Posted by For those who don’t understand the reference, coal miners used to bring a caged canary with them because the bird, being more sensitive to carbon monoxide and other potentially toxic gases, would be an early indicator of trouble. In other words, if the canary stopped singing and passed out in it’s cage, it was probably a good idea to get out as fast as you could. It is with this metaphor in mind that I have followed recent events at Home Capital Group.
Readers will remember that I wrote a piece about the Canadian housing bubble at the beginning of the year that can be summarised as “Canada has a huge and unsustainable property bubble that will eventually pop and cause financial and economic havoc – but probably not this year.” For those who haven’t followed the saga of Home Capital, it is a “sub-prime mortgage lender” but being Canadian, we prefer the term “alternative lender”. I actually wrote about this sector in my earlier piece saying it they made up some 12.5% of the market in 2015 (probably more by the end of 2016 but I’m too lazy to look it up). These things are important to me because they are sometimes the best signals of how frothy a housing bubble is becoming. The weirder lending structures become (i.e., the three-generation mortgages in Japan prior to their bubble collapse in 1990 or the NINJA lending in the US sub-prime property bubble in 2007) and the more “non-regulated” (that means non-bank) lenders start popping up, the more advanced the bubble is.
But the media, being what it is, reassures us that Home Capital is only about one percent of the $1.4trn mortgage business in Canada. The problem is that the 45 mortgage brokers who engaged in “improper conduct” are still licensed which tells you two things: that the regulator has zero teeth and that these practices are systemic and widespread – not just a few bad apples. Home Capital, being a marginal lender, finances itself primarily by using expensive debt in the form of Guaranteed Investment Certificates (the Canadian way of saying term or time deposit but adding the word guarantee in it to make it sound safer – it’s not by the way). “Deposits have plummeted to $391 million from $2 billion, and while the firm has $12.9 billion in guaranteed investment certificate deposits its ability to attract new funding is in doubt. Indeed, on May 1, Home Capital said it would draw down at least half of a $2-billion emergency credit line it secured a few days prior from the Healthcare of Ontario Pension Plan.” That is, in reality, a de-facto government bail-out (although not directly as they used a quasi-government agency to do it with) but a more accurate description would be a band-aid as it does not solve the underlying problems at Home Capital; it only stabilises the short-term cash hemorrhaging – at the hefty cost of an effective interest rate of 22.5%. That Home Capital is drawing down funding that expensive tells you just how doomed they are. Even lousy third-tier property developers in China don’t pay rates anywhere close to that (maybe about a third of that rate to be clear).
At least the boys on Bay Street had the intelligence to circle the wagons before the Indians attacked as Equitable (another alternative lender like Home Capital) lost $75m in deposits in just three days and quickly got all big six Canadian banks to give it a $2bn line of credit to shore up confidence. American’s let Bear Stearns go bust and laughed as they picked the carcass clean – until Lehman Brothers imploded six months later. According to the Financial Post, “Many analysts see Home Capital — regardless of its ultimate fate — as an isolated issue. “It’s not the beginning of the end,” said Benjamin Tal, deputy chief economist at CIBC, noting the housing market is instead more vulnerable to a recession or rising interest rates. “Home Capital is not the ultimate test.” He may be right… it could be a case of nothing to see here folks, move along, move along. But the dead canary at the bottom of the cage should be enough of a warning for the rest of us.