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Why the Stock of the Year Could Go Under

Over the past several weeks, shares of Home Capital Group Inc. (TSX:HCG) have fallen significantly. The bad news has been for existing investors, while the good news has been for short sellers and potential investors sitting on the sidelines waiting to jump in.

The latest development is potentially very good for those with a high appetite for risk. Shares of Home Capital Group, which are now trading near $8, may offer investors an opportunity to more than double their money in a matter of months. The bad news is, there is also a chance of bankruptcy.

Last week, the company announced the extension of a line of credit in the amount of $2 billion at a rate of 10%. This is good news for some, but it is an absolute disaster for others. The major challenge faced by the company is in the ability to finance new mortgages. While Home Capital Group offers competitive rates of interest on guaranteed investment certificates (GICs) in addition to high-interest savings accounts, which are more liquid, the net inflow of capital into these products has turned into net outflow.

Why is this?

While certain deposits are made directly through the company, it is important to note the majority of GIC deposits come in from outside brokerage firms offering third party GICs. To make this challenge that much more daunting, out of the brokerages selling the company’s GICs, only a small proportion are independent. Most are owned by the big banks.

It has been reported that a number of brokerages owned by Canada’s big banks have either stopped offering Home Capital Group’s products or have placed limits on the purchase of these products.

While there is probably no conspiracy, it should be noted that bank-owned brokerages placing restrictions on the deposits going into any one company may be seen as anti-competitive. Let’s not forget: banks are also in the business of originating mortgages. Wouldn’t there be less competition for Canada’s banks if the biggest alternative mortgage company disappeared?

At a current rate of 10% interest on the new $2 billion line of credit, the company has two options to ensure its long-term survival. The first option is to find a lower cost of borrowing in order to be able to fund new mortgages. At a cost to financing mortgage lending at 10%, the company will not be making many new loans.

The second and more profitable approach would be to run off the existing mortgages, collecting interest and fees from the products under administration. As of December 31, 2016, the tangible book value of the company was close to $25 per share. Barring a complete housing crash, the company will hopefully be able to turn the page and make patient investors very wealthy.

For dividend investors: beware! A dividend cut may be best for the long-term prospects of the company.

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Fool contributor Ryan Goldsman has no position in any stocks mentioned.

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