Brian Gaynor: Debt dependence dangerously out of fashion

New Zealand's addiction to debt is extremely dangerous. The addiction
occurs at both a national and individual level.

We are currently spending approximately $43 million more offshore every day than we earn and most of this has to be borrowed. This means that the country is effectively acquiring an additional $10 of overseas
debt per person per day.

This is plunging us deeper and deeper into debt and according to the
OECD we are the third most indebted country, behind Iceland and ungary,
among its 30 members.

It is the same story on an individual level. In the 10 years ended February 2009 total individual debt surged from $62.7 billion to $175.1 billion. Thus New Zealanders have borrowed an additional $30 million plus per day over the past decade and we now have individual borrowings of $41,000 per head of population.

There has been a substantial increase in individual borrowings throughout the world over the past few decades but New Zealand is more
indebted than most because of our combination of high personal debt and
low savings. As individuals we spend more than we earn every year and
when we borrow from our banks the funds have to be sourced from offshore because of our negative savings rate.

As a consequence our banks borrow offshore, on-lend to us and we spend it on houses, overseas trips and imported goods. This exacerbates the
country's huge net international investment deficit.

One of the most important points to note about debt is that it goes in and out of fashion. Sometimes it has been extremely fashionable to borrow while in other periods this strategy has been ruinous. The most successful individuals are those who know when to borrow and when to repay debts.

The early 1880s was a period of abundant credit, massive confidence and a speculative sharemarket and land boom in Auckland. Bank loans in
the city surged by 75 per cent in the four years ended December 1884 as the fledgling financial organisations, particularly the Bank of New Zealand, imported a huge amount of funds from Britain.

The city was in a speculative frenzy as farmland in Ponsonby, Mt Eden and North Shore was converted into residential housing.

But the boom came to an abrupt end on July 7, 1885 when the chairman of
the National Bank of New Zealand announced in London that his bank would write-off 100,000 on Auckland-based property loans. According to
R.C.J. Stone the BNZ sought to fortify its position throughout the colony by pulling in advances even at the risk of alienating sound clients and some of the leading businessmen of the city
could no longer meet the crushing interest burden of indebtedness from
past speculation.

Foreign funds dried up, the city experienced a 10-year slump and many
of its elite businessmen never recovered. A run on the Auckland Savings Bank in September 1893 was followed by a government guarantee of
the BNZ. The recession finally eased in 1895 when workers began to save and place their deposits in the Auckland Savings Bank.

One of the few survivors of the slump was Lawrence David Nathan
whose company merged with Lion Corporation in 1988. Lion Nathan,
which has been Australia-based since 2000, was the subject of a full takeover offer from Kirin this week.

Borrowings went out of fashion after the 1885-1895 slump but were back
with a vengeance again in the 1920s, particularly in the United States.
However the Great Depression gave the clear message that excessive
borrowings were imprudent and individual debt levels were extremely
low during the 1940 to 1980 period.

Debt came back into fashion in the 1990s with the deregulation of the
finance industry.

Deposits are the raw material of financial institutions with loans being the revenue earner. The more loans a financial institution makes the more profit it generates. The higher the risk, the higher the interest rate it charges on the loan.

Over the past few decades financial institutions have had a surfeit of
deposits and a plethora of innovative financial structures that has enabled them to aggressively promote loans.

Credit cards are one of the more obvious forms of profitable lending as
financial institutions are able to charge particularly high interest rates on these.

Financial institutions targeted individuals in New Zealand because
the Government has had a frugal approach to borrowing and many
businessmen are still hung over from their aggressive borrowing binge in the 1980s.

In addition large companies have been able to obtain cheaper offshore syndicated loans.

Financial institutions have been extremely successful in creating the
myth that debt is an important ingredient in wealth creation.

The success of highly geared hedge and private equity funds has enhanced this image as has the rise and rise of Graeme Hart, who is probably the country's most highly indebted individual through his various companies.

The Blue Chip fiasco is probably the worst example of the myth connecting debt and wealth creation. Under the Blue Chip model a large number of elderly people, who were debt free, were convinced to borrow against their home in order to create additional wealth.

This was sold as a risk-free approach yet many of the individuals
who accepted this flawed advice are now facing major financial hardship.

The conflict between debt and savings is not helped by the confusing
policies of governments and central banks.

Politicians and central bankers encourage individuals to save yet when borrowers are under stress they immediately drop interest rates to the
disadvantage of savers. Why do central bank governors always rush to rescue borrowers but have little regard for savers? Why do elderly investors, who have prudently saved, have to accept lower interest rates because borrowers have overextended themselves?

Although financial institutions must accept some of the blame for
aggressively promoting high-risk loans there is also a degree of greed and laziness as far as the borrowers are concerned.

There is an element of greed when individuals borrow to purchase non-
essential items they cannot afford in exchange for large repayments in the future. There are clear signs of laziness when individuals believe that they can make a lot of money by borrowing more than 90 per cent of the purchase price of a residential property.

Asset price bubbles, which are fuelled by abundant credit, create
losers as well as winners and add to the total pile of debt.

For example, if the average price of a house doubles from $175,000 to
$350,000, as it did between 2003 and 2007, then the purchaser at the early price would have to have $35,000 of equity, assuming 20 per cent equity, and $140,000 of borrowings.

The purchaser at $350,000 would have to have $70,000 of equity and $280,000 of debt based on the same assumptions.

House price increases make it far more difficult for new home buyers to
enter the market and increases the level of debt, mainly sourced from
offshore, on the same house.

The recently released 147 page OECD report on New Zealand delivers
yet another warning that our debt levels are far too high. The OECD's last major report on Iceland, which was released in February 2008, had a similar message and that small island country has experienced an economic meltdown since then.

But the most important message for us is that debt is going out of fashion and we have failed to anticipate this development. Economic growth was fuelled by borrowings in the 1990s and early 2000s but equity will play a much more important role in any recovery.

This is why we have to replace debt with equity as many of our major
companies have done recently through share placements.

* Disclosure of interests; Brian Gaynor is an executive director of Milford Asset Management.