On the principles of greed...

The first rumbles were back in May 2005, prompting the probligo to put this out.

Now at that time, and the reason for selecting “Four Prominent Bastards”, the big fear back then was the impact of Freddie Mac (yes I mis-typed “Mae” at the end) on the investment community, and the likelihood of the collapse of both Freddie and Fannie.

Then in December last it was raised again, following the Bush “rescue plan”.

Now as I understand it, the idea of the rescue plan was to “support” those who were in danger of default on their loan, with the intent of protecting the investments made to Freddie Mac and Fannie Mae.

But in fact, the malaise runs much deeper, as can be seen in this country.

In the increasing “investment products” of recent times come the “Portfolio Investment Entity” (PIE). Now these little sweeties for the hopeful rich are the product of a tax law change effective 1 October last year. Essentially they differ from the more traditional Unit Investment Funds in that the capital gain in a PIE is not taxed, whereas the capital gain is a fundamental of the UIF and hence is taxable as “income”. From Herald –

What is PIE?
A PIE (Portfolio Investment Entity) is a tax effective managed fund. They range from "on-call" cash management accounts to funds that invest in assets such as fixed interest, property and shares. PIEs do not tax capital gains on New Zealand and most Australian shares (as is the case with conventional managed funds), and tax on income from New Zealand dividends and cash investments is capped at 33 per cent (falling to 30 per cent on 1 April), or 19.5 per cent if that is your marginal tax rate.
This means that by investing in a PIE, effectively investors receive more interest. If a return of 10 per cent is taxed at 39 per cent, the tax-paid return is 6.1 per cent. If that same return is taxed at 33 per cent, the tax paid return is 6.7 per cent.

So, what is the connect between Freddie, Fannie and PIE? In very large part it is the nature of the backing investment for the deposit to the fund. I invest $100k in a PIE at 9% interest. The PIE invests my money in suitable securities that will cover the 9% interest plus a suitable “administrative income” (which I would pay as part of the cost of belonging to the UIF). So, it has led to promotions like the following –

What is it called and what sort of savings product is it?
UDC Finance's Term Maximiser Fund is a managed fund under the new portfolio investment entity (PIE) tax rules.

What is the company behind it?
UDC is a subsidiary of the ANZ National Bank. It is New Zealand's largest finance company, and lends solely on plant and machinery.

Who is the target market?
UDC says it suits people in retirement, nearing retirement or saving for a particular goal.

What return does it offer?
Its opening rate is 9 per cent annually, with interest paid quarterly. For investors on a 39 per cent marginal tax rate, this is the equivalent of 10.68 per cent under the PIE regime.

...and so on

How strong a stomach do you need for it?
Mild. This term fund doesn't have a Standard & Poor's rating. However it invests in UDC's debentures, which have an investment grade AA rating from Standard & Poor's.

OK!! Now that really is interesting; for this reason. I found this Mary Holm column dating from 2003 while looking for (confirmation bias warning) the line of connection between the various elements that need to be covered.

Q. Re borrowing at 6.1 per cent and investing at 8.28 per cent - interesting opinion from you in last week's column, in that you seem to be advising us to pay scant attention to 23 of the Herald's 24 investment adverts!

However, Mary, please don't resign on principle, as we always enjoy your words of wisdom.

On a more serious note, we would appreciate your comments on our approach to offerings with G6 ratings.

We're in our late 70s, with well over half a million in savings etc.

About 50 per cent is in Kiwi Bonds, 40 per cent is in the main banks, and 10 per cent is in G6-type investments.

Those include $50,000 in capital secured deposits with Capital & Merchant, covered by Lloyds of London Mortgage Indemnity and Mortgage Impairment Insurance Policies.

We two antiques hope you will advise us. Stay young!


A. I'm trying to. But then I get letters like yours that seem to imply that I should write with half an eye on the advertisers. That's enough to age any journo! Seriously, though - and not because of any pressure from anyone - I'm not dismissing investment in higher-interest products.

But they are considerably riskier than banks. Go in with eyes open.

For the benefit of those who don't know what a G6 rating is, Bondwatch is a service which rates finance company investments - from G1, safest, to G8, riskiest.

Of a G6 rating, Bondwatch says: "Ability to meet current obligations dependent upon favourable economic and/or business conditions. Concerns about security over the longer term."

I should add, though, that your Capital & Merchant capital secured deposits pay lower interest than the "investment deposits" discussed last week. So they are almost certainly somewhat safer.
...

As I said last week, I know little about the company. But I wouldn't put that much in any single company of that type.

Sure, the wording about Lloyds, insurance and so on sounds comforting. But I don't know what it means. Do you?

Too often, when things have gone wrong with similar investments in the past, words like that - along with "secured" and "guaranteed" - didn't amount to much.

Sage advice, especially when lined up against the findings of the various Receivers and Liquidators appointed to the failures in the “investment industry”.

But the link I wanted is proving elusive. At least one of the failed investment companies was in fact fronting for another, parent company, and the investments of the funds received were almost exclusively in that parent company. The specific example I was seeking was a company seeking investments in NZ, offering interest at 8% interest plus. The investments were passed to the parent, an Australian property development company which had several times (as I hear it) been running very close to the wind with marginal developments in Queensland and NSW. The Receiver, appointed during last year, has announced that investors will get back only 40% of their investments and likely less than that.

Now the link between Mary Holm’s article, failed investment companies, through to Freddie Mac and Fanny Mae, and finally to PIEs is the nature of the backing investment to my money. Go back to the Herald article that defines PIE and you will see that they are “funds that invest in assets such as fixed interest, property and shares.” And the question has to be asked “What fixed interest, property and shares?” In the case of Freddie Mac and Fannie Mae it is becoming clear that they were being regarded as lenders of last resort; they picked up loans which no one else was prepared to take on board, but which had in some way (second, third and fourth mortgages perhaps?) been secured against property.

At this point one has to wonder just what manner of need or desire would have prompted a person to take out secured borrowing against their property. Was it for the initial property purchase? Or was taken out subequently as security for the purchase of a car, or boat, or holiday? Even worse, was the secured borrowing taken as a margin investment in an opportunity that offered a higher rate of return; borrow at 8% and invest at 10%.

So, a bank holds a “fixed interest” paper with the property as security in the form of a second or third mortgage. The true property value might cover 105% of the first mortgage. What a risk if the second mortgage defaults! Particularly if the second mortgage is for 20% of the property value! The borrower might well be able to cover the repayment at present but come two or three years’ time things can change dramatically. So the bank hedges its risk by selling the mortgage paper to one of its personal investment arms – the PIE system – or Freddie or Fanny.

Without belabouring that any further, there is another solution. Perhaps the loss from the failed “investment” should head in the other direction; not to the mum and dad investor at the bottom of the PIE, but to the originator of the investment paper, the ones who (please pardon the pun here) are holding the crust.

If a bank, or finance house, has made a bad investment that is where the risk should return. It should not (as has been the case thus far) be the mum and dad investors who have been (quite unknowingly) sold a PIEce of worthless paper.

If a retailer has sold a $5000 plasma screen to a family with an annual income of $30,000 then it is that retailer who accepts the loss when the HP falls over. That gives the retailer some specific rights, and he also takes the very specific risk of the failure. If the HP is factored to a finance house, that is done most oftenly “with recourse”.

I will leave that thought hanging. It gives good indication of the failings I see in Freddie and Fannie. It gives a good lead to what I see as the solution for their failing. From Forbes –

NEW YORK (Thomson Financial) - U.S. stocks fell further Friday after U.S. Treasury Secretary Henry Paulson indicated that a bailout of troubled mortgage giants Fannie Mae and Freddie Mac was not on the horizon.

...

'Today, our primary focus is supporting Fannie Mae and Freddie Mac in their current form as they carry out their important mission,' Paulson said in a written statement. 'We appreciate Congress' important efforts to complete legislation that will help promote confidence in these companies.'

Fannie Mae was last down 43% at $7.55 and Freddie Mac was shedding 47% at $4.27, paring earlier losses to $6.68 and to $3.89, respectively.

And in the matter of "greed", Al the Old Whig I think it was put out the idea some while back that "greed is good". Al, I agree. But at some point one has to accept the inevitable bout of indigestion.