22/02/2012 - 11:06

Nightmare on Wall Street the sequel

22/02/2012 - 11:06


Save articles for future reference.

Some US brokers are betting on sub-prime bonds again, which should sound a warning to investors everywhere.

Some US brokers are betting on sub-prime bonds again, which should sound a warning to investors everywhere.

IF you thought the sub-prime mortgage industry in the US was a nightmare not to be repeated, you’re wrong. Not only are low-quality, high-risk mortgages back, they are proving popular with investors.

What’s driving revised interest in sub-prime mortgages, of the sort made to people who will struggle to make repayments, is the hunt for yield in a world where a lowly 1 per cent return on money is causing greedy behaviour.

Back in 2008 it was the collapse of the sub-prime industry, or more particularly the collapse of the financial institutions that believed in a ‘strength in numbers’ theory, which triggered the GFC still being played out in Europe.

What happened was that seemingly sensible banks and insurance companies became convinced that, if you put enough sub-prime mortgages into the one corporate vehicle, the good mortgages (those on which debts were being serviced) would outweigh the bad (the non-performing loans).

It was a theory that did not work, spectacularly, partly because it was aided by some banks deliberately marketing mortgages to people who could barely make the first repayment, let alone service a 20-year debt, which had the horrible feature of a ballooning interest rate as the debt got older.

Today, investors are boasting once again about the high returns they’re getting on investment funds that specialise in exactly the same sort of mortgage vehicle that almost destroyed the US economy.

In some cases the return on sub-prime bonds parcelled up by brokers are returning more than 10 per cent. One broker told the The Wall Street Journal newspaper that yields of 7 per cent to 9 per cent were common, which is many times more than can be achieved on most other forms of investment in the US.

Australia will not be immune from this remarkable return of high-risk strategies as part of an investment portfolio because our returns are also much less than they once were, and greedy people always crave more than is sensible.

If a bank is offering 4 per cent on deposits, someone will double that number. If the US is having a sub-prime re-run it might even be time for Western Australia to revive its discredited mortgage-broking industry.

The central issue is the pursuit of yield on invested funds in a world where the top central bank, the US Federal Reserve, has said it will keep interest rates close to 0 per cent for as long as it considers necessary, or until there is a full-blown economic revival – whichever comes first.

The theory behind a 0 per cent interest rate (or more likely 1 per cent) is that it will encourage business and consumer activity, which it will as more people realise that they might never see rates that low again in their lifetime.

But, as with sub-prime, there is a flipside, which in the current situation is the encouragement that low interest rates give to investors to seek out a higher return on their cash.

Until now the biggest beneficiary of the low interest rate world has been gold, which in bullion form pays no interest, but does offer the potential for capital gain.

Sitting on a bar of non-performing gold is not enough for many investors who are also being swayed by sub-prime bond salesmen that the worst of the crisis is over, that US house prices will not fall another 30 per cent as they did over the past four years, and that the improving economy is creating more jobs, which means borrowers can service their debts.

Will sub-prime work this time? Yes, for a while. But at the first hint of an economic downturn watch the industry crash again because it is a perfect example of high return invariably meaning high risk.

Art sales

GOLD is not alone in benefiting from a low interest rate world, and being pretty at the same time. The same can be said of art, which at the top end is experiencing a remarkable boom.

The best recent example of the art boom was the world record $250 million paid late last year by the gas-rich Middle East country of Qatar for a work by Paul Cezanne.

For a tiny country, which is the world’s biggest exporter of liquefied natural gas and has gas reserves to last at least 300 years, the Cezanne was a bargain, even if close to double the previous highest price for a painting, $140 million for a Jackson Pollock.

Interesting as the record prices might be, there are other factors at work.

Firstly art, like gold, does not pay an interest on the funds invested. If the owner ever wants to sell he must hope for an increase in capital value.

Secondly, the Qatari purchase seems to have triggered an art boom with more records being set at a London art auction last week.

The auction house Christie’s reported that it had achieved sales totalling $130 million, well above an early estimate of as little as $87 million. Top dollar went to a Francis Bacon portrait, which changed hands for $32 million.

Best comment from the sale, and the one that goes straight to the heart of the low interest rate world, was from Robert Read, a London art specialist who said after the auction that: “There is a lot of cash around at the moment and not many places to put it”.

In time, someone will dredge up that comment and cross-reference it to an even older one about fools and their money being soon parted.

Zinc control

IT’S not often that lowly zinc earns a headline, which is hardly surprising as it is one of the world’s least interesting metals, with its major use being in galvanised steel.

Expect a change ahead as the proposed merger of the mining house, Xstrata, with commodity trader, Glencore, comes under closer inspection by government and steel mills that are the major buyers of zinc.

What worries the customers is that a combined ‘XstrataGlencore’ will not only be the world’s biggest zinc miner, it will also be one of the biggest smelters of the metal, and the biggest trader.

In other words, the supply (and price) of zinc could be controlled by one company, which competition regulators frown on.


“Risk comes from not knowing what you’re doing.”

Warren Buffett


Subscription Options