Sub-prime mortgage lender, Home Capital Group was in all sorts of trouble. The Canadian lender was facing a cash crunch and a loss of confidence with customers across Maple country. As the biggest provider of home mortgages to self-employed individuals, Home Capital Group has been battling disinvestment on a large scale.
The Ontario Securities Commission (OSC) recently settled a contentious lawsuit with Home Capital Group, but not without heavy costs (C$30.5 million). The company also settled a major class-action lawsuit for intentionally misleading investors vis-a-vis the underwriting process. As a result, depositors were pulling their funds from the Toronto-based company en masse.
Enter Berkshire Hathaway and Warren Buffet
‘… HCG’s ability to originate and underwrite well-performing mortgages… make this a very attractive investment…’
The billionaire investor and strategist wasted no time compiling a bailout package for Home Capital Group valued at C$2 billion, the equivalent of US$1.5 billion. This credit line is geared towards Home Trust Corporation. Additionally, Berkshire Hathaway will purchase common shares of Home Capital Group valued at C$400 million.
Initially, Buffett’s group will purchase 16 million common shares valued at C$153.2 million and then invest an additional C$246.8 million to buy the other 24 million shares. The second investment requires the approval of Home Capital Group shareholders, while the first investment can take place without their approval.
The C$2 billion credit line is notable, since it will effectively replace the costly financing from the deal in April 2017. According to preliminary reports, the interest charged on the Canadian home mortgage company’s line of credit will be 9.5%. It will eventually decline to 9%. Berkshire Hathaway will pay on average $10 per share, which is a 33% discount on the stock price as at Wednesday, 21 June 2017.
Leading analysts are heartened by Buffett’s intervention. They believe that this is a strong endorsement of the Canadian sub-prime mortgage lender, and it will bolster confidence in the Canadian mortgage industry. Such bailout-style investments are not uncommon for the big-league US investor. In 2011, he dropped $5 billion into Bank of America (BAC) to prevent it from going belly up.
What Is the State of Canada’s Housing Market?
The state of the Canadian economy is difficult to gauge at this time. For example, cities like Toronto and Vancouver are characterized by steep appreciations in property prices. This is fueling anxiety in the markets, leading some to believe that a property bubble is forming in the country. If sub-prime mortgage lenders are continuing to finance this industry, it could be subject to a correction, or worse. The fate of Home Capital Group is important, since it was ensconced in a scandal 3 years ago where it severed ties with scores of brokers.
Many large-scale investors in the company are scared of the prospects that lay ahead. The dilution of the stock price thanks to Berkshire Hathaway has possibly saved the company, but not served the interests of existing shareholders who will now pay the price. Buffett’s C$2 billion loan will be effective by the end of June and will replace the current loan between a major investor and Home Trust Company.
Canadian Economy Remains Ironclad with a Few Chinks in the Armour
Currently, Canada has a stable credit rating of AAA. This credit rating is a barometer of the financial stability of the Canadian economy for pension funds, sovereign wealth funds, and institutional investors. It plays heavily into the country’s ability to borrow cheaply on international markets. The Economist reported in mid-June that Canada’s housing market is extremely overheated.
While the collapse of Lehman Bros and the banking crisis that followed did not impact Canadian lenders, it appears that the tide is slowly turning. Today, the top 20 banks in the world feature 3 Canadian banks. These include Toronto Dominion, Royal Bank of Canada, and Scotia. Now however there are concerns that Canadian moneylenders are acting recklessly and driving up a property bubble. In just 10 years, the price of property in Canada has ballooned 76% and household debt to GDP has increased from 74% to 101%. These are indeed troubling times.
Lenders are scrambling to offer the best mortgage deals, and the best credit card offers in Canada, and customers are lapping it up. However, the rapid increase in credit growth is a prelude to a possible financial crisis. The Canadian government has been working hard to eliminate speculation in the housing market, and Montréal may be next in line. Canadian bankers use the defence that mortgage debt is evenly dispersed and that it forms a minor component of household indebtedness.
Regulation remains a concern with Canadian lenders, since small banks and financial institutions are not required to adhere to stringent rules. In Canada, the return on equity for banks is typically 15% – 20%, and since the financial crisis Canadian profits have increased by 100%. Now, bank returns make up 1.3% of gross domestic product, which is significantly higher than the United Kingdom and the United States.