Home and heartache
Gerry Soloway was beloved by investors for creating a profit-making machine called Home Capital Group. This is how the company grew to become the biggest name in Canada's alternative mortgage market – and why everything he built is now at risk of crashing down
When Gerry Soloway announced early last year that he was stepping down as chief executive officer of Home Capital Group Inc. at the age of 77, after nearly three decades at the helm, he was supposed to be leaving behind a solid legacy: a blue-chip financial firm with low loan losses and solid growth.
The company he founded had blossomed into a profit-gushing mortgage lender valued at about $2.5-billion and with assets of more than $20-billion, a fivefold increase in 10 years.
The stock, though well off its highs, still reflected this success. Long-term investors were sitting on average annualized gains of more than 30 per cent since 1995, or a 260-fold increase.
But perhaps most important, Mr. Soloway had become the public face of alternative, or non-prime, mortgage lending in Canada. He was a pioneer in extending loans to self-employed workers, recent immigrants and borrowers with weak credit histories that had been rejected by more risk-averse banks.
"The chartered banks have nothing to fear from us," he once said in an interview with Canadian Business magazine. "We're going to be in our niche and we are going to stick to our niche. We are not a threat to anybody."
Today, though, this promise is on shaky ground.
Home Capital Group is floundering under regulatory scrutiny of its underwriting and disclosure standards, and investors are fleeing. The company's future is in doubt, driving concerns about potential contagion into other Canadian lenders.
The trouble began when Home Capital Group announced in 2015 that it had suspended 45 mortgage brokers for submitting fake or altered verification documents.
Mr. Soloway downplayed the suspensions: "There never was a concern about the credit quality or the valuation of the properties," he told analysts on a conference call. "It was only relating to the income documentation."
Earlier this month, things took a turn for the worse. The Ontario Securities Commission alleged that three current and former senior executives, including newly retired Mr. Soloway, did not properly disclose these underwriting irregularities to investors, which has further eroded confidence in the company.
In the background, the financial advisers and brokers who steer their clients' savings to Home Capital were pulling back. That led to an extraordinary press release on Wednesday morning: the company was suffering from a run on the bank. By Friday, Apr. 28, the company's high interest savings deposit balances had dropped to an estimated $500-million, down from more than $2-billion at the end of last year.
The shares nosedived 65 per cent on Wednesday, after Home Capital announced that it required a financial lifeline to offset fleeing depositors, whose money fuels the mortgages that Home Capital provides.
Many of the big banks are now limiting sales of Home Capital Group's guaranteed investment certificates (GICs) to their clients. Their reticence calls into question the fate of the $13-billion worth of GICs that Home Capital currently has on its books and will need replacing as they mature. Many of those certificates come due in 2017.
A $2-billion line of credit from Healthcare of Ontario Pension Plan (HOOPP) didn't come cheap: Home Capital Group will pay a 10-per-cent interest rate, a 2.5-per-cent rate on undrawn balances and a fee of $100-million – or a whopping 22.5-per-cent effective interest rate on the first $1-billion it borrows.
Though Home Capital Group's share price rebounded impressively on Thursday, it ended the week barely above $8, or roughly where the stock traded during the depths of the financial crisis in 2008.
Ominously, the company's problems are weighing on the share prices of other mortgage lenders, smaller regional banks, mortgage insurers and even the biggest banks.
Among the many casualties: Equitable Group, a rival mortgage lender, fell 32 per cent on Wednesday and another 17 per cent on Friday; Genworth, a mortgage insurer, fell 8 per cent on Wednesday; Canadian Western Bank fell 5 per cent; and even giant, internationally diversified Royal Bank of Canada fell a total of 3.6 per cent over three days.
"The market's reaction clearly suggests that Home Capital Group's issues could spread across the sector," Gabriel Dechaine, an analyst at National Bank of Canada, said in a note.
The turbulence implies that some investors – particularly short-sellers, who profit when stock prices decline – believe that Home Capital Group is the first sign of an overheated housing market that has begun to crack.
Some observers believe that Canadian home prices could be dragged down if deposit brokers withdraw funding from other alternative lenders, essentially shrinking the number of prospective home buyers in the market.
"We see this developing into a broader credit slowdown story, which will hurt new cash flow into Canadian housing," analysts at Montreal-based Pavilion Global Markets said in a note.
The Pavilion analysts believe that even monetary policy could be affected: "In our view, this will have negative macro consequences for the country, impeding the Bank of Canada's ability to raise interest rates and maintaining a weak currency."
For all the mayhem it has caused this week, Home Capital Group began with a simple premise: Many Canadians were being turned down for mortgages by the banks, but were in fact good customers that could meet their debt obligations as well as anyone.
Mr. Soloway recognized this gap in the mortgage landscape when he worked as a lawyer doing mortgage and commercial work.
"Throughout my practice, I noticed that the minute an application did not fill the criteria, no matter how secure the transaction was, the individual borrower had great difficulty in getting funded," he told the Toronto Star.
He took control of Sonor Resources Corp., an insignificant oil and gas exploration company. Through a share swap in 1986, he acquired the small, privately owned Home Savings & Loan Corp., headquartered in St. Catharines, Ont.
He changed the name and began financing just about anything he could, but the downturn in 1989 forced him to focus on residential lending, a niche that proved highly lucrative as he built institutional ties and a broker network.
With the proper underwriting know-how and big down-payments, non-prime loans were a gold mine. Home Capital Group's model looked even better as interest rates declined. The shrinking margins on the prime loans offered by the big banks made the higher rates on non-prime loans – currently at least 1.5 percentage points more – the envy of Bay Street.
Since 2000, the value of Home Capital Group's loans has risen more than 20-fold, to $18-billion in 2016. Over the same period, annual profit rose to $247-million, from less than $11-million. And money set aside to cover bad loans has fallen steadily, to just 0.02 per cent at the end of last year.
Home Capital Group became a stock-market darling, and Mr. Soloway was a hero to investors, which included some of Canada's most prominent mutual fund managers. "They love me today. That's terrific," he told The Globe and Mail in 2004, after reporting particularly strong quarterly results.
The company's success attracted competition, which fuelled the rise of non-prime lending in Canada.
Non-prime loans have been growing at more than double the pace of traditional prime loans, due to low interest rates and tighter financial regulations imposed on the bigger lenders.
Last year, non-prime lending volumes in the broker channel grew by more than 20 per cent, according to DH Corp. In the fourth quarter of 2016, non-prime lending was 19 per cent of broker originations, up from 9 per cent in 2011.
The role of non-prime lenders, though they control just a small fraction of the overall mortgage market, has also attracted the attention of regulators at a time when many observers are growing concerned about rising home prices in Toronto and Vancouver and what happens if the housing market turns.
The Bank of Canada has expressed concerns about the risks posed to the financial system should an unregulated mortgage finance company (MFC) run into problems: "If a large MFC were to fail or be unable to fund new loans, it would be disruptive for the mortgage market, possibly magnifying the impact of the downturn," the central bank said in its financial system review in December.
Though the warning was directed at companies such as First National Financial Corp. and Street Capital Group Inc. – both hit hard this week in the stock market – the issue of contagion would appear to apply to others as well.
Some investors, seeing the market turbulence this week, have drawn comparisons with the U.S. market, where subprime loans popped the housing bubble and contributed to the start of the financial crisis. A number of U.S. short-sellers delighted in repeating this comparison in various tweets.
Most observers, though, believe that Home Capital Group's problems aren't signifying broader issues with non-prime loans, the housing market or the financial system.
"What we are witnessing now is not the ultimate test of the subprime market," said Benjamin Tal, deputy chief economist at CIBC World Markets. "The ultimate test will be an economic shock such as a recession or higher interest rates."
Rob McLister, founder of RateSpy.com, a mortgage-comparison tool, noted that Home Capital Group's mortgage performance is top-notch, but the company made horrendous management decisions.
"Its insufficient oversight of document validation and bad-apple brokers was only compounded by questionable investor disclosures," Mr. McLister said in an e-mail. "These are not standard industry practices and Home's problems are therefore not epidemic."
Mr. Dechaine, the National Bank analyst, believes that contagion fears are overblown, despite what the market may be signalling.
"For perspective, Home Capital Grup has a sub-$20-billion mortgage book, which translates to minnow status relative to the $1.1-trillion of residential real estate credit on Big Six balance sheets," he said in his note.
He added: "And since the market is more focused on the funding of these loans rather than on their credit quality, it is important to differentiate the diversified funding structures of Big Six banks relative to HCG's (and others) that rely in large part on a single source: broker deposits."
Still, big questions remain, and the uncertainty will likely hang over Home Capital Group and possibly the entire
Canadian financial sector until answers emerge.
Among the most pressing questions: What triggered the crisis of confidence among the big banks, causing them to limit sales of Home Capital Group GICs? Is Home Capital Group's loan book in good shape? Why did the company see the need to pay double-digit rates for a financial lifeline from HOOPP?
And, of course, what will become of Home Capital Group and Mr. Soloway's legacy?
When Mr. Soloway announced in 2016 that he was stepping down as CEO, he left on an upbeat note: "I know that the company is in great hands, and I am very confident in their ability to take Home Capital to new heights," he said in a statement.
A year later, confidence is nowhere to be found.
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