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Risk-tolerant investors should pounce now on Laurentian shares

When Laurentian Bank of Canada revealed during a conference call with analysts on Tuesday afternoon that it had discovered some problems with its mortgage underwriting standards, investors didn't take the news well at all.

Before you could say "Home Capital Group," Laurentian shares plunged nearly 11 per cent from their intraday high, for their worst one-day dip since 2009. The shares retreated another 1.3 per cent on Wednesday.

Is this a dip worth buying?

The selloff certainly brings to mind the recent problems experienced by Home Capital, the alternative mortgage lender that caters to home buyers who don't qualify for loans from regular banks.

In 2015, Home Capital announced that it had severed ties to 45 independent brokers who had submitted mortgage applications with falsified income information – disclosure that led to an investigation by the Ontario Securities Commission, executive departures, a run on deposits, an emergency loan and a withering stock price that reflected fading hopes for the company's future earlier this year.

Other mortgage lenders, such as Equitable Group Inc., also took it on the chin, reflecting concerns about the broader housing market and Canada's financial system.

No wonder investors are now highly sensitive to announcements about mortgage underwriting irregularities: Even small initial problems can lead to big headaches down the road.

Laurentian's initial problems indeed look small relative to the size of its loan book. The bank said that it would repurchase $89-million of mortgages sold to a third party. It added it could find another $124-million in mortgages that need to be repurchased as it investigates its loan book over the next two months.

So, that adds up to $213-million in potential problem mortgages out of a residential loan book of $18.5-billion, which is just more than 1 per cent.

"This is largely a documentation and securitization-eligibility issue," Laurentian chief executive officer François Desjardins said during the call with analysts, according to Bloomberg News. "It is not material for the bank, its operations, its funding nor its capital. We have worked to change processes to ensure that this issue is resolved."

Investors beg to differ, and analysts aren't exactly easing their concerns with Canada's eighth largest lender.

"At this time, we have no reason to believe there is a credit problem that will stem from these issues, but we take little comfort in that statement considering the importance of these risks," Robert Sedran, an analyst at CIBC World Markets, said in a note.

Darko Mihelic, an analyst at RBC Dominion Securities, cut his price target on Laurentian's stock to $55 from $60 previously.

He added: "Given limited disclosure at this time, in our view, there are too many unknowns and the potential for the size and scope of Laurentian's mortgage investigations to increase is in our view high. Other risks and uncertainties could emerge and impact the company's transformation/earnings power in ways we cannot currently fathom."

No one likes uncertainty, but let's look at the offsets: rising profits, an inexpensive stock and a big dividend.

In its fiscal fourth-quarter results released the morning of the mortgage disclosure bombshell, Laurentian reported a profit of $58-million or $1.63 a share after making some adjustments. That's up nearly 11 per cent from last year's fourth-quarter profit, on an adjusted per-share basis.

Given this growth, the shares look cheap: They trade at less than nine times expected 2018 profit, which is significantly cheaper than the average of nearly 12-times expected profit for Canadian banks.

Laurentian also raised its quarterly dividend by a penny, to 63 cents a share, which gives the stock a yield of more than 4.5 per cent.

Using Home Capital as a template, it might pay to wait and see if more bad news – such as bigger-than-expected mortgage repurchases – emerges as the lender combs through its originations.

If you can handle the risk, though, pounce now amid the confusion. The market has no patience for Canadian lenders that are acknowledging problems with their loan books because of lingering concerns with the country's housing market – but this impatience is leaving cheap stocks in its wake.

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