Q&A Friday is published every Friday while there is demand. Email your questions to vern@vov.co.nz. We won’t publish your name.

How Did It Happen?

Question: Hey Vern, Firstly I’d like to say that without people like you, these white collared thieves would just simply get away with this. Good on you for carrying the torch for us. I dread getting mail about all this mess because it just brings back the pain. Our money is all gone, the guys that took it are holidaying in Hawaii or wherever, the guys that advised us to give the other guys our money have mostly changed jobs or towns and are untouchable. Am I alone in this feeling?

What I’d really like to know is how did all this happen and how did they get away with it? I’ve been told that Northplan, who had signed papers saying they could invest our money as they saw fit, sold that right or portfolio to MFS, who in turn used our money without our knowledge to replace their money in their failing investment houses, and then wound everything up! So they extracted their money, replaced it with ours without our knowledge and then those businesses slowly but surely went belly up, and there’s nothing we can do about it? Have I been ill advised?

Vern says: Wow, that’s a big question, and a damn good one too! I suspect James Usmar would like to answer this question but as a professional investment advisor might be constrained in what he is professionally able to say. Sometimes it’s easier for someone outside the industry to be more open about these things, so rather than put James in a difficult position I will attempt to answer your question as best I can.

Let’s talk about a hypothetical finance company. Its borrowers are property developers who take out a first mortgage on their high-risk, speculative property development with a bank. But the developer doesn’t want to tip any money in himself so he gets a second mortgage, and sometimes a third mortgage, from a finance company.

The finance company borrows money from mum & dad investors who are lured in by the advertising which promotes the finance company as rock solid with a history dating back to the Renaissance, well-known “names” as directors (often senior Government officials or ex-politicians), conservatively run and generally as safe as houses. (Yeah, right we say with hindsight.)

The finance company pays you 8% interest, pays 2% commission to the financial planning company (over twice the going rate compared to a “safe” finance company), and another 2% as a “marketing subsidy” to the financial planning company as a [legal] bribe to encourage it to tip all its mum & dad investors’ money into the shaky finance company. That’s 12% in total they have to pay to get your money, and all this happens behind closed doors without you knowing anything about it.

Developers are charged say 15% to 20% interest, but because they don’t have any money the finance company says, “That’s okay, we’ll just add the interest to the loan balance and you can pay it when you sell your property development.”

Here’s the interesting bit. Each year the finance company calculates the interest that has been added onto the loan (money it has not received yet) and lists it as profit.

It then announces its huge [paper] profit to the world and projects an air of success, which causes more money to flow in from investors.

And because it’s made so much profit it is able to declare a generous dividend and pay its owners $85 million.

But it’s just a paper profit remember, so where does the $85 million come from? There’s only one place it can come from… the money flowing in from mum & dad investors via financial planning companies. It’s like a legal Ponzi scheme. Legal in this country anyway.

When the economy hits recessionary times, as it always does, and things turn to custard, as they inevitably do, we enter what property expert Kieran Trass calls the banks’ cycle of losses.

If it’s a cycle of losses for banks, what is it for finance companies? This time around it was total devastation. Finance companies went under, property developers went broke, and us investors lost our money. But the finance company directors who saw it coming managed to legally extract their money by declaring huge dividends on the paper profits.

This is nothing more than legalised theft. Robin Hood seems to have switched sides folks… he’s robbing from the poor to pay the rich.

This is the battle that Suzanne Edmonds fights today. She’s doing a great job agitating at high levels to “fix the system”.

Returning to the above scenario, if the company that owns the financial planning company also owns a couple of finance companies that are finding it difficult to get enough money, it’s doesn’t take much imagination to recognise the temptation for them to divert investors’ money into those finance companies. And they don’t need your permission because they conned you into signing a power of attorney allowing them to do so.

They can then use your money to repay the money they lent to the finance company, declare profits, pay themselves a fat dividend, and be sitting pretty when it goes belly up. If they still had a bit of money invested, they can even say, “Poor me, I’ve lost money too!”

What about disclosure rules, I hear some ask? Easy… just get the spin doctors to write the necessary disclosure in such a way that investors are not alarmed, and get your silver-tongued sales reps (dressed up as financial planners) to either gloss over it or “massage” you into believing it is fantastically beneficial for you.

That’s why disclosure rules won’t fix anything. We need harsh penalties like Australia and most other countries in the Western world, not more disclosure.

Most investors used financial planning companies because they didn’t have the skills to analyse all the offerings and disclosures, and trusted the so-called experts.

It is wrong for Government to rely on caveat emptor – let the buyer beware. There absolutely should be rules and penalties in place to protect investors from legalised theft and unscrupulous dealers.

Let’s hope we join the rest of the civilised world in putting such protections in place.

This entry was posted on Friday 25th June 2010 and is filed under Q&A Friday. Both comments and pings are currently closed.