KGB INTERROGATION: Mike Tilley

Stephen Bartholomeusz: Mike Tilley, thanks for agreeing to the interrogation. With me I've got Bob Gottliebsen and James Thomson, one of our senior journalists and columnists who is filling in for Alan Kohler who is on leave.

Mike, I'll open the batting. You were once an investment banker to the star corporates advising them on crises and taking advantage of other people's distress. What's it like being a principal in the middle of the maelstrom?

Mike Tilley: Well it's a completely different experience being the one that is ultimately responsible for all the decisions compared to the experience of being somebody who could sit back with the benefit of no direct responsibility. I have to say, my 25 years of advising – and more often than not advising people in extremely difficult situations on how to solve problems – has been the best training that I ever could have had for what we've been going through in the last four of five months.

SB: Is it personally traumatic though?

MT: Well look, I'm probably regarded by most people that know me as a relatively unemotional person so I don't find it traumatic. I do find the almost unending negativity that exists in sentiment towards almost everything in the world at the moment sad, because the truth is there are some problems in the world but there are also some very good things and some great opportunities and we all need to work through the things that are going on at the moment. There will be another tomorrow and the sun will come out tomorrow and people will make money today and tomorrow and so it's not all bad.

SB: Your share price has been smashed Mike, falling from more than $6 to less than $2 in the space of a few months. Is that a fair reflection of the impact of sub-prime on your business model?

MT: No it's not. I think it's a consequence of two things and what I really don't want to do here is be seen to be somebody who is standing up complaining about short selling, because I believe that efficient markets require short selling but of course efficient markets also require transparency and integrity so that's another issue but we've been at the receiving end of two things.

One is that hedge funds, absolutely appropriately, have been globally short selling financial stocks and it's almost indiscriminate and you know, their view about negativity towards financials around the world has so far proven to be absolutely correct and they've all made a lot of money out of it and I think they've all been very clever.

But we've been in the middle of that and I understand that there have often been hedge fund desks calling brokers saying 'Sell a billion dollars worth of Australian financials short. We don't care what you can get, just wherever you can borrow the stock, sell it short' – and we've been caught up in all of that.

The second thing affecting us, which is not affecting many of our peers, is that because we are a life insurance company we have to fair value account. We value on a mark-to-market basis, but we've got assets in our balance sheet that are high quality fixed income assets.

We've got corporate loans that are high quality corporate loans that we've had to mark to market – and obviously disclose the extent of those mark to market adjustments to the financial community. But the banks who also hold identical assets don't have to fair value account.

They account on a yield-to-maturity basis. There's a difference in accounting treatment which is established by the law and at the moment we are bearing the disadvantage of that different accounting methodology. It creates uncertainty because there are people who don't have days and days and weeks and weeks to analyse the difference between, say, us and the banks.

Quite rightly they'll think 'Well that's too hard, we don't understand that. Why are you marking down the value of your fixed interest and corporate loan book when a major bank isn't?' That's been a justifiable and reasonable basis for people to say, if it's too hard to understand and there's uncertainty then it's probably easier to take our money somewhere else. So I think there are quite valid reasons for why the price has fallen. It doesn't make it any easier.

Robert Gottliebsen: Mike, just some detail. What's the breakup between your managed fund to the annuity streams and the funds managed for outsiders.

MT: Well in total we manage funds or administer funds of about $85 billion. Now within that $4 billion is annuities. While our balance sheet is at risk on that $4 billion, and it's not at risk on the other $81 billion, it's relatively small.

I think another issue that we've had in terms of establishing understanding about our business is that the vast majority of our income is from base fees, recurring base fees for funds and assets or funds under management and assets under administration. So there's a perception that we might be in some way like some of our so-called peers – that all our money is made out of asset sales and out of performance fees and things like that.

In the December half we had a cash operating profit of $130 million after tax for the six months, which is about 20 cents a share, and there were no performance fees or profits from the sale of assets in that cash operating profit.

What people also don't recognise is that fair value accounting requires us to mark both our assets and liabilities to market. So in our statutory accounts at the moment we show that the cost of servicing our annuities for statutory purposes is at about the 15 year swap rate, which is close to 7 per cent, whereas our real cash cost of servicing the annuities, the amount we actually pay the annuitants, is 4.75 per cent average across the book and the average tenure of our book is close to seven or eight years, and in cash terms we carry 20 per cent capital to our liabilities. Now if you compare that to the average bank, the average bank carries 5 or 6 per cent capital instead of 20, the average tenure of their balance sheet is probably 45 or 50 days and we mark all of our assets to market which means that you know, in our fixed interest portfolio we probably marked that down by close to $170 million since June.

RG: About 58 per cent of those life assets are in debt and receivables. What exactly has the effect of the turmoil been on that particular segment of the portfolio?

MT: Within that, 85 per cent of it is investment grade or better with significant amounts in cash and AAA-rated securities. But even AAA-rated securities have blown out so we've got AAA securities issued by the Commonwealth Bank, for instance, that we bought at 120 basis points over the Reserve Bank cash rate that today are probably trading at 185 over. So we've had to mark those down to market, whereas in reality the probability of those securities not repaying 100 cents in the dollar is almost infinitesimal. I mean it's almost unimaginable.

RG: Mike just one more question before I hand it to James – infrastructure funds and infrastructure assets have been pummelled by the market. Do you think that's been fair. Do you think there's a different outlook for them and how has it affected you.

MT: Well I think firstly you've got to go to look at the underlying assets and what we have seen in global markets at the moment is strong demand continuing for quality infrastructure assets.

But are the underlying assets under pressure in terms of valuation? We're definitely not seeing that. What we're actually seeing is still strong demand and we're also seeing significant amounts of money being invested into wholesale infrastructure funds by large global investment groups – sovereign funds, high net-worth families, big pension funds.

Large, large amounts of infrastructure capital is continuing to be raised in wholesale funds. I think what's happened is that Australia has developed infrastructure as an asset class way ahead of the rest of the world and Macquarie Bank deserves the credit for that. They've done an amazing job in creating a new global asset class.

Maybe private equity was the last time that happened. Hedge funds, private equity and infrastructure probably have been the only three new genuine asset classes in the last 50 years, but Australian investors were attracted to infrastructure funds because they were being advised by brokers that property trusts were starting to increase their gearing.

If I go back ten years ago, most property trusts were only geared to 30 or 35 percent. Property trusts never did any development, never tried to be fund managers, only invested in Australia and a property trust was a very good alternative to putting your money in a bank deposit. You got a higher yield and you got a real prospect of capital growth and they were very low-risk places to put your money.

That changed over the past five to seven years and they became much higher risk and they invested internationally and they took on much more gearing and I think brokers, retail brokers, rightly started to say to clients 'You know, these are much more risky and here are these infrastructure funds that have a very low beta in terms of their income risk and they appear to be producing higher returns on equity than property trusts'.

So property trusts were aiming for 10 per cent return on equity and infrastructure funds initially were sort of aiming for 14, so a lot of people started to move out of property trusts into infrastructure funds – retail funds and a lot of people started to move or just to invest in there.

Then it became easy to margin loan against shares in retail infrastructure funds so a lot of people margined themselves into those funds, but the fundamental weakness of all those listed retail funds was that very few of them had significant institutional investment in them.

And so when people started to get nervous and it looked like credit spreads were blowing out, rumours started to circulate that maybe infrastructure funds weren't going to be able to refi, it's no great surprise that you know, unit prices started to fall.

As unit prices started to fall people started to worry about their margin positions and people were being margined out and so you had a lot of selling and you didn't have a lot of institutional support for the retail funds. There was a lot of institutional money in wholesale infrastructure funds, but they were always concerned about the risk of mark to market for their model.

Retail pricing has very little relativity to the underlying value of the assets, so you've seen these funds really take a hammering and from a personal investment perspective I think that many of them offer enormous value at the moment because the underlying quality of the assets is such that you're able to buy through some of the retail funds into assets that in the wholesale market will trade at 30, 40, 50 percent premiums to the look-through value that's on offer in the retail market.

James Thomson: Just on that Mike, you've received an offer for your infrastructure fund this week. What's your strategy in defending that offer? Are you trying to repel the bid entirely or trying to get a better price? You've talked about how the assets are undervalued at present. What's the strategy there.

MT: Well I should clarify. We haven't received an offer. What we've received is a letter that involves a proposal which is conditional on lots of things including finance so I think we need to be clear about that. So frankly it's a bit difficult to respond to something that is so hypothetical.

Our strategy with the Challenger Infrastructure Fund which really I announced on February 25 is that we believe that the underlying assets were very conservatively valued at the end of December. Essentially we had an independent valuation conducted on the assets every six months. The instructions to the independent valuer at December were that they should review their valuation methodology to ensure that they had appropriately taken account of rising credit spreads – and the probability that loan to value ratios would shrink over time and also the increased cost of equity as reflected by the cost of equity of listed infrastructure vehicles.

So having gone through all of that the valuers came in with an independent valuation of $4.05 per unit. Now I'm quite confident, based on what we know about the strength of the market out there for wholesale funds, that those values are conservative and that I could easily realise individual assets for materially more than the current carrying value, but we thought that the conservative value was a very appropriate approach given the dislocation in global markets.

While the market is undervaluing the units, the right thing for us to do is to look to what assets in the fund we might realise at a good price today, which will bring forward profitability and valuations that the valuers might take a year or two to catch up with. We can use that money where appropriate to reduce the overall gearing across the other assets and, to the extent that we think it's appropriate, maybe to look to buy back units. So that's the strategy that we've set off on towards the end of February and all I can say is watch this space.

In terms of the offer, or the proposal to make an offer, you know, we have a responsible entity that is essentially the board of the Challenger Infrastructure Fund and the responsible entity board is 80 per cent made up of independents and that board has hired UBS to advise it on how it should respond to this and so we're working cooperatively with that board. They will go through the process of determining whether this is an offer that's capable of becoming a deal, and to deal with it and other approaches that they might get in due course, but it's not really us running the strategy. We're not setting out to repel anything. Our interest is really ensuring that the units trade at fair value.

SB: Earlier you referred generally to the hedge fund assaults on financials around the globe. There's been a specific assault on Challenger and you've been reported to have referred activity in your shares to the regulators. Can you confirm that? An if it is true can you describe in broad terms what do you think happened to your shares?

MT: Well we haven't referred activity in our shares to the regulators, so I'm not quite sure where that view has come from. We've been subjected to an enormous number of completely untrue rumours – even one rumour that we owed Societe Generale $2 billion that had been called and that we couldn't meet the payment and you know, our board was sitting in the boardroom with the administrators and they were going to wind the company up. We've never had any relationship with Societe Generale. Our biggest loan with any organisation is with the ANZ Bank and we're drawn to $50 million on that loan, so that's our biggest loan in the whole company.

We are entirely retail funded across our whole business and as I say we have one loan with ANZ and it's only drawn $50 million. That could be drawn to $350 but it's not. So that was an extraordinarily malicious and untrue rumour that coincided with a major decline on that day in our share price.

But there have been days when we've had up to 70 rumours and one of the problems here is there is a requirement in the ASX listing rules that companies should make an announcement to deny a rumour but you know, do they really think we're going to make 70 announcements in a day?

In Japan and the United States it's a criminal offence to short sell without holding borrowed stock to cover. I think that's a sensible rule. I'm not against short selling, but I don't think you should be able to short sell bare. Take a ridiculous situation – what if somebody bid $20 a share for Challenger today. Most of the people that are short who are not based in Australia and have no assets or employees in Australia would simply shrug their shoulders and say to the ASX sorry, we're not settling and there's nothing you can do about it.

SB: Mike, with this multitude of rumours, do you think it's just the general market environment or is there something sinister and systemic about it.

MT: Let's assume that I'm a hedge fund manager and I borrow stock – say, $50 million worth of stock in any company, call it Company A and it's going to cost me probably $20,000 or $30,000 a week to borrow $50 million worth of stock. If that stock falls 10 per cent in price, I've made $5 million in a week on an outlay of $20,000 or $30,000. The incentive for me to encourage bad news around that stock is just out of all proportion to the risk of getting caught, so we would say that there have been malicious untrue rumours spread not only about us but about other very good quality stocks that clearly have no reason for people to be concerned about them. Those rumours have been directly linked to falls in share prices and people have profited enormously from that.

RG: Mike, just changing the subject, the securitisation of mortgages has virtually dried up. How has that affected you and when do you think it might open up again?

MT: Well look, I mean we've got no idea when it might open up again. Global capital markets are in the worst shape I've ever seen in my life. I have been going back and rereading all the books I can about 1929-34. It looks to me like it's very much similar sort of circumstances. I'm not suggesting that we're in global depression, but certainly there seems a lack of liquidity in global markets happening.

What the market doesn't seem to be acknowledging here – particularly the Federal Reserve in the US but central banks more generally – is that all of the banks are desperately short of capital and when banks are short of capital they have to shrink their balance sheets and when they shrink their balance sheets then they eventually take out of the economy all of the capital that creates productivity improvements. When you don't have productivity improvements you don't get economic growth and so you know, by not making the banks raise capital the central banks are essentially creating their own sort of recession around the world, and we're not immune from it here.

I think the banks here are also tight on capital. Nowhere near as tight as they are in the US and parts of Europe, but we've got a catastrophic shortage of capital amongst the major banks in the world and they're all desperately shrinking their balance sheets. So while that's going on, it's hard to see how credit markets will get back into good shape.

The other thing that's going on – and we talk a lot to all of our regular investors in our securitisation programmes – is that most of the investors are not banks. They're life insurance or pension funds and they're also mark-to-market investors.

The problem they've got is if they go and buy an asset today and call it a AAA-rated security at 110 basis points over [bank bills] the probability is that it will be marked to market to 180-over tomorrow or the next day or the day after so there's enormous volatility in these markets.

So while they've bought a great asset that they have no intention of ever selling, they get absolutely hammered by the lack of liquidity in the secondary market...where the buy-offer spread reflects the fact that the only sellers are desperate sellers and the only buyers are absolute bargain hunters.

The traditional market makers who create liquidity in the secondary market that keep the price at a fair level compared to the new issuance price are pretty much out of business or sitting on their hands at the moment. So till that liquidity problem in the secondary markets starts to trade on more reasonable terms – and that doesn't mean normal spreads but just that there's some liquidity there – the origination market will remain closed and I don't know whether that's going to be significant.

RG: How does it affect you?

MT: It could affect us, but much more important for us is that we've got significant warehousing capability. We could be writing much more volume of mortgages at the moment if we wanted to, so liquidity is not really the number one issue for us.

At the moment all the banks are losing money on their mortgage portfolios and we don't write business at a loss. So the issue for us at the moment is that the banks are pricing their mortgage portfolio at what is a loss for them – they're 80 per cent wholesale funded and their wholesale funding margins have blown out by 140 to 170 basis points – they cannot be even breaking even on their portfolios at the pricing that they've got there now.

And in a funny sort of way, I don't know whether the Government really understands this. But, you know, someone from the Government said to me that of course Labor governments love to bitch slap the banks on mortgages – it's politically the perfect time to do that, but of course the other side of it is if the banks aren't making money then eventually they'll stop lending. And if you look at the bank mortgage origination volumes in January and February you'll see the banks are withdrawing from new origination of mortgages at a rapid rate.

We've stopped writing any real volume around about November because it was clear that we couldn't make money on new mortgages and I won't write business we can't make money on.

We're only a 2½ per cent market share participant, so we can come and go pretty much as we please. We've got very flexible distribution so it doesn't really matter to us. I mean at the moment we're cutting our costs back to reflect the lower volume. Our business is more profitable when you write less volume because a lot of our costs are up front costs and distribution and so our profitability is improving. The quality of our book is improving as mortgages get paid down over time but there will come a time maybe 12 or 18 months from now where if markets haven't reopened we will start to see some run off, and that run off will start to impact our profit there.

On the other side, though, in the last year or maybe two years we've moved into distribution in a big way and we now own 40 per cent of a listed vehicle called Home Loans which is a major mortgage distributor which distributes third party products, not our own. We also essentially own a company called Plan which is the largest mortgage broker aggregator. We also essentially own a company called Fast, which is the third largest mortgage broker aggregator and we own another company called Choice, which is the fourth largest. So about 60 per cent of all the brokers in Australia now work for us and so the distribution component of our business is moving from being none of our profit you know, 12 or 18 months ago, to a situation within another 12 months where it will be something like 40 to 50 per cent of profits. So we've got a significant growth of profit happening out of distributing essentially bank product, and we are happy that they are writing loans at a loss because that makes it easier for us to sell them. And in our manufacturing area, we'll wait until the market returns to normality and profitability and then rebuild from there.

SB: Mike, I'm very conscious that we've taken up a lot of your time. Thank you very much for sharing your views and insights with us.