INSIDE THE RISE & FALL of HOME CAPITAL
‘LIKE THE PERFECT STORM’: AN FP INVESTIGATION INTO THE EVENTS THAT TOOK HOME CAPITAL TO THE BRINK
More than two weeks before the public would get the first inkling of problems at Home Capital Group
Inc., the alternative mortgage lender found itself under heightened scrutiny — and not for the first time — from Canada’s top banking regulator.
In a letter dated June 23, 2015 and addressed to the company’s founder and then chief executive Gerald Soloway, the Office of the Superintendent of Financial Institutions detailed the concerns that were building around the company.
"Significant corporate governance issues, AML (anti-money laundering) concerns and internal control breakdowns pertaining to practices in underwriting residential mortgages” had been identified at Home Trust, Home Capital’s fully owned subsidiary, OSFI wrote in the letter, a copy of which was obtained by the Financial Post. And the regulator was taking action. OSFI said it was raising the lender’s intervention rating from “Stage 0” to “Stage 1,” or “early warning,” putting the company back into a process of enhanced regulatory oversight known as staging. The letter also laid out a series of measures, including imposing stricter capital controls and ordering a thirdparty review of management and the company’s corporate governance structure.
In a move that foreshadowed the crisis of confidence that would later bring Home Capital to the brink of collapse, OSFI also insisted that Home Trust assess "legal and reputational issues related to securities law and the appropriate public disclosure” related to the mortgage fraud issues that had been discovered at the company the previous year.
By June 2015, Home Capital had already conducted a significant internal investigation, dubbed Project Trillium, into the mortgage fraud issues.
It had terminated underwriters and cut ties with dozens of brokers that had been helping fuel the company’s growth, leading to a noticeable decline in new mortgages, or “originations."
It had, as the company and three of its officials, including Soloway, would later admit in a settlement with the Ontario Securities Commission, already misled investors about the decline, telling them that factors such as the weather and the struggling economy were to blame.
But the problems at Home Capital were still a tightly held secret, known only to company insiders and a widening circle of regulators, who had significant concerns about the company’s processes and its leadership.
The supervisory letter, another letter from OSFI, interviews with more than 10 people familiar with matters at Home Capital, as well as additional documents obtained by the Financial Post, all suggest that the mortgage fraud issues and the problems they begat were not just a simple lapse, but rather a symptom of deeper issues at the company, including a profit- first mentality and weak corporate governance.
An internal emphasis on growth led Home Capital to launch new initiatives, such as the Accelerator suite of insured mortgages, while trying to rein in expenses, a combination that strained existing systems and resources, said one source.
"It was like the perfect storm.”
HCG DISCOVERED THAT ITS ACCELERATOR UNDERWRITING TEAM ... WAS FALSELY DOCUMENTING THAT THEY HAD COMPLETED INCOME VERIFICATION STEPS WHEN THEY HAD NOT ... — EXCERPT OF STATEMENT OF AGREED FACTS BETWEEN HOME CAPITAL, OSC
THEY HAD BEEN PAYING ATTENTION BEFORE, BUT OSFI REALLY STARTS PAYING ATTENTION WHEN THEY SEE THIS.
— SOURCE ON IMPACT OF PUTTING INSURED MORTGAGES BACK ON BALANCE SHEET
SIGNIFICANT CORPORATE GOVERNANCE ISSUES, AML (ANTI-MONEY LAUNDERING) CONCERNS AND INTERNAL CONTROL BREAKDOWNS PERTAINING TO PRACTICES IN UNDERWRITING MORTGAGES.
— JUNE 2015 LETTER FROM FEDERAL BANKING REGULATOR TO THEN HOME CAPITAL CEO GERALD SOLOWAY
Home Capital’s bread and butter had always been its “classic” mortgages.
For the company, “classic” meant lending to those who didn’t qualify for traditional bank loans — for example, borrowers who were self-employed or had once been bankrupt, or who were new to the country and had no credit history.
It was an observation about the self-employed that Soloway made during his years as a real estate lawyer for one of Canada’s major banks that had sparked the idea for Home Capital in the first place.
“I saw these individuals were very creditworthy and they had good down payments and they had great capacity to service the loans, but they were getting turned down,” he told the Financial Post in July 2015.
Soloway, known to many simply as Jerry, was described by some who know him as a brilliant, “larger- than- life character” who was “respected and liked” and even “revered” for turning his company into a stock market darling, as well as for his keen knowledge of the mortgage industry.
Others, however, said he could be “mercurial” and controlling.
“Everybody knew Jerry was the boss, and if you pissed off Jerry, there was a feeling that there was a risk of getting kicked off the board,” one person said, referring specifically to the company’s earlier days.
For his part, Soloway, who is now retired but responded through his lawyer to a list of questions submitted by the Financial Post for this article, said Home Capital “grew and succeeded as a team.” And grow it did. By 2007, under his tutelage, the Torontobased company had delivered a return on equity of more than 20 per cent for 10 consecutive years — with earnings that year up 33.1 per cent to $90.2 million.
Even as the U. S. subprime mortgage crisis triggered a bust in global financial markets in the fall of 2008, it remained boom times for Home Capital.
“It’s the best of times because Home recorded ... the best quarter in its history,” Soloway told analysts on a third quarter conference call in November 2008, according to a Bloomberg transcript. “However, it’s the worst of times, when one looks at the financial volatility and unrest that has been experienced around the world.”
Earlier that year, in June, as it became apparent that subprime lending was becoming the scourge of the U. S. financial system, Home Capital moved to diversify, launching a suite of fully-insured mortgage products that were guaranteed by the Canadian government. They called the program Accelerator. “The Accelerator program ... will be a permanent part of our business plan on a going-forward basis,” Soloway told analysts on that November 2008 conference call, according to a Bloomberg transcript. “It not only is a good way to transfer some of the risk off the books, but it is a product that’s fully insured.... The benefit of that is proving to be far greater than I originally thought.”
While insured loans had lower margins than the “classic” variety (on which Home Capital could charge higher interest rates as the lender of last resort), they could also be securitized and moved off Home Capital’s balance sheet, freeing up capital to lend more and boost revenues.
“It’s like low hanging fruit,” said one source.
It would be this program — ironically designed to reduce the company’s risk profile — that would play a central role in the scandal that brought the mortgage lender to the brink of collapse less than a decade later.
After Accelerator’s launch, insured mortgage originations at Home Capital grew quickly.
The value of securitized residential mortgages more than doubled in 2008 to $ 1.5 billion, then leapt again by more than 70 per cent the following year, to $ 2.6 billion.
Accelerator accounted for 46.1 per cent of all single- family residential mortgage originations in 2009 — up from just 9.9 per cent a year earlier.
Proposed regulatory changes in the fall of 2009, however, made the “low-hanging fruit” much harder for Home Capital to reach.
That October, OSFI released a draft advisory ahead of the conversion to International Financial Reporting Standards (IFRS). Under this new accounting framework, securitized insured mortgages would have to be put back on the balance sheet, meaning Home Capital would need to put up more capital to satisfy regulatory ratios, or lend less.
This change was a big blow and Soloway told the Financial Post in February 2010 there would be “hardship if the rules are implemented as they are now proposed because it would limit the ability of small companies to do CMHC- insured mortgages, the safest type of business because they are insured by the government.”
But there was another drawback as well.
When the accounting change took effect in 2011 and more than $8.24 billion in insured mortgages were added back onto Home Capital’s balance sheet — dramatically increasing its total assets to $ 17.7 billion and raising its capital requirements — the company came under more intense regulatory scrutiny, said a source.
“They had been paying attention before, but OSFI really starts paying attention when they see this,” a source said. “It’s an order of magnitude, almost, bigger.”
Other changes were also afoot in the mortgage and financial industries.
In 2012, OSFI proposed an overhaul of its risk-management guidelines for boards or directors, emphasizing director competency, risk-management systems and oversight.
It also issued guidelines outlining its expectations for “prudent residential mortgage underwriting,” a set of rules known as B-20. The regulator was worried the financial system was becoming too vulnerable to growing household indebtedness. In turn, OSFI set out some key principles for lenders, including adequately assessing a potential borrower’s ability to service its debt.
And in July of that year, then- finance minister Jim Flaherty made changes to the country’s mortgage rules — including reducing the maximum amortization period to 25 years for insured mortgages and limiting government-backed mortgage insurance to homes under $1-million — in a bid to cool down an overheated real estate market.
The moves all came amid a renewed emphasis on corporate governance by the banking regulator, an effort to apply one of the lessons of the financial crisis.
By that point in 2012, however, the relationship between OSFI and Soloway had already become “acrimonious,” sources said.
Three sources said he had little patience for risk controls or corporate governance, an approach that put him at odds with the regulator.
OSFI, sources said, had even been pushing for him to step down and make way for a successor.
“They ( OSFI) felt that Jerry was not in the best interest of the financial services industry as a whole,” a source said. “They felt that he did not appreciate or understand or respect the need for control and governance, and that’s why they wanted him out.”
Another source said they never heard the regulator call for Soloway to go, but understood that having a more conservative person at the helm of the business was seen as preferable. While OSFI, in response to a series of questions, said that it “cannot comment on any specific institution that it regulates and supervises,” Soloway disputed the notion that there was friction with the regulator, and
said that they never told him they wanted him to step down.
“I had an appropriately professional relationship with OSFI,” Soloway said, adding that it was “totally untrue” that either he or the company’s board — of which he “was only one member” — emphasized growth and sales ahead of risk management and good corporate governance.
Around this time, Home Capital was also starting to invest significantly to improve its oversight functions.
“Home Trust was a small place that had grown, and was still growing, into a much bigger place and was in the process of formalizing its risk management practices,” a source said.
But it was not there yet. And the company’s growth was about to reignite.
Almost immediately after the new rules that forced the company to put insured mortgages back on its books had been put in place in 2012, Home Capital had begun casting about for a solution.
At a June 2012 investors’ day, the company’s then- chief financial officer Robert Blowes said the company had submitted a proposal involving a form of security called interest- only strips to OSFI, according to CanadianMortgageTrends.com.
Interest- only strips are based solely on the interest payments from a pool of mortgages, which give investors the right to receive a portion of the interest. The act of selling this interest to a third party qualifies mortgages for off-balance sheet treatment under IFRS accounting rules.
In the fall of 2013, OSFI gave Home Capital the go-ahead to use IO strips, and the company wasted no time in revving up the Accelerator engine again.
“This favourable ruling confirms that off-balance sheet capital treatment can be achieved for securitized mortgages in certain situations and has resulted in an immediate increase of the Company’s unutilized lending capacity,” Home Capital said at