Chapter 26
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Finance Companies
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.
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Chapter Preview
• In this chapter, we examine how finance
evolved and what they do. Topics include:
– History of Finance Companies
– Purpose of Finance Companies
– Risk of Finance Companies
– Types of Finance Companies
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Chapter Preview
– Regulation of Finance Companies
– Finance Company Balance Sheet
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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 auto really developed
the industry. Since banks didn’t offer car
loans in the early 1990s, finance
companies developed to fill the void.
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History of Finance Companies
• By the end of 2006, banks held $743 billion
in consumer loans, while finance
companies held $629 billion. Clearly banks
didn’t stay out of consumer financing for
long.
• Finance companies moved into business
financing (lease financing, etc.).
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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).
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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.
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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.
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Types of Finance Companies
• Figure 1 on the next slide shows the
distribution of loans made by the three
types of finance companies: business,
sales, and consumer.
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Finance Company Loans
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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.
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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.
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Types of Finance Companies
• Figure 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 3.
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Business Finance Company Loans
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Business Finance Company Loans
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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.
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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.
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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 the can be
charged.
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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.
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Finance Company Balance Sheet
• Table 1 on the next slide presents the
aggregate balance sheet for finance
companies as of 2007.
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Finance Company Balance Shet
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.
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Finance Company Balance Sheet
• Liabilities. Their primary source of funding
either equity (about 11% 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.
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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
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Finance Company Balance Sheet
• Figure 4 on the next slide shows the growth
in finance company assets from 1980
through 2006.
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Finance Company Balance Sheet
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Chapter Summary
• Managing Credit Risk: basic techniques for
managing relationships and rationing credit
were reviewed.
• Managing Interest-Rate Risk: the essential
techniques of measuring interest-rate risk
for both income and capital affects
were presented.
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