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Making Sense of Home Capital Group Inc.

Home Capital Group Inc.  (TSX:HCG) is a heartburn-inducing company. In the middle of March, investors were sitting pretty with each share trading at about $25. By the end of April, shares had plummeted to under $6 per share. Since then, the company has been on the rise again, but even now, the company is still down 50% from where it was.

What happened and what should investors do?

A lot of the drop stems from an investigation by the Ontario Securities Commission (OSC). It was investigating multiple senior executives at Home Capital Group for knowingly using false documentation to provide mortgages. Naturally, investors weren’t interested in being part of the company with that bad press, and the company stock tanked. The CEO was fired, and some were talking about how the company would completely fail.

But then Uncle Warren came to the save the day. Warren Buffett’s Berkshire Hathaway Inc.  (NYSE:BRK.A)(NYSE:BRK.B), through subsidiaries, invested $400 million in new shares of the company. On top of that, Berkshire offered a $2 billion line of credit to help Home Capital Group continue lending — without this, there would be no way for Home Capital Group to experience any growth. The line of credit comes with a 9% interest rate, but what else could Home Capital Group do?

So, in the short term, the company is in a good position. It’s got a big advocate in Berkshire and two billion reasons not to go out of business.

Where does Home Capital Group go from here? One problem with the 9% line of credit is that it limits who Home Capital Group can lend to. Specifically, it needs to offer a double-digit interest rate to a prospective borrower for it to cover the cost of the line of credit and make any sort of return on the loan. That doesn’t even take into consideration default rates which, when talking about lower quality mortgages, increase in probability.

To ensure that Home Capital Group can continue making loans without ever having to pull from the line of credit, it’ll need to do a better job convincing individuals to open high-interest savings accounts. And the new CEO, Yousry Bissada, comes from a consumer background, so he’ll likely steer the company in the correct direction.

If Bissada can increase the sources of funding to ensure the company can continue making mortgages, the company may begin growing again. However, if Home Capital Group has to actually use the Berkshire line of credit, the conversation we’ll be having next year is more likely to be an obituary.

So, should investors consider buying?

I’m avoiding Home Capital Group for a few reasons. First, I believe the brand is tarnished, and that’s going to hurt it. Second, new sources of funding are going to be difficult to come by. And finally, with home prices already pretty expensive, most mortgage projects worry me. Nevertheless, if the company can rebrand and get new sources of funding, Home Capital Group could begin to experience growth, providing a solid return for investors. It was only a few months ago that shares were trading at about $25. Maybe the company can achieve that again.

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Fool contributor Jacob Donnelly has no position in any stocks mentioned. The Motley Fool owns shares of Berkshire Hathaway (B shares).

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