In Home Capital's Mortgage Mess, Blame the 'Unlucky' Brokers
Home Capital’s troubles started with “unlucky” brokers. That’s what Canadian banks and insurers call the mortgage merchants who get caught submitting fraudulent loan documents.
Home Capital Group Inc. disclosed that 45 independent brokers submitted loan applications that misstated borrowers’ income and other details. A securities regulator accused the company of misleading investors about the fraud, and that sparked a run on deposits at the lender. Yet the brokers, whose names are now on databases maintained by lenders and mortgage insurers, can still win business since they haven’t been prosecuted for fraud. Unlucky doesn’t necessarily mean unemployed.
The failure to stop such practices is exposing cracks in Canada’s vaunted regulatory structure, drawing parallels to the U.S. a decade ago. So-called Ninja loans — an acronym for mortgages made to borrowers with no income, no job or assets — helped sink the U.S. housing market and led to the worst financial crisis since the 1930s. Canada emerged relatively unscathed from the 2008 crash, with officials crediting tougher regulations and lending standards. Yet Home Capital’s experience shows that the system of rooting out brokers who submit false documents doesn’t even put those brokers out of business.
“The early days of growth in the subprime market in the U.S. were like this — then it got out of hand,” said Jim MacGee, an associate professor of economics at Western University in London, Ontario. “At some point, you’re going to have people who take short cuts. When people are facing pressure to get into a house, you have brokers who are facing pressure to get them in there. They just hear, ‘How can you get me in there?’”
Even when regulators do go after brokers, the process can take years. In one case, Hamilton, Ontario, broker Dinesh Khanna allegedly forged signatures on behalf of unwitting clients, charged them exorbitant fees and lined up family members as lenders, taking possession of the home when the clients couldn’t pay, according to court documents filed by the Financial Services Commission of Ontario. While some of the accusations of rule-breaking were as early as 2009, it wasn’t until 2015 that Khanna’s license was suspended, according to FSCO. Khanna’s lawyer declined to comment in an email.
“You will always be behind as a regulator,” said Thorsten Koeppl, an associate professor in the economics department at Queen’s University in Kingston, Ontario. “You’re being outsmarted by the marketplace. We can’t avoid a crisis. But what we’ve learned from 2008 in the U.S. is how to deal with the crisis. And that’s what we can take away.”
As the U.S. housing crash went global a decade ago, Canada largely avoided the pain because of the conservative lending of its largest banks, which originate most residential mortgages in the country. But after millions lost their homes or jobs in the U.S., and home-value declines decimated whole communities, Canadian policymakers wanted to ensure that never happened. They raised lending standards, targeting the over-leveraged homebuyer, who’s got an average C$1.67 in debt for every dollar made.
Regulators tightened mortgage rules a dozen times in the past five years, helping drive borrowers to alternative lenders including Home Capital, which picked up first-time buyers, immigrants, the self-employed and those with shallow credit histories who could no longer tap the banks. Business flourished for independent brokers, who submit applications across a range of lenders — from shadow companies to companies like Home Capital as well as Toronto-Dominion Bank and Bank of Nova Scotia.
In Ontario, which contains more than one-third of the country’s population and its fastest-growing housing market, independent brokers were responsible for C$142 billion in mortgages in 2015, a 21 percent jump from the prior year, according to the most recent FSCO data. The nation has about C$1.45 trillion in mortgage credit outstanding.
Canada’s 9,000 brokers and the taxpayer-backed housing agency’s exposure to them is tracked province-by-province. In Ontario, FSCO oversees them, the ministry of finance sets regulations including the law that governs brokers, and the federal Office of the Superintendent of Financial Institutions oversees some of the lenders these brokers work with. Canada Mortgage & Housing Corp., the nation’s housing agency, insures about half of the nation’s mortgages.
A FSCO spokesman declined to comment. Home Capital, through spokesman Boyd Erman, said it “keeps regulators appropriately advised of developments in its business.” An OSFI spokeswoman and Ontario ministry of finance spokesman directed questions on brokers and regulation to FSCO.
CMHC spokesman Jonathan Rotondo said in an email that the agency works “proactively with partners throughout the industry to combat mortgage fraud,” rarely sees fraud, and when there is reasonable evidence of it, the agency can declare coverage void.
The patchwork regulation makes it easier for brokers to fall through the cracks, according to Ben Rabidoux, founder of economic research firm North Cove Advisors Inc. As part of his research, he speaks almost daily with brokers.
“One thing that always surprises my U.S. clients is how prevalent these broker fraud examples are in Canada because it wasn’t until the crash when all the fraud was revealed in the U.S., and we’re not there yet in Canada,” Rabidoux said by phone.
It’s why each lender and insurer that works with independent brokers has its own database of lawyers, brokers and agents tied to mortgage applications that contain misrepresentation — anything from forged letterheads to inflated income, according to executives at three of the country’s lenders and insurers. Once added to the list, names are shared among institutions during regular meetings throughout the year, said the executives, who asked not to be named as they discuss the industry’s inner workings.
The system, started after 2008, alerts companies to more closely scrutinize documents submitted by those brokers. They’re called “unlucky” only because they can’t label them “fraudulent” in a landscape where regulators lack resources to investigate and prove fraud in every case, the executives said.
So far, the instances of fraud in Canada haven’t resulted in a surge in defaults. The parallels with the U.S. foreclosure crisis of a decade ago are also limited, because Canadian banks don’t offer exotic mortgages that include features such as introductory teaser rates that jump after a certain period.
In the U.S., the frauds were sometimes more brazen and extended beyond the brokers. Mortgage dealers using lax standards lined up the kinds of exotic mortgages now synonymous with the crisis. Hundreds of subprime lenders then packaged and sold the loans to banks, which turned them into securities and sold them to investors. When borrowers began to default, the failures spread quickly from subprime to prime mortgages. There’s no evidence to suggest this is happening north of the U.S. border.
But there are some similarities. Mirroring the U.S. experience, prices in Canada’s largest cities have rallied at a record pace. Across Toronto, all housing types — from condos to detached properties — rose 25 percent in April from a year earlier, with homes selling in as few as three days. Growth slowed in Toronto in the first two weeks of May and sales fell 16 percent from last year as a new tax on foreign buyers helped cool the market. In Vancouver, still Canada’s priciest housing market, prices surged 11 percent to about C$940,000 in April.
As in the U.S. a decade ago, the high prices and low interest rates in Canada — with the overnight lending rate floating below 2 percent for nearly a decade — mask the potential fallout from lending to people who can’t afford it. They can always sell or refinance as their home values rise.
The lender risk system kicks in when regulation doesn’t.
In 2014, a whistleblower reported to Home Capital’s board of directors that some of their 4,000 independent brokers had submitted fraudulent documents. Once executives started digging, the company soon uncovered more and the investigation expanded. On Oct. 30 of that year, Home Capital flagged it to Canada Mortgage & Housing Corp., according to 390 pages of documents released by the agency under a freedom of information request.
Insurers immediately added the 45 brokers to their lists of unlucky brokers, but it was too late. They’d already backed about C$2 billion in loans submitted by these brokers, with rates and terms for some based on inflated income.
Although Canada’s regulator and housing agency knew of the mortgage fraud at Home Capital nine months before it was made public, it wasn’t until Home Capital issued a press release on July 29, 2015, to shareholders and borrowers that the agency’s internal communications revealed concern. The next day, a CMHC staffer flagged potential risk in an email:
“I’m wondering if we have done (or are planning to do) any analysis on our exposure to the Home Trust income documentation fraud,” one email to internal insurance and operations executives from a CMHC spokesman said. The documents show Home Capital prepared a list for CMHC and OSFI of all mortgages related to the brokers. CMHC, OSFI and Home Capital declined to comment on the documents.
Home Capital has never disclosed how many fraudulent mortgages and what amount it found on its books, and CMHC has yet to disclose how many of those they’ve insured. About a fifth of Home Capital’s C$17.8 billion mortgage book is insured, as insurance is mandatory when a home buyer doesn’t have a 20 percent down payment.
Genworth MI Canada Inc., Canada’s second-largest mortgage insurer, after CMHC, said in April that Home Capital-originated loans make up only 1 percent of its business and the delinquency rate on those loans was below 0.2 percent as of March 31. Canadian lenders have an average arrears rate of 0.28 percent as of February, according to the Canadian Bankers Association.
According to Home Capital, the lender didn’t expect credit losses from the mortgages originated by the 45 brokers. In the CMHC emails obtained under the freedom of information request, CMHC staff say it appears the agency’s “risk is minimal.”
Meanwhile, mortgage fraud in Canada may only be growing. Between 2013 and 2016, suspected instances of fraud among mortgage brokers jumped 52 percent in 2016 from five years prior, according to Equifax, a consumer credit and research firm. Nearly two-thirds were from Ontario.
James Thorne, a money manager at Caldwell Investment Management Ltd., doesn’t need to be convinced. He hasn’t held Home Capital stock for at least two years, when the firm first disclosed the broker fraud.
“You usually don’t find one cockroach. If you find one, there are many more,” he said by phone from Toronto. “We have a tendency to assume the negative event is a one-off. History suggests this assumption is incorrect.”