A world-wide property boom ended in the global financial crisis of 2008 and New Zealand was affected by both. Many New Zealand finance companies surfed the property wave, including Allan Hubbard’s. Most of them were tipped on their head.

The boom had produced a flood of money. The main problem for finance companies was not how to raise funds but how to find credible places to lend it. The tide of incoming cash was so big, however, that it led to lazy and dangerous practices. Robert Stannard, the statutory manager who had helped restore the PSIS group in the 1970s and handled the Cornish Group receivership earlier in the 1970s, believed the flood of money into finance companies was a cause of SCF’s demise. He saw the issue as an ‘honourable’ man (Hubbard) attracting too much money to handle well.1

Finance companies operate in the areas of the market that the banks generally avoid, such as property development and used car finance. In ‘normal’ market conditions their combined market share is less than 5 per cent of the trading banks. But between 2001 and 2007, conditions were far from normal and investors chased higher returns by pouring their money into finance company debentures. The trade-off for investors was of course that to get higher interest rates they had to accept higher risk. Finance companies had to offer higher interest rates to compete for investors’ money while ensuring that the rates were not so high as to spook savvy investors who might question the risk involved.

To offset risk, finance companies should have substantial capital, enough to absorb mistakes. Most of the companies were lying about their capital, pretending that unpaid interest on loans would definitely be received and thus could be accrued and treated as retained revenue, inflating profits and thus capital. Many companies, SCF included, were operating without any effective capital.

Head of KPMG’s financial services division, Godfrey Boyce, summed it up well in the firm’s 2006 Financial Institutions Performance Survey:

Overall, one would have to conclude that the risks encompassed within the [finance company] sector don’t appear to be reflected in the rates being offered. In particular, there is not a strong correlation between the companies suffering the highest levels of nett bad debt expense and the level of return being offered on debentures. This reflects a market trend where an admission of high risk would potentially make it difficult to raise funds.

In short, many finance companies were mispricing risk and for several years they got away with it, aided by lazy or incompetent financial advisers who either couldn’t or wouldn’t research finance companies to back up their investment recommendations. Instead they just ploughed their clients’ funds into the companies offering the highest brokerage fees, whatever the risk to their clients.

Lenders did not realise that they were taking all the risk with property development lending, often without any effective control of the project. This was utterly irresponsible moneylending. For a long time, however, the truth lay hidden: company accounts, including Hubbard’s, were impenetrable. Most analysts and auditors weren’t doing their job of asking hard questions. They joined the frenzy.

In the 2002–7 booms, many companies offered to fund property developments. Many finance companies chased this high-margin lending, as did some banks. Until 2007, the funds were easily raised. The finance companies’ choice was to withdraw from offering debenture issues or to accept the money on offer and compete for the right to lend to property development projects, even as the buying interest for property was dwindling. Some, like Bridgecorp and St Laurence, sought lending in Australia. Strategic and Bridgecorp chased deals in Fiji. All of these loans proved disastrous. Hanover went to Spain and lent New Zealanders’ savings on apartment buildings in the most unlikely places. Many such buildings remain empty to this day, the loans never repaid.

There were hints and clues about the impending disaster, but they were hard to find. In the five years before the global financial crisis of 2008, as discussed earlier, SCF grew at a compounding rate of 25 per cent, an astonishing increase. The main source of that growth was a 540 per cent increase in property and business loans, according to the company’s annual reports. These loans in 2008 accounted for nearly $580 million, as shown in Chapter 3.2 Yet these figures are mysterious. Just one year and three months after SCF presented its June 2008 figures its adviser, Forsyth Barr, produced a very different summary of its lending.3 Business and property lending, Forsyth Barr said, amounted to $1.2 billion out of a total loan book of $1.7 billion and was largely made on the basis of interest-only loans or on the basis of no regular repayments at all, with repayment in one lump sum at the conclusion of the loan. I suspect FB’s figures were more insightful than the SCF presentations of its business.

Anyone reading FB’s figures would correctly conclude that a high percentage of these property and business loans were not made on the basis of repayment in instalments. I estimate at least a third were not repaying anything. Since 2003, in other words, SCF had changed its lending practices so they were similar to those of a poorly managed bank. The company was, in effect, entirely reliant on extremely high levels of renewals and new money to pay its overheads and continue to lend. A company relying on incoming money to repay its redemptions has a distinctive description, understood universally. Hubbard, his board, McLeod and his lenders had converted SCF into a giant quasi-Ponzi scheme.

Yet this conclusion could not be reached by reading the information provided to investors, auditors, regulators, the trustee, credit-raters and any of the brokers who sought to analyse its prospects. Perhaps its directors were also fooled by the presentation of figures, although they might have expected to understand these figures in the annual report, which they signed. Particularly they might have wanted to assure themselves that the company was solvent and amply liquid, with incoming and outgoing cash requirements skilfully managed.

The 2008 maturity table would have reassured them if they were willing to be misled. It displayed the following:

Group Liquidity Profile (June 2008) in millions

Assets 0–6
months		 7–12
months		 1–2
years		 2–5
years		 Beyond
5 years		 Total
Receivables 9.7          
Property for Resale   5.9        
Shares in Associates 17.7       0.8  
Investments 16.3   15.9 9.4    
Deposits 0.3   1.0      
Cash & Cash Equivalent 402.8          
Advances 345.6 236.8 404.6 469.5    
Totals 792.4 242.7 421.5 478.9 0.8 1,936.3
 
Liabilities
Creditors 22.8          
Borrowings 455.9 368.7 385.1 417.0 125.5  
Totals 478.7 368.7 385.1 417.0 125.5 1,775  

The schedules revealed that $1,035 billion of loans were to be collected within a year.4 That figure would have provided all the cash flow SCF needed to meet all commitments.

What is indisputable is that much less than half of this was repaid into the schedule displayed. The discrepancy is likely to have had two causes. Any loan with a six-monthly review clause may have been erroneously displayed as ‘reclaimable’ in six months, as though a reviewable loan can be repaid at the lender’s demand. These loans in turn were displayed as ‘repayable in six months’. Any loan defined as ‘at call’ may have been assumed to be collectible at call, and thus ‘repayable’. The reality was that loans on half-completed projects can be reviewed but cannot be repaid. The charts were utterly misleading. By including such loans, they grossly overstated the amounts of cash scheduled to be recovered in the short term.

 

Understandably, investors often make decisions driven more by their emotions than reason or analysis. The two strongest emotions driving investor behaviour are fear and greed. Greed can drive them to underestimate risk and chase unrealistically higher returns, while fear of losing will see them pull their money and put it in the bank or even in their pockets, as the BNZ investors were going to do, in Timaru when they queued outside the bank in 1989.

This is what happened in the non-bank lending sector in 2006–8. First, some of the more exposed and weaker finance companies started failing. The market was further spooked by the 2007 meltdown of the huge US sub-prime mortgage market. This then triggered the global financial crisis. Investors reacted by bailing out of their non-bank fixed interest investments. So higher-risk companies that had been borrowing short and lending long didn’t stand a chance. Certainly, SCF suffered in 2010, its trustee5 Yogesh Mody speculating that rich investors were reducing their deposits to amounts below the maximum guaranteed by the Crown.

The case of AXA (formerly known as National Mutual) illustrated the situation. In the early 2000s AXA ran several mortgage funds. One of them was the Mortgage Backed Bonds or MBB fund. In October 2008 it totalled $229 million and comprised a range of first-ranking mortgages over established commercial properties. It had no low-equity loans (the maximum it would lend was 70 per cent of a property’s value), had a 58 per cent average loan-to-valuation ratio, 14 per cent liquidity, no related-party lending, no loans in arrears and had never had a default. Its pre-tax annual returns for the previous three years had averaged close to 9 per cent. In short, it was a solid, well-managed, well-performing mortgage investment – but even it couldn’t weather the storm.6

As AXA chief executive Ralph Stewart put it, the issue was ‘contagion’, with investors failing to differentiate sound from poor investments – just wanting to get out of any non-bank mortgage investments. So AXA was forced to suspend investors’ right to exit the fund. Too many were wanting to leave, and it couldn’t afford to pay them all out immediately. To do this, AXA would have needed to sell mortgages at a discount in a falling market, which would have disadvantaged those investors who chose to stay in. The suspension stayed in place for over a year, and was followed by an orderly wind-down of the fund and return of capital to investors. During the suspension AXA continued to make income distributions to investors.

AXA was unusual in looking after its Mum and Dad investors ahead of the banks. AXA hoped to address its liquidity issues by suspending redemptions for the institutional investors (mostly banks, with a total of about $117 million) while letting retail investors (with a total of $112 million) continue to invest new funds or pull out. However, after three months it had to freeze all redemptions. Most finance companies showed no such respect for investors. The trustees, paid to protect investors, showed little appetite for intervention or for demanding disclosure to investors. There seemed to be no focus on the truism that mortgages should not be funded by investors who have been promised immediate access to their money.

Citing these examples is not just displaying wisdom after the event. In 2005 the Securities Commission noted finance company trustees could improve their act. Prompted by the rapid growth of finance companies, in September 2004 the Commission published a discussion paper, Disclosure by Finance Companies, and invited public submissions. It then reported back in April 2005:

However, it was almost ten years before there were any significant reforms. In late 2008, in response to the global financial crisis, the National government established the Capital Markets Taskforce, which reported back with various recommendations in late 2009. These recommendations made their way into the Financial Markets Conduct Act 2013 (which replaced the Securities Act 1978 and various other securities laws), and included a more rigorous licensing regime for independent trustees.

 

Prior to 2008, property developers were in a rare position of having lenders chase their business. They did what rational people do. Those like the 2018 mayor of Queenstown, Jim Boult, tendered their loan applications, seeking the lowest rate or the most favourable terms.8 Boult funded a property project in Central Otago without having to provide a guarantee of the debt. Foolish moneylenders fought for such lending opportunities, agreeing to waive personal guarantees or offering low lending fees or rates, effectively under-pricing risk. In the High Court, former National Cabinet Minister Barry Brill told how Money Managers released his guarantee in return for a profit share of a Rotorua development that subsequently failed.9 The people whose money was lent and lost should have benefited from that profit share, had it eventuated. Instead, those investors had lost the guarantees of a wealthy borrower, waived in return for a benefit they may not have received. There was no transparency in this type of trade-off of risk and return.

Many companies, including SCF, put a review clause into property loans which meant that the developer’s loan could be recalled, perhaps at each six-month interval, if the lender was not happy with the progress. It was this clause that made it possible to describe the whole loan as having a six-month maturity rather than being a five-year loan with a regular review period. The loan was displayed as ‘repayable’ after six months and included in cash-flow projections. Each such loan might go into the maturity schedule, displayed as though the lender could fund the loan with a six-month or slightly longer deposit. This meant the loan book’s maturity profile was misleading. No developer could have repaid anything until he had completed his development, sold it, produced titles, and collected money from the sales. To imply that the developer could meet a demand to repay after six months was to imply that other finance companies or banks would refinance the loan. How probable was that? A stalled project, or one that was not hitting its key milestones, would hardly attract a new lender, even in years of high liquidity.10 Yet many finance companies still reported these property loans as being collectible upon any review date. Auditors, trustees and regulators must have acquiesced. This practice fooled analysts and credit-raters. It might also have fooled McLeod and the directors of SCF. They seemed ready candidates for being fooled by their own data.

The other seriously misleading practice was in the coding of loans. Credit-raters and analysts like to focus on the diversity of a loan portfolio. A property developer might buy bare land and prepare to build a mix of properties, including lifestyle lots, wineries, a motel and perhaps some residential sections. Is the administrator in head office instructed to code this loan as a property development loan, a wine industry loan, a motel loan or a residential housing loan? Which would sound the most agreeable to an analyst or a potential investor? Experienced moneylenders would have defined a winery loan as a loan made to an existing winery, perhaps to build new plant, extend the wine-making facility, build a restaurant for tourists, or buy land to plant more grapes. A motel loan was a loan to a motelier, perhaps to refurbish, or build a new unit, improve the car park, or buy out the freehold of his lease. A loan to buy and develop bare land would be a straightforward property development loan. In the case of the winery loan and the motel loan, the correct code would identify established cash flow and be based on whether the borrower had incoming cash to service the loan. To describe a developer’s project as a motel loan or a winery loan would deceive most people, making it seem like a loan to an established business rather than a loan to a developer hoping to sell to people who might build a business. The risk is entirely different. The developer has no incoming cash with which to reduce the loan and the risk. Did Hubbard understand this?

The question must be asked whether the SCF directors failed to understand that they had created a company that relied on new deposits to meet its obligations. My definition of a company that can meet its obligations only by raising new deposits is that it is a quasi-Ponzi company. In SCF’s case, Hubbard’s contributions when needed spared SCF the harsh sobriquet of ‘Ponzi’ but by my definition it was close to being a Ponzi company. The published maturity schedules looked robust. But the directors may have been misled by the logic used for coding loan types. Even if that sounds implausible, it might have been true. The directors were not experienced financiers with long apprenticeships in moneylending.

 

If Standard and Poor’s had been alert to the reality of South Canterbury Finance’s business model, it might have rated the company in 2008 D rather than its actual rating of BBB-. However, it should be noted that between 2000 and 2007, S & P’s international standards were very low and by 2009 were so discredited that its subsequent restoration to respectability must be seen as miraculous.11 Standard and Poor’s reputation was not helped by its dubious claim that it could employ any numerate person and quickly teach them to be a rating analyst. It used sandwich-board advertising in New York to recruit from the streets. S & P was never held accountable for its misleading rating globally. Why? In New Zealand, S & P behaved with more sobriety. By 2007 many New Zealand finance companies had chosen not to be rated by it or other rating agencies such as Moodys or Fitch, partly because the rating fee was often high. Yet collectively these companies were attracting billions of retail investors’ money, were widely used by fund managers and institutions, and were being sold by countless financial planners and investment advisers whose knowledge was nil, and whose recommendations were often sold on the credit rating of the company. Before the early 2000s, managed funds and listed securities were financial planners’ and investment advisers’ preferred investments, and they were reasonably well served for research in this area, but not so for debt securities such as finance company debentures. If professional advisers were largely in the dark, their clients didn’t stand much of a chance of getting the kind of advice they needed to make informed investment decisions.12

The Securities Commission’s April 2005 report summarises the problem:

Several respondents expressed concern that rating agencies are unregulated and that there is no standardised rating system for finance companies. Several noted that for a rating to be meaningful the rating agency had to be reputable and competent. It was also considered that there would be less confusion about the meaning of ratings if there was regulated disclosure of credit ratings.

Respondents were also concerned that investors should be able to differentiate between a rating that results from an independent, in-depth assessment of the company and a rating that involves no detailed internal review of an entity and is based only on publicly available information.

The expense associated with obtaining a rating was also of concern and several respondents noted that this cost meant most finance companies could not afford to be rated by internationally accepted credit-rating agencies. It was noted that investors may place too much reliance on a rating alone and may not seek to confirm its quality and meaning. It was also noted that there are currently some issues with disclosure of rating information because some rating agencies consider some of the rating information may be their own proprietary information.

In October 2005, Anthony Davies, then a financial journalist, who assisted with the research for this book, attended a workshop entitled ‘Do you have a defendable policy on investing in finance company debentures?’ at an investment advisers’ conference. The workshop was conducted by Wayne McCarthy, a director with Lower Hutt firm First Financial Planning.13 He had worked across treasury operations, lending and financial services for around twenty-five years, including a stint at St Laurence. He contended that few advisers had a defendable or rational methodology to back up their finance company recommendations – and there were scores of finance companies in the market at the time. To prove his point, he ran three case studies – St Laurence Mortgages, Bridgecorp Finance and Capital & Merchant Finance – but didn’t identify them until the end of the workshop. His case studies summarised the companies’ histories, focusing on lending reputation, related-party lending and management history. He then detailed the companies’ total assets, equity to total assets and income to total assets ratios, loan concentration and loan book profile, and impaired assets. Advisers were then asked which company or companies they would consider recommending and which they would avoid. There was little agreement. He then suggested a few guidelines as starting points: select only companies approved or recommended by a rating system you understand, limit total finance company exposure to 20 per cent of an investor’s portfolio with no more than 5 per cent in any one company, invest in secured debt rather than capital notes, and invest for terms of only two years or less.

The sad reality is that too many advisers’ recommendations were based on marketing sales pitches and which companies paid them the highest level of brokerage. Although SCF, UDC, Marac, St Laurence and Strategic paid standard brokerage levels, the likes of Bridgecorp, Capital & Merchant Finance and others paid twice or even three times as much. In an honourable world, commission levels should never influence investment advisers’ recommendations. But back then the world was far from ideal, and there is no evidence that things have since improved markedly.

 

So just how bad did the advisory industry become in the lead-up to the GFC? A 2005 High Court case tells the story.14 In the 1990s and early 2000s, Money Managers (MM) was probably New Zealand’s largest and highest-profile investment advisory network. Its founder was Doug (Somers) Edgar. He had never worked in banks or in capital market companies: he was a property investor and a salesman. In 2000 Money Managers’ head of marketing, Alasdair Scott, negotiated a deal with Neal Nicholls of National Mortgage Brokers (NMB) to sell to clients a $36.5 million two-year contributory mortgage scheme. The contributory mortgage (then the largest to date in New Zealand) was to fund a property development on Auckland’s North Shore. It was agreed that Money Managers would be paid 2.5 per cent commission for all clients’ funds raised. Rather than commit to a two-year term, Money Managers would place its clients’ funds for one year and then give them the option to roll over or redeem (withdraw) their investments. Where investors chose to redeem and Money Managers found replacement investors, they would be paid a further 2 per cent commission. In any event, more than 80 per cent ($30.3 million) of investors chose to roll over. At this point MM and NMB fell out. Money Managers claimed it had been agreed it would be paid a further 2 per cent commission ($606,090) on the rollover funds. NM disputed this.

The dispute ended up in court and the court’s judgment was in favour of Money Managers. Justice Venning wrote:

Most advisers would have thought that it was the investors’ best interests that should have driven Money Managers’ client recommendations, not the brokerage deal. When investment advisors give advice you can bank on, it’s supposed to be the clients who do the banking.

Sadly, this wasn’t an isolated incident of investment advisors basing their recommendations on their own remuneration and applying leverage to get more commission out of finance companies.

 

By 2008, SCF had more than 500 financial intermediaries referring client money to it including all the banks, the NZX broking firms, financial planners and our company. But Hubbard and Gloag were rarely visited by inquisitive brokers, fund managers or analysts.15 Very few investors had expert help.

They were phoney financiers in almost every city. I recall Trevor Ludlow, head of National Finance in Auckland, arriving uninvited in my office. He wanted to persuade me to recommend his finance company debentures to my clients. I responded that there was zero chance of that happening but if he wanted to talk rugby and share a cup of tea then we could go to a nearby café and talk. It was lunchtime. He grinned, we did just that and then he left. He was no more a financier than he was a circus acrobat. We did not waste a second discussing his phoney finance company. National Finance subsequently collapsed in 2006 and Ludlow was convicted and jailed for making false statements in a prospectus, the offer document a lender needed to issue in order to raise funds from the public.

The day after Ludlow visited me he arranged a newspaper advertisement in our Kapiti local paper, which also published a weekly article I wrote on financial markets. Beside my article he placed a banner across an advertisement for his company. The banner read ‘Rated by Chris Lee.’ He did not mention the ‘rating’ I assigned to National Finance. My assessment was E, the worst grade I used. The newspaper did not ponder whether the advertisement might mislead anyone. To this day it surprises me that the media accept all advertisements without any inspection of their claims. One newspaper editor told a senior journalist not to submit an article heavily critical of Bridgecorp because ‘its advertising revenue is important’.16

I had published a grading of most finance companies from 2002. I rated most finance companies C, D and E; the biggest group by some distance was E. Later the website interest.co.nz and a Wellington fund manager, Grosvenor, published gradings. They, too, were trying to differentiate companies on the basis of their research. But investors received very little help.

Despite the obvious gap in the market, S & P could not attract mandates other than from UDC, Marac Finance, SCF and Geneva Finance. Sometime before 2008 it proposed a new, much cheaper rating system and asked to meet me in Wellington to discuss its proposal.17 S & P believed its ratings would be similar to mine in relative terms. But the S & P proposal never advanced. Most companies did not want to be inspected and would not pay to be identified as weak.

A rating downgrade was critical, because when a company becomes ‘sub-investment grade’ few mainstream institutional investors will invest in it. (This is another reason why finance companies that knew they would be identified as sub-investment grade were in no hurry to be rated.) A sub-investment grade company will have to pay higher interest rates for its debt because it is deemed to be higher risk. The downgrade can trigger bank covenants or clauses in deeds requiring immediate repayment of loans. This happened with SCF in 2009, the ‘Year from Hell’, when it lost its investment grade rating. Its US Private Placement funders then demanded full repayment of their $120 million long-term funding for SCF plus a further US$45 million in penalties. That in turn led to a string of crises that culminated in the incineration of a billion dollars.