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Sunday, June 21, 2009

The Perfect Storm

Storm Financial (would you have given your money to a financial adviser with a name like that?) was founded in 2004 by Townsville local Emmanuel Cassimatis - a former MLC insurance agent - and his wife and former secretary Julie. It had 14,500 clients when it collapsed into administration, then receivership in January by which time it had turned into a Financial Storm.

The group charged upfront fees of 7 per cent on all funds raised (mostly borrowed money as they convinced investors to borrow more and more) - which reached a peak of about $4.5 billion last year - and management fees of 1 per cent a year after that, as well as receiving "kick-back" commissions from the funds in which they invsted their clients' money.

Investors were encouraged to share the (impossible?) dream of making money out of virtually nothing: borrow against the value of their houses, buy shares with the borrowed money, borrow against the value of those shares to buy even more shares, and so ad infinitum - as their now defunct website suggested, "Investing successfully is about fulfilling your full financial potential; not about being constrained by the limits of your present position" - until the market turned and the dream became a nightmare.

So how did that desparate sailing-couple, Vivienne and Murray Withers, shown at the beginning and end of those video clips, finish up with nothing except a huge mortgage on their house? Here's an example of how it might have happened which assumed a relatively 'safe' 75% lending margin (some Banks lent as high as 100%!) and completely ignored very heavy bank and interest charges - not to mention the upfront 7% and ongoing 1% commission to our friends Emmanuel and Julie:

1) They borrowed 75% against their $1 million house

2) They invested the borrowed $750,000 in shares

3) They borrowed another 75% against the first lot of shares to buy another $562,500 worth.

4) This could have gone on several more times like the veritable financial perpetuum mobile it seemed to be but let's assume they came to their senses and stopped there. They now held shares totalling $1,312,500 and had loans totalling $1,312,500

5) Then the 'unthinkable' happened: the sharemarket dropped 50% and the value of the shares was reduced to $656,250. The lenders called for top-up money to restore the 75%/25% margin failing which they sold all shares at $656,250 (perhaps even lower!) which left a shortfall of $656,250 against the loans. All shares were gone and the 'gambler' - sorry, investor - was left with a debt of $656,250 against the house which would also need to be sold to repay the balance of the loan.

Push up the gearing to 85, 95, even 100%, continue the "buy, borrow, then buy again" routine a few more times, allow for an even steeper drop in share values (some of Australia's most conservative company shares had dropped to as little as one-third of their former value at the climax of the shake-out), and it's easy to see how that housewife fighting back her tears could have finished up with nothing except two margin loans totalling 2.5 million dollars! Or the 73-year old granny who finished up with a 1.18 million margin loan and a $256,000-debt on her house! Welcome to the real world of high-stakes finances!

Did our friend Emmanuel explain this possibility to his sucker-clients? He seemed to have laughed those loans off as a Claytons loan - "the loan you have when you are not having a loan." Of course, every 100%-geared up client meant a doubling of Storm Financial's fees!

Some of those investors didn't look sophisticated enough to withdraw money from an ATM, let alone buy and sell shares. Who did it for them? And who told them what to buy and what to sell? Given the number of clients, Storm Financial could have been in no position to individually monitor and manage those portfolios. Did they use a cookie-cutter routine of 'get-set-and-forget' with the same shares for all their clients? A highly dangerous strategy even with a paid-up portfolio which allows one to sit it out when things go bad; totally suicidal with a highly-geared portfolio when each market downturn could mean a margin-call and a potential sell-off! What analysis, if any, was good old Emmanuel referring to when he said, "In the analysis we did, we did not believe the house was at risk"? What professional expertise did this former insurance salesman possess that made him think he could bet his clients' money (and worse, his clients' BORROWED money!) on his aberrant model of an ever-rising market? Even at the absolute nadir of the collapsing market in October 2008, when the index had almost halved from where it had been just five months earlier, and when Storm Financial were finally forced to send out this letter, urging clients to convert what was left of their portfolios into cash, they advocated that clients should NOT use the cash to repay their 8%-interest margin loans, but to keep it on deposit at 4% "so that the cash can be switched back into equities to gain from any upswing in the future." Many people instructed Storm Financial to switch to cash. Had Storm Financial acted on those instructions, a lot of pain could have been avoided. But here's the kicker: not one of those instructions was acted on ... read more.

There are many questions: such as who declared on the bank's loan application form that the unemployed widow shown in the video clip, who finished up with a $300,000-debt, had a MONTHLY after-tax income of $104,000 ? And what was the 'sales pitch' employed by those dozens, if not hundreds, of Storm Financial's 'investment consultants'? What presentations and promises did they make to their would-be investors? What a pity I'm already in retirement! I would've loved to get my hands dirty on a bit of forensic audit work!

Those people must have had some idea of how dangerous a game it was they were playing. I mean, our 'yachtie' Maurice, who wondered aloud on-camera how the banks could have lent him $2 million, didn't look like someone who'd spent his life selling shoelaces door-to-door. He must've realised how dangerously deep he was into this high-stake poker-game! Was it greed that conquered all their fears, that stopped them from asking some searching questions? Any suburban accountant or solicitor could have told them of the dangers!

Of course, had things gone their way, had the market gone UP by 50% to give them a PROFIT of $656,250 - and all on borrowed money! -, they would no doubt have rubbed their hands with glee and regarded the rest of us, who conducted their financial affairs with a little more caution, as complete simpletons. However, now that the party is over for them, they're desperately trying to portrait themselves as innocents who have been had. As my Canadian friend Chris put is rather succinctly, "Playing dumb is not an option!" They were all playing "double-or-nothing" - and got it, one way or the other!