In February 2016, Gerald Soloway announced he was stepping down as CEO of Home Capital Group, a mortgage provider he co-founded 30 years ago. Home Capital, based in Toronto, is an alternative or non-prime lender, issuing mortgages to people generally turned away by traditional banks, such as the self-employed or new Canadians with a limited credit history. “The team at Home Capital today is second to none,” Soloway said in a press release. “I know that the company is in great hands, and I am very confident in their ability to take Home Capital to new heights.”
Since then, the company’s share price has plummeted 78 per cent, the deposits it relies on for funding are quickly evaporating and Home Capital’s future is in doubt. The problems started in July 2015, when the firm disclosed it had cut ties with 45 mortgage brokers after an internal investigation revealed that borrower income and employment information had been falsified in order to obtain loans. In April, the Ontario Securities Commission accused the company and three executives, including Soloway, of misleading investors for failing to disclose the impact of the investigation for months. (Home Capital has said the allegations are without merit and that it has satisfied disclosure requirements). Investors have pulled funding from a key source of financing for Home Capital, threatening its ability to continue operating. Not even a $2-billion credit lifeline the company secured in late April has been enough to allay fears of a collapse.
The alternative lender is a tiny player in the country’s $1.4-trillion residential mortgage market, accounting for roughly one per cent, and it’s far from a household name. But there are good reasons why the Home Capital debacle should concern all Canadians. To long-time observers, the company embodies some of the worst practices of the mortgage industry—sketchy lending practices, inadequate internal controls and alleged management misconduct. It’s the kind of activity that, after the U.S. subprime lending industry started unwinding in 2007, Canadians were assured didn’t happen here. “The rapid growth in non-traditional mortgage lending does have some potentially ominous parallels with what happened in the U.S. a decade ago,” David Madani, a senior economist with Capital Economics in Toronto, wrote recently. The company’s stumbles have sent various players racing to shore up confidence. Finance Minister Bill Morneau said in a statement that he was watching the Home Capital situation “very closely,” and that he’s been in touch with the heads of federal financial regulatory agencies. Other alternative lenders have been reassuring investors their businesses are sound, even as share prices fall. For now, the likely outcome is simply for mortgage lending to slow, as banks tighten lending conditions across the country, says David LePoidevin, the founder of LePoidevin Group, a portfolio management firm in Vancouver. That in itself would be a big change for Canada’s housing market, which has been fuelled by cheap credit: any slowdown in lending will ultimately weigh on home prices. The much darker scenario—albeit remote—is that Home Capital’s problems turn systemic, causing depositors and investors to lose faith in other financial institutions, and sending the country into the sort of crisis that housing doomsayers have long predicted.
The risk wouldn’t be so great, critics charge, if the regulatory response to Home Capital had been stronger. Mortgage professionals in the province are regulated by the Financial Services Commission of Ontario (FSCO) and, after Home Capital revealed it suspended some of the brokers in its network, the agency conducted its own review into the matter. “Most of the brokers and agents who were the subject of our review continue to be licensed mortgage brokers and agents,” an FSCO spokesperson wrote in an email, adding that the agency requires a higher standard of proof to discipline brokers than an individual lender does.
The upshot is the improper conduct of the 45 brokers disqualified them from working with Home Capital—but apparently not with other institutions. “I’m disappointed, but not surprised,” says Bruce Joseph, principal broker at Anthem Mortgage Group in Barrie, Ont. “There’s not enough punishment or enforcement to scare people out of engaging in this,” he says. Goosing incomes or fudging employment details to secure a mortgage is often seen as a victimless crime, which Joseph says is a false assumption. For one thing, the practice can artificially inflate home prices, making the affordability problem worse in some markets.
This kind of behaviour is not limited to Home Capital. “It’s an industry-wide problem,” says Mike Rizvanovic, a financial services analyst at Veritas Investment Research. “When you have a hot market where people are reaching more and more just to get that home that next month they can’t afford, then they’re going to get more creative.” A recent notice of action issued by the Financial Institutions Commission in B.C., which regulates mortgage professionals in the province, shows how creative people can be. The commission accused one broker of submitting false financial information for six different borrowers, and failing to verify the accuracy of documents for 22 other mortgage applications. In one case, the broker is alleged to have submitted altered Canada Revenue Agency documents to show a borrower was a self-employed fish “trader” with an annual income of more than $75,000. In reality, the borrower worked as a fish filleter and earned just $30,000 per year.
Quantifying mortgage fraud is impossible, but in January, Equifax Canada said its data showed a 52 per cent increase in suspect mortgage applications since 2013. Of those, two-thirds were from Ontario. A survey conducted by Equifax found that 13 per cent of Canadians believe it’s acceptable to tell a “little white lie” when applying for a mortgage, and eight per cent admitted to misrepresenting facts on a credit application.
But such numbers don’t indicate how many fraudulent applications actually result in loans. After Home Capital disclosed its mortgage issues two years ago, the CEO of private mortgage insurer Genworth MI Canada reassured investors on a conference call that fraud was actually declining. Software to detect suspicious activity, along with more stringent underwriting checks imposed by the Office of the Superintendent of Financial Institutions (OSFI), which regulates banks and lenders, help weed out problem applications. Last year in Ontario, new regulations were also implemented that prohibit mortgage professionals from failing to act when they know they’re being used to “facilitate dishonesty.”
Yet the problems at Home Capital have also raised questions about Canada Mortgage and Housing Corporation (CMHC), which backs the vast majority of mortgages that require insurance. Matt Robitaille, an independent investor in Thunder Bay, Ont., filed an access to information request for documents related to Home Capital at CMHC, and posted more than 400 pages of heavily redacted emails online in March. The emails show that Home Capital notified CMHC (and OSFI) of an “internal investigation” in October 2014. A CMHC official summarizing the conference call with Home Capital executives noted that the agency “thanked [Home Capital] for coming forward with the information and for being proactive in working together with CMHC to prevent fraud.” An exchange between CMHC officials the next day shows they suspected fraud was already an issue. “I think your speculation of this being a situation of [redacted] fraud may be correct,” reads one email.
It’s not clear what steps CMHC took after the initial conference call in 2014. But, there was a flurry of activity the following July when Home Capital disclosed it had terminated brokers and a media firestorm erupted. Emails show CMHC officials planned to “formally request” the names of the suspended brokers, along with the account numbers for all CMHC-backed loans they wrote. That would allow CMHC to determine what other lenders these brokers were working with, and to get a handle on how potentially widespread the problem was—nine months after Home Capital contacted CMHC.
“Disclosures like this just continue to give me conviction that the CMHC is just way behind the eight ball when it comes to this issue of fraud,” says Ben Rabidoux, president of North Cove Advisors, a research firm that provides analysis on the Canadian economy and housing market. Rabidoux’s impression after reading the documents is that CMHC was more concerned with controlling the narrative in the media than getting ahead of a potential problem.
CMHC did not respond specifically to a list of questions from Maclean’s about the documents, citing the ongoing legal proceedings against Home Capital. Spokesperson Jonathan Rotondo said in an email that the agency is “a committed partner in fraud prevention,” and rarely sees evidence of mortgage fraud. “When there is reasonable evidence of it,” he said, “the insurance can be declared void.”
In the months following CMHC’s praise of the company’s “proactive” approach to preventing mortgage fraud, Home Capital executives were busy keeping material information from investors, according to the OSC. Home Capital completed its investigation into its lending practices in February 2015, which revealed the company’s internal controls were inadequate, and had not detected the scale of fraudulent documentation flowing through the firm. So-called “phantom ticking,” where employees claimed to have verified income but hadn’t actually done so, was a “systemic” practice, the OSC charges.
In the end, the brokers cut loose by the company were responsible for originating $881 million in residential mortgages in 2014, about 10 per cent of originations that year. In the following months, Home Capital also tightened its underwriting controls and, together, the changes resulted in a slowdown in business. But in financial documents, the company blamed “cold weather” and general economic conditions. It took five months for Home Capital to fully disclose the reasons behind the decline.
The charges from the OSC not only sparked a huge drop in Home Capital’s share price, but spooked depositors who provide the company with funding. The firm partly relies on offering high-interest savings accounts to obtain capital to issue mortgages. Deposits have plummeted to $391 million from $2 billion, and while the firm has $12.9 billion in guaranteed investment certificate deposits, its ability to attract new funding is in doubt. Indeed, on May 1, Home Capital said it would draw down at least half of a $2-billion emergency credit line it secured a few days prior from the Healthcare of Ontario Pension Plan.
According to National Bank Financial analyst Jaeme Gloyn, there are a few possible outcomes for Home Capital. The company could muddle along, or sell itself to another financial institution. OSFI, the industry regulator, could even force a sale, bringing together a consortium of financial institutions to assume the company’s mortgage assets. In the meantime, the uncertainty is weighing on financial markets. Other lenders have seen their share prices drop, notably Toronto-based Equitable Group, whose stock plunged 47 per cent in April. “It’s somewhat unfair that they get caught up in this because they have not shown any of Home Capital’s issues to be prevalent in their own businesses,” says Rizvanovic at Veritas, “but it’s bringing into question the viability of the business model.”
The overarching risk is that depositors who fund alternative lenders through high-interest savings accounts or GICs now view these companies as too risky to trust with their money, and funding dries up. Lenders could raise rates to entice depositors or change their funding model. Both options would raise funding costs, which would be passed to borrowers through higher mortgage rates. “There’s no question that it’s negative for credit markets in Canada, and specifically housing,” Rabidoux says.
Would-be homebuyers generally turn to alternative lenders when they can’t get a mortgage from a traditional bank; if rates creep up in that segment, some could find themselves shut out—and Ontario would feel it most. Home Capital and Equitable Group conduct most of their business in that province, and both have grown rapidly. Home Capital’s assets under administration grew 76 per cent to $27.3 billion between 2010 and 2015. Equitable Group’s have swelled 55 per cent since 2014. Madani at Capital Economics thinks Home Capital’s plight might prove pivotal by highlighting how “looser credit standards have fuelled the massive run-up in house prices, particularly in Toronto.” Prices in Toronto and surrounding cities have also ballooned more than 30 per cent year-over-year, prompting the province last month to announce a package of 16 measures to stabilize the market, including a 15 per cent foreign buyer tax. The effect of these measures could now hit at the same time as tightening credit conditions—potentially slowing the market more than the government is anticipating. As Marc Charbin, a financial services analyst at Laurentian Bank Securities, said in a less-than-reassuring note: “While the possibility of this issue impacting the broader housing market is undeterminable, it is certainly not out of the question.”
The issues facing Home Capital, it’s worth emphasizing, are unique. Companies typically face such crises when buried with debt. But Home Capital is not experiencing significant losses in its loan book; borrowers are not defaulting. Equitable, meanwhile, obtained a commitment for a $2-billion funding facility in May from a syndicate of Canadian financial institutions, including TD and CIBC: a sign some players are betting Home Capital’s problems won’t spread. Still, if a mortgage lender can face a crisis of confidence when real estate is booming, the fallout should the market ever turn will not be pretty.