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Long-Term Investors: Steer Clear of Equitable Group Inc.

In this time of relatively high consumer debt levels in Canada and little room for debt growth, the increased risk appetite of certain Canadian lenders looking for higher returns on equity (ROE) has led to a precarious situation, one which resembles the U.S. housing market pre-crash.

Lenders such as Equitable Group Inc.  (TSX:EQB) have posted impressive ROE numbers over the past four years. Since 2012, the ROE for Equitable Group has ranged from 18.7% in 2012 to 16.9% in 2016. The company acknowledges the slight decline in ROE over the past five years, but it has made it clear in the 2016 annual report that the company is committed to meeting its relatively high ROE targets.

Lower-quality lending boosting ROE numbers 

The way Equitable Group intends to meet its targets is by increasing the percentage of its loans to residential borrowers across Canada, continuing the move away from its commercial lending base, which is considered to be safer, but it typically carries lower rates of interest for loans.

Equitable Group notes that “while attractive returns can be garnered on a variety of loan types, single family residential mortgages typically generate a higher ROE than do commercial mortgages because they require less regulatory capital.” The company has moved towards increasing its percentage of residential mortgages accordingly each year since 2009.

Single-family lending now makes up 46% of the company’s lending portfolio with the average mortgage rate sitting at 4.63%, which is equivalent to the company’s posted five-year rate on its website. This means that customers, on average, do not get a discount off the posted rate for their mortgages — something symptomatic of the average borrower having less-than-stellar credit.

Equitable Group has begun heavily marketing its lending services to those with weak credit, charging higher rates of interest on its loans and thereby increasing its lending portfolio ROE. This is an excerpt directly taken from the company’s residential lending page: “Let Equitable Bank’s ‘customer first’ approach help you achieve your aspirations of home ownership — whether you’re self-employed, a new immigrant to Canada with limited or no credit history, a credit-challenged individual, or an investor.”

In other words, Equitable Group is looking to increase its portfolio of borrowers that traditional banks won’t touch. In the company’s annual report, Equitable Group says this using “fluffier” language: “Equitable operates with a branchless banking model and competes in niche lending and savings markets that are not well served by the larger Canadian banks or in which we have a unique advantage … With this approach, we aim to grow earnings, produce a ROE for our shareholders in the mid to high-teens, and maintain strong regulatory capital ratios.”

As I have stated before, you can’t have high returns without taking on excess risk.

Equitable Group appears to be exposed heavily to the Toronto and Vancouver markets — markets which are currently considered to be overheated and due for a significant correction. I’m staying as far away as I can.

Stay Foolish, my friends.

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Fool contributor Chris MacDonald has no position in any stocks mentioned.

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