Where's the Bank of Canada on Coventree stumble?

Specialty finance is a flourishing niche in Canada, with firms such as Home Capital (HGC:TSX), Xceed (XMC:TSX), Coventree (COF:TSX), Quest Capital (QC:TSX), etc. Despite a very established and successful oligarchy of chartered banks, these firms have all found a way to carve out profitable businesses on what might be suspected to be less-than-fruitful terrain.

We are in a similar mode, but still very early in the growth phase relative to these firms.

The lessons of the credit swoon past few months are multifaceted, but the key one came crystal clear again yesterday: own your funding source if you want to have a sustainable business. The domestic chartered banks thrive and surive, in part, due to their deposit bases. Ask any bank CEO how important the overnight “free cash balance” is to their funding and annual profits: they might tell you that without it they wouldn’t know where to begin.

The basic deposit client gives the banking fraternity a wonderful source of liquidity AND cheap funding (“cheap” once you’ve built a national 1,200 retail branch network), something that is essential these days.

U.S.-based Countrywide Financial is thought to be able to avoid long term solvency concerns in large measure due to their strategy of taking deposits from their customers, not just providing loans. They turned themselves into a bank when they had the chance.

But, here at home, firms like Coventree were able to grow their conduit business to a stunning $16 billion of outstandings without the benefit of deposit clients. The idea wasn’t unique, but both sides wanted their services. Firms looking for a non-bank conduit for small ticket leases, non-standard mortgages or loans were able to sell their packages into a Coventree conduit, and institutions looking for a well-diversified group of interest-generating assets were able to pick up some incremental yield over the risk free rate.

Cormark and RBC Capital Markets took them public last November, raising about $40 million in common shares. For the quarter eading March 2007, movements in asset values within one or more “variable interest entities” caused havoc on the income statement. $57 million of unrealized losses on financial instruments, $29 million of unrealized losses from deriviatives, and $32 million of unrealized foreign exchange losses made for a quarterly loss of $115 million. It was non-cash of course, so Coventree used a measure called “net income excluding VIEs”, even though VIE represented 90% of the firm’s revenue.

In their Q2 2007 MD&A they put it bluntly: “Excluding unrealized gains, the Company’s results are below management’s expectations as revenues, excluding VIEs, have remained relatively flat during the successive quarters since March 31, 2006 while operating expenses have increased during these respective periods.”

Retained earnings went from $42 million to negative $73 million. Operating activities produced negative $26.8 million, although actual cash outflows were just $6 million for the quarter.

But, $16 billion of assets on a cash balance of $57 million? ~$40 million of which came from November’s IPO? Gives you a sense of just how reliant they were on a robust commercial paper program – something that must have always clear to IPO investors.

But that transparency didn’t transend to the actual innards of the various loan packages. While they used luminous names such as “Comet” and “Apollo”, the buyer of the commercial paper didn’t have complete visibility into what individual assets made up the ABS they were ultimately financing. The Dominion Bond Rating Service issued ratings of the structure, but couldn’t be asked to review each loan in the underlying ABS.

Coventree management referred yesterday to “problems that initially seemed isolated to a few U.S. subprime mortgage lenders have led to broader concerns related to debt capital markets generally”. They’ve obviously not been reading the WSJ or even our backwater blog (see example post “Bear Stears catches subprime cough, Australian corporate bonds get a cold“, June 26-07). More than 70 U.S. subprime lenders have been slowing – or rapidly – going out of business since March when their funding sources dried up.

As an interim step, Coventree will utilize the market out clauses in their contracts to delay refinancing hundreds of millions of dollars of their commercial paper program. And they’ll tap their banking syndicate for up to $700 million on their “liquidity lines”.

Once the halt was off and Coventree started trading again yesterday afternoon, something strange started to happen to shares of the Royal Bank and Bank of Montreal. Investors who had bid the shares up after the CIBC pre-announced good news earlier in the day, now no longer wanted to hold those two specific banks.

Could it have something to do with Coventree? In two short hours, both the Royal and BMO lost about $1 billion of market cap. BNS and TD didn’t experience anything similar, although the Royal appeared to trade up in the U.S. aftermarket. National Bank, which uses Coventree for administration services on their own conduits, lost about 2% as well…although on a smaller market cap. that’s “just” a couple hundred million.

The debt market is one continuum, as we saw again yesterday.

If the market upheaval that Coventree is experiencing means they can no longer issue paper, what kind of impact will this have on the small and mid-sized businesses that benefit from that $16 billion of funding? Let’s not forget that the Coventree commercial paper program was being used to finance office equipment, non-standard Canadian mortgages, car leases and so forth.

Between March 2006 and 2007 the average balance of Coventree’s outstanding conduits grew by about $1.5 billion. Let’s assume there was some organic growth there, and not market share gains. The trickle down effect of that financing, if it evaporates, can’t be ignored.

The German banking regulator worried about the broader impact of trouble at a relatively small SME bank called IKB (see post “Subprime infection spreads to Germany“, July 30-07). If Coventree operated under a bank licence, OFSI and the Bank of Canada would be rallying today to ensure that the $16 billion of client lending going on there is preserved for the sake of the economy.

But, as a specialty finance firm, it appears they might be left to drift, hoping that the market for their commercial paper returns within the next 364 days. Certainly no new loans can be written, but at least the existing portfolio can be preserved, as if it were in formaldehyde. And there’s always the chance that National Bank (NA:TSX) acquires them at an attractive price for NB.

But perhaps the Bank of Canada should pay some attention to the impact of $16 billion of potentially lost purchasing funding? After all, Scotiabank’s corporate & gov’t loan portfolio is merely ~$26 billion. Having stepped in last week to keep the chartered banks liquid, what about Coventree?

MRM
(disclosure – we own BMO and BNS in our household)