Time value of money
If something can be gained from current round of finance company collapses there is some useful analysis being written which demystifies how this industry works.Anne Gibson wrote a great article on Saturday that showed how the various types of finance institutions work in a deal.
Say a developer wants $1 million to spend on a property: the first phone call would be to a trading bank such as ANZ or Westpac for an initial $600,000, because banks usually loan only a conservative portion for high-risk high-reward commercial projects.
Banks, being naturally cautious, will usually only advance this portion because if the deal goes bad, they estimate they can at least recover 60 per cent of a property’s value, particularly in a forced or mortgagee sale.
First mortgage taken care of.
That leaves the developer still searching for the remaining $400,000.
The second call would be to a second-tier lender like Hanover Finance, regarded as a cut above the rest in the entrepreneurial world of mezzanine funding. Hanover might well stump up $200,000.
Second mortgage resolved, even if the interest bill is about 15 per cent.
That leaves the developer hunting down the remaining $200,000, so a lender-of-last-resort like Bridgecorp might be courted for this amount.
Third mortgage down, even at a punitive 20 per cent-plus interest.
All this works fine in a good market when property prices are rising. But what say the developer gets into trouble, can’t make sales anticipated so can’t repay the interest or principle on the $1 million?
Even worse, often the interest isn’t paid. Rather it is capitalized into the loan. So if the project is delayed or much worse, the market heads south, then the lender of last resort might loose 100% of their financing.
Watch what happens to the costs over 3 years.
Interesting that if the project is delayed (without the end value going up), or if the market moves -those invested in the lender of last resort may loose 100%. Those 12.5% interest rates don’t look like they compensate for risk any more do they?
Connecting that article with Brian Gaynor’s article on the Capital Market Development Task Force:
Brian had this shocking fact
The total value of the country’s residential housing stock has surged from $81 billion to $614 billion since the end of 1986, whereas the total value of all domestic companies listed on the NZX has risen from $42 billion to just $62 billion over the same period.
We just do not invest in productive businesses.
… investors have been driven into the finance company sector in an attempt to achieve higher returns because they have no confidence in the sharemarket.
This finance industry crisis is therefore symptomatic of how broken our domestic capital markets are. It’s time for New Zealand to step back and radically change our structure to create an environment that encourages investment and productivity to allow businesses to flourish – earning the money for the social services we so desire.
31 July 2008 #