Chapter 6 - Finance Companies by fanzhongqing


									Chapter 6: Finance

   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
     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


     A charge over real property as security
      for a debt (for example, a mortgage)

     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

     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


     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
    Industry information on leasing companies is

         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.

     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
    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
                                               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.

   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
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
     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
     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
       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
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
      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
     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
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
   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
     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
     ...
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
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

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