How did Home Capital find itself in this downturn?

Share

The speed of Home Capital Group Inc.'s downturn can seem baffling. How does a highly profitable lender with a three-decade history that once had a market value of more than $3.5-billion suddenly find itself in a possible fire sale?

Welcome to the business model used by some specialized lending firms, where leverage can backfire and confidence can disappear in a blink.

Home Capital carved out a niche in the mortgage market that is different from major lenders such as the Big Banks.

It specializes in alternative or non-prime loans to customers who can't satisfy stringent rules on income history.

Many of these customers are self-employed workers or small business owners. Others are recent immigrants or prospective home buyers with spotty credit records.

These home buyers may appear to be riskier than the prime borrowers who get their mortgages from the Big Banks, but low default rates suggest they are not. Home Capital has experienced low loan losses, partly because of the stable economy and rising home prices, but also because non-prime borrowers want to become prime borrowers. That is, they are motivated to pay their bills.

The way Home Capital Group funds these mortgages is similar to other lenders: Money comes into the company in the form of high-interest savings accounts and guaranteed investment certificates (GICs), and it goes out in the form of mortgages. What's different is that big banks also have a big base of deposits that come into chequing accounts on which they pay little or no interest.

These incoming and outgoing totals have surged in recent years, reflecting the company's impressive growth. Deposits were $15.9-billion at the end of 2016, up from $6.4-billion at the end of 2009. Similarly, total loans were $18-billion in 2016, up from $5.5-billion in 2009.

Home Capital, like other lenders, makes its money by charging more for mortgages than it pays on deposits. This spread, called the net interest margin, was 2.37 per cent in the fourth quarter of 2016.

That might not sound like much, but it is: Since Home Capital can charge higher rates on non-prime mortgages and has low loan losses, margins are fatter. And the company generates this margin using depositors' money, which is a form of leverage: The value of its loans dwarfed shareholder equity, or the net worth of the company.

That slim net interest margin helped generate a profit of more than $247-million in 2016 on shareholder equity of $1.6-billion, for an impressive return on equity of 15.3 per cent.

This business model worked well for years. Depositors were happy to buy GICs and put money into the company's high-interest savings accounts, reaping a higher return than they would get at a big bank.

Leverage is helpful when things are going well, but it doesn't provide much of a financial cushion when things go wrong.

And things did go wrong. In 2015, the company dismissed a number of brokers for improper income verification. The Ontario Securities Commission this year then alleged that management was slow to disclose this problem to investors. Also, the company's chief executive officer was fired and the chief financial officer was forced to step aside. Company founder Gerald Soloway stepped down from the board.

The allegations have not been proven. Home Capital has said the allegations are "without merit."

But the situation has eroded confidence in the company. Depositors began to bolt last month, which turned into a run on the bank. They have withdrawn about $1.6 billion from Home Capital's high-interest savings accounts at last report.

Deposits of $100,000 or less are covered by the Canada Deposit Insurance Corp. But some of these savings account depositors may have had more with Home Capital.

Short on funds, Home Capital turned to a pension fund for a $2-billion line of credit to offset the outflow – but agreed to pay an exorbitant effective rate of 22.5 per cent on the first $1-billion drawn.

Suddenly, deposits were costing more than mortgages were generating, decimating the company's future earnings power and its share price. It closed on Friday at $5.85, down 77 per cent since the start of April.

The fate of outstanding GICs is still unknown: What happens when they mature? Will depositors continue to buy them?

Without a healthy flow of incoming funds, analysts say Home Capital business will be difficult to sustain.

Want to interact with other informed Canadians and Globe journalists? Join our exclusive Globe and Mail subscribers Facebook group