Retail investors may be unwittingly taking on risks by investing in mortgage investment corporations (MICs), warns Toronto-based Hamilton Capital Partners Inc.
In a new letter to investors, the boutique investment firm notes that, in the ultra-low interest rate environment, high yielding MICs have become a popular product among retail investors. However, after reviewing some of these vehicles, it warns investors about the risks of these products.
“What we found behind these high yield products was concerning to us, particularly given the potential for a generalist investor to significantly underestimate the actual credit risk of certain MICs,” it says.
It points to a couple of ways in which investors could underestimate those risks. For one, it suggests that many investors may believe MIC portfolios are dominated by lower risk, owner-occupied, residential mortgages due to legislated minimum requirements on residential content. “However, for some MICs we found, the ‘residential’ content was primarily, if not exclusively, higher risk residential construction/development loans, including the riskiest category of all – undeveloped land,” it says.
Additionally, it says that many investors may overestimate the protection offered by a ‘low’ loan-to-value ratio. “It is not sufficient for investors to accept the safety of a MIC’s yield based on this metric, which in many instances incorporates a significant number of subjective assumptions,” it says.
Overall, Hamilton Capital reports that, for some of the MICs it reviewed, “the risk profile of the underlying mortgage portfolios skewed overwhelmingly to higher credit risk, be it through significant exposure to the most risky loan categories, excessive concentration in individual names/geographies, and/or subordinated collateral positions. This was particularly true for those MICs with outsized exposure to construction and land development.”
The letter stresses that the most important lesson learned from the last U.S. credit cycle was that construction/land/development loans, “stand out as having a dramatically higher risk profile than all other mortgages/real estate loans (even subprime).” And, it notes that many of the MICs it reviewed had “excessive exposure” to these sorts of loans, which supports the higher yields.
It can be hard to assess some of these risks in a rising housing market, it notes. But, if Canadian home prices decline materially, it says, “the consequences for all real estate lenders, including mortgage investment corporations, is likely to be negative as losses emerge; the question will be how much.”