Risk, Moral Hazard, and the Moochers of South Canterbury Finance

“Worry is a sign of health. If you’re not worried, you’re not risking enough.”
- attrib. to Gnomes of Zurich

THE FRAUD TRIAL OF South Canterbury Finance directors brings the question of moral hazard back into the headlines once more, moral hazard being the situation in which governments invite businesses to privatise profits and socialise their losses, and then fall around in wonder when they do.

Such was the case in 2008 when Michael Cullen, with John Key’s explicit support, introduced the Retail Deposit Guarantee Scheme – putting up taxpayers’ assets as backing for the risks taken by NZ bankers.

I said here when the govt’s Retail Deposit Guarantee Scheme was announced that it created a problem of moral hazard—that it would simply encourage finance company to take more risks to make their high interest payouts, and encourage more “investors” to seek out these higher interest rates knowing you and I would bail them out when there was a problem.

Right on cue, as it turns out, a mid-level Timaru finance company with a modest book decided it would allow taxpayers to bear the risk of it making a play to make it big.

Just four months after the Cullen/Key scheme was introduced, their modest book

had increased by a whopping 25% “as depositors chased the higher interest rates being offered by the company, safe in the knowledge their money would be returned by the government if the company went under. Seven months in, deposits had grown to $800 million, and the company’s risk profile had grown through a series of loans to property developers.  By the time South Canterbury Finance asked to be placed in receivership in 2010, it owed depositors $1.7 billion.¹

In short, as the company's chief executive Sandy Maier explained in 2010 “South Canterbury Finance ramped up its risky real estate loans after it signed up to the Government's scheme that protected its investors' money.”  Taxpayers on the hook, without their consent, protecting the money of depositors seeking interest rates that were too good to be true.

And so the disaster inevitably came to pass – the taxpayer eventually sending out a welfare cheque totalling $1.6 billion to the company’s 35,000 depositors (that’s around $45,000 per moocher), and the company’s chief executives truly made it big by being responsible for the biggest NZ bailout ever.

SO WHO WAS REALLY at fault here?

Was it the Finance Company directors taking inordinate risks they knew the taxpayer was going to bear?

Was it those moochers seeking interest rates they knew were too good to be true, but “protected” by taxpayers’ money?

Was it the free market²of profit and loss, that the government’s scheme had with malice aforethought short-circuited?

Or was it those two dopy yet earnestly self-important politicians, Michael Cullen and John Key, who coldly and consciously devised and signed up to a scheme encouraging just what happened to happened – and all the cheerleaders in industry and journalism who all reckoned it was a scheme for the ages?

PERHAPS THE MOST important point to make her again is about risk and why people take it—and why they take more of it when they think someone (especially a government) has their back covered.

That’s why so many finance companies thought they were safe enough to take risks—because they had the Reserve Bank’s monetary spigot producing new credit, and the government’s guarantee to protect their risky use of it.

That’s why so many builders, architects and home-buyers thought they were safe and weren’t taking risks—because they had the Building Act, the Building Industry Authority, the Department of Building and Housing, the New Zealand Building Code, the Building Research Association of NZ and all the consent processes and inspections of Territorial Authorities to protect them.

That’s why so many banks thought they were safe to be pumping out all that counterfeit capital to keep the housing bubble going—because the govt’s Reserve Bank and credit-rating agencies with govt-granted monopolies told them all was well, al was safe, all was under control, when it wasn’t.

In short, the more government regulation there was, the less folk thought they needed to regulate themselves—because if Big Brother is doing it as swimmingly as Big Brother says he is, why need we do so ourselves?  So roll on that short-term thinking that causes disasters.

Mark Thornton observes about the phenomenon, which is both endemic and worldwide:

The public is told that regulators do not cause problems; they prevent them. They police the economy. They are the watchmen that have been endowed with the wisdom, ability, and selfless devotion to the public good.
    There are indeed many people who work as government regulators that are very smart and well-trained that have public spirit and the public good in their hearts. There are also plenty of cads and knuckleheads that work as regulators [some of them now scurrying for their lives in the Ministry for Primary Industries].
    The problem with government regulation is that you cannot fine-tune the regulations: nor can you perfect the regulatory work force in such a way to make regulation work in anything but a superficial way. The truth is that regulation instills confidence in the public so that they let down their guard and makes them less cautious while at the same time distorting the competitive nature of firms in the marketplace.
    After every economic crisis there are calls for new regulations, more funding, and more controls. Economic wisdom dictates that we be ready to contest those calls when the next crisis of the interventionist state occurs.

“To widen the market and to narrow the competition, is always the interest of the dealers,” observed Adam Smith.)

Or, to put it bluntly, there will always be folk willing to take risks with other people’s money. It is not the job of government to absorb those risks for them – and if they do, it will always end badly.

* * * *

1. As reported by Radio NZ this morning.

2. The Myth of Deregulation is so all-fired powerful that even hard-bitten journalists who think they’re immune to such things have bought the myth wholesale. Despite the obvious evidence right in front of their eyes, they’ve bought the idea, especially, that for the last decades we have had “completely free markets and capital flows.”  Free markets! What are they smoking! These hot-shot economics reporters are apparently blind to the fact that in the markets of the last decades there has been virtually no price or profit relationship left untouched. You think the age of Muldoonist price controls and interference with profits are dead?  In the last few decades the “orthodoxy” worldwide has overseen:

• interest rates controlled by an economic dictator with powers Muldoon would have killed for;
• specific interest rates, such as home mortgages, manipulated through subsidies as well as price controls;
• indirect currency controls virtually everywhere;
• direct government manipulation of the gold market by both world govts and the IMF;
• asset price floors—in addition to the ‘Greenspan put,’ we’ve had money printed and “toxic” assets bought, anything to keep asset values raised ;
• wage floors, essentially a guarantee of widespread unemployment in a downturn;
• wage ceilings, especially for executives;
• direct price controls, especially in medicine and education;
• good old-fashioned protectionism—not just currency manipulation, but outright tariff and non-tariff barriers;
• the dismissal of business bankruptcy and liquidation as “old-fashioned”;
• pumping up illusory profits by inflating the money supply, creating an inflationary illusion of profitability and prosperity;
• the grant of virtual monopoly powers to the very credit agencies that didn’t know a bad thing even when it was held right under their nose.*

These are just a few of the means by which govts ran price controls and interference with profits in recent decades—and still are.  But Colin Espiner, Bernard Hickey, Fran O’Sullivan and hundred of thousands of others trained to view all this as part of a “free market” are too braindead to see them for what they are, and  with the failure of this system of control they call instead for the controls to be tightened!

They have the frankly braindead notion that somehow the people in govt responsible for creating, overseeing and extending this economic disaster need to “take back” the reins they never gave up.  They have apparently either lost the brains they once had, or have now reached the point (as it has with most educated in mainstream economics) where the real world has outstripped their learning, so have resorted to the siren cry of the braindead everywhere: “Bring me more big government! Now!!”