Wednesday, June 4, 2014

Home Capital Group: The Golden West of Canada?

Donville Kent is a fund manager from Canada. They are proponents of the idea that buying high-return companies is the ultimate investing strategy. According to their latest newsletter, "The 'Holy Grail' of equity investors are companies like Home Capital that have as their key attribute the ability to consistently earn an ROE of 20% or better."

I don't mean to pick on Donville, because they have a good track record and seem to have a lot of integrity, but I think that Home Capital is a great example of a company where consistently high ROE does not make an investment good.


What Home Capital does

In corporate presentations, Home Capital describes itself as "Canada's leading alternative financial institution" which underwrites "mortgages not meeting lending criteria at traditional financial institutions." In other words, it lends money to subprime and alt-a borrowers.

As Donville's newsletter makes clear, this has been a very profitable business, with ROEs above 20% every year since 1998:

1998     20.7%
1999     21.8%
2000     23.2%
2001     23.8%
2002     24.3%
2003     27.4%
2004     31.4%
2005     31.8%
2006     27.4%
2007     28.9%
2008     27.8%
2009     28.2%
2010     27.3%
2011     27.1%
2012     25.5%

For context, here is what Canadian house prices have done over the same period:



(Chart from World Housing Bubble)

As the chart shows, Canada is in the midst of a truly phenomenal housing bubble. The prudent thing to do in a market like this is to reduce risk by cutting back on lending, which results in lower ROEs in the near term. Home Capital has done the opposite: it has expanded its loan book as the market has gotten frothier, maintaining its ROE by lending against increasingly inflated assets.


Comparison with Golden West

Golden West Financial was a large savings and loan association in California. Like Home Capital, Golden West consistently earned high ROEs and was a pioneer in introducing new kinds of loans and serving borrowers that larger banks didn't serve very well.

Investors and competitors alike admired Golden West. According to Wikipedia, "In 1990 The New York Times called the company 'the Nation's Best-Run S.&L.'" I have an old Peter Lynch book in which he praises Golden West for its entrepreneurial flair and cost-control efforts, much like how Donville praises Home Capital.

Wachovia acquired Golden West in 2006. Two years later, Wachovia became one of the biggest casualties of the housing bust, with surging NPLs, and had to sell out to Wells Fargo in a distressed sale. Most of Wachovia's problem loans had originated at Golden West.

Golden West had lent aggressively during the housing bubble, and its loan book was so toxic that it nearly destroyed a much larger bank. If the company hadn't been acquired, it would have gone bust pretty quickly.

Reassuringly, Donville writes that "Home Capital typically only lends the first 70% of a home’s value. Therefore, if a housing correction were to ensue, the downside risk to Home Capital would be small because the first loss would be absorbed by other lenders or the home owner."

Unfortunately, Golden West's lending was pretty similar: "Golden West did not move into the business of making loans with loan-to-value (LTV) ratios of 90%, 100%, or more, which became an accepted practice in the early and mid-2000s. Golden West’s average LTV ratio remained at about 71%."


Conclusion

Golden West shows-- and I think Home Capital will soon show-- that earning consistently high returns isn't a good thing for lenders. To the extent that they can earn higher returns by operating more efficiently, that's great. But lending prudently often necessitates sacrificing ROE to maintain asset quality and avoid fatal risks.

4 comments:

  1. Thanks for highlighting Golden West.

    1- From what I understand, Golden West really tried to make good loans. The high LTV meant that foreclosures rarely resulted in losses for them. After the Wachovia merger, things get a little muddier because underwriting standards loosened, management wasn't the same, and accounting doesn't break out the pre-merger loans. But it seems that Golden West only accounted for a very small portion of Wachovia's losses. Its loan book seemed to be one of the *least* toxic loan books out there. It seems that Golden West truly deserved the praise it received.

    2- Golden West did well as a stock. Perhaps a better example of a well-managed company being a bad stock would be NVR (it went bankrupt but has done incredibly well post-bankruptcy).

    3- Home Capital is a different story. They run a lot of leverage and are chasing a very small spread. The annual report states that the ROA is around 1.4%. Not a lot of margin for error.

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    1. Nevermind about the last comment. Both Home Capital and Golden West have low ROAs and high leverage.

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    2. Nevermind about Golden West trying to make good loans. Their pick a payment loan was clearly a dumb idea. https://web.archive.org/web/20060315133347/http://www.worldsavings.com/servlet/wsavings/loans-new/pick-a-payment.html?place=WeLoLoEH1827

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    3. Hey,

      When Wachovia acquired Golden West, my impression at the time was that Wachovia was eager to grow in mortgage lending and lowered its lending standards post-acquisition (and let Golden West people take over the combined mortgage department), but they were already pretty low at Golden West before the acquisition. It had a history of making "innovative" loans like the pic-a-pay mortgages. You probably realize this, but the pdf from "Golden West World," while it has a lot of facts, is also revisionist history that presents Golden West in a misleadingly positive light.

      I think the basic similarity between Golden West and HCG is that they're both lending against overvalued assets, which makes their low LTVs seem more conservative than they really are. If Canadian house prices are 100% above historical averages, then a 70% ltv loan becomes a 140% loan at the average. They also both lend to alt-a borrowers who probably have less ability/willingness to stick with an underwater loan.

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