LESSONS LEARNED OR A CASE OF LAPSED MEMORY – THE

DEVELOPMENT FINANCE CORPORATION

Wednesday, 4 March 2009

INTRODUCTION

You have asked that I set out the background and subsequent unfolding of events in
respect of the Development Finance Corporation of New Zealand Limited (DFC) so as
to highlight similarities in risk relative to various policies being considered at present
as means for managing the impacts of the current recessionary environment.

I have drawn from:

 Such (now extremely scant) written resources as remain including material

recorded by the then Reserve Bank Governor Don Brash, some of the
remnants of Court documents relating to the statutory management process,
passing references in various historical volumes, and,

 Remaining notes and references in texts I made from the time when I was
working for the State Owned Enterprises Unit of the Minister of State Owned
Enterprises. Our involvement focussed on the relative potential of each of the
various solutions to the DFC failure to affect the integrity of the SOE model.

In the figures reported throughout the following discussion I have noted the dollar
equivalent in 2008 dollars so as to allow consistent comparisons to be made.

ORIGIN

The DFC was established by Act of Parliament in 1964 at a time when N.Z. had
virtually no banking services of any kind outside of standard retail banking. At that
time Sir Frank Renouf had yet to “introduce” so called merchant banking to N.Z. and
non retail commercial finance – both debt and equity – was arranged as either:

 A private amongst what today would be termed “high net worth individuals”
and their families,
 Through direct government grants, subsidies or other like interventions, and,
 Quasi government monopolies in the form of producer boards.

The entity established in 1964 was owned by a group of private banks and insurance
companies (as to 70%) , with the Government and the Reserve Bank holding the
remaining 30% of shares.
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The entity was reconstituted in 1973 with the government taking full ownership. The
DFC was, at that point re capitalised to some $10.0m (2008: $178m). Subsequent
governments invested more in the DFC such that by 1982 its paid up capital was
$25.0m (2008: $81.6m). The 2008 figures indicate the impact of inflation over the
period 1973 – 1982 as well as the “performance” of the institution in respect of
equity (rather than total capital).

PURPOSE AND FUNCTIONNING

Significantly in terms of the current context, the DFC was set up to provide advice
and funds to new and growing – especially export industry – businesses. In its early
years the DFC was able to lend only in cases where no satisfactory alternative
sources of funding could be found. This rule of operation was abolished in 1970.

The Board of Directors consisted of representatives from Trade and Industry and
Treasury with the majority of the Board, including the Chair (Mowbray et al), having
private sector backgrounds (Sutton et al).

The DFC was not funded directly by government but raised money most notably
through Eurobond issues, along with the issue of floating rate certificates of deposit
and bearer notes. This activity was facilitated by the government guarantee it held at
the time. The successful issues coupled with the government guarantee resulted in
an AA rating from Standard and Poors and a significant international profile.

Up until the mid eighties DFC focussed its lending in agriculture, food processing,
tourism and commercial property. Criteria for lending related to “the prospect of
profitability” in new ventures, extent of effective N.Z. ownership and potential
contribution to the N.Z. economy.

Significant competition began to affect the bank in the mid eighties and it re
structured into divisions comprising DFC Ventures (VC and equity investment), Zeal
corp (investment banking, swaps, arbitrage, forex, futures trading), and DFC Trade
Finance.

From 1985 on the DFC became increasingly aggressive in both capital raising and in
lending and its activity fell less and less under the monitoring eye of its owner. The
DFC was never constituted as an SOE and never subject to any of the accountability
regimes faced by SOEs. It was essentially unmonitored by any party external to the
board.

PRIVATISATION

In 1988, in line with the asset sales policy of the time the DFC was sold to the
National Provident Fund (80%) and Salomon Brothers (20%). The National Provident
Fund might not, in strict terms, be considered to be altogether a private organisation
in that it consisted then (as it does now) of a portfolio of “contributions”, made by
government employees contributed on a defined benefit basis and managed by a
Board of Trustees under a statute.
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With the privatisation the government guarantee was withdrawn but – and this was to
prove a major difficulty (see below) the majority of the portfolio of assets consisted of
contracts made with parties at the time when the guarantee was in place and the
government was the DFC’s owner.

In March 1989 the DFC’s assets stood at some $2,900 m (2008: $4,727.0 m) – on and
off balance sheet.

REVIEW – AND STATUTORY MANAGEMENT

Asset prices (financial and non financial) had steadily declined throughout the late
1980s after the 1987 equities crash and its prolonged fall out in N.Z including the
effects spreading to related markets such as commercial property.

In August and September of 1989 the DFC reviewed its loan books and concluded
that the company was essentially insolvent with a provisioning requirement for on
balance sheet bad debt of some $900.0 m (2008: $1,467.0 m).

The shareholders were unwilling to support the institution. In theory, since the DFC
had been privatised, the government had no interest in the insolvency or demise of
the institution. Indeed shedding precisely this kind of risk was a primary purpose in
the original asset sale. As a practical matter the government of the day felt unable to
allow the DFC to collapse in an orthodox fashion for two main reasons:

 Some 90% of the DFC’s off balance sheet business (around $3.9 billion or
$6.63 billion in 2008 dollars) – mainly swaps - (since all derivative business
was off balance sheet under the then prevailing accounting rules) involved
major international banks as counter parties which created significant
reputational risk to the NZ financial system. Certainly that was the view of the
Reserve Bank at the time, and,

 A number of those banks were domiciled in countries (notably Japan) with

which N.Z. had significant and sensitive trade and diplomatic relationships –
as well expectations that an implicit government guarantee lay behind the
original transactions generating what were, by this point, liabilities of
considerable magnitude.

The joint decision of the Reserve Bank and the government was therefore to place
the DFC in Statutory Management – under a regime which granted the Statutory
Manager (Sandy Maier ex CEO of Citibank’s NZ operations) all the rights and powers
of the Board and shareholders.

RESOLUTION

Resolving the problem was far from simple. Defaulting on the swap book for example
could have had deleterious impacts on the foreign exchange market (and DFC was a
significant player in that market complicating matters further) and certainly
disadvantaged creditors.
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In the event, contractual obligations on the swap book were met and it was sold in
1990 to Barclays for some $429.0 m (2008: $652.0m versus $3.9m in notional
principal). This component of the Statutory Management was considered a significant
success (it certainly appears to have “saved” $180 m which would have been lost
through default) as much by way of showing good faith as anything else – and thus
setting up reasonable conditions for dealing with the on balance sheet assets.

As noted, sour loans meant that a provision of at least $900m would have been
required. The alternative was some sort of negotiated agreement between the
government and the shareholders (Nat Provident and Salomon Brothers). Neither the
shareholders nor the government were prepared to inject the necessary equity into
the business to support its book – the government because of the way such a move
would undermine the SOE policy of full commercial exposure, and the shareholders
for obvious orthodox reasons.

The gap between value of assets and what creditors were owed amounted to some
$800.0m (2008: $1.30 billion). Negotiations began from this point of departure. By
October 1990 a deal had been negotiated.

In summary it involved an injection of funds by all shareholders so as to facilitate

repayment of all senior debt plus concessional interest by 1997 and for subordinated
creditors by 2005. A tranche of zero coupon bonds effected this arrangement. In
exchange creditors waived all claims against the government, the shareholders and
others.

COSTS AND LESSONS

It is almost impossible to assess accurately what the DFC saga cost the taxpayer.
Certainly an original investment in today’s terms of $178m ended up in a loss
exceeding $5.0 - $6.0 billion. Throughout the lifetime of the organisation it is far from
clear that additional losses were not incurred as well – leading for example to the
injection of funds in 1982.

In addition, it is likely that the country’s financial system was put at some risk – if
only reputational risk – and the possibility of policy compromise existed. While there
is a technical and legal argument that the government did not underwrite the
resolution of the DFC problem, it is equally clear that in fact:

 The government used its (then) newly passed Statutory Management

legislation,
 The central bank played a leading role in ensuring resolution,
 The government’s staff superannuation scheme invested significantly in the
resolution, and,
 The government itself did likewise.

Investing counterparties did not lose other than in terms of the difference between
concessionary rates of interest and market rates and in terms of time and therefore
opportunity cost of capital. They did not for example suffer the fate of investors in
some US banks in 2008.
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The management lessons learned or to be learned are or were essentially matters

internal to financial services institutions – the need for internal auditing, the need to
separate loan review from lending, the need for effective lending policies and like
matters. Important – but essentially internal matters of professional finance practice.
The “big” lessons ought to have been that:

 Simply because investment in a “sector” is deemed to be important to an

economy there exists no good reason for government institutions to invest in
such sectors,
 Government institutions – largely because their boards and management face
perverse incentives relative to owners, systematically make poor quality
decisions which lead to high risk and losses,
 There are numerous superior policy alternatives to governments attempting to
operate as commercial or investment banks.

It is unclear – at least to this author – that these lessons have been internalised or
remembered.