Tuesday 31 August 2010

Propping up the finance companies [updated]

A brief potted history; somebody correct me if I have this wrong (a few such corrections now below). I'm mostly going on memory and mine's not the greatest.

During the 2008 New Zealand election campaign, the Australian government moved to provide deposit insurance to the Australian banks. Michael Cullen, then Kiwi Finance Minister, announced that New Zealand would do the same. Nobody bothered getting Treasury and Reserve Bank in for prior consultation, so the whole thing was guaranteed to be a mess - the issue arose because Australia moved and because we were mid-election. Cullen got Key to agree to things in principle, with details to be worked out. The scheme wound up covering a bunch of dodgy finance companies that no sane government deposit insurance scheme ever ought to cover. The initial draft regs were so ridiculous that folks here in the Econ department considered setting up a few finance companies where we'd all invest in each others' companies, have all the companies go broke, then collect from the deposit guarantee scheme. Others had very similar ideas. Drafting regs on the fly during an election campaign is about the worst way of setting policy, but that's what we did. Thanks, Michael Cullen. And thanks John Key for going along with it. RBNZ fixed the stupidest parts of the regulations, but dodgy finance companies got to stay in, paying premiums that were low relative to their risk, with cross-subsidy coming from premiums paid by the banks.

Update: Cullen had had preliminary chats with Treasury prior to Australia's moving, with Treasury's advice provided here. Treasury worried that covering banks and not finance companies could be distortionary, sending money from finance companies to banks. That's not crazy, but it does argue for actuarily fair insurance premiums, as recommended by Treasury at p. 14-15, not the system we wound up with when the final regs were drafted in haste during the election campaign.

Now, what's a finance company, my non-Kiwi readers may ask. So did I. The typical finance company sells term deposits to investors at high interest and lends the money out to such trustworthy folks as 16 year olds with no income and no collateral who want to buy crappy old Japanese cars, put loud exhaust systems on them, and race them around town. When these trustworthy loan recipients pay back their very high interest loans, the finance company pays out its investors at the very high promised interest rates. Now, some of these companies went bankrupt during the financial crisis. And a bunch of people who'd invested their life savings in companies lending money to teenagers with no income for buying depreciating assets began wailing that they never could have imagined that these finance companies paying high interest rates actually might have had risks attached. When folks like me asked why the hell these folks were taking really really risky term deposits at 10 or 12 percent when they could have gotten rock-solid term investments from RaboBank that were paying around 8 percent, nobody could give me an answer beyond "they needed the extra money". Nice. And because it was an election campaign and because nobody during an election campaign wanted to tell a now-bankrupt retiree that his choice to get an extra $40 a month in interest had consequences, these companies got the same deposit guarantees as the banks.

Ok, so that's a finance company. One of the finance companies, South Canterbury Finance, seemed a lot less dodgy than the others. Its founder, Alan Hubbard, lived a frugal life and invested in things like farms instead of in things like cars loans. Except it seems that he was being awfully generous in his administration of things, trying to work more as a one-man regional development agency but doing it with other peoples' money. I'm cool with charity. But the end result of this kind of socially conscious investment is bankruptcy.

The government should have moved to pull finance companies out of the deposit guarantee scheme a year or more ago. The best they could manage was a winding down of the current scheme with a successor scheme to start up a month from now, restricted to companies rated BB and up. Since SCF was covered on the old scheme, the government was stuck: either bail out SCF or let them go into receivership and pay out under the deposit guarantee scheme. The former had lower front loaded costs but potentially high long term costs; the latter gets it all done with. I think I'm glad they chose the latter, if I understand things correctly.

But instead of moving to scale back the guarantees, they're ramping things up. Previously ineligible investors are now covered. Maybe there's some really good reason for this and I've just not been paying enough attention. This ought to be the time to be killing finance company eligibility for government deposit insurance, not expanding it. And I'm not sure why we're conferring rents on folks who were betting last week that the government would provide a bailout:
South Canterbury Finance investors, including all bondholders but not preference shareholders, have been told to spend their cash wisely when they are reimbursed by the government a total of $1.6 billion following the company’s receivership today.

In addition, the government is negotiating a loan of up to $175 million to the receivers for repayment of prior charges over South Canterbury’s assets, including a $100 million facility arranged through investor George Kerr’s Torchlight fund.

The payment under the Crown guarantee appears more favourable to South Canterbury investors than to those in other failed finance companies in recent times.

This is because some depositors and investors in long-dated bonds will now be repaid – having earlier been told not to expect anything.

This also represents a significant payday for plucky investors who bought South Canterbury 2012 bonds in the last days of last week at an 80% discount to their value today.

South Canterbury chief executive Sandy Maier said today that the payout under the guarantee scheme would lessen the impact on the South Island economy, where much of the company’s funding base and lending activities were based.

“Very shortly there’s going to be a massive infusion of liquidity in the South Island as all these debenture holders and bond holders get their dough,” Mr Maier told a media conference in Christchurch.

“I hope they do wise things with the money next.”
Hey! That's one way of running quantitative easing! Instead of helicopter money, just give it to the folks who'd bet on the government never ever being willing to let folks eat their own losses.

Bernard Hickey has been covering SCF for ages; TVHE today also is good. AntiDismal called the other day for ending deposit insurance. I'd be reluctant to pull deposit insurance for the banks until after the current financial mess is over with. And even then, I'd worry that the government now has zero credibility in the face of potential bank default and so may be stuck with deposit insurance for the longer term - at least in that case, they collect premiums on the insurance.

If things stay as they are, the message to Kiwi investors is pretty clear. Forget all that "diversify your portfolio" nonsense. Put everything into a government-guaranteed roulette wheel. Heads you get high interest payments; tails the government covers you. Here's the list of companies covered by the deposit guarantee scheme; just be sure that the product you purchase is covered under the extended deposit insurance scheme through the end of 2011 and that the maturity date falls prior to end 2011.


  1. One point that you won't remember since it was snuck out under the radar: Treasury and the Reserve Bank were in talks with Cullen beforehand, and they recommended that if a deposit guarantee were introduced it should have certain features - one of them being that finance companies should be included. See this link:


  2. Man, I'm a sucker. I think all of the 2009 interest on our house deposit (earning a lousy 3% in the bank) just got wiped out by our proportion of the $1.7B taxpayer liability. Nice. Pretty sure all the cost cutting in Health and Education just got wiped out also. Oh well, as long as those 'Mom & Pop' investors don't have to eat their risk, I guess that's all that matters.

  3. @Miguel: Nice catch, will update. Thanks!

    @Hefe: You should have put it in a finance company, apparently.

  4. Do you know how much the government collected in premia for the deposit guarantee scheme? I've heard talk of up to $900m, but can't find the exact figure anywhere.

    I'm just wondering, because there's a lot of talk of "NZers paying $400 apiece for the bailout" (NZHerald et al.), where, in fact, they might not pay anything at all if the bailout costs less than the premia collected from banks etc. by the government.

  5. Some year-old numbers here - $228 million as of June 2009. Apparently this year's figures come out mid-October. But most of this comes from banks, not finance companies. Even if premiums were close to the losses, it would be as a big subsidy from banks to finance companies.

    The $400 figure is nonsense as the firm still does have assets that are worth something and will eventually be sold off.