There has been an awful lot of news on these two alternative mortgage originators over the past week so I thought I would write a blog on what is going on with them, how it might affect our High Rock clients and the potential fall-out on the Canadian housing market.
First of all, High Rock clients never owned any Home Capital (Trust) Stock, GIC's or overnight High Interest Savings Accounts (HISA). We smelled a hornet's nest some time ago. In fact, about one-and-a-half years ago, in one of our Institutional mandates for Scotiabank, we were actually "short" Home Trust Co senior unsecured bonds. We were short them at a dollar price of around $100.50 and they are now at $85.00 (remember being short means you sell at $100.50, borrow the bonds to deliver to the buyer, and then buy back when the bonds fall so being "short" means one has a negative view of the company). With a negative view, we obviously were never "long" or invested in any part of Home Capital at any time. Rest easy.
As for Equitable, we used to park our excess cash in their overnight HISA. I know the CEO personally (not well, but have cycled with him once per year over the past 6 years...not that cycling with a CEO once per year is a reason to invest in a company). Regardless, we have not owned Equitable HISA for over half a year.
As nice as Andrew Moor is (and he is a very nice guy), we decided to revert to the most simplest of rules with regards to investing in financial institutions (yes, even buying an overnight HISA deposit is investing...remember ABCP (Asset Backed Commercial Paper)?. That simple rule as is follows: A Financial Institution (FI) usually borrows short term (overnight out to 90 days) and invests in loans (mortgages in this case) that typically have a longer term like 30 years (typically 5yr rate resets). Once the FI loses it's ability to fund it's business...it is done. They need constant access to capital at the right cost of capital to continue to make the business model work.
With an overall negative firm (High Rock) view on Home Capital, we thought there would be possible funding contagion to Equitable as well, and so, months ago, we moved our cash overnight deposits to a large Insurance company. Now these insurance companies are largely doing the same thing (borrowing short term funds and investing in longer term assets, like mortgages) but to no where near the same degree as Home and Equitable. And then we got even more conservative about two weeks ago and moved our overnight cash from this large insurance company to a large Canadian bank. If I get even more nervous, it will quickly move to t-bills.
You may ask, "but aren't these Home and Equitable Bank HISA and GIC's covered by the Canadian Deposit Insurance Corporation (CDIC)?"
Sort of. Only accounts up to $100,000 are covered by CDIC insurance. Accounts over that amount are left as "unsecured creditors" so if something bad happens (insolvency) with that deposit-taking institution, you are standing in line with your claim waiting (more like hoping and praying) to get some of your money back. And the real problem with CDIC insurance is the following: even though your <$100,000 deposits are insured, who knows how long it would take to get paid your cash back in the event of a default? No one seems to really know how this "workout" works out. My idea of cash is that it is readily available. I don't want to stand in line and wait 30 days, 60 days etc etc. No thanks.
So think about all of the Advisers (note the "e" here, not an "o") at the banks and dealers who put their clients in Home or Equitable because they picked up an extra .25% on their HISA or GIC's? And then remember how the ABCP at Coventree came to an abrupt end? I do. I had a front row seat as the Head of Canadian Credit Trading at Merrill Lynch Canada. Merrill, like most other FI's in Canada, was a liquidity provider to Coventree. I won't go into detail about what happened (call if you are interested and have 3 hours to spare) back then with ABCP but I am acutely aware of how FI's fund and how to avoid an embarrassing situation.
Now think about all these Advisers today. Some may have shorter memories than others but I would think it would be very embarrassing to have your client money stuck in Home or Equitable HISA or GIC's. In fact, what we have uncovered the past week is that the banks themselves are not even offering their Adviser network any Home deposits over $100,000 (so only insured deposits). That is to say, the banks themselves don't want to deal with a potentially embarrassing situation.
And you might say, "But Home just got a $2 billion lifeline?"
Yes they did, but it is up to $2bln of secured financing that came at an extremely high cost of capital (~20%), so much so that the business model doesn't make sense (borrowing at 20% from HOOP to lend out mortgages at 4%?). The reason why Home stock and bonds got hammered last week was because this $2bln secured line of "rescue financing" or "debtor in possession (DIP) financing", effectively "primes" the stock and bonds. What "primes" means is that Hospitals (HOOP) needs to be paid back in entirety before any unsecured bonds get paid back (forget about the stock). Bottom line for Home - they have lost access to the capital markets and funding and that ain't good.
Compare Home's lifeline with HOOP at 20% to Equitable's lifeline at ~3%. First of all, all 6 Canadian Banks sound like they are in the syndicate as back-stop lenders to Equitable so clearly the Banks have much more confidence in Equitable than Home. Also, it is not even clear whether Equitable will need to draw-down part of their $2bln backstop facility.
"How will this affect the Canadian housing market?"
There is a case to be made that as mortgages come up for refinancing (certainly at Home) that they will not be able to refinance them due to their new cost of capital being so high. If Home is unable to refinance these mortgages, those mortgages may look to other providers, like Equitable. Now Equitable just got a $2bln standby line of credit by all 6 Canadian Banks (Equitable likely won't even need to draw any of that down due to their longer-term funding schedule) so I suppose they will have excess liquidity to pick up some of Home's mortgages, should they like the credit quality of those mortgages. Either way, there will likely be some pressure on the lower-end of the housing market due to this funding pressure on Home.
At the end of the day, we will be extremely cautious with how we invest our excess cash. It is beyond tricky out there right now.