CHAPTER 23 Consumer Finance Operations

Chapter Objectives n Identify the main sources and uses of finance company funds n Describe the risk exposure of finance companies n Explain how finance companies interact with other financial institutions

Types of Finance Companies Finance Companies Consumer Sales Commercial

Types of Finance Companies n Consumer finance companies make direct loans to consumers n Sales finance companies concentrate on purchasing credit contracts from retailers n Commercial finance companies provide loans to medium and higher risk companies n Captive finance companies, subsidiaries of manufacturers, lend to support sales of their parent company and other areas

Sources of Finance Company Financing Bank Loans Commercial Paper Deposits and Capital Market Financing Capital

Sources of Finance Company Funds n Finance companies use bank loans as a source of funds and consistently renew the loans over time n Commercial paper l A short-term money market source but finance companies roll over their issues to create a permanent source of funds l Secured commercial paper allows smaller and medium-sized firms access to the market l Well-known firms use direct placement

Sources of Finance Company Funds n Some states allow finance companies to accept customer deposits n Bonds are used as a long-term source of funds and the use of this source depends on l Expectations about future interest rates l The balance sheet structure l May be subordinated to bank loans n Capital comes from retained earnings or issuing stock and serves as a base for leveraging

Exhibit 23.2 Finance Company Lending Areas Business Loans $335.1 Billion 33% Consumer Loans $254.9 Billion 25% Real Estate Loans $98.5 Billion 10% Other $313.7 Billion 31%

Uses of Finance Company Funds n Finance companies make many kinds of consumer loans in the form of personal loans l Auto loans/leases offered by a finance company owned by the manufacturer: direct or sales financed l Home improvement (second mortgage), mobile home and other kinds of personal loans: direct or sales financed l Credit cards which can be used at a variety of retail stores u Company logo cards operated by finance company

Uses of Finance Company Funds n Credit card loans in which a retailer sells a credit contract to a finance company l Customers make payments to the finance company l Support “Ninety-days Same As Cash” loans l Gives the finance company access to new customers

Uses of Finance Company Funds n Business loans and leasing are used to finance the cash cycle of companies l Cash cycle is the amount of time it takes between when inventory is purchased, the product is sold and customers pay l This financing is often backed by accounts receivable or inventory n Leveraged buy-out loans n Factoring of accounts receivable

Uses of Finance Company Funds n Leasing l Finance company purchases equipment l Leases it to businesses n Real estate loans l Mortgages on commercial real estate l Second mortgages on residential real estate

Regulation of Finance Companies n Federal regulations apply if finance companies are acting as bank holding companies or are subsidiaries of bank holding companies n State regulations apply otherwise n Subject to interest rate ceilings and a maximum term or amount for the loan in some states

Risks Faced by Finance Companies n Liquidity risk l Finance companies do not hold assets that can be easily sold in the secondary market u May securitize loans u Depend on liability liquidity l Maintaining access to money and capital market is the primary liquidity management focus l Balance sheet structure does not call for much liquidity because of little deposit outflow

Risks Faced by Finance Companies n Interest rate risk is less for depository institutions because the maturity of assets and liabilities may be matched closely n Assets are typically not as rate sensitive as liabilities n Can use adjustable rates and shorter maturities on their loans to manage risk n Derivative contracts are used to manage interest rate risk

Risks Faced by Finance Companies n Credit risk l The major risk faced by finance companies l Loan delinquency rates are typically higher than for other kinds of institutions l Charge a higher interest rate to compensate for the risk l High return, high risk nature of loans makes performance sensitive to prevailing economic conditions

Captive Finance Subsidiaries n Captive finance subsidiaries (CFS) have several characteristics l They are a wholly owned subsidiary with the primary purpose to finance sales of the parent company’s products and services l Provide financing to distributors of the parent company’s products l Purchase receivables of the parent company l May diversify into other lending/leasing operations

Captive Finance Subsidiaries n Motives for creating a captive finance subsidiary shown by the example from the auto industry l Can finance distributor and dealer inventories l Makes production less cyclical for manufacturer l An effective tool in retail marketing n Growth in the industry occurred between 1946 and 1960 l More liberalized credit policies l The need to finance growing inventories

Captive Finance Subsidiaries n Advantages of captive finance subsidiaries l Corporations can separate manufacturing and retailing from financing l Makes it easier and less expensive to analyze each segment of the parent l Captive establishes credit rating separate from parent n Comparison with other financial institutions l No reserve requirement l No restrictions on how to obtain funds l Competitive advantage in retail sales

Valuation of a Finance Company n Value of a savings institution depends on its expected cash flows and required rate of return  V = 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 +

Valuation of a Finance Company n Factors that affect cash flows E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions Where:  E(CF)= f (  ECON,  R f,  INDUS,  MANAB) ECON = Economic growth MANAB = The ability of the institution’s management ++

Valuation of a Finance Company n Economic growth l Positive affect because it enhances household demand for consumer goods l Economic growth reduces defaults n Change in the risk-free rates l Cash flows inversely related to interest rate movement l Short term sources of funds means their rates change as do those of other interest rates

Valuation of a Finance Company n Change in industry conditions which include regulatory constraints, technology and competition n Change in management abilities

Valuation of a Savings Institution n Investors required rate of return  k = f(  R f,  RP) ++ R f = Risk free interest rate Where: RP = Risk premium

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

Participation in Financial Markets n Participate in a wide range of financial markets l Money markets l Bond markets l Mortgage markets l Stock markets l Futures markets l Options markets l Swap markets

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