Chapter 18 : Consumer Finance Operations

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Chapter Objectives
Identify the main sources and uses of finance company funds Describe how finance companies are exposed to various forms of risk Explain how finance companies interact with other financial institutions

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Types of Finance Companies

Consumer finance companies make direct loans to consumers Sales finance companies concentrate on purchasing credit contracts from retailers and dealers Commercial finance companies provide loans to firms that can not obtain financing from commercial banks
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Types of Finance Companies

Consumer

Finance Companies

Sales
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Commercial
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Sources of Finance Company Financing

Bank Loans Commercial Paper Deposits and Capital Market Financing

Capital
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Sources of Finance Company Funds

Finance companies use loans from banks as a source of funds and consistently renew the loans over time Commercial paper A short-term source but finance companies roll over their issues to create a permanent source of funds Secured commercial paper allows smaller and medium-sized firms access to the market Well-known firms use direct placement
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Sources of Finance Company Funds

Some states allow finance companies to accept customer deposits Bonds are used as a long-term source of funds and the use of this source depends on
Expectations about future interest rates The balance sheet structure

Capital comes from retained earnings or issuing stock

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Finance Company Lending Areas

R e a l E state L oan s $ 98.5 B illion 1 0%

C on sum e r Lo an s $ 25 4.9 B illion 2 5%

B usine ss L oa n s $33 5 .1 B illio n 3 3% O ther $31 3.7 B illio n 31%

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Uses of Finance Company Funds

Finance companies make many kinds of consumer loans in the form of personal loans
Auto loans offered by a finance company owned by the manufacturer Home improvement, mobile home and other kinds of personal loans Credit cards which can be used at a variety of retail stores
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Uses of Finance Company Funds

Credit card loans in which a retailer sells a credit contract to a finance company
Customers make payments to the finance company Gives the finance company access to new customers

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Uses of Finance Company Funds

Business loans and leasing are used to finance the cash cycle of companies
Cash cycle is the amount of time it takes between when inventory is purchased, the product is sold and customers pay This financing is often backed by accounts receivable or inventory

Leveraged buy out loans Factor accounts receivable

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Uses of Finance Company Funds

Leasing
Finance company purchases equipment Leases it to businesses

Real estate loans

Mortgages on commercial real estate Second mortgages on residential real estate

Relative importance of uses of funds

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Regulation of Finance Companies

Federal regulations apply if finance companies are acting as bank holding companies or are subsidiaries of bank holding companies State regulations apply otherwise Have ceilings which put a maximum on the loans size Subject to interest rate ceilings and a maximum term for the loan
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Balance sheet of finance company

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Risks Faced by Finance Companies

Liquidity risk
Finance companies do not hold assets that can be easily sold in the secondary market To raise funds they must borrow Balance sheet structure does not call for much liquidity because they would not have unexpected deposit withdrawals

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Risks Faced by Finance Companies

Interest rate risk is less than for depository institutions because the maturity of assets and liabilities is relatively short Assets are typically not as rate sensitive as liabilities Can use adjustable rates and shorter maturities on their loans to manage the risks
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Risks Faced by Finance Companies

Credit risk
Represents an important source of risk Loan delinquency rates are typically higher than for other kinds of institutions Charge a higher interest rate to compensate for the risk High return, high risk nature of loans makes performance sensitive to prevailing economic conditions
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Valuation of a Finance Company

Value of a finance companies depends on its expected cash flows and required rate of return
( V = f [( E(CF), ( k] +

Where:
V = Change in value of the institution E(CF) = Change in expected cash flows k = Change in required rate or return
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Valuation of a Finance Company

Factors that affect cash flows
( E(CF)= f (( ECON, ( Rf , ( INDUS, ( MANAB) + +

Where:
E(CF) = Expected cash flow ECON = Economic growth Rf = Risk free interest rate INDUS = Prevailing industry conditions for the institution MANAB = The ability of the institutions management
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Valuation of a Finance Company

Economic growth
Positive affect because it enhances household demand for consumer goods Economic growth reduces defaults

Change in the risk-free rates

Cash flows inversely related to interest rate movement Short term sources of funds means their rates change as do those of other interest rates
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Valuation of a Finance Company

Change in industry conditions which include regulatory constraints, technology and competition Change in management abilities

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Interaction with Other Financial Institutions

Interact in various ways with other financial institutions Concentration in commercial lending means they are closely related to commercial banks, savings institutions and credit unions Compete with savings institutions and increase market share when their competitors have problems
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Participation in Financial Markets

Participate in a wide range of financial markets
Money markets Bond markets Mortgage markets Stock markets Futures markets Options markets Swap markets
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Multinational Finance Companies

Large multinational companies with subsidiaries in many countries Reasons why finance companies go global
Enter new markets Reduce exposure to the U.S. economy

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