The crisis at Canadian alternative mortgage provider Home Capital Group (OTCPK:HMCBF) has sparked a slew of claims among pundits that an epic Canadian housing bust is nigh. This, it is believed, will cause Canada's financial system to fall into a crisis, causing the stock of the major banks to plummet and smaller alternative lenders to collapse. It is the rationale behind two of Canada's largest banks being among the most shorted stocks on the Toronto Stock Exchange.
What happened at Home Capital?
In an article early last month, I took the opportunity to take a closer look at the disaster unfolding at Canada's largest alternative lender Home Capital to determine whether it relates to mortgage fraud and substandard lending practices. While it was certainly precipitated by a scandal regarding fraudulent mortgages that was uncovered by the lender in 2015, it was not the quality of its mortgage portfolio that took it to the brink of collapse.
Rather it was a crisis of confidence in the lender.
This was sparked by an investigation by the Ontario Securities Commission centered around allegations that Home Capital failed to meet its continuous disclosure requirements and that management had misled investors and some officers had potentially engaged in insider trading.
That turned into a massive run on its deposits which took Home Capital to the verge of collapse and has left it facing a severe liquidity crunch with management warning in its first quarter 2017 results that the company may not remain a going concern.
The consensus among regulators and international ratings agencies is that Home Capital's mortgage book is sound.
Fitch went as far as to say:
Home Capital's liquidity problems were idiosyncratic and that asset quality doesn't appear to be an issue . . .
That view is supported by the Canada Mortgage and Housing Corporation or CMHC which stated:
We have no significant concerns about the quality of the mortgages in the Home Capital portfolio . . .
Canada's Minister of Finance Bill Morneau said:
Home Capital's risk has been contained and that financial checks and balances are working as they should.
While the governor of the Bank of Canada Stephen Poloz went on to say:
Home Capital Group Inc.'s troubles are unique to the mortgage lender and there's no evidence they're spreading to other parts of the country's financial system.
Even big six bank Canadian Imperial Bank of Commerce or CIBC (NYSE:CM) took a position in the beleaguered alternative lender. It did this after stress testing how it would hold up in different scenarios including a housing bust and concluded that Home Capital was undervalued, despite the crisis.
This further underscores that there are no fundamental problems with credit quality at Home Capital. What each of these factors indicates is that the issues at Home Capital are not systemic and relate solely to a very public loss of confidence in the company.
How vulnerable is Canada's financial system to a housing bust?
The belief that Canada's housing market is caught in a massive bubble, or more specifically the regional markets of Toronto and Vancouver, that is on the verge of collapse has attracted considerable interest from short sellers. This is because it is believed that it would have a significant impact on Canada's financial system, its banks and alternative lenders.
At this time Canada's second largest bank by assets Toronto-Dominion (NYSE:TD) is the second most shorted stock on the TSX and the third largest Bank of Nova Scotia (NYSE:BNS) is the 13th most shorted. Canada's financial stocks have been heavily shorted by U.S. hedge funds for some time and it has become known as a widow maker trade, causing many short sellers during recent years to incur considerable losses.
Nonetheless, many now believe that the near collapse of Home Capital has validated the decision to short Canada's banks. This, however, couldn't be further from the truth because not only is Home Capital's crisis not related to issues around credit quality, but there are significant differences between the Canadian financial system and that which existed in the U.S. during the housing boom.
Lack of subprime mortgages
A key cause of the meltdown of the U.S. housing market and financial system was the considerable volume of subprime mortgages. In 2006, at the peak of the housing boom, subprime mortgages made up over a third of all U.S. originations. Whereas in Canada, subprime mortgages currently only make up roughly 5% of all mortgages issued.
More startling is the differences between those mortgages classified as subprime. In the U.S., many were straight out fraudulent mortgages or had such relaxed underwriting standards that they were given to borrowers who under no circumstances would normally qualify for a loan.
The majority of those mortgages originated were non-recourse loans. This meant that once the borrower could no longer meet the repayments, usually after the honeymoon period had ended and the loan was renewed at a higher rate, they would simply vacate the property with no recourse for the lender against them. This drove home prices ever lower as greater volumes of repossessed properties came on to a market that was already in free fall, causing prices to cascade in such a manner that it appeared there wasn't a bottom in sight.
Those loans classified as subprime in Canada typically do not meet the stringent underwriting standards of the big six banks but are of significantly higher quality than those classified as subprime in the U.S. a decade ago.
Typically, a subprime borrower is a person with no or a less than perfect credit history and an unstable income such as being self-employed, leading to a FICO score of less than 620.
There is no evidence of systemic mortgage fraud in Canada as occurred in the U.S. in the run-up to 2007. This is supported by the views of the CMHC and private credit rating agencies such as Fitch from their statements regarding Home Capital's loan portfolio and the mortgage portfolios of the major banks.
Furthermore, the majority of mortgages issued in Canada are recourse loans which means that any shortfall in the amount owed by a borrower after defaulting on the loan and the property being foreclosed can be legally recovered by the lender. This creates an incentive for borrowers to meet their repayments and where they are unable to do so, to approach their financial institution with a view to renegotiating the loan.
Stricter prudential regulation
Then there is the far stricter level of prudential regulation in Canada when compared to the U.S. more than a decade ago. The Bank of Canada has shown no hesitation to issue warnings and push for tighter regulations where required to reinforce the stability of the financial system.
This has resulted in the prudential regulator in the Office of the Superintendent of Financial Institutions, or OSFI, implementing stricter underwriting standards for mortgages along with other tighter prudential requirements. These actions have created a stronger financial system, helped to cool an overheated housing market and reined in lending excesses in recent years.
This is in stark contrast to the U.S. where over a decade ago both Congress and regulators supported the private financial sector's drive for short-term profits. They did this by repealing legislation aimed at regulating the conduct of financial institutions, loosening capital requirements and overriding anti-predatory state laws.
This combined with Congress trying to ensure that anyone who wanted to buy a home had access to credit, triggered a feeding frenzy among private financial institutions which did whatever it took to cash in on the booming housing market. That along with poor risk management practices and an extremely lax approach to checking mortgage applications for accuracy created the tremendous influx of poor quality and fraudulent loan applications.
As stated by two of Trump's economic advisers Lawrence Kudlow and Stephen Moore:
Under Clinton's Housing and Urban Development (HUD) secretary, Andrew Cuomo, Community Reinvestment Act regulators gave banks higher ratings for home loans made in 'credit-deprived' areas. Banks were effectively rewarded for throwing out sound underwriting standards and writing loans to those who were at high risk of defaulting.
As in every bubble, no one wanted the gravy train to stop, greed kicked in and everyone wanted to make as much easy money as they could. This fueled rapidly rising house prices and give a leg up to the next round of frenzied speculation. No one, from mortgage brokers to the major banks, wanted the merry-go-round to end.
An important backstop for mortgage lenders in Canada is the significantly high level of mortgage insurance. It is compulsory for all mortgages with a loan to valuation ratio or LVR of greater than 80%. For the big six banks which control the mortgage market roughly half of all mortgages are insured.
Insurance forms an important backstop for the banks and financial system in general. This is because any financial shocks that impact Canada's heavily indebted households and spark a sharp increase in loan delinquencies to rise sharply will be covered by that insurance. That means there is time for the banks to renegotiate the loans and come up with alternative means of recovering the balances outstanding.
Furthermore, Canada's banks have taken a relatively conservative approach to managing risk which means that the uninsured portions of their mortgage portfolios have low average LVRs. The average LVR for the banks is estimated to be well under 60% and in many instances it is far lower. At the end of the fiscal second quarter 2017, Toronto-Dominion's average LVR for its uninsured mortgages was 53% and for Scotiabank it was 51%.
Credit quality remains high
The national non-performing loan ratio is 0.6% or less than half of the 1.4% reported in the U.S. in 2007 at the height of the housing boom. Even Toronto-Dominion and Scotia Bank have ratios that are well below that which existed in the U.S. in 2007, reporting 0.85% and 1%, respectively, for the first quarter 2017.
Surprisingly, despite the claims that their loan portfolios are comprised of high-risk subprime loans, alternative lenders such as Home Capital and Equitable Group (OTC:EQGPF) have gross impaired loan ratios. At the end of the first quarter, they were 0.18% and 0.25%, respectively.
Nevertheless, for the banks that ratio includes all impaired loans and is not solely representative of the credit quality of their mortgage portfolios. If we drill into the mortgage portfolios of Toronto-Dominion and Scotia Bank, the ratio falls to 0.23% and 0.67%, respectively, underscoring the high credit quality of those portfolios.
An interesting observation from this exercise is that Canada's two largest alternative lenders as inferred by their GILs ratio have mortgage portfolios of the same quality or higher than Canada's second and third largest banks.
While the housing markets of Toronto and to a lesser extent Vancouver are certainly hot, I am not convinced that Canada is caught in the grip of a massive housing bubble. As I have argued previously, the dynamics of constrained housing supplies and the fact that both are gateway cities with high amounts of external and internal migration that is causing housing demand to surge are behind spiraling prices.
Nonetheless, even if Canada's housing market were to cool sharply or even collapse, the impact on Canada's banks would not be as great as the short sellers and other pundits claim. The combination of mortgage insurance, tighter underwriting standards, stricter prudential regulation and low LVRs will significantly mitigate the fallout from any sharp decline in housing prices in Canada's financial system. Then there is the lack of contagion caused by securitized mortgage instruments which were bought by many institutions on the assumption that they were a low-risk investment. These caused the fallout from the housing bust to spread like wildfire across the financial system, bringing its very viability into question.
For these reasons along with the considerable checks and balances in place in Canada's financial system, the fallout from a housing correction would not spread like wildfire across the system and trigger a U.S. style financial meltdown.
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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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