F446 Chapter 6: Finance Companies

Finance companies – the primary function of these is to make loans to both individuals and corporations- they differ from banks in that they do not accept deposits but instead rely on short- and long-term debt as a source of funds- they often lend to customers commercial banks find too risky- are financial intermediaries that borrow funds for relending, making a profit on the difference between the interest rate on borrowed funds and the rate charged on the loans- the lack of regulatory oversight for these companies enables them to offer a wide scope of “bank-like” services and yet avoid the expense of regulatory compliance- since these companies are heavy borrowers in the capital markets and do not enjoy the same regulatory “safety net” as banks, they need to signal their solvency and safety to investors- having sufficient capital and access to financial guarantees are critical to their continued ability to raise funds- these companies operate more like nonfinancial, nonregulated companies
S, S, & C of the Industry – first finance company originated during the Depression- finance companies have been among the fastest growing FI groups in recent years- industry is quite concentrated, with the largest 20 firms accounting for more than 65% of its assets- many of the largest finance companies tend to be wholly owned or captive subsidiaries of major manufacturing companies
Reasons for finance company growth 1. the attractive rates they offer on some loans2. their willingness to lend to riskier borrowers than commercial banks3. their often direct affiliation with manufacturing firms4. the relatively limited amount of regulation imposed on these firms
Captive finance company – a finance company that is wholly owned by a parent corporation- a major role of these is to provide financing for the purpose of products manufactured by the parent
3 types of finance companies 1. Sales finance institutions2. Personal credit institutions3. Business credit institutions
Sales finance institutions – specialize in making loans to the customers of a particular retailer or manufacturer- given that these institutions can frequently process loans faster and more conveniently (generally located at the purchase location) than depository institutions, they compete directly with depository institutions for consumer loans- e.g., Ford Motor Credit
Personal credit institutions – specialize in making installment and other loans to consumers- these institutions will make loans to customers that depository institutions find too risky to lend to due to low income or these customers being a bad credit risk- they compensate for the additional income by charging higher interest rates than depository institutions and / or accepting collateral that depository institutions do not find acceptable- e.g. AIG American General
Business credit institutions – companies that provide financing to corporations, especially through equipment leasing and factoring- as a result of factoring, the corporate customer no longer has the worry of whether the accounts receivable may or may not be delayed and thus receives cash for sales faster- e.g. U.S. Bank Equipment Finance
factoring – the process of purchasing accounts receivable from corporations (often at a discount), usually with no recourse to the seller if the receivables go bad
Assets 1. Consumer loans2. Mortgages3. Business loans
Consumer loans – consist of motor vehicle loans and leases, other consumer loans, and securitized loans- motor vehicle loans and leases are traditionally the major type of consumer loan (51.4% of the consumer loan portfolio)
Mortgages – residential and commercial mortgages have become a major component in finance company portfolios- since finance companies are not subject to as extensive regulations as are banks, they are often willing to issue mortgages to riskier borrowers than commercial banks for higher interest rates and fees- the mortgages in the loan portfolio can be first mortgages or second mortgages in the form of home equity loans- interest on mortgages secured by residential real estate is tax deductible, while the interest paid on other types of consumer loans are not tax deductible
Securitization of mortgages – involves:1. the pooling of a group of mortgages with similar characteristics2. the removal of these mortgages from the balance sheet3. the subsequent sale of interests in the pool to secondary market investors- this process results in the create of mortgage-backed securities, which can be traded in secondary mortgage markets- the finance company (or depository institution) that originates the mortgage may still service the mortgage portfolio for a fee
Business loans – represent 30% of the loan portfolio of finance companies- finance companies have several advantages over commercial banks in offering services to small business customers
Advantages in offering services to small business customers 1. They are not subject to regulations that restrict the types of products and services they can offer2. Because they do not accept deposits, they have no bank-type regulators looking directly over their shoulders3. Being in many cases subsidiaries of corporate-sector holding companies, finance companies often have substantial industry and product expertise4. Finance companies are more willing to accept risky customers than commercial banks5. Finance companies generally have lower overheads than banks
Liabilities and Equity – to finance asset growth, finance companies have relied primarily on short-term commercial paper and other debt (longer-term notes and bonds)- finance companies are now the largest issuers in the short-term commercial paper market1. Bank loans (8.3% of assets)2. Commercial paper (3.1%)3. Debt due to parent (14.4%)4. Debt, other (61.9%)5. Capital, surplus, and undivided profits (12.3%)
Regulation – like depository institutions, finance companies are subject to any state-imposed usury ceilings on the maximum loan rate assigned to any individual customer- like depository institutions, finance companies are regulated as to the extent to which they can collect on delinquent loans
Signaling solvency and safety – usually sent by holding higher equity or capital-to-asset ratios (and therefore lower leverage ratios) than banks hold

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