Five Factors That Are Now Pushing Canadian Bond Yields LowerApril 24, 2017
The Latest Canada and U.S. Employment Data Raise the Same Vexing QuestionMay 8, 2017
Last Wednesday the shares of Home Capital Group (HCG) Inc. plunged 65% after the Ontario Securities Commission (OSC) alleged that several of the company’s senior executives knowingly misled investors by downplaying the impact that an internal mortgage-fraud investigation was having on the company’s funded volumes.
At that time, HCG announced that it had completed an internal investigation into the submission of fraudulent income documentation which led to the suspension of 45 mortgage brokers who together had accounted for almost $1 billion in single-family residential funded mortgage volume over the prior year (2014). The company also laid off some front-line staff but otherwise downplayed the severity of the incident. The OSC now alleges that senior management misrepresented the severity of the fraud and its impact.
For a market that has been inundated with headlines about housing bubbles and record-high debt levels, this was all investors needed to hear before running for the exits. In addition to the stock selloff, savers lined up to pull their money out of the company’s high-interest savings accounts in a classic run on the bank. In what seemed like the blink of an eye, the company’s war-chest of around $2 billion in deposits shrank to less than $500 million.
To cover that call for cash HCG had no choice but to secure a $2 billion emergency line-of-credit at an interest rate of 22% on the first billion borrowed. Suddenly the sharks were circling and market watchers began to wonder aloud if the Canadian mortgage market had just experienced its “Lehman moment”.
As this was unfolding several of my clients who had borrowed from other non Big-Five bank lenders called me to ask if their lender was now in danger of going bust and wondering what, if anything, they should do.
In today’s post I’ll provide a summary of the clear message I gave to them, and include my take on five key questions relating to last week’s events.
- Was last week’s HCG plunge the Canadian mortgage market’s Lehman moment?
Not even close. When Lehman Brothers collapsed it was the straw that broke the camel’s back, but there was a lot of other straw weighing down that camel. The U.S. mortgage market had become the wild west, where mortgages were no longer being underwritten to any discernable standard and where risky loans were being passed around like hot potatoes. If you want to read a detailed breakdown of the many fundamental differences between the U.S. and Canadian mortgage markets, here is a link to a post I wrote as the U.S. housing crisis was unfolding – and keep in mind that this was written before our policy makers introduced five rounds of mortgage-rule changes that tightened our residential mortgage underwriting standards to today’s levels. Bluntly put, I don’t think any fully informed observer would draw comparisons between the systemic failures that led to the U.S. housing crisis and those that led to the run on HCG last week.
- Is HCG the tip of a giant mortgage-fraud iceberg that is about to be uncovered?
I have been working in Canadian lending and brokering for the past seventeen years, including as a vice-president of a publicly listed lender and then as an independent mortgage broker dealing with a broad cross section of Canadian lenders, so I think I am qualified to have an opinion on this matter. My experience tells me that HCG will not prove to be the tip of the iceberg for widespread mortgage fraud.
In my days as a VP on the lending side I lived through the rigorous approval process for becoming an insured lender. And since becoming a broker, I have worked in partnership with several lenders who have applied for banking licenses. The process is arduous and the audits are extensive. If you are trying to get a tough deal approved, the last place to try is a small non-bank lender that is either applying for a banking license or that was recently approved. These lenders know they have to walk on water not just during the approval process, but on an ongoing basis for years thereafter. (Fortunately, an independent mortgage broker has many competitively priced alternatives to turn to.)
Furthermore, the Office of the Superintendent of Financial Institutions (OSFI) undertakes rigorous and regular lender audits and is actively enforcing its lending regulations (unlike in the U.S. during its housing crisis where the regulators were asleep at the switch). Because our regulators are vigilant, our lenders would have to commit outright and extensive fraud in order to circumvent OSFI’s rules, and this would be very difficult to hide over the longer term. While U.S. lenders routinely offloaded their risk by selling their mortgages to third-party investors, the vast majority of Canadian residential mortgage loans stay with their originating lender. And as such, if a Canadian lender knowingly overlooks material information they will be answering for it when that loan goes in to default. (And there isn’t much of that going on by the way. Our residential-mortgage loan default rates continue to hover at miniscule levels.)
- What is the greatest HCG-related threat to our mortgage market?
To quote Franklin Roosevelt, “The only thing we have to fear is fear itself”. Banking and lending rely on trust and confidence. In times of crisis, fear begets fear. Against that backdrop, profitable and otherwise healthy lenders can become imperilled if investors and savers suddenly decide to withhold or withdraw their capital.
So far we have seen contagion fear impact the share prices of other Canadian lenders, which are being tarred with HCG’s brush to varying degrees (including the Big Five banks). When the market panics, everyone shoots first and asks questions later and that creates the risk that other lenders may get caught in HCG’s wake. But when the dust settles the market turns from a voting machine back in to a weighing machine, and reason returns.
- What will happen if HCG goes bust?
It’s important to remember that if you have a mortgage with HCG you already have their money – not the other way around. And provided you make your contracted payments, no problem of theirs could or would ever force you to repay the money you have borrowed prior to the maturity of the loan.
In the best case scenario, HCG forgets that you owe them money and you never hear from them again!
Kidding aside … in the highly unlikely event that the current market panic renders a lender inoperable, the company would be put up for sale and its portfolio of mortgages would be purchased by another lender. Interestingly, small Canadian lenders have to plan for this risk before they are even allowed to make their first loan. The regulators require them to line up a larger lender who will step in immediately if they can’t continue doing business, and this minimizes the potential for any disruption to borrowers.
In a practical sense, if HCG can no longer conduct business the company will be sold and its existing borrowers will simply be notified once a new lender has purchased their mortgage and advised to call a different number for future follow-ups. At the end of their term, borrowers who have paid as agreed will, as normal, receive a renewal offer from their new lender, but at that point they will also be free to leave and borrow from any other lender in the market.
Most importantly, the lender who purchases your mortgage cannot arbitrarily change the terms of the agreement, for example, by raising your interest rate or calling the loan etc. (which should allay every borrower’s worst fear).
- How is this still unfolding HCG event likely to play out?
Although it’s tough to be certain, my best guess is that the real damage will be limited to HCG.
The issue at the heart of the current debacle is that executives failed to disclose material information to shareholders. The fraud, while serious, was dealt with more than two years ago and apparently the mortgages themselves are still largely being paid as agreed. Even if the extent of the fraud proves more widespread than first estimated, there is absolutely no evidence of similar fraud schemes at other lenders.
On the bright side, in every crisis there is opportunity. HCG has been the largest sub-prime residential-mortgage lender in Canada for years and if its volumes drop that will expand opportunities for other sub-prime lenders. At the same time, the increased tightening of our mortgage regulations has expanded the number of borrowers who no longer qualify for prime-mortgage financing and this will provide those same lenders with a strong tailwind at their back once the dust settles.
Five-year GoC bond yields rose one basis point this week, closing at 1.01% on Friday. Five-year fixed-rate mortgages are available at rates as low as 2.39% for high-ratio buyers, and at rates as low as 2.49% for low-ratio buyers. If you are looking to refinance, you should be able to find five-year fixed rates in the 2.64% to 2.79% range, depending on the terms and conditions that are important to you.
Five-year variable-rate mortgages are available at rates as low as prime minus 0.80% (1.90% today) for high-ratio buyers, and at rates as low as prime minus 0.70% (2.00% today) for low-ratio buyers. If you are looking to refinance, you should be able to find five-year variable rates in the prime minus 0.45% range (2.25% today), depending on the terms and conditions that are important to you.
The Bottom Line: The HCG debacle that unfolded last week quite understandably spooked investors in the company’s stock and savers who had deposits with the company. But for the reasons outlined above, I believe that HCG’s problems are just that – HCG’s problems. All my varied insight and experience in the Canadian mortgage market tells me that this type of fraud simply does not exist at other independent lenders. Furthermore, comparisons between the U.S. and Canadian markets are simply wrong-headed. While HCG has challenging days ahead, I think the risk of significant market contagion is very low – and if HCG does have to close its doors, its borrowers would experience minimal disruption as a new lender steps in to fill the void.