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Globe Investor Reflections of a fund manager who used to own Home Capital

Michael McCloskey is the founder and president of GreensKeeper Asset Management

The unfolding Home Capital Group Inc. saga is both tragic and full of irony.

We fully exited our position in Home Capital in the fourth quarter 2016. This is a stock that we have purchased and sold on several occasions over the past five years. At one price, we viewed it is attractive, and at another less so. There were two main issues that factored into our decision to exit the stock at that time. First, as the media reminds us daily, the Canadian housing market is not cheap. That doesn't mean that a selloff is inevitable. However, it does mean that the risk for mortgage lenders like Home Capital is heightened. Second, there were a number of company-specific issues that gave us pause. Third-party mortgage broker fraud, the retirement of the founding CEO and slowing mortgage origination. We concluded that we were better off taking profits and investing elsewhere.

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Turns out, that was a good move. Over the past year, Home Capital's stock is down 84 per cent and the company has lost over $2-billion of market value. Over a billion dollars of that decline happened in the past seven days. The reason? A classic run on the bank.

Due to a bank's deposit-taking funding model, banks are creatures of the public's confidence. Once that confidence is lost, a bank's ability to continue to do business is put in jeopardy. Several years ago, Home Capital encountered a major mortgage fraud issue in its business which the market had previously learned about and digested. However, one week ago the OSC released its widely reported allegations of misleading disclosure relating to that incident. One of the OSC's mandates is to maintain public and investor confidence in the integrity of the capital markets which is presumably why they brought the allegations forward. Ironically, their actions have had the effect of spooking Home Capital's investors and exacerbating the stock's selloff.

Part of Canada's banking regulator's (OSFI's) mandate is to control and manage risk and ensure that Canadian banks are sound. A little-known fact is that several years ago OSFI encouraged Home Capital to broaden its funding sources by growing demand deposits. Historically, almost all of Home Capital's funding came from fixed-term deposits (GICs) which were locked in and closely matched to the term of the company's assets (mortgage loans). In the past month, $591-million of those demand deposits have been demanded by customers and are now gone. This forced Home Capital to seek a $2-billion liquidity line that bears an effective interest rate of at least 15 per cent. Borrowing at 15 per cent and lending at less than 10 per cent doesn't work. But it does buy Home Capital some time, albeit at a huge financial cost. The irony here is that OSFI's goal of reducing risk by having Home Capital diversify its funding sources may have perversely contributed to the current run on the company's funding.

Over the past few years, a number of short sellers have been betting on Home Capital's demise. Some have been suggesting that the company is an outright fraud while others have tried to make mountains out of financially immaterial molehills. The reality is that most of these investors have been shorting Home Capital because of Canada's expensive housing market, the fact that Home Capital is a "pure play" on the Canadian housing market and their prediction of a Canadian housing price crash.

We concur that housing is overvalued in Canada. However, to date there has been no housing crash and Home Capital continues to make enormous profits ($58-million in the first quarter alone). They were and remain a good lender. But their funding is drying up fast. Over the past week, these short bets turned out to be very profitable, but ironically for different reasons than most short sellers anticipated. And their actions likely contributed to the current bank run.

So how does the Home Capital story, which is still very much in progress, ultimately play out? We can think of several possibilities. Perhaps they can find a permanent CEO and muddle through, albeit badly scarred and at a severe financial cost. But at least they will live to fight another day and preserve a meaningful portion of their book value.

Another possibility is that OSFI arranges for a major Canadian bank to buy Home Capital, possibly with a regulatory backstop protecting the buyer against losses for a period of time until the business is stabilized.

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Yet another possibility is that OSFI provides enough short-term liquidity to Home Capital and oversees an orderly liquidation of the bank's assets and the full and orderly repayment of depositors. But this doesn't fully deal with a key problem. The company's $11-billion of non-prime mortgages will come up for renewal in the next few years. If Home Capital isn't around to renew them, who is? The company built its business lending to borrows that the major banks wouldn't or couldn't lend to.

Given that related financial services stocks have started to wobble, we are certain that the significance of properly managing this situation is not lost on anyone involved. Contagion is very dangerous in banking and it can happen very quickly.

The latest chapter in the Home Capital saga is a sad one. Over the decades, Home Capital had been one of the best performing stocks on the TSX. The ultimate outcome is too tough for us to handicap. But we do hope that it ends well for everyone involved. The company's many honest and hard-working employees deserve a better ending to what had been a wonderful success story.

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