By David Goncalves
The issues that Home Capital (known by many as Home Trust) is currently facing are unique. A bank would typically deal with a disaster like this when overexposed with debt or when facing substantial losses in its loan book. Home Capital’s mortgage book is not in significant defaulting. Surprisingly, many analysts suggest Home Capital’s default rate is lower than some of the big banks. So then, how does a 30-year-old company leading the way in “alternative lending” come to this?
Let’s start with who its clients are. The bank normally issues loans to borrowers that the big banks and insured lenders stay away from. A typical customer could have good credit and irregular income, like those who are self-employed. It could also be investors or infill builders who exceeded the big bank lending policies. Customers could even have credit issues, unpaid income taxes, or be new to Canada. This type of mortgage loan tends not to be insured by CMHC or by other insurers.
The lending practices that exposed Home Capital should concern all Canadians. In January 2017, Equifax Canada alleged that there has been approximately 52% increase in suspicious mortgage applications since 2013. It is estimated that 65% were from Ontario. A study conducted by Equifax found that 13% of Canadians believe it is suitable to tell a “little white lie” when applying for a mortgage. Eight percent of those surveyed admitted to misrepresenting the facts on a credit application.
It all started in July 2015, when Home Capital made public that an internal investigation had confirmed that 45 brokers had submitted over $800 million in residential mortgages with forged incomes and employment information. In April 2017, the bank disclosed that it had stopped taking applications from those 45 mortgage brokers. Since the end of March 2017, Home Capital has lost more than $3.5 billion of deposits. This started with the big banks and most of Bay Street halting the purchase of Home Capital GICs. The sudden decline was a clear lack of confidence from the financial sector. In April 2017, Ontario’s securities regulator announced that in 2015 Home Capital had failed to disclose the extent and possible fraud among some mortgage applications. At that moment, investors started pulling funding. This is a main source of financing for the bank and so this action affected its ability to operate. Since then, its stock value has fallen 78%. New deposits fell drastically to $391 million in days. On May 1, Home Capital had to draw down more than half of a $2-billion emergency credit line secured a few days prior from the Healthcare of Ontario Pension Plan. When taking all fees and interest into consideration, this facility has an effective interest cost over 20%. Subsequently, the bank sold approximate $1.5 billion of assets at a 30% discount.
Alternative lenders make up roughly 1% of market share in the country’s $1.4-trillion residential mortgage market. So, why should Canadians worry? Previously, Home Capital made up more than approximately double the market share of its closest competitor. Immediately after Home Capital started unfolding, on April 19 many of the remaining alternative lenders started increasing rates, lender fees, and down payment requirements and began cancelling some of their lending products. Some lenders even stopped lending on commercial loans, stopped refinancing residential properties, and stopped lending to investors. They did this because, with Home Capital out of the way, their application volume doubled overnight. The remaining lenders, truthfully, do not have the financial capacity to fund all the incoming applications, so they cherry-pick the best deals. End users purchasing a primary residence are considered to be the lowest risk.
The investor pool of lenders just shrunk and it could be 18 months or longer before we see the alternative lending space normalize. Expect mortgage lending to slow down as banks tighten lending across the country. Investors need to update their goals and their lending strategy on how to achieve that plan. Back to my question: How does a 30-year-old company leading the way in alternative lending come to this? I’ll leave you with the idea that it could have started with a “little white lie.”