What has the GFC taught us about Mortgage Funds?

If the Global Financial Crisis (“GFC”) has achieved one positive thing from investors’ viewpoint, then it may be the re-emergence of respecting “risk” and what effect it has on your savings.  This respect of risk had in many cases been forgotten by many investors, advisors and the people who manage the investment assets.

The most obvious symptom of this forgotten respect for risk was the poor pricing of risk.  As interest rates became lower and lower, the competing lenders were tempted to lower the risk margins they applied to ensure they continued to attract market share.  Our office heard brokers say things like “if the project runs into trouble, just holding the property will fix any shortfall”.  These types of statements ignore the underlying reason for the trouble the project experiences.

Lessons for Mortgage Funds

For Mortgage Funds, the GFC exposed the key differences between different Fund designs.  There are two types of Mortgage Funds, and then two types of investment styles (for a full explanation of these differences, see this article).  Debenture Funds and Pooled Managed Investment Schemes (“Pooled Funds”) both ran into significant liquidity problems.  Many larger institutional funds had their redemptions frozen while others were wound up as insolvent.

Contributory Schemes suffered much less from liquidity concerns.  The Association of Mortgage Investment Corporations (“AMIC”) represents a number of contributory schemes in Victoria and has not reported any significant failure among its members.

The key reason for the difference is the matching of maturities.

Pooled Funds have many investments that have long maturity dates, but allow investors to withdraw within much shorter periods.  Therefore, when an event occurs (such as the 2008 Commonwealth bank deposit guarantee scheme, or a series of high profile defaults), investors will naturally want to withdraw funds and when too many do this at the one time, the freeze on redemptions becomes inevitable.

In most contributory schemes, investors commit to invest in a particular mortgage for the duration of its term, without a right to withdraw from the investment prior to that maturity date.  This does not mean they are immune from problems.  If a loan is not repaid on the maturity date and sufficient investors want to withdraw, a similar problem can arise.

The key is that in a contributory scheme, the contagion is restricted.  The only investors affected by a defaulting loan in a contributory scheme are the investors in the individual mortgage that experiences problems.  In a Pooled Fund, every investor is affected.

So why invest in Mortgage Funds?

The GFC has caused investors to think about the risks that each asset class has imbedded in them and respect them.  Risk cannot be avoided, even if you put all your funds into cash (because inflation risk will reduce the purchasing power of the cash).  Risk can, however, be managed so that different risks offset one another.

Financial advisers often tell clients to have a mixture of assets in an investor’s portfolio.  The question is, why would Mortgages Funds have any role in a portfolio?

Many investors will hold shares and other equity investments in order to access capital growth.  The GFC clearly demonstrated that potential capital growth comes with the risk of capital losses.  Shares generally behave in a volatile manner – prices can vary greatly in the short term, both up and down.  This volatility makes it difficult for investors to determine when to exit an investment if required to do so.

Dividends on shares have been slashed during the GFC.  While these may return to previous levels, investors have seen the combined loss of capital and dividend income make a significant difference to their portfolio returns.

Having a percentage of your investment portfolio in a Mortgage Fund can:

  • Help to smooth out the returns compared to the volatile listed assets – particularly for super funds, the variation of returns that the share market brings can be disconcerting.  It is great when the market is up, but not so great when it goes down.  A mortgage investment can provide a fixed interest return to help smooth these out;
  • Provide cash flows that are predictable and regular – investors may often be reinvesting returns from equities back into further shares, or may be in pension mode in a super fund.  Each of these examples need an investment that will provide cash returns at regular intervals in order to meet the needs of the investor;
  • Help manage taxation consequences of capital gains – an investor that holds unrealised capital gains may need to have some flexibility about when those capital gains are crystallised.  A spread of mortgage investments can provide sufficient maturity dates to allow for capital to be available without capital gains tax consequences.

These and other benefits can assist investors to manage the risk that is present in holding wealth in any form.  Care needs to be taken to ensure that all aspects of risk have been considered.  Where possible, investors should consult an investment advisor that has experience considering these types of investments.  Even with this approach, investors should still respect the risks they face when investing.