Opinion: Now finance companies are a NZ$5.85 bln problem for the government

By Bernard Hickey The announcements overnight that Standard and Poor's has downgraded Marac Finance and South Canterbury Finance from investment grade BBB- to BB+ 'junk' should concern their banks and the government. It is the strongest signal yet that the lead-up to the planned expiry of the retail deposit guarantee scheme on October 12 next year will be anything but smooth. There is now a significant risk that trustees will be tempted to pull the trigger on finance company receiverships in the lead-up to the scheme's expiry to ensure their depositers will get 100% of their money back by exercising the government guarantee. The finance company sector is increasingly desperate for either the government to outline its plans to replace the scheme with some form of deposit insurance or at the very least to simply extend the scheme to October 2011 to match the expiry of Australia's scheme and buy some time.

Without some announcement soon, finance companies will have to stop lending as depositors refuse to roll over their investments beyond the October 12 deadline. Given most of the remaining finance companies try to match their lending maturities with their funding maturities, this means they will have to stop making loans expiring beyond the October 12 deadline. A couple have alternative sources of funding, but most still rely on retail debenture investors. South Canterbury had NZ$1.48 billion of debentures outstanding as at December 31, while Marac has NZ$769 million of debentures oustanding. That is a NZ$2.25 billion problem right there. Overall, we at interest.co.nz estimate that finance companies covered by the guarantee owe retail depositors up to NZ$5.85 billion. If trustees were to force all of them into receivership on October 11 next year, that would be a major fiscal problem for the government. Let us not even think about the building societies and credit unions, who also lack investment grade credit ratings. This uncertainty creates the risk that all finance companies except UDC, which is backed by AA rated ANZ, will have to stop lending shortly unless the government clarifies what it plans to do. Many have already stopped lending. This could turn into another credit crunch, but in a much more crucial part of the economy. The property development finance company credit crunch of 2007 and 2008 saw the demise of Bridgecorp, Capital and Merchant and MFS, along with moratoria for Strategic Finance, St Laurence, Dorchester and North South. They have all stopped new lending, throwing the residential and resort development sectors into chaos. New small business credit crunch? The next phase of the credit crunch could see plant, equipment, car and small business lending from finance companies dry up. That would have a devastating effect on small to medium businesses who are heavy employers and are usually unable to find funding from banks. A chill is already settling over the sector given much plant and equipment lending is for maturities of 3-4 years. The next penny to drop will be consumer lending by finance companies, which tend to have shorter durations.

Many had hoped that the ongoing move to Reserve Bank regulation of Non Bank Deposit Takers (NBDTs), which includes finance company, building societies and credit unions, would force a rationalisation of the sector. This is where healthy finance companies or banks would scoop up the weak to create something even stronger with an investment grade. That rationalisation never happened amid the carnage of failures and moratoria. It certainly won't happen now given the potential leaders of the rationalisation are themselves under clouds. Both Marac and South Canterbury will struggle to recover their investment grade credit ratings. Standard and Poor's made clear they could cut their ratings further unless they are successful in raising fresh capital and held out little hope of reversion to BBB-. South Canterbury's owner Allan Hubbard, 80, is scrambling to pump in extra cash and to find a new cornerstone shareholder to manage a succession from Hubbard to new shareholders. An IPO in this market and after last night's downgrade is unthinkable. A full takeover by a bank, possibly one owed substantial amounts by South Canterbury, is more likely. The same can be said for Marac Finance's shareholder, which is the NZX-listed Pyne Gould Corp. It is finalising a fresh capital raising and was looking at changing Marac's status to a bank, possibly with an IPO. That will now be very difficult. It is still mired in its shareholding with the flailing PGG Wrightson. Forced marriage ? At some point the Reserve Bank and the government may have to step in to force rationalisation. That could include a forced marriage or takeover of one or both of them by a bank. The alternative scenario is that somehow PGC and Hubbard are able to raise the fresh equity capital. Even then Standard and Poor's has said upgrades back to investment grade will be difficult in the current economic climate. Will retail debenture investors be confident enough to put their money in junk bonds at reasonable interest rates post the expiry of a guarantee? They may do it with some sort of insurance scheme, which is likely to be expensive for the finance company, or through much higher debenture interest rates, or a combination of both. Junk rated debt maturing after October 2010 should be offering much more than they are now. Our rates table for all institutions offering deposits of more than a year shows finance companies offering around 7-8% for 2 year debentures, which is just 3-4% above government bond rates. Junk bonds in the United States are currently trading around 9% above government bond yields, Bloomberg data shows. That means finance companies should be offering at least 13% or double what they are now to compensate the investors for the risk involved. I certainly wouldn't be telling my mother in law to invest in deposits or debentures in any non-investment grade rated banks, finance companies, building societies or credit unions that expire after October 11 next year. Meanwhile, Bill English and John Key may be spending more time on the plane to Timaru and other places over the next few months hammering out deals and cajoling finance companies to fix their balance sheets. A few Treasury officials will also have their work cut out for them.