The Home Capital Group (HCG) story is quite a roller-coaster story. The Berkshire (BRK) Buffett deal raises at least as many questions as it answers. Before I get into this, I want to state that I don’t have a position in HCG. HCG is a subprime lender and I have no interest in that business. I never bought HCG or short it. A lot of the comments surrounding HCG are either by people 1) who are losing a lot of money 2) short-sellers trying to make the stock crash. I don’t have a horse in this race but I’m following the developments.

Let’s back up a little bit. This is from the Ontario Commission (OSC):

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HCG
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  • On July 10, 2015, HCG announced that an ongoing review of its business partners had led it to terminate certain brokers, causing an immediate drop in Originations. The next trading day, HCG’s stock price fell 18.9%, resulting in an approximate $600 million loss in market capitalization and significant investor harm.
  • Prior to this announcement, from February 2015 until July 2015, HCG misled its shareholders as to the immediate and on-going causes of the decline in Originations. Internally, HCG knew it had terminated certain brokers because it had discovered fraud in HCG’s broker channels.
  • …HCG was receiving fraudulent employment income documentation through its broker channels which had not been detected by HCG’s underwriting controls.
  • Specifically, when asked about the decline in Originations for Q1 2015, Soloway attributed the continuing decline in originations to a range of factors including cold weather, macroeconomic conditions and a cautious approach to lending. Given the information known to Soloway, including as contained in the May 4 Memo and the President’s Report, his statements were materially misleading and untrue.

Back in April 2017 HCG was formerly accused of “materially misleading statements” to its shareholders, blaming the decline in its mortgage business to “external vagaries, such as seasonality and competitive markets.” In fact, it was internal fraud that was depleting Home Capital’s bottom line. All these troubles originated in 2014 and early 2015 when the lender’s brokers provided “fraudulent employment income documentation” on some of the home buyers.

The accusations by the OSC led to a crisis of confidence. There are repercussions to what happened. Several news reports have tried to create a U.S.-style sub-prime mortgage crisis by playing up recent problems experienced by HCG. The accusations combined with the media freaking out led to a run on HCG. What’s a bank run? When you deposit money in a bank, the bank loans it out. So it’s not there for you to access. They keep a small portion on reserve that they can give out in case people want to withdraw money, but if there’s ever a situation where a sufficient number of people lose confidence in the bank and try to get their money out at the same time, the money’s not going to be there. You’re going to be screwed. Depositors freaked out and started pulling their money out of HCG. The deposits are HCG’s cheap funding. Now the cheap funding is gone and had to get a $2 billion very expensive emergency loan.

Let’s be clear. From what we know so far, Home Capital has a governance problem, not an accounting one (yet). There are a lot of questions. If HCG’s management is so confident in their $25 book value, why would they sell shares to Buffett for $10? This confirms what everybody is saying about your company: “Your numbers are fake”. Why are they having a hard time selling their loans? Why would they accept such crazy terms on their bailout loan? If the loans are as good as they state they are, why give $2 of collateral for every dollar of loan?

And what about Buffett? His investment in HCG was a blow to short sellers and left people in a bit of a daze. Buffett famously said to sell when others are greedy and to buy when people are fearful. HCG fits the bill. But he also said to do business with people with integrity and high ethical standards. HCG fails that test miserably after its many ethical lapses. The Buffett deal parallels those made with Goldman Sachs and Bank of America in the wake of the financial crisis

Anyone claiming that Berkshire investing in Home Capital somehow discredits short-seller Marc Cohodes fails to see the genius of both investors. Buffett structured a deal where he can’t lose. And it is still possible that HCG is a zero.

I looked at the HCG when it was around $6 in back in April after it crashed. And when I say I looked at it, I didn’t know if I should short it or go long. But I came to my senses. Does anybody have a clear picture of the state of Home Capital’s finances? It’s way too messy and too speculative. Now the stock is trading at $16 but I don’t regret by decision. It’s the process that matters. With HCG trading at $16, it doesn’t confirm anything. I will stay on the side lines. This story is not over.