Finance company sector turned on its head

The government’s deposit guarantee scheme has turned the finance company sector on its head, with investors now pouring money into these companies.

Tuesday, 2 December 2008

McDouall Stuart yesterday released its annual report on the finance company sector and has concluded there is optimism now.

Head of Research, John Kidd, says it has been an incredible year for finance companies.

While there has been plenty of bad news including the global credit crisis and a steep downturn in the domestic property market and “a major crisis of confidence” the sector is looking more robust.

Kidd says that, despite the apparent gloom, finance companies have genuine reason for optimism.

In particular the government guarantee has enormous implications. “That decision turned the finance industry on its head,” Kidd says.

“Probably the scheme’s most striking feature is its effect of decoupling default risk (the risk of a company defaulting on its payments) from loss-of-money risk (the risk that investors will actually lose money from a default event). The upshot is that depositors do not need to worry about the risk of losing their money if they deposit money with a guaranteed retail deposit taker”.

“Investors have been very quick to understand the opportunities the guarantee scheme has presented.”

“Because of their lending models, finance companies are able to offer higher deposit rates than banks. Although finance companies tend to present higher credit risk than banks, for investors, the risk of losing money is no different.”

He says some companies simply cannot absorb the volume of deposits coming in. “We are hearing that some are returning large volumes of application money to depositors.”

Deposit rates are dropping fast as companies react.

Kidd labels this an unintended, but predictable outcome of the guarantee scheme. “Investors are responding logically, taking advantage of opportunities being thrown up by risk arbitrage.

“This is not a healthy outcome” says Kidd. “Just when investors were starting to appreciate that there is no such thing as a riskless return, the guarantee scheme signals that there is. The scheme ignores all the lessons of the past two years, where investors learned the hard way the consequences of mispricing risk”.

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