Street Capital Announces 2017 Third Quarter Results

Department of Finance – October 2016

In October 2016, the federal government's Department of Finance announced new mortgage insurance rules, with the most material items being increases to the qualifying rate for new insurable mortgages and the elimination of mortgage insurance on most refinance transactions. These changes, along with previous changes that eliminated mortgage insurance for purchases over $1.0 million and amortizations greater than 25 years have, as expected, decreased the volume of mortgages that qualify for individual or portfolio mortgage insurance. Since most of the Company's purchasers of prime mortgages securitize these mortgages through the NHA MBS and CMB programs, these changes have reduced the available funding for prime, but now uninsurable, mortgages. This has led to a marked decrease in prime mortgage origination volumes for the Company and other mono-line mortgage lenders. While the Company has the advantage of being a Schedule I Bank and having access to CDIC-eligible insured GICs funding, the cost of funds through the broker GIC channel, combined with the capital requirements for prime uninsurable mortgages, makes funding these mortgages on its balance sheet uneconomical compared to higher margin Street Solutions mortgages.

As well, in 2016 OSFI introduced higher regulatory capital requirements for mortgage insurers. This increased the cost of portfolio insurance for lenders. Higher portfolio insurance costs in certain segments further reduce the size of Street Capital's addressable market of prime mortgages, as large banks that choose to hold these mortgages on balance sheet without portfolio insurance can do so at much higher margin than a lender requiring insurance. 

While the Company continues to actively explore and prioritize access to alternative funding options for prime uninsurable mortgages, so that it can expand its suite of mortgage products, the development of funding options is progressing at a much slower pace than desired. In the meantime, Street Capital Bank only offers prime uninsured mortgages on a limited basis. To the extent funding for this product remains unavailable the Bank will continue to experience reduced prime origination volumes.

OSFI B-20 – October 2017

Additional regulatory changes occurred most recently on October 17, 2017, when OSFI released amendments to Guideline B-20–Residential Mortgage Underwriting Practices and Procedures ("Guideline B-20"). The amendments had originally been proposed in July 2017, and they will be effective on January 1, 2018. The basic framework of Guideline B-20 has not changed:  the five fundamental principles for sound residential mortgage underwriting remain. However, OSFI tightened and clarified its expectations, and introduced new expectations, namely:

• Requiring a GDS/TDS stress test for all uninsured mortgages of the greater of i) 2.00% above the contractual interest rate, or ii) the five-year benchmark rate published by the Bank of Canada;
  
  
• Requiring that Loan-to-Value ("LTV") measurements remain dynamic and adjust for changes in local market conditions in order to accurately reflect the associated risks; and
  
  
• Expressly prohibiting co-lending arrangements that are designed, or appear to be designed, to circumvent LTV limits, or other underwriting policy or legal limitations.

The federal government has also proposed lender risk sharing arrangements that could further affect the insurable mortgage market, and provincial governments in British Columbia and Ontario have recently introduced, and may further introduce, measures intended to slow house price appreciation in those provinces.

It will take some time to fully understand the full impact that the combination of these changes will have on housing activity and prices, and ultimately on mortgage activity and mortgage rates.

As stated previously, the recent changes in Guideline B-20 have the potential to reduce the size of mortgage a borrower may qualify for, as well as require more documentation for self-employed borrowers, and therefore reduce the level of uninsured mortgage lending activity originated by OSFI-regulated financial institutions. However, management is maintaining its previously outlined origination targets for Street Solutions, given that they are relatively modest compared to the overall size of the addressable market.

There remains a great deal of uncertainty in the housing markets, making it challenging to predict outcomes, and as a result the Company's views can change over time in response to observed factors and market trends.  

Prime Mortgage Lending

Recent regulatory changes, discussed above, have reduced the volume of prime mortgages that qualify for insurance, leading to a decline in the Bank's lending activity in the prime insurable mortgage segment in 2017.

While it remains difficult to estimate the potential reduction in prime mortgage activity in the market and for the Bank, the Company has been able to maintain strong origination volumes for prime insurable mortgages. The Company has more than adequate funding for this product and there continues to be strong market demand, and the Bank remains competitive in this mortgage segment. 

For mortgages that previously qualified for mortgage insurance, i.e.:  prime uninsured mortgages, the Bank is offering these mortgages on a very limited basis. As discussed, the Company remains active in pursuing additional funding for this specific product, but there remains uncertainty regarding both the timing of funding availability and the potential profitability of these mortgages through new funding structures. As such, management is maintaining its conservative view of overall new prime origination volumes. The Company expects that total new prime originations volumes for 2017 will be 30%-35% below 2016. For new sales of prime insurable mortgages, for which funding remains stable, management expects gain on sale rates in the range of average rates earned over the last two years.

Softness in new originations of prime mortgages will be partly offset by the Bank's expected highly profitable renewal activity in Q4 2017, 2018 and 2019. Based on the maturity profile of the MUA, the Bank will experience material increases in renewal activity over these periods, as evidenced in this quarter. Gain on sale rates for renewal volumes are expected to be in the range of averages earned over 2017. To optimize this revenue stream, the Bank will continue to focus on its service and retention activities. The Bank's almost $28 billion of MUA provides both a sustainable portfolio of quality revenue generating assets and a customer base to drive significant value over the coming years as it expands into additional product areas. It should also be noted that the stress test associated with the recent changes to Guideline B-20, which applies to all refinances of mortgages or a change in mortgage lender, potentially buoys renewal rates in 2018 and beyond. Management will monitor this carefully.  

Uninsured Mortgage Lending

The Bank launched its uninsured mortgage product, Street Solutions, in Q2 2017. The market response was very positive, with many existing mortgage broker partners welcoming another provider in this segment. For the nine months ending September 30, 2017 the Street Solutions originations were $142 million, and therefore the Company was close to the lower end of its targeted $150 - $200 million in mortgage origination and funding targets for 2017. In mid-October the Bank put a hold on new commitments for closings in 2017. The Bank continues to take applications for closings in 2018 and still expects to meet its target originations for this product in 2018 and 2019. 

Funding and Liquidity

The Bank continues to diversify its off-balance sheet funding sources in the prime insurable mortgage market and on-boarded one new institutional investor during Q3 2017. When investors purchase prime insurable mortgages at commitment, the Company transfers substantially all of the risks and rewards of the ownership of the mortgage. The Company's access to this funding is more than adequate, and the Bank remains competitive in this mortgage segment.

The Bank has a secondary source of funding for prime insurable mortgages, through their securitization. However, when the underlying mortgages remain on the Bank's balance sheet, they attract a commensurate increase in regulatory capital in the calculation of the Bank's leverage ratio. During Q3 2017, the Bank did enter into a transaction to securitize and sell, through the CMB program, a $43 million 10-year mortgage loan on a multi-unit residential property. The purchase of an accompanying outright seller swap allowed the Bank to get off balance sheet treatment for this transaction and recognize an upfront one-time gain, rather than net interest income over the mortgage term.

In order to fund its on-balance sheet loans and liquid assets (e.g.: Street Solutions mortgages, uninsurable prime mortgages, stamped mortgages, bridge loans and liquid investments such as Treasury Bills), the Bank offers a full product suite of CDIC insurance-eligible retail GICs ranging in terms from 1 to 5 years, including a 90-day cashable option. Currently, the Bank's GIC distribution strategy is focused on the third party deposit broker network, including IIROC, MFDA, RDBA and MGA members. Management believes the Bank is well-positioned to penetrate this channel, and is in the process of hiring a business development manager who will be charged with diversifying the Bank's deposit broker relationships. Success in building a well-diversified portfolio of stable retail term deposits will enable the Bank to meet its targets for uninsurable mortgage originations. During Q3 2017 the Company raised net $126.1 million in new deposit funding, bringing total deposits, net of broker commissions, to a total of $198.3 million at September 30.

Operating Expenses

In Q3 2017, the Company accrued additional restructuring expenses of $0.5 million. The initial restructuring in Q2 2017 involved the reduction of approximately 10% of the Company's workforce, and associated reorganization expenses of $2.5 million, pre-tax, were recorded as a component of operating expense in Q2 2017. Together with the $3.6 million retiring allowance recorded in Q1 2017 for Mr. DaRocha, the former President, total pre-tax reorganization expenses in 2017 are $6.6 million. The anticipated ongoing expense savings from the staff reduction are between $1.5 million to $2.0 million per year. However, as the Bank more formally defines and develops its mid- and long-term strategy and priorities, the Company expects to add additional staff with the relevant skills and experience to execute on its strategy. The Bank is still targeting positive operating leverage for the twelve months of 2018 and in 2019.

Strategic Priorities

Management continues to evaluate the go-forward strategy for the Bank, and will finalize its strategic plan and 3-year financial projections for presentation to the Board later in Q4 2017. In the near-term, the Company plans to focus on delivering against its 2017 objectives and positioning the Bank for success in 2018 and beyond. Among these initiatives is the selection and implementation of a core banking system, which will facilitate the Bank's expansion of its product offerings and improvement of the customer experience.

Given the near-term strategic priorities and in consideration of balancing the use of the Bank's resources, both financial and people, management has de-prioritized the implementation and launch of the credit card program. The credit card program was not expected to add materially to revenue over the mid-term, so there are no changes to the financial outlook.

Business Developments

On September 1, 2017, as previously announced on June 29, 2017, the Company's former CEO and acting President, Mr. W. Edward Gettings, retired from Street Capital Group Inc. and Street Capital Bank. Mr. Gettings has continued to serve as a member of the Company's Board of Directors.

Also on September 1, 2017, as previously announced on June 29, 2017, Duncan Hannay, a seasoned financial services and technology executive leader, assumed the responsibilities of President and CEO of both the Company and Street Capital Bank.

On September 5, 2017, the Company announced that Jeff Marshall, an experienced financial product development and marketing executive, was appointed Chief Product and Marketing Officer of Street Capital Bank. Mr. Marshall assumed these responsibilities on the date of the announcement.

On September 28, 2017, the Company announced that Greg Parker, an experienced capital markets, treasury and risk management leader, has been appointed Executive Vice President, Capital Markets and Treasury of Street Capital Bank. Mr. Parker assumed these responsibilities on October 23, 2017.

Financial Expectations – 2017 to 2019

Note: The Bank may not realize the financial expectations indicated below if business or competitive conditions, the regulatory environment, the housing market, or general economic conditions change, or if any of the other management assumptions do not materialize in the amount or within the timeframes expected. Please refer to the Forward-Looking Information, below.

Management's financial expectations for new prime originations have been modified for 2017 since last quarter, but remaining financial expectations remain unchanged since they were originally presented on May 10, 2017.

Financial Highlights
The following tables set out the financial highlights for the three and nine months ended September 30, 2017:

(in thousands of $, except where defined)		For the three months ended or as at							For the nine months ended or as at
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