Submitted by Marc Cohodes And @DonutShorts
The past two months have been a roller coaster ride for Home Capital shareholders culminating in the announcement of Berkshire Hathaway’s investment in the company this week. But the deal raises at least as many questions as it answers, not least of which is whose interests are being served? There are many professed facts about the company and the events of the last two months that just don’t add up. We think shareholders and the public are still a long way from discovering the truth of what has transpired at the company. Given the evident intervention in the Home Capital drama by various arms of the Canadian government, there must be something vital to the economy at stake here. It seems to us that a deep dive into the Home Capital story is in order.
It all starts with Gerry
The most salient fact to know about Home Capital is that it is a veritable extension of the person who ran it for almost 30 years, Gerald Soloway. Soloway and fellow Home Capital board member John Marsh gained control of a public shell company in 1986 and merged the then tiny Home Savings of St. Catharines into the shell. From this humble start, Soloway grew Home into the 9th largest bank in Canada, and was by all accounts, a domineering presence within the company (so domineering, in fact, that he was viewed internally as still running the company even after handing the CEO reins to Martin Reid.) In a very real way, the culture of the company reflects the values and character of Soloway himself. So far so good, a Canadian success story, right? The fly in the ointment is that Soloway is a serial, convicted fraudster, going back even before the start of the Home Capital story, and it appears that many of the business practices of the company reflect his penchant for cutting corners. Soloway was fined by the Ontario Securities Commission (OSC) in 1987 for failing to publicly disclose stock sales of Fleet Aerospace while he was a director of that company, and was banned from trading in public markets for a one year period. Marsh was also a director of Fleet and was intially charged with Soloway, but the charges were later dropped. In the Home Capital mortgage fraud disclosure case, Soloway was sanctioned with a $1MM fine and a 4 year ban from serving as an officer or director of a publicly traded company.
Among the corner cutting that has been documented at Home Capital was ‘Phantom Ticking’ (false confirmation) of the income verification process by Home Capital employees on prime Accelerator mortgages that are guaranteed by the Canadian taxpayer. The OSC described the Phantom Ticking phenomenon as “learned and systemic” within the Accelerator underwriting group. In addition, Home Capital’s mortgage underwriting and sales groups reported up through the same channel of the organization until quite recently, violating a fundamental check and balance in the management of credit risk. We have also learned that Home Capital systematically engaged in a process of selling newly delinquent loans to Re-Charge Corporation, a company partially owned by William Walker, Home Capital’s lead outside counsel who is currently a director of the company. We understand that Re-Charge frequently recast the delinquent loans in a process that many would characterize as predatory lending and left the borrowers with little equity in their homes. The company’s relationship with Re-Charge was undisclosed until it was highlighted in a Seeking Alpha post last year. Home Capital also engaged selling the second lien portion of “bundled” loans (an underwriting practice that OSFI has deemed unsound) to a company controlled by Gerald Soloway’s daughter. This related party dealing was similarly undisclosed until revealed by third parties. Having studied the company carefully for the last three years, we have concluded that these dubious policies and procedures were “open secrets” at Home Capital, akin to what transpired at Wells Fargo in its recent scandal, and not the work of a few “bad apples” at Home.
The optimists on Home say, not to worry, Soloway’s gone, all the problems have been fixed. But are they? The head of Home’s mortgage operations for at least the last seven years, Pino Decina, remains in that position. That is Pino picutured below accepting an award at a charity event organizaed by Kiran Kaushal, head one of the mortgage brokers widely known to have been terminated by Home in the wake of the income verification scandal.
Robert Blowes, who sat in the CFO chair while the income verification fraud transpired, has once again assumed that role in the company and remains on the board. Moreover, Blowes oversaw the reporting of the company’s Q3 2014 financial statements in November of that year, five months after the mortgage fraud was discovered, three months after Project Trillium had commenced, and within days of the terminations of the Home employees that were integral to the ‘Phantom Ticking’ activity. Nothing was said about any of these things in the earnings press release or conference call for that quarter. That’s Blowes’ idea of full disclosure. Likewise, Bonita Then, who sat on the audit committee for the entirety of the income verification fraud and the ensuing cover-up, has been in the CEO’s chair since February. More importantly, the great bulk of the organization is unchanged since the mortgage fraud was discovered. The people who grew up in a culture that enabled things like Phantom Ticking, Re-Charge, loan sales to Soloway’s daughter, and other “learned and systemic” ethical shortcuts are, for most part, all still employed by the company. Will there be a re-education camp for these employees to unlearn these bad habits and dubious ethics of the 30 year Soloway era?
What’s Going on with the Board of Directors?
But wait, you say, there’s new leadership at the board level. Well, that’s only partially true, as there are still several holdovers from the Soloway days. Even ignoring that disturbing fact, however, it’s worth looking at the actions of the board since some of the “new blood” assumed their seats. We first note that Brenda Eprile, the current Chair, was on the board in late April when the $2B credit facility with HOOPP (pension plan for Ontario healthcare workers) was approved. You will recall that this financing included a 5% upfront fee, a 10% rate of interest and a commitment fee for any undrawn amounts of 2.5%. Moreover, HOOPP received collateral equal to twice the value of a portion of the loan, and four times the value of another portion. In keeping with its history of shoddy disclosure, the company has never disclosed what collateral is backing these two portions of the HOOPP loan. You might also remember that HOOPP’s identity as the lender was hidden from shareholders for two days until reported by Bloomberg, and that HOOPP’s CEO Jim Keohane (who later described the loan as a DIP or bankruptcy loan) was a Home Capital board member at the time, and Kevin Smith, then the Chair of Home’s board, was a HOOPP board member. How’s that for incestuous and unethical? We note that the terms of this financing effectively preclude operating profitability at Home with any material portion of the credit facility drawn down.
Following the announcement of the HOOPP loan, several new board members were added in early May, among them Alan Hibben an ex-banker with experience running troubled financial institutions and a close confidante of Kathleen Wynne, the Premier of Ontario. In addition, the former heads of OMERS and the Ontario teachers’ pension plan joined the board on May 8. Also during this period Eprile, who had served as an Executive Director of the Ontario Secuirities Commission (OSC), became Chair of the Home Capital board. In mid-May, James Lisson joined the board, having most recently been employed in the Canadian Department of Justice. You will note the extraordinary coincidence of so many new directors having ties to the Canadian federal or Ontario provincial government in one form or another.
The board’s primary task in the ensuing weeks was to find a more permanent and cheaper source of financing to replace the HOOPP loan which was a 364 day facility that was destroying Home’s profitability. RBC and BMO were engaged to solicit interested bidders. Over the ensuing seven weeks, non-disclosure agreements were signed with 70 parties, and the press was rife with the leaked names of purportedly interested parties – Goldman Sachs, Credit Suisse, Apollo, Blackstone, Brookfield, Catalyst, Onex, and all of Canada’s Big 6 banks, in an apparent effort to kite the stock. We have direct confirmation that some of these leaked names never showed any interest in the company. Clear evidence of the company’s leaking can be seen in this tweet by notorious Financial Post columnist and Home Capital shill Terence Corcoran – note the date in particular:
Perhaps the OSC might want to have a chat with Mr. Corcoran about the details of this “big big scoop” and the identities of any third parties to whom it was conveyed.
According to Bloomberg and the Globe and Mail, Berkshire was contacted by a BMO banker on June 9th. After briefly studying the company but conducting no formal due diligence, Berkshire responded on June 12 with a no-conditions offer that was followed by a meeting of Buffett lieutenant Ted Weschler with Home Capital directors on June 13 and a hand shake deal on June 14. Remarkably, after leaving no stone on Bay Street unturned, with a portfolio of mortgages that Home Capital’s management, board, and cheerleaders in the press had all insisted was “money good”, the board voted to effectively renew the profit-killing HOOPP deal with Berkshire, except this time around for good measure they threw in an offer to sell 39% of Home Capital’s shares at a 60% discount to book value in return for a 50 basis point discount on the interest rate. Huh? Why would anyone with a sound balance sheet of “money good” loans agree to such a deal? Further highlighting the extraordinary nature of this transaction was Home’s need to invoke the “financial hardship” clause with the TSX to complete the sale of the first 20% of its stock without shareholder approval (with the balance subject to a vote in September). Again, why does a bank with a balance sheet full of “money good” loans need to invoke such a clause?
Curiously, on the same day that Home and Buffett shook hands on this deal, the Company announced a settlement of the OSC’s charges, in which it admitted defrauding its shareholders and agreed to pay a $30MM fine. Bloomberg reported that the release of the terms of the settlement by the OSC before they had formally approved by the administrative court “raised eyebrows among regulatory experts” and added that such a step was “something the OSC itself acknowledges is unusual.”
Of further note, on June 23, two days after the Berkshire investment was announced, Bloomberg reported that Alan Hibben had expressed interest in the CEO position and was among four finalists being considered for the job. It’s curious that a director wouldn’t have disclosed this interest at the outset of the process and that he had been selected as a finalist shortly after revealing his interest.
Whose interest is the Board Representing?
So let’s review the bidding here. In late April, the company agrees to a usurious credit facility with what is effectively an arm of the provincial government in which the major participants and decision makers have conflicts out the wazoo. A major revamp of the board ensues, resulting in no fewer than 5 directors who have deep historical ties with some element of either the Canadian federal or Ontario provincial government. This is followed by a highly unusual and perhaps unprecedented short circuiting of the OSC settlement process on the same day that a wide ranging search for new financing ends with an agreement with a late-to-the-game partner to provide financing that promises to hand shareholders an even worse earnings outlook than the HOOPP deal, the terms of which would have made a loan shark blush. Oh - and the late-to-the-game investor, just happened to have dinner with Premier Justin Trudeau and Fin Min Bill Morneau a few weeks before that handshake. And now, Hibben, the close confidante of Wynne’s, suddenly throws his hat in the ring to be Home’s CEO. So is the board serving the interests of the shareholders here in doubling down on the HOOPP deal while throwing in 39% of the stock for good measure? Remember, the balance sheet is filled with loans that are “money good” we are told. Or are they doing the bidding of the political class in Ottawa and Toronto, who are desperately trying to avoid the ugly optics of bank meltdown on their watch, and decidedly less worried about the shareholders’ interests?
Shareholders and the Public have Unanswered Questions
In the wake of the Buffett investment, other financial institutions will no doubt be “encouraged” to once again give their clients unfettered ability to invest in Home Capital GICs (and, indeed, we’ve already seen a “Warren has your back” story touting Home’s GICs in the Globe & Mail). But does anyone have a clear picture of the state of Home Capital’s finances (aside, perhaps, from its board which has seen fit to do two loan shark-worthy financings in the last 60 days?) Can the banks permit such access while upholding their fiduciary duty given how little is known about the true state of Home? The two rating agencies that follow the company currently assign a junk rating to its credit. The Globe and Mail reported that the bank has been staged by OSFI, so are buyers of uninsured GICs being put in harm’s way? What kind of risk does a renewed GIC marketing effort pose to the CDIC and Canadian taxpayers? If these questions seem overwrought, recall that on April 21, then chair Kevin Smith told shareholders the company’s business was “robust and on the right track” only to be follwed six days later by the announcement of a “DIP like” financing with HOOPP. You’ll pardon us if we take the company’s pronouncements at less than face value. The OSC has collected 22,000 pages of evidence and has deposed nine witnesses. Wouldn’t it be better for the shareholders and the public to know what they have learned? And what is the status of the Accelerator mortgages that were fraudulently originated and the brokers who originated them? What ongoing risk do they pose to CMHC and therefore taxpayers? Are we sure the scale of the problem is only $2B or did the problems start earlier? Isn’t a thorough accounting of the worst Canadian bank scandal in decades in order, or is that overwhelmed by the desire of the powers that be to sweep it all under the rug?
What is Warren Thinking?
Which brings us to the question of why would Warren Buffett invest in a company such as Home Capital? On the one hand, the deal parallels those made with Goldman Sachs and Bank of America in the wake of the financial crisis and squares with his motto of being greedy while others are fearful. Yet Buffett has built his reputation on, and takes fierce pride in, doing business in a highly ethical manner with people and businesses of similar character. We can see no way in which Home Capital, with its many ethical lapses in its dealings with both its shareholders and its customers, fits with the Buffett M.O. To our knowledge, this is the only company that Buffett has invested in that has previously admitted to defrauding its shareholders.
As we have documented, a culture of cutting corners seems deeply rooted in Home Capital and is unlikely to be quickly changed just by swapping out a few headshots at the top of the org chart. Buffett is said to take comfort in the people on the board of directors, yet his lieutenant had only one meeting with them prior to making a commitment to invest, and a number of the decisions and statements made by members of the board in the last two months are hard to square with a robust defense of shareholder interests or even honest communications with the public. Moreover, the continuing presence of Pino Decina and Robert Blowes in the management ranks seems antithetical to the Buffett philosophy displayed here:
"If you're looking for a manager you want someone who is intelligent, energetic, and moral," said Buffett. "But if they don't have the last one, you don't want them to have the first two."
As discussed above, both were deeply engaged in overseeing either the shady mortgage oringinations or the process of covering them up.
Similarly, in the wake of the Salomon Brothers scandal, Buffett said in his testimony before Congress:
“The spirit of compliance is as important, or more so, than the words about compliance.”
Home Capital’s challenged relationship with the letter of compliance, much less its spirit, can be seen in its long record of shoddy disclosure to shareholders (and its frequent insouciant response when called out on disclosure failings), its staging by OSFI and the manifold evidence of substandard control systems, and the instances of shabby treatment of its customers as detailed here, for example: https://www.canlii.org/fr/qc/qccq/doc/2015/2015qccq4137/2015qccq4137.html
Buffett summarized his Home Capital investment thesis as follows:
"Home Capital's strong assets, its ability to originate and underwrite well-performing mortgages, and its leading position in a growing market sector make this a very attractive investment," said Warren E. Buffett, Berkshire Chairman and Chief Executive Officer.
At best, this description of Home seems aspirational to us, and unsupported by the facts that we are familiar with today. Moreover, it would seem impossible to make any definitive statement about the health of the buiness or the quality of its assets given the events of the last year at the company and the sketchy disclosure of the last two months. We would caution members of the investing public on blindly following Buffett into this stock. He is investing on much different terms that they are, and this deal seems very “off spec” compared to his usual investment guidelines. Berkshire is a conglomerate with interests across a wide range of industries and countries. Perhaps there are unspoken terms of this investment that benefit Berkshire, though not Home Capital shareholders, that have yet to be revealed.