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Globe Investor Why Home Capital shares surged Tuesday despite a key question unanswered

Globe and Mail columnist David Berman.

The Globe and Mail

After Home Capital Group Inc. reported that a buyer is looking at its mortgage book, investors jumped at the beaten-up stock without knowing a crucial bit of information: What is this mystery buyer willing to pay?

Investors, knowing that the value of Home Capital rests to a large extent on confidence in its loan book, aren't sweating over the details.

They bid up shares by 29.7 per cent on Tuesday, to $8.86. That marks the highest level for the stock since the company was caught in a dramatic downturn on April 26.

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Related: The rise and fall of Home Capital

No doubt, the rally is underpinned by some promising developments. Home Capital has been attracting a new roster of capable directors and its deposit base of guaranteed investment certificates (GICs) appears to be holding relatively steady, at $12.64-billion.

But Tuesday's move followed an announcement from Home Capital that an unnamed party may buy up to $1.5-billion worth of mortgages.

Tantalizingly, the lender hinted that the size of the deal could expand: "The Third Party has also indicated an interest in further expansion of this arrangement at a later date," it said in a statement

Home Capital, which specializes in non-prime loans to customers who have typically been rejected by the major banks, has about $18-billion of mortgages in its loan book, which means that the purchase is relatively small.

Nonetheless, it could provide a much-needed boost of confidence. The value of Home Capital's mortgages has been in doubt ever since the lender announced last month that it needed a financial lifeline to offset fleeing depositors from its high-interest savings accounts.

What it got was a $2-billion line of credit with onerous terms: Home Capital agreed to pay an effective rate of 22.5 per cent on the first $1-billion drawn, raising big questions about the health of its collateral – that $18-billion mortgage book.

Some observers were also concerned about potential knock-on effects. If no one had confidence in the mortgages that Home Capital had underwritten, the housing market could take a hit if these mortgages are not renewed.

In a particularly messy scenario of potential contagion, even major banks could suffer as home prices fall, which may explain why the share prices of the Big Six have retreated from recent highs.

Home Capital's stock reflected this gloomy outlook. The share price plunged 65 per cent on April 26 alone. Despite a few bounces since then, the price touched an intraday low of $5.06 on Monday.

If someone is now interested in buying these mortgages, it suggests some confidence in Home Capital's loan book. And that means that the lender's beaten-up share price could be worth more – perhaps a lot more.

Home Capital's book value, which reflects what the company would be worth if it is carved up, is $25 a share, or nearly three-times the current share price. Selling the loan book at a slight discount could still generate significant value.

In its announcement on Tuesday, Home Capital was short on details. It did not say what value it was getting for its mortgages. Are they being sold at a discount? If so, how steep?

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There are other questions, too. Who is this prospective buyer? And how likely is the deal to proceed? Are other buyers circling the loan book?

Home Capital also gave itself plenty of wiggle room. In a news release, the company said that the third party "wishes to purchase" mortgages but said that the intention to buy was "non-binding."

In other words, this is hardly a done deal. But it provides an early hint that the worst-case scenarios involving Home Capital, its lending peers and the Canadian housing market may be overblown.

Although the big banks retreated slightly, they may have have been reacting to a commodity-led downturn that weighed on the benchmark index.

But some rival mortgage lenders, which had been caught in a sector-wide downturn for the past couple of weeks, rallied.

Equitable Group Inc. closed at $48.37, up 6.5 per cent. Street Capital Group Inc. closed at $1.21, up 5.2 per cent. First National Financial Corp. closed relatively flat, at $25.19, up 2 cents.

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Without important details from Home Capital, though, it's hard to know if this rally has legs.

Read more: The rise and fall of Home Capital

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