Meet XCEED, Another Canadian Alternative Lender
Another Canadian alternative lender of note is Xceed, a subsidiary of MCAN. Xceed offers insured and uninsured mortgages, with characteristics such as minimum credit scores as low as 500, and LTVs of up to 90% with secondary financing as described in the advert for brokers below:
These X-Series loans were introduced by Xceed after it was purchased by MCAN in 2013, with the ultimate goal of generating deals for the insured side, according to Micheal Misener, then VP and CIO of MCAN. (3) Note that Mr. Misener left MCAN in Q2 of 2016, take note of that timing.
MCAN Single Family Origination Explode, then Collapse
MCAN's single family mortgage origination numbers between 2013 and 2017 is shown in the chart below:
MCAN acquired Xceed in Q1 2013, and you can see the expected bump single family originations in the following quarter. Originations were then roughly flat until Q3 2014 when they exploded, then peaked in Q3 2015 before falling back to 2013 levels in 2016. Management attributed the growth in origination starting in 2014 as Xceed outperforming expectations, but the following collapse in 2016 was attributed to a new underwriting system and software upgrade. Management indicated that origination growth would resume after the new system was implemented, but instead origination collapsed further in Q1 2017, to levels not seen since BEFORE Xceed was acquired. MCAN's Q1 2016 report provides the following insight:
It appears that after implementing the new mortgage underwriting system, Xceed was finding and declining a significant amount of business that did not meet their underwriting standards. Just how much business was declined? Management doesn't say, but for context, at the peak in Q3 2015 over $200 million in mortgages were originated, while in Q1 2017 that number fell to under $17 million. That's pretty significant considering in 2015 MCAN expressed a desire to GROW the Xceed business.
While the patterns observed in MCAN's Xceed business are interesting on their own, when one steps back and looks those patterns in the context of what was happening in the broader Canadian alternative lending space, and specifically at Home Capital, during this time another picture is painted.
MCAN and Home Capital Group, a timeline
A timeline of events for Home Capital Groups was sourced from the Globe and Mail (4) and compared to events at MCAN. In late 2015, HCG publicly disclosed mortgage fraud in it's broker channels, coincidentally MCAN single family origination peaked around this time. The drop in originations at MCAN began in earnest in Q1 2016 and was blamed on a new underwriting system and software upgrades. A bunch of red flags then appear at MCAN in 2016 Q3 including the disclosure of a new risk related to accuracy and completeness of borrower information and the departure of a key executive who oversaw Xceed.
2013 Q1
- MCAN aquires Xceed, an alternative lender in Canada
2014 Q3
- Home Capital Group “became aware of irregularities” associated with certain mortgage applications and launches an investigation.
- Sudden growth noted at MCAN, credited to Xceed
2015 Q1
- HCG files annual financial statements for 2014 and blames a decline in mortgage originations on “external vagaries such as macroeconomics, seasonality and competitive markets,” according to the OSC
2015 Q3
- HCG publically discloses fraud in broker channels
- Mortgage originations at MCAN peak
2016 Q1
- MCAN originations start to decline, new underwriting systems blamed
2016 Q3
- Micheal Misener, VP and CIO who oversaw the Xceed business, leaves MCAN
- MCAN adds a new risk to it's disclosure concerning the accuracy of borrower information
2017 Q1
- HCG terminates CEO Martin Reid.
- Originations at MCAN collapse further, declines blamed on new rules in underwriting software
- HCG discloses that the OSC served several current and former executives with enforcement notices concerning disclosure
Based on the timing of these events, it seems possible that some of the business terminated by Home Capital found it's way over to Xceed and provided for some of the explosive growth noted in that business. When the fraud at HCG was discovered, MCAN may have started to investigate it's own channels, and it's likely they found problems based how much business was declined after.
Trouble Brewing in Insured Mortgages?
Recall that MCAN purchased Xceed with the stated purpose of generating deals on the insured side. Those insured mortgages are securitized, sold, and moved off the balance sheet. It's difficult to track where these types of products end up, but they are frequently purchased by other financial institutions such as banks, insurance companies, and MICs. Banks and insurance companies are complex businesses and it's difficult to see how specific products in their portfolio are performing, but we can look at publicly traded MIC's. That data from Eclipse MIC, a public MIC is revealing:
A significant number of recently issued insured mortgages appear to be going into arrears. Note that these are likely not Xceed originated mortgages, and this information is shown only to demonstrate the possibility of a wider problem in the insured mortgage market.
Who's On the Hook?
It's tough to say where these losses will end up. One would think the mortgage insurance companies, are going to end up with elevated losses, but in the case that systemic origination fraud is discovered coverage might be declined. If losses are large enough the private mortgage insurance companies may find themselves in a difficult situation, leaving the MICs on the hook.
Disclosure: While this post should not be taken as investment advice, the author has modest short positions in both HCG and MKS. HCG is a high conviction short, while MKS is a much lower conviction call as the company does not appear to have the same funding vulnerabilities as HCG and the Xceed portion of their business represents only a portion of the companies value. Shorting MKS would be a bet on contagion from HCG spreading to other lenders.
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