KEY POINTS:
Back in the bad old days, parents used to dread receiving their kids' school reports.
At least those whose delinquents regularly scored a C - or even worse, a D or E - from their despairing teachers, did. Those whose darlings frequently managed As and Bs only had to struggle with their natural inclination to push their children even harder.
These days, such simplistic gradings are no longer fashionable in primary or secondary schools, although they still seem to be the norm at universities. But they are about to become very fashionable indeed in the finance industry, as bureaucrats scramble to clean up the non-bank finance sector, after a string of high-profile collapses over the past 18 months.
Sometime in the next couple of years, all finance companies with more than $10 million in assets or $2 million in capital - and that's almost all of them - are likely to be required to undergo a mandatory credit rating, from an approved rating agency.
Presumably, the aim is to give a largely ignorant public at least some kind of tool with which to compare the plethora of finance companies that are still willing to fund such risky activities as property development or consumer loans.
Which all sounds thoroughly sensible, except some in the industry are warning that it might not be the panacea it seems.
Independent credit ratings as we know them today began in the United States in the 1850s, when investors in the booming railroad industry sought independent advice.
Today, there are more than 130 corporate rating agencies worldwide, which rate everything from entire countries to tiny nooks and crannies of the economy. However, just three companies dominate the sector worldwide: Standard & Poor's, Moody's and Fitch Ratings.
Over the years, many critics have accused the "big three" of running an oligopoly. In 1996, economist Thomas Friedman commented that "there are two superpowers in the world today in my opinion. There's the United States and there's Moody's Bond Rating Service. The United States can destroy you by dropping bombs, and Moody's can destroy you by downgrading your bonds. And believe me, it's not clear sometimes who's more powerful."
If only, say its critics. Moody's failure to detect the deterioration of Enron until it was too late was among the spurs for a shake-up of the industry, which among other things, has seen the US Securities & Exchange Commission officially endorse four more ratings agencies: insurance sector specialist A M Best; Canada-based Dominion Bond Ratings; plus two Japanese-based agencies, Rating & Investment Information (R&I) and Japan Credit Rating Agency (JCRA).
And another major review is now under way in the US following the sub-prime housing crisis, to find out whether the credit-rating agencies improperly inflated their ratings of mortgage-backed securities.
"It seems to me that credit rating agencies are playing both coach and referee," Democrat Senator Robert Menendez was widely quoted as saying just a fortnight ago.
Naturally, the agencies have denied such accusations, pointing out that their reputations are the very essence of their livelihoods. But no one was sure whether to believe Standard & Poor's president Kathleen Corbet when she insisted at the end of August that she was leaving for family reasons.
As it happened, the same day that hearings began on Capitol Hill last month, a group of Australian and New Zealand academics were meeting in Melbourne to discuss our own response to what has become known as the global credit crunch.
The group, which calls itself the Australia-New Zealand Shadow Financial Regulatory Committee, is the local version of similar committees worldwide. It was set up at the end of last year by a group of university professors and researchers who are all experts in the fields of banking, economics and finance.
The group's conclusion is perhaps a little surprising: it has cautioned against over-reacting to the finance and insurance company collapses we have already seen on both sides of the Tasman.
At present, the Government plans to require finance companies to obtain ratings from an approved agency, though legislation to make that the law has not yet been introduced. When and if it goes ahead, the requirements will not take effect for some time - possibly not until 2010.
The Shadow Financial Regulatory Committee notes that it is somewhat ironic that New Zealand is considering more heavy-handed regulation than Australia, given our traditional inclination to be the good cop, rather than the bad one.
In Australia, finance companies will remain answerable to the Australian Securities and Investments Commission, but here they will come under the ambit of the Reserve Bank.
Other regulations the Government has announced in New Zealand include the need for finance companies to hold a certain amount of cash relative to their sales; restrictions on lending to related parties; and for directors and senior managers to be deemed "fit and proper". Trustees will also be given clearer powers.
Interestingly, the professors are less than enthusiastic about the latter move, noting that in Australia, trustees were abolished for managed investment schemes in 1993. Perhaps, they suggest, requiring a minimum number of independent directors would be more efficient and less costly.
Nor do they support finance companies being regulated by the Reserve Bank, believing that it might give some investors the idea that the central bank will bail them out if things get tricky.
As for credit ratings, the committee appears less than enthusiastic. It argues that ratings could give a false sense of security, given their limitations. And they might also be unnecessary, if trustees are doing their job properly, it suggests.
The committee's own suggestions for cleaning up the sector include:
Encouraging better financial literacy;
Ensuring potential investors will actually understand any new disclosure requirements;
Eliminating conflicts of interest for financial advisers;
Developing some sort of secondary market for investors who want to quit their investments before the due date; and
Introducing a deposit insurance scheme for less risky companies, as happens overseas.
But it is important, they argue, that we still let companies fail, and allow investors who have "knowingly accepted" exposure to high-risk financial assets, to lose money. If we don't, it will send the wrong message to the whole financial industry, and distort how it works.
Professor Glenn Boyle is head of finance at Victoria University, and executive director of the NZ Institute for the Study of Competition and Regulation. He is also co-chair of the transTasman shadow finance committee.
You might expect him to be rather dry, but Boyle is anything but. He happily admits to doing his own dough on listed vending machine company VTL, which stopped trading last month after Nathans Finance, which it owned, was put into receivership.
VTL's problems show that NZX is wrong to argue that continuous disclosure is the solution to investor ignorance, argues Boyle. And likewise, mandatory credit ratings would not have stopped the recent string of finance company collapses, because they wouldn't have rung alarm bells in time to help anyone.
The problem with credit ratings, he claims, is that they are based on "black box" methodology, involving some highly sophisticated mathematics and statistics, "the latter of which involves essentially the assumption that the future will look much like the past".
Most of the time that assumption is correct, so most of the time credit ratings are a good indication of risk, he concedes. But occasionally, some sort of shock comes along that makes the whole system go pear-shaped - the sub-prime mortgage fiasco being a case in point.
It is not coincidence that so many finance companies have gone under in the past 18 months - it is largely a domino effect that credit ratings could not have foreseen, he suggests.
"What we're starting to see is liquidity drying up. The last three or four [finance company collapses] have suffered from that, and the problem is that no credit rating is going to protect people from that."
Perhaps, although regular reviews by rating agencies can provide some guidance. The recent decision by Standard & Poor's to place Geneva Finance on "creditwatch negative" was a signal that the agency was considering downgrading Geneva's rating due to the current crisis - which it since has.
But the problem with such moves is that they send such a strong signal, they can actually trigger investor flight. Ironically, that is one of the arguments put forward by the major agencies for the sudden collapse of Enron, which was declared bankrupt just days after its investment-grade ratings were downgraded.
Boyle's other concern with credit ratings is their cost, and the potential for finance companies to shop around for the best rating they can get. He is also concerned that only allowing certain agencies to operate here will stifle competition.
The major agencies are believed to not even get out of bed for less than $30,000. Finance companies are a fundamental source of money for small businesses, and if they are forced to charge more to cover their costs, it could have a "significant adverse effect" on economic investment, growth and activity, says Boyle.
"I suppose the caveat is that the benefit of a rating, compared to none at all, is that at least some information has been provided, compared to none at all. So it's a small tick, but whether it's a sufficiently big tick to require all companies to do this, I'm doubtful about."
There is, of course, also the risk that investors will be none the wiser - or perhaps even more confused - because of the ridiculously complicated, and far from uniform, alphabetical rating systems that most agencies use.
Some in the industry have been rather surprised, for example, to see Hanover Finance gloat so publicly about its BB+ rating, awarded to the company in April by Fitch.
Compared to its competitors, Hanover has spent an enormous amount advertising the rating. Yet BB+ is not even investment grade. In the US, bonds with such ratings are as known as "junk", although the comparison in this market is probably not quite fair.
Hanover CEO Sam Stubbs, who joined the company in May after a decade with Goldman Sachs in London and Hong Kong, is not about to apologise for its decision to publicise the rating. While the company will obviously aim for a higher rating next time, it's comfortable with where it sits in the scheme of things, says Stubbs.
Fitch told Hanover it was penalised because of its size on a global scale, and its concentration on the property sector, he says. "That's a conscious decision by us to stick to our knitting. We're not going to diversify just for the sake of it just to get our credit rating up."
He also notes that a BB+ rating still indicates only a tiny probability of default.
Obviously, he concedes, Fitch was keen to work with Hanover, to get its foot into the New Zealand market. But Hanover was also keen to hire a rating agency with an international reputation.
"The principal reason for doing it was we wanted to be early. We wanted an independent assessment. We felt it was the right, proper thing to do. It's what you have to do overseas if you run these sorts of organisations."
And as for the cost, if anyone in the finance industry pleads that they can't afford, say, $50,000 to provide an independent opinion of their creditworthiness, then they probably shouldn't even be in the business, he argues.
But if a company as large as Hanover can't get an investment grade rating, then how on earth are the dozens of others out there going to fare once they become mandatory?
Well actually, they're probably going to fold, or get taken over, or quietly give up the fight, suggests Kapiti Coast sharebroker Chris Lee. And so they should, he argues.
Lee has not exactly endeared himself to many of the industry's minnows - or even some of its larger players - by publishing his own rankings, based on his own company's research, over the years.
After decades in the industry, he is not far away from retirement, and is delighted that he might finally have persuaded officials to set up an Ombudsman to oversee a sector that he regards as woefully underscrutinised.
Even now, tales of outrageous behaviour in the industry are still surfacing, says Lee. The owner of a popular investment website, for example, is said to have recently downgraded a particular finance company's score on his site because it refused to pay for an advertisement. And the shenanigans that went on over Bridgecorp and its relations with some financial advisers are likely to persuade even the most reluctant investor to reconsider the Chinese sharemarket on a bad day, he muses.
Boyle remains unmoved. In the long run, any initiatives that will help the public understand the finance sector - and in particular the relationship between risk and reward - have to be a good thing, he agrees.
But there are two golden rules of investing that everyone should know, he says: "Rule one is that people are going to lose money; and rule two is there is nothing the Government can do about rule one."
Sure, but do all investors really "knowingly accept" such risks? One thing that has become clear in the wake of Bridgecorp's collapse is that many don't seem to have the faintest idea how their money is actually being used.
Ron Keene is a self-confessed veteran of the finance scene, having spent the best part of three decades working for the National Bank in merchant finance. He also ran General Finance in the mid-80s, and the Southland Building Society in the early 90s. Lately he's been using his experience to run his own Wellington-based risk advisory business, Risk Analysis.
Keene has considerable sympathy for many of those who stand to lose a big chunk of their savings in companies like Bridgecorp.
Far from being rich and greedy, many are simply retired, and entrusted the sums they accumulated over their working lives to companies they had every reason to believe would look after their money, he says.
They are the kind of people who rely on high interest rates to ensure they have enough money to belong to the local bowling club, and to take the odd trip to Taupo, he says. Many distrust the sharemarket after the 80s crash, and many were reassured by the fact that no finance companies of any note had defaulted on their interest payments for a very long time.
While many are now understandably switching to bank deposits, they are likely to struggle once interest rates inevitably drop, he believes. And like most in the industry, Keene believes there will be yet more failures before the non-bank sector starts to stabilise.
Having witnessed regulation fall in and out of favour with officials several times during his career, Keene is somewhat cynical about the latest review. But a properly regulated market just might give some investors a better insight into how it works, he believes.
"The question has to be asked: `At the end of the day, is anyone going to be safer?' Well, maybe not, but at least they might know a bit more about it if they want to read it. In my opinion there is a reasonable amount of transparency around at present, but most retail investors in New Zealand don't read that stuff, or they can't understand it, and the same may be true of financial advisers."
As for credit ratings, "it's good for credit rating agencies, because now they've got a captive market," he muses. "But it's not the only answer."
