Copyright © 2012 Pearson Prentice Hall. All rights reserved. WEB CHAPTER 26 Finance Companies

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview  Suppose you need to buy a car, but don’t have the $20,000 handy. Most dealers will help arrange financing for you. And the companies they often use are finance companies. Along with consumer loans, finance companies are involved in lease finance and other business services.

© 2012 Pearson Prentice Hall. All rights reserved Chapter Preview  In this chapter, we examine how finance companies evolved and what they do. Topics include: ─History of Finance Companies ─Purpose of Finance Companies ─Risk of Finance Companies ─Types of Finance Companies ─Regulation of Finance Companies ─Finance Company Balance Sheet

© 2012 Pearson Prentice Hall. All rights reserved History of Finance Companies  Finance companies date back to the 1800s when retailers started offering installment credit, requiring equal payments to repay loans. Prior to this, loans were typically balloon loans.  Mass marketing of autos really developed the industry. Since banks didn’t offer car loans in the early 1990s, finance companies developed to fill the void.

© 2012 Pearson Prentice Hall. All rights reserved History of Finance Companies  By the beginning of 2010, banks held $1,177 billion in consumer loans, while finance companies held $684 billion. Clearly banks didn’t stay out of consumer financing for long.  Finance companies moved into business financing (lease financing, etc.).

© 2012 Pearson Prentice Hall. All rights reserved Purpose of Finance Companies  Most finance companies issue commercial paper and use the proceeds to make loans.  Unlike banks, finance companies are largely unregulated. States may limit the size of a loan contract to a consumer borrower, but that is about it.  Exist to service both consumers and businesses with tailored products (usually not offered by banks).

© 2012 Pearson Prentice Hall. All rights reserved Risk in Finance Companies  Default risk is the greatest risk, and finance companies often lend to those who can’t get financing otherwise.  Liquidity risk can be an issue, as their assets (loans) are not easily sold. A need for cash can cause problems.

© 2012 Pearson Prentice Hall. All rights reserved Risk in Finance Companies  Roll over risk refers to the need to continue to borrow in the commercial paper market. If the market dries up, they may not be able to maintain their loans.  Interest rate risk is also present. Most of their assets are medium-term loans, funded by short-term commercial paper.

© 2012 Pearson Prentice Hall. All rights reserved Types of Finance Companies  Figure 26.1 on the next slide shows the distribution of loans made by the three types of finance companies: business, sales, and consumer.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Loans

© 2012 Pearson Prentice Hall. All rights reserved Types of Finance Companies  Business Finance Companies offer loans secured by accounts receivable and other business assets—something banks were reluctant to do prior to the 1940s.  They also factor accounts receivable— giving companies, say, 90% of the book value of A/R in return for the actual payments when received—essentially a secured loan.

© 2012 Pearson Prentice Hall. All rights reserved Types of Finance Companies  They also specialize in leasing. They often buy the asset and then lease it back to the company (helps in repossession for late payments). This may be a tax advantage if the company needing the asset cannot benefit from the depreciation expense.  Floor plans help, for example, car dealers pay for all the cars on their lot.

© 2012 Pearson Prentice Hall. All rights reserved Types of Finance Companies  Figure 26.2 on the next slide shows the types of loans made by business finance companies. The dollar value of business loans outstanding then follows in Figure 26.3.

© 2012 Pearson Prentice Hall. All rights reserved Business Finance Company Loans

© 2012 Pearson Prentice Hall. All rights reserved Business Finance Company Loans

© 2012 Pearson Prentice Hall. All rights reserved Consumer Finance Companies Consumer finance companies offer loans to help consumers buy furniture, home improvements, and refinance small debts. Typically, consumers can’t get credit elsewhere—and may be high credit risks. Two exceptions are home equity loans and retail credit cards.

© 2012 Pearson Prentice Hall. All rights reserved Sales Finance Companies Another type of finance company is the sales finance company. For example, if you want to buy a GM car, GMAC will be happy to assist with the financing. Also known as captive finance companies, these companies are owned by the manufacturer to help with the sale of the manufacturer’s products.

© 2012 Pearson Prentice Hall. All rights reserved Regulation  Since there are no depositors or government insurance, regulation is limited.  Regulation is typically designed to protect consumers. For example, Regulation Z requires the disclosure of the APR on loans.  Usury laws limit the interest rate that can be charged.

© 2012 Pearson Prentice Hall. All rights reserved Regulation  State and federal regulation do limit their ability to collect on delinquent or defaulted loans. However, there are few regulations in the business loan market—government assumes that business are sophisticated enough to protect themselves.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet  Table 26.1 on the next slide presents the aggregate balance sheet for finance companies as of 2007.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet  Assets. Their primary asset is their loan portfolio, although they do need to maintain a contra-asset account reserve for loan losses to charge off expected loan defaults.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet  Liabilities. Their primary source of funding is either equity (about 12% of assets) or loans. As mentioned already, finance companies are active in the commercial paper market. Captive finance companies can also borrow directly from their parent company.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet  Income. Their income comes from several sources: ─Interest income from their loan portfolio ─Loan origination fees ─Credit insurance premiums ─Some have also expanded into income tax preparation services

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet  Figure 26.4 on the next slide shows the growth in finance company assets from 1980 through 2009.

© 2012 Pearson Prentice Hall. All rights reserved Finance Company Balance Sheet: Growth in Assets

© 2012 Pearson Prentice Hall. All rights reserved Chapter Summary  History and Purpose: the history and background of these companies was presented—essentially, how they filled the void left by banks.  Risk: the essential risks faced by finance companies was covered: roll over and interest rate risk.

© 2012 Pearson Prentice Hall. All rights reserved Chapter Summary  Types: the basic classification of finance companies was reviewed, primarily by the type of customer served.  Regulations: other than consumer protections laws, we discussed why finance companies aren’t heavily regulated.

© 2012 Pearson Prentice Hall. All rights reserved Chapter Summary  Balance Sheet: we reviewed the breakdown of the assets and liabilities held by these companies.