Saturday, December 22, 2007

How many exceptions break the rule?

Australians have felt themselves the Lucky Country for many years and many reasons (even though it was a bit of a slur, issued with a bit of tongue in cheek irony originally), and have generally applied that blessing to dodging the American-centred subprime mortgage mess. The Four Pillars sing as one to the tune of "it isn't happening here".

But there are small contagions popping up. Will these small events mutate into a larger pandemic? At this point, it would seem not, even though it is hard to believe in a paradigm of disconnect in a world of finance hard wired to the same trading screens.

Some isolated cases of the subprime flu are the subject of 2 reports in the Sydney Morning Herald today.

Councils to mount legal action over extensive subprime losses:

Wingecarribee Shire Council, in the Southern Highlands, is suing Lehman for "deceptive and misleading conduct" in selling $3 million of subprime-linked collateralised debt obligations, the council's managing director, Mike Hyde, said yesterday.

New York-based Lehman, which manages up to $1 billion on behalf of 35 councils in NSW and Western Australia, might face further action as the assets in its US mortgage-linked product have declined amid a shakeout in global credit markets.

"We strongly deny the claims made in the press statement that we have not acted in their best interests, or that we have engaged in any misleading or deceptive conduct," Sinead Taylor, a spokeswoman for Lehman said.

Lehman Brothers Australia, which was rebranded from Grange Securities after being acquired by Lehman, is offering to buy Wingecarribee's CDOs for less than 16 per cent of their face value.

No escape from the subprime meltdown
Steve Howell and Stuart Fowler were this year's smartest guys in the room. In the airless, driven world of hedge funds they were top performers.

This reputation has not survived the collapse of one of Basis Capital's hedge funds, Basis Yield, at a total cost to Australian investors of $320 million. Another fund, the Aust-Rim Diversified Opportunity Fund, is limping along with losses of 50 per cent with a total loss to Australian investors of about $160 million.

The [unnamed] fixed interest manager says: "Every non-Australian investment bank has been basically slaughtered by subprime. The world's greatest collection of clever people."

These banks and broking firms with gold-plated names such as Citi, Bear Stearns and Merrill Lynch had suffered losses of $US29.8 billion ($34.7 billion) by the end of November, according to Fortune magazine. Morgan Stanley topped that up on Wednesday with a further $US9.4 billion in losses.

In this context the collapse of Basis Capital's hedge fund from June is a small, compelling and very public example of a massive disruption happening behind the gilded doors of the world's financial powerhouses.

The disruption has gone on to claim the mortgage lender RAMS and the property trust Centro as loans they were seeking simply dried up - with every likelihood of more problems to come as major debt insurers now face credit rating downgrades.

The example of Basis Capital exposes a global financial system with linkages that are far-reaching, surprising and not entirely logical. It shows how defaults on mortgages by US home owners resulted in a loss of $1.5 million for a West Australian charity that helps children with deafness and blindness. And how a small council on NSW's Mid-North Coast has invested $25 million of its $75 million in direct investments into risky fixed interest assets.

What killed Basis, and crucial to the understanding of what has spurred the financial crisis throughout the world, was not a classic credit crisis in which rising defaults prompted greater and greater losses.

"What they clearly didn't realise was that everyone was on the same trade and the moment something went wrong you got that avalanche," says the fixed interest manager who knew Howell and Fowler through the conference circuit.

This phenomenon of forced sales and write-downs is shown quite spectacularly in continuing attempts by the boutique asset consultant Grange Securities to flog off its collateralised debt obligation in Australia.

Grange is still offering financial planners by email nothing less than a fire sale of a grab bag of collateralised debt obligations with Australianised names such as Esperance, Blaxland, Flinders, Kakadu and Blue Gum.

Grange, now known by the moniker of its US investment bank owner, Lehman Brothers, marketed almost $1 billion of these complex debt products to councils throughout Australia. Grave questions are being asked about the level of knowledge councils had about the fixed interest assets they were buying.

The email shows the face value of these investments has fallen substantially from their issue price, in some cases by almost 30 per cent. But the obvious risks are still not enough to deter Grange from attempting to pass them on to investors through financial planners.

Port Macquarie-Hastings Council on the Mid-North Coast counts $25 million of collateralised debt obligations among its direct investments - or a third of its $75 million investment portfolio, including many sourced from Grange.

The council is holding on, hoping it will all go away: it has not marked down any of the collateralised debt obligation it is carrying in its investment portfolio despite the likely loss in value.

The Senses Foundation in Western Australia helps children who are deaf and blind to communicate with their parents, among other services.

The charity lost more than $1.5 million when the Basis Yield fund operated by Basis Capital Funds Management collapsed.

The foundation's chief executive, Debbie Karasinski, says the issue of how Senses came to be invested in Basis was with its lawyers. It used a Perth asset consultant, Counterpoint.

"Senses Foundation has an investment policy and it has an investment adviser. The question for us is whether Basis sat within the foundation's policies," she says.

The Combined Fund, which is a Melbourne-based industry superannuation fund for teachers in private schools, appears to have a similar story after losing $12.4 million.

To a large degree, the product disclosure statements were bulletproof, adequately warning investors of the risks of the fund.

Super funds and local governments might reasonably be expected to look after themselves. The real surprise is Basis Capital and other collateralised debt obligation-style products were and are widely available to mum-and-dad retail investors.

As Basis succeeded it began to find more and more retail investors through various investment "platforms", which allow financial planners to invest their clients' money.

Eventually various margin lenders were offering people the ability to invest in Basis Yield, borrowing up to 80 per cent of their investment. This added even more debt to an already debt-fuelled vehicle.

"I remember being struck at the time seeing it in margin lending platforms," says an asset consultant who put clients into the still-surviving Aust-Rim Diversified Opportunity fund.

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