Canadian Housing Financing Market

There are three companies that come to mind that are directly related to Canadian residential housing financing: Genworth MI (TSX: MIC), Home Capital Group (TSX: HCG), and Equitable Group (TSX: EQB).

I’ve done extensive research on all of them in the past and I am research-current with all three companies. I do own shares of MIC from the summer of 2012.

The first, which should be no surprise to regular readers here, deals with mortgage insurance. The second and third deal with direct financing of home mortgages (both first-line and refinancing). If a mortgage is required to be insured (which is usually the case for higher ratio mortgages and refinancings) then CMHC and Genworth MI get involved and charge a premium in exchange for the lender being able to give out a lower rate of interest.

HCG today announced that its mortgage originations were down from the previous year and its stock price cratered roughly 15% as of the time of this writing.

Genworth MI is down about 4% in sympathy, although Equitable Group is in the “white noise” range for the markets (i.e. relatively unchanged).

A downturn in mortgage originations will materially affect HCG and EQB’s profitability, while this has more of a muted effect on Genworth MI as cash proceeds from mortgage insurance are not accounted for as revenues until they are recognized according to prior experience (net of expected default losses).

The takeaway to this message is that if Genworth MI gets disproportionately trashed in the upcoming days, it is likely unwarranted as the fundamental profitability in Genworth MI is not through volume, but rather the solvency of the lenders in question. Genworth MI also has the advantage of being able to run off its insurance book and still receive a boost in market value as it is trading below book value, while HCG and EQB are trading above book value.

Option implied volatility does suggest that institutional interest suspects further volatility. Tread carefully as always!

Market musing while being inactive

I hate to sound like a broken record, but I’ve still been doing nothing other than research but nothing worth investing in at the moment except for one illiquid play mentioned in an earlier post.

Here is a series of miscellaneous observations:

* I note that Apple (AAPL) continues its slide down to the point where I am wondering if they are pricing that the company is not going to be able to keep its premium pricing strategy. On paper, they are still massively profitable, but if competition continues to chip away at their product line (mainly through Samsung on the phone front and a variety of other realistic competitors on the tablet front), they might run into revenue growth problems. The company in their last fiscal year (ended September 2012) made $156.5 billion in revenues and this year the analysts are projecting an average of $182.8, which is a $26.3 billion increase year-to-year. This is a huge amount of growth and the law of large numbers will likely be catching up to Apple in short order.

* CP Rail (CP.TO) is trading at absurdly high valuations at present. They performed a change in management and the market is giving the new CEO a lot of credit, but the railroad business is very mature and I don’t have a clue why they are giving the equity such a huge premium at the moment. I’d be a seller at this price range (the C$130 mark).

* Anybody remember the big scare about rare earths a couple years ago when China started restricting the supply and most of those stocks went crazy? The big play here, Molycorp (MCP) has continued to slide into the gutter now that the market reality of the perceived shortage has completely gone away. The substitution effect is very powerful and MCP shareholders are holding the bag.

* Likewise, most other fossil fuel commodity companies, including my favourite company that has been so overrated by many, Petrobakken (PBN), are continuing to suffer. It is similar to how most gold mining companies are not faring nearly as well as the underlying commodity – it costs an increasing amount of money to extract the resource, so even if the commodity price is increasing, if your costs are increasing, you are not going to make much money. Even Crescent Point Energy (CPG.TO) is starting to lose its lustre.

* The other commodity market that is continuing to get my curiousity up is currency trading – the US dollar has continued to outperform most of the other global currencies. The only way that I play this is that I try to hedge my portfolio by having some US-denominated securities rather than using leveraged speculation.

* The two Canadian Real Estate financing proxies, Home Capital (HCG.TO) and Equitable Group (ETC.TO) warrant a further look. HCG has faded somewhat off of its 52-week high, but Equitable is still there. If people are still hyper-bearish on the Canadian real estate market, these two companies should be the first on anybody’s short selling list. Non-performing loans are still around the 0.3% level and currently still do not show any real signs of distress in the market. I am still riding the wave on Genworth MI (MIC.TO) and believe there is still a reasonable percentage gain to be realized from current price levels. The loan companies, however, are hugely leveraged and I’m finding it difficult to see value there when book values are so significantly below market prices.

* Long term interest rates have also taken a nose dive – the Canadian 10-year bond was skirting at the 2% yield a month ago, but now they are back down to 1.8%. The world is awash with capital and there are few places to deploy it where you’ll generate yield at an acceptable risk level. Eventually the leverage party will end and the fallout is going to be very brutal. Whether this happens in 2013, 2014 or later, nobody knows. But there will be fallout, and figuring out how to brace yourself for the fallout will be a big financial challenge over the next decade.

Misconceptions on Canadian mortgages

There have been quite a few media articles about how the recent rule changes has kneecapped the Canadian real estate market. It should be pointed out that these rule changes were strictly in the context of having CMHC (a federal crown corporation, so if they fail, then the public picks up the bill) insure such mortgages.

It does not include private lenders or insurers (such as Genworth (TSX: MIC)). So private lenders and insurers are free to make bone-headed decisions, such as providing zero-down financing and prime minus 1% rates to 450-rated credits if they deem it to be in their best interests.

Since the major chartered banks are really only interested in arbitraging their mortgage portfolio risk by getting CMHC to pick up the downside, they have been much more reluctant to give mortgages outside of the 25-year amortization, 5% down payment guidelines. The two major private lenders in the Canadian market are Equitable Group (TSX: ETC) and Home Capital Group (TSX: HCG) which have to make their own decisions with respect to giving out mortgages.

The share prices of both of these companies should be leading indicators with respect to the Canadian real estate market as a whole. The analogies in the USA, such as Novastar Financial, have long since gone insolvent for well-documented reasons. The semi-equivalent of CMHC, Freddic Mac and Fannie Mae are still publicly traded, but will not likely be returning capital to shareholders ever unless if the US government decides to make their obligations disappear.

I would be cautious of the Canadian private lenders without trying to thoroughly examining their loan portfolios. Doing this is not an easy job, even on the inside. They are producing disproportionately large earnings per share strictly through the usage of leverage, which in itself is not a bad thing, but you don’t know how secure those assets are. In the case of Equitable, one sees a company that has about $10 billion in mortgages outstanding, about $5.3 billion of it has been securitized (wrapping them up in happy packages, insuring them, and then selling to market) – the only problem of the securitized assets is that your net interest margins on them are piddling low – 0.49% in the last quarter, compared to the very relevant 2% more you get with the non-securitized assets.

ETC’s book value per common share is $27.46 (at June 30, 2012) and is currently trading at $31.49, so there is a premium assigned to their operations.