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Tide of Destruction - Eureka Report Article

May 30, 2007

	Tide of destruction By Scott Francis

PORTFOLIO POINT: Unsecured investments in property construction are an extreme hazard that investors should avoid.

Here we go again! How many times does it have to happen? Australian Capital Reserve, a finance company we highlighted only six weeks ago in Eureka Report, has gone into administration owing $300 million and leaving 7000 retail investors facing losses.

The ACR collapse is bigger than Westpoint or Fincorp and it's worse because this time the warning bells were ringing loud and clear ... yet nobody shouted 'Stop!'

Today the chief regulator - Tony D'Aloisio, chairman of the Australian Securities & Investments Commission - tried to explain the restraints placed on the regulator as it faces up to $1 billion in investment losses in this sector.

But there are too many questions answered - and too much at stake. As Simon Ibbetson of ratings agency Standard & Poor's suggests in his interview with Michael Pascoe today, there are more disasters to come because, as Ibbetson says: "Every day we see adverts for very speculative type operations that are paying high commissions to financial planners and brokers, and we just wonder where those schemes are going to end up."

What has happened?

Australian Capital Reserve was a heavily advertised investment scheme that used direct media contact through television and radio to target older investors. (Remember the advertisements with the oversize cricket ball promising to hit the other investment returns for six? That was Australian Capital Reserve.)

In common with Fincorp and Westpoint, the underlying assets of ACR were loans made to related parties for property construction.

In fact, ACR is so similar to the Westpoint and Fincorp collapses that it brings to mind the quote that "insanity is doing the same thing over and over again and expecting to get a different result". I think we can define investment insanity as investing in any scheme that offers related party investment loans to be used for property construction.

Keep in mind the context of this collapse, and the Fincorp and Westpoint collapses. Australia is in a period of relatively stable and low interest rates, low unemployment, strong consumer confidence, stable and consistent economic growth and well controlled inflation. Any group of investment schemes that collapse in this prosperous environment must be seriously flawed! And they are.

The common thread

There are four key similarities between Westpoint and Fincorp.

The investment scheme was heavily promoted through advertising, (Fincorp was also heavily advertised and Westpoint aggressively promoted through commission-based financial planners/sales people).
The assets of ACR, like Fincorp and Westpoint, were used to finance property construction.
The assets of ACR, like Fincorp and Westpoint, were used for loans to "related parties".
The assets of Fincorp and Westpoint were largely second mortgage finance, which meant that someone else had a higher claim on the assets when they collapsed. In the same way, ACR investments are described as "unsecured notes", which implies that there are secure investors with a higher claim on their assets.

The inherent risks

Property construction is risky and related party loans don't work. Property construction is a much riskier business than simply buying a completed property. There are risks involved with the construction, timing and then final sale or leasing of the property assets. It is significantly more risky than purchasing an existing property. Investors in Australian Capital Reserve were exposed to these construction risks because the loans made on their behalf were backed by property construction activities.

Related party loans have to be one of the greatest conflicts of interest in the financial services industry, a big statement in an industry that has conflicts of interest around almost every corner.

Here is a thought. ASIC put a stop order to Australian Capital Reserve's prospectus - and therefore its ability to raise extra money - on March 9. Less than three months later the scheme collapsed.

Quite often in construction lending the interest is capitalised (added to the loan) rather than paid in cash. This was the case at Fincorp. I am not certain that this was happening with Australian Capital Reserve, although it may very well have been, administrators McGrath Nicol will soon find out..

Conclusion

There comes a time when you stop believing in Santa Claus, the Easter Bunny and the Tooth Fairy. Right now is the time to stop believing in high yielding pseudo-fixed interest investments based on property construction lending, related party loans and aggressive marketing.

A Clear Direction Financial Planning