Dikkii's financial tips #6: Risk and inflation

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

It's actually been quite some time since I last posted an update in this series, and since then, I've rejigged the order of my planned modules just a little.

So before I get too far into this series, I thought I'd touch on the single most important concept for any investor.

Risk.

Risk is such a fundamentally important subject, I reckon that it should be added as the fourth R in primary and secondary education. It is that important.

And sadly, a lot of the time, investors just don't get the whole risk thing until it's too late.

We're hearing a lot about risk at the moment.

Take the current credit crunch in the States, for instance. Risk existed there before the crunch just as much as it does now, even if a lot of professional investors failed to properly account for it. The whole concept of sub-prime lending revolved around lending money out to a demographic that was horribly risky in the extreme. So when it all went pear-shaped, there was suddenly a wailing and a gnashing of teeth that told the world that a whole bunch of financial journalists really dropped the ball on this one.

Prior to that, in Australia, we had issues with mezzanine financing when four medium to largish property developers went belly up leaving a whole heap of investors out of pocket.

And, although gaol is certainly beckoning for at least one of the miscreants who ran the show at one of the property developers in question, we don't appear to have learnt our lesson.

So let's have a look at risk, as it relates to investing. Back in the day, risk was really only discussed with my clients while they did their own self assessment as to where they thought they placed themselves on a basic risk profile.

This was a process, I felt, that was open to all sorts of biases and error. I'll go into this some more in a later post when I get round to looking at risk profiling.

Risk is a huge area. I'm sure that it's possible that you could get a subject stream out of it at university, but I'm really going to discuss one risk area in this post.

Specifically Investment Risk. And only the major ones that cover personal investment.

Investment risk really covers a broad area in itself, so I don't see how I'm going to give it justice here, properly, but today, we'll look at some risks that you really ought to be aware of before you go ahead with any type of personal investment plan.

Let's get started.

1. Market Risk.

Market risk is, ironically, the most understood of all investment risks by mug investors. In a nutshell, market risk is the risk that your investment value will suffer due to adverse market movements.

An example of being adversely affected by this risk might be this - you might have bought 100 shares in XYZ Company for $10 each, making a total investment of $1,000. If the share price drops to $9 per share, then you have, on paper at least, suffered a loss of about $100.

I know that many people who will steer clear of the stockmarket for this reason - yet strangely, they don't appear to see it as an issue in the property market. Odd, but I put this down to heightened transparency and liquidity in the stockmarket. If properties were traded on an open and transparent exchange, I think it would be a different story.

Market risk is managed through diversification. One ideally wouldn't just own shares (directly or beneficially) in XYZ, they'd own shares in plenty of companies.

This, of course, does not mean that you're immune to overall market movements. We can manage this a little better by diversifying between markets. This is the reason why people often have property and fixed interest portfolios in addition to shares. And cash - which is not subject to market risk.

Also, market volatility tends to smooth itself out over the longer term. So examine your investment time horizon, and ensure that your portfolio is not inappropriate.

2. Credit Risk.

Credit risk is fairly straightforward in theory. Basically, it's the risk that if you lend money to someone, they're either not going to meet their interest payments, or possibly not pay back some or all of your initial principle.

In practice, it's a veritable nightmare. Credit ratings for some institutions can change overnight, and when someone goes belly up and is unable to pay their investors, you just want to be sure that you aren't going to lose your life savings.

Credit risk affects cash and fixed interest investments, but not property, shares or much else for that matter. But this doesn't make it any less of a concern.

Again, credit risk is best managed by diversification, both by having a diversified portfolio of cash and fixed interest investments, and diversifying into different asset classes such as shares and property.

Credit ratings are certainly useful, but at the end of the day, 20 AAA-rated fixed interest securities are better than one. This is a false dichotomy, (though still a valid statement) but I'm sure that you understand why I'm not mentioning any other possible scenarios, of which there are many.

3. Currency Risk

I just love this one. Where you have an investment in a currency denominated in anything other than the one that you're used to, currency risk is the risk that the exchange rate changes and your investment reduces in value as a result.

Here's a good example. The Australian dollar has appreciated markedly against the US dollar over the past three or four years. Consequently, anyone in Australia who invested in a US dollar denominated asset at the start of that period might be looking at paper losses, if they convert the current value of those assets back to Pacific pesos. Assuming, of course, no (or a small amount of) capital growth in the US dollar value of the asset itself.

There are actually quite a number of ways that investors can use to guard against currency risk. Diversifying your asset base (I know I sound like a broken record here, but chant this one like a mantra, kids) is one. If you have international assets in your portfolio, don't just have ones from one country. Have many from many countries.

It would be rare for investors to have only international assets dominated in currencies other than their own. Most of an investor's portfolio will be denominated in their own currency. This is further diversification.

Lastly, where foreign exposure exists, do be aware that currency hedging exists. This can be offered relatively cheaply - quite a lot of international equity funds have a hedged version and an unhedged one. The hedged version will normally be slightly more expensive, fee-wise, but for additional diversification, you could very easily have some of your international exposure in a hedged portfolio and the rest in an unhedged one.

Note that when people talk about "hedge funds", it doesn't normally relate just to currency hedging, or international equity funds that use currency hedging.

4. Liquidity Risk

Liquidity risk is another that has reared it's ugly head throughout the sub-prime lending and mezzanine finance crises.

Basically, this is the risk you take that you will not be able to cash in your investment quickly either at the end of your investment horizon, or at any other time for that matter. Such as emergencies.

Liquidity risk pops up in a lot of places. Thinly traded shares in small listed companies are heavily subject to it - when you want to sell, will there be a buyer? Term deposits - you can't normally access these until maturity. Superannuation is another - it's no good if you're trying to get access before retirement. Residential property can have settlement periods of up to 180 days.

The best way to manage liquidity risk is to explore each of your assets in turn and know how liquidity risk might affect them. And then come up with strategies to avoid the risk itself taking into account your own personal circumstances.

For example, you could possibly choose to buy shares in blue chip companies that are heavily traded and minimise your exposure to smaller capitalised companies. Use term deposits for money that you know that you definitely will not need until maturity. Use superannuation for money that you know you definitely will not need until retirement. Selling a residential property? Try to negotiate a shorter settlement period if you need the cash, and so on.

The rule of thumb is to know the asset, and how it fits in with your overall plans for the money invested.

And did I say diversify? This helps, too.

5. Inflation

Well, inflation is a right bastard of a thing.

The risk here is a simple one, but overly conservative investors don't understand it very well at all, based on my experience.

Its best explained like this: Imagine that you buy $100 worth of groceries today. If we assume a rate of inflation of 3% per annum, this means that those same groceries will cost $103 this time next year, and about $106 in two years time.

Thus, if we invest in a bank account paying 4% during that period, the return on your funds as measured by the buying power of that money is going to be greatly reduced by that rate of inflation in the meantime. Add in the impact of taxation, and you stand to go backwards, not in dollar terms, but in purchasing power terms.

Again, diversification is the key here. Historically, cash and fixed interest investments have been heavily subject to inflation so it pays over the medium to long term to diversify into investments that have the potential to provide capital growth, such as shares and property.

In the short term, you may have no choice but to accept "losses" caused by inflation. Growth assets are generally considered hot potatoes in the short term.

6. Opportunity Cost

Let's say you invest in shareholding A over a period and that asset returns 6% consistently over that period.

But at the end of that period, you find out that you could have invested in shareholding B instead, which returned 7%. It may be ludicrous to suggest that you could have known about this at the start of that period, so let's just use a statement uttered by sensible investors everywhere whenever they hear about this:

"No one is psychic."

Needless to say, there is no way that you can control for what is, essentially, speculation in hindsight.

Accept your opportunity costs with good grace, and wish investors in shareholding B good luck. You didn't "win" today.

7. Interest Rate Risk

Interest rate risk is simply what might happen due to a rise in interest rates.

Fixed interest is really susceptible to this. Imagine that you have a portfolio of bonds. If interest rates were to rise unexpectedly, this has the disadvantage of making bond yields go up, which really means that your bond portfolio has just decreased in value, all other things remaining constant. In this context, this is another type of market risk.

Indirectly, this can also affect shares and property - companies will find it harder to remain profitable if the cost of their borrowings increases. Property becomes less attractive to buyers if their interest bill is higher.

Conversely, cash becomes more attractive - if interest rates increase, the income from cash investments will normally increase. Likewise also, international assets should increase in value in domestic pricing - all other things remaining constant, a currency's exchange rate with the rest of the world should go up if the central bank of that currency raises interest rates.

Diversification ensures that some of the risk that interest rates might increase is absorbed and also turned to an advantage in spots. Of course, knowing your assets helps as well.

And if you're invested via a gearing strategy? Well, I think you can work out what's going to happen in this scenario.

8. Reinvestment Risk

Reinvestment risk is the risk that your investment might come to an end sooner than you expect.

A good example is if you provide a mortgage to someone to invest in a property, and they pay it back sooner than what you expected. You then have to go ahead and reinvest the money again elsewhere.

Sometimes this can happen with other assets - a company you hold shares in might, for example, be subject to a takeover bid for cash, and you then end up receiving cash for your shares if the takeover is successful.

This can cause problems from a tax perspective.

Diversifying your portfolio will minimise the impact of such events when they occur.

9. Manager Risk

Your investment is subject to decisions made by the manager responsible for your investment's performance.

A good example of this might be where a managed fund (or mutual fund, if you're reading this from North America) that you invest in might suddenly terminate due to a decision by the manager of that investment. You might then find that they've redeemed your investment and you then have to do something with the proceeds of that redemption. This particular example is also a good example of reinvestment risk.

Another one is where the manager changes the methodology by which a particular fund invests. This happens occasionally, and can make it somewhat annoying when you have invested in a particular managed fund for a particular reason - say, for example, the managers's particular investment methodology.

This makes diversification imperative - if your reasons for investing in a particular asset evaporate overnight, or you end up receiving the proceeds of a forced redemption, this can play havoc with your own personal tax planning, particularly if you're relatively highly exposed to that particular asset.

Different fund managers of different management styles is usually considered prudent and is an excellent example of further diversification.

10. Fee Risk

Financial advisers who work on a commission basis will never discuss this risk.

Fee risk is basically the risk that any fees that you incur will reduce returns, and may even reduce the capital invested.

It's best to manage this risk through crunching some numbers yourself to see how exposed a position you find yourself in. I normally suggest taking your amount invested and working out a years worth of fees based on that figure. And then shopping around.

You would be surprised at the figures that you may end up obtaining.

The good news is that your fees might actually be reduced by a market downturn. Of course, we're talking in dollar terms. In percentage terms, they may actually increase as a result.

In addition, fees serve to exacerbate negative returns. Know your fees and how to minimise them.

11. Personal Events Risk and Property Risk

No discussion of risk would be complete without discussion of this. These are the risks that something might happen to you, or your personal property.

This might not directly impact your investing, but can certainly indirectly impact, particularly if you find yourself having to draw on your investments to fund an unexpected personal event.

Always ensure that you have adequate insurance in place covering personal property such as home and contents cover and comprehensive vehicle insurance.

Legal liability insurance is always good - in today's litigious society, you may need it when you least expect it.

Likewise you can't put a figure on the usefulness of private health and term life insurance. Mortgage protection and credit card cover is useful, but not as cost effective nor does it cover for as much.

Travel insurance is something that you should never leave home without.

Lastly, ensure that you have a valid Will and Enduring Power of Attorney in place, or at least accessible if anything happens to you. An Enduring Power of Attorney (Medical Treatment) or its equivalent is also a good idea.

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This list is by no means exhaustive, so don't rely on it being a be all and end all. For more information regarding the risk that you're facing specifically, your adviser should be able to tell you more details.

Just remember, that if you know your risk and how you're managing it, then the return side of things - the sexy bit - should be easier to manage.

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Dikkii's financial tips index

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 sub-prime mortgage meltdown

As Michael Bains might say - "Silly humans!"

Sub-prime mortgages were something on my radar, until one of my Facebook buddies (and former primary schoolmate) posted this on my FunWall.

I hate FunWall, but I love this. This says all you need to know about the whole stupid mess - and how financial engineers can sell anything.

And it's hilarious, too.

Personally, I think that there should be arrests to come out of this, but we won't see any. Enjoy.

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.

Total carnage

July and August 2007 is proving to be one serious downer for investors, and this blogger, if he didn't exactly tip it, certainly knew that fall-out was imminent.

So far, in Australia, as we speak, markets are down about 12%, and it looks like it's going to continue for some time. The story is similar around the world.

So what's causing it this time?

When the markets had their last major quiver, back in March, this blogger tipped that it would pass and that things would soon be back to normal again, soon.

The reason for the volatility in March was a slide in the Shanghai Stock Exchange, and, as tipped by this blogger, there was absolutely no reason why this should have been seen to have had the major impact on markets that it did.

This time around, I'm tipping that markets around the world will have more lasting problems, and the impact from these will be a little more heavily felt.

Allow me to demonstrate.

The first thing that should be realised, is that this little bit of mayhem is being caused by problems in the US housing sector created by too much money being lent to people who shouldn't have been allowed to borrow in the first place. In delightful understatement, these are called, 'sub-prime' mortgages.

Lenders in the US were bundling up their loan books and then on-selling them on to the market in securitised packages. This had the double impact of raising further money for lenders to continue their risky activities, and re-locating the credit risk on the money lent to the new owners of the loans in question. The most common arrangement was called a collateralised debt obligation, or CDO.

This is not a new practice. Lenders have been doing this for some time. And not just lenders of 'sub-prime' mortgages.

A lender in Australia, RAMS, recently floated on the Australian Stock Exchange (ASX). RAMS floated at a share price of about AUD $2.50 back in July. RAMS' share price is now around AUD 89c and there is nothing that their management can do about it.

RAMS is not really exposed to 'sub-prime' activity (which is called 'non-conforming' in Australia). However, RAMS needs to be able to on-sell it's current mortgage book, otherwise, it will not be able to continue to lend money out to people.

And if no one is willing to buy RAMS' current crop of mortgages from them, then RAMS is going to have to discount the whole package until they can find a buyer. Hence the fall in RAMS' share price.

RAMS will have trouble selling the current lot of mortgages because the institutions that buy this kind of security from them are now reconsidering if this sort of security is worth the risk. And that is regardless of the quality of RAMS mortgage book - mortgages of any type, hell, fixed interest of any type is now being re-assessed across the board and investors are now expecting higher returns for the risk that they're taking on.

Anyway, RAMS investors really have to ask themselves could they have foreseen this? I don't believe that they could.

But this whole meltdown doesn't just end with the lenders, folks.

The debt securities sold by the lenders have been traditionally bought by fund managers for their mortgage and fixed interest portfolios. Normally, these are considered defensive assets - all other things remaining equal, mortgage and fixed interest funds are recommended as short to medium term investments within a portfolio, and form the defensive part of most Australians' superannuation funds.

But investment in CDOs is crystallising risks far riskier than what would normally be considered prudent.

So mortgage funds and fixed interest funds are going to take a hit. This is bearable. At least I would have thought.

But it turns out that quite a lot of buyers of these investments are a different type of fund manager again.

Hello, hedge funds. Fancy seeing you here?

Hedge funds, in their never-ending quest to satisfy investors seeking lower risks and greater returns for their investment whilst at the same time kicking a shitload of fees in the direction of fund managers have had their snouts in the trough for some time.

This was apparently a no-brainer for your average inscrutable hedge fund manager. Borrow at standard rates and invest in a fixed interest security paying well more than your standard mortgage or fixed interest rate of return. And then do it again. And again.

The end result of this was that some hedge funds, in their search for endless returns were geared several times over mainly as a result of idiotic risk assessments that had these sub-prime mortgages being seen as relatively low-risk, when the reality is substantially different.

So much money was whizzing round the economy and inflating asset prices that when the housing price crunch set in in the US last year, there was going to be problems. Bear Stearns was the first company to feel the heat and have advised that the investors in two of their hedge funds are unlikely to get anything back.

In Australia, we heard problems initially from Basis Capital, a fund manager whose products were actually rated AAA from Standard and Poors. Not long after this, Macquarie Bank have advised that some of their hedge funds are suspending new investment and redemptions, because they are having a hard time valuing their portfolios.

So what for the broader market?

Well a lot of the sell-off that we are seeing has to be driven by hedge fund activity. Hedge funds own other assets and it makes sense that they simply have to liquidate large sections of their portfolios just in order to ensure that their offerings are sufficiently liquid when the investors come a calling.

On top of that, because hedge funds are so opaque in their operation, investors in the broader market simply don't know the level of exposure of other businesses.

One municipal council in Sydney is facing losses of up to AUD 60c in the dollar due to some unwise investment in CDOs directly.

And all this is contributing to an environment where borrowing is going to be so much harder in the months ahead - which stymies investment by you, me and businesses. About the only people who should be rubbing their hands together with glee are going to be the banks - their main lending operations come from quality mortgages, and they don't relay on sourcing cheap funds by way of securitisation to do it.

This is going to be nasty, folks. For me, what makes matters worse is that all my money is currently invested and I don't have any more to plough into what appears to be a corrected market. And for most Australians, superannuation returns will be the worst this year that they have been in quite some time - probably about 7 years.

On the plus side, it does appear that that Australian stock market has fixed up the serious over-valuation that has been identified for some time by financial journalists. It means that some rationality has returned to the table.

But things may actually get worse before they get better. This is not like March, folks.

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.

Great debacles of our time: The great mezzanine financing collapse (part 3)

This is part 3

Part 1 is here.

Part 2 is here.

It is with great displeasure that I announce that Bridgecorp has gone under.

This, sadly, means that a fourth major mezzanine financier has gone to the wall, and appears to have taken with it about AUD $25 million of investors' money.

I don't really want to add much more to this. It's a sad tale, and I don't know much about Bridgecorp's circumstances. Suffice to say, there can't be much more carnage on this front.

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.

Dikkii's financial tips #5: How the hell do cheques work?

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

Anyway, I have to return to banking just one teensy weensy last time, because I did promise regular commenter Plonka a round up of cheques.

Cheques, as I responded at the time, are amazingly complex instruments. The law as it relates to cheques is remarkably finicky, and horrible. There are so many different bits to them, that I could not begin to explain - but I'll have a go. It's worth knowing.

Back in the day, they were explained to me as a three way agreement between the person signing the cheque, the person that they're giving the cheque to and the bank that the cheque is drawn on.

I prefer to think of it as an IOU.

In any event, what normally happens is this. You write out a cheque, you hand it over, and money flows from your account to the other person's.

Let's look at all the bits - and there are many.

The drawer

(Pronounced: draw-rer)

Not someone's undies, this is the name of the account from which the cheque is drawn. It's usually indicated on the cheque somewhere between the amount in words bit and the space for the signature. Usually looks like "JM BLOGGS", "MP AND LF CITIZEN", "MEGA CORPORATION LTD" or even "J AND P DOE TA SMALL BUSINESS ITF THE DOE FAMILY TRUST".

Note the shorthand - I always thought this looked unprofessional, but it appears to be commonly accepted that AND indicates a joint account or partnership, TA indicates a registered business name ("Trading As") and ITF stands for "In Trust For".

The drawee bank

(Pronounced: draw-ree)

This will be normally shown up on the top left hand corner of a cheque. Underneath that will be the drawee branch. This is the bank and branch of the drawer's account.

The payee

This is the person, persons, company or other entity to whom the cheque should be paid. It will normally have the word "pay" at the start of the line and the words "or bearer" or "or order" at the end. Sometimes it will be made out to cash, in which case, the words "please pay cash," or just plain "cash" will be written.

"Or bearer"

This means that the cheque can be accepted by anyone holding it. Under current conversion laws a bank would be pretty stupid to rely on these words, however a bit of lenience is normally given (within reason). Normally a bank will not allow third party bearers to deposit a cheque made out to someone else - it's just too risky for the bank.

I am reliably informed the stolen third party cheque lawsuit involving a certain "Mr Cash" is an urban myth.

"Or order"

The opposite of "or bearer". This means that the cheque must go into an account name that matches that whom the cheque is made out to. Crossing out the words, "or bearer" means the same thing as "or order".

For example - a cheque is made out to "Tom and Sue Jones or order" - this must go into a joint account set up in the name of Tom and Sue Jones. No exceptions.

Usually, an "or order" cheque needs to be endorsed (signed on the back) by the payee, but the bank is normally deemed to be acting in good faith if it follows the rules in the above paragraphs.

Amount in words vs amount in figures

These need to match up. If one is different to the other, the lesser figure only may be accepted. This is always fun with Generation Y who, according to stereotypical "research", are illiterate, innumerate and belligerent.

Signature

The cheque must be signed in accordance with the operation method of the drawer's bank account. If the account requires two signatures, then the cheque must have two signatures.

I used to get a good laugh when young kids would come into the bank with one of their parent's cheques made out to cash, and only one dodgy signature where two were required. Cheeky little rascals!

The crossing

This is normally two parallel lines drawn vertically or diagonally across the cheque. Occasionally you'll see the words "not negotiable" as well. They mean the same thing - the cheque must go into a bank account and cannot be cashed.

Sometimes you might see the words "account payee only" written - this has the same effect, plus it also does the job of the words"or order" - the cheque must go into a bank account in the name of the payee specifically and it cannot be cashed.

Crossings may be pre-printed on a cheque which can cause great confusion - attempting to cash a cheque made out to "cash" with a crossing is nigh on impossible.

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So what happens when a cheque is deposited, and why does it take so long?

Let's follow one along the trail.

1. Day one.

A cheque is deposited into a bank account. Normally, a cheque debit is processed off-site, usually overnight. The only thing that may (but not always) happen immediately is that an amount is credited to your bank account. If this deposit credit is processed off-site with the cheque, it will also be processed overnight.

Any amounts credited to the payee's bank account during the day on day 1 will be subject to clearance - that is, they will actually be in their bank account that day, however, a hold is placed on those funds so that you can't touch them. Normally for three working days.

And even though some bank branches are open on weekends, now, this does not include those days.

2. Day two

Transactions processed off-site go through some batch reconciliation process which means that you won't notice the deposit in your bank account until the next day.

What will also be noticed the next day, is that the drawer's bank account will also have been debited.

But if you check both accounts, you'll see that they're showing transaction dates of day 1.

So why does clearance still apply?

Well, imagine that the drawer has overdrawn his account. Debits have to fund a credit, and the credit (the deposit) must be processed. Therefore, so too does the debit (the cheque).

The overdrawing will show up on a report which the drawee branch manager gets the next day (day 2) first thing. The manager has two options - allow the overdrawing, or dishonour the cheque.

If the manager dishonours the cheque, she will create a credit dishonouring the cheque and crediting the funds back to the drawer's account. The debit that funds this credit must be made to the payee's bank account. Both sides of this transaction will be processed off-site and will go through the same overnight batch reconciliation process I alluded to above.

Needless to say, the dishonour will not show up in the depositor's account until day 3.

3. Day three

Both sides of the dishonour will have the same date as day 2, but they normally will process overnight.

This means that when the payee checks their account that morning (day 3), the funds that were subject to clearance will have gone from their account.

If the cheque is not dishonoured, the funds will still be subject to clearance that day, though, because it won't be until this time that the cheque will have had a chance to physically make it back to the drawee bank for perusal.

Not all cheques get looked at by the drawee bank, but some do. Any irregularities such as funny signatures, third party cheques etc will have one more window for dishonour. This will happen overnight. So will the lifting of the hold on any uncleared funds that haven't been dishonoured.

4. Day four

Normally, this will be when the payee is finally able to access their funds, assuming that the cheque has been honoured.

With Credit Unions and Building Societies, a couple of extra days may be allowed. Their paper trail is somewhat more convoluted than banks.

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So, if you've read this far, you're probably about to ask, "What about pay cheques? My bank let's me draw against them straight away."

Firstly, banks are under no obligation to do this - this may be done as a favour. Nothing more. No magical solution gets around the paper trail that must be followed above.

Secondly, history shows that employers who aren't organised enough to do their payroll properly are most likely to be ones who dishonour cheques. Resign immediately and get a job with a more organised employer.

Thirdly, fraudsters are all over badgering bank staff to let them draw against uncleared cheques by calling them "pay cheques".

And finally, if your liquidity situation is such that you need to access those funds immediately, then you have a different set of problems.

But what about bank cheques? Aren't they as good as cash?

In a nutshell, no. Bank cheques can be forged or stolen. Thus they're subject to the same rules as every other cheque.

Try to get anyone paying you money to credit your account directly. It's far less messy than cheques. Cheques are, as I mentioned before, a form of IOU, and as with all IOUs, it's the payee who bears the risk.

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Dikkii's financial tips index

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.

Great debacles of our time: The great mezzanine financing collapse (part 1)

I haven't really blogged much about this, but the dominoes are really starting to roll within mezzanine finance in Australia. After Westpoint went down, we've now seen Fincorp and Australian Capital Reserve (ACR) hit the deck as well.

The fact that this is even major news speaks volumes about 2 things:

1. Where financial advisers stand to gain significant commissions from the sale of such products, can there be any more evidence that commission-based advice is completely wrong?

2. Where such risky products are offered, should this ring alarm bells on the general level of investor financial literacy if investors go into these with all guns blazing?

First of all, what do we mean by mezzanine financing?

Basically, in all these instances, the company that was the end user was building property developments. Sound OK, so far?

In order to undertake this level of development, money needs to be borrowed, usually from banks, to fund purchase and/or construction.

However, this will only go part way. You know how banks will generally lend up to 80% of a property's value? And possibly a bit more if the bank (which the borrower pays for, natch) buys Lender's Mortgage Insurance?

Well, more money will quite often be required for property development.

This is where mezzanine financing comes in.

Mezzanine finance is usually sourced from the issuance of certain financial instruments, usually debentures and unsecured notes. This promises the investor a fixed rate of interest for a fixed term, and at the end, the borrower pays back the principle, together with any interest that is owed.

Debentures are usually secured through a trust deed over the company. Unsecured notes are, as the name would suggest, not secured.

But the security provided for debentures is not normally worth the paper it's written on, unless the security provided are specific assets. If it is only security over the company itself, then debenture-holders will rank behind secured creditors if the borrower is wound up.

In the case of Westpoint, Fincorp and ACR, the "secured creditors" are the banks who have lent to these companies and have first mortgage claims over specific assets. So all is good for them, provided that employees are paid, the taxman gets his cut and the administrators/liquidators get paid, though not necessarily in that order.

Unsecured notes will then normally rank behind debentures. Shareholders will be last, in the unlikely event that there is anything left over after the banks have mopped up.

The main problems, though, with these were in the points raised above. Let's look at them one by one:

1. Financial adviser commissions

I've heard, but I can't pin it down, that in the case of Westpoint, commissions paid to advisers were as high as 10%. This means that for a $10,000 investment, a financial adviser would be collecting a commission of up to $1,000 up front, not allowing for cuts that his dealer group may keep. Not only that, but the commission was paid for by Westpoint themselves, it wasn't recouped from the investor through an "entry fee" arrangement.

Now in all my years of providing advice, it was rare that any product would provide anything up front of more than 4%. And even then, this would normally be recouped via an entry fee, so that the investor essentially paid the fee.

Ostensibly, this means that Westpoint were paying a 10% commission to advisers on top of the interest rate applicable to the notes that they had written. That's some seriously expensive borrowings.

The interest rates were quite high, too. But I'll come to this later.

I can't find any evidence to suggest that Fincorp and ACR were being invested in via financial advisers, so I'll have to assume that his problem was specific to Westpoint.

2. Mezzanine finance and portfolio theory

From what I can tell, advisers appeared to be completely ignorant about the nature of these investments.

Debentures and unsecured notes are medium to long-term instruments that promise a rate of interest paid in regular instalments, together with a return of capital at the end.

This means that they are fixed interest investments, just like bonds and term deposits.

Because the funds were used for what was ostensibly property investments, advisers were not only recommending these to people as part of their fixed interest portfolio, but also as part of their property portfolios.

This is erroneous in the extreme.

Not only that, but it appears that advisers were, in some instances, recommending that investors stick all this part of their portfolio into the one instrument.

Portfolio theory tells us that this is a silly thing to do. For most investors - my guess 90-95% - portfolio theory tells us that diversification achieves a greater return for a given level of risk.

Usually, the risk that is managed through diversification is market risk, however there are other risks out there, two of them being credit risk and interest rate risk. Diversification provides an effective way of managing both of these risks, by "not putting all one's eggs in the one basket".

But if you're going to stick an entire segment of your portfolio in the one asset - your diversification is reduced. And because of this, your exposure to something going wrong is greatly increased.

It's fair to suggest, and studies back up this suggestion, that advisers were really only thinking about their commissions when recommending this sort of product.

Again, I can find no evidence to suggest that Fincorp and ACR's ones were being sold through financial advisers, so this problem appears to be Westpoint-specific.

However, my point about diversification applies to all investors who used this sort of product still stands, and I'll discuss this some more in due course.

3. Financial literacy and retirees

In the case of ACR, I remember seeing advertisements on TV last year where interest rates of up to 9.15% were being offered. I remember at the time breathing a snort of disbelief and thinking to myself, "Surely that can't be sustainable."

And obviously, it wasn't.

However, as I've mentioned before at various spots throughout my blog, the general level of financial literacy throughout the Australian public is not particularly good.

The first thing that anyone should learn before they invest a cent is this old maxim:

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

Anyway, the advertising that ACR was doing was calculated to ensnare retirees. I'm told that Fincorp and Westpoint were doing this too, at various times, but retirees are an interesting demographic.

Why?

A. They're usually cashed up. They've retired from the workforce, and they often have a significant chunk of money to play around with, either in the form of superannuation, or equity in their homes.

B. It would appear that retirees are not particularly financially savvy compared to later generations. This blogger would contend that later generations aren't all that better, but I'll leave that post for another day.

C. Retirees generally like investments that pay regular income.

So it would appear to be a no-brainer - when presented by advertisements showing excellent rates, why wouldn't retirees go in for this hell for leather?

In my book, aiming one's advertising at retirees is only slightly better than how the music industry, alcohol and tobacco companies target their advertising at kiddies.

This doesn't make it any less vile.

I'm going to call a halt here - there's plenty more that I'd like to write, but it needs a second part. Stay tuned.

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.

Dikkii's financial tips #4: A case study in banking

Welcome to Dikkii's financial tips.

This is a series where I attempt to provide some sort of guidance to financial matters without breaching the Corporations Act by actually providing advice.

Today, we're going to conclude our discussion on bank fees by giving you some idea of the kind of banking undertaken by one who is hell-bent on reducing their fees.

Namely, me.

I will point out at this juncture that I may not be a good role model for your personal banking needs - I will admit from the outset that I have more accounts than I need. But the idea that I'm trying to convey is this: by looking at the fine print, you can save a heap of money on your personal banking, and make life easier for you.

To put that another way, it is up to you to work out what your personal banking needs require - mine may totally not reflect yours. I am not saying that this is a good strategy - even though it works for me.

I will also limit my discussion to deposit accounts. Where necessary, I may discuss lending accounts, but this will, by and large, be limited to their relevancy.

Also, I will use terminology which I introduced in Dikkii's financial tips #2: Why are there so many different accounts? and Dikkii's financial tips #3: How do I reduce my bank fees? so click here for explanation of account and fee types, respectively.

Lastly, thank goodness that bank fees are all over. There's heaps more interesting stuff in this big, wide, financial world.

So on to the case study.

1. Transaction accounts

I have two of these. One of them, I don't need, but I'll discuss that later.

The main one is with a big four bank.

I choose to have my main transaction account with a big four bank, because I value convenience. This particular big four bank has one of Australia's largest network of ATMs, which I find particularly useful.

Normally, this account is subject to an account keeping fee of $5 per month, and allows unlimited EFTPOS, ATM, phone, internet and over the counter withdrawals. If you use another bank's ATMs, there is a fee of $1.50 per use.

I pay no account keeping fee for the use of this account, because I own enough shares in the bank to give me an exemption.

This account is a joint account which I share with my wife. While she is good about using just the ATMs that the bank provides, I'm not so disciplined. We usually pay about $3 per month in other bank ATM fees, and this is totally avoidable. Mea culpa, I'm afraid.

Our account has never been overdrawn, ever. This is because, we always leave a small amount, about $20 in our account at the end of each week.

Our transaction account will usually only have enough cash in it for our weekly cash requirements. Plus the aforementioned margin of $20 which is purely there for any fees at the end of the month.

My other transaction account has a balance of about $2 in it, and hasn't been used in over two years. It is with a credit union, and only exists because I have an unsecured (and reuseable) line of credit with the credit union that I also haven't used in two years.

I keep the unsecured line of credit for emergencies, but the last time I used it was to transfer $1 into the credit union transaction account, which I promptly transferred back into the line of credit again. Just to keep it available.

No account keeping fee is charged on my credit union accounts, and no transaction fees are charged, unless I have cash access. I only have phone and internet access, so I'm charged nothing.

Total fees on transaction accounts = $3 per month, if that.

2. Cash management accounts

I do have one of these. And it's with another big four bank entirely.

Now I don't actually use this account much at all. I got this account initially because my online stockbroker, which is owned by the big four bank from the previous paragraph will give me a fantastic discount on trades for having one of these, and settling my trades through it.

To make it difficult, the account in question needs to be opened with a minimum of $5,000 and only pays interest on balances above this figure, but I only trade about once every couple of months, if that.

So the day after the account was opened, I transferred the money I opened the account up with straight out and back into the online account it had come from. The account would be lucky to have any more than $2 in it at any one time, and I only use it to settle trades and pay my margin loan repayments (direct debit).

It is account keeping fee exempt, and comes with a maximum of 15 electronic transactions, including direct debits for trades and margin loan repayments. Naturally, I'm unlikely to be breaching this at all, so no fees here.

Total fees on cash management accounts = $0

3. Online accounts

I have two of these - one is a joint account which I share with my wife and is with the same institution that our joint transaction account is with. This is where we keep our (admittedly small) "slush fund". The joint transaction account is the nominated account.

The other is in my name and is with yet another institution again. This account is kept to store the funds required to service my margin loan. The nominated account for this is my cash management account.

Most of my salary is directly credited into our joint online account, with a small portion credited to my personal online account. My personal online account also receives the odd credit from dividends and managed fund distributions.

Money from the joint online account is "drip fed" in weekly instalments into our joint transaction account for weekly cash requirements. This is excellent for budgeting.

On top of that, a small portion is transferred from our online account to our transaction account in monthly instalments for bills such as rent and credit card payments.

Money from my personal online account is mainly fed monthly to my cash management account to service my margin loan repayments.

Like most online accounts, these charge no account keeping fees or transaction fees. They also pay a high rate of interest - while they may not be the greatest interest rates on the market, I have absolutely no intention of chopping and changing online accounts just to chase rates - I don't have enough cash to make this a worthwhile exercise.

It would just be a few basis points of interest anyway.

But I still pool money in them - with the exception of one bank's ludicrously humiliating offer, online accounts usually pay a high rate of interest from $1 balances upwards.

Total fees on online accounts = $0

4. Interest

All this time, I have discussed fees, and haven't really broached the subject of interest.

Given the way bank accounts work at the moment, I choose to have as much of my (and my wife's) money in our online accounts at any one time. This ensures that maximum interest is paid and that we only have funds that we need for cash purposes in our transaction account.

We get paid into our online accounts. There the money stays until we need it. Using this strategy with credit cards means further fee saving and interest maximising opportunities, but I'll leave that until I discuss credit cards more.

You can even have more fun rorting the banks with your home loan, but I'll leave that until another day as well.

All in all, I think I do pretty well - I count a total of about $3 per month in fees, all of which can be avoided if I was a bit more disciplined.

You can probably do it with a little more finesse than what I've done it. You just need to know your account types and know your fees. Knowing your interest rates should be the last step.

Lastly, be creative - banks rely on people doing things the same way. If you do it differently, you can consider yourself in front of the game. It's that easy.

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Dikkii's financial tips index

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.