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I CIB DAZED

On June 21, 2017   /   Blog, News, The Chairman's Corner  

June 2017

A much-heralded element of the federal government’s commitment to an expansion of infrastructure spending in Canada has been the announced intention to create a Canadian Infrastructure Bank (“CIB”).  It is through the CIB that the government intends to channel an initial $15 billion of public capital that is to be partnered with private capital invested by many of the world’s largest institutional investors, some of whom happen to be none other than Canadian pension funds.  These Canadian pension funds, it seems, are active investors in infrastructure globally, but have few if any comparable investments in Canada.

The response to the creation of the CIB has to date been generally positive, with the usual and expected cynical whispers being of the “the devil will be in the details” variety.  While it is certainly clear that this proposal can go radically off the rails with insufficient attention to the details, are we really certain that there is not also a fundamental conceptual flaw to this plan that no attention to detail can paper over?

Let’s start with the basics.  There is a very simple model in which an entity like the proposed CIB can provide a very valuable role in stimulating infrastructure spending.  Many of the public infrastructure assets that desperately require renewal in Canada are buildings and utilities that fall under municipal or provincial jurisdiction.  As the only level of government that has at its disposable an ease of access to the wealth of the country through its ability to tax incomes, the federal government possesses the highest debt rating and thus enjoys the lowest costs of borrowing.  Establishing the CIB to provide timely payment guarantees on debt issued by lower rated Canadian provinces and municipalities to fund infrastructure construction makes obvious sense.  CMHC has long done the same for funders of residential mortgages, and it is a model that is easily understood and accepted.

This model could be further extended to private funders of public infrastructure, but only in circumstances in which:

  1. the applicable infrastructure is of a type that could generate sufficient user fees to permit it to be fully self-funding; and
  2. the private investors are comfortable bearing all the risks associated with the construction and operation of such infrastructure.

In such circumstances, the federal government could, through a timely payment guarantee of project specific debt issued by the private investor group, effectively buy down the cost of financing the project and, it would be hoped, thereby subsidize user fees to the extent of those incremental amounts that would otherwise have been required to repay more costly debt.

Unfortunately, while there are many infrastructure projects that can meet condition 1, there are few private investors that can meet condition 2.  Most large infrastructure projects are highly levered to matters of public policy.  Take for example a toll road.  The expected user load can be influenced greatly by development plans that might redirect population growth patterns, industrial policies that might eliminate or relocate industries or environmental policies that might rebalance personal automobile versus public transit use, to name a few.  These risk elements are beyond the control of the private investor and much more firmly in the control of government, and particularly the federal government, who controls the largest portion of Canadian public spending.

In the face of this reality, private partners in public infrastructure development consortiums will necessarily require immunization from this element of risk transference.  The federal government will accordingly be forced to retain the bulk of the demand risk associated with these projects.  This would leave only the on-time and on-price construction risk and the operating cost risk to be borne by the private investors.  A model in which the most material risk to return cannot be shared among parties is not one that lends itself to joint equity investments.  The construction risk can more effectively be externalized to private interests through a fixed price construction contract without the need of the creation or involvement of the CIB.  Similarly, operating costs can be externalized through a well negotiated management contract.  In other words, the risk transference opportunities in infrastructure finance that are truly available to the federal government do not require the creation of the CIB.

Without risk transference, the only benefit that can be realized by the federal government through private participation in the CIB is as a source of liquidity, allowing the federal government to fund more infrastructure development without adding to the federal debt load.  However, that can only be justified on a public policy basis in circumstances in which the return that must be paid to the participating private investors is less than the federal government’s cost of borrowing.  That will never be the case.

Sadly, the only case that can be made for the CIB as a means of attracting private capital to fund infrastructure is the political expediency of avoiding on-balance sheet borrowing at considerable public expense.  Sunny daze indeed.

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HOME ON THE RANGE

On May 16, 2017   /   Blog, News, The Chairman's Corner  

May 2017

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We live in a time of great cynicism.  Altruism was long ago abandoned as the default assumption for the motivation behind any public or private act.  Personal gain and self-preservation reign as the presumed guiding principles for all.  The holder of the most powerful office in the world offers only the most half-hearted of policy justifications for the dismissal of a public servant leading an investigation that strikes at the very heart of the legitimacy of the office holder.  Conspiracy theorists have never been so blessed with more abundant fodder for cynicism and dismay.

It is in the context of these times that both private and public commentators have raised an eyebrow at both the timing and substance of the recent announcement of the intention of the Ontario Securities Commission to prosecute Home Capital and three of its current and former officers for breaches of timely disclosure obligations.

The basis for the cynicism can be stated fairly simply.  The prosecutions relate to omissions to disclose the termination of a number of mortgage brokers as sources of residential mortgage origination in March 2015 following a six month internal investigation that uncovered misrepresentations in the stated income of applicants brought to Home Capital by such brokers.  The terminated brokers had historically been the source of roughly 10% of Home’s annual volume, which would suggest that the impact upon both new originations and the expected default rate within the existing pool of Home Capital originated mortgages would be both negative and material.  However, the public announcement of the OSC enforcement action has come more than two years after the date on which the alleged disclosure should have been made and just less than two years after it was actually made.  Whatever impact these broker terminations had upon Home Capital’s originations have long ago been reflected in Home Capital’s results and share price, and no increase in defaults has been observed with respect to those mortgages that were referred to Home by the now- terminated brokers.  On these facts, it is difficult to understand how this prosecution would benefit public holders of common shares of Home Capital, or even other Home stakeholders, leading some to suggest another motivation behind this prosecution.

Increasing levels of concern about the state of the Canadian residential real estate market has been expressed by both Canadian policy makers and foreign financial commentators for some time.  The regulatory response to this issue has, however, been blunted to some extent by the inability of the Bank of Canada to raise interest rates to cool excess demand for fear of pushing anemic levels of GDP growth back into recession.  Instead, the task has been left to CMHC and OSFI to use mortgage insurance eligibility restrictions and prudential lending guidelines for banks, respectively, to constrain the availability of mortgage funding to existing and prospective Canadian homeowners.

While the introduction of these constrictive policies has been relentless and significant, it has not stemmed the tide of rising house prices or the corresponding rise in Canadian household debt.  This is particularly so in the Southern Ontario market in which Home Capital is most active, leading some to speculate that the prosecutorial action by the OSC is actually motivated by a broader public policy desire to sideline not only a significant source of liquidity to the mortgage market but also one that openly caters to borrowers of lower credit quality.  Take out Home Capital, the conspiratorial thinking goes, and you remove from the market prospective home buyers that are unlikely to find other financing with which to bid up home prices.  The conspiracy theorists go further, seeing the fingerprints of OSFI on the decision of all of the Big Six banks to wrap their arms around Home’s closest sectoral counterpart, Equitable Bank, ensuring that the resulting liquidity firestorm burns out at the feet of Home Capital only.  A controlled burn orchestrated to tame the residential market wildfire.

This “conspiracy” is not one motivated by personal gain or self-preservation but by the pursuit of what many would agree is a laudable public policy objective.  Nonetheless, if true, it would represent a perversion of the policy purview of the OSC, whose mandate is investor protection, not the maintenance of macro prudential economic policy.  Ends cannot justify means, the critics roar, with justifiable scorn. But do the facts bear out this conspiratorial interpretation of the OSC action?

Fundamental to this question is a review of the mandate of the OSC.  It is indeed investor protection, but it is always the protection of investors in general and hardly ever that of specific investors.  Breaches of securities laws are almost always compensable by monetary fines against the issuer itself and the officers responsible for the breaches.  Fines levelled against issuers that are large enough to compensate investor losses caused by the breach would amount to literally robbing Peter to pay Peter.  Similar large fines against responsible officers would be symbolic only, since it would be rare indeed that such a large fine would be recoverable against an individual.  As a result, fines generally cover little more than the cost of enforcement.  Their value as tools of investor protection is rather as a deterrent to others who might otherwise consider such actions in the future than they are a means of recovery for losses caused by breaches.

In that context, the prosecution of Home Capital seems far less futile or curious.  Properly functioning public capital markets require the timely dissemination of all material non-public information known to an issuer that could impact its business.  The determination of the materiality of any non-public information is the critical challenge for issuers.  To disclose everything that occurs within a business would place the investors in the position of having to distinguish the material from the trivial.  Judgment is required, and where issuers determine that information is insufficiently material to warrant the issue of a timely disclosure report, they take a risk.  If and when that information makes its way to the marketplace and it is greeted with a market reaction that indicates that the market does indeed view it as material, the issuer may well have breached its timely disclosure obligations.

In the case of the Home Capital disclosure, the broker terminations in March of 2015 do appear to meet this first principles test of materiality.  In the week following the July 10th disclosure of the broker terminations, Home Capital equity dropped in value by just under 25%.  In the period from September 2014, when the broker application irregularities were first noted internally at Home, to the July 2015 disclosure, Home Capital equity underperformed its closest sectoral counterpart, Equitable Bank, by a material margin save and except for a brief rally following Home’s announcement of a dividend increase in late March 2015.  Finally, both trading volumes and short interest in home peaked in November 2014, during which the broker application anomalies were being investigated.  Not only does the non-disclosed information seem demonstrably material, there is some evidence to suggest that the non-disclosure may have influenced trading volumes and values.

None of this should be interpreted as suggesting that reasonable legal and moral defences to these allegations are not available to Home and its officers, including but not limited to good faith reliance on third party advice.  There is further no suggestion of insider trading; none is evidenced by the insider trading reports filed in that period and the OSC has certainly made no such allegation.  Of course, in this case, the fact that 45 brokers would have been made aware of Home’s termination of their placement privileges would have created a very broad group of non-insiders who would have been aware of this change to Home’s origination capacity, making the situation all the more perilous from a disclosure standpoint.  In any event, what seems to be beyond debate is that the OSC was faced with an example of non-disclosure of a material change by a public company that it could not ignore without severely undermining the deterrent impact of those rules.

As to the 21 month delay between the disclosure of the theretofore undisclosed material non-public information and the public announcement of the OSC action, we now know that during that period of time settlement discussions were underway.  Given the economic realities of the value of recoveries in the context of contested OSC prosecutions, it is neither surprising nor scandalous that this option was so thoroughly canvassed before revealing the details of the prosecution publicly.  Earlier disclosure of the intention to prosecute would have done nothing to offset any trading disadvantage experienced by parties trading in the market between March and July of 2015, but may well have precluded the possibility of settlement.

The OSC was duty bound to move on the Home non-disclosure.  If OSFI moved to discourage the resulting liquidity contagion, it would have done so in furtherance of its own mandate to maintain the stability of Canada’s regulated financial institutions.  Conspiracy theorists will have to once again turn their attention southward.

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THE ADULT IN THE ROOM

On April 18, 2017   /   Blog, News, The Chairman's Corner  

April 2017

trump Putin Russia ChinaAfter the legislative and popular failure of his forays into immigration and healthcare policy, the even more complex world of geopolitics has emerged as the favoured policy ground for Donald Trump.  Surprisingly, the un-nuanced and instinctive approach that he brings to every issue has provided him with some initial wins, both in terms of popular approval and arguable strategic merit.  The Middle East in general and Syria in particular is not a space in which any global power can hope to make lasting change by imposing a solution to any of the problematic schisms in the region.  Indeed, it is beyond doubt that it was the hubris of Britain and France believing that they could create sovereign states that aligned with their own arbitrarily defined spheres of influence in 1916 that got the region into the disarray that it finds itself today.

Against that backdrop, it is reasonable to argue that all that the UN or NATO or any Western power can and should do at this point is monitor the emerging regional actors and make sure that the means used to establish and/or consolidate power in the region are not unconscionably harmful to civilian populations.  By launching an attack to degrade Assad’s air capacity and dropping a powerful MOAB to similarly degrade the capacity of ISIS in Afghanistan, the Trump administration has arguably met that standard.  By providing a wrist slap to both the Shia-backed Alawite regime in Syria and the Sunni-led ISIS forces in Afghanistan, the US has reminded both sides that they will not tolerate excesses.  While it is ironic and unnerving to think of Donald Trump asserting himself as the adult in the room in the region, these moves, however conceived, have probably done just that, and would probably have been even more unreservedly saluted had they been an initiative of the previous administration.

So much for the good news.  The downside to all of this is The Donald’s inclination to go back to revisit every successful scenario again and again, be it post-election campaign-style rallies or successive seasons of The Apprentice.  There is more than a little reason to fear that he has decided that if it works in the Middle East, it has to work on the Korean peninsula.  That is not to say that it can’t; a more aggressive tone with North Korea may be exactly what is required to push China into exercising greater control over its volatile client state.  It is just hard to see Trump, or even the more seasoned heads in his administration, having the nuanced understanding of the geopolitical subtleties necessary to make this a constructive rather than destabilizing development.  The balance of power that steadies Korea is one in which the US is already an active participant as the patron of the South.  Its intercessions cannot be cautionary to both sides; they are already a partisan, and increased activity can only be a provocation.

In Syria, a successful return to influence in the region did not depend upon the prudence and wisdom of Putin’s Russia.  The success of Trump’s Korean strategy will entirely hinge upon the ability of Chinese President Xi Jinping to be the adult in the room.

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