Hubbard’s empire wasn’t doomed to fall. Even in the years leading up to 2008, SCF had ample opportunity to avoid the self-destructive behaviour of its competitors. The financial climate had, on the other hand, clearly deteriorated. There was a growing suspicion of the New Zealand Stock Exchange, whose leader, Mark Weldon, was polarising and, I thought, unsuited to the role. Two examples of the NZX’s woeful performance under Weldon spring to mind, one from 2005 and one from 2007.
In December 2005, the Securities Commission published a report on the collapse of Access Brokerage in September 2004, leaving a $4.8 million hole in its client funds trust account. The NZX (and its predecessor, the NZSE) had always been responsible for supervising sharebroking firms, and in 2003 it also became the frontline regulator of New Zealand’s listed markets.1 The Commission’s report found that:
As well as running the trading platform for New Zealand’s sharemarket, the NZX is itself listed on the market and controls a number of other listed entities, notably its SmartShares suite of index funds. In February 2007 the NZX was forced to suspend one of these funds, the NZX Australian 20 Leaders Fund (smartOZZY), from trading after it had missed its 31 December 2006 filing date and still hadn’t filed almost two months later. The NZX tried to play it all down, but the Securities Commission wasn’t impressed. NZX Discipline, the NZX’s disciplinary tribunal, also highlighted the episode in its 2006/07 annual report.3
Market regulators and supervisors needed to be on top of their game: there had been a surge in the number of wide-boys in the market, people with low personal wealth and no understanding of the high standards expected of those in charge of other people’s money. Many new finance companies were built on swamp land. Finance companies had grown in number from a bare handful of survivors of the 1987 crash to around five dozen by 2008. Some of the worst were allowed to list their shares and specific securities on the stock exchange. Weldon did not seem to understand. Most of these finance companies were governed by directors who seemed to know little of the risks of non-bank moneylending, and were often managed by people whose greed knew no bounds. While they talked about investing cautiously and nurturing their companies, they were stripping out dividends and buying yachts and holiday homes.
This new culture lay largely hidden because of the apparently low standards of the regulators, the auditors, the trustees, and the credit-raters. Investment statements and prospectuses displayed detailed numbers and a confident narrative. Very few analysts or brokers did any finance company research. Those few who tried to analyse information assumed that the base numbers reflected the truth and had been verified by those with access to the files. I made this mistake too. There was never a conspiracy by the directors, the executives, the auditors, the trustees and the regulators to peddle dishonest numbers, but, as we have learned, there was inexperience and incompetence, often mixed with unsound accounting principles and a selfish agenda. The result was shoddy presentation of figures. None of those whose job was to produce company reports seemed to realise that hiding the truth ends in ignominy, if not jail, for the perpetrators. When confidence wanes, investors will abandon any financial institution. Take the story of Hanover Finance, formerly Elders Rural Finance (ERF). When it was ERF in the 1990s this small company had ample capital and undertook low-risk rural lending. Clients of our firm supplied it with many millions of dollars. ERF was later taken over by two self-serving Auckland entrepreneurs, Eric Watson and Mark Hotchin, and ultimately became a mezzanine lender, filled with related-party loans under a new name, Hanover Finance. By July 2007 Hanover’s group held $33 million of our clients’ money, about 2 per cent of total portfolios. Hanover boasted a Fitch credit rating barely a notch below our smaller banks, a rating astonishingly confirmed by Fitch just weeks before Hanover defaulted in July 2008.
In July 2007 I became pessimistic about Hanover and wrote to its chief executive, Sam Stubbs, seeking an assurance that Hanover would receive a capital injection from its two shareholders, Watson and Hotchin. Stubbs was helpful. He is an excellent communicator, a polished salesman. He doubted that the two shareholders could fund $100 million of new capital but thought they could produce low tens of millions.4 This was not enough to reassure me, so my firm advised clients not to renew their investments with Hanover. By the time Hanover went broke in July 2008, my clients had withdrawn all but $3 million, and that figure would have been lower but for the fact that some clients took a contrary view.
Or take the case of Countrywide Bank, at that time a small New Zealand-owned organisation, which had converted from a building society to a bank. In the early 1980s there was a bank named Countrywide but also a company named Countrywide Transport. The transport company fell into receivership. On that day a careless radio news clip announced that ‘Countrywide’ had been placed into receivership. It did not clarify the message. A wise news editor might have stated and re-stated that Countrywide Transport had nothing to do with Countrywide Bank, and might have allowed a bank official to confirm that. Instead, some listeners thought they were being told that Countrywide Bank was in trouble. Countrywide Bank had many branches throughout New Zealand, including one in Lambton Quay in Wellington. Within an hour of the radio report, queues stretched outside the bank’s doors in Wellington’s main retail street. It took days, not hours, to restore confidence. Many millions were withdrawn in cash during this needless panic. Some investors never returned to the bank.
And then there was a story that involved South Canterbury Finance. This was in 1989, when the government-owned Bank of New Zealand was known to be faltering. The BNZ had admitted an excess of bad corporate and property loans in the crazy era that led to the 1987 sharemarket crash. Its lending in Australia was especially disastrous. It had funded many improbable commercial property purchases, it had supported many of the country’s least orthodox businesses, and it had backed far too many optimistic property developments. It had even underwritten a set of foolish transactions by an inexperienced business leader who sought to underwrite the future price of his company’s shares.
A staid, somewhat pretentious, culture existed in the BNZ, right down to the board lunches, rumoured to include pheasant or quail followed by tawny port. The BNZ’s hierarchical values were well illustrated by an incident involving its future chief executive, Peter Thodey, who joined the bank as an ambitious young man. Thodey had become branch manager of General Finance’s Featherston Street office in Wellington while still in his twenties. In the early 1980s he left General Finance to join the BNZ. On his first day at the BNZ, Thodey was shown his new office in the bank headquarters, where there was a big desk, a chair and a wardrobe. Though still young, Thodey wore a hat to work, and often carried an umbrella. Sitting at his new desk, Thodey received a visit from the bank’s property manager, who was ticking the boxes on his checklist when his eyes fell on the wardrobe. ‘What is that doing here?’ the horrified property manager asked. Thodey’s status did not entitle him to a private wardrobe. Thodey could have only a hat stand. Within days the BNZ carpenter appeared, the wardrobe was dismantled, and a shining hat stand appeared. Order was restored.5
This oddly British-looking bank was not a wise lender. Its employee Peter Travers headed an inexperienced division that dealt enthusiastically with a large number of unlikely and dubious borrowers. The result was chaos, hundreds of millions of write-offs, and a badly scarred bank. By 1989 the BNZ, previously partially on-sold to the public at $1.75 per share, had lost the confidence of the sharemarket. Its profitability was poor, its bad debts numerous. Its shares had fallen to 43 cents and were being sold off by fund managers. Around that time the people of Timaru heard the rumour that the BNZ bank was in trouble.
The owner and chairman of South Canterbury Finance, Allan Hubbard, was driving to his offices in George Street in Timaru when he came across a growing queue outside the BNZ, which was near SCF’s and Hubbard’s office. Hubbard knew an opportunity when he saw one. He walked to the queue, discovered people frantic to extract their money from the bank, and told them that it would be most unwise to walk away from the bank with thousands of dollars in their pockets. Years later he told me that he invited those in the queue to re-deposit the money with his company, South Canterbury Finance, just up the road. He arranged for staff to handle the new cash deposits (anti-money-laundering laws might have made that awkward in today’s world). The queue gradually moved up the street to the SCF office, pockets full. When calm was restored, SCF gathered up all the cash now recorded as being on deposit in SCF and headed back to BNZ, where the very same cash was returned as an SCF deposit. Kevin Gloag, then one of SCFs executives, laughs at the memory. The BNZ was SCF’s main banker. Hubbard told this story with great delight and recalled that afterwards SCF had more Timaru depositors than any of the banks in town.6
Confidence in financial institutions is earned by a large capital base, managed by cautious and honest people and overseen by wise directors, meticulous auditors, intelligent trustees and well-informed, energetic regulators, all supported by good laws and a tight trust deed. None of these were evident in October 2008. Standards varied. The New Zealand Securities Commission was not respected. Many financial planners were discredited. Trustees were mostly amateurish. Finance companies had been failing – Provincial in 2006, Bridgecorp in 2007, and literally dozens more in 2008, including Hanover Finance, Strategic Finance and St Laurence. Some had external credit ratings. The latter two were rated by Axis Rating as stronger than the TSB.
For many years South Canterbury’s funding support relied on Allan Hubbard’s public image, his Presbyterian thrift, personal dignity, familiarity with rural sector standards, total commitment to clients and extreme wealth. His image helped create SCF’s credit rating and facilitated its rapid ascent to the second level of finance companies alongside Marac and just behind UDC. Its South Island reputation was another strength. In New Zealand banking circles, it is often said the banks fund in the ‘mainland’ and lend in the North Island cities. SCF could raise money in impressive amounts in most rural areas, and in South Island cities, where Hubbard’s wealth was known, his mana was intact, and his philanthropy was celebrated.
But even in the years before SCF began its descent, the image was false. By allowing Hubbard to borrow from SCF to take over problem accounts SCF had hidden bad debts, aiming to satisfy the credit-rating agency, Standard and Poor’s, that its lending book was of high quality.7 If a loan went sour, as by 2008 many had, then Hubbard would take it out of SCF’s book by lending SCF money to himself or his other companies, using that borrowed money to repay the bad loan. No default was registered. Hubbard would service the new loan. A sour loan to a failed borrower thus became a loan to Hubbard. He intended to recover the bad deal he had taken over, or to use his other sources of wealth to repay his SCF loan. By 2008 his annual income might have been ten million dollars, and he was never shy about borrowing from any willing party.8
The Crown Deposit Guarantee Scheme of 2008 had sought to take account of the danger of related-party loans, but was often gamed by risk-taking market participants who relied on ambiguous or badly drafted rules.9 South Canterbury Finance definitely gamed the system, once infamously using a family member of its director, Ed Sullivan, to pretend that he was a borrower. Years later, some SCF directors were charged over the alleged concealment of related-party loans. Sullivan was the sole director found guilty. Hubbard’s death in September 2011 meant he escaped the fraud charges about to be brought.
Whereas the deposit guarantee scheme was designed to avoid a collapse, SCF used the rules to expand its deposit book rapidly and to continue high-margin, high-risk lending as it had done since 2003. The annual reports from 2001 through to 2003 showed stable growth in areas where repayments were made each month. However, the 2008 annual report shows just what damage the new lending team had done between the time Rolleston left and McLeod and his team had control. They had gone for exponential growth. Between 2003 and 2008 overall lending had tripled, from $476 million to $1,457 million, as the following chart highlights.10
| Lending Type ($ millions) | 2001 | 2002 | 2003 | 2008 |
|---|---|---|---|---|
| Agriculture, Fishing, Forestry, Mining | 54 | 55.8 | 67.4 | 163.9 |
| Manufacturing | 12.9 | 15.7 | 24.9 | 63.7 |
| Construction | 10.3 | 9.4 | 11.2 | 35.6 |
| Wholesale & Trade | 18.2 | 19.2 | 23.3 | 92.9 |
| Hotels, Motels, Restaurants | 6.8 | 6.5 | 6.2 | 71.3 |
| Transport, Storage, Communication | 50.9 | 56.9 | 53.3 | 232.0 |
| Finance & Insurance | 69.5 | 84.4 | 99.6 | 109.3 |
| Personal, Housing | 72.0 | 81.1 | 99.3 | 111.0 |
| Property, Business | 58.8 | 73.6 | 90.5 | 577.5 |
| Totals | 353.4 | 402.6 | 475.7 | 1,457.2 |
Funding this growth in 2009 was easy. Debenture investors just needed to limit the duration of their deposit to the expiry date of the guarantee, to invest less than a million, and to be sure not to use trust structures as the investor (the deposit guarantee scheme covered only retail deposits, and not trust, corporate or wholesale deposits). They could then enjoy high rates and the government guarantee. Up to a million was guaranteed for retail investors until October 2011, later extended to December 2012, though from October 2011 the maximum guarantee was $250,000. Of course, ultimately Key’s government repaid everyone, for reasons that are discussed later.
South Canterbury Finance pursued its growth strategy without the constraint of competent governance; its small group of directors was ineffective. Hubbard had no-one applying skilled judgment to the lending process. He himself, as already explained, was a risk-taking entrepreneur with no moneylending skills. SCF pursued this unwise search for rapid profit increases in a financial world that was fragile and by 2007 was falling apart. Major banks and lending institutions were failing around the globe. One was the 280-year-old Halifax Bank of Scotland (HBOS), whose New Zealand arm was known as BOSI.
In the years leading up to the 2008 crash, BOSI had played an aggressive role in New Zealand, lending quickly to almost any borrower and funding ambitious projects backed by minimal capital in places like Queenstown, Fiji and Albany, north of Auckland. BOSI had formed a close link with the ill-fated Strategic Finance and at one stage was planning to buy a controlling interest in it.11 After 2008 BOSI faced horrendous losses from its aggressive New Zealand lending and was one of many banks that quit the property lending field and ceased to exist in this country. Its many distressed loans were virtually given away to scavenging entrepreneurs. Its parent company, the Halifax Bank of Scotland, had to be rescued by the Bank of England.
Banks lost hundreds of millions in New Zealand and none lost more than Westpac. In the decade before 2008 it had invested heavily in high-margin property lending and bottom-tier corporate business. The tightening of bank policies in 2008 sucked almost all liquidity out of that market, forcing most second-tier property developments to stall, with no funds to complete the projects. Unfinished, they were often worthless. Bad debts would result. Lenders and other creditors were badly hurt. To survive, the developments needed more funding and time. Neither were readily obtained from petrified moneylenders. As banks departed, the opportunity for smart lenders to cherry-pick the best deals became obvious.
If South Canterbury Finance had not been committed to funding poorly chosen property developments it would have been one of the rare lenders with open doors after 2008. Lack of competition by then meant margins crept even higher. This allegedly reflected risk but in fact was profiteering from the desperate developers’ plight. If SCF had been properly governed and managed it would today be nourishing the best of the developers and facing little competition. But South Canterbury Finance had no clever, experienced property lenders. None. The SCF subsidiary Face Finance had excellent, trained lenders. They could scarcely believe SCF’s lending strategies. Their views were ignored or even scorned by the Westpac brigade who, after 2003, were running the company. The records later showed that before the crisis in 2008 the company was already hiding bad debts that would have engulfed its real capital. Its lenders were funding people whose portraits would now make up a rogues’ gallery.
SCF’s board was dysfunctional, dominated by Hubbard. His excessive confidence in his lending judgment had not been matched by a track record. He backed losers, often. Hubbard’s naivety as a lender was never more obvious than in his agreement to lend, or ‘invest’, $30 million in the Lord of the Rings trilogy. Not a dollar was returned. The film industry is notorious for its prior charge mentality, leaving the box-office revenue to be paid to the clever people in the sector, but leaving the individual profit and loss accounts in the red. Hubbard claimed to be mystified by the ‘losses’ of these films.12 His due diligence had been non-existent.
Many other unwise loans were approved. SCF’s executive lending skills and experience were in areas unrelated to the sectors in which it chose to chase high-margin loans. Rather than offsetting Hubbard’s failings, the executive replicated them. Lenders were rewarded for achieving growth but not judged by their nett returns.
Of course, 2004 was the critical year. Hubbard’s significant errors began when he lost the support of the one man who could, and did, exercise the power of veto on him. When Humphry Rolleston agreed to sell his shares in Southbury Group back to Hubbard and depart, the finance company’s descent began and accelerated.
If SCF had continued with its instalment lending, based on tangible securities, growing at a sustainable rate, Hubbard would have had a long-term company, paying him dividends each year. Instead SCF went out of control. In earlier years Hubbard had been able to inject funds to offset bad debts, perhaps $50,000 here, $100,000 there, and maybe even a million or two elsewhere. When the bad debts became measurable in tens of millions, he panicked. He began to shuffle assets. He began to cheat. He destroyed his lifetime achievements.