If I started a gold company, sold shares to raise capital, and then lent that money to junior developers but promised investors it's safe because gold prices haven't really budged, you'd probably wonder what happens if the global economy recovers and the price of bullion falls.
You'd be right to worry.
Yet few people are asking the same question about mortgage investment corporations like Timbercreek Mortgage Investment Corp. and Trez Capital Mortgage Investment Corp. even though they're more or less doing the same thing in real estate. These firms finance themselves by selling shares that typically pay investors yields around 7 to 9 per cent, and then lend the money they raise out to the likes of construction companies and condo developers.
Retail investors keep gobbling up their financings. Earlier this month Timbercreek raised $60-million and Trez Capital just financed another $85-million in December. To market themselves, each MIC uses its own language, but the pitches all boil down to this: our historical performance is solid, so there's nothing to worry about.
The heart of the issue: "higher loan yields have higher credit risk," Mr. Wessel noted.
Or in Mr. Taylor's words: "Given that some of them [MICs] yield 8 per cent in a world where one can borrow from a bank at 3 per cent, what kind of loans are these corporations making?"
Mr. Wessel dug through some of the MIC's documents and found that the residential content "was primarily, if not exclusively, higher risk residential construction/development loans, including the riskiest category of all – undeveloped land."
"The significant credit risk of certain MICs has been obscured by a robust real estate market supported by large increases in home prices/property values," he added.
Does that mean MICs are disastrous products, like the sub-prime packaged mortgages? Nope. The underwriting standards on a mortgage, for one, are much tighter in Canada.
But Mr. Wessel says it's pretty fair to compare MICs to the banks south of the U.S. border that loaned loads of money to construction companies. Just ask RBC how that turned out. (Hint: they ultimately sold their U.S. operation.)
So yes, there is risk, and retail advisers, be cautious of who you're putting into these investments.
If you deem them to be safe for a particular client, Mr. Wessel stressed diversification. One MIC he looked at had 25 per cent of its portfolio in only four second mortgages. Also, look at what kinds of companies are borrowing from the MIC. Construction, land development and undeveloped land are the riskiest borrowers in the event of a market correction.
(Tim Kiladze is a Globe and Mail Capital Markets Reporter.)