Posted on May 13, 2013 by 1

Review of NSW Local Government Investments – A Progress Report

A review of Local Government Investments has found that changes implemented by the State Government  since the Global Financial Crisis (GFC) have started to curb losses from investments in Collateralised Debt Obligations (CDO‘s).

The Review of NSW Local Government Investments  April 2013 (Review) has been published on the Division of Local Government web site, and summarises the position of Councils after two amendments to the Ministerial Order on permitted investments under section 635 of the Local Government Act.

Prior to the GFC a number of financial services providers marketed investments products to Councils that promised higher than usual returns along with the security which Councils require.  Lehman Brothers, through its Grange Securities arm, aggressively marketed investment products which were, in hindsight, too good to be true.

We have previously reported on Wingecaribee Shire Council v Lehmann Bros. Australia (in liquidation) [2012] FCA 1028 where Rares J found that Lehmann Bros had failed in its obligations to Councils on a number of grounds.  One of the chief means by which Lehmann Bros. were able to convince Councils to invest was by promoting their financial products as meeting the requirements on the Ministerial Order. The previous Ministerial Order under s 625 had allowed Councils to invest in schemes which held a rating from various recognised rating agencies like Standard & Poors.

It transpired however that the ratings agency classification failed to convey the true risk exposure of these loan packages which we now refer to as ‘sub prime’ loans.  Although the loans gained AA+ and equivalent ratings, the reality was that the loan portfolios were dangerously risky, and this misled many Councils into assuming that they were acquiring products which were safe.  They were not.

Following the GFC and losses by many Councils in the hundreds of millions, the NSW Government instituted the Review of NSW Local Government Investments 2008 by Michael Cole (Cole Report).  The Cole report recommended a number of changes which the Government adopted which included:

• removing approval of investments on the basis that the product met with a stated approval from a recognised investment rating business
• removal of purchase of land as an investment category
• excluding CDOs as a category of approved investments
• establishing policies whereby investment sellers could not also be investment advisers to Councils
• while prohibiting investments in future CDOs as a legitimate category of investment, allowing Councils to maintain existing CDOs to prevent immediate losses ensuing as a result of a need to sell the compromised investment immediately (a process referred to as ‘grandfathering’)

The Review by the Investigations and Performance Group of the Division of Local Government is an update on how the changes to the Ministerial Order are progressing.

In short, the Review found:

• Councils in NSW have reduced their exposure to structured financial products from about $1 billion in 2007 to $395 million as at June 30 2012.
• As at 30 June 2012 Councils are anticipating further future losses of $170 million from CDOs and capital protected products.
• Total actual losses as prjected by the Cole Report in 2007 were $250 million.  The actual losses as at 30 June last year were $362 million.

The Review is a timely reminder of the impact which the GFC has had on Council finances.  As Government presses the argument that some Councils are financially unviable, the impact of operators like Grange are still being felt more than five years after they led many Councils into investing in America’s sub prime market.

Surprisingly, although the credit agency ratings which were mandated by the Ministerial Order proved to be entirely erroneous for Council investments, the Review still sees ratings agencies as an important part of investment strategies for Councils.  According to the Review, ratings agencies ‘provide an investor with a service, allowing them to concentrate on their operations and not needing to undertake considerable research and rating reviews’. (Review, page 5)

This summary appears to fly in the face of both the experience of Councils in the sub prime fiasco, as well as the findings of Rares J in the Lehmann Bros. Federal Court case.  Ratings agencies appear to offer a simplistic ‘blunt instrument’ to assessing risk which cannot be viewed in isolation from the circumstances of the financial product offered.  In an environment where the investment salesperson and adviser cries ‘let the buyer beware’ whenever a product fails, one wonders what an investment rating offers to a buyer in the first place.

Tweet