KEY POINTS:
The recent volatility on world financial markets has been blamed on United States sub-prime mortgage problems.
But a number of other issues are contributing to the nervousness. These include the huge amount of leverage and risk that investors have taken on in recent years and large potential losses
that can occur when interest rates rise and bond prices fall.
Many of these high-leverage, high-risk investments have been sold to investors by financial institutions that seem to place a high priority on the huge fees they generate.
New Zealand has not been immune from this phenomenon. Two products - Macquarie New Zealand Fortress Notes and Equity Partners Infrastructure No. 1 - are clear examples of the high leverage, risk and fee structures that have become common around the world.
Macquarie New Zealand Fortress Notes
According to the March 2005 prospectus: "Macquarie New Zealand Fortress Notes are an opportunity to invest in a new debt security aiming to deliver a high yield derived from a leveraged exposure to a portfolio of senior secured corporate loans."
This meant money raised from the public would be invested in a wide range of US corporate bonds on a highly leveraged basis. The prospectus contained the following example of the proposed investment structure:
* Funds raised in NZ through the issue of notes - NZ$50 million.
* These funds converted into US dollars - US$36 million.
* Leveraged funds (borrowings or use of derivatives) - US$180 million.
* Total value of bond portfolio - US$216 million.
In this example New Zealanders would invest US$36 million in the fund but gain exposure to a US corporate bond portfolio worth US$216 million because the fund would effectively borrow an additional US$180 million.
The prospectus indicated that the initial interest payable to note holders would be the bank bill rate, which was 7 per cent, plus a premium of 4.5 per cent equal to 11.5 per cent.
The notes offered an attractive interest rate but this was a high-risk structure for a number of reasons:
* The quality of the bond portfolio, which has an average weighted Standard & Poor's credit rating of mid BB- to B+, is low.
* The default risk increases when interest rates rise.
* The NZ note holders carry nearly all the default risk. For example, if 5 per cent, or US$11 million, of the portfolio defaults, the value of the notes, based on the prospectus example, would fall 30 per cent from US$36 million to US$25 million.
One of the key features of the Fortress Notes is the extremely generous fee structure. The portfolio manager, which is two-thirds owned by Macquarie Bank, receives a fee of 0.9 per cent a year based on the total value of the portfolio, including leverage. This equates to 5.4 per cent of the value of the notes.
In addition Macquarie was entitled to another fee for "at least one year following the initial period ending August 31, 2005" for introducing prospective financiers.
The Fortress Notes, which raised only $28.7 million, have been adversely affected by the recent nervousness on world markets. The total value of the portfolio has declined 4 per cent but the net asset value of the notes has dropped by an estimated 20 to 25 per cent because of the 6-to-1 gearing.
It is important to note that the reduction in the value of the portfolio represents the theoretical outcome if the entire loan portfolio was liquidated at current market prices. The manager believes that it "has no reason to believe that the loans in the portfolio will not continue to pay their periodic interest and repay the principal outstanding at par".
Trading on the NZDX, which has been very light, reflects the nervousness on world bond markets with the Fortress Notes last going through at a 20 per cent discount to the issue price.
Equity partners infrastructure company no. 1 (epic)
Epic, which recently raised $96.7 million from NZ investors, is another product of the Macquarie "fee factory".
Issue costs were projected to be $7.3 million or 7.6 per cent of the amount raised. This includes brokerage of 4 per cent paid to the lead manager Macquarie Equities New Zealand and 2 per cent to the promoters, which also include a Macquarie company.
Epic's only asset is a 2.57 per cent holding in a Guernsey-incorporated special-purpose vehicle that owns 47.65 per cent of British infrastructure company Thames Water Utilities. As a result, Epic has a 1.22 per cent indirect holding in Thames Water. The prospectus contained no substantive information on the water company.
Thames Water, which has become more highly geared since it was acquired by Macquarie interests last December, had net earnings of £190.5 million for the year ended March 31, 2007, a 22.5 per cent decline on the £245.9 million in the previous year. Earnings fell because of a big increase in operating and interest costs.
Thames Water will not pay a final dividend for the March 2007 year. Thus Epic's dividend for the March 2008 year, which represents an estimated yield of 9.1 per cent on the $1-a-share issue price, will be funded by borrowings.
The management company will be paid 1 per cent a year, or nearly $1 million, even though there is effectively little or nothing to manage.
Another notable feature of the issue is that it has no maturity date, it will not be listed on any stock exchange and there is no promise that a market will exist for Epic shares.
A multitude of Fortress Notes and Epic-like products have been created around the world in the past few years as investors have been willing to take on more and more risk to maximise their returns.
This highly leveraged investment strategy has been rewarding for investors and product providers in a low-interest-rate environment but it is extremely dangerous when interest rates rise and borrowers are no longer able to meet their interest and repayment obligations.
The US sub-prime mortgage market is the root cause of the problem because a large number of these mortgages have been packaged into highly leveraged investment products similar to the Macquarie NZ Fortress Notes. Many hedge funds have also adopted highly leveraged structures similar to the Fortress Notes.
US homeowners are defaulting on their sub-prime mortgages and the financial institutions that provide leverage to the investment vehicles holding these mortgages are making calls on their loans. This is forcing managers to sell sub-prime mortgages below their face value and the problems have spread to other credit markets because of the huge number of high-risk investment vehicles that have invested in these markets.
The fallout has also spread to ING Regular Income Fund. This fund, which was sold to NZ investors as a low-risk product, is now priced at an 8 per cent discount to the issue price because of its exposure to US corporate credit markets through Collateralised Debt Obligations (CDOs).
The volatility on world markets is expected to continue as more and more highly leveraged investment vehicles are forced to sell securities to meet margin calls from their leverage providers.
The clear lesson from this volatility is that leveraged investment vehicles are extremely rewarding in a rising market but can cause major problems, for investors and financial markets as a whole, when prices fall.
* Disclosure of interests: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.
