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.
Allied Farmers' announcement this week regarding the Hanover loan book reconfirmed the dire situation in which finance company investors have found themselves.
As the accompanying table shows, the original gross value of the Hanover loan book acquired by Allied Farmers was $527.2 million.
Before the Allied Farmers acquisition this portfolio incurred a write-down of $220.6 million relating to specific bad debts. Under New Zealand IFRS accounting rules there was a positive $72.1 million adjustment, representing the present value of the capitalised interest.
There was also a small positive net adjustment of $17.5 million for support packages supplied by Hotchin and Watson minus loans realised before the changeover.
Allied Farmers announced on Monday that the portfolio has been written down by a further $220.7 million, from $396.2 million to just $175.5 million. This latest write-down is largely due to Hanover, not Allied Farmers.
The first $20.7 million write-off represents a decrease in value approved by the Hanover board before the assets were transferred.
The next $56 million is essentially a reversal of most of the $72.1 million IFRS positive adjustment for the present value of the capitalised interest as most of this interest will not be paid. There has also been a $27.9 million write-down in property, mainly Five Mile next to Queenstown Airport, an Australian property write-down of $16.8 million and a whopping $99.3 million impairment on Kawarau Falls.
The latter is Nigel McKenna's massive development on the other side of Queenstown Airport where Stages 1, 2 and 3 are all in receivership.
Allied Farmers has a $19 million second mortgage over Stage 1, which is considered to be worthless, and a second mortgage of $73 million over the yet-to-be started Stage 2. The latter is behind Fortress, a tough US funder that doesn't grant any favours to holders of second mortgages.
Hanover investors received 72c for every 100c of secured deposits in the form of 3.4794 Allied Farmers shares at 20.693281c each. These shares will rise and fall with the value of the Hanover portfolio and this week's asset write-down had a big impact on Allied Farmers' share price.
Hotchin and Watson established and operated a finance company for which investors continue to pay a huge price.
But the most extraordinary development is that Hotchin and Watson are still raising money from the public through FAI Money, formerly FAI Finance, and its accounting policies and disclosures are just as poor as Hanover's.
FAI traditionally offered secured and unsecured personal loans but its latest prospectus reveals that the board and shareholders have decided that the company may now engage in the provision of property development and property investment finance to the property development/investment sector.
The prospectus also reveals that FAI's accounting policies on interest are exactly the same as Hanover's. In other words, interest capitalised on property developments is accrued over the course of the loan instead of being recognised when it is received.
In addition, KPMG was the auditor of Hanover Finance and is the auditor of FAI Money.
But, more importantly, there is no disclosure of the Hanover debacle and the role Hotchin and Watson played in this.
A great deal of emphasis is placed on FAI's Credit Committee, which comprises the CEO, credit manager and an independent member of the board.
But neither the CEO nor credit manager are listed in the Company Directory section and David Henry, who is FAI Money's only independent director, was the chairman of Hanover and doesn't appear to have much property development expertise.
FAI's investment statement, which is the most widely used document by investors, is also woefully inadequate as it doesn't include a list or description of directors and executives.
It also contains only vague comments about the company's approach towards property lending.
New Zealand has minimal investor protection with the exception that public issuers must fully disclose all important issues. This is based on the premise that investors can then make fully informed and rational investment decisions.
In light of this, why have Hotchin and Watson not been required to disclose in the FAI offer documents that they made a complete hash of Hanover Finance and have caused considerable hardship and financial distress to individuals who invested in that company?
* Disclosure of interest; Brian Gaynor is an executive director of Milford Asset Management.
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Correction, clarification and apology
A column entitled "Hanover's Shameful Slam-Dunking" dated 29 November 2008 asserted that Hanover's prospectus should have included information that most of Hanover's loans were second mortgages and that interest on loans was capitalised. Another entitled "Hanover Debacle Must be Turning Point" dated 6 December 2008 asserted that Hanover adopted misleading accounting policies in relation to capitalised loans. The Herald accepts that Hanover's prospectus No. 36 accurately disclosed on pages 55-61 that most of Hanover's loans were second mortgages and that the interest on the loans was capitalised, and retracts and apologises for the suggestion that Hanover misled or withheld information from the public as to the nature of its lending.
Articles entitled "Hanover House of Cards Doomed to Fail" dated 6 March 2010 and "Mark Hotchin: The Man Behind the Money" dated 19 February 2011 asserted that Hanover declared dividends out of non-cash profits, and an article entitled "Brian Gaynor: Message to Hotchin - own up or shut up" asserted that those dividend payments should not have been made. The first two of these articles also asserted that Hanover was, in effect, operated like a Ponzi scheme. The Herald acknowledges that Hanover was not a Ponzi scheme, and that Mr Hotchin did not act illegally in receiving dividends from Hanover, and apologises if any readers took those messages from these articles. The main purpose of all of these articles was to call for greater regulation of the finance industry.
