Finance Companies - masters of their own downfall
Since 2006, 45 finance companies have failed, 200,000 deposit holders have been affected and over three billion dollars have been put at risk. It has been an undeniable travesty of justice, and slowly people have been held accountable. Many of the guilty have been exposed, and flaws in our reporting and regulatory systems have been examined.
Putting greed, transparency and the other issues aside however, the finance company crisis highlights one of the oldest and most well-known axioms of finance. It is a testament to the same mistake made time after time since finance markets have existed. It has taught us again of the fundamental importance of the separation of debt and equity.
Equity markets (or share markets) have been around since the formation of the Dutch East India Company in the early 17th century. They allow individual investors to pool their resources by purchasing shares in (ie, a share of) a limited liability company. The investors are rewarded by the innate tradable value of their shares which rise and fall depending on the speculative, future earning potential (or not) of the company.
Share markets are an invaluable tool, without them it would be difficult for businesses to make large scale investments and form mega-companies. If share markets did not exist, the word millionaire would not be common place in our vocabulary today. Companies funded through the equity of the shareholders are able to take risks. If the risks do not pay off, the value of the investor’s shareholding will decrease. If the company runs out of money, more shares are issued and the same result will probably occur.
Conversely, debt markets like the finance company market in New Zealand until 2006 offer fixed interest by aligning those with cash to those that require it. Interest is charged, based on perceived risk, a margin of which is paid to the investor. Unlike equity markets the investors of the company are not the owners of the company. For this reason the finance company cannot be speculative and must operate within the parameters of their investment statements.
The two systems work well independently of each other, but are like oil and water when mixed. This was demonstrated in 1929 when we learnt the folly of combining debt markets with equity markets.
The 20’s were a time of affluence and wealth. A buoyant market led banks to become involved in investing in the share market, a term known as investment banking. This large-scale leveraged purchasing of shares inflated the market creating wealth for all.
On Black Thursday, the frenzied bubble that the Investment Banks created, could no longer contain themselves and burst with horrific consequences. As a result the largest share market crash in history occurred which ultimately led to the Great Depression.
As a result of the mayhem caused by investment banks, in 1933 with 25% of the US population out of work, US Congress passed the Glass-Steagall Act. The Glass-Steagall Act prevented trading banks from undertaking investment activities (acting as Investment Banks). It embargoed the marriage of debt and equity in an attempt to constrain geared investment pushing up market values to such unsustainable levels again.
The Act worked, and though we have had share market crashes, the likes of 1929 have never been repeated. Some compare the 1987 crash to the 1929, but they were nothing like each other. Soon after 87, the markets rallied again; there was not a decade of sustained poverty as the 30’s were. Over time, however, the lessons of the Great Depression were forgotten and in 1999 the Glass Steagall Act was repealed.
Performing as investment acts, this time the banks pumped depositor’s money into the property market. This resulted in the lines between debt and equity becoming blurred, pumping up property values to unrealistic and unsustainable levels.
We could see the lines being blurred at home as well with a flurry of finance companies using depositor’s money to lend to the property market. This in itself would not have been a problem if the finance companies operated within their trust deeds. The problem was intercompany lending. While the term has been used a lot since 2007, the reason for intercompany lending has not been well identified in the media.
When a finance company found itself in trouble with a property development loan, rather than report the loss and risk investors pulling out en-mass, the finance company would convert the debt to equity on its balance sheet and essentially own the failing development. This prevented the finance company having to report a loss and stopped any investor panic. Apart from the obvious moral consequences of this, by failing to report the ailing property development losses to the market, finance companies themselves propped up and inflated the value of property. Eventually, in 2006 the bubble could no longer be restrained and the markets collapsed.
The financiers were quick to blame the property market crash on their demise, but this is simply not accurate. It was the finance company’s own actions that precipitated the property market bubble to such a point that a property crash was inevitable. It was happening here and it was happening everywhere in the world.
And there you have it: by ignoring one of the most fundamental tenants of finance, to separate debt and equity markets, financiers created the 2007 property crash and ultimately orchestrated their own demise.
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