The finance companies also had less reason to minimise risk.
Some companies took advantage of the guarantee to grow their business substantially - South Canterbury Finance grew its deposits by 25 per cent after the guarantee was put in place.
Now we are all paying for that silly move.
Finance company debentures (FCDs) were very much the right product at the right time from the perspective of the financial-planning industry. Back then many retail investors and their advisers focused on return and commission respectively, ignoring risk.
FCDs promised something of an investment nirvana to both parties: a higher income than Mum and Dad could get in the bank, at the same time as offering financial advisers similar levels of commission and trailing fees to those available from selling share funds.
In contrast, less speculative fixed-interest investments such as government stock, SOE bonds, etc, paid no commission, no trailing fee and required any fees that were sought from the client to be shared with a stockbroker.
It is ancient history by now that the FCD adventure turned out disastrously. But the legacy of many financial planners' conflicted advice is now seeing the light of day in court cases around the country.
Today's story is about a recent judgment in favour of a retired gentleman for the sum of $70,000 against a financial adviser.
The judgment is interesting because it shows how well the courts have understood the issue and, most importantly, what they concluded a reasonable investment strategy was, and presumably is.
The situation was as follows.
The client approached the financial adviser, who had a certified financial planner (CFP) qualification and was a member of a professional body, for investment advice on "low- to medium-risk investments". Gareth Morgan, incidentally, has long argued that CFPs were responsible for a disproportionate share of bad advice, so he can add this sorry episode to his list.
The client invested a total of $272,000 in the debentures of four different finance companies over the period June 2000 to October 2004. All of these companies subsequently went bust to one degree or another.
If that advice wasn't bad enough, in October 2004 the client wished to redeem early a $100,000 investment in Bridgecorp. But the adviser refused to process the redemption request. The client then contacted two of the finance companies he had invested in and arranged withdrawals himself.
In 2009, the client lodged a formal complaint against the adviser with the professional body, which considered the advice given and, according to the court records, wrote to the adviser saying that "it is prepared to dismiss the complaint if you accept you have been censured and if you meet costs of $2000". Hmmm.
In February 2010, the client filed proceedings against the adviser for $119,000.
What I find incredible in this case was the opinion of the two "experts in their field" who were called upon to inform the court as to whether the advice given was acceptable or not and why. One of the "experts" said that "a reasonable financial adviser" would have invested 10 per cent of the total capital of the client in each of Bridgecorp and Property Finance debentures.
In my view, this is a ridiculous comment and quite wrong.
Firstly, we should look at what industry best practice is, taking the actions of superannuation funds and other professional investors as a guide.
Typically, large funds have 40 per cent of their investments in bonds and about 95 per cent of their bond investments are in what is known as investment-grade bonds - that is, those issued by institutions such as governments, SOEs, city councils, banks, etc.
Junk debt typically would not represent more than 5 per cent of a professional investor's bond portfolio and, even then, it is likely to be diversified via a dedicated high-yield debt fund over at least 50 companies.
On this basis, and assuming the client had no other assets (the client's other investment assets are extremely relevant to this case but don't appear to have had a mention), the client would have invested next to nothing in finance company debentures.
Secondly, modern financial theory, which one would assume would be known by individuals with a CFP qualification, says that the least-risky portfolio is the market portfolio. So the question before the court should have been: to what extent are finance company debentures represented in the universe of fixed-interest instruments available to retail investors?
The answer to this question is that about 95 per cent of the local fixed-interest market is made up of government stock, SOE bonds, city council bonds, bank deposits, etc.
On this basis, too, FCDs would have had a minimal allocation in a properly diversified portfolio. Furthermore, this analysis ignores the fact that a prudent investor would have had some of their bond portfolio invested offshore.
A third reason to avoid FCDs - one which has been outlined in this column many times before - is the fact that in times of market stress, bond markets bifurcate. In other words, when events like the European crisis occur, the prices of low-risk bonds go up and the prices of high-risk bonds go down.
If the client in this case had an equity portfolio, he shouldn't have had any exposure to FCDs, as FCDs offer no diversification benefits.
Again, it's not unreasonable to expect that a CFP should have known this. Nevertheless, in determining the losses and damages caused by the financial adviser, the court took into account the evidence of the expert witness and reduced the judgment for losses from about $119,000 claimed to $73,000.
Another issue is the way the Code Committee Standards have allowed some of the worst offenders in the New Zealand financial-planning scene to glide into authorised financial adviser (AFA) status without much effort at all, including the adviser at the centre of this case.
I asked the Financial Markets Authority what additional training an adviser with a CFP had to undertake to become qualified as an AFA under the new regulations.
The FMA advises that this is covered in the AFA Code of Conduct Schedule, which shows that of the three unit standards required to become an AFA - excluding the ethics standard, which everybody has to sit - a certified financial planner was able to avoid two of those unit standards.
These were Unit Standard A, which details the advice process and products, and Unit Standard C, the professional practice advice process and complying with legislation. It's a funny old world.
Brent Sheather is an Auckland-based authorised financial adviser and his adviser/disclosure statement is available on request and free of charge.
