Why finance companies fall over

– John Edmundson

While New Zealand has not yet experienced financial turmoil of the type facing the USA, there has been an unprecedented series of collapses of finance companies over the last two years. It is easy to simply blame the directors of these companies as individuals, identifying their greed and the criminality they have resorted to. This is the approach that the mainstream and financial media have taken, in some cases with a quite critical eye, but the problems are deeper than that.

The collapses began in 2006. The first significant company to go was Provincial Finance, known for its “Solid as, I’d say” endorsement from ex-All Black Colin Meads. Established as a mortgage lender, by December 2005 this represented only 6% of its business, while vehicle loans by then accounted for 83% of its lending.

While real estate holds its value or appreciates during good economic times, cars begin to depreciate the moment they are driven out of the yard. Defaults on loan payments from typically low-income, overstretched borrowers became rife, and Provincial Finance was left with increasing numbers of repossessed vehicles. The problem became so severe that the company bought a car yard to sell the 150 repossessed vehicles a month that they were saddled with.

By 2006, the whole edifice was in receivership, along with two others, National Finance 2000 Ltd and Western Bay Finance. At the time of the Provincial Finance failure, commentators responded by advising “mum and dad” investors to be more careful with their investments, but declaring that the collapse “doesn’t mean the entire sector’s dodgy”.

By November 2007, ten more finance companies had collapsed. and there was more to come. As recently as last month another company, Dominion Finance Group, went down owing $224 million.

A major focus of media reporting of the collapses in the sector has been on the greed and criminality alleged against various company directors. There is certainly plenty to suggest that greed does motivate people in the finance sector, and there is also no doubt that not all of what is done is entirely above board.

Rod Petricevic, head of high profile failure Bridgecorp, had his beginnings with Michael Faye and David Richwhite, the three of them exiting Securitibank before its $31.5 million collapse in 1976. Undeterred, Petricevic went on to establish Euro-National Finance, which collapsed in the 1987 crash. The judge in the Euro-National Finance case decided that it was appropriate that Petricevic be allowed to rise “phoenix-like from the ashes of his economic disaster”, and Peticevic seized the opportunity with both hands. His new incarnation, Bridgecorp, collapsed owing $458.7 million.

In both the Euro-National and Bridgecorp cases, controversy has arisen around Petricevic’s taking out millions of dollars in loans before the companies collapsed. In both cases there have been attempts to recover luxury vehicles and properties owned by family trusts.

The need to maximise profits, and the potential to succumb to the temptation of high-risk, high-return investment opportunities, is a feature of capitalism in all its forms. But it is perhaps most obvious in the financial sector. The finance company collapses have been characterised by massive over-extension of lending, far beyond the margins considered “safe” by the industry. For example, when Capital and Merchant Finance failed in late 2007, it had a debt equity ratio of 17.7, when industry wisdom would suggest an ideal ratio of six. This means Capital and Merchant Finance had lent nearly three times as much money as it “should” have, according to its own industry standards.

As long as everyone continued to make repayments, this sort of over-extension was manageable, if risky. As soon as one failed, however, it exposed others, especially as there were direct financial connections between the various companies. Hanover Finance, for example, had lent $4 million to Bridgecorp, so was immediately in trouble when Bridgecorp got into difficulty. When an economy is growing and healthy, credit is one of the most important devices to enable the expansion of capital. But when things go wrong, everyone wants cash, and they want it yesterday.

There is no doubt that greed has played a part in the decision making in the boardrooms of the failed finance companies. Likewise, there have been clear cases of illegal action on the part of some of the directors of these companies. But to blame the collapses on the moral failures of individual capitalists would be a serious mistake.

The pressures that drive capitalists to take risks with other people’s money are a permanent part of the capitalist system. That people who get themselves into directorships of finance companies are tempted to break the law in order to maximise profit is simply a logical outcome of the normal functioning of capitalism.

Of course the people who do commit fraud or other financial crimes should not be absolved of their responsibility. But the phenomenon of financial collapses and the loss of people’s life savings when these companies do collapse will be an intermittent but permanent feature of the economy as long as we live in a world dominated by the pursuit of profit over human need.