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Since fall 2008, when the turmoil in the U.S. financial sector began in earnest, Standard & Poor's Ratings Services has seen significant deterioration in credit quality among specialty finance companies. These companies are nonbank lenders that make loans to a wide array of businesses—often in the middle market—and to consumers for specific uses, such as car purchases or education.
In fourth quarter 2008 and first quarter 2009, there were 25 downgrades among the 39 companies we rate. In the same six months, there were no upgrades.
Because specialty finance companies often differ from commercial banks in how they obtain funding, the assets they hold, and the lines of business on which they focus, we believe the recession has placed them under stresses that call into question the viability of their business model, perhaps even more so than banks. In this economy, can these companies continue operating the same way? And after the crisis has passed and economic activity has increased, will they still be around to prosper?
To answer those questions we must consider the centrality of financing. In the near term, we expect the specialty finance companies that we rate to be increasingly susceptible to the vagaries of the credit markets. Unlike banks, which are funded in large part by deposits, these companies mostly float public debt, get funding from institutional lenders, or rely on the securitization markets.
When those options narrow, as they recently have, we're more likely to see diminished margins, less lending, weakened liquidity, lower ratings, and more defaults. Those concerns have recently led three of the largest finance companies—CIT Group (CIT), American Express (AXP), and GMAC—to seek bank holding company status, which in the long term will enable them to expand their depository capabilities and makes them eligible for certain government assistance.
We must also look at the type of assets in company portfolios to get a better understanding of their futures. Three companies that we rate have recently been in selective default: GMAC, Residential Capital (twice), and Thornburg Mortgage. All three are closely tied to the real estate or auto markets, which this recession has hit especially hard.
To have a successful business model, we think finance companies must ultimately make some tough choices, especially about their loan portfolios and their funding options. For example, they will have to decide whether, in the long run, they can continue selling or securitizing loans, or if they would be better off holding them on the balance sheet. They must decide if it's wise to continue in a specific line of business, diversify, or exit the field altogether. And they will have to examine their funding options closely to make sure that they will have the liquidity and capital they need no matter the economic environment.
Although a handful of finance companies still carry investment-grade ratings, our outlook on the sector remains negative given the weak economic outlook, seized-up credit markets, and deterioration in asset quality—a peril for those financing consumer credit, real estate, autos, student loans, and commercial loans. Even previously highly rated companies such as General Electric Capital (GE), which we downgraded to AA+ from AAA in March 2009, are feeling the effects of the recession.
We think it's likely that the quality of most asset classes will get worse as the recession wears on, resulting in continued charge-offs. Deterioration in asset quality will also mean that finance companies will have to continue to keep a close eye on whether they have enough capital to absorb these potential losses.
But even when the economy revives, the critical question for these institutions will be the state of the credit markets. Finance companies will remain highly exposed to credit-market dislocations, and that vulnerability will, most likely, heavily influence their prospects.
When funding becomes difficult and business conditions deteriorate, finance companies must reexamine how they operate. Unlike large, complex banks, they generally don't have trading, investment banking, or other diversifying income-producing operations. And most can't collect deposits from individual and business customers. Typically, finance companies have been confined to relatively narrow business niches such as student loans or real estate, and have had to devise ways to make those niches profitable.
Funding, specifically the asset-backed securities markets, had been accessible until the recent crisis. However, this part of the equation has changed and, in all probability, changed permanently. To see how finance companies may adapt, one must understand the funding sources finance companies can tap.
Specialty finance-company funding generally comes from four sources, each of which carries its own risk. Obtaining this financing depends not only on the accessibility of the credit markets but on a company's own credit quality and investor appetite for risk:
Unsecured debt. Access to this funding depends highly on investor perception of credit risk. Currently, as a result of the economic downturn, that perception is not favorable.
Secured borrowings. The availability and acceptability of a company's collateral determines the accessibility of this type of funding. These funds are also subject to margin calls, which at times have been very costly.
Commercial paper. This short-term funding is usually restricted to companies with short-term ratings of A-2 or better, thus making it unavailable to financially weaker companies.
Securitized products. This funding is available to the degree to which investors are willing to buy, and is limited by the asset classes in which they are interested. Much of the turmoil in today's credit markets, however, stems from confusion about the value of many of these products, and as a result investor appetite has been limited.
Finally, some funding is now available through government assistance programs. Finance companies that have been approved by the Federal Reserve to become bank holding companies can apply to access the Temporary Liquidity Guarantee Program, under which the Federal Deposit Insurance Corp. guarantees payment of certain senior unsecured debt. In addition, the Term Asset-Backed Securities Loan Facility can facilitate the issuance of asset-backed securities by certain finance companies. Neither of these government programs, which only date from October and November 2008, respectively, has been in operation long enough to determine its ultimate impact on the industry.
Of necessity, these companies are seeking ways to weather the immediate crisis before they can develop long-term strategies. We think that leaves them with some other options, which differ in attractiveness and viability.
Pursue mergers and acquisitions. Industries under pressure sometimes resort to mergers to cut costs, build market share, and shore up their finances. But with the onset of the recession, and the continuing tightness in the credit markets, merger-and-acquisition activity has generally declined. We see few, if any, buyers for low-rated companies in distress.
Convert to bank holding-company status. Finance companies that can convert to bank holding companies can improve their liquidity by collecting deposits and taking advantage of government aid programs. Although three large companies with national footprints—CIT Group, American Express, and GMAC—have already done so, it's unclear how many others can or will follow.
Originate to hold. Finance companies may have to reevaluate their strategies of selling off loans, either in full or in securitized form, when credit-market uncertainties remain high. Securitized loans are hardly in high demand at present. The flip side is companies would need sufficient capital to support their portfolios. Growth would likely be suppressed as a result of the same capital need.
Cede loans to others. Some might ultimately cede business to other lenders, such as commercial banks, which have somewhat easier access to funding than do the specialty finance companies. Such a move could remove some funding pressures from the finance companies, but at the cost of losing business that might never return.
Conserve cash. We see a heightened concern now about liquidity. Cash is king and in the near term, finance companies will seek to conserve as much of it as they can. Because portfolio quality will likely weaken, more capital will be necessary.
Violate selected covenants and hope for waivers. An ongoing danger to credit quality will be increased concern about covenant violations. The recession has, in many instances, diminished cash flow and caused some finance companies to violate or come close to violating covenants of their borrowings. For companies where this is the case, it is a rating consideration. As risk appetites diminish among lenders, we would expect covenants to become more restrictive, further pressuring the finance-company sector.
Pursue orderly liquidations. Ultimately, we believe some companies will find it too difficult to continue profitable operations, and consider terminating their current operations. Since 1995, a number of finance companies have gone out of business completely. Others may be thinking about liquidation. New federal initiatives, if implemented, could also end private-sector involvement in the student loan business, ending a once-lucrative business for the lenders that participated in it.
Ultimately, we can see no easy way for finance companies to weather the recession. Whatever tactics they choose to maintain liquidity, ensure adequate capital, and maintain their creditworthiness will mean hard choices that could affect not only present business profiles, but postrecession ones as well.
McNatt is a senior features editor for Standard & Poor's Securities Services .
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