Managing risk in the financial sector
Prime Minister Kevin Rudd’s visit to the US this week coincided with the US administration’s release of finance sector reform proposals that have been described as the most sweeping since the Great Depression.
The thrust of the changes is to widen regulation and supervision of financial institutions, whether they be securities firms, banks, or savings and loans institutions.
The Federal Reserve would also gain oversight of Wall Street securities firms, which have recently secured access to the central bank’s emergency lending facilities.
What does this have to do with Western Australia? The US often leads the world on economic and regulatory reform, so we need to be careful that US practice is not automatically accepted here.
The reality is that Australia’s financial system has stood up very well compared to the disaster befalling the US.
The sub-prime crisis has become an unmitigated disaster in the US, whereas Australia’s banks and other lenders are in relative terms bastions of virtue and restraint.
We need to keep this in in mind when we reflect on the shock collapse of stockbroking firm Opes Prime, which most Western Australians had never heard of until a week ago.
When it was placed in receivership by the ANZ Banking Group, it was generally assumed that Opes Prime was a small fry Melbourne broking firm that had gone badly awry.
We have since learned that Opes Prime had a $1.1 billion margin lending book, with ANZ and Merrill Lynch providing most of the funds.
What’s more, its clients included directors and investors in a swag of Perth-based mining and exploration companies.
In many cases, the directors looked like heroes when the stock market was roaring but now face the risk of serious loss.
Use leverage carefully
Margin lending has long been considered a legitimate investment tool – using the equity in your existing assets to borrow money so that you can buy extra assets.
But there are at least a couple of basic qualifiers.
Investors should diversify their risk – borrowing money to buy more shares in one company is not a prudent step.
Second, investors need to ensure they can service their debts – and that includes meeting margin calls.
ABC Learning Centres’ Eddie Groves remains the biggest victim of the current stock market squeeze, after he was forced to sell nearly his entire holding of ABC shares to repay margin loans.
The problem extends to blue chip companies.
Goodman Group’s Greg Goodman and United Group’s John Leupen have been forced to sell big lines of stock at ‘fire sale’ prices because they wanted to remove any nervous uncertainty in the market.
The Opes Prime failure is bound to fuel uncertainty in the market.
If a little known broking firm advanced $1.1 billion in margin loans, what other high-risk problems are lying undetected? Broking firm Tricom held about $2 billion in margin loans when it got into strife earlier this year.
The list of potential losers is long.
The lenders, such as ANZ Bank and Merrill Lynch, will be hoping their status as secured creditors will minimise, and possibly avoid, any losses.
The borrowers with highly geared margin loans will be hoping there is some equity left after the secured creditors take their cut, but that is far from guaranteed.
The third group at risk are the ‘ungeared’ investors who are likely to watch the value of their stock fall.
There is a lesson in this saga for all investors, including those whoshy away from the stock market in favour of property.
Thousands of property investors also employ gearing to lift the size of their portfolio.
Many, if not most, financial planners would say that investors who fail to use gearing are mugs.
But just like share investments, there comes a point where property investments become risky.
Think of the case studies that regularly feature in the investment ads – low to middle income earners who have accumulated a portfolio of five or 10 investment properties.
The strategy works well when property values are rising and tenants are reliably meeting their payments, which allows the investor to service their increasing debts.
These favourable conditions continue to prevail in the Australian property market but, like any investment, there is no guarantee.
With broking firms looking shaky, investors losing money, superannuation funds facing negative returns and property values weakening, there are inevitably calls for regulators and governments to step in.
That could make matters worse.
Any suspicion that governments will bail out misguided investors and lenders will simply encourage more risk taking.