The Split Capital Investment Trust Crisis - Assignment Example

The Split Capital Investment Trust Crisis Discuss the factors that led to the split capital investment trust crisis. Adams and Clunie, 2006 lay the blame for the split capital investment trust boom at the end of the 1990s on the dangerous financial products created through product innovation and financial engineering with high inherent risk, by fund managers in pursuit of high fees and the lack of education and understanding of the gullible investors that was responsible for these gullible investors to fall prey to these financial products. So what were these dangerous financial products and how did they come about? Split capital investment trust companies are those investment trust companies that offer more than one class of share capital, wherein different rights are offered on income and capital. The objective in this differentiation in the financial products is to make available risk, income and tax preference options based on the required of potential investors. These offerings are designed such that they can be wound up at a future date normally extending to seven or ten years (Adams, 2004). The norm in split investment trust companies was traditional splits consisting of income shares and capital shares and quasi splits that had an added zero-dividend preference shares. Income shares had a low risk and high income and were a suitable investment for elderly people, while capital shares offered high income with an element of risk involved. The zero-dividend shares received no income and so attracted no income tax and had the added benefit of being paid off first at the time of liquidation of the trust. The high risk for the capital shares came from their being the last in terms of settlement at the time of the liquidation of trust (Adams, 2004). Spurred by the buoyant financial markets in the 1990s and the pursuit of fees by the fund management firms and their broker/advisors, who were invested with the day-to-day management of the investment trust products led to a the aggressive combination of the traditional splits and quasi-splits wherein all income shares, capital shares and zero-dividend preference were combined in what came to be known as the barbell trusts (Adams, 2004). Barbell trusts as their name suggests consist of a growth portfolio at one end and an income portfolio at the other and nothing in between. The problem in this was that the growth portfolio invariably was invested in an area of growth that was popularly attractive at that period of time and carried a high risk potential. The barbells were however high yielding securities and found an easy market with investors, who had gone used to high returns in the decades gone by, which was a feeling that was shared by the fund managers. Banks parted with loans amply to the barbell trusts, since there was strong collateral, leading to a high level of bank debt with its accompanying risks to the investor in barbell trusts. The fund managers in addition siphoned off large amounts of money as management fees and expenses for issue expenses. A core feature in a barbell trust is the high level of bank debt that could lead to demands for repayment. The barbell trusts thus presented a picture of growth portfolio of high volatility and an income portfolio with high capital risk (Adams & Angus, 2001). The plummeting of the stock markets caused the barbell trusts into debt, causing the banks to call for repayment through the sale of the assets of the trusts, which left the private investors with just a little of their original investment in these trusts leading to the split capital investment trust crisis (Farrow, 2002). 2. Who was responsible for the crisis? It is easy to simply point the finger at the barbell trusts and the fund managers that pushed these dangerous products into the hands of gullible investors carry the responsibility for not stress testing the products that they offered to the extent it was necessary prior to offering these volatile financial products to investors not sufficiently informed of the inherent risks (Mansfield, 2002). Many investors made these investments on the basis of the advice of their financial advisors. This implies that the advisors acted blindly mainly relying on the product information provided by the product providers, instead of taking enough time and putting enough effort into evaluating the financial products being offered and the assessing the risk inherent to the products as demanded by their status of independent financial advisors (Adams, 2004). The was a lack of vigilance on the part of the Financial Services Authority (FSA), which may have stemmed from their lack of technical expertise to handle the issue. Finally, there is the role played by the Treasury Select Committee inquiry and the financial journalists. Though there were warning signals in 2001, most of the financial articles were supportive of the volatile financial products. In 2002, the Treasury Select Committee inquiry triggered a complete switch in the financial articles to the other end of the spectrum, wherein all the split investment trusts were given the same hue, causing even the good to be taken down with the bad, snowballing into the crisis (Adams, 2004). 3. What lessons should have been learned from the crisis? The first lesson is in the governance of the investment trusts. The board of the trust must be formed prior to the marketing of the new trust. This will enable the directors of the trust to be able to guide the trusts structural design, thus avoiding the pitfall of leaving it in the hands of the managers and the trus advisors. Independent finacial advisors must live up to the expectatioons of the word independent in their name by maing their own evaluation of fiancial products and the inherent risks and no merely go by what is given to them by the financial product providers. Journalsists reporting in the finacial field should act more frepsonsible in the articles that they write, so that they do not fuel mass reaction to all and sundry, when the situattion does not warrant it. The appropriate technical competence must be available or created within the FSA to enable it to carry put its monitoring function more efficently. This also implies that the FSA has to demonstrate more vigilance in carrying out its responsibilities. Lastly, though not the least, is the requirement for adequate finacial education of the consumer of financial services. It may be useful to strat this intiative at the school level. Personal finance curriculum is currently a non-statutory component of the curriculum. This needs to be changed to make personal finance compulsory in schools. This however, will not make the problem disappear immediately and this places the responsibility on all the parties involved in financial products to be aware of this and act in a desired manner (Adams, 2004). 4. Briefly outline any similarities between the split capital investment trust crisis and the recent financial crisis. The easy money policies in the new millenium meant that the banks and financial institutions were flush with funds that needed to be lent to generate profits. The sector of the economy that the finacial institutions and the banks chose was the housing sector with iots pent up demand. Money was lent easily and without too much verification of the payback ability and this led to people borrowing more and more money for housing purposes, without really assessing their payback ability. In 1994 a mere five percent of the all mortages in the U.S. were classified as sub-prime, which by 2006 had grown to more than twenty percent. This was a refelection of the reality in the US economy, which though growing was top heavy with most of the benefits being derived at the higher end of the pyramid. Housing loans were easy to get from the commercial and people kept taking it building up their debt that was based on an artificial rise in real estate prices due to the boom in real estate as a consequence of this largesse by the banks. The banks were happy and continued to race after the phantom profits from the these loans. The bubble was building and the failure of the trickle down effect from the top of the pyramid to the lower elements of the pyramid caused the bubble to burst. What started slowly soon snowballed due to the negative press and the fast depreciating real estate prices. The banks that had minimal exposure faced difficulties, but survived, while those in deep went down, plunging the world in a financial crisis (Karam, 2008). The sub-prime mortgage crisis in the U.S. that led to the global finacial criisis highlights the risks involved when financial institutions shift from the originate-and-hold model to the originate-and-distribute model. In the originate-and-hold model, the banking isntitutions as lenders retain the loan assets in their balance sheets and hence are prone to undertake rigourous lending analysis prior to making loans. In the originate-and-distribute model, the banking and other financial institutions packages the stream of earnings from the loan assets to other investors, more keen on the returns that they got. By converting the loans into immediate securitization and sale, there was less diligence maintaining the earlier high credit standards, leading to loans with high risk or sub-prime mortgages (United Nations, 2008). In the split capital investment trust crisis and the current global financial crisis buoyant financial conditions was the basis for innovation in the investment trusts and the banks. The innovation in the case of the investment trusts was the combination of the traditional splits and quasi-splits (Adams, 2004). In the case of the financial institutions it was the shift from the traditional originate-and-hold model to the innovative originate-and-distribute model (United Nations, 2008). In both cases the result was high risk. In the case of the barbell trusts it was high risk financial products (Adams & Angus, 2001). In the case of the financial institutions lowering of diligence in credit analysis, leading to the sub-prime mortgages (United Nations, 2008). The motive behind the investment trusts innovation and the financial institutions innovation was the same and that was to utilize the opportunity to make the most amount of profiut for themselves, with little regard to the manner in which it was attempted to be generated. In both cases a deficiency in the monitoring authorities was present.The consequences of this greed was the same in people losing money, but in the case of the split capital investment trust it was limited to the United Kinghdom, while in the case of the sub-prime mortgage crisis, it balloned into a global crisis, from which the finacial institutions and the world are yet to fully recover. Literary References Adams, A. & Angus, R. 2001, ‘For Whom the Barbell Tolls…’, Professional Investor, vol.11, no.3, pp.14-17. Adams, A. & Clunie, J. 2005, ‘The split capital investment trust saga: Lessons for financial services marketing’, Journal of Financial Services Marketing, vol.10, pp.218-227. Adams, A.T. 2004, The Split Capital Investment Trust Crisis, Hoboken, New Jersey. Adams, A. 2004, ‘Lessons of the split capital crisis’, DOWJONES Financial News [Online] Available at: http://www.efinancialnews.com/assetmanagement/pensionfunds/content/546436 (Accessed Nov 12, 2009). Farrow, P. 2002, ‘Split-caps head for zero’, Telegraph.co.uk [Online] Available at: http://www.telegraph.co.uk/finance/personalfinance/investing/2758513/Split-caps-head-for-zero.html (Accessed Nov 12, 2009). Karam, G. 2008, ‘Root causes of the current global financial crisis’, [Online] Available at: http://yalibnan.com/site/archives/2008/06/root_causes_of.php Mansfield, B. 2002, ‘THE REGULATION OF AND LIABILITY FOR SPLIT CAPITAL COLLECTIVE INVESTMENT SCHEME’, Irish Student Law Review, vol.10 [Online] Available at: http://www.islr.ie/Reviews/2002/split-capital.php (Accessed Nov 12, 2009). United Nations. 2008, World Economic Sitiuation and Prospects 2008, Academic Foundation, New Delhi. . Read More