NZ Herald 26 March 2011

AA cast of characters — some more deserving than others.

Broadly speaking, a finance company operates similarly to a bank — taking in money from some people and lending it to others — except that the people who borrow are riskier.

They might be property developers, buyers of cars or appliances, home buyers with low security or businesses hoping to grow. Sometimes the borrowers are related to the finance company executives, who don’t always disclose that key fact, and don’t pay enough attention to the borrowers’ ability to repay. But that’s not always the case.

The borrowers may have already been turned down by a bank, but a finance company will take them on — in exchange for receiving high interest.

In turn, the finance company pays higher-than-bank interest to those who invest in it. Sadly, though, in New Zealand in recent years the interest was often not sufficiently high to compensate for the risk. Investors were either too naïve to realise that, or were talked into the investments by so-called financial advisers who paid more attention to the commissions they would earn than to their clients’ well being. Boy, it makes me angry just writing this.

But I digress. Let’s find out what happened to the money invested in the fictional Iffy Finance Co.

Iffy lends to property developers, who use the money to buy land and pay people to put in utilities, build houses and so on — and perhaps to also live the high life.

The developers plan to sell the properties for much more than they have borrowed, pay back Iffy, and enjoy the profits. Because they won’t get any income until the end, they don’t pay interest in the meantime, instead rolling it up to pay in a lump sum when the loan matures.

Somewhere along the line, though, things come unstuck, and the development isn’t completed. Perhaps the developers have chosen a bad location. Or there are problems with costly regulations. Or everything takes longer and costs more than expected. Or demand for property slumps.

Who wants to buy a failed half-built development? Its value crashes, and the developers are unable to fully repay their loan — let alone any interest.

Meanwhile, investors in Iffy have expected to receive interest, and some have wanted their money out when their deposits mature. Because the developers aren’t even paying interest, the only way Iffy can make those payments is out of new money coming in from new investors. That continues for some time, until word gets out that Iffy looks iffy, and too few people make new investments. Interest and maturity payments cease, and the receivers are called in.

So where did investors’ money go? Some went to the people who sold land and goods and services to the developer. They earned it legitimately. Some went into interest and principal repayments to earlier investors — the lucky ones.

Then there are the advisers who got their commissions. And Iffy’s directors and executives may have been handsomely rewarded for their role. While receivers try to get at least some money back from these people, it’s not always easy. It might be tied up in trusts or companies — which, again, makes me angry! Or the executives and directors might have spent it on services or travel — spending that can’t be recovered.

In a recent Herald article, Karyn Scherer quoted receiver Damien Grant as saying, “Ninety per cent of the files that come across my desk, there is an opportunity to make a director personally liable for something if I had the money to chase them. The problem is not the law. The problem is who is going to fund it. And finding a creditor who is prepared to throw good money after bad is really hard.”

Despite these difficulties, companies like Iffy usually have some assets that the receivers can sell. But, of course, the receivers have to be paid for their services — which eats another hole in investors’ money. And then Inland Revenue, employees and others have first go at the proceeds of sales.

In the end, investors usually end up with a portion of their investment, but too often it’s way less than they put in.

The lesson: stick with banks — unless you know lots about a finance company.

AI don’t need it, thanks. I’ve verified what you’ve said using the mortgage comparison tool on www.mortgagerates.co.nz. To find it, click on Mortgage Rates and then on Compare Mortgage Rates. Scroll down for the advanced tool, which graphs many different lenders’ rates and the OCR from January 2002 on.

The tool shows that this is a similar situation to the one in last week’s column — it’s not fair to single out National Bank. Recently, many lenders have set their floating mortgage rate at a bigger margin above the OCR than in the past. They have also sometimes changed mortgage rates when the OCR was unchanged, and not always upwards. In fact, in late 2009 National dropped its floating rate considerably while the OCR stayed put.

But is the OCR what we should be using here? “The OCR is not the margin that banks work on,” says David Chaston of www.interest.co.nz. “It is more properly the 90-day bank bill rate — and even that is a bit of a simplification.”

While the OCR influences the 90-day bank bill rate, so do other factors. “The bank cost of funds for floating mortgages can include other elements — and these other elements became much more important since the Lehman bust and the GFC (global financial crisis),” says Chaston. “Basically, the GFC has added about 1 per cent to the ‘risk’ of money.”

How come? New Zealanders aren’t saving nearly enough to provide all the mortgage money, so the rest is borrowed from overseas. And overseas investors “look at risk differently these days. New Zealand homeowners have borrowed up to their eyeballs, and in 2011 the overseas investors don’t see that as a good thing.”

They’re not willing to lend to New Zealand unless they receive a higher interest rate. Hence the widening gap between the OCR and mortgage rates.

“If you borrow excessively, you will have to pay the piper at some point,” adds Chaston.

Another point: Playing around with the mortgage comparison tool shows that the dissimilarity between the OCR path and the mortgage rate path is more marked for fixed mortgages than floating. The line for longer-term fixed loans, in particular, is pretty different from the OCR line.

That’s because still more factors feed into fixed loans — notably interest rate forecasts, which are tricky. More on that in the next Q&A.

P.S. You’re right about not expressing the 2.2 per cent gap properly. You should really say “2.2 percentage point” gap. The difference between 7.75 per cent and 9.95 per cent is actually about 28 per cent.

It’s a common mistake, and usually it’s obvious what the person means. There are times, though, when it’s not clear.

For example, somebody says, “The city used to be home to 10 per cent of the country’s population, but that has now grown by 20 per cent.” Does that bring us to 12 per cent or 30 per cent? If it’s the latter, the person should have said, “it has now grown by 20 percentage points.”

Accuracy is good!

AIt all depends on what will happen to floating rates over the next couple of years.

And a quick look at a few economists’ thoughts about where interest rates are going left me with the conclusion: Who knows? Like share and property prices and foreign exchange, there are so many factors that feed into interest rates that forecasting them seems impossible.

Your question — or variations on it — must be the most common question my friends ask me. If the questioner hasn’t yet got a mortgage, my answer is to go half fixed and half floating. Why?

• Having half the loan fixed means you have certainty about at least some of your mortgage payments.
• Having half the loan floating means that if you receive windfall money — perhaps from an inheritance, redundancy or lottery win — you can repay that money without penalty.
• And regardless of what happens to interest rates, half your loan will end up looking good — the fixed part if interest rates rise, the floating part if they fall. Half is not as good as 100 per cent, but it sure beats zero.

It’s different for you, though, because you already have a fixed loan. And given that floating rates are now considerably lower than what you are paying, the bank won’t want you to switch even half your money to floating.

Ask them what penalty they would charge for you to make such a switch. I suspect it will be quite hefty. If you fork out that money and then floating rates rise, you won’t be a happy chappy.

You’re probably better off just gritting your teeth for a couple more years. Then — regardless of how fixed and floating rates compare at the time — you might want to move to half and half.