DBRS Upgrades Home Capital Group Inc. to BB (low) and Home Trust Company to BB, Positive Trend

DBRS Limited (DBRS) upgraded the long-term ratings of Home Capital Group Inc. (HCG or the Group) to BB (low) from B and upgraded the Group’s short-term ratings to R-4 from R-5. DBRS also upgraded the long-term ratings of HCG’s primary operating subsidiary, Home Trust Company (HTC or the Trust Company), to BB from BB (low) and confirmed HTC’s short-term rating at R-4. The trends on all ratings have been revised to Positive from Stable, with the exception of the trends on HCG’s short-term ratings, which remain Stable. The Intrinsic Assessment for HTC was raised one notch to BB from BB (low), while the Support Assessment for HCG remains at SA3, which implies no expected systemic support for the Group.

KEY RATING CONSIDERATIONS
The rating actions and Positive trends reflect DBRS’s recognition of the speed of the progress made by HCG in restoring market confidence, stabilizing its performance and regaining its position in the mortgage finance industry. The Group has taken strides to repair relationships with brokers and regain some of its lost market share as it emerged from its liquidity crisis in 2017. Furthermore, HCG has secured more traditional sources of liquidity and has reduced its funding costs. Importantly, with asset quality remaining strong, the Group has returned to a full year of profitability. However, DBRS 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
A continued buildup of stable-term direct deposits and further diversification of funding away from dependence on brokered deposits could lead to positive rating actions. Moreover, regaining market share in originations while improving profitability and maintaining sound asset quality 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 or insufficient liquidity to meet redemptions.

RATING RATIONALE
In 2018, HCG undertook various initiatives to repair and improve its mortgage broker relationships in order to drive stronger originations with the ultimate goal of regaining its position as Canada’s largest Alternative-A mortgage provider. 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. During that period, HCG’s loans under administration (LUA) shrunk to $22.5 billion at YE2017 from $25.8 billion at YE2016, as the Group sold some of its residential and commercial assets. However, the Group’s efforts have proven successful, with total originations up 15% during 2018 to $5.4 billion. Furthermore, the Group announced a three-year technology investment plan aimed at improving operating efficiency, client interaction and service levels to brokers. The “IT Roadmap” involves an upgrade of the core banking system and the addition of new digital tools.

Earnings rebounded in F2018, with the Group reporting net income of $133 million, up from $8 million in F2017, yet still well below historical levels. Despite increases in originations and renewals, interest income declined by 7% to $765 million in 2018 from $819 million in 2017, as the Group reported under a full year of lower LUA. Positively, HCG has reduced its funding costs considerably, with interest expense down by 20% year over year (YOY) to $413 million. The rates HCG now pays on deposits are in line with the rest of the market. Furthermore, in Q3 2018, the Group was able to secure a $500 million standby facility from two of Canada’s largest banks to replace the $2 billion line of credit provided by a wholly owned subsidiary of Berkshire Hathaway Inc. (Berkshire), thus further reducing costs.

Asset quality remained sound in 2018, with impaired loans-to-gross loans at 0.59% as at December 31, 2018. Management continues to invest in improving risk policies and procedures in order to maintain the Group’s reputation for good underwriting, which DBRS believes is crucial at this point as HCG attempts to regain its position in the mortgage market. Positively, the Office of the Superintendent of Financial Institutions’ new B-20 mortgage underwriting guidelines, which include a higher stress test on uninsured mortgages, have had a positive impact on HCG. The new guidelines, which include higher hurdle stress tests, have benefitted the Group, as some of the large bank borrowers chose to obtain their mortgages at HCG knowing they would not easily qualify for mortgages at the larger institutions, thereby improving the overall credit profile of HCG’s clients. Nevertheless, DBRS 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 non-prime market segment.

The Group continues to be highly dependent on broker deposits, which comprised 79% of its $13 billion total deposits as at December 31, 2018. Nevertheless, HCG is growing its direct-to-consumer channel through its Oaken Financial offering, and as such, directly sourced deposits have increased by 32% YOY to $2.7 billion. Meanwhile, unencumbered liquid assets totalled $1.0 billion as at YE2018, almost triple the amount of demand deposits on the balance sheet. 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.

During Q4 2018, HCG initiated a substantial issuer bid (SIB) offering to purchase for cancellation up to $300 million of common shares. The SIB, which was oversubscribed, saw the subsidiary of Berkshire reduce its holding in the Group to less than 10% from approximately 20%. Consequently, HTC’s Common Equity Tier 1 ratio declined to 18.9% as at YE2018 from 23.2% as at YE2017. Nevertheless, capitalisation remains strong in DBRS’s opinion, with a healthy capital cushion. Additionally, no dividends were declared as the Group focuses on reigniting growth.

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

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

The applicable methodology is the Global Methodology for Rating Banks and Banking Organisations (July 2018) 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 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.

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

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