I am still coming to terms with the collapse in shares of Home Capital. It wasn’t supposed to play out this way. The Canadian alternative mortgage lender saw its shares fall from an all-time high of $54.86 in August of 2014 to a low of $5.85 in May of 2017. At the time, I was working as an analyst at one of Canada’s largest asset managers. I spent 2014 and 2015 following only the Canadian banking sector. I saw the events at Home Capital up close.
The company was in the crosshairs of short sellers for years prior to its 2017 crisis. As an alternative lender in Canada’s frothy housing market, many shorts saw parallels between Home Capital and some of the worst-performing American subprime lenders. Steve Eisman, made famous in Michael Lewis’ The Big Short for his success betting against the US subprime bubble, was one of the first to come out publicly as a bear on Home Capital in 2013. And from there the criticisms continued for years.
The problem is that Home Capital was not the sequel to the US subprime debacle. Canadian house prices were still rising. Every alternative mortgage at Home had an equity cushion of at least 20%. Home had significant reserves of capital to absorb any loan losses, and there weren’t any loan losses, even from fraudulent mortgages discovered at the company in 2014. And yet, the lender was brought to the brink of failure by a run on deposits in late April of 2017.
Years later, I remain troubled by the events at Home Capital because they weren’t supposed to happen. They add a whopping asterisk to the investing concepts of intrinsic value and the Mr. Market analogy outlined in The Intelligent Investor. Treat the stock market as if it were a volatile neighbour, advises Ben Graham, the father of value investing. Sometimes Mr. Market offers to sell stock at a discounted price, other times he will agree to buy shares at an inflated quotation. The fluctuations in his mood should not inform the investor’s estimate of a security’s value. Stocks are worth the intrinsic value, the present value of future cash flows. Take advantage of Mr. Market’s oscillations when they provide an attractive opportunity, otherwise ignore him.
Mr. Market was quite depressed about Home Capital’s prospects for several years, but the fundamentals remained solid. Until that was no longer true. Mr. Market’s mood, the tsunami of negative sentiment circulating in the capital markets and media, became so dour that it actually eroded the intrinsic value of the company. The line between perception and reality proved more fragile than in Ben Graham’s analogy.
Thanks to Michael Lewis, there’s one thing that Steve Eisman is known for above all – shorting housing bubbles. So when Eisman expressed concern about overvaluation in Canadian housing at the Sohn conference in 2013, people paid attention. Eisman’s worries were really nothing new. Unlike the US, where house prices fell by upwards of 30%, Canadian house prices skated through the financial crisis relatively unaffected. Many analysts believed Canadian housing was overdue for a correction.
“After years of lecturing America about loose lending, Canada now must confront a bubble of its own,” declared a headline from The Economist in February 2012. The Bank of Canada was also worried, routinely fretting over the “elevated level of household indebtedness” and “imbalances in the housing market”. Across the country, household debt levels rose faster than incomes for two decades as lower interest rates made debt service more manageable. Home prices marched higher. There was reason to be concerned.
To Eisman’s mind, Home Capital looked vulnerable. “If housing rolls over, this company is going to have serious problems,” said Eisman in The Financial Post. Serving the “alternative” piece of the market, Home Capital appeared to be the Canadian equivalent of toxic American subprime lenders, those that had served NINJA borrowers (No Income, No Job, No Assets). For investors that missed the opportunity to profit from the US subprime debacle, here was the chance to participate in the sequel.
Only the reality of Home Capital’s business is more nuanced. Home was founded in the late-1980s by Gerald “Gerry” Soloway. A real estate lawyer by background, Gerry saw firsthand the kinds of deals being financed in the Canadian mortgage market. He observed that the mammoth Canadian banks were letting good deals slip through because of overly rigid underwriting criteria. There was good business to be done at the fringes of the market, you just had to look at it differently.
The large Canadian banks focused on the income and credit score of the borrower. Home took an asset-based approach to lending. Instead of mitigating risk principally through the borrower’s capacity to repay, Home looked to the property itself to provide protection. Home emphasized downpayments, accurate property appraisals, and lending in liquid markets where a sale could be executed quickly in the event of foreclosure. Serving this niche was very lucrative for Home shareholders, with the stock price increasing two hundred fold from the mid-1990s through to 2013.
As Home’s roots suggest, it is actually quite different from a US subprime lender. Start with the nature of the alternative mortgage book – loans made to entrepreneurs, those new to Canada, or people with bruised credit. Where subprime mortgage loans in the US were often made at or near 100% loan-to-value (LTV), the average LTV in Home’s alternative mortgage portfolio at the end of 2013 was just 68%. House prices would have to fall meaningfully before Home could even be in a loss position on its loans1.
Home also retains all of its alternative mortgages on balance sheet - it eats its own cooking. Many subprime lenders in the US securitized their loans after origination, collecting a fee and leaving third-party investors on the hook if the loans turned sour. This introduced a conflict of interest problem where the US lenders were incented to shoot for volume over quality. Not so for Home.
Home was also well-capitalized with large amounts of shareholder money set aside just in case loans went bad. Think of capital as the rainy day fund for a bank. At the end of 2013, Home’s common equity tier 1 ratio, the standard capital measure for a bank, was 16.8%, well-above the less than 10% level at the large Canadian banks and those of US subprime lenders pre-crisis 2 3.
Home Capital in 2013 bore little resemblance to a US subprime lender circa 2005. Home was not shoveling money to those with only a faint hope of repaying it. Home was scooping up credit-worthy borrowers that had slipped through the cracks. Yes, the housing market was frothy and Home would be hurt along with all lenders if a correction came. But its business model was sound and its balance sheet was conservative, capable of withstanding even a 40% correction in house prices.4
Home’s stock dipped in the days following Eisman’s presentation, but then quickly reversed course. Trading at only 6.5x earnings and 1.7x book value with a 2012 return on equity of 25%, the stock was cheap. On the back of rapid loan growth facilitated by a robust housing market, the lender posted strong results through the balance of 2013 and the first half of 2014. Earnings per share rose by 17% in the second quarter of 2014. The stock doubled. Founder and then-CEO Gerry Soloway, chafing at the short’s skepticism, held forth on a July 2014 conference call:
“Now before I conclude this conference call, I'd like to tell you a story of Home and the hedge fund shorts. At a hedge fund conference in New York City in 2013, Steve Eisman, a money manager made famous in the book The Big Short…addressed his audience at this conference. His prime recommendation was to short Home Capital stock…
“Now there are many strategies on how to deal with the widely disseminated call for a short sale of a company - from a robust reply which in some cases may include legal action to ignoring the short call…and focusing on the business. Home took the latter course of action. We kept our mouth shut, our heads down and continued to produce increasing profitable financial results quarter after quarter…depending on when the short was taken, the share price has increased anywhere between 87% to over 100% in the 14 months from the time that Mr. Eisman made his call to short Home stock.
“On July 3, 2014, Steve Eisman's hedge fund was shut down. The main reason reported was that its performance lagged behind the market according to a Wall Street Journal online article. However, Home continues to outperform the market and our market sector.”
Soloway’s victory lap would prove premature. Eisman’s presentation at the Sohn conference was not the last time confusion about Home’s business would cause problems for the company. In fact, as Soloway spoke these words, the seeds of the lender’s near collapse were being planted.
A Friday night press release is the best way for a company to slip out an inconvenient development it hopes will go unnoticed. Investors and analysts have left the office for the weekend. Many will not check in again until Monday morning at which point there will be a wave of additional news to drown out the Friday release. Skeptics are well-versed in this corporate trickery. So when Home Capital put out a cryptic press release on a quiet Friday in early July 2015, short sellers were intrigued.
In the release, titled “Home Capital Provides Update on Q2 Origination Volumes”, the lender disclosed that mortgage originations, the dollar value of new loans issued to borrowers, would be down in the second quarter - and not by a small amount. Originations of Home’s core alternative mortgages fell by 16%. Home also had a small business offering prime insured mortgages in direct competition with the big banks. Here results were even worse, with originations down 55% for the second quarter.
“Home Capital’s ongoing review of its business partners led to the Company terminating relationships with certain mortgage brokers, which caused an immediate drop in originations,” began the fourth paragraph of the press release. Home did not have branches or a borrower-facing salesforce of its own, instead originating all of its mortgages through third party brokers. Acting as an agent for the borrower, the broker shops around for the best mortgage deal. The brokers were Home’s connection to the borrower, collecting all documentation required to underwrite the mortgage on Home’s behalf.
On Monday morning, speculation swirled. Investors rushed to make sense of this announcement. It was a surprising discontinuity. Home’s origination volumes had also fallen short the prior quarter, down 10% on the alternative side and 38% on insured, but management said nothing about the termination of mortgage brokers at that time. Asked repeatedly about the shortfall on the company’s conference call in May, Soloway blamed the weather and macroeconomic caution:
“The first quarter traditionally is the slowest quarter for adding new noninsured mortgages. And that was exacerbated in 2015 by extremely harsh winter conditions. What happens is people do not like to list their homes in the middle of a blizzard or heavy snow conditions, and as a result, there are fewer properties for sale and usually fewer sales.
“But in addition, the company also continued to apply caution with its lending approach. Given the continued macroeconomic uncertainty, we're talking about a falling dollar, falling oil prices, gloomy economic reports during the first couple of months of the year, all of which caused Home to take a very cautious approach to some loan opportunities…”
With Home Capital stock down 19% for the day, the reason for the broker terminations began to circulate among investors: fraud. Some mortgage brokers had submitted incorrect documentation about the borrowers to Home Capital. The home buyers were not as credit worthy as initially thought.
Home provided more detail a few weeks later in a July 29th press release. “In late 2014…an external source alerted Home Capital’s Board of Directors to possible discrepancies in income verification information submitted by certain mortgage brokers.” In some instances, the documents used by Home to verify a borrower’s income, things like pay stubs and T4 tax slips, had been stretched or fabricated entirely. Home found 45 mortgage brokers that submitted applications with falsified documentation. It suspended its dealings with all 45.
Though Home only suspended 45 brokers out of the 4,000 that it worked with at the time, the suspended brokers were high volume, accounting for 12.5% of total originations in 2014. It now seemed that the broker suspensions were a contributor to the origination shortfall in Q1, not simply weather and economic caution as Soloway had claimed. So why did management obfuscate the cause with Q1 results? We will return to this later.
For those skeptical of Home Capital, July 2015 was bliss. Add fraudulent mortgages and questionable management disclosure to the list of knocks against the company. The shares were down by about a third from the July 10th close. And yet, in the July 29th press release, Home stated that, “it is unlikely this matter will lead to credit losses”. In other words, while the borrower might not be as credit-worthy as Home thought, the loans were still money-good. Investors were overreacting. But how could mortgage fraud not lead to losses?
Home offers two kinds of residential mortgages. Its alternative product, our focus so far, is for those that do not fit the rigid underwriting criteria of the big banks: self-employed, new to Canada, and bruised credit. The maximum loan-to-value for alternative mortgages is 80%. Home also does a small amount of prime insured mortgages in competition with the big banks. These are borrowers with more traditional income sources, typically a salaried employee with a T4 tax slip, and LTV could be as high as 95%. These mortgages are insured by the federal government, insulating the lender from any credit losses.
The fraud at Home Capital carried across both the alternative and prime insured mortgage books. It ranged from the fairly innocuous – overstating the number of years of employment or mischaracterizing tips as salaried income, for example – to the severe – outright fabrication of T4s to inflate income. But importantly, Home found no problems with the property appraisals – the value of the dwelling was accurate – and no issues with credit scores. As an asset-based lender, Home’s focus was always more on the property than the borrower for its alternative mortgage product. But, beginning in 2012, OSFI, the Canadian banking regulator, concerned about excesses in the housing market, pushed all banks to elevate standards for borrower underwriting. Staffed with former big bank executives accustomed to looking almost entirely to the borrower, not the property, OSFI pushed Home in this direction. Home was to “build up a file in order to give comfort that this was a good borrower,” said one source.
Under the new rules, some borrowers no longer qualified for an alternative mortgage with Home. Rather than be forced into the private mortgage space where rates could hit double-digits as compared with the 5%-area for a Home alternative mortgage, brokers fabricated or exaggerated income information5. As an asset-based lender, the substantial equity cushion meant that this was still good business for Home, within its risk appetite. They would have continued to issue these loans even with the true, not inflated, picture of a borrower’s income. But OSFI was tying Home’s hands, forcing more attention on income. The fraud was about prettying up a borrower that Home was fundamentally comfortable with to meet OSFI’s standards.
Home’s alternative mortgages typically renew after a year or two. While the loans will be repaid over 25 years, borrowers hope to improve their credit file in relatively short order and graduate to a prime mortgage. They desire the short renewal window so that the Home mortgage can be swapped for one with a rate 2-2.5% lower. However, this short renewal window also provides Home with the option to de-market a loan, to force the borrower to find a different lender, quite regularly. They are not stuck with a bad underwriting decision for the entire 25 year amortization of the mortgage.
The fraud on the alternative side of the book was dealt with quickly. Mortgages with problem documentation were either re-underwritten to comply with OSFI standards at the time of renewal or not renewed at all, forcing borrowers to seek an alternative source of financing. And no credible analysis of the situation would have raised a concern about potential credit problems. House prices were strong and these loans had at least a 20% equity cushion. How does a lender lose money with a property solidly above-water?
On the prime insured side, brokers were also chasing a better rate for their clients by fabricating income information6. Even with a distorted view of income, losses on these mortgages did not seem likely. House prices were strong so the borrowers were above water and on the insured side, the federal government was supposed to be on the hook for any losses. There was a possible exception - in the event that employees of the lender were complicit in mortgage fraud, losses could be “put back” to the lender. But Home Capital management believed that no employees were complicit, even though a few employees had been fired as a result of an internal investigation7. In Home’s mind, this was a problem with the third-party mortgage brokers. Prime insured mortgages typically renew every five years providing an opportunity to re-underwrite the problem loans well before the final payment.
“These are not people who set out to get something, who didn’t want to make the payments and comply,” Soloway was quoted in the Globe & Mail at the time. “These are people who wanted a home and in order to facilitate it some of the documentation was not accurate. But the value of the home was accurate and the credit score was accurate and that’s why they’re performing so well." The results bore this out. Home experienced no uptick in credit losses in the years following discovery of the fraud8. In fact, according to one source, sitting in 2021 with full hindsight, the mortgages from the problem brokers actually performed better than the rest of the portfolio!
It’s official – the mortgage fraud at Home Capital was a giant nothing. It did make for a good story, though: Amid the backdrop of a bubble in Canadian housing, management at subprime lender covers up mortgage fraud. With that as his springboard, Marc Cohodes pounced.
Most investors and short sellers see themselves as spectators, watching the hockey rink from a distance with little ability to influence the result. Sure, they can shout some encouragement or point out the position of an opposing player, but this has little effect on the game, just as it would have little effect on the business. The investor’s job is to predict who will win the game and by how much, not to play the game. The on-ice action, the business reality, and those in the stands, equity investors, are separate and distinct.
Marc Cohodes takes a different approach. He is an activist short. He does not confine himself to the traditional spectator role, but uses aggressive and unorthodox tactics to reshape the game itself from the stands. He will loudly challenge coaching decisions, berate the referees, and heckle the players. Sometimes, it works. The coach decides to bench a star player, the linesman overturns an important call or the home team is distracted by the unusually raucous crowd. From the seats, Cohodes alters the trajectory of the game.
Cohodes is a seasoned short seller, beginning his career at Rocker Partners in 1985. Known for his “disarming candor and high-octane mouthiness,” according to Richard Sauer in Selling America Short, Cohodes took over Rocker Partners in 2007 and changed the name to Copper River Management. His time at the top was short-lived as, according to Sauer, the firm posted losses of 55% in 2008. Squeezed by margin calls and a ban on short selling in September 2008, Copper River had to close positions at an inopportune moment. Cohodes now invests only for himself from his California chicken farm.
Beyond simply chasing profit, Cohodes, according to Sauer, sees himself as a stock market vigilante, “out for truth and justice.” Sauer, a former SEC attorney turned Copper River employee, relays one “legendary episode” in which Cohodes, “appeared at a shareholder meeting in a striped referee shirt and, after every management statement he deemed misleading, blew a whistle and threw a red penalty flag”. “I’m a serious, serious guy. I can’t stand this stuff…I’m on top of this. I am driven. I am focused. And I’m not going to end ‘til I hear the whistle blow,” Cohodes said during an interview with Canada’s Business News Network in early 2017.
Ask any investor about Marc Cohodes and the crisis at Home Capital and the first word to come to mind is likely to be Twitter. Not fraud. Not credit losses. Not deposit run. But Twitter. Twitter is Marc Cohodes’ medium of choice for advancing his negative views about a company. Through it, he seeks to colour the perception of other fans in the crowd, the investors, so that the arena in which the game is occurring is as inhospitable as possible for the players, the management of the target company. From his initial involvement with Home in mid-2015 through to the near-collapse in early 2017, Cohodes tweeted unrelentingly about the lender.
Consider this series of tweets from November 2015. “HCG doesn't realize that I will grind their sorry asses until they come clean or give up,” reads one from November 4th. “The great thing about HCG holders is that they think Mgt is Legit. Laughable,” reads another from earlier that month. And this from November 19th, tweeted alongside a picture of a Pinocchio puppet on a bicycle, “Soloway driving to the office to sell more of his HCG shares”9.
Cohodes also disseminated his views through mainstream media, receiving coverage in major Canadian news outlets like The Globe and Mail, Financial Post, and Business News Network (BNN). “Home Cap with these mortgage things, they paint one story to investors which is, to me, it’s completely false, it’s a false narrative. They’ve had incredible turnover. They don’t disclose things properly. The [Ontario Securities Commission] is clearly involved in this. I think OSFI is staging Home Cap. And Home Cap’s public disclosure at best is poor and is extraordinarily disingenuous,” said Cohodes in an October 2016 interview with BNN. A July 26, 2015 article in The Globe describes Cohodes’ view on the company this way:
“Mr. Cohodes is convinced there is more to the story of what caused Home Capital to miss expectations by so much at a time when its biggest market, the Greater Toronto Area, is in the midst of a housing-price boom. He gets up at 3 a.m. and spends hours studying the company's financials, making calls to brokers, journalists, analysts and investment friends in Canada. He has memorized old television interviews with company officials and has reviewed past calls with analysts ‘102 times’ looking for subtle nuances in their statements. While a major bank might be able to shrug off such a setback, Mr. Cohodes is betting that Home Capital's share price has further to fall. ‘HCG is not too big to fail,’ he says. ‘It's not in anyone's national interest to keep them around. Anyone can do what they do.’”
At the Grant’s Interest Rate Observer investment conference in late-2016, Cohodes, an American, spoke about Home Capital while sporting a red jacket with “Canada” emblazoned on the back. “According to sources who used to be at the company and people familiar with the matters, the [mortgage origination fraud] allegedly began in January, February, March of 2014...HCG didn’t admit to it until July 2015,” he said. “In some of their disclosures in 2015, their numbers were wrong. I had a very good friend ask them a question on a conference call about the discrepancy of the numbers and as you folks know, numbers are usually not wrong, they’re usually proofed and gone over again and again and again. These numbers aren’t wrong, and they said it was a typo,” he continued. “Here are some of the departures in 2016, twice as many left in 2015,” Cohodes said while displaying a slide naming 33 former employees.
Cohodes also has a knack for charming his audience, “[Then CEO] Martin Reid happens to be the only bank president I’ve ever known who actually wears an earring. Nothing against earrings, I’ve just never seen it on a bank president…I’ve been doing this long enough when I see a bank president with an earring, that kinda turns me on. Not in that kinda way though”.
What is so remarkable about the commentary from Cohodes, aside from the sheer volume, is the absence of balance and analytical rigour. There is no clear investment thesis. There is no careful assessment of risk and reward. There is no room for ambiguity. Only complete and utter conviction that the stock is going lower and the company and its management team are somehow defective. The apparent objective is simple – raise doubt and undermine investor confidence.
Even though what Cohodes passes off as analysis would get him laughed out of the offices of most serious investors, amazingly, it seems to work. The goal does not appear to be persuasion, but rather dissuasion. A short seller like Cohodes does not need to convince investors of a particular view, arguing, for example, that the stock is worth 30% less or that competitive dynamics will shift to the detriment of the company. It is sufficient to raise doubt, to hurl plate of spaghetti after plate of spaghetti at the wall and hope something sticks. Confidence, after all, is emotional, not rational. It is, according to Nobel Prize-winning psychologist and economist Daniel Kahneman, “not a reasoned evaluation of the probability that [a] judgment is correct,” but rather, “a feeling which reflects the coherence of the information and the cognitive ease of processing it.” The more disconfirming evidence Cohodes can inject into the conversation, and the more salient it is in the investor’s mind, the less confident an investor will feel about buying a stock.
So when he mentions mortgage fraud, typos in investor materials, employee departures and earrings all in the same presentation, there does not need to be a unifying theme. Who knows what all this means about the worth of the company. But it raises doubt. It gives the appearance that something is amiss. The defense attorney has not proffered an alternative theory, but has convinced the jury that the prosecution has not surpassed the threshold of reasonable doubt.
Cohodes does not restrict himself to casting doubt in public - he makes private appeals as well. Most public companies are followed by a group of “sell-side” analysts. Employed by banks and brokers, these analysts carefully parse every corporate development and regularly publish research reports with their investment recommendations. I spoke to several sell-side analysts who claim to have communicated with Cohodes. They told me that their interactions ranged from frequent voicemails urging a more bearish outlook to a declaration that the analyst’s “career would be over” unless the stock were downgraded.
In the Fall of 2017, Cohodes turned his attention to another Canadian company, Badger Daylighting. At the Grant’s conference that year, he provided a handout to the audience, a copy of a letter sent to Badger’s Board of Directors. The letter states:
“Mr. Cohodes was told that, in about April 2014, Badger managers raised $75 million in capital from about 15 individuals that was not reflected on Badger’s books. The money is due to be repaid in 2019, with interest at 15%, payable monthly through Badger’s payable accounts to “ghost” companies. Greg Kelly, the CFO at the time of the off-book investment, resigned from the company in May 2014, along with others in his department. Those people have personal knowledge of the off-book capital investment.
“Mr. Cohodes recently analyzed the publicly available financial statements of Badger to determine whether he could confirm or deny the information he received. He determined that the information about an off-book capital investment that is being repaid appears to be true…”
An unnamed person tells Cohodes that Badger has $75 million of high interest debt not recorded on the balance sheet. He determines this information “appears to be true” and circulates it to investors. This is an allegation of very serious accounting fraud which Cohodes supports only with hearsay.
Sometimes Cohodes’ pronouncements are just plain wrong. Following Home’s July 2015 preannouncement, Cohodes appeared to confuse revenue, the spread earned by Home on its loans, with originations, the volume of new loans issued by Home. He tweeted, “…HCG misses Revenues by 600 million” when in fact it was originations that had declined by about $600 million versus the prior year, not revenue. In May 2016, he tweeted “The Shadow Banking System of which HCG is part of is what will blow Canada up.” This was simply inaccurate – shadow banks operate without regulatory oversight while Home Capital was and is overseen by OSFI.
Cohodes appeared to misunderstand the basics of a bank balance sheet in a November 2016 tweet. “Best Finance Man I have ever Known is The Late Great Mike Farrell. He said always Match Funding with your liabilities…” But funding for a bank – the deposits and other borrowings it uses to make loans – is a liability. It is owed to someone else, not owned by the bank. You can’t match liabilities with liabilities.
With the spaghetti approach, the reliance on hearsay and tweets that can be outright wrong, why do people pay any attention?
Well, Cohodes seems to have credibility. Sprinkled throughout any presentation or interview with the short seller will be references to his past successes, clashes with companies decided in his favour. “The Harvard Business School published a case study about my efforts in NovaStar Financial: A Short Seller’s Battle,” Cohodes wrote in an op-ed in The Financial Post. NovaStar, a failed US subprime lender, was a favourite reference point for Cohodes during his involvement with Home Capital. He also seeks out the on-the-ground perspective from former employees and competitors. This contributes to the appearance that Cohodes knows “what is really going on” at a company. One source told me that a private investigator offered former Home Capital employees up to $1,000 to have a cup of coffee and dish about Home10.
Home Capital’s internal investigation into the mortgage fraud was named “Project Trillium”. Cohodes mentioned Project Trillium as early as October 2016 in interviews with the media, even though it had never been disclosed to investors. When the existence of Project Trillium was later confirmed by the Ontario Securities Commission in an April 2017 filing, the short seller’s credibility soared. He seemed to have special insight into developments at the company. It made statements like, “…but I have a whole lot more, and I cannot wait until the final story’s told on Home Cap…” believable, even frightening.
It didn’t hurt that the share price of companies targeted by Cohodes often behaved in ways that were, well, unusual. Many professional investors spend their days glued to computer screens, watching stock prices on a minute-by-minute basis. Investors begin to worry if a stock moves without explanation. “I must be missing something,” an investor might think. The price chart doesn’t match the narrative about how the stock should be trading. Confidence is reduced.
Stocks targeted by Cohodes raise all sorts of alarm bells. Sudden drops of 5% or more often occur on no news. Investors turn to Cohodes’ Twitter feed to explain the move. On May 12th, 2017, the day that Cohodes first aired his short view on Badger, the stock fell by 16% and a further 10% the next day11. Whatever the cause of the drop, it enhanced Cohodes’ credibility. The mere mention of his name appeared to be sufficient to send some investors running for the exits.
The share price often serves as a proxy for public opinion, and it gave investors more reason to doubt themselves. It’s a twist on Solomon Asch’s conformity experiment. Subjects line up and are asked to answer a trivial question – which of the three lines shown matches the length of the reference line? But there’s an important caveat. All but one of the subjects are actors, instructed to provide the incorrect answer. As the experimenter progresses down the line to the volunteer, hearing incorrect reply after incorrect reply from the actors, the subject begins to question their perception. “I must be missing something,” they think. And so, in a substantial percentage of cases, the subject responds incorrectly to a question about which there ought to be no doubt.
Cohodes tends to select situations where there is some fundamental issue or concern about a company. In Home’s case it was the backdrop of a Canadian housing bubble and mortgage fraud. In the words of one analyst, he “sees a wobbly leg of the stool and tries to kick it out”. He piles on with his Twitter tirades and media interviews, creating as much doubt as possible, silencing the home crowd or perhaps even turning them against the home team. This creates a hostile environment for management of the target company and guarantees that any minor slip-up will be scrutinized.
For most businesses, a declining share price and loss of investor confidence would be annoying, but should have little effect on long-term value. The game continues uninterrupted even if the home fans are cheering for the away team. However, Home Capital is a special type of business – it’s a bank. Banks are confidence institutions. They borrow money on a short-term basis from the public and lend it out on a longer-term basis. All banks need depositors to believe that cash is available at all times, even though this is an illusion. If just a relatively small fraction of depositors request their money back at the same time, the institution is in trouble. This is known as a run on the bank.
For a bank, Home Capital was about as insulated as possible from a run. The great majority of Home’s deposit funding, 83% as of the end of 2016, came through guaranteed investment certificates (GICs). These deposits were locked-in for one to two years with no early withdrawal privileges. Home matched these fixed deposits with mortgages of a similar term. Take in a two year GIC, make a two year mortgage12. If Home was unable to replace the funding, the mortgage could be called in. Unfortunately, Home’s funding was only largely matched, 17% of deposits were still repayable on demand13. This would prove to be the crack in Home Capital’s otherwise impenetrable armour.
The 2015 storm clouds at Home Capital appeared to be parting by early 2016. Earnings were stable, the mortgage portfolio returned to growth, and there were still no credit losses from the fraudulent mortgages. Home took an important step with year-end financial results in February 2016, announcing a large share buyback for $150 million, or 6% of the stock.
Share buybacks are usually celebrated by investors. They’re a sign that management believes the shares are undervalued. Retiring stock at a discounted valuation will increase the value of the shares that remain outstanding. But in Home Capital’s case, the early 2016 buyback was important for an additional reason.
Banks are regulated entities. Decisions about what to do with their capital must be cleared with the banking regulator, OSFI. OSFI will not permit capital to be returned to shareholders, through higher dividends or share repurchases, if it is concerned about the health of the institution. The buyback approval signaled that OSFI was comfortable that the fraudulent mortgage issue was in the past. There were no material losses to come.
Home Capital stock was trading at 7.5x earnings or about 1.5x book value. The Canadian housing market remained strong and the company was set to see an acceleration in loan growth. OSFI provided reassurance. Sure, there was a lot of short seller attention on the company, but time would pass, the company would continue to post strong results, and concerns about mortgage fraud would fade. What was not to like?
The final act in the Home Capital drama occurred in the early months of 2017. It culminated in the run on deposits in late-April that, according to The Globe and Mail, brought the company within hours of failure. There is no direct causal link between a particular event and the concerned feelings of depositors underpinning the run. We can only examine the constellation of factors present and speculate about which proved decisive in the erosion of faith at Home Capital. “There’s not just one grain of sand that knocked the castle over,” said one source.
Against a backdrop of doubt about the company stoked by Cohodes and other short sellers, Home Capital was reprimanded by the Ontario Securities Commission (OSC) for its 2015 disclosure of mortgage fraud. As an Ontario-headquartered company, the OSC is the capital markets regulator for Home Capital, overseeing issues including investor disclosure. In addition to the OSC notice, the Board made the questionable decision to suddenly terminate CEO Martin Reid without a successor in-place and for no clear reason. In early 2017, these two events ignited already smoldering public concerns into a fire.
On February 10th, 2017 another Friday night press release from Home Capital, this time announcing an enforcement notice from the OSC. The OSC arrived at the “preliminary conclusion” that Home Capital had failed to meet its obligations during the period in 2014 and 2015 when the company was aware of mortgage fraud but had not yet disclosed it to investors. According to the OSC, shareholders had been misled by management about the cause of the origination decline.
Investors weren’t quite sure what to make of this. It felt like the OSC was revisiting ancient history. The mortgage fraud issue had long since been resolved; more than two years had elapsed without any credit losses. These sorts of OSC actions were typically settled with a small fine. They shouldn’t impact the share price. One person described Soloway’s attitude towards the OSC investigation as dismissive, bordering on arrogant: “How much is this going to cost me? $10 million? $20 million?” The stock fell 6% on Monday.
Cohodes tweeted several times on the back of the OSC notice. “I share my thoughts with more than just Twitter on HCG…I have a feeling the Queen Street Cowboys [Cohodes’ nickname for the OSC] are just starting their ride. GLTFA”. Indeed. Cohodes’ efforts to take down a company appear to extend beyond confidence erosion. Amidst the feeling that there is something wrong, Cohodes still requires a catalyst.
“I identified a number of questionable management and accounting practices with Home Capital Group, disclosed that information publicly and provided it to the Ontario Securities Commission,” Cohodes states in an August 2018 affidavit. Reach-out to regulators appears to be a key part of Cohodes’ playbook. From the stands, he coaxes the referees to rule against the home team. Richard Sauer describes his relationship with Marc Cohodes while working as an enforcement attorney at the Securities and Exchange Commission this way:
“Cohodes, however, was incredibly persistent. There was no limit to his desire to convert me—and the financial world at large—to his views about particular companies. He was the hardest-working man in the hedge-fund industry, so eager and palpably sincere that hanging up on him would have felt mean-spirited…
“Good cases were not easy to come by, so I could not afford to be picky about sources. No one would confuse a short-seller slamming a stock with an impartial third party. But it is a rare thing for anyone to rat out a company from pure public-spiritedness, and no one with a long position ever does so at all. I had learned years before that self-interest did not preclude good research. To the contrary, the one often led to the other…
“And, damn, Marc was persistent. The odds quickly mounted that whenever the phone rang, it would be him with a new fact or insight.”
Jump ahead from early-February to mid-April. The OSC converted the “preliminary conclusion” into a formal proceeding against Home Capital and three employees – Gerry Soloway, CEO Martin Reid, and CFO Robert Morton. As far as the OSC was concerned, this was a clear case of corporate wrongdoing. Instead of disclosing the mortgage fraud to investors, as was their responsibility, Home tried to bury it.
On first inspection, it’s hard to take issue with the OSC’s stance. How could management possibly think it was okay to conceal mortgage fraud? Even whispers of altered documentation on July 13th, 2015 were enough to tank the stock 19%. Plus, Soloway in particular had gone out of his way to obfuscate the true cause of the origination shortfall on the May 2015 conference call, blaming everything from weather to macroeconomic caution when he knew that broker terminations were a key driver.
Yet, upon closer inspection, things aren’t so clear. Instead of a black and white case of corporate malfeasance, this turns out to be an exercise in distinguishing shades of grey. Consider that, as per the OSC materials:
“Upon learning of the irregularities involved in mortgage applications, HCG conducted an internal investigation, the Board of Directors established an independent committee to oversee the investigation and appointed an accounting firm to assist in the investigation. HCG consulted with its external professional advisers throughout the investigation, including following the earnings call with analysts.”
Home Capital also disclosed the issue to all interested parties – OSFI, the Canada Mortgage and Housing Corporation, and its auditors.
This wasn’t a cover-up. Turns out, a special committee of the Board, chaired by Home Director Jim Baillie, a former Chairman of the OSC, was comfortable with the disclosure. The company also hired external advisors, including respected law firm Torys. No problem in their mind either. This bears emphasizing. A former Chairman of the OSC and the best legal advisors that money can buy both signed-off on the disclosure with which the OSC was now taking issue.
But why? Isn’t it obvious that mortgage fraud is a material issue, “a change in the business, operations or capital of the issuer that would reasonably be expected to have a significant effect on the market price or value of any securities of the issuer”? Well, not exactly. “Fraud is part of the business,” said then-CEO Martin Reid in a July 2016 interview with BNN. “Any market, whether it’s the market for mortgages or the market for passport applications will have some element of fraud,” said a source. In other words, this kind of thing happens from time-to-time in the Canadian mortgage market. According to an Equifax survey published in 2017, “13 per cent of Canadians felt it was okay to tell ‘a little white lie’ when applying for a mortgage…” and “16 per cent said they believe mortgage fraud is a victimless crime”. If this sort of thing was happening across the industry, did it really need to be disclosed?
Consider this: mortgage brokers in Ontario are regulated by the Financial Services Commission of Ontario (FSCO). Of the 45 brokers that were suspended by Home Capital, only two were disciplined by FSCO. In only one of the two disciplinary cases was the broker’s license actually revoked. The other got off with a $5,000 fine. FSCO decided that in 44 out of 45 cases, the individuals responsible for the fraud at Home Capital could still work as mortgage brokers in Ontario.
Remember that the financial impact of the mortgage fraud was minor. There were no credit losses. Earnings didn’t even go down on the back of the fraud, though the growth trajectory did slow. By late 2015, only a year after the fraud was discovered, loan growth had reaccelerated. Yes, the stock price fell precipitously on the back of the disclosure about broker terminations, but could management be held responsible for the capriciousness of investor moods? If the fraud had never been disclosed, investors would have only seen a temporary slowing in mortgage and earnings growth. That’s it.
Still, even though fraud was a normal part of the business, even though management determined the issue would not have a significant effect on the financial results, even though a former Chairman of the OSC and external legal advisors signed off on the disclosure, why not just tell investors the whole story to be safe? Management believed, according to sources, that Home would be able to quickly offset the impact from the terminated brokers. “This was Home Capital,” said a person familiar with the matter. Home was known for the aggressive pursuit of growth. The origination shortfall in the slow winter months would be recouped by the spring selling season. “Slower business growth over the next quarter [emphasis mine] will give us the opportunity to develop and implement fundamental strategic changes to the business,” wrote Reid in an internal presentation.
I think there is more to the story. Remember, the company’s deliberations about disclosure are occurring amidst a backdrop of misconception and short seller scrutiny. Any negative data point would be seized by skeptics to drive down the shares and erode confidence. Home was stuck. Do you expose the wobbly leg of the stool and give shorts the opportunity to kick it out or try to fix it in private?
Less than two months after the preliminary OSC notice, Home Capital issued a shocking update. On March 27th, 2017, Home announced that CEO Martin Reid would be leaving the company, effective immediately. Director Bonita Then, a former snack foods executive, would take over as interim CEO. Twitter lit up. “The shoes should begin to drop in HCG. If you own the stock because you think it’s cheap you will get your Clock Cleaned. THESIS DRIFT KILLS,” tweeted Cohodes after the announcement.
Investors were puzzled. It’s unusual for any company to abruptly terminate a CEO with no successor in place, but it’s especially rare for a financial institution where confidence is paramount. Reid had been the heir-apparent to Soloway, the public face of the company to most investors. Now he was being fired after only a year in the role. It didn’t make any sense. “Maybe Cohodes was right. Maybe there is something rotten at the company,” investors thought to themselves.
Management and Directors sought to reassure shareholders. Reid was terminated for performance reasons. The housing market was on fire and Home wasn’t achieving its potential. It should be growing faster. For many investors, this explanation seemed dubious. Didn’t the Board understand the level of skepticism in the market? Why not at least have a transition period to a permanent replacement?
Sources familiar with the situation suggest that Reid was not viewed by Soloway as his long-term replacement. He was meant to be a bridge to someone else picked by Gerry. Soloway, eager for an acceleration in financial performance and dismissive of concerns about bad optics decided it was time for Reid to go. The Board, stacked with those sympathetic to Soloway, were happy to comply.
Reid’s firing was a gift to the short sellers. It completed the narrative that something was off at the company. The alternative, that the Board had simply been so out of touch as to fire the CEO at a time when questions were already swirling, was difficult for many to believe. Cohodes appeared on BNN the following day with the shares down by 10%:
“Home Cap has been covering up their mortgage fraud issue for the better part of three years. They still haven’t come clean with investors. Former employees send me letters to my PO Box saying that the mortgage fraud is probably closer to $5 billion than $2 billion. And it’s time for the adults in Canada who regulate and oversee this company to take action, because what’s going on is frankly an embarrassment. For this company to still operate and to still tell people mis-truths of what’s going on, it’s ridiculous. And now they have a lady who ran something called Humpty-Dumpty Foods as the CEO. I can’t make this stuff up…”
The stock continued to drift lower into mid-April and plummeted over 20% on April 20th, the day after the disclosure of the full OSC proceedings. Cohodes again appeared on BNN:
“First of all, I really commend the OSC, who I also call the Queen Street Cowboys. I’m thrilled that they’re riding on Home Cap and I think that this is just the first of very many shoes to drop. I think the fraud at this company is widespread.”
The media rang the alarm bell. “Home Capital shares plunge after OSC accuses executives of making misleading statements,” blared a headline in The Globe. “The allegations come less than a month after the surprise departure of Home Capital’s second CEO in less than a year,” read an article in The Financial Post.
Home was now only days away from the apex of the crisis. But to an investor, calmly assessing the facts, there was little amiss. Through all the noise, Home was fundamentally strong. There were no credit issues. Capital ratios were robust. The housing market was on a tear. And, in an effort to calm investor nerves, Home pre-released earnings on April 21st for Q1 2017 showing EPS growth of 6%. Through this lens, the stock appeared to be a steal trading at less than 5x earnings and 0.7x book value – its lowest multiple ever.
But public perception had become totally divorced from reality. Home Capital was a subprime lender during a housing bubble with fraudulent mortgages on the books. Book value could not be trusted. The company had just fired their CEO for dubious reasons and the stock was in the toilet, now down by two-thirds from the all-time high in 2014. “I think that the fraud at this company is widespread. It extends to the Board…It’s top to bottom,” Cohodes declared on BNN.
And then things fell apart. On April 21st, rumours flew that Scotiabank had restricted client access to Home Capital GICs, the doing of a “mid-level” employee according to one source. Scotia’s move was a major indictment of Home, taken by a large and highly respected Canadian financial institution. While the financial consequences of this action were negligible in the short-term, the optics were atrocious. “SCOTIA BANK YANKS HCG GIC’S THIS MORNING…” Cohodes tweeted that day. It did not matter that the move was reversed by Scotia over the weekend as news traveled up the chain of command at the bank. The damage was done.
Remember Home Capital’s near-impenetrable armour? That 83% of deposits were locked-in, but the remaining 17% in high interest savings accounts could be withdrawn in a matter of days. Home lost two-thirds or $880 million of its high interest deposits the week of April 24th. By the beginning of May, virtually every dollar deposited with Home that wasn’t contractually locked-in was pulled, an unthinkable situation for any bank but especially shocking in light of Home’s strong financial position, robust results, and the fact that, as stated by the company on a conference call in early May, 90% of all deposits were insured by the federal government14. It was as if Cohodes had shouted “Fire!” in a crowded theatre, triggering a stampede for the exits, but there wasn’t even a hint of smoke.
This was absurd. Depositors were rushing to pull government guaranteed deposits from a sound institution. Turtle Creek, Home Capital’s largest shareholder at the time, would later summarize the episode this way:
“What surprised most market participants, including us, was the speed and severity of the loss of confidence in the company. The fact that it happened in the face of an exceptionally strong credit environment made it all the more unusual. In particular, there had been: no collapse in house prices; no hikes in interest rates; no jumps in unemployment; no increases in mortgage arrears; and, no deterioration in the overall profitability of the company. In other words, the run on the bank was not triggered by credit issues at Home Capital. Rather, the public lost faith in the company as a deposit taking institution because of a feeling that there was something wrong.”
On April 26th, Home confirmed the worst. The lender had obtained an emergency $2 billion line of credit to replace the fleeing deposits. The terms of the emergency line were terrible. Home would pay a $100 million commitment fee, 10% interest on amounts drawn on the line, and 2.5% on anything undrawn. These terms were awful given Home charged an average rate of about 5% on its alternative mortgages. Earnings would be wiped out. That the terms were so bad only deepened the sense among investors that something was wrong.
Perception that Home Capital was distressed created actual distress for the company. The stock collapsed to only $6, down 65% on April 26th. “BOOM BOOM OUT GO THE FUCKING LIGHTS $HCG,” Cohodes tweeted triumphantly. Investors rushed for the exits. We “don’t invest in things that are on fire,” said one prominent Canadian asset manager while liquidating its position.
Short sellers15 began calling for Home Capital to be wound-down by the regulators, as sometimes occurs in the case of a troubled bank. “Home Capital Group – it is time for the Canadian regulator to act,” proclaimed Australian short seller John Hempton, a newcomer to the Home Capital story, in a headline on his blog. Trading at only one-quarter of book value for a bank that had reported an annualized ROE of 16% for the quarter ended only one month prior, investors had given up. This was capitulation. Yes, there would be some erosion to book value from the emergency line, but if Home could restore confidence, it would likely return to trading at book value or higher, a potential 4x increase in the shares.
This was indeed the bottom for Home Capital. It marked the beginning of a rebirth that included perhaps the most surprising twist in the whole saga.
The change was swift. On May 5th, veteran finance executive Alan Hibben replaced Gerry Soloway on the Board. Days later Hibben was joined by Claude Lamoureux, Paul Haggis, and Sharon Sallows, all experienced Directors with deep financial services resumes. Home sold off non-core assets to bolster liquidity. It settled the OSC action in mid-June for an immaterial payment of $10 million. The press speculated about a potential sale of the company or strategic partner. The stock recovered, rising to the mid-teens by June, more than doubling off the bottom.
Outflows of deposits at Home Capital had slowed to a trickle at this point as high interest savings account balances bottomed at a paltry $100 million, down 95% from the late-March level. But the amounts in Home’s longer-term GICs also continued to drift lower as maturing deposits were not being fully replaced with new money. Home would need to address the slow GIC bleed in order to solidify its foundation and return to growth. Confidence had to be restored. “The only way to stop a bank run,” goes the old saying, “is to stack bars of gold in the windows”.
Home could sell the business in its entirety, perhaps to a private equity firm. Out of the public spotlight and in the hands of a strong sponsor, confidence could be restored to the Home name, driving a reversal in deposits. But that would mean public shareholders would miss out on the opportunity to participate in a recovery. Better to look for a partner capable of restoring confidence to take a minority stake in the firm. Shareholders would be diluted, but could hang around to see most of the gains from a turnaround.
Home Capital announced its partner on June 21st and it was a name no one expected – Warren Buffett. Berkshire Hathaway would invest $400 million to take a 40% stake in the company and replace the existing $2 billion line of credit on better terms16. “Home Capital’s strong assets, its ability to originate and underwrite well-performing mortgages and its leading position in a growing market sector make this a very attractive investment,” said Buffett. Cohodes was still in the crowd, riling up the fans and heckling the home team. But now Gretzky jumped over the boards, becoming the fifth man on the ice. The game was decided. Cohodes didn’t stand a chance.
Why would Buffett bother with Home Capital? The investment was inconsequential to Berkshire with its hundreds of billions in assets. Even a 10x increase in the shares would be a rounding error. Perhaps this was a favour to Canadian Prime Minister Justin Trudeau, resolving what might have been a problematic situation for the Canadian financial system. Some thought Buffett couldn’t resist a moneymaking opportunity, no matter how insignificant. While I could not reach Buffett for confirmation, the most compelling explanation was offered by someone close to the situation: “He felt it was not fair that a decent business got into trouble”.
Whatever Buffett’s reasoning17, the investment worked. GIC flows improved. Home hired a new CEO and CFO. The lender emerged from the crisis, reborn.
I tried to speak with Mr. Cohodes. I was eager for some nuance. I wanted to know why he thought OSFI had authorized a large share repurchase in 2016 if there was “top to bottom” fraud at Home. I wanted to know how he explained the Buffett investment, whether it caused him to doubt his own conviction. I wanted to know if he felt that things at Home had gone too far.
Alas, I was headed for disappointment. He agreed to speak with me, but ended the conversation as we zoomed in on the details. He’s suing Home Capital and did not want to prejudice his case18. “Here’s the weird thing with Home Cap…you know I’m suing them, right? I want to be careful…let me talk to my Canadian lawyer about what I can discuss or should discuss with Home Cap…I know an awful lot about Home Cap that has never come out. I want to see what [my lawyer] wants me to do,” he said. Fair enough. I didn’t hear anything further.
Short selling is a tough game. The upside is capped at 100%, but the downside is unlimited, at least theoretically. Add to the equation that it can be costly to borrow and short shares - at one point, the cost to short HCG was about 30% per year. If Home did not go to zero within three years, the short seller would lose money. Against such a stacked deck, a short’s desire to engineer a downside catalyst is more understandable. The trade only works if a stock is going way down, and fast.
I wonder whether Cohodes feels any remorse about what happened at Home. Without the opportunity to ask him, I am left to speculate. Perhaps he has made his peace that influencing the on-ice action from the crowd is the only way to make it as a short seller, having been scarred by the losses at Copper River in the financial crisis. Perhaps he genuinely believes that the companies he targets are truly rotten. Or maybe he sees the line between perception and reality as fluid. There are no spectators and players, that’s a false distinction. In the markets, we are all on the ice, battling it out in a war for control of the narrative.
Short sellers serve an important function in the markets. A skeptical eye amongst an investing public inclined to optimism dampens excesses that would otherwise occur. For every case of “short and distort” like Home Capital, there must be tens or even hundreds of “pump and dumps”, stocks that are over-promoted so that management and other insiders can sell their holdings at inflated prices. In aggregate, “pump and dumps” are a more serious hazard to investor health. Yet something feels more troubling about a situation like Home Capital.
The enterprise of innovation naturally entails a certain amount of speculation and loss. That is part of the game. That is how we move forward as a society. Losses are inevitable and whether they come from a bona fide attempt to create a new product or an overly promotional management team is hard to say. Chalk the losses up to the greater good.
Taking down a sound business like Home Capital is not pro-social. In fact, it feels like the opposite. We have evolved as a species to default to truth19, to believe what we are being told. To trust others so that we can work together. We are evolutionarily hardwired to find the doubt and skepticism of the short sellers distasteful. It is better that ten guilty persons escape than that one innocent suffer. And perhaps there’s an element of loss aversion – damage done to an existing company sticks more prominently in our mind than shortfalls relative to excessively optimistic promises.
I don’t know how to prevent another Home Capital. There are specific lessons we could draw. Securities regulators should be careful when bringing actions against financial institutions, for example. Or the Canada Deposit Insurance Corporation should do more to publicly shore-up confidence when an institution is in distress. But history is unlikely to repeat exactly.
I do know that there is a conspicuous asymmetry governing the actions of corporations and short sellers. Home Capital was reprimanded for disclosure that was, in my estimation, in a grey zone, while Cohodes was free to speak his mind. As short sellers hurl allegation after allegation at a company, responding to one will only foster an investor expectation that all future criticisms will be similarly refuted. To let one pass unaddressed would create the appearance of truth. Companies must respond to nothing or everything while bound by securities regulations. That is not an easy position to be in.
I interviewed many people for this story. Even though we were discussing events of 3-5 years ago, the memories are still raw. What happened at Home struck a nerve.
Home Capital marked a turning point in my career as an investment analyst. Process and outcome should be correlated in investing, though imperfectly. I was not prepared for such an extreme divergence, for a complete breakdown of the Mr. Market analogy. "If you can keep your head when all about you are losing theirs…,” writes Kipling, “Yours is the Earth and everything that’s in it”. But not so with Home Capital. I would have been better off losing my head. Resisting the pull of emotion to remain coolly logical about the facts did me no good.
My troubles are inconsequential relative to some Home employees. Consider former CFO Robert Morton. He joined the company just as the mortgage fraud was surfacing. He was the junior person in the room when deciding how it should be disclosed. A former Chairman of the OSC signed off on the disclosure. External legal advisors supported this conclusion. The financial impact was believed to be immaterial (later proved correct) and quickly recoverable through redoubled growth efforts. And if that wasn’t enough, Morton, still anxious about the appropriateness of the disclosure, “stated in a memorandum to the Audit Committee of HCG's Board of Directors, dated May 4, 2015, that the deterioration [in Q1 originations] could not be attributed to seasonality and weather alone, and he raised a concern about the need to publicly disclose the terminations”. He was of course overruled and no such disclosure was made.
Morton was reprimanded by the OSC, pushed out of Home Capital, fined, and sanctioned by the accounting board. His name was dragged through the mud. What else could he possibly have done? With a bit of bad luck, what happened to Morton could happen to many public company executives, unlikely though it may be.
In 2014, when the mortgage fraud occurred, Home Capital was an imperfect company. In 2017, during the deposit run, Home was also an imperfect company. It remains an imperfect company today. Like all companies. To investors on the outside, hungry for a crisp narrative, business can seem black and white. There are good companies, and bad. Strong managers, and weak. But reality is always more complex than the stories we tell ourselves.
Home Capital is not blameless. The entrepreneurial culture under Soloway was too growth-oriented, inappropriately eschewing the systems and processes that had become necessary as Home matured. The lender grew its high interest savings account balances in the years leading up to the crisis to reduce funding costs - the rate on the savings account was lower than for longer-term GICs. This juiced profits, but exposed Home to greater risk of a deposit run, even if that risk was low20. And the Board, populated with people handpicked by Soloway, took an aggressive stance on disclosure and made a foolish decision to terminate Reid as CEO.
The climate of doubt fostered by the short sellers, Marc Cohodes chief among them, magnified the weaknesses and mistakes at Home. It blasted every negative development through a megaphone. Though the details would differ, what happened at Home could happen at other public companies should they experience some business setbacks and find themselves the target of a motivated short seller. Businesses like Home that require access to capital are especially vulnerable. The mood of a volatile Mr. Market can alter intrinsic value. Perception can become reality. This should make us all uncomfortable.
Beyond house price declines, there are costs to foreclose on a property if the lender takes possession. They vary depending on the condition and liquidity of the property and the obstinacy of the borrower, but on average would amount to 10% of the home’s value. Also, banks are levered institutions and so the average LTV isn’t as important as, say, the 80th or 90th percentile. At the end of 2013, the average LTV on Home’s portfolio was 68% with 27% of the portfolio at an LTV between 75 and 80%.
The Common Equity Tier 1 (CET1) capital ratio is computed by dividing the tangible common equity of the bank by the risk-weighted assets (RWA). RWA weights the various assets on a bank’s balance sheet by their riskiness, so that more capital is required to be set aside in support of riskier assets than safe ones.
For example, Countrywide Financial reported a Tier 1 risk-based capital ratio, a more lenient standard than the CET1 capital ratio reported by Home, of 11.8% in 2007.
Consider a crude stress test on Home’s balance sheet at the end of 2013. Assume house prices fall 40%. This would put LTV at 100%+ for about 75% of Home’s borrowers. Assume a 10% cost of foreclosure for an average loss to Home of 25% on foreclosure (LTV is maximum 80% at origination). Home’s CET1 ratio at year-end was 16.8%. To take it to 10%, the level of the big banks, close to one-quarter of the 100%+ LTV loans would have to default (or 18% of Home’s total alternative mortgage portfolio). This is in-line with default rates on the very worst subprime vintages (’05-’07). It also assumes the shock happens instantaneously (ie. there is no additional capital accretion through earnings). With ROEs in the 20s at the time, Home was accreting about 400 bps of capital per year pre-dividend. Also note that I only stressed the alternative residential portfolio (accounted for 80% of the loan book at the time). 10% CET1 even in this draconian scenario is quite robust.
To my knowledge, there is no proof that it was the brokers, and not the borrowers, that fabricated the information. However, one source noted that if borrowers were responsible for the fraud, we would expect to see mortgages with problem documentation randomly distributed across brokers. This was not the case. Problem documentation was concentrated at the 45 suspended brokers, and especially prevalent within a subset of the 45.
Relative to the US, it is easy to fabricate or alter income information on a mortgage application in Canada because borrowers only need to submit a copy of their T4 income tax slip as proof of income. In the US, lenders are permitted to verify income directly with the IRS, while in Canada lenders cannot check with the CRA. It is apparently for privacy reasons that Canadian lenders are not permitted to verify income with the CRA. This policy may have the effect of creating an uneven playing field between the big banks and smaller lenders. The large banks own the broader banking relationship and so can see an individual’s paycheck hitting their account. Smaller lenders would not have access to this sort of detail.
Home terminated a few of its underwriters, the Home employees responsible for assessing the riskiness of a loan, after the fraud was discovered. Some Home underwriters were engaged in "phantom ticking": falsely documenting that they had completed income verification steps when in fact they had not done so. According to a KPMG report leaked online, the top producing Home underwriter was originating loans at a rate three times that of the next most productive underwriter. This should have been a red flag. Regarding put backs, the long bull market in housing has left the rules untested for a very long time. The meaning of “complicit” is unclear.
Refer to the stress test above. Even if default rates were elevated due to fraud, the collateral values were good. We would need to see house prices down very significantly (40%+) with subprime-like default rates before Home’s capital position would have been in jeopardy.
Soloway sold about 1.5% of his Home Capital holdings in November 2014.
The source did not offer any evidence connecting Cohodes to the private investigator.
That day was a busy one for Badger. The company also reported soft quarterly results and Veritas Investment Research initiated on the company with a negative view.
For clarity, the mortgage would pay down or amortize over 25 years, but the loan would renew every 1-2 years.
This proportion was quite conservative relative to the large banks. For example, as of year-end 2016, 89% of TD’s personal deposits could be withdrawn on demand while the same figure was 70% for RBC, much higher than the 17% at Home.
A technical note on the deposit run. Home Capital offered its high interest savings account to clients of financial advisors through the fundserv platform. Effectively, the high interest savings account was dressed up as a mutual fund, providing clients with a convenient vehicle for cash that would also provide some yield. As concerns grew about Home, some wealth managers switched off advisor access to the savings account, triggering an automatic liquidation across all client accounts. Thus, the speed of the outflows was in part due to the structure of the holdings, with a top-level decision maker able to force liquidation at the individual client level.
Cohodes was far from the only short seller betting against Home Capital, but he was the most vocal. At times, the short position in Home reached 30% of outstanding shares, valued in excess of half a billion dollars.
The Berkshire deal was structured in two tranches of 20%. Canadian exchange regulations required that shareholders be given the opportunity to vote on the second tranche. With confidence restored by the initial investment, shareholders voted down the second tranche. Berkshire sold its shares about a year and a half after the initial investment, in late 2018. “…Berkshire’s investment in Home is now not of a size to justify our ongoing involvement. Although we have decided to substantially exit from our investment, we will continue to cheer from the sidelines for our friends at Home,” said Buffett in a December 2018 press release.
Though Buffett was initially contacted about the opportunity, it was actually Ted Weschler at Berkshire who conducted diligence and negotiated the deal.
Cohodes opted out of the class action settlement related to the disclosure issues. According to Home’s annual report, he “claims to have altered his investment strategy, covering at least some of his short position between March and June of 2015.” He is seeking $4 million in damages.
Truth-default theory was developed by Tim Levine and explored in Malcolm Gladwell’s bestseller Talking to Strangers. In essence, the theory states that people are inclined to believe others are telling the truth unless provided with overwhelming evidence of deception.
The high interest savings account balances nearly doubled in 2015.
Who (Almost) Killed Home Capital Group?
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