|Shares Out. (in M):||440||P/E||0||0|
|Market Cap (in $M):||40,000||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
|Borrow Cost:||General Collateral|
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Canadian Housing Market Correction / Collapse – Alpha Short: “It’s Already Happening…”
A Canadian housing market correction / collapse is imminent and the bail-out of alternative sub-prime mortgage lender Home Capital Group (HCG) is only the first domino to fall…
In response to massive mortgage fraud at HCG, regulators are cracking down, enacting stricter mortgage underwriting regulations, strengthening anti-money laundering efforts, and instituting foreign buyer taxes…
…At the same time, mortgage rates are increasing due to monetary policy tightening and a more hawkish stance by the Bank of Canada…
…putting severe pressure on Canadian consumers who are over-levered by almost any measure and cannot afford increasing mortgage payments much less a new house…
The combination of increased government regulation, rising interest rates and over-levered Canadian consumers will result in tightened mortgage availability and originations, decreased housing demand and a severe correction in housing prices. Recent housing data, particularly out of Toronto and Vancouver suggests that “it’s already happening.” In Toronto, home sales volume between June and September is down ~37% compared to the same period last year. Additionally, inventory is ballooning, with active listings up 109% in September. Home appraisals performed only months ago are already stale due to rapidly dropping prices (Toronto home prices declined 35% in August, up low single digits in September), forcing appraisers to have a second look at properties they have already assessed. In Vancouver, purchases by Chinese buyers during the Chinese New Year have cratered, declining ~87%.
We have been monitoring the Canadian housing market bubble the past 18 months and initiated a short position in HCG after the completion of a Dutch tender. HCG announced a Dutch tender in March 2016, allowing senior executives to sell shares at a premium in the midst of a regulatory investigation involving the management cover up of mortgage application fraud. We covered our short position after an ~80% correction in the stock price following a proceeding filed by the Ontario Securities Commission (OSC) against the company for misleading investors as well as an emergency “DIP” financing capital raise.
On 6/22/17, HCG was effectively bailed out by Warren Buffett, which the market interpreted as a vote of confidence for the Canadian housing market as a whole. The reality is that Warren Buffet structured a deal in which he effectively cannot lose, at the expense of existing HCG shareholders (see appendix B for summary). We were surprised that an isolated forced bailout would create such a tremendous opportunity to increase our alpha short bet while at the same time providing time to re-underwrite.
Recommendation: SHORT a basket of Canadian mortgage lenders, mortgage insurers, banks and Canadian housing / economic growth ‘proxies’
TABLE OF CONTENTS
II. Increased Regulatory Scrutiny – “The long arm of the Law”
VI. Conclusion – “The Next Big Short”
VII. Illustrative Trade Structure
VIII. Appendices: “The Cutting Room Floor”
Appendix D: EQB vs. HCG loan growth
Appendix E: Gerald Soloway
Appendix F: Alberta and the oil price crash
Appendix G: Ownership overlap between Canadian Banks
Appendix H: Miscellaneous charts
Home Capital Group “The first domino to fall”
The bail out of alternative sub-prime mortgage lender Home Capital Group (HCG) by Warren Buffet, although attractive for Berkshire Hathaway, (3x overcollateralization, 9% yield and a free call option on the common equity price at a ~50% discount) is a bad deal for HCG shareholders; in response to massive mortgage fraud, regulators are cracking down
Home Capital Group (Ticker HCG) is a Canadian alternative lender offering deposit, mortgage lending and credit card issuing services. Historically, the bull thesis centered around HCG’s market leading position in the Canadian alternative mortgage lending space as well as robust origination volumes. In the summer of 2015 however, the company began to unravel:
7/10/2015: HCG disclosed a review of its broker network and various broker relationship terminations, negatively impacting originations (www.prnewswire.com/news-releases/home-capital-provides-update-on-q2-origination-volumes-513372331.html)
7/27/2015: Director James Baillie resigned from the board for personal reasons, several months after indicating his plan to resign (http://www.newswire.ca/news-releases/home-capital-group-inc-announces-director-resignation-518703191.html)
7/29/2015: HCG provided an update on its broker network review and disclosed the suspension of 45 mortgage brokers relating to the systematic falsification of income on loan documents in order to drive origination volumes (http://www.newswire.ca/news-releases/home-capital-group-inc-provides-additional-disclosure-regarding-broker-suspensions-and-revises-material-change-report-519581321.html)
2/29/2016: HCG announced that founder Gerald Soloway was stepping down as CEO, replaced by Martin Reid (http://www.newswire.ca/news-releases/home-capital-group-announces-ceo-succession-570556541.html)
8/23/2016: Various short sellers began to uncover undisclosed, related party entities, harboring off balance sheet mortgage exposure in order to hide non-performing loans (https://seekingalpha.com/article/4001541-home-capital-group-time-re-charge-loan-loss-provisions)
2/10/2017: HCG issued a press release disclosing an OSC enforcement notice received by the company. The notice indicated that the company failed to meet its continuous disclosure obligations relating to its broker network review of the systematic falsification of income and subsequent remedial steps taken back in 2015 (http://www.newswire.ca/news-releases/home-capital-group-inc-discloses-osc-notice-613444083.html)
3/14/2017: HCG issued a press release disclosing that OSC enforcement notices were sent to several current and former officers and directors relating to disclosure and, in some instances, trades in the company’s shares (http://www.newswire.ca/news-releases/home-capital-group-discloses-osc-notices-to-individuals-and-class-action-filing-616162394.html)
3/14/2017: HCG announced the termination of CEO Martin Reid after less than a year on the job, named board member Bonita Then as interim CEO (http://www.newswire.ca/news-releases/home-capital-group-announces-departure-of-ceo-martin-k-reid-appointment-of-interim-ceo-and-commencement-of-search-for-permanent-replacement-617228533.html)
4/19/2017: The OSC issued a formal statement of allegations including misleading disclosure and failure to satisfy continuous disclosure obligations relating to its broker network review (http://www.osc.gov.on.ca/en/Proceedings_soa_20170419_home-capital.htm)
4/26/2017: HCG announced a $2Bn emergency DIP capital raise amidst a “run on deposits” (http://www.newswire.ca/news-releases/home-capital-announces-non-binding-agreement-in-principle-with-major-institutional-investor-for-credit-line-of-2-billion-620463103.html)
6/14/2017: HCG announced a settlement with the OSC for $10MM, OSC expense reimbursement and various penalties for ex CEOs Gerald Soloway and Martin Reid (http://www.newswire.ca/news-releases/home-capital-announces-agreements-to-settle-osc-and-class-action-matters-628505203.html)
6/21/2017: HCG announced an agreement with Berkshire Hathaway for an investment of up to $400MM in common equity and a new $2Bn credit facility (http://www.newswire.ca/news-releases/home-capital-reaches-agreement-with-berkshire-hathaway-for-investment-of-up-to-c400-million-in-common-equity-and-provision-of-new-c2-billion-credit-facility-630038203.html)
HCG has become the poster child for mortgage fraud in Canada, however, an entire ecosystem of alternative lenders and insurers have pursued the same growth at any cost mentality. For example, several brokers fired by HCG for mortgage application fraud, including an individual named Rizwan Qureshi (http://www.bnn.ca/cohodes-vs-home-capital-testing-the-short-seller-s-claims-1.593533), went on to join HCG competitors including Equitable Group (Ticker EQB CN). EQB’s total loans grew ~50% since 4Q’14, when Rizwan Qureshi and perhaps other brokers joined the company, in the midst of HCG’s mortgage fraud investigation.
As the dust settles at HCG and within the broader alternative mortgage lending ecosystem, regulators are beginning to crack down.
Increased Regulatory Scrutiny – “The long arm of the Law”
The HCG case study of “growth at all costs” is forcing the regulators hand to fundamentally change how the mortgage lending and broader housing market ecosystem operates by enacting stricter mortgage underwriting regulations, strengthening anti-money laundering efforts, and instituting foreign buyer taxes; at the same time, Chinese capital controls will negatively impact the flow of foreign real estate investment in Canada, a major driver of the housing market boom
Increased government intervention in the housing market by The Office of the Superintendent of Financial Institutions (OSFI), the Ontario Securities Commission (OSC) and various local / provincial government authorities will tighten credit and negatively impact housing demand. In July 2016, the Office of the Superintendent of Financial Institutions (OSFI) communicated its intention to increase supervisory scrutiny on mortgage underwriting practices of federally regulated lenders http://www.osfi-bsif.gc.ca/Eng/fi-if/in-ai/Pages/rfmrm.aspx). Provisions laid out in the July 2016 letter in include:
Requiring a qualifying stress test for all uninsured mortgages
Requiring that Loan-to-Value (LTV) measurements remain dynamic and adjust for local market conditions
Expressly prohibiting co-lending arrangements that are designed, or appear to be designed to circumvent regulatory requirements
OFSI finalized the above provisions on October 17, 2017, and will take effect in January 2018 (http://www.osfi-bsif.gc.ca/Eng/osfi-bsif/med/Pages/B20_dft_nr.aspx). The most impactful change announced by OSFI is the establishment of a new minimum qualifying rate, or “stress test,” for borrowers making a down payment of more than 20% of the home’s value. The stress test requirement is stricter than what was originally proposed and requires buyers with uninsured mortgages to prove that they can afford payments based on the greater of the Bank of Canada’s five-year benchmark rate (currently ~4.9%) or their mortgage rate plus two percentage points.
In addition, OSFI released draft changes to Guideline B-20 which is meant to deter and detect money laundering and terrorist financing activity (http://www.osfi-bsif.gc.ca/Eng/fi-if/rg-ro/gdn-ort/gl-ld/Pages/b20.aspx). It has long been suspected that money laundering has helped to feed demand for housing during the boom (http://globalnews.ca/news/3350193/canada-launder-money-real-estate-report/).
New housing measures were also recently introduced by the OSC. In April 2017, the OSC unveiled its Fair Housing Plan, which introduced a number of demand- and supply-side measures, including:
The non-resident speculation tax, a 15 per cent tax on the purchase or acquisition of an interest in residential property located in the Greater Golden Horseshoe area by individuals who are not Canadian citizens or permanent residents or by foreign corporations and taxable trustee.
The expansion of rent controls to all rental properties, including those built after 1991
Measures designed to increase housing supply, including: freeing surplus provincial land for residential construction, empowering municipalities to introduce a vacant homes property tax, providing a rebate for a portion of the development charges related to the construction of new rental units
Much like the non-resident speculation tax enacted in Ontario, Authorities in British Columbia instituted a similar 15% foreign buyers tax in Vancouver back in July 2016. After the tax was enacted, Chinese real estate inquiries in Vancouver plummeted and this same impact will likely be felt in Toronto.
Recently, A massive money laundering scheme was uncovered at a Vancouver area casino, popular with Chinese gamblers (https://www.bloomberg.com/news/articles/2017-09-25/big-chinese-cash-bets-put-vancouver-casino-in-laundering-probe) …as if regulators weren’t already on high alert…
In addition to the laundry list of domestic regulatory interventions, various capital control measures instituted by the Peoples Bank of China (PBoC) will also impact foreign demand for housing. These capital controls include various anti-money laundering measures and new rules that strictly prohibit export of capital for buying bonds, “insurance-type” products, and real estate (http://www.businessinsider.com/chinese-capital-controls-effect-on-real-estate-2017-3).
Taken together, these regulatory measures both in Canada and China, will have a chilling effect on Canadian housing demand and the availability of credit.
Rising Interest Rates – “Stupid is as Stupid does”
The decision by the Bank of Canada to begin tightening monetary policy in concert with other central banks around the world, is ill-advised considering wage growth is decelerating, inflation is stubbornly low and a material driver of economic growth has been a housing bubble; rising mortgage rates will put tremendous pressure on over-levered Canadian consumers who cannot afford increasing mortgage payments much less a new house
According to Bank of Canada, the economy appears to be humming along.
“Canada’s economy has been robust, fueled by household spending. As a result, a significant amount of economic slack has been absorbed. The very strong growth of the first quarter is expected to moderate over the balance of the year, but remain above potential. Growth is broadening across industries and regions and therefore becoming more sustainable” – Bank of Canada, 7/12/17
Recent trends in average hourly earnings for Canadian consumers as well as inflation seem to paint a different picture however. The annualized 24-month average change in wage growth for Canadian consumers has dropped below 2% and inflation has remained subdued between 1-2%. Considering that the U.S. Federal Reserve is concerned with US wages which have averaged ~2.5% in 2017, and inflation approaching its 2% mandate, monetary tightening by the Bank of Canada is alarming.
Source: Bloomberg L.P. Pricing data
Additionally, Canadian economic growth has become increasingly driven by the housing market boom. In a June 2017 financial system review, the Bank of Canada characterized imbalances in the housing market as a key vulnerability, despite its rosy depiction of the overall economy. (http://www.bankofcanada.ca/wp-content/uploads/2017/06/fsr-june2017.pdf). Since the U.S. housing crisis, the Canadian housing market as reached nosebleed highs and residential investment as a share of GDP in Canada is closely tracking levels seen in the U.S. from 1991 to 2006.
Source: https://www.bloomberg.com/view/articles/2017-06-21/canada-s-housing-bubble-will-burst?utm_content=view&utm_campaign=socialflow- organic&utm_source=twitter&utm_medium=social&cmpid%3D=socialflow-twitter-view
Bank of Canada figures show that 14% of all private business loans from chartered banks are now bound for so-called real estate operator industries, (largest share in the history of data back to 1981) and 7% of all Canadian workers are employed in the housing construction industry, almost double the share of housing construction workers in the U.S.
On July 12, 2017, despite average wage growth below 2%, low inflation and economic growth increasingly driven by a housing market bubble, The Bank of Canada raised its target for the overnight rate to 0.75%, the first hike since 2010 (http://www.bankofcanada.ca/2017/07/fad-press-release-2017-07-12/). In an even more surprising move, The Bank of Canada raised rates again on September 6, 2017, increasing the target for the overnight rate to 1.0% (http://www.bankofcanada.ca/2017/09/fad-press-release-2017-09-06/). The market appears to believe that more tightening is to come as 10 year government bond yields are hitting multi-year highs
Source: Bloomberg L.P. Pricing data
Considering the majority of mortgage debt in Canada are adjustable rate mortgages, an increase in interest rates will immediately impact a large swath of Canadian homeowners. A recent analysis by The Huffington Post found that a return to “normal” mortgage rates would put severe pressure on many Canadian homeowners (http://www.huffingtonpost.ca/2016/08/02/mortgage-rates-canada-debt-crisis_n_11262930.html). Assuming mortgage rate normalization to ~5% would imply the following changes in monthly payments:
The average mortgage payment on a house bought at today’s average price ($503,301) would rise by $620 per month, from $2,078 to $2,698.
In Toronto, average payments on an average-priced house would rise by $923 per month, from $3,079 to $4,002.
In Vancouver, payments would rise by $1,097 per month, from $3,677 to $4,774.
Given that a recent poll found half of Canadians couldn’t even afford $200 more in monthly payments, those projections paint a frightening picture (http://www.huffingtonpost.ca/2016/02/16/poll-finds-half-of-respondents-within-200-a-month-of-being-unable-to-pay-bills_n_9242222.html). Rising mortgage rates will put tremendous pressure on over-levered Canadian consumers who cannot afford increasing mortgage payments much less a new house.
Mountains of Consumer Debt – “It’s time to collect”
A boom in consumer mortgage and home equity debt has been the lifeblood of the Canadian economy; unfortunately, by almost any measure, Canadian consumers have taken on unsustainable amounts of debt and have maxed out all available forms of credit setting up a hard landing for domestic housing demand
In order to understand the magnitude of the consumer debt problem in Canada, look no further than growth in home equity lines of credit (HELOCs). According to OFSI, total outstanding HELOC debt reached ~$280Bn in 2Q17, ~15% higher than levels seen in 2014. HELOCs have become popular among Canadian consumers in recent years as way to access cash by borrowing against housing price gains. A material correction in housing prices would be catastrophic for consumers with $280Bn of HELOC debt.