Finance Companies Chapter 6 © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

-26-2 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 one of the largest commercial mortgage lenders in U.S.

-36-3 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  Highly concentrated Largest 20 firms: 65 percent of assets

-46-4 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 FleetBoston Financial. Equipment leasing and factoring  Key Bank locally

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-86-8 Largest Finance Companies

-96-9 Balance Sheet and Trends  Business and consumer loans are the major assets 52.8% of total assets, Reduced from 95.1% in  Increases in real estate loans and other assets.  Growth in leasing  Finance companies face credit risk, interest rate risk and liquidity risk.

Balance Sheet and Trends  Consumer loans Primarily motor vehicle loans and leases. Anomalous low auto finance company rates are anomalous following 9/11 attacks.  Attempts to boost new vehicle sales via 0.0% loans lasted into  By 2003, rates 3.5% lower than banks on new vehicle rates

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.  Payday loans 390 percent APR (Implication for EAR is staggering!)

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  2006 average home equity loan $82,872  Defaults in subprime and relatively strong credit mortgages in 2007

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.

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

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

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  Mid 2000s problems arose 2005, 2006: falling home prices and rising interest rates Pullback from subprime loans

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

Regulation  With less regulatory scrutiny, finance companies must signal safety and soundness to capital markets in order to obtain funds.  Lower leverage than banks (11.4% capital- assets versus 10.36% for commercial banks in 2006).  Captive finance companies may employ default protection guarantees from parent company or other protection such as letters of credit.

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

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