Chapter 3: Finance Companies Flashcards
What is the primary function of finance companies? How do finance companies differ from DTIs?
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 that they make. The heavy reliance on borrowed money has caused finance companies to generally hold more equity than DTIs for the purpose of signaling solvency to potential creditors. Finally, finance companies are less regulated than DTIs, in part because they do not rely on deposits as a source of funds.
What are the three major types of finance companies? To which market segments do these companies provide service?
(1) sales finance institutions: specialize in making loans to customers of a particular retailer or manufacturer.
(2) personal credit institutions: specialize in making installment loans to consumers.
(3) business credit institutions: provide specialty financing, such as equipment leasing and factoring, to corporations. In factoring, finance companies purchase the accounts receivable at a discount from corporate customers and assume the responsibility for collecting the accounts.
What are the major types of consumer loans? Why are the rates charged by consumer finance companies typically higher than those charged by commercial banks?
Consumer loans involve motor vehicle loans and leases, other consumer loans, and securitized loans, with loans involving motor vehicles taking 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 generally considered to be riskier.
Why have home equity loans become popular? What are securitized mortgage assets?
home equity lines of credit, or HELOCs have become popular as they provide a way for home owners who have a mortgage with a DTI (typically a bank) to use their home as collateral to set up a line of credit which can be drawn down and repaid like a revolving credit. This is particularly useful for homeowners with short-term borrowing needs. It is also useful as a source of credit even after the mortgage has been paid in full and is often marketed to retirees who want to maintain a line of credit after they have stopped working.
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) generally carries considerably less default or credit risk than the original mortgage or equity line because of the effects of diversification.
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 extensive regulatory monitoring that banks have;
(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; and
(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.
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 major issuers of commercial paper, often with direct placements to mutual funds and pension funds. North American finance companies obtain almost 60 percent of their funding from debt due to parents and debt not elsewhere classified.
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 and other debt markets.
Economic recessions may affect this market more severely than the effect on deposit drains in the commercial banking sector. In addition, the riskier asset customers may have a greater impact on the finance companies.
