Launching Morningstar's Captive Finance Credit Ratings

In late 2009, Morningstar announced the launch of corporate credit ratings, initiating ratings on 100 firms. Then in 2010, we began rating financial institutions including banks and insurance companies. Since then, we've published ratings on more than 700 corporate and financial institution issuers. We are now adding captive finance entities (CFEs) to the roster of issuers for which we provide ratings, with a rating methodology takes into account any potential linkage in creditworthiness between a parent and its captive finance business.

Our system for rating a CFE is similar to our bank methodology: It emphasizes economic moats and competitive analysis, a CFE's ability to generate free cash flow, and the uncertainty surrounding a CFE's future prospects. However, the ties inherent in the relationship between the parent and its finance business play a critical role in rating the credit worthiness of a CFE.

The spectrum of credit rating linkage between a parent and a captive finance entity ranges from inextricable at one extreme to completely independent at the other. Morningstar expects that, in most cases, credit rating linkage will be inextricable, but recognizes the potential for disparate credit ratings. In extremely rare situations, a more independent rating may be appropriate. In the rare case where the rating linkage is considered detached, the respective creditworthiness of the parent and the CFE may or may not lead to both having the same credit rating.

When determining the degree to which creditworthiness is linked, the process that Morningstar analysts follow includes creating pro forma financials for the parent with the CFE on an equity basis and for the CFE on a stand-alone basis; analyzing the CFE financial assets to determine the concentration in the parent's business; conducting a thorough analysis of any formal agreements between the parent, the CFE, and debtholders; and researching the corporate fundamentals of the parent and CFE, respectively, to determine the economic reality of their relationship.

Create Pro Forma Financial Statements
For the purpose of determining each entity's creditworthiness, Morningstar analysts begin the credit rating process by determining whether independent pro forma financial statements of the parent and the CFE can be created, such that the captive finance entity can be accounted for on an equity basis on the parent's pro forma financial statements and the CFE's pro forma financial statements can be analyzed on a stand-alone basis. If the CFE is organizationally treated as a strategic business unit to provide financing only for the parent's products, is not separately incorporated under a subsidiary legal structure, is not required to file separate financial statements with governing authorities, and is reported only as part of the consolidated financial statements of the parent, then the link between the parent and the CFE is inextricable, and we assign the same credit rating to both entities.

Business Concentration
Once pro forma financial statements have been created, Morningstar analysts then begin preparation of a credit rating recommendation for the parent and for the CFE to present to the credit rating committee by using our credit rating methodology. Our analysts begin by analyzing the composition of the CFE's asset portfolio. In most cases, Morningstar will consider the rating of the parent and the CFE as inextricably linked if 75% or more of the CFE's financial asset portfolio is derived from the parent. In addition, Morningstar will consider the ratings independent if 25% or less of the CFE's financial asset portfolio is derived from the parent. However, we emphasize that these percentages are not hard-and-fast break points.

Formal Agreements
In many cases, there are formal credit-related agreements between the parent and the CFE in the form of guarantees, cross-default provisions, support agreements (also known as financial threshold or keepwell), and comfort letters. Morningstar analysts research credit agreements and bond indentures of the parent and the CFE looking for these agreements and the potential impact to the linkage between the rating of the parent and the CFE. For example, if a parent were to provide an irrevocable guarantee of the CFE's debt and if there were cross-default provisions in the credit agreements or the bond indentures of either the parent or the CFE, Morningstar may consider the credit rating linkage of the parent and the CFE to be inextricable.

Corporate Fundamentals
Quite apart from formal agreements is the economic reality of the relationship between the CFE and the parent. If the two entities are tightly bound economically, Morningstar factors that into the assessment. The first and primary consideration here is the purpose served by the CFE. This consideration is partially answered in Morningstar's initial steps in determining credit rating linkage, as the existence or lack of separate financial statements and the degree of business concentration may be indicative of the CFE's purpose.

In researching corporate fundamentals, a top-down analysis of the CFE is performed, including an analysis of the stand-alone credit rating of the CFE. Some cases in which corporate fundamentals play a significant part could include situations where formal agreements between the parent and the CFE are not present, but management of the parent firm directly influences asset quality and lending policies of the CFE; substantial dividend payments to the parent from the CFE are regularly made; or a history of financial subvention exists between the parent and the CFE. In these cases, Morningstar would likely consider these corporate fundamentals and the economic implications of intracompany transactions as creating an inextricable link between the credit ratings of the parent and the CFE.

 

Entity Name Ticker  Credit Rating Ford Motor Company  (F) BBB- Ford Motor Credit   BBB- Textron Inc.  (TXT) BBB- Textron Financial   BBB- Caterpillar Inc.  (CAT) A- Caterpillar Financial Services   A- Deere & Co  (DE) A John Deere Credit   A

 

Where to Learn More
We think it's important to be as transparent as possible about how we arrive at the ratings for captive finance entities. Click here to go directly to a more detailed explanation of our methodology.