ch6 1

1
BUFN 722

• ch-6
• Finance Companies

2
Overview

• In this segment ... Finance Companies
• Activities of finance companies
• Competitive environment
• Size, structure and composition
• Regulation
• Global issues

3
Historical Perspective

• Finance companies originated during depression.
• Installment credit
• General Electric Capital Corporation.
• Competition from banks increased during 1950s.
• Expansion of product lines
• GMAC is largest commercial mortgage lender in
  U.S.
• Industry is highly concentrated
• Largest 20 firms account for more than 80 of
  assets.

4
Finance Companies

• Activities similar to banks, but no depository
  function.
• May specialize in installment loans (e.g.
  automobile loans) or may be diversified,
  providing consumer loans and financing to
  corporations, especially through factoring.
• Commercial paper is key source of funds.
• Captive Finance Companies e.g. GMAC

5
Major Types of Finance Companies

• Sales finance institutions
• Ford Motor Credit and Sears Roebuck Acceptance
  Corp.
• Personal credit institutions
• Household Finance Corp. and American General
  Finance.
• Business credit institutions
• CIT Group and Heller Financial.
• Equipment leasing and factoring.

6
Largest Finance Companies
7
Balance Sheet and Trends

• Business and consumer loans are the major assets
• 58.8 of total assets, 2000.
• Reduced from 95.1 in 1977.
• Called Accounts Receivable
• Increases in real estate loans and other assets.
• Growth in leasing (largely due to tax incentives
  of 1981 Economic Recovery Act).
• Liabilities and equity
• cannot accept deposits so rely heavily on issuing
  short-term commercial paper to finance assets

8
Balance Sheet and Trends

• Consumer loans
• Primarily motor vehicle loans and leases.
• Recent low auto finance company rates are
  anomalous.
• Generally riskier customers than banks serve.
• Subprime mortgage lenders
• Recent increase in loan shark firms with rates
  as high as 30 or more.
• Payday loans
• Other consumer loans about 25.8 of consumer loan
  portfolio, December 2000.
• personal cash loans
• mobile home loans
• loans for consumer goods

9
Balance Sheet and Trends

• Mortgages
• Recent addition to finance company assets
• Smaller regulatory burden than banks
• May be direct mortgages, or as securitized
  mortgage assets.
• Growth in home equity loans since passage of Tax
  Reform Act of 1986.
• Tax deductibility issue.

10
Mortgages

• Residential and commercial mortgages have become
  a major component of finance companies asset
  portfolios
• Often issued to riskier borrowers and charge a
  higher interest rate for that risk
• Securitized mortgage assets - mortgages packaged
  and used as assets backing secondary market
  securities
• Bad debt expense and administrative costs of home
  equity loans are lower and have become a very
  attractive product for finance companies

11
Business Loans

• Business loans comprise largest portion of
  finance company loans.
• Advantages over commercial banks
• Fewer regulatory impediments to types of products
  and services.
• Not depository institutions hence less regulatory
  scrutiny and lower overheads.
• Often have substantial expertise and greater
  willingness to accept riskier clients.
• Business-lending also includes equipment loans or
  leasing, purchase accounts receivable, small farm
  loans, wholesale loans/leases of mobile homes,
  campers and trailers

12
Business loans

• Major subcategories
• retail and wholesale motor vehicle loans and
  leases
• equipment loans
• tax issues associated when finance company leases
  the equipment directly to the customer
• other business loans and securitized business
  assets

13
Liabilities

• Major liabilities commercial paper and other
  debt (longer-term notes and bonds).
• No deposits
• Finance firms are largest issuers of commercial
  paper (frequently through direct sale programs).
• Commercial paper maturities up to 270 days.

14
Industry Performance

• Strong loan demand
• Strong profits for the largest firms
• e.g. Household International, Associates First
  Capital, Beneficial
• Most successful have become takeover targets
• Citigroup/Associates First Capital,
• Tyco International/CIT Group

15
Industry Performance

• High risk has a downside
• Subprime lending Jayhawk Acceptance Corporation
• Cityscape Financial Corp., Aames Financial Corp.,
  Advanta, FirstPlus Financial Group, The Money
  Store, Associates First Capital
• FTC scrutiny of subprime lending practices
  violating Truth in Lending Act, Fair Credit
  Reporting Act, Equal Opportunity Act

16
Electronic Lending

• Mainly mortgages completed over the Internet
• E-Loan
• Suffered with the dot-com downturn

17
Regulation of Finance Companies

• Federal Reserve definition of Finance Company
• Firm, other than depository institution, whose
  primary assets are loans to individuals and
  businesses.
• Financial intermediaries that borrow funds to
  profit on the difference between the rates paid
  on borrowed funds and charged on loans
• Subject to state-imposed usury ceilings.
• Much lower regulatory burden than depository
  institutions.
• Not subject to Community Reinvestment Act.
• Being heavy borrowers in capital markets, they
  need to signal their safety and solvency to
  investors

18
Regulation

• With less regulatory scrutiny, finance companies
  must signal safety and soundness to capital
  markets in order to obtain funds.
• Lower leverage than banks (10.9 capital-assets
  versus 8.5 for commercial banks).
• Captive finance companies may employ default
  protection guarantees from parent company or
  other protection such as letters of credit.

19
Global Issues

• In foreign countries, Finance companies are
  generally subsidiaries of commercial banks or
  industrials
• In Japan, ownership of finance companies by banks
  created opportunities when banks hit by increase
  in nonperforming loans
• GE Capital/Japan Leasing Corporation

20
Risks Faced by Finance Companies

• Liquidity risk
• Finance companies do not hold assets that can be
  easily sold in the secondary market
• To raise funds they must borrow
• Balance sheet structure does not call for much
  liquidity because they would not have unexpected
  deposit withdrawals
• Interest rate risk is less than for depository
  institutions because the maturity of assets and
  liabilities is relatively short
• Assets are typically not as rate sensitive as
  liabilities
• Can use adjustable rates and shorter maturities
  on their loans to manage the risks

21
Risks Faced by Finance Companies

• Credit risk
• Represents an important source of risk
• Loan delinquency rates are typically higher than
  for other kinds of institutions
• Charge a higher interest rate to compensate for
  the risk
• High return, high risk nature of loans makes
  performance sensitive to prevailing economic
  conditions

22
Captive Finance Subsidiaries

• Captive finance subsidiaries (CFS) have several
  characteristics
• They are a wholly owned subsidiary with the
  primary purpose to finance sales of the parent
  companys products and services
• Provide financing to distributors of the parent
  companys products
• Purchase receivables of the parent company
• Motives for creating a captive finance subsidiary
  shown by the example from the auto industry
• Can finance distributor and dealer inventories
• Makes production less cyclical for manufacturer
• An effective tool in retail marketing

23
Captive Finance Subsidiaries

• Growth in the industry occurred between 1946 and
  1960
• More liberalized credit policies
• The need to finance growing inventories
• Advantages of captive finance subsidiaries
• Corporations can separate manufacturing and
  retailing from financing
• Makes it easier and less expensive to analyze
  each segment of the parent
• Comparison with other financial institutions
• No reserve requirement
• No restrictions on how to obtain funds
• Competitive advantage in retail sales

24
Valuation of a Finance Company

• Value of a finance company depends on its
  expected cash flows and required rate of return

?V f ? E(CF), ? k
?k f(?Rf , ?RP)

• Factors that affect cash flows

?E(CF) f (?ECON, ?Rf , ?INDUS, ?MANAB)
?
Where
? V Change in value of the institution
? E(CF) Change in expected cash flows
? k Change in required rate or return
Rf Risk free interest rate RP risk
premium ECON Economic growth MANAB The ability
of the institutions management INDUS Prevailing
industry conditions for the institution E(CF)
Expected cash flow
25
Valuation of a Finance Company

• Economic growth
• Positive affect because it enhances household
  demand for consumer goods
• Economic growth reduces defaults
• Change in the risk-free rates
• Cash flows inversely related to interest rate
  movement
• Short term sources of funds means their rates
  change as do those of other interest rates
• Change in industry conditions which include
  regulatory constraints, technology and
  competition
• Change in management abilities

26
Interaction with Other Financial Institutions

• Interact in various ways with other financial
  institutions
• Concentration in commercial lending means they
  are closely related to commercial banks, savings
  institutions and credit unions
• Compete with savings institutions and increase
  market share when their competitors have problems

27
Participation in Financial Markets

• Participate in a wide range of financial markets
• Money markets
• Bond markets
• Mortgage markets
• Stock markets
• Futures markets
• Options markets
• Swap markets

28
Multinational Finance Companies

• Large multinational companies with subsidiaries
  in many countries
• Reasons why finance companies go global
• Enter new markets
• Reduce exposure to the U.S. economy

29
Pertinent Websites

• Aames Financial Corp. www.aames.net/afc/index.chi
  
• Advanta www.advanta.com
• American General www.americangeneral.com
• Federal Reserve www.federalreserve.gov
• CIT Group www.citgroup.com
• Citigroup www.citigroup.com
• Consumer Bankers Association (H.E.L.)
  www.cbanet.org
• Federal Trade Commission www.ftc.gov
• Wachovia Bank www.wachovia.com
• Ford Motor Credit www.fordcredit.com
• GE Capital Corp. www.ge.com/gec
• GMAC www.gmacfc.com
• Household International www.household.com
• The Wall Street Journal www.wsj.com