Morningstar DBRS Confirms HomeEquity Bank's Long-Term Issuer Rating at BBB (low); Stable Trend

DBRS Limited (Morningstar DBRS) confirmed its Long-Term Issuer Rating and Long-Term Senior debt credit rating on HomeEquity Bank (HEB or the Bank) at BBB (low). The trends on both credit ratings are Stable. The Bank's Intrinsic Assessment (IA) is BBB (low) with a Support Assessment of SA3. The SA3 designation, which reflects no expectation of timely external support, results in HEB's final credit ratings being equivalent to the Bank's IA.

KEY CREDIT RATING CONSIDERATIONS
The credit rating confirmations and Stable trends reflect the Bank's leading franchise in the niche market of reverse mortgages in Canada. Despite the challenging operating environment, HEB's profitability remained resilient in 2023, and Morningstar DBRS expects this trend to continue. Additionally, the Bank's risk profile remains sound with minimal loan losses, while funding and liquidity have been stable and capital buffers are currently sufficient to absorb loan losses in a stressed environment. Nevertheless, HEB's very limited revenue diversification could make the Bank susceptible to potential losses under stressed economic conditions. The credit ratings also reflect Morningstar DBRS' expectation that credit quality metrics may modestly deteriorate in the near to medium term compared with 2023 levels amid a still-elevated, albeit declining, interest rate environment. Furthermore, the Bank's monoline product offering, the limited size of the reverse mortgage market in Canada, and a heavy reliance on brokered deposits remain credit rating constraints.

CREDIT RATING DRIVERS
A more diversified funding mix, including directly sourced client deposits, while maintaining sound asset quality, would lead to Morningstar DBRS upgrading the credit ratings. Credit ratings would also be upgraded if the Bank were able to materially improve its product and revenue diversification.

Morningstar DBRS could downgrade the credit ratings in the case of substantive funding pressure caused by limited access to the brokered deposit market or a sustained deterioration in asset quality.

CREDIT RATING RATIONALE

Franchise Combined Building Block (BB) Assessment: Weak/Very Weak
As a Schedule I Canadian Chartered Bank, HEB is the largest reverse mortgage provider in Canada. However, the Bank operates in a niche market segment with a loan portfolio of $8.0 billion as of Q2 2024 that is composed exclusively of reverse mortgages with a variety of distinctive features. With no branch presence, HEB sources mortgages through various distribution channels, including referral relationships with major Canadian banks and mortgage brokers. While HEB's competitive position remains largely unchallenged and barriers to entry are higher compared with the traditional mortgage market, any new potential entrants could significantly undermine the Bank's market position.

Earnings Combined Building Block (BB) Assessment: Good/Moderate
With a steady and strong net interest margin (NIM), HEB generates good levels of earnings that can cover heightened provisioning expenses. Despite higher operating expenses, net earnings expanded by 9.3% year over year (YOY) to $84.3 million in 2023 on the back of stronger net interest income (NII). NII grew 20.9% YOY to $221.4 million in 2023, supported by strong growth in the loan portfolio and high interest rates. NIM as calculated by Morningstar DBRS expanded by 7 basis points (bps) YOY to 3.2% in 2023. The Bank has one of the best efficiency ratios among its peers, at 38% in 2023, benefitting from not having a branch footprint. Nevertheless, HEB's noninterest income, which mainly comprises mortgage administration fees and net gains on sale of mortgages, is minimal, accounting for less than 1% of total operating revenue in 2023, which positions the Bank at the bottom of its peer group average.

Risk Combined Building Block (BB) Assessment: Good/Moderate
The Bank's asset quality remains good with very few loan losses. In a challenging operating environment, growth of HEB's reverse mortgage book slowed to about 18% YOY in 2023 from 22% YOY in 2022, although still strong compared with the average growth of 17% in the past five years. Because of bulk appraisals of the underlying properties, gross impaired loans (GILs) increased 14 bps YOY to 0.64% of gross loans in 2023, while the net charge-off ratio stood at just 3 bps. Morningstar DBRS notes that, per Office of the Superintendent of Financial Institution guidelines, reverse mortgages with a loan-to-value ratio greater than 83% are classified as GILs, and this approach is not directly comparable with GILs on conventional mortgages. Reflecting an uncertain economic outlook and bulk appraisals of the loan book, provision for credit losses totalled $21.3 million in 2023 compared with $8.3 million in the previous year. Given HEB's monoline business model and elevated home prices, particularly in the Greater Toronto and Greater Vancouver areas, Morningstar DBRS remains cautious that a potential real estate market downturn would adversely affect the Bank's asset quality.

Funding and Liquidity Combined Building Block (BB) Assessment: Moderate
Broker-sourced deposits accounted for about 90% of HEB's funding base in 2023. Overall, total deposits grew 13.9% YOY to about $6.2 billion in 2023. Although they are nonredeemable term deposits, Morningstar DBRS views these as having higher flight risk upon maturity compared with directly sourced client deposits. The Bank has been diversifying its funding base by opening wholesale funding channels, including senior medium-term debt with an outstanding amount of $349 million and capital market deposit notes of $175 million in 2023. It also has access to the Bank of Canada standing-term liquidity facility and a committed, revolving credit facility with the large Canadian banks. On the balance sheet, liquidity levels are sufficient given the Bank's lending model.

Capitalization Combined Building Block (BB) Assessment: Good
Supported by internal capital generation and a reduction in risk-weighted assets (RWA), HEB's CET1 ratio increased by 250 bps YOY to 16.3% in 2023. At this level, the Bank has a sufficient capital cushion over the minimum regulatory requirement to support growth and absorb potential losses in a stressed environment. HEB uses a standardized Basel III approach on an all-in basis. With the updated Capital Adequacy Requirements guideline in effect since April 2023, the Bank's RWA reduced in 2023, as its reverse mortgages qualified for a lower risk weighting. HEB has limited flexibility to raise external capital given its private ownership structure. However, Morningstar DBRS notes that the Bank's ultimate parent is Ontario Teachers' Pension Plan Board (rated AAA with a Stable trend by Morningstar DBRS), the administrator of Canada's largest single-profession pension plan.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://dbrs.morningstar.com/research/440640.

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 Factors in Credit Ratings (August 13, 2024), https://dbrs.morningstar.com/research/437781.

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

The principal methodology is the Global Methodology for Rating Banks and Banking Organisations (June 4, 2024), https://dbrs.morningstar.com/research/433881. In addition, Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings (August 13, 2024) https://dbrs.morningstar.com/research/437781 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 ratings were initiated at the request of the rated entity.

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

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's 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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