Finance Companies

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.

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.)

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 company’s products).

• Between 1975-1999, the industry experienced over 1200% growth, making it one of the fastest growing industries in the financial services sector.

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.

Finance Companies - Types 1 Sales Finance Institutions - specializes in making loans

to customers of a specific retailer to manufacturer (e.g. Ford Motor Credit, Sears Roebuck Acceptance Corp.).

2 Personal Credit Institutions - specializes in making installment and other loans to consumers (e.g. Capital One, Household Finance Corp., MBNA, etc.).

3 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.

Finance Companies - Loans (Receivables) Outstanding

Source: Federal Reserve Bulletin - Survey of Finance Companies, 1996

Category Billions of Dollars Growth (Percent) Share of Total (%)1990 1996 Cumulative Annual Rate 1990 1996

Total 505.3 771.4 52.7 7.3 100 100Owned 480.4 645 34.3 5 95.1 83.6

Securitized 24 126.44 408.4 31.1 4.9 16.4Business 258.9 341.3 31.8 4.7 51.2 44.2

Owned 255.8 305.7 19.5 3 50.6 39.6Securitized 3.1 35.6 1051.5 50.3 0.6 4.6

Consumer 185.2 326.3 76.2 9.9 36.7 42.3Owned 163.4 259 58.5 8 32.3 33.6

Securitized 21.8 67.3 209.2 20.7 4.3 8.7Real Estate 61.2 103.8 69.5 9.2 12.1 13.5

Owned 61.2 80.4 31.2 4.6 12.1 10.4Securitized na 23.5 na na na 3

Total Net Assets 530.7 824.6 55.4 7.6

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.

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.

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).

Business Loans - Sub-categories• Retail loans and leases.

• Wholesale loans - loan/lease agreements between parties other than the company’s 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 customer’s facilities.

Equipment Loans/Leases• From the finance company’s 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.

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).

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 FI’s.

Mutual Funds

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

Mutual Fund Functions 1 Opportunities for small investors to invest in financial securities.2 Opportunities to diversify risk.3 Lower transaction costs and commissions by passing on

economies of scale.4 (In most cases) free exchange between funds within the mutual

fund company.5 Automatic investing6 Check-writing priveleges on some money market funds and even

some bond funds.7 Automatic reinvestment of dividends and automatic withdrawals.

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

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.

Mutual Fund Types

Source: Investment Company Institute

Net Assets of Mutual Funds(billions of dollars)

  Feb 03 % of Total Jan 03 % chg Dec 02

Stock Funds 2,538.50 40.50 2,597.7R -2.3 2,667.10

Hybrid Funds 323.2 5.16 324.7R -0.5 327.4

Taxable Bond Funds 838.8 13.38 811.5R 3.4 796.6

Municipal Bond Funds 332.2 5.3 326.7R 1.7 328.5

Taxable Money Market Funds 1,950.40 31.11 1,991.1R -2 1,997.20

Tax-Free Money Market Funds 285.2 4.55 282.5R 1 274.8

Total 6,268.40 100.00 6,334.2R -1 6,391.60

R=revised data

Mutual Fund Types

Source: Investment Company Institute

  Feb 03 Jan 03 Feb 02

Stock Funds 4,750 4,750R 4,759

Hybrid Funds 479 477R 486

Taxable Bond Funds 1,273 1,270 1,282

Municipal Bond Funds 770 771 807

324

Taxable Money Market Funds 677 678 688

R=revised data

Number of Mutual Funds

Total 8,260 8,257R 8,346

Tax-free Money Market Funds 311 311

Components of Return from Mutual Funds 1 Income/dividends2 Capital gains - when a mutual fund sells assets at higher

prices3 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.

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

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).

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.