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Six ways to avoid another Bridgecorp - Eureka Report Article

July 4, 2007
Six ways to avoid another Bridgecorp
By Scott Francis

PORTFOLIO POINT: Several basic steps can help protect investors, starting with checking whether a proposed investment has attracted the regulator's scrutiny.

Is there no end to it? The collapse of Bridgecorp, the trans-Tasman property finance group, leaves investors facing losses of $450 million. Worse, it brings the cumulative bill for failures in this construction finance sector over the past 18 months to well above $1 billion.

The first three failures - Westpoint, Fincorp and Australian Capital Reserve - were little known. However, with Bridgecorp more cautious investors even had access to research that supported it as an investment option, an issue that Michael Pascoe explores in more detail today.

With each new failure new depths of weakness are exposed. It is now becoming clear the property finance business is poorly regulated, highly speculative and (under a privatised ratings system) exceptionally difficult to analyse.

How do investors understand these investments, and protect themselves from the increasingly obvious downside - which is the loss of large portions, or perhaps all, of their investment capital?

Let's start by looking at the details of the Bridgecorp

Bridgecorp is a property development company, whose activities have in the past have come under scrutiny by ASIC. About 12 months ago ASIC received a "Consent Order" against Bridgecorp finance, which included restrictions on the raising of further funds.

A previous stop order by ASIC also meant that much of Bridgecorp's recent fund-raising activity had been focused in New Zealand, with the expected collapse likely to have a much bigger impact on New Zealand investors. It is believed more than 15,000 Kiwi investors have money at stake.

Bridgecorp enticed investors with promised yields of more than 9%. As Eureka Report has regularly detailed, 9% is a very poor return for the risk that is taken in these type of products; listed property trusts on the ASX routinely return well above 10%.

The Bridgecorp website provides some interesting information about lending procedures. This is directly from the website:

Features of Bridgecorp's finance packages are:
up to 100% of development cost
subdivisions, development, building and renovating funding considered
presales not always required
mezzanine funding available
interest only and capitalised interest facilities considered
lending against registered valuation not purchase price

What does all this mean? Mezzanine funding refers to "second mortgages", which are mortgages where someone else has first claim to the assets. Therefore second mortgages are riskier than first mortgages. "Lending against registered valuation" is further explained in another part of the website, where it states that "We will lend up to 100% of development costs based on a registered valuation of the completed project."

This lending to the "valuation as if completed" is a real problem because if the project collapses prior to completion it will never actually achieve that valuation. The capitalisation of interest, while common in property construction loans, also provides another level of risk for investors, as the loan increases over time with the interest just being added on to the loan, not being paid back. So the loan increases and increases, with no real interest payments being made to the investor.

How do you protect yourself?

1: Beware of ASIC scrutiny. ASIC had been involved with Fincorp, Australian Capital Reserve, Westpoint and Bridgecorp prior to their collapses. The bottom line is this: where ASIC has to step in and have an involvement with an investment provider, it is because there are often real problems. In an investment environment where there are so many choices, why would you go with any investment that had behaved in such a way as to attract ASIC's attention?

2: Accept that risk and reward are related. Nobel prizes have been awarded for research that looked at the way risk and reward must be related. There is no way around this relationship. The only reason Bridgecorp was offering returns of more than 9% was because no one lent them money at 7%, 8% or 9%. Why? Because those lenders knew they were simply too big a risk.

3: Accept that property construction is a risky process. Property construction, with capitalised interest and lending against "property valuations as per completion" is clearly a very speculative business. There are risks associated with construction and then with the sale of the business. Property construction is a very different game compared to investing in a completed or existing property.

4: Beware of aggressively advertised investment opportunities. When investment schemes are aggressively advertised to retail investors ("mum and dad" investors), the financier may have failed to persuade institutional investors to take up the investment opportunity. It would have been far easier for Bridgecorp (or Fincorp, Westpoint, Australian Capital Reserve) to simply organise one loan with one bank. Why didn't they? Because the banks would not enter such business with them. So they turned their efforts to raising funds from the less financially sophisticated retail investors.

5: Do you need exposure to property construction in your portfolio at all? Perhaps this should be the first point. Do you even need to be investing in portfolios that lend money for property construction activities at all? We have more than 100 years of evidence of how the Australian stockmarket and traditional fixed interest markets provide reasonable returns to investors. Direct residential property has also proved itself as an investment class over many decades, and listed property trusts now have three years of evidence supporting their use on portfolios. So why invest in property construction loans at all?

6: Diversification is a powerful friend. Diversification across (and within) asset classes is a powerful ally in reducing the damage from any failed investment. Keep in mind that no investor in Bridgecorp / Westpoint / Parmalat / HIH / Enron or World Com expected their investments to be reduced to being practically worthless. However, a well diversified portfolio at least cushioned the collapse for many investors.