Why the Government shouldn’t bail mortgage fund investors out: Bartholomeusz

The push for banks to buy assets from the frozen mortgage funds raises some delicate issues for the funds and the Australian Prudential Regulatory Authority.

A genuine arms-length commercial decision by a bank to buy assets from a fund, and in the process create liquidity for the fund so that it can meet redemption requests, isn’t a particularly concerning issue, provided the bank is motivated by the profitability of the transaction.

Whether a fund would be quite as interested in the deal, given that it would almost certainly mean having to sell assets at less than optimum value, thereby reducing returns for continuing investors, is a different matter. Again, though, that would be a matter involving commercial and fiduciary judgements.

The Federal Government could, if it wished, achieve the same objective if the Reserve Bank or the Australian Office of Financial Management were allowed to provide short term liquidity against prime rated paper held by mortgage or cash trusts – and the effect on the funds would probably be the same.

If the funds were given some legislated flexibility to apply some form of discount for redemptions from otherwise frozen funds, the impact on those investors willing to wait out the freeze could, however, be ameliorated.

The more disconcerting suggestion is that where the mortgage fund or cash management trust is a subsidiary of a bank, the bank should step in and either acquire assets or provide funding for redemptions. That would be a potentially dangerous development.

One of the core principles under which APRA regulates financial conglomerates is a clear demarcation between authorised deposit-taking institutions and their non-ADI subsidiaries.

APRA’s own requirements state explicitly that, as a general rule, an ADI should not undertake any third-party dealings with the prime purpose of supporting the business of related entities.

APRA and its predecessors have been at pains to separate market-related funds management activities from banking operations, and to ensure there is no confusion in the minds of investors about the level of protection they gain from dealing with a bank-owned manager.

Any protection or services ADIs provide to funds management businesses has to be explicitly disclosed in product disclosure statements and APRA will force the ADIs to hold capital against any risk the relationship might create. In the absence of a formal legal agreement to provide support, the ADI is required to make it clear that it does not stand behind deposits/or investments with the non-ADI subsidiary.

That is simple common sense and prudence. If the regulatory imperative is to protect the interests of deposits – which now, given the introduction of depositor guarantees, means protecting the taxpayers’ interest – allowing banks or other ADIs to bailout their funds management activities would introduce new market-related risks into their own balance sheets.

A run on a funds management business would drain liquidity and probably capital from the parent organisation. It would introduce a new potential pipeline of contagion into the banking system and another layer of moral hazard.

Investors in mortgage funds and cash management trusts and other funds with market-linked returns that aren’t regulated by APRA chose to expose themselves to higher risk in pursuit of higher returns. For those invested in funds managed by the banks and other big managers, their capital funds appear quite safe, albeit locked up, and their income continues to flow.

The Government’s guarantee of bank deposits has definitely had a significant impact on the position of the mortgage funds in particular, but fundamentally has just amplified and accelerated a retreat to security that was already underway.

The fact that it has had an impact doesn’t justify a weakening of the prudential standards within the core of the system that the Government took such dramatic measures to protect.

If there is a price to be paid for unlocking frozen funds for those who want immediate access to them, it should be paid by the investors who received the higher returns in exchange for a risk that has now eventuated – not by bank shareholders or taxpayers through a relaxation of the prudential standards that have served the core system well through the credit crisis.

This article first appeared in Business Spectator