Councils Count The Collateral Damage

Sydney Morning Herald

Thursday April 3, 2008

How apt the term "fallout" has proved to be in relation to the subprime mortgage crisis in the United States. The effects are far more widespread than expected, and are proving enduringly toxic. NSW councils are the latest victims. The Cole inquiry estimates they have lost as much as $400 million on investments in American subprime mortgages. The loss, which may ultimately be worn by ratepayers, is the latest reminder that we still don't know how much is at risk in this crisis, or how long it will last.

Only this week, the Swiss banking giant UBS doubled its subprime-related write-downs to $41 billion, and that was just days after the fire sale of the American investment bank Bear Stearns. Who will be next? Certainly, there are more names still to be added to the list of victims. Many ordinary Australians are already on it; the cost of their mortgages has been rising steadily while the value of their superannuation has been heading south, along with prices on the sharemarket. So, while this week's pause in official interest rate rises is welcome, and yesterday's uptick in sharemarkets is encouraging, don't imagine that the worst must be behind us.

The hapless councils, meanwhile, are working out who they might sue. Perhaps the most alarming aspect of their losses is that the councils were following the rules; they had prudently kept to the guidelines that were supposed to guarantee the security of their investments. The mortgages they bought had been given high ratings by reputable ratings agencies. The State Government says, helpfully, it's not its fault the ratings have proven worthless.

The old rules aren't working any more with home mortgages either. Australians had come to expect that interest on mortgages would rise (and fall) in line with movements in the cash rate set by the Reserve Bank. That had largely been the experience with the 12 straight increases in the official rate since the end of 2001. The subprime shakeout has changed that. The banks are now running ahead of increases in official rates. They plead that the wholesale price of money is going up faster than the Reserve Bank's rates and they have no choice but to pass on the higher cost to their customers. So, while the Reserve Bank has raised rates by a total of 1 percentage point since the middle of last year, the banks have averaged a 1.3 percentage point increase on standard mortgages.

With the banks taking the lead, the Reserve Bank can afford to wait and see. Many experts now think official interest rates will not rise again this year, and will fall in 2009. However, the banks may keep increasing interest rates, and then prove slower than the Reserve Bank in reducing them. So those with mortgages may be paying the price of the subprime crisis for quite some time to come.

The pain from the subprime fallout is nowhere more intense than on the sharemarket, where over-extended investors have been unable to repay loans used to buy shares. The security for these so-called margin loans is the shares they finance. When share prices fall, the shares may be sold to make good the loans.

The bitter irony is that the market is being manipulated by professional traders who deliberately drive prices down to make money from short-selling (selling shares they don't own and later buying them back for less than they sold them). The Australian Stock Exchange and the Australian Securities and Investments Commission have been left spluttering on the sidelines as traders exploit loopholes in the rules supposed to regulate short selling.

The collapse of the Opes Prime stockbroking firm has highlighted another trap for investors. Opes Prime, now in receivership, says clients who bought shares on margin loans do not, in fact, own the shares. The shares were, instead, retained by Opes Prime as security for $1.1 billion it had borrowed from banks to finance its clients' share purchases.

The banks are now claiming - and selling - the shares. Some Opes Prime clients are fighting the banks, claiming they were misled about who would own "their" shares. Many clients who thought they had substantial share portfolios may well end up with nothing. Those who claim they were misled, will no doubt look for someone to sue, while those who failed to read the fine print of their contracts will have only themselves to blame.

It seems that no sooner does a boom go bust than its lessons are forgotten. Investors big and small abandoned themselves to the exuberance of a sharemarket that, until recent months, was enjoying a record run, while around the world, the biggest and the best in banking and finance have been caught out by the subprime crisis, their losses still mounting steadily.

Some will see a rough justice in the subprime fallout; big rewards mean big risks, and if some are caught out, that's the chance they knowingly took. Unfortunately, financial upheavals are not so discriminating; the state's councils are now to be counted in the serious collateral damage.

© 2008 Sydney Morning Herald

Back to News Index | Back to Home