The business and economic news that is dominating Canadian media is how an alternative mortgage lender named Home Capital Group has lost over 80% of its value over the past week. This has led to speculation that the company won’t survive and it could be sold off as it continues to lose liquidity.
Before we actually understand what that actually means, we all need to understand just what does Home Capital Group do? And what impacts it has for the real estate industry.
Alternative Mortgage Lender
When people go to buy houses, most individuals go to their local bank branches first to try to secure a mortgage. That’s the most simplest form of getting money to buy a house. You present information about your employment and income, and the bank determines how much money they are willing to lend you based on your risk profile.
For some people, the bank will refuse to qualify them for a mortgage. That’s because these individuals may be self employed, have sporadic income from year to year, or the person may have bad credit because they have large outstanding loans.
Since these individuals are “at risk” to the bank, they are unqualified to get a mortgage. That doesn’t mean that these individuals can’t buy homes. Quite the contrary. These individuals can go to mortgage brokers, or seek out alternative mortgage lenders. These are lenders that are willing to take on the extra risk to lend to these individuals, but they charge a higher interest rate on the mortgage.
Where Does The Money Come From?
Home Capital Group is one of these alternative mortgage lenders. They seek capital through GIC and demand deposits from every day Canadians and use that money to lend out to risky borrowers. You might wonder what kind of fools would lend money to these alternative mortgage brokers if they are in the business of risky mortgages? Well… quite frankly, a lot of people.
You have to realize that people don’t like risk, but they like money. The only way to get a safe return is through savings accounts and GICs. This is where the alternative lenders get their money. Conservative investors that want to collect interest while protecting their capital.
That’s why on subway platforms and billboards around big cities you see advertisements for 2.0% or 2.5% interest on high interest savings accounts or GICs. Just like the one you see to the left. Oaken Financial, EQ Bank are some of the names that you’ll see floating around. These offers are not coming from the big 5 banks, but from alternative mortgage lenders. They can afford these type of interest rates on their savings accounts because they lend out to their high risk clients at 4.5% to 5.0%.
When you deal with risky creditors, the behaviours of your brokers follow. It’s not hard to see brokers doing anything they can to close a deal. That’s exactly what Home Capital Group’s brokers got caught doing. Over 40 brokers were caught overstating incomes of mortgage applicants. Talk about getting your hand stuck in the cookie jar.
This ultimately led to the dismissal of the brokers, but also an audit by the OSC (Ontario Securities Commission) into the practices of Home Capital Group. No doubt there are some mortgages that were drawn up that should never have happened. You have to wonder what executive allowed these decisions to be made and what heads will roll?
This is the type of risky behaviour that leads to a fragile and frothy housing market, when those that shouldn’t be buying homes are given large loans that they might not be able to pay back.
Needless to say, getting caught with your pants down wasn’t good for Home Capital Group. The faith of investors were rattled sending shares down over 80%. This led many who had money deposited in Home Capital Groups account to start withdrawing their money.
This was true even though deposits are insured up to $100,000 by CDIC. But seriously. If you had money in a bank that you knew might be going under and performing illegal activities, you would take your money out of there too. The truth is, we only believe in a company if we have faith and trust. Once that’s lost. Goodbye!
Just like a deadly virus that spreads amongst the population, Home Capital’s failures had a direct impact on similar alternative lenders. Just check out the stock price on Equitable Group’s stock, better known as EQ Bank.
This is how emotional investing works. When people start running for the exits, the herd starts to grow. It’s the panic-like selling that starts making things worse. Despite decent earnings from Equitable Group, this didn’t stop people from withdrawing their money. Just like Home Capital’s depositors, people are doing the same for other alternative mortgage lenders.
Is It The End?
Is this the straw that breaks the camel’s back? Probably not. Home Capital only provides mortgages to a very small group of home owners. It’s closer to 1%. The main outcome for this is probably a buyout of the company by another bank who will take the risky mortgage portfolio at pennies for the dollar. Unless Home Capital can regain the trust of depositors, when the GICs come due later this year and a run on their remaining $13B in capital is gone, then there will be no other recourse but to close business.
What this might do in the short term is lower the appetite for mortgage lenders to take on risky borrowers. This might make it more difficult for the self-employed or seasonal worker to buy a home.
Additionally should Home Capital fold, that would mean one less company in the mortgage business. With less competition, it could lead to higher interest rates for risky individuals seeking unconventional mortgages. When there is less supply, there are always higher prices to pay. Just like the housing market!
As for housing prices in general, there shouldn’t be any big impact so long as the home owners continue to pay their mortgages. Unless interest rates rise, or these risky mortgages come up for renewal there shouldn’t be any direct impact to the housing market. You can still sleep tight, but there seems to be some ripples in the foundation that some people should be wary of.