Chapter 6: Finance Companies Business 4039 Finance Companies Are non-deposit-taking FIs that provide financing to businesses and consumers. Finance companies can be either specialized by industry/activity or diversified. They can be independent, captive, or government-owned. A captive finance company is one that is wholly owned by another firm. Captives tend to specialize in providing consumer and wholesale financing for the industry of the owning company (example – Ford Credit or GMAC) Acceptance Financing The largest finance companies in Canada are the captive leasing and acceptance companies in the automotive industry. General Motors Acceptance Corporation Ford Credit Chrysler Credit Have over 10 billion dollars each in Canadian assets and dominate the industry Most other auto manufacturers in Canada also have captive finance companies. From 80 to 85 percent of car sales are financed (either bought on time or leased) These companies’ major activity is providing leasing and accepting car loans: they purchase at a discount from the car retailer the sales financing contract (and the lien over the vehicle) Captive automobile finance companies and other FIs lending to durable goods retailers also lend to retail auto distributors against the security of inventories (called floor plans), proving working capital finance. Important Terms Defined Acceptance Company A finance company that purchases extended payment purchase contracts from sales companies at a discount. Important Terms Defined Lien A charge over real property as security for a debt (for example, a mortgage) Leasing Leasing has grown rapidly to exceed the importance of acceptance financing for companies. Leasing involves long-term provision of equipment in exchange for a stream of payments that amortizes the purchase cost at a rate of interest high enough to offset the cost of funds, risk and administrative expenses. Over half of the leasing is automobile leasing, one of the few FI activities that banks cannot do, directly or indirectly. Other industries where leasing is common include aircraft, construction machinery, medical equipment, telecommunications equipment, oilfield equipment, rail rolling stock and computer hardware and software. Other Finance Company Activities In addition to acceptance, working capital financing, and leasing, a finance company may also provide factoring, consumer and business lending, export financing, and real estate lending. Balance Sheet and Trends Leasing dominates the business segment while personal loans dominate the household credit side. Independent finance companies source their funds from the short-term and long-term capital markets, so they must maintain good credit ratings. Captives can fund themselves internally. Finance Company Industry Consolidate Balance Sheet (Dec. 1999) Amount Amount (C$ (C$ Assets millions) Percent Liabilities millions) Percent Cash and Deposits 1,399 2.5% Short-Term Paper 17,855 31.6% Business and Retail Credit Long-Term Paper 23,819 42.2% Retail Sales Financing 7,934 14.1% Bank Loans 7,854 13.9% Wholesale financing 6,264 11.1% Other Liabilities 510 0.9% Business financing 942 1.7% Total External Liabilities 50,038 88.6% Leasing and Rental Contracts 13,945 24.7% Non-Residential Mortgages 54 10.0% Owed to Parent and Affiliated Companies2,962 5.2% Total Business Credit 29,139 51.6% Shareholders Equity 3,463 6.1% Total Liabilities and Equity56,463 100.0% Household Credit Residential Mortgages 1,815 3.2% Personal Loans 12,390 21.9% Total Household Credit 14,205 25.2% Other Receivables 1,279 2.3% Allowance for Doubtful Accounts -524 -0.9% Investments in Subsidiaries 10,000 17.7% Other Assets and Investments 965 1.7% Total Assets 56,463 100 Important Terms Defined Financial Lease A contract that gives the lessor sufficient cash flow over its term to recover the full cost of the asset. Important Terms Defined Operating Lease A straight rental of the asset, whereby the term is less than the expected life of the asset and the lessor does not recoup the full asset cost during the term of the lease. For example, a short- term car lease. Important Terms Defined Factoring The process of purchasing accounts receivable from corporations at a discount, usually with no recourse to the seller if the receivables go bad. Finance Companies Finance companies are difficult to study, yet they play an increasingly important role in financial intermediation Industry information on leasing companies is available: Canadian Leasing and Finance Association 151 Young Street, Suite 2110 Toronto, Ontario M5C 2W7 CLFA does a survey of its companies each year. The organization has some 70 members but the list is not published. Regulation Finance companies differ from other FIS because they are NOT regulated by specific federal or provincial acts. Because they take no deposits and issue no obligations to retail investors, they are spared regulatory oversight. One Federal Act – the Small Loans Act, did specifically govern some finance companies’ lending to consumers, but it was repealed in 1994. Specific activities of other finance companies are covered under various provincial and federal laws, and each of the government-owned finance companies was incorporated by special legislation, but there is no unified regulatory framework for finance companies as a group. Regulation … Lack of regulatory oversight does not imply lack of monitoring. Finance companies are heavy issuers of finance company paper in capital and money markets; therefore, their solvency is of great interest to institutional investors who purchase their paper. Finance companies typically maintain higher capital-to-asset ratios than banks. To raise the creditworthiness of their paper, finance companies may also use default protection guarantees from their parent companies and/or standby letters of credit and standby lines of credit from banks. Public-sector Finance Companies Crown Corporations owned and operated by the federal government of Canada of relevance include: 1. Canada Mortgage and Housing Corporation (CMHC) 2. Export Development Canada (EDC) 3. Farm Credit Corporation (FCC) 4. Business Development Bank of Canada (BDC) The provinces have their own government-owned FIs that tend to guarantee (in addition to administering programs, extending grants, and/or determining tax breaks) to promote specific industrial and social policies. Government Finance Company Summary Figures in Millions of Canadian dollars Five-year Annual Income Assets Guarantees Five-year Asset Employees (Five-year (End of Equity (End and Average Grow th FI Mandate (End 1998) Average) 1998) 1998) Insurance ROA Rate CMHC Advancement of housing 2,366 30.4 21,900 252 201,450 0.01% 14% EDC Promotion of exports 708 118 15,262 1,680 28,112 0.43% 23% FCC Lending to farmers 900 41.5 6,125 592 1 0.85% 11% BDC Promotion of small business 1,085 28.2 4,588 507 - 0.84% 11% 5,059 218.1 47,875 3,031 229,563 0.53% 15% Crown Finance Companies Except for CMHC, none of the crown finance companies is large. In aggregate, the loans of all government FIs are just over three (3%) percent of the assets of the banks. Taken together, they show modest profitability and moderately fast growth. CMHC Established in 1946 Headquartered in Ottawa Only funds supporting mortgage insurance and mortgage- backed security guarantees pursuant to the National Housing Act are reported in the foregoing table. These guarantee funds allow new home owners to obtain mortgages more easily and have led to the creation of a thriving MBS secondary market in NHA securities. Because housing continues to be a top priority for Canadians, it is likely that CMHC will continue its rapid rate of growth notwithstanding its lack of profits. Export Development Canada Headquartered in Ottawa Began as Export Credits Insurance Corporation in 1944…became EDC in 1969. Its mandate is to stimulate the export of Canadian goods and services by providing credit insurance, loans, guarantees, and other financial services. EDC’s loan programs include supplier credits and buyer credits. The government’s subsidy of the EDC is somewhat understated by the five year average income. Budgetary appropriations from the government of Canada to account for debt reductions resulting from defaults of sovereign borrowers have averaged about $150 million per year for the last 10 years. With the growth in international trade, the EDC’s role is likely to increase. Supplier Credit An export credit loan to the exporter for working capital financing. Buyer Credit A medium- or long-term export credit loan to the importer, granted at the request of the exporter, to finance the purchase of capital equipment or engineering services. Farm Credit Corporation Head office is located in Regina The oldest of the government’s FIs Created originally as the Canadian Farm Loan Board in 1929 to help Canadian farmers establish and develop viable farms by providing long-term loans and other financial services. – Farmers were traditionally at a disadvantage when approaching FIs. – Small farmers were independent business people, engaged in relatively high-risk ventures, with limited information, limited capital and high investment needs. – When the Farm Loans Board was established, Canadians did more farming than any other activity. Business Development Bank of Canada Headquartered in Montreal. Seeks to promote and assist in the establishment and development of business enterprises in Canada by providing financial assistance, management counselling, management training, information and advice and by giving particular attention to the needs of small and medium-sized business. 1995 Parliament gave the BDC is new name (it was formerly known as the Federal Business Development Bank) and increased its power to lend and tap capital markets. With assets less than $5 billion, the BDC is able to provide only a small fraction of the credit needed by small business. This has led to BDC programs emphasizing extending financial consulting to small, start-up businesses, providing seed capital to technology firms, and co-financing with commercial banks. Question 6 - 1 What is the primary function of finance companies? How do finance companies differ from banks? The primary function of finance companies is to make loans to individuals and corporations. Finance companies do not accept deposits, but borrow short- and long-term debt, such as commercial paper and bonds, to finance the loans. The heavy reliance on borrowed money has caused finance companies to hold more equity than banks for the purpose of signaling solvency to potential creditors. Finance companies are less regulated than banks and other deposit-taking institutions in part because they do not rely on deposits as a source of funds. Question 6 - 2 What are the three major types of finance companies? To which market segments do these companies provide service? The three types of finance companies are: (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Sales finance companies specialize in making loans to customers of a particular retailer or manufacturer. An example is General Motors Acceptance Corporation. Personal credit institutions specialize in making installment loans to consumers. Business credit institutions provide specialty financing, such as equipment leasing and factoring, to corporations. Factoring involves the purchasing of accounts receivable at a discount from corporate customers and assuming the responsibility of collection. Question 6 - 3 What have been the major changes in the accounts receivable balances of finance companies over the 31-year period from 1977 to 2008? From Tables 6-2 and 6-3, for U.S. finance companies, the gross amount of accounts receivable has decreased from 95.1 percent of assets to 80.4 percent of assets. Real estate loans and other assets have replaced some of the consumer and business loans since 1997 and are 21.6 percent of assets in 2008. Question 6 - 4 What are the major types of consumer loans? Why are the rates charged by consumer finance companies typically higher than those charged by banks? Consumer loans involve motor vehicle loans and leases, other consumer loans, and securitized loans, with loans involving motor vehicles involving the largest share. Other consumer loans include loans for mobile homes, appliances, furniture, etc. The rates charged by finance companies typically are higher than the rates charged by banks because the customers are considered to be riskier. Question 6 - 5 Why have home equity loans become popular? What are securitized mortgage assets? Since the U.S. Tax Reform Act of 1986, only loans secured by an individual’s home offer tax-deductible interest for the borrower. Thus, in the U.S., these loans are more popular than loans without a tax deduction, and finance companies as well as banks, credit unions, and savings associations have been attracted to this loan market. Securitized assets refer to those assets that have been placed in a pool and sold directly into the capital markets. In the case of mortgages, the resulting capital market asset is a mortgage-backed security which (1) reflects a small portion of the total pool value; (2) can be traded in the secondary market; and (3) carries considerably less default or credit risk than the original mortgage or equity line because of the effects of diversification. Question 6 - 6 What advantages do finance companies have over commercial banks in offering services to small business customers? What are the major subcategories of business loans? Which category is largest? Finance companies have advantages in the following ways: (1) Finance companies are not subject to regulations that restrict the types of products and services they can offer. (2) Because they do not accept deposits, they do not have the severe regulatory monitoring. (3) They are likely to have more product expertise because they generally are subsidiaries of industrial companies. (4) Finance companies are more willing to take on riskier customers. (5) Finance companies typically have lower overhead than commercial banks. The four categories of business loans are (1) retail and wholesale motor vehicle loans and leases, (2) equipment loans, (3) other business assets, and (4) securitized business assets. Equipment loans constitute more than half of the business loans in the North American market. Question 6 - 7 What have been the primary sources of financing for finance companies? Finance companies have relied primarily on short- term commercial paper and long-term notes and bonds. While bank credit has been a major source of funds, the use of bank credit has been declining, as finance companies have become the largest issuer of commercial paper, often with direct placements to mutual funds and pensions funds. Question 6 - 8 How do finance companies make money? What risks does this process entail? How do these risks differ for a finance company versus a commercial bank? Finance companies make a profit by borrowing money at a rate lower than the rate at which they lend. This is similar to a commercial bank, with the primary difference being the source of funds, principally deposits for a bank and money and capital market borrowing for a finance company. The principal risk in relying heavily on commercial paper as a source of financing involves the continued depth of the commercial paper market. Economic recessions may affect this market more severely than the effect on deposit drains in the banking sector. In addition, the riskier customers may have a greater impact on the finance companies. Question 6 - 9 How does the amount of equity as a percentage of total assets compare for finance companies and banks? What accounts for this difference? Finance companies in North America hold relatively more equity than banks. The difference may be partially due to the fact that the banks have insured deposits. This insurance makes the debt safer from the depositors’ and stockholders’ perspective. As a result the banks can take on more debt than the uninsured finance companies. Question 6 - 10 Why do finance companies face less regulation than do banks? How does this advantage translate into performance advantages? What is the major performance disadvantage? By not accepting deposits, the need is eliminated for regulators to evaluate the potentially adverse safety and soundness effects of a finance company failure on the economy. The performance advantage involves the avoidance of dealing with the heavy regulatory burden, but the disadvantage is the loss of the use of a relatively cheaper source of deposit funds. Review Question 1 What accounts for the rapid growth of finance companies in recent years? Finance companies have grown rapidly because they can provide many of the same services as regulated FIs without having to pay the same regulatory burden (eg., periodic filings, submission to inspections, restrictions of activities). They may also have niche expertise that allows them to price industry specific expertise that will allow it: » to price the equipment to be leased or financed against a lien more accurately, and » to dispose of the equipment in the event of default with less loss than a bank. Review Question 2 Why do finance companies have higher capital- assets ratios than other FIs even though they are unregulated? Finance companies must finance themselves in money and capital markets by issuance of commercial paper (finance company paper) and other notes. This paper has no guarantees and must have the highest credit ratings in order to be accepted by investors. That requires that comfortable cushions of capital be maintained. Review Question 3 In terms of size, the government-owned FIs are generally not very important. Total assets of all four together are less than $47 billion (I.e., smaller than any of the Big Six). Both the CMHC and the EDC have had substantial guarantees and insurance outstanding. CMHC has about $200 billion, mainly backing NHA mortgages. Its guarantees underpin most of the mortgage-backed securities in Canada. The EDC has about $28 billion in guarantees and insurance outstanding, making it a large player in export finance. ... Review Question 4 In terms of role, each of the four provides subsidized financial services to a sector of the economy considered critical from a political perspective. CMHC helps first-time home buyers EDC helps exporters FCC helps farmers BDBC helps small businesses all sectors that substantial portions of the Canadian public feel have been under served by private sector FIs. Review Question 5 Venture capital firms provide capital to young, privately owned firms with superior growth potential. A venture capitalist typically looks to a future initial public offering (IPO) in order to realize its return on investment. It generally takes several years between the injection of venture capital and the establishment of a successful track record by the young firm (assuming it succeeds) sufficiently credible to allow the firm to go public at a reasonable IPO price. During this period, the venture capitalist usually can not profitably sell its stake in the young firm to private investors either. This period of growth determines the longer investment horizon of the venture capitalist.
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