Stephen Bartholomeusz
Easy pickings
Perpetual’s shares have fallen about six per cent so far since it announced yet another profit downgrade flowing from write-downs within a cash fund it manages. Yet even as the losses from the fund hit $26 million, Perpetual says it continues to attract inflows.
That apparently perverse behaviour by investors demonstrates the Janus-like qualities of the sub-prime crisis. Losses for some represent opportunities for others. It also highlights the role that accounting standards are playing in exaggerating and, for some, worsening the scale and impact of the crisis.
The Perpetual fund in question is its Exact Market Cash Fund and the reason Perpetual, rather than investors in the fund, has suffered losses is that the group has guaranteed investors’ capital and a return equal to the bank bill rate – it exposed itself and its balance sheet and earnings to the market risk of the underlying assets in the fund.
Those assets are mainly domestic credits – including asset-backed securities – with at least AA credit ratings and with an average term to maturity of less than 18 months. There are no sub-prime exposures in the fund but the global contagion emanating from the US sub-prime markets has still impacted the value of the fund’s assets because of the blow-out in spreads.
Perpetual hasn’t been selling down the fund’s portfolio and crystallising losses but is forced by fair value accounting standards to mark the assets to market in what is a malfunctioning market, even for well-rated securities.
The effect is to produce non-cash losses, but push up the yields to redemption from the assets on their written-down values – over time the write-downs will be clawed back through the running yields.
The reasons investors are continuing to invest in the fund despite the write-downs are the guarantees of capital and returns. Perpetual would be prepared to continue to accept inflows because some holders of asset-backed securities are liquidating their holdings within a highly-stressed market and incurring actual losses. It gains any upside in the fund beyond the guaranteed returns.
The flip side of Perpetual’s situation is therefore the ability to buy securities at big discounts to their face value and lock in aberrationally high yields-to-redemption.
Around the globe hedge funds and investment banks are starting to raise capital to do exactly what Perpetual is doing and buy securities from distressed sellers at discounts to face value that produce in some cases remarkable yields to redemption.
Before the Macquarie Fortress trust was refinanced earlier this month its asset backing had tumbled from $1 per note to 35 cents as it was forced to continually write down the value of its portfolio of US corporate loans in line with the market. It sold some of the portfolio, at a loss, to meet bank covenants. The notes traded at prices as low as 5 cents.
Then the trust was refinanced with borrowings that aren’t tied to market values. Provided there are no defaults in the underlying portfolio, noteholders could get back 83 cents in the dollar, although probably not for some years. The notes are trading at about 23 cents today.
The mark-to-market accounting treatment imposed by the international accounting standards has been blamed for contributing to the meltdown in asset-backed securities markets, because it can force a self-perpetuating downward spiral in asset values as funds are continuously forced to sell assets to meet banking covenants, particularly in distressed markets with minimal if any liquidity.
In the US there has been something of a controversy over a letter sent by the Securities and Exchange Commission last month to US chief executives and chief financial officers reminding them that there was a long-standing clause in the fair value standard, FAS 157, that allowed them to use other approaches to valuation than mark-to-market when prices were being set in the context of forced liquidations and distressed sales in illiquid markets.
While the clause was always in the standard, the SEC’s decision to highlight it has been seen as encouragement to use it to avoid write-downs. It would, however, appear to be a pragmatic way to try to defuse some of the destructive impacts of the interaction between the crisis and the standard in illiquid and falling markets. The assets still have to be valued on a credible basis.
In the meantime, the net present value of the future cash flows from portfolios of good underlying credits held by stressed institutions provide an opportunity that 'vulture funds' and investors are now starting to exploit.
