Somewhere on Bay Street, Gordon Nixon is enjoying a moment of schadenfreude at the expense of BMO Nesbitt Burns.
Mr. Nixon, chief executive officer of Royal Bank of Canada, knows what a rotten business it is selling mortgages in the United States, the land of easy credit and easier refinancing terms. RBC's U.S. mortgage division had a terrible time in 2003 and 2004 and caused him no end of grief, until the bank finally sold it this spring.
Now the Nesbitt folks are learning all about it, from a different angle. Their investment bankers delivered to the market FMF Capital Group, the U.S. mortgage lender that's just set a land-speed record for Fastest Blowup by an Income Trust. Taken public at $10 in March, the shares can be found on the sale rack at your local Buck-or-Two Shop, priced at 85 cents after last week's decision to suspend distributions.
Sources say the Ontario Securities Commission has started collecting information from the six brokerage firms in the underwriting syndicate. It's not a full-blown investigation, and perhaps nothing will come of it, other than some richly deserved embarrassment for Nesbitt and a cautionary tale for investors.
FMF, for those who managed to sidestep the shrapnel and don't know the company, is in the mortgage-origination business. It sounds very safe and boring, but in the U.S., it's not. FMF's business model is to find people who need money to buy a home, then sell those loans to other investors at a profit, usually within 35 days. Most of its business is so-called "sub-prime" mortgages -- generally, borrowers with poorer credit. It operates in 38 states.
Naturally, then, when it came time to go public, FMF looked to the Toronto Stock Exchange as the best place. FMF may not have any executives, customers or offices here, but it is based in Southfield, Mich., and isn't Michigan right on the border with Canada? You can see the logic.
What our country does have is a group of yield-crazed investors and investment banks willing to cater to them. So out the door went FMF units, promising an 11-per-cent yield that was as solid as Jell-O.
In fairness to the underwriters, they warned us. The risks are in the prospectus, starting on page 122. The clearest relevant one is interest rates, which hit the company in a couple of ways. If rates rise before FMF can sell the loan, the mortgage becomes less valuable when it's sold. Higher rates also deter people from buying homes or refinancing their existing mortgages, which cuts into the company's origination fees. An investment on FMF was really a bet on interest rates falling even lower.
FMF's business has another, less obvious risk. In some cases, the institutions that buy its mortgages can send them back -- if, for example, the borrowers default in the first three months. (Early defaults were part of the reason for the distribution cut.) FMF is on the hook even when its customers lie. That's right: "Whether the mortgage loan applicant, the mortgage broker . . . or one of FMF Capital's employees makes a misrepresentation, FMF Capital generally bears the risk of loss . . . ."
Like we said: it's a brutal business. But you wouldn't have known it by the presentation FMF and Nesbitt pitched to investors during the pre-IPO road show, a copy of which we've obtained. One of the graphs, which shows a history of rapidly rising mortgage deals, is titled, "Predictable results."
At the end, they give a helpful list of "comparable income funds." One is DirectCash, which operates automated teller machines and debit terminals. Another is Royal LePage Franchise Services, which charges fees to a network of real estate agents. Curious choices, no? Nesbitt, though, has turtled, refusing to discuss FMF.
A more relevant peer group for FMF might have been U.S. mortgage REITs -- but then, that might have made the IPO a harder sell. Mortgage REITs have a long and miserable history of volatility, driven by swings in the interest rate cycle (see chart). FMF should never have been a Canadian income trust, which is why some of the biggest dealers wouldn't touch it. One no-show: RBC Dominion Securities. Who says bankers never learn?
© The Globe and Mail
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