Description

Short: Home Capital Group (HCG)

Stock Price        $36

Market Cap        $2.5 billion

$ Volume / day    $5 million

Borrow rate        GC

I recommend short-selling HCG as a way of gaining short exposure to

(1) Housing prices in Canada, specifically the Greater Toronto Area (GTA), and

(2) Subprime lending practices.

I think the short is a timely, asymmetric risk/reward. HCG currently trades at 1.7x book value. I think a fair multiple is 0.5x or less, with substantial impairments coming. There is a reasonable chance of the equity being a zero if there is a correction in housing prices.

Note that this morning’s stock price drop reflects a Q2 warning PR that the company put out Friday evening, which is discussed below. The writeup price is the current price at which you can execute the trade. I think the stock is just as good of a short now as it was before.

Canada has a subprime lending problem

How can Canada have a subprime lending problem? Didn’t they learn from the US experience in the previous decade? The Canadian regulators, in fact, created strict lending rules to prevent mortgage abuse, but this has actually made the problem worse through unintended consequences.

Mortgage loan insurance is mandatory for federally-regulated lenders to insure “high-ratio” mortgages, or those with an LTV over 80%.

The Canada Mortgage and Housing Corporation (CMHC), a federal agency, is largest mortgage insurer with 42% market share. CMHC is supervised by the Office of the Superintendent of Financial Institutions (OSFI). The rules governing CMHC have gradually become more and more strict over time — CMHC used to insure 40 year mortgages in 2006, but that limit has been brought down to 25 over time. The threshold for high-ratio mortgages was dropped from 85% to 80%. Maximum debt service ratios have also been brought down over time, and a maximum loan size was set at $1 million.

This all sounds great in theory. Unfortunately, with rapidly rising housing prices, borrowers are increasingly unable to qualify for traditional mortgages under this strict set of rules. Canadians have increasingly turned to a private market of nonbank lenders who operate outside the bank regulations and are able to offer uninsured, high LTV loans.

http://www.bloomberg.com/news/articles/2015-01-21/shadow-lenders-fuel-risk-as-canadian-home-prices-soar-mortgages

Matrix Mortgage said business has almost doubled each year since operations began in 2008. Matrix agents field calls from its second-floor office in north Toronto from customers who see their advertisements that say: “Bad credit? No credit? Mortgage approved.”

Because private lenders lend to borrowers who can’t meet CMHC requirements, they must charge higher interest rates. Because they charge higher interest rates, they adversely select for low-quality borrowers. These borrowers are, by any reasonable definition, subprime borrowers.

Estimates of the size of the shadow lending market are all over the map. Depending on the source and time period, estimates range anywhere from 5% to 20% of new mortgages. The only thing I am certain of is that it is both material and growing much faster than the overall market.

Perversely, many of the private lenders are financed by individual investors seeking refuge from a ZIRP world. There are many anecdotes in the press of individuals taking out mortgages and investing the proceeds into … private mortgages! The term “cascading default” should not even be in the conversation of individual mortgage borrowers, but it appears that it is.

Some villains of the US subprime crisis are back in Canada: The zero-down mortgage, the interest-only mortgage, and the HELOC. The minimum downpayment on insured mortgages is regulated at 5%. Lenders have circumvented this by offering a 5% cash rebate upon closing (the rebate is priced into the interest rate). HELOCs have returned in various forms. HCG offers a HELOC Visa card: http://www.equitylinevisa.ca/

HCG is a subprime lender with subprime problems

HCG describes its core customer as being “Alt A or near-prime” and “underserved by banks”. The distinction between near-prime and subprime is a fuzzy one that is highly dependent on the honesty of brokers and HCG itself. I believe that many of these borrowers will turn out to be bad credits when all is said and done.

HCG markets its business in two segments “Classic Mortgages” and “Accelerator Mortgages”. HCG describes Classic borrowers as “conforming and non-conforming ‘B’ clients.” Accelerator borrowers are described as “‘A’ clients with good credit”. In the financial reports, Classic is called Traditional. Don’t be confused by the Orwellian language — Classic/Traditional are the uninsured mortgages.

In 2014, originations of Traditional mortgages were $5.9 billion, about 2/3 of total originations. However, because Traditional loans are all held on-balance sheet while some of the Accelerator mortgages are securitized and sold off-balance sheet, HCG’s balance sheet exposure is even more concentrated in Traditional loans ($10.8 bil out of $13.7 bil, or 79%).

HCG has an effectively zero loan loss reserve. Their total allowances are $37 million on a loan book of $18 billion. HCG would justify this by pointing to their NPL ratio — which is 0.25%. In a rising / stable market where homes can be sold at a profit, this isn’t surprising. Even with recession on the horizon, there is normally a delay between a borrower losing his income and delinquencies.

Last Friday night, HCG issued a press release warning on Q2. The press release can be found here: http://finance.yahoo.com/news/home-capital-provides-q2-origination-211900969.html

Home Capital's single-family residential mortgage originations for the second quarter of 2015 were as follows:  (a) traditional mortgage originations were $1.29 billion in Q2 2015, as compared to $1.53 billion in Q2 2014 and $0.96 billion in Q1 2015; and (b) Accelerator (insured single-family) residential mortgage originations were $280.0 million for Q2 2015, as compared to $619.6 million in Q2 2014 and $180.0 million in Q1 2015.

And this is the key language that tells us that now is a good time to short:

Home Capital's ongoing review of its business partners led to the Company terminating relationships with certain mortgage brokers, which caused an immediate drop in originations.

There are two really amazing things about the update. First, they’ve cut their Accelerator (prime) originations in half year over year. These terminations of brokers indicates to me a significant risk of origination fraud. I also wonder: how bad are the subprime loans if half the prime loans are “bad”? Second, the company guides to flat earnings for the quarter and “does not expect to change its mid-term targets”. I have trouble understanding how that can be the case when they just cut originations by 30%. The only answers I can think of are really bad for the company.

I believe that the unsavory practices of HCG’s brokers will be found to be essentially the same as the practices of brokers in the US during our housing bubble. When people are incentivized to cut corners or look the other way, that’s exactly what they will do. It’s likely that HCG’s loan book will be a lot uglier than the pretty pictures in its annual reports.

HCG’s CEO maintained 2015 guidance as recently as the earnings call on May 10. That is almost halfway into Q2. While, technically, they continue to maintain 2015 guidance, the only thing one could conclude from Soloway’s comments on May 10 was that there were no material known issues. I do not believe this management can be trusted to tell us how bad things really are. In a lending business, that is probably the most important investment factor.

Despite HCG already being my largest short position going into the weekend, I added on Monday morning. I think the trade can work in the short term, even if housing prices don’t correct, if the market decides to re-rate the stock to reflect the risk of origination fraud that seems to be an issue based on Friday’s PR

Canadian (and specifically Toronto & Vancouver) housing is in a bubble

“We look at the housing market like a food chain. The first-time homebuyers are really the plankton. And if you don’t have plankton in the ocean, you’re going to eventually starve out even the big whales and the sharks. You need that first time homebuyer to buy that home so the next person can move out to buy their own home.”

-- Stuart Levings, CEO Genworth MI Canada

One widely used measure of housing affordability is the median multiple (median price divided by median household income). In the 2014 Demographia survey, Toronto ranked as the 13th least affordable metro area in the world, with a median multiple of 6.5, just behind world-class metros such as London, Los Angeles, Silicon Valley, and Hong Kong. Vancouver ranked as the 2nd least affordable metro area in the world, with a median multiple of 10.6. While I don’t deny that Toronto and Vancouver are both lovely cities with distinct charm, they lack the economic opportunities, global culture, and amenities of the world-class cities that are similarly priced on a median multiple basis. Thus, I believe that Canadian metros are among the most overpriced metros in the world, and far more overpriced than even global affordability rankings might appear to indicate.

Another measure of housing affordability is rental yield. Net rental yields on Toronto condos appear to be around 3-4%. The yield on the Canadian 10-year is 1.68%. This spread appears to be too low. If the rental yield were to rise merely to 5% (still probably too low), this would imply a significant price decline. Note that in Canada, sales tax must be paid on new construction homes. So the rental yields on developer units is actually even lower.

HCG is extremely concentrated in the province of Ontario, with 87% of its uninsured book in Ontario. The combined loans for BC and Ontario was 92% of the uninsured book.

Canada at high risk of a recession

The collapse of commodity prices, especially crude oil, is pushing the Canadian economy into a recession, which will catalyze a downturn in housing prices. Real economic problems in China may continue to be negative for commodity prices. Mining and Oil & Gas constitute 7.9% of GDP as of April 2015 (SAAR), according to Statistics Canada. The housing market has already begun to soften in energy producing regions, such as Alberta, although it has not shown up yet in delinquency numbers because there is typically a 6-9 month delay from job loss to delinquency. Also, some producers are delaying layoffs; but this may be unsustainable should energy prices remain low or go lower. Real estate constitutes a further 12.5% of GDP and construction is 7.1% of GDP. A housing price correction may cause a material feedback effect on GDP. Canadian GDP contracted by -0.1% in Q1 of 2015. It is looking likely that GDP will contract again in Q2, officially marking a recession.

A disconfirmatory point to the above is that Ontario Q2 GDP (not yet reported) will probably be positive based on the jobs number. However, if Canada does fall into recession, I think that will eventually have a negative impact on Ontario real estate.

Variant perceptions / What do the housing bulls say?

Consensus seems to be that there is no housing bubble. It’s no surprise that the Bank of Canada would say there is “no bubble” in its public rhetoric, however, even the Bank’s own estimate, published last December in its Financial System Review, has the housing market overvalued by 10-30%.

http://www.theglobeandmail.com/report-on-business/economy/economic-strengths-to-overtake-oil-gloom-poloz-says/article24149175/

The sell side is also over-optimistic. RBC, which recently published a widely-cited report on Housing affordability, downplays affordability concerns in most Canadian markets

http://www.rbc.com/newsroom/_assets-custom/pdf/20150622-HA.pdf

RBC measures housing affordability as the percentage of median household income required to service mortgage payments, property tax, and utilities. These measures make certain assumptions, such as a 25% down payment and a 25-year fixed rate mortgage. In no way do these measures accurately reflect the servicing costs of private mortgages; nor do they take into account the BOC key interest rate being at an all-time low excluding 2009. I would argue that median price to median household income is a more valid measure of affordability. Regardless, even the optimistic RBC admits that affordability is deteriorating in Toronto. The strongest argument I think one could make is that, in a ZIRP world, multiples should be at all time highs, simply for lack of alternative investment opportunities. While there is an element of truth to this, I don’t think it supports current prices. Given that Toronto can just continually build upwards, eventually supply will outstrip demand.

One common view in Canada is that “the market is unique”. Of course, every bubble market is viewed as unique until it is not. As Keynes famously said, the most dangerous words in investing are “things are different this time.”

http://www.bnn.ca/News/2015/6/25/Real-Estate-Watch-CIBC-economists-pop-the-housing-bubble-argument.aspx

There are many arguments for why “Canada is not the US”, I won’t get into them all, ultimately I think the psychology of buyers is probably very similar.

Another common argument is that LTVs in Canada are low as a result of the OSFI regulations. To some extent this is true, although some of the low LTVs are due to price appreciation and not conservative underwriting.

The weighted average LTV at origination for HCG’s uninsured mortgages was 73.1% (73.7% in Ontario). Current weighted average LTV (i.e., using estimated market value) was 60.7% for HCG’s uninsured book. Compare this to Freddie Mac’s LTV at year-end 2007: 71% on a FICO score of 723 (Fannie Mae’s was similar). Subprime lenders in the US had LTVs in the 80s.

CMHC has an LTV of 54% on updated property value (LTV at origination is undisclosed). Genworth breaks out its LTVs at origination:

LTV Ratio        Percentage of loans

90-95%        65%

85-90%        23%

80-85%        4%

<80%            7%

Average LTV at origination for the growing number of uninsured/private mortgages is likely extremely high. All reported LTVs do not account for cash rebates upon closing which are used to create effective 100% LTVs.

In the end, LTVs cannot prevent a correction in housing prices, it can only affect loss severities. Loss severity given default in a distressed housing market is significantly worse than loss severity in a normal housing market. A useful study was recently published on Freddie Mac’s experience since 1999. Severity on 60-80% LTV ranged from 22% in pre-bubble vintages to 36% in 2006-2007 vintages.

http://www.urban.org/sites/default/files/alfresco/publication-pdfs/2000092-Loss-Severity-on-Residential-Mortgages.pdf

Given any material correction in housing prices I think HCG has significant downside here.

Risk factors

The main risks to the thesis are timing, macro, and policy response.

Catalyst

• Canadian recession

• China’s economic issues leading to continued drops in commodity prices

• China’s stock market issues spilling over into the Vancouver housing market