Smith Financial’s deal for Home Capital shakes up alternative lending space

by Bailey Amber
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Ripples from the $1.7-billion transaction could extend to other pockets of the banking space, analysts say

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One of the biggest players in Canada’s non-bank mortgage market is giving the sector a vote of confidence in the face of a housing downturn that has put pressure on origination volumes and share prices.

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Smith Financial Corp., a holding company controlled by First National Financial Corp. co-founder Stephen Smith, announced Monday that it was acquiring alternative lender Home Capital Group Inc. for $1.7 billion.

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The $44-per-share cash offer came at a 63 per cent premium to the company’s closing share price on Friday and was well-received by the analyst community, which largely saw it as a good value offer for Home Capital shareholders.

Smith Financial already owned 9.1 per cent of Home Capital’s shares as well as a significant stake in EQB, the parent to alternative lender Equitable Bank, but the ripples from this transaction could extend to other pockets of the banking space, analysts said Monday.

Canaccord Genuity Corp. analyst Scott Chan noted that the transaction could benefit regional banking players such as Canadian Western Bank and Laurentian Bank, which have alternative mortgage exposures. He added that it could also renew attention on the potential sale of HSBC Canada, another mortgage industry player.

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“We believe (the Royal Bank of Canada) is still the most likely acquirer as they can fund the entire HSBC Canada transaction with excess equity … but would have competition concerns given its (number one personal and commercial banking) share in Canada,” Chan wrote in a Nov. 21 note.

The deal comes at a time when rising interest rates have been reducing the demand for mortgages and raising the risk of a recession. Home Capital’s third-quarter results showed the effect of the slowing housing market, with single-family mortgage originations plunging by 28 per cent from a year earlier.

But Nigel D’Souza, a financial services analyst at Veritas Investment Research, said the drop in mortgage demand and rising default risks as mortgages come due for renewal come with an upside, in that higher interest rates will allow lenders to generate higher interest income from loans and mortgages.

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“We think the mortgage rates are going to start benefiting bottom line, you’re going to see margins expanding starting in the fourth quarter for Home Capital, and that’s what we expect to drive a lot of the earnings growth for the business,” D’Souza said, adding the EQ Bank saw its shares jump following its third quarter results partly because the company reported a higher net interest margin.

National Bank of Canada analyst Jaeme Gloyn estimated in an Oct. 24 note that 66 per cent of Home Capital borrowers would need to renew their mortgages over the next 12 months and could expect to pay $1,190 more on monthly payments on average.

Higher rates also mean that fewer customers are likely to leave companies like Home Capital since the rates would likely be higher at other companies, D’Souza noted, making the company’s client retention rate higher.

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D’Souza also said that despite recession risks and a more anxiety about mortgage defaults, Home Capital’s risk-adjusted interest margins are what matters most if the economy gets worse.

“For Home Capital, in order for the risk-adjusted margin to have an unfavourable outlook, credit losses would again have to significantly exceed credit losses that Home Cap experienced during the financial crisis,” D’Souza said, adding that such losses would have to be about two or three times higher for it to be a significant concern.

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Though some analysts have been warning of mortgage default risks, D’Souza suggested that any impact would be limited.

“So, even if there is a default, they could still go through a forced sale of that property and probably recoup the entire loan value,” D’Souza said, adding that home prices would need to decline significantly over the short term and borrowers would have to default following that drop-off in value before Home Capital starts taking sizeable losses. “For that reason, I don’t think it’s likely that you’re going to have these outsized credit losses that are going to more than offset the benefit from margin expansion.”

D’Souza said that the deal was unlikely to alter the share of the market held by alternative lenders.

“I don’t think you’re going to see this change the dynamics of the mortgage market, how it functions, how it would affect customers looking for a mortgage or the market share of different lenders in the space,” D’Souza said. “I think it only really changes things materially for Home Capital shareholders. That’s really who benefits from this transaction.”

Overall, D’Souza said, the Big Six maintain a stranglehold on roughly 70 per cent of the country’s mortgage market.

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