Ratings

With virtually all finance company business lines coming under greater competitive pressure, defining strategic initiatives and backing each with the necessary resources has become imperative for success. On the consumer side of the business, the ability to compete in various product offerings often is dictated by operational efficiencies and economies of scale. For example, marketing and processing costs are causing the credit card business to become concentrated toward the low-cost producers. Similarly, the traditional distribution backbone of the consumer finance industry—the store-front loan office—is being challenged by more efficient telemarketing and direct mail avenues. Companies that choose to maintain large branch networks will be under pressure to increase productivity.

On the commercial finance side, the focus on core businesses versus the "shotgun" approach is evidenced by the growing popularity of target marketing and the development of niches. As part of this strategy, commercial finance companies establish a strong presence and expertise in a particular industry or type of equipment. This enables the niche player to provide more specialized service.

These commercial finance companies generally are not the lowest-cost providers of financing or leasing services. In most instances, however, price is a secondary consideration for the customer; high-quality, expert service is of paramount concern. Industry and equipment expertise at a leasing company also provides a more successful and effective remarketing capability, resulting in higher realized equipment values relative to booked residuals. These residuals give the lessor the option of pricing the product more aggressively relative to competitors, or providing a higher level of service to increase or, at least, maintain market share.

But there are negative aspects of a niche strategy, the most obvious being the risk of concentration. Reliance on a particular sector or specialized equipment type can become an albatross if there is a downturn in that industry or declining values on the equipment. This is apparent among major lenders in energy or agriculture, which have experienced serious setbacks. Another negative aspect occurs when competitors, observing the favorable returns and volume generated by other niche operators, rush to invade those sectors, often with unrealistic pricing.

Asset quality is the primary consideration when assessing credit risk at a finance company—as with banks. However, given the higher margins and commensurately greater risk typically associated with finance company assets, it is impossible to separate asset quality from the all-in cost profitability of a particular asset or the capital needed to prudently support it. Understanding these crucial relationships begins with analysis of the finance company's receivables.

Standard & Poor's analyzes finance company portfolios on both a qualitative and quantitative basis. The qualitative analysis encompasses the composition of the portfolio with respect to type, mix, and diversity of receivables and evaluation of growth prospects. Standard & Poor's assesses underwriting standards, as well as basic characteristics of receivables such as consumer versus commercial and secured versus unsecured loans. The size of the portfolio on both an absolute and relative basis is another important consideration. There is less risk associated with a portfolio that is diversified in terms of geography, customer base, and type of product, manufacturer, or supplier. Management's philosophy regarding concentrations is reviewed, along with its growth plans. Finally, the basic characteristics of the portfolio are examined over periods of both growth and contraction.

As part of its quantitative analysis, Standard & Poor's measures receivables in terms of delinquencies, charge-offs, and recoveries. Since finance companies have broad latitude in defining these categories, explanations of policies with respect to payment definition, charge-offs, extensions, and rewritten business are essential to make comparisons meaningful. In determining the adequacy of reserves for losses, Standard & Poor's looks at reserve coverage levels and trends relative to peer groups for certain portfolio characteristics. The methodology for establishing reserves is assessed. Reserve sufficiency is evaluated in light of underwriting standards, the portfolio mix, and economic environment.

Leverage, or the amount of debt in relation to the capital base of equity plus reserves, is a crucial factor in the rating process. When analyzing leverage, Standard & Poor's uses a building-block approach to arrive at a composite asset risk profile for any one particular finance company. Using industrywide data, relative risk of various subportfolios is derived. In turn, leveragability of each subportfolio is set forth within each specific rating category. It is important to note that the leverage guidelines are generic starting points. Actual firm-specific guidelines depend on all the interrelated factors—qualitative and quantitative—that compose each issuer's operating track record.

In reviewing the asset-liability function, Standard & Poor's evaluates the level, trend, and stability of the net interest margin and the flexibility inherent in the pricing structure. As with any financial institution, the means by which management measures the impact of interest rate changes on profit, their tolerance for acceptable risk levels, and the techniques employed to moderate these risks are discussed and reviewed.

Historically, finance companies have borrowed exclusively from the commercial paper and term debt markets, often with laddered term debt structure determined to match anticipated asset maturities. Changes in debt structure often were limited to shifts in the mix of short- and long-term debt as interest rate cycles changed. The growth of the intermediate-term debt market has provided additional flexibility.

The diversification of fund sources is beneficial as it adds liquidity and funding stability. Unlike banks and savings and loans, finance companies do not carry investment portfolios and, therefore, lack this dimension of asset management. Standard & Poor's reviews the debt structure maturities relative to both asset maturities and expected cash flows to judge the liquidity inherent in the balance sheet. A firm's borrowing capacity, such as bank lines or the potential to establish securitized or collateralized borrowing arrangements, also is discussed.

Increasing competition and tax law changes are pressuring yields downward in business traditionally developed by finance companies. As such, profitability is becoming more dependent on operating efficiencies, portfolio quality, and margin protection. Profitability is viewed on an historical basis and relative to peers. Growth rates, yields, spreads, and returns are reviewed. ROA, the primary ratio, should be viewed within the context of risk and reward. This is particularly important as competitive pressures on yields continue to force many finance companies to expand their lending activities into higher-risk segments. Finance companies previously lending to Fortune 1,000 businesses, for example, have had to expand their markets to Fortune 2,000 businesses. Therefore, operating efficiency is becoming a more crucial measure of a firm's ability to generate profits in an environment of intense price pressure. Standard & Poor's expects operating efficiency increasingly to become a key variable in the analysis of profitability.Ownership/Affiliation

By drawing on its parent company's strength through a support agreement, a noncaptive finance subsidiary can raise its rating above that attainable on its own, often as high as its parent's. As a result, the subsidiary gains a competitive advantage over other independent finance companies, which operate within more stringent guidelines to maintain their credit quality.

There are no boilerplate support agreements to ensure a high rating. But the most common agreements contain minimum net worth maintenance and income and fixed charge coverage maintenance requirements. These usually have covenants that set a maximum debt-to-equity ratio or a minimum current assets-to-current liabilities (liquidity) ratio. Also included is an assurance that the parent will maintain 100% ownership of the subsidiary.

Support agreements can be closed or open ended. Closed-end agreements have a maximum dollar contribution or a termination date. Open-end agreements place no limitation on dollar contribution and, therefore, are viewed more favorably. However, Standard & Poor's recognizes that a parent may be legally restricted from providing open-dollar investments in its subsidiaries.

Noncaptive finance subsidiaries that lack formal support agreements but have a history of parental support also may receive a higher rating than their standalone performance would indicate.