The Warren Buffet Factor

A lot has changed since Warren Buffet decided to invest in Home Capital and the Canadian housing market.

The billionaire’s company, Berkshire Hathaway, gave the beleaguered company a $400 million cash infusion along with a $2 billion line of credit. 

Prior to this, Home Capital was in challenging position, predicated by a damaging allegation in April that the company had misled its shareholders by disclosing too late that an internal investigation found evidence of fraud and had cut ties with 45 brokers. Although the alleged non-disclosure had occurred at least two years prior, and the company’s business fundamentals were solid, the effect was immediate -- account holders started to withdraw their money, which resulted in a small “run” on deposits.

Shareholders started to sell, resulting in a drop in share price. This phenomenon also spread to a few other alternative lenders in the market, who also saw their share prices fall, for no apparent reason.

While the Home Capital controversy shook up the market somewhat, and fed the rumour mill with talk of bubbles, etc., none of that has come to pass. 

Home Capital Overview

Based in Toronto, the publicly-traded company offers mortgage lending, deposits and credit cards through its principal subsidiary Home Trust. Ninety per cent of the Home Capital’s business originates from uninsured mortgage clients who are turned away from traditional Banks.

As one of Canada’s largest alternative lenders, the company is an important player in the country’s housing market. A niche-market lender, Home Trust was one of the go-to lenders that mortgage brokers used for self-employed borrowers as well as those with some damaged credit. When the crisis occurred, brokers had to quickly find other mortgage lenders to take up the slack.

 If Home Capital was a bigger player in the market, there could have been dire consequences. Its mortgage loan portfolio is approx. $20 billion compared to the $1.1 trillion in residential mortgage loans of the Big-Six banks.

Was there a real issue?

Most analysts acknowledged that the underlying fundamentals of the company were steady, although the allegations created uncertainty.  Mike Rizvanovic, an analyst with the Veritas Investment Research in Toronto said in a Financial Post interview, “This is a very peculiar situation where Home Capital has no issues around credit, and no issues with a capital shortfall. Yet they are being decimated in terms of their viability as an ongoing entity.”

Clearly, Warren Buffet agreed.  Not only does his investment put much-needed capital into Home Capital, it was also a strong endorsement for the company. 

“Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment,” said Buffet, Berkshire’s chairman and chief executive officer, in a statement.

The Buffet Factor in Action

Almost immediately, Home Capital shares went up. Other alternative lenders also saw their shares recover. Depositors are coming back, lured somewhat by an excellent interest rate on deposit accounts. 

 

The other immediate effect was increased confidence in the Canadian housing market as a whole. Many mortgage brokers were forced to find alternative lenders when Home Trust depositors began pulling out their money, leaving the company with a liquidity problem. Mortgage brokers have now begun referring business to Home Trust again.

Warren Buffet’s investment sends a strong, positive message about Home Capital and also about Canada’s housing market.

Creating a competitive lending environment

The ongoing government policies that have intended to slow the housing market have certainly shown their desired effects over the past few years.  We have seen changes to amortizations, debt service ratios; reduction in the maximum amount Canadians can borrow to refinance their current homes from 85% to 80% loan-to-value, and limits on the maximum loan-to-value on HELOCs to 65%. The hardest hit was first-time homebuyers. And the most recent changes affected investors, those who purchase second homes, and the self-employed.

However, recent economic conditions suggest that mortgage activity will trend upwards for the near future as a modest rise in employment -- 1.2% in 2014 and 1.9% in 2015 according to CMHC’s most recent Housing Market Outlook -- and disposable income is projected to support housing activity.

House prices in many markets are still increasing and sales are healthy in most parts of the country. This is causing concern for Canada’s top banking regulator. Mark Zelmer, deputy superintendent of the Office of the Superintendent of Financial Institutions (OSFI), in a speech last week, focused on the continuing growth in household debt relative to income.

“I would not presume to claim that borrowers are acting irrationally or do not know what they are doing. But, by the same token, it is clear that the ability of the household sector as a whole to absorb major shocks is less now than it was a decade ago,” Zelmer said in a prepared speech.

Zelmer also said stress tests that show Canadian banks are prepared for a downturn, should not be viewed as overarching “safe harbours” because they are based on models and arbitrary assumptions. “Boards and senior management of financial institutions need to apply judgment in a forward-looking manner and not become too complacent in their capital planning exercises,” he said.

While the mortgage rule changes have created a tighter lending environment among the Big Banks, smaller institutional lenders are developing mortgage products to fill the void. Banks do carry a slight competitive edge in the market because they can cross sell to customers. However, smaller lenders are becoming more innovative with their product offerings, which is good news for consumers.

According to Paul Grewal, president of Street Capital Corporation, smaller lenders are continuously looking at different ways to provide a broader product line in order to differentiate itself from the competition.

“Market competition is always fierce and a healthy component of any industry. Although recent mortgage regulation changes have not reduced market competition as a whole, the industry is definitely changing.”
It’s not surprising that OFSI is speaking out now. The spring mortgage market is always a time of high competition and as a result, lower mortgage rates are being offered across the industry. “Competition is always beneficial to consumers -- more choice, more competitive pricing and more product selection are being offered,” Grewal said.

Street Capital is currently in the process of restructuring to become a bank, which will enable the lender to offer new products and services like credit cards and GICs through the mortgage broker channel. This, in turn, will help create a competitive environment for mortgage brokers who will be able to diversify their offerings to consumers.

Hassan Shaikh, Assistant Vice President, Investments, for MCAN Mortgage Corporation, agrees that innovation is key to ensuring a competitive environment that will benefit consumers.
“We, as lenders, have to bring something to the table; one factor might be competitive interest rates,” he said. “However, there are many factors.”

Some of the other factors are those that a consumer won’t see directly but will feel the effects. For example, Shaikh mentions turnaround times and relationship management as two important factors. A smaller lender is better able to move on mortgage transaction quickly, which has a distinct advantage for a certain type of client.

Also, by having built a strong relationship with an underwriter, a broker will have the added benefit of working with a processing team who will try to get an approval on the more difficult deals. This makes the broker invaluable to his client.

Overall, consumers are the beneficiaries of a competitive environment. The introduction of new mortgage rules was the genesis for change, and for a time, it looked as if the competitive environment had been eroded. The industry lost lenders; lenders eliminated many of their product offerings; and the pool of potential home buyers was reduced.

However, smaller lenders and new specialized lenders have stepped up to the plate and the industry is, once again, competitive.