Download Consumer finance companies

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.
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Chapter Outline
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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
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Types of Finance Companies
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Consumer finance companies focus on providing
direct loans to consumers
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Sales finance companies concentrate on purchasing
credit contracts from retailers and dealers
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Their main source of funds is long-term loans
Their main use of funds is providing relatively small loans
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
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Sources of Finance Company
Funds
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Loans from banks
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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
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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
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The best-known finance companies can issue commercial paper
through direct placement
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Sources of Finance Company
Funds (cont’d)
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Deposits
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Some states allow finance companies to offer customer
deposits similar to those of depository institutions
Bonds
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The decision to issue bonds versus some alternative short-term
financing depends on the company’s balance sheet and
expectations about future interest rates
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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
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Finance companies can build capital by retaining earnings or by
issuing stock
Finance companies maintain a low level of capital
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Uses of Finance Company Funds
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Consumer loans
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One of the most popular consumer loans is the automobile
loans offered by a finance company that is owned by a car
manufacturer
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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
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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
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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
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Uses of Finance Company Funds
(cont’d)
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Business loans and leasing (cont’d)
 Leasing
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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
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Regulation of Finance Companies
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When finance companies are acting as bank holding
companies or are subsidiaries of bank holding
companies, they are federally regulated
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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
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Risks Faced by Finance
Companies
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Liquidity risk
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Finance companies generally do not hold assets that could be
easily sold in the secondary market
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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
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Both liability and asset maturities of finance companies are
short or intermediate term
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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
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Risks Faced by Finance
Companies (cont’d)
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Credit risk
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Credit risk is a major concern since the majority of funds are
allocated as loans to consumers and businesses
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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
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September 11 caused businesses to cut their expansion plans and
reduce their need for loans
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Captive Finance Subsidiaries
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A captive finance subsidiary (CFS) is a wholly owned
subsidiary whose primary purpose is to:
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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
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Captive Finance Subsidiaries
(cont’d)
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A CFS:
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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
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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
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CFSs have diversified their financing activities to include more than
just the parent company’s products
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Valuation of a Finance Company
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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:
V  f E (CF ), k 

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-
Factors that affect cash flows:
E (CF )  f ( ECON, Rf , INDUS, MANAB)

-
?

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Valuation of a Finance Company
(cont’d)
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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
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Stronger demand for loans with fixed rates
Finance companies rely on short-term funds
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Valuation of a Finance Company
(cont’d)
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Factors that affect cash flows (cont’d)
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Change in industry conditions
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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
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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
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Valuation of a Finance Company
(cont’d)
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Factors that affect the required rate of return by
investors:
k  f ( Rf , RP )
 The
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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
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Interaction with Other Financial
Institutions
Type of Financial
Institution
Interaction 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
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Participation in Financial Markets
Type of
Financial Market
Participation 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
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Multinational Finance Companies
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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.
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Finance companies enter foreign countries to
enter new markets and to reduce their exposure
to U.S. economic conditions
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