Portfolio manager says funding in the worst corner of the market will disappear, leaving investors stranded and facing big losses
Dustin Van Der Hout warned investors off Private Mortgage Investment Corps back in August 2017. His alarm bell has now reached fever pitch after the COVID-19 pandemic ravaged markets and left investors exposed to what he believes are the structural flaws and high cost of poor quality private MICs.
The Richardson GMP portfolio manager authored an article three years ago that raised concerns at the “less regulated, less scrutinized and more opaque world” of Private MICs. Among them were liquidity mis-matches between investors and loans; the result of people being rejected by banks and large alternative lenders such as Atrium or Home Capital. This is compounded, he argued back then, by high collateral valuations and extreme household leverage levels.
He said MICs “play a dangerous game”. Typically short duration and high-yield mortgages, they are required to pay out 100% of their income as distributions to investors, which allows them to avoid corporate taxes. Van Der Hout explained that the illiquid and short-term nature of their loans are not required to be “marked-to-market’, allowing them to maintain a constant NAV, assuming that interest income exceeds expense and losses.
Herein lies the danger, which has been highlighted by the recent downturn. MICs are not allowed to reinvest their earnings and are, therefore, dependent on new investor dollars to grow. A decrease in distributions acts as a warning sign and could result in redemption requests. To avoid this, low quality ones may choose to buy riskier mortgages or – big alarm bell! – dip into new investors’ funds to maintain the yield.
Van Der Hout said three years ago that this was a “slippery slope” and now, amid a global pandemic that has triggered a recession, he told WP the majority of what was mentioned in the original article has happened.
He said: “Almost every single private mortgage in Canada is now frozen. And the ones that aren't, should be. Every single security in the world went down about 30% in March in April, including the best real estate in Canada. Then I look at RioCan and SmartCentres REIT and they’re down 40-50%. Even the best real estate in Canada is down a lot.
“Any mortgage investment corp that is closed has no way to value what they have. Every asset in the world is worth less than it was two months ago, so if you're still open for redemption, anybody who's getting out at par or the current value is stealing from clients who remain in the fund.”
Van Der Hout believes two imbalances in MICs have been exposed by the market downturn. Firstly, that people went into this investment thinking it was liquid, which is not the case when redemptions are halted, and, secondly, that a lot of these funds are poor credit.
While careful not to paint all MICs or private loans with the same brush, he believes that in a lot of cases, they're “garbage”. “When you own the worst quality stuff, and you go through a recession, which we're in, the worst stuff is going to do the worst.”
In a recent National Post article, Evan Siddall, president and CEO of the Canada Mortgage and Housing Corporation (CMHC), said the country could see claims from defaulted mortgages reach $9 billion as a result of the coronavirus. As many as 20% of mortgages could go into arrears if the economic situation in Canada does not improve, Siddall added, and real estate will go down by 9-18% over the next 12 months.
Van Der Hout said: “That’s the quality stuff, right? That’s the good stuff – we’re talking about the bad stuff here!”
The issue comes down to who will roll over the loan? If you have a mortgage with a bank, it’s in the bank’s interest to make it work. But if you’ve been refused by them, and large publicly traded real estate players have also waved you away, you're left with a mortgage no one will take on in this risky environment.
“Anybody who used to want to lend to someone in a high-risk neighbourhood is now like, ‘whoa, whoa … the coronavirus is out there … I understand risk now … we're not in a market that's going up 10% a year, we're in a dropping market where people are fearful. Funding at the worst corner of the market is going to disappear and because investors are asking for the money back, they'll just have a much more difficult time rolling over that mortgage, because there's no investors lining up to buy these low-quality mortgages.”
Part of the allure of private MICs is the promise of greater income compared to flagging GICs and bonds. Of course, with a higher rate of return comes more risk but when mortgage funds are paying 8%, Van Der Hout said that investors are really taking on more risk once management fees and transactional costs are factored in. The real cost to the borrower, therefore, may actually be 12-14% of risk.
For those investors locked up in one of these funds, the future of your money is now out of your hands and dependent on whether they open back up. If the quality of the MIC was good enough, the investor will “take a haircut” and, in the big picture of having taken 8% for a number of years, take a 10-15% hit on the chin. Van Der Hout's concern is that many investors who allocated too much to their portfolio will be hit with much bigger losses.
He said: “We'll see who has the quality. Some of these funds will do great but my guess is that there's a very large percentage of them that held garbage and are going to perform like garbage.”
He added: “A lot of these mortgage funds are going to say, ‘well, it was the coronavirus’. To me, that's not the story. The story is the economy ebbs and flows and you always end up hitting a turbulent, difficult time. This shouldn't be people blaming it on COVID-19; this is what happens when you own poor quality through the top part of the cycle.”