PrefBlog

It was an up-and-down month, but in the end TXPR ended up with a tiny gain on a total return basis: 1527.46 on April 28 vs. 1527.41 on March 31.

It’s always nice when a sharp eMail comes in to spice up the day! Assiduous Reader JT writes in and says:

James I was surprised and shocked to see no comment on the PrefBlog about Home Capital!!

I am sure you have an opinion, since the regulator is deeply involved and may have pushed HCG into that capital raise.

I am sure I’m not the only regular viewer wondering what you might have to say.

I wait with interest with your comments.

Well! As we know the story so far begins with the OSC Statement of Allegations:

2. On July 10, 2015, HCG announced that an ongoing review of its business partners had led it to terminate certain brokers, causing an immediate drop in Originations. The next trading day, HCG’s stock price fell 18.9%, resulting in an approximate $600 million loss in market capitalization and significant investor harm.

3. Prior to this announcement, from February 2015 until July 2015, HCG misled its shareholders as to the immediate and on-going causes of the decline in Originations. Internally, HCG knew it had terminated certain brokers because it had discovered fraud in HCG’s broker channels. In fact, in February 2015, HCG was completing a six-month investigation into fraudulent employment income documentation (“Project Trillium”) which was overseen by a special committee of the Board of Directors (“the Board”). Project Trillium confirmed that HCG was receiving fraudulent employment income documentation through its broker channels which had not been detected by HCG’s underwriting controls. In particular, the findings of Project Trillium highlighted the scale of the fraudulent documentation flowing through HCG, and the serious systemic underwriting control deficiencies within HCG. Given the findings of Project Trillium, HCG implemented two significant changes: (1) termination of certain broker relationships; and (2) specific remediation of its underwriting processes and controls.

This gradually led to a very nasty time for the company’s investors:

Short sellers are gloating, investors are writhing in pain – and everyone else is wondering whether Home Capital Group Inc.’s troubles will reverberate beyond the home lender’s withering stock.

The share price of the Canadian mortgage lender fell 65 per cent on Wednesday, extending the total decline this year to more than 80 per cent.

There were funding difficulties and speculation of a ‘Wile E. Coyote Moment’ for Canadian house prices:

Home Capital revealed Wednesday that clients pulled money out of its high-interest accounts over past four weeks, with balances falling $591-million to $1.4-billion. The company said the pace of withdrawals picked up in the past week. Many of Home Capital’s customers are relatively sophisticated.
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Home Capital plans to right the ship by locking in capital, which in turn will stem the exodus of deposits. If that happens, this crisis of confidence will pass. Traditional factors such as interest rates, supply and demand will set prices in residential real estate markets. But if Canada’s alternative mortgage lenders face an unexpected liquidity crisis, the housing market is in for a potentially nasty downturn.

Now it seems that emergency funding at a penalty rate has alleviated the panic a little:

Home Capital Group Inc. shares roared back Thursday, as the beleaguered mortgage lender firmed up an emergency multibillion-dollar loan and signalled that it may sell itself.

The stock closed up 34 per cent on the Toronto Stock Exchange, its biggest one-day increase in more than 20 years, as some investors wagered that the company is regaining its financial footing – at least for the time being.
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In a release on Thursday, the company said it had a firm commitment on a $2-billion credit line with a 10-per-cent initial interest rate and a $100-million initial fee from a “major Canadian institutional investor.”

However, DBRS has downgraded the firm:

DBRS Limited (DBRS) has today downgraded Home Capital Group’s (HCG or the Group) Senior Debt rating to BB from BBB (low) and its Short-Term Instruments rating to R-4 from R-2 (low).
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Concurrently, DBRS has placed all ratings Under Review with Negative Implications
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To address its deteriorating liquidity position, the Group announced this morning that it has reached an agreement in principle with a major institutional investor for a credit line of up to $2.0 billion, for which it expects a firm commitment later today. This high-cost 364-day facility would be secured against a portfolio of HTC mortgages. In exchange for the immediate liquidity, HTC would be required to pay a $100 million non-refundable commitment fee and make an initial withdrawal of $1.0 billion. The interest rate on outstanding balances would be 10.0% in addition to a standby fee on undrawn funds of 2.5%. In DBRS’s opinion, the resulting interest and fee payments totalling $225 million at best, or $300 million if fully drawn, over the next year on the facility would put material pressure on earnings. Indeed, even in the best-case scenario of drawing the minimum $1.0 billion on the facility, these costs would represent 67% of the Group’s FY2016 income before taxes of $335 million. Moreover, other funding costs are likely to trend higher while originations are likely to decline, given the recent provincial government’s proposed measures to temper the overheated Ontario housing market, placing further pressure on earnings.

… with S&P not far behind:

S&P Global Ratings said today it lowered its long-term issuer credit rating on Home Capital Group Inc. (HCG) to ‘B+’ from ‘BBB-‘ as well as its short-term issuer credit rating to ‘B’ from ‘A-3’. At the same time, we lowered the long-term and short-term issuer credit ratings on Home Trust Co. to ‘BB’ and ‘B’ from ‘BBB’ and ‘A-2’, respectively.
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On April 27, HCG announced that its subsidiary, Home Trust, has reached a binding agreement with a major institutional investor for a 364-day credit line in the amount of C$2 billion (of which C$1 billion has to be initially drawn), which would be secured against a portfolio of mortgages originated by Home Trust. While the access to the credit facility serves to fortify liquidity amid increased market anxiety, we believe the terms are highly onerous. We estimate that with an upfront non-refundable commitment fee of C$100 million, an interest rate of 10% on balances outstanding, and an additional 2.5% standby fee on undrawn funds, the all-in cost to borrow the first C$1 billion is an effective annual rate of 22.5%.

Well, I don’t really have a big problem with the regulators on this one. The allegations are serious and will be hard to defend at the hearing. There may have been some regulatory involvement in the funding agreement and contemplated sale – which would be grossly improper – but I’m not going to jump the gun on this one; I’ll wait until evidence, if any, emerges regarding regulatory clerks pretending to be hot-shot determiners of corporate financing.

It is, however, interesting to compare this with what happened with Manulife during the crisis, in which a major capitalization problem was addressed by sucking political arse until the rules were changed, mitigating the problem dramatically. Being a member of the Club can have great value, well worth a few highly paid positions on the payroll for ex-regulators!

I’m much more interested in the recent regulatory grandstanding over binary options:

The Canadian Securities Administrators (CSA) today published for comment National Instrument 91-102 Prohibition of Binary Options. The proposed instrument would prohibit advertising, offering, selling or otherwise trading a binary option to an individual.

The details admit the pointlessness of this sound and fury:

By publishing the Proposed Instrument, we are not suggesting that current offerings of binary options in Canada are legal. Many of these products and the platforms selling them have been identified as vehicles to commit fraud. We emphasize that no offering of these products, including by a broker, dealer or platform, has been authorized in Canada. All current offerings in Canada are therefore illegal, with only limited and narrow exceptions for transactions with highly sophisticated investors.

Nevertheless, some persons are using misleading information to promote these products as legal and legally offered. It is our intention that the Proposed Instrument will make it explicitly clear that these products may not be advertised, offered, sold or otherwise traded to an individual in Canada

In other words, the regulators are so upset that criminals are offering these products that they’re going to make it illegal for Canadian firms to compete with the criminals to meet the demand. That’ll show ’em!

I discussed the regulators lackadaisical attitude toward binary options fraud on March 1, noting:

It’s much easier and just as well rewarded to simply sit in the office and play ticky-box with desperately cooperative Canadian firms.

Readers of the Globe story that I linked at the time will remember:

[senior investigator at the Manitoba Securities Commission ] Mr. [Jason] Roy said it is not easy for Canadian regulators to go to Israel to seek justice, however. He said investigators cannot identify the perpetrators behind the frauds.

[A fraud victim’s son] Mr. [Tomas] Ferreira said his family was contacted by a lawyer in Israel who is trying to win restitution for victims. He would also like Israeli police to investigate and lay fraud charges.

How about that, eh? It never occurs to our Wise Regulators to go after the fraudsters in their home jurisdictions. It never occurs to them to pick up the damn ‘phone and call the damn Israeli Securities Authority to develop a campaign … or to hire their own Israeli lawyer to start causing trouble for the crooks. The only thing our beloved regulators know how to do well is play ticky-box with desperately cooperative Canadian firms.

PerpetualDiscounts now yield 5.10%, equivalent to 6.63% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 3.75%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 290bp, a slight (and perhaps spurious) widening from the 285bp reported April 19.

One thing struck me when reading an account of how some Syrian refugees are doing, now that the first year of special supports has come to an end:

A few among the 28 government-assisted families who have settled in Leaside Towers have found work in the neighbourhood – some frying up halal chicken at the Popeyes, or stocking shelves at Iqbal Halal Market. But some see a disincentive to taking a minimum-wage job: In Ontario, if you are on Ontario Works and get a job, half your earnings over $200 are deducted from your welfare cheque. As they see it, they’d be bringing home so little money that they’re better off using that time to focus on improving English, or running their households, which can consume much of their day.

half your earnings over $200 are deducted? Well of course they’re better off using that time to focus on improving their English or running their households. That’s a complete no-brainer and returns us to a question I have often discussed on PrefBlog, the effective tax rate for low earners.

I advocate a guaranteed minimum income – administered through the tax system, as a refundable tax credit – with more rational marginal tax rates … if you make $20,000 per year, you should pay a tax rate of – say – 10% on your next $1,000, regardless of where the $20,000 comes from. Only in this way can we really say we are making an effort to help people get out of the poverty trap. When we tax that $1,000 at 50%+, we’re clearly just chanting slogans and affirming our moral superiority.

Where’s the incentive to volunteer for an extra shift? Where’s the incentive to take a risk and move in order to get a slightly better job? Nowhere, that’s where. It’s craziness.

So it was with interest that I read today of an Ontario pilot project with respect to basic income:

About 4,000 recipients will be randomly chosen from the three regions. One group will start receiving the so-called basic income as soon as this summer, and the remainder will be part of the control group, which will not receive any payments, according to a provincial spokesman. A single person could receive up to $16,989 per year. A couple could get up to $24,027 annually.
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However, if an individual is receiving income from a job, the government will deduct half of his or her earned income.

Utterly moronic. I have no words to express my disgust at the cruelty of those who would even consider slapping the poor with a 50%+ tax rate – or perhaps it is their cynical machinations to ensure the failure of the pilot programme that disgusts me. I’m not sure how explicit taxes will work, but I suspect that in practice the “+” in “50%+” will be a significant number – particularly when more subtle taxes, like disqualification from ‘geared to income’ pricing, are considered.

There were two charts I found particularly interesting in a Globe “Explainer” regarding Ontario’s proposed housing legislation.

The first provides a historical count of rental units by type:

Click for Big

That’s as good an explanation as any of the benefits that rent control brings.

The second is a historical accounting of individuals owning multiple properties in the region:

Click for big

That’s as good an explanation as any of the effect of poor stock market returns on the housing market; an effect which is exacerbated by low interest rates.

Meanwhile, it was a pretty nasty day for preferred shares. There was no major change in bond yields today, so I suppose we’ll just have to put this one down as a delayed reaction. TXPR was rebalancing today; it is obvious that this might lead to high volume, but an influence on direction is less clear.

The TXPR Total Return Index is now slightly negative for the month. The smoothness of today’s decline makes me suspect the day’s action was due to selling from one big player … but that is merely speculation!

Click for Big

So, what the Liberal government of Ontario has done for electricity, they are now doing for housing:

Ontario’s Fair Housing Plan introduces a comprehensive package of measures to help more people find affordable homes, increase supply, protect buyers and renters and bring stability to the real estate market.

The roots of the housing price boom are:

• low interest rates
• an explosion of CMHC guarantees, and
• unsatisfactory stock market returns

I don’t see anything in the plan that addresses any of that.

So the Toronto real estate market is on fire and, as usual, there are those who consider this a bad thing. So far we’re blaming foreigners and speculators … we only need to bring short sellers into the mix to complete the trifecta! But I found the following chart in an otherwise unexceptional puff-piece to be fascinating:

Click for Big

PerpetualDiscounts now yield 5.08%, equivalent to 6.60% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little under 3.75% so the pre-tax interest equivalent spread is now about 285bp, a significant widening from the 275bp reported April 12.