I first read an article about Canada’s housing bubble back in late 2009, during my former life as a tracker of investment newsletter performance at The Hulbert Financial Digest.

While perusing a kitchen-table publication called The Contrarian’s View, whose candid editor once cautioned that he’s a rotten stockpicker, I encountered an excerpt from an article that had originally been published on a popular blog called Mish’s Global Economic Trend Analysis.

At that time, we were all still reeling from the collapse in the U.S. housing market and eager to extrapolate that experience to high-flying housing markets in other countries. Misery loves company, after all.

Anyway, the aforementioned excerpt showed a listing for a modest mid-century fixer-upper in Vancouver that was listed for C$1.05 million, or around US$997,000 at the time.

The sad-looking house in that ad, which noted “house is livable” and that the basement had been subdivided into three bedrooms, was all too reminiscent of what had happened in the U.S. just three years earlier, when similarly sad-looking houses in need of TLC were being listed for upwards of $500,000 in the less-fashionable areas of the D.C. suburbs (in other words, my milieu).

However, this listing showed that the price for such a property in Vancouver was roughly double that of what I had previously considered excessive in the D.C. area.

The blog’s proprietor, Mike “Mish” Shedlock, warned that prices on such properties would eventually crash 75% or more. And based on that listing alone, I was ready to believe that the implosion was imminent.

But here we are more than seven years later, and the debate between those warning of a hard landing in Canada’s real estate market and those hoping for a soft landing continues.

Meanwhile, the price of Canadian real estate has continued to rise, even as policymakers have made significant efforts to dampen demand.

The average single-family home now costs C$1.5 million in Vancouver, while the average home price in Toronto is nearly C$917,000. And those are just the averages across the metro areas. In the actual cities, prices are significantly higher.

The First Cracks?

However, Canada’s housing market may have just had its New Century Financial moment. At least, that’s what the cynics are saying.  

For those who don’t remember, New Century was the first major U.S. subprime lender to blow up during the period leading up to the Global Financial Crisis.

As borrowers began to default on their New Century-originated mortgages in late 2006, the mortgage lender’s own sources of capital began to dry up, culminating in the firm’s death spiral during the spring of 2007.

But the situation in Canada is markedly different. Indeed, it’s almost stereotypically Canadian because so far it does not actually involve borrowers defaulting on their loans, but rather a breach of regulatory decorum.

The company in question, Home Capital Group Inc. (TSX: HCG, OTC: HMCBF), is one of Canada’s largest alternative lenders and is known colloquially among mortgage brokers as “the lender of last resort.” Borrowers in the alternative mortgage category are typically self-employed, new immigrants, or small business owners—the riskier credits that the country’s Big Six won’t touch.

Home Capital’s problems began in early 2015, when the board was tipped off that certain members of the company’s outside broker network had been falsifying borrowers’ income statements.

In response, the firm initiated a six-month investigation that prompted it to terminate its relationship with 45 brokers, as well as fire a handful of employees on its in-house underwriting team.

The company also identified the relatively small subset of mortgages that were originated under questionable circumstances and flagged them for close monitoring. And it made its underwriting process much more stringent.

These steps subsequently led to a substantial decline in lending volume. Instead of immediately disclosing the situation to investors, Home Capital’s executives blamed the first quarter’s results on seasonal factors.

Only during the following quarter’s earnings call, which occurred after the company completed its internal investigation, did management finally acknowledge the real situation—a lag of about five months. At the time of that revelation, Home Capital’s share price plunged sharply, but then later recovered.

Fast-forward almost two years, and the Ontario Securities Commission decided that the company did not properly fulfill its responsibilities for disclosing the situation to investors. We agree.

With three current and former longtime executives under investigation for temporarily hiding fraudulent mortgage activity, Home Capital’s share price has plummeted and is now down more than 80% over the trailing year.

With access to capital quickly disappearing, the company was able to secure a crucial C$2 billion emergency line of credit to remain operating, though the loan was obtained on onerous terms (the effective interest rate is 22.5%).

Nevertheless, it seems unlikely that Home Capital can remain a going concern for long. Odds are it will end up selling off its $18 billion mortgage book to other lenders.

Most alarming, perhaps, is the fact that Home Capital’s financial straits precipitated a run on the company’s banking operations, with customers having redeemed about C$1.6 billion of high-interest deposits over the past month, reducing the company’s balance to just C$391 million as of Monday.

Crisis of Confidence

Incredibly enough, as of the fourth quarter, the ratio of Home Capital’s non-performing loans to total loans stood at just 0.30%, which is just below the company’s five-year average of 0.31%. By contrast, the same ratio averaged 0.63% across Canada’s Big Six banks.

In other words, thus far, Home Capital’s woes were precipitated by a crisis of confidence, rather than a wave of defaults.

History, as the old saying goes, doesn’t repeat itself, but it often rhymes. With headlines reminiscent of those that appeared prior to the U.S. housing crash, people are apt to panic first and ask questions later.

As we’ve shown, the details here may be different, but the human reaction could end up being the same nonetheless: a liquidity crisis for one firm rapidly evolves into a contagion.

In the wake of this debacle, one of Home Capital’s primary competitors in the Canadian alternative-lending space, Equitable Group Inc. (TSX: EQB, OTC: EQGPF), has seen its own shares take a dive.

More disturbing is that Equitable’s customers also made a run on the firm’s banking operations, with what management characterized as “elevated but manageable” average daily net deposit outflows of C$75 million during the final week of April, equivalent to about 2.4% of its total deposit base.

To ensure liquidity if it suffers a run of similar magnitude as Home Capital, Equitable secured a C$2 billion loan facility from Canada’s Big Six.

For now, that show of financial-sector strength means this particular mess will likely be contained, even if there’s an elevated possibility of systemic risk.

However, the near-term result is some tightening of credit across the board, which could weigh on real estate prices, since it will drag out deals or cause them to come undone.

Although Home Capital’s mortgage book accounts for just 1% of Canada’s C$1.45 trillion mortgage market, the loss of this lender of last resort could cause a slowdown in real-estate activity at the margins.

Of course, the other concern is that the practice of falsifying borrowers’ income statements is much more widespread in Canada than this episode indicates.

After all, Home Capital may have terminated its relationship with a bunch of shady brokers, but they probably just took their business elsewhere.

The good news is that the types of loans in which Home Capital and Equitable specialize account for just 13% of Canada’s mortgage market.

Still, even if the financial sector and policymakers successfully stem the contagion, this is a situation that bears watching.