Sunk by housing derivatives

The fund invested in collateralised debt obligations (CDOs), which are priced based on an underlying parcel of mortgages. Basis Capital invested in CDOs over US "subprime" mortgages.

These are the highest-risk mortgages because they are those taken out by people who struggle to service their mortgages even in the best of economic times, let alone during the GFC.

The wealthy can afford to take a punt but not so small investors. ANZ Bank has compensated thousands of New Zealand investors, mostly retirees, who lost hundreds of millions of dollars in 2008, in two funds managed by its ING funds management arm. The funds were invested mainly in CDOs and other high-risk investments. The bank's financial advisers had put many of the investors into the funds.

US subprime mortgages were always riskier than their Australian counterparts. That's because in Australia, when a borrower defaults, the lender goes after the defaulter if the proceeds from the sale of the house do not extinguish the debt.

American mortgages are "non recourse" and lenders cannot go after the borrower. The lender has only the proceeds of the sale of the house from which to recover its exposure. Consequently, as American house prices fell and borrowers saw the value of their houses fall to less than their mortgages, they left, posting the keys back to the lenders.

US mortgage lenders were greedy but they weren't stupid. They covered the risks that the borrowers could not repay their mortgages. That risk mitigation was made possible by the investment banks, who created CDOs that were on-sold to investors. It was the investors in the CDOs who ended up carrying the risks, leaving the mortgage lenders to get on with their irresponsible lending. CDOs were, up until the GFC, one of the fastest-growing categories of financial derivatives. With the collapse of US house prices, the defaults in repayments on the mortgages that were bundled up in the CDOs made the CDOs worthless.

But back in 2002, the "Sage of Omaha", Warren Buffett, called derivatives, which include CDOs, "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal". He said the risks were not only for individual investors but to the whole financial system.

A derivative is nothing more than a piece of paper whose price derives from an asset. They can have a legitimate role in helping companies spread their risks to others. But it's when they are used for speculation that they have the potential to become dangerous.

Six years ago, I was contacted by one of the big investment banks who thought I needed to be educated in CDOs. I was told how terrific they were for small investors and how I should write about them.

The diagrams showing how they worked were mind-boggling in their complexity. That was enough for me. Small investors should keep away. However, I naively reasoned that if professional fund managers wanted to go there, they would hold CDOs as part of diversified portfolios. But Basis Capital did have a big exposure, particularly to one big chunk of CDOs it bought from Wall Street investment bank Goldman Sachs.

Further, Basis Capital borrowed against this exposure, which while increasing the returns ramped up the risks even more.

Basis Capital is now taking legal action against Goldman Sachs in the US, claiming it was deceived by the investment bank into the buying the CDOs. The lessons for small investors are clear: stay away from complex investment products that are not easily understood. Complexity is always a hazard for small investors, just as much as it appears to have been for Basis Capital.