Contagion: Home Capital Bank Run Spreads To Another Canadian Mortgage Lender

As discussed first thing this morning, the fate of Canada's largest alternative mortgage lender, Home Capital Group, appears to have been decided over the weekend, when in the span of just one week, over 70% of the company's deposit base had been withdrawn, effectively mothballing the business, leaving just a sale or liquidation as the two possible outcomes even as a $2 billion emergency line of credit keeps the company afloat, at least until HCG's $12.8 billion in GICS mature some time over the next 30 to 60 days.

Predictably, the news of the ongoing bank run once again spooked shareholders, who sent its stock sliding by 10%, and wiping out two-thirds of the company's market cap in under 2 weeks.

A bigger red flag emerged when concerns about possible contagion appeared to have been justified Canada's Equitable Group, another alternative mortgage lender, said Monday it had started seeing “an elevated but manageable” decrease in deposit balances, traditionally a polite way by management to admit a bank jog is taking place. The company said that customers had withdrawn an average C$75 million each day between Wednesday and Friday, and while the withdrawals so far are modest, and represented 2.4% of the total deposit base, the recent HCG case study showed how quickly such a bank run could escalate. And while liquid assets remained at roughly C$1 billion after the outflows, the company also announced that it had taken out its own C$2 billion credit line with a group of Canadian banks, just in case the bank run was only getting started.

Having taken preemptive action, Equitable’s loans terms were more favorable than Home Capital’s, which as reported last week is paying an effective rate of 22.5% on the first half of the C$2 billion credit line that it tapped Monday from the Healthcare of Ontario Pension Plan.

According to Bloomberg, Equitable is paying a far more modest 1.25% interest rate on the drawn portion, and a 0.75% commitment fee and a 0.5% standby charge.

Trying to mitigate concerns, Andrew Moor, CEO of Equitable said that “the issues affecting the well-known trust company in Toronto are their issues alone, and it’s unfortunate the banking industry has been dragged into it." He spoke on a call to discuss earnings, which were published almost two weeks earlier than planned due to the Home Capital selloff.

To be sure, looking at historical credit losses, Equitable would be deemed quite safe, barely ever having seen any, which in retrospect may be troubling: another company which is in the same boat is none other than Home Capital Group.

Following news of the Equitable loan, a relief rally sent shares of the lender soaring by 26% to C$46 in Toronto, helping recoup some of the 41% drop from last week. Other Canadian bank stocks that had fallen last week also recovered Monday. First National Financial Corp., a mortgage lender, jumped 2 percent. Bloomberg notes.

So while Canada's nervous investors, not to mention its regulators, exhaled a breath of relief today hoping that things are back to normal even as they continue to keep a close watch on Equitable and other alt-lenders to see if the panic has subsided, attention turned to Home Capital's bonds. Bloomberg reports that Home Capital’s bonds maturing in December next year were trading little changed at 90.6 cents on the dollar on Monday, according to Bloomberg data, yielding about 10 percent, compared with less than 3 percent on April 19. Home Capital also has C$325 million in 2.35 percent bonds maturing on May 24.

“Things are perhaps all right from the bondholder’s perspective, but not certain and the bonds reflect that,” said Mark Carpani, a portfolio manager at Ridgewood Capital Asset Management, with C$1.1 billion in assets. He said he doesn’t hold any Home Capital bonds and declined to comment at what level he’d consider buying them.

While an optimistic outlook may be warranted, the biggest risk as explained this morning, remains with HCG's C$12.8 billion in GIC deposits which are essential to fund its mortgage business, and which represents 1 percent of the Canadian mortgage market. Withdrawals could accelerate as these short-term deposits mature.

What is the worst case scenario?  Declining deposits could lead to a windup of the company, which would be monitored by the federal bank regulator, the Office of the Superintendent of Financial Institutions, according to Bloomberg. The lender said Thursday it has hired BMO Capital Markets and RBC Capital Markets to conduct a review of strategic options, signaling that a sale may be on the table.

“OSFI maintains ongoing relationships with the financial institutions it supervises,” Annik Faucher, an OSFI spokeswoman, said by email. “While we are prevented by law from discussing the affairs of the individual financial institutions we regulate, or our ongoing supervisory work, I can confirm that OSFI is continuing to monitor the situation closely.”

Concern about the viability of HCG has extended to the Canadian government itself, with Finance Minister Bill Morneau saying in a statement that he has been monitoring the Home Capital situation “very closely." 

“I was pleased to see Home Capital’s funding issues resolved by market participants,’’ Morneau was quoted as saying. “What I’ve seen over the last few days is proof the system is working as it should, where institutions facing challenges find market-based solutions.”

Actually, the funding issues are anything but resolved, as the next 30-60 days may reveal.

However, it is perhaps the hint of a government backstop that prompted Home Capital’s biggest investor to announce he is sticking with the company, adding to its position. Toronto-based Turtle Creek Asset Management Inc., which owned 14% of Home Capital as of the end of February, praised the lender for its low loss rate and underwriting practices.

“To be clear, we have not sold shares; indeed, the opposite is the case," according to an investor letter, signed by Chief Executive Officer Andrew Brenton, managing partner Jeffrey Cole, and managing partner Jeffrey Hebel. “We are obviously not happy with recent developments at Home Capital, but we remain focused on long-term value creation for you, our fellow investors.

Well, as long as the "fellow investors" are fine with the short-term value destruction, all should be well. Ironically, for investors like Brenton, the "best" possible outcome would be the worst one, or runaway contagion and bank runs, which would force the government to step in and do what the US government did nearly a decade ago: bail out not only Canada's housing market, but also its insolvent mortgage lenders, as well as any other banks and financial institutions that would be slammed by the bursting of Canada's housing bubble.