Opinion: Why those arguing for a co-investment fund should look at the DFC history

By Brent Wheeler Many policy makers and commentators have a short memory when it comes to running the type of public-private investment fund or bank proposed at the Jobs Summit. New Zealand used to have just such a public-private financial institution in the 1960s, 1970s and 1980s before it failed at a public cost of at least NZ$6 billion. It's worth looking at the history of the Development Finance Corporation of New Zealand Limited (DFC) to highlight the risk of building a similar institution to deal with the current recession. The DFC was established by Act of Parliament in 1964 at a time when N.Z. had virtually no banking services of any kind outside of standard retail banking. At that time Sir Frank Renouf had yet to "introduce" so called merchant banking to N.Z. and non retail commercial finance "“ both debt and equity "“ was arranged as either:

• A private loan amongst what today would be termed "high net worth individuals" and their families,
• Through direct government grants, subsidies or other like interventions, and,
• Quasi government monopolies in the form of producer boards.

The entity established in 1964 was owned by a group of private banks and insurance companies ( 70%) , with the Government and the Reserve Bank holding the remaining 30% of shares. The entity was reconstituted in 1973 with the government taking full ownership. The DFC was, at that point re capitalised to some $10.0m (2008: $178m). Subsequent governments invested more in the DFC such that by 1982 its paid up capital was $25.0m (2008: $81.6m). The 2008 figures indicate the impact of inflation over the period 1973 "“ 1982 as well as the "performance" of the institution in respect of equity (rather than total capital). Significantly in terms of the current context, the DFC was set up to provide advice and funds to new and growing "“ especially export industry "“ businesses. In its early years the DFC was able to lend only in cases where no satisfactory alternative sources of funding could be found. This rule of operation was abolished in 1970. The Board of Directors consisted of representatives from Trade and Industry and Treasury with the majority of the Board, including the Chair (Mowbray et al), having private sector backgrounds (Sutton et al). The DFC was not funded directly by government but raised money most notably through Eurobond issues, along with the issue of floating rate certificates of deposit and bearer notes. This activity was facilitated by the government guarantee it held at the time. The successful issues coupled with the government guarantee resulted in an AA rating from Standard and Poors and a significant international profile. Up until the mid eighties DFC focussed its lending in agriculture, food processing, tourism and commercial property. Criteria for lending related to "the prospect of profitability" in new ventures, extent of effective N.Z. ownership and potential contribution to the N.Z. economy. Plenty of Zeal and too many losses Significant competition began to affect the bank in the mid eighties and it re structured into divisions comprising DFC Ventures (VC and equity investment), Zeal corp (investment banking, swaps, arbitrage, forex, futures trading), and DFC Trade Finance. From 1985 on the DFC became increasingly aggressive in both capital raising and in lending and its activity fell less and less under the monitoring eye of its owner. The DFC was never constituted as an SOE and was never subject to any of the accountability regimes faced by SOEs. It was essentially unmonitored by any party external to the board. In 1988, in line with the asset sales policy of the time the DFC was sold to the National Provident Fund (80%) and Salomon Brothers (20%). The National Provident Fund might not, in strict terms, be considered to be altogether a private organisation in that it consisted then (as it does now) of a portfolio of "contributions", made by government employees contributed on a defined benefit basis and managed by a Board of Trustees under a statute. With the privatisation the government guarantee was withdrawn but "“ and this was to prove a major difficult. The majority of the portfolio of assets consisted of contracts made with parties at the time when the guarantee was in place and the government was the DFC's owner. In March 1989 the DFC's assets stood at some NZ$2.9 bln (2008: NZ$4.727 bln) "“ on and off balance sheet. Asset prices (financial and non financial) had steadily declined throughout the late 1980s after the 1987 equities crash and its prolonged fall out in N.Z including the effects spreading to related markets such as commercial property. In August and September of 1989 the DFC reviewed its loan books and concluded that the company was essentially insolvent with a provisioning requirement for on balance sheet bad debt of some NZ$900 million (2008: NZ$1.467 billion). The shareholders were unwilling to support the institution. In theory, since the DFC had been privatised, the government had no interest in the insolvency or demise of the institution. Indeed shedding precisely this kind of risk was a primary purpose in the original asset sale. As a practical matter the government of the day felt unable to allow the DFC to collapse in an orthodox fashion for two main reasons:

• Some 90% of the DFC's off balance sheet business (around NZ$3.9 billion or NZ$6.63 billion in 2008 dollars) "“ mainly swaps - (since all derivative business was off balance sheet under the then prevailing accounting rules) involved major international banks as counter parties which created significant reputational risk to the NZ financial system. Certainly that was the view of the Reserve Bank at the time, and,
• A number of those banks were domiciled in countries (notably Japan) with which N.Z. had significant and sensitive trade and diplomatic relationships "“ as well expectations that an implicit government guarantee lay behind the original transactions generating what were, by this point, liabilities of considerable magnitude.

The joint decision of the Reserve Bank and the government was therefore to place the DFC in Statutory Management "“ under a regime which granted the Statutory Manager (Sandy Maier ex CEO of Citibank's NZ operations) all the rights and powers of the Board and shareholders. Too damaging to NZ's reputation to be allowed to fail  Resolving the problem was far from simple. Defaulting on the swap book for example could have had deleterious impacts on the foreign exchange market (and DFC was a significant player in that market complicating matters further) and certainly disadvantaged creditors. In the event, contractual obligations on the swap book were met and it was sold in 1990 to Barclays for some NZ$429.0 million (2008: NZ$652.0 million versus NZ$3.9 million in notional principal). This component of the Statutory Management was considered a significant success (it certainly appears to have "saved" NZ$180 million which would have been lost through default) as much by way of showing good faith as anything else "“ and thus setting up reasonable conditions for dealing with the on balance sheet assets. As noted, sour loans meant that a provision of at least NZ$900million would have been required. The alternative was some sort of negotiated agreement between the government and the shareholders (Nat Provident and Salomon Brothers). Neither the shareholders nor the government were prepared to inject the necessary equity into the business to support its book "“ the government because of the way such a move would undermine the SOE policy of full commercial exposure, and the shareholders for obvious orthodox reasons. The gap between value of assets and what creditors were owed amounted to some NZ$800.0 million (2008: NZ$1.3billion). Negotiations began from this point of departure. By October 1990 a deal had been negotiated. In summary it involved an injection of funds by all shareholders so as to facilitate repayment of all senior debt plus concessional interest by 1997 and for subordinated creditors by 2005. A tranche of zero coupon bonds effected this arrangement. In exchange creditors waived all claims against the government, the shareholders and others. It is almost impossible to assess accurately what the DFC saga cost the taxpayer. Certainly an original investment in today's terms of NZ$178 million ended up in a loss exceeding NZ$5.0 billion to NZ$6.0 billion. Throughout the lifetime of the organisation it is far from clear that additional losses were not incurred as well "“ leading for example to the injection of funds in 1982. In addition, it is likely that the country's financial system was put at some risk "“ if only reputational risk "“ and the possibility of policy compromise existed. While there is a technical and legal argument that the government did not underwrite the resolution of the DFC problem, it is equally clear that in fact:

• The government used its (then) newly passed Statutory Management legislation,
• The central bank played a leading role in ensuring resolution,
• The government's staff superannuation scheme invested significantly in the resolution, and,
• The government itself did likewise.

Investing counterparties did not lose other than in terms of the difference between concessionary rates of interest and market rates and in terms of time and therefore opportunity cost of capital. They did not for example suffer the fate of investors in some US banks in 2008. The management lessons learned or to be learned are or were essentially matters internal to financial services institutions "“ the need for internal auditing, the need to separate loan review from lending, the need for effective lending policies and like matters. Important "“ but essentially internal matters of professional finance practice. The "big" lessons ought to have been that:

• Simply because investment in a "sector" is deemed to be important to an economy there exists no good reason for government institutions to invest in such sectors,
• Government institutions "“ largely because their boards and management face perverse incentives relative to owners, systematically make poor quality decisions which lead to high risk and losses.
• There are numerous superior policy alternatives to governments attempting to operate as commercial or investment banks.

It is unclear "“ at least to this author "“ that these lessons have been internalised or remembered. * Brent Wheeler is a former Senior Treasury Analyst and former Senior Analyst at the SOE Monitoring Unit. He currently runs his own economic policy and advice consultancy, Brent Wheeler Limited. He also has a blog Eye2theLongRun