Property Development Loans Likely Big Trouble for South Canterbury Finance

Today Marac Finance's owner Pyne Gould Corporation announced its results for the second half of 2009, and the news is good:

Marac Finance recorded a net profit before tax of $8.2 million, after including a one off $3.3 million pre-tax provision for a previously announced loan irregularity.

Perpetual Group contributed $3.7 million, while Perpetual Asset Management (PAM) made a pre tax contribution of $1.9 million. PAM’s investments include Real Estate Credit (the ex Marac property loans) and the Torchlight Credit Fund.

During the period PGC strengthened Marac’s balance sheet by investing a further $35 million in new capital, not requiring Marac to pay a dividend and arranging the sale of $175 million of property loans at face value to another PGC subsidiary.

The property loans that were taken off Marac are reported as follows:

While there will be the usual interest in the South Island-based finance company’s bottom line when it reports its interim results tomorrow, it’s the dodgy loans hanging over its head that still needs to be acknowledged.

The company has shifted around the full $175 million in property development loans between its subsidiaries and ate an $85 million write-down on the loans in its 2009 earnings.

So, PGC decided last year to provision 49% for impairments on its property development loans, and today its results appear to confirm this was fair, given no further losses reported from that source.

Meanwhile, South Canterbury Finance has announced that it has had to recognise further losses on 'assets previously identified as impaired.' Although the company's communications are fairly vague, I believe that it is the property development loans that are the major source of the trouble. Let's have a look at what we know about them from the prospectus.

Property Lending
The Company is winding down and, where possible, divesting its exposure to property development lending by proactively working with its existing clients in this sector to reduce their level of borrowings from South Canterbury Finance. Due to the current lack of liquidity in the property market, it is anticipated that this will be a gradual process.
As at 30 June 2009, the Charging Group’s net receivables in the property sector were approximately $485.7 million or approximately 29.8% of its total receivables. As at 30 June 2009, property lending consisted of approximately 265 loans with an average loan settlement value of approximately $1.89 million. Twelve property loans are for amounts in excess of $10 million each, with the largest property loan (hotel business) being $44.9 million. Almost all of the loans in the property sector are interest only loans and, for the majority of those loans, interest is capitalised during the term of the loan and only paid on maturity. In the Company’s experience, lending of this nature is not uncommon particularly in the case of loans for property developments.
As at 30 June 2009, total impairment provisions relating to the Company’s property lending portfolio were $48.4 million, being approximately 9.96% of the portfolio and 3.0% of the Company’s total net receivables. Property lending has traditionally been development lending or lending secured over land held for future development, typically for 6 to 24 months secured by way of a first or second registered mortgage. As at 30 June 2009, approximately $275 million (or approximately 57% of the Charging Group’s property sector loans were secured by a first ranking mortgage and approximately $210 million (or approximately 43%) was secured by a second or subsequent ranking mortgage. The Company significantly reduced its lending of this nature in early 2008 but has been required to continue funding development costs for existing borrowers to enable the completion of projects. At the time of origination of those loans, there were clear exit strategies, mainly involving the sale of the project. However, in many cases the exit strategy has not eventuated for a variety of reasons such as defaults by purchasers and the failure of the developers to complete subdivisions in time.

How can we interpret these details?

1. We have to add back $48.4 million to 'net receivables in the property sector were approximately $485.7 million' to get the gross receivable amounts. So the total property development loans were $534.1m, and the provisions were 9.06% of the gross amounts, rather than the somewhat misleading '9.96%' figure quoted in the prospectus.
2. The company has been trying to get out of these loans since early 2008, so by now they should either be repaid or in quite a sorry state. 'Due to the current lack of liquidity in the property market' the company does not expect to be able to sell or collect these loans for a long time.
   
3. 57% secured by first mortgage -- the company will collect something from these loans or the proceeds from selling the land/project. I'd guess at least 50%. The other 43% ' secured by a second or subsequent ranking mortgage' in many cases they will get nothing from these loans, as the holder of the first mortgage takes all the proceeds and still wears a loss.
4. Compared to the property development loans of Marac finance, provisions made by SCF is 9%, far less than the 49% provision made by Marac finance's parent PGC for what are probably quite similar loans.
5. If SCF was to recognise or realise similar levels of losses as PGC has on Marac finance's the additional losses over and above current provisions (as at 30 June 2009) would be $213m, which would wipe out SCF's remaining equity.
6. Current conditions in the property development sector are still bad and have been getting worse since late last year. Today's National Business Review (paper edition) leads with a story 'Hanover assets worse than Allied thought' reporting about similar assets that were appraised and picked over late last year, resulting in a transaction, and subsequently showing more trouble than expected. In effect, those assets are now trading at about half of the value imputed to them late last year, in the form of Allied Farmers shares on the NZX.
   
7. SCF could need very substantial additional capital to cover possible losses on, or actual losses incurred in divesting itself of, its risky and impaired assets.