The company recently stepped in as a lender and investor to a troubled Canadian mortgage lender, Home Capital Group (TSX:HCG)(NASDAQOTH:HMCBF), while serving up a fresh investment in a domestic real estate investment trust, Store Capital (NYSE:STOR) at a modest discount to its recent trading price.
Berkshire goes to Canada
Canadian real estate escaped the 2008 financial crisis virtually unscathed, taking a short breather during the downturn in 2008 and 2009 before rising to new highs. But North America's strongest housing market could be nearing an inflection point, as the Canadian government has recently taken steps to curb robust price appreciation that has been driven largely by foreign investment and loose lending standards.
For subprime lenders like Home Capital Group, housing price declines could cast a light on the dangers of fast loan growth in hot markets. The bank recently settled with a Canadian regulator over poor disclosure about mortgage fraud. Earlier, in May, the company experienced a run on its deposits, as nervous customers pulled their savings from its high-interest accounts as news of fraud became a recurring headline.
It's often been said that banks die because of liquidity, not insolvency. When deposits flee, even well-capitalized banks can fail as their long-lived assets (mortgages and other loans) can't be readily sold to fund withdrawals. The rapid loss of deposits put Home Capital Group in a perilous position of having to prove its creditworthiness and shore up the liability side of its balance sheet. The company moved to secure an emergency line of credit from a pension fund in the amount of $2 billion Canadian dollars to provide liquidity as depositors fled.
But a $2 billion CAD credit line wasn't enough to appease its customers. According to the company's disclosures, liquid assets and its undrawn amounts under its facility added to just $1.23 billion CAD on June 20, down from $1.99 billion CAD on May 1.
For Home Capital to stem a decline in deposits, it needed more than money; it needed credibility.
The Berkshire backstop
Last week, Berkshire stepped up to fill the credibility gap, agreeing to provide a $2 billion CAD line of credit, replacing the pension fund as Home Capital's banker. It also agreed to make a smaller equity investment to acquire up to 38.39% of Home Capital Group's outstanding stock for $400 million CAD.
While Buffett may have lavished Home Capital with praise in the press release describing the investment, the terms of the agreement suggest that it needed a high price to get involved. Berkshire agreed to terms that put it in a position where it seems almost impossible for it to lose money, regardless of where Home Capital goes from here.
Berkshire's $2 billion CAD line of credit at a 9.5% interest rate is secured by a pile of mortgages worth $5.4 billion CAD. Berkshire's equity investment of $400 million CAD was made at a price a third lower than its then-current closing price, and the size of the equity investment pales in comparison to the interest and fees it should earn on its secured line of credit. It's easy come, easy go for Berkshire, which agreed to hold its Home Capital Group shares through a short lock-up period of just 90 days.
While this deal may have similarities to Buffett's crisis-era deals with Goldman Sachs and Bank of America, investors may want to spend more time dissecting the nuances. Consider that when Berkshire made investments in American banks it injected capital by way of preferred stock, which sits above stockholders, but below depositors and other lenders.
In contrast, Berkshire Hathaway's loan to Home Capital sits on top of the capital structure, secured by $5.4 billion of specific collateral. The equity investment -- small potatoes compared to the interest and fee income from the facility -- was made at a price of $10 per Home Capital Group share, a third less than the market price at the previous close. Berkshire's investment had an embedded margin of safety far larger than any of its financial crisis investments in America's banking institutions.
Berkshire is getting paid handsomely to effectively lease out its reputation. The Canadian housing market would have to become truly disastrous for Berkshire to lose money, given it extended credit at only $0.37 on the dollar of collateral value.
A bet against "retail armageddon"
Two days after its Home Capital bailout, Berkshire Hathaway was back at the table to ink another big investment. On Monday, it was announced that Berkshire agreed to buy 18.6 million shares of Store Capital at a price of $20.25, a modest 2.5% discount from its closing price on Friday, but well below its 52-week closing high of over $31 per share.
Equity REITs acquire properties to lease to corporate tenants, often with the help of a heaping pile of leverage. But unlike Home Capital Group, Store Capital isn't in need of emergency financing to help it fend off creditors.
Store Capital doesn't have any lenders knocking at its doors, and its most significant maturities won't come due until 2019, when it will make approximately $343 million of scheduled principal payments and balloon payments on its liabilities. Its liabilities and their maturity profile are par for the course in the world of real estate. This isn't an emergency scenario, hence why Berkshire received only a modest discount to acquire shares of the company.
This appears to be a deal in which Berkshire and Store Capital were able to split the cost savings of raising capital privately. According to the Wall Street Journal, Berkshire reached out to Store Capital to make the investment, not the other way around.
When the REIT filed to sell nearly 8.7 million shares to the public in March, Store Capital shares sold at a 5.5% discount to their closing price net of fees and discounts. Under the terms of the private placement with Berkshire, Store Capital will issue new shares at a mere 2.5% discount to the most recent closing price. With this deal, Store Capital can skip the fees it would ordinarily pay to an investment bank by selling stock directly to Berkshire.
Store Capital isn't perfect. It, like many retail REITs, has a few troubled tenants in its portfolio. Applebee's and O'Charley's restaurants, which make up 2.8% of base rent and interest, combined, have reported declining same store sales as younger eaters dine elsewhere. (Applebee's is private, but O'Charley's is partially owned by SEC filer Fidelity National Financial). Privately held outdoor retailer, Gander Mountain, which made up 2% of its base rent and interest revenue, recently declared bankruptcy, but some stores should remain open in the hands of Camping World Holdings.
Regardless of the apparent decline in all things retail, one of Buffett's lieutenants sees value in the REIT's depressed share price. Ted Weschler, who followed the company after it reached out to Berkshire for an investment three years ago, called Store Capital to make an investment about a week prior to the deal's closing, according to the WSJ.
Berkshire as an investment banker
With more than $90 billion of cash on hand, Berkshire Hathaway is part of a select group of financial industry titans whose fundamentals get better as the world turns for the worse. With stock prices lofty, and cash piling to record levels, Berkshire would arguably be a better investment if stock prices were lower, and investment opportunities more plentiful.
To be sure, these two transactions amount to Berkshire flexing its muscles more than a needle-moving investment. In total, Berkshire put less than $3 billion to work between the two transactions, a rounding error compared to its $654 billion balance sheet. But it's a sign that when a unique, billion-dollar transaction is on the table, Berkshire is one of the few companies that can write billion-dollar check sizes and get a warm welcome when it takes a seat at the table.