Even when an economy turns sour, there’s a group of companies that benefit from the malaise. In the case of the current credit crunch, it is small Canadian mortgage originators and lenders that are finding opportunities in the insured residential mortgage market.

Prior to August 2007, margins on conventional mortgages were very low, and using deposits to fund mortgages did not produce reasonable returns for lenders. “It was hardly worth it,” says David Taylor, president and CEO of London, Ont.-based Pacific & Western Credit Corp.

Now, margins are above historical norms — and when the credit crunch is resolved, margins are not expected to return to such low levels. This provides an opportunity for lender Pacific & Western and Toronto-based mortgage originator Home Capital Group Inc. to develop a potentially lucrative new line of business. For Toronto-based mortgage originator First National Financial Income Fund, the opportunity is not new; however, the improved margins should give a boost to the company’s earnings. And for Toronto-based mortgage originator Xceed Mortgage Corp., the insured mortgage business provides a lifeline.

Although conventional mortgages are much less profitable than the alternative mortgages Xceed had been originating and securitizing before the credit crunch hit, the company believes it can garner healthy volumes and decent earnings in the insured mortgage segment — enough to ensure its survival.

Here’s a closer look at the four companies:

> First National Financial Income Fund. This income trust gets its earnings from its 20% interest in First National Financial LP, whose main business is providing, underwriting and servicing “prime” residential mortgages — insured and conventional uninsured mortgages for which the loan value is 80% or less of the underlying property’s value. First National then sells some mortgages to institutional investors, mainly banks and trust companies, and securitizes others.

First National services the mortgages, the main source of its earnings, says Rob Inglis, the firm’s vice president of finance.

To a large extent, the service earnings insulate First National from the ups and downs of mortgage spreads. The company is affected to the extent that it can make a profit on its mortgage origination costs. In the period before the credit crisis hit, spreads were tight and the company’s goal was to break even on the origination business.

Now, gross margins on insured conventional mortgages — the difference between the mortgage rate and Government of Canada bonds of the same duration — are approaching 300 basis points, vs the 90-bps low in mid-2007. As a result, First National is able to sell mortgages at prices that give the company a return on origination as well.

First National had been offering Alt-A mortgages, which are for people who have good credit ratings but have trouble getting a mortgage because they can’t prove that they will have the income to pay off the mortgage. But the company has discontinued this business — at least, for the time being — because it is riskier and currently offers margins that are only slightly higher than those on prime mortgages.

First National’s total single-family residential mortgages under administration were $23 billion as of June 30, of which about 60% are insured. First National also offers multi-unit residential and commercial mortgages, which accounted for $13.5 billion in MUA as of that date.

The company distributes its mortgages through the fast-growing mortgage broker channel, which now accounts for about a third of Canadian mortgage originations, vs 14% nine years ago. Inglis notes that the growth in the channel is coming from clients less than 40 years old, who are likely to search the Internet for their mortgages rather than go to their local bank branch.

First National’s competitive advantage is that it offers one-stop shopping for mortgage brokers, who can source both insured and uninsured mortgages, Inglis says. In addition, First National offers fast, high-quality service through its proprietary Merlin software, which it developed eight years ago.

First National funds its mortgages by selling them to institutional investors and through various securitizations, which include bank-sponsored asset-backed commercial paper, National Housing Act mortgage-backed securities and the Canada Mortgage Bond program.

First National’s net income was $6.5 million in the six months ended June 30, vs a loss of $3.5 million during the same period a year earlier.

There 12.6 million outstanding units of the trust, which are widely held. A unit closed at $7.60 on Oct. 10, a 67.3% drop from the $23.25 high in July 2007, just before the credit crisis hit.

@page_break@First National increased its monthly distribution rate to 11.25¢ per unit in August ($1.35 annualized) from 10.417¢ ($1.25 annualized).

> Home Capital Group Inc. The credit crisis has taken its toll on Home Capital’s share price, which closed at $24.37 on Oct. 10, down 39.1% from its high of $40 in July 2007. Its 34.5 million shares are widely held.

There is, however, nothing wrong with Home Capital’s fundamentals or its growth prospects. Its rolling 12-month return on equity was 30.4% as of June 30. This past summer, it increased its dividend to an annualized 52¢ a share from 48¢; in 2003, the annualized dividend was only 8¢.

Home Capital’s main business is alternative mortgages for individuals who don’t qualify at other financial institutions because of poor credit ratings. This is a riskier segment than Alt-A mortgages, but Home Capital has proved that its underwriters can distinguish between individuals who are likely to pay off their mortgages and those who probably won’t.

Home Capital also offers home-equity loans and alternative credit cards for those establishing or re-establishing their credit rating.

Home Capital’s recent foray into insured mortgages takes the firm into a new market. Company president Nick Kyprianou believes this business segment could account for 40% of revenue within the next few years. In 2009, he expects the company will originate $500 million in insured mortgages.

Home Capital finances its mortgages through guaranteed income certificates that are sold through deposit brokers across the country. Home Capital also securitizes mortgages to increase the capital available for further mortgages — and it will certainly do that with insured mortgages. Given their low risk, securitized insured mortgages represent a very good market. As of June 30, Home Capital had $1.7 billion in mortgage-backed security assets under administration.

Like First National, Home Capital distributes through and has strong relationships with mortgage brokers. Home Capital’s competitive advantage lies in its high level of service, including quick turnarounds on mortgage applications, Kyprianou says. The company aims to give an answer on applications within 24 hours, vs the 72-hour average at the banks.

Home Capital reported net income of $51.7 million in the six months to June 30, up from $43.2 million during the same period a year earlier. Revenue was $108.6 million, vs $91.4 million. The company boasts an efficiency ratio — non-interest expenses as a percentage of revenue — of 29.6%, vs 27.6% last year. This is way below the efficiency ratio for Bank of Nova Scotia, for example, which was 54.8% in the nine months ended July 31 and 53.1% in the same period a year earlier; Scotiabank is the most efficient of Canada’s Big Five banks. (See page 44.)

> Pacific & Western Credit Corp. President and CEO Taylor believes insured mortgages will provide the catalyst for strong gains in Pacific & Western’s revenue and earnings that the small bank failed to find in the low-margin credit markets prior to August 2007.

Through Pacific & Western Bank, parent Pacific & Western has always purchased insured mortgages from mortgage originators but wasn’t making much money on them prior to the credit crisis. Now that margins have gone up, Pacific & Western is aggressively buying insured mortgages. It has already purchased $80 million worth of mortgages since early September and expects to buy about $50 million a month going forward. “It will be a big part of our business,” says Taylor, “optimally, about a third.”

It won’t be difficult for Pacific & Western to fund mortgages because it has good relationships with about 100 deposit brokers, including big banks and small independents. Like First National, Pacific & Western has proprietary software, which it has recently updated.

The other parts of Pacific & Western Bank’s business include project lending and equipment leasing, mostly to public entities such as hospitals, school boards and municipalities, but it has been expanding the equipment-leasing business to investment-grade companies. The bank also finances large multi-family real estate construction; it will continue to expand in all these areas.

Pacific & Western also introduced an accounts-receivable funding program in 2005. Although there is interest, there aren’t many customers yet. However, Taylor has high hopes, given the current tight credit conditions and the difficulty companies may have finding financing elsewhere. He notes that the bank has updated its software for this product so that it can be used on BlackBerrys.

Pacific & Western reported a net loss of $4.3 million in the nine months ended July 31, vs net income of $1.6 million a year earlier. A major reason was a pretax $3.7-million impairment writedown on securities. But even without that, there was a loss of $577,000. Net interest income was $7.4 million in the nine months, down from $11.9 million in the same period a year earlier.

Pacific & Western’s share price closed at $3.78 on Oct. 10, down from a high of $14.45 in August 2006. It has 13.6 million widely held shares outstanding.

> Xceed Mortgage Corp. This company had to get out of alternative mortgages because it doesn’t have a deposit base, like Home Capital does, from which to finance mortgages, and investors are no longer prepared to buy securitizations that include these mortgages.

Xceed waited six to seven months after the collapse of the non-bank ABCP market, in which it had raised its funds through securitizations, before deciding to shift to the less profitable but viable insured mortgage market. Xceed’s chairman and CEO, Ivan Wahl, notes that not only are margins much lower in the latter market but there is also more competition.

Xceed reported a slim profit of $1.6 million in the third quarter ended July 31, down from $6.5 million the year before. For the nine months, it reported a net loss of $13.6 million, vs net income of $18 million in the same period in 2007.

Xceed’s revenue plunged by 68.6% in the nine months to $15.9 million from $50.6 million, with lower expenses providing some offset. In the third quarter, expenses were down 38.6% to $4.3 million from $7 million a year earlier. Wahl says Xceed has reduced staff to about 40 from 150 and cut other expenses as much as possible.

What has allowed the company to survive so far is income from securitizations put in place before the credit crunch hit. This business provided $9.7 million in revenue in the nine months, down from $38.5 million in the same period the year prior. The company also has a $500-million line of credit from Germany-based Deutsche Bank AG.

Xceed’s plan is to sell into the Canada Mortgage Bond program. These bonds are not only guaranteed by the Government of Canada but are also backed by the underlying real estate assets. They currently trade at about 65 bps above Canada bonds of the same duration. CMBs are usually five-year bonds, but three- and 10-year bonds are also issued. Wahl expects that Xceed will originate $500 million worth of CMBs in fiscal 2009 and will return to its previous volume of $1.5 billion within a few years.

Xceed also hopes to diversify within a year into the conventional uninsured market, which has somewhat better margins and in which it already has the expertise to do the due diligence required.

Xceed’s share price closed at 81¢ on Oct. 10, way down from a high of $10.20 in February 2006. There are 27.5 million shares outstanding; Wahl owns about 25% of these shares and four institutional inves-tors together hold another 50%. IE