First National Financial Q1 2023 Earnings Call Transcript

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May 1, 2023

There are 7 speakers on the call.

Operator

Morning, ladies and gentlemen, and welcome to First National's First Quarter Analyst Call. This call is being recorded today, Monday, May 1, 2023. At this time, all callers are in a listen only mode. Later, we will conduct a question and answer session and instructions will be provided at that time on how to queue up. Now it is my pleasure to turn the call over to Jason Ellis, President and Chief Executive Officer of First National.

Operator

Please go ahead, sir.

Speaker 1

Thank you, operator, and good morning, everyone. Welcome to our call, and thank you for participating. Rob Ingalls, our Chief Financial Officer, joins 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 for the company's future performance. This information is subject to risk and uncertainties and should be considered in conjunction with the risk factors detailed in our MD and A.

Speaker 1

I'll start with our short run expectations. In our last call, we indicated Our expectation that mortgages under administration would grow this year, but that originations would be lower in the first half of 2023 than in the first half of twenty twenty two. Mortgages under administration have in fact Grown to a record level despite lower origination in the quarter. We continue to expect that 2nd quarter originations will fall short of the $12,200,000,000 we generated in last year's comparative period with year over year reductions in both residential and commercial volumes. That was not, however, the sum of our 2023 outlook.

Speaker 1

We also expressed our view that a more constructive housing market would emerge in the second half of this year. Our view in this respect is unchanged as well. We are already seeing signs of price stabilization and increased activity in the housing market. We still expect improvement in origination volumes in the second half. This constructive second half outlook assumes That the Bank of Canada will not raise interest rates again this year, that reduced uncertainty will encourage buyers to act and that employment levels will remain strong.

Speaker 1

In general terms, we are expecting increased housing activity, but Absent the incentive of extremely low interest rates, we are also expecting a reset to more traditional pre pandemic origination volume. As you know, originations, including renewals, are important in the maintenance and growth of mortgages under administration, and we can grow MUA in the short term even without growth in origination. Additionally, originations are not always material to earnings in the quarter in which they occur. Both points were illustrated in Q1 and form useful context for our Q2 outlook. Thinking about sources of future business, we expect prime mortgages to dominate our single family lending, complemented by continued contributions from our Excalibur Alt A business.

Speaker 1

Excalibur has not reached a point of maturity, So the portfolio has room for expansion. The recent addition of sales coverage in the Prairies reflects our thinking. As a result of the market for this product and our expanded distribution, we think Excalibur volumes in 2023 will compare favorably to 2022. Despite the relatively small portfolio size, our limited credit exposure And the strong historical performance, there does seem to be a disproportionate amount of attention paid to the Excalibur program by some interested parties. For those who worry about credit risk, some Excalibur facts may be of interest.

Speaker 1

The average credit score of borrowers is over 750. This is not a product defined by weak credit. The average loan to value of Excalibur Mortgages is 68% And Excalibur mortgage origination is limited to properties in primary and secondary centers where there is a high degree of housing liquidity. You may recall, out of an abundance of caution, we did not release any provisions related to this portfolio at year end, given the uncertain economic outlook. However, the portfolio continues to exhibit strong credit performance with no realized losses in all of 2022 or year to date.

Speaker 1

We are not currently forecasting any change in the credit quality or performance of the Excalibur program. First National will always be known as a prime lender, but since relaunching Excalibur, it has been a valuable and risk managed source of business. On Single Family Prime, we continue to enjoy strong relationships with mortgage brokers and continue to offer competitive mortgage rates and broker incentives that reflect our position as a leading lender in the broker channel. We also continue to realize And in the Q1, we saw a modest increase in retention rate. Notable in the quarter was increased borrower interest in 3 4 year term fixed rates.

Speaker 1

Typically, the preferred term for prime borrowers is 5 years. This shift in term may reflect borrowers' views that fixed rates will have declined by 2026, allowing them to renew sooner into a lower mortgage coupon. Generally, new origination has shifted back to fixed rates Regardless of term, with just 9% of new borrowers selecting an adjustable rate in Q1 compared to 56% in the same quarter last year. The portfolio of adjustable rate mortgages continues to perform well with no signs of stress from higher interest payments. 30 90 day arrears numbers remain low and attest to portfolio resiliency and conservatism.

Speaker 1

For our commercial mortgage business, we remain at the view that this year's volumes will be dominated by insured lending in the multiunit residential space. CMHC programs, including MLI Select launched last year are very popular with borrowers. That said, CMHC recently announced an increase in premiums for all forms of multiunit residential housing effective in June, The first increase in 6 years. It remains to be seen how borrowers will react, but even with the change, which ranges from 85 basis points to 155 basis points. Line pre amortizations and high loan to values make insured mortgage products Uniquely valuable and competitive in the multiunit space.

Speaker 1

The preponderance of insured multiunit mortgages in our commercial portfolio Also creates risk management advantages for First National during times of stress for assets like offices and shopping malls. As it relates to conventional commercial loans, they are funded by investing partners with no residual credit risk to First National. Thinking about profitability, our outlook assumes the tailwinds that push securitization NIM ahead in Q1 will continue in the Q2. Specifically, we anticipate normalized spreads between Prime and SEDAR compared to last year And a continued moderation of prepayment trends, allowing the securitized portfolio to grow and slow the amortization of capitalized upfront origination costs. To put context to that comment, our fixed rate in HAMBS Was prepaying at about 14% annualized in Q1 last year.

Speaker 1

This year, it's 4%. In Q1 last year, our adjustable rate NHA MBS portfolio was prepaying at a 22% annual rate. This year, it's down to 12%. Of that 12%, about a third is attributable to conversion from floating to fixed rate, a trend that is also slowing. As a result, mortgages pledged against securitization Have grown with a positive impact on net interest income.

Speaker 1

Given the way the yield curve has evolved, we're also now generating positive carry on our hedging activity, a reversal from much of last year, which is also something we anticipate will continue. Before wrapping up, a comment on funding. We have a large and diversified pool of funding sources. It has an approved issuer of NHA MBS And seller into the Canada Mortgage Bonds Program, we use securitization to minimize our funding costs. So it is noteworthy that the recent federal budget included paragraph on the CMB indicating that the government is reviewing the program in relation to its regular borrowing strategies with a view to capturing the credit spread on the CMB program and reinvesting their spaces in affordable housing programs.

Speaker 1

The government has promised additional details in its fall 2023 Economic Statement. We would surmise from this announcement that some funding will continue to be available, and we hope that the government's new strategy will be as effective in providing stable and predictable funding as the CMB has been for the past 22 years. To summarize, we expect originations in Q2 to be below last year's levels with improvements in the second half of twenty twenty three, Net interest margin tailwinds to continue to support profitability and good performance by the First National team as we continue to capitalize on all available opportunities to serve our stakeholders. Now over to Rob.

Speaker 2

Thanks, Jason. Q1 performance tracked To the expectations we set on our last call, MUA grew 7% year over year to a new record $133,000,000,000 despite a 21% decrease in total mortgage origination. We experienced that volume decline in both single family, down about 25% or $1,400,000,000 and commercial, which is down 12% or about $288,000,000,000 In context, single family volumes were still $1,700,000,000 above the level we generated in Q1 2019 Before the pandemic led to extraordinary housing activity and this year's commercial originations are 600,000,000 higher than before the pandemic. In light of today's realities and perhaps return of traditional winter seasonality, We are very happy with Q1 2023 originations. Since we issued Q1 results on Friday, I'm certain everyone took the weekend to analyze the results.

Speaker 2

Accordingly, I will be brief. Starting with Q1 revenue, continuing the trend of the last five quarters, it grew year over year. All of the 23% increase reflected higher mortgage coupons in our securitized portfolio, a result of rising rates over the past 12 months. Net of the impact of higher interest rates incurred to fund this portfolio, revenue was about 176,000,000 including changes in gains and losses on financial instruments. Because of the large move to interest rates, this revenue changed by $39,000,000 year over year.

Speaker 2

Excluding fair value based revenues, net revenue grew 9% from the 2022 Q1 as the growth in securitization NIM and mortgage investment income offset lower placement fees. Placement fees were lower by 13%, a result of lower origination. The gains on deferred placement fees, which We earned in originating and selling multis to institutional investors more than doubled year over year. This reflects success in our commercial segment with a mix of insured versus conventional mortgages tilted as we expected to favor the insured business. Q1 mortgage investment income was 46% above last year as we earned more interest income on the portfolio and on mortgages accumulated for securitization.

Speaker 2

Mortgage servicing income was also almost the same year over year, reflecting 2 offsetting factors. 1st, servicing income grew in tandem with MUA and benefited from higher interest earned on escrow deposits. These positive gains are offset by reduced fees earned on activity in our 3rd party underwriting platform, which reflected the slower housing market. Unlike Q1 last year when the inflationary environment drove bond yields higher, we into large gains On the short bonds we used to hedge single family commitments, bond yields fell to open 2023 as the market priced in a possible recession. This created a quarterly loss on short bonds of about $11,100,000 Looking now at expenses.

Speaker 2

We continue to operate with a much larger team than we did in 2019 before the pandemic. That's well justified given the origination volumes remain well ahead of 2019 levels. Even so, we have kept a sharp eye on expenses in the context of an inflationary environment. Brokerage fees increased 27% over last year on a similar decrease or decreased 27% over last year on a similar decrease in single family mortgages originated for institutional investors. Generally, per unit fees were comparable to the 2,002 Q1.

Speaker 2

Going forward, per unit broker fees will continue to reflect market dynamics, which is very competitive right now. Looking at our core measure of profitability, Q1 pre fair market value income increased 32% year over year. This change reflected the cumulative The effect of growth in our securitized mortgages creating 5 10 year income streams. This net securitization income plus Higher commercial mortgage placement fees with institutional investors in Q1 drove this core measure higher. Ongoing profitability Support ongoing dividend payments, an annualized rate of $2.40 per share as well as the company's reputation as a high yielding stock.

Speaker 2

Our payout ratio in the quarter was 103% or 84% excluding gains and losses on Financial Instruments. Now in closing, given the market reset and our expectations entering 2023, results for the Q1 were well in line with our expectations, projections that reflect First National's resiliency, the benefit of diversification and revenue sources and of course the ongoing value of what is now A $133,000,000,000

Speaker 1

of MUA.

Speaker 2

We expect Q2 will be another challenging period for the market and First National by extension, but our outlook for the first half of the year remains constructive. Now, we'll be pleased to answer your questions. Operator, please open the lines. Thank you.

Operator

Thank you, sir. Ladies and gentlemen, we will now begin the question and answer session. One moment please for your first question. Your first question will come from Geoff Kwan at RBC. Please go ahead.

Speaker 3

Hi, good morning. My first question was just if there's any numbers you can give behind Seems like the percentage of borrowers this year that have renewed, that have been able to renew with no problems, given the high rates and everything going on. And also too, it's just Any sort of numbers again, percentage of borrowers, whatever that have sought help, as they've had any sort of difficulty making mortgage payments?

Speaker 1

Yes. Hi, Jeff. So 0% is the answer. As it relates to our adjustable rate portfolio, So those mortgages where payments reset along with changes in the prime rate, we continue to see an arrears rate in that Portion of the portfolio that is equal to or less than the entire portfolio. So we're not seeing any issues on that side.

Speaker 1

And as it relates to the fixed rate borrowers who are now renewing into a higher rate environment than they were 5 years ago, we're not seeing any issues. In fact, We've noted that our retention rate has increased slightly overall on renewing mortgages. And we're not currently engaged in any programs to relieve borrowers who are having any problems because we're not seeing it yet.

Speaker 3

Okay. That's helpful. And then just my second question was And Excalibur, thanks for the data points that you gave in your opening remarks. But I'm just wondering if you can remind just what credit risk you might have, Given how you're funding it, but also to what the typical mortgage terms are on those Mortgages and any exposure to variable rates within the Excalibur segment?

Speaker 1

Sure. Well, as it relates to variable rates, There is no exposure. The Excalibur program is a fixed rate program exclusively. We have no adjustable rate option. It tends to be or it is 1, 2 3 year fixed rates.

Speaker 1

And I would say that probably SKUs towards the 1 2 year rates being the most popular. As it is with our prime book, we continue To renew and move forward with our Excalibur book without any signs or indication of stress from the borrowers through that renewal process.

Speaker 3

Okay. And on the credit, Chris?

Speaker 1

Right. On the credit piece, yes. So, like all of our originations, We fund our Excalibur program through a combination of securitization and whole loan sales to 3rd party balance sheets. Rob might be able to check me on this, but I think we probably have in the context of $2,000,000,000 worth of Excalibur in our securitization programs, but I'm not sure if that's right, Bob. Does that sound right to you?

Speaker 2

Yes, that's close enough. I think maybe a little bit more, but Things happen by around $2,000,000,000

Speaker 1

Around $2,000,000,000 And of that, Jeff, our actual exposure from a credit perspective Would represent 15% of that principal balance, 15% representing our credit enhancement in the program to

Operator

Your next question comes from Nik Priebe at CIBC Capital Markets. Please go ahead.

Speaker 4

Okay. Thanks for the question. I'm just trying to understand the relationship between a pair of trend lines that seem a bit counterintuitive to me. So over the past 12 months, Total originations and renewals are down 15%, but total mortgages under administration are up 7%. And if I were to compare that to 2021, which was With a stronger housing market environment, originations and renewals were up by about the same magnitude, but MUA only grew 4%.

Speaker 4

So I guess in that context, my question is, what conditions are necessary for an acceleration of MUA growth? Like would you expect A recovery in the housing market activity later this year to translate to a higher level of MUA growth above and beyond 7%?

Speaker 1

That's an interesting two point comparison there, Nick. So, can you just repeat for me again the two moments in time or the few data points you were referencing?

Speaker 4

Yes, Sure. I mean, if I just look at the past 12 months, total originations and renewals are down 15% year over year, but total mortgages under administration are up 7%. And then I just compare that to 2021, as we would agree to a stronger market environment. And that year originations and renewals were up 14%, but MUA growth was comparatively slower at 4%.

Speaker 1

I think the answer probably boils down to the During prepayment speeds that we saw. So, during the pandemic, originations were Stream to be sure, but as I even mentioned during my comments, I think we were seeing prepayment speeds. And if we were to use our NHMBS portfolio as a reference Point for the market, fixed rate portfolios were paying at something like 22% annualized. It was hard to keep up with the runoff in the portfolio. So one of the benefits we've seen With this moderation in the market as a result of higher rate is the incentive and propensity for borrowers to prepay For the benefit of refinancing your mortgage perhaps away sooner has gone away.

Speaker 1

So I think it's a prepayment speed thing, But you've piqued my curiosity, so I'll probably look at the various inputs and maybe send a note out if I can. It's originations versus renewals versus liquidations and we'll see how those all fit together. But I think prepayment speed is the answer.

Speaker 4

Yes. Okay. No, that makes sense. It's kind of what I suspected. And I think last quarter you had signaled that securitization NIM could benefit from certain tailwinds in 2023, Particularly on the floating rate component of that portfolio, now that policy rates have stabilized at least temporarily, do Do you expect any further benefit beyond the level achieved in Q1?

Speaker 4

Or is that Q1 seconduritization NIM a pretty reasonable Baseline expectation for the balance of the year?

Speaker 1

I think it's a pretty good expectation. Jim, I mean, at the very margin, all else being equal, there's a little bit of room left on that basis between the prime rate On the mortgages and 1 month SEDAR, which forms the coupon on our adjustable rate MBS, I think in the quarter that probably averaged in the context of 170 basis points. I think the longer run average between those two benchmarks Should be 180 to 185. So there's a little bit of room there yet.

Speaker 4

Okay. All right. Very good. That's it for me. I'll pass the line.

Speaker 4

Thank you.

Operator

Your next question comes from Etienne Ricard at BMO Capital Markets. Please go ahead.

Speaker 5

Thank you and good morning. On credit quality, the regulator noted extending amortizations as a risk for financial institutions. The first part of my question is what patterns are you seeing on amortization periods coming up for mortgages coming up for refinancing. And the second part is, are you seeing more competitive pressures From lenders that might be more willing to take on risk via longer amortization periods.

Speaker 1

Okay. So, the first part of the question would be, pressure on Amortizations on renewals. So all of our mortgages amortize according to contract. So our, the mortgages on our portfolio that have resetting coupons are adjustable rate mortgages. And so their payments Change with every change in prime, which means those borrowers stay on AM.

Speaker 1

So when they come up to maturity, No adjustments are required and there has been no extension or pressure on their amortization term. So that's not a We're dealing with at First National specifically. In terms of competition from peer lenders Willing to offer longer amortizations. Our principal addressable market is The insured Prime 1 as it relates to the single family space. And obviously, there we have amortizations Scribed by CMHC and then on the conventional side similarly OSFI has limits of On amortization.

Speaker 1

So we're not seeing amortization as a point of competition. The only place we see that would be in the Alt A space. And we do see some Alt A lenders offering longer amortizations in the 35 to 40 year range perhaps, but it's not material in the context of our business.

Speaker 5

Understood. And as you noted, the government announced its intention to launch consultations on the Structure of the Canada Mortgage Bond Program, I recognize it is still early in the process and details have yet to be released. That being said, what would you say needs to be preserved in the current structure of the CMB In order to ensure continued liquidity in the securitization market?

Speaker 1

I think liquidity will be maintained. I think the government in what little it has said made it clear that it's important that whatever Paths may follow, there will be continued liquidity for mortgage funding, especially mortgage funding that supports The mandate for creating rental stock and affordable housing generally. But I think structurally For First National and lenders like us, the regular frequency and dependability of the CMB issuance allows us to Communicate C and B funding effectively at commitment to the borrowers. So we're able to Quote a spread over a hedgeable reference benchmark. So we can offer borrowers CMB Plus locked them in at a spread that allows them to then hedge their underlying CMB interest rate risk And properly price out and proceed with their projects.

Speaker 1

So I think that ability to see into the future and reference and hedge against A knowable execution is critical to the program and we'll be communicating that to the Department of Finance as best as we can.

Speaker 5

Thank you very much.

Operator

Your next question will come from Graham Ryding at TD, please go ahead.

Speaker 1

Hi. You touched on it a little bit, but I was just wondering, are there any sort of arrears numbers you could provide both On your single family prime and your Excalibur, maybe just what sort of change you're seeing quarter over quarter, year over year on the rears front? Yes. So broadly speaking, unchanged. So 30 days plus, which would be, I guess, A much broader measure is unchanged period over period.

Speaker 1

So virtually record low, Graham. On the Excalibur side, we had a small increase in absolute numbers Like half a dozen mortgages in the 90 day plus increase quarter over quarter, but The total number of mortgages is like 11. So in a percentage term, it might look as though the Excalibur Program changed materially in the 90 day plus in terms of it's just we started from such a low base that a couple of loans Trickled into the 90 day plus, but those loans specifically have low loan to values, are in liquid centers and Actually don't present any risk of credit loss at this point. Okay, understood. The CMB, are there any sort of changes here that you're anticipating?

Speaker 1

Or is this situation still Very fluid. And how much are you funding annually currently through the CMB program? Yes, the situation is decidedly fluid. So I mean there's really very, very little information other than this idea that they've presented in the budget. As far as our utilization of the CMB, I would say probably fair to say that we maximize our utilization every quarter.

Speaker 1

Changes to the CMB structure or the way funding related to the CMB is delivered Should be manageable. Again, we don't really know what form that's going to take. And not forgetting that there's always just the direct Secondary market for NHANBS issuance as well. So that may evolve to fill a gap if necessary. And can you remind me, is the CMB primarily, are you funding your multiunit Originations through that program or is it both single family?

Speaker 1

Both.

Speaker 3

Yes. So we would leverage

Speaker 1

the Canada Mortgage Bond for both Single family and multifamily. However, the tenure for First National tends to be an exclusively multifamily strategy. Okay, understood. And then just my last question, if I could, just broadly speaking, obviously, there's been lots of pressure in the U. S.

Speaker 1

On the regional banking front, Just with funding and liquidity, have you seen any impact on your business from a funding perspective? No, none whatsoever. So unfortunately, it would seem that the nature of our banking system in Canada Has proven it's resilient in terms of just having big DSIBs and national banking presence. By extension, with the deposit taking institutions within the business, we've seen absolutely zero change in their appetite to acquire mortgage assets. And anecdotally, I understand that Assi has been speaking to some of the smaller and medium sized banks.

Speaker 1

And fortunately, it wouldn't seem that there's been any impact on deposit

Operator

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

Speaker 6

Yes, thanks. Just wanted to dig into the expense side just a little bit. So if I'm breaking it down using sort of stable commissions on commercial originations, Obviously, you talked about a spike or a jump in employee wages and benefits expenses. Just wondering if you can Frame that a little bit for us. What kind of wage increases are you seeing across the board?

Speaker 6

And is there is that more sort of in your, Let's say blue collar employees versus white collar employees, maybe a little bit more color around that.

Speaker 1

I don't know, Rob, do you have Any insight there?

Speaker 2

Yes. Sure. We don't define employees like that, James. They're all employee.

Speaker 6

No, I just

Speaker 2

In general, like there's an across the board merit or inflationary increase that we provide to employees in January of every year. I think this year it was higher just because inflation was higher, the cost of living was higher, right? So I think just in terms of Q1 versus Q1, flat sort of in terms of number, but up 3% wherever it was because of Higher wages.

Speaker 1

I'd probably add to that too that over the course of the pandemic, We definitely saw a lot of migration in terms of employees. And I think the housing market, especially Given how active it was, we did see a lot of pressure on our residential underwriting team. So there may have been also some Salary adjustments along the way there that have accumulated over the last 18 months.

Speaker 6

Okay. Fair enough. And then on the other operating expense What I've understood in the past is that lower interest rates would help in terms of lowering the cost of hedging, which Something that flows through there, but and we saw again a fairly low number in Q4. It spiked up quarter over quarter here in Q1. You identified some travel expenses as some of the drivers, I guess, for a year over year increase.

Speaker 6

But What would be driving that Q4 to Q1 increase in other operating expenses?

Speaker 2

Well, James, first I'd add that I think we reclassed all the hedging, right? So the hedging could be a big number if there was The change between SEDAR and Government of Canada rates, so that now shows up in interest expense, right? So we have We presented the comparative numbers such that all those numbers are now in interest. That won't have an impact on other operating expenses.

Speaker 6

Okay. And so what's driving the Q4 to Q1 specifically and then when thinking about Q1, it's about $18,000,000 Is that a as we think about other operating Is there something in Q1 that bumps that number higher versus Q4 and then it will trickle down or move lower in Q2 and Q4? How

Speaker 2

One thing is technology a little bit. I think at the end of sort of every year you have to pay for various things for Crypto security, for example, just the licenses for Microsoft, which everybody in the whole office uses that we tend to sort of we We pay those and amortize those on occasion, but sometimes we just say, you know what, we'll put it through in Q1 and be done with it. So I think Q1 is a bit heavy in terms of that Expense. And we have a launch for commercial and residential. They have off Site team meetings to launch the year, which are a little bit expensive.

Speaker 2

We shouldn't have a big deal in terms of Overall cost, but in terms of Q4 versus Q1, that will pop up a little bit, maybe less than $1,000,000

Speaker 6

Understood. And that's I think you said crypto security, but I just wanted to refer you to that cybersecurity.

Speaker 1

You meant cybersecurity. Yes, yes. No crypto activity.

Speaker 2

Many money is on cyber.

Speaker 6

Got it. All right. Thanks, guys.

Operator

There are no other questions on the phone lines. So I will turn the conference back to Mr. Jason Ellis for any closing remarks.

Speaker 1

Okay. Thank you again, operator. Before we depart, a reminder that First National will host our Annual Meeting of Shareholders on Tuesday, May 16, 2023 at the TMX Market Centre in Toronto starting at 10 am. We look forward to seeing you there and reporting on our Q2 results this summer. Thank you for participating and have a great day.

Operator

Ladies and gentlemen, this does conclude your conference call for this morning. Again, we would like to thank you for your participation and we ask you to please disconnect your lines.

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