Headline news of “bad mortgages” gives many investors the heebie-jeebies, considering the fact that the Global Financial Crisis, which gripped the U.S. banking industry, is only a decade old.
In 2017, a run on deposits held at alternative mortgage lender Home Capital Group Inc. (TSX:HCG) due to improper income disclosures on a significant portion of the company’s mortgage portfolio led to a sharp decline in the company’s share price and sent shock waves within the alternative lending and conventional lending spaces.
More recently, shares of Canadian lender Laurentian Bank of Canada (TSX:LB) have dipped more than 5% over the past two weeks, as investors continue to re-evaluate the lender’s risk profile after an announcement that the bank would be buying back $392 million of problematic mortgages from a third party. The announcement followed an initial assessment of the total amount of “mis-flagged” mortgages more than a month ago at much lower numbers. With the number of problematic mortgages climbing, concerns that we have only seen the tip of the iceberg have led to a general sell-off over the past two weeks.
A common practice in the mortgage industry is for lenders to originate mortgages and subsequently sell off the debt instruments at a profit to other large financial institutions, which may then turn around and package said mortgages into securities which can, in turn, be sold for a profit. While Laurentian does not necessarily fall into the category of a “non-prime” lender like Home Capital, the bank is competing with a handful of other very large and powerful competitors and is often seen as a go-to lender for those without the ability to be serviced by Canada’s largest banks.
Whether or not the mortgage brokers originating loans on behalf of Laurentian acted in such a manner that would constitute “willful wrongdoing” remains to be seen; however, Laurentian does not believe this is the case. Despite more than half of Laurentian’s B2B mortgages sold to an unnamed third party containing “documentation issues,” ($392 million out of $655 million in loans audited), the company believes this issue is not widespread and will not have a material impact on earnings moving forward.
Bottom line
The reality remains that Laurentian bank is a niche lender in the Canadian mortgage scene, and while $392 million in loans is a drop in the bucket for banks such as Royal Bank of Canada (TSX:RY)(NYSE:RY) with a market capitalization of more than $156 billion, for Laurentian, a lender with a total market capitalization of only $2.2 billion, I believe this situation may be more serious than initially indicated, given the percentage of loans which were found to be inadequate in the aforementioned isolated audit.
Instead of Laurentian Bank, consider the following companies in your pursuit of building a portfolio filled with excellent companies for the long term.
