Centro: The warnings we all missed

What is amazing about the Centro collapse and the Citicorp writedowns is that, with the benefit of hindsight, both companies made the same mistakes that have caused countless corporate downfalls in recent decades. And in each case there were clues to the looming demise that we did not pick up.

So let’s look at what we can learn from each situation and apply it to the future. In the case of Centro, what fooled me, the directors, the banks and the superannuation fund managers was that, unlike so many previous crashes, the underlying assets were well-managed (shopping centres) with high cash generation.

In the US, these centres represented a fantastic hedge against any recession because the American economy would have to sink very low before food retailing was affected.

But Centro and Citicorp shared a common flaw that has wrecked so many companies: they had complex asset ownership structures that masked basic problems from not only shareholders but management and directors.

In the case of Centro, the basic structure was complex and assets were owned in different levels with different stakeholders, and studded around these complex structures were joint ventures. It was a reporting nightmare. In the case of Citicorp and many other banks, including Merrill Lynch, they were selling off loans to illiquid structured investment vehicles (SIVs) forcing the banks to buy back the paper. Australian banks’ securitsation structures have access to liquidity but have not been tested by major defaults. Citicorp operated across the globe in a vast number of sectors and reflected the genius of former chief executive Sandy Weill. Successors often have difficulty managing such organisations.

Unlike Centro, Citicorp and Merrill Lynch made a mistake that often hits companies: they simply didn’t look at the underlying asset behind the revenue generation. Instead, they gained solace from the fact that “everyone was doing it”. Sub-prime loans were being generated by mortgage dealers and had not the slightest chance of being repaid under the terms set out.

What’s significant is that in the 1970s, Citicorp and the other leading US banks did exactly the same thing, but instead of lending to US residents who could not pay they lent to impoverished countries that also had not the slightest chance of repaying. In three decades all corporate memory had been erased.

Yet the combination of complex structures and assets of dubious worth caused the Enron collapse and has been a characteristic of bad bank lending in many Australian property booms.

It is always difficult for shareholders to determine that a lending asset class is flawed but one would have thought that the broader US investment community would have had the resources to do the work.

Nevertheless, we have two clear lessons: beware of complex joint venture structures and don’t invest in companies unless you are very clear how they make their money.

The Centro collapse was triggered by another feature of past collapses: massive over-borrowing. Yet when you looked at the group’s presentations for the year to June 30, 2007, borrowing seemed to be under control. However, with hindsight there was a clue that we all should have picked up. The gearing of Centro Properties on a so-called “look through” basis (which incorporate joint ventures) rose from 26% to 48% and the asset backing for the shares fell from $3.63 to $2.29. The company had explanations for these events, which obscured the fact that Centro was exceeding its own borrowing guidelines and had done so very quickly. It was a clear warning signal.

But there was a third clue that we all should have picked up. No company should ever undertake more than one large expansion at a time. I will never forget BHP being pushed to the edge of collapse in the 1990s when it undertook two huge projects – Magma Copper and the WA hot briquetted iron plan – that were both disasters. Centro undertook three big international acquisitions and doubled its funds under management in one year. At the same time it undertook a major time-consuming internal structural merger. That sort of expansion and internal reorganisation requires everything to go right. Many Australian and international companies have simply collapsed under the management strain of over-expansion. When it is based on borrowed money and a complex ownership structure it is a lethal cocktail.

Of course these are hindsight judgements, which in the case of Centro were obscured by the basic soundness of the business. Although sub-prime fallout triggered Centro’s collapse, slower growth would have enabled management to focus on the vulnerability of the group.

An obvious structural weakness for Centro was that one of the layers of ownership held two unlisted property trusts where superannuation funds could withdraw money, very similar to the unlisted property trusts that collapsed the last downturn. For years superannuation funds had been hosing money into these two funds so it seemed inconceivable that a run might develop. The original plan was that if there was a run, the holding company (Centro Properties) would inject the extra money. And in past years it could have done that, but at the time of crisis Centro Properties was highly leveraged and it simply wasn’t possible.

What is amazing is that three of Australia’s big four banks lent Centro Properties most of its $3.5 billion unsecured loans. What this shows us is that, like Citicorp, some of our bankers have forgotten the lessons of history. It is ironic that if there had been a little bit of old-fashioned corporate conservatism among our big banks it might have just triggered an alert on the Centro board, which would have saved the company given the quality of its assets. Australian bank shares have fallen sharply, partly in line with all other global banks.

This has confused a lot of Australian stockbrokers, who point out that Australian banks don’t have the sub-prime exposure of Citicorp. Centro and loans to the US Countrywide group are danger signs. But the Australian banks have two other structural problems that are similar to Citicorp and Merrill Lynch.

First, while the Australian banks’ lending quality may be better than Citicorp, Australian banks are very dependent on overseas borrowings and on the workings of the derivative market, which converts US dollar borrowings to Australian currency. The cost of those loans has already risen and could rise further. Given the attitude of the Australian Government, there will be great pressure for the banks to not pass on these extra costs.

Citicorp also depends on the wholesale funding market. The US Federal Reserve is flooding the American banks with money so that they can continue to maintain customer lending in the face of a wholesale market that has contracted and become more costly. The second weakness Australian banks share with Citicorp is that mindless government regulations have turned bank board meetings into useless box-ticking exercises to comply with so-called “corporate governance”. Most of it is a waste of time and after directors have gone through a day or so of this soul-destroying useless activity there is grave danger that they will not spend enough quality time looking at the base strategies of the business.

I am sure this contributed to Citicorp and other US bank boards not focusing on the stupidity of the sub-prime circus. Australian banks’ regulation is not as bad and they are not as complex but mindless regulation makes them potentially vulnerable.

Investors should realise that there are a few more nasties to come out of the US and it is this fear of the unknown that pushes the market down day by day. For example, “monoline” insurance companies have insured $US2.3 trillion worth of loan risk, including about $US600 billion in vulnerable US assets. Some of the insurance companies are simply not in a position to stand anything more than token claims and have been as silly as the sub-prime banks. Yet vast sums have been lent on the basis that these insurance guarantees accord triple-A ratings to dubious paper.

In addition, there is a commercial property crisis in the UK and S&P 500 companies have $US2 trillion in goodwill, which will create more big writeoffs in the US downturn. The real problem is that we went for so long in the good times that we forgot the lessons from the past.