Question 22: The liberalisation of financial markets in the 1980s was also meant to make the raising of capital for business easier and cheaper. What was the result?

4 Mar

The raising of capital was made easier and cheaper – but the small investors who handed over their life savings to the new financial speculators were wiped out twice – in 1987 and again in 2006.

The first round of liberalisation resulted in a financial boom and collapse in the period 1984-87. This saw tens of thousands of small investors lose their life savings. Financial companies were exposed as little more than Ponzi schemes using new borrowings to repay old debt and claming false profits. Amazingly nothing was done to regulate this market until we had the experience repeated with the wave of financial company collapses that began in 2006. This has led to billions of dollars being wiped out in value. Again small savers who invested their life savings with the best and brightest of the financial world have been wiped out. The fund owners and managers have been largely protected with few prosecutions and their own fortunes protected behind the ubiquitous family trusts.

New Zealand Herald columnist Brian Gaynor summed up the experience in a March 6 article:

Investors were presented with positive financial accounts, consistent with our accounting standards, which encouraged them to invest in finance companies that were only able to repay investors if they attracted new borrowings when borrowers defaulted.

The Companies Office, Securities Commission, accounting profession and independent directors were asleep at the wheel as many investors lost a major percentage of their life savings.

Owners of these finance companies, particularly Mark Hotchin and Eric Watson, are still issuing woefully inadequate investment statements and prospectuses as they continue to borrow money from the public.

Why are these businessmen still able to raise money from the public without fully disclosing their involvement in failed companies?

Ponzi schemes are an investment proposition whereby the promoters announce unrealistic returns and repay loans, or interest on these loans, from contributions made by new investors.

Many of our property-related finance companies involved interest on loans being capitalised and this interest was only received by the finance company when loan principals were repaid.

Take, for example, a finance company with $500 million of interest capitalised loans to property developers and $500 million of debenture borrowings from the public at an average interest rate of 8.5 per cent a year.

This finance company has to pay annual interest of $42.5 million on these debentures yet it may receive no interest on its property development loans unless they are repaid, which is often not the case.

Thus, in this simple example, the finance company would have an annual cash deficit of $42.5 million and interest on debentures, plus any redemptions, could only be paid out of funds contributed by new investors.

This large cash deficit was concealed by accounting policies that allowed companies to accrue, or take into account, interest over the duration of a loan rather than when interest was paid. Thus finance companies would show that they had received interest when they hadn’t and reported a profit even though they had a substantial cash deficit from operating activities.

To make matters worse, dividends were then declared out of these non-cash profits and paid out of newly acquired debenture funds.

Thus the interest on debentures, the repayment of debentures and the dividends paid to the owners of these finance companies were all sourced from new debenture money.

This result, while unintended, has the same effect as a Ponzi scheme, and Ponzi schemes are quickly shut down by most competent regulators around the world.

In addition, it appears that a number of owners of finance companies sold properties to developers at vastly inflated prices and these purchases were 100 per cent funded by a finance company owned by the vendors.

In other words, investors in property-related finance companies were like lambs to the slaughter. They didn’t have a chance, particularly when the property development market collapsed and most developers couldn’t repay their loans or the capitalised interest on these loans.

The Listener reported April 3 that “According to a tally kept by business journalist Bernard Hickey….48 finance companies with a total of $6 billion in investor funds have failed since the first, National Finance, went under in May 2006. Judging by the estimated returns from receiverships and moratoria, he estimates $3 billion of that money will never be recovered by investors.

“Hickey thinks 100,000 people have been directly affected by the finance company scandal – ‘people who have lost money, or whose parents have lost money’.” As one observer commented to the listener: “Ma and pa investors have been skinned alive.”

It reminds me of the joke “the best way to rob a bank is to own one”. Except in this case the people robbed were small investors and their life savings – often retired with no way of recovering from the disaster.

(Part of a series of extracts from “Exposing Right Wing Lies” by Mike Treen, Unite National Director)

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