Morningstar DBRS Changes Trends on Home Trust Company’s Credit Ratings To Stable And Confirms All Credit Ratings

DBRS Limited (Morningstar DBRS) changed the trends on the credit ratings of Home Trust Company (HTC or the Company) to Stable from Positive. Morningstar DBRS also confirmed all of the Company’s credit ratings, including its Long-Term Issuer Rating and Long-Term Deposits credit ratings at BBB and its Short-Term Issuer Rating and Short-Term Instruments credit ratings at R-2 (high). The Intrinsic Assessment (IA) for HTC is BBB, while its Support Assessment is changed to SA3 from SA1, reflecting no expectation of timely systemic support.

KEY CREDIT RATING CONSIDERATIONS
The trend changes to Stable from Positive reflect Morningstar DBRS’ assessment that downside risks to HTC’s credit ratings have increased and the Company’s credit strengths are now largely balanced against its credit weaknesses. With the Company’s decision to cease originating and securitizing insured single-family residential and insured multi-unit residential mortgages, Morningstar DBRS expects HTC’s portfolio concentration risk to increase as prime single-family residential mortgages comprised about 19% of total on balance sheet loans in 2023. HTC’s business model is concentrated in real estate, particularly higher-risk, Alt-A mortgages. Additionally, as seen in 2023, elevated interest rates and market uncertainty could continue to negatively affect HTC’s mortgage originations and overall credit performance.

Despite a concentrated effort to diversify its funding base, HTC remains highly dependent on broker deposits, which, in Morningstar DBRS’ view, are a key credit ratings constraint. The Company is considering issuing its first Euro-denominated covered bonds in the foreseeable future, which Morningstar DBRS would view favourably; however, HTC has yet to demonstrate a track record of success for this type of debt issuance, which could present some execution challenges. Morningstar DBRS also notes that HTC’s capital buffers, although still solid, have declined notably while the Company’s credit ratings have been on a Positive trend. Furthermore, capital levels are expected to continue trending downward in 2024–25, in line with HTC’s capital optimization strategy. At the current capital level, HTC is no longer a positive outlier when compared with its peers.

On the other hand, the credit ratings are supported by HTC’s solid market position in the Alt-A mortgage space with a long track record of low loan losses. Despite a challenging operating environment, the Company demonstrated resilient and robust profitability with good operating efficiency in 2023, compared with most of its peers.

The Company’s IA is positioned below the IA range, reflecting HTC’s highly concentrated business model in Alt-A real estate lending and a high reliance on broker deposits with significantly less funding diversity than its peers. These are nuances specific to the Company that make it susceptible to material adverse changes in the Canadian real estate market.

CREDIT RATING DRIVERS
Morningstar DBRS would upgrade HTC’s credit ratings if the Company were able to significantly diversify its funding sources, including a sustained increase in the share of directly sourced deposits. Increased diversification in HTC’s loan book and revenue mix would also result in a credit ratings upgrade.

Conversely, Morningstar DBRS would downgrade the credit ratings if there were 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.

CREDIT RATING RATIONALE

Franchise Combined Building Block (BB) Assessment: Good/Moderate
HTC 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 about 66% of total on balance sheet loans as of December 31, 2023, with Ontario remaining HTC’s largest market. In addition, the Company offers commercial mortgages, consumer lending, and deposits via brokers and financial planners and through its direct-to-consumer deposit brand, Oaken Financial. Affected by high interest rates, mortgage originations decreased 36.4% year over year (YOY) to $6.0 billion in 2023, primarily in the single-family residential mortgage portfolios. In 2024–25, HTC expects total on balance sheet loans to decline from the 2023 level of $21.4 billion before rebounding marginally in 2026 because of the loss of prime mortgage originations, partially offset by a moderate expansion in the Alt-A portfolio and strong growth in commercial mortgages. As part of its growth strategy, HTC is considering introducing new products in the coming years, including construction financing insured by Canada Mortgage and Housing Corporation (CMHC, rated AAA with a Stable trend).

Earnings Combined Building Block (BB) Assessment: Good/Moderate
HTC reported net income of $210.8 million in 2023, representing strong 37.4% YOY growth, supported by higher total revenue, partially offset by an increase in total operating expenses and provision for credit losses (PCL). Net interest income grew 19.3% YOY to $521.7 million in 2023, resulting in a 29 basis point (bp) expansion in the net interest margin of 2.42% for the same period (as calculated by Morningstar DBRS). Adjusted operating expenses however were down by 0.8% YOY to $246.4 million in 2023 despite higher salaries and benefits; as a result, the adjusted efficiency ratio (as calculated by Morningstar DBRS) improved to 42.4% in 2023 compared with 50.7% in the prior year. Total PCL also increased to $27.6 million in 2023 compared with $19.4 million in 2022. However, HTC generates sufficient earnings to cover potential loan losses in the current economic environment as reflected by low levels of PCL as a share of income before provisions and taxes at 8.2% for 2023.

Risk Combined Building Block (BB) Assessment: Good
Amounting to $21.4 billion as at December 31, 2023, HTC’s gross on balance sheet loans grew modestly at 1.6% YOY in 2023 compared with a 13.6% YOY expansion in the prior period. The increase in gross loans was driven by growth across all business lines excluding insured mortgages. In a challenging operating environment, HTC’s loan impairments increased to a manageable 1.38% of gross loans in 2023 compared with 0.25% in the prior year (according to Morningstar DBRS’ calculations), largely because of increased impairments in single-family residential mortgages and commercial mortgages. Although the current levels of loan impairments are higher than the pre-pandemic levels, HTC's overall asset quality remains good and broadly comparable with its peers. Meanwhile, net write-offs continued to be negligible at 0.01% in 2023.

Funding and Liquidity Combined Building Block (BB) Assessment: Moderate
In the aftermath of the 2017 liquidity crisis, HTC has made a concerted effort to diversify its funding base through directly sourced deposits and various capital markets initiatives, including securitization programs and institutional deposit notes. The Company continued to grow its direct-to-consumer deposits through its Oaken Financial offering, which increased 8.7% YOY to $5.3 billion and accounted for 32% of total deposits in 2023. Nevertheless, HTC remains highly dependent on broker-sourced deposits, which comprised about 68% of its $16.6 billion total deposits as at December 31, 2023. Furthermore, the Company ceased originating and securitizing insured single-family residential and insured multi-unit residential mortgages in late November 2023.

Capitalization Combined Building Block (BB) Assessment: Good
HTC’s regulatory capital is good, with a fully phased-in Basel III CET1 ratio of 14.0% as of December 31, 2023, well above the regulatory minimum of 7%. In 2023, the CET1 ratio decreased by 130 bps from its 2022 level of 15.3%, reflecting a decrease in regulatory capital resulting from the payment of dividends to HCG. In 2023, the Company's dividend payout ratio was above 164%. In line with its capital optimization strategy, HTC is expecting the dividend payout ratio to remain above 100% in 2024 with a potential reduction below 100% starting in 2025. Despite a further reduction in capital buffers, Morningstar DBRS expects HTC's capital ratios to remain comfortably above the regulatory limits and broadly in line with the peer average.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://www.dbrsmorningstar.com/research/429941.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024) at https://dbrs.morningstar.com/research/427030.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (22 June 2023), https://dbrs.morningstar.com/research/415978. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (23 January 2024), https://dbrs.morningstar.com/research/427030 in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://dbrs.morningstar.com/about/methodologies.

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 dbrs.morningstar.com.

The credit rating was initiated at the request of the rated entity.

The rated entity or its related entities did participate in the credit rating process for this credit rating action.

Morningstar DBRS had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.

This is a solicited credit rating.

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS’ outlooks and credit ratings are under regular surveillance.

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

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