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Market bets against Home Capital have just plunged. Here's why

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Sean Kilpatrick/THE CANADIAN PRESS

The huge short position in Home Capital Group Inc., which peaked at more than 50 per cent of shares outstanding at the end of April, has been cut roughly in half over the past few weeks, according to data and analytics research firm IHS Markit Inc. Yet, it may not signal any higher degree of confidence in the beleaguered company's future.

Since the summer of 2015, the short position had hovered around 30 per cent. That changed late last month, when the number of outstanding shares sold short rocketed to more than 50 per cent after the Ontario Securities Commission accused the alternative mortgage lender on April 19 of misleading disclosure. Several banks reacted over the following days by capping their clients' deposits at Home Capital's subsidiaries to keep them under the $100,000 threshold insured by the Canada Deposit Insurance Corp.

As reports of Home Capital's eroding deposit base came in, questions about its viability surfaced, since the loss in deposits was cutting into the financing source for issuing new mortgages. This ability to issue new mortgages is very important to Home Capital because of the high turnover rate in its mortgage portfolio. Once holders of its mortgages get a better credit rating, they often switch to a lower cost mortgage at a major bank.

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To stem the outflow of deposits, the company obtained a $2-billion loan from a pension fund. The onerous terms alarmed shareholders and triggered panic selling that knocked the stock down 65 per cent on April 26.

However, in early May, the huge short position began to tumble and is now about 25 per cent of outstanding shares, Markit research analyst Simon Colvin said. Short positions are essentially bets that stock prices are going to fall.

"This is mostly driven by the fact that holders of Home Capital shares who would normally facilitate shorting activity [by letting their shares be lent out] have sold out of their positions in recent weeks," Mr. Colvin said. In other words, there has been a large change in the ownership of the company shares, and the new owners are less willing to loan out their stock.

As a result, "over half of the shares that were in lending programs at the start of last week are no longer available to lend," Mr. Colvin observed in a note he wrote earlier in May. And the "remaining inventory is nearly fully loaned out."

With this scarcity in loanable shares, the remaining short-sellers who wish to keep their positions open have had to pay much higher fees to their brokers to borrow whatever is available. "The fee to stay short in Home Capital is now prohibitively expensive," Mr. Colvin said, at an interest rate of more than 50 per cent.

Such high borrowing rates put pressure on the shorts. But it does not necessarily mean a short squeeze will emerge. Even if it did, with the reduced short interest, the spike upward in price would not be as dramatic as it could have been earlier.

That said, if a large number of these remaining short sellers suddenly decide to buy shares to return the ones they borrowed to sell, there could be an upward spike in prices. This spike, in turn, could cause other short sellers to cover, boosting the stock more.

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One spark that could set off a short squeeze would be if more good news came out of the company; another could be further buying of shares by investors who do not allow their shares to be lent out. There is also the possibility that the covering may not happen all at once, but in stages that lend support to the stock over a period of time.

Nonetheless, Home Capital's troubles are serious enough that there is the chance that it could go out of business. That means anyone buying the shares these days should be willing to accept the risk of losing a great deal, or even all, of their capital invested in the stock.

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