Expert sheds light on 'misaligned incentives' and underappreciated risks in Canadian alternative credit space
While Ben Rabidoux has a reputation as a critic of Canada’s mortgage-related investment space because of his work over the past 10 years or so, he is not out to cast any broad-brush aspersions.
“I have some long-time friends in the space that I think are extremely good underwriters, and I have invested alongside them,” the president of North Cove Advisors told Wealth Professional. “But there are a lot of fly-by-night operators out there, and my concern with the private lending space is that there can be these misaligned incentive structures between the investors and the investment management team.”
If ever there was a commentator qualified to allege that, it would be Rabidoux, who will share his insights during Thursday's virtual WP Advisor Connect: The Rise of Alternative Investments event. The event is free for advisors and features a lively and informative agenda.
Rabidoux's company, a subscription-based intelligence service catering to institutional investors, provides high-level economic commentary that draws heavily from obscure but very relevant data sources. That’s overlaid with information obtained directly from realtors, housing developers, and other sources of on-the-ground insight on trends that could move the needle on the macroeconomic front as well as credit performance at large financial institutions.
“Every now and then, I'll pick up and follow a thread where a particular lender might have gotten aggressive on a credit product, or potentially is doing something fraudulent or somewhat untoward,” he said. “Eventually you discover that there’s probably a real theme here. There’s a lot of smoke and potentially a fire, and I deliver a lot of value to clients by warning them about it.”
Rabidoux has had a fairly good track record of sounding the alarm on idiosyncratic credit blow-ups in Canada’s lending ecosystem. That includes the syndicated-mortgage space, where he saw clear signs of aggressive representations that pushed the limits of reasonable assumptions. His criticisms led to a lawsuit from Fortress Real Developments Inc., which was dismissed under SLAPP suit legislation; even with the expedited dismissal, the case cost Rabidoux six figures in legal fees that he has yet to recoup.
Earlier this month, the Financial Services Regulatory Authority of Ontario (FSRA) ordered Fortress to pay $250,000 in administrative penalties for its role in promoting untenable investments that cost thousands of retirees their life savings.
“It took a full-on blow-up of a lot of their projects and a lot of lost investor funds before people really clued in,” Rabidoux said. “I actually put the story in front of a major newspaper with a dedicated real-estate investigative arm back in 2014, and they said they didn’t want to touch it because of the litigation risk.”
The clout that companies can wield with an army of lawyers, he said, has a chilling effect on both the fourth estate and critics who might hold them accountable for illicit behaviour. And while investors might expect offerings that promise rich returns on the order of 8% to have already been scrutinized by regulators, Rabidoux’s experience suggests even that shouldn’t be taken for granted.
“You assume that regulators are doing their own due diligence and operating to protect the investors, but they're not,” he said. “My experience is you can put a case on a platter for them, but you can’t expect them to act on it … They’ve put in all these safety protocols and better disclosure rules after all the investors were absolutely destroyed on this.”
Even in the broader credit intermediation and mortgage brokering space, Rabidoux said, a climate of bad behaviour persists because of Canada’s inadequate system of penalties. The vast majority of fines dispensed, he said, are administrative penalties that amount to a small fraction of the commissions bad actors reap. That creates an incentive for brokers to push the boundaries, as well as for management to plead ignorance and look the other way.
It’s with that in mind that he urges investors to be cautious when it comes to today’s markets for private lending and mortgage investment corporations (MICs). Based on conversations with his mortgage contacts, he has the sense that the space is attracting a lot of retail capital amid a dramatic search for yield.
“These mortgage investment corporations have delivered very high returns with low losses for a lot of years, which is a reflection of the underlying housing cycle they operated in,” Rabidoux said. “A lot of MICs that have sprung up in the last 10 years have never seen a housing cycle, and have taken on this dramatic reach for yield. Some of the more popular ones have taken to funding second and third mortgages because of the higher yields, with the investors not fully understanding the repercussions in the event that those mortgages go delinquent.”
In his review of MICs, he’s found many instances where the principals don’t provision for potential credit losses, which are viewed as a drag on returns. Ideally, when a second mortgage goes into default, the second mortgage lender would pay off the first mortgage or at least pay to keep it current such that they can control the power of sale or foreclosure process. If they don’t do that, Rabidoux said, the first mortgage holder accrues all fees and missed payments ahead of them.
“Not only that, you’re incentivized to deal with the property quickly, which may not be in the best interest of the second mortgage holder,” he said. “These MICs that skew heavily toward these second mortgages that hold no capital, they stand to get absolutely obliterated when the economic cycle turns.”
And while retirees may be advised that MICs are not liquid investments, they may not fully appreciate the repercussions of that type of liquidity risk, including the possibility of losing their rights to redeem funds invested under stressed market conditions. And because they don’t look at the assets within the portfolio, a lot of investors in MICs end up putting their hard-earned money in non-performing assets that a charitable person would say were misappraised.
“I want to be clear that not all mortgage investment corporations are made equal,” he said. “I've personally met with founders of some very large, very well established, very conservative MICs that are lending in first position, with very conservative loan values on highly marketable, relatively liquid real estate in big city centres. … The returns on those investments can make a lot of sense given their risk.
“But there's still a lot of stuff happening in the mortgage space that I am not comfortable with,” he continued. “If I were an advisor to a retail client, I would want to take a serious look at what's in the portfolio of some of these MICs before I had my clients put their money into them.”
Ben Rabidoux will share more of his thoughts and insights during WP Advisor Connect: The Rise of Alternative Investments, a free-to-attend live virtual event for advisors to be held this September 24. Those interested to register may click here.