Back in December last year, we examined a small Canadian lender called Home Capital Group (TSE: HCG). The C$1.9B business, trading at a price-to-earnings ratio of 7x and a price-to-book value of 1.2x, hardly looked expensive by the conventional metrics. And this was especially so given its pre-tax return on equity was north of 20 percent and the business carried with a Common Equity Tier 1 capital ratio of 16.5 percent – which is typically considered more than adequate.
But it was the nature of HCG’s business model, the context of the market in which it was positioned and a number of recent “red flags” that had us concerned.
You see HCG has spent the last 30 years lending to homeowners who do not meet the lending criteria of typical financial institutions. And in recent years, HCG has built up a significant loan concentration in one geography: Ontario, most of which relates to one city, Toronto. And over 60 percent of the loans on its balance sheet are uninsured – meaning HCG shareholders bear the full risk of these loans turning sour.
Now this is a risky set-up for sure. But there is no reason why a business like this should necessarily go bust. But there was one big problem: Toronto real-estate – and its enormous bubble. You see, while the rest of Canada’s property markets were deflating, a handful of regions, including Toronto and Vancouver, were experiencing unusual price appreciations.
In large part, the property price appreciations in these regions stemmed from the significant inflow of foreign money, particularly from China. With such incredible rates of price appreciation, trading properties – even by those who really could not afford to – became something of a sport.
Of course, should the music stop and property prices begin to fall, it would be far from clear if HCG’s loans could be recouped in full. And with the ratio of HCG’s assets-to-equity at around 13x, only a 7.7% reduction in asset values would completely wipe out the bank’s equity. This is the dark side of leverage.
So we found it intriguing that Jerry Soloway, who had run HCG for the last 30 years, stepped down all of sudden in May 2016. This came just six months after 45 HCG mortgage brokers were suspended for allegedly falsifying income information to boost mortgage sales.
But it also came in a year during which a number of structural changes which could undo the Toronto property market started to emerge. Internationally, Beijing was making it more difficult for foreigners to move capital out of the country. While domestically, regulators were tightening macro-prudential rules – particularly with respect to uninsured mortgages. Had Jerry Soloway seen the writing on the wall one year in advance?
Soloway had, but the writing on the wall did not relate to the Toronto real estate market. It actually related to his handling of the discovery of fraud in his mortgage broker network. He had lied to the market. And now regulators were coming for him.
Here’s how the events of the last week unfolded:
April 19: Ontario Securities Commission (OSC) stated that: “From February 2015 until July 2015, HCG misled its shareholders as to the immediate and on-going causes of the decline in Originations. Internally, HCG knew it had terminated certain brokers because it had discovered fraud in HCG’s broker channels.”
April 21: Chairman Kevin Smith states: “We remain confident about the Company and its future… However, the Board believes the business could and should be doing even better. For that reason, the Board took the decision last month to replace our [new] chief executive officer…”
April 24: Jerry Soloway announced he will step down from HCG’s board; and Robert Morton will be replaced as CFO.
April 26: HCG announced a non-binding agreement in principle with a major institutional investor for a credit line in the amount of C$2 billion.
Of course, when a bank seeks such a large credit line, its liquidity position is called into question and stockholders lose confidence and flee. HCG shares collapsed 65% in a day, as illustrated below.
Home Capital Group stock price (C$/share):
HCG was a great example of an Asymmetric short. Asymmetries are one of the elements we look for in a great short. Unfortunately, we were unable to profit from the collapse of HCG on behalf of our investors. While we did attempt to short the stock at the beginning of 2017, there was insufficient stock to borrow – a requirement to execute a short position. (We were quite obviously not the only investor trying to short the stock). So we were unable to capture this particular opportunity, this time. We are due for some better luck next time.