Canadian bank run contagion begins

Via Bloomberg:

Home Capital Group Inc. extended declines after the Canadian mortgage lender reported additional deposit withdrawals, prompting one of its biggest rivals to seek a C$2 billion ($1.5 billion) credit line to stem any contagion across the country’s financial markets.

Home Capital fell 13 percent to C$6.96 in Toronto, bringing its two-week drop to about 69 percent, on concern that redemptions of guaranteed investment certificates by nervous investors would worsen a cash crunch. High-interest deposits have declined about C$1.6 billion, or 80 percent, over the past month to C$391 million, the companysaid Monday.

“They could be at risk,” said Jaeme Gloyn, an analyst at National Bank Financial Inc. “If investors are pulling their high-interest savings accounts, it’s natural to think that other clients would also be looking to pull their GIC investments.”

The selloff in Home Capital’s stock and bonds, sparked by allegations that it misled investors about its mortgage book, are raising concern that its funding woes may spread to other mortgage lenders. That could derail a red-hot housing market that’s been a key driver of growth for Canada’s economy, accounting for as much as a fifth of output.

Equitable Group Inc., another alternative mortgage lender, said Monday it took out a credit line with a group of Canadian banks after it started seeing “an elevated but manageable” decrease in deposit balances. Customers withdrew an average C$75 million a day between Wednesday and Friday. The withdrawals represented 2.4 percent of the total deposit base. Liquid assets remained at roughly C$1 billion after the outflows.

And from Greater Fool comes texture:

In a moment: are the banks safe?

Let’s set the scene with comments from two blog dogs sitting on opposite sides of the real estate maelstrom. First a poster we’ll respectfully call Dick:

“People, don’t listen to Turnster, he knows nothing about nothing. If you bought into RE 1 year ago, 2, 5, 10, 15, 20 you are golden no matter what. Open your eyes and see for yourselves – RE in Canada will always be of value and will never go down in price. NEVER! There ain’t no bubble here. RE prices simply have caught up with the levels where they should have been in the first place. TO is a major cultural and economic city. I bought last years and it’s gone way up! And always will. And everyone will want to live here. The demand for RE will never dry up. NEVER!”

And here’s a further update from Derek, the dude who blissed out last month when his house went in a bidding war for lots more than he expected: $2.25 million. Then the buyer got cold feet while the other bidders fled. Lawyers are fighting. Derek’s in a funk.

“Well the shit show continues. Buyers did not even respond to our lawyer. We had hoped maybe they would come to their senses but have waited long enough. I just can’t believe peoples mentality. Stick your head in the sand and hope it goes away. So it looks like we are relisting on Monday.

“Really nervous that the market has changed and we will be at a terrible disadvantage now. Dealing with all this and maybe having to sue them is really not the way we had planned on having this happen. Most people I talk seem to feel that I will win if this is the outcome but obviously we are nervous.”

And finally, another dog who just sold for far less than anticipated after an attempt to create a bidding war failed. No offers – even for a detached in prime 416.

“At the beginning of April in this area there was a boat load of sales, before Ontario dropped the hammer.  Since then, just four sales.  Listings have tripled.  Bidding wars being held, but no offers.  Condos listings exploding. Now I just got to find a desperate owner willing to take a haircut on rent.”

Yeah, everyone sees reality through their own lens of experience. The guy who bought recently wants nothing more than validation for having made a sacrifice – which is exactly what it takes to buy into a bubble market. So he pumps, gloats and pumps harder. The person who wants to sell and can’t, sees nothing but disaster looming. The guy who swallowed a lump pf pride and took less, rationalizes the action. It’s impossible to know if the market switch has flipped from ‘Insane’ to ‘Scared,’ but something is afoot.

Days ago the savvy investment wonks at Mawer money managers sold almost three million shares in Home Capital Group, squeaking out the door before it shut behind them. The loss would be staggering, and now the company’s chief investment officer, Jim Hall, is saying some serious things about what the collapse of Home Cap might suggest about the whole mortgage financial business and even (gasp) the Big Banks.

Could the looming death of Canada’s biggest non-bank lender cause a run on deposits at other institutions as depositors start to understand their money went to finance a housing market that could blow up?

“The probability has gone from infinitesimal to possible — unlikely, but possible.” He told the Financial Post. “If depositors or bondholders start to lose faith in their banks, well then that becomes systemic.”

Yikes. Spooky words from a guy who manages $40 billion in assets. And while Home Cap’ mortgages represent just 1% of the entire Canadian home loan business, even little wounds are serious when you’re dealing with a system built on confidence. People blindly put their savings into the GICs and high-interest accounts of outfits like EQ Bank and Home Trust because they got a little more interest and were too trusting to ask when the cash went. (Most of it was loaned out to home-buyers who required high-ratio mortgages and didn’t qualify at the bank.) Now many depositors are desperate to get their cash back – and Home had to borrow $2 billion at usurious rates from an insider to stay alive. As a result, its stock plunged and the corporate carcass is now for sale.

See how it works? Not pretty. And fast.

There’s little doubt our big banks are secure, despite their jaw-dropping exposure to residential real estate. (If you want to worry, fret about the credit unions.) But the residential real estate market is just as susceptible to sharp U-turns in sentiment as GIC-holders in operations like Home or EQ.

On Friday US ratings agency Fitch hoisted a red flag over the GTA’s runaway, but conflicted, market. Ontario’s recent 16-point plan will bite, it says, and it could all start with those universal rent controls – since that market (as we’ve been telling you) has become dominated by speckers.

“The proposed rent controls could dampen price growth in the condo market if the rent investors can charge tenants is limited. Investors who are highly leveraged may be forced to sell, which could begin downward momentum that leads speculators to follow suit. Further, if all measures are passed, municipalities will have the power to introduce a tax on vacant units to encourage sales or rentals of unoccupied units, which may discourage speculators from holding onto vacant properties.”

Well, make up your own mind about what comes next. Dick has.

And from John Hempton comes some damn good advice:

Home Capital Group is an aggressive Canadian home lender that has hit a very rough patch. If you want a history Twitter will do it well. They have been fighting with Marc Cohodes (a very well known short seller) and you will find a timeline of the unfolding disaster by following Marc’s tweets. [Disclosure: I have known Marc for 17 years and we are friendly.]

The crisis came this week when Home Capital Group entered into an emergency loan. The press release is here – but the salient points are repeated below:

TORONTO – April 27, 2017 – Home Capital Group Inc. (“The Company” TSX: HCG) today announced that its subsidiary, Home Trust, has secured a firm commitment for a $2 billion credit line from a major Canadian institutional investor. 

The Company also announced it has retained RBC Capital Markets and BMO Capital Markets to advise on further financing and strategic options. 

The $2 billion loan facility is secured against a portfolio of mortgages originated by
Home Trust. 

Home Trust has agreed to paying a non-refundable commitment fee of $100 million and will make an initial draw of $1 billion. The interest rate on outstanding balances is 10 per cent, and the standby fee on undrawn funds is 2.5 per cent. The facility matures in 364 days, at the option of Home Trust. 

The facility, combined with Home Trust’s current available liquidity, provides the Company with access to approximately $3.5 billion in total funding, exceeding the amount of outstanding High Interest Savings Account (HISA) balances. 

Home Trust had liquid assets of $1.3 billion as at April 25, plus an additional portfolio of
available for sale securities totalling approximately $200 million. 

Access to these funds is intended to mitigate the impact of a decline in Home Trust’s HISA deposit balances that has occurred over the past four weeks and that has accelerated since April 20. The Company will work closely with the lender to have the funds available as soon as possible.

This on the face of it is an extraordinary loan. It is secured by giving the collateral and costs something between 15 and 22.5 percent depending on how much is borrowed.

Its also extraordinary because of what it does not mention. It does not mention who the lender is and it does not delineate what the precise capital is.

But we know that this is being used to pay High Interest Savings Balances. We know there is a run on the bank here here and the run is several hundred million dollars per day.

This is desperation financing. They are securing mortgages (average interest rate below 5 percent) to borrow funds that cost 15 percent or more. The negative carry is huge. A financial institution cannot stay in business under these terms.

The stock reacted – dropping 60 percent in a day. The Canadian exchange busted some trades about $8.20 (because it thought that they were done in error). Mine were amongst the busted ones. I was perfectly happy to sell at that price however in their wisdom the exchange thought that mine was a fat-finger trade. [Disclosure – transaction to sell 30,000 shares at 8.19 was reversed.]

But it is extraordinary because it gives the following details.

a). The loans are secured by 200 percent of their value in mortgages (which makes the investment almost riskless – and Mr Keohane goes to some lengths to describe how low the risk is), and

b). Me Keohane says the deal is more akin to a “DIP deal”. DIP stands for debtor in possession and he is thus saying the deal is bankruptcy finance.

This is an extraordinary position for Mr Keohane to take. He was an insider to both institutions (a true conflict of interest).

What he is saying is that he isn’t taking any risk because he has taken all the good collateral and he expects Home Capital go go bankrupt.

And note that he will make 15 to 22.5 percent return (more if the loan is repaid early in a liquidation) whilst taking no risk.

I have two words to say to this: fraudulent conveyance. In a rushed deal (one that truly surprised the market) done with undisclosed insiders up to four billion of the collateral and maybe three hundred million dollars of book value has been spirited away. And at basically no risk the recipient of all this largess.

Wow that was audacious.  More audacious than just about anything I have ever seen on Wall Street.

Jim Keohane seems to recognise what he has said because almost immediately he says that he doesn’t know what the acronym DIP stands for.

That surprised me: Mr Keohane uses the phrase DIP Financing precisely and accurately and in context and then says he doesn’t know what it means. You should note that Mr Keohane is a very sophisticated fixed income player. (If you want a guide to how sophisticated read this…)

The position of the Canadian Government

The Canadian Regulator is put in an extreme bind. Up to $300 million of value has been spirited away from a highly distressed institution.

The regulator however has guaranteed a very large amount of funding of Home Capital (guaranteed deposits). They should be alarmed at up to $4 billion in collateral being spirited away to HOOP. This effectively subordinates the insured depositors and in the event of Home Capital’s failure will cost the taxpayer several hundred million dollars.

This is not an idle concern. The funding itself indicates that it is very likely Home Capital will collapse. And a former director described this as akin to DIP Financing.

If I were the regulator

If I were the regulator I would be doing my duty here. My duty here is to protect the taxpayer.

Very rapidly Home Capital needs to find a buyer to assume the government insured obligations. It does not matter if this happens at 20c per share. Indeed from a regulatory perspective it is better if it happens at a low share price because it gets rid of claims of bailouts inducing moral hazard.

If Home Capital cannot find a buyer then it should be liquidated. Immediately. And the transaction with HOOP should be reversed under standard bankruptcy rules for reversing fraudulent conveyance. There is no reason that taxpayers should accept subordination to a loan yielding 15-20 percent.

Indeed regulators have a duty to stop that sort of thing.

Yep.

David Llewellyn-Smith
Latest posts by David Llewellyn-Smith (see all)

Comments

  1. Researchtime

    This could be huge – its bloody comes out from no where… yeah, we all knew the Canadian market was overpriced. But from Thursday last week, to now – this story has gone totally bonkers! And it makes perfect sense.

    Those with investments in Australian banks, beware, I have just remarked to a mate, if we get subprime numbers like the US, everyone of the major four Oz banks will be bust 4x over!!! (i.e. listed equity will be wiped out 4x over).

    • Ronin8317MEMBER

      Unlike the subprime in the US, the OZ banks can fudge the default rate by giving home owners non-payment periods. That’s one of the benefit of having the mortgages on your book, but it would only kick the can down the road for 12 months at best.

      • Foreign lenders won’t fall for that trick for too long. That will drive up rates of borrowing for the banks, who will pass it on to borrowers, who will feel more panic and stress…. and you can see where that heads.

    • I transferred our money out of Oz for exactly that scenario. I may have to do it again actually.

      I have asked here before but never received a reply… Would it be possible to do an article on this scenario and come up with a reasonably argumented calculation to see whether Australian Government would even be able to shoulder a collapse of the Financial System?

      With the banks so exposed to RE both here and in NZ and reliant on off-shore funds… is Australia another Iceland?

      • Arrow2MEMBER

        Is there an Aussie equivalent to Home Capital ie one without big bank backing? (So not Aussie Home Loans I guess). Rams?

      • BrentonMEMBER

        Rams is a Westpac subsidiary.

        Maybe something like Newcastle Permanent, but a little bigger.

  2. NikolaMEMBER

    All eyes on the second lender. If they get in serious trouble then we will witness a meltdown in Canadian real estate.
    Such events will have an impact on Australian markets.

    • Tassie TomMEMBER

      I’m betting that all the short sellers’ eyes are also on the second lender.

  3. Mining BoganMEMBER

    It’s been said before that we travel about six months behind Canadia.

    Ooooohhhh…

      • PeachyMEMBER

        No, haven’t you been paying attention to what has happened here, time and again, over the last decade or so?

        The six month lag gives our government/regulators time to prepare for and neutralise this threat. Forewarned is forearmed, remember?

        This is a huge fucking calamity because it may defer the bursting of our bubble yet again.

    • Bah. They’ve been getting 5 year fixed rates of 1.99% and stuff like that. We’re nowhere near 1.99% 5 year fixed. So obviously we’re different. Also we don’t like Ice Hockey down here. And our economy doesn’t stop every winter. And we don’t have Trump refugees fleeing across the border and taking our jerbs. And no French province!

      You know what Canada’s real problem was? No Reusa. They go on about how pretty their PM is, but never mention his property portfolio.

  4. It appears to be on like Donkey Kong. But don’t worry prices will never go down Toronto / Vancouver / insert city will always be desirable to live with clean air and good schools and wealthy Chinese looking to park their monies…

  5. Willy2MEMBER

    – “Greater fool” is a great site. Have been visiting it for years.
    – YIkes. Only one regulator has been sounding the alarm in Canada and now it seems the entire RE is in trouble. Again: Yikes.

  6. Note the speed of the transformation from regal financier to dust.

    Can’t happen here? It is certain to, given our debt levels.

    Don’t Buy Now!

  7. Willy2MEMBER

    – Quote (from “GreaterFool.ca”):

    “There’s little doubt our big banks are secure, despite their jaw-dropping exposure to residential real estate.”

    Sure, and I was born yesterday. Right ??

    • Straya mate! Safest banks in the world. So smart they avoided the GFC… don’t be a crashnik!

      • Willy2MEMBER

        – Too bad I already choose the alias “Willy2”. But otherwise I would have chosen the alias “crashniks”. It precisely reflects what my thoughts are regarding our australian banks.

    • PantoneMEMBER

      That’s one thing I’ll never understand about Gareth, he acknowledges that Canadians are in even more debt than the Americans ever were but still insists that the banks are safe. Mind boggling.

      • Willy2MEMBER

        – Mr. Garth Turner has some more weird ideas. He thinks that rising interest rates are inflationary but they are Deflationary.

      • I used to read him everyday, but not so much lately (its depressing watching him correctly predict things and get no traction with it)…I suspect what he means is “The govt will save the banks- all losses passed onto the unwashed masses”. So technically everyone’s money is safe, it just wont be worth very much. He used to go on about price of cabbage or lettuce or something to illustrate the point.

      • Patience, my friend. In time, he will seek *you* out, and when he does, you must bring him before me. He has grown strong. Only together can we turn him to the Moron Side of the Force.

  8. SoMPLSBoyMEMBER

    “They are securing mortgages (average interest rate below 5 percent) to borrow funds that cost 15 percent or more. The negative carry is huge. A financial institution cannot stay in business under these terms.”

    Orbital ‘re-entry’ at the ‘wrong’ angle!

      • Researchtime

        Japanese have… and look at their market, down every year for two decades!

      • Researchtime

        Only if its negative like Denmark… then jump in!

        I think you miss the point with NG, it works only if you have alternate incomes. Look at WA, many knew they had massive windfalls, and tried to do the wise thing and buy property as a form of enforced savings. The NG part was a nothing, because house prices kept going up…

        Thats the key thing about NG that everyone over looks. It is only attractive (a) if you have capital gains. Perth capital gains were enormous, until they weren’t! and (b) if you have other income to offset (massive job losses, especially among those in mining sector – precisely the cable/group who borrowed and bought. The horror will last decades).

        Sydney capital gains are enormous, BUT… The one thing saving Sydney (and a certain extent Melbourne) is that we have 25% foreign buyers, of which, 80% of those (so 20% of the entire market) are Chinese. Think about that forma moment, one in five Sydney buyers is a Chinese citizen; a cashed up buyer, doesn’t need debt!

        This is the key point – Mum’s and Dad investors have actually been pulling back for close to 12 months now from a numerical point of view (flat to substantially down from an investment perspective, accounting for the 16% you increase in valuations y-o-y). The property market, should be in the midst of an almighty crash – BUT ITS NOT! Why???

        A small step aside; many of the Chinese know that bad things are about to happen in China, and are increasingly desperate to get their savings out. Official monetary figures show that monetary outflows are actually expanding despite all the regulation.

        Lets put this into extreme perspective, Kyle Bass wrote recently that official monetary controls are so extreme in China, that large Western companies operating in cannot expatriate ANY earnings/monies (not a single dollar, for months) – although certain arrangements have been made since, but miniscule.

        Now ponders that for a brief minute – if large multi-national companies cannot take any moneys outside China at present – what is accounting for the massive monetary outflows?????

        KEY POINT: Its Mum’s and Dads, but in particular, the super rich. They have made good, now thy are fleeing. And trust me, money is still easily taken out via back channels. Western companies have to use official channels, and are literally stuffed… doing any real business in China almost impossible according to some.

        Now back to point – where is a lot of that Chinese money running to? Houses, in Particular, London, Sydney, Singapore, Toronto, etc. Also massive farmland deals. Medium businesses, anything that produces a positive cashflow. They (the Chinese) don’t care about the potential return. In fact, from what I have heard, they are getting increasingly desperate, they literally don’t care if the houses are over priced – because the alternative is far worse if it all gets confiscated back at home. Moreover, they travel abroad, Sydney still looks cheap to them – honestly… good schools, good weather, good governance, clean and safe. And I don’t blame them.

        That is the real story. Everything else is just political BS. The Labour Party in NZ claim they will send all the illegals back – everyone knows, they are few and far between. Its all perfectly legal, and there is a host of data to back up what I have said above.

      • Researchtime

        Labour Party in NZ claim they will send all the illegals back – everyone knows, they are few and far between. In fact, given NZ is far more rigorous in documentation via buying and selling houses that Oz, illegals are IMHO entirely absent. And NZ Labour know this. Its all perfectly legal, and Labour don’t intend to change anything. Its just talk, talk…

  9. adelaide_economistMEMBER

    Interestingly this has caused me to look into Canadian bank deposit guarantees. They only have a C$100,000 limit (versus A$250,000 in Australia) and that limit is per person, not per account (so it’s C$100,000 all up, whereas in Australia it’s A$250,000 per institution – so say RAMS and Westpac accounts combined are only covered up to A$250,000 but cash in separate institutions has its own A$250,000 limit). Even worse it seems Canadian credit unions generally aren’t covered by the (federal) guarantee because they are created/operating under provincial laws.

    Of course it does raise the question of how viable the A$250,000 per institution ‘generosity’ is if put to the test because I can’t actually see how depositors would be made whole in the event of widespread calls on the guarantee without it being made contingent on a variety of access conditions- ie limits of drawdown over time, or purpose of use.

    • bolstroodMEMBER

      I understood that the Australian Govt bank guarantee is capped at $20billion per institution.
      I am happy to be corrected on this.
      If it is the case a smaller credit union may be a safer place to have money as it’s deposits would fall under the cap.
      Again happy to be corrected.

  10. Researchtime

    A great pop into my inbox – have to post in full, a day late, so it won’t impinge!

    **************

    Property Bubbles Everywhere As If It Were 2007 Again
    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.

    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.

    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
    Chief Investment Officer

  11. This gets really interesting when it spreads to one of the 6 D-SIBs:

    – Bank of Montreal
    – The Bank of Nova Scotia
    – Canadian Imperial Bank of Commerce
    – National Bank of Canada
    – Royal Bank of Canada
    – The Toronto-Dominion Bank

    http://business.financialpost.com/fp-comment/joe-oliver-how-the-budgets-bank-bail-in-changes-could-cost-canadian-depositors

    HCG will be strip-mined of any assets of value, with those assets transferred to a new private-sector financial institution which can pick up where HCG left off. The husk left behind will contain toxic “assets” and liabilities, the losses from which will have to be realised by some party.

    Remember how Bank of America ended up with Countrywide?

    D-SIBs are the last line of private-sector defence before things get socialised with a government bailout. Should this snowball like the US did as the private-sector plays pass-the-bomb, then expect depositors with net deposits > CAD $100,000 to find themselves bailed-in and the new owners of bank equity with a significant haircut, Cyprus style (Dijsselbloem’s “template”).