Brent Sheather: The warnings started back in 2002

I almost choked on my coffee a couple of weeks ago when I read Anne Gibson's Herald article on finance company debentures.

She quoted financial planner Chris Lee as saying that no one had warned investors about the risks of finance company debentures.

Lee, who apparently put his clients into Strategic Finance and other debentures, said "no doubt there will be some clever sods out there who will tell you they foresaw it. They are cleverer than ... the auditors, the trustees, the credit rater and cleverer than me. It is a pity they chose not to share their wisdom before it all happened.

"NZ has a dreadful record ... for staying silent when speaking up is the responsible thing to do. How many people knew about ... Bridgecorp, Nathans, Capital + Merchant and MFS ... but said nothing?"

I'm not sure how many people said nothing but lots of people warned against finance company debentures including Mary Holm, Gareth Morgan, Frank Pearson, Tony Hildyard (from Tower) and me.

In fact if Lee had been a regular reader of the Herald business section he would have read at least five articles specifically warning of the dangers of finance company debentures and CDOs with the first appearing as early as September 2002. The first finance company to go bust was Provincial Finance in June 2006.

Let's take a look at some of those stories. The first, Weekend Money on September 21, 2002, looked at an actual investment plan by a financial planner.

The story began "with shares off the menu for many investors, more and more advisers and stockbrokers are focusing on fixed-interest products as a low-risk alternative for their clients. Unfortunately, financial advisers' views of what constitute "low-risk" bonds vary widely.

"Once we could say with some certainty that shares were more risky than property, which was in turn more risky than bonds. But in today's market some bonds are riskier than some shares.

This is compounded by the tendency of advisers to always diversify a share portfolio by buying shares in a wide range of companies, but often leaving the bond component concentrated in just two or three bonds.

"Thus, investors switching from the perils of the stockmarket to the security of bonds may unwittingly be jumping out of the frying pan into the fire. Finance company debentures are in another league of risk completely. One of the fundamentals of prudent banking practice is to diversify one's loans across various industries, yet this financial plan sees the family trust having about 80 per cent of its assets lent to companies exposed to New Zealand property developments.

"Property development finance is high risk; this country has an unenviable history of property development company failures. There are also structural problems with the debenture market; in this country the secondary market for these things - where existing debentures are bought and sold - is often non-existent. That means there is little in the way of independent price-setting.

"Prices are set by the issuer, usually having regard to the yields offered by similar organisations. With more liquid debt investments, such as those issued by the Government and state-owned enterprises, an active secondary market with institutional buyers and sellers sets a benchmark for new issues.

"And because there is little trading, there is no incentive for brokers or intermediaries to research the outlook and risk of each company. In times of market stress ... higher-risk bonds change their spots and start acting like shares, falling in value even as lower-risk bonds rise in value. This occurs because investors worry that the impending difficult times will result in risky companies defaulting on their debt.

"Higher-yield bonds thus offer little diversification and are a bit like umbrellas that you can use only when it is not raining. One fund manager ... said professional investors frequently had minimal exposure to small, local, unlisted finance company debentures because of their high default risk and lack of liquidity."

That sounds like a warning. It certainly wasn't a buy recommendation!

Next up was Weekend Money April 3, 2004, which quoted Warren Buffett: "When we can't find anything exciting in which to invest, our default position is US treasuries. No matter how low the yields on these instruments go, we never reach for a little more income by dropping our credit standards or extending maturities."

The article concluded: "A bit of good advice there too, perhaps, for the fans of local high-yield finance company debentures." That is a pretty clear negative view too.

September 5, 2005, and Clouds Over Finance Firms reads "a slowdown probably won't pose much of a problem for our major banks and companies but it could cause major pain for the clients of finance companies who are borrowing at high double-digit interest rates.

"When you have to borrow from finance companies it is unlikely that you have a reliable cashflow positive business. If you did you would probably be borrowing at a lower cost through a bank. So, it's on the cards that the client borrowing from XYZ Finance is developing some asset, usually a property, which he or she hopes to flick on at a higher price as soon as possible to pay back that loan.

"Remember, too, that funding costs through your favourite finance company only start with the 8-9 per cent offered to mum and dad. To this must be added the 1-2 per cent commission typically payable to a financial planner plus the operating costs of the finance company plus a margin for profit. All up costs to Mr Property Developer are likely to be easily in the 11-12 per cent range.

"To put that number into perspective, most major listed companies in New Zealand today would love to find projects which could produce a 12 per cent return as their cost of capital is only around 8-9 per cent. Often the higher your cost of capital, the greater the significance of a slowdown on your business.

"With no high inflation down the road to bail out poor investment decisions when the music stops, things could get rather nasty for the entrepreneurs that use finance companies as a prime source of their funding. New Zealand investors - 'mums and dads' trying to squeeze the maximum out of their savings - now apparently have record sums invested in finance company debentures.

"Are they inadvertently financing the clients the mainstream banks won't? With levels of debt much higher locally and overseas, the implications of a tougher economic environment may now be significantly different from even a few years back." Hmmm, no doubt about the conclusion there either.

The next warning about finance company debentures came on October 8, 2005, in which we said that the high annual fees charged by financial planners meant they had to put their clients into risky assets in order to generate worthwhile returns after fees.

"This high risk arises usually in two different ways: too much in shares, or junk debt. Financial advisers with a 3 per cent annual fee structure implicit in their investment plans face a dilemma. They can either put together a medium-risk portfolio, as with the asset allocation of the average pension fund and, after fees, generate the same sort of returns one can get from the bank - or else they can wind up the risk of the portfolio.

"The latter scenario usually prevails. The two favourite strategies are stuffing portfolios with lots of shares or hedge funds and, instead of buying investment-grade bonds, go for the junk debt option of finance company debentures and CDOs.

"Nowhere is the local financial planning industry's predilection for things risky more notable than in the fixed-interest sector. What else could explain the popularity of high-risk, illiquid, poorly-researched finance-company debentures in New Zealand?

"It's no surprise that this sort of junk rarely appears in most institutional debt portfolios. Professionals know that bonds stabilise portfolios at times of stress but that, at the first sign of trouble, junk bonds change their spots and fall in price just like shares.

"But if you are a financial adviser with 6 per cent bank rates as your benchmark and a 3 per cent fee overhead, then 9 per cent bonds from XYZ Finance is a prayer answered. Collateralised debt obligations and leveraged bond funds are the other local manifestation of a high fee structures side-effect. Virtually no local adviser understands them and anecdotal evidence shows few of their owners actually know they own them. But this hasn't stopped millions of dollars of mum-and-dad savings flowing into these high-risk products normally frequented by the likes of hedge funds and the odd member of the Saudi royal family."

The local financial planning and stockbroking fraternity has come in for criticism over bad investment advice with the authorities now scrambling to legislate against bad practice.

This ignores the fact that the single biggest reason for misrepresenting a client's risk profile is a high annual fee structure. With many financial planning firms charging 2-3 per cent in annual fees, they must, in order to beat the bank, recommend high-risk portfolios.

The answer to this problem is not regulation. It needs to be driven by the investing public - demanding realistic annual fees from their advisers and threatening to leave the money in the bank as per Warren Buffett's good advice of April 2004.

* Brent Sheather is an Auckland stockbroker/financial adviser and his adviser/disclosure statement is available on request and free of charge.