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.

Why AMP got busted

This is something that I didn’t think that I’d re-visit for a little while, however, the whole situation that blew up last week requires some reflection.

For those who don’t know, AMP Financial Planning was pinged in a big way by ASIC for an large ongoing amount of inappropriate advice being given out.

Basically, what was happening was that advisers were recommending that their clients roll over their superannuation to another fund, which was, more often than not, administered by AMP.

This isn't bad in itself.

But they were doing it enough to warrant a second look by the corporate regulator. And they were giving inadequate reasons for such recommendations whenever they did it. Finally, they weren't discussing what it was going to cost clients to roll over.

Now it’s the worst kept secret in the industry that advisers are under pressure to do exactly that – sell the products provided by the company that you represent.

And why not? It’s bleeding obvious to even the most financially illiterate observer that an AMP-branded adviser, or anyone else for that matter, is going to be told to push the products of the hand that feeds them.

But from the other perspective, how many mug investors know that Godfrey Pembroke, for example, is a member of the National Australia Bank group of companies, which also includes MLC? How many investors know that RetireInvest is part of the global ING group?

This blogger was formerly employed by and represented another financial institution which also just happened to have funds management, life and general insurance and banking operations.

Yes. We were told in no uncertain terms that, although we had various products from various providers on our approved product lists, we were to make sure that our first choice was from the providers in our group of companies.

This, when it was painted in such stark language, caused me to re-think my career in financial services.

Now I left the advice business in 2003 when it became clear to me that working for the same company as the product provider caused all sorts of dodgy situations.

My personal experience went something like these:

Story 1:

Boss-man: (at a meeting of advisers in the area/region/zone/district) We need sales to improve. So we’d like you to “churn”.

Adviser 1: Isn’t that unethical?

Boss-man: Other areas/regions/zones/districts are doing it.

Adviser 2: Surely that doesn’t mean that we should.

Boss-man: Look. All you have to do is find some good reasons to get your clients to do it.

Adviser 3: Could you provide us with some written guidelines that illustrate how we can do this ethically?

Boss-man: No. This is simple, straightforward stuff. You should be able to work out how to do this. Or maybe you think that a job here is not for you?

Note that “churning” is a particularly smelly practice that involves swapping existing clients from one product to another for no reason at all other than to collect another fee on the way through.

Story 2:

Boss-man: (at a sales seminar) I’ve brought in a “BDM” to explain to you why you should consider moving your clients in product X to product Y.

BDM: Thank you, Boss-man. Folks, your clients are currently in the equivalent of a Mitsubishi Magna (large-medium family sedan, for those outside Australia). How good would it be if you could move them to a Rolls-Royce?

Adviser 4: Sticking with your car analogy for a moment, what if what they really need is not a Magna or a Rolls Royce, but a Toyota Corolla?

BDM: Who wants one of those, really?

Adviser 4: Isn’t that between us and our clients?

Note that a BDM (Business Development Manager) is a representative of the product provider who liaises with the advisers similar to how a drug company sales representative might liaise with a doctor.

Doctors don’t get sales commissions, though.

But let’s put that aside and look at the argument.

Financial institutions such as life companies, fund managers and banks all rely on a dealership network of sorts to market their products.

“So what?” they say, “Doesn’t Ford and Toyota rely on a network of dealerships to sell their cars? Don’t Telstra and Vodafone relay on a network of dealers to sell their mobile phones?”

This is a valid argument.

If an investor goes into the office of a financial adviser from AMP or anyone else who also manufactures financial products, he should expect to receive advice that products from AMP are the best for him.

And, in some way, shape or form, he will receive a Statement of Advice to that effect. It will say that the product that the adviser is recommending is most appropriate for him for reasons A, B and/or C.

It’s at this point that the uninitiated usually ask “Hang on. If they’re providing advice, shouldn’t they be considering all products equally?”

Well, they should at least be considering a broad spread of products, yes.

Certainly, that spread should be a lot broader than what would be on your typical Approved Product List (APL) for your adviser from the particular dealership that that adviser works for.

Where a financial institution’s argument about being a dealership for in-house products comes unstuck is in the question asked above. And if you muttered "Conflict of Interest" under your breath, give yourself a point.

Does a car salesman for Toyota consider that they are an “auto-adviser”?

Should a mobile phone salesman at a Vodafone branch be considered an adviser?

The answer is a no-brainer. Product advice of any sort requires products from a variety of providers to be considered. At least, if you would like objective advice to be provided, anyway.

The dealership argument is a sound one. However, it is rendered null and void by the fact that the dealers themselves are simply not advisers – they are salespeople.

A financial institution, at this point, will jump up and down and scream, “How, then, do we get our product out there, for Joe Public to invest in/buy/use?”

The answers to this are pretty easy, actually:

1. Produce stuff that is worth it to consumers to use. Concentrate on old-fashioned values like high returns, low fees, simplicity and ease of use and easy to read documentation. There are companies out there who are doing this now, and who do not rely on a network of financial advisers to sell their product.
2. Cut out the middle man and advertise directly to clients. Clearly, you’re uninterested in providing a service that’s worth anything to anyone if your advice network is merely an expensive rubber stamp. Why would, or should, clients accept bits being sliced off here or there if there is no value being provided?
3. Call your network of advisers, “salespeople”. This is just telling it how it is. Why mislead clients further by creating the expectation that they are getting something objective?
4. Put advisers’ APLs into a client friendly brochure. Why continue to be bashful about the fact that advisers are tied to a particular provider? What is it that you’re really ashamed of?

The fact is that AMP got busted. But it could have been anyone.

AMP are to get an enforceable undertaking from ASIC and this will probably last for the next few years at least.

Bravo to ASIC for targetting the dealerships.

It should, of course, be remembered that the advisers are every bit as complicit as the dealership that they represent. Yes, I know it's hard saying no, but if soldiers can be found guilty at war crimes trials for merely following orders, then advisers should, most certainly, not get off lightly in the least.

But it is clear to even the most disinterested of observers that it was AMPFP's internal policies in the first place which has lead to ASIC's action.

Having an interest in the industry, the very important piece of wishful thinking is that the progressive move away from commissions towards fees-for-service should prevent this sort of thing from happening in the future.

Sadly, I'm not positive that this will be the case. AMP will still require sales. So too will other institutions that produce their own products. And thus there will always be some kind of pressure on advisers to tow the line.

But the four points I've outlined above would, at least, make the whole thing a lot more honest.

Disclosure: This blogger owns shares in National Australia 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.