1. 1 Chapter 22 Consumer Finance Operations Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

2. 2 Chapter Outline Types of finance companies Sources of finance company funds Uses of finance company funds Regulation of finance companies Risks faced by finance companies Captive finance subsidiaries Valuation of a finance company Interaction with other financial institutions Participation in financial markets Multinational finance companies

3. 3 Types of Finance Companies Consumer finance companies focus on providing direct loans to consumers  Their main source of funds is long-term loans  Their main use of funds is providing relatively small loans Sales finance companies concentrate on purchasing credit contracts from retailers and dealers  Their main source of funds is commercial paper  Their main use of funds is providing relatively large loans Commercial finance companies have been created to provide loans to firms that cannot obtain financing from commercial banks It is difficult to classify most finance companies as a particular type today

4. 4 Sources of Finance Company Funds Loans from banks  Finance companies commonly borrow from commercial banks and can consistently renew the loans over time  Some finance companies use bank loans mainly to accommodate seasonal swings in their business Commercial paper  Only the most well-known finance companies have been able to issue commercial paper  As secured commercial paper has become more popular, most finance companies have access to this market  Most finance companies issue commercial paper using commercial paper dealers The best-known finance companies can issue commercial paper through direct placement

5. 5 Sources of Finance Company Funds (cont’d) Deposits  Some states allow finance companies to offer customer deposits similar to those of depository institutions Bonds  The decision to issue bonds versus some alternative short-term financing depends on the company’s balance sheet and expectations about future interest rates When assets are less rate sensitive than liabilities and interest rates are expected to increase, bonds provide financing that is insulated from rising market rates Capital  Finance companies can build capital by retaining earnings or by issuing stock  Finance companies maintain a low level of capital

6. 6 Uses of Finance Company Funds Consumer loans  One of the most popular consumer loans is the automobile loans offered by a finance company that is owned by a car manufacturer e.g., General Motors Acceptance Corporation  Finance companies offer personal loans for home improvement, mobile homes, and a variety of other personal expenses  Consumer loans are often secured by a co-signer or by real property  Maturities on personal loans are typically less than five years  Some finance companies offer credit card loans through a particular retailer  The main competition in the consumer loan market is from commercial banks and credit unions

7. 7 Uses of Finance Company Funds (cont’d) Business loans and leasing  Commercial loans: Are obtained by companies to finance the cash cycle Are short term but may be renewed Are often backed by inventory or accounts receivable Are sometimes used to finance LBOs  Finance companies commonly act as factors for accounts receivable They purchase a firm’s receivables at a discount and are responsible for processing and collecting the balances Factoring reduces a business’s processing costs and provides short-term financing

8. 8 Uses of Finance Company Funds (cont’d) Business loans and leasing (cont’d)  Leasing Finance companies can purchase machinery or equipment and then lease it to businesses Real estate loans  Finance companies offer real estate loans in the form of mortgages on commercial real estate and second mortgages on residential real estate

9. 9 Regulation of Finance Companies When finance companies are acting as bank holding companies or are subsidiaries of bank holding companies, they are federally regulated  Otherwise, they are regulated by the state Finance companies are subject to a loan ceiling, setting a maximum limit on the size of the loans they can make Finance companies are subject to ceiling interest rates on loans provided and to a maximum length on the loan maturity Finance companies are subject to state regulations on intrastate business

10. 10 Risks Faced by Finance Companies Liquidity risk  Finance companies generally do not hold assets that could be easily sold in the secondary market Their balance sheet structure does not call for much liquidity since all of their funds are from borrowings  Overall, the liquidity risk of finance companies is less than that of other financial institutions Interest rate risk  Both liability and asset maturities of finance companies are short or intermediate term They are not susceptible to increasing interest rates as are savings institutions They can still be adversely affects because their assets are typically not as rate sensitive as their liabilities

11. 11 Risks Faced by Finance Companies (cont’d) Credit risk  Credit risk is a major concern since the majority of funds are allocated as loans to consumers and businesses Customers who borrow from finance companies usually exhibit a moderate degree of risk The loan delinquency rate of finance companies is typically higher than that of other financial institutions  The performance of finance companies can be quite sensitive to prevailing economic conditions because their loans entail both relative high returns and high risk  Impact of the September 11 Crisis September 11 caused businesses to cut their expansion plans and reduce their need for loans

12. 12 Captive Finance Subsidiaries A captive finance subsidiary (CFS) is a wholly owned subsidiary whose primary purpose is to:  Finance sales of the parent company’s products and services  Provide wholesale financing to distributors of the parents company’s products  Purchase receivables of the parent company An operating agreement between the captive and the parent company contains specific stipulations The numbers of CFSs grew rapidly between 1946 and 1960 as a result of liberalized credit policies and a need to finance growing inventories

13. 13 Captive Finance Subsidiaries (cont’d) A CFS:  Can be used to finance distributor or dealer inventories until a sale occurs  Can serve as an effective marketing tool by providing retail financing Advantages of captive finance subsidiaries  A CFS allows a corporation to clearly separate its manufacturing and retailing activities from its financing activities  A CFS has no reserve requirements and no legal prohibitions on how it obtains funds or uses funds  Sale items such as cars may depend on the financing arrangements available CFSs have diversified their financing activities to include more than just the parent company’s products

14. 14 Valuation of a Finance Company The value of a finance company is the present value of its future cash flows  The value should change if expected cash flows or the required rate of return change: Factors that affect cash flows:

15. 15 Valuation of a Finance Company (cont’d) Factors that affect cash flows (cont’d)  Economic growth Economic growth increases cash flows via increased household demand for consumer loans Finance companies are very sensitive to economic conditions because they offer relatively risky loans  Change in the risk-free interest rate A finance company’s cash flows are inversely related to interest rate movements  Stronger demand for loans with fixed rates  Finance companies rely on short-term funds

16. 16 Valuation of a Finance Company (cont’d) Factors that affect cash flows (cont’d)  Change in industry conditions Some finance companies may be valued higher if state regulators give them the opportunity to generate economies of scale by expanding throughout the state Expansions create more competition, which causes some finance companies to gain at the expense of others  Change in management abilities Managers attempt to make internal decisions that will capitalize on the external forces that the institution cannot control Finance companies need skilled managers to analyze the creditworthiness of borrowers and assess how future economic conditions may affect their ability to repay their loans

17. 17 Valuation of a Finance Company (cont’d) Factors that affect the required rate of return by investors:  The risk-free rate is positively related to inflation, economic growth, and the budget deficit, but inversely related to money supply growth  The risk premium is inversely related to economic growth and to the company’s management skills

18. 18 Interaction with Other Financial Institutions Type of Financial InstitutionInteraction with Finance Companies Commercial banks and SIs  Finance companies compete with banks and SIs for consumer loan business (including credit cards), commercial loans, and leasing  Finance companies obtain loans from commercial banks  Finance companies have acquired some commercial banks  Some finance companies are subsidiaries of commercial banks Credit unions  Finance companies compete with credit unions for consumer loans Investment banking firms  Finance companies issue bonds that are underwritten by investment banking firms Pension funds  Insurance subsidiaries of finance companies manage pension plans of corporations and therefore compete with pension funds Insurance companies  Insurance subsidiaries of finance companies compete directly with other insurance companies

19. 19 Participation in Financial Markets Type of Financial MarketParticipation by Finance Companies Money markets  Finance companies obtain funds by issuing commercial paper Bond markets  Finance companies issue bonds to obtain long-term funds  Subsidiaries of finance companies purchase corporate and Treasury bonds Mortgage markets  Finance companies purchase real estate and provide loans to real estate investors  Subsidiaries of finance companies purchase mortgages Stock markets  Finance companies issue stock  Subsidiaries of finance companies purchase stocks Futures markets  Subsidiaries of finance companies use futures contracts to reduce the sensitivity of their bond portfolio to interest rate movements and may trade stock index futures to reduce the sensitivity of their stock portfolio to stock market movements Options markets  Subsidiaries of finance companies sometimes use options contracts to protect against declines in particular stock holdings Swap markets  Finance companies engage in interest rate swaps to hedge interest rate risk

20. 20 Multinational Finance Companies Some finance companies are large multinational corporations with subsidiaries in several countries  e.g., the consumer finance division of Household International has more than 1,000 offices in the U.S., Canada, Germany, and the U.K. Finance companies enter foreign countries to enter new markets and to reduce their exposure to U.S. economic conditions