FIVE INVESTOR TAKEAWAYS FROM THE HOME CAPITAL DEBACLE.
Some Canadian companies have recently had a rough spell, especially those focused in the subprime mortgage lending sector and Home Capital Inc. in particular.
The company’s ongoing situation provides some important lessons for real estate mortgage market and average investors alike. Here are five main takeaways.
1. Don’t let euphoria drive the bus
The Canadian housing market is receiving a lot of press lately given the bubblelike action in Toronto and Vancouver. Unfortunately, rational decision- making gets thrown out with the bathwater when euphoria takes over and investors make rash decisions for fear of missing out.
You can’ t blame them since there can be a lot of money made in these momentum- like environments, as evident by the doubledigit yearly price appreciations and those able to charge high interest rates on subprime mortgages.
That said, momentum can change and suddenly work against you, so it is helpful to remain rational and know the risks before making any investment decision.
2. Size doesn’t necessarily mean safety
Investors often find safety and comfort in crowds, which is not unusual human behaviour. But just because t here’s more money being managed, more people involved and more investments being made doesn’t necessarily mean there is less risk.
Home Capital at its peak in August 2014 had a $ 3.85- billion market capitalization. It was a federally regulated trust company, growing its large deposit base to match its high rate loans, generating impressive profitability, and was a market darling among analysts and some institutional investors. What could go wrong? Just about everything.
3. Know what you own
Home Capital’s business model is essentially lending out depositor money at a healthy spread. It provides high- rate subprime mortgages and relies on a steady flow of money to fund these mortgages from high-rate interest savings accounts and guaranteed investment certificates (GICs).
Things started to quickly unravel when the flow of those deposits reversed, thereby creating a run on the company.
On the surface, this may seem to be a very unusual situation, but the problem is that it is a specialty lender operating in a black- box environment by sourcing mortgages from unregulated mortgage brokers who are highly incentivized to provide a steady stream of borrowers.
It is therefore unfair to compare Home Capital from a risk perspective to the Canadian banks, which are more diversified among product streams and have a more stable deposit base paired with a significantly less risky lending portfolio.
4. Risk goes with return
A l ittle common sense goes a long way. We’ve heard the arguments about low default rates and high loan- tovalue ratios, but Home Capital’s loan books are based on borrowers who don’t qualify for mortgages from Canadian banks.
What happens if interest rates rise and servicing costs explode higher? What happens if the economy enters a recession, which will affect high- rate mortgage holders t he most? How many of those loans quali- fied on falsified data?
The bottom line is that risk goes hand in hand with returns and subprime mortgages are high- risk investments.
5. When there’s smoke, get out
We read a great quote the other day from an investment manager who said they don’t own companies that are on fire. But it’s even better to get out whenever smoke starts to appear and there were plenty of smoke signals at Home Capital.
For starters, the company in July 2015 said it had terminated relationships with some of its mortgage brokers and the former Ontario Securities Commission ( OSC) chair who oversaw its internal investigation announced his resignation from the board. Home Capital’s share price then was near $ 49 per share.
In early February 2017, the company received an OSC enforcement notice, and a month later on March 14, it issued another release stating that OSC notifications had been sent to “several current and former officers and directors of the Company, relating to disclosure and, i n some i nstances, trades in the Company’s shares.”
Then on April 19, the OSC issued a formal statement of allegations, i ncluding misleading disclosure and failure to satisfy continuous disclosure obligations. The stock dropped to $ 22 from $30 during this period.
Investors were given one last chance to exit on April 24 at about $ 17.50 per share when the CFO was moved to a role “outside the financial reporting group” and the company’s founder, Gerald Soloway, announced he would step down from the board.
Finally, on April 26, the company announced it had to seek a new $2-billion line of credit and that its balance for high- interest savings accounts had fallen by more than 30 per cent.
Investors reacted by sendi ng the company’s share price down to just below $ 6 per share.