The United States is not the only nation confronting a household debt crisis. We, too, have a subprime lending market and it is managed by our collective bag of finance companies. The collective sum of savings at risk in this sector is reported to be $16 billion.

Put another way, that's nearly a third of the total value of our stock exchange, just over 10 per cent of annual gdp, and $4000 for every man, woman and child in the country. The US situation is nearer US$500 billion.

On every measure that is significantly less than our own problem with subprime debt. New Zealand's position is four times worse than the American situation which has brought on a global confidence crisis. Work out for yourself what that means for our domestic economic outlook.

How did we let this sector get so big and so badly run?

While this sounds brutal, the investors themselves are to blame. For the past 15 years investors have poured money into this sector without demanding compensation for the risks they are taking – and worse, having no desire to understand the risk.

Investors lacked the will or the capacity to objectively assess what they were doing. A basic lack of financial literacy within the population allowed this bubble of lending to accelerate.

Now a quick and selective chronology:

During the 1980s interest rates at the bank for depositors were routinely more than 18 per cent. With high inflation and tax at 33 per cent the real return, however, was negative. It was better to buy assets. Despite this, a large portion of the population chose bank deposits over assets and got used to a very high headline rate of interest. They lacked the financial literacy to understand that, in fact, the crown was stealing their money insidiously through inflation and taxes.

When interest rates (and inflation) fell in the early 90s, these investors saw interest rates drop. It was therefore tempting to respond to advertisements promising high interest rates.

Initially finance companies offered a high rate relative to the banks. They also lent out at a high rate and on prudent terms.

In short, investors and companies got paid for the risk they were taking.

Then of course others followed and finance company liquidity increased faster than they could lend it out. So the interest rate paid to investors progressively dropped to the point where the margin paid above the bank rate made no sense at all.

Then you have the financial advisers. During the late 1980s life assurance salesmen seeing the writing on the wall for selling insurance (whole of life assurance was always a dumb product because it confused risk and saving), thought the next wave would be to organise the public's saving and investing habits.

Out of this grew a fund management industry and financial advising "profession" that sold the public modern portfolio theory and efficient market theory. This ensured that all who followed the recommended model would, in the words of Warren Buffett, "do average less costs". For most investors, over the last 10 years this approach has practically produced after-tax returns of less than what they would have got from a bank term deposit.

Of course, investors hate paying for advice – but also don't like to do any work themselves either. Here is another lesson, investor: there isn't any free lunch.

So guess what happened? The salesman (they call themselves a profession) gave you some financial information, sometimes dressed up as education, took your money, and the people they gave the money to paid them a commission.

Now this would not be a problem if every investment paid the same commission rate, but of course they don't. Some syndicated property transactions were paying up to 5 per cent. Bridgecorp paid 3 per cent. And don't fool yourself, investors ultimately pay the commission. And this model is exactly how the life assurance industry did and still works. The more you think things change, the more they are the same.

So what did these advisers do? They sold investors the belief that finance company bonds were a fixed interest security and allocated significant lumps of investment capital into the sector.

Sure, some of them spread it around so as to diversify risk. Others piled into Provincial and Bridgecorp because of the high commissions. (Interestingly, one planner who criticises other planners who funded Bridgecorp was a major recommender of Provincial.)

Sure these bonds have a fixed return, but the security is a facade. What you have when you buy finance company bonds is a quasi equity in terms of risk. If you are accepting a fixed return for an equity risk, you have just sold your upside short.

As big lumps of money came into the finance companies, what did they do? They didn't leave it in the bank, they had to get it out "working".

So the credit criteria were loosened. Commissions were paid to finance brokers without recourse, car dealers were provided funding lines without having any responsibility for the loans they wrote. Provincial would, for example, lend to people with bad credit reports as long as they had no actual defaults at the time of the loan.

Why would you lend to someone who has demonstrated an unwillingness to pay? This, however, is just one example. There are many.

Here is a lesson for finance companies: Sometimes it is better to do nothing and go on holiday than do dumb stuff just because everyone else is.

So the problem is this. Investors and finance companies alike behaved like uninformed irrational lemmings.

So how do we fix this and what should investors do?

* We do not need more regulation, we need more common sense.

* In the short term, to avoid a meltdown, the Reserve Bank should be empowered to review the lending practices of all finance companies. Those that get a tick should be given a liquidity guarantee from the Reserve Bank. If they have to call on the guarantee to meet depositor demands then they should pay a rate appropriate for the risk. (ie: a high one).

* If the Reserve Bank did in effect provide a guarantee on good finance company notes, it would ensure the good companies don't go down with the bad when the run on funds really gets momentum.

* Identifying the bad ones early, which this process would help, is a good start to an industry clean up.

* In the short-term the trustees for the debenture holders need to do their job, properly. Many have been asleep at the wheel.

* Investors need to wake up and realise that to survive they cannot ignore the basics of financial survival. The NZSA will next year launch a comprehensive financial literacy programme. Our programme will be funded with charity funding, not bank sponsorship or the like. Our programme will not be an infomercial.

* Finance companies need to simplify their prospectuses. You can judge an investment in a finance company quite easily if you know what their lending criteria is. This should be published, and no loans written outside the lending criteria, including to related parties. If investors don't like the way they lend, they don't invest. In addition the companies should disclose the total of all loans outside of lending criteria and update this monthly, so investors have a feel for the level of risk building up in the loan book.

* Long term Reserve Bank scrutiny, clear covenants and reporting obligations to the trustee for the investors, and trustees that act, should do the trick.

* Bruce Sheppard is chairman of the Shareholders Association.

- © Fairfax NZ News