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There’s going to be a lot of Home Capital Group (HCG) announcements as this story unfolds in coming days. We’ll track them here…

Update #7: April 28, 3:35 P.M.

  • Equitable Group shares are down 16% following a 50 bps hike in its deposit rates.
  • Former Home Capital director Jim Keohane was on BNN today. Good on him for having the guts to speak publicly. His comments did much to assuage fears about an imminent demise of the company. Here’s some of what he said:
    • His fund’s investment was not a “high-risk” investment because it was overcollateralized by high-quality mortgages (effectively 2.8 times coverage for each dollar HOOPP lent, which makes fear mongering like that from ZeroHedge seem absurd)
    • The loan was intended to “keep the doors open” at Home and “prevent a liquidation of the company.”
    • “There’s a possibility it could continue as a going concern” and not be sold off, he said
    • Keohane was asked if Home would have folded in a few days had HOOPP not made that loan. His response was, “probably not” but it was a “cushion to protect that from happening.”
    • Keohane was not in a conflict of interest, he says, because he recused himself from all decision-making with respect to the deal.
    • Most of the fraud-related mortgages have already “rolled off the books” at Home and no longer present a default risk to the company.

Update #6: April 28, 10:55 A.M.

  • $291 million worth of depositors fled yesterday
    • Here’s Home’s release about it. If management is smart, it’ll keep making frequent disclosures of its status (like this) to win back some degree of investor confidence.
  • The stock is down 2% to $7.86 as of this writing
  • “We’re getting close to seeing action by the regulator.”—Veritas Investment Research analyst Mike Rizvanovic  (via Globe and Mail)
  • Former Home Capital director Jim Keohane will be on BNN at 2 p.m. ET. Investors will be watching his every word for clues about Home’s fate. It’s possible we won’t hear from Home’s CEO or Chair unless they’ve got a solid plan to stabilize the company.
  • On an editorial note, we will not keep chronicling Home’s deposit situation or stock performance going forward unless it changes materially. Suffice it to say, no one’s going to be surprised if the company sheds more high-interest deposits near-term, but the pace is slowing. Its all-important GICs have been much stickier, however, remaining near $13 billion.

Update #5: April 27, 10:35 P.M.

  • Due to media speculation, HOOPP has issued a press release on its loan to Home.
  • Director Jim Keohane has resigned from Home’s board after the fund he manages provided a $2-billion loan to the embattled company. (More from the Financial Post)
  • S&P downgraded Home Capital’s credit rating to junk status (B+).
  • Veritas Investment Research analyst Mike Rizvanovic estimates that its emergency credit facility “at best gives Home Capital a one- to two-month stopgap.” (src: Globe and Mail) You can bet Home’s fate will be clear well before 60 days. 

Update #4: April 27, 4:55 P.M.

  • The company’s shares rallied hard in the last hour, closing up 34% on the day. There was a constant bid with no material pullbacks, which doesn’t happen by accident (a lot of short covering, a lot of speculative buys and perhaps some strategic buys from well-informed parties).
  • “Over the past week..short bets turned out to be very profitable, but ironically for different reasons than most short-sellers anticipated. And their actions likely contributed to the current bank run.”—Michael McCloskey, founder GreensKeeper Asset Management (via Globe and Mail [sub.])
  • “As rough as the past few days have been, we are very focused on getting this company back on track and doing everything we can to make that happen.”—Chairman, Kevin Smith (via Reuters).
  • Bad loans account for just 0.24% of Home’s loan book, reports Reuters, down from 0.34% a year earlier.

Update #3: April 27, 3:40 P.M.

  • In an email today to brokers, Home Trust EVP, Pino Decina stated: “Home Trust has weathered difficult times during its 30-year history, and has always risen above…We are taking the necessary steps to deal with this situation…If your client has a mortgage with us, rest assured nothing has changed.”
  • Home’s apparent funder has a conflict, says law professor: “HOOPP President and Chief Executive Officer Jim Keohane sits on Home Capital’s board and is a shareholder of the mortgage lender.” (More from Bloomberg)
  • Home Capital’s stock has made a new high on the day (an important short-term positive that suggests the balance of investors aren’t giving up on the company and/or think it will be successfully sold).

Update #2: April 27, 1:05 P.M.

  • Bank analyst: “We now assume that Home Capital will not be able to access sufficient deposit funding going forward, and the company will likely move into liquidation mode.” (This same analyst simultaneously raised his rating of HCG from hold to speculative buy.)
  • “We think [a sale] is at a substantial premium to current levels. We believe HCG’s book may be attractive to several banks that could run the business with materially lower funding costs, particularly if they have regulatory support for the deal.”—GMP Securities analyst Stephen Boland (via Bloomberg)
  • HCG is expected to axe its dividend to preserve cash flow.

Update #1: April 27, 11:00 A.M.

  • A sale seems increasingly likely. HCG has retained RBC Capital Markets and BMO Capital Markets “to advise on further financing and strategic options.”
  • Its high interest savings deposits are reportedly down to roughly $814 million versus ~$2 billion last month, a roughly $600-million outflow of depositors in the last few days
  • The company now says it has a firm $3.5-billion in current liquidity and $12.98-billion in outstanding GICs.
  • Healthcare of Ontario Pension Plan is reportedly the emergency lender that gave Home a liquidity lifeline yesterday.
  • The stock (symbol: HCG-TSX) has rebounded 13% to $6.99 (too early to call it a dead cat bounce).
  • Amid all the downgrades, a few analysts have raised their ratings of Home’s stock to “buy” and “outperform.”
  • Big banks are reportedly limiting client investments in Home GIC’s to $100,000, CDIC’s insurance limit.

Quotes:

  • “We have a hard time viewing the challenges (Home Capital) is facing as a systemic event, particularly since there is no indication of credit deterioration in the mortgage portfolio of (the company)…With the market cap of HCG having dropped to ~$400m we are skeptical that any of the banks will step up as a buyer of the company. At this stage of the HCG fallout a purchase of the underlying loan book would be a more straight-forward process than an acquisition of the common equity.”—Scotiabank (via BNN)

 

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Rumours about the severity of fraud at Canada’s biggest non-prime lender appear to be overblown. Based on Home Trust’s assurances on yesterday’s conference call, this past month may go down as a lesson for the industry, but it won’t go down as a harbinger of systemic risk.

The call revealed some interesting nuggets about how the mortgage industry operates. Here were some notable takeaways:

In a Nutshell

  • The company says the fraud it uncovered in broker files centred on “falsification of income verification documents.”
  • “The deficiency was that some of these (job) letters had been altered,” said Home Capital Group CEO Gerald Soloway. “…Instead of making $64,000 the person suddenly made $84,000.”
  • The fraud was revealed by an anonymous letter sent to a member of Home Capital’s board.
  • “We did inform the insurers and OSFI very early on,” said Home Trust President Martin Reid. Most of the questionable mortgages were insured and they will retain their insured coverage (unless it’s later determined that the company was responsible for the fraud).

The Extent of It

  • The 45 brokers Home terminated had been submitting questionable deals over a timeframe that ranged from a few weeks to several months, depending on the broker.
  • The bulk of the problem files were submitted in 2014, but some were submitted prior to 2014.
  • Of the $960 million worth of mortgages these brokers did last year, “the vast majority were on the level,” said Soloway. Only “a very small portion” of the deals were questionable.
  • Most of the terminated brokers had submitted more than one deal with falsified documentation. “Some of it could have been caught by the broker,” says Pino Decina, EVP Residential Mortgage Lending at Home Trust.
  • Reid said there is “no proof that the mortgage brokers themselves are responsible for this but the business flows through them so we hold them accountable.”  
  • “In 26 years, it’s not the first time we’ve delisted a broker,” adds Decina. “Unfortunately it does happen, but nonetheless these cases are not representative of the broker community as a whole…”
  • On the conference call Soloway admitted: “Maybe we discontinued relationships with a few more than we should…Maybe a year or two out we’ll look at onboarding (some of) them.”

It Wasn’t an Inside Job

  • In our interview, we carefully clarified one key point with Decina. He says there were no instances found where a Home Trust employee was aware of fraud, but subsequently allowed the mortgage to close. That had been a widely circulated rumour for weeks now.
  • A “small number” of employees were terminated following this incident. Decina notes simply that they “could have done a better job” during the underwriting process.

OSFI’s Take

  • On the conference call, an RBC analyst asked what many were thinking—that is, whether OSFI had given the company a clean bill of health. That prompted the most animated response of the day as Home’s CEO vehemently replied, “We as a company don’t talk about OSFI and what they’ve done…Ask your chairman of the Royal Bank if he’d like to comment on his OSFI relationships the next time they have a quarterly call…”
  • When we approached the banking and trust regulator, it told CMT: “OSFI is prevented by legislation from discussing the results of its supervisory work publicly.”
  • Apparently banks and trustcos are too, although it seems silly to outside observers that a company cannot make factual disclosures about OSFI investigations in public.
  • Either way, it’s a safe bet that OSFI has left no stone unturned on this issue. Home capital is a heavily regulated entity.

HomeTrust

Reporting Broker Wrongdoing

  • “Some of the [suspended] brokers are still in business,” said Soloway, which astonished many observers on the call. The main reason: those brokers haven’t been found guilty of anything by the authorities.
  • OSFI says, “There are a number of different activities that can be considered fraud, and depending on the nature of the activity, a financial institution may have a duty to disclose the offense to the appropriate agency (e.g., RCMP, FINTRAC, Provincial Regulatory Authority).”
  • Home Trust did not report the brokers to the police. “We didn’t see any clear evidence (of wrongdoing on the brokers’ part) to report to the authorities,” Decina notes.
  • “The regulators and insurers are aware of who we had issues with,” noted Soloway.
  • “We took a hard-line approach” even if a broker had only one instance of falsified documentation, said Decina.
  • Interfinance Mortgage Corporation was reportedly one firm that Home cut off, according to this National Post story. We asked Ontario’s mortgage regulator (FSCO) if it could confirm this. It said, “To maintain the integrity of all of our investigations, we can neither confirm nor deny the existence of any specific complaints or investigations against individuals or businesses.”
  • Home could not report any brokers to REDX, a private industry repository of alleged fraud, because the company doesn’t subscribe to the system.
  • All this said, if FSCO does investigate these brokers (and why shouldn’t it?) and it does find wrongdoing, the agency could then take enforcement action.
  • It’s a sad reality in our business that fraud allegations are not more aggressively reported and investigated. Lack of resources, PR risk and legal liability are some of the reasons that we don’t see regulatory enforcement more often.

Industry on Notice

  • Despite the mortgage industry’s rigorous underwriting overall, you can bet that at least a few lenders will be further tightening income review policies in the wake of this debacle. No one wants this kind of risk and media attention.
  • In turn, brokers who seem to knowingly submit “bad paper” may be dealt with more harshly than before, as they should be. Hopefully the few bad apples in our business realize that lenders and insurers share information on shady brokers regularly.

Fraud is Part of the Lending Landscape

  • Every lender sees fraudulent applications and documentation. They have since the beginning of lending. In fact, virtually all lenders allocate for fraud in their profitability models.
  • Equifax estimated industry-wide mortgage fraud at $600 million in 2012, which was roughly 30 basis points (0.3%) of the $200 billion in annual originations.
  • “All the insurers do annual and semi-annual reviews of our portfolio,” said Reid, as they do with all lenders. Insurers “expect a certain percentage (of files) will be offside.”
  • From a broker standpoint, if you’re in this business long enough you’re bound to have unscrupulous clients send you illegitimate documents. The fact that you unwittingly forwarded those documents to a lender does not make you a criminal.

A Contained Problem

  • CAAMP issued a statement Thursday, rightly noting that, “Any amount of fraud is too much.” But we have to be realistic and add some perspective. Home axed 45 brokers, out of a pool of ~18,000 brokers in Canada who originate $70 billion a year, says CAAMP. Industry arrears are just 28 basis points and, by far, the #1 factor causing arrears is unemployment/underemployment, not fraud.
  • Gary Mauris, who runs Dominion Lending Centres/MCC, the nation’s largest mortgage brokerage operation with 3,600 agents, 71,000 annual originations and $23 billion in volume, told CMT, “At DLC we’ve come across maybe half a dozen instances of fraud in almost 10 years in the business.” 
  • Most fraud is obviously unreported, but the absolute amount in our business is still measured in basis points, not percentage points. And believe you me, fraud occurs in bank and credit union branches as well.
  • “All of the insurers have conducted audits,” Soloway said. “…They’ve all indicated that our arrears and underwriting procedures are solid.”
  • Interestingly, from an arrears standpoint, the fraudulently obtained mortgages have actually been performing better than Home’s portfolio overall, said the company. That may just be chance.
  • Given this reality, Home Capital’s clarifications and short covering, it wasn’t surprising to see the market bid up Home’s stock 13% yesterday.

Client Impact

  • As for the mortgages that were improperly obtained, “We’ll look at them on a file-by-file basis” at renewal,” says Reid.
  • Home “may require (more) income verification” from these clients.
  • The company is “proactively” contacting some of the borrowers and updating their documentation.

Early Disclosure Helps

  • This debacle may make a good case study someday on how not to manage disclosure of damaging news.
  • Given all the harmful rumours flying around and the destruction of shareholder equity, many believe the company’s disclosure about the extent of the fraud was too long overdue. Had people known that it was “only” 45 brokers and no employees or appraisers were involved, the damage could have been mitigated. This proves that a little information is dangerous, with the market drawing conclusions prematurely based on a lack of detail.
  • The company cited quiet period regulations as part of the reason it waited until earnings to discuss the extent of the fraud. Yet it nonetheless made other comments about the incident during that period (which ran between the end of the second quarter and the release of Home’s quarterly earnings announcement).

Next Steps for Home

  • The company will absolutely recover from this incident but it won’t be a cakewalk. The terminated brokers accounted for 7% of non-prime and 32% of prime originations in 2014. That’s a truckload of volume to make up.
  • As a result, we wouldn’t be shocked to see Home sharpen its pencil on rates, run more promotions, improve broker compensation and/or add other broker perks to generate volume gains. The company also said it would broaden the number of brokers it does business with, redo its broker portal and add a new broker loyalty program later this year.
  • Home has now separated its sales and underwriting functions, and strengthened its income verification procedures. Those procedures include running income docs through a specialized team. Previously, “we didn’t phone to verify the income,” says Soloway. “…We now…won’t do an insured loan that requires proof of income…(without verifying income and employment).” On a side note, Home has not been the only lender to not phone employers.
  • The company will now try to put this nightmare behind it and get back to business, but the street will undoubtedly be watching for any reoccurrence of these events.
  • As our interview concluded, Decina had this to say: “Despite all the online comments and unfounded speculation about Home Trust’s future, we are grateful for the continued support of the many brokers we work with each day. Home Trust has been a dedicated participant in the broker channel for over twenty-five years and remains committed to…our broker partners.”

 

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For days now, investors and industry types have been impatiently waiting to hear why Home Trust terminated numerous mortgage brokers. Today we got Home’s explanation.

The company said the following in a disclosure requested by the Ontario Securities Commission:

  • 45 individual mortgage brokers were cut off (about 1% of the company’s broker relationships)
  • The alleged reason: “Falsification of income information” (i.e., fraud, albeit the company doesn’t refer to it as such)
  • It found no evidence of falsification of property values
  • These shunned brokers originated $960.4 million of single-family residential mortgages in 2014, out of $7.6 billion in total Home Trust originations
  • 60% of the questionable mortgages were for Home Trust’s prime “Accelerator” products (i.e., they were largely insured mortgages)
  • This potential fraud was identified by “an external source” in late 2014, the company says.

Home said it is “comfortable” this issue is not widespread in its portfolio, adding, “The Company continues to actively monitor the subject mortgages and notes that there have been no unusual credit issues.”

You can read about the measures the company took to prevent this from happening again here: link. These include “requests for more detailed documentation and income verification from brokers.”

Interestingly, we’ve been approached by three lenders asking if we know which brokers Home terminated. It seems that several lenders and mortgage investors are trying to identify these allegedly shady originators, so they can ban them.

We’ll have full analysis of these developments after the company’s 10:30 a.m. conference call Thursday. If you’re following this saga, you can listen in on that call here: http://www.homecapital.com/ir_webcasts.asp

Canada’s Biggest Mortgage Fraud

BMO-mortgage-fraud Canada’s largest-ever mortgage fraud unfolded in the press last week.

The fraud reportedly involved straw buyers who were paid up to $8,000 to buy properties for the alleged ringleaders. The accused perpetrators picked cheap homes in neighbourhoods of more expensive homes, used the surrounding home prices to grossly inflate subject property values, created forged documents to fake borrower income, and skipped town with the mortgage proceeds.

BMO is suing hundreds of people including its own employees, Realtors, over 18 lawyers, mortgage brokers, and an MP.

Details are scarce at the moment because BMO is restricted in commenting. There’s also an ongoing RCMP investigation.

An RCMP officer told CBC, “We have a number of issues. First of all, we have real estate agents to interview, mortgage brokers to interview, bankers to interview. And then we have a mortgage file to review — and it’s a huge documentary evidence file that we have to review and it can take years to investigate.”

BMO acknowledges that nothing has yet been proven and says no customers were directly affected.

“…This experience has provided some learning that we have applied to further enhance our due diligence,” said a BMO spokesman.

No doubt.

Other lenders’ risk management departments are also likely reviewing their underwriting and closing policies.

AUTOMATED APPRAISALS

One practice this fraud puts under the microscope is that of automated computerized appraisals. Lenders use them to significantly speed up the approval process and reduce costs for consumers. However, Bob Aaron, a Toronto real estate lawyer, suggests automated appraisals may be problematic.

“The banks have been either deliberately or accidentally lulled into believing what the values are – either because they’re sloppy or because they’ve made a conscious decision to ignore values,” he says. He suggests human appraisers may help prevent fraud better than electronic ones.

That may be true in some cases.

On the other hand, tighter margins and fraud potential have made risk management departments more vigilant in the last few years. Their confidence in automated valuation systems (AVSs) comes with good reason. AVSs are highly efficient and they reliably value billions of dollars of real estate every year.

According to insurer representatives we’ve spoken with, automated appraisals are accurate to within +/- 5% of actual value over 99% of the times that they’re relied upon (often they’re not used and a real appraiser is dispatched instead).  Rarely is there a incident of magnitude attributed to AVSs, but when such incidents do make the press, it makes people question them.

MORTGAGE FRAUD IN CANADA

mortgage-fraud-preventionA Criminal Intelligence Service report pegs Canadian mortgage fraud at “hundreds of millions” of dollars per year. The Financial Post says it ranges from $300 million to $1.5 billion. To put that in perspective, that’s roughly 3/100ths to 15/100ths of a percent of all mortgages outstanding.

Apart from prevention measures (i.e.  more detailed documentation reviews, technological safeguards, etc.), the industry would also like to see greater deterrents to mortgage fraud. In fact, CAAMP (the mortgage industry’s trade group,) petitioned the government last year to stiffen penalties for mortgage fraud.

“We suggested the penalties should be tougher for mortgage fraud, that time in prison should be doubled. People should absolutely go to jail,” said CAAMP president, Jim Murphy, to the Globe.

There is no better time than the present (after a major event like BMO’s) to revisit the campaign against mortgage fraudsters. Sights also have to be set on the smaller players. For example, we know that some people in our industry knowingly misrepresent and/or omit key information during the application process. They think it’s no big deal, but it is. The actions of these few diminish trust in our profession by lenders and public, and it hurts all of our reputations. Industry participants who falsify mortgage information need to be dealt with firmly and (when caught) removed from the business permanently.

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Sidebar:

  • Here are more facts on mortgage fraud from the CBA: Link
  • A 2007 report by the FBI suggested 80% of reported mortgage fraud in the U.S. involved industry insiders!
  • Here’s a sample automated appraisal report from MPACexample
  • Here’s a report on automated appraisals from the Appraisal Institute of Canada
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  • You can’t get a mortgage without talking to someone.
  • Online mortgages are an invitation for fraud.
  • You can’t assess mortgage suitability online.
  • Digital signatures aren’t safe.
  • You can’t cross-sell an online mortgage customer.

These are the modern-day urban myths of Canada’s mortgage market. And each quarter that goes by, more smart people develop technology to disprove them.

Alterna Bank is the latest lender to show the industry how it’s done. A few weeks ago the bank launched Canada’s first fully digital “end-to-end” mortgage application.  

It lets borrowers apply for approval, upload their documents and close the mortgage, all online, with zero face-to-face or telephone contact with the lender.

While a few other mortgage providers allow homebuyers to submit mortgage applications online and upload documents, a mortgage specialist must speak to the borrower and walk him or her through the remaining steps. Alterna Bank says its mortgage specialists are still available to help, but live support is purely optional.

That seems diametrically opposed to what some banking executives preach, regarding the importance of cultivating borrower “relationships.” Common wisdom is that one-on-one rapport leads to more referrals and cross-selling (and in most cases it does).

But Alterna believes that relationships are built mainly on a pleasing customer experience, not “selling” the customer. “We’re trying to put people before profit,” says Alterna CEO Rob Paterson. “There is no campaign to try and sell you something [non-mortgage-related at Alterna]. We’re focused on the specific need you have and time you have.”

Alterna Bank Mortgage ApplicationAnd one of those needs is the need for speed, speed of approval. Here’s how Alterna’s app works:

  • Application submission takes 8-15 minutes, says the bank.
  • “We’ve decreased the amount of screens to get you a pre-approval,” says Paterson. “A lot of apps are in the 14-screen area.. We’re around 8-9.”
  • Borrowers receive an instant pre-approval with a 90-day rate hold, conditional on the normal documentation.
  • Alterna keeps the customer informed of every step of the process, via email updates and its online portal.

Alterna’s app was developed by Lendful, a fintech company in which it’s invested millions. In truth, the application seems plain and uninspired compared to the benchmark of e-mortgage interfaces, Quicken’s Rocket Mortgage. But it’s simple and easy to understand, and the process is well automated.

Alterna’s model has some notable facets:

  • Less initial commitment
    • “Most of the big banks force you to give personal details upfront before they’re willing to talk to you about rates and what-if scenarios,” says Paterson. “We reversed it….Come kick the tires with us and use the tools….educate yourself, and then when you’re comfortable with that, then give us personal information and get a pre-approval.”
  • The bank uses OCR (optical character recognition) to speed up data extraction from client-uploaded documents.
    • Human fulfillment officers are still employed to review documentation as necessary.
  • Credit bureaus are pulled automatically when the borrower applies.
  • A “significant percentage” of Alterna’s underwriting is automated based on its approval formulas.
  • Alterna uses all digital signatures.
    • Big props for that. Digital signatures dramatically improve borrower convenience and satisfaction. This is one area where paper-dependent lenders need to wake up and realize what millennium they’re in.
  • The bank uses an “everyday low pricing” policy with its online application to take the haggling out of the rate process.
    • Alterna’s rates are currently quite beatable at 2.68% for a 5-year fixed. This might be a weak link in its model. Its target market—DIY borrowers—are online rate shoppers. Alterna doesn’t yet have the brand or marketing clout of a major bank to convince people that speed and ease is worth a rate premium. That said, Paterson notes that automation “allows us to provide better rates…,” which suggests Alterna could compete more aggressively over time.

The bank’s niche is the DIY mortgage shopper, which Paterson estimates comprises “about 15-20%” of borrowers, a number he says is “definitely going to grow.”

The bank developed this app because “do-it-yourselfers are educating themselves” about mortgages, he says. “They’ve been looking for a digital solution to support their choice of buying online. As people start to use digital applications like Apple pay and Uber, financial services is a natural extension of that.”

DIY borrowers are “time starved” and “very trusting of the digital space,” adds Paterson. Many of them are Millennials, who have a “strong comfort level” making big-ticket purchases online.

He maintains that DIY apps are “not going to eliminate physical branches completely or eliminate the broker channel. Everyone has interaction preferences,” he says. But, “Over the next 5 years, a digital component could be upward of 50% of the mortgage market.”

That will kill jobs in our business, Paterson admits. But it will essentially be a “repurposing [of] the types of jobs in the industry.” Mortgage providers will “still be leveraging people to come up with more technology…”

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Consultation-FB“…Lenders have, as I’ve said in the past, no skin in the game and therefore the incentives are misaligned with good risk management.”

This quote, from CMHC CEO Evan Siddall, encapsulates policy-makers’ narrative on Canadian mortgage underwriting. This is what the public is reading about Canada’s housing market—and it worries them, but it shouldn’t.

(Siddall later told me that he misspoke, and that lenders do have skin in the game, but “not enough.”)

Siddall asserts that lenders are prone to moral hazard. “You would not design an insurance system with the insured having something more at risk.”

He adds, “Canada’s mortgage insurance system is one of very few, if any, insurance systems without a deductible.” He says our housing market is “not a well-designed system,” asserting that “a lender should not offload so much of its risk.”

“This is about aligning interests to face an unknown future with a more ‎robust system. It’s more about regime design, not current conditions.”

And so, he and the Department of Finance have what they think is a solution. After two years of CMHC preparing us for this inevitability, regulators have released a proposal whereby lenders eat more losses on government-guaranteed mortgages.

Here’s what we know about it so far, based on high-level industry conversations and yesterday’s announcement from the Department of Finance (DoF):

  • How risk sharing will likely work: Lenders would file a claim with the insurer when a borrower defaults, the insurer would pay 100% of the lender’s claim (if eligible) and then bill that lender for its share of the loss in the following quarter.
    • This would leave securitization investors insulated from risk, a wise move that avoids utter destruction of the NHA MBS market.
  • How much loss would lenders share: The amount would equal roughly 5% to 10% of the outstanding loan principal. That’s $15,000 to $30,000 on a $300,000 mortgage.
    • We’ll bet on the lower end of that 5-10% range for two reasons: a) Anywhere near 10% would be hugely disruptive for lenders, and b) regulators like to sometimes throw out big numbers so the market is thankful when they impose a smaller number.
  • How would it affect competition: The DoF writes, “Lender risk sharing could change competitive dynamics in the mortgage market.” Could? Whomever drafts this stuff has comedic talent. Reducing insurance coverage will hammer competition even further, potentially costing Canadians hundreds of millions in extra interest each year.
    • Here’s another statement from Friday’s release that might have been drafted by Captain Obvious: “Small lenders with fewer or less cost-competitive funding sources may…be less able than large lenders to absorb or pass on increased costs.”
      (I’m sure some policymakers would suggest we’re making implicit assumptions about the future here; that need not be true. But I don’t see how an RBC and a small monoline lender could possibly weather these changes equally.)
    • Insurers and funders buying mortgages will now have lender counterparty risk (i.e., risk that the lender won’t be able to pay its share of claims). Potential outcomes:
      • Insurers may increase premiums disproportionately for smaller, less capitalized lenders.
      • Funders may buy mortgages from smaller lenders at much less favourable prices, limiting their ability to compete.
    • How might consumers fare: Here’s what we expect:
      • Mortgage rates will shoot up as lenders try to offset this new cost, and as bank challengers become less able to undercut the banks.
      • Lending will partially dry up, or incur material surcharges, in rural, remote, high-unemployment or economically undiversified areas.
      • Insurance premiums may drop (one potential bright spot in all of this).
    • How much could rates jump: In short, meaningfully.
      • The DoF writes, “Preliminary analysis suggests the average increase in lender costs over a five-year period could be 20 to 30 basis points.1 (That’s over five years.)
      • Preliminary estimates from four lenders we spoke with are that the DoF’s estimates are laughably low, that the rate increase required to offset these changes is at least 15-20 basis each year.
      • The DoF suggests rates could rise more for “loans with lower credit scores in a region with historically higher loan losses.”
    • When would this take effect: We’ll get more clarity on this by Tuesday, but the final regs could be out before next summer, and it might take another 1-3 quarters to implement.

 

Is This All Justified?

Canadians are taking on too much debt. No question about it. And extreme housing prices in Toronto and Vancouver are flashing a red alert.

But this proposal isn’t about that. According to the feds, it’s about future underwriting quality and aligning lender incentives.

The government and CMHC charge that lenders don’t have enough reason to avoid risky lending. Yet, to the best of our knowledge, the Department of Finance has never publicly released any data to support this. 

In fact, CMHC’s own numbers peg insured NHA MBS arrears at a paltry 0.28% for banks (five times lower than in the U.S.), and a microscopically low 0.11% for mortgage finance companies (MFCs). 

The Charges Against Lenders

Officials claim that lenders aren’t sufficiently motivated to underwrite prudently, yet the government possesses the ultimate hammer already: It can deny insurance claims if lenders don’t underwrite to the exact specifications the DoF itself has created.

Officials say that lenders can’t be trusted to avoid moral hazard, but the government can easily compel regulated insurers to audit lenders and police underwriting effectiveness. Heck, if they’re not audited enough, audit them more.

Officials assert that arrears data are a “rear-view” indicator, but we’ve had decades of low arrears. How many years of rear-view indication do we need before we can start believing it?

Officials charge that the housing finance system hasn’t been tested yet, but what kind of test was the worst financial crisis since the Great Depression?

Officials warn that debt-to-income is at an all-time high, but lenders must already decline heavily indebted borrowers that don’t meet federal guidelines.

Officials downplay equity as a risk mitigator, but who loses money on a 75% LTV bulk insured mortgage?

Officials argue that MFCs get a free ride on taxpayers’ backs, but Ottawa is riding on lenders’ backs at the same time, through lender-paid insurance premiums, securitization guarantee fees, socioeconomic homeowner benefits and a more robust economy that generates higher tax revenue.

Officials charge that indebted borrowers are a risk to the mortgage system, but credit quality has soared since 2007 with 81% fewer sub-660 credit score borrowers, reports Genworth.

Officials suggest MFCs are “unregulated” and prone to fraud, but you don’t get arrears rates averaging 1 in 300 by turning a blind eye to fraud. (Of course, “unregulated” is a gross mischaracterization since, by virtue of their securitization activities, MFCs are subject to bank and insurer underwriting rules in B-20 and B-21.)

Officials argue that these moves encourage the further development of a private mortgage funding market, but where is this mythical market they speak of, what is Ottawa doing to cultivate it and how will it address the huge spread differences between bank-sponsored covered bonds and uninsured RMBS from lenders without investment grade credit ratings?

Officials say there’s excess risk to the economy, but withdrawing insurance support risks future liquidity crises, surging interest costs, less discretionary spending, employment losses in the economy’s #1 sector, a further entrenched bank oligopoly, falling equity in people’s #1 asset, wealth-loss effects and so much more.

Officials claim government-backed insurers have too much risk, but why not increase insurance premiums like every other insurance company in the world when risk is unacceptable? (Hint: It’s because insurance premiums are already actuarially too expensive for the true risk. That’s a fact by the way—if you believe CMHC’s own regulator-approved stress tests.)


Mandate Creep

The government has overstepped its mandate by stripping Canada’s world-class mortgage finance system of liquidity. Its incessant attacks on competition and mortgage choice can only result in higher costs for consumers, and the purported benefits don’t counterbalance these costs.

Consider taxpayers’ risk:

  • Ottawa guarantees roughly $774 billion of insured mortgages.
  • Arrears have averaged less than 1 in 300 (five times less than south of the border).
  • Average equity on CMHC’s insured mortgages is 46.8% (contrary to public perception, insured mortgages are not all high-ratio) and just 1 in 5 CMHC-insured borrowers currently have less than 20% equity.

Consider taxpayers’ reward:

  • CMHC has returned $20 billion in profit to taxpayers since 2006.
  • Insured lenders have saved consumers over $3 billion of interest in that time frame.

This is a question of cost-benefit, and Finance has simply not made its case. 

Suppose for a moment that Canada’s housing market gets annihilated. Imagine a U.S.-style housing catastrophe where an astronomical 6% of all prime insured mortgages go in arrears, with a 33% loss on each—again, insured mortgages have built-in equity buffers so 33% may not be realistic. That amounts to a $15-billion hit on insurers. (In reality we must assign a probability to a housing crash, so implied future losses are potentially less than this.)

But wait. CMHC alone has $16+ billion in capital plus more in unearned premiums. Moreover, Moody’s research pegs insurer losses in a U.S.-variety crash at less than half our estimate, or $6 billion.

Will a tail event burn through insurers’ capital someday? You bet your sweet bippy it will, just like the most expensive hurricane of all time (Katrina) ate a chunk of Allstate and State Farm’s capital. But you don’t complain about tail events if you’re in the insurance business. You price for them.

So let’s review. The current system has yielded over $23 billion in benefits to Canadian families and, housing armageddon notwithstanding, nothing is coming out of taxpayers’ pockets. 

Are Regulators Pulling the Wool Over Canadians…?

Objective data provides no economic rationale to dismantle what is arguably the most stable housing finance system in the world. Loss sharing is “a solution in search of a problem,” explains First National’s Stephen Smith, and he’s dead on.

Even banks—who could gain on rivals if this rule passes—challenge Ottawa’s rationale. “We don’t understand what a deductible is intended to achieve as a policy outcome,” Canadian Bankers Association policy expert Darren Hannah said. “If it’s supposed to be something to improve the quality of underwriting, well the quality of underwriting is already very strong.”

And, by the way, the government is not proposing “risk sharing” here. It’s proposing “loss sharing.” There’s a difference, because arguing that lenders incur no risk is an uninformed position that ignores their exposure to claims denial, loss of “approved-lender” status, loss of funders, loss of securitization conduits, loss of investors, losses for default management costs, loss of irrecoverable lender-paid conventional insurance premiums and loss of vital renewal and servicing revenue.

Penalizing lenders and consumers will not reduce defaults materially because lenders themselves are not a significant reason why borrowers default. Defaults are a function of unemployment, economic shocks, housing price shocks, overindebtedness, personal disposable income, interest rates, borrower confidence, loan-to-value ratio, loan amount, loan purpose, mortgage age, mortgage term and rate type—most of which can be underwritten for.

If a small group of mostly unelected policy-makers want to nonetheless force Canadians to pay thousands more for a mortgage, at least foster securitization alternatives that alleviate the disproportionate burden on small and mid-size lenders, and preserve consumer savings through competition. 

As it stands, the DoF is picking favourites, issuing press releases embracing competition while simultaneously destroying it, and costing consumers far more than they’ll ever save.

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Sidebar: Yours truly doesn’t purport to be Merlin the Mortgage Policy Wizard and have all the answers. So if you see things differently, give us your take here. Just one humble request, and that is to keep posts civil and supported by fact. We won’t waste readers’ time by publishing comments that are rude or baseless.

Sidebar 2: Special thanks to the class acts on the Department of Finance and CMHC media relations teams. We’ve widely and publicly questioned their organizations’ policy choices but the professional folks over there always cooperate when we need answers.


1 A very rough estimate of the amount rates have fallen due to competition from brokers and insured lenders, and $1.8 trillion in mortgage volume over the past decade. A Bank of Canada study in 2011 found that “the average impact of a mortgage broker is to reduce rates by 17.5 basis points.” This, interestingly, approximates the broker’s advertised savings today (i.e., if you compare the lowest advertised 5-year bank rate, minus 10 bps discretion, and the average rate advertised by 100 of Canada’s most prominent mortgage brokers, as tracked by RateSpy.com).

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Justice FBA few months back, B.C.’s mortgage broker regulator fined and banned Jorawar Singh Gosal from the broker industry for 10 years. Mr. Gosal admitted to doctoring a client’s income documents to get his mortgage approved.

Given Gosal’s admission, we asked FICOM if it had referred his case to the authorities for prosecution (hoping it would say “yes”). Unfortunately, FICOM’s spokesperson couldn’t speak to the specifics of the case, citing legal reasons.

He did say this: “As a matter of course, in any file where there may be potential criminal activity or breaches in other regulatory areas, we refer files to the appropriate agencies, regardless of whether or not they choose to pursue the information.”

So that’s good. We’ll infer that FICOM sent Gosal’s case to law enforcement.

Make no mistake, altering documents to deceive a lender for personal gain is a criminal offence.

According to the Department of Justice:

Subsection 366(1) of the Criminal Code prohibits forgery, which is where a person “makes a false document, knowing it to be false,” with the intent that the document should be acted on as though it was genuine.

Under section 321 of the Code, “false document” is defined to include: a document “that is made by or on behalf of the person who purports to make it but is false in some material particular”. The offence of forgery is complete, where the person who makes it knows it is false, and where they intend that some other person act on the document believing it to be genuine.

Subsection 368(1) prohibits the use of a forged document as though it were genuine. The offences of making a false document and using a false document are both punishable by a maximum of 10 years in prison.

Under section 380 of the Code, fraud comprises two elements: (1) deception or some other form of dishonest conduct, coupled with (2) deprivation or risk of deprivation of another person’s property. Mortgage-related fraud is subject to the Criminal Code and is punishable by a maximum of 14 years in prison, where the value of the fraud was over $5000, and by a maximum of 2 years where the value was less than $5000.

So, given all this, we could assume Gosal was investigated by law enforcement and that they’re taking all appropriate measures. Or can we?

So far there’s been no formal charges laid that we could find in court records. Perhaps it’s just a matter of the criminal investigation needing more time.

Mortgage Fraud_FBWhat we do know is that consent orders are not enough. Document fraud usually gets handled internally in the lending industry, without the benefit of public exposure (which would strengthen deterrence). When it is referred to law enforcement—which by no means happens in the majority of cases—it’s all too often not pursued due to “insufficient resources.” That’s exactly what keeps the back door open for bad apple brokers.

Weasel agents need to be eradicated from our business, not only for the risk they cause lenders and borrowers, but for degrading consumer confidence in our profession. Regulators need to reward whistleblowers, like the OSC now does, and make offenders pay for those rewards.

It’s time to make examples of such embarrassments to our industry. Criminals fear jail time more than a $4,000 fine and a licence ban (which should be a lifetime ban, by the way, not just 10 years).

While we’re on this topic, whatever became of those alleged fraudsters who sent bad paper to Home Trust? Nary a peep about whether any of them were charged. That’s unfortunate. Really…and truly…unfortunate.

 

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Martin_Reid_Home_TrustEarlier in the week we ran an interview with Home Capital Founder Gerald Soloway, who’s retiring this spring. His career accomplishments leave big shoes to fill, and that’s where our next interviewee comes in.

Home Capital’s soon-to-be-CEO Martin Reid is dedicated to boosting the company’s broker market penetration and driving its stock to new highs. But that won’t be without challenges.

We were curious about Martin’s take on some of the risks Home Trust faces, so we asked him about them, and he graciously answered.

Here is that interview:

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CMT: How has last year’s experience with document fraud made Home a better lender?

Martin: While Home Trust has always had a strong risk-management focus, it is fair to say that this incident has served as a catalyst for us to broaden our scope and further strengthen Home for the future. At the same time, we understand that it is critical that we not lose sight of the need to maintain a strong, broker-first focus for which Home has long been known. We feel that the revamped processes we have put in place achieve this balance and we are very pleased with the progress we have made on this front.

CMT: Why are the shorts wrong about Home Capital?

Martin: In my view, the shorts are not just wrong about Home Trust, but they’re missing the mark on the entire Canadian housing sector. Certainly house prices will fluctuate in response to market conditions, but the Canadian housing market is not repeating the experience that led to the U.S. crisis.

One of the leading contributors to the U.S. housing collapse was a dramatic increase in lending to unqualified borrowers. In Canada, mortgage lending may be on the rise, but with the regulatory tightening of the last few years it has been to high quality borrowers who are purchasing properties in an active, robust market that continues to be supported by strong fundamentals.

There are other important differences as well, not the least of which is that in Canada, you cannot simply walk away from your property without suffering significant and long-lasting damage to your credit. Alberta is an exception in this regard, but during the height of the crisis in the U.S., holders of underwater mortgages were handing in their keys in droves. This led to an oversupply of properties adding further downward pressure on prices.

CMT: What is it going to take to knock down the Toronto and Vancouver housing markets, and how do Home’s stress tests suggest it would fare in a 20% correction?

Martin: As long as demand for homes in Toronto and Vancouver continues to significantly outpace supply, we expect prices to continue to rise in these two cities, albeit likely at a slower pace than what we have seen the last couple of years. In fact, in Toronto February results show that sales were up 21 percent while prices rose 15 percent compared to February 2015. Given this level of activity there is no indication that the supply-demand imbalance is set to narrow any time soon. This is especially true of the single family homes.

It is worth noting that while detached units remain in high demand, the luxury condo market in both cities does appear to be over-supplied and this could lead to a levelling or softening of prices. This does not represent a risk to Home Trust as condos represent only about 7% of our business with much of that in townhouse-type condos.

Factoring a 20% correction in prices into our models, we would obviously see an impact on our business but it would not automatically result in a dramatic increase in losses. It might require a slight adjustment to our work priorities around originations and possibly an increase to the collections side of our business. Canadians will typically continue to make their payments even when the value has dropped. Even so, a 20% retracement is highly unlikely in the face of the significant demand for resale properties, and until this demand eases, a correction seems unlikely. What we are more likely to see would be a levelling off of prices in the Toronto and Vancouver markets.

CMT: Where are the biggest growth areas going forward? Is “A” lending, with all the competition, still a promising long-term profit generator?

Martin: Our primary growth area will continue to be our traditional “Alt A” business. We obviously know this segment well and feel there is significant capacity to expand in the coming years as more borrowers find they may no longer qualify for prime mortgages.

Regulatory tightening in the past as well as the Big 6 banks tightening in response to a slower macroeconomic environment will cause more strong quality borrowers to fall short of the lending criteria required by the large banks, hence providing the opportunity for Home.

We also expect to see an increase in the ranks of workers categorized as self-employed, as well as new Canadians with limited Canadian credit history. Both groups have traditionally been under-served by the major financial institutions and for these borrowers we have our Classic mortgage product.

While the “A” side has not been our core focus, it does allow us to offer a full suite of competitive products to the mortgage brokers. In 2015 we launched our “Ace Plus” product that caters to those individuals that just barely miss qualifying for a prime insured mortgage. This is really new territory for Home and we see lots of growth in this product in 2016. We see an opportunity to attract more borrowers who just miss qualifying for an insured mortgage with the banks.

CMT: Thank you, Martin.

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Gerald SolowayIf you look at all the people still in the mortgage business, few have changed the lending landscape like Gerald Soloway.

A former lawyer, Mr. Soloway built a small savings and loan company with 12 employees into Canada’s largest alternative lender with 700+ employees. In the process, he created over $2 billion of shareholder value.

Gerry was a trailblazer in lending to self-employed borrowers and those with meagre credit histories. His Home Capital Group is a testament to the successes possible in non-prime lending.

We were thankful to have a few minutes of Gerry’s time last week for some Q&A. He shared thoughts on industry regulation, Home’s risk-management improvements and the changes brokers can expect in the years to come.

Here is that interview…

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CMT:  Gerry, it’s been almost three decades since you started Home Trust. If you had to look back and pick the two or three biggest changes you’ve seen in the mortgage industry since then, what would they be?

Gerry:  There have been many changes to the mortgage industry over the years, but if I were to narrow it down to just a handful of the events that I believe have had the greatest impact, I would say it is the tremendous increase in the use of mortgage brokers. As more borrowers discover the benefits of working with a mortgage broker, I expect we will see an even greater number of individuals bypassing their financial institution in favour of dealing with a broker.

This rise in the use of brokers goes hand-in-hand with the increase in the number of responsible borrowers who, despite having an adequate down payment, and who have the ability to manage their payments, still get turned down by the major banks. These individuals deserve greater consideration and this is where mortgage brokers working with lenders like Home Trust provide an invaluable service.

It goes without saying that there has been tremendous regulatory change in the 30 years that I’ve been in the business and there is little doubt that more changes are coming to our industry. I see this as an opportunity for the broker community as borrowers will need the specialized services and knowledge of a mortgage broker to help them navigate the requirements.

And of course, I must mention the extremely low benchmark interest rates and the effect this has had on the industry for close to a decade now. I know there are many out there that are too young to remember the sky-high rates of the early 1980s, but it was not all that long ago that rates touched 20% and remained in the double digits through the 80s and well into the 90s.

CMT:  Why was now the right time to retire as CEO?

Gerry:  I would have thought that for someone approaching their 78th birthday this summer, that it would not be any great surprise to be contemplating retirement. My wife of 56 years and I are both in good health and it just seems that now is a good time to not be working full time.

This decision was very easy to make knowing that Home Trust is in good hands with Martin Reid at the helm supported by an extraordinary team of talented professionals. Martin has been president for six years and both the board of directors and I have the greatest confidence that he will lead the company to even greater success in the coming years.

Of course, I’m not retiring entirely; I will have the opportunity to continue to serve Home as a director and I am looking forward to working closely with the board and the senior management team.

CMT:  In hindsight, what would you have done differently to mitigate the fraudulent applications sent to Home Trust in 2014-2015?

We do acknowledge that the issue with the suspended brokers highlighted a need to improve our process around income verification. Although our practices at the time were consistent with industry standards and requirements, this event has underscored the importance of continually reviewing and evaluating risk-management controls.

Risk management is critical to our business and Home Trust has always had well-defined protocols in place. We have been particularly diligent in our appraisal process and we use a group of outside appraisers who have proven themselves to be very careful and accurate in their evaluations. We also have our own in-house appraisers who review this work and on the rare occasion where there is any concern regarding the accuracy of the original appraisal, one of our Home Trust appraisers will conduct a follow-up.

As part of our credit check on all applicants, we pull credit bureau reports directly so we can ensure that all borrowers have a solid credit history. This is also a critical step in validating the credit worthiness and background of  all our borrowers.

As a result of this experience, we have since enhanced our processes and strengthened controls including the direct confirmation of income before advancing the mortgage on all applications. I believe it’s worth mentioning that our response to this situation was widely supported by the broker community.

CMT:  What’s your prediction for how industry competition will evolve by 2020?

Gerry:  I expect there will be a number of changes in the industry over the next few years but these are really just a continuation of the events we are seeing now. I strongly believe that the number of clients requiring the services of a mortgage broker will continue to increase in the years ahead. This will be due largely to the regulatory changes that have tightened the lending criteria thereby making it more difficult for individuals to qualify for an insured mortgage.

In fact, I think it is entirely possible that requirements for insured loans could see a further tightening. I would not be surprised to see the minimum 10% down payment now required on the portion of the price exceeding $500,000 to be extended to the full price of the property.

Because of the regulatory burdens placed on regulated deposit-taking lenders, I do not anticipate an increase in the number of regulated lenders; in fact, there may well be a consolidation in the numbers as small companies may find it too difficult to be profitable on a small-scale basis. This was precisely what led to Home Capital’s purchase of CFF Bank last year and we are well on the way to fully integrating CFF Bank into Home’s operations.

Finally, it is a certainty that the Internet will continue to play an increasing role in our industry. The ease with which lenders and brokers can connect and transfer information has revolutionized the way we manage our business and has led to a dramatic increase in efficiencies. Home Trust continues to leverage these technologies with the development of tools like our new online broker portal, Loft, which greatly improves the ease with which our team interacts with the broker community. Of course, nothing will ever replace the personalized service and the individual relationships we have developed over the years.

CMT:  Many thanks, Gerry.


Coming Soon: CMT will feature its chat with Martin Reid, Home Capital’s upcoming CEO, later this week.

 

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Mortgage Fraud_FBIt’s been a tough nine months in the press for mortgage brokers. Off the top of my head, I can think of four headline stories of broker fraud in the major media, including one of the whoppers of all time, the Home Trust fiasco.

And now, Canadian Press (CP) has added more tales of broker malfeasance to the public spotlight. (See them here if you haven’t already.) Since most people remember bad more than good, stories like this stay in the nooks of our psyche. That influences some—even if subconsciously—to choose non-broker mortgage providers.

What gets lost in this shuffle are the numbers. As CP writes, FSCO received 91 broker complaints in 2014-2015. That’s less than 1 in 100 brokers, assuming it includes agents too. From recent headlines, you’d think it’s more like 1 in 10.

Even 1 in 100 is unacceptable, of course, but we can’t imagine it’s far worse than certain other professions. The Law Society of Upper Canada—which regulates lawyers in Ontario—fielded 6,155 complaints about law professionals in its most recently reported year of 2014.

There’s not a service industry on God’s green earth that doesn’t generate complaints or have bad actors. What matters here is that the public is protected as well as can be practical, and the tiny slice of shady operators not be allowed to tarnish the hard work of Canada’s 10,000+ dedicated full-time agents.

It’s unfortunate that CP’s article hints that broker fraud is near-epidemic without comparing complainant trends. In the latest reported year in Ontario, broker, agent and brokerage complaints were down from the prior year.

Moreover, many of the headline scandals we’ve seen as of late relate to brokers who sell bad mortgage investments to unsuspecting consumers. That’s not the business brokers are in, by and large. This minute exception is painting the rest of us with a tar-coloured brush. More severe penalties and regulatory oversight in the area of mortgage investment referrals might go a long way.