We are going to focus this week on two stories from the property market; one in Canada and one back home here in the UK. Property market analysis is not exactly the main focus of our day job, but these stories may well have important implications for financial markets, which of course is what our day job is all about.
It is no secret with our readers that we have had a bearish fundamental bias for quite some time now. We have tried our very best to supress these bearish feelings as financial prices move further into bubble territory supported by extraordinary central bank policies and also the activities of price insensitive buyers (central banks, companies buying their own shares and index providers). However, we do believe that these forces will ultimately dissipate and that there will one day be another bear market.
Nobody knows what will be the visible trigger or triggers for the next bear market (academics are still unsure of the cause of the 1987 stock market crash!). We still look back at 2007 and pinpoint the collapse of two highly leveraged Bear Sterns hedge funds in June of that year as the first visible evidence that the financial bubble was bursting (the property bubble began to burst in 2006 in the US). So, we present these two stories as evidence that leveraged speculation by unsophisticated investors is rife today, and that visible problems are emerging.
We will start this week on the story of the collapsing share price of Home Capital Group (HCG), the largest non-bank mortgage lender in Canada. The shares collapsed by over 60% last week after it emerged that the Company had arranged an emergency liquidity line via a C$1.5 billion loan facility. The reason for the liquidity need appears to be some C$600 million of deposits had been withdrawn and they had to plug the gap. As can be seen in chart 1 below, the 60% decline on Wednesday was not the start of the bear market for Home Capital Group; the shares have now fallen by 85% from the 2014 high. In our opinion, this story has an eerie parallel with Northern Rock in 2008 in the UK – a mortgage provider suffering a deposit run.
Chart 1 – Home Capital Group share price
What is quite extraordinary is that the liquidity line, provided by an undisclosed counterparty, is on such poor terms for the company that bankruptcy would seem assured at some point. There is a non-refundable C$100 million fee, the rate of interest is 10% on outstanding balances and there is a 2.5% standby fee on undrawn balances. So, the effective interest rate on the first C$1 billion (the minimum drawdown amount) is 22.5%, falling to 15% if the entire liquidity line is drawn down. On a cursory analysis, this does not seem sustainable to us.
Home Capital Group appears to have been using quite aggressive loan tactics helping sub-prime borrowers, and funding those mortgages with customer deposits. Now that the company is in trouble because nearly C$600 million in deposits has been withdrawn, what will the remaining depositors think? Will they leave their hard earned cash with HCG and assume that the new loan will save the day? Or will they make a more rationale choice and get their money out as fast as possible – act first and ask questions later. We know what we would do if we had any cash with HCG!
The story took another twist late in the week when it was disclosed that the lender is the Healthcare of Ontario Pension Plan (HOOPP) which represents over 320,000 workers. Quite a move by what should be a relative conservative investor one would think. Either the loan will be made good and HOOPP will make a lot of money, or HCG collapses anyway and the loan may not be paid out in full. Even conservative pension plans have to take risks, and who are we to say that these guys don’t know what they are doing. However, the twist comes from the fact that President and CEO of HOOPP also sits on the board of Home Capital Group and is also a shareholder. The conflict of interest here is extraordinary, and you have to ask where the corporate governance structure for a large pension plan is. Also, why did HCG not approach other investors to keep the transaction more at arms length from the directors?
What is extraordinary is that a mortgage provider could get into such difficulty during an unprecedented boom in the Canadian property market. As can be seen below, Canadian property prices have been in a massive bull market since at least 2000, and barely wobbled during the 2008 Global Financial Crisis. The comparison with US property prices is stark. With Canadian household debt to income ratios through the roof as well, there is little doubt that this is an extraordinary bubble. Frankly, the casual observer has to wonder whether the troubles of Home Capital Group, the largest non-bank mortgage lender in Canada, are a sign that all is not well and that the bubble is close to popping.
Chart 2 – Canadian House prices
Moving on, but staying with the property theme and something we also found to be quite extraordinary. Last week, the FT ran a story headlined “UK public finance: councils build a credit bubble”. With our view that central banks globally have helped create bubbles in nearly everything, we are naturally drawn to these sorts of headlines and so dived in to read the story.
According to the FT, “Across the UK, local councils have been plunging into the commercial property market or embarking on residential property development, either for sale or for the private rental market.” Quoting a property expert, “They are punting like drunken sailors all around the country” says a bemused fund manager who has been outbid by local authorities on more than one investment this year.
Just by way of some background for our non UK readers here. UK local councils or authorities do usually have cash on hand. Through local taxes on housing, central government funding and other smaller sources of revenue, these entities do have cash which they have to hold somewhere. We also know that they are prone to reaching for yield, or put another way, taking risks to achieve a higher return on this cash. We know this because a number of them had deposits with Icelandic banks (that were paying above market rates) when they all collapsed in 2008. Luckily for them and their taxpayers, these local authorities were bailed out on that occasion.
The cash that these entities have is for funding current expenditure. What these entities are doing now is borrowing money cheaply in an attempt to earn a higher return from the tenants of their properties. This is possible because UK local authorities are able to borrow at central Government rates, which for them work out at less than 1% on short dated loans and only a bit above 2% for long dated loans of up to 50 years maturity. In the words of the FT, this activity is known in the hedge fund world as pursuing the “carry trade”, and is not dissimilar to what the two Bear Sterns hedge funds were doing prior to their collapse in 2008.
Being able to borrow at much cheaper rates than the private sector, UK local authorities are able to outbid professional property investors. Since the beginning of last year, it is estimated that UK councils have bought nearly £1.5 billion worth of commercial property, and in some cases, with greater than 100% loans. This is good old fashioned speculation with borrowed money – what could possibly go wrong?
It would appear that the motivation for this speculation is to plug gaps in the budgets of these local authorities. As the FT points out, this sort of local government financial speculation has been seen before. Similar activities were seen in Japan during their 1980s property bubble, was seen in Orange County California when they were forced into bankruptcy in 1994 after a US$1.6 billion derivatives loss, and is being seen on an industrial scale in China today where local governments generate sometimes over half of their revenue from property transactions of various sorts.
As noted at the beginning, we bring these property market stories to you not because we are experts on this subject. We highlight these stories as evidence of the unbridled and leveraged speculation that is occurring today, less than 10 years after the last crisis, courtesy of the extraordinary policies that have been and continue to be pursued by our central banks. We have said many times that there would be future unintended consequences to these extraordinary policies.
Quite frankly, we are always amazed that, broadly speaking, our policymakers have been allowed to make some of the same mistakes that they made in the run up to the last crisis in 2008. It is widely accepted that too much debt was part of the problem in 2007, and yet since that time, it is estimated that global debt has increased by about US$70 trillion – a staggering sum of money. Central banks have pursued extraordinary policies whilst our politicians have failed to make any substantive positive changes to the structure of the real economy.
This commentary has begun to get a little longer than usual, but we would like to make two more points. First, we continue to have conversations with people who state that inflation must surely come from all the money printing we have seen. Well, the answer is that we have already seen the inflation; simply in asset prices much more so than consumer prices. So long as central banks print money to buy existing financial assets, the likelihood of rapidly rising consumer prices is low. If, however, they started funding national Treasuries directly and the newly printed money was injected straight into the real economy, then we would see consumer prices rising more rapidly (and asset prices rise less rapidly?). Currently, this is not legal for the big developed market central banks and is unlikely without another crisis.
Secondly, we need to realise that once we reach a certain level of debt (and that was years ago), each Dollar of new debt is simply bringing forward future demand into the present. This creates the illusion of a better current economic outcome, but will come at a cost of lower future consumption. Globally, we have been playing this game at an extraordinary pace since the last crisis, and there comes a point when society simply cannot or will not be able to increase debt fast enough to keep the economy growing. We are already seeing signs of stress in the US, with Auto sales softening, disappointing retail performance and delinquencies rising on all types of consumer debt.
We also have to mention China here, which was very much part of the reflationary response unleashed on markets after the Q1 2016 rout. The creation of new debt in China in the last 10 years is faster than pretty much any other country in history, and this is definitely not sustainable. We could also have highlighted a story that emerged from China this week about a failed Wealth Management Product that is unable to repay investors due to fraud. This is interesting as fraudulent activities is also part and parcel of financial bubbles. China is a problem for the future, and we doubt whether they will let anything untoward happen before their 19th party congress in October, but once this is out of the way, China probably becomes a headwind for global growth.
The issue here is that taking on too much unproductive debt is ultimately deflationary when society reaches the point of saturation. To state the obvious, it seems to us that the vast majority of investors and market commentators are still worried about consumer inflation. We continue to believe that deflation will be the problem when the next recession and bear market strikes. If this were to occur, then we will basically see a rerun of the 2008 crisis and safe income unencumbered by high levels of debt will be highly sought after, especially given the demographic and ageing trends apparent in nearly all developed economies.
Of course, given the track record of our leaders, we have to suspect that they cannot or will not tolerate another major crisis, even though it is their policies that have brought us to where we are today. We have to suspect that laws will be re-written, and that central banks will directly fund Government spending and we will truly see inflation wiping out holders of nominal debts. But we doubt that society will allow laws to be re-written to allow central banks to directly fund central governments until after the next crisis is well under way. The key question today is whether we are finally seeing visible signs that the crisis is slowly but surely beginning. Let’s not forget how the 2008 crisis seemed to unfold slowly at first, and then rapidly as panic really began to set in. The time for investors to act and protect their capital is well before the panic stage sets in.
Stewart Richardson
RMG Wealth Management
