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Mortgage lender Home Capital Group Inc. has a financial problem that is really a crisis of confidence.
Right now, this is a meltdown at a scandal-plagued company that just fired its CEO amidst a regulatory investigation. But in Canada's overheated residential real estate market, there are analysts predicting Home Capital's woes could be the pin that pops a housing bubble.
Home Capital and its peers run their businesses based on an act of faith: Clients entrust their cash to high-interest savings accounts and GICs offered by these institutions. That money is lent to home buyers, many of whom can't get a mortgage from the big banks.
For this business to work, depositors have to believe they will get their money back. That trust is breaking down at Home Capital, the country's largest alternative lender. The problems surfaced last week, when Ontario regulators alleged the company failed to disclose flaws in its mortgage business. That kicked off a series of executive departures.
Home Capital revealed Wednesday that clients pulled money out of its high-interest accounts over past four weeks, with balances falling $591-million to $1.4-billion. The company said the pace of withdrawals picked up in the past week. Many of Home Capital's customers are relatively sophisticated.
They are financial advisers who park their own clients' cash at Home Capital because rates on savings accounts are up to three times what the banks offer.
Laurentian Bank Securities analyst Marc Charbin flagged the risk that the exodus from savings accounts continues to pick up steam and Home Capital's pool of GIC deposits may also also run dry. At the end of last year, the company had nearly $16-billion worth of deposits – but more than $9-billion of that was money that it must repay on demand or some time in 2017. Its biggest source of deposits is GICs that are sold by third-party brokers and advisers. Mr. Charbin said: "Worst case, this could cause a run on the bank."
The crisis of confidence here is not fundamentally different from the woes that brought down investment bank Lehman Brothers in the global financial crisis, or froze the Canadian asset-backed commercial paper market a decade back. When investors suddenly stop committing capital to a financial institution or product, the unexpected lack of liquidity is fatal. The fact that the underlying business or asset is sound doesn't ensure survival – recall that long after the initial crisis, when all seemed lost, holders of that frozen commercial paper got paid back.
On Wednesday, Home Capital's woes spread as the company's stock price dropped 65 per cent and shares in rival mortgage lenders such as Equitable Group Inc. and First National Financial Corp. took a beating. That leads to the scenario that pops a housing bubble.
For mortgage lenders, surviving a crisis of confidence means finding new sources of liquidity. To that end, Home Capital announced Wednesday that it is negotiating a $2-billion line of credit with an unnamed institutional investor, likely a U.S. hedge fund. That money will be used to back the company's mortgage portfolio. If you've ever failed to pay your credit-card balance, you'll recognize the cost of Home Capital's loan. National Bank Financial calculates the effective interest rate on the first $1-billion is 22.5 per cent, and the rate is 15 per cent if the entire $2-billion is needed. This is emergency financing meant to stave off disaster.
Home Capital plans to right the ship by locking in capital, which in turn will stem the exodus of deposits. If that happens, this crisis of confidence will pass. Traditional factors such as interest rates, supply and demand will set prices in residential real estate markets. But if Canada's alternative mortgage lenders face an unexpected liquidity crisis, the housing market is in for a potentially nasty downturn.
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