Morningstar

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See also credit rating agencies.

Morningstar rates financial firm debt

In late 2009, Morningstar announced the launch of corporate credit ratings, initiating ratings on 100 firms. Since then, we've published ratings on nearly 350 firms in a variety of industries. We are now adding financial institutions to the roster of companies for which we provide ratings, albeit with a few changes to our basic rating methodology.

Our system for rating financial companies is similar to the methodology used for nonfinancials: It emphasizes economic moats and competitive analysis, a firm's ability to generate free cash flow, and the uncertainty surrounding a firm's future prospects. Still, there are a few important differences.

For example, we've developed a Bank Solvency ScoreTM, using ratios specific to financial companies. We also incorporate a Stress Test ScoreTM. This measures a financial institution's ability to handle credit losses based on potential stress-case loss rates by loan type, company-specific income projections, and our analysts' assessment of underwriting quality. Taken as a whole, the four separate scores fold into a final credit rating, which we believe provides a thorough perspective on a lender's financial health.

We evaluate a firm's moat and other core business characteristics in a Bank Business Risk Score The Stress Test Score incorporates a bank's loan mix, along with our analysts' estimates of underwriting prowess and future income. These metrics allow us to clearly evaluate a bank's ability to handle macroeconomic stress. The Bank Solvency Score ranks a financial institution's performance in terms of capital adequacy, asset quality, earnings power, and liquidity against hundreds of its peers. Our market-driven Bank Distance to Default Score uses option pricing theory to evaluate the risk that the value of a bank's assets will turn out to be less than the sum of its liabilities, denying it the benefit of a minimum capital cushion.

I. Bank Business Risk Score The Business Risk Score is based on six elements, each evaluating a different aspect of the risk associated with a particular financial institution:

Economic Moat Rating An essential part of our company analysis is the Economic Moat rating, which encapsulates our view regarding a company's competitive advantage, and its ability to earn excess returns on capital.

Uncertainty Rating Morningstar's Uncertainty Rating represents our estimate of the predictability of future cash flows to equityholders. Because equity is the residual value of a firm after satisfying creditors, it represents a cushion against losses for bondholders.

Size Larger financial firms benefit from greater access to the capital markets.

Management Grade Our analysts assign companies a Stewardship Grade, which captures our view of both corporate governance practices and management's skill. The Stewardship Grade is adjusted as necessary to reflect a management team's concern for the interests of bondholders.

Dependence on Capital Markets We score financial institutions based on their need to access the capital markets. For example, a firm that depends on short-term repo funding is far more vulnerable than one funded by low-cost core deposits.

Geographic/Business Line Concentration In general, firms concentrated in one geographic area or business line are more vulnerable than those with more diverse operations. Companies with a variety of loan types, geographic exposures, and sources of fee income score higher than highly concentrated firms.

II. Bank Solvency ScoreTM In developing the Bank Solvency Score, Morningstar bank analysts selected six accounting ratios measuring capital adequacy, asset quality, earnings power, and liquidity for financial institutions. Each quarter, approximately 1,500 bank holding companies, representing the vast majority of assets in the banking system, are ranked based on each of the selected metrics, with the weighted scores producing a relative ranking of virtually the entire banking system.

III. Stress Test ScoreTM The Morningstar Bank Stress Test ScoreTM evaluates a bank's ability to handle additional macroeconomic stress and consequent losses in its loan and securities portfolios. Based on the stress tests conducted under the Supervisory Capital Assessment Program, the Stress Test Score differs in two important ways.

First, it is conducted on a rolling basis each quarter. Thus, it continually measures a bank's ability to handle additional stress beyond any losses that are already recognized, whereas the SCAP tests were conducted on a one-time basis.

Second, the Bank Stress Test Score utilizes Morningstar analysts' forecasts of future pre-tax, pre-provision earnings and expenses for individual banks—the same forecasts used in our discounted cash flow models for equity valuation. In contrast to the relative rankings produced by the Bank Solvency Score, the Bank Stress Test Score produces an absolute measure of capital. Therefore, the average Bank Stress Test Score across our coverage universe will increase as total banking system capital increases, and decrease when financial companies add leverage. This potentially provides an early warning in boom times, and an indication of safety in times of crisis.

III. Bank Distance to DefaultTM Like the Distance to Default measure for nonfinancial companies, the Bank Distance to Default ranks companies on the likelihood that they might encounter financial distress. The more likely the value of a company's assets is to fall below the sum of its liabilities and a small capital cushion, the greater the likelihood of financial distress. The measure treats a company's equity as a call option on the company's assets, with the total liabilities being the strike price. The Distance to Default expresses how many standard deviations separate the current value of assets from the strike price.

The Final Credit Rating

When combined, these four factors create a ranking system for measuring an individual corporation's financial strength against that of other firms in our coverage universe. All of these factors are then reviewed by a Morningstar credit rating committee made up of senior members of the research staff, where additional adjustments to rankings may be made--for example, by incorporating outside factors such as the potential for government assistance. The committee then decides on the final rating—AAA through C—to award the company.

Our credit ratings are issuer ratings, meaning they apply to the corporate issuer, not to any specific bond. We define the ratings, however, to apply to any senior unsecured debt of the company in question, which covers the bulk of corporate debt outstanding. Also keep in mind that a credit rating is not an investment rating—it's not our opinion on whether a company's bonds or other securities are "buys" or "sells."

Even if credit ratings do not translate directly to buy or sell recommendations, the ratings do have direct relevance for bond investors. By comparing bond issues from companies we consider to be of comparable credit quality, we can identify individual bond issues that appear potentially overpriced or underpriced. These investment ideas, along with weekly credit updates on our coverage list and all the underlying assumptions that go into the credit ratings, are available through our institutional service.

Where to Learn More

We think it's important to be as transparent as possible about how we arrive at the ratings for individual firms. Click here to go directly to a more detailed explanation of our methodology.

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