Finance Companies
Finance Companies
• Finance Company - The Federal Reserve defines
finance companies as any firm whose primary
assets are loans to individuals and businesses.
• Finance Companies vs. Banks and Thrifts
– Some finance company loans are similar to commercial
bank loans (i.e. commercial and auto loans), but others
are aimed at relatively specialized areas such as high
risk (low credit quality) loans to business and
consumers.
– Unlike banks and thrifts, finance companies do not and
cannot accept deposits. Instead, they rely on short and
long-term debt for funding.
Industry History and Composition
• The first major finance company was originated
during the Depression when GE created GE Capital
Corp (GECC) to finance appliance sales to cash
strapped customers unable to obtain installment credit
(a loan that is paid back to the lender with periodic
payments consisting of varying amounts of interest
and principal).
• By the late 1950s, banks had become more willing to
make installment loans, so finance companies began
looking outside their parent companies for business
(GECC now offers leases on rail cars, planes,
leveraged buyout financing, mortgage servicing and
other loans to its customers.)
Industry History and Composition
• The industry is very concentrated (the 20 largest
firms control 80% of the assets). In addition,
many of the largest finance companies such as
GMAC tend to be wholly owned or captive
finance companies - a finance company wholly
owned by a parent company (usually, they serve to
provide financing for the purchase of the parent
company’s products).
• Between 1975-1999, the industry experienced
over 1200% growth, making it one of the fastest
growing industries in the financial services sector.
Industry Growth
• Competitive loan rates.
• Willingness to lend to riskier borrowers.
• Affiliation with manufacturing firms that have
sought means to grow.
• Limited amount of regulation imposed.
Finance Companies - Types
1 Sales Finance Institutions - specializes in making loans to
customers of a specific retailer to manufacturer (e.g. Ford
Motor Credit, Sears Roebuck Acceptance Corp.).
2 Personal Credit Institutions - specializes in making
installment and other loans to consumers (e.g. Capital One,
Household Finance Corp., MBNA, etc.).
3 Business Credit Institutions - provide financing to
corporations, especially through equipment leasing and
factoring - the process of purchasing A/R from
corporations (often at a discount), usually with no recourse
to the seller should the receivables go bad.
Finance Companies - Loans
(Receivables) Outstanding
Category
Total
Owned
Securitized
Business
Owned
Securitized
Consumer
Owned
Securitized
Real Estate
Owned
Securitized
Total Net Assets
Billions of Dollars Growth (Percent)
Share of Total (%)
1990
1996 Cumulative Annual Rate 1990
1996
505.3
771.4
52.7
7.3
100
100
480.4
645
34.3
5
95.1
83.6
24
126.44
408.4
31.1
4.9
16.4
258.9
341.3
31.8
4.7
51.2
44.2
255.8
305.7
19.5
3
50.6
39.6
3.1
35.6
1051.5
50.3
0.6
4.6
185.2
326.3
76.2
9.9
36.7
42.3
163.4
259
58.5
8
32.3
33.6
21.8
67.3
209.2
20.7
4.3
8.7
61.2
103.8
69.5
9.2
12.1
13.5
61.2
80.4
31.2
4.6
12.1
10.4
na
23.5
na
na
na
3
530.7
824.6
55.4
7.6
Source: Federal Reserve Bulletin - Survey of
Finance Companies, 1996
Real Estate (Mortgages)
• Finance companies are often willing to issue
mortgages to riskier borrowers than commercial
banks.
• Mortgages include all loans secured by liens on
any type of real estate either by direct lending or
as a result of securitizing mortgage assets purchasing mortgages and using them as assets
backing secondary market securities.
• Mortgages can be first mortgages or second
mortgages (home equity loans). Secondary
mortgages are increasingly attractive due to lower
bad debt expense and lower administrative costs.
Consumer Loans
• Consumer loans include motor vehicle loans and
leases and other consumer loans (i.e. credit cards,
furniture financing, appliance financing, cash loans,
etc.).
• Finance companies generally charge higher rates of
interest on consumer loans due to riskier customer
they lend to. High risk customers are often referred to
as “sub-prime”.
• Loan sharks - sub-prime lenders that charge unfairly
exorbitant rates to desperate borrowers. The “sharks”
may also use lower rates but charge high fees. The
fees may be “disguised”. Other tricks include lower
rates but excess collateral.
Business Loans
• The largest portion of finance company assets.
• Finance companies often have advantages over
commercial banks in lending to small businesses.
– They are not subject to regulations that restrict the type of
products and services they can offer.
– Because they do not accept deposits, they have no bank-type
regulators establishing capital requirements.
– In cases where they are subsidiaries of corporate sector
holding companies, they may have industry and product
expertise.
– Willingness to accept riskier customers.
– Lower overhead (no need to expense tellers/branches in
order to get deposits).
Business Loans - Sub-categories
• Retail loans and leases.
• Wholesale loans - loan/lease agreements between
parties other than the company’s consumers (i.e.
GMAC provides financing for GM dealers for
inventory floor plans, until the car is sold, the dealer
only pays for the cost of the financing and not the cost
of the car).
• Equipment Loans/Leases - the finance company may
own or lease the equipment directly to its industrial
customer or provide financial backing for a working
capital loan or a loan to purchase or remodel the
customer’s facilities.
Equipment Loans/Leases
• From the finance company’s perspective, a lease is
often preferred to the sell and financing of
equipment.
– Repossession of equipment (in the event of default) is
less complicated when the finance company retains the
title.
– A lease agreement generally requires no down payment
making it more attractive to the business customer.
– When the finance company retains the ownership, it
receives a tax deduction in the form of depreciation
expense on the equipment.
Liabilities and Equities
• Commercial paper - finance companies are the
largest issuers in the market (21% of total
liabilities and capital in 1996).
• Other debt - due to parent holding company and
other not classified.
• Loans from banks - this is less than in the past
(2.2% of total liabilities and capital in ‘96).
• Capital surplus (11% of total liabilities and
capital in ‘96).
Finance Company Regulation
• The lack of deposits exempts finance companies from the
extensive oversight of the federal and state regulation
experienced by banks and thrifts. Because of the lack of
regulatory oversight, finance companies are able to offer
bank like services, but avoid the expense of regulatory
compliance.
• Like depository institutions, finance companies may be
subject to state imposed usury ceilings on the max loan
rates charged to customers.
• Because of their heavy reliance on money and capital
markets, finance companies need to signal their safety and
solvency to investors. As a consequence, finance
companies often maintain higher credit ratings than banks
and carry higher capital to assets ratios.
• Finance companies operate more like non-financial, non
regulated companies than the other types of FI’s.
Mutual Funds
Mutual Funds
• Mutual fund- intermediary that pools the
financial resources of investors and invests those
resources in (diversified) portfolios of assets.
– Open end mutual fund - a fund that sells new shares
to investors and redeems outstanding shares on demand
at fair market value (the majority of funds).
– Closed-end mutual fund - a fund with a fixed number
of shares outstanding. The shares are exchange traded
and may sell at a discount or premium to fair market
value. Real estate investment trusts (REITs) are a
common form of closed end investment company
Mutual Fund Functions
1 Opportunities for small investors to invest in financial
securities.
2 Opportunities to diversify risk.
3 Lower transaction costs and commissions by passing on
economies of scale.
4 (In most cases) free exchange between funds within the
mutual fund company.
5 Automatic investing
6 Check-writing priveleges on some money market funds
and even some bond funds.
7 Automatic reinvestment of dividends and automatic
withdrawals.
Mutual Fund History
• First fund established in Boston in 1924.
• Initially, industry growth was slow - in 1970, 360
funds held about $50B in assets. By 2000, more
than 7800 different mutual funds held total assets
of over $6.8B.
• Recent explosive growth can be attributed to:
– the advent of the money market mutual fund (‘72)
– the advent of tax exempt money market mutual funds
(‘79) and tax exempt funds (‘80)
– the explosion of special purpose equity, bond, emerging
market and derivative funds
– the proliferation of 401(k) plans
– market growth
Mutual Fund Types
• Open-end and closed-end
• Long-term funds
– Equity funds (common and preferred)
– Bond funds
– Hybrid or balanced funds (stock and bonds)
• Short-term funds - comprise both taxable and tax-exempt
money market mutual funds. Money market do not have
FDIC insurance (consequently, they typically have higher
yields). Some money market mutual funds are covered by
private insurance &/or implicit or explicit guarantees from
management companies.
• Prospectus - regulators require that mutual fund managers
specify the investment objectives of their funds in the
prospectus.
Mutual Fund Types
Net Assets of Mutual Funds
(billions of dollars)
Feb 03
% of Total
Jan 03
% chg
Dec 02
Stock Funds
2,538.50
40.50
2,597.7R
-2.3
2,667.10
Hybrid Funds
323.2
5.16
324.7R
-0.5
327.4
Taxable Bond Funds
838.8
13.38
811.5R
3.4
796.6
Municipal Bond Funds
332.2
5.3
326.7R
1.7
328.5
Taxable Money Market
Funds
1,950.40
31.11
1,991.1R
-2
1,997.20
285.2
4.55
282.5R
1
274.8
6,268.40
100.00
6,334.2R
-1
6,391.60
Tax-Free Money Market
Funds
Total
R=revised data
Source: Investment Company Institute
Mutual Fund Types
Number of Mutual Funds
Feb 03
Jan 03
Feb 02
Stock Funds
4,750
4,750R
4,759
Hybrid Funds
479
477R
486
Taxable Bond
Funds
1,273
1,270
1,282
Municipal Bond
Funds
770
771
807
Taxable Money
Market Funds
677
678
688
Tax-free Money
Market Funds
311
311
324
8,260
8,257R
8,346
Total
R=revised data
Source: Investment Company Institute
Components of Return from Mutual Funds
1 Income/dividends
2 Capital gains - when a mutual fund sells assets at
higher prices
3 Capital appreciation in the underlying values of
existing assets adds to the value of mutual fund shares
(NAV)
– Net Asset Value (NAV) - the market value of the assets in the
mutual fund portfolio divided by the number of shares outstanding.
Each day, mutual fund assets are marked-to-market or adjusted to
reflect current market prices. In open-end funds, the NAV is the
price that investors obtain when they sell shares back to the fund or
the price they pay to buy new shares in the fund on that day.
Mutual Fund Costs
• Two types of fees incurred by mutual fund investors: 1)
sales loads 2) fund operating expenses
• Load vs. No-load funds
– Load funds - funds that charge a 1X sales or
commission charge to compensate a registered
representative of a broker (front - end loads). Back-end
loads (differed sales charges) are sometimes charged
when shares are sold.
– No-load funds - funds that market shares directly to
investors and do not use sales agents working for
commissions
Mutual Fund Costs
• Operating expenses - annual fees are charged (as a
% of assets) to cover all fund level expenses
(management, administration, shareholder
services, etc.). 12b-1 fees - (generally in no-load
funds) are fees charged to meet fund level
marketing and distribution costs (limited to 25
bps).
Mutual Fund Regulation
• Heavily regulated industry with the SEC as the primary
regulator.
• Securities act of 1933 - requires fund registration and
dictates prospect procedures.
• Securities Exchange Act of 1934 - appoints the NASD
to supervise mutual fund share distribution.
• Investment Advisers Act and Investment Company
Act of 1940 - establishes rules to prevent conflict of
interest, fraud, and excessive fees or charges for fund
shares.
• The National Securities Markets Improvement Act
(NSMIA) of 1996 - exempts funds from oversight by
state securities regulators.