The sub-prime contagion has now reached as far from the USA, geographically, as it possibly can: Australia. In July Basis Capital, arguably the best-known home-grown hedge fund manager in the southern hemisphere, ran into serious trouble after defaulting on margin calls to several of its creditors. At the time of writing its survival was in the balance.
Sub-prime problems were never supposed to spread this far south. Australia has a sub-prime market – locally it’s called non-conforming housing loans – but it is tiny compared with the US industry. The Reserve Bank of Australia, the country’s central bank, spelled this out in the most recent edition of its twice-yearly Financial Stability Review, in March. Non-conforming housing loans, it said, "account for an estimated 1% of all outstanding mortgages, well below the 15% sub-prime share in the United States". The 90-day arrears rate on securitized non-conforming loans has increased over the years, to 5.25%, but that’s barely problematic.
Australia has been hit not because of its domestic real estate market but through the handful of domestic fund managers that venture into the US market. Of these, Basis has long been something of a poster child.
Formed in 1999 by Steve Howell and Stuart Fowler, Basis was built to undertake both fund management and securitization. It launched two funds, both of them with multi-asset-class styles and a focus on looking for inefficiencies and arbitrage, particularly in the debt markets. The second of them, known to international investors as the Basis Yield Alpha Fund, has had a strong focus on structured debt and in particular CDOs, including distressed assets.
Basis was remarkable for seemingly being able to generate consistently high returns with very low risk. Its earliest fund, the Basis Pac-Rim Opportunity Fund, has consistently delivered double the performance of its most appropriate index, the CSFB/Tremont Multi Strategy Index, despite having similar or sometimes lower volatility. Consequently, Australia’s battery of research houses embraced the manager and its funds: as recently as a month ago it had the highest possible ratings from six different research groups, among them Standard & Poor’s (which had shortlisted it for an award this year). It won accolades at home and abroad and attracted about $1 billion under management. Correspondingly, and now unfortunately, it became the first manager to attract retail investors towards the complex asset class of structured debt.
Many research analysts admired Basis for its risk management skills, and that appeared to have been vindicated when sub-prime problems kicked off earlier this year. In February, the Yield Fund made a 1.14% loss – the first monthly decline in its 38-month history – and then made it back again the next month. Basis had been exposed to the 2006 sub-prime mortgage collateral, which was in deep trouble, but it only had a small part of its portfolios there. It had hedged, and had also diversified into mainstream European and US securities that were doing much better.
Yet in June, Basis disclosed a 13.93% decline in the Yield Fund for June and halted redemptions. And then things got much worse. Basis had gone to a range of creditor banks to supply leverage for the fund. Those banks reassessed the value of Basis’s holdings, prompting them to make margin calls, at least some of which were missed; several creditors declared default and some, believed to include Citi and JPMorgan, have been trying to sell off the fund’s assets.
Basis’s only public comment on this has been a disclosure to unitholders lamenting the fact that since there is no liquid market for selling these securities, the creditors are likely selling them well below book value, and bemoaning the fact that the fund manager "cannot control the exercise by financiers of their enforcement rights". At the time of writing it seemed that the best case would be a halving of the value of the Yield Fund and a serious dent in the sister fund (which has a holding in it); the worst case, if asset values continue to decline and banks continue to bail out, would be the collapse of the fund.
That would be a blow for Australia’s emerging hedge fund industry. Hedge fund managers in Australia control $34 billion directly, small by global standards but increasing rapidly, and have trebled assets in two years, according to Invest Australia, a state-owned agency. It has taken them this long to earn a hint of trust from Australian investors well aware of the bad press hedge funds have been subject to elsewhere in the world.
It is thought that few local managers have major exposure to US sub-prime, since most of them focus on equity-related strategies. The domestic banking sector is unlikely to be hit either, with most of Basis’s creditors being international (others include Lehman Brothers, Morgan Stanley and Merrill Lynch).
But investors – including a hospital foundation invested in the fund – are going to be scarred by the experience. Accountancy firm Grant Thornton has been appointed to clear up the mess. But even if a rescue succeeds, the darlings of Australian alternative investment will have a mountain to climb to regain the country’s trust.