Thursday, April 27, 2017

Canada's Subprime Mortgage Crisis?

Home Capital secures $2-billion lifeline as shares collapse:
Shares of beleaguered mortgage lender Home Capital Group Inc. plunged 65 per cent on Wednesday as the company revealed it was negotiating an emergency $2-billion line of credit to shore up its finances after depositors rushed to pull money from their savings accounts.

The news shook Bay Street as analysts raised concerns about the company’s viability if investors continue to withdraw more funds from their accounts at Home Capital’s wholly owned financial subsidiary, Home Trust.

Home Capital is Canada’s largest alternative mortgage lender, providing subprime loans to people who don’t qualify for traditional bank mortgages.

The company relies on deposits to provide the money to make loans.

Its financial struggles, which stem in part from a regulatory investigation in Ontario, underscore the pressure that is building in parts of the housing market.

Home Capital is one of a number of lenders that provide a path to home ownership for people who would otherwise find it hard to borrow money for a house. But at the same time, the company has come under scrutiny for what some critics say are lax lending practices that have added fuel to real estate prices.

Laurentian Bank analyst Marc Charbin said the announcement of withdrawals suggests deposit brokers “are losing faith” in Home Capital.

“Worst case, this could cause a run on the bank,” he warned in a statement to clients Wednesday.

Analyst Jaeme Gloyn of National Bank Financial said the news “could spur other investors and deposit agents to continue redeeming high-interest savings accounts or demand deposits.”

However, Home Capital said it is well capitalized. The company said the expected new line of credit, combined with Home Trust’s current available liquidity, would give it access to more than $3.5-billion in total funding, which is more than twice the amount of the balances in the high-interest savings accounts.

“Access to these funds is intended to mitigate the impact of a decline in Home Trust’s [high-interest savings account] deposit balances that has occurred over the past four weeks and that has accelerated since April 20,” it said.

Canada’s banking regulator, the Office of the Superintendent of Financial Institutions Canada (OSFI), said Wednesday it is “monitoring the situation closely.”

Home Capital revealed Wednesday that depositors have withdrawn $591-million since March from their high-interest savings accounts, leaving a remaining balance of $1.4-billion.

“The company anticipates that further declines will occur, and that the credit line would also mitigate the impact of those,” it said.

Home Capital did not reveal who it was negotiating with for the new borrowing facility, but said Wednesday it expected “a firm commitment would be agreed to later today.”

Despite the drop in savings deposits, Home Capital said balances of its guaranteed investment certificates (GICs) have remained “essentially unchanged.” As of Dec. 31, 84 per cent of Home Trust’s deposits were GICs and other products payable on fixed dates, and 16 per cent were demand deposits such as savings accounts.

“Unlike the decline in high-interest savings [which depositors can withdraw at any time], Home Trust’s GIC deposits mature over time and have remained stable in recent weeks,” Home Capital chairman Kevin Smith said in an e-mailed statement.

Mike Rizvanovic, analyst with Veritas Investment Research, said the biggest fear is a possible run on the GICs.

“We don’t know if the same thing is going to happen to the fixed deposits, but if it does,” Mr. Rizvanovic said, “then this business cannot exist.”

As the financial crisis of 2008 and 2009 demonstrated, financial-services companies are built on investor confidence. If confidence starts to slip, panic can quickly take over and cause stock prices to plummet in the blink of an eye. Over the past week, fears have grown that potentially put Home Capital’s business model in jeopardy.

Home Capital’s financial problems have been growing since March, when it revealed the Ontario Securities Commission was investigating the company’s disclosures to investors. The company fired its chief executive officer shortly after.

Its troubles escalated last week when the OSC unveiled a series of allegations, accusing the company of making “materially misleading statements” to investors. The regulator also named a number of current and former executives in its allegations. Earlier this week, more impending top-level departures were announced, including the planned exit of its chief financial officer early next month.

But the most immediate problem for Home Capital has been a growing lack of support from other financial institutions, who steer clients into Home Trust’s high-interest savings products. Roughly 70 per cent of Home Trust’s total deposits are GICs placed by third-party brokers. Without those deposits, the company can’t adequately fund itself – barring a massive bailout.

Most of Canada’s biggest banks – including Royal Bank of Canada, Bank of Montreal, Bank of Nova Scotia and Canadian Imperial Bank of Commerce – have recently limited the amount of money their customers can invest in Home Trust’s high-interest savings accounts and GICs to a maximum of $100,000, which is the amount insured by Canada Deposit Insurance Corp. (RBC’s limit does not apply to clients who use its discount brokerage.)

Investors have interpreted the banks’ caution as a lack of confidence in Home Trust’s stability, and have liquidated Home Capital’s shares, driving them down to their lowest level since September, 2003. Home Capital’s market value fell from $1.1-billion Tuesday to just $384.6-million.

Mr. Charbin of Laurentian Bank said the GIC deposits may be vulnerable. GICs have fixed terms and there are penalties for early withdrawals, so investors have less flexibility to move them quickly. But they could “follow the same trajectory” as the high-interest savings deposits when they are renewable, he said.

Home Capital’s new borrowing has not come cheap. It said the new credit line under negotiation would carry a 10-per-cent rate of interest on the first $1-billion borrowed, and 2.5 per cent on the remainder. The company will also pay a $100-million “commitment” fee, which is non-refundable.

The company warned the borrowing costs “would have a material impact on earnings, and would leave the company unable to meet previously announced financial targets.”

Mr. Gloyn said that if Home Capital’s planned funding materializes, it would be paying an effective interest rate of 22.5 per cent on its first $1-billion of borrowing, or 15 per cent if the company uses the full $2-billion facility. He said that could drive down 2017 profit per share by 20 to 40 per cent.
Armina Ligaya of the National Post also reports, Home Capital shares plunge after mortgage lender seeks $2 billion credit line as deposits decline:
Shares of Home Capital Group Inc. plunged 65 per cent Wednesday after the embattled mortgage lender said it was seeking a $2 billion line of credit to backstop a significant decline in deposits at its subsidiary.

Home Trust has seen deposits drop by nearly $600 million in recent weeks and Home Capital said that it expects the withdrawals to accelerate.

The mortgage lender said that the terms of the proposed credit line — negotiated with “a major institutional investor” — would “have a material impact on earnings, and would leave the Company unable to meet previously announced financial targets.”

Analysts suggested the loan could come with an effective interest rate as high as 22.5 per cent on the first $1 billion.

Home Capital said the non-binding agreement in principle would be secured against a portfolio of mortgages originated by Home Trust.

“Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA (high interest savings account) deposit balances that has occurred over the past four weeks and that has accelerated since April 20…. The Company anticipates that further declines will occur, and that the credit line would also mitigate the impact of those,” the company said.

Home Capital added that it expected a “firm commitment” for the loan facility on Wednesday.

A spokeswoman for the Office of the Superintendent of Financial Institutions told the Financial Post in an email that it is “monitoring the situation closely.”

The development comes just days after Home Capital announced an executive and board shuffle in an effort to reassure investors after the Ontario Securities Commission accused the mortgage lender of misleading disclosure.

The allegations relate to Home Capital’s disclosure following the discovery that some loan applications contained falsified income information, after which the company cut ties with dozens of brokers in 2014.

On April 19, the securities regulator filed a statement of allegations and notice of hearing against the company; founder and former chief executive Gerald Soloway; chief financial officer Robert Morton; and former president and chief executive Martin Reid.

None of the allegations have been proven, and Home Capital’s chairman of the board Kevin Smith has said the company will “continue to vigorously defend our approach to disclosure” in the OSC proceeding, to be held May 4.

Home Capital announced on Monday that Soloway would retire from the board of directors as soon as a suitable replacement is found, but run for re-election at its annual general meeting next month. Morton is set to step aside after the company’s first quarter results are filed next month, and will be assigned new responsibilities outside the financial reporting group. Reid was terminated from his role as CEO of Home Capital in March.

“It is surprising to us to see the situation deteriorate so quickly given the related issues of concern occurred over two years ago,” said Jeff Fenwick, an analyst with Cormark Securities Inc, in a note to clients on Wednesday. “However, the constant vocal accusations by short-sellers combined with the OSC’s recent statement of allegations appear to have fanned the flames of uncertainty and triggered the HISA outflows.”

These demand deposits, as well as fixed deposits such as Home Trust’s Guaranteed Investment Certificate (GIC) deposits, help fund Home Capital’s mortgage lending.

High interest savings account balances at Home Trust have fallen by $591 million in the period from March 28 to April 24 to $1.4 billion, Home Capital said Wednesday.

Jaeme Gloyn, an analyst with National Bank of Canada Financial Markets, said Home Capital’s announcement could “spur other investors and deposit agents to continue redeeming high interest savings accounts and or demand deposits.

“This represents $2.5 billion, or 16 per cent of HCG’s total deposit funding structure. This will further impact margin pressure as HCG uses more of the expensive credit line,” he said in a note to clients on Wednesday.

The loan facility, combined with Home Trust’s current available liquidity, would give Home Trust access to more than $3.5 billion in total funding, more than twice the amount of outstanding high interest saving account balances, the company said.

As part of the agreement, Home Trust would be required to pay a non-refundable commitment fee of $100 million and make an initial draw of $1 billion. The interest rate on outstanding balances would be 10 per cent, and the standby fee on undrawn funds would be 2.5 per cent, Home Capital added.

Gloyn said this translates to an effective interest rate of 22.5 per cent on the first $1 billion, declining to 15 per cent if fully utilized.

“We estimate non-securitized cost of funds could increase 60 bps to 100 bps, or almost double the current average cost of deposits,” he told clients. “This could negatively impact 2017 EPS (earnings per share) by 20 per cent to 40 per cent, and 2018 EPS by 30 per cent to 50 per cent.”

Home Capital has already seen reputational risk in the wake of the OSC allegations result in liquidity issues. Last Friday, the Bank of Nova Scotia briefly stopped offering Home Trust’s broker GICs — a major source of the mortgage lender’s non-securitized funding. Home Capital said that Scotiabank intended to resume sales of its broker GICs on Monday, but it and other leading financial institutions instituted a $100,000 per client cap (the upper limit for coverage by Canada Deposit Insurance Corp. insurance).

Home Trust GICs and high interest savings accounts deposits are eligible for CDIC insurance.

Home Capital said Wednesday its GIC deposits remained essentially unchanged between March 28 and April 24, when it stood at $13.01 billion.

Demand deposits represent roughly 13 per cent of their funding, but these GIC deposits represent roughly 71 per cent, said Mike Rizvanovic, an analyst with Veritas Investment Research in Toronto.

“That’s the last shoe to drop. If that starts to go, then they don’t have a viable business structure any more. They can’t exist … that’s the last unknown,” he said in an interview.

This won’t be apparent for a few weeks as the holders of those GICs are unlikely to cash those in before they mature due to the built-in penalty, Rizvanovic added.

Of Home Capital’s total GICs, 52 per cent mature in less than a year, and 36 per cent are due to mature between one and three years, he noted.

“This is a very peculiar situation where Home Capital has no issues around credit, and no issues with a capital shortfall. Yet they are being decimated in terms of their viability as an ongoing entity,” Rizvanovic said.

Home Capital shares closed at $6 in Toronto, Wednesday, down 64.89 per cent from Tuesday’s close of $17.09.

Shares of other non-bank mortgage lenders were also hit Wednesday — with Equitable Group shares down 31.65 per cent to $40.75 and Genworth MI Canada shares down 7.87 per cent to $33.12 — amid investor concern about the alternative mortgage lending model and recent moves by both the federal and provincial governments to cool down the overheated housing market, particularly in Vancouver and Toronto, analysts say.
Allison McNeely and Doug Alexander of Bloomberg also report, Home Capital Slumps as New Loan Flags ‘Existential Crisis’:
Home Capital Group Inc.'s shares plunged more than 60 percent after the mortgage lender disclosed a costly new loan to tide it over as its deposits dwindle, intensifying a spiral of bad news for the company.

The C$2 billion ($1.5 billion) loan is coming from an institutional investor that Home Capital did not identify, and the lender’s agreement is non-binding. With a 10 percent interest rate plus other fees and charges, the company is effectively paying 22.5 percent on the first C$1 billion it borrows, which falls to 15 percent if it uses the full C$2 billion available to it, according to Jaeme Gloyn, an analyst at National Bank of Canada.

“They did what appears to be to us a very expensive deal,” said David Baskin, president and founder of Baskin Wealth Management in Toronto, a former investor in Home Capital stock. “Basically they blew up the income statement in order to save the balance sheet, which I guess if you’re facing an existential crisis is what you have to do.”

Ontario’s securities regulator last week accused the company of misleading investors and breaking securities laws. On Wednesday, Home Capital shares dropped as much as 64 percent in Toronto to C$6.11, their lowest since 2003 after their biggest ever one-day drop. Other home lenders’ shares declined as well, with Equitable Group Inc. falling 32 percent, Street Capital Group Inc. down 7.5 percent, and First National Financial Corp., 8.5 percent.

Home Capital’s troubles come as housing prices have jumped in Canada. In Toronto, home affordability reached its worst level since 1990 at the end of 2016, according to a report from Royal Bank of Canada.

‘Monitoring the Situation’

The credit line will be secured by a group of mortgage loans made by Home Trust, the Toronto-based firm said in a statement Wednesday. Home Capital expects a firm deal later the same day.

Home Capital’s external spokesman Boyd Erman declined to comment beyond the statement. Canada’s banking regulator is “monitoring the situation closely” but isn’t allowed to disclose details of any supervision, Annik Faucher, spokeswoman for the Office of the Superintendent of Financial Institutions, said in an emailed statement.

The company has C$325 million worth of bonds due May 24, according to data compiled by Bloomberg. Home Capital’s “steep” commitment fee and the interest rate on the loan “are surprising numbers for a company that was ostensibly investment-grade,” said Andrew Torres, founding partner and chief investment officer at Toronto-based Lawrence Park Asset Management, which holds Home Capital’s notes maturing next month. “We’ll refrain from commenting further until we get more details.”

OSC Allegations

Home Capital Founder Gerald Soloway will step down from the board when a replacement is named and Robert Blowes will assume the role of interim chief financial officer, the company said Monday.

The new loan will provide Home Capital with more than C$3.5 billion in total funding, more than twice the C$1.5 billion in liquid assets it held as at April 24. It also has C$200 million in securities available for sale; high interest savings account balances were at around C$1.4 billion, after having fallen C$591 million from March 28 to April 24. Lenders such as Home Capital rely on deposits to help fund their mortgage loans.

“The company anticipates that further declines will occur, and that the credit line would also mitigate the impact of those,” Home Capital said.
What a mess! I warned investors not to touch shares of Home Capital Group last Friday in my comment on why we should be very afraid of these markets:
[...] my recent comment on Canada's real estate mania has proven to be extremely popular.  I'm increasingly concerned about Canada's $1.1 trillion shadow banking system which is now half as large as banks, and you can see the dominoes are beginning to fall as Home Capital (HMC.TO) melted down yesterday on the stock market the same day Ontario was trying to hammer housing (read Garth Turner's latest, Cold Comfort).

Still, Home Capital's stock is bouncing up today (wouldn't touch it with a ten-foot pole!) and I was surprised to see the Royal Bank is the latest Canadian firm to explore a sale of bonds backed by uninsured residential mortgages after that bank's CEO warned of a frothy Canadian housing market.

Also, Ted Carmichael discusses Toronto's real estate boom, stating that while some say that house prices will never decline, the city's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.

To my former BCA Research colleague, Steve Poloz, who is now the Governor of the Bank of Canada, all I have to say is "be very afraid of Canada's housing bubble."
On Thursday, shares of Home Capital (HMC.TO) enjoyed a huge dead cat bounce, gaining 33% after Wednesday's massacre (click on image):

My advice remains the same as last Friday: don't touch these shares with a ten-foot pole!

Now that shareholders have been destroyed, what will happen to those people invested in Home Trust's GICS? As stated in one of the articles above, Home Trust GICs and high-interest savings accounts deposits are eligible for CDIC insurance, but that only covers up to a maximum of $100,000 (principal and interest combined) per depositor per insured category.

Right now, every major bank in Canada is probably sending out a memo to its financial advisors: "Be very weary of Home Trust GICs, there could be a possible run on them."

What about bondholders? This sums it up:
Andrew Torres, founding partner and chief investment officer at Toronto-based Lawrence Park Asset Management, which holds Home Capital’s notes maturing next month. “We’ll refrain from commenting further until we get more details.”
Poor guy is probably petrified of what's going to happen next with this company which secured a loan at onerous terms to "mitigate the effects" of Home Trust's dwindling high-interest savings accounts deposits.

What I would love to know is who is this mysterious institutional investor that is lending Home Capital C$2 billion ($1.5 billion) at such onerous terms? (see update below)

Is it a major Canadian pension fund through its private debt operations, a US private equity shark, or is it a major Canadian bank that is scared of contagion effects as a meltdown in Canada's subprime mortgage market can explode Canada's housing bubble and sink the economy into a debt deflation nightmare.

Keep in mind a few of Canada's big bank CEOs have been sounding the alarm on Canada's housing bubble recently, pleading with the government to intervene. CIBC’s exposure to a real estate correction is highest among Canada’s banks but others are very worried too.

This may be one reason why Canada's big banks have been exploring their own foray into Canadian subprime mortgage debt, perhaps knowing that they need to step in to prevent a total collapse of this market:
Royal Bank of Canada is the latest Canadian firm to explore a sale of bonds backed by uninsured residential mortgages.

The bank is testing investor interest in a deal that would bundle mortgage loans to borrowers with credit ratings just below prime, known as “alt-A” mortgages, according to Tim Wilson, chief financial officer of Equitable Group Inc., one of the lenders which is originating the loans being bundled.

“Along with the banks, we’re trying to understand what the investor appetite could be in terms of both volume and price,” Wilson said by phone from Toronto. “Once we get a sense of that, we can make decisions about size, and even if the opportunity makes sense at all.”

Canadian banks are eager to package uninsured home loans into bonds after the federal government last year made it harder for lenders to get government guarantees on mortgages. Bank of Montreal is planning a residential MBS to securitize C$2 billion ($1.5 billion) of prime uninsured mortgages. National Bank of Canada is exploring investor interest in a deal that would be backed by MCAP Corp. “alt-A” mortgages.

Hot Housing Market

The RBC deal would be sponsored by Steel Curtain Capital Group LLC and Ashley Park Financial Services. It may also include mortgage loans from Home Capital Group Inc., according to people familiar with the matter, who asked not to be identified because the deal is private.

Spokesmen for Toronto-based Royal Bank of Canada and Home Capital declined to comment. Representatives for Paradigm Quest Inc., a mortgage servicing company that is affiliated with Ashley Park, weren’t immediately able to comment.

Steel Curtain Capital is exploring opportunities for creating a multi-lender residential mortgage securitization platform in Canada and is speaking to multiple lenders and third-party service providers, owner Frank Pallotta said by phone. He declined to comment on the deal being marketed by RBC.

The prospective offering comes as Ontario announced measures Thursday aimed at cooling Toronto’s hot housing market, including a 15 percent tax that will apply to foreign buyers of residential properties containing one to six units in the greater Toronto area. Home prices in the city jumped a record 33 percent in March from the same month last year. Affordability in the city reached its worst level since 1990 at the end of 2016, according to a report from Royal Bank of Canada.

Subprime borrowers are generally considered to be home-buyers with FICO scores below 620 and mortgages with a loan-to-value ratio above 80 percent. The credit scoring scale from Fair Isaac Corp. ranges from 300 to 850.
It will be interesting to see how Canada's regulators respond to the big banks' foray into Canadian subprime mortgage debt and more importantly, who will be dumb enough to buy this debt given what happened in the US in 2008.

I don't know, maybe Canada's big banks are so scared of what happens if Canada's housing bubble bursts that they're "exploring" ways to keep the subprime mortgage market alive for a few more years.

But the meltdown of Home Capital Group is a warning to big banks, regulators and the CMHC, Canada's real estate mania has reached epic proportions and it threatens not only our economy but the entire financial system.

And truth be told, as Garth Turner notes in his latest comment, Where there's smoke..., this couldn't have come at a worse time with US policy shifting into protectionist mode against Canada.

All this tells me to keep shorting the loonie, the Bank of Canada won't dare raise rates in this environment, and if things get even worse as the US economy slows (like oil prices collapsing below $30), we will see rate cuts and our own QE in Canada. Good times, eh?

Below, Bloomberg's Allison McNeely reports on Home Capital's existential crisis. I also embedded another clip below with legendary short seller Marc Cohodes who has long been Home Capital's most vocal critic. He joins Bloomberg TV Canada's Lily Jamali to discuss what the embattled Home Capital Group needs to do to right the ship. I agree with him: "Jesus Christ couldn't right this ship."

Lastly, for all you delusional Canucks who think real estate prices never go down, read Ted Carmichael's latest comment where he discusses Toronto's real estate boom, stating that while some say that house prices will never decline, the city's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly. And if it does, we're all in trouble!

Update: Bloomberg reports the Healthcare of Ontario Pension Plan  (HOOPP) is the fund that gave Home Capital a C$2 billion ($1.5 billion) loan. It also states that HOOPP President and Chief Executive Officer Jim Keohane sits on Home Capital’s board and is a shareholder of the mortgage lender and this represents a clear conflict of interest:
Richard Leblanc, a law professor at York University, said the loan appears to represent a conflict for Keohane given his two roles.

“It’s a conflict, absolutely,” Leblanc said from Toronto. “An independent director should not have any commercial relationship with the entity at all. I mean he can loan the money but he should resign from the board.”
The article also states the Toronto-based lender hired RBC Capital Markets and BMO Capital Markets to advise on “strategic options”. Home Capital’s external spokesman Boyd Erman and representatives for HOOPP and Jim Keohane declined to comment.

There are only two things I will say. Jim Keohane is one of the nicest, most honest pension fund managers I've ever come across. There is no way he didn't inform HOOPP's board of directors of his role prior to entering this transaction and I wouldn't be surprised if he vacated Home Capital's board after entering this deal (I'll put it to you this way, if it wasn't kosher, he would have been fired on the spot).

I mention this because the idiots on Zero Hedge are posting dumb comments on that website calling Jim a crook and that's just pure nonsense. Bloomberg's reporters should also be more careful with what they publish because the optics look bad and they're contributing to this speculation.

More importantly, if you look at the terms of the deal, they are extremely favorable to HOOPP -- ridiculously favorable -- so in the end, this is yet another great deal for HOOPP no matter what happens to Canada's housing market (with these onerous terms, you would need a severe correction of close to 70% in housing prices for HOOPP to lose money on this deal).

Anyway, HOOPP remains the best funded pension plan in Canada. People should read its press releases here, not the garbage written on Zero Hedge or other sites. In fact, HOOPP just released a statement on the Home Trust Company:
The Healthcare of Ontario Pension Plan (HOOPP) today confirmed that it has agreed along with a syndicate of lenders to provide a secured line of credit in the amount of $2-billion dollars to Home Trust Company. Normally HOOPP’s policy is not to disclose information on our investments, however, given the amount of media speculation, we have decided to disclose this information today. Like any investment, this decision was made in the best interest of our members’ financial needs. We have a long history of providing these types of investments as appropriate, risk-balanced vehicles to meet our overall return targets. This investment followed all the appropriate due diligence.
Enough said. It's deals like this one where there is an asymmetric payoff which explains why HOOPP is one of the best pension plans in Canada and the world. Also worth noting in the press release that other investors were part of this deal, so HOOPP didn't go it alone.

Update #2: Scott Deveau, Allison McNeely and Doug Alexander of Bloomberg report, Home Capital Group director Keohane resigns after fund backs $2 billion loan:
The head of an Ontario pension plan has stepped down as a director of Home Capital Group Inc. after his fund agreed to provide a $2 billion loan to help offset a run on deposits at the struggling Canadian mortgage lender.

Healthcare of Ontario Pension Plan President and Chief Executive Officer Jim Keohane said he recused himself from the lending talks and stepped away from Home Capital’s board last Tuesday before formally resigning on Thursday. He also said that Kevin Smith, Home Capital’s chairman, has stepped down from HOOPP’s board.

“We were involved in the deal with a syndicate of other lenders,” Keohane said in a telephone interview. “With the possibility of us getting involved with a deal with Home, clearly that changes the business relationship between HOOPP and Home. It’s obvious a conflict exists there.”

“I was not involved in any decision making on the other side of this at all,” he said.

Home Capital didn’t identify the lender in separate statements Wednesday and Thursday, though people familiar with the process told Bloomberg News that the health-care workers pension is backing the loan. The Toronto-based lender said it hired RBC Capital Markets and BMO Capital Markets to advise on “strategic options” after it secured the one-year loan, according to the statement.

HOOPP confirmed in a separate statement late Thursday that it has agreed, along with a syndicate of lenders, to provide the $2 billion credit line.

“Normally HOOPP’s policy is not to disclose information on our investments, however, given the amount of media speculation, we have decided to disclose this information,” according to the statement.

A Home Capital sale could be the next step for the mortgage lender, which faces allegations by Ontario’s securities regulator that it misled investors on disclosures about an internal investigation. Home Capital’s internal probe found 45 outside brokers falsified income information on mortgage applications.

A sale becomes more likely if the firm can’t reverse a decline in its Guaranteed Investment Securities deposits, GMP Securities analyst Stephen Boland said earlier in a note.

“We believe HCG’s ability to raise GIC deposits and maintain operations is uncertain,” Boland said in the note before Home Capital’s statement Thursday. “Unless GIC costs stabilize, a run off scenario or sale is a growing possibility.”

Home Capital shares fell 65 per cent Wednesday, after the lender said the terms of the loan will make it hard to meet financial targets. The stock rebounded Thursday, rising 34 per cent to $8.02 in Toronto. The stock traded as high as $56 less than three years ago.

The credit line from the pension fund provides additional liquidity for Home Capital. HOOPP is a Toronto-based pension plan which represents more than 321,000 health-care workers in Ontario, with assets of about $70 billion. Home Capital’s external spokesman Boyd Erman declined to comment.
Loan terms

The one-year credit line from HOOPP has a 10 per cent interest rate on outstanding balances and a 2.5 per cent rate on undrawn amounts. The finalized agreement follows an announcement early Wednesday that Home Capital had reached a non-binding agreement in principle with an institutional investor for the loan.

Under the terms of the loan, Home Capital is required to make an initial C$1 billion draw and pay a non-refundable commitment fee of C$100 million. The loan is secured by a pool of mortgages originated by Home Trust, the company’s mortgage origination subsidiary.

S&P Global Ratings downgraded Home Capital Thursday to junk with a B+ rating, from BBB-, the lowest level of investment grade. The senior unsecured rating on Home Trust was lowered to BB from BBB. DBRS Ltd. downgraded Home Capital to BB from BBB (low) and placed all ratings under review with negative implications on April 26.
Bank interest

Boland said estimates on a sale price for Home Capital would be speculative, but said commercial banks may be interested. Home Capital’s market value has plunged to C$515 million, from about C$3.5 billion in 2014.

“We think this is at a substantial premium to current levels,” he said. “We believe HCG’s book may be attractive to several banks that could run the business with materially lower funding costs, particularly if they have regulatory support for the deal.”

Meanwhile, short-sellers are betting against Home Capital and rival mortgage lender Equitable Group Inc., with short interest positions surging since mid April. Shares of the two firms are the most shorted among Canadian financial companies, with investors having short interest in more than 56 per cent of the shares available to the public, according to data compiled by Markit. Genworth MI Canada Inc., a mortgage insurer, also has about 31 per cent of its stock shorted, the data show.
Like I said, even though there could be more upside from these levels, I wouldn't touch shares of Home Capital but it's clear that HOOPP and other lenders entered a great deal. It's also clear that Jim Keohane did the right thing by recusing himself and then resigning from Home Capital's board after the deal was made and put his members' best interests first.

Wednesday, April 26, 2017

New York City's Private Equity Woes?

Martin Braun of Bloomberg reports, NYC Pensions' Push Into Private Equity Yields Index-Fund Returns:
New york City's biggest pensions have invested about $13 billion with private-equity firms in pursuit of large returns. They would have done better with a low-cost stock index fund.

The city’s $63 billion teachers’ and $58 billion civil employees’ funds have earned an annualized return of 9.15 percent and 9.1 percent after fees, respectively, on their buyout, venture capital and “special situations” funds since the late 1990s. That’s less than the 9.5 percent they would have earned by putting the money into the Russell 3000 -- the stock-market benchmark the plans expect their private-equity portfolios to beat by 3 percent a year.

“We’re more-or-less break even and that’s a disappointing result,” said Scott Evans, chief investment officer of New York City’s pension funds. “What you have here is the mathematics of a very large tail of unproductive funds weighing down performance.”

New York’s experience shows that the private investment pools are no magic bullet for generating gains needed to cover the benefits due as aging workers retire. With state and local pensions holding almost $2 trillion less they need, the funds have piled into riskier asset classes such as private equity, hedge funds and real estate over the past decade, seeing the higher-fee investments as a way to achieve the more than 7 percent returns they count on each year.

New York City’s five public employee pension funds were $65 billion short of the assets needed to cover promised benefits as of June 30, 2016.

Public pensions’ investments in so-called alternative assets such as private equity and real estate -- which are harder to value and sell -- have more than doubled over the past decade and now account for almost a quarter of their portfolios, according to Cliffwater LLC, a Marina del Rey, California-based firm that advises institutional investors.

With the influx of cash leaving the firms competing for takeover targets, the industry has struggled to shine: While average buyout funds historically beat stocks by 3 to 4 percent, those formed since 2006 have done no better than the equity market, according to a 2016 study by professors from the University of Virginia, Oxford University and the University of Chicago, who reviewed the holdings of almost 300 institutional investors through June 2014.

Efforts by banking regulators to limit the amount of high-interest debt that private equity firms can foist onto target companies -- as well as competition from cash-rich public companies mounting their own takeovers -- may also be restraining returns, said Eileen Appelbaum, senior economist at the Center for Economic and Policy Research in Washington.

“More equity and less debt also mean less possibility for outsized performance,” said Appelbaum.

New York’s smaller pensions fared slightly better with their private-equity investments than the civil employees and teachers pensions. Its plans for police officers, firefighters, and school administrators beat the Russell 3000 by 1 percentage point or less.

Still, none achieved the city’s stated goal of earning 3 percentage points more than the Russell 3000, despite the higher fees and risks -- including having money locked up for years.

Too Many’s Too Much

New York City’s private equity portfolio, channeled into about 220 different funds, is “overdiversified,” pension officials say. The civil employees’ and teachers’ pensions committed more than $5 billion to dozens of funds that started investing between 2006 and 2008, when William C. Thompson was comptroller.

The performance of New York’s venture capital and energy investments were particularly poor: The civil employees’ pension returned 3.2 percent and 0.4 percent respectively in those categories. New York has since stopped investing in startups.

Instead of giving up on private equity, New York is concentrating its new investments into about 30 large firms and another 30 "emerging managers," typically women or minority-owned firms, that the city has “high conviction in."

For example, the teachers’ and civil employees’ pensions have committed $630 million to Vista Equity Partners after investments in a 2007 fund returned 18 percent more than the Russell 3000. A 2011 fund returned 8 percent more.

“This is an asset class where it pays to be narrow and to be deep with the partners you have confidence in," Evans said.

Not all of the city’s private equity investments are with firms that have consistently delivered outsized gains. For example, four of New York City’s five pensions committed about $40 million combined to Centerbridge Capital Partners III, a buyout fund, even though the firm’s previous fund returned 4.1 percent as of Sept. 30, 2016, according to data from the California State Teachers’ Retirement System.

Given the 10-year life of a typical private equity fund, it’s too early to render a judgment on the new approach.

However, data from fund vintages in 2011 and 2012 are encouraging, beating the public market equivalent between 2 and 5 percentage point, according to city pension documents.

“The good news is the weight of the new funds and the concentrated portfolio has been rising,” Evans said. “We think we’re on the right track.”
This is a good article which demonstrates a lot of the problems with US public pension funds' approach to private equity.

Here are my quick takeaways after reading this article:
  • Over-diversification: Any public pension fund that is investing in 200+ private equity funds shouldn't be surprised their PE program is delivering mediocre results over the long run relative to public markets. In private equity, it's better to concentrate on a few funds as there is evidence of performance persistence among the "top-quartile funds" but academic studies have cast some doubt on that long-held belief. Still, one thing is for sure, too much diversification in private equity is a losing strategy which will ensure paying excessive fees for mediocre long-term returns. Also, this problem has hampered New York City's pensions for some time now, it's not something new.
  • Fees matter a lot: US public funds need to be a lot more transparent on the fees being doled out to their private equity partners. If over ten years, they are paying multi-millions in fees, this needs to be publicly disclosed so people can understand whether the long-term performance net of fees and all other expenses is worth the effort to invest billions in private equity.
  • Lack of governance: The article demonstrates why US public pension funds consistently underperform Canada's mighty PE investors which have the right governance to hire experienced managers who can thoroughly evaluate the performance of private equity funds and quickly evaluate co-investment opportunities to lower the overall fees of their private equity program. They can also invest directly in companies and keep them on their books for longer periods than the typical PE fund. But to do all this, you need the right governance which separates pensions from political interference and you need to compensate your senior private equity managers appropriately to attract and retain top talent at your pension. US public pension funds are just not there and will likely never be there in terms of adopting this Canadian governance model.
  • VC nightmare: "Unless you're invested with top VC funds, forget venture capital, your pension will lose its shirt." That's what I was told from Sequoia Capital's Doug Leone back in 2004 when I was working as a senior investment analyst at PSP. It took me forever to get through to him, I kept persisting, but he eventually met with Gordon Fyfe and Derek Murphy and told them the same thing: "Don't waste your time with VC, you'll lose your shirt." Later when I worked at the Business Development Bank of Canada (BDC), I saw what Leone was warning of as their VC program back then was a disaster. People have this misperception that investing in venture cap is easy. It's not. Most pension funds and other institutions that invest in this space have lost billions because it's one area where truly top funds differentiate themselves but most of them don't want or need pension money (they are fighting over whether to accept more money from Harvard, Yale, and other top endowment funds).
  • Minority-owned nightmare?: In the US, a lot of public pensions have a mandate to invest in minority-owned funds targeting women and other minorities. While the goal is admirable, more often than not, the performance isn't and there are serious questions as to whether or not these minority-owned fund investments are in the best interests of beneficiaries and stakeholders of these public pensions. Having said this, as someone who has lived with Multiple Sclerosis (MS) for close to twenty years now and has seen and experienced firsthand the negative effects of discrimination due to a physical handicap, I'm a hardcore stickler for real diversity in the workplace and think public pensions have a social responsibility to hire all minorities and help truly qualified emerging managers, especially women and other minorities that routinely get shunned when it comes to raising capital. Still, while there are some success stories when it comes to minority-owned funds, the truth is all public pensions need to first focus on what is in the best interests of their beneficiaries and stakeholders and not invest in minority-owned funds for the sake of fulfilling some social mandate. But these aren't mutually exclusive goals if done properly (see this NAIC  document).
  • Private equity delusions: I honestly don't know where this goal to attain a 3% annualized return over stock market in private equity comes from. No doubt, there needs to be a premium because pensions are tying up capital for a long time, but there is a J-Curve in private equity and most pensions are fine taking some illiquidity risk in private equity, real estate and infrastructure to outperform public markets over a long investment horizon. But as more and more institutional investors rush into alternatives, returns and premiums are necessarily coming down. Still, given the mixed results of private equity programs at US public pensions which are failing to deliver, many need to ask some hard questions in regards to whether their approach to this asset class is all wrong. It's also worth noting these are treacherous times for private equity and there are serious concerns over misalignment of interests. In fact, CNBC's Leslie Picker reports that private equity firms are putting a higher value on buyout targets than at any point since the financial crisis. Given this environment, it's no surprise that many of the biggest private equity investors, including CalPERS, are struggling to deliver the targetted returns in this asset class.
  • Beta bubble keeps expanding: Having said this, as the beta bubble keeps expanding, many investors are growing increasingly scared of what lies ahead. Some legendary investors are peddling nonsense to scare investors but there are legitimate concerns that these markets are going to head south as the next economic shoe drops in the US. In this environment, it makes sense to allocate more in private equity in anticipation of massive market dislocations over the next year.
Every time I write these comments, it reminds me how grossly underpaid I am for the work I put into this blog. If you read my comments regularly, please be considerate and donate or subscribe to this blog on the top right-hand side under my picture to show your appreciation. I thank all my supporters, big and small.

I'd also like to take this opportunity to remind my readers that I am open to consulting mandates and better yet full-time work here in Montreal. If you are looking for someone with my experience, competence, a solid network and great attitude, please feel free to reach out to me at to explore opportunities at your organization. Thank you!

Below, Mario Giannini, CEO of Hamilton Lane, talks about opportunities in the private credit and equity spaces in Asia. And CNBC's Leslie Picker reports on what makes tech so popular for private equity. Make sure you read her article on why private equity firms are putting a higher value on buyout targets than at any point since the financial crisis.

Tuesday, April 25, 2017

CPPIB Preparing For Landing?

Benefits Canada reports, CPPIB to sell Irish aircraft leasing company:
The Canada Pension Plan Investment Board and its co-investors have announced the sale of Dublin-based aircraft leasing company AWAS to Dubai Aerospace Enterprise Ltd.

The CPPIB first invested in the company with European private equity firm Terra Firma in 2006.

“We are pleased with the outcome of this transaction,” said Ryan Selwood, managing director and head of direct private equity at CPPIB. “We continue to believe that the aircraft leasing industry is a highly attractive market for CPPIB over the long term and look forward to exploring future opportunities to invest in the sector at scale, subject to market conditions.”

AWAS leases airplanes to 87 airline customers in more than 45 countries and has assets totalling about $10 billion as of last November. The company owns 214 aircraft with an average age of 5.8 years, and has also ordered 23 new aircraft.

In March 2015, AWAS sold 84 aircraft to Macquarie Group Ltd. Since then, it has continued to grow its business and portfolio.

The deal is subject to regulatory approval and is expected to close in the third quarter of 2017.
The Telegraph also reports, Guy Hands' Terra Firma sells aircraft leasing investment to Dubai-based rival:
Private equity baron Guy Hands has sold an aircraft leasing business his hedge fund Terra Firma has co-owned for more than a decade.

The fund, alongside co-investors and the Canada Pension Plan Investment Board (CPPIB), has sold the Dublin-based aircraft lessor Awas to Dubai Aerospace Enterprise, the largest aircraft lessor in the Middle East. The terms were not disclosed.

Awas was formed in 2006 when Terra Firma and CPPIB bought the underlying business and later snapped up rival Pegasus in 2007. It now boasts $7.5bn of owned aircraft assets that it leases out to 87 airlines in more than 45 countries. Besides the 214 aircraft it owns, Awas also has 23 new ones on order.

At acquisition in 2006, Awas owned 154 Airbus and Boeing aircraft, with long-term leases and what the investors saw as good rental income.

Terra Firma said its decision to invest in the company was based on its view the aviation sector would grow rapidly, with the world fleet expected to double by 2034, and steady demand from airlines for leased aircraft.

International Airlines Group said in its recent results in February it had 32 additional leased aircraft compared to the same period last year partially due to fleet renewal with 13 less owned aircraft.

But some airlines are eyeing greater levels of ownership, with easyJet stating in its full-year results in November last year the size of its leased fleet had decreased by 6.4pc to 64 while its owned fleet rose by more than 10pc to 180 thanks to its recent purchase of 20 A320 aircraft.

Mr Hands, chairman and chief investment officer of Terra Firma, said it was “the right time for Terra Firma to realise maximum value for our investors”.

“Under our ownership, we have transformed the company to better reflect the fast-changing market that it serves,” he said.

“This has been achieved through an active aircraft acquisition and disposal strategy to optimise the business’ portfolio and align with its diverse customer base.”

The sale of the business comes just over two years after the company sold 84 aircraft to Macquarie Group, a transaction that Terra Firma said was a significant stage in preparing the business for sale.

Dubai Aerospace Enterprise was founded in 2006 and counts airlines such as Emirates, EVA Airways, easyJet, Wizz and EgyptAir among its customers.

Ryan Selwood, managing director, head of direct private equity, at CPPIB, said in spite of the sale it would look for other opportunities in the aircraft leasing space in the future.

Goldman Sachs is acting as financial advisor and Milbank as legal advisor to the seller. The deal is subject to regulatory approval and is expected to close in Q3 2017.
Anshuman Daga of Reuters also reports, Dubai Aerospace to buy aircraft lessor AWAS, catapults to top tier:
Government-controlled Dubai Aerospace Enterprise Ltd (DAE) is acquiring Dublin-based AWAS, the world's tenth biggest aircraft lessor, in a deal that will add over 200 planes to its fleet and more than double the size of its current business.

AWAS is the latest asset to be sold in the rapidly consolidating global aircraft leasing industry whose top 50 lessors had a fleet value of $256 billion last year, according to consultancy Flightglobal. The sector is seeing increased investment from players in emerging markets such as China, which were also in the running for AWAS, sources said.

Reuters had reported in December citing sources that AWAS had been put up for sale in an auction that could value the lessor at $7 billion, including debt.

DAE, controlled by the government of Dubai, signed a definitive agreement to buy AWAS from British financier Guy Hands' private equity firm Terra Firma Capital Partners and Canadian Pension Plan Investment Board (CPPIB), the companies said on Monday. They did not disclose financial terms of the deal.

DAE, which calls itself the largest aircraft lessor in the Middle East with a portfolio of 112 planes, said the combined company will have an owned, managed and committed fleet of 394 planes with a total value of over $14 billion. It will have more than 110 airline customers spread across 55 countries.

"This acquisition of AWAS is strategically compelling and propels DAE into a top 10 aircraft leasing platform," DAE Managing Director Khalifa H. AlDaboos said in a statement.

"Our leasing business has been growing at a rapid clip and this acquisition will more than double the current size of our business..."he said.

Paid for in U.S. dollars, aircraft are comparatively easy to re-lease to various airline operators across the world.

AWAS has a fleet of 263 owned, managed and committed narrow and wide-body aircraft, including a pipeline of 23 new aircraft on order to be delivered before the end of 2018.

DAE said its transaction will be financed by the group's internal resources and committed debt financing. The deal is subject to regulatory approvals and is expected to be completed in the third quarter of this year.

The latest sale marks the exit of Terra Firma and CPPIB from AWAS, in which they first put in money in 2006. In 2015, Macquarie Group bought about 90 planes from AWAS for $4 billion.

DAE was advised by Freshfields Bruckhaus Deringer LLP and Morgan Stanley & Co. LLC. DAE was also advised by KPMG and Latham and Watkins LLP. Goldman Sachs is acting as financial adviser and Milbank as legal adviser to the seller.
You can read CPPIB's press release on this deal here. What do I think of this deal? It's a great deal for all parties involved.

Let me provide you with some background. Back in March 2011, CPPIB spent $266 million to help fund an expansion of AWAS:
The Canada Pension Plan Investment Board has pledged to spend $266 million to help fund expansion at Dublin-based aircraft leasing firm AWAS.

AWAS has a fleet of over 200 commercial aircraft on lease to more than 90 customers in approximately 45 countries. It employs roughly 120 people worldwide, and has 110 aircraft on order from Airbus and Boeing.

CPPIB's investment adds to the $347 million US that CPPIB has already directly invested in the company.

The investment is part of $529 million US in total that AWAS secured to fund its expansion plans Thursday. The other major partner is Terra Firma — which pledged an additional $246 million US — but other investors are also putting up $17 million US.

CPPIB already owns 16 per cent of AWAS and the investment will increase its stake to 25 per cent. Terra's stake will increase to 60 per cent, and other investors will own the remaining 15 per cent. CPP's stake could increase beyond 25 per cent because it has committed a further $200 million US that AWAS could draw on at a later date.

The aircraft leasing firm's plan to grow comes at an opportune time, CPPIB management said in a release.

"We are delighted to help fund AWAS' acquisition strategy at what we feel is an attractive point in the aviation cycle to invest," said Andre Bourbonnais, senior vice-president for private investments at CPPIB.

"We see this as another affirmation of the value of our proven platform, growth strategy," AWAS president Ray Sisson said of the deal.

The CPPIB invests surplus money from employer and employee contributions that aren't required to pay current retirement benefits. It had $140.1 billion in assets at the end of December.
As you can see, CPPIB can also thank André Bourbonnais (and Mark Wiseman) for this deal which netted it a very handsome return (AWAS was bought for roughly $4 billion and reportedly sold for over $7 billion).

Interestingly, Mr. Bourbonnais is now the CEO of PSP Investments which launched its own aviation leasing platform back in 2015 (SKY Leasing) with industry veteran Richard Wiley (Jim Pittman who is now the head of private equity at bcIMC worked on that deal).

What does Dubai Aerospace Enterprise (DAE) get from this deal? It's catapulted to a top tier global  aircraft leaser and will enjoy rental income for many more years ahead but will likely ride out some turbulence in the short run depending on how bad the next global economic downturn is (you can read more on giants of aircraft leasing here).

If you look at the latest press releases from CPPIB, you'll see it has been very busy lately with mega private deals which I would characterize as more defensive in nature (this after I recently stated CPPIB is sounding the alarm on markets).

For example, along with Blackstone, it recently acquired Ascend Learning from private equity funds advised by Providence Equity Partners and Ontario Teachers’ Pension Plan.Ascend is a leading provider of educational content, software and analytics solutions.

Today CPPIB announced that it and funds affiliated with Baring Private Equity Asia (BPEA) announced their intention to purchase all outstanding shares of, and to privatize, Nord Anglia Education, Inc. (Nord Anglia), the world's leading premium schools organization, for a purchase price of USD 4.3 billion, including repayment of debt:
  • Nord Anglia operates 43 leading private schools globally in 15 countries in China, Europe, Middle East, North America and South East Asia
  • Funds affiliated with BPEA are the majority shareholders of Nord Anglia and BPEA controls 67% of Nord Anglia’s issued and outstanding share capital
The transaction is subject to shareholder approval and customary closing conditions.

Keep in mind, this mega deal comes after another deal announced in March when CPPIB and Singapore's GIC bet big on US college housing.

Why invest billions in private schools and higher education? It makes perfect sense from a long-term perspective. It's a play on global wealth inequality and how rich foreigners will spend a lot of money sending their kids to private schools and US colleges.

But it's also a play on the need for students from all socioeconomic backgrounds to invest in higher education to compete in an increasingly more competitive workplace where certain skills are highly coveted (interestingly, the Fed's Kashkari thinks spending on education, not infrastructure, is the key to US economic growth).

Lastly, please take the time to read this recent interview with John Graham, Managing Director, Head of Principal Credit Investments at CPPIB. Graham discusses CPPIB's approach in private credit investments, including which segments are most attractive in this space and how CPPIB is dealing with increased competition from other institutions getting into private debt markets.

Below, highlights from the 18th Annual Global Airfinance Conference Dublin, that took place on 18th - 20th January 2016 at the Convention Centre in Dublin.

Also, a 2014 clip on why Asia's richest man, Li Ka-shing, is aiming to buy his way into the global aircraft leasing business as his flagship investment firm holds talks with lessors on building a portfolio of planes.

Lastly, Howard Rubel, Jefferies managing director, shares his thoughts on Boeing's quarterly results and outlook on growth. I'm not as bullish as he is on Boeing in the near term but listen to what he says on the outlook for air traffic and freight driving demand for aircrafts.

As you can see, the aircraft leasing business is growing and competition is heating up in this space as investors look to capitalize on long-term growth in Asia, the Middle-East and elsewhere.

Monday, April 24, 2017

Vive la République?

Fred Imbert of CNBC reports, Dow rises 200 points as French election results spark rally; Nasdaq hits all-time high:
U.S. equities soared on Monday as investors cheered the results of the first round in the French presidential election.

The Dow Jones industrial average soared more than 200 points, with Goldman Sachs and Caterpillar contributing the most gains. The S&P 500 popped about 1 percent, with financials surging more than 2 percent to lead advancers. The Nasdaq composite hit a new all-time intraday high, rising more than 1 percent.

Early results from the French election showed Emmanuel Macron and Marine Le Pen advancing to a presidential runoff. Far-right candidate Le Pen and centrist Macron were largely expected to pull ahead in the first round of the French contest. The two had led most of the polls leading up to the election.

Le Pen and Macron will face off again on May 7. Most polls show Macron easily beating Le Pen in the second round.

"While I don't believe the US stock market was worried whatsoever about the French election in terms of its pricing and recent action ... it's clear that we dodged a bullet with the high likelihood of a Macron Presidency," said Peter Boockvar, chief market analyst at The Lindsey Group, in a note.

European stock markets skyrocketed across the board, with the pan-European Stoxx 600 index popping more than 2 percent. The French CAC 40 rose more than 4 percent to hit a nine-year high.

The euro also rose sharply against most major currencies. The common currency briefly broke above $1.09 against the U.S. dollar and last traded around 1.2 percent higher at $1.0856.

Macron "is the prohibitive favorite to win the presidency in two weeks thereby leaving far too little time for his challenger to make up any significant ground," said Jeremy Klein, chief market strategist at FBN Securities. "Although the outcome hardly qualifies as a surprise, investors breathed a huge sigh of relief."

U.S. stock futures rose more than 1 percent in the premarket.

That said, investors are also staring down the barrel of a potential government shutdown. Government funding will end Friday unless Congress can agree on at least a temporary funding resolution.

The last time the government shut down was Oct. 1 through 16, 2013. During that time, the S&P 500 rose about 1.6, but not without some volatility. The index moved more than 1 percent three times in that time period.

"There's a lot of anxiety over a government shutdown. One would hope we learned from the last time we went through this," said Bruce McCain, chief investment strategist at Key Private Bank.

The possibility of a shutdown comes as President Donald Trump is about to conclude his first 100 days in office. On Friday, Trump promised to make an announcement about much-anticipated tax reform this week, but it was not immediately clear how much he would reveal or what form it would take.

Expectations of tax reform have been one of the pillars of the stock market's postelection.
Early Monday morning, investors are cheering Macron's first round victory. Bank stocks are soaring and Deutsche Bank spiked by 10%. French bonds and stocks and the euro all rallied after the French election.

It now looks like Emmanuel Macron is a shoo-in for the upcoming May 7th vote based on the first round results and second round projections (click on image):

Barring a stunning upset, it doesn't seem likely that Marie Le Pen will pull off a Donald Trump or Brexit moment in France, which is why markets are rallying so much after the first round of French elections.

But while investors are breathing a sigh of relief, nothing has really changed in terms of the global economy and markets. The next economic shoe is dropping in the US and that should be the main focus going forward.

Moreover, the truth is the reflation trade is doomed and Europe faces big challenges like Greece and Italy and low birthrates in southern Europe after years of economic hardship.

In short, even though risks of Frexit have dissipated, nothing has changed when it comes to the big deflation versus inflation theme I keep obsessing over when looking at what ails the world economy.

Also, I have to laugh when I read markets got what they anticipated. Obviously not or else you wouldn't have seen such a powerful relief rally across risks assets and the euro.

And while I wouldn't  worry too much of legendary investors warning of why we should all be very afraid of markets, I still maintain tough times lie ahead:
If the US dollar rebounds in the second half of the year, we can get that dollar crisis I warned of late last year, but it seems like the Trump Administration is well aware of this risk and trying to limit the odds of this outcome, talking down the dollar lately.

We shall see how it plays out but be careful reading too much into the US dollar's recent selloff, in my opinion, it's a temporary move due to bullish speculative positioning at the start of the year.

As far as stocks are concerned, given my views on the reflation trade being doomed, I would be actively shorting emerging markets (EEM), Chinese (FXI), Industrials (XLI), Metal & Mining (XME), Energy (XLE)  and Financial (XLF) shares on any strength here (book your profits while you still can). The only sector I trade, and it's very volatile, is biotech (XBI) but technology (XLK) is also doing well, for now.

Still, early in the second quarter, high beta stocks are losing momentum and selling off. I still maintain that if you want to sleep well, buy US long bonds (TLT) and thank me later this year. In this deflationary environment, bonds remain the ultimate diversifier.
I would also be booking profits on Euro stocks (FEZ) as they soar today to a new 52-week high and start shorting them as we move into May 7th (click on images):

Be careful here, don't get caught up in all the hoopla of the French elections, there are much bigger problems to contend with all over the world, especially in Europe.

Take advantage of any relief rally to lighten up on cyclical sectors and add to defensive sectors and US long bonds (TLT). Don't buy the nonsense that European stocks and emerging markets offer attractive valuations relative to US stocks. They are relatively cheap for a good reason, there is no better, more diversified, more liquid stock market in the world than the US stock market, and when the world is in trouble, everyone seeks refuge in US markets. Period.

Below, the results of round one of the French election are in – and the markets are taking notice. And Laurence Haim, spokeswoman for the Emmanuel Macron campaign, speaks with CNBC's Michelle Caruso-Cabrera about the second part of the French election as Macron faces off against Marine Le Pen.

I also embedded an older (2014) clip where BBC's Newsnight's Robert Peston spoke with then French Economy Minister Emmanuel Macron about his new strategy to restore the French economy and stabilize the Eurozone.

If he wins, Emmanuel Macron and Europe's other leaders have serious issues to contend with, least of which is the slowdown in the US economy and ongoing debt crises in Southern Europe.

Update: Roland Lescure, the former CIO of the Caisse, spoke with CBC's Anne-Marie Dussault on the French elections. You can watch this interview here (in French).

Friday, April 21, 2017

Be Very Afraid of These Markets?

Katherine Burton and Katia Porzecanski of Bloomberg report, Paul Tudor Jones Says U.S. Stocks Should ‘Terrify’ Janet Yellen:
Billionaire investor Paul Tudor Jones has a message for Janet Yellen and investors: Be very afraid.

The legendary macro trader says that years of low interest rates have bloated stock valuations to a level not seen since 2000, right before the Nasdaq tumbled 75 percent over two-plus years. That measure -- the value of the stock market relative to the size of the economy -- should be “terrifying” to a central banker, Jones said earlier this month at a closed-door Goldman Sachs Asset Management conference, according to people who heard him.

Jones is voicing what many hedge fund and other money managers are privately warning investors: Stocks are trading at unsustainable levels. A few traders are more explicit, predicting a sizable market tumble by the end of the year.

Last week, Guggenheim Partner’s Scott Minerd said he expected a "significant correction" this summer or early fall. Philip Yang, a macro manager who has run Willowbridge Associates since 1988, sees a stock plunge of between 20 and 40 percent, according to people familiar with his thinking.

Even Larry Fink, whose BlackRock Inc. oversees $5.4 trillion mostly betting on rising markets, acknowledged this week that stocks could fall between 5 and 10 percent if corporate earnings disappoint.

Caution Flags

Their views aren’t widespread. They’ve seen the carnage suffered by a few money managers who have been waving caution flags for awhile now, as the eight-year equity rally marched on.

But the nervousness feels a bit more urgent now. U.S. stocks sit about 2 percent below the all-time high set on March 1. The S&P 500 index is trading at about 22 times earnings, the highest multiple in almost a decade, goosed by a post-election surge.

Managers expecting the worst each have a pet harbinger of doom. Seth Klarman, who runs the $30 billion Baupost Group, told investors in a letter last week that corporate insiders have been heavy sellers of their company shares. To him, that’s “a sign that those who know their companies the best believe valuations have become full or excessive."

He also noted that margin debt -- the money clients borrow from their brokers to purchase shares -- hit a record $528 billion in February, a signal to some that enthusiasm for stocks may be overheating. Baupost was a small net seller in the first quarter, according to the letter.

Another multi-billion-dollar hedge fund manager, who asked not to be named, said that rising interest rates in the U.S. mean fewer companies will be able to borrow money to pay dividends and buy back shares. About 30 percent of the jump in the S&P 500 between the third quarter of 2009 and the end of last year was fueled by buybacks, according to data compiled by Bloomberg. The manager says he has been shorting the market, expecting as much as a 10 percent correction in U.S. equities this year.

China Slowdown

Other worried investors, like Guggenheim’s Minerd, cite as potential triggers President Donald Trump’s struggle to enact policies, including a tax overhaul, as well as geopolitical risks.

Yang’s prediction of a dive rests on things like a severe slowdown in China or a greater-than-expected rise in inflation that could lead to bigger rate hikes, people said. Yang didn’t return calls and emails seeking a comment.

Even billionaire Leon Cooperman -- long a stock bull -- wrote to investors in his Omega Advisors that he thinks U.S. shares might stand still until August or September, in part because of flagging confidence in the so-called Trump reflation trade. But he said that they will eventually resume their climb and end the year moderately higher.

Likely Culprit

While Jones, who runs the $10 billion Tudor Investment hedge fund, is spooked, he says it’s not quite time to short. He predicts that the Nasdaq, which has already rallied almost 10 percent this year, could edge higher if nationalist candidate Marine Le Pen loses France’s presidential election next month as expected. Jones tripled his money in 1987 in large part by correctly calling that October’s market crash.

While the billionaire didn’t say when a market turn might come, or what the magnitude of the fall might be, he did pinpoint a likely culprit.

Just as portfolio insurance caused the 1987 rout, he says, the new danger zone is the half-trillion dollars in risk parity funds. These funds aim to systematically spread risk equally across different asset classes by putting more money in lower volatility securities and less in those whose prices move more dramatically.

Because risk-parity funds have been scooping up equities of late as volatility hit historic lows, some market participants, Jones included, believe they’ll be forced to dump them quickly in a stock tumble, exacerbating any decline.

“Risk parity,” Jones told the Goldman audience, “will be the hammer on the downside.”
Is Tudor Jones right to worry about risk parity strategies? First, for those of you who don't know about risk parity, I draw your attention to this CME paper authored by people working at the Clifton Group, Understanding Risk Parity.

It states the following:
In its simplest form, risk parity seeks to balance the contribution to total portfolio risk from each asset class that composes a diversified portfolio. A traditional 60% equity / 40% fixed income portfolio, which is the base of many investors’ portfolios, is not diversified. Approximately 90% of the risk in this traditional portfolio is concentrated in equities, due to the fact that historically equities have been three times more volatile than fixed income securities. Risk parity seeks to avoid this concentration of risk through the construction of a more diverse, risk balanced portfolio.
The authors then go on to highlight common criticisms of risk parity:
Like all investment strategies, risk parity has its detractors. One common criticism is that this strategy requires leveraging low-risk assets, primarily bonds. Risk parity allocations create an overweight to bonds in order to equalize the contribution to risk from all asset classes. Levered bond strategies performed well over the last several years as interest rates declined sharply since the onset of the financial crises in 2007. Risk parity critics note that given today’s interest rate environment, investors should have tempered expectations for the performance of their bond holdings in the future.

These critics may miss the objective of a risk parity approach, which is to have equal contributions to risk from all asset classes in the portfolio. The purpose of seeking equal contributions to risk from varied asset classes is to limit the potential economic impact to any one asset class in the portfolio. By equally weighting risk across a broad array of other asset classes such as equity, real estate, credit spreads, commodities, and inflation bonds, risk parity is not dependent solely on bonds as the source of diversification or return. It is important to note that a rise in interest rates would impact a risk parity strategy in different ways, depending on why interest rates were rising.

A gradual rise in interest rates as a result of a period of economic stability and prosperity would be positive for a risk parity approach. Although bonds may underperform in this environment, growth assets such as equities, real estate, and credit spreads would likely exhibit above average performance. If interest rates rise in response to increases in inflation expectations, a risk parity approach should benefit from exposure to inflation sensitive asset classes such as commodities and inflation linked bonds. In summary, because diversification is central to a risk parity strategy, there will likely always be some asset classes in the portfolio performing below expectations. However, at the same time other asset classes may well be performing above average.

The goal of the strategy is to allow the investor to collect the average risk premium across all asset classes over time in the most efficient manner possible and thus realize a superior risk-adjusted return.

Another criticism leveled at risk parity is that it often employs leverage. Risk parity strategies target a total level of portfolio volatility commensurate with an investor’s risk and return objective. To achieve this objective, a risk parity strategy may employ economic leverage in the form of futures contracts and financial leverage in the form of repurchase agreements and over-the-counter swaps. At a 10% risk target, it is not uncommon for a risk parity manager to have 200% cumulative exposure. This amount of leverage is required to equalize the risk contribution from low-risk assets like nominal and inflation linked bonds.

Leverage by itself is not a problem. Anyone who has used a mortgage to finance the purchase of a home has been exposed to leverage. What is critical is how that leverage is managed. It is here that the diversification prevalent within the portfolio and the operational and implementation experience of the manager are important. Diversification must be considered not only at the total portfolio level, but also among the various asset classes that are levered within the portfolio and therefore may require daily liquidity. Proven operational experience in managing leverage is key to risk parity managers. This experience should include having systems in place to monitor leverage levels on a real-time basis and developed plans for managing the strategy through challenging market environments. Assuming the diversification and experience criteria are met, the amount of leverage employed in a risk parity strategy should not create excessive risk to the investor.
Now, risk parity strategies have become very popular as rates plunge to historic lows and equities reach high valuations. In Canada, two of the best pensions -- HOOPP and OTPP -- do their own risk parity strategy internally instead of farming it out to an external manager. In order to do this properly, they too have invested heavily in systems and their portfolio managers are very experienced in managing leverage across asset classes (also, unlike other Canadian funds, their investment policy allows them to take on the leverage required to do this strategy internally).

But most pensions and large investors aren't able to do risk parity internally so they farm it out to big hedge funds like Bridgewater or AQR, two well-known risk parity titans.

How do risk parity strategies perform? Let's have a look at the Salient Risk Parity Index which is a quantitatively driven global asset allocation index that seeks to weight risk equally across four asset classes — equities, rates, commodities and credit. The Index is calculated daily, rebalanced monthly, and targets a 10% volatility level.

Below, you can see the annual returns which can be found here along with monthly and weekly returns (click on image):

As you can see, it's not always smooth sailing for risk parity strategies. In 2008, this index was down 17%, which was a lot better than what stocks did that year, but in 2015 it was down 12%, considerably underpeforming the stock market.

Incidentally, risk parity woes contributed to Bridgewater's lackluster performance in 2015, but last year risk parity performed well and so did Ray Dalio's behemoth fund, earning $4.9 billion for its clients, all due to its All-Weather (risk parity) portfolio which outperformed its flagship Pure Alpha portfolio.

But if you listen to Paul Tudor Jones's warning, you'd think risk parity strategies are doomed and they can heavily influence all risk assets, especially stocks.

Here is where I tune off. Why? Because he over-exaggerates their effects on the market, which is why the quants are firing back at his claims:
For AQR Capital Management LLC, a giant in the risk parity field, the concerns are overblown, with any selling forced by the strategy having an “utterly trivial” impact on the $23 trillion U.S. equity market.

“There are scenarios in which risk parity funds sell equities, but the possible magnitude of that is very small,” said Michael Mendelson, a risk-parity portfolio manager at AQR.“Some reports have grossly exaggerated the potential impact.”

Jones, who oversees $10 billion in his Greenwich, Connecticut-based Tudor Investment hedge fund, is the latest active asset manager to whip up fears surrounding the automated strategies that were a favorite target of bank researchers during the selloffs in August 2015 and early 2016. The strategy has less than $150 billion invested in it, according to data provider eVestment, most of at AQR and Bridgewater Associates’ All Weather Fund.

That’s significantly lower than the roughly $500 billion Jones estimated. And of that total, only around a third is investing in equities, Mendelson said. That compares to the nearly $2 trillion in market value that evaporated from U.S. equities during the last stock market correction.

“Even on a sharp move in the stock market, the positioning changes would be utterly trivial and would have about zero impact,” Mendelson said.

Cash Fleeing

Risk parity bases its allocations to different asset classes on risk rather than capital, as in the typical 60-40 stock-bond fund. So, for example, U.S. Treasures and international government bonds often play a larger role in risk parity funds than in other asset pools, while stocks usually take up a smaller slice.

In addition, money has fled risk parity funds in seven of the past nine quarters, for net outflows of more than $16 billion among funds tracked by eVestment.

But even in the scenario that Jones lays out, the funds wouldn’t dump their stock holdings for a variety of reasons, according to Edward Qian, who’s credited with coining the term risk parity. Because of the safer asset concentration, the strategy performs relatively better when stocks tumble and wouldn’t need to sell as much as a traditional 60-40 portfolio, Qian said.

“They’re always focused on the equity portion of risk parity, saying that equities might have a terrible time and other scary fear mongering things,” Qian said. “Even if someone has a stop loss or equity reduction program, it can’t be a significant player in those time periods.”
In short, while risk parity strategies are intellectually appealing and have positive performance attributes, they really aren't as popular as people think. A lot of pensions aren't sold on the idea of risk parity and a lot of them cannot undertake this strategy, at least not in-house which is why they farm it out to big shops.

In order to draw inference on risk parity strategies, you need to see total assets under management of these strategies as a percentage of total stock and bond market capitalization, which is still peanuts.

Sure, at the margin, when risk parity strategies get whacked it can cause problems in markets for a brief period, but I'm not sold on the idea that "risk parity will be the hammer on the downside."

This is pure nonsense from a "legendary investor" who has been underperforming and cutting fees to keep investors onboard.

Is Janet Yellen afraid of Paul Tudor Jones and risk parity? Of course not, the Fed can crush macro gods like Tudor Jones, Ray Dalio and George Soros like little bugs, and it has a lot more arsenal in its war chest than what most investors think.

Are there reasons to be afraid of these markets? You bet. My chief concern -- and that of the Fed -- remains global deflation. This is why I'm highly skeptical of the reflation trade everyone is buying hook line and sinker, especially now that the next economic shoe is dropping and the Fed is considering to shrink its balance sheet, which ironically will only exacerbate global deflation.

Large investors are also preparing for the next downturn by rushing into alternative assets but investing in these strategies has been mixed and if deflation does strike, it's safe to assume there's nowhere to hide except good old US long bonds (TLT) which from a risk-reward perspective, remains my top recommendation this year and probably next year too (click on image):

But things move very quickly in these high frequency, Twitter infested schizoid markets. We shall see what happens after the French elections this weekend and if the Trump Administration is able to pass tax cuts and its infrastructure spending program (if so, US long bonds could get hit again but I would use that pullback to buy more).

All this to say stop listening to the dire warnings of legendary investors. Unless you're privy to their trading books, you have no idea how they're positioned and performing and whether they want to send out false signals to scare people off.

My rule of thumb is to look at what they're actually buying and selling every quarter but don't base any investment decision on what top fund managers are buying or warning of. More often than not, you'll get badly burned.

These markets are ruthless, unrelenting and just brutal.  Everyone from top traders to lowly retail investors is finding it hard to make money. But one thing is for sure, there is a major beta bubble going on in public markets and you need to be well diversified to mitigate against downside risks.

In the meantime, everyone is dancing to the music worried about what happens when the music stops. This is why I hate these markets and why I'm an ardent defender of large, well-governed defined-benefit plans which ensure people can retire in dignity and security (read Mauldin's latest, Angst in America, Part 4: Disappearing Pensions and my recent comment on America's growing retirement angst).

One final note, my recent comment on Canada's real estate mania has proven to be extremely popular.  I'm increasingly concerned about Canada's $1.1 trillion shadow banking system which is now half as large as banks, and you can see the dominoes are beginning to fall as Home Capital (HMC.TO) melted down yesterday on the stock market the same day Ontario was trying to hammer housing (read Garth Turner's latest, Cold Comfort).

Still, Home Capital's stock is bouncing up today (wouldn't touch it with a ten-foot pole!) and I was surprised to see the Royal Bank is the latest Canadian firm to explore a sale of bonds backed by uninsured residential mortgages after that bank's CEO warned of a frothy Canadian housing market.

Also, Ted Carmichael discusses Toronto's real estate boom, stating that while say that house prices will never decline, the city's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.

To my former BCA Research colleague, Steve Poloz, who is now the Governor of the Bank of Canada, all I have to say is "be very afraid of Canada's housing bubble."

On that note, where are the contributions to this blog? I work very hard every single day to provide all of you with great insights on pensions, markets and the economy and I'm getting tired of asking for handouts. Be polite, please take the time to donate or subscribe to this blog on the top right-hand side to show your support. I thank every single one of you, especially those on a fixed income, who support my efforts.

Below, risk parity has been one of the trendiest investment strategies in the world since the financial crisis. This FT Markets clip explains what exactly it is and why institutional investors like it.

Also, Guggenheim Partner’s Scott Minerd says he expects a "significant correction" this summer or early fall. Highly likely but who knows if "sell in May and go away" proves to be right this year? Stay tuned, quant hedge funds might ramp this market up even more before they pull the plug.

Update: One astute global macro trader told me "it's more vol control strategies that de-lever quickly as vol rises." In particular, he sees more risk from vol targeting annuities, not risk parity strategies and thinks that US equities have further upside as positioning and sentiment is too cautious. Like I said, stay tuned, we'll see what happens next week and in the second half of the year.