Property financing this decade has protected trading banks but exposed finance companies like Bridgecorp and eventually Hanover to extreme risk.
The danger could now be creeping closer to our main banks as the mezzanine financiers topple. For the past eight years or so property financing has worked like this:
Say a developer wants $1 million to spend on a property: the first phone call would be to a trading bank such as ANZ or Westpac for an initial $600,000, because banks usually loan only a conservative portion for high-risk high-reward commercial projects.
Banks, being naturally cautious, will usually only advance this portion because if the deal goes bad, they estimate they can at least recover 60 per cent of a property's value, particularly in a forced or mortgagee sale.
First mortgage taken care of.
That leaves the developer still searching for the remaining $400,000.
The second call would be to a second-tier lender like Hanover Finance, regarded as a cut above the rest in the entrepreneurial world of mezzanine funding. Hanover might well stump up $200,000.
Second mortgage resolved, even if the interest bill is about 15 per cent.
That leaves the developer hunting down the remaining $200,000, so a lender-of-last-resort like Bridgecorp might be courted for this amount.
Third mortgage down, even at a punitive 20 per cent-plus interest.
All this works fine in a good market when property prices are rising. But what say the developer gets into trouble, can't make sales anticipated so can't repay the interest or principle on the $1 million?
The heat will go on the developer but eventually, one of those three lenders - often the most desperate - will issue court demands for the payment, forcing the issue.
But without cash flow, the developer is still stuck.
So one of the three lenders will then force the property's sale, exercising their rights under the mortgage. But what happens if prices have fallen 20 per cent and only $800,000 is recovered at sale? Bridgecorp might get nothing, standing third in line behind the other two lenders. So Bridgecorp investors are the ones who suffer first.
The bank and Hanover would get most of their money. Their investors are fine.
What if the market was much worse and only $600,000 was recovered at forced sale? Hanover takes the hit and the bank gets its money. This scenario explains why Hanover Finance cannot pay its investors.
The financier has loaned long and borrowed short: developers need years to complete a project but Hanover's investors were only short-term depositors.
"This scenario is de rigueur," said a senior banking official, adding that the developer often wasn't even called on for regular repayments, sometimes for some years. Loan fees and interest rate were also often capitalised into the loan, so all repayments were often deferred long into the future.
" Things like cost overruns occur, there's little or no wriggle room for contingencies greater than budgeted for, pre-sales are slow to settle, and so it goes on.
"Then we get a reversal in the market as is occurring and has been going on all this year so the second and third-tier lenders are hamstrung because their source of day-to-day funding dries up due to mum and dad investors losing confidence.
"This makes it difficult for businesses like Hanover to fund their own operations and their repayments trickle to a middle-aged male's prostate-hampered flow. Defaults occur and the house of cards falls over."
What some property experts are beginning to wonder now is what will happen if less than that $600,000 was recovered on the property used here as an example.
LEVELS OF LENDING
1: Trading banks
2: Second tier lender - Hanover
3: Lender of last resort - Bridgecorp