Determinants of Interest Rates

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Finance Companies
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Finance Companies

• Finance Company - The Federal Reserve defines
  finance companies as any firm whose primary
  assets are loans to individuals and businesses.
• Finance Companies vs. Banks and Thrifts
• Some finance company loans are similar to
  commercial bank loans (i.e. commercial and auto
  loans), but others are aimed at relatively
  specialized areas such as high risk (low credit
  quality) loans to business and consumers.
• Unlike banks and thrifts, finance companies do
  not and cannot accept deposits. Instead, they
  rely on short and long-term debt for funding.

3
Industry History and Composition

• The first major finance company was originated
  during the Depression when GE created GE Capital
  Corp (GECC) to finance appliance sales to cash
  strapped customers unable to obtain installment
  credit (a loan that is paid back to the lender
  with periodic payments consisting of varying
  amounts of interest and principal).
• By the late 1950s, banks had become more willing
  to make installment loans, so finance companies
  began looking outside their parent companies for
  business (GECC now offers leases on rail cars,
  planes, leveraged buyout financing, mortgage
  servicing and other loans to its customers.)

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Industry History and Composition

• The industry is very concentrated (the 20
  largest firms control 80 of the assets). In
  addition, many of the largest finance companies
  such as GMAC tend to be wholly owned or captive
  finance companies - a finance company wholly
  owned by a parent company (usually, they serve to
  provide financing for the purchase of the parent
  companys products).
• Between 1975-1999, the industry experienced over
  1200 growth, making it one of the fastest
  growing industries in the financial services
  sector.

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Industry Growth

• Competitive loan rates.
• Willingness to lend to riskier borrowers.
• Affiliation with manufacturing firms that have
  sought means to grow.
• Limited amount of regulation imposed.

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Finance Companies - Types

• Sales Finance Institutions - specializes in
  making loans to customers of a specific retailer
  to manufacturer (e.g. Ford Motor Credit, Sears
  Roebuck Acceptance Corp.).
• Personal Credit Institutions - specializes in
  making installment and other loans to consumers
  (e.g. Capital One, Household Finance Corp., MBNA,
  etc.).
• Business Credit Institutions - provide financing
  to corporations, especially through equipment
  leasing and factoring - the process of purchasing
  A/R from corporations (often at a discount),
  usually with no recourse to the seller should the
  receivables go bad.

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Finance Companies - Loans (Receivables)
Outstanding
Source Federal Reserve Bulletin - Survey of
Finance Companies, 1996
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Real Estate (Mortgages)

• Finance companies are often willing to issue
  mortgages to riskier borrowers than commercial
  banks.
• Mortgages include all loans secured by liens on
  any type of real estate either by direct lending
  or as a result of securitizing mortgage assets -
  purchasing mortgages and using them as assets
  backing secondary market securities.
• Mortgages can be first mortgages or second
  mortgages (home equity loans). Secondary
  mortgages are increasingly attractive due to
  lower bad debt expense and lower administrative
  costs.

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Consumer Loans

• Consumer loans include motor vehicle loans and
  leases and other consumer loans (i.e. credit
  cards, furniture financing, appliance financing,
  cash loans, etc.).
• Finance companies generally charge higher rates
  of interest on consumer loans due to riskier
  customer they lend to. High risk customers are
  often referred to as sub-prime.
• Loan sharks - sub-prime lenders that charge
  unfairly exorbitant rates to desperate borrowers.
  The sharks may also use lower rates but charge
  high fees. The fees may be disguised. Other
  tricks include lower rates but excess collateral.

10
Business Loans

• The largest portion of finance company assets.
• Finance companies often have advantages over
  commercial banks in lending to small businesses.
• They are not subject to regulations that restrict
  the type of products and services they can offer.
• Because they do not accept deposits, they have no
  bank-type regulators establishing capital
  requirements.
• In cases where they are subsidiaries of corporate
  sector holding companies, they may have industry
  and product expertise.
• Willingness to accept riskier customers.
• Lower overhead (no need to expense
  tellers/branches in order to get deposits).

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Business Loans - Sub-categories

• Retail loans and leases.
• Wholesale loans - loan/lease agreements between
  parties other than the companys consumers (i.e.
  GMAC provides financing for GM dealers for
  inventory floor plans, until the car is sold, the
  dealer only pays for the cost of the financing
  and not the cost of the car).
• Equipment Loans/Leases - the finance company may
  own or lease the equipment directly to its
  industrial customer or provide financial backing
  for a working capital loan or a loan to purchase
  or remodel the customers facilities.

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Equipment Loans/Leases

• From the finance companys perspective, a lease
  is often preferred to the sell and financing of
  equipment.
• Repossession of equipment (in the event of
  default) is less complicated when the finance
  company retains the title.
• A lease agreement generally requires no down
  payment making it more attractive to the business
  customer.
• When the finance company retains the ownership,
  it receives a tax deduction in the form of
  depreciation expense on the equipment.

13
Liabilities and Equities

• Commercial paper - finance companies are the
  largest issuers in the market (21 of total
  liabilities and capital in 1996).
• Other debt - due to parent holding company and
  other not classified.
• Loans from banks - this is less than in the past
  (2.2 of total liabilities and capital in 96).
• Capital surplus (11 of total liabilities and
  capital in 96).

14
Finance Company Regulation

• The lack of deposits exempts finance companies
  from the extensive oversight of the federal and
  state regulation experienced by banks and
  thrifts. Because of the lack of regulatory
  oversight, finance companies are able to offer
  bank like services, but avoid the expense of
  regulatory compliance.
• Like depository institutions, finance companies
  may be subject to state imposed usury ceilings on
  the max loan rates charged to customers.
• Because of their heavy reliance on money and
  capital markets, finance companies need to signal
  their safety and solvency to investors. As a
  consequence, finance companies often maintain
  higher credit ratings than banks and carry higher
  capital to assets ratios.
• Finance companies operate more like
  non-financial, non regulated companies than the
  other types of FIs.

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Mutual Funds
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Mutual Funds

• Mutual fund- intermediary that pools the
  financial resources of investors and invests
  those resources in (diversified) portfolios of
  assets.
• Open end mutual fund - a fund that sells new
  shares to investors and redeems outstanding
  shares on demand at fair market value (the
  majority of funds).
• Closed-end mutual fund - a fund with a fixed
  number of shares outstanding. The shares are
  exchange traded and may sell at a discount or
  premium to fair market value. Real estate
  investment trusts (REITs) are a common form of
  closed end investment company

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Mutual Fund Functions

• Opportunities for small investors to invest in
  financial securities.
• Opportunities to diversify risk.
• Lower transaction costs and commissions by
  passing on economies of scale.
• (In most cases) free exchange between funds
  within the mutual fund company.
• Automatic investing
• Check-writing priveleges on some money market
  funds and even some bond funds.
• Automatic reinvestment of dividends and automatic
  withdrawals.

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Mutual Fund History

• First fund established in Boston in 1924.
• Initially, industry growth was slow - in 1970,
  360 funds held about 50B in assets. By 2000,
  more than 7800 different mutual funds held total
  assets of over 6.8B.
• Recent explosive growth can be attributed to
• the advent of the money market mutual fund (72)
• the advent of tax exempt money market mutual
  funds (79) and tax exempt funds (80)
• the explosion of special purpose equity, bond,
  emerging market and derivative funds
• the proliferation of 401(k) plans
• market growth

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Mutual Fund Types

• Open-end and closed-end
• Long-term funds
• Equity funds (common and preferred)
• Bond funds
• Hybrid or balanced funds (stock and bonds)
• Short-term funds - comprise both taxable and
  tax-exempt money market mutual funds. Money
  market do not have FDIC insurance (consequently,
  they typically have higher yields). Some money
  market mutual funds are covered by private
  insurance /or implicit or explicit guarantees
  from management companies.
• Prospectus - regulators require that mutual fund
  managers specify the investment objectives of
  their funds in the prospectus.

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Mutual Fund Types
Source Investment Company Institute
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Mutual Fund Types
Source Investment Company Institute
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Components of Return from Mutual Funds

• Income/dividends
• Capital gains - when a mutual fund sells assets
  at higher prices
• Capital appreciation in the underlying values of
  existing assets adds to the value of mutual fund
  shares (NAV)
• Net Asset Value (NAV) - the market value of the
  assets in the mutual fund portfolio divided by
  the number of shares outstanding. Each day,
  mutual fund assets are marked-to-market or
  adjusted to reflect current market prices. In
  open-end funds, the NAV is the price that
  investors obtain when they sell shares back to
  the fund or the price they pay to buy new shares
  in the fund on that day.

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Mutual Fund Costs

• Two types of fees incurred by mutual fund
  investors 1) sales loads 2) fund operating
  expenses
• Load vs. No-load funds
• Load funds - funds that charge a 1X sales or
  commission charge to compensate a registered
  representative of a broker (front - end loads).
  Back-end loads (differed sales charges) are
  sometimes charged when shares are sold.
• No-load funds - funds that market shares directly
  to investors and do not use sales agents working
  for commissions

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Mutual Fund Costs

• Operating expenses - annual fees are charged (as
  a of assets) to cover all fund level expenses
  (management, administration, shareholder
  services, etc.). 12b-1 fees - (generally in
  no-load funds) are fees charged to meet fund
  level marketing and distribution costs (limited
  to 25 bps).

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Mutual Fund Regulation

• Heavily regulated industry with the SEC as the
  primary regulator.
• Securities act of 1933 - requires fund
  registration and dictates prospect procedures.
• Securities Exchange Act of 1934 - appoints the
  NASD to supervise mutual fund share distribution.
• Investment Advisers Act and Investment Company
  Act of 1940 - establishes rules to prevent
  conflict of interest, fraud, and excessive fees
  or charges for fund shares.
• The National Securities Markets Improvement Act
  (NSMIA) of 1996 - exempts funds from oversight by
  state securities regulators.