The debenture dilemma

With interest rates on term deposits not as good as they used to be, there is a temptation to chase returns elsewhere.

However, many investments favoured by retiree investors that promised higher interest, such as mortgage funds and property-related debentures, have run into trouble. Many mortgage funds are in the process of being wound up and money returned to investors, years after they first got into trouble. And there has been a string of failures among the debenture issuers. The most recent was Banksia; about 3000 investors in Banksia debentures face losses of up to $350 million, according to receivers.

Debenture issuers that have come to grief are from those that use investors' money to lend for property development and invest in property directly. Developers borrow from the debenture provider at higher interest rates because the banks will not lend to them or lend only so much. In exchange for the higher interest, debenture holders are exposed to the riskier "funding gap". The debenture providers are not covered by the government guarantee, which covers the first $250,000 in a term deposit or online savings account offered by banks, mutual banks, credit unions and building societies that are regulated by the Australian Prudential Regulation Authority (APRA). Also, investments not regulated by APRA are not required to have minimum capital requirements and other safeguards that prudentially regulated institutions have.

The Australian Securities and Investments Commission (ASIC) has been hounding debenture issuers on disclosure of the risks since at least 2002. The regulator has forced debenture providers to be much more specific about the risks in their disclosure documentation and their advertising.

But the regulator has done all it can on the disclosure front. For instance, if a debenture issuer is undercapitalised, ASIC cannot stop the issuer continuing to raise money from the public.

This month, ASIC put forward proposals to strengthen the regulation of the debenture sector, including mandating minimum capital and liquidity requirements for debenture issuers and strengthening the disclosures they must give to potential investors. Following consultation with the debenture issuers, the government and APRA, there will be a final decision on the new framework, including transitional arrangements to the new standards.

The debenture issuers can be expected to push for the proposed changes to be watered down. Let's hope the government and regulators keep the interests of small investors, diffuse and weak as they are, top-of-mind in the face of the concentrated and focused interests of debenture issuers.

ASIC commissioner, John Price, says the proposals will help ensure debenture issuers are more financially resilient, but they will not prevent failures. "For this reason, it is important to understand debenture investments are higher risk than a deposit with a bank, building society or credit union that is prudentially supervised by the Australian Prudential and Regulation Authority," Price says.

Investors should be careful about debentures generally, but there are big differences in the degree of risk between providers. Some are relatively lower risk but small investors are unlikely to be able to assess those risks themselves which is why a higher minimum of standards are needed.