Tuesday, September 1, 2009

10 LESSONS FROM FINANCE COMPANY SECTOR CRASHES IN NEW ZEALAND

1. Liquidity. It helps to know what it is and to value ALL assets having regard to liquidity. Liquidity is the ability to buy and sell more or less at will, on a timely basis, without materially affecting price. Simply not selling does not mean that value is maintained. Failure to crystallise losses which would otherwise be revealed through an absence of liquidity does not keep the genie in the bottle - it merely puts off the day of reality check.

2. Property. This is generally not a liquid asset. Property is no different to any other asset but sales take place over an extended period in an often thin market with significant transaction costs (mainly search and validation costs). Even a "perfect sale" often has a six week settlement period, documentation takes significant amounts of time to prepare, validate, examine and have signed. If cash is needed rapidly do not look to property sales as a saviour.

3. Debenture Stock. The instrument provides only uncertain security. The right to stand in a queue behind other claimants for a share in what is left of the assets of a business is worth only what the value of such a share of whatever those assets might be worth upon realisation. In this sense debenture stock offers a form of residual claim without any of the upside of equity investments. Worse the changing value of the assets against which the debenture is a claim is opaque and difficult for an investor to determine with any certainty.

4. The Trustee Scheme of Regulation. This is amongst the most bizarre of the illusory regulatory regimes developed in a vain attempt to protect investors. In NZ no trustee has been sued. Trustee management and trustees have no "skin in the game" and face very weak incentives to perform - vague reputational capital at most. Some companies have connections to investment companies - Perpetual Trustees and Marac finance have the same parent for example. Trustees can do no more than monitor and investors have to pay for the impoverished service they provide while creating an illusion of protection.

5. Related Party Transactions Lead to Risk. Even where the related party is "rich", too many related party transactions generate risk because they reduce diversification and indeed concentrate risk in particular asset classes and with particular individuals. This risk concentration is far more of a problem than concerns about "crooked or questionable dealings". The latter is not generally an issue. Concentration of risk is a problem and no amount of disclosure or Chinese wall building can remove it.

6. Reinvestment Rates. Reinvestment rates do not grow and shrink in even, smooth, linear increments. Instead, declines especially come in "chunks", or quanta so that a rate might decline in the sequence 70% - 60% - 59% - 35% - 30% zero. Business models built on the need for continuous reinvestment are therefore subject to significant reinvestment rate risk. This problem is even worse when the business is growing - the more loans written the higher the risk, and thus the more likely the default on repaying early investors. Such business models have as their base the Ponzi scheme.

7. Provisions Based on Existing Losses. Generally companies work hard to prevent crystallising losses. They don't like the bad press. In many cases defaults on loans are "shelved" by extending loan terms, granting exemptions, "re structuring" loan payments and otherwise not crystallising losses. The loss history is therefore an inadequate description of loan default. Provisioning based on history is therefore likely to significantly understate future losses. Provisioning should instead be based on likelihood of loan default and resulting loan value after liquidity is taken into account.

8. Capitalising Interest and Fees. Much credit assessment is aimed at determining an acceptable amount to be lent given the credit risk of the borrower. Practices such as capitalising interest and fees into the loan may add to that amount. Ability to repay the total amount owing on such loans is not apparent until the loan matures. Moreover, the need to capitalise interest is typically generated by a lack of cash at the time the loan is made – in itself a common indicator of unacceptable credit risk. Capitalising interest tends to “grow the book” of the finance company and with loans of potentially dubious creditworthiness.

9. Prior Charges and Ranking. Both security of investment and payment of interest are typically subject the paying of “prior charges”. In plain terms, other creditors are placed “ahead” of investors thereby diminishing the value of investor security. Where that security is a debenture the investors claim is weakened. It has been common for debt capital raised by finance companies to carry a prior charge status which effectively reduces investors to a residual status “behind” banks and like institutions.

10. Poor Response to Distress Problems. The most common response by finance companies in distress was denial. The key form this takes is refusal to sell down assets aggressively and at prices which crystallise losses. The hope is that asset values will improve. Often this results in adding to a losing position. Restructuring by swapping in second mortgages so as to release cash has a similar effect in that additional risk is added to an existing strained position. Moratoria which are not accompanied by attention to unwinding related part transactions, asset sell downs, loss crystallisation and business plan re thinks frequently prove to be palliative at best.

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