South Canterbury too big to fail

South Canterbury Finance's rating downgrade last week, less than two months after it was granted an extension of New Zealand government guarantee, raises question on whether the extension was approved on the premise that the company was "too big to fail."

In late March, the NZ government approved South Canterbury's application for extension under the retail guarantee scheme, which means its eligible depositors would get the guarantee protection until the end of December 2011.

While the company had the minimum BB rating to qualify for the guarantee, what seemed to be have been ignored was the fact that the rating was accompanied by CreditWatch negative from Standard & Poor's and which implied a one-in-two likelihood of a downgrade in the rating within three months.

The Treasury had the option to either refuse or delay the approval on the basis of negative CreditWatch as its policy guidelines clearly provide it with such a discretion.

Specifically, the policy states "the decision to enter into a Crown Guarantee with any specific entity under the extended scheme is at the sole discretion of the Crown."

And in South Canterbury's case, two other factors that Treasury could have considered in declining the guarantee were "the credit worthiness of the entity, including any rating agency reports on the entity," and "the related party exposure of the entity."

But the Treasury chose not to exercise its discretion, approving the guarantee just a few days before the company reported audited results that were much worse than the initial report, and where the auditors did not endorse the company's going concern view. The hurried approval left one wondering whether the government deemed the company was, among finance companies, probably too big to be allowed to fail.

There is no denying the fact that South Canterbury is one of the largest and until recently was one of the successful finance companies, providing finance and loans for over 80 years. There is also little doubt that the company has impacted the lives of many people over the years by providing resources at crucial times.

But the global financial crisis and some poor investment decisions have meant the company has had to take huge impairment provisions and losses which has led to a sharp fall in its capital.

Indeed in the six-month period to December, South Canterbury had lent 18.25% of its total net advances to its six largest borrowers, up from 14.76% as of June 30. Related party advances also rose sharply in just six months to NZ$310 million as of June 2009, from NZ$162 million in December 2008. By December 2009, such borrowing fell slightly to NZ$295 million but the fall was mainly on account of impairment provisions.

The aim of the guarantee is to protect the interests of eligible depositors but by approving South Canterbury's extension it looked as though the company was being thrown a lifeline.

In the government's own words, "It is important to remember that it is the eligible depositors that are guaranteed rather than the company. The Crown retail deposit guarantee scheme was introduced to maintain depositor confidence by protecting eligible depositors".

It is well understood that without the benefit of the government's guarantee extension, South Canterbury would not have been able to attract reinvestments or fresh deposits to replace more than 90 per cent of its borrowings due to expire within the next few months. The guarantee provided it with the much needed lifeline, but with the rating downgrade it is again uncertain how much of a lifespan the company now has.  While depositors remain protected until the end of December 2011, one can't deny the fact that many New Zealand depositors have now become savvy enough to not just look at the guarantee provision but also at the current credit rating.

To make matters worse for South Canterbury Finance, founder-chairman and major shareholder Allan Hubbard has resigned from his position and offered to become "President for Life." At the same time, Hubbard indicated he was looking to take a new equity partner to ensure an orderly succession.

Hubbard's quiet exit from a key position won't be looked upon favourably by the company's loyal investors, neither does it bode well for the company that he is no longer looking to infuse any new capital.

South Canterbury seems to be an example of the "moral hazard" problem that was discussed before the extension scheme was announced. The government had noted that as a result of the under-pricing of risk due to the subsidised fee schedule, the current deposit guarantee scheme had created distortions in financial and capital markets. The consequence of this is while the gains of the riskier decisions will be accrued to the depositors and finance company, the potential losses will be borne by the taxpayer.