Rating the Mortgage Funds

In the wake of the Westpoint disaster, the move by ratings agency Standard & Poor's to run tape measure over mortgage funds is timely.

S&P associate director Peter Ward warns that mezzanine financing and promissory notes carry a "contagion risk", and that investors often misunderstand of these products. He says S&P empasises the need for diversification in managers' portfolios.

The S&P review found, surprisingly, that some funds bend the risk/reward rules by offering higher rewards but with carefully managed risk. Ward says their experience, expertise and processes of the managers help keep risk levels in check. That leaves conservative funds, bound by their own strict rules, with the problem of generating returns.

Michael Pascoe: Standard & Poor’s has broken down the industry into conservative, hybrid and high risk. High risk '” it means Westpoint to a lot of people at the moment.

Peter Ward: High yield; the actual subgroup is high yield.

Meaning high risk.

Yes, it’s certainly a higher-risk/higher-return parameter but it is important to differentiate between the mortgage funds and the likes of, say, you mentioned the Westpoint mezzanine notes and promissory note issues. Certainly, mortgage funds are far more diversified than those mezzanine notes. They invest primarily in a diverse pool of mortgages. First mortgage and second mortgage-backed security and also liquid investments as well. So they’re not exposed to just one borrower, one property, one project. And not exposed to related party transactions either.

Somewhat perversely, your work shows that it’s the conservative funds that really have a bigger problem at the moment. Is that a fair reading?

In regards to '¦

Getting a decent return on risk. On the competition in the market.

Yes certainly. I mean competition is one of the causes for the sub-optimal performance as well. Certainly the banks have a voracious appetite to write new property finance transactions and perhaps are able to be a little bit more flexible in regards to their lending parameters and may gear slightly higher than some of the mortgage funds. They may also lower their margins in order to get the business on board, therefore creating a situation whereby the mortgage funds may be restricted by their own lending parameters and therefore a build-up of liquidity in those funds.

At the other end of the spectrum and the high-yield/high-risk area: it is more risk yet S&P says it’s reasonable.

Yes. We believe that those high-yield managers are able to manage those risks. We’ve undertaken the review speaking to the management of those particular funds '” looking at their experience and expertise in managing that type of debt funding. We’ve also looked at their processes in regards to how they originate basically cradle-to-grave '” from the origination point through the credit assessment, credit approval, management of the loan throughout the loan term.

S&P has rated four high-yield mortgage funds. Is your view of the industry coloured by the fact that those four are all decent funds. The more dubious ones haven’t been included?

Certainly, we’ve rated four funds out of that particular subgroup and there’s certainly others out there that would fall into that category.

Is there a bit of self-selection there, that only the good want to be rated by you?

That’s a distinct possibility because obviously a rating has a significant impact on the mortgage fund manager’s business, and if they believe that there’s a distinct possibility that they may get a sub-investment grade rating, they may well abstain from the rating process.

The four high yield funds you’ve rated are all doing 1.5 percentage points better. That’s in a fairly benign interest rate environment though. What happens to them when times get tougher?

A couple of things could happen. First, the performance may become more volatile. They may have increased experience of loan arrears and defaults and possibly losses, so that reflects the high risk associated with them. What actually may happen over time is that the margins may actually increase.

There’s been an international compression of risk premiums. Is that a concern?

I think that’s indicative of where, in particular, the conservative mortgage funds have experienced that compression. So it’s probably reflective of a global environment as well.

From the point of view of the investor: can they think the end user of these funds '¦ how bad must they be if a bank doesn’t want to lend to them?

I wouldn’t say necessarily that those borrowers actually go into a mortgage fund because they can’t get money from the banks. Quite often they do actually prefer to deal with the mortgage funds. They quite often get a better turnaround time and sometimes better service.

And between the conservative and the high-yield there are the hybrids. How do they rate?

They rated pretty well. Basically, the hybrid multi-sector was comprised of Colonial funds. The manager then has moved towards developing this asset allocation to fixed interest securities.

Looking at the industry, was there any area that did concern you?

I think one of the biggest areas of concern was in regard to the possible contagion risk associated with the likes of the mezzanine notes and the promissory notes, and perhaps a misunderstanding of the nature of those particular products. It’s something that we’ve emphasied in regards to the diversification issues and the structuring of those particular products, that they are different. It’s important that investors and financial planners actually understand it.

Where do you think the cut-off rate is in yields between acceptable high-risk/high-yield and ultra-high-risk?

I guess it’s more on the actual risk parameters themselves that determines what risks they are actually taking.

So there’s no particular figure you see in a promised return that makes you think, 'This looks dangerous’.

I’d probably be more focused on the lower end. I mean, once you get up to gearing of about 90% you’re looking at almost taking an equity position in the particular project itself. If you go much higher than that then most certainly you probably are taking an equity-type risk in that.

At the conservative end, the blurring of perhaps some of the labelling and perhaps if funds are reflecting a higher return than the rest of the pack, we will scrutinise that and we have scrutinised that. It has actually resulted in one of the funds being reclassified from the conservative sub-group into the high-yield sub-group.