Home Capital – Don’t know why it is trading up

The power of Berkshire is strong – why would shares of (TSX: HCG) go up when the acquisition price is so dilutive to existing shareholders (selling 19.9% of the company for CAD$9.55 and another substantial chunk of equity at CAD$10.30 to a 38% ownership interest) and the company cannot even obtain a better rate on a secured line of credit than 9%?

They managed to sell $1.2 billion dollars of commercial mortgages between 97 to 99.61 cents on the dollar, which leaves the question of how much their residential portfolio is worth. How can this investment by Berkshire and the line of credit be good for anybody but Berkshire, or more specifically anybody but common shareholders?

Now that short sellers have been crushed to death, I’m going to guess the next month or so will likely represent the “top” of their stock price. Borrow rates are 75% right now so I’m not touching it.

Book value with this stock purchase, FYI, goes down to under CAD$20/share. So even on a price-to-book metric, HCG is almost trading like a regular mortgage provider – except with the very relevant fact that their cost of capital is well above what they can receive in mortgage interest! How they plan on making money by issuing 5% mortgages and loaning money from the credit facility at 9% or 10% is beyond me. Maybe they’ll make it up on volume!

There is absolutely no reason why Genworth MI should be trading up 10% on this news either. They are in much, much, much better financial shape than HCG, and shouldn’t be trading at less of a discount to book value than HCG is!

Home Capital / Equitable Group Discussion #2

A few news items which are salient as this saga continues:

1. Home Capital announced a HISA balance of CAD$521 on Friday, April 28 and a GIC balance of $12.97 billion. On May 1, this is $391 million and $12.86 billion, respectively (another $220 million gone in a day). Their stock is down 21% as I write this.

2. Equitable announced their quarterly earnings and are up 35%. This was a pre-announcement as they previously stated they would announce on May 11, 2017. They announced:

* A dividend increase.

Between Wednesday and Friday, we had average daily net deposit outflows of $75 million, with the total over that period representing only 2.4% of our total deposit base and with the most significant daily outflows being on the Wednesday. Even after those outflows, our portfolio of liquid assets remained at approximately $1 billion.

Obtained a letter of commitment for a two-year, $2.0 billion secured backstop funding facility from a syndicate of Canadian banks, including The Toronto-Dominion Bank, CIBC, and National Bank (“the Banks”). The terms of the facility include a 0.75% commitment fee, a 0.50% standby charge on any unused portion of the facility, and an interest rate on the drawn portion of the facility equal to the Banks’ cost of funds plus 1.25%. This interest rate is approximately 60 basis points over our GIC costs and competitive with the spreads on our most recent deposit note issuance, and as such will allow us to continue growing profitably.

So their credit facility cost $15 million to secure $2 billion (relative to $100 million for HCG), lasts two years (relative to 1 year for HCG), and also have a standby charge of 0.5% (which is 2.0% less than HCG), and a real rate of interest of approximately 3% (compared to HCG paying 10% for their outstanding amount, and I’m assuming the Bank’s “cost of funds plus 1.25%” works out to around 3%).

I haven’t had a chance to review their financial statements in detail yet. But securing two billion on relatively cheap terms like this is going to be a huge boost to their stock in the short run.

Very interesting.

Genworth MI (TSX: MIC) is also down a dollar or 3.5% today, which is more than the usual white noise of trading. It dipped even lower today.

Home Capital Group, Equitable Group

Home Capital (TSX: HCG) and Equitable (TSX: EQB) have been hammered today as a result of fallout of the Ontario Securities Commission allegations that certain Home Capital Group executives have contravened the various regulations. They continue to perform damage control, today announcing their CFO (who was under the OSC investigation) will be stepping down and other various board changes.

Borrowing rates for Home Capital spiked to 26% today. Equitable, which normally has been an inexpensive borrow, had its cost to borrow rise to 2.75%.

Implied volatilities on options for HCG is also very expensive at present, around 110% for near-dated options and around 90% for a couple months out. EQB does not have options trading on their shares.

There has been an avalanche of media coverage (both in print and social media) about Home Capital and their woes. They have been pushed down to about 25% less than tangible book value.

This spill-over has not occurred to Genworth MI (TSX: MIC) at present.

Canadian Housing Finance stocks, April 13

On April 13, three notable companies associated with Canadian housing pricing fell considerably: HCG, EQB and MIC.

There were a bunch of other companies that had issues, but it looks like that the trio above were fairly pronounced in the day’s list of losers:

April 13, 2017 TSX Percentage Losers

CompanySymbolVolumeClose% Change
Nthn Dynasty Minerals LtdNDM4,841,0272.17-10.3
Intl Road Dynamics IncIRD203,2032.81-10.2
China Gold Intl Res CorpCGG1,269,5942.43-9.3
Home Capital Group IncHCG972,60621.70-8.6
Aphria IncAPH6,005,7937.21-8.3
Equitable Group IncEQB287,51263.41-8.3
Fennec Phrmctcls IncFRX12,5375.50-8.0
Silvercorp Metals IncSVM1,516,9934.94-8.0
Alacer Gold CorpASR1,881,2092.52-7.7
Street Capital Group IncSCB28,4891.40-6.7
Taseko Mines LtdTKO794,6751.52-6.2
Trilogy Energy CorpTET182,4814.95-6.1
Genworth MI Canada IncMIC221,17434.63-6.0
Top 10 Split TrustTXT.UN9,8634.08-6.0
Guyana Goldfields IncGUY916,0127.41-5.4
Golden Star Resources LtdGSC548,2681.09-5.2
Continental Gold IncCNL852,8253.91-5.1
Arizona Mining IncAZ501,4501.96-4.9
Great Panther Silver LtdGPR387,1652.00-4.8
Argonaut Gold IncAR1,036,6442.43-4.7

I’ve been trying to find what caused this spontaneous meltdown in equity prices.

My 2nd best explanation is that Bank of Canada Governor Stephen Poloz is putting a torpedo to the Toronto housing market by making explicit statements about the 30% year-to-year rise in valuations and about how there is no explanation for it. Specifically, he stated “There’s no fundamental story that we could tell to justify that kind of inflation rate in housing prices, and so it’s that gap between what fundamentals could manage to explain and what’s actually happening which suggests that there is a growing role for speculation“, which is a mild way of saying that people are basically trading houses in Toronto like they did with Tulip Bulbs in the Netherlands in 1636.

He also politely stated that if you believe that housing prices are going up 20% year-to-year, it doesn’t matter whether he raises interest rates by a quarter or half point, and he could even raise them 5% and it wouldn’t make a difference (although it would be rather fun to see him try and see all the mathematical financial models predicated on stability go out the window in one massive flash crash).

However, my primary reason why I think the three stocks crashed is a simple announcement:

==========================

Media Advisory
From Department of Finance Canada

April 13, 2017
Minister of Finance Bill Morneau will hold a meeting with Ontario Finance Minister Charles Sousa and Toronto Mayor John Tory to discuss the housing market in the Greater Toronto Area.

A media availability will follow the meeting at approximately 3:30 p.m.

Date and Time
2:30 p.m. (local time)
Tuesday, April 18

Location
Artscape Wychwood Barns
601 Christie Street
Toronto, Ontario

==========================

Being somewhat experienced with the nature of government communications, there is no way you can get a federal and provincial Liberal with a Conservative mayor doing a joint announcement on something without it leaking to the marketplace.

The only question here is how deep they’re going to stick their silver-tipped oak stake into the heart of the Toronto real estate vampire.

Who’s short on Genworth MI?

Genworth MI has 57.2% of its shares outstanding held by Genworth Financial (NYSE: GNW). This leaves approximately 39.3 million shares outstanding in the public float. Q4-2016 in the following annotated chart refers to the quarterly earnings report at the end of February 7, 2017:

On January 31, 2017 there was a reported short position of 2,844,353 shares and on February 15, 2017 that position increased to 3,188,297. This is a 343,944 share increase in short interest since their earnings report (which means that somebody is taking on a position to profit from their presumed downfall).

Borrow rates on MIC are relatively modest, at around 2.75%.

That said, when the price increases and short interest rises it will raise volatility – is the entity with deeper pockets the one that is accumulating shares and driving up the price, or are they the ones that are selling shares and applying downward pressure on the price? It is impossible to say without the benefit of retrospect, but if either party exhausts its funds or changes the pace that they are accumulating or distributing, it will result in higher price volatility. Imagine if those 3.2 million shares that are shorted decide that it is time to cover their position. Could there be a short squeeze? Share volume has been higher than normal lately which suggests that there is interest in both sides of this price battle to see who breaks first. Right now, clearly the winning side is the one accumulating shares and slowly raising the bid – I noticed the same price trend post-Presidential election, where the algorithm was simply “accumulate shares at whatever rate that it is sold to you and raise the bid by a nickel each trading hour until you hit some sell pressure”.

Technical analysis these days is simply about guessing the competing algorithms at work and who has the most money behind them – almost no institutions use non-algorithmic trading anymore as such manual trading leaks information like a sieve which increases frictional costs (you’ll get front-runned).

Genworth MI reports Q4-2016

Genworth MI (TSX: MIC) reported their fourth quarter a couple weeks ago. This post is a little late in the game (and irritatingly, a conference call transcript has not been made available and I have had to suffer the indignity of actually listening to the conference call). By virtue of the Canadian housing market not imploding over the quarter, the company likely exceeded market expectations, which registered a 10% price spike since their announcement.

Here are some of my takeaways:

* Loss ratio is exceptionally low, at 18% for the quarter. Management projects 25-35% for 2017 as they identified that Fort McMurray and Quebec were abnormally low in Q4-2016 and that a more normalized loss ratio is to be expected in BC and Ontario (which have been quite dormant in terms of mortgage defaults).

* Book value is up a little bit to $39.28, which is $2.46 more than the previous year. The market value continues to converge to book.

* Premiums written, Q4-2015 to Q4-2016, was down about 20%. Portfolio insurance is down as expected per the rule changes, and transactional insurance is down due to the changes in the mortgage rules. The new capital requirements and new premium changes will kick in at the end of March which will offset reduced volume with price increases.

* Investment portfolio continues to be managed in line with previous quarters, in addition to the losses incurred by the preferred share portfolio seemingly normalizing (and if rates continue to rise, discounted rate-reset shares should fare quite well in that environment).

* Regulatory ceiling for private mortgage insurance was raised from $300 billion to $350 billion, which makes this a non-factor for the next while (a low risk that did not materialize).

* New capital requirements result in a “recalibration” of the minimum capital test ratio. The company is internally targeting 160-165%, and each percentage point is about $25 million in capital. Once they head over 165% then the surplus will likely be distributed via buybacks or dividends – it does not look like anything special is going to happen on this front in 2017 as they will be using retained earnings in order to buffer the capital levels. The new OFSI regulations have grandfathering components with respect to the capital requirements which should mathematically ease in the new capital requirements (especially with the evaluation and testing of the mortgage books acquired 2016 and earlier), but the MCT ratio is not likely to materially climb higher to the point where one can start thinking of extra dividends or buybacks.

* Insiders have exercised options and dumped stock after the earnings release, which is a negative signal.

I will warn readers that I have also lightened my own position in Genworth MI in the days ahead (i.e. after they announced) of the earnings announcement, my first sale since the second half of 2015. The last quarter was undoubtedly a good one for the company. I still have a large position in the stock, but I was reducing my position strictly for reasons that it had gotten too concentrated and I want to reduce my overall portfolio leverage. There is still a lot of runway for Genworth MI to run up to the low 40’s as they have everything going correct for them fundamentally and are generating a lot of cash in a semi-protected business environment. The whole country has been so bearish on Canadian housing that they forget to realize there are considerable pockets of profitability and Genworth MI is one of the spaces where there is money that continues to be made – I am guessing that the short sellers have gotten killed on this one.

CMHC increasing mortgage insurance premiums

CMHC announced this morning they will be increasing mortgage insurance premiums on March 17, 2017.

The changes are significant for those interested in mortgages with a 10-20% down-payment:

Loan-to-Value Ratio Standard Premium (Current) Standard Premium (Effective March 17, 2017)
Up to and including 65% 0.60% 0.60%
Up to and including 75% 0.75% 1.70%
Up to and including 80% 1.25% 2.40%
Up to and including 85% 1.80% 2.80%
Up to and including 90% 2.40% 3.10%
Up to and including 95% 3.60% 4.00%
90.01% to 95% – Non-Traditional Down Payment 3.85% 4.50%

The changes were a result of the OFSI changing the capital holding requirements of mortgage insurance institutions in Canada (affecting CMHC, Genworth MI and Canada Guaranty) and I have telegraphed this well in advance in my previous analyses of Genworth MI.

It is quite probable that Genworth MI will follow suit and this will result in a substantial increase in premiums written for the company in the 2nd to 4th quarter of 2017. The market has not picked up on this at all.

Details of Genworth Financial merger

There are lots of juicy details of the merger proposal with Genworth Financial in their preliminary proxy filing. In particular there are some hints that Genworth MI in Canada will get sold off whether this merger is successful or not.

Despite all short-sellers and naysayers believing that the Canadian housing market is going to crap, Genworth MI continues to appreciate post-Trump and is still trading 10% below their book value. They’ll continue to be mystified when the stock will break through its all-time highs it reached back in November 2014:

Not coincidentally, that’s when I last sold shares. I will note the price has been adjusted multiple times due to their rather large dividend (currently $1.76/share), and whether the Genworth Financial merger is successful or not, it is quite probable that Genworth MI Canada will be sold for as much as can be sought for it, because doing so before the Canadian housing market collapses is the only smart thing to do.

In terms of valuation, one can make a good claim for over CAD$40/share.

The market is also not appreciating at all the notion that mortgage insurance rates will be headed higher in early 2017 due to capital changes. The last time mortgage insurance rates went higher, the stock went up about 10%.

They are also somewhat buoyed by the “good politics, bad policy” decision by the BC government to extend a 5-year interest-free loan, matching dollar-for-dollar on the first 5% of a downpayment (for an insured mortgage). It would be a poor decision for a prospective buyer in BC to not take advantage of this, but they would need to pay mortgage insurance to do so.

Genworth MI reports Q3-2016

Genworth MI (TSX: MIC) reported their Q3-2016 report. This was a very “steady as she goes” type report fundamentally, with little hidden surprises. Some highlights:

* Stated book value per share is $39.01 (means the company is trading 29% below book value, which is a huge discount – I will also point out there is about $2.48/share of goodwill, intangibles and the deferred policy acquisition costs, so the most absolute conservative valuation of tangible book value is roughly $36.50/share diluted).

* Loss ratio goes to 25%, up from 20% in the previous quarter mainly due to oil-producing (Alberta, Sask) delinquencies and defaults. Delinquency rate is still at 0.10%.

* Investment portfolio is up another $200 million in invested assets (3.2% average yield).

* Transactional written insurance premiums down 15% from quarter of previous year; portfolio insurance up 7%, which was somewhat surprising given the rule changes after Q2-2016 (quarter-to-quarter comparisons here are not that useful due to seasonality).

* Minimum capital test under soon-to-be-replaced OSFI rules went up to 236% from 233% in previous quarter.

* Dividend raised from 42 to 44 cents (I was expecting a 3 cent raise, but this is probably to ensure they keep raising capital levels for the new rule changes – market may not like this although in strict financial theory they’d do best to scrap the dividend and repurchase shares at current prices).

* Credit score increases of client averaging 752 from 744, gross debt service level is 24% (would lead one to suspect that absent of catastrophe, clients would continue to pay mortgages above all else)

* They seemed to figure out how to stop losing money on buying Canadian preferred shares. They really should just outsource this to James Hymas, who I am sure will be able to provide superior risk/reward on these investments.

The big question is the looming impact of regulatory changes, an issue previously discussed on this site. Some snippets:

* On the issue of OSFI capital calculation changes, the “new” target is 150% (from 220%), and in the new framework, they are at 155-158%, the previous June 30, 2016 quarter had it at 153-156%.

* Impact of BC announcement of 15% property transfer tax on foreign buyers in Vancouver area:

As of August 2, 2016, foreign individuals and corporations will be subject to an additional 15% land transfer tax on the purchase of residential property in Metro Vancouver. The Company does not expect these changes to have a material impact on its business, as foreign borrowers are typically not eligible for high loan-to-value mortgage insurance.

* Impact of the mortgage changes and applicability of transactional and portfolio insurance on various mortgage properties:

After the Company’s review of the mortgage insurance eligibility rule changes announced October 3, 2016, it expects that the transactional market size and its transactional new insurance written in 2017 may decline by approximately 15% to 25% reflecting expected changes to borrower home buying patterns, including the purchase of lower priced properties and higher downpayments.

As the result of clarifications provided by the Department of Finance after the October 3, 2016 public announcement, the Company now expects that portfolio new insurance written in 2017 may decline by approximately 25% to 35% as compared to the normalized run rate after the July 1, 2016 regulatory changes for portfolio insurance. The new mortgage rules prohibit insuring low loan-to-value refinances and most investor mortgages originated by lenders on or after October 17, 2016.

Notes: I had anticipated transactional insurance would drop by 1/6th (so this is within the 15-25% estimate), and I thought portfolio insurance would get completely shot up (which is going to be the case).

Basic calculations would suggest that if transaction insurance gets dropped 20%, the annual run-rate is about CAD$521/year, plus whatever insurance premium increases that will happen in 2017 as a result of heightened capital requirements. I had originally given some conjecture that this number would be CAD$570 in the end – which is still a pretty good number even if the combined ratio goes up to 60% or so – you’re looking at a very, very, very profitable entity.

Portfolio insurance will taper down and contribute about $60 million/year in written premiums.

Going forward, Genworth MI should produce about $570-580 million/year in written premiums, without increases in mortgage insurance premiums.

Cash-wise, at a 50% combined ratio (30% loss and 20% expense) and a 26% tax rate, shareholders are looking at $210-215M/year or about $2.32/share in operating net income. A $6.2 billion investment portfolio at 3.2% blended yield gives $1.60/share, taxed at 26%. Combined, the entity would still pull in cash at $3.92/share – considering the $27.86 share price currently, this is trading at a P/E of 7, at a book value of 30% below par… needless to say, an attractive valuation.

I generally do not care about the top-line revenue number as this just represents an amortization formula of the unearned premium reserve. However, analysts and uninformed members of the public do tend to care about this since revenues translate into bottom-line results, and this number will continue to rise over the next year above the $162 million they booked this year. The only thing that will change this is a change in claim experience and time – for any given insurance policy, more of it gets booked in the earlier stages of the policy than the later ones. The increasing revenue number will result in higher amounts of higher reported net income, and higher EPS.

Questions for conference call:
– Impact of Genworth Financial’s acquisition on Genworth MI – what restrictions would there be on equity repurchases – and asking about the out-right sale of the MIC subsidiary (which, at current values, has to be put on the table);
– Ability/willingness for Genworth MI to repurchase shares at extremely discounted book value per share prices;
– Regulatory impact of private mortgage insurance $300 billion cap (currently at $275 billion for all private entities, MIC at $221 billion);
– What the MCT internal target will be with the new OSFI capital regime.

Final thoughts: Right now, repurchasing shares of Genworth MI is such a no-brainer shareholder-enhancing decision. I hope management can snap on it. The common shares are trading on the basis of Canadian real estate fear and not in any regard to the underlying financial reality which show an entity that is generating a massive amount of cash.