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SPECIAL REPORT ON WESTPOINT: HARD LESSONS LEARNED A SECOND TIME
We have been shocked and deeply moved by the personal trauma and financial hardship wrought by the collapse of mezzanine property financier Westpoint. Around 4,000 investors have lost $320m. Some of these investors put all their life savings in Westpoint. Others borrowed, even mortgaging the family home, to invest in Westpoint. They have lost all their investment and still have to pay interest on the loan and repay it, now without any tax advantages, or they could lose their homes. This is sickening. With the socially disastrous collapse of Estate Mortgage in the early 1990s still fresh in the minds of those advising or investing then, we hoped Australians would not have to learn the lessons from the collapse a second time. But history has come around again.
The Westpoint collapse is a product of its time. It occurred at a time when choice in the investment of superannuation funds is government policy and DIY super is highly popular. Encouraged by this, advice to self-fund retirement and a need for income, some investors were always going to be vulnerable. The current prosperity and optimistic investing climate are also relevant, with many investors never having seen a downturn. The number of investors condemned to hardship by the collapse and the amount of retail money lost are signs some investors do not have the skills to be responsible with their own money.
According to the liquidator of most Westpoint companies the reasons for Westpoint's failure include: "high gearing, extensive delays, inappropriate and costly financial structuring, ineffective remedial action by management and inappropriate or ineffective risk management." The liquidator is investigating actions against directors for insolvent trading, preference payments, uncommercial transactions, unreasonable director-related transactions, and misleading and deceptive conduct.
As advisers dedicated to helping investors preserve and grow their hard-earned capital we are always appalled to see investors lose life savings in a collapse. Having noted the investing public's outrage at the collapse and how Westpoint was recommended, and the consequent media coverage, we thought investors would be interested in how to avoid becoming a victim of future property finance collapses.
We are not going to give advice on whether Westpoint investors should join class actions arising out of the collapse.
How to avoid getting caught in a property finance collapse
First, NEVER invest all your life savings in a property financier in the first place. This is one of the most dangerous and least transparent investment sectors and the higher interest rate is not worth the risk of losing the capital it has taken you decades of work to save. It is beyond belief that some advisers could have recommended people put all their money into property development.
Make it your business to know common interest rates, for example on retail deposits, bank bills and prime commercial loans. If you come across an investment opportunity offering an interest rate even one percentage point above these rates then you need to know why that is. If a borrower pays you, the lender, a premium above prime bank lending rates then that is because the banks weren't prepared to lend to that borrower at prime rates. This was because the borrower was high-risk. The borrower has had to turn to the public instead. And you know what professional investors say about public money: it's the dumbest money.
Professional investors demand returns of 20-30% to fund property development, reflecting the enormous risks. If you are being offered Westpoint's 12% then you are being done like a dinner. The developer is exploiting your inexperience to get away with cut-price finance and you are not being compensated for the risk assumed. The devastating irony for some Westpoint investors was concluding a 12% return was not too far above bank rates and was therefore not too risky. After all, the corporate regulator says to avoid high returns because they mean high risks, doesn't it? Investors who did not understand the underlying risks in mezzanine property finance ended up demanding a return far less than they should have received.
Just because the financial planner says it's a "mortgage trust" doesn't mean it's safe. The safest mortgage trusts own first mortgages, which means the lender is first in line to be paid out if the borrower defaults and the asset has to be sold, over completed and tenanted residential properties. In contrast Westpoint and other mezzanine financiers bankroll the construction and sale of new properties by filling the funding gap, left after the banks refuse to put up any more money, with second mortgages. They are in the queue behind the banks in the event the developer cannot sell all the apartments. The risk profiles of the two mortgage trusts could not be more different. Other kinds of mortgage trusts fall in the middle of the risk spectrum. Mezzanine investments can be useful to wealthy, experienced and diversified investors who are told about the high risks and can afford a failure, but small investors are best advised to be very cautious.
Ask where the distributions come from if the underlying asset is a property which is incomplete and therefore not earning rental income. We can tell you where they probably come from: the subscriptions of new investors. Such schemes are "Ponzi schemes", where until the underlying project, concept or investment succeeds, investors get their distributions only if the promoter can keep attracting funds from new investors. This places your distributions and your ability to redeem your investment at great risk. Other risks in property finance are loans to related parties, lack of diversification and the capitalisation of interest.
Know which organisations are banks and which aren't. Some Westpoint investors thought Westpoint was a bank, saw their investments as deposits and assumed they were government-guaranteed. This is almost unbelievable. (The government actually doesn't guarantee bank deposits but charges its prudential regulator with ensuring banks never fail.) Walk out if a financial planner ever tells you a company, scheme or fund which lends to property developers is as safe as a bank.
The ritzier the office and the more impressed you feel, the more you are being sold, not advised. Beware of glossy documents and impressive slide presentations.
Understand the risk of contagion in unlisted funds, promissory notes or debentures. A run of collapses could lead to a stampede for the exits from similar vehicles, resulting in the vehicles quickly exhausting their liquidity and becoming unable to make further repayments without selling assets into a falling market.
Understand that regulation of high-yield investment schemes and property finance is incomplete and evolving. From time to time some managed funds are found to be illegal and not regulated by the Corporations Act, which insists on certain standards of disclosure and ethical behaviour. The resulting court cases can take years. Also, ASIC only regulates how funds raise money, not what they do with it. And ASIC does not regulate the issuers of high-yield, property-related promissory notes and debentures.
In any case regulators can't save you from yourself and you can't turn to the regulator or the government after a collapse and expect to be paid out. It's tough, but you are on your own in the investment world and class actions after the event are not where you want to be. The good news is with consistent application and study of successful personal investing, and a keen and sceptical mind, you can protect yourself from a very large proportion of collapses.
Understand the legal loophole which exempts promissory notes with a value of at least $50,000 from the strict disclosure requirements in the Corporations Act. This exemption, introduced in 1981, assumes investors of a certain size are sophisticated enough to need only an information memorandum, not a product disclosure statement or prospectus. We think the $50,000 threshold is out of date given many investors begin retirement with portfolios worth hundreds of thousands.
Exercise maximum caution with financial planners if you are new to Australia or do not speak fluent English. Greedy and unethical advisers will attempt to use your inexperience and unfamiliarity with the language against you, criticising the saving and investment culture of your first country and telling you the fund they're pushing, which they will describe as the Western or Australian way of investing, is superior. Some Westpoint investors were new immigrants who were told exactly this.
Educate yourself about Australia's grim history of property busts and collapses, which stretches back to the mid-19th century. Pay particular attention to the Mainline and Cambridge Credit collapses of 1974, the commercial property crash of the late 1980s and the Estate Mortgage disaster of the early 1990s. Just because it hasn't happened for a long time doesn't mean it can't happen again tomorrow. Investment disasters happen usually because new generations of investors haven't had the bitter experiences which taught hard lessons to earlier generations. Anyone who lost money with Mainline or Estate Mortgage would not have touched Westpoint.
Financial planners are now required by law to disclose commissions on recommended products. Remember to ask about this. Rates of trailing commissions of more than 2.5% and upfront commissions of more than 4% - some planners who recommended Westpoint were paid 10-12% upfront - are above industry norms and are flashing red lights. High commissions are a sign the product manufacturer is having trouble raising money - why else would they pay so much? We support ASIC's suggestion of a "disclosure cap" which requires advisors to alert consumers to unusually high commissions.
But continue your search for independent advice untainted by commissions. Aim to build a portfolio large enough, and have a relationship with your financial planner which is long enough, to make it worth your while paying a fee for advice rather than having the planner remunerated by commissions from product manufacturers. Have the planner rebate to you any commissions. It seems not only were no commissions rebated to Westpoint investors, the commissions were paid from pooled investors' funds and not deducted from individual subscriptions.
Finally, rather than investing in a property financier for a 12% interest rate, no capital growth and with all its hidden risks, consider investing in quality listed companies which have a long history of increasing their dividends. You'll be amazed how quickly your total dividend income grows.