Morningstar DBRS Assigns Long-Term Issuer Rating of BBB With a Stable Trend to Fairstone Bank of Canada

DBRS Limited (Morningstar DBRS) assigned credit ratings to Fairstone Bank of Canada (Fairstone or the Group), including a Long-Term Issuer Rating of BBB and a Short-Term Issuer Rating of R-2 (high). The trend on the credit ratings is Stable. Fairstone's Intrinsic Assessment (IA) is BBB with a Support Assessment of SA3. The SA3 designation, which reflects no expectation of timely external support, results in the final Long-Term Issuer Rating being equivalent to the IA.

KEY CREDIT RATING CONSIDERATIONS
The credit ratings and Stable trends reflect the Group's solid market position in the Alt-A mortgage space, particularly in the province of Ontario, through its fully owned subsidiary of Home Trust Company (HTC), and growing franchise in the near-prime and nonprime consumer lending sector under the Fairstone brand across Canada. Despite a challenging operating environment, the Group demonstrated resilient and robust profitability on a pro forma basis with good operating efficiency in 2024 compared with medium-sized Canadian banks. In addition, Fairstone's good balance sheet fundamentals, including solid liquidity and capital, support the credit ratings.

On the other hand, the Group's funding remains highly dependent on brokered deposits and lacks sufficient diversification, which, in Morningstar DBRS' view, is a key credit ratings constraint. The credit ratings also consider the Group's material exposure to near-prime residential mortgages and near-prime and nonprime consumer loans, which heighten the risk profile as reflected by marked increases in impaired loans in the recent past. Moreover, Morningstar DBRS is concerned about the increasing economic and geopolitical uncertainty, particularly as it relates to U.S. trade policy, which could result in a combination of an economic slowdown, rising unemployment, and higher inflation in Canada and have a disproportionally negative impact on the Group's profitability and asset quality compared with more diversified Canadian banks.

Fairstone's IA is positioned below the IA range, reflecting its lack of funding diversity as well as its concentrated business model focused on near-prime residential mortgages and near-prime and nonprime consumer loans. Additionally, the more challenging operating environment associated with macroeconomic uncertainty from U.S. policy initiatives could potentially lead to higher-than-expected deterioration in the Group's profitability and asset quality.

CREDIT RATING DRIVERS
Morningstar DBRS would upgrade the credit ratings if the Group further diversifies its funding sources while maintaining a similar financial performance. Continued diversification in the business mix, while improving the overall risk profile, would also result in a credit ratings upgrade.

Conversely, Morningstar DBRS would downgrade the credit ratings if there were a significant deterioration in the Group's asset quality or substantial funding pressure caused by deposit outflows. Additionally, the credit ratings would be downgraded if there were significant integration-related operational issues.

CREDIT RATING RATIONALE
Franchise Combined Building Block Assessment: Good/Moderate
On January 8, 2025, Fairstone and HTC announced the closing of the combination transaction. The combined group now operates under the parent legal entity, Fairstone, and includes a family of existing brands, including Home Trust Company, Oaken Financial, Home Bank, Fairstone Financial Inc., EdenPark Inc., and Fig Financial Inc. As an alternative lender, Fairstone offers a wide range of lending products, including residential and commercial mortgages, secured and unsecured personal loans, credit cards, retail financing, digital loans, and auto financing, to more than 2 million customers across Canada. On a consolidated basis, the Group's pro forma assets totalled about $30.9 billion as at December 31, 2024, with HTC accounting for about 74% of total assets. HTC is one of Canada's leading Alt-A mortgage providers for borrowers who are self employed, new immigrants, or those recovering from bruised credit. Residential Alt-A mortgages formed about 47% of total on-balance sheet loans of the Group in 2024, while nonmortgage consumer loans contributed about 24% in the same period.

Earnings Combined Building Block Assessment: Strong/Good
The Group's pro forma net income was $540.2 million in 2024, a significant increase of 32.3% year over year (YOY), supported by higher total revenue and partially offset by an increase in total operating expenses and provision for credit losses (PCL). Net interest income grew 12.9% YOY to $1.8 billion in 2024, supported by a 49-basis-point (bp) expansion in the net interest margin to 6.30% (as calculated by Morningstar DBRS). Meanwhile, adjusted operating expenses increased by 3.1% YOY to $693.0 million in 2024; as a result, the efficiency ratio (as calculated by Morningstar DBRS) improved to 33.9% in 2024 compared with 37.0% in the previous year. Total PCL also increased to $581.6 million in 2024 compared with $502.4 million in 2023, largely driven by the volume increases as well as credit migration in nonmortgage consumer loans. Lastly, noninterest income grew 8.6% YOY to $232 million in 2024, driven mainly by higher interchange revenue on credit card purchases, higher service fee income related to credit cards, higher commission on sale of optional products, and higher creditor insurance income related to credit cards. However, the share of noninterest income in total revenue was only 11.4% in 2024, which Morningstar DBRS views as a credit ratings constraint. On a positive note, Fairstone historically demonstrated stronger returns with higher yields on a risk-adjusted basis compared with its peers, which contributes to the Group's ability to absorb higher credit losses.

Risk Combined Building Block Assessment: Good/Moderate
The Group's pro forma gross loans increased 2.2% YOY to $28.4 billion in 2024, driven by growth across most nonmortgage consumer loans. However, on a stand-alone basis, HTC's gross loans contracted marginally at 0.4% YOY to $21.3 billion for the same period because of the discontinuation of insured mortgage originations. Fairstone exhibits weaker asset quality metrics than its peers, reflecting its exposure to Alt-A mortgages and consumer loans offered to near-prime and nonprime customers. The Group's impaired loans increased to 2.8% of gross loans in 2024 compared with 1.8% in the previous year, reflecting increased impairments across most business lines. Meanwhile, net write-offs amounted to 1.8% of gross loans in 2024 compared with 1.5% the year before. On a stand-alone basis, HTC's gross impaired loans ratio deteriorated by 119 bps YOY to 2.6% in 2024 mostly on single-family residential and commercial mortgages. Nevertheless, the net write-offs ratio continued to be negligible at just 5 bps for the same period. Meanwhile, Fairstone's lending book (excluding HTC's loans) had a gross impaired loans ratio of 3.3% in 2024, compared with 3.0% the previous year, and net write-offs ratio stood at 8.0% in 2024.

Funding and Liquidity Combined Building Block Assessment: Moderate
The Group's total deposits (including deposit notes) grew 5.6% YOY to $21.5 billion in 2024 and accounted for about 80% of total funding. The Group's funding is highly dependent on broker-sourced deposits, which Morningstar DBRS views as a credit ratings constraint. The brokered deposits comprised about 74% of the Group's $21.3 billion total deposits (or about 59% of total funding) in 2024. The Group continues to grow its direct-to-consumer deposits through its Oaken Financial offering, which amounted to $5.4 billion and accounted for 25% of the Group's total deposits (or 20% of total funding) in 2024. At the Group level, demand deposits accounted for only about 4% of total funding in 2024. Additionally, the Group uses various secured funding programs, including residential mortgage-backed securities and bank-sponsored securitization conduit programs funded by uninsured single-family mortgages as well as pools of consumer loans and credit cards.

Capitalization Combined Building Block Assessment: Good
The Group's capital position is good, comfortably above the regulatory limits and broadly in line with the peer average. Reflecting an increase in risk-weighted assets, the Group's pro forma CET1 ratio decreased by 45 bps YOY to 13.9% in 2024. The dividend payout ratio was 98% in 2024 compared with 157% in previous year. Fairstone is expected to maintain its total capital ratio within a 14.0% to 14.5% range and CET1 ratio above 13%. On a stand-alone basis, HTC maintained good levels of capital in 2024 as indicated by its CET1 ratio of 13.81%, while Fairstone (on a stand-alone basis) had a CET1 ratio of 14.00% in 2024, both well above the regulatory minimum of 7.00%.

Further details on the Scorecard Indicators and Building Block Assessments can be found at https://dbrs.morningstar.com/research/454455.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
Governance (G) Factors
Corporate/Transaction Governance is a relevant factor in the credit analysis, but it does not affect the credit ratings or the trends assigned to Fairstone. Morningstar DBRS finds the issuer's corporate structure reduces board and audit independence. Of the board of director's 13 members, only four are independent while the remaining nine are affiliated with the ownership group. This factor is incorporated into Fairstone's Franchise grid grades.

There were no Environmental/Social 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 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.

For more information on Morningstar DBRS' policy regarding the solicitation status of credit ratings, please refer to the Credit Ratings Global Policy, which can be found in the Morningstar DBRS Understanding Ratings section of the website: https://dbrs.morningstar.com/understanding-ratings

The conditions that lead to the assignment of a Negative or Positive trend are generally resolved within a 12-month period. Morningstar DBRS's trends 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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