Brian Gaynor: Investors didn't know money could sail away

Brian Gaynor

The failure of Credit Sails, where investors have lost more than 98 per cent of their money, is another indictment of the New Zealand investment sector.

Risk and failure are part and parcel of the investment world but the problem with this product, and many others in New Zealand, is that they are aggressively sold to relatively unsophisticated investors who aren't clearly informed of the risks involved.

This is because our prospectuses and investment statements do not explain, in ordinary language, the real risks associated with an investment.

There is also no regulatory agency willing to grab this issue by the horns and raise the level of pre-issue disclosure.

The Credit Sails (Credit Saleable Index Linked Securities) prospectus was registered on May 3, 2006, with the objective of raising $100 million from the New Zealand public to invest in a CDS (credit derivative swap) structure.

The structure was unbelievably complex and it is doubtful if anyone who invested in this product had any real idea what they were getting into.

Nevertheless the issue, which had a 6-year duration and was organised and underwritten by Forsyth Barr, raised $91.5 million.

The fund-raising was successful because the interest rate was 8.5 per cent compared with the Official Cash Rate (OCR) of 6.75 per cent at the time.

Another contributory factor was that brokerage was "payable at the rate of 1.75 per cent on all applications subject to a firm allocation and 1.25 per cent on all other applications" to participating NZX firms and other approved financial intermediaries.

Thus individuals and organisations were encouraged to invest in an incredibly risky structure in order to obtain a slightly higher annual interest rate. The largest Credit Sails investors include the New Zealand Methodist Trust Association, Youth Development Endowment Trust, the Otago Foundation Trust Board, Southland Hospice Charitable Trust, Otago-Taieri A&P Society, the Roman Catholic Bishop of the Diocese of Dunedin, Congregational Christian Church in Samoa (Addington) Board, Dunedin Diocesan Trust Board and the Dunedin Orphans' Club.

These organisations have suffered big losses because they were effectively insuring the dodgy loans of highly leveraged Icelandic banks.

Credit default swaps were originated by JP Morgan Chase in the late 1990s. They were created because banks became concerned about the amount of credit risk they carried on their balance sheet. A CDS is effectively an insurance policy whereby a bank pays a fee to another party to assume the credit risk over a proportion of the bank's loan book.

A CDS is really no different to personal insurance. We pay a fee to an insurance company to assume the risk over our car or our house. The insurance company makes money if there are no claims and it loses out if the claims are in excess of the fees or premiums received.

The whiz kids on Wall St produced computerised models, based on historic credit failure rates, which calculated the probability of failures.

These assessments were included in the Credit Sails prospectus although they were not easy to understand.

In simple terms - and this is a simple explanation of an extraordinarily complex transaction - Credit Sails took over the insurance risk associated with a $3 billion international corporate bond portfolio.

The $91.5 million raised was effectively used as an insurance bond that would be returned to investors when the arrangement expired in December 2012.

The interest received by investors was effectively the fee or premium income for insuring the portfolio.

It is clear from emails received from investors that they had no idea they were taking part in an insurance scheme rather than having a direct exposure to a corporate bond portfolio.

There is a huge difference between an insurance scheme and direct investment in bonds from a risk and returns perspective.

New Zealand investors were effectively insuring a $3 billion bond portfolio for a fee of $50.6 million. The latter figure is made up of the annual interest rate of 8.5 per cent over the 6.5 years of the scheme.

The mathematics of the scheme was as follows:

* The insured bond portfolio was worth $3 billion.

* $144 million of losses were covered by other protection.

* All losses of more than $144 million would be the responsibility of Credit Sails although liability was effectively capped at $91.5 million.

The prospectus claimed that a Standard & Poor's analysis concluded that the six-year default rate on an A-rated corporate bond was only 0.966 per cent.

On this basis the failure rate on the $3 billion portfolio was expected to be just over $30 million over the 6-year period. This was more than covered by the $144 million of other protection.

Looking at it another way, Credit Sails investors were effectively insuring the equivalent of 3000 houses for $1 million each with a $91.5 million bond they expected to get back. They didn't realise that a once-in-a-lifetime forest fire was about to rage through the area. The complex computer models compiled by the Wall St whiz kids didn't take this into account.

Investors received a fatal blow this year when it was revealed that the portfolio had total loan losses of $560.6 million.

This was well above the $144 million of losses covered by other protection and Credit Sails is now virtually worthless.

Standard & Poor's assessment was totally wrong, as loan losses represent 18.69 per cent of the portfolio after less than three years, whereas the rating agency predicted loan losses of 0.966 per cent over 6 years.

Investors will receive only 1.17c, plus interest, for every $1 invested. The meagre payment will not be made until December 22, 2012.

The $560.6 million of losses came from just six of the 120 portfolio companies. These losses were.

* Lehman Brothers, USA, $55.2 million.

* Washington Mutual, USA, $52.5 million.

* Kaupthing Bank, Iceland, $128.1 million.

* Glitnir Bank, Iceland $133.1 million.

* Landsbanki Islands, Iceland. $135.5 million.

* Idearc, USA, $56.2 million.

How did Credit Sails incur such large individual losses when the prospectus stated that the maximum exposure to any entity would be $45 million?

This insurance-type structure has been a disaster for investors because if they had a conventional corporate bond portfolio, with only six of the 120 investee companies in trouble, then they would probably have lost about 5 per cent of their capital instead of 98 per cent-plus.

The first question that needs to be asked is; were investors misled?

The answer is no because the prospectus contained more than 40 pages of detailed information that would have allowed an extremely experienced and knowledgeable investor to spot the risks.

The next questions are: was this product sold to the wrong investors and did these investors have sufficient skills and experience to assess the risks? The clear answers are yes to the former and no to the latter.

New Zealand is probably the only country where these incredibly complex products are sold to retail investors. Credit Sails was promoted to church groups, charitable organisations and individual investors who probably had no idea what they were getting into.

The issue was sold to these investors even though the prospectus and investment statement were more suited to Harvard University MBA (honours) graduates.

It is difficult to know if the promoters and financial advisers of these issues are greedy or just plain naive, but the end result is that they destroy enormous wealth, create huge hardship for charitable organisations and do terrible damage to investor confidence and our capital markets.

Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.

bgaynor@milfordasset.com