Refer to Theory in Practice 3.1, concerning Home Capital Group (HC), describing the issues faced by HC following public revelation of problems with its high-risk mortgage portfolio and its failure to disclose.

Required

a. As noted in the vignette, HC 's share price fell significantly when its mortgage problems were revealed. Share price also fell when HC obtained its $2 billion line of credit from an Ontario pension fund at a very high rate of interest. In addition, while not reported in the vignette, share price rose following the settlement of the OSC investigation. Other important events, however, received no significant market reaction. For example, there was little reaction in May 2017. when HC suspended its dividend, and announced prestigious new directors. The appointment of a new CEO in July 2017 also drew little market reaction.

Are the share price reactions and non-reactions to these various events consistent with efficient securities market theory? Explain why or why not.

b . Warren Buffet's Berkshire Hathaway paid $9.55 per share for nearly 20 percent of HC's equity. Just before the purchase HC's share price was $15.42. Yet, share price quickly rose to $16.65 following the purchase, with a further increase to $19.00 the next day. Why did Warren Buffett receive this discount? Was the subsequent rise of share price to $19.00 consistent with efficient securities market theory? Explain.

Theory in Practice 3.1

The potentially serious consequences of violating MD&A requirements are illustrated by the case of Home Capital Group.¹⁶

Home Capital Group (HC) is a large Canadian financial services company, offering mortgage lending and other financial products, such as deposits and guaranteed investment certificates. High-risk mortgages are a large component of its business. These are granted to individuals who have insufficient credit standing to borrow from more demanding sources, such as banks.

HC's mortgages were arranged by mortgage brokers, not by HC itself, and were then submitted to HC for approval. However, for a number of years, some brokers submitted false borrower income information, which HC became aware of only in June 2014. As a result, in addition to terminating 45 offending brokers, HC implemented time-consuming new controls over its processing of mortgage applications. The result was a decrease in the number of new mortgages issued by HC, raising questions in the marketplace about the declining business. In the MD&A of its 2014 annual report, HC attributed the decrease to economic factors and strong competition, with no mention of the fraudulent brokers.

In June 2015, a whistleblower reported the fraud to the HC Board of Directors audit committee. The report was quickly reported by HC to the Ontario Securities Commission and publicly announced. HC's share price fell by almost 20 percent.

HC's troubles quickly expanded. Its three most senior executives either resigned or were fired. In 2017, the OSC announced an investigation, alleging these persons had certified financial statements that contained materially false information. In a subsequent settlement, HC paid $30 million, the former CEO received a fine of $1 million and was banned from acting as director and officer of any public company for 4 years. The former CFO and Treasurer each received fines of $500,000 and were banned for 2 years.

Even more serious, investor confidence in the integrity of HC fell, and investors withdrew about 95 percent of their high-interest deposits and stopped buying its GICs. These withdrawals seriously reduced HC's ability to grant new mortgages. It seemed that HC might become insolvent, but in April2017, it was able to arrange a $2 billion line of credit from an  Ontario pension fund, although at a very high rate of interest. The market interpreted this line of credit as bad news, and HC's share price fell by 60 percent. However, armed with new senior officers and with prestigious new directors added to its Board, in June 2017 HC obtained a $2 billion loan from Warren Buffett's Berkshire Hathaway Inc. on much better terms. Berkshire also bought a 20 percent (approx.) interest in HC, at a price of $9.55 per common share. Share price quickly rose to $16.65 on the Toronto Stock Exchange and to $19.00 the next day.17

Thus, HC survived this catastrophe. Still, the sequence of events must have seemed eerily familiar to investors who had lived through the 2007-2008 market meltdowns in the U. S. (Section 1.3). Housing markets in Toronto and Vancouver were extremely active and, in the view of many, in bubble territory. Now a major financial institution was brought to its knees by lax mortgage lending practices. Indeed, investor concerns arose that HC's lack of transparency could exist in other financial institutions. For example, the share price of HC's major competitor fell by 25 percent, and that firm also obtained a $2 billion line of credit to protect itself in case the unease spread. Furthermore, Moody's Investor Service downgraded the debt of major Canadian banks shortly after HC obtained its initial line of credit in April 2017.

However, existing Canadian regulations contained the potential crisis without further apparent government interference. For example, most Canadian provinces do not allow a homeowner to simply walk away from a house when its value is less than its mortgage. Other assets of the homeowner can be seized for amounts owing. Also, strict regulations to obtain a mortgage are in place, such as minimum down payments and limitations on the length of amortization periods. Regulations such as these reduce the likelihood of mortgage default and increase investor trust in the financial system, suggesting that the lessons of the 2007-2008 market meltdowns have not been forgotten.

Nevertheless, these events illustrate the power of information (in this case, the lack of it) and how failures of full disclosure can have widespread effects.