Last week, Home Capital Group shares plunged 65% in one day as the company revealed it was securing a $2 billion line of credit to secure its finances after depositors rushed to pull money from their savings accounts.
Home Capital’s subsidiary, Home Trust, is Canada’s largest alternative lender, providing subprime loans to people who don’t qualify for traditional bank mortgages. So when the news broke; clients, friends and family bombarded me with questions asking ‘what does this mean?’ Since these question were more from an investor’s angle rather than a mortgage, I enlisted a colleague’s help on this one for deeper insight. Here’s his/her view as a Investment Associate for a private capital group… Leave us a comment with your thoughts!
Background: In 2014, Home Capital received an anonymous letter indicating potential issues with brokers acting fraudulently, including the falsification of income. While the Company knew of this and launched an investigation, on subsequent earnings calls, analysts / investors noted that originations were declining, but the Company blamed this on a more competitive environment. In mid-2015, the Company publicly disclosed that it had become aware of brokers acting fraudulently and had proceeded to sever ties with those complicit brokers. The shares took a beating at that point. They also further revealed in November of 2015 that their internal investigation was ongoing and only 25% complete, but also noted that the value of mortgages originated from the complicit brokers was higher than initially thought, which also sent shares plummeting.
Fast forward about a year and a half and one might think this issue has blown over, but in early 2017, the OSC alleged that the Company failed to meet its continuous disclosure obligations and that the Board and executives knew of the issues, but delayed the disclosures. Likely that they did not accurately disclose the issue with broker fraud until almost 9-10 months later from when they knew, all the while they were taking action in the background and hoping this would be a small issue that could be swept under the rug. Management alleges that there was no wrong doing and they would defend itself against the OSC’s claims.
CEO Martin Reid was fired in March 2017 the CFO Robert Morton was sent to another part of the organization and the Co-Founder and former CEO Gerald Soloway has resigned from the board. Is this an omission of guilt or to remove the distraction facing the company?
The Current Situation
Home Capital has a 30+ year track record of operating in the subprime space, which is where it started. Subprime is much riskier business and to have a solid track record of good ROE generation is an indication that they know how to underwrite. Genworth MI, one of the 3 mortgage default insurers in Canada, has also noted that the loans it insures from Home Capital exhibit better delinquency and default rates than other lenders which may suggest that the actual mortgage portfolio is of good quality. However, the processes and checks and balances that go into taking on that mortgage appear weak to the market (as noted above) and there is a fear that if these mortgages blow up, the Company may go under and people won’t get repaid. While the Company had once said this was only a small portion of the book, the actions of Home have caused people to think otherwise.
Suffice to say, the Company has now lost the confidence of not only investors, but also its customers/depositors. Based on the Company’s actions, while these fraudulent loans may form a small part of the portfolio, the lack of transparency has spooked the market and individuals. Possibly the Company is hiding further information. The whole idea of banking and lending is built on trust, especially at the retail level which is supposed to be one of the safest forms of lending (which is why you get such a low interest rate on these deposits). I lend you $100 (i.e. invest in a savings account) and expect to get that money back at some point in time, with some interest. As the bank, you go and lend that out at a higher rate to generate a spread as profit for yourself. If I have an inkling that they will not get repaid, I will withdraw my funds because I have lost confidence in the bank’s ability to repay in full. This is exactly what is happening at Home Capital right now as seen by the substantial withdrawals in its most liquid product – pretty much a run on the bank. HISAs (High Interest Savings Account) deposits have fallen from $2bn to ~$520M (as of 04/28/2017) and the Company expects continued outflows.
Home relies on this deposit funding as a cheap source of financing, so they can generate a good spread and earn income when they lend out to borrowers (primarily mortgages). The Company has historically been a subprime / alternative lender, but has moved into the prime space in recent years. Mortgage rates charged to subprime / alternative borrowers are higher than prime borrowers. For illustrative purposes, prime borrowers may have a rate of ~2.5%, while alternative borrowers are charged ~5% and subprime in the low double digits. To finance their prime mortgages, they need cheap financing from GICs / HISAs, etc. to make the spread work. Now the customers are taking back their cash from Home, to attract new deposits, they will likely need to increase their offered interest rates, which will lead to spread compression and lower earnings. The additional impact here is they may need to increase mortgage rates to compensate for higher funding costs, which makes them less competitive, or face spread compression. Either way, future earnings and cash flow is reduced. This represents a good opportunity for some of the other alternative lenders, such as Equitable or Street to pick up market share.
HISAs can be withdrawn pretty easily without penalty which is why this funding source of the Company has seen the biggest withdrawals first (GICs can be redeemed but at a significant penalty if redeemed early). The Company recently secured a short term solution to mitigate some of the cash outflows in its HISAs from the Healthcare of Ontario Pension Plan (HOOPP) because if the Company does not have sufficient liquidity to repay demand deposits, then it will be in default. As noted above, lenders will take the deposits and lend out that money for the mortgages. This also creates a matching problem since mortgage terms are typically 5 years (but can be anything from 1, 2, 3, 4, 6, 7, etc.), so having match funding is very important to avoid the situation above. If you have lent out all your demand deposits into 5 year mortgages, you won’t have enough liquidity to repay demand deposits (which are redeemable at any time). That’s why term GICs (e.g. 18 / 24 / 36 months etc) are sold. The problem is, Home Capital likely does not have enough liquidity to meet the withdrawals on its HISAs which is why it needed the solution from HOOPP, but it’s very expensive capital. The terms are $2bn credit facility, $1bn must be drawn with interest rates on the drawn of 10% and 2.5% on the undrawn. The facility is good for 1 year and Home was required to pay a $100M underwriting fee, so an interest rate as high as 22.5%. This is a negative signal to the market that it likely had liquidity issues and would have trouble raising additional funds in the near future. The day this was announced the stocks plummeted almost 65%. As a side bar, the CEO of HOOPP was on Home Capital’s Board and the Chairman of Home Capital’s Board was on HOOPP’s board. At first, the institutional white knight that provided the loan remained anonymous, until reports surfaced that it was HOOPP, at which point both resigned off of each other’s boards. In my opinion, this is just another example of shady dealing and had the institution not been revealed, they may have remained on each other’s respective boards.
Alternative lenders rely on third party distribution for its products. Last Friday, ScotiaBank announced it would stop selling Home Capital products through its distribution channels, but retracted that on Monday, but capped the amount to $100,000 per product. The $100,000 is significant because that’s the amount that CDIC will insure, so in the event that Home Capital blows up, that amount is insured and would absolve ScotiaBank of any backlash if it doesn’t backstop additional losses. The ScotiaBank announcement does not help Home’s cause and likely strikes more fear or causes potential customers to go to a competitor.
There is a reasonable probability that Home Capital no longer is a going concern. They have a significant amount of GICs that mature within the next year (~52%) and will need capital to make good on its obligations and 36% in 1 – 3 years. While the HISA problem can be solved with the credit facility, the maturing GICs represent a substantially larger amount (total GIC balance is ~$13bn) and need a longer term funding solution. If the Company cannot generate sufficient term deposits to support its mortgage book at an attractive cost, then earnings will continue to bleed or worse yet, Home will be insolvent.
The Company is now exploring strategic options and possibly looking for a white knight to save them, having hired RBC / BMO. The problem is there likely is not a natural buyer for the whole business, which would be the cleanest and quickest resolution. The big Canadian banks would only want the Company’s prime mortgage book. Equitable and Street Capital which are direct competitors to Home are too small to swallow the whole company without having to raise equity. Given the contagion spread from Home Capital to these stocks, raising equity now would be not be value maximizing for current shareholders and any significant block of equity raised likely will be dilutive, so hard to see these guys buying the book. There are also complications for an institutional investor such as a pension plan or investment firm to owning a Schedule I bank (which is required to be able to accept retail deposits), so hard to see this group making a run. The likely outcome is splitting the mortgage book up and selling it for parts to try to maximize value. Given the amount of bears in the US on the Canadian housing market, hard to see them wanting to come in. However, if you believe that the mortgage portfolio is good quality, buying the mortgages at a discount and running them off (e.g. collecting cash as they get paid down), is a good investment opportunity and something that many investors may be interested in – they just will value the business as a run-off rather than providing any value for the franchise / operations and origination capabilities (which arguably, people probably see as close to zero at this point). So there is embedded value in the mortgage portfolio, but the real concern is that Home Capital isn’t around long enough to collect all that cash since its depositors are knocking on its door and they want their cash back now vs. in 3 – 5 years when most of the mortgages will likely be up for renewal. Of course, if Home decides to not renew and people need to go search for another provider of capital, that could be problematic for the housing market and prices if doors are shut.
The issues at Home Capital are spreading out to other companies that have exposure to the Canadian housing market (e.g. non-big 6 bank lenders / underwriters). Genworth MI was down 8%, Equitable down 32%, First National 11%, Street Capital 10%, etc. the same day that Home fell 65%. The fear is that customers will start to raid other alternative lenders and funding sources will dry up for these lenders, creating a death spiral similar to what Home is experiencing. Further, if the loans that Home originated were indeed bad loans, Genworth MI which is a mortgage insurer will get hit with losses. If Home Capital goes under, a significant chunk of liquidity has just evaporated. Home capital is a small fish in a big pond, but that does suck liquidity from the market which means fewer dollars of supply and could impact house prices given scarcity of financing for “new to Canada” or those with lack of income history (arguably some of the marginal buyers who may be propping up prices). If home prices do fall, that could cause severity to go up upon defaults which would be bad for the mortgage insurers and lenders in general where they could not get mortgage default insurance. This is potentially a worst case scenario if Home goes bankrupt and funding for alternative lenders dries up.
A bail out is not outside the realm of probability. If we learned anything from the US crisis, liquidity in the market is critical to ensure the proper functioning of the banking system, which impacts the economy as a whole. If there is confidence that the alternative lenders will continue to have access to liquidity, then letting Home disappear likely does not cause significant damage, but if this spreads, then buckle up … it’s something to continue to monitor closely in my opinion.