Go Placidly Amid The Noise and Wait

Given the carnage on the markets over the last week or so, it was only a matter of time before the we got some irresponsible media reports.

So far, I give a qualified single thumb up to the media for restraining themselves from the kind of sensationalist and hysterical spectacle we saw during the tech wreck. At no stage have we seen the media, en masse anyway, hinting that everyone should sell up before (paper) losses get too great. At least, in Australia, anyway.

The reasons for this are twofold:

1. The tech wreck ended up as, by and large, a bit of a non-event in this country. We're not a hi-tech country. We weren't subject to mass IPOs of dubious quality floating on the market in the same way that countries like the USA were. Needless to say, those in the media who got a little crazy after the events of 2001 looked like geese, and probably felt a little sheepish afterwards as well.

Enough with the animal insults.

2. The Australian economy is in great shape. Our banks are totally not in need of "guaranteeing" in the same way as what is going on in Europe and North America at the moment. Never mind that, though. Our Federal Government guaranteed them today.

OK. Up until quite recently, we did have a bit of an inflation problem. On top of that, we did have a real estate bubble that, thankfully, appears to have sprung a slow leak thanks to our (still relatively) high interest rates. But in the overall scheme of things, we're doing OK.

We don't have a property price crisis like over in the States, though. Yet.

It did make me wonder though, during the week, when I turned on the news to see that some commentators are now starting to consider the distinct possibility that a housing price slump could hit Australia. I would personally welcome this, however, it could cause some grave havoc.

Consider this: In the 1980's, the median house price was set at around about three times gross household income, based on figures I saw during the week. Now, it appears to be about seven and a half times. In real terms, this is simply too much for most householders to afford, and should ring alarm bells anywhere, in the same way that the USA's foreign debt at around 350% of US GDP is at the moment.

By the end of the week, the massive spin doctoring machine that is the Real Estate guilds in each state had reversed this talk, and were even talking up their industry, with headlines like "Housing Prices Bottoming Out", amongst others.

You have to hand it to the RE guilds. The media is totally in their thrall. Media Watch, a couple of weeks ago focused on the attention that Sydney newspapers paid the sheer spin and dishonest figures that the Real Estate Institute of New South Wales like to put out to support their arguments. Figures that, when compared to those churned out by the Australian Bureau of Statistics, seem totally incredulous. The Daily Telegraph even held up the REINSW as being the "peak body" when it came to these figures.

I'm at the point that when I see a property story on the news, I simply don't believe a word of it if there is even only a one-word quote from anyone associated with these bodies. The fact is, the RE guilds represent real estate agents. They do not present fair figures honestly, and how the media don't see through the rubbish that they put out every week is one of life's little mysteries that we'll never see solved.

But on the whole, the media has been relatively controlled on the stampede for the exits that we're seeing in equity markets at the moment.

I did, this week, see something that made me wince.

Marcus Padley, a stockbroker, and regular columnist for The Age usually writes some insightful articles on finance.

Padley, for those who don't know, possesses a sharp mind and one of the silliest egos in finance this side of the late Rene Rivkin. He writes a tip sheet, which is relatively highly regarded, called "Marcus Today". Obviously, Padley was oblivious to the groans that went on around his office when he decided on that one.

Padley wrote an article in The Age which in my honest opinion, is the stupidest and most irresponsible op-ed piece during a financial crisis that I have ever seen. It was titled, "Take your money and run - it's worthless advice".

Cop a geek at this. Padley writes the following choice quotes:

"If I was still holding stocks, yes I'd still sell them... But I come at it not with an opinion about the direction about the sharemarket, but from a human perspective."

Padley has essentially held out a red rag to the bears and said, "Go on. Sell up. You know that you want to."

"But [don't hold on to your stocks] if you can't afford any more losses and are in pain. The definition of "can't afford" in my book is this, if I had to go home to my wife and tell her our expectations are going to have to be lowered."

(My emphasis)

OK. We're all going to have reduced expectations as a result of this. In Padley's opinion, everyone must sell everything, lock, stock and barrel.

"Who wants to play in a casino? The volatility has reduced the market to a casino. In a casino, no opinion has any value."

Your average investor might just as well give up at this point and shoot craps, because this is what Padley is suggesting that the market is no better than.

This is despite the fact that we know a great deal of market behaviour over the long term, which tilts the odds firmly back in the direction of an investor. Unlike our craps table at the casino, which is rigged against you from the start.

This is just the first third of an article which Padley manages to break every rule in responsible journalism. By essentially saying, "everyone should sell, without question," Padley has crossed the line into Personal Financial Advice territory, and should have the book thrown at him by ASIC.

Elsewhere Padley offers these little gems, which I have paraphrased:

• Avoid losses. Therefore, avoid the market as well. It doesn't matter if you are in it for the long term or not.
• I agree that the herd mentality is good. Stick with it and you can't go wrong.
• Optimism is just that. Even if it backed up by the sheer force of history that suggests that investing for the long term requires a buy and hold approach.

Honestly, the whole thing almost reads like a parody. If this is Padley's idea of a joke, it's not funny, and he should be hauled over the coals as soon as the moment arises.

On top of this, Padley is a stockbroker. This means that whenever another sale is done, he collects a commission from it. Ka-ching!

Out of 5 stars, I give this disgraceful effort a bitch slap. Padley needs to wake up to himself.

Standard but necessary disclaimer: Only a complete idiot would think that any of this plausibly constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Great debacles of our time: Brokers get broken

Oh this is a right pickle.

Once upon a time, stockbrokers were venerable institutions with names like JB Were & Sons, Potter Warburg, Ord Minnett and others. They screamed integrity, even if you knew that the way they profited was by buying and selling shares, hence putting them in situations where conflicts of interest can and did arise.

Over time, advising their clients on share trading became much of a side event, as they branched out into areas that could "add value" to their revenue flows.

Derivatives trading became more prevalent. Then full financial planning services. Institutional advice. And margin lending.

About the same time, fund managers, custodians and superannuation funds were finding that they could open up more income flows by lending out their shareholdings to other institutions or investors. The money that flowed from this was valuable.

Why would anyone borrow shares? There appears to be two main drivers for this:

1. Borrowed shares can be sold, thereby covering an activity known as "short selling", which is where you sell securities that you don't possess. You can then buy them back later, which you need to do before passing the securities back.

2. Holders of borrowed ordinary shares can vote on resolutions of listed companies.

The mechanics of stock lending is a weird one to me - and I don't really know the full legal reasons why. When shares are lent, legal title actually passes from the lender to the borrower.

So what actually happens here?

Normally, when title to a security changes hands, there is a Capital Gains Tax (CGT) event. Where stock lending is concerned, for no apparent reason, this rule appears to head straight out the window.

So if the lender is not being pinged for the transfer of securities, one would expect that they have retained some sort of beneficial ownership. In which case, normally, when the shares in question are sold by the borrower - this should give rise to a CGT event for the lender. This doesn't appear to be the case either.

Legal responsibility for the CGT on shares being sold and then bought back would appear, then, to lie in the hands of the borrower. And I'm not really sure how this works, given that what I know of our CGT rules, assets need to be bought before they can be sold.

(Although, it should be noted that most share borrowers fall into the category of "professional investors", in which case, profits retrieved from the selling and buying back of shares would appear, to this observer, to fall into the income category, which makes the whole thing a little bit simpler to work out.)

Which means that ordinary tax laws go out the window a little bit here, and there must be some loopholes or explicit exemptions that are currently in place to facilitate this sort of activity.

But back to brokers again.

Eventually, someone had to connect the dots and work out that margin lending and stock lending could be combined in a profitable way. This would have been a no-brainer for stockbrokers, given that margin lending (or pretty much most lending arrangements for that matter) and stock lending are largely unregulated.

Brokers, who by now had extensive margin lending operations, were changing their arrangements with regards to margin lending subtly. The scope of the change was minor, but a biggie nonetheless: Brokers would assume ownership of the securities outright, rather than merely taking a charge over them.

Then, the broker could on-lend the securities in question.

I don't expect that this is limited to a handful of firms, either. While I have no evidence to back this up, I suspect that the practice is rampant, and it's only some who have been caught doing this.

Consequently, it was only a matter of time before a broker found themselves in hot water over this.

Tricom's problems came to light at the start of this year, when there was a huge slide in the value of stock markets around the globe precipitated by the woes in the US housing and credit markets. Essentially, they had lent out so much of their clients' stock, that when the slide hit and their clients were selling, they couldn't get the stock back in time to enable settlement for the sales made by their clients.

Tricom is still in business. They've since been bailed out by a lot of their owners and clients. Which makes them incredibly lucky.

More worrying was the problems caused by the collapse of another stockbroker not long after. Opes Prime collapsed after similar problems, however Opes Prime's problems were far sillier.

Opes Prime already were exposed to completely ridiculous practices that they'd put in place where they were accepting small listed companies as security for margin loans. This is not normally done.

Normally, margin lenders won't accept shares for security if they lie outside the ASX100, or maybe the ASX200 at a pinch. Opes Prime appeared to accept shareholdings in micro-caps, which was phenomenally silly.

Malcolm Maiden, in The Age described Opes Prime as the "margin lender of last resort".

Indeed, Marcus Padley said somewhere that the value of shareholdings outside the All Ordinaries Index posted as security came to in excess of 65% (if my memory serves me correctly) of Opes Prime's total book. Unbelievable!

Anyway, compounding this was the insistence of Opes Prime to take advantage of lax stock lending laws to move shareholdings between accounts in order to avoid making margin calls on clients' accounts. This was dangerous stuff, and eventually, the losses were going to be big.

ANZ Bank got dragged into this, as they were Opes Prime's principal financier, and held title themselves to much of Opes Prime's stock. How they did this, I'm not really sure. Opes Prime would have been extraordinarily stupid to have allowed ANZ to have ownership of the shares in question, given their practices.

At the end of the day, both the ASX and ASIC have come under heavy fire for allowing situations like Tricom and Opes Prime to happen. I'm not sure why - they couldn't really have prevented this, anyway. I'll talk about this some more in a few moments.

As a postscript to this, broking firm Lift Capital have just gone under, after inappropriate margin lending arrangements with three of the company's directors sent this firm under.

So the question remains - why is only investment covered by the financial services provisions of the Corporations Act? Why isn't lending?

This is more a gripe than a question that I'm going to attempt to answer today.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.

Great debacles of our time: The great mezzanine financing collapse (part 2)

This is part 2.

Part 1 is here.

We were starting to really get stuck into the the sheer carnage caused by the collapse of Westpoint, Fincorp and ACR.

In part 1, we looked at a couple of burning issues created by these debacles:

1. The role that adviser commissions played in the collapse of these businesses and the loss of investor savings;
2. Mezzanine finance and portfolio theory - how is it that advisers can spot a wildebeest when it walks and quacks like a duck? and;
3. Financial literacy and retirees. Is it wrong to target a vulnerable sector of the community when pushing risky products?

The media has been completely enjoying this horrific financial pile-up. And why wouldn't they? There are thousands of angles to explore this from - advisers, investors, the companies involved, the executives, the trustees, the liquidators administrators, the federal government, regulators etc.

And why not? They all had a role to play in this. Whether good or bad, savoury or otherwise.

I'll do my best to cover some of the angles, but I'll re-iterate the important lesson to be learnt from this:

"If it looks too good to be true, that's normally because it is."

Let's look at some interesting stats from this. According to an article in the Fin of Saturday 2 June, 2007 by Robert Harley, the following numbers come up. There were:

• 20,000 investors burnt; and
• AUD $800 million lost.

No matter which way you crunch the numbers, this adds up to serious money and serious lost dreams.

The financial regulator, ASIC, is looking very battered and bruised after some fire from both sides of Parliament. But was ASIC being made a scapegoat?

This blogger thinks that they were. And these are the reasons why:

4. Mezzanine finance is a risky proposition.

Even though the issue of debentures and unsecured notes are done through a trustee, there is very little recourse available through a trust deed for investors. The trust deed itself is normally written by a the company who is issuing the paper.

Trustees are usually appointed through a tendering process whereby the one that offers their services most cheaply will win out. Not only that, but during the tendering process, preference will be given to trustees who promise no questions asked.

Trust Company, the trustee appointed to look after ACR's investors maintains that ACR did all that was required from Trust, and met all their obligations under the trust deed right up until the bitter end.

Is this a conflict for trustees?

I don't really think so - provided that there is proper disclosure given up front. If this is done, then the job of the trustee is mostly done. The trustee just needs to look after the rest, but they still have a duty to act on behalf of the investors.

How about ASIC?

ASIC polices the issue of these investments, but really only up to the point where disclosure is concerned. If the issuer of this paper is meeting their disclosure requirements, then ASIC's job is done.

How the company that has issued the debt then operates in servicing their debt obligations is between the trustee, the company and their investors.

This is a bit different to a bank or a superannuation fund.

Banks and super funds have their day to day activities policed by a number of bodies, all of whom ensure that their prudential and regulatory duties are being upheld.

For banks, the regulatory side of things is monitored closely by the Reserve Bank, and APRA monitors their prudential undertakings to ensure that all is good.

Super funds also have APRA keeping tabs on their prudential requirements, except for DIY super funds which are looked after by the ATO. The ATO also looks after super funds' regulatory arrangements.

In the case of debentures, unsecured notes and other debt instruments, there is no body that looks after the prudential goings on of the company that issues them - it really is caveat emptor.

This adds a whole new level of risks that banks and super funds don't have.

Where disclosure is inadequate, this is pretty much the only area where ASIC can step in and so something about it. And in fact, ASIC did so - the article in the Fin reports that ASIC stopped ACR from issuing capital raisings three times until they fixed stuff up. Which ACR did.

ASIC also issued 11 warnings about Fincorp's goings on both before and after their CEO, Eric Krecichwost resigned as CEO (and as a director) in 2005.

This would appear to point the finger of blame in an entirely new direction, and in a direction that investors will not like, at least for investors who didn't use financial advisers:

5. Investors really only have themselves to blame

This really only applies to investors who just saw the advertisements and went berzerk. It doesn't really apply to investors who sought financial advice.

ASIC appeared to be doing everything short of double-checking the disclosure given by these companies for mistakes and errors.

But the whole deal looked too good to be true for retail investors.

What happens in the institutional world?

Harley's article mentions that where professional lenders, like the ubiquitous Macquarie Bank are concerned, rates of 20% or higher are the norm.

(By the way, just once I'd like to do a post where I don't mention Mac Bank. How in the name of Crikey do these guys end up in everything that I write?)

Anyway, you can bet that where professional lenders are involved, all sorts of caveats are written into the contract to ensure that the lender has some recourse.

Retail offers simply don't have this kind of bargaining power. These investors were pretty much sitting ducks for the walloping that they got, and I hate to say it, but they really only have themselves to blame.

6. How do we protect investors from this sort of thing happening again?

Well this is an age old question.

Investing, much like supply, demand, democracy, revolution and innovation only works because of two base human emotions - fear and greed.

I would also add laziness to this, but I'll detail why on another day.

Investors who got burnt were basically shovelling everything that they had into these investments. In a nutshell, they got greedy.

Of course, where advisers were involved, this complicates things a little, and the blame shouldn't be sheeted home to investors entirely.

Portfolio theory says that putting large slabs of your cash into the one asset is a very silly thing to do, and history has borne this out. Diversification, while it won't protect people from market nosedives, will protect people from problems with particular parts of a portfolio.

But if you throw everything into one asset that goes belly up, you are in deep trouble.

Tony D'Aloisio, the new chairman of ASIC, says that all products like these coming on to the market should all be professionally rated.

This is possibly a constructive solution, but D'Aloisio knows only too well that investors will bear the cost of such risk ratings.

D'Aloisio's other solution is better, though:

7. Can we educate investors about risk?

I think that risk is so important that I honestly believe it should be taught at school as the fourth 'R'.

I'll do a Financial Tip on risk a little down the track, hell possibly even three, but risk is so important, and it's through misunderstanding of risk that people go on to get burnt in the way that they have.

I believe that we can educate investors about risk, but this should start in secondary school.

Trying to educate mature Australians about risk is shutting the gate after the horse has bolted type stuff. It really is.

Australians' financial literacy is shocking. But risk would be an excellent place to start fixing this discrepancy up. And I for one will support any initiatives that ASIC puts in place to improve this particular piece of general financial knowledge.

It's the most important piece there is.

Edit 13/06/2007: I lay the blame for quite a lot of this squarely at the feet of investors, which oversimplifies things a little bit. In the case of Westpoint investors (and some others), however, quite a lot of them sought financial advice, and the advisers in question recommended the debt in question. I've done a couple of edits to rectify this, but I may explore Westpoint's situation in a future post - it warrants some additional comment space.

Disclosure: This blogger owns shares in Macquarie Bank Limited.

Standard but necessary disclaimer: This is not advice. Only a complete idiot would think that any of this constituted advice. It's not even vaguely reasonable to consider this to be advice. If you are in any doubt as to the content of this, see a good, independent financial adviser immediately. They do exist.