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New Zealand Finance Holdings: John Callaghan

Tuesday 25th October 2005

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New Zealand Finance Holdings listed on the New Zealand Stock Exchange in October 2004 after a $2.94 million float priced at 30 cents a share. In April, it reported a 71.2% rise in annual net profit to $2.8million, beating its mid-December 2004 forecast of more than $2.5 million. In the current year, it has purchased Approved Mortgage Brokers for $1.2 million worth of shares priced at a nominal 45 cents. It has also bought Property Pack Wellington's residential mortgage book and secured a $100 million funding line from Westpac.

Sharechat: What are the terms of the Westpac funding line? Will it operate similarly to your AMS funding?

New Zealand Finance Holdings managing director John Callaghan: The terms are it's a warehouse facility which acts as a holding ground for securitisable mortgages. Does it act like AMS? No, it allows us to become an AMS so that we originate and securitise mortgages in our own market place under New Zealand Finance Mortgages Ltd. That can be originated through our in-house broker channels but can also be originated through external broker sources and directly.

SC: Will Westpac have recourse against New Zealand Finance Holdings?

JC: No. New Zealand Finance has provided a service indemnity. How it works is we originate paper, reinsure through Gemico. Once we get certain volumes, we securitise it. It's very hard under the new accounting standards, as you will find over coming years with the major banks, to take balances off balance sheet. That's not saying it can't be done but the changes have made the process considerably more difficult. Someone else takes on the credit risk - even though they may still be on balance sheet, we've still eliminated the risk from a credit perspective. If you securitise a $200 million book, you might have to obligate a $1 million liquidity line to it and all of a sudden you've got to bring the whole $200 million back on your balance sheet. The credit risk may have been eliminated but it's still there from a balance sheet perspective. It allows us to considerably accelerate growth whilst eliminating risk. We've developed a business in lending in the non-conforming industry. We've added to that the model of distribution and continued to grow that. All we're doing now as we grow is dumbing down our risk profile and tapping into more of the mass-market commodity stuff. We've established all those platforms. We've done the higher risk profile fairly well over the last seven years. We've only written off $23,969. It has been a great seven years to be in the industry. As I pointed out to a major lender, if you compare our right-offs as a percentage of assets, we've had a better performance than probably all the major lenders. That's because we've concentrated on mainly residential mortgage based lending.

SC: How long do you expect it will take you to on-lend the Westpac line?

JC: In the resources that we've been involved in to date, we're funding through secured debenture stock from the general public which we achieve at a rate that's considerably higher than we've achieved through this funding line. All of a sudden we can provide a more broader range of products. It's allowed us to produce a product that competes with the banks. In terms of what we would be prepared to fund now through that channel, it opens up a considerable volume of business that we can look a placing out through our existing broker channels. Obviously, the broker needs to place the business for the benefit of the client, but if we provide a product that's competitive and meets the client's needs, I suppose a broker takes a path of least resistance. If there's an in-house product that meets their needs, and they're getting the service to meet that need, then they will place that business with our team. We might pick up some of the share that might have gone to Sovereign. All of a sudden we've got a broader range of products we can offer. Maybe previously we were placing 3% through our brokers and maybe now it will be 6%. The risk profile is obviously lower so the margin declines also. It's not as if we suddenly double our profits.

SC:Are you going to keep the Property Pack name?

JC: No. Really the Property Pack purchase that we took on board was more a purchase of a data base and attached to that was a considerable trail volume and a considerable number of active clients that allows us to continue to grow our broking-based channels.

SC: Why is the projected return so high (50% pre-tax in the first 12 months) and will that last?

JC: The trail volume alone will return the investment in two years. Attached to that was the data base which had never been mined for insurances and a considerable volume of other past purchasers or clients. It's a data base that's not attached to a broker. Presently we have a full time PAYE person who looks after the business. We potentially will be looking at offering through the new (Westpac) program a fairly competitive renewal package under New Zealand Finance Mortgages. Our first port of call is to directly approach them and offer a very competitive fixed-rate renewal package. Once we've mined it from that perspective, we will then distribute it to broker channels. The brand will be the Approved brand. As an example, we've just taken on a new franchisee in Hastings. Some of the data base is Hastings and Napier-based because it's the old Forsyth Barr book. That franchisee has purchased a new franchise and also the book of those clients. The business has a considerable volume of business in Christchurch and we're looking for a couple of new franchisees to come on board in Christchurch which will distribute to that business as well. We're finding a lot of new franchisees love the opportunity to get into a business that's up and running. It gives them a good base straight away rather than starting from scratch.

SC: Are you looking to buy more mortgage broking operations?

JC: We will always look at additional distribution channels. We will look at each on their merits. I would be a lot more conservative and reluctant to look at acquisitions of finance businesses. The due dilligence process on a finance book is quite complicated and you never can find all the bad eggs.

SC: How much potential for organic growth do you see?

JC: Presently we have two brands, New Zealand Mortgage Finance and Approved which we purchased at the beginning of the year. That in itself has considerable growth (potential) throughout New Zealand. If you take a direct example and look at the likes of Pero, they have about 95 brokers throughout New Zealand now. We presently have under the two brands only 38 so there's still considerable organic growth to be had. We seem to be growing at almost a franchise a month.

SC: Will mortgage broking be the company's biggest income generator in 2006?

JC: It depends on how much the other thing grows. From our perspective, yes, it is a big income generator of our business now, but the other side of the business will continue. It's a process, as we grow, of ensuring that we have a balanced income stream. Rather than being a finance company, totally reliant on interest and fee generation, the broking side of the business is a good income stream and will continue to be a big part of the business.

SC: Why is so much of your direct lending short term?

JC: Being good lenders, and our debenture profile, means we will always be short-term in nature to ensure that we keep very good liquidity. The short-term nature allows it to be a very profitable and cost-effective book.

SC: Is that likely to change?

JC: The new type of business we're generating through the new (Westpac) line will change that profile, but the debenture-based funding will always be short-term. It's the nature of matching the interest against the funding thing.

SC: But your debentures profile means you could lend longer-term than you are doing?

JC: Yes. We have a very short-term (lending) profile at the moment whereas our average debenture funding would be in the 14 to 18 month bracket. It allows us to achieve very good finance returns in our lending. If you look at our finance book in the market place, we're probably on of the lowest geared and on of the most profitable. National Business Review rated us number one in May last year for return on assets against all the lenders. From a gearing perspective, considering the additional equity we've thrown in in the last 12 months, I wouldn't know exactly where we stand at the moment, but we've got one of the most conservative debt prospectuses in the market place.

SC: What's your view on the outlook for the housing market?

JC: Mr Bollard is obviously not too happy about his inflation targets being breached and is having a bit of a talk about it. Fundamentally, I think there's too many positive statistics out there still at the moment. I don't see a major correction at all. However, I see a flattening and maybe a slight decline. For there to be a bit of a correction we would have to see unemployment rates rise up quite a bit. At the moment we've got people with the perception that if I lose my job tomorrow, I can walk into another one the next day. There's not a lot of conservatism happening out there. I think that would be the key statistic to watch.

SC: Has there been any slowdown in issuing debentures?

JC: As a finance company, we've yet to go out and promote ourselves to the financial planning community. In the last six months, we've been very conservative in our approach to deposit growth through the general public because of not wanting to become totally reliant on the debenture-based funding mechanism. Hence our relationship with Westpac. Purposely we haven't looked at massively growing our deposit base. We've still had good growth. I would say it's probably been reduced as a result of the publicity that's occurred in the last six or seven months. If that publicity wasn't there, I would say new growth would be higher. Something like 54% of our deposit base is still directly with the public as opposed to financial planners. A number of other finance companies are fairly reliant on the financial planning community for their deposit growth.

SC: What's your reinvestment rate?

JC: In the last quarter it was just over 78%.

SC: If we do get a housing market downturn, how is that likely to affect the company?

JC: There are two sides of it. We're a finance company that's very much first mortgage based with what I would consider to be conservative ratios. If you compare the average LVR on our book compared to the banks' mortgage books, we would probably be lower. So I'm very comfortable with the quality of our book to sustain a downturn. The history of the last seven years and the fact of our bad debt write-offs - I would say, yes, in a downturn we would have more bad debt write-offs, but they would be manageable. On the broking side of the business, this is very much a numbers game which results in commission income. A downturn would individually affect broker volumes but, considering the growth we're going though at the moment, I don't see a downturn having any lasting affect. The other part that's taking off is the non-conforming and low-doc market in New Zealand.

SC: Why have subordinated notes and preference shares and who owns them (apart from director Pat O'Connor owning $300,000 of the notes)?

JC: The preference shares are owned by Pat O'Connor. There are three original shareholders. When I first set up this company, Pat O'Connor was the backer. Hence he still has these preference shares. He feels safer having the money with me than having it in the bank. The subordinated notes were put in place in the early years when our growth was considerable because we had a very conservative balance sheet with only a 86% total liabilities to total assets ratio. Another reason to put them in place was a number of long-term depositors were looking for a slightly higher return. We don't promote the product at all, but if a client is looking for a better return, our board has identified the additional risk of the notes, but it provides another option for the client.

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