What went wrong in Australia?

American Securitization, December 2007

In April, Stuart Fowler was having a conversation with American Securitization about the impact of sub-prime on his business. The co-founder of Basis Capital, a highly successful Australian absolute return manager with around US$3 billion under management and advice in credit instruments, was recalling that his fund had suffered its first month of losses in its more than three year history that February, thanks to the negative publicity and illiquidity in credit markets caused by sub-prime. But since then, he reported, the manager had made it all back again and now appeared to be well-positioned.

 But within months of our conversation, Basis was in trouble; by August one of its two main funds, a structured credit vehicle called the Yield Alpha Fund, was in liquidiation, and the other had lost half its value. Investors in the yield fund have been told to expect to lose 80 cents in the dollar on their investments. Today Basis is trying to split its surviving fund, the Pac-Rim Opportunity Fund, in two in order to improve liquidity and get moving again.

 And Basis is not alone. In November another absolute return manager active in the credit markets, Absolute Capital, which is half owned by ABN Amro, appointed an administrator to run its operations after being hit by sub-prime related losses. The appointment relates to the company as a corporate entity rather than its funds, but that may not appease investors in them, who have been banned from making redemptions since July. The impregnable Macquarie Bank has suffered losses in one of its credit market products. And RAMS, a home loans company, raised $700 million in a July IPO only to run into trouble the following month when it was unable to roll over $6 billion in funding; it has since lost 90 per cent of its stock market value and been sold to Westpac, which will run off the institution’s loan book and return whatever it makes from it to shareholders.

 This was not the idea. Australia was supposed to be immune to sub-prime. There can surely be no other nation with such a proud and emotional attachment to its real estate, where advancement is tied so closely to land; Australia has some of the healthiest default figures in the world, and non-conforming lending (the Australian equivalent of sub-prime) is minute by US standards. Back in March, when sub-prime was becoming a global slogan, the Reserve Bank of Australia pointed out that non-conforming housing loans “account for an estimated 1 per cent of all outstanding mortgages” compared to 15% in the US. And, consistent with that, Australia’s own commercial banks still look healthy.

 It is true that exposure to complex structured credit like CDOs goes a lot further down the investment spectrum in Australia than most countries – even to retail – but it hasn’t proven to be so much of a problem at that level, where the structures have always required long term holding, so haven’t needed liquidity, and in any event have only generally invested in highly rated tranches.

 So what happened? Two things: while Australian homeowners don’t tend to borrow in a sub-prime fashion, Australian fund managers – among the world’s sophisticated – have been active in some markets where with retrospect they should not have dabbled. And the global hit to credit markets has created big problems for anyone trying to roll over debt, with Australia no exception. Australia, like many other corners of the world, underestimated the degree to which sub-prime would prove contagious to much healthier credit worldwide.

 The funds themselves were complex ventures, and to an extent it is tempting to say: well, buyer beware. But here one gets to one of the real complexities and controversies of the Australian situation. Basis in particular had enjoyed extraordinary success and an utterly unblemished reputation right up until the day it suspended redemptions and never came back. It had become a widespread holding of local councils, hospitals, and retail investors. And it had become so, in very large part, on the back of glowing recommendations from the various independent rating agencies who crowd the Australian industry.

 At the time Basis ran into trouble, the manager, founded in 1999 by Fowler and Steve Howell, had five star ratings (or some equivalent plaudit) from almost all of the major researchers in Australia, among them Morningstar, Lonsec, InvestorWeb, Standard & Poor’s and Zenith. All of these groups would have done detailed research on the fund and its investment approach; generally it is commonplace for them to return every six months, requesting highly detailed breakdowns of portfolios.

 In the fall-out of the Basis collapse, there has been a lot of talk of suing these institutions from financial planners who feel badly misled by the advice they got from these research groups. No such suit has yet made it to court, but antagonism remains high, with the whole research model – with the fee often paid by the target of the research – in question. Besides, another problem is that the investors caught up in Basis and other sub-prime wobbles were not all sophisticated, but were highly visible.

 Take, for example, the Princess Margaret Hospital Foundation, which manages funds for a children’s hospital in Perth. It had $1.4 million of its $12 million portfolio in the Basis Yield Fund, the one that has collapsed. You don’t get much more emotive than a children’s hospital: how many baby incubators does $1.4 million get you? Others include the Western Australia Local Government Superannuation Plan, with $5 million invested, and the Victorian Combined Fund, which covers the pension savings of private school teachers, understood to have $22 million invested with Basis.

 The there’s Western Health, which operates a network of public hospitals across the state of Victoria, which had an investment portfolio of A$8 million at June 30, according to its annual report. Part of that money was invested in a CDO called Federation managed by a group called Grange Securities, a specialist debt group that has recently become the Australian arm of Lehman Brothers. Western Health is believed to have lost $2 million already, although the losses have not yet been realised and could always come back (or, for that matter, get worse). $2 million doesn’t sound a lot. But Grange is believed to be advising well over 100 councils in Australia with $1 billion in investments between them. Elsewhere, Wollahra Council in New South Wales is understood to have $9 million in CDOs; figures like these are hardly unusual.

 One knock on effect of this exposure is likely to be a greater scrutiny of the ability of local councils to assess complex risk. The New South Wales government is expected to change the rules on council-level investment next year. But then, when councils are advised by professionals, who back up their recommendations with glowing independent research reports, can they really be blamed?

 Shortly after Basis got into trouble, American Securitisation spoke with Anthony Serhan, head of consulting at Morningstar. “You have to look below the rating and read the report that goes with it,” he said. “We are comfortable with the report we had out on Basis. We said there are no free lunches, this thing is highly linked to credit markets and you shouldn’t have a lot of money in it.”

 In fact, the reason Basis’s fund collapsed are complex: it will be debated for years whether the fund could have survived if some of its bankers had not exercised their right to take over and sell the fund’s assets after Basis missed a margin call. (The Australian arms of five US banks – Citigroup, Morgan Stanley, JP Morgan, Merrill Lynch and Goldman Sachs, which in Australia is called Goldman Sachs JB Were – have been ordered by a New South Wales supreme court to hand over all documents they have relating to Basis before and during its move towards liquidation, which promises to give a revealing insight into the way banks make decisions about collateral at times of high stress.) Hedge fund managers believe that in these situations banks make a bad situation worse by creating a fire sale for perfectly good assets that are just stricken by a temporary drop in liquidity; banks, of course, have the law on their side in seizing assets when a margin call gets missed.

 Nevertheless, the top-drawer ratings that were still sitting proudly on the Basis site as its flagship fund began to fall were an embarrassment to the rating agencies, and may yet prompt a change to the way that whole industry is run and remunerated. There have been calls for financial planning networks (Australia has perhaps the highest level of intermediation in financial advice anywhere in the world) to develop their own in-house research capabilities rather than relying on third party reports. If nothing else, this may mark the end of the strikingly close relationship between the ordinary Aussie punter or pension fund and highly structured debt securities. Buyer beware.