DBRS Limited (DBRS Morningstar) confirmed the Long-Term Issuer Rating and Long-Term Senior Debt rating of Home Capital Group Inc. (HCG or the Group) at BBB (low) and the Group’s Short-Term Issuer Rating and Short-Term Instruments rating at R-2 (middle). DBRS Morningstar also confirmed the Long-Term Issuer Rating and Long-Term Deposits rating of HCG’s primary operating subsidiary, Home Trust Company (HTC or the Trust Company), at BBB and the Trust Company’s Short-Term Issuer Rating and Short-Term Instruments rating at R-2 (high). The trends on all ratings remain Positive. The Intrinsic Assessment (IA) for HTC is BBB, 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 rating confirmations and Positive trends reflect the continued positive momentum in HCG’s franchise and earnings. HCG has executed well and made significant strides in regaining its position in the mortgage finance industry, particularly as a leader in the Alt-A space. Additionally, HCG has further diversified its funding sources and improved its liquidity position. While the ratings reflect HCG’s good asset quality and history of low impairments and charge-offs, the ratings are constrained by HCG’s concentrated real estate-related business model. In general, DBRS Morningstar remains concerned about the effect that the combination of Canadian household debt levels that remain near an all-time high, with still relatively elevated home prices, and high interest rates may have on the real estate sector.
DBRS Morningstar also notes that, in November 2022, the Group entered into a definitive agreement (the Arrangement Agreement) to be acquired by a wholly owned subsidiary of Smith Financial Corporation (SFC), which was subsequently approved by shareholders after the expiration of the go-shop period. Completion of the Arrangement Agreement is subject to obtaining the required regulatory approvals, including that of the Office of the Superintendent of Financial Institutions (OSFI), which are expected by mid-2023. DBRS Morningstar will review its ratings for HCG once the approvals are in place and there is more clarity on the post-transaction structure.
The Bank’s IA is positioned below the Intrinsic Assessment Range (IAR) reflecting HCG’s concentrated business model, which makes it more susceptible to adverse changes in the Canadian real estate market, as well as the uncertainty surrounding the SFC transaction and ultimate post-transaction structure of HCG.
DBRS Morningstar will upgrade the ratings if the acquisition is completed without material changes to HTC’s structure, leverage, and operating model as a standalone OSFI regulated institution, along with further progress in diversifying funding sources and continued strong financial performance.
Conversely, DBRS Morningstar will downgrade the ratings if there were material operational issues with the SFC acquisition or a significant change in the Group’s operating structure, which would increase structural subordination. Additionally, significant losses in the loan portfolio as a result of unforeseen weakness in underwriting and/or risk management, disproportionate growth in commercial originations that weaken the risk profile, or substantive funding pressure caused by deposit outflows would also result in a ratings downgrade.
Franchise Combined Building Block (BB) Assessment: Good/Moderate
HCG is one of Canada’s leading Alt-A mortgage providers for borrowers who are self-employed, new immigrants, or recovering from bruised credit. Residential Alt-A mortgages formed around 53% of the Group’s $27.3 billion loans under administration as of December 31, 2022. At the onset of 2022, the rebound in economic activity led to healthy growth in volumes for HCG, particularly within its core customer base as well as commercial mortgages. However, as the year wore on, and with rapidly rising interest rates, house prices began to moderate and home buyers decided to sit on the sidelines. Total originations rose by 7% in 2022, versus 27% in the previous year, to end at $9.5 billion in F2022. This trend was witnessed across the board for most banks and is expected to continue in 2023 as the Bank of Canada maintains higher interest rates.
Earnings Combined Building Block (BB) Assessment: Good/Moderate
As with other banks, margin pressure, particularly from rising deposit costs, led to an 11% year-over-year (YoY) decrease in net interest income in F2022 to $440 million. Yet the Group’s net interest margin (NIM), which is one of the highest amongst Canadian banks, is expected to rebound in 2023 as HCG benefits from a unique circumstance where mortgages reprice faster than at other banks, as the average term of an Alt-A mortgage is 18 months. On the other hand, loan loss provisions were higher, especially when compared with the reversals seen in F2021, as the Group prepares for an economic slowdown. Overall, earnings fell by 39% YoY to $150.3 million but remained higher than pre-Coronavirus Disease (COVID-19) pandemic levels. Management expects volumes to rebound toward the end of the year and for the NIM to stabilize as the market normalizes.
Risk Combined Building Block (BB) Assessment: Good
HCG’s asset quality continues to be strong, with loan impairments forming just 0.25% of gross loans in F2022 versus 0.17% in F2021 (according to DBRS Morningstar calculations). These levels continue to be low compared with historical trends as government stimulus during the pandemic created a boon in the economy, particularly in the housing sector where prices rose rapidly. As a result, many borrowers chose to sell their property to resolve their situation rather than default on their mortgage. As rising interest rates moderate housing market activity and affordability, DBRS Morningstar expects impairments to normalize toward historical levels in the short to medium term.
Funding and Liquidity Combined Building Block (BB) Assessment: Good/Moderate
Although on a downward trend, the Group continues to be highly dependent on broker-sourced deposits, which comprised a still-high 69% of its $15.9 billion total deposits at December 31, 2022. Positively, HCG continues to grow its direct-to-consumer channel through its Oaken Financial offering, and directly sourced deposits have increased 12% YoY to $4.9 billion. Additionally, the Group further diversified its wholesale funding, with $425 million in issuances of residential mortgage-backed securities funded by uninsured single-family mortgages in F2022, along with the re-launch of a $200 million deposit note. HCG continues to use the various securitization programs run by Canada Mortgage and Housing Corporation (rated AAA with a Stable trend by DBRS Morningstar).
Capitalisation Combined Building Block (BB) Assessment: Strong/Good
HTC’s CET1 ratio was a strong 15.3% at YE2022 but down from 18.4% at YE2021. In 2022, for the first time since 2017 the Group commenced payment of a recurring quarterly cash dividend of $0.15 per share upon publishing their F2021 results in Q1 2022. Furthermore, the Group launched a Substantial Issuer Bid and renewed its Normal Course Issuer Bid.
Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/411515.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).
All figures are in Canadian dollars unless otherwise noted.
The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (https://www.dbrsmorningstar.com/research/398692/global-methodology-for-rating-banks-and-banking-organisations; June 23, 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.
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.dbrsmorningstar.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.
The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.
For more information on this credit or on this industry, visit www.dbrsmorningstar.com.
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