Credit Ratings Revisited

Over the next few months finance companies will need to obtain credit ratings as part of the government's steps to improve the sector's very tarnished image.  There is no doubt that some finance companies managed to survive the credit crisis by virtue of the safety net provided by the Crown Guarantee.  The test for their survivorship will come once the Crown Guarantee is removed.  It will then come down to how good their management is in terms of managing their assets and obtaining deposits from investors.

There are a number of credit ratings used in the New Zealand investment market.  The three international global ratings providers Fitch Ratings, Standard & Poor's and Moody's, provide a global benchmark allowing comparison with all local debt issued both locally and internationally.  A number of insurance companies use another international ratings agency, AM Best which specialises in insurance company ratings.

For a company to be issued a rating they appoint one of the independent ratings providers to stringently scrutinise their business.  The evaluation process comprehensively examines a number of areas including market position, internal procedures, the experience and competency of key personnel, balance sheet integrity and profitability and diversification of the asset base.  These, combined with other financial measures, ultimately determine the underlying credit security of an organisation.  The ratings company uses these factors to draw its conclusion on the ability of the company being examined to repay an investment quickly and on the original investment terms.

Over the past week or so, Asset Finance, a small finance company headquartered in Whakatane has just received a credit rating of 'B' from international ratings agency Standard & Poor's.  Asset Finance was the first finance company to voluntarily withdraw from the Crown Guarantee Scheme.  It was claimed that the scheme was too expensive for them.  For a small company, that could well be the case, as potential investors would still expect to receive a premium for investing with them, rather than for example with a much larger finance company such as Marac.

Just because a financial institution has a credit rating, it does not reduce the risk of it failing.  It is a guide as to how likely the company is to default.  A “Bâ€� S & P credit rating implies a 3 – 11% chance of a default over a one year period.  Equate that with a major bank’s rating of AA, and there is a 0.01 – 0.02% chance of a default.  In other words there is 300 times as much chance of a default when investing in a finance company with a B rating compared to investing in a bank with a AA rating. 

How then should investors be compensated for investing in lower rated companies? The answer to that is for the company to pay the investor a risk premium.  For an investor to rationally consider investing in the B rated company, there needs to be a massive risk premium provided in the return to compensate for the likelihood of a default.  Risk premiums are seldom of a sufficient magnitude to adequately reward investors.  The Crown Guarantee was costing finance companies approximately 3% more than the major banks were paying.  This fee was probably far too low, and reflected that any failures would largely be paid for by taxpayers as a whole, rather than out of the levies collected from the finance companies. 

Just because a company does not have a credit rating does not necessarily preclude it being a good company to invest with.  A number of publicly listed companies without credit ratings issue debt.  The key is to understand what you are investing in, and not putting all your eggs into the one basket. 

Disclosure: As required under the Securities Markets Act 1988 and the Securities Markets (Investment Advisers and Brokers) Regulations 2007, a Pascoe Barton disclosure statement is available on request free of charge, by contacting Pascoe Barton Limited on (07) 306 0080 or from www.pascoebarton.co.nz.