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Fincorp
Investors have only themselves to blame for Fincorp debacle
Nick Renton AM - May, 2007

It may sound cruel, but the main blame must lie on the shoulders of the investors themselves. They ignored two very important investment principles, which are further discussed below:

“Never put all your eggs in the one basket”
“The higher the interest rate the greater the risk”

Of course, the prime responsibility for running a company rests with its board of directors. These are also responsible for ensuring that all product disclosure statements are accurate and not misleading.

The Australian Securities and Investments Commission (ASIC) is not a guarantor of the companies it regulates - in the same way that the Reserve Bank of Australia (RBA) and the Australian Prudential Regulation Authority (APRA) do not guarantee bank deposits, despite common beliefs to the contrary.

ASIC can prosecute for breaches of the law, although this is usually too late for the victims of the company failure involved. However, prosecutions no doubt act as a deterrent to other companies and thus help to protect investors generally.

ASIC can also take steps to force companies to withdraw misleading advertisements, but it can never prevent boards making commercial misjudgements.

The administrator of Fincorp, KordaMentha, indicated that the main causes of its failure were commercial in nature, including paying too much for some land and not developing its properties quickly enough. Furthermore, the investors in Fincorp notes and debentures did not seem to understand what phrases such as “secured by property” really meant. There is an enormous difference between lending of the security of income producing assets - such as residences, shops, offices or factories - and lending (as here) on vacant land. The latter involves considerable construction and marketing risks.

The Fincorp trustee, Sandhurst Trustees, was also not a guarantor of the loans. The duties of a trustee are defined in the relevant trust deed. In fact, Sandhurst went further than required, by commissioning a report from unnamed accountants. This in effect gave the group a clean bill of health.

Spread

If an investor has ten investments of approximately equal size and one of them goes bad then the investor has lost 10 per cent of the original money - an unfortunate outcome, but not the disaster which would have occurred if all of the money had been put into that one investment.

Similarly, in terms of income, if nine of the ten do well, returning, say, an average of 10 per cent per annum, then the non-receipt of income from the tenth would still produce a reasonable 9 per cent return on the entire portfolio.

For these reasons it is usually a sound strategy to have a “spread”, in other words, a series of different investments rather than just a single one. The greatest tragedy of the Fincorp disaster was the number of investors who put their entire life savings into just this one vehicle.

Risk & Reward

All investments involve some risk, but not all risks are equal. Most investments involve compromises between conflicting goals and investors need to bear that in mind. The old adage “the higher the interest rate the greater the risk” is still true today.

This traditional saying is of general application, but it may warrant some illustration. Consider a company which is keen to increase its market share:

It decides to pay higher rates of interest on its deposits than those available from its competitors.
This succeeds in attracting new funds.
It is then faced with the necessity to on-lend these funds at a margin in order to cover its costs.
It can achieve this only by charging higher rates of interest on its loans than those being charged by its competitors.
The only borrowers willing to pay such higher rates in practice are those who constitute a greater-than-normal risk of default.
On a typical portfolio such defaults will then indeed occur.
Defaults mean not only trading losses instead of trading profits but also a reduction in cash flow.
The company therefore needs to step up its deposit-taking even further.
It thus needs to offer even higher rates of interest to its depositors.
This sets up a vicious circle of greater defaults, higher interest rates, greater defaults, and so on.
Eventually the regulator has to step in and/or the company needs to close its doors for ever.

Higher-than-normal interest rates should serve as a clear warning to investors. Commercial organisations do not offer above average returns for the fun of it.