When we first said three weeks ago that the spectacular, sudden implosion of Canada's largest alt-lender Home Capital Group or HCG - whose fate we had followed closely since 2015 - was Canada's own "New Century Moment", the parallels were more than just the obvious: like in the US, it took the market nearly a year to realize the full implications of the subprime collapse which first manifested in the failure of New Century and its subprime lender peers. When all was said and done, the world's central banks had to pump (and still do) trillions into the financial system to stop it from disintegrating.
Slowly but surely, Canada is starting to appreciate just how serious the Home Capital failure is, and how the unprecedented bank run that has led to 94% of retail deposits fleeing the troubled lender...
... is just the first step of what will likely be a very painful process, which will likely culminate with either a government bailout, or a financial system on the verge of panic.
Today, the Globe and Mail has published an in-depth report putting the HCG pieces together, or as the G&M itself puts it, the "dramatic story of a financial institution’s near-collapse."
How quickly can a financial institution go from seemingly healthy and solvent to being on the verge of liquidation? The answer: hours. Here is the background:
It was late in the evening on Sunday, April 30, when lawyers working for Home Capital Group Inc. dialled into a call with lawyers representing the company’s new lending syndicate. The troubled mortgage lender had negotiated a $2-billion credit line just days earlier, emergency money the board felt was needed to survive after a high-profile run on deposits at subsidiary Home Trust. The company planned to draw down the first $1-billion from it the next morning, May 1.
But the deal was getting bogged down in a last-minute dispute over details of the funding, according to two sources familiar with the talks. As the conversation proceeded late on Sunday, it became increasingly evident that the fate of the financing was hanging in the balance. Another call at 2 a.m. on Monday ended badly with no agreement, a source said.
There was no room for error. Home Capital was hours from the start of its business day, and it was critically low on capital. The board had determined the company could not open its doors for business Monday morning without the financing in place, the sources said.
As the dispute continued, officials from Canada’s banking regulator, the Office of the Superintendent of Financial Institutions (OSFI), were on standby to launch a process to take control of the company Monday, a move that would have almost certainly forced some form of wind-up of Home Capital’s business, the sources said.
In the end, some time prior to 7 a.m., the lawyers hammered out a deal on final terms of the loan, allowing the first $1-billion to be transferred Monday. When business started a couple of hours later, only a small circle of exhausted insiders knew how close the company had come to collapse.
The collapse started on April 19...
... much of the unrelenting focus on the company is also due to the rarity of a financial institution failing in this country. Canada Deposit Insurance Corp. (CDIC), which insures deposits in the event of a bank failure, hasn’t paid a claim since 1996.
Many commentators have pinpointed April 19 as a pivotal date when the Ontario Securities Commission unveiled an explosive enforcement case against the company and three of its executives, accusing them of making misleading disclosure to investors about mortgage underwriting problems in 2014 and 2015. But if the OSC announcement sparked a conflagration at Home Capital, it was only because there was so much dry tinder already in place to ignite. The case landed amid a broader backdrop of concern about the company’s financial condition, a loss of faith in senior management and the board, and extreme nervousness about the vulnerability of a non-prime mortgage lender deeply exposed to Toronto’s overheated housing market.
... but the seeds of failure had been planted years ago, roughly around the time we first noticed HCG and accused it of issuing "liar loans." It took regulators two years to catch up.
The first alert about the OSC case, for example, emerged late on a Friday afternoon on Feb. 10, when many had already left for the weekend. Home Capital Group issued a two-paragraph release revealing it had received an enforcement notice from the OSC, relating to disclosures in 2014 and 2015 about an internal investigation that found information on some loan applications had been falsified, leading to suspensions of 45 mortgage brokers. The enforcement notice said OSC staff had reached a preliminary conclusion about problems at the company, but Home Capital still had an opportunity to respond before the commission decided whether to launch disciplinary proceedings.
Why were regulators confused for so long: the answer is that unlike many comparable companies, the "ponzi scheme" at Home Capital worked at an extremely efficient pace, which created an image of stability as long as the money flowed in. However, once it stopped, all bets were off: This is precisely what emerged in February:
Home Capital had no trouble writing a growing number of new mortgages for non-prime borrowers in a hot housing market last year, but it also saw many of those customers leave at the first opportunity when their mortgages came up for renewal. Borrowers at Home Capital typically sign on for one-year or two-year mortgages in the hopes of moving to a mainline bank with a cheaper lending rate once their credit history is established. That leaves Home Capital facing constant churn, analyst Jeff Fenwick of Cormark Securities said, making its retention data one of its most closely watched metrics.
Of the $13.3-billion in residential mortgages on Home Capital’s books at the start of 2016, Mr. Fenwick estimates $6-billion or 45 per cent “rolled off” during the year – a rate of attrition far higher than faced by bank lenders, whose customers tend to opt for five-year mortgages.
“This is one disadvantage for a lender like Home – there is a consistent treadmill of origination activity that needs to happen in order to prevent the mortgage book from shrinking,” he said.
In a statement in February, Mr. Reid said the attrition rate was disappointing, telling analysts that performance in 2016 was “muted” by lower-than-expected renewals. He said improving retention would be a priority in 2017.
Then the bank jog started:
Canadian Imperial Bank of Commerce made a decision that would prove important, at least in hindsight. The bank issued an internal directive to financial advisers on March 28, telling them to limit their clients’ exposure in Home Trust’s GICs to the $100,000 limit insured by Canada Deposit Insurance Corp. The decision meant financial advisers had to shift assets above that cap to other institutions. Around the same time, Royal Bank of Canada made a similar move for clients of its full-service brokerage division. Bank of Montreal also imposed caps, but will not say when it introduced the limits.
Home Capital would later disclose that savings account withdrawals began to mount at the end of March, around the same time that these policies were implemented.
Meanwhile, Home Capital's shares started to plunge, as short sellers pounced:
During the same period, short-sellers moved into overdrive to fan fears about Home Capital, while filling social-media sites with speculative claims and half-truths. Short-sellers, who bet that a company’s share price will fall, have targeted Home Capital aggressively since the summer of 2015, making it consistently one of the most-shorted companies in Canada.
“The short-sellers to their credit were enormously successful in raising fear,” said a Toronto-based fund manager who held Home Capital shares. “If the short-seller’s job is to sow fear and confusion, they were very successful in doing it.”
But the reak crackdown started on April 19:
It was amid this worry, less than a week after the April 13 share price drop, that the OSC unveiled its allegations in the evening of April 19. While many of the main issues laid out in the statement of allegations had been previously disclosed by Home Capital, there were new details about the volume of material the company had collected in an internal investigation into its mortgage loan problems from mid-2014 to early 2015, but had not reported publicly until July, 2015, when pushed by the OSC to provide disclosure to investors. When markets opened the following morning, April 20, Home Capital’s share price began to crater.
A key concern was that the release came just hours before the Ontario government unveiled a series of measures to cool off Toronto’s housing market on the morning of April 20, including imposing a new 15-per-cent tax on foreign buyers. The combination of both was seen as a double-whammy, hitting Home Capital at a vulnerable time in the housing cycle.
The bank jog then became a silent bank run, first for the bank's core providers of funding: other banks.
On the morning of Friday, April 21, as investors scrambled out of Home Capital shares, a message popped up on financial advisers’ computer screens at Scotiabank. It was an internal notification from ScotiaMcLeod head Rob Djurfeldt, announcing that as part of an “ongoing review of 3rd-party products,” the bank would no longer allow the sale of Home Trust GICs. While some other banks had already limited sales of Home Trust products to the $100,000 CDIC cap, the memo suggested Scotiabank was going even further to cut off sales entirely. It was taken by many – including Home Capital itself – as a signal of a loss of faith in the company.
Over the subsequent weekend, however, Scotia abruptly changed course and put Home Trust back on its platform with a $100,000 limit per client. Some players in the market jumped to their own conclusions that a regulator was involved in the reversal.
This was the first regulatory intervention. It wouldn't be the last:
“When Scotia dropped Home Trust on a Friday, only to put them back on the following Monday, everyone connected the dots,” that regulators were involved somehow, said Lee Matheson, managing director with Toronto-based hedge fund Broadview Capital Management Inc., which has had a short position in Home Capital for the past 18 months. Alex Besharat, senior vice-president at Scotia Wealth Management Canada, was part of the discussions held internally at Scotia that weekend about whether to put Home Trust’s GICs back on its platform. “There was a lot to that decision – it wasn’t just sort of a one-dimensional decision,” he said in an interview.
OSFI turned down multiple requests for comment, saying it is prohibited from commenting on institutions it supervises or its supervisory work.
By this point, retail depositors realized things were going south fast, and proceeds to start pulling their own money out of the bank at an accelerating pace.
By Monday morning, April 24, Home Capital was facing a raft of withdrawals from depositors. The public nature of Scotiabank’s move was part of the reason for the rush, with Home Capital itself announcing Monday morning that the bank had put its products back onto its platform. The announcement served to ensure any financial advisers still unaware that other banks had quietly limited client exposure weeks earlier were now fully aware of at least one major bank’s moves to cap deposits at Home Trust. Many brokers and financial advisers quickly moved client funds to other institutions, unwilling to jeopardize their deposits for a slightly higher interest rate offered by Home Trust’s high-interest accounts.
Home Capital officials watched the pace of client withdrawals climb quickly on Monday, and decided they needed to do more to reassure the markets. That same day, the company announced that Mr. Soloway – Home Capital’s founder, who had remained on the board after stepping down as CEO in 2016 – would depart entirely as a director “when a replacement with recognized expertise in financial services is named.” However, the company said Mr. Soloway would still stand for re-election at the annual meeting, which was then scheduled for May 11, but has since been delayed until June 29.
It also announced Mr. Morton would step down as CFO, but only after the first-quarter financial results were filed. He would take on a new role as head of special projects, and would be replaced by Robert Blowes as interim CFO. Board chair Kevin Smith said the changes were aimed at rebuilding market confidence in the company. But the moves were again too little, and too late.
The first admission by HCG itself that it was on the verge came on April, duly noted here.
On Wednesday, April 26, the company made its first disclosure to alert the markets about the run on Home Trust’s savings accounts, saying deposits in high-interest savings accounts were down by almost $600-million to $1.4-billion from $2-billion at the end of March.
The announcement sparked a far broader panic, and was the first indication that many in the public had of the size of the company’s problems. Savings account withdrawals would accelerate rapidly through the subsequent days, leading to a classic unstoppable run on the bank caused by depositor panic. The company most recently revealed Home Trust has just $125-million left in its high-interest savings accounts, a decline of over 90 per cent since late March.
And the punchline of what until now was not known: the regualtor intervention amd the last minute rescue attempt:
Canada hasn’t seen a run on a bank such as this in decades, and many in the current crop of regulators have no personal experience dealing with the sort of crisis that unfolded in late April at Canada’s largest alternative mortgage lender. A source said regulators began co-ordinating discussions “early on” in the crisis, before Home Capital was front page news, but no one anticipated the company was so vulnerable. Last summer, OSFI had no concerns with the company’s capital levels, liquidity or stress test results, according to another person familiar with the matter.
But as the week of April 24 progressed, regulators grew worried they may not be able to halt the company’s slide. At one meeting involving officials from OSFI, CDIC and the federal finance department, there was discussion that Home Capital could collapse by early May, based on the pace of withdrawals and its remaining capital, the source said. Participants even discussed a scenario where Home Trust could fail, which would require Finance Minister Bill Morneau to sign an order giving OSFI control of the bank, the source said.
In the first two weeks of the crisis, top leaders and their staff – including OSFI, the Bank of Canada and Canada Deposit Insurance Corp. – were on the phone “every hour” to discuss their response, the first source said. At one point, a meeting at one regulator’s headquarters was interrupted repeatedly as officials left the room in a steady stream to answer urgent calls about Home Capital, the source said.
A focus of regulators has been on ensuring Home Capital remains “orderly,” the two sources said, and especially that there is no contagion to other institutions, including other specialty lenders such as Equitable Bank. Key regulators who monitor system risks in the financial system – including the federal finance department – have also held Sunday morning conference calls to discuss plans for the week ahead, with the heads of the organizations typically on the calls.
The rest of the story is mostly known to regular readers: for now it concludes with Brenda Eprile, the company's new Chair and former OSC executive director, trying to instill confidence.
Ms. Eprile said a committee of the board is also actively talking to new CEO and CFO candidates as one of the next top priorities. She said she feels “a real sense of optimism” that Home Capital is now stabilizing, especially after strong new directors like Mr. Hibben joined the board last week and immediately rolled up their sleeves to tackle a host of issues.
“There’s a real sense that we can make it,” she said. “We just have to be very hunkered down and do our plan, and the company can be restored to a very positive future.”
And if that doesn't work, there are always Canada's taxpayers.
In a separate interview, the Globe and Mail spoke to Canada's Finance Minister who said he expects a private solution to the crisis at Home Capital which still has "strong assets", and added that the government is very focused on Home Capital Group, and repeated that he doesn't see Home Capital's problems as being a broader real-estate market problem. The punchline: while he believes a bailout is "unlikely to be necessary", he won't rule out a bailout of Home Capital Group.
For the full Home Capital sage, there is much more in the full Globe and Mail article.