How Treasury ignored RBNZ's advice on "high risk" Equitable Mortgages which ultimately failed carrying NZ$178 mln of taxpayer guaranteed deposits

By Gareth Vaughan

Treasury let Equitable Mortgages into the Crown retail deposit guarantee scheme despite the Reserve Bank's view that the property lender, which ultimately failed whilst holding about NZ$178 million in Crown guaranteed deposits, wasn't eligible because it primarily provided financial services to a related party.

This is revealed in Auditor General Lyn Provost's audit report on the implementation and management of the Crown retail deposit guarantee scheme.

Equitable Mortgages, part of the Equitable Group controlled by the rich lister Spencer family headed by Chris Spencer, applied to join the Crown guarantee scheme on October 14, 2008. An affirmation was received by the Reserve Bank from its trustee, Trustees Executors, on November 4, 2008 which raised no concerns.

However, Provost's report says the Reserve Bank's view was Equitable Mortgages wasn't eligible for the scheme because it primarily invested in the Equitable Property Mortgage Fund,  an investment fund governed by a trust deed formed in 2007 to hold most of the Equitable Group's mortgages. It was managed by Equitable Property Finance, another arm of the Equitable Group whose trustee was also Trustees Executors. The Fund invested in loans secured by first mortgages over commercial, industrial and residential properties.

"It was the Reserve Bank's view that Equitable Mortgages was providing financial services to a related party, which was contrary to one of the main eligibility criteria in the policy guidelines (which set out the criteria considered by Treasury when assessing applications)," says Provost.

"However, the Treasury took a broader view and determined that, because of the trust arrangement and the nature of the transactions, the recommendation of ineligibility from the Reserve Bank was not persuasive. The Treasury concluded that it was in the public interest for a guarantee to be granted, so the application was approved on December 4, 2008."

Receivers were appointed to Equitable Mortgages last November after the company's management told Treasury it no longer had a viable business given the tough economic climate and it would struggle to meet new Reserve Bank capital requirements. At the time about 6,000 secured debentureholders were owed NZ$192.3 million and the company had NZ$188.4 million worth of loans outstanding.

Treasury says it has since paid out about NZ$161.8 million of taxpayers' money to about 3,500 Equitable Mortgages depositors under the extended Crown retail deposit guarantee scheme, representing about 91% of depositors and amounts owing. In the latest receiver's report receivers Grant Graham and Brendon Gibson of KordaMentha say they have repaid NZ$35 million to investors and the Crown, or about 18% of the money owed. They say it won't be possible to recover the full  outstanding loan balance, meaning taxpayers' face a loss.

Equitable Mortgages' demise is under investigation by the Financial Markets Authority,

Problems identified including a large funding mismatch

Provost notes that before joining the Crown guarantee scheme, Equitable Mortgage's deposits had been in decline. But after it joined it experienced significant growth to NZ$141 million by March 31, 2009. Nonetheless, the Reserve Bank and Treasury's monitoring revealed issues such as large exposures to individual borrowers, much vacant land or development lending, poor loan book performance, a large funding mismatch, and only modest capital levels until a NZ$4 million capital injection in March 2010.

Equitable Mortgages was, however, profitable and its mortgages were first mortgages only, with conservative reported loan-to-valuation ratios. The company applied to join the extended Crown retail deposit guarantee scheme on February 5, 2010, met all the relevant eligibility criteria including having a BB credit rating from Standard & Poor's, and was accepted into the scheme on March 19, 2010. By this stage a Treasury appointed inspector - appointed under the guarantee deed - had been monitoring the company for eight months. Equitable Mortgages had a shareholder support mechanism and insurance underwriting in place to provide support of up to NZ$20 million.

Ultimately, after its credit rating was downgraded to BB- in August, 2010, and a new prospectus was issued in September 2010 as the Equitable Group was rationalised into a single issuer structure, Equitable Mortgages sought to diversify lending, and despite shareholders injected NZ$10.5 million of capital, receivership beckoned.

Equitable Mortgages consistently rated 'high risk'

Provost says that, although Treasury was vigilant in monitoring Equitable Mortgages during the scheme and met with its directors and shareholders, Treasury officials relied too much on implicit additional shareholder support.

"Throughout the scheme, Equitable Mortgages was consistently ranked as high risk, with recognised issues with liquidity, capital, loan exposures, and loan delinquencies," Provost says. "Although shareholder support was an important consideration, it should have been only one of many indicators of ongoing viability."

"In our view Treasury should have tested the strength of the shareholder support by requesting a written guarantee of the obligations of Equitable Mortgages or otherwise analysing the position without this support on a 'what if' basis," Provost adds. "Without this explicit support, the financial position of Equitable Mortgages should have been more closely scrutinised and analysed with associated detailed reporting and escalation to senior management in the Treasury."

Treasury aware South Canterbury Finance would probably fail when granting extended guarantee

Meanwhile, Provost notes that when South Canterbury Finance applied to join the extended guarantee scheme in January of last year, Treasury was "well aware" it was more than likely the company would fail and trigger the guarantee, as it ultimately did on August 31, 2010 leading to a NZ$1.58 billion payout to investors.

"By early 2010, the Treasury knew from its inspector's report that South Canterbury Finance's risk management and governance systems were inadequate for such a large company. The Treasury knew that South Canterbury Finance had little hope of meeting the Reserve Bank's new prudential requirements for finance companies, which were to become effective later that year. However, the Treasury accepted South Canterbury Finance into the extended scheme because excluding the company would likely have resulted in its immediate failure."

She says because South Canterbury Finance's deposit base didn't increase after mid-2009, nor did the taxpayer's liability. Treasury's view was that while the company continued to operate there was the opportunity for a "private sector solution" to emerge to reduce taxpayer liability.

"The Treasury decided to accept South Canterbury Finance into the extended scheme on April 1, 2010 to provide it with an opportunity to achieve a solution to its funding and capital challenges," Provost says.

When the company was accepted into the initial Crown guarantee scheme Treasury "could not" know how vulnerable the company really was. That said, its deposit base increased by a quarter in the four months after the scheme was introduced and its loan book increased in the early part of 2009, with many loans made to property developers and with capitalising interest and second mortgages, increasing South Canterbury Finance's risk profile.

"Although we cannot say for certain, closer monitoring of South Canterbury Finance earlier in the scheme might have helped identify its problems and allowed the Treasury to take earlier steps to constrain the Crown's liability," Provost says. "Closer investigation of South Canterbury Finance's specific circumstances would be needed to determine which, if any, tools might have been appropriate."

Provost notes, however that Treasury's analysis and research was "plentiful, comprehensive and thorough."

'Treasury did well setting up & running the scheme during a difficult time'

In a statement, Treasury Secretary Gabriel Makhlouf says Provost's report is a good account of the retail deposit guarantee scheme, noting she recognises the scheme achieved its objectives and Treasury responded well when setting up and running it during a very difficult time.

Treasury has "learnt lessons" and put in place initiatives addressing the need to improve project planning, reporting and escalation.

"Ms Provost’s recommendations are welcome. The Retail Deposit Guarantee Scheme was put in place very rapidly and during a very difficult time. The introduction of the scheme and the Treasury’s management of it were good but not perfect, so there are valuable lessons to learn,” Makhlouf says.  See Makhlouf's full statement here.

'Treasury dropped the ball'

Meanwhile, Green Party co-leader Russel Norman has revealed Treasury used the services of 200 consultants at a cost of NZ$13.8 million to taxpayers over the past two-and-a-half years. About one-third of the  consultant spend was attributed to work on the Crown Retail Deposit Guarantee Scheme, Norman says, the management of which the Auditor-General has found Treasury "dropped the ball" on.

 “Would the money have been better spent employing staff internally to manage the Scheme?" Norman asks. See the full list of Treasury's consultants here including Trustees Executors, trustee to both South Canterbury Finance and Equitable Mortgages.

Also see: Auditor General says Treasury lacked financial prudence in administering Crown Retail Deposit Guarantee Scheme; Let taxpayer risk grow

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