Credit Ratings and Finance Companies

Now that finance companies must have credit ratings, it is a lot easier for the public to come to grips with the respective credit worthiness of the finance company, or for that matter Credit Union, Building Society or Bank.  It has also effectively removed a number of companies from the Crown Guarantee Scheme (CGS).

To be eligible for the revamped CGS, a credit rating of not less than BB is required.  The estimated probability of a BB rated company defaulting over a one year period is 0.6% - 1.6%.  The Crown Guarantee Scheme effectively decreases the default risk to that of the Government, currently AA, or a 0.01% - 0.02% chance of a default over a one year period.  If the New Zealand Government were to default, there would be total economic chaos in this country, and most likely many other countries.  It would be a lot worse than what was experienced in the meltdown from which our economy is currently recovering.

If a financial institution cannot make the grade to qualify for the Crown Guarantee, why would anyone consider lending them money? There is only one logical reason, and that would be that they were paying a large risk premium in order to offset the risk for the investor.  Most investors underestimate the level of investment risk, and most borrowers are not prepared to pay investors sufficiently high premiums.  The result until something goes wrong is that under the rules of supply and demand, relatively low risk premiums need to be paid to retail investors, often with little or no real security behind their investment.

With a multitude of finance companies in receivership or moratoriums, investors are seeing first hand the results of having insufficient investment security.  Few receiverships will see investors achieving greater than a 70% repayment of capital.  The capital repayments could take over five years, and there will be no interest payments.  Effectively an investor in say 2005 thinking they were making a two year investment, has provided a finance company with an interest free loan for maybe eight years, and for good measure only gets back say fifty percent of the capital lent.

Even if a finance company qualifies for the Crown Guarantee, there is the risk that they will have a credit downgrade which could mean the loss of the guarantee.  There is a real risk that some finance companies have an unsustainable book of business.  In order to survive they need depositors to roll over their maturing investments at levels often well above the highs that prevailed during the halcyon days of finance company deposits in the early 2000’s.

Some finance companies historically survived because of their relationships with offshore financial institutions.  These companies effectively provided the bridging finance to support any mismatches of their loan book durations.  This worked well, until too much pressure came on, and then these companies acted to tighten their security.  In most cases their position was superior to other investors.  For the investor, they have effectively changed from being the white knight, to being the darth vader.

Now may not be the best time to be investing in a finance company.  A few companies will survive and prosper, but there could well be collateral damage.  Experience shows that failures are not isolated events, and even what were considered the best, have shown that this was not good enough.