Revealed: The Real Reason Mortgage Funds are Frozen

This morning we were going to congratulate Westpac on their mind-blowingly ingenious move of increasing interest rates by 0.45%, even though the Reserve Bank of Australia (RBA) had only increased rates by 0.25%.

Don’t believe all the spin about ‘higher funding costs.’ There’s much more to it than that. What Westpac has done is the banking equivalent of hitting a six back over the bowler’s head…

Forget that, it’s the equivalent of doing a reverse sweep to hit the ball for six over the wicketkeepers head.

We don’t normally praise the banks for being smart, but if we see someone from Westpac today we’ll be sure to give them a high-five.

But don’t worry we haven’t gone soft on the banks. We’re just impressed Westpac is taking advantage of the most rigged market there is – interest rates. And the fact they’re playing the RBA for the fools they are makes it even better.

More on that tomorrow. But for today…

I thought it was worth carrying on from yesterday’s Money Morning. You know how much your editor likes to ‘carry on.’

Anyway, as a refresher we wrote how it was possible for managers of mortgage funds to get away with not paying out redemption requests to investors.

In our view, failure to pay funds out on demand is the equivalent to a business being insolvent. Any way you look at it, if you can’t pay out on an obligation then you’re insolvent.

Arguing that the invested assets are illiquid is no excuse.

A business that can’t pay a bill could hardly placate creditors by claiming they’re not insolvent because a piece of machinery is worth $1 million. Or they’re not insolvent because a forklift is worth $100,000.

If you can’t pay your debts when due then you’re the ‘I’ word.

It’s as simple as that.

But there was something else that struck us about this pathetic affair. It’s that these mortgage funds are closed to new investors.

Now, in one way that’s fair enough. Just as a creditor doesn’t want an insolvent company to incur more debts, investors in mortgage funds wouldn’t want new investors increasing the obligations of the fund. Especially when they can’t cope with their existing obligations.

But why wouldn’t the fund want to attract new investors? Surely if the fund has liquidity issues then getting new investors to pour money in will allow the fund to pay investors that want to get out.

Of course, you could argue that’s a Ponzi scheme, paying out old investors with new investors money.

But it would only be a Ponzi scheme if the old investors were paying out the par value. And if they weren’t aware of the risk.

It wouldn’t be a Ponzi scheme if the fund was priced according to the market value. For example, the market value in the case of mortgage funds would be significantly lower today than they were two years ago.

After all, a new investor wouldn’t want to pay $1 today when the price was $1 two years ago. The new investor would only want to pay 80 cents or maybe even a bit less.

And funnily enough there’s a precedent for this kind of pricing scheme. It’s called a “stock market.” It’s something you’re probably familiar with, but it would seem the mortgage funds aren’t.

And that’s where it all becomes clear.

It all becomes crystal clear why the mortgage funds don’t want new funds invested and why they are happy to let the old timers who have invested their retirement cash in their fund wait forever.

So, we’ll ask the question again, why would a mortgage fund not accept new investors?

The answer is simple. And it’s got nothing to do with regulations or laws or protecting investors. It’s all to do with protecting themselves and their industry.

If these mortgage funds continued to accept new investors the fund would need to adjust the unit prices lower in order to take account of the higher risk of investing in the fund.

New investors would expect a discount. Just like share investors expect a discount when shares of a company appear to be a higher risk. As editor of a small cap newsletter I’m pretty familiar with stock prices being discounted for risk!

But of course, revaluing the units lower would be like kicking themselves in the teeth. And that’s never an attractive proposition.

A lower valuation of the fund would have at least two knock on effects.

First, it could jeopardize their borrowing arrangements. You see, what normally happens with redemptions is that if a fund is short of cash it will borrow funds from a bank as a short term cover until it can dispose of an asset.

Obviously the banks don’t do that for love. They charge interest and would also have certain capital requirements of the fund. For example that in order for the bank to lend say $1 million, the value of the fund must be, say $50 million. Or something like that.

But if the fund has to borrow a whole lot of cash from the banks to pay out redemptions, revaluing the fund value lower will create some nasty problems for the fund.

One could be that the bank will charge a higher interest rate on the borrowed money, or worse, that it will demand repayment of the debt.

Which would be a bit tough considering it doesn’t have the cash to begin with.

The second knock on effect for the fund is the matter of who else invests in the mortgage funds. We’re not just talking about old pensioners who have invested directly in these things. Who else do you think would invest in them?

Other funds perhaps? Other funds that are managed by the same funds management group maybe?

You’ve got it. If AXA, AMP or Perpetual revalue the mortgage funds lower, then their other funds will have to revalue their holdings in those funds lower too.

And if the mortgage fund has to discount the unit price by 20% to attract new investors, that new price isn’t going to do much good for the returns of the funds that have invested in it.

You can bet your bottom dollar that the other fund managers wouldn’t buy you too many drinks down the pub on Friday lunchtime if you did that.

In that instance, as a fund manager you’ve got a choice. Do you think about your smaller investors and their need to recover their money?

Or do you think about the fund manager who’s invested in your fund – and who’s probably part of the same firm – and make sure you keep the price of the fund artificially high so the other fund’s returns aren’t affected?

Quite frankly it’s a no-brainer. And the fact that $15 billion of mortgage funds is still frozen one year later confirms where the priorities of the fund managers lay.

Cheers.
Kris.

60-Second Market Round Up
by Shae Smith

The S&P/ASX200 closed up yesterday to 4,762.40, a gain of 43 points. The miners performed well yesterday, with Lihir Gold [ASX: LGL] ending at $3.73 up 4.19%, and Newcrest Mining [ASX: NCM] higher by 4.97%, closing to $39.26.

The Dow Jones Industrial Average was down overnight by 10,452.68 or 18 points. The Fed has said the American economy has grown ‘modestly‘ over the October to mid-November period.

In the UK overnight, the FTSE finished up by 15 points to 5,327.39. Traders and investors sat back today, and are waiting for Friday’s US jobs report to come out.

The Nikkei was up 0.38% to 9,608.94

The price of gold has once again reached another new high. Overnight, gold reached $1,217.10, and has continued to remain above $1,200 this morning.

The price of spot gold in Australian dollars is trading at $1,313.58, while in US Dollars it is trading at $1,214.93. The price of silver in Aussie dollars is $20.78 and in US Dollars it is $19.22.

The Aussie dollar versus the US dollar is trading at USD$0.9249, and against the Japanese Yen JPY80.82

Crude oil closed at USD$76.46

For the biggest movers on the market yesterday click here…

That’s all the market news I have for you today. I’ll be back tomorrow, and hopefully the papers will have found something else to write about instead of Tiger Woods’ transgressions.