Dear Mr. Morneau...
IT’S TIME TO STEP IN AND SAVE HOME CAPITAL
Funds that we manage own shares in Home Capital Group Inc., the majority of which were purchased after the major sell-off last month. We are writing to ask Finance Minister Bill Morneau to act to save the company, which we believe is the victim of aggressive U. S. investment bears who are drawing unwarranted comparisons with the 2008 U.S. housing crisis.
Let’s begin with the U. S. crisis, which was precipitated by a deterioration in asset quality that had been either not noticed or ignored. Each month, asset quality weakened, delinquencies accelerated, and foreclosures spiralled out of control.
A series of increasingly lax underwriting standards ( i. e. 2 per cent money down and 40-year terms) fuelled a speculative boom in which lenders “spread the risk” through the securitization market. No reputable agency — Moody’s, Standard & Poor’s, Goldman Sachs, etc. — raised the spectre of a housing bubble because they were making too much money in underwriting/ rating/ syndicating loans. Rather they ignored/explained away the weakening monthly credit quality data and said falling housing prices were impossible.
Canada was one of the few industrialized nations in 2008-2010 that did not have a mortgage bubble that led to an asset quality issue which subsequently promulgated a banking crisis/recapitalization. Why? Put simply — Canada’s underwriting standards, among the strictest in the world, never weakened. Down payment minimums were never watered down in an attempt to achieve lowincome housing affordability targets or community investment act targets. Nearly all provinces in Canada (except Saskatchewan and uninsured mortgages in Alberta) have recourse mortgages( particularly the provinces where alternative mortgages are more prevalent). That means an owner can’t just walk away from his house scot free — lenders go after your wages, your car, and any other assets, including hockey skates! There is no tax deductibility of mortgages in Canada.
Canadian mortgage regulation has only gotten more stringent with the B-20 regulations passed in 2012. Today, the longest amortization period is 25 years, there is a 5 per cent minimum cash down payment (20 per cent for investment properties) and the maximum debt to income is 40 per cent. All “alternative mortgages” are underwritten to below an 80 per cent loanto value at inception. Finally, there is no securitization market for alternative mortgages so Home Capital (and other “alternative lenders”) have enormous “skin in the game.” In short, the world’s most stringent mortgage regulations have only become tougher.
Let’s look at the facts. Canada Mortgage and Housing Corporation (CHMC’s) delinquent loans in 2016 were only 32 basis points of the total loan book. Fannie Mae, the U.S. counterpart, had serious delinquent loans of 112 basis points — or 3.5x-times greater — in 2016. Home Capital’s “alternative mortgages” — a category the bears often falsely associate with subprime — had only 24 basis points of delinquent mortgages in the first quarter of 2017 and one basis point of annualized net charges. This means Can- ada’s “alternative” mortgages are today performing nearly 75 per cent better than fully underwritten conventional mortgages in the United States. Said another way, Home Capital lost less than one dollar for every $ 1,000 lent in the latest reporting period.
Yet facts don’t deter Canadian housing market bears. In search of the Big Short 2 — Canadian edition — U. S. hedge funds have been aggressively shorting Canadian banks and mortgage companies. Each day a new hedge fund shorts Canada and brags to its shareholders how smart they are in newsletters and on television. Bloomberg and other news outlets are filled with news stories with titles like, “Contagion fears rise in aftermath of Home Capital Group’s collapse.” Each story seems to surpass the last in hyperbole and sensationalism.
In an absolute sense, the bears have been right on the Home Capital short. The stock has declined about 65 per cent in the past 3 months. But they were right for the wrong reasons. Home Capital, we believe, was a victim. It was third-party brokers who are alleged to have fraudulently altered mortgage applications. That operational issue became a disclosure issue when the provincial securities commission alleged that the mortgage concerns were not disclosed in a timely manner.
To be clear, we believe there is no excuse for the failure to report the fraudulent broker activity in a timely manner. We support the recommendations to punish management by the OSC. However, the key bear narrative, that current management is covering up massive asset quality issues at Home Capital, does not fit the data set. In fact, Genworth Canada, which has insured a large amount of the mortgages that were fraudulently submitted by third- party brokers to Home Capital, announced on April 26 that, “At present, our delinquency rate with respect to Home Capital originated mortgages is less than our overall business delinquency rate of 0.21 per cent ...”
There is still no evidence that asset quality issues exist today i n Home Capital’s mortgage portfolio — or anywhere in Canada. However, the crisis of confidence and run on deposits has resulted in alternative mortgage rates rising by at least 50 basis points and perhaps as high as 100 basis points in some instances in the month of May — an increase of between 10 per cent and 20 per cent. The increase in mortgage rates has levied a “tax” of at least $300 per month in the form of higher monthly payments for every Canadian securing an alternative mortgage in May vs. April. While the Canadian government may want to slow down the rate of price increases for the “fat cat” foreigners and executives buying million-dollar downtown condos, do they really want to put the brakes on home ownership for striving immigrants or cash income workers in the outer ridings? Does Canada really want to let fear of an asset quality issue develop into an actual asset quality issue which drives the cost of capital higher for all other financial institutions and sends reverberations throughout the Canadian financial markets?
Finance Minister Bill Morneau should, as his predecessor did in 2008-2010, provide stronger leadership to calm the waters in the Canadian finance sector. He should encourage Canada’s big banks to do what they recently did for another alternative Canadian mortgage company ( Equitable Bank), provide a lending backstop that halts a run on deposits and gives Home time to move forward. Perhaps a shortterm lending facility by the Bank of Canada accompanied by a Ministerial statement to Home depositors and mortgage holders about the guarantees provided by the CDIC would help.
Home has an impressive track record in the Canadian housing market serving a niche of hard- working firstgeneration Canadians. Shareholders, borrowers and depositors don’t deserve to be taken down by a combination of a disclosure dispute with a provincial regulator and U.S. short-sellers. Asset quality is not an issue in Canada, nor is the strength of the larger banking sector, but a failure by the Canadian government to act on the Home Capital funding issue could lead to The Big Short 2 — Canadian edition.