Credit Analysis of Financial Institutions

For example, suppose a US$10 million stock portfolio is invested in a number of stocks
with a weighted average beta of 1.2. If the investment manager believes that the one percentile
worst-case scenario is that the stock market index could fall 40% in one year, then based
on the CAPM the annual VaR of the portfolio may be specified as US$4.8 million:

VARP = – BPRMVP
= –1.2 (–40%) (US$10,000,000)
= US$4,800,000

The ‘worst-case’ scenario that is used to stress test a portfolio can be determined in one of
two ways:

⦁⦁ choose various values for one or more of the risk factors that impact the portfolio as was
done in the above example; or
⦁⦁ choose catastrophic events that have occurred in the past (the stock market crash of 1987,
the Great Depression, the hyperinflation in Germany in the 1920s, and so forth).

The strengths of this method of determining the VaR of an investment are:

⦁⦁ it is simple and can be done with little cost; and

⦁⦁ markets can perform in abnormal ways. This method can explicitly assume such
abnormalities because it is not necessarily wedded to past variances, correlations, normality,
and so forth.

The weakness of the method is that it does not generate a reliable estimate of the portfolio’s
VaR for four reasons.

1 If the portfolio’s mix of stocks changes over time, the VaR will change over time as
well, even if the ‘worst-case’ scenario remains unchanged. VARs change; they cannot be
determined once and assumed to remain fixed over time.
2 If the ‘worst-case’ scenario is changed from time to time, for different measurement periods,
the same portfolio mix will yield different VARs. Again, VARs change over time; it is
not a ‘set it and forget it’ concept.
3 The ‘worst-case’ scenario is determined subjectively. This means that there is likely to be a
bias in the selection of the worst-case scenario caused by the experience of the investment
manager. It is likely that in October 1929 investors would not have envisioned a worst-case
scenario being as bad as the market crash turned out to be. If the ‘worst-case’ scenario
is not chosen to be as bad as the worst case really is, the VaR will be underestimated.
4 There is no good way of defining the probability that the worst case will occur.

Problems associated with VaR analysis

VaR analysis is useful in assessing risks. However, it should not be used as the sole factor
in assessing risk as JPMorgan Chase found out with its early-2012 trading losses (see Box

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3.2). Users of VaR should be cognisant of the limitations and pitfalls of this risk assessment
technique as well as the large amount of subjectivity that it requires; they should not be
too enamoured by the mathematical and statistical concepts that it employs. Some of the
problems associated with VaR analysis are as follows.

⦁⦁ VaR only looks at the absolute monetary risk in a portfolio; it does not measure the
trade-off between risk and return. Thus, it is not a useful tool for ranking various investment
alternatives which different expected returns and risks. VaR might be able to show that
one portfolio is more risky than another, but if that portfolio also has a higher expected
return, VaR alone cannot determine which portfolio is superior; it can really only rank
investments whose expected returns are equal.
⦁⦁ There is no one, single methodology that can be employed to compute VaR. The
methodology requires the investment manager to make a number of assumptions regarding
what models are most appropriate for valuing assets (that is, CAPM, APT, fundamental
factor models, Black-Scholes, linear models, non-linear models), the values of the variables
that comprise the models, the stochastic process that describes the price path that asset
prices can take (that is, normal, lognormal, skewed, and so forth), and the percentile that
defines the ‘worst-case’ (alpha). Different VaR methodologies and assumptions produce
vastly different risk assessments for the same portfolio. Furthermore, there is no clear
pattern that enables the analyst to determine whether or not one methodology is superior
for particular situations. This means that the analysis is highly subjective and depends on
the skill and intuition of the technical people who are performing the statistical analysis.
Investment managers who often are not trained well in the statistical skills required by the
method are, therefore, left dependent on conclusions reached by risk managers that are
based on assumptions that may turn out to be unrealistic. Garbage in, garbage out, again.
⦁⦁ The VaR analysis is a statistical one that is most useful in capturing quantifiable market
risks; it is less able to assess the risks associated with events such as a major political
upheaval, regulatory risk, personnel risk, and so forth.
⦁⦁ The VaR produced by the analysis depends on the percentile that is chosen to represent
the ‘worst-case’ (negative) return. If the percentile chosen were to be 1%, the VaR could
be vastly different than if it is chosen to be 5%.
⦁⦁ VaR is most useful for measuring short-term risks (one day to two weeks) under normal
market conditions. Investment results could actually become a lot worse than indicated by
even a 1% VaR. For example, if one examines a normal curve, even though the return
associated with the 1% area under the left tail may be significantly negative, there are
still infinitely more negative possible returns to the left of that point on the distribution.
As was indicated previously, VaR analysis often does not pick up the truly disastrous
scenarios that are often the causes of most problems. It is at such times that correlations
among assets increase, putting more value at risk than at times when the correlations are
at low, normal levels, liquidity breaks down, pricing information disappears, and hedging
strategies fail.
⦁⦁ The analysis requires actively traded assets whose price histories are known. Many financial
institutions invest in private placement loans, swaps, insurance contracts, and so forth that
are not actively traded. While these assets can be appraised using some model, appraised

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values are notorious for being wrong and much less volatile than market prices. Therefore,
whenever appraised values based on models are used in VaR analysis, the risks are likely
to be understated.

Because of these problems associated with VaR analysis, research is being directed toward
finding market-based alternatives to risk assessment. One approach that appears promising
is to base risk measures on how much it would cost to obtain insurance against a risk.

Applications of VaR for the investment manager

While VaR is primarily a risk-management tool, the concept may be adapted to help other
aspects of the portfolio management process.

Using VaR to help construct more efficient portfolios

VaR offers a framework for measuring and analysing risk that can be applied in a consistent
manner to a variety of assets. Thus, it provides a way of comparing the risk of an equity
portfolio to the risk of a bond portfolio or an international portfolio. It provides invest-
ment managers with a better insight into the nature and the types of risk that they may
be taking. Consequently, it can help minimise negative surprises. By measuring the VaR of
a portfolio if it contains an asset and performing the measure again assuming the asset is
not included in the portfolio, it is possible to isolate the risk of the asset in the portfolio
context. In addition, VaR enables investment managers to assess the individual risk factors
that are impacting on their portfolios, the amount of exposure the portfolios have to each
risk factor, and the risk factors that are most critical. This is important information for
managers to have, because it can indicate how hedges should be performed, and it alerts
the manager about which risk factors need to be given the most attention.
The VaR methodology permits the investment manager to evaluate various asset allo-
cations to determine the most efficient portfolios. The variance/covariance VaR method is
particularly useful in that it can alert a manager to those few fundamental risk factors that
are crucial to obtaining an optimal return/risk ratio in a way that might not be so obvious
when using the conventional asset-oriented MTP analysis.
VaR can also be used to set an overall risk limit on a portfolio, that is, portfolios can
be constructed that maximise some return/risk ratio in the conventional sense but that still
adhere to an additional constraint that the VaR over some period shall not exceed some
predetermined limit. This VaR constraint can be stated in absolute dollars, as a percentage
of the value of the overall portfolio, or the value of the portfolio’s VaR relative to the VaR
of some benchmark portfolio.
One problem with using VaR in this way is that the quantitative nature of the analysis
may be misunderstood by clients and/or senior management. Highly quantified results tend to
mesmerise clients, who may place more faith in VaR than is warranted. It should always be
communicated to non-technical management personnel and to clients that the VaR-measured
risks tend to depend on past market conditions holding up in the future. Furthermore, while
there may be a low probability that losses will be greater than VaR suggests, greater losses

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are possible. Garbage in, garbage out is a characteristic of all quantitative methodologies;
VaR is no exception to this rule.

Use of VaR in performance measurement

The standard measure of risk-adjusted performance is the Sharpe ratio:

RP – RF
S=
sP

It is tempting to substitute VaR for the standard deviation of portfolio returns as the measure
of risk used to calculate the risk-adjusted return of the portfolio. However, there are two
drawbacks to this.

1 Sharpe ratios tend to be directly comparable among a group of investment managers

because there is one consistent way of computing the standard deviation of portfolios.
However, there are many different ways of computing VaR. Without a standard way of
computing VaR, it would be impossible to directly compare a ratio such as

RP – RF
X=
VARP

This is especially true if the VaR of the portfolios being compared are produced by
different companies.
2 VaR is a measure of the risk of the current portfolio, whereas the standard deviation of
a portfolio is a measure of the portfolio’s volatility in the past. Thus, VaR is an ex ante
risk measure, while a portfolio’s standard deviation is an ex post measure of volatility.
In order for VaR to be a substitute for standard deviation, it would have to be measured
frequently and averaged over some past period of time. Furthermore, because VaR is an
ex ante measure of risk, it is inherently an estimate of future risk, if the current portfolio
remains intact. Being a forward-looking measure of risk, it is difficult to see how VaR
can measure the performance of a portfolio in the past. By its very nature, performance
measurement is backward rather than forward-looking. Therefore, it would appear that the
standard deviation, which is a backward-looking risk measure, would be a better param-
eter to be used in assessing the risk-adjusted (past) performance of a portfolio manager.

While VaR has some serious drawbacks as the risk measure that can be used to measure
the risk-adjusted performance of a portfolio manager, it might be used to determine the
relative risk that a manager is taking relative to his or her peers. However, for VaR to be
used in this way:

⦁⦁ the VaR calculations for the manager and the peer group must be computed using the
same methodologies and assumptions. In other words, a standardised VaR calculation
must be used. However, even if competitors could agree to some standardised method for

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measuring their VARs, it is not clear that the same method can, or should, be applied to
different kinds of assets for reasons already discussed; and
⦁⦁ the composition of the portfolios of all the members of the peer group must be known.
It is unlikely, however, that competitors would disclose their portfolios to each other.
Consequently, one manager would measure his or her VaR using whatever assumptions
and methods that appear appropriate for his or her portfolio, while another manager
would be free to measure his or her VaR using whatever assumptions and method that
that manager believes to be appropriate. The result would be VaR measures computed
(perhaps) in very different ways, thereby making them incomparable.

If it is unlikely that VaR can be used to compare the risks of individual members of a peer
group, it might be possible for an investment manager to measure the VaR of his or her
portfolio for a given time horizon with the VaR of an indexed or benchmark portfolio. For
example, portfolio managers who already have their performance measured relative to the
S&P 500 index could have the risk of their portfolio compared with the risk of the S&P
500 index by computing the VaR of the portfolio and the VaR of the S&P 500 index using
the same method. These two measures of risk would be comparable, as long as the invest-
ment style of the manager was similar to the assumed ‘style’ of the index (that is, large
capitalisation stocks, well diversified, and weighted by market capitalisation). If comparable,
the VaR of the manager could be divided by the VaR of the index to obtain a measure of
relative risk, similar to a beta for the portfolio. This ‘VaR beta’ could be used to determine
a ratio similar to the Sharpe ratio, that is, a measure of the portfolio’s return in excess of
the risk-free rate per unit of ‘VaR beta’ risk taken.

Summary: VaR versus standard deviation as a measure of risk

The traditional measure of asset and portfolio risk is the standard deviation of the prob-
ability distribution of possible portfolio returns. While it has its drawbacks, the standard
deviation is a good measure of risk because it is simple to calculate, is easy to implement,
and is a comparable measure that can be used to compare the risks of two or more port-
folios. However, as mentioned previously, the standard deviation essentially measures past
risk, that is, it measures how volatile an asset or portfolio has been in the past. While this
might be appropriate for the purposes of performance measurement, when one is performing
an accounting of how a portfolio manager has performed in the past, the standard deviation
of a portfolio’s return is not a forward-looking measure of risk (unless one assumes that the
future will be the same as the past). VaR, on the other hand, is a forward-looking measure
of risk, particularly if Monte Carlo simulation or any method that uses valuation models is
employed. Thus, VaR provides more meaningful information about expected (future) portfolio
risk. But, as experienced recently with extreme market volatility and large trading losses, the
result is only as good as the data inputs.

1
Basel Committee on Banking Supervision, Bank for International Settlements, ‘Fundamental review of the trading
book – consultative document’, May 2012.

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Chapter 4

Finance companies

Finance company analysis

The financial crisis near the end of the 2000s left even the largest finance companies severely
constrained by a scarcity of funding sources. Although funding is currently easier to obtain,
and to some extent cheaper, the credit analyst should be attentive to each finance company’s
ability to fund its growth in loans to customers.
The analytical framework that follows for assessing finance companies highlights the
particularities of the finance industry. There are two main segments within this industry:
commercial finance and consumer finance. Special factors include:

⦁⦁ the lack of uniform regulatory oversight of the industry worldwide creates a wider variation
in reporting standards by finance companies than other regulated financial institutions;
⦁⦁ among the critical areas of difference in reporting standards are delinquencies, earnings
recognition, and lease residual valuation. Information on some of these areas only can be
obtained directly from the finance companies;
⦁⦁ moreover, the financial crisis of 2008 brought about heightened regulatory oversight, most
notably in the US with the Dodd-Frank Wall Street Reform Act of 2010 which specifically
set up a new agency to supervise and coordinate consumer protection legislation;1 and
⦁⦁ in short, the analyst is confronted by non-uniform reporting standards which renders
international comparison of finance companies somewhat challenging.

Without access to low-interest funding sources, such as deposits or similar funds available to
banks or insurance companies, finance companies rely more on capital markets and institu-
tional sources for financing. Since these are confidence-sensitive sources, finance companies
generally show relatively lower leverage and more prudent liquidity-management policies.
Accordingly, the capital structure and access to a variety of funding sources are likely to be
the prominent factors affecting the credit-risk profile of a finance company.
Commercial finance companies provide alternative non-bank financing to commercial
entities based on the value of the financed asset(s). This requires most commercial finance
companies to specialise in specific types of asset classes to provide expertise in service. This
also leads to a relatively lower degree of price sensitivity but greater cyclical effects for the
commercial finance industry than for others such as banking.
Unlike the commercial finance segment, the consumer finance industry is highly frag-
mented, with many companies offering essentially the same commoditised products to
consumers. As a result, and unlike the commercial finance companies, price sensitivity is
relatively higher. Furthermore, the competitive factors favouring the successful companies are
size of operation/market position and technological advancement in new account sourcing,

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application processing, and customer servicing. Acquisitions and investments in technology

are recent strategic operating trends in the industry.
The consumer finance companies deal with a large volume of small receivables, with
more standardised product features (repayment schedules, interest rate indexing standards),
and other features pursuant to consumer protection guidelines as may exist in many coun-
tries. Thus, the asset receivables and corresponding liabilities funding these assets primarily
are processed, managed, funded and sold in bulk, typically through the securitisation market
where it exists. Accordingly, the liability structure of consumer finance companies may reflect
more securitisation than that of commercial financial companies.
Commercial finance companies are subject to the cyclical forces specific to their respec-
tive product niches, from new competitive factors drawn into a niche by high margins, to
the larger economic conditions affecting borrowers’ capital spending or receivable turnover.
Consumer finance companies, on the other hand, are subject to consumer credit cycles, which
in turn are tied to economic conditions. It is, therefore, essential for the analyst to understand
the specific product line(s) that a finance company specialises in, and to conduct an analysis
over at least a full cycle of credit expansion through contraction (see Boxes 4.1 and 4.2).
Key company-specific issues are assess for finance entities, including the competitive envi-
ronment, management and strategy, funding and liquidity, financial and operating leverage,
capital adequacy, earnings sources and stability, and risk management.
Taken together, these factors result in a determination as to whether the given finance
activities add to or potentially detract from the financial strength and flexibility of the specific
finance company under study.

Box 4.1
Leasing
Leasing is a major activity by most commercial finance companies around the world. Although
there are financial institutions that deal exclusively in lease financing (see Chapter 5), finance
companies have benefited from the tremendous growth in the preference by companies,
and now individuals, to have the use of an asset without outright ownership. Automobile
leasing by individuals is a striking example of the acceptance of lease financing as opposed
to conventional bank loan financing.
The ownership of assets is not as important as the ability to use them in a profitable
manner. Leasing provides the same ability to use capital assets as outright ownership. Leasing
is similar to borrowing, and it provides the same type of financial leverage.
Historically, land and buildings were the types of assets most often leased, but today
it is possible to lease almost any kind of fixed asset. The lessor is the owner of the leased
property (in this case the finance company) and receives such tax benefits of ownership as
depreciation write-offs and, where they apply, investment tax credits. The lessee buys the
right to use the property by making lease payments to the lessor.

Continued

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 Finance companies

There are three common types of leasing arrangements.

1 Under a sale and leaseback, a company owning an asset sells the property and simulta-
neously leases it back for a specified period at specific terms. This arrangement provides
an alternative to simply borrowing against the property on a mortgage loan basis.
2 Operating, or service, leases provide for both financing and maintenance. Ordinarily, these
leases call for the lessor to maintain and service the leased equipment, and the cost of
maintenance is built into the lease payments. These leases are frequently not fully amor-
tised; that is, the payments required under the lease contract are not sufficient to recover
the full cost of the equipment.
3 Financial, or capital, leases are fully amortised; however, they do not provide for maintenance
and are not cancelable. They differ from a sales-leaseback only in that new equipment is
purchased by the lessor from a manufacturer rather than from the user-lessee.

Leasing is often referred to as off-balance sheet financing because neither the leased assets nor
the lease liabilities appear on the company’s (lessee’s) balance sheet. A company with exten-
sive lease arrangements would have both its assets and liabilities understated in comparison
with a company which borrowed to purchase the assets. The company that leases would
show a lower debt ratio. International accounting standards, following the US example, require
companies to capitalise certain financial leases and thus to restate their balance sheets to
report leased assets as fixed assets and the present value of future lease payments as debt.
Any prospective lease must be evaluated by both the lessee and the lessor. The lessee
must determine whether leasing an asset is less costly than buying it, and the lessor must
decide whether or not the lease will provide a reasonable rate of return.

US GAAP and IFRS proposal

Both US GAAP and IFRS boards are expected to finalise new lease accounting in 2012. What
is new for the credit analyst is the obligation by lessees to capitalise all leases (bringing
them on-balance sheet), except contracts for a maximum of 12 months which can remain
off-balance sheet.

Modaraba companies
Primarily found in Islamic finance, a modaraba company is a fund in which a partner(s)
provides funds and another partner(s) provides the skill and efforts in some trade, business
and industry permitted by Islamic law. The provider of the funds becomes the beneficial asset
owner which makes the company’s activities a close match to conventional leasing activities
found in non-Islam finance.

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Credit Analysis of Financial Institutions

Box 4.2
Factoring
Factoring is the process of purchasing accounts receivable from corporations (often at a
discount) usually with no recourse to the seller should the receivables go bad. It is a form of
short-term financing from the non-recourse sale of accounts receivable to a third party, known
as the factor. The factor assumes the full risk of collection, including credit losses. There are
two basic types of factoring: (i) discount factoring, in which the factor pays a discounted price
for the receivables prior to the maturity date; and (ii) maturity factoring, where the factor pays
the client the purchase price of the factored accounts at maturity.
Factoring can be on a notification, or a non-notification basis. The typical method in
accounts receivable factoring is non-notification financing, in which the client’s debtors are
not notified and the client remits payments to the factor as they are received. As mentioned,
factoring is normally done without recourse, meaning that the factor does the credit evaluation
before credit is extended and assumes the risk of non-payment. Whereas factoring carried out
on a recourse basis is called accounts receivable or debtor financing. The differences between
accounts receivable financing and factoring are summarised below.

Accounts receivable financing versus factoring

Accounts receivable
financing Factoring

Credit function performed by Borrower Bank/finance company

Collection function performed by Borrower Bank/finance company
Proceeds allowed via Loan Purchase
Cash reserve required No Yes
Account ownership Borrower Bank/finance company
Debtor notification No Yes
Cost Lower Higher

Types of activity
Unlike retail banks and savings institutions, finance companies are not dependent on deposits
as a source of funds and have had far greater flexibility in choosing the types of loans and
investments to be acquired. In addition, finance companies have been relatively free to inno-
vate and to seek out various types of loan and other investment portfolios.
In some cases, finance companies have paved the way in developing profitable lending
innovations and in establishing the relative safety of many types of lending operations.
Examples of lending activities of this type include direct consumer lending and the develop-
ment of retail time sales lending activities. However, once the industry developed successful
lending programs such as the financing of retail automobile time sales contracts, it experienced

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severe competitive pressures from other financial institutions such as banks. In many cases,
other lending institutions entered and eventually overtook certain traditional finance company
lending markets once the finance companies had established the relative safety and profit-
ability of those markets.
Nevertheless, a review and discussion of the major categories of consumer and business
receivables held by finance companies is useful to the understanding of consumer financial
services and finance company operations (Exhibit 4.1).

Exhibit 4.1
Major types of loans and advances extended by finance companies

Customer receivables Business receivables

Retail passenger automobile paper Wholesale paper
Mobile homes – Automobiles
Revolving consumer instalment credit – Other consumer goods
Personal cash loans – Equipment and industrial
Second mortgage loans Retail paper
Other consumer instalment loans – Commercial vehicles
– Business, industrial, and farm equipment
Lease paper
– Automobile paper
– Business, industrial, and farm equipment
Other business credit
– Loans on commercial accounts receivable
– Factored accounts receivable

Source: Author’s own

Retail passenger automobile paper

Retail passenger automobile paper refers to receivables generated through the sale of new or
used automobiles under terms of a conditional sale (or similar) contract. Receivables such
as these are originated through automobile dealers and are subsequently sold or assigned to
a financial institution. A typical procedure is as follows.

1 The automobile dealer negotiates the selling price and trade-in allowance for a new or
used car with the purchaser.
2 Following agreement on these cash sales terms, the dealer may offer to finance the auto-
mobile with the customer to pay monthly payments over time. Given an extended payment
arrangement, the sale would be termed a ‘time sale’ as opposed to a ‘cash sale’.

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Credit Analysis of Financial Institutions

3 The customer at this point may choose to: (i) pay the cash price from their own funds;
(ii) arrange financing directly through a lender of their choice; or (iii) accept the dealer’s
offer to finance the automobile.
4 If the dealer’s financing offer is accepted, the customer will complete a credit application.
5 Information concerning the transaction – for example, price and description of the auto-
mobile, down payment, requested contract maturity and credit information – is telephoned
or otherwise transmitted to the lending institution.
6 On the basis of information submitted, the lending institution will (verbally) approve, reject,
or suggest modification of contract terms (required down payment, maturity, co-signer,
and so on).
7 If the contract is approved by the lending institution, the sale is consummated. The contract
is endorsed by the dealer and sold or assigned to the lender, who in turn issues the dealer
a cheque (or money transfer) for the principal balance financed.

Certain features of the time-sales contract and its subsequent sale or assignment to the lender
are noteworthy and influence the potential risk and profitability of the transaction.
First, the nature of the dealer’s endorsement influences the level of risk inherent in the
transaction. The contract may be endorsed ‘without recourse’, with ‘full recourse’, or in
some other way so as to partially protect the lender in the event of customer default. If the
endorsement is ‘without recourse’, the dealer has no responsibility in the event of customer
default and any collection or collateral repossession expense must be borne by the lender.
If a ‘full recourse’ endorsement is used, credit risk for the lender is substantially reduced
or eliminated, and the dealer is committed to absorb the losses in the event of customer
default. Under terms of a ‘partial repurchase’ or other limited recourse agreement, the dealer
is obligated to absorb losses up to some fixed sum or is perhaps obligated only until a given
number of payments have been paid by the customer.
Hence, the nature of contract endorsement is important from a managerial aspect.
Obviously, if all else is equal, the financial institution would prefer to have all contracts
endorsed on a full recourse basis. Even in the case of full recourse endorsements, however,
the financial institution faces certain risks. Full recourse endorsement by financially unsound
dealerships may provide little protection to the lender. Even in the case of financially sound
dealerships, risk exposure may be substantial if the institution relies excessively on dealer
endorsements and relaxes credit standards or regularly accepts contracts with cash advance-
ments in excess of the ‘quick’ or wholesale value of the collateral. The extent to which
recourse endorsements may be required by financial institutions varies over time as well as
with the nature of the collateral and the geographic location. In larger urban areas where
lenders compete vigorously in the retail automobile paper market, a lender who wishes to
participate in this market may have little choice other than to purchase the paper on a non-
recourse basis, particularly with regard to contracts secured by new automobiles. On the
other hand, dealers in rural areas tend to have fewer financing outlets and must frequently
endorse time sales contracts on a recourse basis.

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 Finance companies

Mobile home/trailer financing

Although not a common practice in many markets, mobile homes and trailers may be financed
through mortgage instruments in ways that are similar to the financing of residential real
estate. More commonly, however, is for the financing arrangements to resemble to that for
automobiles, that is, through use of conditional sales type contracts.
Several aspects of the financing of mobile homes and trailers by finance companies differ
from those of new automobile financing. Principal differences include higher finance rates
and larger average amounts financed. Maturities for mobile home and trailer loans have
averaged about 13 years in recent times compared with about four and a half years for new
cars and about 45 months for used cars.
Like automobile financing, conditional sales contracts for mobile homes and trailers may
be subject to full or partial dealer recourse arrangements. Dealer participation in finance
charges is found in many markets.
Finance company managers should exercise considerable care in establishing relation-
ships with individual dealers, evaluating credit applications, and selecting terms for two
basic reasons:

⦁⦁ mobile homes and trailers (unlike residential property) have traditionally been subject to
rapid depreciation; and
⦁⦁ in the event of customer default, the sale of mobile homes and trailers are more complex
and may result in greater potential loss.

Revolving consumer instalment credit

During the 1970s and 1980s, revolving credit was the fastest growing single segment of the
consumer credit market in the developed world. Revolving credit is accessed mainly with
credit cards and is extended by banks, retailers, and gasoline (petrol) companies, among
others. The major finance companies offer credit card products as well and, in particular,
personal cash loans.
Personal or direct cash loans constitute a large portion of finance company receivables.
Unlike other types of loan receivables such as those secured by automobiles or mobile homes
and trailers, direct cash loans are typically small in size. They may be secured by household
goods and other miscellaneous assets, or may be unsecured. Finance rates for personal loans
in excess of 20% are common even where inflation rates are in single digits. Although these
finance rates have traditionally been high compared with the rates associated with automobile
loans, for example, finance company personal loans tend to be relatively small in size and
are costly to administer. Also, because of competitive pressures, increasing funds costs, and
state-mandated interest rate ceilings, the relative profitability of personal loans by finance
companies has fallen over the years.
A particular problem area for finance company management with regard to small personal
loans is the fact that finance companies must compete for funds in money and capital markets
where interest rates are not regulated.

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Credit Analysis of Financial Institutions

From a management perspective, the future attractiveness of the market for relatively
small personal loans is questionable at best. Indeed, the proliferation of bank credit cards that
carry cash advance privileges has likely contributed to a declining need for small personal
cash loans, at least in the developed markets.

Second-mortgage loans
A second-mortgage loan (sometimes called a ‘home equity loan’) is one secured by real
estate but where the real estate collateral is subject to some prior lien. The prior lienholder
has priority in the event of foreclosure and liquidation of the real estate collateral. Home
equity loans are an attractive alternative to high rate personal cash loans and where real
estate prices have risen substantially.
From a managerial perspective, home equity loans provide substantial flexibility. Such
loans when properly made and documented would be expected to carry little risk. Exceptions
may occur, of course. A prolonged recession in the local economy, for example, could
impact negatively on employment opportunities and depress property values. Maximum
second-mortgage loan rates and collection procedures are generally specified in the laws of
various countries.
Typically though, such loans may be made at fixed interest rates or at floating rates
tied to some index, such as the base lending rate. They may call for principal and interest
payments over some fixed interval or they may call for interest-only payments for some speci-
fied time period, for example, 10 years, with the principal due at maturity. Some lending
institutions make home equity loans with the customer borrowing the entire equity in their
home (the difference between the property’s value and the first mortgage, if there is one).
Most, however, require that some minimum equity, say, 20% remain in the home after
home equity loan proceeds are disbursed. Many home equity lending programs provide the
customer with a line of credit where the customer has the option of drawing against the
line until the maximum credit is reached.

Example
TransHome Financial is a finance company subsidiary of a large bank holding company.
The subsidiary specialises in second-mortgage loans where the customer’s home serves as
loan collateral. The company’s lending policy provides that home equity loan customers may
borrow up to 85% of the ‘quick’ sale value of the real estate collateral, less the existing first-
mortgage loan. The quick value is assumed to be 95% of appraised value. As an example,
suppose a customer’s property appraises at US$80,000 and the existing first-mortgage is
US$40,000. The quick value would be US$80,000 ¥ 0.95 = US$76,000, and the customer
could borrow US$76,000 ¥ 0.85 – US$40,000 = US$24,600. Of course, TransHome requires
that the customer have an acceptable prior credit payment history and that the company
verify statements contained on the loan application such as income and length of employment.
In addition to the above-mentioned lending policy which concerns loan collateral and
customer character, the company has developed certain guidelines as a measure of loan
repayment capacity and which are applied to home equity loan applications. On average, for

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example, TransHome has found that the typical consumer home equity loan applicant has
62% gross salary income remaining after taxes, social security, and certain other required
expenditures which are common for most households. On average then, this 62% of gross
salary is available to meet mortgage, auto, debt payments, and other expenses typically
incurred by consumers. TransHome’s statistical analysis of its customer base has also shown
that consumer applicants require a minimum of US$150 per month per household member
in remaining income after mortgage and other debt obligations so as to cover items such as
food, personal, other miscellaneous expenses.
Mike and Rachel DuPont have applied for a home equity loan with TransHome. Their
combined salaries total US$5,000 per month and they have two dependent children. Over
the years, their home has appreciated in value and was recently appraised at US$175,000.
The DuPonts’ existing first-mortgage payment is US$1,150 per month and their current
first-mortgage balance is US$100,000. Auto loan payments total US$250 each month, and
minimum monthly payments on bank credit card and other revolving credit arrangements
amount to US$200 per month. The DuPonts would like a fixed-rate home equity loan with
monthly payments spanning 15 years in the maximum amount possible for educational
purposes. The current annual percentage rate (APR) quoted by TransHome is 6%. Collateral
and repayment capacity analysis is summarised in Exhibit 4.2.

Exhibit 4.2
Home equity loan analysis

Maximum property collateral value US$141,313

(US$175,000 x 0.95 x 0.85)
Maximum home equity loan US$41,313
(US$141,312.50 – US$100,000)
Required monthly payment US$349
(15 year, 6%, US$41,313 loan)
Maximum capacity payment US$900
US$5,000 x 0.62 – US$1,150 – US$450 – (US$150 x 4)

Source: Author’s own

The maximum property loan value is 85% of the quick sale value or US$141,313. After
deducting the existing mortgage loan of US$100,000 the maximum home equity loan is,
therefore, US$41,313. The required mortgage loan repayment of US$349 is determined by
using a present value annuity factor table (US$41,313/83.322) or a financial calculator. It is
the payment associated with a present value of US$41,313, with payment occurring monthly
over fifteen years and where the annual interest rate is 6%. The highest home equity monthly
payment that the DuPonts could afford, given TransHome’s policy guidelines, is US$900.
Consequently, the DuPonts qualify for the home equity loan and TransHome Financial
would approve the loan.

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Evaluating consumer credit applications

The analysis of consumer credit applications is similar to business credit evaluations in some
respects and different in others. In both cases, the five Cs of credit (character, capacity,
capital, conditions, and collateral) must be considered.
Character refers to the reputation of the potential borrower in terms of their perceived
reliability in repaying the loan. Finance companies, as do other consumer lenders, contact
prior or existing creditors, the names of which are typically disclosed by the applicant in
the credit application. These credit references are asked to burnish information concerning
the applicant’s record with them. In addition to direct contact with creditors, the lender
might communicate by telephone or electronically with the local credit information agency
or lenders’ information exchange, where a file containing the applicant’s credit repayment
history is maintained. This file frequently contains employment history and residence infor-
mation in addition to an evaluation of loans and other credit repayment history. In most
developed countries today, the credit evaluation agency will have accumulated this credit
information as the result of the applicant’s prior requests for credit and subsequent inquiries
from other lenders.
Capacity refers to the applicant’s potential ability to repay the loan from current income
or existing resources. The credit manager must evaluate the applicant’s ability to repay the
loan, in view of the borrower’s existing financial obligations and income limitations.
Capital is an indication of the degree of commitment by a borrower. For consumer
loans, it represents the down payment that the borrower can provide; for example, for the
purchase of an automobile, the borrower might put 10% of his or her own funds towards
the purchase price with the remaining 90% financed by a loan. For business entities, the
analyst looks to the company’s leverage. The higher the leverage (debt to equity), the less
owners appear committed to financing their own business, seeking outside sources instead.
Conditions refer to the fact that individual and business borrowers are not operating
in a vacuum but are influenced by external factors such as the jobs market, inflation, and
general economic conditions.
Collateral represents the security to which the lender may turn in the event of loan
default. Collateral repossession in order to liquidate a loan is viewed as a last resort by
finance company lenders.

Credit scoring
Finance companies are great users of credit scoring techniques for deciphering borrower
creditworthiness, especially for consumer loans. In essence, credit scoring is the evaluation
of a business or consumer loan application by the use of a statistical model. A commonly
used methodology is multiple discriminant analysis (MDA), which is widely used by research
companies. Credit scoring estimates the repayment probability based on the information
in the credit application and a credit bureau report. The two main types of credit scoring
include application scoring for new accounts and behaviour scoring for accounts that have
activated and are carrying balances.

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Application point scoring systems assign points to various credit criteria, such as income,
number of existing credit accounts, time at residence, and so on. An applicant who scores
enough points to pass the cut off score (usually selected by the lender) is considered cred-
itworthy. Another application scoring technique, decision tree scoring, also calculates the
repayment probability, though it does not assign points to credit criteria. Behaviour scoring
models, on the other hand, measure a borrower’s ability to repay debt, giving an early
warning about potentially delinquent accounts. Banks and other credit grantors, such as
finance companies, use credit scoring to increase profitability of a loan portfolio, reduce the
number of unprofitable accounts, and systematically process a large number of applications
at lower cost.

Importance of receivables
In finance companies, the receivables, which have an absolute currency value, are the prin-
cipal asset. Therefore, finance companies are considered more liquid than most other types
of businesses. This should make them easier to evaluate as credit risks, and a lender should
be able to determine risk exposure more accurately.
In an ideal world, banks like to see their customers completely free from bank debt for
a certain period each year. One reason is to ensure that current borrowings do not perform
the functions of equity. For finance companies, however, banks merely look to a rollover or
rotation of debt and do not require a total clean-up (repayment). Such a clean-up, first of
all, would not be possible because a finance company would have to liquidate a substantial
portion of its receivables to do this. Second, considering the usually high degree of liquidity
which exists, such an action is not necessary nor would it serve any economically useful
purpose.
Finance companies hold two major types of receivables: business and consumer receiv-
ables as discussed below.

Business receivables – wholesale paper

Wholesale paper refers to trust2 agreements or similar legal documents which arise during
the course of inventory financing. To induce sellers of ‘big-ticket items’ such as automobiles,
heavy duty trucks, farm equipment, and other items which are frequently sold on time sales
contracts to offer these contracts to a particular lender, a finance company (or other lender)
may offer to finance the wholesale value of the dealer’s inventory. Such financing – also
referred to as ‘floor planning’– is typically provided as an accommodation to the dealer.
Suppose that a franchise for a new car or truck dealership is awarded to a businessperson
in the local area. The dealership will be expected to develop a certain amount of retail
time sales finance paper, and it is likely that a number of financial institutions will have an
interest in purchasing this retail paper. The dealer, on the other hand, will likely carry large
inventories of the product, and these inventories must generally be financed. Typically, one
or more lenders would approach the dealer and offer to finance the inventory in exchange
for the opportunity to finance the retail contracts. The lender may agree to establish a floor
plan line of credit whereby the dealer maintains inventory financed by the lender up to the

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amount of the established credit line. Once the floor plan arrangement has been negotiated,
the manufacturer will be authorised to draft on or bill the lender for subsequent shipments
of inventory items to the dealer. As the dealer sells the floor planned units, payment is
expected to be remitted for sold items promptly to the lender.
Because of competitive conditions, wholesale dealer paper is typically financed at break-
even interest rates, with the interest rate tied to the prime or base lending rate plus, say, 1%.
Because of the small interest rate spread and the inventory monitoring cost, floor planning
in and of itself is not a particularly profitable operation. Wholesale financing accommoda-
tions are generally provided to the dealer with the expectation that the dealer will offer
‘compensating retail paper’ to the lender. On the basis of experience, the lender knows
that a considerable portion of big-ticket items such as new cars, trucks, and so on, are
financed. Since the dealer is in a position to control the placement of a certain proportion
of the retail time sales paper, the dealer is expected to offer this paper to the lender who
has provided the floor plan accommodation. Of course, if the floor planning lender rejects
a particular financing transaction, the dealer may well seek to sell the time sales contract
to some other lender.
Floor planning can involve considerable risk to the lender, and considerable management
attention should be given to its control. Even relatively small dealers may require floor plan
lines in significant amounts. For large dealerships, the value of floor planned inventory can
be in excess of the dealer’s equity investment.
The risk of potential loss through wholesale financing is perhaps greatest during depressed
economic periods when dealer sales volume may be low. Indeed, examples abound where
particular dealers, faced with high fixed costs and working capital requirements, have defaulted
on inventory trust agreements. The default may go undetected by the lender for a considerable
period of time because the dealer simply defers payment on sold inventory items and enters into
a floor plan ‘float’. The float may at first involve a delay in payment of sold inventory items
for a few days with the proceeds from current sales used to pay the lender for floor planned
units sold in the prior time period. If depressed economic conditions continue, the float may
build gradually over time, reaching the point where the lender suffers considerable losses.
Although the nature of wholesale financing is such that the risk of a dealer being ‘out
of trust’ is always present, controls can be instituted to minimise potential losses. Frequent,
unannounced floor plan inventory checks by the lender are a critical component of such
controls. Insistence on the timely preparation and submission of dealer financial statements,
followed by analysis of such statements on an ongoing basis, is another means of control.
Finally, management should systematically evaluate the quantity and profitability of the
compensating retail paper purchased from individual dealers. If the quantity and quality of
the retail paper is insufficient to justify the investment and risk associated with the dealers’
wholesale receivables, and if this condition cannot be improved, the floor plan line should
be terminated.

Business receivables – retail

In addition to time sales contracts secured by consumer durables, finance companies also
purchase time sales contracts secured by commercial assets such as heavy-duty trucks, farm

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equipment, and other industrial products. Frequently, commercial time sales contracts secured
by assets such as these are purchased from dealers in ways that are similar to the procedure
described for retail passenger automobile paper.
On the one hand, the financing of commercial equipment carries with it the prospect for
enhanced profitability. The amount financed under individual contracts tends to be substantial
when compared with consumer durables such as automobiles or household products. On the
other hand, collateral such as heavy-duty trucks and other types of industrial products is
difficult to dispose of in the event of default. Because of the large balances financed and the
lack of a readily available secondary market for most types of industrial equipment, there
exists considerable risk of loss on individual times sales contracts.
Large finance companies with branches located throughout the country have competitive
advantages in the financing of certain types of industrial equipment. First, it is possible to
diversify portfolio holdings of this paper on a geographic basis, reducing the impact of credit
losses caused by regional economic slowdowns. Second, banks are reluctant to purchase
contracts secured commercial vehicles financed for ‘owner-operators’, because the equipment
may be far away and physically difficult to repossess in the event of default. From a prac-
tical point of view, the lender must have the capability to enforce terms of the time sales
contract, and as a last resort, to take physical possession of the collateral when it appears
that the purchaser is unable or unwilling to meet their contractual obligations. Large finance
companies with a national network of branches have this capability.

Consumer receivables
Finance companies that cater to consumers generally have an extensive branch network to
reach those individuals, although Internet marketing and access to customers is challenging
the need for physical branches. Consumer receivables of a large finance company might
include the following:

⦁⦁ first mortgage loans;

⦁⦁ home equity loans;
⦁⦁ automobile loans;
⦁⦁ credit card receivables (including brand name, co-branded, affinity, and private label cards);
⦁⦁ student loans; and
⦁⦁ unsecured loans.

Default risk, of course, is greater among consumer receivables than business receivables which
means that the analyst should pay very close attention to loss ratios and reserve policies.

Types of debt
Finance companies use various classes of debt to finance their operations. The classes may
carry different names depending on the country and the financing options available. Senior
subordinated, junior subordinated, and capital notes, for example, have become part of a
finance company’s capital base in many developed markets. Generally, combined subordinated

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and capital debt do not exceed shareholders’ equity. Senior debt, which consists of long-
term debt, bank borrowings, and commercial paper, is added to this base to complete the
borrowing side of the balance sheet. The mix of this senior debt is dependent on the liquidity
of the finance company’s portfolio. The term of the debt should approximate the term of
the receivables.
The company that has five-year receivables should have more long-term debt than the
company whose receivables turn over every 60 days. A portion of every finance company’s
portfolio matures within one year, and this should be supported by short-term debt. Therefore,
every finance company needs bank lines, if just to cover commercial paper (or similar short-
term debt) outstandings and seasonal fluctuations.

Liability management
Finance companies are typically more leveraged than banks. Lacking deposit funds as a
major source of debt, finance companies must bid for funds in a competitive marketplace.
With the cost of funds being a major part of their total costs, finance companies depend
on skilful liability management to minimise interest expense and achieve a satisfactory level
of profitability.
However, minimising the cost of funds is only one consideration in liability manage-
ment. A second major factor is interest rate risk. The average finance company loan has a
maturity of several years. A shorter liability maturity exposes the finance company to the
risk of having to refinance maturing liabilities at interest rates higher than the net rates being
earned on loans. In a period of falling interest rates, liability maturities longer than loan
maturities can leave the institution in the position of being committed to high-cost sources
of funds while competition is driving down the rates charged on loans. Thus interest rate
risk is a major consideration in liability management.
Finally, availability of funds is a major consideration for finance company management.
Money and capital markets are quite impersonal; they make no commitment to provide funds.

Bank loans
Finance companies have traditionally relied on retail banks and other financial institutions
as key sources of funds and frequently borrowed against revolving credit lines. Such reli-
ance is particularly true for the smaller finance companies which lack access to national or
international credit markets.
Bank borrowing is often accomplished by drawing down on a pre-negotiated revolving
line of credit. This source of borrowing has the important advantage of ensuring avail-
ability. However, interest rates on such lines are frequently tied to the prime or base rate;
the cost of bank credit varies from the prime rate for the soundest companies to three or
four percentage points over prime for smaller companies. Thus the interest rate may vary,
and the benefit of ensured availability is offset by exposure to interest rate risk. In some
markets, credit arrangements of this type require a compensating balance and/or a fee of,
say, 0.5% to 1.0% of the credit line. Charges or balances are frequently required regardless

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of whether or not the line is used. Therefore, a price is paid for availability which makes
bank credit a sometimes expensive source of funds.

Money market funds

The commercial paper market component of the money market is a major source of funds for
large finance companies–particularly in the US and to a growing extent in the euro-commercial
paper market. A principal reason for the popularity of commercial paper among finance
companies is the fact that interest rates for the paper are consistently below a bank’s prime
or base rate. It should be noted, however, that the rate of interest applicable to commercial
paper does not represent the entire cost. Smaller issuers generally place their paper through
dealers who charge a fee. Larger companies place commercial paper directly with inves-
tors; thus large companies are faced with the expense associated with the maintenance of
commercial paper managers and staff.
In addition to selling costs, commercial paper issuers face the cost of maintaining backup,
unused lines of bank credit, as expected by the investment community. Under normal circum-
stances, maturing commercial paper is redeemed through issuance of new paper. However,
there may exist market conditions under which the issuer would find it difficult to ‘roll over’
maturing paper and would be forced to rely on bank credit to redeem it. Since these lines of
credit are typically paid for with non-interest compensating balances or by direct payment
of fees, part of the cost savings of commercial paper is offset by the cost of ensuring avail-
ability of funds through banks.

Bonds and other long-term debt financing

Like industrial companies, finance companies rely on bonds and other long-term debt as
sources of financing. Long-term sources have the advantages of ensuring the availability of
funds at a fixed interest rate for a specific period of time. Thus they provide a solution to
the availability problem.
One major disadvantage of long-term debt is that it has historically been more expensive
than short-term funds. However, this disadvantage is somewhat offset by the fact that most
bonds are callable; they can be retired early, at the option of the issuer, typically with the
payment of a call premium. If interest rates rise after a bond has been issued, the issuer
continues to pay interest at the prior low rate. On the other hand, if market interest rates
fall, the bonds can be called and replaced with a new, lower interest rate issue. Thus the
higher average cost of long-term debt is at least partially offset by inclusion of the call
feature or by other features that provide flexibility in adjusting to changes in interest rates.

Equity capital
Finance companies differ from most other financial institutions in that regulators are less
conservative when it comes to imposing minimum equity levels. In fact, some countries do
not impose minimum equity requirements at all. Thus, finance companies operating in those

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markets are free to choose a debt-to-equity ratio in keeping with market forces and their
own objectives.
Finance companies face two major considerations when choosing a financial structure.
First, like any company, they recognise that the value of the owner’s investment is affected by
financial leverage. A higher debt-to-equity ratio can lead to a higher return on equity if funds
are invested in assets which earn a rate of return greater than the cost of debt. However,
beyond some point, further increases in debt increase the risk of insolvency, which drives
up both the interest rate on debt and the required return on equity. Finance companies with
less risky and better diversified asset portfolios can use proportionately less equity.
In addition to the threat of insolvency, finance companies must consider the effect of
their equity ratios on their access to the debt markets. Finance companies that allow equity
cushion to fall too low may find it difficult or impossible to market commercial paper.
Similarly, a low equity ratio may impair the company’s ability to acquire other short or
long-term funds at reasonable cost.

Ratio analysis
Ratio analysis is a very meaningful technique to determine whether further study of a
particular company is needed. Finance companies, by their nature, lend themselves easily
to statistical analysis. The major body of ratios can be broken-down into four areas: asset
quality, liquidity, leverage, and earnings.

Preliminary indicators
Average owned receivables represent the average amount of finance and lease receivables
carried on-balance sheet.
Average managed receivables include both currently owned receivables and previously
securitised receivables sold with limited recourse that continue to be managed (or serviced)
by the company. For those companies that utilise securitisation as a funding source, managed
receivables serve as the asset base against which to measure total finance income.
Average managed assets consist of securitised receivables added to total owned assets.
Managed assets include income-producing assets other than finance receivables, such as
investment securities and insurance operations for many large finance companies. As such,
managed assets serve as a good benchmark against which to analyse total revenues, operating
expenses, and net income. Lines 23, 25, and 29 in Exhibit 4.3, respectively, calculate these
three income statement items as a percentage of average managed assets.

Asset quality ratios

The most important asset category for a finance company is its receivables. Therefore, quality
is a function of collection experience and the creditworthiness of the underlying borrower-
customer. Quality is also a function of how quickly those receivables can be converted to
cash but the maturity profile of receivables is seldom made available in many reporting
environments.

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The size and quality of the receivables portfolio is also affected by the renewed trend, post-
financial crisis, towards securitisation, especially by the larger finance companies. Securitisation
is the packaging or conversion of existing receivables and their sale in the form of market-
able securities to investors. Many of the large finance companies report these securitised
receivables as part of their overall receivables, in which case they are labelled ‘managed’
receivables or assets. Managed receivables may appear on or off-balance sheet depending
on the sponsor’s (finance company’s) degree of servicing and retaining an interest in those
receivables (see Boxes 4.3 and 4.4).

Leverage ratios
Finance companies, as a group, represent one of the most highly leverage industries around.
The nature of finance company operations is essentially debt-based and given the relatively light
regulatory environment in most countries, capital requirements are also small in comparison
to deposit-taking institutions.
Line 16 in Exhibit 4.3 calculates a traditional debt to equity ratio. Line 17 calculates
the same ratio with managed debt, which equals on-balance sheet debt plus securitised
receivables. A comparison of the ratio with the traditional debt to equity ratio indicates an
aggregate level of securitisation activity. A securitiser is not required to guarantee payment
to investors in securitisation beyond any credit enhancement. Nevertheless, many analysts
feel this ratio reflects ‘effective’ leverage. These analysts assume that a securitiser’s credit
enhancement and subordinate interest in the cash flows associated with securitisations, as
well as the securitiser’s incentive to retain securitisation as a continuing source of funding,
require the company to service those receivables as effectively as it would service its own debt.
Line 19 reflects owned receivables net of reserves available to service consolidated senior
debt. Lines 20 and 21, meanwhile, reflect the overall pool of managed receivables and
managed assets, respectively, available to service managed senior debt.

Earnings ratios
Gross finance revenue/Average managed receivables (line 22) captures the additional income
for finance companies that securitise a portion of their receivables and measures interest and
lease income earned on straight receivables for non-securitisers.
Interest expense ratios (lines 26–28) are, for the most part, calculated on a consolidated
basis, integrating managed securitisation information when available. Line 27 adds deprecia-
tion expense to interest expense in the numerator to reflect the additional expense associated
with operating leases utilised by many of the diversified companies.

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Exhibit 4.3
Preliminary indicators and ratios

Assets
1 Average owned receivables
2 Average managed receivables
3 Average managed assets
4 Consumer real estate receivables/Total receivables
5 Other consumer receivables/Total receivables
6 Retail contract receivables/Total receivables
7 Commercial receivables/Total receivables

Asset quality ratios

8 Consumer delinquencies (60+ days)/Total receivables
9 Commercial delinquencies (60+ days)/Total receivables
10 Reserve for losses/Total receivables
11 Loss provision/Average receivables
12 Net charge-offs/Average receivables
13 Reserve for losses/Net charge-offs
14 Recoveries/Gross charge-offs

Leverage ratios
15 Short-term debt/Total senior debt
16 Total debt/Net worth* + loss reserves
17 Managed debt/Net worth + loss reserves
18 Subordinated term debt/Capital funds
19 Owned receivables net of reserves/Senior debt
20 Managed receivables net of reserves/Managed debt
21 Managed assets/Managed debt

Earnings ratios
22 Gross finance revenue/Average managed receivables
23 Gross revenue/Average managed assets
24 Operating expenses/Total revenues
25 Operating expenses/Average managed assets
26 Interest expense/Average owned receivables
27 Interest and depreciation expense/Average owned receivables + operating leases
28 Interest expense/Average total consolidated debt

Continued
 Finance companies

29 Consolidated net income/Average managed assets

30 Consolidated net income/Average net worth
31 Dividends/Consolidated net income
32 Interest coverage ratio (EBIT**/Interest expense)

* Net worth = total shareholders’ equity.

** EBIT = earnings before interest and tax.

Source: Author’s own

Box 4.3
Securitisation
Securitisation is the process of converting bank loans or finance company receivables and
other assets into marketable securities for sale to investors. Securities offered for sale can be
purchased by other financial institutions or non-bank investors.
By securitising bank loans and credit receivables, financial institutions are able to remove
assets from the balance sheet if certain conditions are met – boosting their capital ratios,
and make new loans from the proceeds of the securities sold to investors. The ability to do
so, however, is more restrictive since the 2008 financial crisis and Basel III. Nevertheless, the
securitisation process effectively merges the credit markets (for example, the mortgage market
in which lenders make new mortgages) and the capital markets, because bank loans and
credit receivables are repackaged as bonds collateralised by pools of mortgages, automobile
loans, credit card receivables, leases, and other types of credit obligations.
In countries where securitisation is legally recognised, regulatory reporting views a loan
that is converted into a security and sold as an asset-backed security qualifies as a sale of
assets. Generally, the seller retains no risk of loss from the assets transferred and has no
obligation to the buyer for borrower defaults or changes in market value of securities sold.

Risks
The major risks facing finance companies are:

⦁⦁ credit risk: the risk that a borrower or counterparty will fail to perform on an obligation;
⦁⦁ interest rate risk: the risk that the finance company’s asset and liability maturities are
mismatched;
⦁⦁ liquidity risk: the risk that the finance company will be unable to meet its payment
obligations on settlement or due dates; and
⦁⦁ operational risk: the risk that deficiencies in information systems or internal controls will
result in unexpected loss.

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The proper management of the above risks is essential to well-run finance company and to
maintaining its profitability.

Credit risk
A well-run finance company will manage credit risk through careful and prudent underwriting
procedures, centralised approval of individual transactions, and active portfolio and account
management. Underwriting procedures merely refers to the credit assessment of prospective
borrowers and its ability to perform in accordance with established loan terms. A good
finance company will make sure that they analyse the customer thoroughly (business and
consumer), paying close attention to cash flow capacity and collateral values.
Portfolio management consists of adequately monitoring transaction sizes as well as
diversification according to: (i) industry; (ii) geographic area; (iii) property types; and (iv)
identity of borrower. A well-run finance company will have management identify and limit
exposure to unfavourable risks and seek favourable financing opportunities. One approach
involves the use of: (i) loan grading systems to monitor the performance of loans by product
category; and (ii) an overall risk classification system to monitor the risk characteristics of
the total portfolio. These systems should generally consider: (i) debt service coverage; (ii) the
relationship of the loan to underlying business or collateral value; (iii) industry characteris-
tics, principal and interest risk; and (iv) credit enhancements, such as guarantees, irrevocable
letters of credit, and recourse provisions.

Interest rate risk

Management of interest rate risk is performed through the ongoing measurement and quan-
tification of sensitivity to changes in interest rates. Two primary risks of potential loss for a
finance company can occur: basis risk and mismatch risk. Basis risk is the exposure created
from the use of different interest rate indices to reprice assets versus liabilities, such as prime
rate based assets funded with commercial paper liabilities. Mismatch risk is the exposure
created from repricing or maturity characteristics of on and off-balance sheet assets versus
the repricing or maturity characteristics of on and off-balance sheet liabilities.
The larger finance companies are increasingly making use of derivative products, such as
interest rate swaps to manage interest rate risk. Interest rate swaps can be used to:

⦁⦁ change the characteristics of fixed rate debt to that of variable rate debt;
⦁⦁ alter the characteristics of specific fixed rate asset pools to more closely match the interest
rate terms of the underlying financing; and
⦁⦁ modify the variable rate basis of a liability to more closely match the variable rate basis
used for variable rate receivables.

Liquidity risk
Liquidity risk is best managed through: (i) monitoring the relative maturities of assets and
liabilities; (ii) borrowing funds from diversified sources through domestic and international

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money and capital markets and bank credit markets; and (iii) ensuring the availability of
adequate, if not substantial, sources of liquidity such as unused committed bank lines. A
typical finance company will use cash to fund asset growth and to meet debt obligations
and other commitments on a timely and cost-effective basis. Primary sources of funds for a
large finance company are: (i) commercial paper borrowings; (ii) issuance of medium-term
notes and other term debt instruments; and (iii) the syndication, securitisation or sale of
certain lending assets.

Operational risk
The most important types of operational risk involve breakdowns in internal controls and
corporate governance. Such breakdowns can lead to financial losses through error, fraud, or
failure to perform in a timely manner or cause the interests of the finance company to be
compromised in some other way, for example, by its lending offers or other staff exceeding
their authority or conducting business in an unethical or risky manner. Other aspects of
operational risk include major failure of information technology systems or events such as
major fires or other disasters. A finance company can reduce operational risk by developing an
appropriate measurement and monitoring framework, supported by the presence of adequate
internal control policies and internal audit processes.

Foreign exchange risk

For finance companies which operate commercial and consumer finance companies throughout
the world, there is also exposure to foreign exchange risk. Such companies are active users
of forward currency exchange contracts, currency futures, and currency swap agreements to
management foreign exchange risk tied to foreign investment in international subsidiaries and
joint ventures or to hedge the translation of the related foreign currency income.

Box 4.4
New treatment of special purpose entities
Prior to 2007, special purpose entities (SPEs) were largely off-balance sheet arrangements. As
a result of the Enron accounting scandal some years earlier, both US GAAP and IFRS intro-
duced interpretations and standards, FIN 46R and IFRS 10, respectively, to force consolidation
of SPEs under a broad category called variable interest entities (VIEs).
An extract from Ford Motor Company’s annual report of 2011 provides an example.
Ford Credit, the finance company arm of Ford Motor Company, securitises finance receiv-
ables and net investment in operating leases through a variety of programs, using amortising,
variable funding, and revolving structures. Ford Credit also sells finance receivables in structured
financing transactions. Due to the similarities between securitisation and structured financing,

Continued

305
Credit Analysis of Financial Institutions

Box 4.4 continued

Ford Credit refers to structured financings as securitisation transactions. Ford Credit’s secu-
ritisation programs are targeted to many different institutional investors in both public and
private transactions in capital markets worldwide. Ford Credit completed its first securitisa-
tion transaction in 1988, and regularly securitises assets, purchased or originated, in the US,
Canada, Mexico, and European countries.
All of Ford Credit’s securitisation transactions involve sales to consolidated entities or Ford
Credit maintains control over the assets, and, therefore, the securitised assets and related
debt remain on its balance sheet. All of Ford Credit’s securitisation transactions since the first
quarter of 2007 have been on balance sheet transactions. Securitisation transactions have an
effect on Ford Credit’s financial condition, operating results, and liquidity. Ford Credit securitises
its assets because the securitisation market provides it with a lower cost source of funding
compared with unsecured debt given Ford Credit’s present credit ratings, and it diversifies
Ford Credit’s funding among different markets and investors. In the US, Ford Credit is, in most
cases, able to obtain funding in two days for its unutilised capacity in most of its committed
liquidity programs. New programs and new transaction structures typically require substantial
development time before coming to market.
In a securitisation transaction, the securitised assets are generally held by a bankruptcy-
remote SPE in order to isolate the securitised assets from the claims of Ford Credit’s other
creditors and ensure that the cash flows on the securitised assets are available for the benefit
of securitisation investors. As a result, payments to securitisation investors are based on the
creditworthiness of the securitised assets and any enhancements, and not on Ford Credit’s
creditworthiness. Senior asset backed securities issued by the SPEs generally receive the
highest short-term credit ratings and among the highest long-term credit ratings from the
rating agencies that rate them.
Securitisation SPEs have limited purposes and generally are only permitted to purchase the
securitised assets, issue asset-backed securities, and make payments on the securities. Some
SPEs, such as certain trusts that issue securities backed by retail instalment sale contracts,
only issue a single series of securities and generally are dissolved when those securities have
been paid in full. Other SPEs, such as the trusts that issue securities backed by wholesale
receivables, issue multiple series of securities from time to time and are not dissolved until
the last series of securities is paid in full.
Ford Credit’s use of SPEs in its securitisation transactions is consistent with conventional
practices in the consumer asset-backed securitisation industry. Ford Credit sponsors the SPEs
used in all of its securitisation programs with the exception of bank-sponsored conduits.
None of Ford Credit’s officers, directors, or employees holds any equity interests in its SPEs
or receives any direct or indirect compensation from the SPEs. These SPEs do not own Ford
Credit’s shares or shares of any of its affiliates.
In order to be eligible for inclusion in a securitisation transaction, each asset must satisfy
certain eligibility criteria designed for the specific transaction. For example, for securitisation
transactions of retail instalment sale contracts, the selection criteria may be based on factors

Continued

306
 Finance companies

such as location of the obligor, contract term, payment schedule, interest rate, financing
program, the type of financed vehicle, and whether the contracts are active and in good
standing (for example, when the obligor is not more than 30-days delinquent or bankrupt).
Generally, Ford Credit selects the assets to be included in a particular securitisation randomly
from its entire portfolio of assets that satisfy the applicable eligibility criteria.
Ford Credit provides various forms of credit enhancements to reduce the risk of loss for
securitisation investors. Credit enhancements include over-collateralisation (when the principal
amount of the securitised assets exceeds the principal amount of related asset-backed securi-
ties), segregated cash reserve funds, subordinated securities, and excess spread (when interest
collections on the securitised assets exceed the related fees and expenses, including interest
payments on the related asset-backed securities). Ford Credit may also provide payment
enhancements that increase the likelihood of the timely payment of interest and the payment of
principal at maturity. Payment enhancements include yield supplement arrangements, interest
rate swaps, and other hedging arrangements, liquidity facilities, and certain cash deposits.
The following simplified diagram shows Ford Credit’s typical retail securitisation transaction:

Bankruptcy On-balance sheet

remote transaction
transactions (if applicable)

Receivables Receivables Securities

Securitisation
Ford Special
trust
Credit purpose Investors
(special
subsidiary
purpose entity)

Proceeds Proceeds Proceeds

Ford Credit retains interests in its securitisation transactions, including primarily subor-
dinated securities issued by the SPE, rights to cash held for the benefit of the securitisation
investors (for example, a reserve fund), and residual interests. Residual interests represent
the right to receive collections on the securitised assets in excess of amounts needed to pay
securitisation investors and to pay other transaction participants and expenses. Ford Credit
retains credit risk in securitisation transactions because its retained interests include the most
subordinated interests in the securitised assets and are structured to absorb expected credit
losses on the securitised assets before any losses would be experienced by investors. Based
on past experience, Ford Credit expects that any losses in the pool of securitised assets would
likely be limited to its retained interests.
Ford Credit is engaged as servicer to collect and service the securitised assets. Its servicing
duties include collecting payments on the securitised assets and preparing monthly investor

Continued

307
Credit Analysis of Financial Institutions

Box 4.4 continued

reports on the performance of the securitised assets and on amounts of interest and/or prin-
cipal payments to be made to investors. While servicing securitised assets, Ford Credit applies
the same servicing policies and procedures that Ford Credit applies to its owned assets and
maintains its normal relationship with its financing customers.
Ford Credit generally has no obligation to repurchase or replace any securitised asset that
subsequently becomes delinquent in payment or otherwise is in default. Securitisation inves-
tors have no recourse to Ford Credit or its other assets for credit losses on the securitised
assets and have no right to require Ford Credit to repurchase the investments. Ford Credit
does not guarantee any asset-backed securities, although it is the co-obligor of the debt of a
consolidated VIE up to US$250 million for two of its securitisation transactions, and has no
obligation to provide liquidity or make monetary contributions or contributions of additional
assets to its SPEs either due to the performance of the securitised assets or the credit rating of
its short term or long-term debt. However, as the seller and servicer of the securitised assets,
Ford Credit is obligated to provide certain kinds of support to its securitisation transactions,
which are customary in the securitisation industry. These obligations include indemnifications,
repurchase obligations on assets that do not meet representations or warranties on eligibility
criteria or that have been materially modified, the mandatory sale of additional assets in
revolving transactions, and, in some cases, servicer advances of certain amounts.

Source: Author’s own

Finance company balance sheet structure

Assets
In general, finance companies hold most of their assets in cash, shot-term investments (cash
equivalents and marketable securities), receivables, and lease assets. The spreadsheet in Exhibit
4.4 takes this structure into account. According to a recent survey,3 consumer finance compa-
nies have most of their assets in receivables, followed by longer-term investments and operating
leases (ownership of the equipment being leased), then cash and equivalents. Diversified
finance companies show a smaller proportion of receivables but a much larger investment in
operating leases and real estate owned. Similar to a bank, interest receivable (finance charges
receivable) is shown separate from the loans. This is illustrated in Exhibit 4.4.

308
 Finance companies

Exhibit 4.4
Assets

Assets Consumer finance % Diversified finance %

Cash and equivalents   8.4   7.8
Receivables (net of reserves) 63.3 47.4
Finance charges receivable and other   9.7 14.2
Investments and operating leases 10.7 15.0
Fixed assets (net of depreciation)   6.4 14.4
Intangibles (net)   1.4   1.3
Total assets 100.0 100.0

Source: Author’s own

Liabilities and equity

Because consumer finance companies, in general, make shorter-term cash loans to individuals
and smaller businesses, they tend to finance themselves with short-term bank lines and
commercial paper. Diversified finance companies are more reliant on the capital markets
with senior and subordinated debt. This also allows greater leverage (that is, a smaller equity
component) than consumer finance companies in the survey.

Exhibit 4.5
Liabilities and equity

Liabilities and equity Consumer finance % Diversified finance %

Short-term debt 40.3 38.4
Accruals and other   8.7   7.5
Long-term debt 20.9 30.4
Equity 30.1 23.7
Total liabilities and equity 100.0 100.0

Source: Author’s own

Income statement structure

According to the survey, consumer finance companies have slimmer margins than diversi-
fied finance companies. Unfortunately, the survey does not provide a breakdown of interest
expense, loan loss provisions, and other operating expenses such as salaries and administrative

309
Credit Analysis of Financial Institutions

costs. Presumably, ‘all other expenses’ includes depreciation expense related to leased assets
and own real estate.
Due to a significant percentage bite out of revenues by all other expenses, the diversified
finance group shows a much lower profitability before income taxes than consumer finance
companies in the survey. The survey’s income statement data stops at profit before taxes
since tax rates can vary among companies in the same industry.

Exhibit 4.6
Income statement

Income statement Consumer finance % Diversified finance %

Interest income 100.0 100.0
Interest expense, loss provisions, 72.6 70.1
other operating expenses
Operating profit 27.4 29.9
All other expenses (net) 10.3 15.3
Profit before taxes 17.1 14.7

Source: Author’s own

Case study: analysis of finance company ratios

This analysis is based largely on data released by an international bank on the finance
company industry in the US.4 As outlined in Exhibit 4.10, the analysis covers two sub-sectors:
consumer finance companies and diversified finance companies.
Generally, the data reflect mixed results in a sluggish economic environment where port-
folio growth faded, asset quality deteriorated, and finance yields contracted. Overall returns
on assets and equity were mixed – up among consumer lenders and down among diversi-
fied lenders. In the lower interest rate environment, decreased funding costs helped preserve
net interest margins at most consumer lenders but were unable to offset a more precipitous
decline in top-line yields among diversified lenders. In the face of increased write-offs, loss
provisions were up significantly for both groups of finance companies.

Consumer finance companies

As most companies in this sub-sector scaled back portfolio growth in 2011, there was a near
4% drop in average owned receivables at year-end 2011. But ongoing sales of receivables
through securitisation programs sparked dramatic increases in average managed receivables
and average managed assets of 20% and 24%, respectively (see lines 1 to 3 of Exhibit 4.10).
The structure of lending also changed perceptively. Secured loans, largely equipment
and lease financing (line 4), increased from 44% of total receivables to almost 46%, while

310
 Finance companies

other secured consumer loans grew from around 38% to 40% of total receivables by year-
end 2011 (line 5).
Consumer delinquencies, however, were up across the board. These grew from under 4%
to slightly over 4% between the two ending periods, prompting consumer finance compa-
nies to increase their reserves for loan losses (lines 11 and 10, in that order). The increase,
of course, had a negative impact on operating expenses to total revenues (line 24) which
jumped from 34% to 36%. Through more efficient debt management, interest expense was
down significantly (line 26) to 3% from 5% a year earlier. In all, this enabled consumer
finance companies to post some gain in return on assets and return on equity (lines 29 and
30, respectively).

Diversified finance companies

The diversified sector showed much stronger gains in business activity than the consumer
sub-sector. A year-on-year change showed a 25% growth in average owned receivables,
a 51% growth in averaged managed receivables, and a 40% growth in average managed
assets. This is a remarkable performance, given the sluggish economy. At the same time,
the composition of lending varied very little with only a slight move from retail contract
receivables to secured consumer loans (always the smaller component of overall business
activity by diversified lenders) and to commercial loans. See lines 4 to 7 for this movement.
Diversified finance companies were also better adept at controlling loan losses and thus
fortifying asset quality than their consumer finance cohorts. Although additions to loan loss
reserves were up somewhat for 2011 compared with the year before, the percentage increases
were less striking than for the consumer lenders (lines 10 to 11).
Fewer files but with bigger amounts allows diversified lenders to save on paper and
administrative costs for commercial loans which explains the much lower operating expense
levels (lines 24 to 25). Nevertheless, competition is stiffer for commercial loans and diversified
lenders naturally show slimmer margins than consumer finance companies. The diversified
finance companies showed at least 1% return on assets each year – not bad for a financial
institution – but a drop in return on equity despite a higher leverage than consumer lenders
(see lines 29, 30, 16 and 17).

311
Exhibit 4.7
Finance company balance sheet

Assets YR1 YR2 YR3

1 Cash and cash equivalents
2 Marketable securities
3 Receivables
4 Commercial loans
5 Consumer loans
6 Equipment loans and leases
7 Other loans
8
9 Less: allowance for losses of receivables
10 Net receivables
11
12 Investments
13 Operating leases
14
15 Property and equipment, net
16
17 Other assets
18 Sundry intangibles
19
20
21 Total assets

22 Liabilities and equity

23 Debt
24 Commercial paper
25 Bank and other borrowings
26 Senior and subordinated debt
27
28 Total debt
29 Other payables and accruals
30
31 Total liabilities
32 Non-controlling interests
33
Continued
 Assets YR1 YR2 YR3
34 Capital stock
35 Additional paid-in capital
36 Reserves
37 Retained earnings
38
39 Total stockholders’ equity
40 Total liabilities and equity
41
42
43 Contingent liabilities
44

Source: Author’s own

Exhibit 4.8
Finance company income statement

Income statement YR1 YR2 YR3

45 Interest income
46 Interest expense
47 Net interest income
48 Fees and other income
49 Factoring commissions
50
51 Total revenue
52 Operating expenses
53 Provision for losses
54 Depreciation
55 Other expenses
56
57 Income before taxes and extraordinary items
58 Extraordinary items
59 Income taxes
60
61 Net income
62

Source: Author’s own

Exhibit 4.9
Finance company ratio sheet

Ratios YR1 YR2 YR3

63 Assets
64 Commercial receivables/Total receivables (%)
65 Consumer receivables/Total receivables (%)
66
67 Asset quality
68 Commercial delinquencies (60+ days)/Total receivables (%)
69 Consumer delinquencies (60+ days)/Total receivables (%)
70 Reserve for losses/Total receivables (%)
71 Loss provision/Average receivables (%)
72 Net charge-offs/Average receivables (%)
73 Reserve for losses/Net charge-offs (times)
74 Recoveries/Gross charge-offs (%)
75
76 Leverage
77 Short-term debt/Total senior debt (%)
78 Total debt/Net worth* + loss reserves (times)
79 Managed debt/Net worth + loss reserves (times)
80 Subordinated term debt/Capital funds (%)
81 Owned receivables net of reserves/Senior debt (times)
82 Managed receivables net of reserves/Managed debt (times)
83 Managed assets/Managed debt (times)
84 Managed assets/Managed debt (times)
85
86 Profitability
87 Gross finance revenue/Average managed receivables (%)
88 Gross revenue/Average managed assets (%)
89 Operating expenses/Total revenues (%)
90 Operating expenses/Average managed assets (%)
91 Interest expense/Average owned receivables (%)
92 Interest and depreciation expense/Average owned receivables +
operating leases (%)
93 Interest expense/Average total consolidated debt (%)
94 Consolidated net income/Average managed assets (%)
95 Consolidated net income/Average net worth (%)

Continued
 Ratios YR1 YR2 YR3
96 Dividends/Consolidated net income (%)
97 Interest coverage ratio (EBIT**/Interest expense)

* Net worth = total stockholders’ equity.

** EBIT = earnings before interest and tax.

Source: Author’s own

Exhibit 4.10
Analysis of finance company ratios

Averages Consumer sector Diversified sector

averages averages
Line 2011 2010 2011 2010
Assets
1 Average owned receivables 25,074 26,059 56,654 45,254
2 Average managed receivables 31,845 26,458 84,073 55,748
3 Average managed assets 34,602 27,908 110,106 78,652
4 Consumer real estate receivables/Total receivables 45.9% 44.0%   4.8% 3.9%
5 Other consumer receivables/Total receivables 40.1% 37.9% 11.3% 10.5%
6 Retail contract receivables/Total receivables 13.2% 13.3% 35.6% 38.5%
7 Commercial receivables/Total receivables 0.8% 4.8% 48.3% 47.1%

Asset quality ratios

8 Consumer delinquencies (60+ days)/Total receivables 4.10% 3.75%   2.57% 2.86%
9 Commercial delinquencies (60+ days)/Total receivables 5.40% 6.70%   1.83% 2.57%
10 Reserve for losses/Total receivables 5.35% 4.74%   2.08% 1.78%
11 Loss provision/Average receivables 4.27% 3.70%   1.14% 0.96%
12 Net charge-offs/Average receivables 4.60% 4.15%   0.83% 0.74%
13 Reserve for losses/Net charge-offs 1.22 1.28   1.79 2.08
14 Recoveries/Gross charge-offs 10.43% 12.45% 10.55% 14.05%

Leverage ratios
15 Short-term debt/Total senior debt 41.52% 43.66% 35.72% 45.74%
16 Total debt/Net worth + loss reserves 4.36 4.48   6.09 5.92
17 Managed debt/Net worth + loss reserves 5.88 5.46   8.61 7.57
18 Subordinated term debt/Capital Funds 0.37% 0.39%   1.00% 5.11%

Continued
Credit Analysis of Financial Institutions

Exhibit 4.10 continued

Averages Consumer sector Diversified sector
averages averages
Line 2011 2010 2011 2010
19 Owned receivables net of reserves/Senior debt 0.96 1.00   0.88 1.01
20 Managed receivables net of reserves/Managed debt 0.99 1.01   0.91 1.00
21 Managed assets/Managed debt 1.19 1.23   1.24 1.35

Earnings ratios
22 Gross finance revenue/Average managed receivables 14.14% 15.43%   9.95% 10.81%
23 Gross revenue/Average managed assets 13.10% 14.40%   9.27% 10.96%
24 Operating expenses/Total revenues 36.04% 34.24% 19.68% 18.10%
25 Operating expenses/Average managed assets 4.26% 4.60%   1.93% 2.07%
26 Interest expense/Average owned receivables 3.31% 5.49%   4.57% 5.50%
27 Interest and depreciation expense/Average owned – –   7.13% 8.27%
receivables + operating leases (%)
28 Interest expense/Average total consolidated debt 4.85% 5.90%   3.99% 5.23%
29 Consolidated net income/Average managed assets 1.34% 1.02%   1.08% 1.30%
30 Consolidated net income/Average net worth 12.25% 9.31% 10.07% 12.39%
31 Dividends/Consolidated net income 24.26% 59.66% 42.75% 37.29%
32 Interest coverage ratio (EBIT**/Interest expense) 1.46 1.35   1.65 1.64

* Net worth = total stockholders’ equity.

** EBIT = earnings before interest and tax.

Source: Author’s own

Outlook
The study concludes with a neutral credit outlook for the industry. Though asset quality for
both sub-sectors of the finance company industry is expected to improve, margins will likely
continue to contract or remain tight as assets reprice to reflect current interest rates. Thus
earnings growth will remain slow over the next period even if the economy regains strength.
Prudently, finance companies are expected to keep loss reserves relatively high.

1
Consumer Financial Protection Bureau (CFPB), an agency set up by the Dodd-Frank Wall Street Reform Act of
July 2010 and is funded by the US Federal Reserve Bank.
2
Trust: a fiduciary arrangement whereby the legal title of property is held and the property is managed by someone
for the benefit of another. Trusts are found in most common law countries although similar arrangements have
been given legality in recent years in civil or code law countries.
3
RMA, Annual Statement Studies, 2011–2012, Philadelphia.
4
Bank One Corporation (a unit of JPMorgan Chase), May 2012.

316
Appendix 4.1

Finance company balance sheet strength

Balance sheet strength is a function of the level of capital maintained by a company relative
to its operating and financing needs, on both a current and an expected basis. When applied
to finance companies, the analyst should evaluate four general areas of balance sheet risk to
determine balance sheet strength and flexibility:

⦁⦁ asset quality;
⦁⦁ market risk and interest rate risk;
⦁⦁ funding/liquidity; and
⦁⦁ capital and leverage.

Assets quality
The credit analyst should assess both qualitative factors of management’s strategy and
operating constraints, and quantitative measures in terms of the relation of credit costs (loss
provisions, reserves, and charge-offs) to total receivables, level of income derived from these
assets, portfolio growth and capital base. A finance company generates receivables from its
lending activity, which need to be converted into cash in a timely manner and at a loss
and delinquency rate commensurate with pricing expectations or assumptions. Higher losses
and delinquencies than expected in a portfolio not only reflect mispricing of assumed risks,
with direct adverse impact on earnings, but also have implications for the adequacy of loss
reserves and capital levels.
A review of a finance company’s asset quality examines the nature of the asset class and
the portfolio composition and diversification of both its on-balance sheet and off-balance
sheet assets. Examples of off-balance sheet items primarily include unfunded extensions of
credit, derivative products, securitised assets, and certain leases. The first step in analysing
the receivables (both on and off-balance sheet) involves understanding the underlying risk
of the end borrowers. For commercial finance companies, the end borrowers’ respective
industry(ies) determines the nature of the receivables, while for consumer finance companies
the demographics and the product type become the determining factors. Lending to a final
producer, as compared with a middleman or a supplier, affects the turnover of the receiv-
ables. Providing equipment financing is a different risk than lending against the inventory of
a customer for commercial finance companies. Financing cyclical industries will lead to some
cyclicality in the financing company as well. Additionally, receivables can be created on a
secured or unsecured basis. For secured receivables, commercial finance companies’ lending
rates vary for different asset classes (inventory, equipment, or property) and for the different
industries of the borrowers. These factors determine the repayment potential as well as the
liquidity of the finance receivables.

317
Credit Analysis of Financial Institutions

Another area of asset quality relates to management’s accounting policies of non-

performing assets. In contrast to banks, finance companies have greater latitude in their
methods of reporting problem credits, and adjustments may be necessary to convert the
reported levels of non-performing assets in to a common standard for comparability. The
most conservative form of delinquency reporting is ‘original contractual,’ where the delinquent
status remains until all late payments are received. On the other hand, the more popular
method of ‘present contract’ allows for renewals and extensions as a way for receivables to
become current again. Finally, the lease conservative method of ‘recency of payment’ allows
for the receivables to become current without prior delinquencies remedied.
Additionally, when possible, it is important to obtain delinquency and loss rates on
static portfolios rather than on portfolio statistics inclusive of new receivables. If a portfolio
consists of distinct asset classes or sub-portfolios, then statistics on the sub-portfolios need to
be examined individually and compared against like portfolios of peers. This is true also for
companies that purchase or manage receivables of other finance companies, where performance
of owned receivables, as opposed to managed receivables, is analysed separately. Finally, if
available, internal information from companies should be obtained on management’s risk
management and underwriting policies (concentration limits, lending criteria, asset monitoring
and audit, and other credit administration procedures). The composition of the portfolio is
reviewed for any actual concentrations of risk.

Asset quality ratios

The analyst should consider the following ratios to assess the asset quality of a finance
company.

Receivables growth rate and portfolio characteristics

Any rapid change in the portfolio over the past five years, and especially within the recent
year, is reviewed for potentially adverse factors other than business cycles. Aggressive growth
may be achieved by a company at the expense of prudent underwriting principles, or to
mask underlying problems in existing portfolios. Management should have an identified
market opportunity or strategy to support any significant growth in the portfolio. A business
expansion strategy beyond its current or core markets also may be viewed as higher risk
for the company. The fundamental characteristics (such as composition and diversification)
and performance statistics of the portfolio (as measured by the ratios below) would likely
change along with the rapid growth, and are thus assessed against peers’ portfolio statistics
as well as in the context of earnings and capital levels.

Net charge-offs
Average net receivables

Because some portion of non-performing assets eventually becomes actual charge-offs, this
ratio can be a good indicator of trends in credit quality. The recovery rate of charge-offs
also is considered in conjunction with the impact of any cyclical factors to gain a better

318
 Finance company balance sheet strength

perspective on these ratios. To the extent that a company has non-finance subsidiaries, only
statistics related to the finance operations are to be used in the ratios.

Provisions
Net charge-offs

This ratio compares the amount charged with earnings for expected losses and the actual
losses. As such the annual loss provision and cumulative loss reserve should closely track
the actual charge-offs of assets. Any significant deviation in historical trends of the provision
and reserve levels to charge-offs is reviewed with further details on management strategy for
receivable growth and reserve policies. Peer group comparison also is important since there
is wide latitude by management in setting the levels of loss provisions and reserves in an
effort to show higher earnings in a particular year by under-reserving.

Tangible common equity plus reserves

Net charge-offs

This ratio provides an indication of the adequacy of capital in a company as a multiple of

net charge-offs. The multiple should be in line with peers of similar portfolio characteristics
or competing in the same niches. Furthermore, there should be sufficient capital cushion for
a company to sustain the down cycles of its business, when margins are lower combined
with higher credit cost.

Non-performing receivables
Total receivables

Non-performing receivables consist of delinquent and non-accrual receivables in accordance

with either industry standard measurements or the most conservative reporting methods.
This ratio is a forwarding-looking indication as it measures the performance of a portfolio
prior to charge-offs.

Pretax, preprovision income

Non-performing receivables

Also referred to as the earn-out ratio, this ratio illustrates the relation of non-performing
assets to preprovision earnings, measuring the payout ratio of future asset losses from inter-
nally generated cash flow. Pretax, preprovision income represents core earnings and is the
first line of protection against credit losses before capital is affected.

Market risk and interest rate risk

Market risk exposure in the operation of finance companies is predominantly interest-rate
risk. These exposures are created by mismatches between duration or maturity of assets
and liabilities and are part of a company’s asset-liability management. Mismatches may be

319
Credit Analysis of Financial Institutions

structural, caused by the difficulty in completely matching the asset maturities with the liabili-
ties or by unexpected prepayments or early terminations of some assets. Hedging techniques
and interest-rate risk management strategies of a company need to be reviewed and assessed
with regard to the interest-rate assumptions and in comparison with historical performance
against interest-rate volatility. Some mismatches also may be part of a deliberate strategy
to take a risk position on interest-rate movements. The company’s maturity gap report to
be provided by management or published in its annual report is reviewed for the extent of
interest-rate gaps by maturity, and in terms of capital level.
To the extent that trading activity may be part of companies’ operations, market risk
exists in positions taken in their trading books as well. Analysts review management’s market
risk control systems and policies for various internal limits of market risk, as disclosed in
annual reports. Additionally, the following quantitative indicators are recommended:

Non-interest income
Gross operating income

This indicator includes the component ratios of trading income to gross operating income,
investment income to gross operating income, and so on, to the extent that company’s
earning sources include income trading activities, the market price volatility risk present in
these earning streams makes them less stable than credit-related earnings. Trend analysis of
a company’s trading earnings over a period of five years or more should indicate not only
the reliability of this earnings stream but also management’s view and strategy for trading
activities as a source of earnings.

Variable-rate receivables
Variable-rate liabilities

This ratio measures the extent to which a company’s assets and debt are on the same
interest-rate basis. The higher the ratio, the more coverage a company has in assets of its
obligations. However, it also implies that the company is asset sensitive, with its receivables
being repriced at a greater volume than its debt. In a rising rate environment, this would be
beneficial to the company, as it would improve its net interest margin, but more disadvan­
tageous in a declining rate environment.

Value at Risk index

Theoretically, this measurement provides a more robust indication of a trading portfolio’s
market risk and potential impact on earnings. As disclosed in most major annual reports,
the Value at Risk (VaR) index is a statistical probability of potential losses to a company’s
trading portfolio, within a certain defined confidence interval. A useful related ratio is the
multiple of trading income to VaR, which indicates the level of earnings generated by trading
activity as compared with the risk level assumed by a company. However, the financial crisis
of 2008 and more recent events have highlighted the weaknesses of VaR as a truly viable
measurement and should be reviewed with caution.

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 Finance company balance sheet strength

Funding/liquidity
A finance company’s ability to obtain funding as needed to generate receivables is an essential
part of its operating model. An analysis of a finance company’s funding and liquidity risk
addresses three sets of interdependent factors: the company’s cash flow from operations in
relation to its essential cash needs; its asset liquidity in terms of quality and turnover; and
the mix of its funding sources for short-term and long-term needs. It is critical to assess a
finance company’s core liquidity sources for its current operation, as well as its contingent
liquidity sources and operating flexibility in the event of disrupted or reduced access to the
capital markets.
To sustain or protect its niche or core business lines, a finance company would need to
fund two core areas of cash needs: new originations to replenish the run-offs of a portfolio
of receivables, and roll over of maturing debt. These needs normally would be satisfied by a
company’s turnover of the maturing assets and continued access to the securitisation market,
commercial paper and the short-term debt market. Bank lines typically provide back-up
liquidity support to capital market instruments, or directly provide temporary funding to the
company in the event of any disruption in normal channels of funding.
Fast turning and high-quality receivables or finance assets lead to improved liquidity
coming from the normal operating cycle of a finance company. The level of these assets
relative to slower turning assets in a company’s portfolio is a measure of this source of
more immediate liquidity. Cash on hand and other liquid assets besides finance assets are
additional measures of a finance company’s degree of liquidity.
In cases of unforeseen liquidity calls, a company should have sufficient excess internal
cash flows in conjunction with backup lines to withstand a temporary crisis. Alternatively, it
should have the ability to scale back its cash demands for a short period while still preserving
its core niche market position.
The composition of the funding structure of a finance company is assessed in terms of
the diversity, quality, and stability of its funding sources. The depth of the particular market
of investors or demand for funding instruments issued by a company is assessed by looking
at past track records. The company’s access to the debt market is determined by the history
and frequency of issuances, the terms of issuances, and the rate carried on the debt. In the
bank lines, it is essential to understand the quality of these arrangements in terms of the
presence of standard or stringent conditions attached to the bank line facilities; whether they
are advised lines as compared with evergreen (self-renewed) lines; secured or unsecured; and
other, similar clauses. The quantity and diversity of bank relationships of a finance company
are both important factors to review.
Primary liquidity ratios include:

Receivables due within one year

Total receivables

This indicates the scheduled run-offs within a year as a percentage of total receivables.
This ratio should be reviewed in conjunction with the historical trends of run-offs and
replenishments through new originations; the industry cycle and company-specific operating

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cycle as they affect these run-offs; and the collection rate within each maturing category
of receivables.

Receivables due within one year

Short-term debt

If a company’s cash conversion cycle (the length of time for receivables to be converted into
cash) is proportional to its short-term debt financing, then these short-term debt outstand-
ings are fully self-liquidating. Typically, companies use some short-term leverage to finance
a portion of the new originations, in addition to the cash collections. The extent of short-
term leverage utilised by a company beyond its cash collections in funding new receivables
depends on the bank line availability, industry cycle, and management strategy.

Average cash collections

Average receivables

This is an aggregate measure of a portfolio’s cash conversion rate. A parallel ratio can be
calculated by dividing 365 days by this ratio to arrive at the number of days for receivables
to be converted into cash. To the extent of available information, these ratios are assessed
within each sub-portfolio, with any slower collection statistics to be reviewed for further
explanation (nature of the asset; signal of potential delinquency; or slow credit administra-
tion system of the company).

Unsubordinated liabilities less cash and cash equivalents

Monthly cash collections

Senior ranked liabilities net of cash and cash equivalents as a multiple of cash inflow from
collections gauges the number of monthly collections to cover claims on cash.

Senior debt
Gross receivables

This ratio reflects the proportion of gross receivables that would have to be liquidated to
pay senior debt. Senior debt is the primary source of financing utilised by finance compa-
nies for working capital such as financing for the purchasing of receivables. Therefore, it is
important to determine the coverage of senior debt by total receivables.

Bank lines
Bank borrowings and commercial paper

This ratio indicates the extent of coverage of back-up lines of outstanding commercial paper
(where issuable) of a company. The ratio is calculated on the basis of peak, average and
period-end commercial paper outstandings. Other short-term calls on cash additionally may
be considered in relation to bank lines.

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 Finance company balance sheet strength

Capital and leverage

The capital level of a finance company needs to be analysed in terms of absolute level, as
well as relative to an appropriate capital structure (that is, capital adequacy). The absolute
size of a company’s capital essentially determines its niche market and growth opportunities.
Given a certain capital level, the extent of use of financial and operating leverage will affect
the financial strength of the company and its ability to raise funds through the capital markets
and private institutions. The quality of the capital composition also adds to or detracts from
financial strength. An analysis of capital quality addresses the equity or debt-like nature of
various components of capital, as well as the consistency of earnings contribution. Capital
adequacy address whether a company has enough equity to support risk on its balance
sheet; whether asset growth can be supported by proportionate equity growth; whether a
company has the capacity to market commercial paper, medium-term debt and securitised
receivables; and whether capital is being eroded by excessive dividends. A key determinant
of capital adequacy is asset risk, because the size and type of the portfolio ultimately require
capital support directly and indirectly. Off-balance sheet items also can impact credit risk,
growth, and funding.
Besides the impact of intangible assets and equity, a review of the accounting policies
of a finance company also is of paramount importance, since the industry is not subject to
the same regulatory oversight as banking or insurance. Particular attention is put on the
assumptions underlying the reporting of earnings, asset values and liabilities, relative to the
rest of the industry, which could impact capital adequacy.
The following primary capital adequacy ratios are recommended:

Components of capitalisation
Total capitalisation

This includes all the various components of equity and hybrids to total permanent capital
(equity, plus hybrids, plus long-term debt). These are metrics used to gauge the level, quality,
and trends of capital across different finance companies within a peer group. These ratios also
are reviewed in relation to a company’s financing requirements for both ongoing operations
and growth. Strong capitalisation combined with historically consistent equity formation is
a strong indicator of financial flexibility to the capital markets, allowing a company to raise
the funds necessary to build its asset base and defend or bolster its earnings stream.

Components of debt
Total debt

All the various components of debt by tenor, rate basis (floating as compared with fixed),
source (private versus public), are analysed for any vulnerability in the debt structure relative
to the asset base and other financing needs of a company.

Total debt
Tangible equity

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Total debt to tangible equity, long-term debt to tangible equity, and short-term debt to
tangible equity are reviewed over a cycle and against peers. Various measurements of tangible
equity also are used in arriving at several types of multipliers for gauging individual finance
companies. Tangible equity net of investments in non-finance subsidiaries is used to assess
the leverage on just the finance company’s operation. Deferred income taxes, which can
be accumulated to become a significant quasi-equity item, can be added to tangible equity
to measure the extent of tax advantages utilised within some niches of finance companies
(although these companies do have to consistently grow in order to prevent a reversal of
the deferred taxes).

Earnings before interest, tax, depreciation and amortisation (EBITDA)*

Interest expense

and

EBITDA (before fixed charges)

Interest expense + fixed charges (for example, lease payments)

* Alternatively, EBIT alone may be used.

Various ratios of the coverage of interest and fixed charges by EBITDA and other cash
flow equivalent measures provide indicators of a company’s debt-service ability. Furthermore,
any excess debt capacity based on a company’s cash flow relative to debt service require-
ments would lend more flexibility to its financial condition.

Tangible equity
Total assets + securitised assets

This is a measure of a company’s leveraging of its capital to generate assets on its balance
sheet. Finance receivables, investments, and other earning assets should have, as a matter
of prudence, certain capital to be reserved against the respective asset risks. This oper-
ating leverage ratio is another commonly used ratio by the capital markets to compare
a finance company’s leverage against its peers. Total assets include both on-balance sheet
and off-balance sheet assets, since most companies retain the first loss exposure on securi-
tisation transactions. Tangible equity (also called net worth) to total managed assets also
is reviewed.

Retained net income

Average equity

The relation of retained net income to average equity is a good indication of the rate of
capital growth from internally-generated earnings, as opposed to equity issuance. Companies
that plough back more of their earnings to their capital base and ultimately their operations
are more positively viewed from a balance sheet strength perspective than those adhering
to a policy of distributing more of their earnings in the form of dividends to shareholders.

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 Finance company balance sheet strength

Double leverage at the holding company

This ratio is calculated as equity investments in subsidiaries as a percentage of common
equity at the holding company. This ratio not only shows the degree of debt burden across
operating and parent levels, but also can reveal the extent to which a holding company is
dependent on the operating company for dividends in servicing its debt. To obtain a more
direct indication of the holding company’s self-sufficiency in funding, another holding company
ratio is recommended: liquid assets to short-term debt.

Operating performance
As with strong capitalisation and liquidity/funding access, a finance company’s earnings
provide one of the most important aspects of a creditor’s long-term protection measures.
The absolute size of a company’s capital base, while important, can be eroded if a company
lacks solid operating performance. Operating performance is assessed on an absolute and
relative basis to peers, with an emphasis on the profitability of operations and structure and
composition of revenues versus expenses.
As with other areas of analysis, a finance company’s accounting policies on the recogni-
tion of earnings are the first step to analysing its profitability. Ideally, the method used to
recognise earnings should reflect the true economic earnings stream of a company. Reviewing
other, similar companies with the peer group will point out an industry-preferred method
that should allow for better comparability of performance.
There are three main areas of analysis:

⦁⦁ core earnings trends and quality;

⦁⦁ individual business line profitability; and
⦁⦁ overall return and profitability.

Core earnings trends and quality

Core, sustainable earnings form capital to support growth, help maintain an adequate source
of liquidity generation, and protect against a reasonable level of asset losses. Due to the
increasingly fierce competition from banks entering financial services, margins have become
narrower and a greater emphasis is placed on cross-selling more fee-based services to the
same client base.
Sources of core earnings consist primarily (but not exclusively) of interest income and
fee income from a company’s main lines of business operation. Non-core earnings consist
primarily (but not exclusively) of other trading income, investment income, and non-recurring
income such as that generated by asset sales. Gains from securitisation, while they may be
an ongoing essential part of every finance company’s operation, are not viewed as part of
core earnings. Furthermore, careful analysis of these sources of earnings generated from the
sale of assets through securitisation is done before considering them as part of a company’s
non-core earnings.

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The following ratios are recommended:

Net interest income

Average earning assets

Referred to as the net interest margin, a review of its annual growth over a 10-year period
should reveal the trends of a finance company’s profitability over a credit cycle and reflect
any changes in its operating environment. Peer comparisons also reveal a company’s competi-
tive performance. The components contributing to net interest margin (interest income and
interest expense) are analysed to determine future stability and sustainability. Management’s
discussion of results in its financial statements helps relate the company’s profitability to its
business strategy and core business lines.

Non-interest income
Total revenues

The fee-generating sources of income for a finance company are important ways to compare
and preserve its own niche position. The ability to execute these ancillary services to bolster
income while enhancing client loyalty is essential to a finance company’s competitiveness.
The size and historical stability of these fee-income sources are important factors to assess.

Credit costs
Non-interest expense

This ratio is discussed in the preceding asset quality section and sections below.

Dividend
Net income

This annual dividend payout ratio provides information on the rate of dividends paid by a
company to its owners (and may be committed to in a moral sense). Naturally, and as indi-
cated earlier, the lower the ratio, the more positively the company is view by the markets.

Effective tax rate

The tax burden (income tax as a percentage of net income) of a company can depend
on whether it invests mainly in tax-free assets; whether it makes use of tax-advantageous
vehicles where allowed in its tax jurisdiction (such as deferred tax accounting); and other
tax-management opportunities. Knowledge of tax positioning may require an adjustment to
historical profitability of the company.

Individual business line profitability

To diversify from the effects of business cycles in various niches, finance companies may
engage in many types of products. The larger companies also expand into other lines of

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financing as well as related services (insurance, asset management, and so on) to become full
service providers. It then becomes critical to analyse the various sector business dynamics
affecting a company, in terms of competitive factors, operating challenges, and opportuni-
ties versus risks.
A similar analysis of the composition of a company’s interest expense and credit costs
by individual business lines provides an indication of its overall cost structure. A significant
expense item is the provision for asset losses. Finance companies have wider latitude than
banks or other regulated financial institutions in setting the annual provision for asset losses.
Closer examination of management’s policies and classification of problem assets is warranted.
Non-interest expenses, such operating expenses, overhead costs, and other expenses related
to personnel compensation, and the cost of administration are among other categories to be
reviewed by individual business lines.
The following ratios examine the profitability of the various lines of business of a finance
company:

Non-interest expense (overhead expense)

Gross receivables

This overhead expense ratio provides an indication of a company’s operating efficiency.

Low-cot operators can enjoy greater margins and flexibility in dealing with any decline in
revenues, relative to their peers. Conversely, an unfavourable efficiency ratio can force a
company into a defensive position of cost cutting and internal realignments to become more
competitive. Another related ration of efficiency is the number of employees as a percentage
of gross receivables.

Yields on average assets by niche segments

The relative performance of certain assets within a company depends on cyclical factors;
market position of the company in each line of business; and respective business strategies
for those lines of business. Management’s emphasis on some lines of business or strength
in market position usually will translate into a certain yield performance for specific asset
categories. The differences in asset yields determine the optimal asset mix for a company,
which in turn, drives many aspects of the rest of its operations such as capital allocation,
strategies for growth, and so on.
Fee income can be another significant source of earnings for many finance companies
through financial advisory services or insurance. The ratios of fee income total operating
earnings as compared with percentages of various other earnings components provide infor-
mation about a company’s sources of earnings.

Various costs of funds

Cost of funds, commercial paper issuance, short-term borrowings, and other short-term
liabilities are the expense side of asset yields. At a minimum, these costs of fund indicate
the funding sources and relative costs of access to them for a particular institution. At times,

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because these funding sources are based on market confidence, they also can indicate the credit
strength of a company as perceived in the marketplace. This is especially true during certain
crisis events or disruptions in financial markets when credit spreads can widen dramatically
for weak institutions, which can limit funding options very quickly.

Overall return and profitability

Broader gauges of profitability include ratios for measuring performance returns on utilised
assets and capital.

Net income
Average assets

and

Net income
Average managed assets

The ratios return on assets (ROA) and return on managed assets indicate the earnings perfor-
mance of a finance company in its utilisation of assets relative to its peers. This ratio can
be adjusted for pretax income or pretax recurring income. These ratios are reviewed and
highlighted as appropriate, depending on the type and level of different activities undertaken
by a company.

Net income
Average equity

The return on equity (ROE) indicates the earnings performance of a finance company from
the perspective of the shareholders and the equity market.
Both the ROA and the ROE are assessed over a sufficient period of time to establish
historical contexts as well as to cover the entire cycle of credit risk and competitive forces.

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Chapter 5

Leasing companies

In general, leasing companies did not suffer badly during the 2008 financial crisis and the
global economic slowdown that followed. Yet the leasing industry had engaged in the pre-
crisis ‘party’: money was so abundant at such low rates that lessors were ‘forced’ to take
unreasonable residual risks to get deals done. Credit standards were softened in all segments
of the leasing industry (small ticket, middle ticket, and large ticket). Lease terms were length-
ened to further lower payments, and the collateral value of the leased equipment continued to
deteriorate as a percentage of the amount lessors (and their banks) were willing to finance.1
But on the brighter side for leasing companies, there were some interesting developments
post-2008. As industrial companies reduced capital expenditures in response to economic
uncertainty, they tended to become much more conservative with their capital expenditure
budgets and policies and procedures. The equipment replacement cycles are extended as
companies make do with their existing equipment for a longer period. This bodes well for
lessors’ existing lease portfolios.
Furthermore, to grow and prosper, all companies need capital – particularly those that
are in the growth stage of their life cycle. So alternative sources of capital are filling the
void left by the retrenchment of banks. And a conduit for these capital investments is
leasing companies, many of which are establishing relationships with hedge funds, insurance
companies, pension funds, family offices, Shari’a-compliant funds, and the like. Although the
alternative sources of capital will have a higher cost, they will also have more credit and
structuring flexibility. The conservative lending environment and development of alternative
funding sources are substantial opportunities for entrepreneurial lease companies.
On the horizon, however, are dramatic lease accounting changes proposed by IFRS and
US GAAP which will likely result in some lessees choosing non-lease forms of financing.
Since the result is uncertain at the present time, the landscape for leasing companies may
be opaque for several years to come. The credit analyst should follow accounting changes
and their impact on the financial condition of the lessor.

Types of leases
Leasing takes three different forms: (i) sale-and-leaseback arrangements; (ii) operating leases;
and (iii) straight financial, or capital, leases. A fourth form, leveraged lease, is a variant of
the financial lease.

Sale and leaseback

Under a sale and leaseback, a company that owns land, buildings or equipment sells the
property and simultaneously executes an agreement to lease the property back for a specified

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period under specific terms. The purchaser could be a specialised leasing company, an insur-
ance company, a retail bank or even an individual investor. The sale-and-leaseback plan is
an alternative to taking out a mortgage loan.
The company that is selling the property, the lessee, immediately receives the purchase
price put up by the buyer, the lessor. At the same time, the seller-lessee company retains
the use of the property just as if it had borrowed and mortgaged the property to secure the
loan. Note that under a mortgage loan arrangement, the financial institution would normally
receive a series of equal payments just sufficient to amortise the loan while providing a
specified rate of return to the lender on the outstanding balance. Under a sale-and-leaseback
arrangement, the lease payments are set up in exactly the same way: the payments are set
at a level to return the purchase price to the investor-lessor while providing a specified rate
of return on the lessor’s outstanding investment.

Operating leases
Operating leases, sometimes called service leases, provide for both financing and maintenance.
IBM is one of the pioneers of the operating lease contract, and computers and office copying
machines, together with automobiles and trucks, are the primary types of equipment involved.
Ordinarily, these leases call for the lessor to maintain and service the leased equipment, and
the cost of providing maintenance is built into the lease payments.
Another important characteristic of operating leases is the fact that they are frequently
not fully amortised; in other words, the payments required under the lease contract are not
sufficient to recover the full cost of the equipment. However, the lease contract is written
for a period considerably shorter than the expected economic life of the leased equipment,
and the lessor expects to recover all investment costs through subsequent renewal payments,
through subsequent leases to other lessees or by selling the leased equipment.
A final feature of operating leases is that they frequently contain a cancellation clause,
which gives the lessee the right to cancel the lease before the expiration of the basic agree-
ment. This is an important consideration for the lessee, for it means that the equipment
can be returned if it is rendered obsolete by technological developments or if it is no longer
needed because of a decline in the lessee’s business.

Direct financing leases

Direct financing leases, sometimes called financial leases, are differentiated from operating
leases in three respects: (i) they do not provide for maintenance services; (ii) they cannot
be cancelled; and (iii) they are fully amortised (that is, the lessor receives rental payments
which are equal to the full price of the leased equipment plus a return on the investment).
In a typical financial lease arrangement, the company that will use the equipment (the lessee)
selects the specific items it requires and negotiates the price and delivery terms with the
manufacturer. The user company then negotiates terms with a leasing company and, once
the lease terms are set, arranges to have the lessor (the leasing company) buy the equip-
ment from the manufacturer or the distributor. When the equipment is purchased, the user
company simultaneously executes the lease agreement.

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 Leasing companies

Financial leases are similar to sale-and-leaseback arrangements, the major difference

being that the leased equipment is new and the lessor buys it from a manufacturer or a
distributor instead of from the user-lessee. A sale and leaseback may thus be thought of as
a special type of financial lease.
Note: direct financing leases are not to be confused with the accounting treatment of
leases which distinguishes between an ‘operating lease’ and a ‘capital’ or ‘finance lease’ (see
discussion later on the financial statement effects of leases).

Leveraged lease
The leveraged lease is a specialised form of the financial lease but differs in that it involves
at least three parties: a lessee, a long-term creditor and a lessor (commonly referred to as
the equity participant). Other characteristics of a leveraged lease are:

⦁⦁ the financing provided by the long-term creditor must be without recourse to the general
credit of the lessor, although the creditor may hold recourse to the leased asset. The
amount of the financing must give the lessor substantial leverage in the transaction; and
⦁⦁ the lessor’s net investment declines during the early years and rises during the later years
of the lease term before elimination.

The lessor borrows most of the funds needed to acquire the asset from a third party (the
long-term creditor), usually a bank or insurance company. The lessor makes an equity
investment equal to, say, 20% of the equipment’s original costs, and borrows the remaining
80% by issuing non-recourse notes to the lenders, and writes a non-cancellable lease for
the equipment.
The lessor makes an assignment of the lease and lease rental payments to the lender, who
is entitled to repossess the asset if the lessee defaults. In most jurisdictions, a leveraged lease
is a true lease for tax purposes because the lessor, as owner of the asset, is entitled to all
of the tax benefits of ownership, including accelerated depreciation write-offs, deduction of
interest payments on the bank loan, and the investment credit, if any, for the purchase of the
asset. Banks often write leveraged leases for their own customers through leasing subsidiaries.

Financial statement effects: lessee

Lease payments are shown as operating expenses on a company’s income statement, but
under certain conditions neither the leased assets nor the liabilities under the lease contract
appear on the company’s balance sheet. For this reason, leasing is often called off-balance
sheet financing. Proposed IFRS and US GAAP lease accounting changes will restrict off-
balance sheet financing to only lease terms up to a maximum of one year (see Appendix
5.3). The off-balance sheet effect is illustrated in Exhibit 5.1 with the balance sheets of two
hypothetical companies, B (for Buy) and L (for Lease).
Initially, the balance sheets of both companies are identical, and both have debt ratios
of 50%. Each company then decides to acquire fixed assets which cost LCU100. Company
B borrows LCU100 to make the purchase, so both an asset and a liability are recorded on

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its balance sheet, and its debt ratio is increased to 75%. Company L leases the equipment,
so its balance sheet is unchanged. The lease may call for fixed charges as high as, or even
higher than, those of the loan, and the obligations assumed under the lease may be equally
or more dangerous from the standpoint of financial safety, but the company’s debt ratio
remains at 50%.
To correct this problem and to add greater transparency and comparability among
companies, financial analysts and accountants pressured for, and obtained, certain accounting
standards for leases. First, a distinction is made between two types of lease arrangements.

⦁⦁ Finance leases (or capital lease in US terminology), which transfer substantially all the
risks and rewards incident to ownership of an asset. Title may or may not eventually be
transferred.
⦁⦁ Operating leases, which are leases other than finance leases.

Exhibit 5.1
Balance sheet of Companies B and L

Before asset increase

Companies B and L (LCU)*
Current assets 50 Debt 50
Fixed assets 50 Equity 50
Total 100 Total 100
After asset increase
Company B, which borrows and buys
Current assets 50 Debt 150
Fixed assets 150 Equity 50
Total 200 Total 200
Debt ratio: 75%
After asset increase
Company L, which leases
Current assets 50 Debt 50
Fixed assets 50 Equity 50
Total 100 Total 100
Debt ratio: 50%

* Local currency unit.

Source: Author’s own

Companies that enter into finance (or capital) leases must restate their balance sheets to
report: (i) leased assets as fixed assets; and (ii) the present value of future lease payments as a

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 Leasing companies

liability. This process is called capitalising the lease, and its net effect is to cause Companies
B and L to have similar balance sheets, both of which will resemble the one shown for
Company B after the asset increase.
International accounting standards2 require that a lease will be classified as a capital
lease, and hence be capitalised and shown directly on the balance sheet, if any one of the
following conditions exists:

⦁⦁ lease transfers ownership of asset to the lessee at the expiration of the lease;
⦁⦁ lessee has a bargain purchase option that will be exercised with reasonable certainty;
⦁⦁ lease term is for a major part of the economic life of the asset;
⦁⦁ present value of minimum lease payments approximates fair value of the leased asset;
⦁⦁ leased asset is of a specialised nature and only suitable for lessee;
⦁⦁ lessee will bear cancellation losses;
⦁⦁ fluctuation gains/losses of residual value passed on to lessee; or
⦁⦁ lease for secondary period possible at substantial lower-than-market rent.

These rules, inspired by US GAAP accounting standards,3 together with strong footnote
disclosures for operating leases, are sufficient to ensure that no one will be fooled by lease
financing. Thus, leases are recognised to be essentially the same as debt, and they have the
same effects as debts on the company’s required rate of return. Therefore, leasing will not
generally permit a company to use more financial leverage than could be obtained with
conventional debt.
However, the advantages of leasing remain strong:

⦁⦁ the lessee (borrower) is generally able to obtain 100% financing;

⦁⦁ there may be tax benefits for the lessee;
⦁⦁ the lessor receives the equivalent of interest as well as an asset with some remaining value
at the end of the lease term (unless title transfers as a condition of the lease); and
⦁⦁ the lessee is protected from risk of obsolescence.

Analysing the balance sheet

The assets of a leasing company are typically broken down into two groups, receivables
and other assets. This varies from the usual current assets and fixed assets display of a
commercial company.

Accounting note
In the following discussion, it will be assumed that leasing companies are using the direct
financing or finance method of recording leases compared with the operating method. Under
the finance method, the net value of the leases is recorded, which consists of the sum of all
minimum lease payments and estimated residual values less unearned income and an allow-
ance for doubtful accounts. Unearned income and the investment tax credit (if available and
if retained by the lessor) are earned and included in income over the terms of the leases.

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Credit Analysis of Financial Institutions

Under the operating method, the equipment is capitalised on the books and depreciated over
time, with the rental payments recognised as income.

Receivables
In most cases, the receivables section of the assets accounts for 90% or more of the total.
On the balance sheet, they are not broken down between those receivables due in 12 months
and those due after 12 months. However, the footnotes will usually show the receivables
broken out by year for the ensuing five years and thereafter. This breakdown will give the
analyst a feel for the terms of leasing being done by the company and will provide valuable
information in determining the structure of debt that might be used to finance those assets.
Leasing is provided at terms varying from three to 10 years or more. Leasing continues
to be offered at a fixed rental rate and is, therefore, equivalent to fixed-rate financing.
Because of this aspect, many leasing companies have experienced a squeeze on profitability
as a result of the fixed-rate nature of their assets.
Some time ago there was a very heavy reliance on short-term, variable-rate debt financing
to support these assets but with disastrous consequences for many leasing companies. All
leasing companies should try to adopt a proper asset-liability mix which reduces or controls
mismatch risk. Many analysts believe that the more closely the assets and liabilities are
matched, the better off the company. This is true, especially if the average term of the leases
booked is for periods exceeding three years. A prudent analyst should be concerned about
the asset-liability mix and should look for intermediate-term debt financing if less than 50%
of the receivables are due within the next 12 months.
As long as there is longer-term, fixed-rate debt financing available to leasing companies,
they will continue to offer the traditional structure of fixed-lease payments. Both lessors and
lessees are hesitant to entertain a floating-rate or variable-payment structure based on interest
rate fluctuations, since one of the traditional reasons for leasing is to acquire equipment at
a fixed monthly or quarterly payment.

Exhibit 5.2
The leasing company’s balance sheet, year ending 31 December xxxx (LCU* thousand)

Assets
Contracts receivables
Direct finance leases 10,000
Conditional sales agreements 4,000
Gross contracts receivable 14,000
Estimated residual value of leased equipment 1,000
Gross contracts and residual receivable 15,000
Less: Deferred lease income –3,000

Continued

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Deferred residual income –500

Deferred investment tax credit income –500
Reserve for losses –300
Net contracts and residual receivable 10,700
Other assets
Cash 100
Repossessed equipment inventory 150
Prepaid expenses 50
Total other assets 300
Total assets 11,000
Liabilities and shareholders’ equity
Liabilities
Borrowed funds 8,000
Deferred income taxes 900
Other liabilities 100
Total liabilities 9,000
Shareholders’ equity
Common shares 100
Retained earnings 1,900
Total shareholders’ equity 2,000
Total liabilities and shareholders’ equity 11,000

* Local currency unit.

Source: Author’s own

Residual values
In the receivables section, the residual valuations of the equipment on lease are broken
out separately. The question is then raised, is the company conservative or liberal in its
approach to establishing residual values? In the early days of leasing, most companies took
a very conservative approach to residual valuations and established values of no more than
10% of the original cost of the equipment. Some companies were even more conservative
in recording no residual value at the inception of the lease. As markets evolved, and the
leasing industry became more competitive, the residual values tended to increase. During
the 1970s, there was a tremendous drive to do leasing business. As a result, some compa-
nies were forced to take a more aggressive approach to establishing residuals in order to
make the lease look attractive. The analyst should look closely at the residual valuation
policy of the company, since this segment of the asset is very important to the overall
profitability of the leasing company.

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The analyst should keep in mind two points. One, the leasing companies affiliated with
banks or bank holding companies are often limited by laws of their respective countries to
a maximum residual valuation, or 25%, for example. This limitation to some extent reduces
the risk that a bank leasing company can take on lease assets. However, it should be noted
that a 25% residual value on furniture or fixtures would, perhaps, be out of line and would
be considered aggressive. On the other hand, a 25% value on corporate aircraft would be
classified as conservative.
Secondly, it is difficult to establish whether or not a company is reasonable in its residual
valuations if the company is less than, say, five years old. Since the most common term
for leasing is five years, the newer leasing companies have not experienced any meaningful
history of disposing of the residuals at the end of the lease. For those companies that have
track records, it is important that they monitor their experience. The company should have
a residual realisation report which reflects the amount of residual realised compared with the
amount of residual booked at the inception of the lease. If the company sold the assets for
an amount equal to the assumed residual, the residual realisation percentage would be 100.
If the assets were disposed of for an amount less than the assumed residual, the percentage
would be less than 100. Conversely, if they were sold for more, the percentage would be
greater than 100.
A range of 100% to 120% appears totally acceptable. Competitive pressures tend to
hold down the residual realisation values. Most lessors recognise that they are in business
for the long run and are looking to receive their booked residual plus a small profit and
still maintain the satisfaction of their customers.

Reserve for losses

Companies using the finance method of recording leases should reflect a reserve of losses
which is shown as a reduction in the total receivables and expressed as a percentage of
the remaining gross receivables. This reserve is usually set up at the inception of the lease,
and future lease losses are charged to this reserve. The question is then raised as to the
adequacy of this reserve. One recommended ratio is the loss to liquidation percentage as a
measurement of the adequacy of the reserve. This percentage seems to be more useful on
those receivables that mature over several years. The loss/liquidation percentage is obtained
by the following formula:

Periodic cash losses – recovers Net losses

¥
Total payments received during period Liquidations

Once this percentage is obtained, it can be related to the percentage of the reserve for losses
to gross receivables. If the loss/liquidation percentage is less than the reserve percentage, it
could be deduced that the reserve is adequate to cover future losses. This assumes that the
loss experience remains relatively constant over the term of the leases. There can be cata-
strophic or extraordinary losses experienced, but this analysis will give some assurance that
the company is providing an adequate reserve to cover future losses.

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 Leasing companies

Investment tax credit

From time to time, some countries provide incentives for companies to increase their invest-
ment in capital equipment. Purchasers of equipment may be eligible for an ‘investment tax
credit’ (ITC) of up to, say, 10% of the cost of the original equipment. At the time the
lease is negotiated, the lessor negotiates with the lessee concerning the treatment of ITC.
If the credit is retained by the lessor, they will quote a lower payment to the lessee. If the
lessee retains the credit, a higher payment will be quoted by the lessor to the customer.
When the lessor retains the ITC, they have a choice as to how to account for it on their
books. The lessor could use either the flow-through method, which is a direct reduction
of taxes payable during the period, or the deferral method. Under the deferral method,
the ITC is reflected or amortised into income over the term of the lease. The remaining
unamortised ITC might be reflected as a liability or as a contra account and a reduction of
gross assets. It is preferable to view the ITC, where it is available, as part of the earnings
stream of the lease and as being similar to unearned income or unearned residual income,
rather than a liability.

Other assets
The other general breakdown of assets on the balance sheet is usually referred to as ‘other
assets’. In this category there typically will be an account called ‘repossessed’, or ‘off-rent
inventory’. This account should be reviewed closely and compared over time.
Obviously, a rapidly expanding level of assets could be a warning sign. Either the leasing
company is experiencing more than normal repossessions or is having a difficult time selling
the equipment as the leases expire. In most cases, these values tend to be repossessed equip-
ment, since nearly all the equipment under lease is sold to the original lessee. This percentage
could be significantly less in those companies specialising in data processing or computer
equipment where it is quite normal not to purchase the equipment at the end of the lease
contract. The analyst should ask two questions about this equipment. First, is it realistically
valued? Secondly, how long has this equipment remained in inventory?
The leasing company should take the approach of writing down this equipment to its
net realisable value at the time it is repossessed or returned at the expiration of the lease.
Since these assets are classified as non-earning assets, the company should make every effort
to dispose of these assets in a timely manner. The analyst should seriously question those
assets that have been in inventory more than six months.

Liabilities
On the liability side of the balance sheet, the largest liability will be the debt supporting the
lease portfolio. As indicated, the analyst should be observant as to whether or not there is a
reasonable match between assets and liabilities. Another major liability for leasing companies
is the deferred tax account (in countries where such tax treatment is allowed). A significant
part of the yield on the lease transaction is generated from the depreciation benefits accruing

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to the lessor as a result of being owner of the equipment. For tax purposes, the equip-
ment is depreciated using an accelerated method of depreciation, and the timing differences
between income for tax purposes and income for book purposes is reflected in the deferred
tax section. This liability can be looked at as borrowing from the government at no cost.
Thus, the more deferred taxes generated, the more free borrowings.
However, it is important to remember that these deferred taxes are not indefinite borrow-
ings. They must be paid at some later date. In an expanding mode, this deferred tax account
tends to increase in value over time. If, however, the amount of tax leasing being done by the
company levels off or is decreased, the taxable income level of the company will increase as
depreciation decreases over time. At this point these taxes must be paid to the government.

Shareholders’ equity
The equity section of the balance sheet will usually follow the traditional display. The question
of leverage arises, and it is probably the question most frequently asked. What is acceptable
leverage? The analyst must look at the entire balance sheet to determine the answer. It is
generally agreed that ‘acceptable’ tends to be in the area of five or six times (total liabilities
divided by total shareholders’ equity). Some major international finance and leasing companies
are leveraged up to 10 times or more. It would appear that the more matched the assets
and liabilities are, the more leverage one could tolerate. On the other hand, if the company
is financing its fixed-rate portfolio with floating-rate debt, it would be important to have a
capital base to support a rapidly fluctuating interest rate environment.
The quality of the receivables also is important. If the company is experiencing few
credit losses and has a very clean portfolio, this could support higher leverage. On the
other hand, if there appears to be a significant exposure to credit losses, lower leverage is
desirable. The analyst should also look at the interest coverage ratio (discussed further in
the income statement section). The greater the interest coverage ratio, the more leverage the
earnings can support.

Economics of leasing
Before reviewing the income statement, a brief overview of the economics of leasing is
warranted. It is important to recognise that from an income standpoint, the lease is more
complex than a loan. In the latter, the main income is derived from the interest charged on
the loan. In addition, there can be other enhancements to that income, such as loan fees
and service commissions. A lease generally has four components of yield:

1 income from the stream of payments;

2 residual value;
3 depreciation; and
4 ITC (where available).

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When one breaks down the yield on a sample lease, the contributions of the components
to total yield might be as follows:

Contribution to yield (%)

Stream of payments 8.0
Residual 2.0
Depreciation 2.0
ITC (if available) 8.0

It is apparent that on those leases where the ITC is retained by a lessor, a significant portion
of the yield is derived from this credit. This example contemplates a 10% residual at the
end of a 60-month period, and one can see that without the residual the overall yield will
suffer. As the reliance on the residual is increased, the corresponding contribution to yield
increases. Therefore, a realistic approach to residual valuation is important in determining
the pricing of the leases.
In countries where the ITC is available, it is evident that the leasing company must be
able to use it in a timely manner. The following example assumes that the ITC will be used
in a timely way. If it is not, there is a gradual erosion of the gross yield. The following gives
an indication of the erosion of yield as the ITC is deferred to future years.

Yield (%)
ITC timely used 20.00
ITC use deferred:
  12 months 18.50
  24 months 17.00
  36 months 15.75

Likewise, the timing differences between income for tax purposes and book purposes as a
result of accelerated depreciation enhances the yield of the transaction. (This, of course, is
only relevant in countries allowing such accounting methods.) As indicated, the timing differ-
ences, in effect, create deferred taxes, which again are borrowing from the government. It
is assumed that the depreciation can be absorbed on the tax return in a timely manner. To
the extent that this is not accomplished, the gross yield will be negatively affected.
Most leasing companies, on average, will receive a slight amount in excess of the original
residual valuation. Using the example of a 10% residual assumption, the following table
gives an idea of the impact on yield of realising residual values less than, or exceeding, that
originally booked at the inception of the lease.

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Credit Analysis of Financial Institutions

Residual realised* Yield (%)

50 19.0
75 19.5
100 20.0
110 20.3
120 20.6
130 20.8
*Expressed as a percentage of original residual booked.

Analysing the income statement

The income statement of the leasing company may indicate the different sources from which
income is derived, or those sources may be grouped together under the general heading
‘leasing income’.
To review, the sources of income include: (i) income from the stream of payments; (ii)
income from the residual value; and (iii) income from the ITC (where available).
While depreciation is a component of yield, the effect on income is reflected as a reduc-
tion in borrowing costs since it was indicated that the deferred taxes are similar to borrowing
interest-free from the government (where such accounting practices are allowed). There are
other sources of income indicated in the ‘other income’ section, namely extension fees, late
charges and gains on the disposition of leased assets. At the expiration of the lease, the
excess or deficiency of residual realised compared with residual booked will appear as gain
or loss on the sale of lease assets.
The method most commonly used to recognise lease income is the interest method: the
income from the stream of payments, the residual and the ITC is recognised over the term
of the lease at the equivalent interest rate inherent in the lease transaction based on the net
investment in the lease. This will result in income being greater at the beginning of the lease
than at the end of the lease.
The finance method of accounting really could be considered accounting on a net basis.
The difference between the gross receivables on the lease together with the residuals and the
ITC less the cost of the equipment is the ‘income’ on the transaction and is amortised over
the term. The operating method for accounting for leases will reflect the total payments as
income and depreciation as an expense to amortise the cost of the equipment.

Acquisition income
An important consideration for a leasing company is the ‘set-up income’ (also called the ‘first-
day income’ or the ‘acquisition income’). Under most accounting rules, leasing companies are
allowed to recognise, on the day of booking the lease, a certain amount of the income to offset
the initial direct costs. Generally, these costs are marketing costs, commissions, and so on.
The analyst should pay attention to the amount of set-up income recognised, if any, since
it really reduces the unearned income account that will be amortised over the remainder of the

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term. The more recognised at the inception, the less there is to amortise over the remaining
term. A review of many leasing company financial statements reveals that the amount of
set-up income recognised varies from 0% to 15% of the cost of the equipment. The higher
the acquisition income or set-up income, the greater the original gross yield needed in the
lease. Companies with a high percentage of acquisition income find it difficult to maintain
profitability levels if their volume does not increase. They rely on this income to a great
extent, and when this is taken away, book income suffers.
Some companies will also recognise on the first day of booking a lease an amount of
income equal to the provision for losses, which is established at the time the lease is booked.
When this is done, there could be little income left in the unearned income account to be
amortised, and it should be recognised that future income levels could be affected.

Exhibit 5.3
The leasing company’s income statement, year ending 31 December xxxx (LCU*
thousand)

Income from contracts receivable

Lease income 1,200
Interest income 400
Residual income 150
Total contract income 1,750
Less: interest expense 1,200
Net contract income 550
Provision for losses 80
Net contract income after provision for losses 470
Other income
Late charges 10
Gain on lease terminations 70
Total other income 80
Income before operating expenses 550
Operating expenses
Salaries 120
Other operating expenses 130
Total expenses 250
Income before taxes 300
Income taxes 100
Net income 200

* Local currency unit.

Source: Author’s own

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In general, companies with liberal set-up income policies have a fairly high marketing
cost or acquisition cost. It should be noted that the leasing industry, with its aggressive
compensation programs, is quite entrepreneurial compared with the banking industry. Many
leasing companies will pay sizeable brokerage fees to obtain business.
The provision or reserve for lease losses is maintained similar to other companies estab-
lishing a reserve for bad debts. Some companies establish a certain percentage of the equipment
cost as a provision and will book the provision at the commencement of the lease. Most
other companies, however, record the reserve for loss periodically, based on their level of
receivables and their past experience. Companies that have been in business several years
should be able to provide sufficient historical data on their level of losses which can be
matched with current levels of loss reserves. The loss to liquidation percentage, as indicated
earlier, is a good way to establish the acceptable level of the reserve. Usually large charges
or credits to the reserve should be questioned.

Quality of earnings
Quantity of earnings is important but so is quality. The analyst will want to continue to
see a level of earnings meeting or exceeding previous years and, to accomplish this trend,
the quality of the earnings must be present.
There are five areas that affect the quality of earnings: residual realisation history, delin-
quency trends, extension/rewrite policy, charge-off policy and gross margins.

Residual history
As indicated, leasing companies have the ability to enhance the profitability on leases by real-
ising residual values in excess of those assumed at the inception of the lease. When looking
at the periodic earnings, the analyst should look at the reliance of these earnings on gains
on the sale of lease assets. These gains should be reviewed over time and large periodic gains
taken into consideration when comparing one period to another. The analyst should also
note whether any significant losses on the sale of leased assets have been recorded.
The method of payment for the residual could also be important if the method is other
than cash. If the sales price of the residual has been financed, or the terms of the lease have
been extended, it should be verified that the company has a policy of having sufficient collat-
eral to back up the contract or that there is sufficient useful life of the equipment remaining
to support the extended terms of the lease. When the lease is rewritten, most companies
will probably liquidate the residual value on their books in some manner before recognising
any book gain. The analyst should question extended leases that maintain a booked residual
value at the expiration of the extended term.

Delinquency
A second area that could affect the quality of earnings is the delinquency of the portfolio.
Delinquency is an early warning sign indicating problems in the future. Leasing companies

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 Leasing companies

should be tracking their delinquencies from month to month like any other company and
should be exerting sufficient efforts to keep the delinquency at a minimum percentage.
The question of method of reporting delinquencies is raised periodically. Some companies
measure their delinquencies as the ratio of rents past due to the total amounts billed for a
particular period. Perhaps more revealing is to monitor the ratio of delinquencies reported
based on total balances past due to the total portfolio. Merely looking at the payments
that are delinquent could shield significant loss exposure. The standard format to report
delinquency tracks those accounts past due from 30 to 59 days, 60 to 89 days, and 90 days
and over. Tracking these segments is important, and the analyst should be concerned by an
ever-increasing amount in the 90 days and over category.

Extension policy
One area that is most often overlooked by analysts and probably has more effect on the
quality of earnings than any other is the company’s extension and rewrite policies. From
time to time leasing companies will be asked to extend or modify their leases in order to
adapt to their customers’ changing conditions. However, when implementing such a policy,
a company line is needed to protect the company’s assets. A liberal extension policy serves
little purpose to the company and could be deferring the inevitable. This is especially true
when extensions are granted and the customer provides nothing in return – no partial cash
payment, no additional collateral, no guarantees, and so on. A liberal policy could hide
problems and when accumulated over time could spell disaster.

Charge-off policy
The fourth area of concern would be the leasing company’s charge-off policy. There are
two areas on the balance sheet where the charge-off policy comes into play: the receivables
section and the repossession/off-rent equipment account.
A company should have a policy regarding the status of seriously delinquent accounts.
First of all, there should be a mechanism in place to stop accruing income when an account
becomes 90 to 120 days past due. Secondly, when an account becomes more seriously past
due, probably in the area of 180 days, the account should be written down to its net realis-
able value, even though the equipment is not technically repossessed. These accounts may
represent those that are tied up in bankruptcy proceedings where it is difficult to repossess
the equipment and the customer has protection against creditors, which is the case in most
developed markets, until a plan is submitted. The leasing company should recognise this
as a troubled account and adjust its value accordingly, usually involving a write-down of
the receivable.
As indicated earlier, some equipment will be returned to the lessor at the expiration of
the lease and usually will be combined with repossessed equipment to form an equipment
inventory. Before this equipment is transferred to this account, it should be written down to
its net realisable value and any losses should be charged to gains and losses on the sale of
leased assets or the provision for losses. The analyst should pay attention to the trends in
this account since these are non-earning assets and should be disposed of in a timely manner.

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Credit Analysis of Financial Institutions

It should be noted, however, that there could be situations where deferring the sale of the
asset would generate greater values in the future. One example is an agricultural tractor
acquired in December – it may be prudent to hold on to the tractor until the spring, when
it would probably be sold at a higher price.

Gross margins
The last area affecting the quality of earnings is the gross margins of the company. Gross
margin is defined as contract income less interest expense. The gross margin percentage
should be monitored on a periodic basis to see if there are any significant changes in the
margins. Declining margins generally reflect lower pricing as a result of competitive pres-
sures, increasing interest costs or a combination of both. The goal of all companies should
be to maintain the gross margin at the highest possible level in order to pay expenses and
provide a sufficient return on equity (ROE).

Use of ratios
In addition to a common size statement (balance sheet and income statement converted to
percentages), there are six key financial ratios that should be reviewed in the analysis of
leasing companies. These are:

⦁⦁ return on assets (ROA);

⦁⦁ ROE;
⦁⦁ gross margins;
⦁⦁ aggregate total borrowings divided by shareholder’s equity (leverage);
⦁⦁ times interest earned (interest coverage); and
⦁⦁ loss/liquidation.

Of the six, analysts watch most closely the times interest earned or interest coverage ratio
for leasing companies. This ratio is the earnings before interest and taxes divided by interest
expense. It is a measure of the cushion the company has to absorb rapidly fluctuating interest
rates, extraordinary losses, and so on. Historically, a ratio of 1.5 times was the minimum
target. During the early to mid-2000s, however, because of the pressure for improved earn-
ings quality by investors in the financial markets, a higher ratio of 2.0 times or more has
been observed by analysts.
A survey of equipment lessors by Risk Management Associates (RMA)4 included infor-
mation on the key ratios (see Exhibit 5.4).
The survey results indicate that global equipment leasing companies have experienced a
decline in ROE but a strengthening of financial structure through lower debt levels. Industry
trade associations expect a pickup in profitability but remain apprehensive about the impact
of IFRS and US GAAP proposals to force all leases onto lessee balance sheets – except
contracts for a period of 12 months or less.

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Exhibit 5.4
Key ratios

2008 2009 2010 2011

Pretax profit/Equity 23.7% 23.2% 20.0% 16.9%
Pretax profit/Total assets 4.4% 4.4% 4.8% 4.6%
Debt/Equity 5.6¥ 5.7¥ 4.3¥ 3.8¥
Times interest earned 2.4 2.2 2.6 2.3

Source: Author’s own

Box 5.1
Checklist questions
Balance sheet
What is the receivables mix?
What percentage is fixed rate? Floating rate? Equipment concentration?
Industry concentration?
Is the residual valuation conservative? Liberal?
What is the residual realisation experience in percentage terms?
What is the loss/liquidation ratio?
How does the reserve for losses relate to gross receivables (%)?
Are repossessed assets realistically valued?
What is the percentage repossessed/off-rent inventory over 180 days?
What is the debt structure profile? Percentage short-term?
Percentage intermediate to long-term? Percentage floating rate?
Percentage fixed rate?

Income statement and quality of earnings

What income method is used?
To what extent is there reliance on gains/losses of leased assets?
What is the level of acquisition income?
As a percentage of new equipment purchases?
As a percentage of gross income?
Is the provision for losses maintained at a constant level?
What is the delinquency trend? Favourable or unfavourable?
Is the extension/rewrite policy conservative or liberal?
Are repossessions and off-rent equipment adjusted to net realisable value? Is income accrual
stopped on seriously delinquent accounts?
Are accounts written down when seriously delinquent?

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Box 5.2
Success in the ‘new normal’
Global Leasing Resource, an industry newsletter, provided the following advice to leasing
companies and credit analysts alike:1

There is no certain formula for success in a tumultuous economic environment

or in its aftermath. But there are approaches that create a high likelihood that
lease companies can first survive the trauma; second, prosper in its aftermath;
and third, better prepare for subsequent economic downturns.
Play defence. A more cautious approach is to deploy a defensive strategy.
Focus on recession-resistant industries, for example, energy, food production,
healthcare, and telecommunications. Within your chosen recession-resistant indus-
tries, establish relationships with big companies that have large cap ex budgets.
For sub-investment grade calibre lessees, the focus should be to lease mission
critical equipment over short lease terms under ‘true lease’ structures. A defensive
strategy is a variant generally of the flight to quality that has occurred and which,
to a significant extent, still exists. Therefore, you can expect the market to be
more competitive, resulting in lower spreads and overall yields. Because there
are inefficiencies in every market, though, you may find opportunities that defy
the general rule. But by playing in recession-resistant industries, you will obtain
the benefit of industry momentum, which may mean that you can take a little
more risk with lower credit calibre companies to improve your overall returns.
Play Offence. Because of the very nature of the leasing industry – entre-
preneurial, nimble, opportunistic – many lease companies have deployed an
offensive (and riskier) strategy. This involves focusing on industries that have
been substantially hurt by The Great Recession, are generally in some degree of
disfavour by the mainstream providers of capital, and which have significant upside
as the economy recovers – even if not to the pre-crisis level. For example, the
construction, retail, and mining industries suffered considerably over the period
following the meltdown and yet, with some recovery having occurred, various
facets of those industries are doing reasonably well.
As in the defensive approach, within your chosen industry, you should focus
on big companies with large capex budgets. To further mitigate the risk, because
the industry does not have positive momentum, your lessees should have strong
balance sheets and significant market share, despite current (and/or recent)
losses. In disfavoured industries, the positive industry momentum does not exist.
Therefore, you should lease mission-critical or revenue-generating equipment with
an established secondary market (in case you must repossess and remarket the
equipment). And with more challenging credits – whether you are in a defensive
mode or an offensive mode – the lease terms should be shorter, the leases

Continued

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should be structured as ‘true leases’, and you should incorporate as many ‘credit
enhancements’ into the transaction as available. You can expect this approach to
involve more risk and hopefully disproportionately high returns, but more difficulty
in finding financing partners.
Foundation in place. Whether you desire to employ a defensive strategy, an
offensive strategy, or some combination thereof, your level of success will depend
on how well you execute your strategy. And to best execute your strategy, you
must implement (or refine) seven foundational elements:
Origination. Develop predictable deal flow. Without that, nothing else matters.
Vendor finance programs; programs with banks, brokers, and other lease compa-
nies; and direct relationships with lessees are the industry standards for deal
origination. Whatever channels you utilise, you must ensure they generate consis-
tent deal flow.
Funding and liquidity. Develop reliable funding sources that match your
deal flow. The criticality of appropriate funding is obvious. Given the volatility of
the capital markets over the past couple of years, redundancy is essential. And
maintaining internal liquidity to supplement a lease company’s permanent funding
solutions is also important to ensure a lease company’s ability to close transactions.
Specialisation. The leasing industry is a mature industry and, as such, lessors
must continue to determine how to provide new value to their customers. Focusing
in and becoming an expert with respect to specific industries allows lessors to
bring value to all transaction participants, including lessees, lenders, and vendors.
Understanding the players (both companies and individuals), the equipment, the
market dynamics, and industry trends is an important benefit of specialising in a
particular industry, and allows lessors to continue to find new ways to add value.
Customisation. Thoroughly understanding the objectives and needs of your
customers is another key component of adding value and distinguishing your
company from your competitors. If you learn your customers’ objectives and
needs, you are much better prepared to structure financing solutions consistent
with those objectives and needs. Customisation involves lease structure, pricing,
term, invoicing requirements, sales/use/property tax administration, accounting,
reporting, and so on. Specialising in an industry provides a strong base of knowl-
edge that facilitates effective customisation.
Market awareness. In normal economic times, the market (participants, access
to capital, pricing, structure, terms, and so on.) changes gradually and, therefore,
it is much easier for transaction parties to stay apprised of the market as they
are pursuing and completing transactions. But under severe economic conditions,
the market can change overnight and can fluctuate wildly over short periods.
That is exactly what transpired during the first several months after the inception
of the global economic crisis. Customers’ need and demand for equipment fell
precipitously. Availability of capital and the pricing of capital were subject to wide

Continued

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Credit Analysis of Financial Institutions

Box 5.2 continued

swings. To get a deal done, all of the components of the transaction must be
in alignment, for example, the vendor pricing and terms, the lease pricing and
terms, the lessor’s funding pricing and terms. So in a volatile environment, lease
companies must be hypersensitive to market changes.
Efficiencies. It is always important for lease companies to continue to improve
their systems and policies and procedures so that lease processing (transaction
review, pricing, credit analysis, documentation, funding, servicing, accounting and
reporting, and remarketing) is consistently achieving enhanced efficiencies. But in
challenging economic conditions, it is critical. Not only is it essential to stand out
in this regard among your competitors (as viewed from your customers’ perspec-
tives), but it also is a major cost containment measure which, in some cases,
makes the critical difference between survival and closing your doors – forever.
Profitability. This is where it all nets out: transaction flow, customer pricing,
funding availability and pricing, competitiveness, ability to meet your customers’
objectives and needs, ability to process efficiently. In challenging times, particularly
over multiple years, it is critical to achieve profitability – even if not immediately.
Without profitability, the likelihood of long term – and even medium term – viability
is substantially diminished at best. And without profitability, even if only for a
short time, a lease company’s lines of credit and funding relationships become
tenuous (or non-existent). Without competitively-priced funding, a lease company
quickly spirals into oblivion.

1 Ruga, J and Newman, M, ‘Navigating the new normal: the aftermath of the Great Recession’, Global
Leasing Resource (www.globalleasingresource.com), March 2011.

1
Ruga, J and Newman, M, ‘Navigating the new normal: the aftermath of the Great Recession’, Global Leasing
Resource (www.globalleasingresource.com), March 2011.
2
IAS 17. The standard will be revised once IFRS and US GAAP converge on their lease accounting change proposal
expected by end-2012.
3
US GAAP = United States Generally Accepted Accounting Principles. The Financial Accounting Standards Board
issued FASB No. 13, which requires that for an unqualified audit report in the US, companies that enter into
capital (finance) leases must restate their balance sheets to report: (i) leased assets as fixed assets; and (ii) the
present value of future lease payments as a liability. The standard will be revised once IFRS and US GAAP
converge on their lease accounting change proposal slated for end-2012.
4
Risk Management Associates, Annual Statement Studies, Philadelphia, 2012.

348
Appendix 5.1

Deferred taxes

Deferred taxes are usually the result of a difference in the tax treatment for depreciation or
revenue recognition. Using an accelerated depreciation method for tax reporting, for example,
will create a difference in the financial statements prepared on, say, a straight-line deprecia-
tion basis for reporting to shareholders.

Deferred tax illustration

The following example highlights the deferred liability nature of deferred taxes. The assump-
tions are:

⦁⦁ machine purchased for £900 with estimated life of five years and zero salvage value;
⦁⦁ tax rate: 50%;
⦁⦁ accelerated depreciation rate: sum-of-the-years’ digits (that is, 1 + 2 + 3 + 4 + 5 = 15;
5/15 × 900 = 300; 4/15 × 900 = 240; and so on);
⦁⦁ no change in income before depreciation and taxes; and
⦁⦁ no other assets acquired during the five-year period.

Deferred income tax arises because there is a difference between actual taxes paid and income
tax expense reported for financial statements. Underlying this is the distinction between
financial or book accounting and tax accounting. The object of financial or book accounting
is to show the greatest return, whereas tax accounting attempts to minimise taxable income
and save money (cash flow) in the earlier years of an asset.
Deferred tax treatment, however, can only occur where local tax regulations and
accounting practices permit it.

Exhibit 5.5
Deferred liability nature of deferred taxes : depreciation tax savings

Year Straight-line method Sum-of-the-years’ digits Difference

2012 0.50 × £180 = £90 0.50 × £300 = £150 £60
2013 0.50 × £180 = £90 0.50 × £240 = £120 £30
2014 0.50 × £180 = £90 0.50 × £180 = £90 £0
2015 0.50 × £180 = £90 0.50 × £120 = £60 £(30)
2016 0.50 × £180 = £90 0.50 × £60 = £30 £(60)
£450 £450 £0

Source: Author’s own

349
Exhibit 5.6
Statement preparation

Public filing Tax filing

Statement preparation: year 1
Income before depreciation £1,000 £1,000
Depreciation expense 180 300
820 700
Income tax 410 350
Net income 410 350
Statement preparation: year 2
Income before depreciation £1,000 £1,000
Depreciation expense 180 240
820 760
Income tax 410 380
Net income 410 380
Statement preparation: year 3
Income before depreciation £1,000 £1,000
Depreciation expense 180 180
820 820
Income tax 410 410
Net income 410 410
Statement preparation: year 4
Income before depreciation £1,000 £1,000
Depreciation expense 180 120
820 880
Income tax 410 440
Net income 410 440
Statement preparation: year 5
Income before depreciation £1,000 £1,000
Depreciation expense 180 60
820 940
Income tax 410 470
Net income 410 470

Source: Author’s own

Exhibit 5.7
Deferred tax: journal entries

Journal entry: year 1

Debit Credit
Income tax expense 410
Deferred income tax 60
Income tax payable 350
Journal entry: year 2
Income tax expense 410
Deferred income tax 30
Income tax payable 380
Journal entry: year 3
Income tax expense 410
Deferred income tax   0
Income tax payable 410
Journal entry: year 4
Income tax expense 410
Deferred income tax 30
Income tax payable 440
Journal entry: year 5
Income tax expense 410
Deferred income tax 60
Income tax payable 470

Source: Author’s own

Appendix 5.2

Accounting for leases: lessor

According to IAS,1 there are four classifications of leases with which a lessor must be
concerned:

⦁⦁ operating;
⦁⦁ sales-type;
⦁⦁ direct financing; and
⦁⦁ leveraged.

Operating leases
The operating lease requires a less complex accounting treatment than does a finance
lease. The payments received by the lessor are to be recorded as rent income in the period
in which the payment is received or becomes receivable. If either the rentals vary from a
straight-line basis (even amounts) or the lease agreement contains a scheduled rent increase
over the lease term, the revenue is to be recorded on a straight-line basis unless an alterna-
tive basis of systematic and rational allocation is more representative of the time pattern of
earning process contained in the lease.
Additionally, if the lease agreement provides for a scheduled increase in contemplation of
the lessee’s increased physical use of the leased asset, the total amount of rental payments,
including the scheduled increase, is allocated to revenue over the lease term on a straight-line
basis. However, if the scheduled increase is due to additional leased property, recognition
should be proportional to the leased assets, with the increased rents recognised over the years
that the lessee has control over use of the additional leased property.
The lessor must show the leased property on the balance sheet under the caption ‘invest-
ment in leased property’. This account should be shown with or near the plant assets of the
lessor and depreciated in the same manner as the rest of the lessor’s plant and equipment
assets. IAS 17 stipulates that ‘when a significant portion of the lessor’s business comprises
operating leases, the lessor should disclose the amount of assets by each major class of asset
together with the related accumulated depreciation at each balance sheet date’. Further, ‘assets
held for operating are usually included as property, plant and equipment in the balance sheet’.
In the case of operating leases, any initial direct (leasing) costs incurred by a lessor
are either to be amortised over the lease term as the revenue is recognised (that is, on a
straight-line basis unless another method is more representative) or charged to expense as
they are incurred.
Although there is no guidance on this matter under international accounting standards,
logically any incentives made by the lessor to the lessee are to be treated as reductions of
rent recognised on a straight-line basis over the term of the lease. This is also the position
taken under US GAAP.

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 Accounting for leases: lessor

Depreciation of leased assets should be on a basis consistent with the lessor’s normal
depreciation policy for similar assets.

Sales-type leases
In the accounting for sales-type lease it is necessary for the lessor to determine the following
amounts:

⦁⦁ gross investment;
⦁⦁ fair value of the leased assets; and
⦁⦁ cost.

From these amounts, the remainder of the computations necessary to record and account for
the lease transaction can be made. The first objective is to determine the numbers necessary
to complete the following accounting entry:

Debit Credit
Lease receivable XX
Cost of goods sold XX
  Sales XX
  Inventory XX
   Unearned finance income XX

The gross investment (lease receivable) of the lessor is equal to the sum of the minimum
lease payments (excluding executory or administrative costs) from the standpoint of the
lessor, plus the unguaranteed residual value accruing to the lessor. The difference between
the gross investment (that is, minimum lease payments and unguaranteed residual value) is
recorded as ‘unearned finance income’ (also referred to as ‘unearned interest revenue’). The
present value is to be computed using the lease term and implicit interest rate.
IAS 17 stipulates that the resulting unearned finance income is to be amortised and
recognised into income using the effective interest method, which will result in a constant
periodic rate of return either on the ‘lessor’s net investment’ (which is the ‘lessor’s gross
investment’ less the ‘unearned finance income’) or the ‘net cash investment’ outstanding in
respect of the lease (which is the balance of the cash outflows and inflows in respect of
the lease, excluding flows relating to insurance, maintenance and similar costs rechargeable
to the lessee). Further, IAS requires that whichever basis (the ‘net investment outstanding’
or the ‘net cash investment’) is used for allocating unearned finance income over the lease
term, such basis should be applied consistently to leases of similar financial character. The
basis used is also required to be disclosed, and if more than one basis is used the bases
should be disclosed. (This free choice between two different bases of amortising unearned
finance income is not permitted under US GAAP, which requires amortisation using the net
investment basis.)

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Credit Analysis of Financial Institutions

Direct financing leases

The accounting for a direct financing lease holds many similarities to that for a sales-type
lease. Of particular importance is that the terminology used is much the same; however, the
treatment accorded these items varies greatly. Again, it is best to preface the discussion by
determining the objectives in the accounting for a direct financing lease. Once the lease has
been classified, it must be recorded. To do this, the following amounts must be determined:

⦁⦁ gross investment;
⦁⦁ cost; and
⦁⦁ residual value.

Financial reporting for direct financing leases reflects the fact that leases are pure financing
transactions and result in only interest revenue being earned by the lessor. This is because
the fair market value (FMV or selling price) and the cost are equal, and therefore no dealer
profit is recognised on the actual lease transaction. Note how this is different from a sales-
type lease, which involves both a profit on the transaction and interest revenue over the
lease term. The reason for this difference is the conceptual nature underlying the purpose of
the lease transaction. In a sales-type lease, the manufacturer (or distributor, dealer, etc) is
seeking an alternative means to finance the sale of the product, whereas a direct financing
lease is a result of the consumer’s need to finance the purchase of equipment. Because the
consumer is unable to obtain conventional financing, he or she turns to a leasing company
that will purchase the desired asset and then lease it to the consumer. Here the profit on
the transaction remains with the manufacturer while the interest revenue is earned by the
leasing company.
Like for a sales-type lease, the first objective is to determine the amounts necessary to
complete the following entry:

Debit Credit
Lease receivable XX
  Asset XX
   Unearned finance income XX

The gross investment is still defined as the minimum amount of lease payments (from the
standpoint of a lessor) exclusive of any administrative costs plus the unguaranteed residual
value. The difference between the gross investment as determined above and the cost (carrying
value) of the asset is to be recorded as the unearned finance income because there is no
manufacturer’s/dealer’s profit earned on the transaction. The following entry would be made
to record initial direct costs:

Debit Credit
Initial direct costs XX
  Cash XX

354
 Accounting for leases: lessor

Net investment in the lease is defined as the gross investment less the unearned income plus
the unamortised initial direct costs related to the lease. Initial direct costs are defined in the
same way as for the sales-type lease; however, the accounting treatment is different. Unlike
under the sales-type lease, where these costs are required to be charged to expense imme-
diately, under the direct financing lease there is an option available to either: (i) amortise
initial direct costs over the lease term; or (ii) charge them to expense immediately.
Thus, for a direct financing lease, when the first option is chosen, the unearned lease (that
is, interest) income and the initial direct costs will be amortised to income over the lease term
so that a constant periodic rate is earned either on the lessor’s net investment outstanding
or on the net cash investment outstanding on the finance lease (that is, the balance of the
cash outflows and inflows in respect of the lease excluding administrative costs chargeable
to the lessee). Thus, the effect of the initial direct costs, in case the option to amortise is
chosen, is to reduce the implicit interest rate, or yield, to the lessor over the life of the lease.
The following example illustrates the preceding principles.

Example of accounting for a direct financing lease

Emirates Refining needs new equipment to expand its manufacturing operation. However, it
does not have sufficient capital to purchase the asset at this time. Because of this, Emirates
Refining has asked Consolidated Leasing to purchase the asset. In turn, Emirates will lease
the asset from Consolidated. The following information applies to the terms of the lease.

⦁⦁ A three-year lease is initiated on 1 January 2006 for equipment costing US$131,858,

with an expected useful life of five years. FMV at 1 January 2006 of the equipment is
US$131,858.
⦁⦁ Three annual payments are due to the lessor beginning 31 December 2006. The property
reverts back to the lessor on the termination of the lease.
⦁⦁ The unguaranteed residual value at the end of year 3 is estimated to be US$10,000.
⦁⦁ The annual payments are calculated to give the lessor a 10% return (the implicit rate).
⦁⦁ The lease payments and unguaranteed residual value have a present value (PV) equal to
US$131,858 (FMV of the asset) at the stipulated discount rate.
⦁⦁ The annual payment to the lessor is computed as follows:
PV of residual value2 = US$10,000 × .7513
PV of lease payments = Selling price – PV of residual value
= US$131,858 – US$7,513 = US$124,345
Annual payment3 = US$124,345/2.4869 = US$50,000.
⦁⦁ Initial direct costs of US$7,500 are incurred by Consolidated in the lease transaction.

As with any lease transaction, the first step must be to classify the lease appropriately. In this
case, the PV of the lease payments (US$124,345) is equal to 94% of the FMV (US$131,858),
and thus could be considered as equal to substantially all of the FMV of the leased asset.
Next, determine the unearned interest and the net investment in the lease.

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Credit Analysis of Financial Institutions

Gross investment in lease

[(3 × US$50,000) + US$10,000] US$160,000
Cost of leased property US$131,858
Unearned finance income US$28,142

The unamortised initial direct costs are to be added to the gross investment in the lease, and
the unearned finance income is to be deducted to arrive at the net investment in the lease.
The net investment in the lease for this example is determined as follows:

Gross investment in lease US$160,000

Add:
Unamortised initial direct costs US$7,500
US$167,500
Less:
Unearned finance income US$28,142
Net investment in lease US$139,358

The net investment in the lease (gross investment – unearned finance income) has been
increased by the amount of initial direct costs. Therefore, the implicit rate is no longer 10%.
The implicit rate must be recalculated, which is really a search for the internal rate of return.
The lease payments are to be US$50,000 per annum and a residual value of US$10,000
is available at the end of the lease term. In return for these payments (inflows), the lessor
is ‘giving up’ equipment (outflow) and incurring initial direct costs (outflows), with a net
investment of US$139,358 (US$131,858 + US$7,500). One way to obtain the new implicit
rate is through a trial-and-error calculation as set up below (of course, the preferred way is
through a financial calculator):

50,000/(1 + i)1 + 50,000/(1 + i)2 + 50,000/(1 + i)3 + 100,000/(1 + i)3 = US$139,358

where i = implicit rate of interest.

In this case, the implicit rate is equal to 7.008%. Thus, the amortisation table would
be set up as shown in Exhibit 5.8.
Here the interest is computed as 7.008% of the net investment. Note again that the net
investment at the end of the lease term is equal to the estimated residual value.

356
 Accounting for leases: lessor

Exhibit 5.8
Amortisation table

(a) (b) (c) (d) (e) (f)

Lease Reduction PV x implicit Reduction in Reduction PVI net
payments in unearned rate initial direct in PVI net investment
interest (7.008%) costs investment in lease
(b – c) (a – b + d) (f)(n + 1) =
(f)n – (e)

0 US$139,358
1 US$50,000 US$13,186 1
US$9,766 US$3,420 US$40,234 99,124
2 50,000 9,5042 6,947 2,557 43,053 56,071
3 50,000 5,4553 3,929 1,526 46,071 10,000
US$150,000 US$28,145* US$20,642 US$7,503 US$129,358
1 US$131,858 x 10% = US$13,186.
2 [US$131,858 – (US$50,000 – 13,186)] x 10% = US$9,504.
3 [US$95,044 – (US$50,000 – 9,504)] x 10% = US$5,455.
* Difference due to rounding.

Source: Author’s own

The entry made initially to record the lease is as follows:

Debit Credit
Lease receivable 4

[(US$50,000 × 3) + 10,000] 160,000

   Asset acquired for leasing 131,858
   Unearned lease finance income 28,142

When the payment (or obligation to pay) of the initial direct costs occurs, the following
entry must be made:

Debit Credit
Initial direct costs 7,500
  Cash 7,500

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Credit Analysis of Financial Institutions

Using the schedule above, the following entries would be made during each of the years
indicated:

Year 1 Year 2 Year 3

Debit Credit Debit Credit Debit Credit
Cash 50,000 50,000 50,000
  Lease receivable 50,000 50,000 50,000
Unearned finance income 13,186 9,504 5,455
   Initial direct costs 3,420 2,557 1,526
  Interest income 9,766 6,947 3,929

Finally, when the asset is returned to the lessor at the end of the lease term, it must be
recorded on the books. The necessary entry is as follows:

Year 1 Year 2 Year 3

Debit Credit Debit Credit Debit Credit
Used asset 10,000
  Lease receivable 10,000

Leveraged leases
Because of their complexity, leveraged leases are best discussed in an accounting textbook. A
leveraged lease is defined in IAS 17 as a finance lease that is structured in such a way that
there are at least three parties involved: the lessee, the lessor and one or more long-term
creditors who provide part of the acquisition finance for the leased asset, usually without
any general recourse to the lessor. Succinctly, this type of lease is given the following unique
accounting treatment.

⦁⦁ The lessor records his or her investment in the lease net of the non-recourse debt and the
related finance costs to the third-party creditor(s).
⦁⦁ The recognition of the finance income is based on the lessor’s net cash investment
outstanding in respect of the lease.

Disclosure requirements under IAS 17: lessor

⦁⦁ Disclosure is required at each balance sheet date of the ‘gross investments’ in leases
reported as finance leases, and the related ‘unearned finance income’ and ‘unguaranteed
residual values’ of the leased assets.
Preparers are encouraged to disclose, as an indicator of growth, the gross investment
net of unearned finance income from new business added during the accounting period,
after deducting the relevant amount for cancelled leases. Disclosure is also encouraged

358
 Accounting for leases: lessor

of the lessor’s general leasing arrangements and of the future minimum payments to be
received for specified periods in the future.
⦁⦁ Disclosure is required of the basis used in allocating income over the lease term so as
to produce a constant periodic rate of return as required by the standard. Indication is
required of whether the return relates to:
○○ net investment outstanding; or

○○ net cash investment outstanding in the lease.

⦁⦁ In case a significant portion of the lessor’s business comprises operating leases, the lessor
should disclose, at each balance sheet date:
○○ the amount of assets leased under operating leases by each major class of asset; and

○○ the related accumulated depreciation thereon.

It is encouraged to disclose the lessor’s general leasing arrangements, the amounts of rental
income from operating leases and the minimum future rentals on non-cancellable leases both
in aggregate and in a specified future period.

359
Appendix 5.3

International Accounting Standard 17

(IAS 17): Leases

Background
Leasing is a popular financing option for companies. However, the way leasing transactions
have been structured in the past has caused major variations in the presentation of financial
statements. There have been two leasing options available to companies.

⦁⦁ Operating lease – used to finance equipment for less than its useful life, and at the
end of the lease term the lessee can return the equipment to the lessor without further
obligation; and
⦁⦁ Finance (or capital) lease – used to finance equipment for the major part of its useful
life, when there is a reasonable assurance that the lessee will obtain ownership of the
equipment by the end of the lease term.

The proposed revision to International Accounting Standard 17 (IAS 17), Leases, expected
end-2012, will make no distinction between operating and financing leases. Instead, all leases
will be covered under the concept of ‘right-to-use’ asset, which basically means the ability
to use a specified asset over the term of the lease. Different financial statement reporting of
leases will be required. The following are exceptions to the proposed new treatment:

⦁⦁ mineral rights leases;

⦁⦁ leases less than 12 months;
⦁⦁ leases for biological and/or intangible assets; and
⦁⦁ purchase and sale contracts.

Objective of the proposed revision to IAS 17

It is important for users of financial statements to have a clear picture of the lease obliga-
tions of both the lessee and the lessor. The objective of the proposed new standard is to
facilitate a better understanding of debt financing as it relates to leases. The standard is
intended to ensure that leases are reflected properly on the balance sheet and in the state-
ment of cash flows.

Current financial statement presentation

The two leasing options lead to different financial statement presentation for companies,
operating lease option and finance lease option.

360
 International Accounting Standard 17 (IAS 17): Leases

Operating lease option

⦁⦁ Balance sheet:
○○ no inclusion, but a note included concerning the financial obligations for leases.

⦁⦁ Income statement:
○○ lease expense.

Finance lease option

⦁⦁ Balance sheet:
○○ property, plant and equipment – capital lease.

⦁⦁ Liabilities:
○○ short-term debt – current portion of capital lease;

○○ interest payable – capital lease (based on accrual accounting); and

○○ long-term debt – capital lease.

⦁⦁ Income statement:
○○ lease expense – property, plant and equipment; and

○○ financing charge – lease.

The current presentation would mean that certain ratios would be impacted by the proposed
new IAS 17, as shown in Exhibit 5.9.

Exhibit 5.9
Ratio and potential impact

Ratio Operating lease Finance lease

Debt ratios Debt ratios would be impacted. The Debt ratios would increase. This could
current approach allows future lease raise issues with restrictive covenants,
payments to be shown as a note to the especially if the lease has to maintain
financial statements. certain debt levels.
Return on assets (ROA) An operating lease would not be This would increase the total assets and
included in assets, resulting in a more impact ROA.
favourable ROA.
Income statement margins Only one item is shown: lease expense. A finance lease would show two items,
initially larger than a single operating
lease payment: depreciation and
interest expense.

Source: Author’s own

Because of the current treatment of operating versus finance leases, the credit analyst
would be hard pressed to understand fully an entity’s financial results because different

361
Credit Analysis of Financial Institutions

companies would treat leases differently; therefore, ratios could be distorted company by
company and possibly by the same companies within the same industry.

Accounting for lessee

Lessee recognition of the lease (lessee model)
Under the proposed new standard, the lessee will recognise an asset representing its right to
use the leased (‘underlying’) asset for the lease term (the ‘right-to-use’ asset) and a liability
to make lease payments (capitalised long-term debt obligation). Subsequently, the lessee will
divide the lease payment into interest and principal, the former an income statement expense
and the latter an amortisation deduction to the capitalised lease obligation.

Accounting for lessor

Lessor recognition of the lease (lessor model)
The lessor will recognise an asset representing its right to receive lease payments and, depending
on its exposure to risks or benefits associated with the underlying asset, will apply one of
the following accounting methods.
If a lessor retains exposure to significant risks or benefits associated with an underlying
asset, the lessor shall apply the performance obligation accounting method for the lease.

Exhibit 5.10
Financial presentation – performance obligation

Balance sheet Income statement

Underlying asset $ Lease income $
Right to receive lease payment $ Deduct: depreciation expense $
Deduct: lease liability $
Interest income $
Net lease asset (liability) $

Source: Author’s own

If a lessor does not retain exposure to significant risks or benefits associated with an
underlying asset, the lessor shall apply the derecognition accounting method for the lease.

362
 International Accounting Standard 17 (IAS 17): Leases

Exhibit 5.11
Financial presentation – derecognition

Balance sheet Income statement

Residual assets $ Revenue $
Right to receive lease payment $ Deduct: cost of sales $
$
Interest income $

Source: Author’s own

In both cases, the lease is set up as an asset on the lessor’s accounting system. However,
the difference is that under the derecognition method, the ownership of the asset is deemed
to transfer to the lessee as part of the lease contract. The performance obligation method
does not recognise any change in ownership.

1
IAS 17. The standard will be revised once IFRS and US GAAP converge on their lease accounting change proposal
expected by end-2012.
2
The PV factor of amount due in 3 periods at 10%: .7513.
3
The PV of an ordinary annuity of US$1 per period for 3 periods, at 10%: 2.4869.
4
Also commonly referred to as the ‘gross investment in lease’.

363
Chapter 6

Investment management companies

This chapter and the following one deal with an array of investing institutions from invest-
ment companies to pension funds. In general, an investment management company pools
investor resources together and, for a fee, manages and invests the funds in securities or
other assets, such as real estate. For each type of company reviewed, emphasis will be on
its structure, activities and how an analyst determines the soundness of such a company.
Investment management companies have grown in number and size over the past few
decades as securities markets have developed and investor interest has increased – due to
greater sophistication of investors on the one hand and to deregulation and the achievement
of market economies and privatisation on the other hand. These developments have increased
the choice and complexity of money and capital markets around the world.

Investment company
An investment company (sometimes referred to as a portfolio management company) is a
company that, for a management fee, invests the pooled funds of small investors in securi-
ties appropriate for its stated investment objectives. Through these pooled funds, investment
companies offer investors more diversification, liquidity and professional management service
than would normally be available to them as individuals.
Investment companies manage basically two types of funds: (i) open-end, better known
as mutual funds (US) or unit trusts (UK and other world financial centres), which have a
floating number of outstanding shares (hence the name open-end) and are prepared to sell
or redeem shares at their current net asset value (NAV); and (ii) closed-end, also known as
investment trusts, which, like a corporation, have a fixed number of outstanding shares that
are traded like a stock on an official exchange, usually the stock exchange itself.
According to Investment Company Institute (ICI)1 of the US, total worldwide assets
invested in mutual funds was US$23.8 trillion at the end of 2011 in some 73,000 mutual
funds and expected to continue to grow. ICI says there are over 8,600 mutual funds in the US
alone with assets invested in mutual funds of US$11.6 trillion. The Investment Management
Association is the trade association for the £3.9 trillion investment management industry in
the UK. The association has 185 members, accounting for over 90% of the unit trust industry
in the UK; there are just under 2,000 listed as mutual funds with US$817 billion in assets.
A third and fourth type of investment company which have gained in popularity in recent
years are, respectively: (i) the hedge fund (also included under the umbrella of ‘alternative
investment funds’ along with private equity funds); and (ii) the exchange-traded fund. Hedge
funds are run by investment companies or advisers (who are more often referred to as hedge
fund managers), these funds can take both long and short positions, use arbitrage, buy and
sell undervalued securities, trade options or bonds, and invest in almost any opportunity in

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any market where it foresees impressive gains at reduced risk. Hedge funds are extremely
flexible in their investment options because they use financial instruments generally beyond the
reach of mutual funds, which are subject to various regulations and disclosure requirements
that largely prevent them from using short selling, leverage, concentrated investments and
derivatives. Hedge funds, in particular, cater to high net-worth individuals (HNWIs) although
a growing number of institutional investors such as pension funds, insurance companies and
banks are adding hedge fund shares to their basket of investment choices. The real reason,
of course, is their quest for higher returns and portfolio diversification.
Exchange-traded funds (ETFs) have grown from insignificance some 20 years ago to
over US$1 trillion in assets today (US only). The financial crisis of 2008 and subsequent
recession and a low interest rate environment caused a flight from money market funds to
longer term funds and ETFs. These funds are essentially mutual funds or unit trusts listed
on a stock exchange. A major characteristic of most ETFs is their index strategy orientation
which explains their being called also ‘index funds’. Shares in a mutual fund are bought
through a mutual fund company whereas ETF shares are purchased via the stock exchange.
Both, however, fall under the category investment company.
Not to be overlooked is the growth of Islamic funds. Investment companies – not just
in the Middle East and Gulf region but the world over – are offering Shari’a-compliant
funds. Shari’a is an ever-expanding interpretation of Islamic religious law. One of the most
important principles of Islamic religious law is the scriptural injunction against interest, or
riba. Instead, profit is the just return for someone who accepts the risk of ownership. This
prohibition is intended to prevent exploitation and to maximise social benefits; it highlights
the emphasis on social welfare over individual welfare in Islam. Thus, a Shari’a-compliant
mutual fund seeks capital growth through investing in local and international shares.

Investment policies for investment companies

Investment companies, which manage mutual funds, hedge funds or unit trusts, act as conduits
for private investors. The main service that these companies offer is professional investment
management and diversification. Policies for these companies generally cover the following
six points: (i) fund objectives (revolving around the risk/return trade-off); (ii) liquidity needs;
(iii) time horizon; (iv) tax considerations; (v) regulatory constraints; and (vi) any investment
preferences unique to the fund.
The fund objectives of investment companies are as varied as those for individuals. Almost
any risk/return profile is possible. Most mutual funds, for example, state their objectives to
be one of the following categories: growth, value, global, international, fixed income, tax-free
and specialised. Hedge fund strategies vary enormously – many hedge against downturns in
the markets – especially important when there is volatility and anticipation of corrections
in overheated stock markets. The primary aim of most hedge funds is to reduce volatility
and risk while attempting to preserve capital and deliver positive returns under all market
conditions (see section on Hedge funds).
However, all fund managers must adhere to the investment objectives stated in the fund’s
prospectus and advertising literature. As a result, return requirements depend on the stated
objectives of the fund.

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Liquidity needs depend on market conditions and fund performance. In strong markets,
cash flows tend to be positive as new investors enter the fund. In bad markets, or in periods
in which the fund substantially underperforms its peer group, withdrawals may increase,
necessitating the need for more liquidity. On the other hand, time horizons for these funds
tend to be long term. This allows fund managers to focus on a long-term strategy despite
market fluctuations in the interim periods. The exception is hedge funds. Although they are
usually pooled investments (like mutual funds) and structured as private partnerships (unlike
mutual funds), many hedge funds carry substantial leverage and are quite rigid about the flow
of money from clients. Initial ‘lock-ups’ for as long as four or five years are not uncommon;
rarely is money allowed to come in or go out more than monthly. This restriction allows
hedge funds to take positions in the most illiquid corners of the market including options,
futures, derivatives and unusually structured securities.
Tax considerations are minimal in most countries, since the impact of taxes is borne by
the investors in the fund. However, some funds advertise as being ‘tax efficient’, meaning that
they keep turnover low in order to avoid passing large realised capital gains on to investors
in the fund. (Turnover refers to the buying and selling of securities in an attempt to adjust
the portfolio or take advantage of price opportunities.) In addition, there are often special
tax rules applied to investment companies that must be known and adhered to in order to
avoid special tax penalties.
Investment companies are subject to regulatory constraints to some degree in their home
country, except in various offshore locations. Mutual funds, for example, are strictly defined
under America’s 1940 Investment Act, while hedge funds operated under exemptions to the
law; thus, the aura of secrecy and exclusivity. By 1 February 2006, though, hedge fund
managers (investment advisers) meeting certain criteria had to register with the US Securities
Exchange Commission (SEC). One of the criteria was a shorter than two-year lock-up period,
which was aimed at excluding private equity funds that tend to have longer lock-up periods.
This criterion could also have encouraged some managers to lengthen their lock-up periods
to at least two years in order to avoid registration with the SEC and the associated regular
reporting and other requirements. However, lock-up periods are specified at the launch of a
fund, and investors may react with unease to any attempted changes later on.
Most of these regulations impact on the advertising and solicitation of funds, performance
measurement and other factors regarding information given to investors and prospective
investors. Any investment policy is possible, as long as the funds are invested according to
the policy stated in the prospectus and advertising literature.
Some funds have set forth unique preferences in their prospectuses. For example, ‘socially
responsible’ funds refrain from making certain types of investments, such as in the securi-
ties of companies with products or manufacturing processes that are considered not to be
environmentally friendly. Islamic funds will focus on Shari’a-compliant investments which
skirt riba issues. Others invest in growth sectors, income sectors and so forth.

Investment company’s balance sheet

Exhibit 6.1 illustrates the balance sheet structure of one of the world’s oldest mutual fund
and asset management companies, Waddell & Reed Financial (USA).2 Waddell’s funds are

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registered as investment companies with the SEC and information concerning the assets under
management are provided in the notes to the company’s annual report. These assets totalled
US$83.1 billion and US$83.7 billion for year-end 2011 and 2010, respectively. The most
important items of Waddell’s consolidated balance sheet are discussed below.

Exhibit 6.1
Investment company’s balance sheet, 31 December 2011 and 2010 (in thousands)

2011 2010
Assets:
Cash and cash equivalents US$327,083 195,315
Cash and cash equivalents – restricted 50,569 81,197
Investment securities 135,497 192,611
Receivables:
Funds and separate accounts 31,842 27,234
Customers and other 116,996 84,736
Deferred income taxes 11,848 10,622
Income taxes receivable 15,067 4,336
Prepaid expenses and other current assets 10,709 8,999
Total current assets 699,611 605,050
Property and equipment, net 74,028 71,248
Deferred sales commissions, net 68,788 64,710
Goodwill and identifiable intangible assets 221,210 221,210
Deferred income taxes 4,878 –
Other non-current assets 13,681 14,713
Total assets US$1,082,196 976,931

Liabilities:
Accounts payable US$52,134 40,844
Payable to investment companies for securities 104,304 117,596
Accrued compensation 35,117 37,696
Payable to third party brokers 41,125 38,909
Other current liabilities 56,218 46,897
Total current liabilities 156,784 162,517
Long-term debt 198,230 202,899
Accrued pension and post-retirement costs 8,303 15,899
Deferred income taxes 15,707 13,438
Other 5,873 6,277
Total liabilities 384,897 401,030

Continued

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Credit Analysis of Financial Institutions

Exhibit 6.1 continued

2011 2010
Stockholders’ equity:
Preferred stock – US$1.00 par value: 5,000 shares authorised; none issued – –
Class A Common stock – US$0.01 par value: 250,000 shares authorised; 997 997
99,701 shares issued; 99,701 shares issued 85,564 shares outstanding
(85,751 at December 31, 2010)
Additional paid-in capital 216,426 201,442
Retained earnings 721,281 618,813
Cost of 14,137 shares in treasury (13,950 at December 31, 2010) (366,954) (346,064)
Accumulated other comprehensive loss (48,107) (18,027)
Total stockholders’ equity 523,643 457,161
Total liabilities and stockholders’ equity US$1,082,196 976,931

Source: Author’s own from actual financial statements

Cash and cash equivalents

This item is a primary factor underpinning the company’s liquidity position. Waddell’s
primary source of cash is provided through operations. Cash and cash equivalents were
US$327.1 million at 31 December 2011, an increase of US$131.8 million from 31 December
2010. Cash and cash equivalents has a restricted component shown separately of US$50.6
million and US$81.2 million held for the benefit of customers in compliance with federal
securities regulations (US) at 31 December 2011 and 2010, respectively. The increase to cash
and equivalents was impacted by the net sale of investment securities of US$59.0 million
and a US$30.6 million reduction in restricted cash balances. This meant that cash and cash
equivalents represented 30% of total assets, versus an average 26% for similar investment
companies.3

Investment securities
The company’s investments are comprised of government obligations, corporate debt securities
and investments in affiliated mutual funds. Investments are classified as available-for-sale or
trading. Unrealised holding gains and losses on securities available-for-sale, net of related tax
effects, are excluded from earnings until realised and are reported as a separate component
of comprehensive income (see equity section of the balance sheet).
For trading securities, unrealised holding gains and losses, net of related tax effects, are
included in earnings. Realised gains and losses are computed using the specific identification
method for investment securities, other than mutual funds. For mutual funds, realised gains
and losses are computed using the average cost method. Waddell’s available-for-sale invest-
ments are reviewed and adjusted for other than temporary declines in value. When a decline
in fair value of an available-for-sale investment is determined to be other than temporary,

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the unrealised loss recorded net of tax in other comprehensive income is realised as a charge
to net income and a new cost basis is established for financial reporting purposes.
Investment securities dropped 30% between the close of 31 December 2010 and 2011
to meet greater redemptions.

Receivables
Receivables (or debtors in British terminology) comprise two items: (i) funds and separate
accounts; and (ii) customer accounts. Industry norms for the combined items were 15% of
total assets for 2011. Waddell’s receivables were very close, representing 14% and 11% for
2011 and 2010, respectively.

Goodwill and intangible assets

In conformity with US GAAP (similar to IFRS norms), goodwill is no longer amortised but
tested annually for impairment. Waddell showed a significant amount of goodwill and intan-
gible assets. As of 31 December 2011, total intangible assets and goodwill was US$221.2
million, or 20% of the company’s consolidated total assets, compared with an average 7%
for the sector.
Goodwill represents the excess of the cost of the company’s investment in the net assets
of acquired companies over the fair value of the underlying identifiable net assets at the dates
of acquisition. Indefinite life intangible assets represent advisory and sub-advisory manage-
ment contracts for managed assets obtained in acquisitions. The company considers these
contracts to be indefinite-lived intangible assets as they are expected to be renewed without
significant cost or modification of terms. Because of the significance of goodwill and other
intangibles to the consolidated balance sheets, the annual impairment analysis is critical.
Any changes in key assumptions about the company’s business and prospects, or changes in
market conditions or other externalities, could result in an impairment charge.

Long-term debt
This is the chief financing resource in support of the company’s liquidity position and invest-
ment activities. Industry norms were 26% of the total balance sheet for 2011. Waddell’s
position was 18% and 21% at the end of 2011 and 2010, respectively, or well below the
norm. Long-term debt was completely in the form of senior notes issued on the capital
markets. Waddell is favoured with a BBB rating from the major rating agencies.

Equity
Waddell has a strong capital base, or 48% of total footings at 31 December 2011, compared
with only 21% for the industry as a whole. This is due to Waddell’s low level of current
liabilities (14% of total footings, compared with almost 45% for the industry for 2011). The
equity section of the balance sheet shows a sizeable retained earnings (US GAAP does not
allow ‘reserves’ in the European sense), followed by significant repurchase of the company’s

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Credit Analysis of Financial Institutions

own shares. This appears consistent with the company’s already large equity base. The industry
showed a debt-to-worth ratio (total liabilities divided by shareholders’ equity) of 1.5x for
2011; Waddell showed ratios of 0.6x and 0.8x for 2011 and 2010, respectively. Adjusted
for intangibles, however, Waddell’s ratios are higher at 1.2x and 1.6x. This highlights the
importance the analyst must place on the valuation of those intangibles – goodwill included,
for a company the size of Waddell.

Investment company’s income statement (profit and loss statement)

From Exhibit 6.2 it appears clear that the most important source of revenues comes from
underwriting and distribution fees, on the one hand, and investment management fees, on
the other. Shareholder service fees complete the realm of income for investment company
activities.

Exhibit 6.2
Investment company’s income statement, 31 December 2011, 2010 and 2009 (in
thousands, except per share data)

2011 2010 2009

Revenues:
Investment management fees US$530,599 457,538 354,593
Underwriting and distribution fees 532,693 468,057 378,678
Shareholder service fees 131,885 119,290 105,818
Total 1,195,177 1,044,885 839,089
Operating expenses:
Underwriting and distribution 616,031 543,604 449,925
Compensation and related costs 161,401 142,255 124,463
General and administrative 80,533 66,703 58,034
Sub-advisory fees 29,885 27,823 23,202
Depreciation 15,235 14,030 13,653
Total 903,085 794,415 669,277
Operating income 292,092 250,470 169,812
Investment and other income 2,049 8,737 5,039
Interest expense (11,413) (12,723) (12,695)
Income before provision for income taxes 285,728 246,484 162,156
Provision for income taxes 107,269 89,525 56,651

Continued

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 Investment management companies

2011 2010 2009

Net income US$175,459 156,959 105,505
Net income per share:
Basic US$2.05 US$1.83 US$1.23
Diluted US$2.05 US$1.83 US$1.23
Weighted average shares outstanding:
Basic 85,783 85,618 85,484
Diluted 85,793 85,647 85,544

Source: Author’s own from actual financial statements

Revenues
Underwriting and distribution fees come from the company’s sale and promotion of invest-
ment products, primarily mutual funds – or more precisely these fees are derived from sales
commissions charged on front-end load products sold by the company’s financial advisers.
Investment management fees emanate from its asset management activities, also primarily of
mutual fund assets; and shareholder service fees represent a motley of transfer agency fees,
custodian fees from retirement plan accounts and portfolio accounting and administration fees.
As indicated, the company earns underwriting and distribution fee revenues primarily
by distributing mutual funds pursuant to an underwriting agreement with each fund and,
to a lesser extent, by distributing mutual funds offered by other companies not affiliated
with the company. Hedge funds and exchange-traded funds are included. Underwriting and
distribution fees of US$532.7 million for 2011 were up 14% over the previous year due
largely to strong growth in adviser and wholesale revenues.

Operating expenses: underwriting and distribution

The underwriting and distribution expenses of US$616 million grew at a slower pace than
corresponding revenues, or up 13% for 2011 compared with 2010 due primarily to:

⦁⦁ higher adviser and wholesale direct expenses;

⦁⦁ higher compensation expenses; and
⦁⦁ higher general and administrative expenses.

Performance
Despite higher underwriting and distribution expenses, compensation expenses and growth in
general and administrative expenses, Waddell reported a 17% increase in operating income
to US$292.1 million, or 24% of revenues, roughly equivalent to its competitors. In an
effort to meet increased competition, the company has reinforced its selling and distribu-
tion channels which, although costly at first, are expected to bring performance benefits in

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Credit Analysis of Financial Institutions

the near term. As management indicates: the company competes with a large number of
investment management companies offering services and products similar to theirs, as well
as other independent financial advisers. In addition, the company competes with brokerage
and investment banking companies, insurance companies, retail banks and other financial
institutions and businesses offering other financial products in all aspects of their businesses.
Although no single company or group of companies dominates the mutual fund manage-
ment and services industry, many are larger than Waddell, have greater resources and offer
a wider array of financial services and products. The company believes that competition in
the mutual fund industry will increase as a result of increased flexibility afforded to banks
and other financial institutions to sponsor mutual funds and distribute mutual fund shares.
In addition, barriers to entry into the investment management business are relatively few,
and thus, the company faces a potentially growing number of competitors, especially during
periods of strong financial and economic markets.

Mutual fund performance

Analysts should be aware that, according to studies, most mutual funds perform worse than
a naive strategy of direct investment in randomly selected securities or ‘indexing’ (a portfolio
of securities that closely match some benchmark index composition). The primary reason for
this seems to be related to costs associated with mutual funds. These costs include: transac-
tions costs when the fund buys and sells shares, management fees, SG&A (selling, general
and administrative) expenses, and a sales charge or ‘load’ (in some cases). To bolster the
argument that fees tend to cause mutual funds to underperform indexing, these studies have
found that:

⦁⦁ bond funds tend to underperform the returns available from direct investment in bonds
by 1% a year. This corresponds to the average bond fund’s expenses of about 1% of
assets per year;
⦁⦁ no-load funds tend to outperform load funds;
⦁⦁ low-turnover funds with lower transaction costs tend to outperform high-turnover funds;
⦁⦁ funds with low expense ratios tend to outperform funds with high expense ratios;
⦁⦁ the size of a fund does not seem to correlate with performance, holding all other factors
constant; and
⦁⦁ if ‘survivor bias’ is taken into consideration (funds that merge, fold or switch from load
to non-load are not excluded from the studies), the above results become magnified.

Why would an investor invest in mutual funds given these results?

⦁⦁ Mutual funds provide substantial diversification that small investors cannot otherwise
obtain.
⦁⦁ Mutual funds perform record-keeping functions that make tax and other accounting easier.
⦁⦁ Mutual funds can offer specialisation in areas that individual investors might prefer (for
example, global funds, growth-only funds, socially responsible funds, and so on).

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Thus, the analyst should note that funds are now a permanent feature in the range of invest-
ment choices for a growing number of individuals.

Mutual fund categories

There are six general categories of equity mutual fund objectives:

⦁⦁ aggressive growth;
⦁⦁ growth;
⦁⦁ growth-income;
⦁⦁ income;
⦁⦁ international; and
⦁⦁ small capitalisation.

However, analysts should be aware that it is debatable whether the classification of a fund
in one of these six groupings conveys much information about its investment objectives,
the securities in the portfolio or the investment style pursued by its managers. Misleading
classification of mutual funds is a potential problem for investors. Indeed, even though the
number of classifications is small, there is confusion regarding what information is conveyed
by the current classification system. For example, the category descriptions ‘international’
and ‘small capitalisation’ refer to the types of securities that a fund holds, rather than the
funds’ investment objective or style.
Competition among mutual fund companies for assets is keen in developed markets.
Furthermore, with comparative information available from sophisticated sources in those
markets, it is relatively easy for individuals to obtain information on fund performance.
Investors seem to use this information. For example, there is evidence that funds that receive
the highest ratings experience a large inflow of investment funds.
The mutual fund rating services break the funds down into categories and rank them
relative to other funds in the same category. There is evidence that funds that receive superior
performance rankings within a category also attract large amounts of cash flow. Therefore,
an important marketing tool for mutual funds is the receipt of a ‘superior ranking’ within its
category peer group. This becomes a powerful incentive for some mutual fund companies to
have themselves classified into a category where their performance will look superior relative
to that category’s peer group. In some instances, this can result in an overt attempt to be
classified as a certain type of fund, even if the classification received is really not appropriate
(a misclassification).
Incentives to misclassify a fund in order to gain a competitive advantage also exist at
the fund manager level. Fund managers are often compensated on the basis of how well
the funds they manage perform relative to other funds in their peer group. One way to
outperform the competition is to take on more risk, whether or not the higher level of risk
is appropriate, based on the stated objectives of the fund.
The current mutual fund classification system is not well defined and lacks specific and
objective guidelines regarding the characteristics that a fund should possess in order to be
categorised in a particular manner. Since the current classification system is vague, funds

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Credit Analysis of Financial Institutions

can be intentionally misclassified to meet the marketing needs of the fund or the income
needs of its managers.
New mutual funds are especially prone to misclassification. A new fund is often created
because a particular category is performing very well and attracting assets, or a mutual fund
company has a gap in the type of funds that it offers to the public. In either case, the fund’s
category is usually established before the fund is started and a manager is hired. Although fund
objectives must be stated in the prospectus, the language is often vague and flexible enough to
include a large variety of investment styles. What investment philosophy a manager actually
pursues after the fund is started may bear only a marginal relationship to the fund’s declared
investment objective (yet, it will be within the legal requirements of the prospectus’ language).
This is especially the case when the manager’s favoured investment style differs from what
might be appropriate, based on the fund’s stated objective. In addition, many new funds that
are added to a mutual fund company’s ‘family’ of funds are managed by portfolio managers
who are already managing the company’s existing funds; a separate manager is assigned to
the new fund only after it attains a sufficient size to justify having its own manager. To the
extent that the same manager is in charge of several funds, those funds may be managed in
a very similar manner, even if their stated objectives suggest otherwise.
For these reasons, investors – and analysts – should be cautious about accepting the
classification a mutual fund places upon itself in its prospectus and, in some cases, how
others classify it. It is best to examine the assets in the portfolio and the track record of
the manager in order to determine the type of investments that are made and the investment
style that is used.

Box 6.1
Investing in emerging markets via closed-end funds
For most investors, the only practical way to invest in emerging market securities is through
open-end or closed-end funds. Open-end (mutual funds, unit trusts, and other) funds have
a variable number of shares outstanding, and investors purchase and redeem shares at the
funds’ NAV. Closed-end funds (investment trust companies) have a fixed number of shares
outstanding, and the shares trade in the open market at a price determined by supply and
demand.
The majority of emerging market funds are closed-end funds that trade on exchanges.
The reason closed-end funds dominate this asset class is that it is difficult to sell shares of
relatively illiquid securities. Consequently, it would be difficult to raise cash by selling shares
to accommodate redemptions within the open-end context, unless the fund invested in a
number of emerging market securities from different regions. Funds that specialise in single
emerging markets (the Argentina fund, the Chile fund, the China fund, and so forth) tend to
be closed-end funds. Funds that do not specialise in particular emerging countries but invest
in a composite of many emerging markets may use an open-end approach.
Critics of closed-end emerging market funds are concerned that the price of the fund

Continued

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 Investment management companies

shares are influenced by movements in the developed markets’ stock exchanges (notably the
US), rather than by the NAV of the emerging markets themselves, as is the case with open-end
funds. If they are right, the performance of closed-end emerging market funds that specialise
in particular countries might be more correlated with the developed markets than with the
emerging market itself. If this is true, the benefits of diversification in raising the return/risk
ratio would at least be partially lost. In addition, critics of the closed-end and open-end fund
approach to emerging-market investment also raises the fundamental question that applies
to all professional fund management: can fund managers generate returns that are a high as
those of the underlying markets with comparable risk? Just as the vast majority of domestic
fund managers in developed markets are unable to outperform key indices (such the S&P 500
in the US, the FTS100 in the UK, or the CAC40 in France), it may be that the vast majority
of emerging-market fund managers also cannot outperform the emerging-market indices of
the countries in which they specialise.
With respect to performance, a variety of studies1 of country fund returns to their underlying
market returns showed that the majority of the funds underperformed their market index.
Over the five-year period studied, the average monthly geometric mean rate of return for the
country funds was 0.35%, as compared with a 0.70% monthly return for the relevant country
indices. This is a substantial amount of underperformance. In addition, the majority of the
country funds experienced greater volatility than their market index. Thus, the ‘professionally’
managed emerging-market funds offered investors the prospects of less return and more risk
than if investors simply purchased indexed funds in the emerging markets themselves. The
two broadly diversified emerging-market funds fared better. They provided monthly compound
rates of return and average monthly mean returns in excess of their benchmark index (the
Emerging Markets Composite Index). However, both funds’ average monthly standard devia-
tion of returns was higher than their benchmark (although lower than the average standard
deviation of the country funds).
It would appear, based on these studies, that, even if investing in emerging markets
raises the return/risk ratio in theory, in practice, investors might have had a hard time actu-
ally producing such results by investing in emerging-market funds. If such investments are
undertaken, it would appear that the open-end funds that invest in a wide array of emerging
market stocks are the better choice than investing in closed-end single-country funds. Of
course, it is very important to realise that the study only covered a finite period of time; it
is difficult to generalise with such a limited time frame of observations. When dealing with
markets that are very volatile and where currency exchange rates play such a crucial role in
determining outcomes in terms of returns, standard deviations or returns, and correlations
between returns, it is difficult to reach general conclusions almost regardless of the time
period studied. Certainly, however, no such firm conclusions can be reached from only a
limited period of observations.

1 Barry, Peavy and Rodriguez, Emerging Stock Markets: Risk, Return and Performance, 1997. Bogle,
J, ‘The mutual fund industry 60 years later: for better or worse?’ Financial Analysts Journal (CFA
Institute), January/February 2005. Closed-End Fund Association (CEF), June 2012, www.closed-
endfunds.com.

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Fund credit analysis: sources of information

When a potential investor requests information, a fund will typically send a prospectus (a
legal document that is the basic description of the fund and its policies) and its latest annual
report to shareholders, as well as quarterly data and miscellaneous sales literature.
Many funds send reports to shareholders on a quarterly basis. These usually include
a letter that reports on the fund’s performance and current investment policies, and a list
of the fund’s investments (its portfolio). The annual and semi-annual reports include full
financial statements showing the asset/liability structure and the income and performance
of the fund (see Exhibits 6.3–6.6). The financial statements may or may not be repeated in
the prospectus.
For the analyst as well as the investor, it is prudent to read the letter to shareholders.
What do the portfolio managers have to say about the current economic situation? How do
they plan to act in the future? Does their investment outlook make sense? Are their goals
reasonable and in line with investor expectations? Do they give a clear picture of what the
fund has done over the last three, six or 12 months?
The analyst should also review the portfolio list to see what types of securities the fund
owns. The fund may list its holdings by specific industry, or it may use such broad headings
as ‘cyclical stocks’, ‘consumer industries’, or ‘financial stocks’. Are the types of securities held
in line with the type of fund (growth, small capitalisation, income, and so on)? Despite the
type of fund, are the holdings reasonably diversified?
In developed markets, a prospectus is also the norm. The prospectus must be sent to
potential investors before they decide to buy shares. Over the years, mutual fund prospectuses
have become weighted down with large quantities of legal verbiage that can lead to puzzle-
ment about the fund and its policies. But the international trend in recent years has been
towards shorter, simplified prospectuses, with additional information supplied on request.
Nothing is more important in the prospectus than the statement of the fund’s invest-
ment objective and policies. Also important is the information concerning the management
company and its affiliations, and who the directors and officers are. The tendency is to
require that a certain number of directors are not affiliated with the management company.
This is intended to ensure fair treatment of the fund by the manager.
Other sections of the prospectus inform investors how to purchase and redeem shares,
when dividends are paid, which organisation acts as servicing agent or transfer agent, which
bank acts as custodian of the fund’s cash and securities, when reports to shareholders are
issued and so on.
Of interest for the analyst, the prospectus often includes a certain amount of data on
performance (perhaps repeated also in the fund’s annual report). This generally includes a
10-year table of ‘per share capital and income changes’, showing for each year the change in
the fund’s NAV per share and income dividends and capital gains distributions paid. Fund
performance presentation is more and more guided on an international level by the CFA
Institute’s Global Investment Performance Standards (GIPS).4 Working with other professional
investment societies throughout the world, the CFA Institute has put together guidelines for
performance presentation by investment companies for greater clarity and consistency in
the industry (domestic and international), which facilitates comparison and analysis of fund

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performance by analysts. Appendix 6.1 summarises GIPS principal guidelines in performance

presentation.

Investment fund financial statements

As with all presentations of financial statements under IFRS, the latest terminology for an
investment fund, such as a mutual fund or unit trust, is as follows:

⦁⦁ statement of financial position (formerly balance sheet);

⦁⦁ statement of income (formerly income or profit and loss statement);
⦁⦁ statement of changes in net assets attributable to holders of redeemable shares; and
⦁⦁ statement of cash flows.

A complete set of financial statements comprises, as one of its statements, a statement of

changes in equity. However, as there is no equity in the investment fund, no statement of
changes in equity is presented. Instead, a statement of changes in net assets attributable to
holders of redeemable shares is presented. Although IFRSs do not require presentation of this
statement, it nonetheless provides users of the financial statements with relevant and useful
information with respect to the components underlying the movements in the net assets of
the investment fund attributable to the holders of redeemable shares during the year.
An example of IFRS financial statements for an investment fund is given in Exhibits
6.3–6.6.5

Exhibit 6.3
Statement of financial position,* as at 31 December 2011, 2012 (LCU** thousand)

2012 2011
Assets
Current assets
Pledged financial assets at fair value through profit or loss 51 71
Non-pledged financial assets at fair value through profit or loss 2,691 2,346
Balances due from brokers 24,931 16,471
Receivables from reverse repurchase agreements 8,119 12,621
Other receivables 4,744 3,990
Total assets 40,565 35,545

Continued

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Exhibit 6.3 continued
2012 2011
Liabilities
Current liabilities
Financial liabilities at fair value through profit and loss 3,621 1,446
Balances due to brokers 1,643 1,775
Payables under repurchase agreements 2,563 2,234
Other payables 113 111
 Total liabilities (excluding net assets attributable to holders of redeemable
shares) 7,940 5,566

Net assets attributable to holders of redeemable shares 32,625 29,979

Represented by:
Net assets attributable to holders of redeemable shares (valued in accordance 32,647 29,996
with prospectus)
Adjustment to the statement of financial position (22) (17)
32,625 29,979

* Money market mutual fund example.

** LCU = local currency unit.

Source: Author’s own

Exhibit 6.4
Statement of comprehensive income, for the year ended 31 December 2011, 2012 (LCU*
thousand)

2012 2011
Interest income 603 429
Dividend income 272 229
Net foreign exchange loss (19) (16)
Net gain from financial instruments at fair value through profit or loss 3,251 2,397
Total revenue 4,107 3,039
Investment management fees (448) (478)
Custodian fees (112) (84)
Administration fees (66) (62)

Continued
 2012 2011
Directors’ fees (26) (15)
Transaction costs (64) (73)
Audit fees (32) (29)
Legal fees (42) (38)
Interest expense (75) (62)
Dividend expense on short securities positions (45) (19)
Other operating expenses (18) (41)
Total operating expenses (928) (901)
Operating profit before finance costs 3,179 2,138
Dividends to holders of redeemable shares (178) (91)
Total finance costs (178) (91)
Profit before tax 3,001 2,047
Withholding tax expense (45) (39)
Increase in net assets attributable to holders of redeemable shares 2,956 2,008

* LCU = local currency unit.

Source: Author’s own

Exhibit 6.5
Statement of changes in net assets attributable to holders of redeemable shares, for
the year ended 31 December 2011, 2012 (LCU* thousand)

2012 2011
Balance at 1 January 29,979 18,461
Increase in net assets attributable to holders of redeemable shares 2,956 2,008
Contributions and redemptions by holders of redeemable shares:
Issue of redeemable share during the year 6,668 15,505
Redemption of redeemable shares during the year (6,978) (5,995)
Transactions with holders of redeemable shares (310) 9,510
Balance at 31 December 32,625 29,979

* LCU = local currency unit.

Source: Author’s own

Credit Analysis of Financial Institutions

Exhibit 6.6
Statement of cash flows, for the year ended 31 December 2011, 2012 (LCU* thousand)

2012 2011
Cash flows from operating activities
Interest received 619 454
Interest paid (73) (63)
Dividends received 272 267
Dividends paid on short securities positions (45) (19)
Proceeds from sale of investments 9,382 8,271
Purchase of investments (10,613) (17,713)
Net non-dividend receipts/(payments) on securities sold short 629 (2)
Net receipts/(payments) from derivative activities 1,581 (3)
 Net non-interest (payments)/receipts from repurchase and reverse (428) 299
repurchase agreements
Operating expenses paid (808) (848)
Taxes paid (45) (39)
Net cash from/(used in) operating activities 471 (9,396)
Cash flows from financing activities
Proceeds from issue of redeemable shares 6,668 15,505
Payments on redemption of redeemable shares (6,978) (5,995)
Dividends paid to holders of redeemable shares (178) (91)
Net cash (used in)/from financing activities (488) 9,419
Net (decrease)/increase in cash and cash equivalents (17) 23
Cash and cash equivalents at 1 January 71 50
Effect of exchange rate fluctuations on cash and cash equivalents (3) (2)
Cash and cash equivalents at 31 December 51 71

* LCU = local currency unit.

Source: Author’s own

Fund credit analysis: open-end funds

Net asset value
For the analyst and investor alike, the most important item to consider in a mutual fund’s
or unit trust’s financial statements is NAV. Basically, at the end of each day the mutual
fund adds up the market values of the securities (stocks, bonds, and so on) it owns. For
example, if the fund owns 10,000 shares of General Electric, and General Electric finished

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trading or ‘closed’ at a price of US$25 per share, the calculation is simply 10,000 ¥ US$25,
or US$250,000. The fund also adds in the value of its other assets such as cash and any
amounts it is owed. From the total it subtracts any liabilities – amounts that it owes to
others for various fees and other expenses, and so on. The result is the ‘total net assets’ of
the fund. This figure is then divided by the shares outstanding (the total number of shares
held by shareholders) to arrive at the ‘net asset value per share’, which is each share’s
proportionate interest in the fund’s total net assets.
Obviously, if the market value of the securities the fund owns goes up, the NAV per
share will go up, and vice versa.
On a given day, the investors who wish to put money in the fund do so by buying new
shares from the fund at the NAV calculated at the end of the day, sometimes less a commis-
sion. The investors who take money out of the fund do it by ‘redeeming’ shares, that is,
selling them back to the fund, also at the day’s NAV. The exception is the money market
type of mutual funds which make a practice of holding their share values constant, usually
one currency unit per share, and they own securities that ordinarily show only fractional
variations in market value.

Evaluating performance
The most appropriate way to evaluate fund performance is to compare it against many other
funds’ performance. There are three ways a mutual fund can make money for its shareholders:
(i) payment of dividends; (ii) payment of capital gains distributions; and (iii) increase in NAV.

Payment of dividends
During the year the fund receives dividends on the shares it owns and interest on the bonds
and other fixed-income securities it owns. After deducting expenses, including the manage-
ment fee, what is left is ‘net investment income’. Once a year, or in instalments, the fund
pays this net investment income to shareholders as income dividends, in proportion to the
number of shares owned.

Payment of capital gains distributions

The fund may also realise capital gains, that is, it makes profits for its shareholders by selling
securities for more than the fund paid for them. At the end of the year, if these capital gains
outweigh any capital losses (that is, from the sale of securities at less than the fund paid
for them), the difference or net gain is ordinarily paid out to shareholders as a capital gains
distribution. This is allowed, of course, only where local law permits.

Increase in NAV
If the securities in the fund’s portfolio rise in price, on average, then the NAV of the fund’s
shares also will rise, and the shareholder’s investment will be worth more than it was before.

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Credit Analysis of Financial Institutions

Calculating performance
In developed markets some years ago, fund performance was usually calculated by adding only
capital gains distributions and any rise in NAV. The dividends paid were shown separately
as ‘yield’. This perhaps made sense for a shareholder who wanted or needed to spend the
dividend income and wanted it clearly defined, but it was often difficult to compare different
fund performances fairly with each other.
Now most performance statistics are on what is called a ‘total return’ basis, which
takes all three of the above-mentioned elements into account, and shows how the value of a
holder’s investment would grow if all income dividends and capital gains distributions were
reinvested in additional shares.
For example, a fund starts a year with a NAV at LCU10.00 per share and ends with
a NAV at LCU11.00. During the year it pays out LCU0.40 per share in income dividends
and LCU0.70 per share in capital gains. Leaving aside minor adjustments, the quoted figures
would be as follows.
Yield (dividend income):

0.40
= 4.0%
10.00

Performance (old definition):

(11.00 – 10.00) + 0.70

= +17.0%
10.00

Performance: Total return (new definition):

(11.00 – 10.00) + 0.70 + 0.40

= +21.0%
10.00

In a bad year, of course, the NAV of the fund could drop, and performance could be nega-
tive rather than positive.
Of significant importance to evaluate the performance of a mutual fund is the use of
the Sharpe Ratio. The ratio is a measure of how well a fund is rewarded for the risk it
incurs. The higher the ratio, the better the return per unit of risk taken. It is calculated by
subtracting the risk-free rate from the fund’s annualised average return, and dividing the
result by the fund’s annualised standard deviation. A Sharpe Ratio of 1:1 indicates that the
rate of return is proportional to the risk assumed in seeking that reward. The widely used
ratio was developed by Professor William R Sharpe of Stanford University (US).
Performance of a fund over short or long periods may also be compared with other
funds or with the market averages. For example, a growth fund may be compared with an
average of many growth funds. Common or ordinary share funds are often compared with
two or three well-known stock market averages that are found daily in the financial section
of newspapers. Popular stock market averages are the Standard & Poor’s (S&P) 500 and the
FTSE 100. The Dow Jones Industrial Average is probably the most famous of all averages;

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however, as it is based on only 30 very prominent stocks, it is less of a reflection of the

total market picture than the S&P 500 in the US.

Fund expenses
In Exhibit 6.3, the important ratio to focus on is the ‘net operating expenses to average net
assets’, which represents the funds expense ratio. The expense ratio is the percentage relation-
ship between a year’s expenses and the fund’s total net assets. It generally ranges from 0.5%
to 1.5%, and occasionally higher. If a fund receives dividends and interest on its portfolio
that amount to 8.0% of average assets for a given year, and if the expense ratio for the
year is 1.0%, then there will be 7.0% left to distribute to shareholders as income dividends.
How important is the expense ratio? If an investor buys a fund strictly for dividend
yield, the expense ratio is a disadvantage. But in a good growth fund, the expense ratio is
a minor factor relative to total performance. If a fund has achieved a good past record in
the face of a high expense ratio, there is no reason why it should not continue to do so in
the future. A high expense ratio does not mean poor management; more often it reflects a
fund that is small in size, or a management fee that is a higher percentage than average.

Hedge funds
One of the more significant changes in financial markets since the mid-2000s has been the
extraordinary rise of ‘hedge funds’, representing assets under management of over US$2
trillion and the number of active hedge funds of over 10,000 – a jump of almost 20% five
years ago. Although definitions can differ, the term hedge fund is generally understood to
refer to professionally managed pools of capital, typically organised as private partnerships,
that predominantly are invested in publicly traded stocks and bonds, and which are owned
by institutional investors or HNWIs. Thanks to the advent of funds of hedge funds (FOHFs),
more and more individuals of lesser means are able to enter the hedge fund business and
participate in the bewildering array of investment strategies aimed at producing excess returns.
The term hedge fund does not always imply a hedging technique is being used. Hedge
funds today employ different types of strategies, and the appropriate description could simply
be conveyed as ‘any unregistered, privately offered, managed pool of capital for wealthy,
financially sophisticated investors’. Hedge funds are usually structured as partnerships, with
the general partner being the portfolio manager, making the investment decisions, and the
limited partners as the investors. Hedge funds are thus secretive in nature, offer little, if any,
transparency, and can easily escape regulation in most jurisdictions. Hedge fund managers
attempt to produce targeted returns or absolute performance, regardless of the underlying
trends in the financial markets. An increasing number of hedge funds invest in more exotic,
and often less liquid, financial instruments. Some are even going into lending on the junior
level or unsecured loan basis – clearly a hazardous venture as the astute retail banker knows.

Key characteristics of hedge funds

⦁⦁ Hedge funds utilise a variety of financial instruments to reduce risk, enhance returns and
minimise the correlation with equity and bond markets. Many hedge funds are flexible

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Credit Analysis of Financial Institutions

in their investment options (can use short selling, leverage, derivatives such as puts, calls,
options, futures, and so on).
⦁⦁ Hedge funds vary enormously in terms of investment returns, volatility and risk. Many, but
not all, hedge fund strategies tend to hedge against downturns in the markets being traded.
⦁⦁ Many hedge funds have the ability to deliver non-market correlated returns.
⦁⦁ Many hedge funds have as an objective consistency of returns and capital preservation
rather than magnitude of returns.
⦁⦁ Most hedge funds are managed by experienced investment professionals who are generally
disciplined and diligent.
⦁⦁ Pension funds, endowments, insurance companies, private banks, HNWIs and families
invest in hedge funds to minimise overall portfolio volatility and enhance returns.
⦁⦁ Most hedge fund managers are highly specialised and usually trade only within their area
of expertise and competitive advantage.
⦁⦁ Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards
performance incentives, thus attracting the best brains in the investment business. In
addition, hedge fund managers usually have their own money invested in their fund.

What is a fund of hedge funds?

An FOHF:

⦁⦁ is a diversified portfolio of generally uncorrelated hedge funds;

⦁⦁ may be widely diversified, or sector or geographically focused;
⦁⦁ seeks to deliver more consistent returns than stock portfolios, mutual funds, unit trusts
or individual hedge funds;
⦁⦁ is the preferred investment of choice for many pension funds, endowments, insurance
companies, private banks and high net-worth families and individuals;
⦁⦁ provides access to a broad range of investment styles, strategies and hedge fund managers
for one easy-to-administer investment;
⦁⦁ provides more predictable returns than traditional investment funds; and
⦁⦁ provides effective diversification for investment portfolios.

Hedge fund strategies

Currently, there are approximately 14 distinct investment strategies used by hedge funds,
each offering different degrees of risk and return (see Box 6.2). A macro hedge fund, for
example, invests in stock and bond markets and other investment opportunities, such as
currencies, in hopes of profiting on significant shifts in such things as global interest rates
and countries’ economic policies. A macro hedge fund is more volatile but potentially faster
growing than a distressed-securities hedge fund that buys the equity or debt of companies
about to enter or exit financial distress. An equity hedge fund may be global or country
specific, hedging against downturns in equity markets by shorting overvalued stocks or
stock indexes. A relative value hedge fund takes advantage of price or spread inefficiencies.
Knowing and understanding the characteristics of the many different hedge fund strategies
is essential to capitalising on their variety of investment opportunities.

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Box 6.2
Hedge fund styles
∑∑ Aggressive growth: invests in equities expected to experience acceleration in growth of
earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro
cap stocks which are expected to experience rapid growth. Includes sector specialist funds
such as technology, banking or biotechnology. Hedges by shorting equities where earn-
ings disappointment is expected or by shorting stock indexes. Tends to be ‘long-biased’.
Expected volatility: high.
∑∑ Distressed securities: buys equity, debt or trade claims at deep discounts of companies in
or facing bankruptcy or reorganisation. Profits from the market’s lack of understanding of
the true value of the deeply discounted securities and because the majority of institutional
investors cannot own below-investment grade securities. (This selling pressure creates the
deep discount.) Results generally not dependent on the direction of the markets. Expected
volatility: low–moderate.
∑∑ Emerging markets: invests in equity or debt of emerging (less mature) markets that tend
to have higher inflation and greater growth potential, though their fortunes are usually
dependent on the more mature economies. Short selling is not permitted in many emerging
markets, and, therefore, effective hedging is often not available or is difficult to implement.
Will mostly be correlated to stock market direction. Expected volatility: very high.
∑∑ Funds of hedge funds: mix and match hedge funds and other pooled investment vehicles.
This blending of different strategies and asset classes aims to provide a more stable long-
term investment return than any of the individual funds. Returns, risk and volatility can be
controlled by the mix of underlying strategies and funds. Capital preservation is generally
an important consideration. Volatility depends on the mix and ratio of strategies employed.
Expected volatility: low–moderate–high.
∑∑ Income: invests with primary focus on yield or current income rather than solely on capital
gains. May utilise leverage to buy bonds and sometimes fixed income derivatives in order
to profit from principal appreciation and interest income. Expected volatility: low.
∑∑ Macro: aims to profit from changes in global economies, typically brought about by shifts
in government policy that impact interest rates, in turn affecting currency, stock and bond
markets. Participates in all major markets – equities, bonds, currencies and commodities
– though not always at the same time. Uses leverage and derivatives to accentuate the
impact of market moves. Utilises hedging, but the leveraged directional investments tend
to make the largest impact on performance. Expected volatility: very high.
∑∑ Market neutral – arbitrage: attempts to hedge out most market risk by taking offset-
ting positions, often in different securities of the same issuer. For example, can be long
convertible bonds and short the underlying issuer’s equity. May also use futures to hedge
out interest rate risk. Focuses on obtaining returns with low or no correlation to both
the equity and bond markets. These relative value strategies include fixed income arbi-

Continued

385
Credit Analysis of Financial Institutions

Box 6.2 continued

trage, mortgage-backed securities, capital structure arbitrage and closed-end fund arbitrage.
Expected volatility: low.
∑∑ Market neutral – securities hedging: invests equally in long and short equity portfolios
generally in the same sectors of the market. Market risk is greatly reduced, but effective
stock analysis and stock picking is essential to obtaining meaningful results. Leverage may
be used to enhance returns. Usually low or no correlation to the market. Sometimes uses
market index futures to hedge out systematic (market) risk. Relative benchmark index
usually T-bills. Expected volatility: low.
∑∑ Market timing: allocates assets among different asset classes depending on the manager’s
view of the economic or market outlook. Portfolio emphasis may swing widely between
asset classes. Unpredictability of market movements and the difficulty of timing entry and
exit from markets add to the volatility of this strategy. Expected Volatility: high.
∑∑ Multi strategy: investment approach is diversified by employing various strategies simulta-
neously to realise short and long-term gains. Other strategies may include systems trading
such as trend following and various diversified technical strategies. This style of investing
allows the manager to overweight or underweight different strategies to best capitalise on
current investment opportunities. Expected volatility: variable.
∑∑ Opportunistic: investment theme changes from strategy to strategy as opportunities arise to
profit from events such as initial public offerings (IPOs), sudden price changes often caused
by an interim earnings disappointment, hostile bids and other event-driven opportunities.
May utilise several of these investing styles at a given time and is not restricted to any
particular investment approach or asset class. Expected volatility: variable.
∑∑ Short selling: sells securities short in anticipation of being able to rebuy them at a future
date at a lower price due to the manager’s assessment of the overvaluation of the securi-
ties, or the market, or in anticipation of earnings disappointments often due to accounting
irregularities, new competition, change of management, and so on. Often used as a hedge
to offset long-only portfolios and by those who feel the market is approaching a bearish
cycle. High risk. Expected volatility: very high.
∑∑ Special situations: invests in event-driven situations such as mergers, hostile takeovers,
reorganisations or leveraged buyouts. May involve simultaneous purchase of stock in compa-
nies being acquired, and the sale of stock in its acquirer, hoping to profit from the spread
between the current market price and the ultimate purchase price of the company. May
also utilise derivatives to leverage returns and to hedge out interest rate and/or market
risk. Results generally not dependent on direction of market. Expected Volatility: moderate.
∑∑ Value: invests in securities perceived to be selling at deep discounts to their intrinsic or
potential worth. Such securities may be out of favour or underfollowed by analysts. Long-
term holding, patience and strong discipline are often required until the ultimate value is
recognised by the market. Expected volatility: low–moderate.

386
 Investment management companies

It is important to understand the differences between the various hedge fund strategies
because all hedge funds are not the same – investment returns, volatility and risk vary enor-
mously among the different hedge fund strategies. Some strategies which are not correlated
to equity markets are able to deliver consistent returns with extremely low risk of loss,
while others may be as, or more, volatile than mutual funds. A successful fund of funds
recognises these differences and blends various strategies and asset classes together to create
more stable long-term investment returns than any of the individual funds. A wide range of
hedging strategies is available to hedge funds. For example:

⦁⦁ selling short – selling shares without owning them, hoping to buy them back at a future
date at a lower price in the expectation that their price will drop;
⦁⦁ using arbitrage – seeking to exploit pricing inefficiencies between related securities – for
example, can be long convertible bonds and short the underlying issuer’s equity;
⦁⦁ trading options or derivatives – contracts whose values are based on the performance of
any underlying financial asset, index or other investment;
⦁⦁ investing in anticipation of a specific event – merger transaction, hostile takeover, spin-off,
exiting of bankruptcy proceedings, and so on; and
⦁⦁ investing in deeply discounted securities – of companies about to enter or exit financial
distress or bankruptcy, often below liquidation value.

Many of the strategies used by hedge funds benefit from being non-correlated to the direc-
tion of equity markets.

Hedge fund credit analysis

As mentioned earlier in this section, hedge funds are generally private partnerships and,
therefore, are under no obligation to publish financial statements for public consumption.
Aside from the prospectus, an analyst has very little solid financial data on which to base a
credit analysis of the hedge fund. Only the fund’s strategy can be a guide to its risk profile.
Caution is thus advised since it has been less than 15 years since the near failure of the
hedge fund Long-Term Capital Management (LTCM) in 1998 which sent a shudder through
financial markets around the world and brought to the public’s attention the extraordinary
risks taken but such investment vehicles. Along with at a 10% per year failure rate – over-
looked because of the rapid growth in the number of hedge funds created each year – many
funds have been involved in criminal activity or are ‘dodgy’ at best.
Furthermore, recent research reveals that hedge fund return performance is no more stellar
than an average investment strategy: ‘People hear about the top-performing hedge funds, and
they assume those results hold true for the whole industry,’ says the chief investment officer
of a global investment management group. ‘It turns out that, on average, hedge funds are
about average.’ Research conclusion: hedge funds lost an annualised 2.2% over the past five
years, while a 60/40 mix of stocks and bonds gained 3.5% a year.6
In response to the continued expansion of the hedge fund industry, the European
Commission issued a directive in July 2011entitled Alternative Investment Fund Managers
Directive (AIFMD). Full transposition by member states is slated for July 2013. The directive’s

387
Credit Analysis of Financial Institutions

purpose is to address issues about the industry’s capacity constraints and the impact of hedge
funds’ largely unconstrained investment strategies on financial markets. The scope of the
directive is broad and with a handful of exceptions covers the management and administra-
tion of all ‘collective investment undertakings’ which are not subject to the UCITS7 regime
including, inter alia, hedge funds, private equity funds and real estate funds.
The Dodd-Frank Wall Street Reform Act was passed in the US in July 2010, and contains
provisions which require hedge fund advisers with US$150 million or more in assets to
register with the SEC. The Act effectively extends registration and disclosure requirements
to include the hedge fund and private equity industries but implementation of the require-
ments are a work-in-progress. Because hedge funds do not have publicly traded securities,
they are not subject to all of the reporting requirements of the SEC. All the more reason
for analysts to refrain from attempting a normal credit analysis until complete transparency
or further regulation develops – whichever comes first (for further comments see Box 6.3).

Box 6.3
European Central Bank comments on hedge funds1
The hedge fund sector suffered considerable investment losses in 2011, albeit not as large as
those following the failure of Lehman Brothers. Moreover, compared with this earlier period,
the sector was less leveraged, which helped to alleviate funding liquidity pressures stemming
from prime brokers’ margin calls. Larger than usual investor withdrawals still have the poten-
tial to entail funding liquidity risk, despite generally strong investor appetite for hedge fund
investments amid low nominal interest rates. While hedge funds in general appeared to have
quite a limited role within the euro area (at the end of the third quarter of 2011 assets held
by euro hedge funds amounted to 3119 billion), they are part of the complex network of the
‘shadow banking’ sector, either through their involvement in securitisation activities or in the
repo market. The shadow banking sector comprises activities related to credit intermediation,
such as liquidity and maturity transformation, which take place outside the regular banking
system. For the euro area, assets held by shadow banking-related sectors amounted to 311
trillion in the third quarter of 2011. In relative terms, those assets represent 27.7% of the
total assets of the combined banking and shadow banking sector, thus illustrating that the
shadow banking sector plays a significant role in financial intermediation in general and the
funding activities of banks in particular.

1 European Central Bank, Annual Report 2011.

1
Investment Company Institute, 2012 Investment Company Fact Book, 52nd edition, Washington, DC.
2
Waddell & Reed Financial Inc, 2011 Annual Report.
3
Industry data sources: RMA, 2012 Annual Statement Studies, Philadelphia.
4
Global Investment Performance Standards (GIPS®), February 2005; updated 31 January 2006.
5
KPMG, ‘Illustrative financial statements: investment funds,’ March 2010.

388
 Investment management companies

6
Weinberg, N and Condon, B, ‘The sleaziest show on earth’, BusinessWeek, 24 May 2004; Stein, C, ‘Hedge funds
lag behind a generic stock/bond mix’, BusinessWeek, 19 July 2012.
7
Directive 2009/65/EC of the European Parliament and of the Council of 13 July 2009 on the coordination of
laws, regulations and administrative provisions relating to undertakings for collective investment in transferable
securities (UCITS).

389
Appendix 6.1

GIPS®

Global Investment Performance Standards (GIPS®) are a set of ethical principles that establish
a standardised, industry-wide approach to how investment firms should calculate and report
their investment results to prospective clients in a way that ensures fair representation and full
disclosure. GIPS aims to create a single global standard of investment performance reporting
and increase minimum standards worldwide. The GIPS standards were based on and preceded
in North America by AIMR Performance Presentation Standards. The AIMR-PPS® standards
became the US and Canadian version of GIPS. The AIMR-PPS standards converged with the
GIPS standards on 1 January 2006.
The investment community’s need for a common, accepted set of guidelines to promote
fair representation and full disclosure in every investment firm’s presentation of its perfor-
mance results to clients and prospective clients has guided the development of the AIMR
standards – now the GIP standards. The standards are the manifestation of a set of guiding
ethical principles and should be interpreted as minimum standards for presenting investment
performance. The standards have been designed to meet the following four goals:

⦁⦁ achieve greater uniformity and comparability;

⦁⦁ improve the service offered to clients;
⦁⦁ enhance the professionalism of the industry; and
⦁⦁ increase self-regulation.

The GIP standards are voluntary standards for the industry. Investment firms are not required
to comply with the standards when presenting performance, but the standards are widely
recognised as the most effective guidelines for fair and accurate reporting of investment
performance. Below are excerpts from the GIPS official publication as adopted by the CFA
Institute Board of Governors (formerly the AIMR Board of Governors).1
More recently GIPS has issued a guidance statement on alternative investment strategies
and structures, effective October 2012, to complement its existing investment standards.
These ‘alternative investments’ include private equity, private real estate, hedge funds and
derivatives-based strategies, and/or other private investments focusing on real assets, commodi-
ties. The guidance statement is intended to fit neatly in the overall need for global standards
for investment professionals.

Why is a global standard needed?

⦁⦁ The financial markets and the investment management industry have become global in
nature. Given the variety of financial entities and countries involved, this globalisation of
the investment process and the strong growth of assets under management demonstrate
the need to standardise the calculation and presentation of investment performance.

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 GIPS ®

⦁⦁ Prospective clients and investment management firms will benefit from an established
standard for investment performance measurement and presentation that is recognised
worldwide. Investment practices, regulation, performance measurement and reporting of
performance results vary considerably from country to country. Some countries have
guidelines that are widely accepted within their borders and others have few recognised
standards for presenting investment performance.
⦁⦁ Requiring investment management firms to adhere to performance presentation standards
will help assure investors that the performance information is both complete and fairly
presented. Investment management firms in countries with minimal presentation standards
will be able to compete for business on an equal footing with investment management
firms from countries with more developed standards. Investment management firms from
countries with established practices will have more confidence that they are being fairly
compared with ‘local’ investment management firms when competing for business in
countries that have not previously adopted performance standards.
⦁⦁ Both prospective and existing clients of investment management firms will benefit from
a global investment performance standard by having a greater degree of confidence in
the performance numbers presented by the investment management firms. Performance
standards that are accepted in all countries enable all investment management firms to
measure and present their investment performance so that clients can readily compare
investment performance among investment management firms.

GIPS vision statement

⦁⦁ A global investment performance standard leads to readily accepted presentations of
investment performance that: (i) present performance results that are readily comparable
among investment management firms without regard to geographical location; and (ii)
facilitate a dialogue between investment managers and their prospective clients about the
critical issues of how the investment management firm achieved performance results and
determines future investment strategies.

Objectives
⦁⦁ To obtain worldwide acceptance of a standard for the calculation and presentation of
investment performance in a fair, comparable format that provides full disclosure.
⦁⦁ To ensure accurate and consistent investment performance data for reporting, record
keeping, marketing and presentations.
⦁⦁ To promote fair, global competition among investment management firms for all markets
without creating barriers to entry for new investment management firms.
⦁⦁ To foster the notion of industry ‘self-regulation’ on a global basis.

Overview
The Global Investment Performance Standards (‘GIP standards’ or ‘Standards’) have several
key characteristics.

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Credit Analysis of Financial Institutions

⦁⦁ For the purpose of claiming compliance with the GIP standards, investment management
FIRMS MUST define an entity that claims compliance (FIRM). The FIRM MUST be
defined as an investment FIRM, subsidiary or division held out to clients or potential
clients as a DISTINCT BUSINESS ENTITY.
⦁⦁ The GIP standards are ethical standards for investment performance presentation to ensure
fair representation and full disclosure of a FIRM’S performance.
⦁⦁ The GIP standards REQUIRE FIRMS to include all actual fee-paying, discretionary
PORTFOLIOS in COMPOSITES defined according to similar strategy and/or investment
objective and REQUIRE FIRMS to initially show GIPS-compliant history for a minimum
of five (5) years or since inception of the FIRM or COMPOSITE if in existence less than
five years. After presenting at least five years of compliant history, the FIRM MUST add
annual performance each year going forward up to ten (10) years, at a minimum.
⦁⦁ The GIP standards REQUIRE FIRMS to use certain calculation and presentation methods
and to make certain disclosures along with the performance record.
⦁⦁ The GIP standards rely on the integrity of input data. The accuracy of input data is
critical to the accuracy of the performance presentation. For example, BENCHMARKS
and COMPOSITES SHOULD be created/selected on an ex-ante basis, not after the fact.
⦁⦁ The GIP standards consist of provisions that FIRMS are REQUIRED to follow in order
to claim compliance. FIRMS are encouraged to adopt the RECOMMENDED provisions
to achieve best practice in performance presentation.
⦁⦁ The GIP standards MUST be applied with the goal of full disclosure and fair representation
of investment performance. Meeting the objectives of full disclosure and fair representation
will likely require more than compliance with the minimum REQUIREMENTS of the GIP
standards. If an investment FIRM applies the GIP standards in a performance situation
that is not addressed specifically by the Standards or is open to interpretation, disclosures
other than those REQUIRED by the GIP standards may be necessary. To fully explain
the performance included in a presentation, FIRMS are encouraged to present all relevant
ADDITIONAL INFORMATION and SUPPLEMENTAL INFORMATION.
⦁⦁ All requirements, clarifications, updated information and guidance MUST be adhered to
when determining a FIRM’S claim of compliance and will be made available via the GIPS
Handbook and the CFA Institute website (www.cfainstitute.org).
⦁⦁ In cases where applicable local or country-specific law or regulation conflicts with the GIP
standards, the Standards REQUIRE FIRMS to comply with the local law or regulation
and make full disclosure of the conflict.
⦁⦁ The GIP standards do not address every aspect of performance measurement, valuation,
attribution, or coverage of all asset classes. The GIP standards will evolve over time to
address additional aspects of investment performance. Certain RECOMMENDED elements
in the GIP standards may become REQUIREMENTS in the future.
⦁⦁ Within the GIP standards are supplemental REAL ESTATE and PRIVATE EQUITY
provisions that MUST be applied to these asset classes.

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 GIPS ®

Scope
Application of the GIP standards: FIRMS from any country may come into compliance with
the GIPS standards. Compliance with the GIP standards will facilitate a FIRM’S participation
in the investment management industry on a global level.

Historical performance record

⦁⦁ FIRMS are REQUIRED to present, at a minimum, five years of annual investment
performance that is compliant with the GIP standards. If the FIRM or COMPOSITE has
been in existence less than five years, the FIRM MUST present performance since the
inception of the FIRM or COMPOSITE; and
⦁⦁ After a FIRM presents five years of compliant history, the FIRM MUST present additional
annual performance up to 10 years, at a minimum. For example, after a FIRM presents
five years of compliant history, the FIRM MUST add an additional year of performance
each year so that after five years of claiming compliance, the FIRM presents a 10-year
performance record.
⦁⦁ FIRMS may link a non-GIPS-compliant performance record to their compliant history so
long as no non-compliant performance is presented after 1 January 2000 and the FIRM
discloses the periods of non-compliance and explains how the presentation is not in
compliance with the GIP standards.
⦁⦁ FIRMS previously claiming compliance with an Investment Performance Council-endorsed
Country Version of GIPS (CVG) are granted reciprocity to claim compliance with the GIP
standards for historical periods prior to 1 January 2006. If the FIRM previously claimed
compliance with a CVG, at a minimum, the FIRM MUST continue to show the historical
CVG-compliant track record up to 10 years (or since inception). Nothing in this section
shall prevent FIRMS from initially presenting more than five years of performance results.

Compliance
⦁⦁ Effective Date: The GIP standards were amended by the IPC on 7 December 2004 and
adopted by the CFA Institute Board of Governors on 4 February 2005. The effective date of
the revised Standards is 1 January 2006. All presentations that include performance results
for periods after 31 December 2005 MUST meet all the REQUIREMENTS of the revised
GIPS standards. Performance presentations that include results through 31 December
2005 may be prepared in compliance with the 1999 version of the GIP standards. Early
adoption of these revised GIP standards is encouraged.
⦁⦁ REQUIREMENTS: FIRMS MUST meet all the REQUIREMENTS set forth in the GIPS
standards to claim compliance with the GIP standards. Although the REQUIREMENTS
MUST be met immediately by a FIRM claiming compliance, the following REQUIREMENTS
do not go into effect until a future date.
○○ For periods beginning 1 January 2008, REAL ESTATE investments MUST be valued

at least quarterly.
○○ For periods beginning 1 January 2010, FIRMS MUST value PORTFOLIOS on the date

of all LARGE EXTERNAL CASH FLOWS.

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Credit Analysis of Financial Institutions

○○ For periods beginning 1 January 2010, FIRMS MUST value PORTFOLIOS as of the
calendar month-end or the last business day of the month.
○○ For periods beginning 1 January 2010, COMPOSITE returns MUST be calculated by

asset weighting the individual PORTFOLIO returns at least monthly.

○○ For periods beginning 1 January 2010, CARVE-OUT returns are not permitted to be

included in single asset class COMPOSITE returns unless the CARVE-OUTS are actually
managed separately with their own cash balances. Until these future REQUIREMENTS
become effective, these provisions SHOULD be considered RECOMMENDATIONS.
FIRMS are encouraged to implement these future REQUIREMENTS prior to their effective
dates. To ease compliance with the GIP standards when the future REQUIREMENTS
take effect, the industry should immediately begin to design performance software to
incorporate these future REQUIREMENTS.
⦁⦁ Compliance Check: FIRMS MUST take all steps necessary to ensure that they have satisfied
all the REQUIREMENTS of the GIP standards before claiming compliance with the GIPS
standards. FIRMS are strongly encouraged to perform periodic internal compliance checks
and implement adequate business controls on all stages of the investment performance
process – from data input to presentation material – to ensure the validity of compliance
claims.
⦁⦁ Third-Party Performance Measurement and COMPOSITE Construction: The GIP standards
recognize the role of independent third-party performance measurers and the value they
can add to the FIRM’S performance measurement activities. Where third-party performance
measurement is an established practice or is available, FIRMS are encouraged to use this
service as it applies to the FIRM. Similarly, where the practice is to allow third parties
to construct COMPOSITES for FIRMS, FIRMS can use such COMPOSITES in a GIPS-
compliant presentation only if the COMPOSITES meet the REQUIREMENTS of the GIP
standards.
⦁⦁ Sample Presentations: Sample presentations, provide examples of what a compliant
presentation might look like.

Implementing a global standard

⦁⦁ In 1999, the Investment Performance Council (IPC) was created and given the responsibility
to meet the ongoing needs for maintaining and developing a high-quality global investment
performance standard. The IPC provides a practical and effective implementation structure
for the GIP standards and encourages wider public participation in an industry-wide
standard.
⦁⦁ One of the principal objectives of the IPC is for all countries to adopt the GIP standards
as the common method for calculating and presenting investment performance. As of
December 2004, more than 25 countries around the world had adopted or were in the
process of adopting the GIP standards. The IPC believes the establishment and acceptance
of the GIP standards are vital steps in facilitating the availability of comparable investment
performance history on a global basis. GIPS compliance provides FIRMS with a ‘passport’
and creates a level playing field where all FIRMS can compete on equal footing.

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 GIPS ®

⦁⦁ The presence of a local sponsoring organization for investment performance standards is

essential for their effective implementation and ongoing operation within a country. Such
country sponsors also provide an important link between the IPC, the governing body for
the GIPS standards, and the local markets where investment managers operate. The country
sponsor, by actively supporting the GIP standards and the work of the IPC, will ensure
that the country’s interests can and will be taken into account as the GIP standards are
developed going forward. Compliance with the GIP standards is voluntary, but support
from the local country sponsor will help drive the success of the GIP standards.
⦁⦁ The IPC strongly encourages countries without an investment performance standard in
place to accept the GIP standards as the local standard and translate them into the local
language when necessary, thus promoting a ‘translation of GIPS’ (TG).
⦁⦁ Compliance with the GIP standards will provide FIRMS with a ‘right of access’ to be
considered alongside all investment managers, thereby allowing all FIRMS to be evaluated
on equal terms.
⦁⦁ Although the GIP standards may be translated into many languages, if a discrepancy arises
between the different versions of the Standards (for example, TGs), the English version
of GIP standards is controlling.
⦁⦁ The IPC will continue to develop the GIP standards so that they maintain their relevance
within the changing investment management industry and has committed to evaluating
the Standards every five years.
⦁⦁ The self-regulatory nature of the GIP standards necessitates a strong commitment to
ethical integrity. Self-regulation also assists regulators in exercising their responsibility for
ensuring the fair disclosure of information to and within the financial markets in general.
Regulators are encouraged to:
○○ recognize the benefit of voluntary compliance with standards that represent global best

practices;
○○ give consideration to adopting a function favoured by some regulators, namely to

enforce sanctions upon false claims of compliance with the GIP standards as fraudulent
advertising; and
○○ recognize and encourage independent verification services.

⦁⦁ Where existing laws or regulations already impose performance presentation standards,

FIRMS are strongly encouraged to comply with the GIP standards in addition to those
local requirements. Compliance with applicable law or regulation does not necessarily
lead to compliance with the GIP standards. When complying with the GIP standards
and local law or regulation, FIRMS MUST disclose any local laws and regulations that
conflict with the GIP standards.

Basic elements
The GIP standards are divided into eight sections that reflect the basic elements involved
in presenting performance information: fundamentals of compliance, input data, calcula-
tion methodology, COMPOSITE construction, disclosures, presentation and reporting, REAL
ESTATE and PRIVATE EQUITY. The provisions for each section are divided between

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Credit Analysis of Financial Institutions

REQUIREMENTS, listed first in each section, and RECOMMENDATIONS. FIRMS MUST

meet all the REQUIREMENTS to claim compliance with the GIP standards. FIRMS are
strongly encouraged to adopt and implement the RECOMMENDATIONS to ensure that
the FIRM fully adheres to the spirit and intent of the GIP standards.

⦁⦁ Fundamentals of Compliance: Critical issues that a FIRM MUST consider when claiming
compliance with the GIPS standards are defining the FIRM, documenting FIRM policies
and procedures, maintaining compliance with updates to the GIP standards and properly
using the claim of compliance and references to verification. The definition of the FIRM is
the foundation for FIRM-wide compliance and creates defined boundaries whereby TOTAL
FIRM ASSETS can be determined. Once a FIRM meets all of the REQUIREMENTS of
the GIP standards, it MUST appropriately use the claim of compliance to state compliance
with the GIP standards.
⦁⦁ Input Data: Consistency of input data is critical to effective compliance with the GIP
standards and establishes the foundation for full, fair and comparable investment
performance presentations.
⦁⦁ Calculation Methodology: Achieving comparability among FIRMS’ performance
presentations requires uniformity in methods used to calculate returns. The Standards
mandate the use of certain calculation methodologies for both PORTFOLIOS and
COMPOSITES.
⦁⦁ Composite Construction: A COMPOSITE is an aggregation of one or more PORTFOLIOS
into a single group that represents a particular investment objective or strategy. The
COMPOSITE return is the asset-weighted average of the performance results of all the
PORTFOLIOS in the COMPOSITE. Creating meaningful, asset-weighted COMPOSITES
is critical to the fair presentation, consistency and comparability of results over time and
among FIRMS.
⦁⦁ Disclosures: Disclosures allow FIRMS to elaborate on the raw numbers provided in the
presentation and give the end-user of the presentation the proper context in which to
understand the performance results. To comply with the GIP standards, FIRMS MUST
disclose certain information about their performance presentation and policies adopted
by the FIRM. Disclosures are to be considered static information that does not normally
change from period to period. Although some disclosures are REQUIRED of all FIRMS,
others are specific to certain circumstances and thus may not be REQUIRED. No ‘negative
assurance’ language is needed for non-applicable disclosures.
⦁⦁ Presentation and Reporting: After gathering the input data, calculating returns, constructing
the COMPOSITES, and determining the necessary disclosures, the FIRM MUST incorporate
this information in presentations based on the REQUIREMENTS set out in the GIPS
standards for presenting the investment performance returns. No finite set of provisions
can cover all potential situations or anticipate future developments in investment
industry structure, technology, products or practices. When appropriate, FIRMS have the
responsibility to include other information not necessarily covered by the Standards in a
GIPS-compliant presentation.
⦁⦁ Real Estate: These provisions apply to all investments where returns are primarily from the
holding, trading, development or management of REAL ESTATE assets. REAL ESTATE

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 GIPS ®

includes land, buildings under development, completed buildings and other structures
or improvements held for investment purposes. The provisions apply regardless of the
level of control the FIRM has over management of the investment. The provisions apply
irrespective of whether a REAL ESTATE asset or investment is producing revenue. They
also apply to REAL ESTATE investments with leverage or gearing.
⦁⦁ Private Equity: These provisions apply to all PRIVATE EQUITY investments other than
OPEN-END or EVERGREEN FUNDS (which MUST follow the main GIPS provisions).
PRIVATE EQUITY investments MUST be valued according to the GIPS PRIVATE EQUITY
Valuation Principles . PRIVATE EQUITY refers to investments in non-public companies
that are in various stages of development and encompasses venture investing, buyout
investing and mezzanine investing. Fund-of-funds investing as well as secondary investing
are also included in PRIVATE EQUITY. Investors typically invest in PRIVATE EQUITY
assets either directly or through a fund of funds or LIMITED PARTNERSHIP.

Scope and purpose of verification

⦁⦁ Verification is the review of an investment management FIRM’S performance measurement
processes and procedures by an independent third-party ‘verifier’. Verification tests:
○○ Whether the FIRM has complied with all the COMPOSITE construction REQUIREMENTS

of the GIP standards on a FIRM-wide basis, and

○○ Whether the FIRM’S processes and procedures are designed to calculate and present

performance results in compliance with the GIP standards. A single verification report
is issued in respect of the whole FIRM; verification cannot be carried out for a single
COMPOSITE.
⦁⦁ Third-party verification brings credibility to the claim of compliance and supports
the overall guiding principles of full disclosure and fair representation of investment
performance.
⦁⦁ The initial minimum period for which verification can be performed is 1 year of a FIRM’S
presented performance. The RECOMMENDED period over which verification is performed
is that part of the FIRM’S track record for which GIPS compliance is claimed.
⦁⦁ A verification report must confirm that:
○○ The FIRM has complied with all the COMPOSITE construction REQUIREMENTS of

the GIP standards on a FIRM-wide basis, and

○○ The FIRM’S processes and procedures are designed to calculate and present performance

results in compliance with the GIP standards. Without such a report from the verifier,
the FIRM cannot state that its claim of compliance with the GIP standards has been
verified.
⦁⦁ After performing the verification, the verifier may conclude that the FIRM is not in
compliance with the GIP standards or that the records of the FIRM cannot support a
complete verification. In such situations, the verifier must issue a statement to the FIRM
clarifying why a verification report was not possible.
⦁⦁ A principal verifier may accept the work of a local or previous verifier as part of the basis
for the principal verifier’s opinion.

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Credit Analysis of Financial Institutions

Conclusion
The GIP standards are a manifestation of ethical principles of fair representation and full
disclosure. They are not the principles themselves, but a way of achieving those results. The
standards will evolve as the industry, technology and investors’ and analysts’ understanding
of risk and return numbers grow. Currently, the standards exist to provide better commu-
nication of investment results, better understanding of the performance numbers and full
disclosure to prospective clients of how those numbers are calculated.

Box 6.4
GIP example: Realty Management Firm
Disclosures
Compliance statement
Realty Management Firm has prepared and presented this report in compliance with the
Global Investment Performance Standards (GIPS®).

The Firm
Realty Management Firm (the Firm), a subsidiary of ABC Capital, Inc., is a registered investment
adviser under the Investment Advisors Act of 1940. The Firm exercises complete discretion
over the selection, capitalisation, asset management and disposition of investments in wholly
owned properties and joint ventures. A complete list and description of the Firm’s composites
is available upon request.

The Composite
The Core Real Estate Composite (the ‘Composite’) comprises all actual fee-paying discretionary
portfolios managed by the Firm with a core investment and risk strategy with an income focus
having a minimum initial portfolio size of US$10 million. Portfolios that initially qualify are
excluded later from the composite if their asset size decreases below the minimum require-
ment due to capital distributions. The Composite was created in 1998. Composite dispersion
is measured using an asset-weighted standard deviation of returns of the portfolios.

Valuation
Assets are valued quarterly by the Firm and appraised annually by an independent Member
of the Appraisal Institute. Both the internal and external property valuations rely primarily on
the application of market discount rates to future projections of free cash flows (unleveraged
cash flows) and capitalised terminal values over the expected holding period for each property.
Property mortgages, notes and loans are marked to market using prevailing interest rates for
comparable property loans if the terms of existing loans preclude the immediate repayment
of such loans. Loan repayment fees, if any, are considered in the projected year of sale.

Continued

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 GIPS ®

Box 6.4 continued

Calculation of performance returns

Returns presented are denominated in US dollars. Returns are presented net of leverage.
Composite returns are calculated on an asset-weighted average basis using beginning-of-period
values. Returns include cash and cash equivalents and related interest income. Income return
is based on accrual recognition of earned income. Capital expenditures, tenant improvements
and lease commissions are capitalised and included in the cost of the property, are not
amortised and are reconciled through the valuation process and reflected in the capital return
component. Income and capital returns may not equal total returns due to chain linking of
quarterly returns. Annual returns are time-weighted rates of return calculated by linking quarterly
returns. For the annualised since-inception time-weighted return, terminal value is based on
ending market value of net assets of the Composite. For the since-inception internal rate of
return, contributions from and distributions to investors since 1 January 1995 and a terminal
value equal to the Composite’s ending market value of net assets as of 31 December 2004
are used. The IRR is calculated using monthly cash flows. Additional information regarding
policies for calculating and reporting returns in compliance with the GIP standards is avail-
able upon request.

Investment management fees

Some of the portfolios pay incentive fees ranging between 10% and 20% of IRR in excess
of established benchmarks. Current annual investment advisory fees are as follows:

up to US$30m: 1.6%
US$30–US$50m: 1.3%
over US$50m: 1.0%

ICREIF Property Index Benchmark

The International Council of Real Estate Investment Fiduciaries (ICREIF) Property Index
Benchmark has been taken from published sources. The ICREIF Property Index is unleveraged,
includes various real estate property types, excludes cash and other non-property related assets
and liabilities, income and expenses. The calculation methodology for the index is not consistent
with calculation methodology employed for the Composite because the benchmark computes
the total return by adding the income and capital appreciation return on a quarterly basis.

1
AIMR: Association for Investment Management and Research, Charlottesville, Virginia, United States. AIMR is
now known as the CFA Institute (CFA: Chartered Financial Analysts).

399
Chapter 7

Pension funds

Introduction
Pension funds are operated by private companies, private associations, insurance companies,
state and local governments. Pension funds are set up to collect regular contributions from a
corporation, government agency or organisation to provide post-retirement income for eligible
employees. Employer contributions are set aside in tax-free investments. Pension funds are
viewed by the markets as institutional investors and they are among the largest investors in
the stock market, and also invest in fixed-income securities and, to a lesser extent, in real
estate and venture capital limited partnerships. Pension fund managers are required to follow
investment rules as fiduciaries for pension fund assets held in interest.
A recent global pension asset study1 revealed that the average asset allocation for the
seven largest pension markets was 47% equities, 33% bonds, 1% cash and 19% other assets
(including property and other alternatives). The largest pension markets are the US, Japan
and the UK with 58%, 13% and 9%, respectively, of the group of seven pension assets. For
the same group, there has been a clear 10-year trend towards defined-contribution schemes
(44% of pension assets, compared with 35% a decade ago) while defined-benefit plans
have decreased to 56% of fund assets versus 65% a decade before. (As described shortly,
employees generally assume investment risk under defined-contribution pension plans while
employers/sponsors assume that risk under defined-benefit schemes.)
Extending the study to the 13 largest markets, the results indicated that these markets
totalled U$26.5 billion in 2010, up 12% over the year before, or a 10-year compound annual
growth rate of 5% (see Exhibit 7.1).

Exhibit 7.1
Global pension asset study 2011

Total assets 2010 % GDP

(US$ billion)
Australia 1,261 103
Brazil    342 17
Canada 1,140 73
France    133   5
Germany    471 14
Hong Kong    87 38

Continued

400
 Pension funds

Total assets 2010 % GDP

(US$ billion)
Ireland    100 49
Japan 3,471 64
Netherlands 1,032 134
South Africa    256 72
Switzerland    661 126
UK* 2,279 101
US** 15,265 104
Total 26,496 76

* Excludes personal and stakeholder defined contribution assets.

** Includes IRSs.

Source: Author’s own.

Private funds represent the bulk of pension fund assets and are found in the most devel-
oped financial markets for such pension plans, notably the US, the UK and the Netherlands.
In those markets, private funds can be further divided into the following categories, usually
referred to as ‘pension plans’:

⦁⦁ insurance company-sponsored plans;

⦁⦁ non-insurance company plans;
⦁⦁ single company plans; and
⦁⦁ multi-company plans.

Insurance company-related plans are normally used by small companies, as these companies
have found the costs of managing their own plans to be excessive. The plan sponsored by
an insurance company – normally a life insurance company – has the advantage of being
guaranteed by the insurance company itself and not merely by the assets of the particular
fund. The most common (life) insurance arrangement is the ‘group deferred annuity’. With
this plan a paid-up annuity2 is purchased for each employee each month, and the policies
are held by a trustee (usually a bank or trust company). The employee is protected by the
pension plan, and the plan requires minimal management time on the part of the company.
Assets of life insurance-related funds represent a significant share of total pension assets in
the developed markets mentioned.
The remaining three pension plan categories (non-insurance company plans, single
company plans and multi-company plans) are managed in a way similar to other invest-
ment management funds. Contributions to these private plans are made by employees (or
employers and employees), with the contribution typically being made to a fund administered
by a bank or trust company. Because these plans are designed to be fully funded, their assets
are quite extensive in the developed pension fund markets. The trustee invests the funds and
makes payments to the retirees in accordance with the provisions of the plan.

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Credit Analysis of Financial Institutions

Investment policies for pension plans

Pension plans are very important types of portfolios because of their size and importance to
the well-being of those who have an interest in them. Usually, pension plans are organised
as trusts. A trust is a type of investment company and not many countries in the world
allow the creation of this special corporate form.
Since retirement portfolios are so important to the welfare of pension beneficiaries, it is
important that plan objectives and policies be written in a pension plan charter, which serves
as a legal investment policy statement. This charter should be written after duly considering
the following elements of retirement plan objectives and risk constraints:

⦁⦁ risk tolerance;
⦁⦁ return requirements;
⦁⦁ liquidity needs;
⦁⦁ time horizon;
⦁⦁ tax considerations;
⦁⦁ legal constraints; and
⦁⦁ unique circumstances.

The risk tolerance that can be allowed in a retirement portfolio depends on several factors.
One important factor is the type of retirement plan that the portfolio assets are required to
fund. In the most developed market for pension funds, the US, there are two basic types of
retirement plans: defined-benefit plans and defined-contribution plans.
Defined-benefit plans (also called ‘pension plans’) are plans in which the beneficiaries are
entitled to receive a specified benefit on retirement. For example, a retiree might be entitled
to receive an annual pension benefit equal to 50% of the highest earnings achieved over any
consecutive 36-month period while in the employ of the sponsoring company.
The sponsoring company is generally responsible for the payments of the defined benefits
under such a plan (versus a defined-contribution plan where the sponsoring company makes
specific payments to the plan, possibly with complementary payments by the employee, but
the employee assumes the investment risk for future benefits). The performance of the pension
fund simply defrays the cost of these benefits. Consequently, poor investment performance
will result in a higher cost for the sponsor rather than being detrimental to the beneficiaries
of the plan. Only in the event that the investment performance of the pension plan manage-
ment is so poor (producing returns far below the actuarial rate of return assumption on the
pension fund) as to financially impair the sponsor will the beneficiaries suffer. Even then,
the US has a guarantee organisation, the Pension Benefit Guaranty Corporation (PBGC),
which may protect beneficiaries from loss of benefits. Excellent investment performance by
the management of a defined-benefit pension plan portfolio mainly helps reduce the cost of
providing the benefits for the sponsor. Only at the sponsor’s discretion would it result in
improved benefits for the beneficiaries.

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 Pension funds

Box 7.1
Definition of a trust
A trust is a fiduciary relationship in which a person, called a trustee, holds title to property
for the benefit of another person, called a beneficiary. The person creating the trust is the
creator, settlor, grantor or donor; the property itself is called the corpus, trust res, trust fund
or trust estate, which is distinguished from any income earned by it. The trustee is usually
charged with investing trust property productively.

The amount of risk tolerance that can be allowed in a defined-benefit plan depends on
the plan’s funded status (the amount by which the plan assets exceed the projected benefit
obligation) and the actuarial rate of return assumption. If the funded status is high (meaning
the pension fund is overfunded), more risk can be tolerated; if the funded status is negative
(meaning the pension fund is underfunded), less risk can be taken. In the case of an under-
funded plan, the sponsor’s management should consider increasing its contributions to the
plan and reducing its actuarial rate of return assumption in an attempt to increase the funded
status (see Box 7.2). The actuarial rate of return assumption tends to have long-term effects
on plan contributions. If the return is high, contributions tend to be low, and vice versa.

Box 7.2
Minimum funding requirement
Not having enough assets to cover pension plan liabilities is a challenge even in developed
pension fund markets. Regulators generally make specific funding requirements. For example,
the Minimum Funding Requirement (MFR) was a part of United Kingdom legislation in the
Pensions Act 1995, and was introduced on 6 April 1997. Although legislation set out the broad
requirements of the MFR the details of the methods and assumptions to use were specified in
Guidance Note 27 issued by the Institute of Actuaries and the Faculty of Actuaries of the UK.
Shortly after the introduction of the MFR, however, there were a number of modifica-
tions to the assumptions to cope with perceived weaknesses in the original basis. In other
words, the level of assets required by the MFR never proved sufficient to provide the benefits
promised by the scheme which the MFR was supposed to fund.
The Pensions Act 2004 abolished the MFR and introduced a new ‘scheme-specific funding’
basis which is expected to bring more flexibility to individual schemes’ circumstances while at
the same time protecting members’ benefits. For a scheme which had less than 90% of the
assets required, the scheme had to pay the shortfall below 90% within three years. Where
the scheme was between 90% and 100%, the shortfall had to be paid off over a period not
to exceed 10 years.
This new scheme came into force on 30 December 2005 for all pension schemes with
a valuation date after 22 September 2005.

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Credit Analysis of Financial Institutions

Defined-contribution plans (also called ‘profit-sharing plans’) are plans in which the
sponsor is required to fund the pension trust with a specific contribution each year. The
beneficiary, on retirement, is then entitled to receive the value of his or her allotted portion
of the fund.
In the case of a defined-contribution plan, the investment performance of the portfolio
directly impacts on the ultimate benefits to be received by beneficiaries at retirement. Poor
investment results will result in lower benefits, good results will enhance the retirement benefits.
Therefore, the participants of a defined-contribution plan are its principals; the sponsor is
merely their agent. The needs, circumstances and objectives of the individual participant
must therefore be taken into consideration when investing each participant’s portion of
profit-sharing plan assets. Usually, the younger the participant, the more risk can be toler-
ated. However, most profit-sharing plans are invested conservatively because of the fiduciary
duties imposed on trustees (a bank or an investment management company, for example).
The OECD3 adopted guidelines to pension fund asset management as late as 2006. The
guidelines address primarily regulatory issues in each of the member countries. Regulation
should be based on the basic objective of a pension fund which is to serve as a secure source
of retirement income. Other stipulations include prudence, written investment policies, asset
allocation restrictions, use of current asset valuations – in short, principles which allow for
transparency in asset investment procedures by pension fund managers.
Other factors that may also be important in determining risk tolerance for a retirement
plan include:

⦁⦁ the characteristics of the sponsoring company. If the sponsoring employer has a stable
sales growth pattern, low operating and financial leverage and a strong financial base,
more risk can be tolerated in its defined-benefit plans than if the opposite were true; and
⦁⦁ some retirement plans are designed primarily as tax-planning vehicles for the participants.
This is often the case for pension plans for sole proprietors or officers of privately held
companies. Such plans might tolerate more risk than conventional retirement plans.

The return requirements of a pension fund are complicated by the fact that various entities
have an interest in the management of pension fund assets, and each has a different return
requirement.

⦁⦁ The pension sponsor (the company sponsoring the pension plan) would like to keep its
reported pension costs down in order to boost profitability.
⦁⦁ The pension participants and beneficiaries want to ensure that promised (or a maximum
level of) benefits will be paid when they retire.
⦁⦁ The investment manager wants to maximise the expected return on the assets under
management while adhering to reasonable risk constraints. In this regard, one important
objective is to achieve at least the reasonable actuarial rate of return assumption used in
determining the funding requirements of the pension trust.

The need for stable current income is largely determined by the ratio of contributions to
payouts. If the contributions exceed the payouts, not much current income is needed. If

404
 Pension funds

payouts exceed contributions, generation of a large and stable current income is required.
Real returns generally are emphasised and a lot of inflation protection is needed because the
benefits often depend on future wage levels.
The typical pension plan has little need for liquidity, especially if contributions exceed
payouts by a comfortable margin. A prudently managed fund will require that the sponsor’s
contributions cover normal costs and include an amount sufficient to amortise past service
costs and experience losses. If the payouts exceed contributions, more liquidity is needed.
Enough liquidity to cover the amount of the expected shortfall for three to five years, for
example, should be appropriate. Contributory plans, or plans where vesting is fast and with-
drawal is permitted on an employee leaving the company, require more liquidity.
Time horizons usually are long for ongoing concern plans (in some cases they may be
thought of as infinite), although the age distribution of the workforce and its turnover rate
must be factored into the analysis. However, for terminated plans (plans which the sponsors
brought to a close for various reasons) the time horizon is more limited.
Pension funds are either not taxable or enjoy very favourable tax treatment in the devel-
oped markets where they exist. Therefore, there is no or little need for tax-sheltered income.
Most developed markets have laws that regulate the creation and administration of
pension plans to ensure protection for beneficiaries. In essence, pensions have been converted
from fringe benefits offered by employers to a legal claim by the beneficiaries.
It is highly desirable for the investment manager to have the input of plan sponsors,
especially in setting risk constraints and overall asset mix guidelines.

Best investment policies for pension funds

The best policy for a defined-benefit pension fund is one where the financial characteristics
of the portfolio match those of the pension obligations in terms of duration, inflation sensi-
tivity, discount rate and so forth. There is no need to earn a real return greater than that
which is guaranteed by the plan (usually the rate of growth in wages). Often, however, the
plan sponsor would like the fund manager to earn a larger return than the real growth rate
in wages because any extra return will accrue to the sponsor in the form of lower funding
costs. Nevertheless, the investment manager should keep in mind that his or her fiduciary
duty is to the participants and beneficiaries of the plan and not to the sponsor.
A well-diversified portfolio of stocks and bonds providing balanced growth is the optimum.
The degree of aggressiveness depends on the plan and sponsor characteristics as outlined
above and what asset mix appears to maximise the return/risk trade-off.
Except for mature plans, stocks should be 60% to 90% of the assets if history is used
as a guide to policy, since they have produced the best real returns over time. However, it
is not necessarily prudent to simply assume that the future will continue to be an extrapola-
tion of the past. Although history has shown that stocks have outperformed other forms of
investment over the very long run, it also shows that stocks can underperform other assets
for periods that are long enough to be disturbing.
Furthermore, since the 200l collapse of Enron, one of the world’s largest energy compa-
nies, prudent investing rules underscored the limit of 5% to l0% maximum investment in
one company’s shares in a portfolio.

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Credit Analysis of Financial Institutions

Credit analysis of pension funds

The defined-benefit pension plan is of most interest to the analyst because of the importance
of pension obligations. However, pension plans are usually a part of the balance sheet of
the sponsor, that is, a commercial or industrial company. Such companies generally disclose
pension plan information in the notes to their annual reports. The information typically
includes a summary of the amount of pension assets and the pension liabilities to the benefi-
ciaries and whether the plan is over or underfunded. The latter situation is the most important
since it requires the sponsor company to make up for shortfalls in pension obligations and,
in effect, means an analysis of the overall financial condition of the sponsor is warranted.
Unfortunately, the analyst will rarely have information on the fund in isolation but must bear
in mind that the assets of the pension fund (see Exhibit 7.2) are affected by three factors:

⦁⦁ pension funding – contributions;

⦁⦁ return on assets; and
⦁⦁ benefits.

Exhibit 7.2
Obligations and assets of pension funds

Assumptions Benefit obligation Plan assets

Recurring
Discount rate
Service cost Return on
Rate of
compensation + Interest cost plan assets
increase

Volatile

+/– Actuarial gain/loss

+ Contributions
+ Prior service cost

= Gross pension cost

– Benefits paid – Benefits paid

Source: Author’s own

406
 Pension funds

Pension funding – contributions

To provide cash to meet the benefit obligations, employer-sponsors make periodic contribu-
tions to the pension fund. When funding a pension plan, companies can choose from a number
of actuarial cost methods which, along with employer cash flow considerations, determine
both the amount of pension cost accrued and amount contributed to the pension plan.

Return on assets
The pension fund is (usually) managed by a trustee or investment adviser. The return on
assets (ROA) represents the actual return (capital gains, plus dividends and interest) earned
during the year. The ROA can fluctuate from year to year. The analyst should follow this
fluctuation if the information is provided.

Benefits
The benefits paid from plan assets depend, of course, on how pension benefit obligations are
calculated. Projected benefit obligations (PBO) is the most common method; it requires that
projected employee salaries be used to compute pension cost in the financial statements of
the employer-sponsor. The linkage of benefits paid from plan assets and pension obligations
permits reconciliation of the PBO and plan assets.
For the analyst’s information (to better understand pension fund obligations), there are
five factors that can change the benefit obligations of a pension fund from year to year: (i)
service cost; (ii) interest cost; (iii) actuarial gains and losses; (iv) prior service cost; and (v)
benefits.

Service cost
The first element in pension cost is the service cost, the present value of benefits earned
during the current period. This cost is sensitive to all the assumptions used to compute the
pension obligation, most particularly the discount rate. Service cost trends should generally
track employee age and compensation trends, except when assumptions are changed.

Interest cost
The second element of pension cost is interest on the PBO. As the passage of time brings all
future pension payments one year closer, there must be explicit recognition of the increase in
the obligation, that is, accretion of discount. This component is obtained by multiplying the
beginning PBO by the discount rate. The analyst should note that the discount rate used to
compute PBO as of the previous year end is used to compute this element of pension cost
for the entire current year.

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Credit Analysis of Financial Institutions

Actuarial gains and losses

Gains and losses originate when the PBO is recomputed each year due to changes in one or
more actuarial assumptions, such as quit rates (employees leaving the company), retirement
dates or mortality.

Prior service cost

Pension plan amendments may increase (or decrease) previously computed pension benefit
obligations. The changes relating to period of employment prior to the amendment are
known as prior service costs.

Benefits
Benefits paid to retired employees reduce the PBO as a portion of the obligation has been
met. Needless to say, plan assets are only as good as the underlying investment mix. This,
of course, has an impact on the sustainability of benefit payments.

Quantitative assessment
Obtaining the financial statements of pension funds is the major challenge facing a credit
analyst. Representative statements, however, are available depending on the country of juris-
diction. Exhibits 7.3 and 7.4 provide the composite structure of US private pension plans.
The most significant asset is, of course, the plan investment portfolio, representing 9l%
of all the plans’ assets, or 97.8% and 84.6% for defined-benefit and defined-contribution
plans, respectively. Investments are largely holdings of corporate equities, bonds and mutual
fund shares (see Exhibit 7.5). No further details are provided concerning these investments
but regulators generally place restrictions on the types, quality and quantity of financial and
non-financial holdings. Further, pension plans do not operate on the principle of leverage.
Liabilities are an insignificant component of the balance sheet.

Exhibit 7.3
Balance sheet of pension plans

Total Defined Defined

benefit contribution
Partnership/joint venture interests 1.62% 3.33% 0.31%
Employer real estate 0.01% 0.00% 0.02%
Real estate (excluding employer) 0.43% 0.75% 0.18%
Employer securities 4.77% 0.12% 8.34%
Participant loans 1.08% 0.01% 1.90%

Continued

408
 Total Defined Defined
benefit contribution
Loans (excluding participant loans) 0.22% 0.32% 0.14%
Other investments 91.87% 95.47% 89.11%
Total assets 100.00% 100.00% 100.00%
Total liabilities 2.70% 4.36% 1.42%
Net assets 97.30% 95.64% 98.58%

Source: Author’s own

Exhibit 7.4
Income statement of pension plans

Total Defined Defined

benefit contribution
Income (% of total income)
Employer contributions –23.91% –26.51% –22.04%
Participant contributions –18.50% –0.24% –31.62%
Contributions from others –2.15% –0.52% –3.31%
Non-cash contributions –0.12% –0.07% –0.15%
All other income1 144.67% 127.35% 157.12%
Total income 100.00% 100.00% 100.00%

Expenses (% of total income)

Total benefit payments –45.96% –42.32% –48.57%
Corrective distributions –0.13% 0.00% –0.22%
Deemed distribution of part. loans –0.08% 0.00% –0.13%
Other expenses –1.69% –2.53% –1.09%
Total expenses –47.86% –44.85% –50.01%
Net income 147.86% 144.85% 150.01%
1
Includes: interest earnings, dividends, rents, and realised or unrealised gains/losses on investments.

Source: Author’s own

Exhibit 7.5
Balance sheet of pension plans (actual figures, US$ million)

Total Defined Defined

benefit contribution
Partnership/joint venture interests 76,262 67,896 8,367
Employer real estate 502 48 454
Real estate (excluding employer) 20,040 15,280 4,760
Employer securities 224,534 2,487 222,046
Participant loans 50,910 215 50,696
Loans (excluding participant loans) 10,357 6,618 3,740
Other investments 4,320,893 1,948,417 2,372,476
Total assets 4,703,498 2,040,961 2,662,537
Total liabilities 126,825 88,959 37,866
Net assets 4,576,672 1,952,001 2,624,671

Source: Author’s own

Exhibit 7.6
Income statement of pension plans (actual figures, US$ million)

Total Defined Defined

benefit contribution
Income
Employer contributions 224,281 104,013 120,268
Participant contributions 173,540 954 172,586
Contributions from others 20,147 2,054 18,093
Non-cash contributions 1,095 263 832
All other income 1
–1,357,185 –499,605 –857,580
Total income –938,121 –392,320 –545,801

Continued
 Pension funds

Total Defined Defined

benefit contribution
Expenses
Total benefit payments 431,121 166,026 265,095
Corrective distributions 1,185 2 1,183
Deemed distribution of part. loans 743 7 736
Other expenses 15,891 9,936 5,954
Total expenses 448,939 175,971 272,968
Net income –1,387,060 –568,291 –818,769
1
Includes: interest earnings, dividends, rents, and realised or unrealised gains/losses on investments.

Source: Author’s own

The income statement of the total plans shows a sizeable loss, as benefit payments far
exceed contributions to the plans. A short note to the statement filings indicates that income
is exclusive of net gains (losses) from pooled funds, unrealised appreciation of assets and
investment earnings (see the ‘all other income’ line). If these items were included in total
income for the statement presentation, the net loss would be sharply reduced or show size-
able net income as was the case in tax filings several years prior to the most current release.
Ratios are restricted to the ROA mentioned earlier and the attainment of actuarial
assumptions in plan investment objectives. The analyst must rely on plan sponsors for the
veracity of such performance results.

Qualitative assessment
As mentioned earlier, the analyst will have little, if any, information to go by when assessing
the quality of a pension fund’s investment portfolio. Adherence to strict regulatory require-
ments for pension plans in the most developed countries is the main assurance for the analyst
to rely on.
Furthermore, the professional quality of pension fund managers is extremely important,
requiring added research of the analyst to gather such qualitative or non-performance infor-
mation. According to a study, Del Guercio and Tkac4 document that pension fund investors
engage in screening procedures that evaluate first, quantitative performance and subsequently,
non-performance characteristics such as manager’s reputation and credibility. The process
often involves face-to-face meetings, written questionnaires and hiring of consultants. They
interpret these evaluation procedures as the result of agency problems faced by pension
fund sponsors. After the screening process, pension fund investors perform high levels of
monitoring of hired managers.
Managers in the pension segment are often selected and evaluated according to their
investment style or specialty. For example, a sponsor may conduct a search for a manager
that invests only in large-capitalisation value stocks. As a result, the sponsor would compare
a potential manager’s track record to an index of value stocks or other large-cap value

411
Credit Analysis of Financial Institutions

managers. Virtually all pension managers state their investment style and benchmark when
marketing themselves to potential clients.
The Del Guercio and Tkac study points out that typically a corporate treasurer, as a
fiduciary, is responsible for investing the pension assets. An agency problem can arise between
senior corporate management, the corporate treasurer and the outside portfolio managers,
and accounts for many facts about the pension fund segment. Specifically, since the corporate
treasurer must answer to senior management in the event of inferior plan performance, he
or she may choose managers and strategies that reduce their own job risk. As a result, he
or she may tend to choose strategies where blame can be easily transferred to others and
their decisions can be defended ex-post. This may explain why the common practices of
externally managing pension assets and hiring professional pension consultants are popular
because they provide convenient scapegoats in the event of an unpleasant outcome.
OECD guidelines mentioned earlier continues in that vein by stipulating:

Parties who are responsible for the overall implementation of the investment policy
should be identified together with any other significant parties that will be part of the
investment management process. In particular, the investment policy should address
whether internal or external investment managers will be used, the range of their activities
and authority, and the process by which they will be selected and their performance
monitored. An investment management agreement should be required if external invest-
ment managers are used.5

In short, pension fund managers appear to be under much greater pressure than managers of
other investment management companies, notably those handling mutual fund assets. Thus
a quantitative analysis of pension fund sponsors and financial statements (when available)
must be coupled with a qualitative analysis of the managers in charge of fund assets.

1
Towers Watson, Global Pension Asset Study 2011, UK.
2
An annuity is a simple promise to pay a specific amount per month for life, beginning at a particular age. A
paid-up annuity requires no further payments on the part of the recipient. As an example, suppose a company
buys a $l paid-up annuity for each employee each month. An employee who works 40 years before retirement
will receive US$480 per month at retirement.
3
Organisation for Economic Cooperation and Development, ‘OECD Guidelines for Pension Fund Asset Management’,
Paris, 2006.
4
Del Guercio, D and Tkac, P, ‘The determinants of the flow of funds of managed portfolios: mutual funds versus
pension funds’, The Federal Reserve Bank of Atlanta (US), Working Paper 2000–202l, November 2000.
5
Organisation for Economic Cooperation and Development, ‘OECD Guidelines for Pension Fund Asset Management’,
Paris, 2006, p. 7.

412