Buyer beware when it comes to risky contributory mortgages

Friday 7th December 2001

Enron's implosion in the US is having ramifications in Australasia. A number of transtasman banking operations have admitted exposure to the collapsed energy utility and derivatives trader.

The Economist, which rang prescient alarm bells about Enron earlier this year, has characterised the firm as "in effect, a hedge fund with a gas pipeline on the side."

The magazine explained that Enron's demise was akin to that of the infamous hedge fund Long Term Capital Management (LTCM), the US Federal Reserve had to intervene to ward off systemic financial risk, rather similar to the recent failure of a conventional utilities company, Californian-based PG&E. So it seems we have another hedge fund blow-up on our hands.

The consequences of Enron's collapse have yet to work themselves out but the mess is looking pretty sticky.

Probably the US Federal Reserve will not have to intervene financially, but the SEC cops are asking questions about Enron's accounting practices and off-balance sheet loan partnerships which allegedly concealed the company's true debt and profit position.

Forbes.com has speculated that a special prosecutor may be appointed to examine the role of Enron's head, Kenneth Lay. Mr Lay is said to be a personal friend of President George Bush and Vice-President Dick Cheney and has been an active lobbyist for energy deregulation.

Then there are all the threatened lawsuits from shareholders, pension funds, Enron staff and creditors to consider.

Two sobering aspects of the Enron saga have relevance for the investment market in New Zealand. One has to do with the quality of research analysis and broker advice.

Enron was the darling of Wall Street over the last year and its share price went through the roof on recommendations made by brokers and analysts.

This occurred despite claims that Enron's accounts were almost impenetrable.

US brokers and analysts should be some of the best in the world - at least they are paid to be so - yet many of them would have turned out a repeat performance over Enron of their gaffes over dot.coms and the 3G spectrum. How could these people have been so mistaken? Do they ever learn from their errors? How then can investors make well-informed decisions?

The other concern is the demonstration that, yet again, laws do not prevent bad investment results. The US has one of the strictest investment regulatory regimes in the world, yet Enron got away with systematically inflating profit - to the tune of half a billion US dollars - for years before it came clean only recently.

The Economist claims the US Federal Reserve is mulling over how it will plug the regulatory gap Enron had discovered.

Local relevance of the role of law in protecting investors arises with contributory mortgages. As revealed in last week's NBR, the Securities Commission is examining some of these public offerings.

Contributory mortgages are specifically recognised in law through an amendment to the Securities Act and have certain restrictions placed upon them.

One restriction is that they are not allowed to raise more than two-thirds of the registered valuation of the property they are secured against.

There has been some marketing of contributory mortgages on the basis that they are sound investments because of the Securities Act provisions. But as the Securities Commission's investigation makes plain, this legal "protection" does not prevent individual contributory mortgages from turning out to be bad investments.

It is likely that there are more contributory mortgages in trouble than the Securities Commission has fingered so far. It is to be hoped that the commission does a thorough job in cleaning up that investment market.

But its position is like that of the Fed's in trying to prevent the next Enron.

Contributory mortgages can be traps for the unwary, especially fixed-income retirees who watch their returns drop in a falling interest rate cycle such as we have now. The higher interest rates offered on contributory mortgages can then look alluring.

Nonetheless, a contributory mortgage is a hybrid between fixed interest and venture capital. It raises money for a property developer who may be involved in real estate speculation and who obviously cannot borrow the funds required from a bank.

There is risk intrinsic to contributory mortgages that the law cannot completely amend short of abolishing them.

Such investments should never make up more than a modest percentage of an investor's fixed-interest portfolio allocation.

They are certainly not for widows and orphans to rely on and should not get more of an investor's money than he can afford to lose if things go wrong.

Neither the Securities Act nor the Securities Commission can prevent the worst from happening, and with interest rates being down where they are while the general economy deteriorates, we can expect that more investors will be tempted and that more mortgages will go belly up. Caveat emptor.

Comments from our readers

No comments yet