The emerging liquidity crisis in the mortgage fund sector will accelerate a trend toward property financing shifting from the non-bank sector to the banks while providing retail investors with a salutary lesson about the trade off between risk and reward.

It is feasible that much of the $31 billion in funds under management in various unlisted mortgage trusts will find their way back into the banking system as investors seek the safety of government guarantees.

Today’s decision by the $2.8 billion Challenger Howard Mortgage Fund to limit withdrawals is being sheeted home to the federal government’s blanket guarantee on bank deposits.

In fact, the fund has been in a controlled liquidation all year. Net assets of the fund have shrunk by $800 million since January as withdrawal requests have soaked up the fund’s available liquidity.

The rate of withdrawal requests picked up significantly in the wake of the government guarantee on all bank deposits and triggered the fund’s liquidity clause as defined by the Corporations Act.

But that is not a reason for Prime Minister Kevin Rudd to come to the rescue of the managed funds industry. He should use this as an opportunity to remind investors that higher yielding investments outside of the banking system carry higher risks.

Less sophisticated retail investors who believed a mortgage fund was no different from a bank will now have a better understanding that higher returns carry higher risks. Financial planners may also come under closer scrutiny for the recommendations they made, because about two thirds of the funds in the Challenger fund came through wrap platforms.

Those platforms, such as the Westpac-owned BT and St George-owned Asgard platforms, have been behind the acceleration in withdrawal requests from the Challenger fund. Ironically, the bank wrap platforms may be conduits for increases in bank deposits.

Liquidity has been an issue in the unlisted funds sector for more than a year with various mortgage funds, property trusts and hybrid fixed interest funds imposing limits or freezes on withdrawals this year.

Challenger, for example, “temporarily” closed redemptions on its hybrid property funds in August. And on October 16, Challenger amended withdrawals from its $1.8 billion Challenger High Yield Fund to only offer redemptions quarterly.

The Challenger Howard Mortgage Fund has the power to process withdrawals over a period of 60 days when at least 80 per cent of the fund’s assets are regarded as liquid. If the fund becomes illiquid investors can only withdraw if the fund makes an offer of withdrawal.

Those liquidity arrangements were formed in the crucible of the illiquidity crisis in unlisted property and mortgage funds in the 1990s.

If Rudd were to overturn those arrangements and in some way guarantee the liquidity of unlisted funds he would create a moral hazard and undermine the credibility of the entire financial system.

The government did not step in to rescue investors when Westpoint went bust and they should not do that now.

However, the sooner the government releases the terms of its deposit guarantee – particularly the price banks will be required to pay, which in turn will affect the returns they can offer depositors – the better it will be for all participants in the economy. Its release should be accompanied by reminders about the pecking order of risks in the financial sector.

Peter Fray

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