BUFN-ch06.ppt

BUFN722- Financial Institutions ch6 - 1

BUFN 722

ch-6

Finance Companies


Overview

• In this segment ... Finance Companies:Activities of finance companiesCompetitive environmentSize, structure and compositionRegulation Global issues


Historical PerspectiveFinance 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.


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


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.


Largest Finance Companies

Company Name Total Assets

General Electric Capital Services $370,636

Ford Motor Credit Company 174,300

General Motors Acceptance Corp. 168,410

Associates First Capital Corp. 82,957

Household International, Inc. 76,706


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 equitycannot accept deposits so rely heavily on issuing short-

term commercial paper to finance assets


Balance Sheet and TrendsConsumer 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


Balance Sheet and Trends

• MortgagesRecent addition to finance company assetsSmaller regulatory burden than banksMay be direct mortgages, or as securitized

mortgage assets.Growth in home equity loans since passage of

Tax Reform Act of 1986.

• Tax deductibility issue.


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

• 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


Business LoansBusiness 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


Business loans

• Major subcategories:retail and wholesale motor vehicle loans and

leasesequipment loans

• tax issues associated when finance company leases the equipment directly to the customer

other business loans and securitized business assets


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.


Industry Performance

• Strong loan demand

• Strong profits for the largest firmse.g. Household International, Associates First

Capital, Beneficial

• Most successful have become takeover targetsCitigroup/Associates First Capital, Tyco International/CIT Group


Industry Performance

• High risk has a downside:Subprime lending: Jayhawk Acceptance

CorporationCityscape 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


Electronic Lending

• Mainly mortgages completed over the InternetE-LoanSuffered with the dot-com downturn


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


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.


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 loansGE Capital/Japan Leasing Corporation


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 borrowBalance 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 shortAssets are typically not as rate sensitive as liabilitiesCan use adjustable rates and shorter maturities on their

loans to manage the risks


Risks Faced by Finance Companies

• Credit riskRepresents an important source of riskLoan delinquency rates are typically higher

than for other kinds of institutionsCharge a higher interest rate to compensate for

the riskHigh return, high risk nature of loans makes

performance sensitive to prevailing economic conditions


Captive Finance Subsidiaries• Captive finance subsidiaries (CFS) have several characteristicsThey 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 industryCan finance distributor and dealer inventoriesMakes production less cyclical for manufacturerAn effective tool in retail marketing


Captive Finance Subsidiaries• Growth in the industry occurred between 1946 and 1960

More liberalized credit policiesThe need to finance growing inventories

• Advantages of captive finance subsidiariesCorporations can separate manufacturing and retailing from

financingMakes it easier and less expensive to analyze each segment of

the parent

• Comparison with other financial institutionsNo reserve requirementNo restrictions on how to obtain fundsCompetitive advantage in retail sales

ch6 - 24

Valuation of a Finance Company

Value of a finance company depends on its expected cash flows and required rate of returnV = f [ E(CF), k]

V = Change in value of the institution

k = Change in required rate or return

Where:

E(CF) = Change in expected cash flows

+Factors that affect cash flowsE(CF)= f (ECON, Rf , INDUS, MANAB)

+ – ? +

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

k = f(Rf , RP)+ +


Valuation of a Finance Company• Economic growthPositive affect because it enhances household demand

for consumer goodsEconomic growth reduces defaults

• Change in the risk-free ratesCash flows inversely related to interest rate movementShort 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


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


Participation in Financial Markets

• Participate in a wide range of financial marketsMoney marketsBond marketsMortgage marketsStock marketsFutures marketsOptions marketsSwap markets


Multinational Finance Companies

• Large multinational companies with subsidiaries in many countries

• Reasons why finance companies go globalEnter new marketsReduce exposure to the U.S. economy


Pertinent WebsitesAames 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

http://www.aames.net/afc/index.chi

http://www.advanta.com/

http://www.americangeneral.com/

http://www.federalreserve.gov/

http://www.citgroup.com/

http://www.citigroup.com/

http://www.cbanet.org/

http://www.ftc.gov/

http://www.wachovia.com/

http://www.fordcredit.com/

http://www.ge.com/gec

http://www.gmacfc.com/

http://www.household.com/

http://www.wsj.com/

BUFN-ch06.ppt

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