It might seem odd that Australian retail fixed income funds were among the first to be hard hit by exposure to US sub-prime and ABS CDO risk. It is not as if there is even, to use bond market parlance, the Australian equivalent of the Belgian dentist. As Simon Maidment, managing director and head of fixed income at UBS in Sydney, says, Australia’s investor landscape differs markedly from that in Europe or the US. "Historically, retail investors in Australia haven’t owned bonds," he says. "You don’t have people here buying the equivalent of US treasuries or municipal bonds, or AAA-rated Eurobonds from companies like Nestlé. Investors in Australia have been very focused on equities and real estate."
The result, in recent years, has been a perception that it has hardly been worth bothering to market fixed-income products to investors unless they can offer chunky, equity-style returns. "It is true that numerous products are sold in Australia to investors that would not be buyers of the same products in other markets," says Maidment. "Australia, for example, is one of a handful of countries, including the Netherlands and New Zealand, where CDO equity has been sold directly to retail investors in listed form. By good management or good luck up to recently those CDOs tended to perform very well."
The strength of that track record helped to explain why there was such widespread domestic shock when, in the middle of July, the tidal waves occasioned by the US sub-prime crisis arrived in Australia. It was then that Basis Capital Fund Management, one of Australia’s largest hedge fund managers, announced that the value of its flagship Basis Yield Alpha Fund was plummeting. Blackstone was called in to advise Basis on how to avert a fire sale of its assets, and by the middle of August the Sydney-based manager was warning holders of its Yield Fund that their losses might exceed 80%. At the end of the month the fund was put into liquidation.
Basis was not the only Australian fund to get into trouble. Even funds with no direct sub-prime exposure – such as Macquarie’s Fortress Notes and Fortress Fund – suffered from credit market volatility creating mark-to-market volatility.
"The reason you’ve seen four funds in Australia fall over (and there aren’t many funds in Oz) is not because people in Australia are stupid or different, it’s because under the Corps Law they have to report material events to ASIC (Australia Securities & Investment Commission) on a daily basis. What you’ve seen in Australia you will see in the US and Europe in four to six weeks when people have to report," reveals one senior banker.
There are much bigger and more shocking casualties of the US sub-prime crisis than Basis Capital but there is another aspect of the Basis story that is especially notable. This was that this was no bucket-shop outfit located in a dodgy Sydney backstreet. Basis was set up in 1999 by Stuart Fowler and Steve Howell, each of whom had built up more than two decades of banking and structured finance experience at houses such as NatWest, Salomon Smith Barney and American Express Bank. At Basis, they had used that experience to impressive effect, making the firm one of the world’s largest buyers of CDO equity, scooping a number of awards and winning accolades from external analysts and ratings agencies.
So Basis products generated strong investor support but it was the identity of some of the investors that channelled their funds into the Basis funds that is the striking element of the story. As well as a number of Australia’s best-regarded and deepest-pocketed institutions, the local press reported that investors in the Basis Yield Fund included, for example, the Princess Margaret Hospital Foundation in Perth, which had sunk A$1.4 million ($1.15 million) of its entire portfolio (of A$12 million) into the stricken product.
It is no good laying the blame for any of this on Basis Capital, which did exactly what it said on the tin. One of its main objectives, as its website explained, was to deliver equity-like returns on its fixed-income products, which it did con brio. The problem was not so much the funds marketed by Basis Capital as the nature of the investor community that was able to buy into them, which is determined by Australia’s Corporations Law. This dictates that "when dealing in financial products... if the individual provides evidence that they have net assets of A$2.5 million or gross income in the last two financial years of at least A$250,000 a year, they may be considered wholesale investors." In the Lucky Country, which is starting to creak under the weight of its superannuation assets after 16 years of continuous growth, gross annual income of A$250,000 is hardly the preserve of the super-rich. Besides, there is a loophole, according to the Australian government’s website, which says that "an investor may be treated as a wholesale client if they satisfy an adviser that they are adequately experienced to be considered a wholesale investor."
The consequence of this very low threshold, which opens up highly complex structured products to any number of investors unlikely to know their attachment from their detachment points, has been what one Sydney banker describes as a "lot of what you might call regulatory arbitrage". In other words, he says: "Some market participants have sold products to people described as wholesale investors under the Corporations Law, which may be councils or charities as well as high-net-worth individuals, where they ought to be questioning their true level of sophistication."
The Reserve Bank of Australia, saw this particular problem coming at least two years ago. In September 2005 it published an analysis of the ownership of structured credit products in Australia which estimated that since 2002 about 65% of new CDO issuance had been sold to middle-market investors ranging from local governments to university and charitable endowment funds – hardly accounts that are at the cutting edge of sophistication. "Retail investors have tended to buy lower-rated CDO tranches than have their institutional peers," warned the RBA at the time, "potentially leaving them more exposed to losses if the global economy were to suffer a period of economic stress."