The credit failure season is upon us. Most recently, subprime mortgages, Bridgecorp and Basis Capital have been the stars of the show, and before them, it was Westpoint. And this show will go on. Like cockroaches, you can be sure that for every one that rears it’s head, there are dozens more lurking just out of sight.

There is always something a little shocking about credit failure, something that makes it seem so much worse than losing the same amount of money from stock market fluctuations.

Perhaps it's that credit failure invariably involves broken promises. Perhaps it's because it almost always comes as a complete surprise. Or perhaps it's because the losses are permanent. In any event, after the fact, the hunt for scapegoats is always on in earnest.

The cast of villains is normally headed by the promoters, who are denounced for their dishonesty or stupidity – and often rightly so.

Attention then moves to the various experts – typically research houses and investment advisers – of whom the self righteous ask, "How could they have not seen this coming? If they had done any sort of reasonable analysis, surely they should have seen the flaws in the offer?"

Unfortunately, at this point, the experts often turn on one another. "We decided not to recommend this product/offer because we were not happy with the management"... or "the transparency,"... or better still, "because it just didn't smell right". The unspoken implication is that superior analysis would have lead to the avoidance of loss.

This is absolute nonsense. It ignores the fundamental nature of credit risk which is that in every situation, there is some possibility of loss. It's just the chance of making a loss that varies. Just because something is rated AA doesn't mean it cannot fail, simply that it is highly unlikely. Because something is rated BB, it doesn't mean that it will fail, just that it is more likely to fail than a AA-rated security.

And let's not under-estimate the task in front of the rating agencies, research houses and, for that matter, financial advisers. Promoters of these products employ experts whose job it is to put the best spin on a particular situation – not only are these people good at what they do, but they spend all day, every day working out how to do it. And sometimes – shock, horror – they lie!

All good advisers who support products that carry credit risk will have a failure at some time or another. (To those advisers who had never had a credit failure – congratulations! So far you have been lucky, but your time will come.)

The critical issue is not whether advisers avoid credit failure, but how they manage it. Any interest bearing investment that is paying well over the government bond rate is either quite risky, or managed by fools. In today's markets, virtually all reasonable credits can be securitised and sold on the capital markets on fine margins. It's not necessary to pay over the top to raise money. And if something is risky, it can fail. No fancy analysis required.
The key to being a good adviser is to recognise risk when you see it and then have sufficient diversification so that when the inevitable credit event hits, it is just glancing blow – unpleasant, but not enough to derail a financial plan.

Believing you can completely avoid credit failure? It’s nuts, and you can clearly see it’s nuts!

© 2007 financialalert Limited.
All rights reserved. Refer Terms & Conditions of Use