DBRS Morningstar Upgrades Home Capital Group Inc. to BB (high) and Home Trust Company to BBB (low), Stable Trends

DBRS Limited (DBRS Morningstar) upgraded the long-term ratings of Home Capital Group Inc. (HCG or the Group) to BB (high) from BB (low) and upgraded the Group’s short-term ratings to R-3 from R-4. DBRS Morningstar also upgraded the long-term ratings of HCG’s primary operating subsidiary, Home Trust Company (HTC or the Trust Company), to BBB (low) from BB and upgraded the Trust Company’s short-term ratings to R-2 (middle) from R-4. The trend for all ratings is Stable. The Intrinsic Assessment (IA) for HTC was raised to BBB (low) from BB, while its Support Assessment is SA1. HCG’s Support Assessment is SA3, and its Long-Term Issuer Rating is positioned one notch below HTC’s IA.

KEY RATING CONSIDERATIONS
The ratings upgrade is a reflection of the continued positive momentum of HCG’s franchise and earnings. The Group’s management has begun to implement a viable strategic plan to move HCG forward, while investments in technology will allow the Group to launch new products and gain efficiencies. HCG has made significant strides in regaining its position in the mortgage finance industry and repairing relationships with brokers all while maintaining strong asset quality. Furthermore, HCG continues to diversify its funding sources and improve its liquidity position. However, DBRS Morningstar notes that as the Group continues to rebuild, changing dynamics in the Canadian mortgage market are making the industry more competitive and putting pressure on margins.

RATING DRIVERS
An improvement in profitability metrics while maintaining a similar risk profile could lead to positive rating actions. Moreover, an increase in the proportion of stable-termed direct deposits and further diversification of funding away from dependence on brokered deposits would be viewed positively. Conversely, the ratings could come under pressure should there be significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management. Furthermore, disproportionate growth in commercial originations that would weaken HCG’s risk profile could also have a negative impact on the ratings, as would substantive funding pressure caused by deposit outflows.

RATING RATIONALE
In 2019, HCG launched a multi-year strategic plan aimed at defending its core market position while enhancing its various technology systems in order to streamline operations and introduce new products and revenues streams. The Group has successfully repaired its relationships with mortgage brokers, which drove stronger originations, allowing HCG to regain its leading position in Canada’s Alt-A mortgage market. The Group had lost its top position in Q2 2017 due to a liquidity event that stemmed from a crisis of investor confidence resulting from the Group’s issues with broker fraud. Although still not at their pre-crisis levels, HCG’s loans under administration and originations continue to grow, reaching $23.0 billion and $5.7 billion as at YE2019, respectively.

Earnings continued their positive trajectory in F2019, with the Group reporting net income of $136 million, up 3% from F2018 as higher revenue was met by increased spending on HCG’s Ignite Program, an investment to upgrade the Group’s core banking system and to add new digital tools. Indeed, net interest income was up 14% year over year (YOY) to $402 million as the net interest margin improved by 19 basis points to 2.21%. Meanwhile, the efficiency ratio slightly deteriorated to 55.0% in F2019 from 52.1% in F2018 partially due to costs associated with the Ignite Program, which management expects the bulk of the investment to be completed by 2021, at which time the efficiency ratio is expected to revert back to historical levels.

HCG’s asset quality remained strong in 2019, with impaired loans-to-gross loans at 0.58% as at December 31, 2019. Management has diligently enhanced its risk policies and procedures in order to maintain the Group’s reputation for good underwriting, which DBRS Morningstar believes is crucial as HCG solidifies its position in the mortgage market and begins to implement its various growth initiatives. The Canadian mortgage market continues to evolve with the Office of the Superintendent of Financial Institutions proposing changes to the B-20 mortgage underwriting guidelines’ stress tests. These proposals are expected to better align the stress tests with current market rates and are expected to have a marginal impact on HCG. Nevertheless, DBRS Morningstar is cognizant that HCG could be more susceptible to a real estate market correction than its large bank peers that have a more diversified business model, as the bulk of the Group’s retail credit risk lies in mortgage lending within the riskier nonprime market segment.

The Group continues to be highly dependent on broker deposits, which comprise 75% of its $13.7 billion total deposits as at December 31, 2019, although this proportion is on the decline. HCG is growing its direct-to-consumer channel through its Oaken Financial offering, and as such, directly sourced deposits have increased by 26% YOY to $3.4 billion. Additionally, in an effort to further diversify funding, the Group launched a $425 million private placement of residential mortgage-backed securities backed by uninsured single-family mortgages and continues to utilize the various securitization programs run by the federal Canada Mortgage and Housing Corporation. Meanwhile, on balance sheet liquid assets totalled $943 million versus $809 million in demand deposits as at YE2019. In the aftermath of the 2017 crisis and the outflow of broker-sourced demand deposits, HCG now limits demand deposits to a level that is commensurate with its available liquidity.

Capitalization is strong with HTC’s CET1 ratio at 17.6% as at YE2019, implying a capital cushion of $813 million, which is more than adequate to cover loan losses in the normal course of business, in DBRS Morningstar’s opinion. The CET1 ratio declined from its YE2018 level of 18.9%, driven by higher risk-weighted assets as well as HTC declaring a dividend to the Group to fund the repurchase of common shares under the substantial issuer bid, which totalled $150 million. During F2019, HCG renewed its normal-course issuer bid (NCIB) for the purchase for cancellation of up to approximately 5.3 million common shares. HCG has subsequently commenced common share repurchases under the renewed NCIB in Q1 2020. Additionally, no dividends were declared as the Group focuses on organic growth.

The Grid Summary Grades for the Trust Company are as follows: Franchise Strength – Moderate; Earnings Power – Moderate; Risk Profile – Good/Moderate; Funding & Liquidity – Moderate; and Capitalisation – Moderate.

Notes:
All figures are in Canadian dollars unless otherwise noted.

All ratios are per DBRS Morningstar calculation.

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 2019), which can be found on our website under Methodologies & Criteria.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found on the issuer page at www.dbrs.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrs.com.

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