Bottom Dollar / Real Estate Bonds: A Financial Time Bomb

The race for higher yields prompts the purchase of riskier and inappropriate investments, but Israelis can take comfort in the thought that their American and European counterparts are in an even worse situation.

"It's only a matter of time before all the junk the institutional investors bought here explodes in their faces." The "junk" is all the negotiable bonds issued by Israeli real estate companies, mainly those that invest in weak European countries. Over the past few years, Israeli institutional investors have sunk billions into such bonds.

The true economic value of all these Eastern European real estate deals will be put to the test now, as the global real estate and finance markets start to slow down. Even before, however, it was clear that the eagerness of Israeli financial institutions to invest in these companies was puzzling.

"It's a good thing those companies promised to repay their debts when they issued the bonds," continued the source cynically, referring to the lack of suitable securities to back the bonds.

The speaker will remain anonymous, but his opinion concurs with that of the Israeli capital market watchdogs. At least two recently expressed concern over corporate bond prices in Israel, and the manner in which institutional investors are managing their investments in these bonds. Capital Market Commissioner Yadin Antebi, for one, suggested rating the risk of the Israeli companies' bonds based on the global ratings. This would give most Israeli bonds ratings that indicate high risk. This means that a large share of the bonds snapped up with such gusto by institutional investors are actually of very poor quality.

Bank of Israel Governor Stanley Fischer, for his part, used the central bank's report, published Tuesday, to voice his opinion. He called the current situation a "distortion of incentives to institutional investors." "The competitive pressure and greater reporting frequency increases the weight of the short-term considerations for surplus yields, and spurs the institutional investors to seek investment alternatives with higher risks and returns," states the report.

Simply put, the race for higher yields prompts the purchase of riskier and inappropriate investments.

Such investments are indeed time bombs, but contrary to the opening speaker's remark, they will not blow up in the investors' faces, but rather in ours: Those junk investments were made by the provident funds, the insurance companies, the pension funds and the mutual funds, with our money.

Israelis can take comfort in the thought that their American and European counterparts are in an even worse situation: The junk purchased by institutional investors abroad was based on bad mortgages extended to bad borrowers, resulting in the subprime crisis. The Bank of Israel estimates that Israeli institutional investors purchased just NIS 150 million in subprime-backed products.

Israelis can also take comfort in the fact that this is the first time their pension savings have served as a springboard for purchasing inferior assets at dubious prices. This happens in almost every bull market period - in 1992, provident funds bought shares in any widget company trading on the stock exchange. In 2006-2007, they bought bonds in every real estate company. At least bonds are safer than shares.

Still, both instances offer little comfort, especially considering we have little recourse. The general public can try to cling to the past, but the era when a pension was promised and paid by the state is gone forever. The capital market is therefore the public's only source for pension financing, and it is fraught with pitfalls.

Where, then, is the silver lining? Perhaps in the knowledge that at least today, people can learn immediately about any losses in their portfolio, and can make adjustments accordingly, thanks to the reforms that allow them to transfer accounts between investment managers. Now that the pension funds have been removed from the control of the five big banks, customers have many alternatives. And most importantly, befuddled savers have someone to consult, thanks to the Bachar Commission, which turned the banks into pension advisors with no conflicts of interest.

One other comforting thought is that in recent years, pension profits in Israel have been very high, and that over the years, investing pension savings in the capital market - particularly one that customers can understand better and respond to accordingly - has been justified.