There are a lot of Home Capital investors looking for someone to blame.

Today when the company releases its delayed results, everyone will be going over those books with a fine-tooth comb, trying to divine whether the mortgage finance firm will survive and prosper — in which case it's a great buy — or if confidence in the company will continue to slump.

Today's results may not be definitive. It is likely they will just be one more piece of evidence in a battle involving investors and company managers over whether the business model for Canadian subprime lending is sound.

Comparison with U.S.

Comparisons with the U.S. subprime crisis that brought down U.S. banks and the global economy have been rife. But so have patient explanations of why the Canadian situation is completely different.

As usual, when a company — especially a deposit-taking institution of the kind where Home Capital raised its mortgage cash — is threatened with collapse, there is more than one reason.

Home Capital shareholders and their advocates have pointed fingers at short sellers who made public bets that the company's shares would crash. Others have blamed the Ontario Securities Commission, the regulator that declared the company had failed to properly inform its investors.

Boom or bust

And in the background are highly publicized stories of a Canadian property bubble inflating rapidly as it repeatedly soars to irrational levels.

It was bad luck for Home Capital that its crisis came just after a series of moves by federal and provincial governments to bring the residential real estate market under control in a way that some feared could overshoot, leading to a long-predicted market correction.

Anyone worrying about whether a soaring market is a bubble waiting to pop must be on the constant lookout for the trigger that could bring the market down. That's because, historically, markets can continue to climb while containing the seeds of their own destruction.


The Canadian real estate market continues to boom, especially in the Toronto area where home prices recently rose by one-third in a year. (Chris Helgren/Reuters)

Many of us in the media have been warning of an overheated Canadian property market for so long that homeowners, potential buyers and companies profiting from real estate have every reason to be skeptical.

In the case of Home Capital, the OSC announcement in April that it was going to proceed against the company may have been the trigger, but like the shooting of the Archduke Ferdinand, blamed for the start of the First World War, there was a lot more going on.

Going short 

Vocal short sellers have been criticizing the company for years. Of course the opinions of short sellers, who borrow shares and sell them with the expectation they can buy the shares back at a lower price, must always be taken with a grain of salt. For them, success in driving down shares is money in the bank.

Two more factors helped make the mortgage lender unstable. One was that it raised its mortgage funding from depositors through its banking division. The other is the curse of all lenders suffering from a run. 

As Home Capital shares began to slide, it was not just shareholders who began to unload. Depositors began to pull their money out.


Yesterday Home Capital announced that despite efforts to patch up its financing, its deposits continue to fall. (Cole Burston/Bloomberg)

The rules outlined by Office of the Superintendent of Financial Institutions are complicated, but lenders must maintain their Tier 1 capital, which depends on deposits and equity. 

Once those deposits began to fall, the lender was desperate to patch up its Tier 1 ratio, forcing it to borrow cash at an effective rate of 22% from a pension fund and sell off some of its mortgages

There are reports that some of the banks and Home Capital competitor MCAP are offering support.

Underlying Home Capital's decline is its position at the bottom end of the mortgage market.

Canadians are notoriously good at paying off their mortgages. However, by definition subprime lenders, who give out mortgages to people the big banks have rejected, would be first to suffer in a property downturn.

So far there are no obvious signs of a crash in Canadian real estate. A telephone poll from the business news service Bloomberg and Nanos Research says a majority of Canadians believe prices will continue to go up.

If the Canadian property market continues to rise, the portfolio of mortgages held by Home Capital is as sound as it was two months ago. 

So long as today's results contain no surprises and providing Home Capital can stop the hemorrhaging of its capital, it can live to fight again.

But if the company continues to weaken and fail, leaving its borrowers without an alternative source of money when their mortgages come due, Home Capital could itself become the trigger of larger real estate decline.

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