Brian Gaynor: Finance firm crashes highlight risks

The collapse of National Finance 2000 and Provincial Finance is a harsh reminder of the risks associated with finance companies.

The primary risk is that they are almost totally unregulated whereas the 16 trading banks are subject to strict registration obligations and scrutiny by the Reserve Bank, including a requirement to have a credit rating.

By contrast finance companies operate under a disclosure regime, the only conditions being that they must operate under a trust deed and issue a prospectus and investment statement.

The objective of a disclosure regime is for investors to read and study the prospectus and investment statement. Individuals are expected to form their own opinion about the performance and risk of finance companies. There is no requirement for them to have a credit rating.

How many National Finance 2000 and Provincial Finance investors read the prospectus or investment statement?

How many investors in other finance companies have read the prospectus and realise that they have invested in an unregulated sector of the economy?

The Reserve Bank has a number of requirements regarding bank registrations including:

* The applicant must have the reputation, track record and necessary skills to manage and operate a bank prudently.

* Banks must have a minimum capital of $15 million and meet a number of additional capital adequacy requirements.

* The banking group must not conduct material non-financial and insurance activities in excess of 1 per cent of total consolidated group assets.

* Banks must have at least two independent directors and the chairman cannot be an employee.

By contrast finance companies operate outside the jurisdiction of the Reserve Bank and have none of those requirements.

Almost anyone can establish a finance company, issue a prospectus and place advertisements in the daily papers.

National Finance 2000 had capital of only $125,000 as at September 30 last.

Allan Ludlow, who appears to have been chairman, managing director and the only shareholder, previously ran National Finance, which ceased trading after reaching a compromise with creditors.

David Lyall was Provincial Finance's largest shareholder, chairman and managing director until recently. The company's issued capital was less than $15 million throughout most of its history and its non-financial and insurance activities represented more than 1 per cent of total consolidated assets.

Disclosure regimes should require companies to give a realistic analysis of their business in prospectuses and investment statements. In reality, investment statements are almost hopeless in this regard and prospectuses are little better.

The last Provincial Finance prospectus, dated December 2005, made little attempt to analyse the company's $663,000 loss for the six months ended September 30, 2005. Chairman David Lyall wrote: "I'm pleased to report that Provincial Finance Ltd has traded well over the last six-month period, and is in good shape".

How could Provincial Finance have "traded well" when its net earnings fell from $7,065,000 in the six months to September 2004 to a loss of $663,000 in the six months to September 2005?

The only way one could have realistically assessed Provincial's problems was to study the company's last three or four prospectuses and have a good understanding of the Auckland second-hand car market.

Provincial was established in 1987 to provide mortgages to first home buyers, mainly in the South Island, but underwent a dramatic change in recent years.

Since March 2004 its exposure to mortgages had fallen from 27 per cent of total loans to just 6 per cent whereas car loans had grown from 62 per cent to 83 per cent of total lending.

The group's exposure to the Auckland market had grown from 26 per cent of total loans in 2002 to 54 per cent in the latest prospectus even though the company is Christchurch based and all its directors are South Islanders.

Provincial Finance grew too rapidly and expanded into the used car market where it had limited expertise.

The finance company sector as a whole has also grown dramatically in recent years, mainly because of the light-handed regulatory regime and the high shareholder returns.

The accompanying table shows that the 16 registered banks achieved an 18.5 per cent return on average net assets in 2005 compared with 27 per cent for the 44 finance companies included in KPMG's financial institutions performance survey 2006.

Since 2001 the banks' return on average net assets has fallen from 21.8 per cent to 18.5 per cent whereas finance companies have raised their return from 21.2 per cent to 27 per cent.

The net profit to average total assets figures also show that finance companies are extremely profitable. The registered banks achieved a return of 1.16 per cent on average total assets in 2005 whereas the finance company sector achieved a whopping 2.56 per cent return.

Finance companies are extremely profitable because they are able to borrow from individuals at ridiculously low interest rates that do not reflect the risks. They then on-lend this money at high interest rates, sometimes to risky borrowers.

Newspapers are full of finance company advertisements offering to borrow money from the public at interest rates between 8 and 10 per cent a year. Most of these companies have no credit rating and their lending activities are not clearly understood and may be risky.

Meanwhile A+ or better credit rated fixed interest securities are offering yields of up to 7.5 per cent a year on the NZDX. Among these A+ or better issuers are the State-owned Mighty River Power, Housing New Zealand, Dunedin City, Vector-United Networks, National Bank, ANZ Bank and Bank of New Zealand.

If investors can obtain a yield of 7.5 per cent on A+ or better rated securities they should be demanding at least 11.5 per cent from most unrated finance companies.

In other words the interest rates offered by finance companies are far too low.

Although the National 2000 Finance and Provincial Finance collapses have sent shockwaves through the finance company sector most companies are healthy and well run.

As a safeguard, investors should adopt a number of simple guidelines if they are going to invest in non-rated finance companies, particularly those that don't have ordinary shares or parent company ordinary shares listed on a stock exchange. These guidelines include:

* Never invest in an unrated security without reading the prospectus.

* Make sure you are comfortable with the quality and expertise of the directors and management.

* All finance companies should have a non-executive chairman and at least two independent directors.

* The finance company should not have excessive returns. According to KPMG, Provincial Finance achieved a return of 63.4 per cent on average net assets in 2005 compared with an industry return of 27 per cent.

* Make sure the company has not grown too rapidly, and that it has stuck to its area of expertise.

* Never put all your investments into one finance company, adopt a diversified approach.

Individuals who follow these simple guidelines should get a good night's sleep.

Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.