State Owned Asset Sales Are An Unknown

The Supreme Court recently released a judgment that found partial privatisation of Mighty River Power would not stop the government from compensating Maori for any claims they might have under the Treaty of Waitangi in relation to water rights. This means that the sale of Mighty River Power can go ahead and the National government can chalk up a political win.

The problem with the judgment is that it did not change the fact that the world is still in turmoil. The Federal Reserve and other central banks have been pumping liquidity into the financial system and pushing up the prices of financial assets. The New Zealand sharemarket rose nearly 25% in 2012 and billions of dollars is flowing into the marketplace with Kiwisaver contributions and overseas investors building up stakes in NZX listed firms.

But are state owned enterprises really fit for an NZX listing? The financial troubles of Solid Energy should give potential investors in Mighty River Power cause for concern. The fact that a coal mining company could make a mistake with something as important as trends in the global coal price, leading to a massive increase in debt over a short period of time, is not at all surprising when we think about the incentives faced by state owned enterprises.

Because state owned enterprises are seen by bankers as government sponsored entities, they are in a position to engage in risky business and explore pipe dreams that private sector firms would only think about if a potential project could pass their “hurdle rate” or the rate of return on investment required to justify the opportunity cost of the firm’s capital.

The government held a press release once it became aware that Solid Energy was in financial strife, and did not rule out a bailout. With over 1,000 jobs at stake it is likely more taxpayer money will be spent even though $1.5 billion dollars has disappeared in value and therefore proceeds from state owned asset sales. That reduces the lower bound $5 billion dollar estimate to $3.5 billion dollars in a best case scenario.

It would be foolhardy to invest in any former state owned enterprise when surprises such as Solid Energy becoming worthless almost overnight can emerge. We do not know the power companies and all of the details of their fanciful overseas ventures. We do not know the details of their performance bonuses and accounting practices that could lead to a post-listing “oops”.

We are also in the dark with respect to what the Supreme Court judgment effectively greenlighted – compensation for the loss of rights in relation to water. When you add these variables in with the cost of paying investment bankers to handle the sale, potentially as much as $100 million dollars, we have no idea whether the grand plan of selling down state asset sales will achieve anything other than some vested interests benefiting from National government policy.

The Chairwoman of Genesis Energy, former Prime Minister Jenny Shipley, hasn’t been booted despite her involvement as a director of collapsed construction firm Mainzeal Property and Construction, owned by delisted NZX dog Richina Pacific. She said that she should be judged by her results for Genesis Energy but implying she had nothing to do with the collapse of Mainzeal. She hasn’t said anything about Mr Richard Yan, the controlling shareholder of the whole group.

The funny thing is, another Supreme Court judgment ruling that commercial building contractors could carry the can for leaky buildings led to the demise of Mainzeal as “last man standing”. When you add an alleged tendency to underbid on major contracts and an imported management structure of failed UK executives not used to operating in New Zealand conditions, it is hard to see why we should let her wash her hands of the Mainzeal collapse.

State owned enterprises haven’t had nearly as much scrutiny as comparable NZX listed firms like Contact Energy or Vector. We don’t know enough about them and don’t have enough of an open track record to make sure that investors aren’t being sold dogs. Do we really trust the National government to make sure that it doesn’t set up a situation where shareholders in partially privatised SOEs face a “Feltex Carpets” or “Air New Zealand” situation? It’s happened before. It could happen again.

Development Finance Corporation and Solid Energy’s Troubles

The more things change, the more things stay the same. In the heady days of the late 1980’s, one of the first state owned enterprises to come into strife was Development Finance Corporation. In March 1989 it had assets of NZ$2.9 billion dollars, but by the end of the year it was insolvent and needed a government bailout. Yesterday’s announcement that Solid Energy is in financial strife and the National government not ruling out a bailout made me think about this, even though it was before I was even born!

After being placed into statutory management, the process by which most of DFC’s liabilities were settled cost the government $112 million dollars out of the deficit of some $900 million dollars. The reasoning behind having a state owned enterprise engaging in high risk activities like property development lending financed by risky offshore borrowing was clearly faulty. But nevertheless, it was privatised and subsequently placed into statutory management when it emerged most of its loan book was in default. DFC even took a bath on millions of dollars of bloodstock lending!

Because of Development Finance Corporation’s role in the foreign exchange market, it was an early example of “too big to fail” in New Zealand. It could have been placed into receivership and the counterparties who willingly traded with DFC eating their losses just like they would have eaten any profits they made from trades with DFC. But the Reserve Bank and the government of the day didn’t want let it fail.

But what led to Development Finance Corporation’s demise? You could do worse than to think asset sales had something to do with it. In June 1988 80% of the DFC was sold to the National Provident Fund and 20% to Salomon Brothers, the US investment bank. The effect of the transaction was to move DFC from a government guaranteed entity that could borrow on the wholesale money market at lower interest rates into a quasi-government guaranteed entity that could borrow on the wholesale money market as long as it maintained its credit rating.

Of course, when you let an investment bank take charge of a former government entity the entity takes more risk. From 1988 to statutory management, there was a substantial increase in offshore borrowing by DFC. There was also an increase in risky lending to wide boys and other colourful 1980’s corporations. The original idea of financing domestic projects the trading banks wouldn’t because of high risk became less important than creating an environment where DFC executives could enrich themselves in any subsequent management buyout.

What does any of this have to do with Solid Energy? A lot more than you might think. You see, the problem with asset sales that a lot of commentators on the right have ignored is that state owned enterprises have a history of poor returns and poor management. They consistently do dumb things like invest in natural gas when it is not their core competency or plough millions of dollars into a lignite energy pipe dream while ignoring their exposure to the world coal price.

My post yesterday clearly showed how Solid Energy’s financial performance over the past decade has been dismal. Despite an enormous increase in their balance sheet, for most of the decade they did not provide a dividend to the government and even when the world coal price achieved heights no analyst could have predicted, Solid Energy did not deliver high enough returns on the capital it had invested.

It is unclear whether the National governments intention to pretty up state owned enterprises for the asset sale process led to poor decision making around Solid Energy’s debt profile. But they never reached the $100 million dollar dividend target set for them, and quite frankly had no hope of doing so. They were always a high cost base coal producer and it really is a wonder how the government being involved in coal mining ever survived the 1980’s.

One of the things that came out of the DFC collapse was that foreign creditors were angry at losses because they were under the impression that their lending to DFC was under a government guarantee. I will be following the resolution of the Solid Energy financial situation with interest, because if it emerges that Solid Energy has made inferences to the fact it is state owned in overtures to its bankers then it raises the question – what other financial disasters are waiting amongst other state owned enterprises that could be sold off?

The fact that Bill English and Tony Ryall held a press conference saying that wouldn’t rule out a bailout of Solid Energy is disturbing. Since the poorly implemented Crown Deposit Guarantee of the global financial crisis, New Zealand taxpayer dollars have been wasted putting good money after bad. The idea of sunk costs and opportunity cost are completely lost on these mismanagers of societal capital.

If financial institutions are silly enough to lend more money to a company that failed to earn excess profits during a coal price boom in the middle of one of the largest commodity bubbles in global history, they are big enough and ugly enough to eat the losses if the receivers are called in for Solid Energy.

Throwing more taxpayer money down the drain of a mining company that thought it should be exempt from the Official Information Act, spied on environmentalists, spent enormous sums of money moving snails around and wasted its capital on flights of fancy better suited to private investors is exactly the wrong thing to do.

All of the arguments about “too big to fail”, “jobs will be lost” and “the government needs to own a mining company” are all complete and utter nonsense. There should be a Royal Commission of Inquiry that hauls in former CEO Don Elder, all executives, all bankers involved in the loans that are at risk of being called in and all senior executives who received millions of dollars in bonuses.

I’d prefer to see a few million go to QCs getting to the bottom and proving once and for all that state owned enteprises will always be poorly run than a few hundred million go to banksters with no accountability and no implications for the politicians who are supposed to have oversight of the state owned enterprises they are shareholding ministers of.