What Credit Rating for a Financial Institution that ran out of Cash Last Week?

UPDATED (23 Nov): Off all the threats to the future of South Canterbury Finance (outlined here and here), perhaps the most important threat is one of the most difficult to control: the opinions of others. And it is here that some people's opinions are more important than others.


At the top of the hierarchy come the ratings agencies: their opinions are so important that even the government takes notice. The government has made the unwise and unnecessary (see here, and here) decision to guarantee the deposits of financial institutions back in October 2008 until October 2010, and then extended the scheme until the end of 2011, but made the extension reliant on the financial institution getting a BB or better credit rating from a recognised credit rating agency.

Now depositors have come to get rather nervous about the significant chance of making deep losses on their funds in the finance company sector, after getting wise and learning the hard way with dozens of finance companies failing in the 2-3 years leading up to Oct 2008. So, raising funds from debentures without a government guarantee is now very difficult (and expensive), especially with almost all the banks and building societies and credit unions and finance companies offering guaranteed debentures.

So, to conclude the story, South Canterbury Finance is one of the most, if not the most, dependent on getting the extension, and therefore on maintaining a BB credit rating or better. This can be seen from its immediate and emotional welcome it gave the announcement about the extension, and from the fact that it is presently prioritising getting cash in the door ahead of building up a wall of liabilities that fall due on the expiry of the current scheme (i.e. exploiting the guarantee as much as possible).

Since SCF is so absolutely reliant on the guarantee and its extension to get and keep cash coming in the door, it is likewise absolutely reliant on keeping its credit rating at BB or higher. So, what is the outlook for its rating?

According to its prospectus:

The Company currently has a credit rating from Standard & Poor’s. As at the date of this Prospectus, the Company’s long term credit rating was BB+/Watch Negative, implying a one-in-two chance that the credit rating could be downgraded within three months. ... In the Company’s view, if the credit rating is downgraded further, this may further impact the Company’s ability to raise funds from local and offshore institutions and investors under its offers of Stock and Deposits with the result that the Company may not be able to raise the funds it requires to fund its business activities and meet its payment obligations in respect of the Stock and Deposits offered under this Prospectus. A further downgrade may also impact on the Company’s eligibility to participate in the extended Deposit Guarantee Scheme (for further details refer to pages 18 to 19 of this Prospectus) and its ability to operate as a non-bank deposit taker under the Government’s proposed new regulatory regime for non-bank deposit takers.

(Note: the prospectus outlines the credit rating and discusses the issues involved on pages 15 and 16 in a good level of detail, most of which is omitted above.)

Thus the company recognises, correctly, that its future outlook rests very heavily on its rating. This brings us to the question of what it should be rated.

Here is a list of the ratings issued by S&P and what they mean (source: here):

Long-term issuer credit ratings
AAA: An obligor rated 'AAA' has extremely strong capacity to meet its financial commitments. 'AAA' is the highest issuer credit rating assigned by Standard & Poor's.
AA: An obligor rated 'AA' has very strong capacity to meet its financial commitments. It differs from the highest-rated obligors only to a small degree.
A: An obligor rated 'A' has strong capacity to meet its financial commitments but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligors in higher-rated categories.
BBB: An obligor rated 'BBB' has adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

BB, B, CCC, and CC: Obligors rated 'BB', 'B', 'CCC', and 'CC' are regarded as having significant speculative characteristics. 'BB' indicates the least degree of speculation and 'CC' the highest. While such obligors will likely have some quality and protective characteristics, these may be outweighed by large uncertainties or major exposures to adverse conditions.

BB: An obligor rated 'BB' is less vulnerable in the near term than other lower-rated obligors. However, it faces major ongoing uncertainties and exposure to adverse business, financial, or economic conditions, which could lead to the obligor's inadequate capacity to meet its financial commitments.
B: An obligor rated 'B' is more vulnerable than the obligors rated 'BB', but the obligor currently has the capacity to meet its financial commitments. Adverse business, financial, or economic conditions will likely impair the obligor's capacity or willingness to meet its financial commitments.
CCC: An obligor rated 'CCC' is currently vulnerable, and is dependent upon favorable business, financial, and economic conditions to meet its financial commitments.
CC: An obligor rated 'CC' is currently highly vulnerable.
R: An obligor rated 'R' is under regulatory supervision owing to its financial condition. During the pendency of the regulatory supervision, the regulators may have the power to favor one class of obligations over others or pay some obligations and not others. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of regulatory supervision on specific issues or classes of obligations.
SD and D: An obligor rated 'SD' (selective default) or 'D' has failed to pay one or more of its financial obligations (rated or unrated) when it came due. A 'D' rating is assigned when Standard & Poor's believes that the default will be a general default and that the obligor will fail to pay all or substantially all of its obligations as they come due.
An 'SD' rating is assigned when Standard & Poor's believes that the obligor has selectively defaulted on a specific issue or class of obligations but it will continue to meet its payment obligations on other issues or classes of obligations in a timely manner. A selective default includes the completion of a distressed exchange offer, whereby one or more financial obligation is either repurchased for an amount of cash or replaced by other instruments having a total value that is less than par. Please see Standard & Poor's issue credit ratings for a more detailed description of the effects of a default on specific issues or classes of obligations.

In addition to the verbal definitions, there are probabilities of default that may be associated with each rating. The historical mean corporate 1 year default rates for the ratings 1981-2008 (same source) are:
AA: 0.02%
AA-: 0.03%
A+: 0.05%
A: 0.06%
A-: 0.08%
BBB+:0.16%
BBB: 0.28%
BBB-:0.28%
BB+: 0.68%
BB: 0.89%
BB-:1.53%
B+: 2.44%
B: 7.28%
B-: 9.97%
CCC to C: 22.67%

The probability of default of SCF, as perceived by the market, can be estimated from the price of the market traded instruments issued by SCF. These are: preferred shares, and listed bonds.

The preferred shares last traded at 50c in the dollar (23/11/09). These instruments were issued at $1, and, in the event that SCF failed, would be likely to be wiped out (i.e. total loss). If the company recapitalises and recovers full confidence of the market, the shares would be likely to trade at or near $1 again. Thus, it would appear from the price of these instruments that the probability of default of SCF is as high as 50%, well in excess of the historical 1 year default experience of the lowest rated entities of 22.67%. (note: it is also likely that any default or recovery occur within the next 1 year).

The listed bonds are more difficult to assess. If the company fails before the guarantee expires, the bonds are covered by the guarantee, and investors will not lose any promised payments. If the company qualifies for the extension, and then fails within the extension period, again the investors have no loss. The only situation they can lose money is if the company survives the end of the guarantee and then fails before the maturity of the bonds. If the company failed and the bonds were not covered by the guarantee, it is likely that the holders would lose about 50% of what they were owed (this 'loss given default' assumption is merely imported from the figures banks are required to use for exposures to other banks, and does not purport to assess the likely recoveries in this particular case, but I feel that it is not a bad estimate for this case). The longest dated bonds, maturing Dec 2012, have a yield on the last trade of 19.5% p.a. (23/11/09), compared with bonds maturing in just under 1 year and just before the guarantee expires of 7.5% p.a.. The difference between them is 12% p.a. Although it is tricky to assign probabilities, it would appear that this would be consistent with about a one quarter probability of failure within the guarantee (no loss), one quarter probability of failure without the guarantee (50% loss), and a one half probability of not failing (no loss). Again this is appears to put SCF into worse than the CCC to C range, and no matter how I play around with the modelling of this one, discount rates and so on, I can't make it even close to consistent with B-. Note: in the last few weeks SCF securities have significantly improved, so I have adjusted the numbers but the conclusion remains that SCF is priced as a very low rated issuer.

This leaves us to consider the more factual and analytical approach used to fit companies to ratings descriptions cited earlier. This also brings us back to the title of this post: What Credit Rating for a Financial Institution that ran out of Cash Last Week? Although you could match this with the SD rating, since it represented a selective default for the US note holders, you could also argue that since they have remedied the selective default, they don't deserve that anymore. (And SD would be a very bad rating to have.)

Does SCF currently have the capacity to meet financial commitments? Given it ran out of cash last week, and faces a lot of difficulties and hurdles, this is debatable.

Is it more (i) vulnerable to adverse conditions (i.e. will default if external conditions are bad), or (ii) 'dependent upon favorable business, financial, and economic conditions to meet its financial commitments' (i.e. will default unless external conditions are good)? (i) represents the BB and B ratings, and (ii) represents the CCC to C ratings.

It appears to me that a substantial amount of their funding of dairy farm conversions and property developments can fairly be described as 'speculative' -- for the projects to succeed required asset values to go up, as opposed to the projects budgeting to generate positive operating cash flow after paying finance costs. (The same of course goes for their direct holdings of dairy farms, which are making big income losses, as well as capital losses at the moment.) In this sense, they really are in danger of default unless those investments pay off through favourable conditions.

It is more helpful, however, to consider the comments of Standard & Poors itself when it placed SCF on Watch Negative:

We are concerned about the increasing pressure on liquidity; still-weak asset quality; and governance issues including, but not limited to, related party exposures. Since its ratings downgrade, SCF has ceased allotting securities under its existing debenture prospectus (unrated by Standard & Poor’s), provided market guidance of an increase in its unaudited net after tax loss for fiscal 2009 to NZ$69 million, and had two of its four directors resign with pending replacements. These negative developments have occurred against a backdrop of a major restructuring and recapitalization initiative that SCF has said it will announce in coming weeks.
Ameliorating our concerns, to an extent, are that SCF’s principal shareholder has undertaken to underwrite NZ$25 million of SCF’s problem loans, noting that the underwrite agreement is untested and that SCF plans to register a new prospectus with audited financials for fiscal 2009 on or soon after Sept. 30, 2009. Offsetting the benefit of the shareholder underwrite, however, is that about $31 million of dividends will be repatriated to the shareholder from fiscal-2009 profit despite the company experiencing an unaudited net after-tax loss of $69 million.
The CreditWatch action reflects our view that with no debenture prospectus in the public domain, SCF’s funding flexibility and liquidity are undermined at the ‘BB+’ rating at least in the short-term. Technically, SCF does not have access to the new and reinvested debenture funds, which reside in a trust account. This increases pressure on SCF’s funding and liquidity.
Furthermore, SCF’s liquidity levels are modest after the company’s decision to shift its holdings of liquid assets from cash to higher-risk and higher-yield investments and in related party entities of uncertain credit standing. Additionally, U.S. private placement (facility is unrated by Standard & Poor’s) investors continue to review their funding support for SCF, which, if resulted in a requirement to repay the facility, has the potential to significantly exacerbate liquidity concerns.
Liquidity pressures would moderate if SCF were able to permanently maintain a liquidity level that would support its ability to repay the U.S. private-placement issue while at the same time maintaining sufficient excess cash to support daily operations, which are potentially volatile given the confluence of negative developments impacting SCF. Maintenance of sufficient liquidity also depends on continued debenture investor and banker confidence in the company, noting that the unaudited after-tax loss for fiscal 2009 has caused SCF to be in technical breach of the interest-cover covenant on its unused banking facilities. This creates uncertainty in terms of SCF’s ability to access banking facilities at a time when liquidity is paramount. The ratings may be lowered by one or more notches if SCF’s debenture prospectus were to remain out of the market on or soon after Sept. 30, 2009, or if the confluence of actual or potential liquidity concerns caused Standard & Poor’s to consider SCF’s financial strength no longer congruent with our ‘BB’ category rating. In particular, and independent of our other liquidity concerns, should rating triggers embedded in the U.S. private-placement facility result in funding providers withdrawing support for SCF, this would likely significantly exacerbate liquidity concerns and could cause a downward revision of our rating on SCF by multiple rating notches— potentially into the ‘B’ category rating range. Should U.S. private placement investors continue their funding support for SCF, downward rating pressure would likely be less severe.
The ratings equally may be lowered by one or more notches if the company were to announce any new adverse developments that could affect its 2009 financial statements. This is in the context of SCF’s most recent market guidance that they have revised losses upwards because of higher provisions—almost two months after its accounting year ended. The ‘BB+’ rating reflects our view that SCF’s primary shareholder, Mr. Allan Hubbard, will remain committed to providing timely support to SCF if required. If SCF’s credit profile deteriorates, evidence of the shareholder’s support would be required to keep the rating at ‘BB+’. If support is not forthcoming, or is of a type and nature not sufficient to afford debenture- and bondholders’
confidence, it is likely the rating will be immediately lowered.
CreditWatch
The ratings could be taken off CreditWatch Negative within a matter of weeks if:

• SCF is able to demonstrate its ability to reaccess the debenture-investor market with no longterm negative effects impacting its debenture profile;
• Its audit and subsequent fiscal-2009 audited financial statements reveal no new material adverse findings concerning its financial strength;
• It is able to source two or more highly qualified independent directors to assist in addressing weaknesses in SCF’s financial strength profile and guide the company through a major restructure and recapitalization; and
• More generally, Standard & Poor’s gains greater confidence that the support of private placement investors and bankers as well as debenture investors will be retained.
  

The CreditWatch could be longer-lasting if Standard & Poor’s has uncertainties regarding SCF’s restructure and recapitalization plans, after they are announced. In our view, any recapitalization plans favoring debt rather than equity, or involving a complex reorganization of business units within the Southbury Group (unrated) that may weaken the interests of SCF debenture or other liability holders is likely to have a negative effect on our rating. Even so, Standard & Poor’s expects the CreditWatch will be resolved in no more than 90 days.
Even if SCF is able to satisfactorily address negative rating pressures, at best—after the CreditWatch is resolved—it is likely the rating could be affirmed with a negative outlook reflecting near-term pressures on SCF’s financial profile, and medium-term uncertainty concerning restructuring and recapitalization initiatives. Negative rating pressures are not likely to ease until SCF can address liquidity, asset quality, and governance concerns.

This allows for a list of concerns to be made, and SCF's progress on addressing the concerns to be assessed:

1. Liquidity. This appears to be a major concern of S&P, and SCF fails this, running out of cash in late October, losing its banking facility, and with the US note holders pushing SCF to the limit to get their fund back as fast as SCF can pay them. I call this an outright fail.
   
2. Weak asset quality. This continues to be a concern, with recent reports of SCF putting borrowers into receiverships and continued difficult conditions for the borrower's industries (see South Canterbury Finance: New Losses Reported). The only realistic way for SCF to address this kind of problem is to do a 'balance sheet clean up' by disposing of impaired and excessively risky assets, which would require strong capital and big write downs -- SCF hasn't done this because it is not in a position to do so, and also appears unwilling to take aggressive corrective action on that front. I'll call this an outright fail, also.
   
3. Related party exposures. SCF has announced that it plans to gradually reduce these, but it also plans to gradually reduce the loan book, so this cannot be anything other than an outright fail.
4. No debenture prospectus. S&P wanted to see this resolved by 30 September, but it was not until 20 October that the prospectus was registered. Registration alone does not resolve S&P's concerns about debenture investor support, which, without the government guarantee, is not likely to be adequate to meet SCF's funding needs. I'll call this a possible pass.
   
5. US noteholder support. SCF fails on this concern, as mentioned above, the US note holders are getting them funds out as fast as SCF can pay them. I'll call this an outright fail. (The only reason they didn't call a default and demand their funds immediately is because it would have pushed SCF into receivership and resulted in losses for the US noteholders, so SCF was basically playing a game of chicken with them in negotiating to pay them as fast as they can get the cash in the door).
   
6. Banker confidence in SCF. This is an outright fail, with the bank putting its facility, which ranked equally with the debentureholders, on stopdraw and cancelling the facility, and SCF replacing it with a non-bank facility that ranked ahead of debentureholders.
7. New adverse developments in the year to 30 June 2009. This did not occur, so it is a pass.
8. Evidence of support from Mr Hubbard. This one is difficult to assess, however, from past experience, Mr Hubbard has provided support largely other than in the form of cash, in fact his support has been in cases cash-flow negative for SCF, where SCF has part paid cash for assets from related parties, the balance being credited as capital. These facts make me suspect that Mr Hubbard does not have the ability to a) refinance credit facilities granted by SCF to his interests, b) does not have the ability to borrow any further amounts against his other businesses, and c) is not willing to sell assets to raise cash at currently obtainable prices (he does not want to realise his losses). Furthermore, SCF is up to its limits for holdings of equities and other assets Mr Hubbard may wish to tender in lieu of cash should SCF need further support. So, I would suggest S&P may find a lack of evidence of capacity and willingness to provide much further support to SCF. But I won't call this one, I'll leave it as 'unclear'.
   
9. Appointment of independent directors. This has been done so this is a pass.
   

So, of the 9 points S&P seem to be measuring, SCF appears to fail 5, pass or possibly pass 3 and have one unclear result. If S&P comes to the same results as I have, I it appears that SCF is heading for a multiple notch downgrade into a deep junk territory, somewhere between BB- and B-. This would spell the end of SCF by Oct 2010 when the existing crown deposit guarantee ends, and the new one starts without SCF in its ranks.

SCF itself warns:

In the Company’s view, Standard & Poor’s considered that the United States private placement investors were continuing to review their funding support for the Company, and that if they decided to require repayment of the facility, that would, potentially, significantly exacerbate liquidity concerns and cause a downward revision of the Company’s rating by multiple notches, potentially into the ‘B’ rating category.

Despite the new prior charge secured funding line (all used up), this is exactly what has happened: they did require repayment of the facility, and SCF did run out of cash as a result. So, given this, who would be surprised if they get downgraded to B (or worse) within the next month or so?