Decisions Under Uncertainty and the HCG Example

May 31st, 2017 by Potato

A major problem with human decision-making is that we have to do it with incomplete and conflicting information. It’s hard. And there’s a lot of uncertainty and randomness involved — moreso in some areas than others — so it’s hard to fine-tune our decision-making through trial-and-error. In some cases, we may only get one shot at a decision.

A lot of the time we have to weigh the probabilities of different (often conflicting) opinions and bits of evidence. We can take a sort of Bayesian approach, even without getting into the math: based on what we know already, we think some bits of information informing our opinion are likely to be true and helpful, and others are not likely to be true and helpful. For example, if I’m trying to pick where to go for dinner when I’m out of town for a conference, I could ask a few people for their suggestions. I’m going to put more weight on the advice of my friend Alex who has similar tastes to me than I would on the hotel concierge (a complete unknown who may be getting kickbacks to point guests to a restaurant) or my friend Ahab, who cares more about how food is sourced or presented than how it tastes. I’m also going to have a huge prior probability of choosing a pizza place, so it would take a very strong recommendation to move my decision to say a greasy spoon.

In investing, I might put some high probability on the likelihood that the income statement and balance sheet are right, and some low probability that someone ranting on Twitter or on a blog is right, then come to a decision as to whether or not to invest in a company.

The next trick then in your probabilistic model of the world is when do you shift your decision? There’s a lot of good stuff to read out there on the foibles of human decision-making, how we’ll stick to a decision far longer than we should, etc. So try to consciously consider from time to time what new evidence would make you change your mind or your weightings of the probabilities. Granted, most of what comes out in the investing world is non-actionable noise: some analyst somewhere changing a price target or opinion on a stock is not necessarily a reason to change your mind on what the balance sheet is telling you or to sell — and I fully encourage you to get into the habit of ignoring most of that. But maybe something else might come along to outweigh your prior decision: firing the CEO (especially if your thesis revolves around betting the jockey not the horse), or missing targets, or the ascendance of a competitor.

Allegations of fraud, for example, can (and should!) shake your faith in a decision based on book value (because if the financial statements are fraudulent anyway, then any information you got from reading them is worthless for making an investment decision).

I think the Home Capital (HCG) case and the OSC disclosure is a timely example of this in action. For years I have been biased to the short side: I’m a real estate bear to begin with, I’ve heard of some shady lending practices (and conversely, have trouble finding evidence of people who likely shouldn’t ever get a mortgage not being able to find some way to close a deal), but HCG kept making money and writing more mortgages and going up.

Then in 2015 the company disclosed its problems with fraud in their mortgage channel, and the disclosure was quite late, with insider selling associated, and heavily spun to be dismissive (for example, the company framed the number of loans as being less than 5%, but that was comparing the flow in 2014 to the total stock – of that year’s originations, the loans in question were something more like 10%, which really does sound material). Those were red flags to me, and though I wasn’t brave enough to short at the time, I certainly wasn’t going to buy the dip.

But I could see the holding long case being potentially forgivable: maybe you saw real estate continuing on its tear (which it did), which washes away many sins of underwriting; maybe you figured it was a contained, one-time issue that was fully in the open and priced in to the stock.

Short sellers like Marc Cohodes were, however, alleging that management had still not fully disclosed the problems — that the focus on the 2014 originations was missing that the problem could have been bigger (what were those brokers doing in 2012 and 2013?), or that the problems in the company were larger than a few third-party mortgage brokers. Cohodes likes to use clever names: “the Queen Street Cowboys” for the OSC, or “the Potato Chip Queen” for Bonita Then. So in his tweets you may have seen “Project Trillium” referenced and figured that it was just another cute name he made up — after all, I tried several times to find out what the heck it was and there was nothing indexed in Google on it (other than Cohode’s tweets). Last fall was the first time I saw anything more than a tweet in this BNN piece.

But then the OSC statement of allegations came out, and there it was: a reference to Project Trillium, confirming that that was the name of the Home Capital internal investigation into the mortgage fraud issue. And not just that, but that there were “serious systemic underwriting control deficiencies” (which had not yet been disclosed by management). In all the ink spilled over the bank run and collapse in Home Capital’s share price, not many (props to Macleans) picked up on that tidbit. Yet that’s the kind of new evidence that should make an investor immediately re-assess their probability weightings of the evidence – clearly the shorts did know something more than the longs. Sure, it’s not as big a deal as if the allegations were that the books were being cooked, but there are concerns when management is not being forthcoming and transparent about issues — and repeatedly hiding behind their freedom to interpret what is “material”.

With the short lens on, you can start to find things that aren’t total red flags on their own, but look a bit suspicious in light of a company that’s not being transparent (or even actively hiding things wherever possible): like the “other operating expenses” line. Before the issues in 2014, that was broken into subcategories; in 2015 it’s all consolidated and increases from $70M to $90M, then to $123M in 2016. Or the news that HCG partners with a company started owned by the founder’s kids (without disclosing it as a related party transaction, again using the shield of a “not material” interpretation) to do 1st & 2nd mortgage package deals, seen as a way to side-step mortgage rules around borrowed down payments.

In 2015 you may have put a low weight on the opinions of a short-seller like Marc Cohodes in your decision about what to do with HCG. As Marc’s track record as a short of Canadian names has become quite impressive over the past few years (Valeant, Concordia, Home Capital Group to name a few), and as it became clear that he likely knows more about this company than many of the longs speaking on TV, you should probably have increased your weighting of his opinion in your decision of whether or not to own the stock (especially if you were relying on the opinion of talking heads on TV who were on the long side).

This was an interesting case for me to think about, because it was not as cut and dry as Enron or Sino-Forest, where the companies themselves were broken. AFAIK, no one has said that HCG is a complete sham, but the weakness of their controls could be a big issue if the housing market turns, and the number of fraudulent loans (or the slowdown in future business to prevent it from happening again) could be larger than previously indicated. Their lack of transparency is another issue, which IMHO is what underlies the bank run — banks are built on trust and HCG lost that. It’s also likely why they haven’t solved their liquidity issue by just selling loans: they had to massively over-collateralize the HOOPP loan, which on top of the other issues suggests that no one should be paying anywhere near par for mortgages they’ve written (and it only takes about an 8% discount to wipe out the equity thanks to the power of leverage).

So whether your decision is to buy an investment or something totally different, what evidence and opinion did you consider when making the decision? How did you decide how much weight to give one piece of evidence over another? What new evidence would it take for you to change your mind?

Full disclosure: I did purchase a small number of puts on HCG (i.e., I am effectively short).

Footnote: This decision under uncertainty stuff helps show why active investing is so hard. For 99.9% of investors out there, you should probably use a passive index investing strategy rather than messing around with individual stocks — and I just so happen to have an online course that will help teach you how to do that! While I did eventually take a position here, it is very small and could more properly be considered entertainment/gambling money rather than part of my long-term portfolio, which is mostly passive ETFs.

HCG TL;DR

March 17th, 2017 by Potato

Home Capital Group (HCG) is a company with some troubles that is being shorted by some colourful and entertaining (and IMHO likely correct) characters. But the implications of the story go beyond just a stock market tale.

Brief Recap:

Home Capital issues mortgages to borrowers, primarily in Ontario, with a focus on “homeowners who typically do not meet all the lending criteria of traditional financial institutions” (pick your euphemism as long as it’s not “subprime”), as well as traditional business that gets insured by CMHC. Around Sept. 2014 a whistleblower lets them know that several brokers were allegedly sending them fraudulent mortgages (independently, reports come out about people in the industry who help people forge documents). HCG’s CFO announced a retirement in November 2014.

In documents released yesterday, (H/T @TaureauResearch) Home Trust appears to notify CMHC about the issue at the end of October, 2014. CMHC seems amazingly chill about the fraud – no mention publicly or in the documents about cancelling the insurance, adjusting guidelines, or even reviewing anything. Hell, they say this: “CMHC thanked Home Trust for coming forward with the information and for being proactive in working together with CMHC to prevent fraud.” [page 90] The most that seems to happen is to schedule a review for over a year in the future (Jan 2016).

In May 2015, HCG releases its first quarter results, with no mention of the potential fraud issue, despite noticeably lower originations. The release just has a vague phrase about reviews. “The first quarter was characterized by a traditionally slow real estate market, exacerbated by very harsh winter conditions. The Company has remained cautious in light of continued macroeconomic conditions and continues to perform ongoing reviews of its business partners ensuring that quality is within the Company’s risk appetite.”

On July 10, 2015, they state that originations were down in the second quarter, and that they had terminated their relationships with certain mortgage brokers.

On July 29, 2015, they clarified – at the request of the OSC, they note – that in 2014 they were notified about “possible discrepancies in income verification information submitted by certain mortgage brokers. […] The investigation determined that falsification of income information had occurred but that there was no evidence of falsification of credit scores or property values.”

It’s not until after this that CMHC seems to get activated about the possible fraud (that they’re insuring!) On August 4th they ask if they’ve done any analysis about the exposure to the fraud, and on July 30 someone sends around the total exposure to Home Trust (again, redacted so hard to say for sure, but without an analysis of that issue), and that they’ll have a closer look then. On July 31, someone at CMHC appears to say that they can’t transmit information (on the brokers) from one lender to another (page 36, French, partially redacted), in response to an email asking if they have the list of 45 brokers from CMHC (page 37). Not until December 2015 does someone ask if anyone checked whether the brokers in question originated loans through other lenders.

Why Does This Matter?

The matter with HCG itself is just a symptom. It’s important for investors (and short sellers) of that company to understand those events are going on, and to consider what your opinion is of management that waits that long (with a poke from the OSC) to disclose an issue like that. But HCG is just a small player. Beyond that, it’s a sign of what’s happening in the housing market.

Yes, fraud exists in the market (and I’m not talking about HCG here: more generally). But more importantly, moral hazard exists, and there is a huge outcome bias at play. CMHC at first seems to care little about the issue: there are few arrears, so no biggie. But there are few arrears in a housing bubble anyway – no one defaults when their house appreciates 10-20%/yr. Everything seems great until the music stops. Similarly, many voices (including MPs) argue against tightening regulations and that Canada’s financial system is strong because arrears are low.

The message heard by players in the industry then is that there are no consequences for bad behaviour. If arrears pile up 5 years later, well then people may care but it will be too late. In the meantime, fraud is happening in the market (and I’m not alleging at HCG specifically), and there is no sense from the government or the banks that there’s anything wrong. They even call it “soft fraud” or fraud-for-shelter – bending the rules to get a house, which can’t be that bad as long as they pay the mortgage, right? (The one that they can’t technically afford if rates rise.)

There are things that could have been done. Instead of being reactionary, there could have been more proactive actions at CMHC (which to be fair may have happened but not been captured in the FoI release, or been redacted). They could have flagged the brokers in question and checked for any past or future loans with other lenders – and sources suggest that the brokers that HCG stopped doing business with are still in the business, sending loans to other lenders. They could have put the loans back on the lender and cancelled the insurance without waiting to see if there was a claim. And nowhere did I see any mention of whether Genworth was in the loop on the goings-on.

Insured mortgages require the least amount of capital on the balance sheet. Simply putting them back proactively (perhaps with an investigation and some work on improving underwriting processes), even without a fine, would have an impact as the company would have to use capital to hold on to those mortgages, potentially slowing their growth or forcing them to go to the market to raise money. That would have been a small step, but one that would have sent a message that fraud is not cool.

But the bigger issue is that it was reactionary: there’s no evidence in the released documents of CMHC doing anything to prevent these brokers from continuing to write taxpayer-insured mortgages, or even quantifying the exposure until July 2015. It’s not until the matter becomes public and there’s the risk of backlash and people like Ben Rabidoux asking questions that anyone seems to bother to even quantify the potential risk, let alone do anything.

People like to state – with very little supporting evidence – that Canada’s financial system is safe, stable, conservative, etc., etc. But this example seems to show that nothing is actually checked in depth, and rules are only lightly enforced until something breaks into the media and public consciousness.

Yes, today arrears are low and the banks aren’t failing. The point of making a good system with oversight and strong regulations that are actually enforced is to keep it that way.

Advice and The New Model

February 25th, 2017 by Potato

There are many elements to a successful financial life. You’ve got to live within (below) your means, which means developing an ability to budget and deal with cash flow. Create some savings and disaster-proof your life. Then come up with a long-term plan, and get some investments going to make it happen. So a successful financial life looks something like this:

Elements of a successful financial life: saving/budgeting, planning, long-term savings. Picture of text in boxes spread across a life trajectory.

These are all important. How they get done though is different for everyone. Some people find that things comes more-or-less automatically. Other people need help to sort out some or all of this. For example, budgeting and matching up cashflows is really intuitive for me, I barely needed to read anything before I was off handling it on my own, whereas some people need help from a money coach to sort out their budgeting, cash flow, and basic relationship with money.

And at various points, you may need help with something. There’s no shame in that, we’re not all personal finance bloggers obsessing over this stuff, or people with the time to read books and take courses to try to build up the skills to DIY.

But when you go to look for help, a successful financial life may look more like this:

Elements of a successful financial life: saving/budgeting, planning, long-term savings. Picture of text in boxes spread across a life trajectory, with investment products and insurance over-sized.

Traditionally, many advisors only made money if they sold you a product of some sort, especially investments (mutual funds, etc.). So their view of your situation was focused in on that part of the problem they could solve. Planning became less about clarity, goals, and trade-offs than about coming up with a bare framework to support investment purchases.

And that’s not to mention the conflicts-of-interest, such as that some advisors might not even ask you about your debt or budget, and look to invest any cash you have, even if paying off your debt may be a better use for the money. Or that so much of the focus is on investment selection (i.e., active management), which is where you will get little to no value for your money.

Advice — good advice — can be extremely valuable. Lousy advice — distressingly common — can be extremely expensive. If you’re paying your advisor through commissions on mutual funds that you buy, and you’re getting good service and value for those fees, then that’s totally fine. But I don’t see that being the case all that often, and those high fees really eat away at your long-term worth.

Instead, a new model is emerging that I like a lot better: paying for advice in a transparent way, for any part of your life that needs it, then figuring out the products to fit that advice separately, whether through DIY investing in low-cost index funds or using a robo-advisor to handle the investment management part.

In addition to getting value for your money and having transparency, this model lets you put the focus where you need it. If you need a money coach to help you sort out your cashflow and budgeting, you can now find one fairly easily — it’s not a side discussion you cram in while shopping for insurance or mutual funds. If you need to talk more about planning and clarity to figure out what direction your life is going in and how you meet your goals, you can do that.

Do you have confidence in your plan? Wait, that’s backwards: does your plan help inspire confidence in you and where you’re going? It doesn’t have to be a 30-page printed report: a good sketch on a napkin can be really illuminating. But if your plan is really just a few “know your client” bullet points to support some sales goals, you may want to work to figure it out yourself, or find a planner to help get that clarity.

So roughly speaking, here’s how I see the industry in the near future:

Elements of a successful financial life: saving/budgeting, planning, long-term savings. Picture of text in boxes spread across a life trajectory, with money coaches, planners, and robo-advisors to help at each stage.

Each part that makes your financial life tick, you can find some support to help. From a full-service coach/planner/advisor, to semi-automated solutions and support for DIY methods. And for each of those, you’ll pay a transparent fee so you’ll know if you’re getting value for your money.

And this is already happening. Nest Wealth, Wealthsimple, and ModernAdvisor each offer planner dashboards, to allow collaboration with unlicensed (which here means not-salespeople) planners. The planner does the planning and coaching, the robo-advisor does the investment planning, and each can charge for their component of it independently.

For people with larger portfolios, this new model is likely going to lead to better advice at a lower cost. For people with smaller portfolios who are just starting out, paying an hourly rate may cost more than they’d pay even with super-high 3% MERs… however, many people aren’t getting the planning support they want or need anyway, and this way they can get help with the elements that may be more important to them at that life stage, like figuring out their budgeting, or coming to an understanding of what their money is for.

Resources to do this:

Directory of Fee-Only [Fee-for-Service] Planners

Money Coaches Canada

Our robo-advisor comparison tool to find a robo-advisor that fits your needs and situation

My course on DIY investing to learn how to do the investment management part yourself

A reading list to help you get started

Plus loads of other resources out there for financial literacy. Chris at Rags to Reasonable has a free email course on getting a handle on your money (left side of the figure). Cait Flanders has her budgeting system. Bridget Casey has her build a budget course. And all the blogs.

Value Proposition for Investing Course

January 12th, 2017 by Potato

Since finishing the DIY investing course, I’ve had a few questions about what the value of the course is.

The course focuses on behaviour and processes for success, which is important — it’s not just about introducing the concepts and setting you free, but helping you to understand that investor behaviour is a huge factor, and something a lot of investors get wrong.

Everything is also explained clearly, in plain language — that’s my specialty and what I bring to the table. Some ways of explaining and framing things are unique and are not available outside of the course. There’s also a Q&A section so if anything isn’t clear, you can ask me a question and I’ll answer.

Another point of value that the course delivers is inherent to the format: rather than just text or just a person speaking at the front of a lecture hall, the course uses mixed media: text, video, presentations, spreadsheets, tools, templates, as well as active elements like exercises and quizzes. Not everyone learns the same way, and having variety and different approaches will help keep a student’s focus and improve their ability to learn. The material is also available on your schedule, whenever you need it, so you’ll never miss a line.

Finally, the course represents a huge value in time savings as well as the peace of mind in knowing that I’ve curated the vast amount of material out there for you — so you’ll also know when you’ve learned enough and can reduce the information overload. Some have commented that all the information needed to become an investor is available online or in the library, much of it for free. Yes, many people have figured out how to become successful DIY investors before I created the course, and many will continue to do so without the course. However, at this point there are millions of words written on the subject out there. Canadian Couch Potato alone has roughly 1,000 posts in his archives. And while there’s a ton of great material on that blog, it’s not the only one and it still doesn’t cover everything — you’ll definitely want to peruse the archives of Michael James on Money, Blessed by the Potato, Canadian Capitalist, oh and don’t forget Young & Thrifty, Canadian Portfolio Manager, and many more. Plus there are many magazine articles, newspaper articles, podcasts, whitepapers, and a few books. All told, you’re looking at something like one or two hundred hours of reading and having to determine what to follow because some of that freely available information is now out-of-date or just plain wrong.

For comparison, this course from UofT’s School of Continuing Studies will run you $325 (BTW, I’ll be popping in as a guest speaker for that one), but if you don’t happen to live near Toronto and have Thursday evenings free, you’ll likely appreciate the anytime, anywhere nature of an online course. PWL (Dan Bortolotti and Justin Bender) used to help teach people to be DIYers — a service that also included some personalized planning and the creation of a specific portfolio, so not apples-to-apples — for $2500-5000. Many investment coaches will help teach you from scratch, or answer specific questions to get you over any remaining hurdles after reading about it, but unless you can figure it all out in a single short session, that’s going to cost more than the course, too.

The course is not going to be for everyone, and that’s ok. Some people will figure this stuff out on their own, using free resources or a few books, filtering and addressing the conflicting information on their own. Some people are not interested in DIY investing, and will pay someone to handle it for them. For a fair number of people though, I believe the course will provide them with a lot of value in time saved, ease of understanding, and ongoing success.

Send in Your Investing Questions Now

January 12th, 2017 by Potato

The online Canadian Investor’s Conference is coming up, and I’ll have a presentation there. I’ll be recording early next week, so send in any questions you may have about DIY investing now. The conference is free if you can watch it right away, but to see the material later you’ll have to buy a premium pass — click here to enter a draw for a free premium pass (this draw is exclusive to BbtP/VoS readers so your odds should be pretty good).