Short story

I haven't written about the short-selling of stocks here for a long time -- probably since the financial crisis was at its peak.  Now it seems that the short sellers are back to their nefarious business in Canada again, looking to bring down Home Capital, a higher-risk mortgage lender.

The elevated level of risk in the Canadian housing market, particularly in areas around Toronto and Vancouver where an out-and-out bubble has developed, has become an international story.  Bubbles almost always end badly.  There are grave doubts as to whether the steps taken to cool the market by the BC provincial government (last year) or the Ontario government (last month) can be effective, given that the Bank of Canada seems set on maintaining its ultra-low interest rate policy.

If the bubble is indeed going to burst, the first sign of danger will always be a problems at a higher-risk lender.  This was the case in the UK a decade ago, with Northern Rock, and it was the case also in the United States with Countrywide and others. Home Capital is one of the larger higher-risk mortgage lenders in Canada, and in the last few months it has made a number of unfortunate mis-steps. In essence, the company realized some months ago that some of the mortgage brokers feeding its business had not been fully disclosing the financial situation of the borrowers they were introducing.

Since then, as this article by Terence Corcoran in the National Post explains, it's been all downhill for Home.  The Ontario Securities Commission has become involved, there has been a management and board shake-up, and depositors have started to get cold feet and withdraw their funds, creating a liquidity problem.  Most ominous of all, short-sellers have become actively involved, although as Corcoran notes, it's all but impossible to discover just how big the short positions are.

Matters seem to be coming to a head.  Last week Home arranged a large line of credit at a very fancy interest rate -- 22 percent! -- with a consortium of non-bank lenders. This week it has announced a deal for an unnamed buyer to take over a portion of its mortgage book, and also announced its intention to re-orient its entire business model.  To reduce funding pressures, it will focus on sourcing mortgages that can be packaged for sale rather than kept on the company's own books.

It remains to be seen whether this will be enough.  It may at least permit an orderly wind-down of the business, rather than a sudden collapse that could put the entire financial system under strain.  In the meantime, it's appropriate to ask again just what value short sellers bring to the market in these (or any other) circumstances.  When even a right-winger and ardent free-marketeer like Terence Corcoran is all but accusing the shorts of pushing Home into bankruptcy with no regard for the wider consequences, maybe the regulatory authorities need to take a fresh look at the whole pernicious practice.