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3 Factors That Could Sink Home Capital Group Inc.’s Stock Again

There is no doubt that Home Capital Group Inc. (TSX:HCG) has made a lot of progress to get back on its feet after a major liquidity crisis this spring.

The latest information available from this troubled mortgage provider suggests that it’s almost overcome its liquidity issues, especially after it got a bailout by investing czar Warren Buffett, whose Berkshire Hathaway Inc. injected a $400 million equity and provided a $2 billion line of credit.

At the time of releasing its second-quarter earnings last week, the company’s new chief executive officer, Yousry Bissada, assured investors the non-bank home finance provider is back on “sounder footing” and the company is confidently operating as a going concern.

Despite these encouraging revival signs, which include new deposits returning to historical levels, a strong liquidity position, its fully repaying a $2 billion backstop credit line to Berkshire, investors don’t seem impressed.

In July to August 4, Home Capital Group shares are down 18%, wiping out almost all the gains that came with the news of Warren Buffett’s bailout.

So, why are investors not excited about all of the good news that new management is telling? The main reason is that Canada’s economy is going through some major changes which have put Home Capital Group’s recovery on shaky ground. Here are some of the major headwinds the company is facing.

Mortgage rule change

Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), in July unveiled a set of new proposed rules to cool down the housing markets.

These rules, if implemented, would impact a large number of home buyers, limiting the Home Capital Group’s future loan growth.

OSFI’s proposed rule requires home buyers, who have down payments more than 20% of the purchase price, to prove that they could still afford their uninsured mortgages if interest rates were two percentage points higher than the rate they are offered by their bank.

This more stringent stress testing would make it harder for uninsured buyers, which account for a larger proportion of all mortgages in Canada, to be eligible for a new loan. Another proposal is about prohibiting co-lending or mortgage “bundling” arrangements that appear designed to circumvent regulatory requirements.

The co-lending prohibition, if adopted, is expected to have the greatest impact on mortgage companies, like alternate lender Home Capital Group, that primarily provide loans to people who don’t qualify for funding from the big banks.

Home Capital management cautioned investors last week, saying that these rules could have a “material impact on our business strategy going forward.”

Interest rates 

Coupled with the tightening of mortgage rules, the Bank of Canada has also started to hike the benchmark interest rates. After its first rate increase last month, the central bank is likely raise the borrowing cost again in its October meeting as the latest data suggests Canada’s economic growth is strengthening and broadening.

Higher interest rates would certainly put a brake on new home purchases, which have been behind the massive growth in the mortgage lending.

Housing slowdown

The third factor which is creating a lot of uncertainty for the whole banking system is the possibility of housing market crash in the nation’s two largest cities: Toronto and Vancouver.

July’s housing data show that sales in Toronto dropped 40% in July compared to the same month last year after the provincial government imposed a foreign buyers’ tax.

Bottom line

I think Home Capital Group will survive despite all of these challenges, but I don’t believe it’ll be able to return to the pre-crisis level of profitability. Trading at $13.76 a share, less than half of its value a year ago, it’s a bargain for long-term investors. But I don’t see any short-term rally amid these major uncertainties about the housing market and interest rate outlook.

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

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