Finance Companies Chapter 6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 6-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview  In this segment we discuss Finance Companies: Activities of finance companies Competitive environment Size, structure and composition Regulation Global issues

McGraw-Hill/Irwin 6-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Historical Perspective  Finance companies originated during the depression. Installment credit General Electric Capital Corporation. Competition from banks increased during 1950s.  Expansion of product lines GMACCM is largest commercial mortgage lender in U.S.  Industry is highly concentrated Largest 20 firms account for more than 75% of assets.

McGraw-Hill/Irwin 6-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 6-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Major Types of Finance Companies  Sales finance institutions Ford Motor Credit and Sears Roebuck Acceptance Corp.  Personal credit institutions Household International Corp. and AIG American General.  Business credit institutions CIT Group and Fleet Boston Financial. Equipment leasing and factoring.

McGraw-Hill/Irwin 6-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on finance companies, visit:

McGraw-Hill/Irwin 6-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Largest Finance Companies

McGraw-Hill/Irwin 6-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet and Trends  Business and consumer loans are the major assets 51.9% of total assets, Reduced from 95.1% in  Increases in real estate loans and other assets.  Growth in leasing (largely due to tax incentives of 1981 Economic Recovery Act).  Finance companies face credit risk, interest rate risk and liquidity risk.

McGraw-Hill/Irwin 6-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Balance Sheet and Trends  Consumer loans Primarily motor vehicle loans and leases. Recent low auto finance company rates are anomalous—partly due to 9/11 effects.  Attempts to boost new vehicle sales via 0.0% loans lasted into  By 2003, rates 3.5% lower than banks on new vehicle rates

McGraw-Hill/Irwin 6-10 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Consumer loans (continued)  Generally riskier customers than banks serve. Subprime mortgage lenders Jayhawk Acceptance Corp.  From auto loans to tummy tucks and nose jobs  Increase in “loan shark” firms with rates as high as 30% or more.  Other consumer loans about 24.7% of consumer loan portfolio, 2003.

McGraw-Hill/Irwin 6-11 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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  Tax deductibility issue.  Conversion of credit card debt  2003 average home equity loan $69,513

McGraw-Hill/Irwin 6-12 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For information on home equity loans, visit the Consumer Bankers Association at:

McGraw-Hill/Irwin 6-13 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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.

McGraw-Hill/Irwin 6-14 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 6-15 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Liabilities  Major liabilities: commercial paper and other debt (longer-term notes and bonds).  Finance firms are largest issuers of commercial paper (frequently through direct sale programs). Commercial paper maturities up to 270 days.  Consequently, management of liquidity risk differs from commercial banks relying on deposits

McGraw-Hill/Irwin 6-16 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Industry Performance  Strong loan demand  Strong profits for the largest firms e.g. Household International, Associates First Capital, Beneficial Effects of low interest rates  Most successful have become takeover targets Citigroup/Associates First Capital, Household International/HSBC Holdings

McGraw-Hill/Irwin 6-17 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 2002, Citigroup $200 million settlement for predatory lending via Associates First Capital

McGraw-Hill/Irwin 6-18 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Electronic Lending  Mainly mortgages completed over the Internet E-Loan Suffered with the dot-com downturn

McGraw-Hill/Irwin 6-19 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources  For additional information, visit:

McGraw-Hill/Irwin 6-20 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation of Finance Companies  Federal Reserve definition of Finance Company Firm, other than depository institution, whose primary assets are loans to individuals and businesses.  Subject to state-imposed usury ceilings.  Much lower regulatory burden than depository institutions. Not subject to Community Reinvestment Act. Lack the banks’ regulatory safety-net

McGraw-Hill/Irwin 6-21 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation  With less regulatory scrutiny, finance companies must signal safety and soundness to capital markets in order to obtain funds.  Lower leverage than banks (15.1% capital- assets versus 9.1% for commercial banks).  Captive finance companies may employ default protection guarantees from parent company or other protection such as letters of credit.

McGraw-Hill/Irwin 6-22 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin 6-23 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites Aames Financial Corp. Advanta American General Federal Reserve CIT Group Citigroup Consumer Bankers Association Federal Trade Commission First Union Bank

McGraw-Hill/Irwin 6-24 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites Ford Motor Credit GE Capital Corp. GMAC Household International The Wall Street Journal