KEY POINTS:
Investment trends come and go. Back in the late 90s it was all about investing for growth via the world's stockmarkets. Only the unsophisticated invested in local shares.
Two years later the novices were looking sharp as international stocks had dived and NZ shares were outperforming. It almost seems that any investment strategy which becomes particularly popular with investors can be pretty well relied upon to underperform two years hence.
In the last few years many local investors have chased high cash returns via finance company debentures and exotic high yield funds. With the collapse of Bridgecorp the ugly truth about the debenture market is out there for all to see but that other favourite of a go-for-broke, income-focused strategy, structured credit, continues to have the support of financial planners and thus attracts funds from small investors.
While no one locally admits to having lost money yet, this option too is looking increasingly like a very risky strategy and one where, as usual, the higher risks are not offset by higher returns.
In the past few months business newspapers such as the Financial Times and the Wall Street Journal have been full of warnings from experts and commentators highlighting the US sub-prime mortgage meltdown and the consequent potential for a disaster in the credit derivatives markets.
Compounding the situation is that anecdotal evidence suggests most local small investors are blissfully unaware that their savings may be threatened, that they own structured credit instruments and, if they do, what they are.
The experts are worried about collateralised debt obligations (or CDOs, as they are known).
CDOs are securities backed by loans generally and frequently by sub-prime residential mortgages in particular. The latter instruments are house loans to people who more often than not don't have a job, a good credit history and, sometimes not even a house!
The US sub-prime market is huge with more than US$500 billion ($618 billion) issued in each of 2005 and 2006. It has been something of a bonanza in the last few years for all the players: real estate salesmen, mortgage brokers and of course the investment banks cranking out the CDOs.
In fact, it has been so attractive that in many cases the rules have been bent so that people without a hope of even paying the interest have been able to get big loans.
Today with US house prices falling and interest rates rising, defaults have been coming thick and fast. The significance of all this is that CDOs, as leveraged loans, are particularly sensitive to rates of default.
Possibly the best way of appreciating a CDO's unique risk profile is to consider its sensitivity to "credit events" - a company going bust or someone defaulting on his/her home loan. The bottom line is how many credit events can your CDO sustain before you lose your money?
With 100 different loans in one CDO, one might think that all 100 would have to go bust before you lose everything. Unfortunately that is not the case with a CDO and herein is how the risk in "risk and return" peculiarly applies to CDOs.
In essence a CDO is a leveraged debt instrument which is typically cut into pieces - which are called tranches. The safest or AAA rated tranche is protected by the junior tranches and might tolerate 10 loan defaults until investors lose their principal, whereas the riskiest tranche, sometimes referred to as toxic waste, pays the highest interest rate but might only be able to sustain four or five defaults.
So which tranche do Mum and Dad in Auckland own - toxic waste or AAA? Have any credit events already occurred? What exposure is there to sub-prime? All good questions - but on the basis of the current level of disclosure from the funds concerned there is no way of knowing, until the proverbial hits the fan.
Even an AAA-rated tranche of a CDO which referenced a sub-prime portfolio might not avoid a meltdown.
Bill Gross, bond guru at Pimco, the largest bond fund manager in the US, is quoted on his website as saying that many CDOs don't actually merit an AAA rating. This is close to blasphemy in bond circles because Standard and Poors and Moody's have up until now had a long-term history of reasonably prudent analysis.
However, the fact that AAA-rated CDOs pay a far higher interest rate than AAA-rated US Government bonds does tend to hint that something may be very wrong in the ratings systems.
Indeed this month Standard and Poors surprised the market by announcing it was intending to re-evaluate some 800 or so CDOs.
Tim Bond, of Barclays Capital, estimates that if cumulative losses on the sub-prime mortgage pools are much above 7.5 per cent, the AAA and AA CDO tranches are likely to experience downgrades as lower-rated tranches are wiped out by losses.
Closer to home, last week an Australian fund manager specialising in structured credit announced it would suspend redemptions on its retail funds due to its investment in CDOs referencing the US sub-prime market. The fine print discloses that local funds are able to do that too.
Compounding things further is the fact that CDOs seem to be devilishly difficult to price let alone sell. Two US hedge funds run by US broker Bear Stearns just about went bust earlier this month and apparently when the prime brokers to these funds tried to sell the underlying CDOs they quickly came to the conclusion that this wasn't a good option.
The Financial Times describes the CDO market as rife with opacity, illiquidity and shady valuations. Sounds a little like our finance company debenture market.
So where does this leave local investors?
It seems pretty clear that the riskiest tranches of CDOs are only for sophisticated and brave investors with deep pockets and a high risk profile, ie: hedge funds. Then again maybe not even hedge funds as evidenced by the perils of Bear Stearns in the US, Queens Walk in the UK and Basis Capital across the ditch.
Reminds me of one piece of advice a few years back along the lines that one should not panic when making investment decisions; however if one had to panic, he or she should panic before everyone else.
* Brent Sheather is a Whakatane-based investment adviser.
