Scheme's moral hazards snare Government - and taxpayers

Relevant offers

Politics

Fay aims shot at OIO over Crafar ACC levies may climb again Global economy may hit Budget Fay group would meet Chinese undertakings Trevor Mallard: I'm no ticket scalper Govt says asset sales will cut debt Greens: Crafar approval politically motivated Banks named as new ACT leader China 'will see Crafar ruling as racist' Govt may sell smaller slice of SOEs

OPINION: By definition it is never too late to indulge in a bit of hindsight. So it is that the Government's role in the bailout of South Canterbury Finance is now being relitigated, including the deposit guarantee scheme put in place in such haste during the 2008 election campaign.

The details of the scheme can justifiably be questioned, including the level of risk the Government was taking on, the distortions it could create and the fees finance companies had to pay - in essence nothing unless they expanded or their assets exceeded $5 billion, so the main banks were hit and the rest took a free ride. Yet charging them a fee based on their weighted risk could have crippled some.

The big banks at the time were loud in their complaints, and officials in the Treasury and Reserve Bank were privately extremely concerned as well.

The scheme came with a huge inbuilt moral hazard for the Government. Guarantee deposits (and as it turned out interest payments after a default, thanks to a subsequent court case) and you were giving companies at the riskier end of the lending market the incentive to rake in more money and take riskier lending decisions. At the same time depositors would be drawn by the high interest rates on offer, like moths to a flame that could not burn them. Not surprisingly, many made the rational decision to accept a risk-free higher interest rate rather than toddle off down to the high street banks. Mad if you didn't.

But - design details aside - it simply had to be done and done quickly. Those who rightly feel stung - by the $372 per person cost of the SCF bailout - will never have to face what the Treasury bods delight in calling "the counter- factual". What would have happened otherwise? Remember, at the time countries around the world still had fresh in their minds the memory of the mayhem caused by a run on banks, including the likes of Northern Rock in Britain.

In the runup to October 2008, Ireland had launched a guarantee scheme that immediately raised the risk of funds from around the EU flooding into the safe haven banks there. With only preliminary work done here, Australia announced on October 12 its own scheme just as Helen Clark was preparing to launch her election campaign.

With the Ireland example in mind, the danger here was that without a matching scheme, money could stream across the Tasman. IF FINANCE companies and other non-bank lenders were not included, there could similarly be a tsunami of cash out of them and into the guaranteed banks that would have triggered the very collapse that the guarantee was designed to prevent; not just to the finance companies but to the value of underlying assets as companies liquidated assets to satisfy their nervous clients. That in turn could have knocked on to the viability of even solid institutions, including the banks. The guarantee would have become a self-fulfilling prophecy - just before it was swamped.

As an insurance policy against such a scary counter-factual, $372 feels like money well spent.

The revised scheme, which cuts in next month and runs till the end of next year, includes a lower maximum payout of $250,000, down from $1m, higher fees and a lower risk tolerance. As such it is an acknowledgment of the current scheme's flaws as well as the need to quickly wean the finance sector off the state teat.

Again with hindsight, it might have looked better in April to have denied SCF entry to the revised scheme, post October, and it does raise questions for the Government's advisers who were monitoring the company. But it must be remembered SCF has collapsed under the current scheme. Had the extension not been granted it would almost certainly have failed sooner.

The tradeoff was between a definite failure then and a less likely failure later; with a slim chance it could survive and cost the taxpayers nothing.

Setting aside the wisdom or otherwise of the guarantee scheme, the focus now needs to turn back to the web of companies around Allan Hubbard, their practices and the lessons that can be learned for future regulation or investor behaviour.

The links between Aorangi Securities, SCF and the other Hubbard entities, including Hubbard Management Funds and the various trusts, are still being teased out, but there are more nasty shocks to come, with suggestions the Hubbard-controlled Southbury Group - the major shareholder in SCF - was the source of most of the $600 million to $700m in bad loans.

The statutory manager's second report into Aorangi and HMF was issued on Friday and has since been buried under the rubble of the SCF failure.

But it contains some very disturbing information. For instance, how did it happen that "shares and other investments in excess of $13m which do not exist have been allocated by Mr Hubbard to investors within the HMF portfolio"?

How could Mr Hubbard report uninvested funds on hand of $6m on March 31 when cash on hand at that date was less than $350,000?

Under what business model on this planet could Te Tua Charitable Trust be advanced $24m by Aorangi at an interest rate of 10 per cent when the majority of Te Tua loans are interest-free - many to farmers and sharemilkers as a "helping hand" repayable over five to seven years with an initial repayment holiday?

If the total cost to the taxpayer of the SCF crash does not rise above $600m, it will be more by luck than good management.

- © Fairfax NZ News