DBRS Upgrades Ratings of Home Capital Group Inc., Trend Stable

DBRS Limited (DBRS) upgraded the long-term ratings of Home Capital Group Inc. (HCG or the Group) to B (low) from CCC and confirmed its short-term ratings at R-5. Additionally, DBRS upgraded the ratings of Home Trust Company (HTC or the Trust Company), HCG’s primary operating subsidiary. The trends on all ratings are now Stable. DBRS also upgraded HTC’s Intrinsic Assessment to BB (low) from B. The Support Assessment for HTC remains SA3, which implies no expected systemic support for the Trust Company. As a result of these actions, the ratings of the Group, as well as HTC have been removed from Under Review with Positive Implications, where they were placed on August 9, 2017.

The rating actions reflect DBRS’s view that the Group is now in a steady position with the hiring of a full complement of senior executives who were able to restore market confidence and set clear goals for HCG’s future. In addition, deposit and liquidity levels have stabilized. Furthermore, the repayment of funds drawn under the credit facility provided by a subsidiary of Berkshire Hathaway Inc. (Berkshire) and funding costs that are more contained versus the previous quarter have allowed the Group to revert to profitability. Lastly, mortgage renewals have regained momentum while asset quality remains strong.

Over the last four months, the Group has made good progress in hiring a strong management team and filling key positions. The Board of Directors and new CEO have developed a near-term strategic plan aimed at returning the business to a growth trajectory and regaining lost market share by introducing competitive products, improving the level of service to all stakeholders and most importantly, repairing relationships with the mortgage broker community. The completion of Project EXPO in October 2017 and the revision of procedures and policies aimed at improving service to mortgage brokers while adhering to risk parameters should help bolster originations going forward. While DBRS views the near-term strategic plan as sensible, DBRS sees returning the Group’s originations and market share to historical levels in the current market environment as a longer-term process. Indeed, originations totalled $385 million in Q3 2017, down 66% from the linked quarter, while loans under administration decreased by 10% to $23.2 billion.

Importantly for the ratings, the deposit base has stabilized with HCG reporting net inflows in Q3 2017, with deposits increasing by 2%. Positively, the Group has gradually reduced deposit rates to be more in line with market averages after having to significantly increase rates in order to attract deposits following the Group’s liquidity crisis in April 2017. DBRS sees the ability to return deposit rates to those consistent with the market as demonstrating that a level of investor confidence has been restored. Nevertheless, HCG’s current funding costs are still elevated versus historical levels compressing the Group’s net interest margin. DBRS will look for HCG to improve its funding costs, bringing them in line with peers, as at current levels deposit rates pose a drag on the operating profitability of the Group and could inhibit HCG’s ability to continue to operate an originate-and-hold business model.

Positively, the Group’s aggregate liquidity position has improved to $2.7 billion on September 30, 2017, from $1.7 billion as of June 30, 2017, the equivalent of 14% of HCG’s Q3 2017 balance sheet. In addition, with the repayment of the amounts drawn under the emergency liquidity line and the Berkshire credit facility in Q2 2017, HCG was able to reduce its costs and report net income of $30 million for Q3 2017, versus the $111 million net loss reported in the previous quarter. Nevertheless, DBRS expects profitability to continue to be constrained until HCG is able to reduce it funding costs to peer levels.

Asset quality continues to be good with impaired loans at 0.32% of gross loans as of September 30, 2017. As with other financial institutions active in residential mortgage lending, HCG continues to assess the potential impact the Office of the Superintendent of Financial Institutions’ new B-20 guidelines (effective January 1, 2018) will have on originations. On the one hand, the potentially more stringent stress tests could price some of HCG’s client base out of the market; however, HCG’s management expects that it might gain borrowers who may no longer qualify for mortgages at the larger banks. While DBRS recognizes that such a shift in customer mix may improve the credit profile of HCG’s residential mortgage portfolio; DBRS is also cognizant that operational risks in terms of implementing revised processes and executing on improving broker service pose a larger challenge for HCG in the short term.

HCG’s Common Equity Tier 1 ratio rose to 21.25% during the quarter as risk-weighted assets were reduced with the completion of previously announced asset sales. Despite the return to profitability in Q3 2017, no dividends were declared by the Group as earnings retention remains key to restoring HCG’s growth.

The Grid Summary Scores for HTC are as follows: Franchise Strength – Weak; Earnings Power – Moderate/Weak; Risk Profile – Moderate; Funding & Liquidity – Weak; Capitalisation – Moderate/Weak.

RATING DRIVERS
Regaining market share by improving originations while sustaining an appropriate level of profitability and maintaining sound asset quality could lead to positive rating actions. Moreover, further build-up of the deposit base through stable direct channels, decreasing dependence on brokered deposits and a lowering of funding costs in line with peer levels would be viewed positively. Conversely, the ratings could come under pressure if HCG is unable to improve service levels in order to repair and solidify relationships with mortgage brokers. Furthermore, a change in the asset mix that would lead the Group to underwrite a materially larger proportion of commercial loans in turn shifting its focus from its core franchise of underwriting residential mortgages, or significant losses in the loan book that would arise from unforeseen weakness in underwriting and/or risk management processes could also lead to negative rating actions.

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

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link to the right under Related Research or by contacting us at info@dbrs.com.

The principal methodology is Global Methodology for Rating Banks and Banking Organisations (May 2017), which can be found on dbrs.com under Methodologies.

Lead Analyst: Maria-Gabriella Khoury, Vice President, Global FIG
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG & Sovereign Ratings

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

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