This Saturday we had the AGM (followed by the 60-year Gala which I did not attend;by the way, 61 is a nice Fibonacci number). Nothing too exciting other than a few immaterial tweaks in the by-laws and the usual financials. There was a guest speaker in the person of Arkadi Kuhlmann of ING fame, he advocates the lean and mean approach which Duca does not live by having increased the boards remuneration by 50% in just two years. Also , in his interview with Forbes, he said that he liked hiring “difficult” people as they drive innovation. Duca likes like-minded people. He also reminded people in that interview that if you want a friend, get a dog which for some members of management may be the only option. Regulators were never Mr Kuhlmann’s closest allies whereas Duca pretends to worship them.

    To get to the point, there was not much out of the ordinary. For years now the numbers have not changed that much. Interest income 50 mln, interest expense 20 mln, gross margin 30 mln and expenses about 20 mln. leaving a net profit of about 10 mln  Due to fine tuning as in loan loss provisions etc.etc. the actual profit fluctuated from last years “amazing” 12 mln. year to this year’s 98% achieved goal 7 mln. year. What has changed is the size of the balance sheet. The philosophy applied is one of grow-or-die. As residential loans grow organically more or less in proportion to  the the real estate market (the bread and butter and the “knitting” of credit unions), growth is accomplished in good part by deviating from the “knitting” and going into commercial lending. This now constitutes almost 40% of the loan book. If history is a guide Duca does not have a particularly strong credit evaluation ability.

   Over and above this higher level of risk intrinsic to engaging in a business that, using their own numbers is arguable 17x more risky, the real time bomb is the colossal size of their mismatched book. The mismatch in the 2-5 year maturities is now running at $455 mln., this after making all the proper adjustments for capital, swaps and so on, this is a net number! Also, virtually all liabilities have a duration of less than two years so very little will change in the course of the next two years.

   Here is where the above chart enters into the equation. It represents the overnight (technically there is no daylight) interbank rate. It is very much manipulated by the supply of balances and consequently tends to fluctuate less than say, a one month BA. Due to a lack of choices we use this as a reasonable proxy for funding costs, the absolute level of which is less important than the change. At a glance you will see that there are 15 incidents where the rate changed by 3 to 5 %, on average once every 2.7 years. For the past 5 years or more nothing much has happened.

   A move any time now or in the next two years, would cause the gross interest margin to shrink by possible as much as 13.5 mln. A bigger move, which is very possible given the quite state of the market (quite before the storm?), could push this number up to well over 20 mln. Yield-curve flattening or inverting could make that outcome more complex.

   Risk adjusted the commercial loan book may not be as attractive as it seems at first blush, growth at all costs resembles the good old variable cost accounting, a method of doing your business in such a way that you lose on every deal but make it up with volume. This is becoming evident when you see that the longer duration assets earn the lowest percentage of 3.97% (they are the newest?) and if they were to be funded the cost of 5 year money is quoted in the papers at 2.80% leaving a spread of a little more than 1% for highly risky business. The responsibility for the mismatch risk lies with the board, and judging by the rapidly maturing swaps, the degree of engagement as well as sophistication is not encouraging. This is a time bomb akin to playing Russian roulette with 3 bullets in the chambers or not taking Doris Day to heart.

P.S. A 5% sustained change in interest rates, any time in the next two years, assuming a linear distribution over the 3 years of the 455 mln exists, could lead to a loss of income to the tune of about $38 million by the end of the 5th year

We also recommend reading up on the causes of the Savings and Loan debacle in the US, there are quite a few similarities.

You do not need to pay for bonus shares, you get them “for free” provided you do a certain amount of business. When it comes to share based incorporated companies you typically have to pay to get the shares (except for DRIPs etc. etc.) The above two graphs are of Home Capital Group, HCG and Canadian Western Bank, CWB. HCG focuses on table crumbs from the big banks and CWB finances all things yellow that smell of diesel fuel.Both are, shall we say, focused. Inserted in both charts is a red line that represents the value of Duca bonus shares that were introduced in 1998 or 9. The comparisons are not entirely fair but in a very broad brush sense they are, particularly when going back 14 years or so.  The question here is what is better, getting shares for free or paying for them. Can you spot the winners ??

This is the chart for Duca bonus shares. They do not trade so one has to imagine the path, which is illustrated above. Bonus shares  are created by capitalizing earnings and then proportioning them according to some rule, in this case utilization of the services. No money changes hands and these shares do not trade. In a sense they are a pure illusion but it makes the shareholders happy because they feel that they are getting money back, which they are but that money, of course, comes directly out of their own pockets as the result of charging more than the no-profit, mutual co-operative would otherwise require. They are even RRSP eligible even though that can be questioned. When such a co-operative company comes of age they want to become like the big boys and throw aside all the feel good, community, bond and whatever other attributes there may have been and move on to the share-holder predatory Wall street cut-throat model. While in transition there are elements of both models in play at the same time. Very confusing.

   These “shares” are not real shares, no money has ever been paid to get them (their ACB is essentially zero but not under all tax systems). To redeem them you first have to  let them mature which takes 7+ years, than you can only cash in if your fellow members do not want to do so as well; 10% is the max in any year (which does wonders when there is a panic towards the exits). Most are kept as they pay a small 2% bonus and the good old feelings of camaraderie favours staying put. DUCA has roughly 50 mln. of these shares on the books, a liability to the members that they conveniently view as equity.

    There are three possible paths for these shares over the next 10/20 years. Nothing changes and they stay at $1 (in black, I abstract from the 2% return)). Things go really well and everyone is dizzy with happiness and the shares go up. This is the red possibility that could happen with real shares, but never with bonus shares as they will only be redeemed by the company that has no incentive to pay more than a single dollar regardless of how the business grows. Then there is the blue possibility. It never happens gradually as shown. If it occurs it will be sudden and due to a lack of money or will to redeem the shares. This would happen in the event that management overreaches, for instance in the area of commercial loans, or by straying away from their core competenties and moving further afield. Apart from these potential risks it is not rational even in normal times to keep these shares once they have matured as at best you gain 2%, which is ridiculous for a required hold period of almost 10 years. A sell before everyone else comes to the same conclusion.