's a good question. I would say there would be -- we had a competitive rate but not an aggressive rate. I would say there's a huge element -- we have a big franchise value. We have a good -- we have a -- I mean, we are one of the largest mortgage lenders in Canada. We have a broad distribution network. We have people that we hired that have good relationships. We have a reputation as being consistent underwriter. People like doing business with us. So I would say a big factor in that would be our franchise and our relationships just generally with the mortgage broker community in general.
Okay. And you would expect to continue to leverage that and also remain competitive on rates, I guess, on the build-up to $700 million to a billion.
I think that's correct.
Yes. Okay. Shifting then to the commercial bridge loan portfolio, a huge uptake there, can you just talk about what the strategy is for that program, what's the scale that you're looking to achieve, and how you're thinking about credit risk in that portfolio, and the -- I guess there's been a slow trickle of what we'll call credit loss provisions in that portfolio despite a pretty sizable chunk of it that's in arrears? Can you just sort of talk about both scale and credit risk management?
Sure. I'll speak about that. The portfolio is very, very strong. I think we have one project that we've had trouble with, and hopefully we think that that's going to clear up by the end of the first quarter of next year. The other part of the portfolio is very, very clean. We use it for bridge financing for people that are going to CMHC. The duration tends to be very, very short, and the credit on a lot of those loans tends to be very, very high, even institutional type of borrowers. So it's just it takes -- they've got to close on a deal, they need the money before they get CMHC, so we bridge them for that. I think we're actually seeing that it goes up and it comes down quite quickly, because the typical duration of those bridges might only be 30 to 60 days. So we don't have an aggressive plan. We have never had an aggressive plan for our mezzanine book. We use it for opportunities for customers that are well known to us and have this [indiscernible] active strategy over a very short period of time. So it does turn over quite a bit.
We've been probably doing more of that than in past years because we've been generating so much excess capital that we always were in a position for or where we have a lot more opportunities that we could invest in. But with the -- our business is a 40% ROE, so there's huge amounts of cash. Last year you saw we -- that special where we essentially dividended all our income for the year. So what we've tended to have been doing is we tended to put that into mezzanine [indiscernible] particular program.
I think that mezzanine business is supporting our growth in our CMHC business that you can see.
Okay. And so in terms of the --
And one last thing, Jaeme, is look at the cash flows. Look at the cash flows here. In the course of 6 months we invested in 3 million new ones and 408 repaids. So you see in 6 months the whole thing has turned over once, almost. So it's a very quick turnaround.
Right. Right. And should we expect the run rate, then, in that mortgage loan investment book to sort of remain around that $300 million, or, I mean, I guess, is it still just too volatile to pin it down to a specific number?
That's been pretty much fairly consistent over a multitude of years. So I would yes, the opportunities seem to continue to come to us and seem to [indiscernible] the same rate. So I don't see anything changing and making it bigger or particularly smaller.
Okay. So just looking at the securitization book and the mortgages pledged for securitization, I'm looking at Note 3 and it's, I guess, Page 5 of the financial statements, in the disclosures around new origination costs capitalized in the period there's a 3 times uptick in origination costs from 2017 to 2018 for this quarter. That's quite a bit larger than the increase in, I guess, just originations for securitization. So what's explaining that delta or that significant jump?
Well, certainly it's the amount we're doing, obviously. We're doing a lot more securitization. That's in there. Some of it's the interest rate risk or interest rate cycle. Interest rates go up. There's a bigger discount to pay on the HMBS structuring, which is our cross to sort of bear over the course of the term. I think those are the biggest things.
Yes, if we're doing our own secure, we're doing institutional sale, then we get the money right back immediately. If we're doing a securitization we have to -- those costs go into that number. I assume that's the different trough, isn't it?
Yes, sometimes like we're doing a 4% coupon, but because of the rules of an HMBS we have to do a higher coupon [indiscernible] almost 3K, but the yield [indiscernible] is better for us. Also we can do a bond transaction. So that gets in there. It's more of a yield play, so it's more broker fees, and the yield interest rates go up.
Okay. Okay, that's fair. Another couple of quick ones here. Just on the renewals, the success there. I may have missed it, but did you disclose your retention rate in this quarter or let's say in H1 2018 versus historical trends?
I don't think we do disclose, but it's a little bit higher. It's not a lot higher, but it's certainly trending up.
Okay, and the last one, then, going back to the Excalibur, or maybe not the Excalibur program, but the recent announcement from CMHC to allow or to make it easier for self-employed borrowers to get mortgage insurance, what type of impact do you see that happening for, I guess, insured mortgages, in general, and then for the alternative self-employed market, as well?
Well, I think we I think in general think there'll be greater opportunities to do more mortgages for self-employed people, but how material that is I think is difficult to assess at this time.
Okay. Thank you.
We'll go next to Phil Hardie, at Scotiabank.
Most of my questions have been asked and answered, so maybe just one quick one. You talked about some of the changing conditions, the competitive landscape within Quebec versus last year. Maybe you could just give us a bit of color in terms of like how much regional disparity you're seeing in terms of intensity of competition and pricing discipline.
If I had a sense I have always thought in Canada there's been two markets, and it's Quebec and then the rest of the country. And then sometimes you see a little bit of pricing disparity out in British Columbia because the credit union sector out there is a little bit stronger. So sometimes you see some more competitive, more competition out in Vancouver. In general, the DCIPS set the price and people price off of that. So I think that's where you get the real competition. The credit unions being so much more powerful in Quebec, they create a little bit of their own market, and then a little bit of the same effect out in maybe the Lower Mainland. But it's competitive across the country.
Oh, I was just going to ask if you can give us a bit of a historical perspective in terms of kind of how it's shifted today versus in maybe 5 years back.
Well, I'd say the same thing was relevant in Quebec and the Lower Mainland 5 years ago. I think what was unique last year, it was particularly competitive in Quebec. As opposed to being just competitive, it was so competitive that the differences in the rates is you weren't even competitive. It wasn't like you were off 10 basis points. You were off significant numbers. In general, in terms of competition, what I would say to the extent that the DCIPS set the rates across the country and you look at the spread of mortgage rate relative to, let's say, an MBS spread or a 5-year Government Canada bond, it's that you generally see spreads going in and out over the years. It's been in the last year to 18 months that it is consistently tight, consistently at the low end of the range. And I think what's unique it's been for a long period of time, longer period of time than I've seen ever, rather.
Great color. Thank you.
And, Mr. Smith, there are no other questions, so back to you for closing comments.
Thank you, operator. That concludes today's event. We look forward to reporting our third quarter results in late October and look forward to speaking to everybody then.
Again, this does conclude today's conference. We appreciate everyone's participation today. You may now disconnect.