When Australia was enjoying a bull property market, investors – many of them retirees – opted to put their money in mortgage funds as a way of guaranteeing a regular income stream, as well as having the option of redeeming their capital at short notice.
Today, many of these investors – many of whom could ill afford it – are much poorer, and the many mortgage funds that have frozen redemptions and are not paying income to unit holders are pointing their fingers at the global financial crisis. The basis of the problem, they claim, lies overseas.
Well, I beg to differ. Many of the problems afflicting this industry are home grown and need to be addressed before the next upsurge in the property market once again finds investors being short-changed.
But before I outline the three areas most in need of reform, it’s necessary to outline how the industry is structured and why many mortgage funds have either collapsed – Westpoint, Fincorp and Bridgecorp come to mind – or frozen redemptions and stopped paying income to unit holders.
The mortgage fund industry, which is worth about $30 billion, is broadly divided into mainstream retail mortgage trusts (RMTs) and the more aggressive retail debenture funds (RDFs) and hybrids (a cross between RMTs and RDFs).
RMTs, which are worth about $20 billion, are run by large institutions. The management fees they charge are based on funds under management, typically between 1 to 1.5 per cent, with investors retaining all the residual income. With this structure there is no incentive for managers to make higher risk, higher reward and, in all likelihood, higher loss loans.
Although RMTs have their difficulties, they are generally faring well. While redemptions have been closed and lending has ground to a halt, distributions have still been maintained and capital preserved.
The difference with RDFs and hybrids, which are usually managed by non-institutional entities, is stark. In these mortgage funds, investors generally receive fixed returns, with the manager receiving any excess income. Consequently, the interests of the manager and the unit holders are not aligned; the manager seeks the highest return possible to maximise fee income.
The other serious problem to emerge with RDFs and hybrids is the way they have been marketed. They have lauded their fixed returns, usually well in excess of what the banks offer, taking this message directly to the investing public, either via radio or print media.
In adopting this approach they have avoided the industry gatekeepers, such as financial planners. It is part of the gatekeepers’ role to warn investors that higher returns mean higher risk, and that this is the investment prism in which RDFs and hybrids should have been viewed.
High-yield RDFs generally preferred to lend on construction, development and/or development land. More often than not the RDFs relied upon future inflows to fund future liabilities from these construction loans.
In Australia, what brought the crisis in this property sector to a head was the Federal Government’s deposit guarantee introduced last October. In that highly volatile period investors wanted a safe haven and switched their money into bank deposits.
As stated, RMTs are surviving, but the RDF and hybrid sectors have been decimated. The cessation of inflows resulted in many of the funds struggling to fund their construction loan obligations. The underlying security from higher risk loans (being land, half-completed developments and highly geared investment properties) is under valuation threat.
What is critical now is to avoid history repeating itself. In my view, there are three crucial steps regulators must take that will help ensure this doesn’t happen again. They are:
n Related party loans. The sector is strewn with ‘lenders’ happy to indulge in disclosed related party lending. Is disclosure enough? Quite simply, there is a conflict of interest that cannot be resolved.
Can the fund manager who has loaned the money to a related party be relied upon to ask the relevant questions about the performance of the loan? If a receiver is appointed to the company, do they act for the lender or the borrower? At the very least there is a perception problem.
We propose all related party lending be outlawed under the Corporations Act, with breaches liable to criminal prosecution.
n For those related party loans that exist, the current requirements should be expanded to ensure that responsible entities provide unitholders with continuous disclosure of all related party loans. What would this entail? Making copies available on all loan documentation and any variations to it, the ongoing performance of the loan and details about recovery action where a loan is in default, including any action against guarantors. Surely investors are entitled to the benefit of these disclosures in relation to related party loans.
n Liquidity. The propensity for any lender to create ‘un-funded’ future commitments by lending against progressive construction loans must be regulated. Every manager should have to retain sufficient liquidity to meet all future lending commitments. Hopefully this will prevent new funds emerging with the same characteristics of the current RDF and hybrid schemes and ensure that even higher risk construction lending schemes can meet their obligations to investors and borrowers.
Michael Holm is executive chairman of Balmain NB Corporation.
