BUFN 722

1. BUFN 722 ch-6 Finance Companies BUFN722- Financial Institutions

2. Overview • In this segment ... Finance Companies: • Activities of finance companies • Competitive environment • Size, structure and composition • Regulation • Global issues BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

6. Largest Finance Companies BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

16. Electronic Lending • Mainly mortgages completed over the Internet • E-Loan • Suffered with the dot-com downturn BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 company’s products and services • Provide financing to distributors of the parent company’s 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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 institution’s 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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 Journalwww.wsj.com BUFN722- Financial Institutions