The one thing standing in the way of Home Capital’s stock going to zero

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Investors who have been betting against Home Capital Group Inc. are buoyed by the bad news that has pummelled the alternative mortgage lender's share price by more than 70 per cent this month.

Bad brokers? Regulatory investigation? Executive departures? Run on the bank? Desperate terms for a financial lifeline? Home Capital has it all.

But the one element that would complete their investment thesis is still missing: Ontario's housing market is red hot, which provides some confidence in Home Capital's mortgage book.

Related: Home Capital delays results amid bid to restore confidence

And that has short-sellers, who profit when share prices fall, busily offering up views that the market is prone to a crash. They believe that a busted bubble will eviscerate the quality of Home Capital's loan book and perhaps deflate a few other financial firms as well.

Could a big bank get caught in a housing market downturn? Well, an ambitious short-seller can certainly dream big.

The argument for buying Home Capital shares, or acquiring the company outright, rests to a large extent on the quality of the company's loan book. If the loan book is solid – the mortgages were underwritten properly and customers will continue to make their regular payments – then the company should be worth something.

According to Bloomberg, the book value per share is north of $25. At least one investor, David Taylor of Taylor Asset Management, believes the mortgage book could be valued as high as $28 a share, or about three times the stock's current price of $7.72.

He may be onto something. A number of industry observers have argued that Home Capital's loan book is probably in fine shape. They point to recent financial statements: In the fourth quarter, non-performing loans accounted for just 0.3 per cent of gross loans. Provisions for credit losses were a minuscule 0.04 per cent.

No problems there. It seems that Canadian non-prime borrowers, many of whom are self-employed workers who have been rejected for loans by more risk-averse major banks, are very good customers.

But could problems arise? Again, industry observers say that is unlikely. Their optimism rests on the recent performance of the Ontario housing market, which is the centre of Home Capital's residential lending activity.

According to the Teranet-National Bank National Composite House Price Index, Toronto's year-over-year housing prices in March rose 24.8 per cent and prices have risen nearly 50 per cent over the past three years.

The sharp gains raise concerns about affordability. But they also imply that anyone with a mortgage is unlikely to default on it, given that the price increases provide a greater incentive for homeowners to make their monthly payments.

These non-prime customers bought their homes with initial down payments of 20 per cent or more, adding additional comfort as prices rise.

"The delinquency rate on Home Capital's mortgages remains unusually low, which is not a surprise since house prices are still rising rapidly in Ontario," David Madani, an economist at Capital Economics, said in a note.

Not everyone has this confidence in Home Capital's loan book, though. Short-sellers and former investors are calling into question the company's underwriting standards, after it suspended 45 mortgage brokers for submitting fake or altered verification documents in 2015.

But what short-sellers really need is a sharp downturn in the housing market, which could raise default levels at Home Capital and call into question the health of the loan books of many other lenders.

Marc Cohodes, Home Capital's most vocal short-seller, declared on Twitter last week: "$HCG is the Canary(Vulture) in the Canadian Housing Coal Mine."

As Canada's largest alternative lender, Home Capital has long fascinated short-sellers because they believe the company is particularly vulnerable to a popped housing bubble. When the market turns, they believe, problems will show up here first.

They've done well over the past week, but committed short-sellers still need to hear that popping sound.

Home Capital's share price rose more than 11 per cent on Tuesday, and is up about 35 per cent from its intraday low last week. This rebound suggests that something is standing in the way of the stock going to zero.