Sub-prime investor wrath to begin at home

The US sub-prime mortgage loan crisis is likely to be a source of contention between Australian financial planners and clients for months to come, according to Simon Doyle, Schroders head of fixed income and multi-asset.

He said a key reason for the crisis, apart from lax lending standards, lies in the securitisation of mortgage loans into CDOs (collateralised debt obligation), which eventually found their way into the portfolios of “largely unsuspecting Australian investors”.

The various CDO tranches on offer were “snapped up by a globally diverse mix of traditional investment houses and hedge funds to meet client portfolio objectives”, he said.

“Some bought the lower rated CDO tranches, and added leverage to the mix to spice up the returns to investors, many of who will now see a significant loss of their principal.”

Many investors exposed to sub-prime were “in search of stability and income generation, attracted by the high yields on offer given the lack of a term and credit risk premium in more traditional defensive assets”, Doyle said.

“By treating their exposure to these types of assets as quasi-defensive, investors failed to properly value the risk premium for the underlying liquidity risk and downside risk potential of these structures.

“Or more likely, they simply didn’t appreciate that assets like sub-prime CDOs carry risk more akin to equities, and when overlayed with the apparent lack of market liquidity and potential for material capital loss, are in many cases more risky.

“This equity like risk, dressed up as income, has become more pervasive in income oriented portfolios in recent years,” he said.