The Greenspan putz

The distress of those whose money is now stuck in frozen mortgage trusts will not be helped this morning by Alan Greenspan's admission that he got it wrong.

Perpetual, AXA, Challenger and the others might be saying the freeze on redemptions is temporary, but this is a permanent disaster for the financial planning and retail financial services industries, not to mention their customers.

The risks inherent in mortgage securitisation were ignored and underpriced, almost to zero; now they have become all too apparent. While it's true that many mortgage trusts hold loans directly, rather than mortgage securities, the principle of mispriced risk is the same.

In front of Congress overnight, former Fed chairman Alan Greenspan testified that he was in a state of "shocked disbelief” over what has happened. "The breakdown has been most apparent in the securitisation of home mortgages,” he said.

Australian investors in home mortgage trusts, sold to them by financial planners on commission, would be on the edge of the seats at this, waiting for the punch line. It was this: Alan Greenspan has discovered there was a flaw in his ideology. Sorry about that.

But it would be wrong to blame Alan Greenspan, who let securitisation rip, or the financial planners and investment bankers who sold the securities, although they do have a lot to answer for.

Nor is it reasonable to blame Kevin Rudd and Wayne Swan for the confusion around the introduction of the bank deposit guarantee two weeks ago that resulted in a run on mortgage trusts and cash trusts, and the freeze on redemptions.

It would have been better had they more carefully thought through the details of the guarantee before announcing it, but they did not know how soon it would be before a run on smaller deposit-taking institutions started. Time was of the essence.

In a way this situation has been inevitable from the moment the credit crisis began: at its core is the mass migration of capital from higher risk to lower risk, from cold to warmer weather, as it were. Much of time the migration has been at an inexorable walking pace, but occasionally the wildebeest get a fright and stampede.

The decision to guarantee bank deposits, also inevitable, was such a moment.

Mortgage trusts, however, cannot be guaranteed: the money in them is not a deposit backed by regulated capital, but simply a pooled investment.

This is the issue at the heart of the heart of the financial crisis now enveloping the world. Loans were securitised and turned into investments rather than assets of institutions that have a regulated capital buffer and, in extremis, government support.

Government backing is never explicit, but everyone knows that banks are almost never allowed to fail, especially big ones.

Investments in mortgage securities are an entirely different matter. The trouble is that the differences have not been made clear to the investors.

As Alan Greenspan said in his testimony to Congress last night: "With … home prices rising, delinquency and foreclosure rates were deceptively modest. Losses were minimal. To the most sophisticated investors in the world, (mortgage securities) were wrongly viewed as a 'steal'.”

Unsophisticated investors didn't stand a chance.

Now the "steal” is going to work the other way. Mortgage securities vehicles everywhere are being liquidated because their risk is being repriced – in most cases dramatically, to the point where investors don't want their money in them at all.

That is the basis of the run on what's called the "shadow banking system” in the US, as well as the run on Australian mortgage trusts. Those trusts, in my view, will also have to be liquidated – that is the mortgages sold to repay investors.

The only buyers of the mortgages are banks and other government guaranteed institutions. There will be a flood of such mortgages onto the market. The banks will "steal” them – that is, they'll drive a hard bargain.

The irony in this is rich. Although only the non-banks like Perpetual and AXA have frozen their mortgage trusts so far, the banks are at the heart of the financial services system, and it's their financial planners who have been selling the securities.

A couple of years ago an elderly relative of mine took a large sum of money (for him) along to his bank, Bendigo Bank, to put on term deposit.

When he asked what the best account was, the teller suggested talking to a certain financial planner who works for the bank.

The planner showed up on the doorstep two days later bearing a prospectus for Challenger's Howard Mortgage Trust (now closed), recommending that the money should go in there for an extra 0.5 per cent. Some of that, naturally, went to the planner.

My relative would have done it, too, if he hadn't asked me for my thoughts before signing. I pointed out that the money would not be going into Bendigo Bank – to his amazement – and I showed him the commission that the planner was getting, which he had somehow missed. I also said I thought the extra interest was not enough to cover the extra risk.

The money went into the bank, thank goodness, but many others have believed their financial planners, who didn't know any better either.

After all, Alan Greenspan got it wrong as well.

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