Councils, churches hit hardest by sub-prime

WHEN issuers of high-yield securities backed by sub-prime mortgages went on the sales offensive to investors in Western Australia in mid-2007, they pursued the three Cs - councils, churches and charities.

Historically, these institutions are not renowned for making risky investments and have left many pundits pondering how they could invest millions into complex securities, including collateralised debt obligations.

A major player in offering these CDOs in WA was Lehman Brothers Australia, which at the time was trading as Grange Securities.

Last month, LBA, the Asia-Pacific arm of the bankrupt Lehman Brothers franchise, had administrators Steve Parbery and Neil Singleton from PPB appointed to it.

This week, fuel was thrown on to the sub-prime fire when it was revealed that chief executive of Lehman Brothers, Richard Fuld, reaped more than $US300 million ($420 million) in cash and stock bonuses since 2000.

To add further insult to injury, a US hearing heard that huge bonuses were being sought for top Lehman executives even while the bank was pleading to be rescued.

Some 35 councils across Australia - including Melville, Kwinana, Swan, Margaret River-Augusta and Albany - have been caught in the crisis, with a combined $25 million in sub-prime investments. In many cases, LBA acted as adviser, manufacturer, distributor, and asset manager of the CDOs.

KPMG partner Kevin Smout told WA Business News that while LBA's actions were perceived by some to be questionable, many companies within the banking and financial industry manufacture the very products they distribute.

Many local governments in WA were encouraged to invest through LBA following a presentation by the firm's then chief economist Stephen Roberts to the Local Government Manager Australia 2006 conference, of which LBA was a major sponsor.

"Stephen will focus on how councils can make recurrent and substantial additions to their annual revenues by taking advantage of a broader range of investment opportunities and lifting return without increasing risk," the conference's program said.

However, the value of these investments began to tumble in August 2007 and their exposed risk became evident.

At this time, the City of Melville hired PricewaterhouseCoopers to review the independence of Grange - the council's investment adviser - following the acquisition by Lehman Brothers.

PwC advised the council to sit tight on its investments, saying it was "reasonable" to hold the current portfolio with CDO investments.

CDOs are a mixture of investment securities, including mortgages of variable risk - the higher the risk, the larger the return.

The sub-prime mortgages are essentially made to home-buyers with poor or no credit history and carry a higher rate of interest.

Although analysts have suggested that Australia is well insulated from the crisis, it is believed that some Catholic, Baptist, Anglican and Uniting churches across Australia are implicated in losses through sub-prime investments.

The WA Local Government Superannuation Plan had about $10 million of its $1.2 billion investment portfolio invested with Basis Capital.

Basis Capital's Basis Yield Fund won Fund of the Year in 2005 and claimed the Best Fixed Income, High Yield & Distressed Fund Award.

Two years later, Basis Capital sought bankruptcy protection in the US for its Basis Yield Fund.

It experienced massive losses caused by the flow-on effects of the sub-prime meltdown through the firm's exposure to pools of mortgage bonds packaged within CDOs.

The founders of Basis Capital, Stuart Fowler and Steve Howell, maintained that the strategy of investing in a diversified portfolio of CDOs was sound and that the freeze could not be forecast.

By January this year, superannuation funds were hit by the crash, with figures showing a return of about 8.6 per cent on 2007, their lowest since 2003, bringing an end to three consecutive years of double-digit gains.

The $2.8 billion industry fund Westscheme reduced the value of its CDO portfolio by $30 million in July 2007. The fund had $71.6 million invested in CDOs, of which $2 million were sub-prime.

In November 2007, Perth businessman Tony Mitchell pulled the $200 million sale of his Allphones mobile phone chain after falling victim to global credit markets meltdown.

But despite the turmoil, some councils and organisations remain optimistic of retrieving any losses.

City of Melville acting chief executive Marten Tieleman said that the council's existing CDOs are now independent of Lehman Brothers "with the funds kept in custodianship by the Citigroup Bank".

However, Citigroup, one of the biggest financial institutions in the US, in January this year posted the biggest loss in the bank's 196-year history, as rising defaults in home loans forced it to write down the value of sub-prime mortgage investments by $18 billion.