Good tyre kicking research required

Hi Phil,

I have to agree at the basic "farce" apparent in "ratings" re finance coys in NZ.
To have a ratings coy assess a finance coy on often very historical data plus to not even have visited the companies for a "chat" is bizarre.

I had one of the failed companies in one of my buildings and recall a couple of years ago that their whiteboard showed their bad-debt arrears had slipped above the accepted sort of "benchmark" that finance coys tended to use, being 10%.
One of the comments from them was, "could I consider doing some of my seminars to help get some more funds into their coffers to help water down the bad debt ratio...!!!?"

This was clear to me that the attitude of those companies that failed was that they had "sort of lost control of the reins somewhat" and the heirarchy were encouraging their (usually outlying centres) broker/lenders to get loans out, virtually at all costs (often to say vehicles "sight unseen) and with "no recourse on their commissions..!?"

That has been the gradual problem.
The outlying lender/brokers virtually having lots of pressure to get loans done, and obviously without the normally expected prudence required..!
A colleague & I have noted this factor with 3 of the few who have failed in the last year or so, and we noted that fact way back more than 2 years ago, but not suggesting to be a know-all.

The obvious problem now of course is that commentators are often painting a worse-than-necessary picture of many of the existing finance coys who run a relatively tight ship ( those who chase up bad debts, instead of just watering them down with new funds...!!)

There are also finance coys out there who tend to fool investors with their posted deposit rates.
Many times, the unknowledgeable are enticed to invest into those finance coys who "pretend" somewhat to be conservative lenders because they post relatively lower deposit rates..!

How difficult do people really think it should be to analyse a finance coy book say even only on a 1/4ly basis (or even bi-annually)..?

Life, in my opinion, does not really need to be as complicated as some pretend it needs to be..?

My opinion, for what it is worth...
Michael

Phil
I attended the Infinz seminar on Finance Companies on 21 September, which left me with some firm views about this sector, some of which relate to your blog comments about rating agencies.
1. The effect of the new regimes requirements for ratings will cause further industry consolidation. The compliance and rating agency costs will raise barriers to entry, making small finance companies uneconomic.
2. The new regime requires marketing material to include the entire ratings scale, with a description of a company's given rating level. This will firmly place finance companies well below banks and other fixed income choices. The lowest rated companies will be forced to offer rates well in excess of 10%, reinforcing the sense of riskiness and also adding to market consolidation.
3. Disclosure is the name of the game in financial markets now - due to the global credit developments as well as our finance company failures. So while we await the start date for the new regime, investors will demand more information. Failure to oblige will not generate widespread confidence.
4. Liquidity will also be valued as investors will want to be able to exit worrying investments.
5. This will affect not just finance companies but also other opaque securities, such as CDO's and other structured products where investors cannot readily see what they are investing in.
6. Overall I think the new regime will produce a stronger, more sustainable sector, but it may be smaller than at present as risk averse investors seek higher quality places for their fixed income assets.

Phil,

I am completly baffled that financial planners have put their clients hard earned money at risk in finance companies at a rate one to three percentage points above the "risk free" rates that these clients can recieve above a bank deposit. I have heard that a good majority of the people that have lost money did so by going direct with no advice this may be the case but many did seek professional advice and have been gravely let down. I really think this is appaling.

There are no doubt some good finance companies out there with good long term track records and prudent capital ratios but in my mind the risk return trade off was never there especially if they applied the basic of lending Character,Collateral and Capacity. This argument is doubly applicable now, the risk premium on finance company debentures relative to bank deposits should be much higher.

If I knew of the risks and dealings many of these companies which are now in recievership took you can't tell me that someone placing funds was not better informed.

I would not like to be the liability Insurer for many of these firms

Regards
Paul Lyons

I do partly agree with Michael Donovan here, the type of management you apply is, of course, paramount, and Finance 101 NEVER ceased to work, so good principles of management do for a better finance companiy...but have we learned something from the Northern Rock case in UK?
No matter how good or how solid you are, if there is a run on the money, you stand only if the Reserve Bank steps in...in the UK case, the Bank of England was the lender of last resort, AND the UK Govt. stepped in to stem the tidal wave of funds retrieval.

Now, the Reserve Bank here is called to step up controls, fine!, Then rating agencies are called to rate (beware!! All those CDOs, that were rated AA or AAA were not rated so by little unknown NZ based raters, they were rated AA or AAA by the same raters that are now called in as being saviours and guarantors of the sanctity of accounts of NZ finance coys!!) fine even that.

What this all will mean if there is an unprecedented and large scale run on the money as the one we just saw?
Absolutely nothing, zero, zilch !! Unless someone steps in and says that well managed finance coys that comply with regulatory standards AND good management standards do enjoy the same protection as Banks from the Reserve Bank.

If not...we are just deluding ourselves and bestowing extra costs on the sector that will not carry any added benefit.

There continues to be a clear misunderatanding as to what a credit rating is and what is means. A credit rating is an opinion (NOT a statement of fact) on the credit-worthiness of an issuer. In other words, it tells you how likely, in the opinion of the rating agancy, the issuer is to default on its obligations.

This is some way removed from the view above that S&P/Moody's/Fitch are putting themsleves forward as 'saviours' or 'guarantors'. They are not.

When it comes to the ratings of CDOs, bear in mind that at this stage (as far as I know) no AAA-rated CDO has defaulted. The price of the AAA securities may have fallen, and they may have been significantly downgraded, but this does not mean that investors won't get back their interest and principal. In addition, not all CDOs are the same. A CDO backed by sub-prime mortgages is not the same as one backed by investment grade corporate bonds.

The point about the UK situation is valid, but unfortunately there are many commentators in the UK questioning the Bank of England's move since it has injected a huge amount of moral hazard into the banking system. In other words, UK banks can now behave pretty much as they like, since they know that the Bank of England will bail them out of it becomes necessary. Is this really what you want for NZ finance companies?? And just who decides what is and is not a well managed finance company with good management standards, if not the ratings agencies?

Well, a AAA CDO called SPA and issued by Credit Suisse defaulted as far back as 2006.(Rated AAA by ALL the 3 Agencies, S&P Moodys and Fitch).
April 24 2006 that CDO collapsed because many of its underlying securities defaulted.
Final result , out of 340.7 millions composing the CDO, the investor recovered ONLY 177 Million only against the safest senior AAA rated tranche (amounting to 293.5 Millions...so 77 millions were lost on that so called safe tranche!!)
The final result was that the investors holding a portion of the CDO, lost 49% of the money on a safe AAA rated CDO...and this well before the January-July drama unfolded.

On the fact that CDOs are not all the same...that's right. In NZ there is a listed product (no need for names) that has an underlying of investment grade corporate bonds. It is now priced around 86 offered.
No bids, sorry...means no takers , even at that price. Why ? Some of the companies with investment grade ratings have bought (on leveraged debt, of course) some other companies and their rating has been downngraded as a consequence. The good thing is that so far, it is still paying the interest, and the manager is struggling to change the composition of the bonds portfolio to get out of troubles. All my wishes he can succeed, particularly for the final investors, but it is not something I would wish to happen even to my worst enemy, to have to tackle such a problem.
And I handled bonds in 1998/1999 !!!

Sorry, I cannot buy the publicly displayed defense that rating is just an opinion...although technically that's what the fine print of every rating contract tells you.
But when bonds and even sovereign debt is priced based on it's rating..well, it ceases to be just an opinion.
A loophole in regulations has so far allowed rating agencies to be all influential and no liable of anything.
I think that someone not only influencing, but determining the prices should be held liable of at least something, not in all cases, but when it can be assessed that "best practice" was not followed, liability should follow and be swift and sure .
And this brings up the case if rating agencies should be private companies obviously driven (as all private companies) by the need to maximise profits.

I did not say that the UK case was the solution for NZ...and was far by my intentions to say that it should be implemented as a "freehand" to malpractice as having an all powerful backstopper.
The solution is easy and available and replies in full also to this question "And just who decides what is and is not a well managed finance company with good management standards, if not the ratings agencies?"

In Europe, the principle is : If you take money from the general public and pay interest on that, you are fulfilling a banking function.
With that you are subject to full controls of the Reserve Bank, and also to a particular thing called "ratio" established by the banking law and monitored by the Reserve Bank.
The monitoring and compliance to those ratios makes you a well managed financial entity, authorised to take money from the general public, and entitled to protection of the Reserrve Bank as lender of last resort if all compliance is in place.
If you don't comply, the Reserve Bank can:

Seize and manage the company with an appointed Commissioner.

Seize all assets, revoke by authority unclear transactions happened up to 2 years before (as some of the good asset stripping in Bridgecorp case), guarantee the depositors and "pilot" all the crisis up to a safe take over by a stronger entity.

And a lot of other options that have one single scope in mind. Guarantee the savings of the depositors, first, above and regardless of ANY other interest.All in the exclusive power of the Reserve Bank.
That is the price to have a lender of last resort. To be a clean well managed and respected Institution operating under precise ratios established in the banking law.

Doesn't this sound more safe and secure than any rating by the rating agencies ?