The resurrection of Pandora’s box

“A boat is a boat but the mystery box could be anything!” -  Peter Griffin

In the first blog post of this series, I indicated that something didn’t really make sense - people we know who earn roughly the same money as you and I were able to buy real-estate at prices that would be impossible for us to afford. You, too, likely had this same thought at some point. These people entered bidding wars throwing around hundreds of thousands of dollars like they were haggling over the price of some corn at an outdoor vegetable market.  What’s more baffling is that any reputable lender would never lend us these huge sums of money because the odds of us repaying it were slim unless we were willing to resort to eating Meow Mix cat food for dinner every night.  

How were they able to obtain these jumbo loans? Was that gut feeling that something seemed “off” valid? Hold that thought for a moment.

Many of us were led to believe that the Canadian banking and lending sectors were robust, highly regulated and, most importantly, safe. This line has been repeated religiously by politicians, banking executives and media outlets.  We were told that what happened in the United States with shady lending practices, predatory lending, and outright liar loans could not happen here because we are different and better than those cowboys down south.  Fraud and greed bought down the US housing market and us Canadians will never let that happen in the great white north! 

Countrywide Financial, if you don’t remember, was the face of the US sub-prime melt down back in 2008/2009. Countrywide financed mortgage loans and pooled them together to be sold off to other institutions and individual investors in something called Mortgage Backed Securities (“MBS”).  This scheme worked until Countrywide was found issuing mortgages to people with misleading incomes, false credit scores and even dead people.  Mortgage brokers would knowingly submit bogus loan applications and Countrywide would approve them. The executives were aware of the fraud but did not alert the authorities. 

There were some rumblings that something funny was going on in the housing market as people could suddenly purchase homes well outside what their incomes allowed, but it was all dismissed. 

Untold numbers of mortgages were fraudulently issued. People with insufficient, or even zero income, were unable to pay their mortgages when mortgage rates went up. The party ended abruptly when the market for the MBS grinded to a halt and the securities lost most of their value.

Countrywide was nothing more than a fraudulent purveyor of mortgage loans. Fannie Mae and Freddie Mac backstopped these loans in the same fashion as the Canadian Mortgage Housing Corporation here in Canada (which I refer to as the Canadian Moral Hazard Corp). In other words, if people were to default, Fannie or Freddie, would cover the losses.  In the end, Fannie and Freddie could not pay the losses and the federal government was forced to step in.

“Never say never and always avoid always”

Home Capital Group is a self-described alternative mortgage lender who has provided tens of billions of dollars in mortgages to people who are unable to obtain traditional mortgages through the big banks. The word “alternative” sounds hip, fresh, different. Let’s call it what it really is: subprime. Subprime means the borrow has poor credit and/or questionable income; thus, attracts greater risk and a higher interest rate.

Big banks don’t like risky loans so they tend to avoid subprime lending where possible. Subprime banks, like Home Capital and Equitable Group, thrive on risk. It is their lifeblood that keeps the system churning. Without it, they are nothing.

Subprime lending does have its place in the financial system. Not everyone has pristine credit or stable incomes (especially self-employed) and the big banks sometimes do not give potential borrowers a fair shake. However, subprime lenders still have a responsibility to assess the ability of a borrower to pay back the loan; it’s to prevent a repeat of Pandora’s box of plagues back in 2007/2008 in America.

Unfortunately, we fell asleep at the wheel, again.

In 2015, a whistleblower informed Home Capital Group that several dozen of its mortgage brokers were falsifying the incomes for mortgage loan applications. Several underwriters at Home Capital who were on the scam processed the fraudulent applications.  

What is a mortgage broker? They are people who find you the best rate and the best terms when you arrange for mortgage financing. You should consult with one if you need a mortgage because they will likely find a lender who will beat whatever rate your bank is offering. They get paid on a commission basis by the lender once a loan is arranged. No loan, no commission. Thus, there is a monetary incentive to get the deal done. The vast majority are legitimate professionals who play by the rules. 

Mortgage loans slowed down after the several dozen brokers were booted (since they were bringing in oodles of business) and instead of telling their investors what was going on, Home Capital told their investors that the slow down was the result of “bad weather” (as alleged by the Ontario Securities Commission). Home Capital also failed to alert the police of the fraudulent activity.

Disclosure issues aside, at first it was assumed that about $1 billion worth of mortgages were fraudulently obtained.  At the time of publication of this blog post, there is growing concern that this was only the tip of the iceberg. Potentially several billion dollars worth of mortgages were fraudulently obtained.  Many of these mortgages were insured by CMHC - also known as you the taxpayer. What’s worse is that the higher-level executives allegedly instructed their employees not to verify income. It’s anyone’s guess how many loans were issued based on bogus information.  It’s also anyone’s guess how many of these bogus loans ended up in mortgage pools and sold off to unsuspecting investors as mortgage backed securities. I thought we learned some lessons from the Countrywide Financial disaster?

As a bank, Home Capital offered high interest savings accounts at more than 2% which is quite attractive since the Big Banks offer 0.5% or less. You likely saw many of their ads in the subway and on TV in the last few years. You probably know someone who has money deposited with them.  Home Capital used the deposits to make loans some of which were not insured by CMHC, in other words Home Capital took on the full risk. With the falling share price and Ontario Securities Commission investigation, many people are now worried that they won’t be able to get their money back and are withdrawing it at breakneck speeds.

It is a modern day classic bank run. People are pulling out their money just like people did in various European countries when their banking systems imploded.  The capital flight forced Home Capital to take out a massive $2 billion line of credit at a punitive 22.5% interest rate.  That’s more than most people’s credit cards. None of the big banks wanted to get involved with this potentially toxic mortgage book (which speaks volumes).

My math isn’t the best as I’ve repeated before on this blog, but if a bank was to pay 22.5% for funding and lend that same money out at 5-7%, this arrangement won’t last long.  In the words of America’s distinguished short seller and predictor of the US subprime meltdown, Marc Cohodes, “I don’t think Jesus Christ could save this company”.

We know from the events in the USA that it took a single bank failure to ignite a fuse that spread quickly throughout the banking system. Banks are more interconnected than ever and use extreme leverage (lending out several times more than what they have on deposit. Google: “fractional reserve banking” for more info).  Home Capital is reportedly leveraged 16:1. That means they loaned out $16 for every $1 they have on deposit. Gotta love bank math!

Could the Home Capital debacle be fixed? It's possible.  Will depositors lose confidence in other subprime lenders? Has Pandora's Box been opened?  Your guess is as good as mine.

All of this leads us to a rather peculiar, yet highly relevant concept.

The cockroach theory

The cockroach theory is quite straightforward and fortunately no math is involved for this one.  Cockroaches are the vilest of the pests and make us squirm at every instance. They are simply disgusting. If you find a cockroach in your kitchen, the odds are overwhelming that many more are lurking behind the cabinets and in the walls. Even if you put up some traps, you will only catch the stupid ones. If you don’t act quickly, the cockroaches will spread throughout your home and, if you live in an apartment, they will spread to other units.  The longer the problem is ignored, the more difficult it will be to solve.

To permanently get rid of the cockroaches, you need to fumigate the entire place and use highly toxic chemicals to kill every single living organism. Miss one egg and the roaches will be back with a vengeance like Bruce Willis in Die Hard.

Any lender who behaves badly and mortgage brokers who facilitate fraudulent loans are akin to cockroaches. If left unchecked, they will create the same conditions that brought the US to their proverbial knees during their housing crisis a decade ago.

Strong words. I know. However, if someone is facilitating a fraudulent loan and that loan is insured by CHMC meaning every single tax-payer, if the loan goes bad then it's on me, you, your dog and everyone else to cover the losses. We pay enough in taxes and don’t need to pay more because of greedy lenders.

Back to Home Capital, were all the cockroaches caught right away? Was the problem contained? Since there has been no formal investigation and no regulatory body seems interested in combing through all the suspect mortgages during the relevant time period, I suspect this is like putting up a few traps in the kitchen which only caught the stupid ones. In other words, the problem continues to fester and spread.  

And those mortgage brokers who were caught back in 2015? There was a criminal investigation, right? I’m afraid to report that more money was spent investigating who threw a beer can at the Baltimore Orioles outfielder during the Blue Jays playoffs last year than on this. Actually, no money was spent on a criminal investigation; fraud is just so boring.

In case you’re wondering, they were released back into the wild free to continue their business practices as they please. It would be safe to assume that they are continuing their shenanigans with other unsuspecting lenders. “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.”

Justice, Canada style.

Is the Home Capital issue isolated?

As every day passes, there are more and more stories of lenders and brokers misbehaving. No one will freely admit they are engaged in fraud, of course, so most of these stories are anecdotal. However, the stories do paint a freighting picture that the authorities are not in the least interested in liar mortgage loans.

Back in December 2016, well before the Home Capital story blew up, Canadian Business ran a story investigating shady lending practices. Here is an excerpt:

"Such is the desperation that some mortgage brokers will help disqualified buyers bolster their prospects by offering to connect them with people who will create phony salary documents. One Toronto realtor, speaking anonymously, tells of a broker acquaintance who offers such a service. If the buyer can put down a third but can’t show enough income to qualify for a loan, the broker will arrange for fake employment statements that show sufficient income. The cost? Between $2,000 and $4,000."

You’re probably thinking, if someone can put down 33%, who really cares? The problem is the down payments are usually borrowed by means of bundled mortgages and other creative financing. Joe Blow owes three lenders and does not have the money to pay them back. Swell.  

Still not convinced? Go to Kijiji and type in "Toronto mortgage" and contact some of the people that advertise there. As Casper the Ghost once said, "seeing is believing".

Fraud is comparable to an iceberg. Beneath the surface reveals the true magnitude of its reach.

How pervasive is mortgage fraud?

Equifax reported just a few months ago that they have found a 52% increase in suspected fraudulent mortgage applications since 2013.  Fifty-two percent!! Stunning would be an understatement.

Scott Nazareth, mortgage broker at Loanerr (no typo), estimates that 1 in 5 borrowers submit false information on their loan applications.

“It’s an industry-wide problem,” says Mike Rizvanovic, a financial services analyst at Veritas Investment Research.

We really have no firm idea how deep and wide the fraud iceberg is in this country.  The authorities are not interested, regulatory bodies move at a snail’s pace, and lending institutions will only act when someone does the investigative work for them. It seems we are all sticking our hands in the sand hoping everything will just work itself out. Fantastic strategy, eh?  

What we do now is that Pandora’s Box may have been opened and, in addition, the roaches are continuing to spread. 

Is this the sign of a sustainable real-estate market?