On April 14th, two more alternative lenders announced that they were freezing all redemptions on their products, that cash distributions would likely fall and perhaps end, and that they would undoubtedly be taking substantial losses on some of their mortgages. As interest rates on savings accounts and GICs fell over the last few years, yield seeking investors searched high and low for more rewarding places to put their money. Mortgage funds, which pool investors’ money and then invest it in a portfolio of mortgages, took off. As billions of dollars flooded in, attracted by distributions in the range of 8% to 10% per year, these funds were forced away from traditional residential first mortgage lending. Many became focused on the inherently more risky areas of the real estate market: construction financing, bridge loans (made until buyers actually buy units in a project) and even pre-construction development financing.
Even the most inexperienced investor knows this diagram:
The theory is pretty simple. If you want a higher return, you have to take more risk. But while we know this intellectually, from time to time we fall prey to our cognitive biases, or thinking mistakes, and convince ourselves that THIS investment somehow doesn’t follow the rules. In focusing more on the potential yield from these alternative investments and less on the risk, investors fell prey to these fairly common behavioural errors:
- Framing Effect: The investment had been presented as something safe and familiar. We all know about mortgages; what could go wrong?
- Group Think: Many people invested with the same alternative lender and discussed it with others. This validated the investment and led to FOMO, fear of missing out on the hot new thing.
- Confirmation Bias: Alternative lending became huge in the last two years as interest rates fell. Articles talking about it and touting it were unavoidable and confirmed investors in their opinion.
- Loss Aversion: Everybody knows that the stock market is risky, so this looked like a safer way to get similar returns while taking less risk.
We have been wary of alternative investing and have never placed any of our client funds into the various products available, for the following reasons:
- Every new investment vehicle claims to have found a way to get off that risk/return line, either by getting a higher return for the same risk, or by getting the same return for a lower risk. This sales pitch is as old as the markets themselves. While sometimes somebody does develop an edge, it never lasts for long. In the alternative lending business, as more and more money and players came into the sector, lenders ended up doing the opposite of what the investors had hoped. Instead of taking lower risks, they were forced to take higher and higher risks; and at the same time, in a highly competitive market flooded with money, the returns were forced lower.
- One of the greatest things about the stock market is that the investments are liquid. You may not like the prices but you can get your money out at any time. If there is a global pandemic, a financial crisis or a war, you can still trade and if you choose, sell out, take your cash and bury it in the back yard or under your mattress. Not so with any investment where redemptions are not instant and not on demand. Liquidity is only important when you really want it, and that’s when it is most likely to disappear in private investments.
- Stock markets are (absent fraud) transparent. Financial disclosure requirements mean that an investor who chooses to do so can find out pretty much everything that is important to know before investing, or during the course of the investment. Not so in alternative investing where investors probably don’t get much more than a quarterly snapshot of how things are doing, with lax rules about revaluing the underlying deals (so-called “mark to market”) and very little ability to do independent analysis.
I take no joy in the distressed condition of the private lending markets. Many people are going to get hurt, some of them badly. They thought they were investing in pretty safe, conventional investments. Some will find out that they have financed a hole in the ground for a building that will never be completed, or perhaps a half-completed project where the developer has gone broke and the buyers have disappeared.
In investing, as in most things in life, there is no free lunch. We all have to live with the reality of the risk/return line. By doing our homework, understanding our investments and weighing the pros and cons, we can, at least, make good and well-reasoned decisions that should work out pretty well, most of the time. Nobody should expect to do better than that.