First National Financial Corporation (FN-PA.TO) Earnings Call Transcript & Summary

Good morning, ladies and gentlemen, and welcome to First National's Fourth Quarter Analyst Call. [Operator Instructions]. Now it's my pleasure to turn the call over to Jason Ellis, President and Chief Executive Officer of First National. Please go ahead, sir.

Welcome to our call, and thank you for participating. Rob Inglis, our Chief Financial Officer, joined me and will provide his commentary shortly. Before we begin, I will remind you that our remarks and answers may contain forward-looking information about future events or 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. I'll start today with our expectations, and we expect mortgages under administration to grow in 2023 despite lower demand for credit to start the year. That expectation is based on 3 main assumptions: First, although we will experience a reduction in new originations in the first half of 2023 in comparison to the same period last year, we believe there will be a return to a more constructive market in the second half of the year. Of course, this is somewhat dependent on the Bank of Canada's policy decisions. Second, with higher mortgage rates, prepayment speeds have moderated and renewal opportunities will increase as more mortgages reach maturity. Finally, we anticipate continued strength in commercial originations attributable to First National's market-leading position in the insured multifamily mortgage market. As you know, we consider mortgages under administration a key metric. It's an important driver of earnings. Growing MUA in a challenging environment as we did in 2022 is a sign of resilience that speaks to First National's strong market presence across the country, diversity of product offerings and the hard work of our team. We saw the value of this diversification in 2022 as our commercial MUA increased 9% or $3.4 billion year-over-year, while residential was up 4%. Within the multiunit residential market, we expect demands for insured products to remain strong due to the need for more rental housing stock as the leader in that important space, First National stands to be a beneficiary. Last year, insured multifamily mortgages represented about 75% of our total commercial originations. That ratio may edge higher this year until we see a deeper market develop for conventional mortgage assets as lenders of conventional money gained certainty on changing property values. On the residential side, First National continues to profit from its national presence. In particular, market conditions and by extension origination volumes in Quebec and Alberta significantly outperformed Ontario and British Columbia on a year-over-year basis. From a product perspective, our plan for 2023 includes continued expansion of our Excalibur program with focus on Western markets. There is a need for Excalibur and other so-called alternative mortgage products, which are not fully addressed by the big banks. We feel very comfortable in providing credit in the alternative space due in part to our proven underwriting skill sets. At First National, we have always had a rigorous underwriting process, and there are no plans to make changes to our risk management approach to accommodate today's market environment. This is borne out by arrears rates, which remains near all-time lows throughout 2022. Notably, our portfolio of adjustable rate mortgages continues to perform in line with the broader portfolio with no signs of stress related to higher mortgage payments. Analysts on our call often ask about broker compensation. And on this topic, I would say our planning for 2023 includes the assumption that extra incentives will remain fairly common across the industry. We will continue to monitor the market in this respect, and I can tell you, our objective is unchanged. We will offer industry best service and ensure we're competitive with rates and incentives using a disciplined approach to both. Turning to securitization net interest margin. Our assumption is that we will see some favorable tailwinds in 2023. This relates to the normalization of the spread between SEDAR and our prime lending rate on the adjustable rate portion of our securitized portfolio. With the Bank of Canada's aggressive rate hikes, our cost of funds, which relies on SEDAR settings, increased. Revenue from prime-based mortgages also increased but at a delayed pace. As described in our MD&A, this reduced net interest margin by about $6 million in 2022. We are currently anticipating a normalized spread between prime and SEDAR for much of 2023. A second tailwind relates to slower prepayment, which will moderate average liquidation rates on the portfolio and slow the amortization of capitalized upfront origination costs. Recall that in 2020, 2021 and the start of 2022, those liquidation rates were elevated to as high as 18% per annum, with moderation in this rate, the opportunity to grow the portfolio improves. Finally, a brief comment on operating leverage. In the face of a still strong market to start 2022, we continue to grow our underwriting teams only to see demand pull back significantly in the last half of the year. Through natural attrition and deliberate action, we did reduce our residential underwriting capacity in the fourth quarter. That said, First National takes a long-term view of talent. We make a substantial investment in our employees and are prepared to continue to do so in keeping with our outlook and objectives to serve our customers, partners and shareholders. Now over to Rob.

2022 marked First National's 16th consecutive year of profitable operations since its 2006 IPO that's how the company raised distributions to shareholders for the 15th time, Consistent long-term performance, including a 28% after-tax pre-fair market value return on shareholders' equity in 2022 is validating our strategy and value-creation method. The purposes of my remarks, I will assume you have read our MD&A, so I'll focus on a couple of key topics, beginning with MUA. It increased 6% in 2022 and 5% annualized in the fourth quarter. As you just heard Jason say we expect MUA to grow again in 2023, and that's important because our servicing and securitization portfolios generate ongoing income and cash flow. Although the last half of 2022 was particularly challenging, First National posted year-over-year revenue increases in every quarter of the year, including Q4. While the increase was due to higher mortgage coupons on our securitized portfolio. This was largely offset by higher interest cost of funding for this portfolio. More important is the net revenue, which was up 9% for 2022. There were increases in each quarter except the fourth. Q4 net revenue was down 2% from a year ago despite an increase of 5% of securitization NIM, as lower origination led to a 23% drop in placement fees. Q4 mortgage investment income was higher by 92% as we earn more interest income on the portfolio and our mortgages secured accumulated for securitization -- although mortgage administration revenue was consistent with MUA growth, overall mortgage servicing revenue was lower than Q4 2021 by 11% due to low volumes processed in our third-party underwriting division, whose customers faced similar reductions in volumes with the overall industry slowdown. Gains and losses on financial instruments are included in total revenue. However, both fourth quarter showed only small losses as 5- and 10-year bond yields were relatively flat during these periods. Moving now to profitability measures. Q4 income before taxes was up 2% as the company benefited from placement of insured commercial segment mortgages with its institutional customers. Q4 premarket value income, which we consider core profitability increased 4% year-over-year as the impact of adding back the losses on account of financial instruments was insignificant. Now thinking about first and asset performance overall in 2022, we achieved a level of operating profitability that was generally consistent with our own internal forecasting at the beginning of the year. We will publish our internal forecast we've given how the year unfolded and the challenges of the past 6 months, in particular, the results were encouraging. Certainly, the market diversification Jason spoke of across regions, products and asset classes helped considerably. In particular, I would point to commercial mortgage activity as a positive counterbalance to the challenges faced in residential. In Q4, residential segment profitability was lower than a year ago due to lower volumes underwritten for third-party customers. These volumes increased significantly in 2021 and full-time employees were hired to handle the increase in mortgage applications. When this volume fell precipitously in the latter half of 2022, the company suddenly had a head count too large for this business. Earnings are also affected by lower revenues on reduced placement activity against the backdrop of a comparatively more expensive operating environment that included higher per-unit broker fees as incentives were needed to match our competitors. That said, by year-end, with actions during the fourth quarter, we modestly reduced FTE. This will have a small favorable impact on operating leverage in 2023. Meantime, broker fees are set by the market. As Jason mentioned, we continue to take a disciplined approach to rates, incentives in the context of a competitive market. By comparison, our commercial segment was accretive to 2022 results. [ However, ] we did benefit from securitization NIM generated from large pools sold for the CMV in the previous years, but by placing more of this origination with our institutional clients in 2022, the company increased placement fees and deferred placement fees. This strategy creates immediate earnings but also creates cash flow to support operations. Higher interest revenue earned on mortgage investments and escrow deposits were also very favorable to both revenue and income in our Commercial division. Certainly, First National expertise in commercial lending is well recognized by the largest real estate players in the industry to continue to count on us for financing. All things considered, our commercial pipeline starts 2023 in relatively good shape, and we expect the portfolio will grow even with the expectations of marginally lower originations. In closing, 2022 was a uniquely challenging year, but First National more than held its own. On solid performance, we increased our monthly dividend to the annualized equivalent of $2.40 per share effective with the December payment. Payout ratio for the year was about 73% or 94%, excluding the impact of gains and losses on financial instruments. Going forward, our plan is to remain true to our values, including always striving for better and consistency in our risk-managed approach to underwriting. This has served First National well for the past 35 years and will continue to do so for the foreseeable future. That concludes our prepared remarks. Operator, please open the lines for questions. Thank you.

[Operator Instructions] Your first question will come from Etienne Ricard at BMO Capital Markets.

So first, on the 2023 outlook for single-family originations. You are guiding for a soft first half followed by improving activity in the second half. In your comments, you mentioned pre-pandemic 2019 levels as a likely outcome. Now when I look at your origination activity in 2022, it was still 40% plus above 2019 levels. I understand the dynamic with a soft Q1. But my first reaction is returning to 2019 levels seems quite a step down. So any thoughts on how originations should evolve over the next few quarters?

Yes. I think, Etienne, when we mentioned 2019 levels, it's sort of as a broad reference point as opposed to say the frenetic activity we saw during the middle of the pandemic. So I wouldn't take 2019 literally. When we talk about our expectations for next year, it really is a tale of 2 different years within 1. The first half of 2022, featured a strong pipeline of mortgage commitments and preapprovals that had been issued at the prevailing low interest rates, predating the Bank of Canada's rate hiking activity. And as a result, we saw a significant pull-through and actually relatively good activity and funded mortgages through the first half. As we look at the second half of 2022, that's where we saw the more significant decline in residential activity, as the impact of the bank's activities in policy really started to take hold. So to that end, when I look ahead to 2023, I see 2 things. One, I see a first half of originations that will have a very challenging comparison relative to the first half of 2022. And then a second half of 2023 where 2 things are happening. One, a less challenging comparison. So year-over-year, I would say it will look stronger. But in absolute terms, I do expect to see improved activity in absolute terms in the second half relative to the first. But most importantly, I would suggest that we talk about 2019 in general terms, not specifically in terms of volumes, okay?

Right. So from an industry perspective, as opposed to company specific?

From an industry perspective and then even from a company perspective, but not suggesting all the way back, more of a -- that was maybe a general sense of activity as opposed to what the extremes we saw during the pandemic.

Understood. And with OSFI launching a consultation on potential volume limits First, have you seen a rise in the average debt-to-income or TDS ratios for originations in recent years at First National? And second, do you see greater consumer leverage risk today relative to a few years ago?

So our key metrics as it relates to our residential mortgage underwriting have not changed in any material way throughout the pandemic and into 2023. Debt service ratios, loan to values and credit scores are all very comparable. I would say that if there is any sense of increased leverage, it may have been the function of extremely low rates during the pandemic, facilitating loans to income that maybe were higher on average. I think OSFI references 4:1 as sort of a benchmark it likes to think about in terms of loan to income. With its new paper that is out in the market for discussion, I think the idea of a 4:1 loan-to-income or some other kind of loan to income metric, won't have a significant impact on new originations going forward because at the new higher rates, debt service ratios, gross debt and total debt service ratios actually end up being the constraining factor. I think a loan-to-income metric introduced by Asia at this point, future-proofs the industry against borrowers in another low rate environment possibly running away with perhaps unmanageable debt. Does that answer the question?

Yes.

Your next question comes from Geoff Kwan at RBC Capital Markets.

My first question was just given for the mortgages that you originate, you have essentially very little residual credit risk overall. But given you still service those mortgages, have you seen any noticeable impact so far from borrowers that have been either renewing or other types of activity, dispensing the increase that we've seen in mortgage rates over the past year.

No, Geoff. Actually, very, very encouraging. So whether we look at the portion of the portfolio that is securitized or the portion of the portfolio that has been originated and sold to third parties. In the aggregate, our 90-plus-day arrears rate continues to be at all-time lows, and that's true both of our prime and our Excalibur program. It's true of our high ratio and our conventional program. So right now, we're not seeing any signs of stress anywhere in the portfolio. And most notably, on the adjustable rate portion of the portfolio of mortgages under admin, we are not seeing any difference in performance from an arrears perspective. And one other thing that's encouraging is, not only is the 90-day arrears number, still low, but as a leading indicator, the 30-day arrears rate quarter-over-quarter is actually lower. So I would say, at this point, all of our adjustable rate borrowers have absorbed their new hire payments with a great deal of resilience. As it relates to the fixed income borrowers who have been renewing into this environment, they're renewing out of mortgages that are anywhere from 200 to 300 basis points lower than today's market. We're seeing renewal rates consistent with our historical renewal rates, and we're not seeing any stress at the time of renewal from borrowers who are choosing to perhaps not renew or renew a way. So so far, it would seem the Canadian borrower has adjusted well to the new environment.

And just my other question was on your the Alt-A Excalibur business. Has your appetite to originally changed much over the past several quarters, but also those from the funding side. Has there been any changes from your funding partners in terms of the terms that you do it or the demand to provide funding for these mortgages given the weaker housing market environment?

No. So as I mentioned in my comments, we actually haven't made any changes to our underwriting or risk management practices. And that's true both of our proprietary mortgage underwriting guidelines, and that's also true of the eligibility criteria or underwriting guidelines that some of our third-party investors ask us to follow. So we haven't seen any changes. And as it relates to our own appetite as it relates to the Excalibur program, it continues to be constructive. As I mentioned, we're looking to continue growing that line of business as a diversification to our Prime program. And we're not changing the way we approach it. No.

Your next question will come from Graham Ryding at TD Securities.

Maybe just operating leverage, it was obviously an overhang in 2022. It sounds like you've made some adjustments to headcount reductions. Can you just give us your outlook there. If we do see a more muted or a continued sort of muted revenue outlook for 2023, can you keep operating leverage flat? Or would it still be an overhang in 2023..

I think that our decisions in terms of taking affirmative action on full-time headcount is going to be very dependent on the market at this point, cautious about overreaching. What I said in our prepared comments is very, very true. We make a great deal of time and investment in our employees. And I'd like to make sure that we have enough flexibility to adapt to any unexpected changes in the market and continue delivering the kind of service levels, the brokers and our other stakeholders expect. So based on my outlook for this year, if it came to pass, I think any changes to headcount from here on will be subtle, and I expect normal course attrition would take care of most of it. If, however, we see continued softness in the market, if the Bank of Canada is forced to carry on beyond expectations, and that has a material negative effect on origination and by extension revenues. We will have to revisit the headcount. It's unfortunate. The volume of origination that occurred during the pandemic was constructive to be sure, but it also came at a time when there was a significant amount of migration within the labor market, especially in the mortgage industry. So we were hiring not only to support the growth but to replace employees that were leaving. And then it was really quite the whipsaw as things turned the way they did in 2022. So it will take a little bit of time, I think, to adapt to maybe our longer-term operational leverage targets, but it really is right now very market dependent.

I appreciate the commentary you gave on the credit side. How about on the residential side and the consumer? How about on the commercial side, is there anything you're seeing there, either positive or negative in terms of arrears trends? And is there anything that you're perhaps more cautious towards on the conventional side looking into 2023?

Yes. So I mean there's certainly some anecdotal evidence in the media of some commercial defaults in Canada, not with us, fortunately to date. They tend to be focused around new construction. I would say dating back to at least a year ago, the one thing that we did make a material change on was our approach to construction lending -- we have really focused on the largest borrowers with the most significant resources to see them through challenges, especially as construction costs were going up. So that change took place some time ago. Beyond that, no, like residential, we haven't made any significant changes to the way we underwrite. Remembering, of course, that like I said, 75% of originations last year were CMHC multifamily. So we really are following CMHC guidelines with respect to underwriting on those deals. And as it relates to our conventional lending, those loans are, of course, being funded by our third-party investor partners. And in that case, we are working with them in developing the eligibility criteria and the various underwriting guidelines. So -- no sudden movements on our part, but if there was a focus, it is definitely on new construction, where we're being very cautious around our partners.

And maybe one last one, if I could. There was a couple of comments just about changes at the CMHCs making around allocation around -- on the definition of aggregators and then also CMB capacity in 2024. So maybe just on the first piece, is there anything there that could be material to your institutional funding? And then on the CMB piece, would that be material at all to your overall securitization funding capacity.

Right. So CMHC issued advice '18, which is revisiting how it thinks about the distinction between lenders and aggregators. I do understand that there is a clarification pending from CMHC on that advice. We look forward to seeing that to get a better picture. However, I can tell you that even in its current state, we do not anticipate the advice '18 as it relates to NHA-MBS guarantee fees and the distinction between lenders and aggregators, having a material effect on our mortgage funding strategies. We've always worked with counterparties who fell well within the spirit and intent of CMHC's guidelines. And so we don't see a negative outcome from that. As it relates to CMB allocation for multifamily, there is no actual communication in the marketplace right now. CMHC has spoken, I think, to some participants in the market about the preferred allocation for affordability linked 10-year MBS pools into the CMB -- at present, there is, I believe, a 4:1 ratio. So you could have, I think, for every $1 of affordable mortgage, you can add $4 of regular multifamily mortgage and still qualify for an affordability linked pool. I think there is some discussion around that gearing ratio being reduced. We still haven't seen an actual advice from CMHC on that. Should that come to pass, our ability to directly access the 10-year CMB may be moderated. But we continue to have a large group of interested investors in that very high-quality product. So again, it may change the way we think about securitization versus placement, but I don't see it having a material impact at this point.

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

First question just on the mortgage servicing income, looking at that year-over-year decline. Would you attribute the bulk of that to the origination volumes flowing through the third-party underwriting relationship?

That is an accurate assessment. Yes, I would say our traditional mortgage administration revenues grew in sympathy with assets under admin and the change in the total mortgage servicing line would be attributable to lower origination volumes by our third-party underwriting clients.

Going back to your comment around broker expenses and remaining elevated, let's say, last year and that grew -- maybe not elevated, but competitive, I guess, through '23. Just looking at the Q4 number, the broker fee looks a little lighter than the previous 3 quarters. I was wondering if there was any -- is there any sort of like clawback components of that where volumes were just so light that there was some clawback that would reduce that broker expense in the fourth quarter? Or is there anything else going on?

James, it's Rob here. Yes, a few things like that. We set outside [indiscernible] during the course of the year for volume bonus or delivery fees, that kind of thing. And because it was a later year than we thought, we took back some -- a little bit of the broker fees at the end of the year, so that helps a bit. As well we adjusted our absorption on capitalized mortgages, we're selling mortgages to the MBS, et cetera. And typically, we capitalize the fee of the broker fee on there during the course of the year, we used kind of a standard fee of 1.23%, something like that. And by the end of the year, say, was it higher, let's change our capitalization absorption. So I think in Q4, we made the adjustment, as accordingly, we capitalized more to the balance sheet, which is appropriate, which means that less flowed through the expense line. So those 2 things, I think, helped the number in Q4.

Going back to the OSFI draft, I guess or public consultation. Just wanted to get a little bit more color on your thoughts around potentially prescribed limits on GDS, TDS and some other options to maybe perhaps explicitly target that debt service coverage restriction as a component of uninsured underwriting. And I just wanted to get your thoughts around what that could mean. Do you think it's a good policy things along those lines?

Yes. I guess I'm not entirely surprised to see this. One of the interesting aspects of B-20 when it was first introduced was that it was not entirely prescriptive other than a few, I guess, specific metrics. I think most notable amongst those things that were not prescribed were GDS TDS. There were the long understood guidelines, but I think we have seen continued significant exceptions being made both at the D-SIBs as well as the sort of dedicated alternative lenders. And I think that one of the things that OSFI wanted to get out of B20 was comfort and clarity that the stated mortgage underwriting policies were really reflective of what lenders were doing. And I think that the tendency to make exceptions on debt service ratios has probably gotten a little out of hand relative to what they're comfortable with. So I think it is good policy. I think they're going to be fairly generous though, with nonconforming bucket. So I think there will still be an allowance to make quality exceptions where loan-to-value, borrower credit assets or other things help justify the underwriting. I think a potential outcome here may be similar to what we saw following some of the earlier changes to underwriting, I think a lot of what used to be prime conventional mortgages migrated into the Alt-A space and traditional Alt-A lenders like Home and Equitable perhaps saw a very, very nice increase to their average credit quality. I think it's going to be the next leg of that. And I think a lot of what all the lenders are doing today may very well migrate into the Mortgage Investment Corporation or private lender space, and those entities will enjoy an upgrade to credit. I don't think it's going to be a material migration in terms of the overall market. And I think there are some commentators that suggest that an unintended outcome as OSFI is going to lose control of a large piece of the market into unregulated hands. I think that's probably overstated, but I think the biggest outcome is probably just an upgrade in credit for mix and private lenders.

There are no further questions on the phone line. So at this time, I'll turn the call back to Mr. Ellis for any closing remarks.

Thank you, operator. We look forward to reporting our first quarter results in April and hosting our first in-person annual meeting in 3 years on May 16 in Toronto. Details will follow in our management circular. Thanks for taking part in our call, and have a good day.

Ladies and gentlemen, this does conclude your conference call for this morning. We would like to thank you all for participating and ask you to please disconnect your lines.