CHAPTER 6 Financial Services: Finance Companies Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin

6-2 Overview  This chapter discusses finance companies –Activities of finance companies –Competitive environment –Size, structure, and composition –Regulation –Global issues

6-3 Historical Perspective  Finance companies originated during the Great Depression –Installment credit –General Electric Capital Corporation –Competition from banks increased during 1950s  Expansion of product lines –GMACCM is one of the largest commercial mortgage lenders in U.S.

6-4 GMAC  Controversial approval by the Fed of GMAC as a bank holding company –Allowed access to $6 billion in government bailout money –Fed required GM to reduce its holdings in GMAC to 10 percent, from 49 percent

6-5 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

6-6 Finance Companies (continued)  Captive Finance Companies: e.g., GMAC  Highly concentrated –Largest 20 firms: 65 percent of assets

6-7 Major Types of Finance Companies  Sales finance institutions: –Ford Motor Credit and Sears Roebuck Acceptance Corp.  Personal credit institutions: –HSBC Finance and AIG American General  Business credit institutions: –CIT Group and U.S. Bank Equipment Finance –Equipment leasing and factoring

6-8 Web Resources  For information on finance companies, visit: GE GMAC Ford Credit HSBC American General Citigroup

6-9 Largest Finance Companies

6-10 Balance Sheet and Trends  Business and consumer loans are the major assets –56.0% of total assets, 2009 –Reduced from 95.1% in 1977  Increases in real estate loans and other assets  Growth in leasing and business lending  Finance companies face credit risk, interest rate risk, and liquidity risk

6-11 Consumer Loans  Consumer loans –Primarily motor vehicle loans and leases –Historically charged higher rates than commercial banks –Low auto finance company rates are anomalous following 9/11 attacks  Attempts to boost new vehicle sales via 0.0% loans lasted into 2005  By 2002, rates were 3.3% lower than banks on new vehicles

6-12 Consumer Loans (continued)  Generally riskier customers than banks –Subprime lender finance companies –Jayhawk Acceptance Corp.  From auto loans to tummy tucks and nose jobs  “Loan shark” firms with rates as high as 30% or more

6-13 Payday Loans  Payday loans –390 percent APR (Implication for EAR?) –Regulated by states –As of 2009, payday loans effectively banned in 13 states –Controlled in other states via usury limits  Evaded by forming relationships with nationally chartered banks, based in states that do not have usury limits (e.g., South Dakota, Delaware)

6-14 Mortgages  Mortgages have become a major component of finance company assets  May be direct mortgages, or as securitized mortgage assets

6-15 Home Equity Loans –Growth in home equity loans following passage of Tax Reform Act of 1986  Tax deductibility issue  Conversion of credit card debt  Defaults in subprime and relatively strong credit mortgages in ∙ Root cause of the financial crisis in

6-16 Web Resources  For information on home equity loans, visit: Consumer Bankers Association

6-17 Business Loans  Business loans comprise largest portion of finance company loans (30%)  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

6-18 Business Loans  Major subcategories: –Retail and wholesale motor vehicle loans and leases –Equipment loans  Tax issues and other associated advantages when finance company leases the equipment directly to the customer –Other business loans and securitized business assets

6-19 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  Management of liquidity risk differs from commercial banks

6-20 Industry Performance  Strong loan demand and solid profits for the largest firms in the early 2000s –Effects of low interest rates  Not surprisingly, the most successful became takeover targets –Citigroup/Associates First Capital, –Household International/HSBC Holdings

6-21 Industry Performance  Mid 2000s problems arose –2005, 2006: falling home prices and rising interest rates  Sharp pullback from subprime mortgage lending  End of 2009: National all time high for mortgage delinquencies 6.89% –Countrywide Financial acquired by BOA –Major losses by HSBC and others

6-22 Regulation of Finance Companies  Federal Reserve’s definition of finance company –A firm, other than a depository institution, whose primary assets are loans to individuals and businesses  Subject to state-imposed usury ceilings  Lower regulatory burden than DIs –Not subject to Community Reinvestment Act

6-23  Impact of nonbank FIs, including finance companies, on the U.S. economy resulted in greater scrutiny  Fed rescue of several finance companies was a factor  2010 Financial Services Regulatory Overhaul Bill Regulation of Finance Companies

6-24 Regulation  With less regulatory scrutiny, finance companies must signal safety and soundness to capital markets in order to obtain funds  Lower leverage than banks (12.3% capital-assets versus 11.1% for commercial banks in 2009)  Captive finance companies may employ default protection guarantees from parent company or other protection such as letters of credit

6-25 Global Issues  In foreign countries, finance companies are generally subsidiaries of commercial banks or industrials  Importance of nonbank FIs has been increasing over the past decade –Latin America, and central Europe –New Zealand: consolidation, collapse, and restructuring of finance companies

6-26 Pertinent Websites American General Federal Reserve Citigroup Consumer Bankers Association Ford Motor Credit General Electric Capital Corp. General Motors Acceptance Corp. HSBC Finance