Beware the next looming loan crisis

The Australian

In the search for income, sometimes investors can go very wrong.

More than $700m of investor money was lost in 2007 mainly by retirees and SMSFs who had invested in debentures and mortgage funds. Companies such as Fincorp offered up to 9.25 per cent interest, but the problem was that the risks taken to generate these returns did not match the marketing of the product, which was touted as being similar to a term deposit at the bank.

Today, there is another crisis brewing and investors must take note so that they don't fall victim to history repeating.

In my opinion, the next loan crisis will not be from the high-risk mezzanine finance sector where, unlike 12 years ago, there is a large amount of transparency over the risk an investor takes if they invest in these less secure loans. The risk will come an unlikely source - first registered mortgage investments, which are perceived as relatively stable and safe.

Over the past few years, a combination of APRA tightening the rules for investment lending, a weak property market and the banking royal commission has led to the big four banks pulling away from pre-development finance. This is where a developer finds a site prime for redevelopment such as a large block of land with an old house on it with zoning conducive to higher-density dwellings.

Naturally, the developers want to secure the property for themselves so they can develop it. In some cases the developer can pay the owner an option fee, providing the developer with the right, but not the obligation, to purchase the property at a certain price for a certain period of time into the future, but sometimes the owner just wants a clean sale and cash in the bank today.

This is where first registered mortgage investments come in. A lender will usually provide 50 per cent (and up to 65 per cent) of the purchase price of the property and the developer provides the remaining 50 per cent of the purchase price in cash. The term of the loan is anywhere from six to 24 months, being just enough time for the developer to instruct its architect to draw up plans and submit then to the council for approval.

Once the developer has development approval, construction finance is taken out and the initial mortgage is repaid. If no approval is obtained, the site can be sold and the loan repaid from the proceeds.

Interest of 8-12 per cent a year is usually charged to the borrower for this type of short-term finance facility. The lender makes money by charging, say, 10 per cent interest to the borrower, but only paying 8 per cent to investors, keeping the 2 per cent difference as their profit (in addition to other fees they charge the borrower, such as establishment fees).

Needless to say, with cash rates at about 1 per cent just now, investors are very attracted by rates at these levels.

The problem is that dozens of operators have arrived on the scene in recent times, seeing the opportunity to simply connect borrowers who need money with investors who want to lend it, and to take a clip of the ticket along the way.

On one end of the spectrum you have operators such as Balmain, which has been operating for 37 years with a 0 per cent default rate, 200 staff across eight offices and has settled $2.75bn of loans in the past 12 months.

On the other end of the spectrum you have the small-time opportunists that have purchased a financial services licence allowing them to accept investor money and lend to developers.

The larger lenders should have sufficient capital reserves and investor pools enabling them to lend out money only when the borrower meets all the conditions of a thorough credit assessment process. But for the smaller operator, there is immense pressure to lend money out as quickly as possible as they generally start paying the investor interest from day one.

Sydney financial adviser Xavier Lo says; "Imagine a lender with an existing loan fund worth $1bn who receives $1m from a new investor.

"The interest generated on the $1bn would be expected to be comfortably capable of paying all investors their monthly interest returns, even if the $1m is not deployed for months or even years.

"On the, other hand, imagine a small lender with only $2m in existing loans who receives $1m from a new investor.

"As the lender will start paying interest to the investor on the $1m immediately, there is a strong pressure to lend this money out as quickly as possible as they don't have enough scale to hold new cash for long periods of time.”
"This creates a bias for the smaller lenders to approve higher risk loans to get the money out the door.”

The other risk comes from lack of experience and infrastructure. There are comprehensive assessment processes that the larger lenders go through before the borrower receives a cent.

At Balmain, executive chairman Michael Holm says: "In simple terms, the first thing we consider is whether we will be repaid."

If there is a downturn in the property market, higher default rates, changes in laws (such as minimum build quality of apartments) or more willingness from the big four banks to lend, this could cause a run on the smaller mortgage funds leading to catastrophic consequences for exposed investors.

About the author

James Gerrard is the principal and director of financial planning firm