Home Capital Group's (OTC:HMCBF) spectacular meltdown which has seen it lose roughly 80% of its on-demand deposits and its stock plunge by almost 70% in a little more than a month has caused investors to panic. This led to some pundits making ridiculous claims over the state of Canada's housing market and financial system. It sparked a surge in claims that this is the event which indicates that Canada's housing market which some pundits believe is in massive bubble territory has burst. This view has been existence since 2012 and led to significant shorting of Canada's banks and non-bank mortgage lenders.
Since then it has become known as something of a widow maker trade having cost many short sellers considerable sums of money. Not only are the fears surrounding the impact of Home Capital's meltdown overblown but the state of Canada's housing market is misunderstood.
What are the real reasons for Home Capital's crisis?
It appears that the crisis engulfing Home Capital has been misunderstood by many pundits. In recent articles on Seeking Alpha some are going as far as to claim that Canada's largest non-bank lender has made a considerable volume of questionable loans that fall into the same category as the subprime loans that sparked the U.S. housing meltdown.
It is this that they believe is responsible for the dire straitsin which Canada's largest non-bank lender finds itself. These claims at best are misreading the events that have occurred in recent weeks and led to a crisis that more than likely has led to the end of Home Capital as a going concern in its own right.
Since the 2007 U.S. housing meltdown, words such as subprime lending, non-standard mortgages and housing bubbles have not only garnered considerable attention but taken on certain significant negative connotations. This coupled with Home Capital's failure to fully address the fallout from mortgage fraud scandal that was perpetrated by a group of brokers and initially identified in 2014 has sparked a regulatory investigation and class action lawsuit.
The investigation being conducted by Ontario Securities Commission is focused on allegations that Home Capital breached securities regulations by failing to meet its disclosure requirements and there was trading in the company's stock by insiders that potentially contravened relevant laws. It is not related to any breaches of prudential standards or the company's lending practices. These matters are regulated and investigated by the Office of the Superintendent of Financial Institutions Canada (OSFI).
Furthermore, while Home Capital may have misled investors for failing to provide adequate disclosure there is no evidence of systemic fraud with regard to mortgages originated by the lender.
In fact, because of its own internal investigation Home Capital terminated its relationship with 45 brokers and made a public statement that the falsified mortgage applications would not lead to any credit losses. The quality of its loan book over the two years since that scandal was disclosed to investors attests to this.
As at the end of 2016 it had a non-performing loan ratio of a mere 0.3%, well below the 5% plus that many U.S. banks were running in the lead-up to the 2007 housing meltdown. This reflects a mere 20 basis point increase over the equivalent quarter in 2015. For its NPL ratio to spike to a catastrophic level it would require a massive volume of defaults across its loan book, which is highly unlikely. This is further evidenced by the collective allowance for lending losses which has remained stable since the scandal broke.
The government mortgage insurer Canada Mortgage and Housing Corporation or CMHC which insurers the majority of mortgages in Canada went as far as to state:
We have no significant concerns about the quality of the mortgages in the Home Capital portfolio . . .
The real reason for Home Capital finding itself in the present situation is very public loss of confidence in the non-bank lender.
You see, it failed to manage the reputational risk attached to the mortgage scandal.
Furthermore, management failed to adequately understand that any public announcement of an investigation into a subprime mortgage lender in the wake of the 2007 financial crisis would generate a massive wave of fear among depositors and investors. This became a tidal wave that saw Home Capital flooded by a mini bank run where its on demand deposits fell to $192 million or a mere 12th of their balance at the end of 2016.
The sudden and sharp decline in deposits left Home Capital facing a significant liquidity crunch which meant it no longer had sufficient funding to originate new mortgages. The greatest fear is that the situation will only worsen as its CAD$13 billion in guaranteed investment certificates or GICs (fixed term deposits) are withdrawn by investors as they mature of coming weeks.
To combat the looming liquidity crunch Home Capital has secured a $2 billion line of credit at what can only be described as usurious rates. The facility has a 10% interest rate on drawn funds and 2.5% on undrawn balances and some analysts have claimed that the real rate payable is 22.5%. The embattled lender has drawn down CAD$1.4 billion from this facility.
Clearly, Home Capital is incapable of using these funds to profitably write mortgages in a country where the policy interest rate is 0.5%, although it does it give it some breathing space in which to take measures to right the ship.
What is becoming clear is that the securities commission investigation, class action law suit and tremendous run on its deposits leaves Home Capital in the position where it may not survive the crisis in its current form.
This however is not indicative of a systemic failure as occurred in the U.S. during the 2007 housing meltdown.
Is it evidence of a systemic failure?
One of the most spurious claims I have seen is that the crisis at Home Capital will spill over into the financial sector and claim other victims, notably non-traditional mortgage lender Equitable Group (OTC:EQGPF) and even the big six Canadian banks.
The contagion has impacted Equitable Group's stock which has nose-dived 33% in a month and triggered what the non-bank lender described as a mild run on its deposits. But this could be more characterized as a sympathetic response rather than the result of any wrong doing at Equitable Group or issues with the quality of its mortgage book. Credit quality remains solid as evidenced by an NPL ratio of a mere 0.21% which is lower than Home Capital's and Canada's big six banks. This ratio has consistently been at around this level over the last two-years.
Meanwhile lending loss provisions remain low and haven't changed significantly in value for the same period, indicating that credit quality remains stable.
Nonetheless, Equitable Group has wisely sourced additional funding, by obtaining a CAD$2 billion secured funding facility backed by all six of Canada's big banks.
More importantly, this facility has a more palatable 1.25% interest rate on any drawn balance, a 0.75% commitment fee, and a 0.5% standby charge compared to the effective rate of 22.5% being paid by Home Capital.
Even if Home Capital failed it would have little impact on a mortgage market dominated by the big six Canadian banks which control roughly 90% of the market between them. Each of the big six has a high-quality credit portfolio with an average NPL ratio of less than 1% and all mortgages with an LVR of 80% or greater are required to be insured, creating an important backstop.
Furthermore, the average LVR ratio for the mortgage portfolios of the big six comes to around 70% and according to the Canadian Bankers Association means that Canadians have significant equity in their homes. This gives both the banks and borrowers plenty of wriggle room to manage any financial shocks and reduces the likelihood of a massive volume of mortgage defaults, even during economic downturns.
There is also a distinct lack of subprime mortgage with it estimated that they make up roughly a twentieth of all mortgages originated in Canada compared to a fifth in the U.S. during the lead up to the housing crash. These factors will prevent the same volume of rapid defaults that forced U.S. lenders in 2006 and 2007 to flip repossessed properties as quickly as possible, which created a vicious cycle of housing prices cascading ever lower as the crisis deepened.
The view taken by the CMHC support this with it stating:
We are not concerned about either the current state of our financial exposures nor with the Canadian housing finance system in general.
Home Capital's spectacular and very public meltdown is not indicative of any systemic failings or system wide crisis in Canada. It can be attributed to the company failing to effectively manage the aftermath from what could be described as a relatively minor internal mortgage origination scandal.
While there are signs that Home Capital may very well not survive the crisis the long-term fallout across Canada's mortgage industry will be minor.
Aside from the strength of its major banks which control the majority of the market, the conditions that exist in Canada are very different from those that existed in the run-up to the U.S. housing meltdown.
Mortgages insurance is widely prevalent and the big six banks which dominate the mortgage have tight underwriting standards and maintain a conservative LVR for their mortgage portfolios giving them and borrowers plenty of room should difficulties arise. This in conjunction with the majority of loans being non-recourse and the distinct lack of subprime mortgage will prevent the cascading effect of ever lower house prices created during the U.S. housing meltdown as repossessed properties flooded an already overpriced market.
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