Time value of money

If something can be gained from current round of finance company collapses there is some useful analysis being written which demystifies how this industry works.Anne Gibson wrote a great article on Saturday that showed how the various types of finance institutions work in a deal.

Trading banks tremble as mezzanine lenders topple

Say a developer wants $1 million to spend on a property: the first phone call would be to a trading bank such as ANZ or Westpac for an initial $600,000, because banks usually loan only a conservative portion for high-risk high-reward commercial projects.

Banks, being naturally cautious, will usually only advance this portion because if the deal goes bad, they estimate they can at least recover 60 per cent of a property’s value, particularly in a forced or mortgagee sale.

First mortgage taken care of.

That leaves the developer still searching for the remaining $400,000.

The second call would be to a second-tier lender like Hanover Finance, regarded as a cut above the rest in the entrepreneurial world of mezzanine funding. Hanover might well stump up $200,000.

Second mortgage resolved, even if the interest bill is about 15 per cent.
That leaves the developer hunting down the remaining $200,000, so a lender-of-last-resort like Bridgecorp might be courted for this amount.

Third mortgage down, even at a punitive 20 per cent-plus interest.

All this works fine in a good market when property prices are rising. But what say the developer gets into trouble, can’t make sales anticipated so can’t repay the interest or principle on the $1 million?

Even worse, often the interest isn’t paid. Rather it is capitalized into the loan. So if the project is delayed or much worse, the market heads south, then the lender of last resort might loose 100% of their financing.

Watch what happens to the costs over 3 years.

Interesting that if the project is delayed (without the end value going up), or if the market moves -those invested in the lender of last resort may loose 100%. Those 12.5% interest rates don’t look like they compensate for risk any more do they?

Connecting that article with Brian Gaynor’s article on the Capital Market Development Task Force:

An open letter to Lianne Dalziel

Brian had this shocking fact

The total value of the country’s residential housing stock has surged from $81 billion to $614 billion since the end of 1986, whereas the total value of all domestic companies listed on the NZX has risen from $42 billion to just $62 billion over the same period.

We just do not invest in productive businesses.

… investors have been driven into the finance company sector in an attempt to achieve higher returns because they have no confidence in the sharemarket.

This finance industry crisis is therefore symptomatic of how broken our domestic capital markets are. It’s time for New Zealand to step back and radically change our structure to create an environment that encourages investment and productivity to allow businesses to flourish – earning the money for the social services we so desire.

3 Comments

Paul Lattimore
July 7, 2008 at 10:06 pm

Rod, its an education issue as well as a confidence one.

Many NZ’ers have shunned the sharemarket due to “losing a bundle in ’87”, but are still surprised when bubbles burst in other sectors, ala today’s property market. Only when we stop speculating on the next big thing and start investing in genuine, productive businesses will we truly get ourselves back to a first world nation.

Murray MacRae
July 7, 2008 at 9:10 am

Rod, I agree with Brian Gaynor, this problem stems from a lack of understanding and support for the needs of the small investor in New Zealand.

This plays right into the hands of the Finance Companies and the “Unit Trust” suppliers.
The former providing high risk low yeild investments that look good in good times and apalling in bad times (the definition of high risk!), the latter being so overburdened with managent that yeilds can be low yeild relative to the risks taken.

I also think it is an issue of Education as Paul Lattimore suggests. Only when the media, commentators like yourself, Brian, and the public push, will the government (of any persuasion) move on legislation (and possibly capital gains taxes) to bring the markets to heel.

Tony Ryburn
August 8, 2008 at 12:54 pm

Anne Gibson’s point about finance companies being happy with a tail-end charlie security position is well made. Unfortunately this is only one of a long list of serious weaknesses in the business model under which most of them operate.
I recently covered this in detail on the Sharesight blog(www.sharesight.co.nz/blog)

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