Evolution Not Revolution

Pooled V’s Contributory commercial mortgage funds – In 2021 which is best and why?

Evolution is not the exclusive domain of living things such as plants and animals and humankind itself. Importantly, evolution also extends to things that we humans make as well as systems and processes that we develop. Whilst natural evolution can take thousands of years to unravel, those things that people control, can and do evolve much more quickly. Evolving means improving and refining on every level. Take the invention of the aeroplane as an example.

In 1799, Sir George Cayley, an Englishman, developed the concept of fixed-wing aircraft. He deduced that four forces acted on an aircraft that was ‘heavier than air.’ One-hundred-and-four years later, on 17 December 1903, Orville Wright, became the first man to complete a successful aeroplane flight that lasted 59 seconds and covered 260m. Wright’s plane, the Kitty Hawk, had no windows, doors, passenger seats, air conditioning, or toilets and was not pressurised.

Fast forward 220 years, our modern aeroplanes come in many shapes and sizes and some are as luxurious as 5-star hotels and can travel 22 hours non-stop carrying 400-700 passengers depending on the model.

Like the development of the aeroplane, the commercial mortgage fund sector has evolved by improving and refining itself over the past 40 years, to be more relevant to its investors and providing better risk mitigants to prevent financial failures. In many cases, these improvements have come about through valuable real-life lessons in terms of what works and what does not work under various market conditions – and yes – sometimes lessons are learnt the hard way.

The genesis of the “pooled” commercial mortgage fund came about in the early 1980s when “mum and dad” retail investors were attracted to the returns that wholesale investors had been obtaining for some years by investing large sums of money in first registered commercial mortgages. Typically, at that time, there would be one investor who lent money to one borrower.

There was no fund manager available and typically the borrower and investor were introduced to each other by a lawyer or accountant who knew both. It was a bit like a modern dating site where singles go to find each other, except that in the early 1980s, solicitors and accountants would trawl their own databases to “marry up” would-be borrowers with would-be investors and act as the middleman, or to continue the analogy, a dating site promoter.

That process, of course, worked well for investors who had deep pockets and who were savvy enough to know how commercial mortgages worked. They knew how to process the paperwork, how to ensure that payments were made on time and how to ensure that loans were repaid at the end of the term. Importantly, they also needed to know how to commence and fund legal recovery action in the unlikely event that the borrower failed to make the necessary interest payments on the mortgage.

That process, of course, worked well for investors who had deep pockets and who were savvy enough to know how commercial mortgages worked. They knew how to process the paperwork, how to ensure that payments were made on time and how to ensure that loans were repaid at the end of the term. Importantly, they also needed to know how to commence and fund legal recovery action in the unlikely event that the borrower failed to make the necessary interest payments on the mortgage.

In every industry, there are always some unscrupulous players who promise the world but fall short of what they deliver. Consequently, the sector began to have some losses, most particularly with the Estate Mortgage collapse in 1989 which saw a run on the sector. Fund managers met these heightened redemption requests by selling off sufficient mortgages to fund redemptions.

Following the Estate Mortgage collapse, conventional wisdom held that mortgage fund managers should hold heightened liquidity of say 15% as well as arranging a line of credit from a major Australian bank. These lines of credit would be secured by the assets of the fund. Importantly the facility would only be used to fund redemptions in a panicked situation, say like another Estate Mortgage type collapse. The sector thought it had solved any liquidity crisis and indeed ASIC accepted that with these enhancements mortgage funds could continue to be considered liquid investments.

The last 10 years of the second millennium was very successful for the sector, which boomed and saw many new household name players entering the sector. By the turn of the century, the major players were Howards (AKA Challenger), AXA, Perpetual, Australian Unity and Colonial First State and the like. All operated “pooled” funds with the sector estimated to hold over $35 billion in investor funds.

They were what you might call, the top tier players but there were many other middle tiers and bottom tier players who did not always do the right thing. This resulted in some of their investors losing money because their fund manager did not select the right borrowers and or the right property security.

In 1998, the Federal government introduced the Managed Investments Act (MIA), which introduced the notion of Managed Investment Schemes (MIS), which replaced the previous “prescribed interests” regime and introduced the concept of a single responsible entity (SRE) now more commonly known as an RE, to act as both trustee and manager given that the old system had become unworkable. ASIC became and still is the regulator of the MIA.

On paper, the MIA legislation gave investors much more transparency but most importantly required the fund manager to be much more detailed and explicit as to how they would invest their clients’ money.

The sector continued its stellar growth up until the GFC exploded in 2007. By that time, the sector was estimated to be holding over $50 billion in investors’ funds which were still “at call” after the first 6 months. The sector and the national regulator continued to believe that the funds were liquid investments that could pay redemption requests within 24 hours given that there “had never been a serious run on the sector.” Moreover, these fund managers held the belief that their lines of credit with the banks would protect them and their investors.

Interestingly, in the early 2000’s some in the sector thought there should be fixed investment terms to better match maturing investments with maturing mortgages but that was dismissed on the basis that most existing fund managers could not see a situation where a great majority of investors would all rush to them at the one-time to withdraw their “at call” funds. The GFC would quickly prove that theory manifestly wrong!

Whilst many books have been written on the subject, the simple cause of the GFC was greed and debt run amuck. Its effects were compounded by bad lending practices and the scandalous subprime mortgage fiasco in the US which the whole world sadly bought. In Australia, many not-for-profit organisations, local councils, church groups and superannuation funds lost hundreds of millions of dollars.

The movie, ‘The Perfect Storm‘ has given rise to that title being used to describe a disastrous event that was caused by many individual events coming together at one time.

The worldwide fallout from the GFC led to a virtual closing of capital markets thereby making it difficult for Australian banks to borrow funds internationally which at that time they had a high dependency upon. Major banks approached the Federal government to support their international borrowings with a government guarantee.

To facilitate this, the federal government announced on that fateful Sunday night in October 2008 that financial institutions regulated by APRA, and who were ADI’s, would be provided with a sovereign guarantee thereby allowing banks to continue to borrow internationally and guaranteeing that depositors’ investments in ADI’s were safe. Banks, Building Societies and Credit Unions were all the beneficiaries of the sovereign guarantee.

Importantly, in response to concerns from Australian investors as to the safety of funds invested in other than ADI investments including commercial mortgage funds, the then federal government regrettably made several incorrect statements including.

• Mortgage funds (and other non-ADI investments) were riskier; and
• That mortgage funds were a “marked to market” product which they were not.

Commercial mortgage funds were effectively left to fend for themselves and with panic and an almost total loss of confidence by investors in financial markets worldwide and with Australian investors watching their counterparts in the US and in Europe lining up outside of banks and other financial institutions to withdraw their savings, is it any wonder that on the Tuesday following the announcement of the sovereign guarantee for ADI’s only, 58% – on average – of all investors in mortgage funds lined up (so to speak) to withdraw their money.

Not surprisingly, banks withdrew their line of credit facilities to fund redemptions. Later that day, the country’s largest mortgage fund, the Howard Mortgage Fund froze redemptions. By the following Friday, every other major commercial mortgage fund also froze redemptions.

Opponents of the mortgage fund sector claimed the government had been right in its assessment of non-ADI investments, however, any logical and reasoned mind person would realise that no institution including, all ADI’s, keep 58% of their assets in cash just in case it was subject to the biggest run since the great depression of 1932!

With lending markets all but closed, mortgage funds could not sell or liquidate their mortgages as they had done successfully in previous downturns, and so frozen funds were forced to agree to wind down their funds and set up a system of periodic redemptions every three months as and when mortgage loans were repaid.

Importantly, whilst investor funds were frozen, they were not lost, and indeed most top tier mortgage funds continued to pay monthly distributions to investors. Moreover, many funds repaid unit holder capital in full albeit in some cases over periods of up to 3 years. That said, the “pooled fund” proposition was now effectively dead, and commercial mortgage funds could no longer be considered liquid investments. So, after a four-year hiatus period which included consultation with the national regulator, a further evolution of improving and refining saw the establishment of the contributory mortgage fund structure which is now flourishing today with over 40 new entrants over the past three years.

The key attributes of the contributory mortgage fund’s structure are.

1. Investors choose their own mortgage (borrower) & security property type & location.
2. Investors invest in one specific mortgage (not pooled).
3. An Investor can be the sole investor or be a contributory investor along with other investors in the one mortgage (contributory mortgage).
4. There is absolute transparency, and the investor can review the fund managers complete loan file including the property valuation and background on the borrower.
5. Investors choose the level of their investment in terms of the investment amount.
6. Investors choose the loan term which suits them best.
7. The investor’s loan term is fixed and matches the borrower’s loan term.
8. Terms are generally from 6 months to 3 years.
9. Investors cannot access their funds as they are invested for a fixed term and are not “at call” and the investment is classed as “illiquid”.
10. Investor funds are repaid once a borrower repays its loan either:
    – prior to maturity;
    – at maturity; or
    – shortly after maturity.

As to rates of return, as mentioned previously, a fund manager, historically, in the commercial mortgage sector aimed to target an outperformance over a 12-month term deposit of 1.5% p.a. to 2.0%. p.a. In 2021 it is a matter of certainty that the outperformance over 12-month bank term deposits (which are generally about 0.65% p.a.) is generally between 6.0%. p.a. and 8.0%. p.a.

Whilst it is not possible to say that the structure of commercial mortgage funds need not and should not evolve into the future, all the available information and market data and risk factors that are available to me, suggest that the current structure in 2021 of contributory mortgage funds will be a winner for many more years to come.

To that end, Princeton’s contributory mortgage funds are very well placed to continue to provide excellent mortgage investments and outstanding service to its clients all wrapped around capital preservation and sold competitive regular income streams.

John (JT) Thomas

This opinion piece is provided by John (JT) Thomas, a 45-year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the grandfather of the modern commercial mortgage fund sector, JT helped establish and then manage – for 17 years – what became the largest and most successful commercial mortgage fund in Australia – The Howard Mortgage Trust – with assets exceeding $3Billion. Under JT’s stewardship, investors never lost one cent of their investments with Howard’s and indeed, investors always received competitive monthly returns. JT was also Chair of the $50 billion industry sector.

JT has been proudly involved with Princeton Mortgages for 8 years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.