Risk-Reward Trade-Off 101

Posted in Wealth
16/11/2012 Level One

We have recently issued warnings to our clients with regard to the high risks associated with property investment and hybrid products, such as bonds and debentures.

Following the $660 million collapse of Banksia Financial Group last month, investors are again being reminded of the basic lesson of swapping quality and security to go chasing abnormally high returns. The higher the return, the higher the risk.

In a nutshell, Banksia offered investors a high interest return on debentures (unsecured bonds) and then lent the investor’s money out as mortgages and property loans to third parties.

Sounds simple. So what went wrong you ask?

For starters, Banksia didn’t have a banking licence. It wasn’t a bank or even another form of Approved Deposit Taking Institution (ADI). This means the group was not regulated by the Australian Prudential Regulation Authority (APRA), or anyone else, hence investors were not protected by the Government guarantee (that you enjoy from a proper bank) for deposits up to $250,000.

Secondly, a large amount of the mortgages and loans were made for commercial properties and new developments. This means higher-risk property and a much greater likelihood of default.

Thirdly was their balance sheet. As of June 2012, Banksia’s core capital was only $24 million. This modest sum was supporting a whopping $662 million of borrowings to finance a total of $691 million in loans and other assets. When you crunch the numbers, it would take only 4% of the underlying assets to fail and completely wipe out 100% of the capital. And that’s what happened.

Although the collapse occurred in October, warning signs of trouble were already apparent in June. At the balance date, around $24 million of Banksia’s loans were not paying interest and had been classed as “impaired” – or in laymen’s: up the creek. A further $67 million were late on paying interest repayments. These were due to be stamped “impaired”.

The collapse of Banksia is a harsh reminder of other failed financial groups such as Westpoint and Storm. With every one of these failed groups, the same base principle can be seen – there was high-risk property investment involved.

We remind you all that chasing high returns without understanding where your money is, and how it will be invested, is a dangerous game, with dire consequences.

Tips for safeguarding your savings: 

  • Invest with a properly regulated bank or ADI – make sure your money is protected by the Government guarantee;
  • Don’t put all your eggs in one basket – if you are investing large sums of cash it can often be wise to break the amount up into smaller deposits. Further diversification can be achieved by investing with more than one bank or ADI;
  • Don’t trust everyone – just because the guy at your local branch “is a good bloke”, don’t take all he has to say as gospel. Check the facts and if in doubt get independent advice;
  • Trust your gut – if it seems too good to be true, it probably is.

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