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Good morning, and welcome to First National's Third Quarter Analyst Call. This call is being recorded on Wednesday, October 27, 2021. [Operator Instructions] Now it's my pleasure to turn the call over to Stephen Smith, Chairman and Chief Executive Officer of First National. Please go ahead.
Good morning, everyone. Welcome to our call and thank you for participating. Joining me today are Jason Ellis, our President, Chief Operating Officer; and Rob Inglis, Chief Financial Officer. Before we begin, 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. First National's results in Q3 reflected strong demand for mortgages in both our Single-family and Commercial segments and some changing market dynamics. And by that, I mean mortgage spreads narrowed quite substantially from abnormally high levels last year. And as a result, our traditionally strong profit metrics reduced despite higher business volumes. Even so, the cumulative growth and positive earnings performance since the beginning of 2021 led our Board to declare a special dividend from the excess capital generated over that period. To provide some more detail on these comments, I'll begin with quarterly originations. Company-wide, they were up 10%. We think this is an excellent result given that the third quarter of 2020 was quite strong. Results were also pretty much consistent with our outlook for the third quarter, which was for single-family originations to be comparable to Q3 last year and success in growing our commercial originations. In fact, single-family originations increased 4% over Q3 last year to $6.1 billion. Generally, seasonality is predictable in the Canadian housing market. However, in 2020, activity after the onset of the pandemic continued to be strong through the typical slower fourth quarter and on into 2021. I think traditional seasonality will return to the market. But in 2021, we're also seeing market activity levels adjusting back to somewhat more normal levels after the frenetic pace of the past year. That's to be expected and makes our Q3 2021 performance all the more satisfying. What's most important is that First National continues to enjoy strong support in the mortgage broker channel as a result of hard work by our single-family team, supported as always, by MERLIN technology. For our commercial team, Q3 was very busy and successful with new originations ahead of last year by 33%. You will recall that we started 2021 slowly but have more than made up for it in the past 2 quarters. In fact, on a year-to-date basis, commercial originations are 5% ahead of last year. This growth reflects strength in the commercial property markets we serve and like last quarter, renewed demand for conventional loans that augmented overall volumes. The resulting change in product mix did have an impact on profitability, which Rob will discuss in his remarks. Moving on mortgage renewals on the single-family side were lower than last year. We think this is a result of fewer opportunities as more borrowers have chosen to refinance their mortgages to take advantage of the low-rate environment. And commercial renewals were ahead of last year by 48%. This growth was not just about available opportunities, but also reflected the team's ability to maintain long-term relationships by finding the right solutions for borrowers in this market environment. MUA at quarter end was up a healthy 4% year-over-year to a new record high of $122.3 billion, even though the level of prepayment activity somewhat muted the impact of our higher originations. And looking at our results, I would call out a couple of other drivers. One is the ongoing performance of First National's third-party underwriting and fulfillment processing business, which continues to benefit from our clients' success -- probably successes. This business augments administration revenue earned on MUA. We also continue to be pleased with the contributions of Excalibur which notably had lower credit loss ratios than we originally expected. Both of these businesses leverage our technology, our broker relationships and add diversification to our revenue. As I alluded to at the outset of my remarks, mortgage spreads have narrowed over the past 6 months, a sign of renewed competition brought on by greater economic stability compared to last year. In fact, spreads are now as narrow as they were before the Great Recession of 2008. For our commercial business, spreads were 15% to 50% lower than last year, a period when some competitors more or less sat on the sidelines. Result of spread compression was lower revenue and profitability in the quarter. Although I must say that comparing 2021 to 2020, it's a bit like comparing apples to oranges because of the exceptional results in 2020. Nevertheless, earnings were steady and certainly more than sufficient to support the June increase in our common share dividend, which brought the annualized rate to $2.35 a share. As you know, this was the 14th increase in shareholder payout since First National's IPO back in 2006. Even after distributing at this higher level, our common share payout ratio for the quarter was a healthy and sustainable 75%. As a reflection of the strong performance achieved on a year-to-date basis, our Board authorized a special dividend of $1.25 to shareholders of record on November 30. This is our fifth special in the past 5 years. We take pride in the discipline we show in capital deployment, which is borne out by First National's consistently high return on equity, but also in the fact that when we generate capital in excesses -- in excess of operational needs, we return it to our shareholders. Overall, I'm pleased with the results to date. We are moving towards post-pandemic future and our business fundamentals remain strong. Jason will comment on our near-term outlook in his remarks, but first, we'll turn the call over to Rob for his remarks. Rob?
Yes. Thanks, Stephen, and good morning, everyone. This is one of those quarters when growth in MUA, which amounted to about 4% year-over-year and 3% annualized, did not translate into higher revenue or profitability. The effect of narrow mortgage spreads, some other dynamics in the commercial mortgage market each had a more significant impact on our financial results. Now looking at Q3, revenue declined by 5% year-over-year. Most of this was the change was the result of lower revenues on placement transactions. Our unit revenues were affected by mortgage spread compression as well as changes in commercial product mix. The Q3 mix consisted of a greater proportion of uninsured commercial mortgage origination than in 2020 and a reduction in the average mortgage terms of our origination in the quarter, again compared to last year's quarter. Most significantly, the mix change featured a shift in Board demand in favor of 5-year mortgages at the expense of 10-year money, a year ago when we were doing more tenure business as borrowers locked in historically low rates. Placement fees are directly linked to the term of mortgages. And as such, all else being equal, 5-year mortgages provide approximately 50% lower revenue on a per unit basis. Of course, a 5-year mortgage is a renew opportunity in 5 years. The impact of this shift in term was magnified by our funding strategy. In the latest quarter, fewer commercial mortgages were funded through sales institutional investors in favor of the superior economics of our own securitization through NHA-MBS. We traded placement fees today for future net securitization margin. The value of the securitization is only recognized in income for 10 years as opposed to replacement where much of the value is recognized in the current period. It's a case of doing business now and profiting later. Another factor in placement fee math is the Excalibur origination. Volumes increased significantly, but with short mortgage terms of 1 to 3 years, placement fees per unit earned are lower than a 5-year mortgage. Partially offsetting the placement fee dynamic was growth of 15% in net interest on securitized mortgages. This was the result of a 4% year-over-year growth in the portfolio, the addition of wider spread higher mortgages securitized in prior quarters. However, higher single-family prepayment speeds partially offset these positive developments. First National also registered 12% growth in mortgage servicing income due to growing MUA and our third-party underwriting and fulfillment processing business. Now turning to quarterly expenses. They were generally higher than a year ago, reflecting growth and in capacity expansions to support our broader business platform. You might imagine a natural byproduct of higher single-family origination volumes with a year-over-year increase in brokerage fees. What's important is that unit broker fees were generally steady between the third quarters of 2021 and 2020. Salaries and benefit expense increased 22% or by about $8.5 million as FTE increased by 35%. Other operating expenses increased by 37% or $5.1 million, largely due to a $3.7 million increase in hedging costs in support of our securitization programs and a steepening bond yield curve, which makes hedging more expensive. On the bottom line, First National earned $0.78 per common share in the third quarter and $2.51 per share on a year-to-date basis. Now over to Jason.
Thanks, Rob, and good morning, everyone. The third quarter was an incredibly busy period for all members of our team as they responded efficiently and effectively to extraordinary market demand. As you know, First National is in the business of growing, but the pace over the past year has been both unusual and unpredictable. We're not complaining, but we also know that the markets will find some sort of new normal, and we are prepared for that eventuality. We're not sure when it will happen, but I can tell you 2 things. One, we remain positive about the remainder of 2021 and intend to finish the year in a strong fashion and build on that performance next year. Two, we do expect new origination to be lower in the fourth quarter than it was last year, which I think is understandable considering that last year's Q4 was exceptional. Total originations back then were $8.7 billion as home purchasing and commercial originations surged at the close of 2020. Estimates and forecasts are always subject to change and uncertainty. But based on our current market assessment and our commitment pipeline today, residential origination may be up to 25% lower than Q4 2020. However, if this outlook holds, single-family volumes would still be more than 20% above 2019 levels, which puts this in perspective. Canadian monthly home sale volumes from March through September of this year are perhaps indicative of the market seeking out a new level, albeit one that is still higher than before the pandemic. We're not going to get so granular in our short-run growth forecast for commercial. But again, I would remind you that fundings in Q4 last year were very strong at $2.7 billion and more than half of that business closed in December of 2020 alone. This year, our commercial business is also coming off back-to-back quarters of healthy volumes and we feel it will remain strong in Q4 of 2021. It's too early to offer a reliable forecast for 2022, but I would say a balanced view needs to take into account the economic recovery, the reopening of Canada's borders, including to newcomers looking for homes and departments and expectations of lower levels of quantitative easing in the face of inflationary pressures. Whether higher inflation is temporary or longer term is a question that will be addressed in the coming months, and we look forward to this morning's Bank of Canada rate announcement and quarterly monetary policy report for new clues. At this stage, I can tell you that there continues to be strong demand for First National mortgages from institutional investors due to the substantial amount of liquidity in the financial system. Securitization markets also remained robust and continue to provide consistent and reliable funding. Against this generally positive backdrop, First National's objective is unchanged. We intend to remain a leader in the marketplace, and we'll use our competitive strengths, including a now larger talent pool, deep diverse relationships with partners, wide-ranging mortgage products, both insured and conventional, and our reliable business model to serve and succeed. Internally, we're embracing technology more than ever through our current work-from-home strategy and intend to leverage this strength in a post-pandemic world using the lessons we've learned. I will conclude by saying that we will continue to be ambitious in pursuit of opportunities but also disciplined in how and when we allocate capital. This traditional approach has served us well over the past 3 decades. And while we're looking to the future, we will be rewarded today by the fact that First National will continue to generate income and cash flow from our servicing and securitization portfolios together amounting to over $120 billion and the value inherent in our single-family renewal book. This concludes our formal remarks, and now we would be pleased to take your questions. Operator, over to you.
[Operator Instructions] Your first question comes from Etienne Ricard with BMO Capital Markets.
In single family, back to your prepared remarks, that higher refinancing levels impacting renewals recently. So with mortgage rates now rising, how do you expect renewal volumes to trend over the foreseeable future?
Etienne, it's Jason. I'll take that question. So I think the entire industry saw elevated prepayment speeds related to early refinancing or early renewal activities as borrowers sought to lock in these lower rates for extended terms. As rates start to go up, the relative value of a borrower engaging in those activities will be reduced. So I certainly anticipate that First National, as most lenders, will benefit as rates start to rise and prepayment speeds lower. This will be reflected in both renewal opportunities and retention, but also in some of the peripheral benefits to net interest margins on our securitization portfolio as prepayment speeds fall. So I would say that generally that it will be a tailwind for First National into next year.
And the other thing I add, you always have higher prepayment rates during times of heightened market activity because people are, by their very nature, they're buying a new house and they're leaving the old mortgage. So when you have heightened market activity, you see higher prepayment rates.
Understood. And given the step-up in profitability upon renewal for mortgage, what opportunities are within your control to drive this rate higher?
Well, of course, every opportunity to nurture the relationship with our existing borrowers we take. In recent years, we've adopted a much more modern approach to renewals with digital signatures and automated renewal practices, which makes the process much easier and reduces the resistance to the renewal from the borrowers perspective. So I think we're embracing both technology and customer service to make sure we're maximizing utility of those renewals.
Okay. And on headcount, I think you flagged in the MD&A that most of the recent growth to your employee base is in residential underwriting. Could you talk about the expected benefits of having more resources in this department as it relates to broker relationships?
Of course. So obviously, as you've seen, the origination volumes were a record over the last couple of years and necessarily required hiring both on the First National side and through the outsourced underwriting we performed for our third-party clients. The advantage going forward will be that, one, upon initial adjudication of new applications, we'll maintain our turnaround time for the brokers. And the fulfillment stage post adjudication as we're reviewing documents, we'll be that much more efficient. And even if the market moderates from those highest levels that we've seen in recent months, we believe that our staffing levels are appropriate now to deliver great service levels but not over stopped in any respect. So I think that, generally speaking, the -- it took us a while to catch up because it was definitely a difficult labor environment. But now that we're here, we look forward to giving the brokers tremendous service on a go-forward basis.
Your next question comes from Geoff Kwan with RBC Capital Markets.
My first question -- my first question, was you mentioned in your MD&A, just seeing borrowers not just in single family, but also on the commercial side, taking shorter terms. Just wondering if there's any insights, if you can talk about borrower behavior on both sides of the business?
Geoff, I think the spread between the 5- and 10-year rate offering influences that decision significantly. There was definitely a steepening between the 5- and 10-year point on the underlying Canada curve. And then when you combine that with the additional spread on a 10-year CMB versus a 5-year CMB, I think some of our investors were looking to minimizing their monthly service and therefore, we're opting for a 5-year. So no doubt, the shape of the curve and payment has some influence. Some of our biggest borrowers we're looking to maybe diversify or ladder out some of the maturities after winning so heavily on tenure the last couple of years. So a couple of factors for sure. But I would say the steepness of the curve and the relative monthly service on the mortgage is the driving factor.
And so that explains kind of on the commercial multi-unit side, but on the single family, I thought there was also a reference to borrowers taking shorter terms?
No, that was specific to the Excalibur program. Excalibur is the all-day program. It's offered in 1- to 3-year terms typical of that product space. And so while Excalibur experienced tremendous growth quarter-over-quarter and year-over-year, the per unit placement fees generated by selling those mortgages to our investor partners is relatively modest compared to a 5-year just because of the shorter-term nature of the Excalibur loans.
Okay. Got it. So it was just a mix issue as opposed to for within the segment?
That's right. The traditional prime space continues to be dominated by 5-year terms. It has always been and likely will continue to be.
Geoff, the single-family borrower if he's going to play the curve, which a lot of borrowers are doing is to take a floating rate. And actually, the floating rates, there's quite a bit of curve right now between a floating rate mortgage. I think it get rates in the low was a 1 handle and 5 years are in the 2 handles. So there's quite a bit of curve there.
Okay. On the commercial multiunit residential side, can you kind of talk about what you're seeing right now from a competitive dynamic? And if that's changed from, I don't know, say, the past 6 to 12 months?
Geoff, it's Jason again. Yes, we've definitely seen a resurgence in competitive pressures in the space, not unlike our experience some time ago now following the global financial crisis. There was a period where something of a vacuum opened up post -- or in the early stages of pandemic and the ability to originate CMHC multifamily mortgages at historically wider spreads was available to us. There is absolutely no question in recent months and even quarters, we have seen a return to the market of both traditional and even a number of new participants in the CMHC multifamily space. So there's no question there is enhanced competition. And as a result, we've seen that reflected in our average origination spreads.
Yes. Our competitive advantage in that area comes from that. We've been in it forever. And in tough times, like we were -- we didn't step away March, April, May, June, July last year, we were there. The other thing is we have a very good, what I'd say would be a mezzanine rich financing program that would be -- that was -- that we get a lot of borrowers coming to us just because of ease of execution. So they need a size of a loan to bridge until they get the CMHC financing, that could be 6 or 8 months. And we can do that quickly and efficiently. Our competitors that are either maybe potential these sit where that full process is very fraught, uncertain, not too sure how long it takes or some of our other competitors who just have very much to take out of product.
I'd say by our assessment, Geoff, our share of the CMHC multi-market has not been impaired by this renewed competition. Unfortunately, it's just simply had an impact on, I think, market pricing.
Got it. And just my last question was just more from a broader perspective on single-family residential. You talked about the higher refinancing activity. And I just kind of think to the U.S. I mean that's one of the things that's down there, people whenever rates go down people are financed because there's not really much in the way to penalties. But we have the prepayment penalty in Canada. Yet, you still talk about, I guess, higher refinancing activity given the lower rates. I'm just trying to understand, is this a function -- how much of it is coming from people that are, say, getting a new home and already have an existing mortgage versus people that are just trying to take advantage of rates, whether or not to lower the payments or whether or not it's to pull equity out of the home?
I don't -- I guess I don't want to make too much of people refinancing full activities. You'll get people who have floating rate mortgages who may lock in because there's low rates and the penalty on a already made mortgage is 3 months. In fact, probably the penalty there isn't strong enough to compensate for the cost of putting the mortgage on. You may have people who are getting near the end of the term and they have a higher rate, and they might be willing to pay the penalty. But in generally, you can't refinance in Canada for financial advantage. So sometimes people are doing it for almost perception basis than on a realistic basis.
Yes, like Stephen mentioned earlier, there's no doubt an important element was just general levels of activity in the housing market, people are buying and selling and moving, and that's going to create early prepayment. And aside from that, like Stephen said, the interest rate differential penalty in Canada is meant to remove the economic incentive to prepayment. However, I think when rates were as low as they were as people approach the middle toward the end of their term, the penalty is there on the remaining term, but then there is also, I guess, the opportunity to renew early and extend the term of your mortgage in that rate environment. So who knows? Maybe there's an element of fear of missing out on the low-rate environment that drove people. But to answer your absolute question, I don't think we could really say what percentage of those activities are related to moving versus being proactive as a borrower.
Your next question comes from Graham Ryding with TD Securities.
Can you hear me okay? Okay, great. The expectation in Q4, the guidance, and I realize it's not a crystal ball, but your 25% decline year-over-year is sort of what your best estimate is now. Is that a reflection of market activity overall? Or are you seeing any evidence of the bank branch channel regaining some market share on the broker channel?
It's overall activity. So we would have some visibility of how we're doing it for closings and what we did in September and then closings obviously enough over and our pipeline going forward. So I think we -- generally, we tend not to give too much guidance. But I think in this case, we -- given that Q4 last year was exceptional, we want to give some guidance going forward. So I guess the guidance would be as, I think, 25%. Maybe it might not be that much, but that would be market activity as opposed to any share. And then the other thing is the commercial business tends to be quite strong.
Okay. Understood. And then quite a healthy special dividend. Can you just sort of remind us or elaborate maybe on how you measure or look at our excess capital? Is there a base level of shareholder equity that you feel like you need to support business activity?
Well, I think what we tend to do is, we tend to look at the type of capital we need to be an issuer. We look at the capital that we need to maintain are ready and we look at the capital needs for original activity, and we tend to come up with a number and/or all-pay activity, and we look at numbers there. We think we're quite well capitalized as we are -- in fact, we had discussions that we probably had room for even more of a special. But we thought we'd keep it at this level. I think the key, probably, like to remind all investors is that we have -- myself and Moray Tawse owns 75% of the business. We're -- we have the situation here where the management and the shareholders are very aligned. And so if we can't put the capital to good efficient use, we think it's important to return it to the shareholders. Consistently, our ROE has been in the 40% range. And if we can't get good returns, we give it back to the shareholders on a basis that if we do get an opportunity to shareholders as they're [indiscernible] support going forward.
Okay. Understood.
In fact, I would argue -- I would argue to any investors who are public investors is that actually when you -- if you want to be aligned, you want to be in line with people who with companies that have -- who do have actually strong shareholders because they tend to be very focused on efficiency of capital and which Moray and I are...
Okay. Great. And then operating expenses were elevated this quarter. I know you mentioned hedging costs were one factor. Is that something that you expect it's going to persist with your sort of outlook for securitization activity and the yield curve?
It's Jason. Yes, so just the simple math of being short a 5-year Canada bond as a hedge against a 5-year mortgage commitment and then the offsetting repo at the shorter end of the curve. I think that, that dynamic was probably -- it's probably relative steepest over the last quarter. As the Bank of Canada gets closer to increasing the short term, I think we'll see a reduction in that carrying cost of the hedge program. As far as the scale of the outstanding hedging activity, always a function of our decisions around our funding strategy, are we securitizing more, are we placing more with institutional investors and so on. So difficult to say, definitively. But I think that the carrying cost of that hedge program will be the same to modestly lower going forward, all else being equal.
[Operator Instructions] Your next question comes from Jaeme Gloyn with National Bank.
Yes. This question is on kind of what you talked about with consumers, taking the variable rate mortgage and looking at that product, and you're seeing it across all players. Can you give us a little bit more color as to how that impacts placement fee margins on your end or revenue per unit on your end for a variable rate single-family mortgage versus a fixed rate?
There's really not a material difference in terms of placement fees. I mean, in the spectrum of placement fees, some investors on the fixed rate side might have a more dynamic purchase price based on the relative spread environment. But for the most part, our investors are buying mortgages or committing to purchases at the point of commitment so that whether it's a fixed rate or adjustable-rate mortgage, the placement fee is generally the same. So I think that as the shift in origination changes between fixed and floating, the placement fees should be really quite comparable.
Got it. Great. In terms of the dividend payment, yes, nice juicy special this time around. What's the thought process around not increasing the regular dividend at the same time? Or how are you thinking about that regular dividend in the context of 2022 outlook?
Well, that's a really good question. And it brought a lot of discussion at the Board yesterday because we've had specials 5 years in a row now. And we generally had a target. We generally had a target of 60% to 70%. And I think it just reflects a little bit of conservatism of you never want to be in a position when you're lower where you have to lower your dividend or actual dividend. So we've had a conservative payout ratio given the stability of our earnings. So there is some discussion within the Board, and I think nothing has been landed on as to whether maybe we increase that range. So we're 60% to 70% is the capability that we could increase from 70% to 80%, it's at the same, so that is a new range, but that -- and hasn't been decided yet. So -- and there's a view, I guess, how do investors look at your stock. I think to some extent, some investors say, hey, you always hit a record special at First National, so they look at it together. But often when you're looking at metrics, of course, the specials aren't taken into account. So we probably think there's probably some room for maybe changing that range, but we haven't landed on anything yet.
Okay. Good color there. Last one for me, just in terms of the Excalibur program. I guess 2 parts to this. First part is the outlook that you're talking about on market driven for Q4, are you able to provide any granularity on Prime versus Excalibur product? And then the second part of the question is around funding of Excalibur mortgages. These are I guess, entirely sold to institutional investors at this point. But do you have a view on RMBS as we're seeing other players set that type of a funding vehicle up and be fairly successful?
Yes. So we would -- I think, relatively speaking, our Excalibur program is going to perform better than our Prime program because the Excalibur is not quite as -- is tied to housing sales. And at the same time, Excalibur is something we have gotten into in the last 3 years, and we just opened up in Western Canada. We're not in Quebec. It was a business we were in 15 years ago prior to the financial crisis. And what we're finding is, we're getting huge take up just because of the breadth and depth of our distribution platform and our reputation for service and technology. So we're seeing, I think, that, that is growing very strongly. So -- and then on the funding of that, we have diverse funding sources for that. We have a range of institutional investors, but we also have securitization for that. So we balance that as we do on our Prime products between securitizing ourselves or selling to institutions.
And just to add to that, with your reference RMBS, yes, of course, we watch closely the activities over at home capital with their classic RMBS program. We're quite encouraged by their last transaction, and we'll continue to keep a close eye on RMBS as an additional source of funding diversification for the program.
Great. And sorry, Stephen, just one follow-up on your response on the first part of the question where you said that Excalibur maybe not so much tied to housing sales. Can you sort of expand upon that? And what you think the big drivers of Excalibur are or maybe that product in general?
I guess as I reflect upon that a little bit, I think why we're probably often solutions on Excalibur, they are purchases, but often they're refinances. And they refinance this to reflect situations where people don't qualify for a mortgage where you can approve your income. So it's not just necessarily a sale. It's often personal circumstances to the individual. I think the biggest thing is driving our Excalibur business is that I think we're really just in growth mode. And we opened up in Vancouver in March and that succeeded very well. We're having -- adding a team for Excalibur in Alberta, and we feel pretty comfortable about that market. I don't know whether we're going to open up in Quebec in the next year, but there's certainly a market. So we just -- I think it's more an issue. We just had a lot of room there to -- a lot of room there to grow.
There are no further questions at this time. Mr. Smith, please proceed.
Good. Thanks very much, operator. As there are no further questions, we look forward to hosting our fourth quarter results, and I think that will be at the end of -- last week in February, the first week in March. Thanks for taking part in our call and have a good day.
Ladies and gentlemen, this concludes your conference call for today. We thank you for participating and ask that you please disconnect your lines. Have a great day.