Finance Company Operations: How Finance Companies Work

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 22 is one of the shorter chapters in the book, but it covers an important piece of the financial system that most people do not think about. Finance companies provide short and intermediate-term credit to consumers and small businesses. They are not banks. They do not take deposits. But they move a lot of money.

Types of Finance Companies

Finance companies have more than $1 trillion in assets. Some are independent. Others are subsidiaries of big corporations. Think General Motors, Ford, Citigroup, American Express, Capital One, and General Electric.

Madura breaks them into three categories:

Consumer finance companies provide financing for retail customers. They might sponsor a credit card for a retailer so that store can offer its own branded credit card. They also offer personal loans for big purchases like appliances or home improvements. Some provide mortgage loans too.

Business finance companies offer loans to small businesses, typically to finance inventory. A business borrows to buy raw materials, manufactures products, sells them, and uses the revenue to pay off the loan. They also provide business credit cards for employee travel and purchases.

Captive finance subsidiaries (CFS) are the most interesting category. A captive finance subsidiary is a wholly owned subsidiary whose main job is to finance sales of the parent company’s products. The classic example is the automobile industry. Car manufacturers created their own finance companies because banks historically viewed cars as luxury items not suitable for financing. General Motors Acceptance Corporation (GMAC) finances GM car purchases. Ford and Chrysler have their own finance arms too.

The advantages of a CFS are clear. It can finance dealer inventories until a sale happens, which smooths out the production cycle. It serves as a marketing tool by offering retail financing directly. Unlike banks, a CFS has no reserve requirements and no legal restrictions on how it obtains or uses funds. That is a significant structural advantage.

General Electric Capital Corporation (GECC) took the captive finance model further than anyone. It expanded beyond just financing GE products into industrial equipment sales, consumer credit, and second mortgage loans on homes.

Sources of Funds

Here is the key difference between finance companies and banks: finance companies do not rely on deposits. Their funding comes from different places.

Bank loans are a common source. Finance companies borrow from commercial banks and can roll these loans over continuously. Some use bank loans mainly for seasonal swings.

Commercial paper is a big one. Finance companies issue short-term unsecured debt and roll it over to create a permanent funding source. The best-known companies can place commercial paper directly, skipping the dealer and saving on fees. Smaller companies may need to use secured commercial paper or go through a dealer.

Bonds provide long-term funding. When a company expects interest rates to rise, locking in long-term rates through bond issuance makes sense.

Deposits are possible in some states but are not a major source of funds.

Capital comes from retained earnings and stock issuance. Several finance companies have done IPOs to fund expansion.

Uses of Funds

Finance companies channel their money into three main areas:

Consumer loans are the bread and butter. Auto loans from manufacturer-owned finance companies are among the most popular. These subsidiaries sometimes offer below-market rates specifically to boost car sales. Finance companies also offer personal loans for home improvement and other expenses, typically with maturities under five years.

Credit card services are another revenue stream. A retail store sells products on credit, then sells the credit contract to a finance company. The finance company handles credit approval and payment processing. The retailer gets more sales. The finance company gets more customers to potentially cross-sell other financing products.

Business loans and leasing serve the commercial side. Companies borrow to cover the gap between buying raw materials and collecting revenue from sales. Finance companies also act as factors, purchasing a firm’s accounts receivable at a discount and taking on the collection responsibility and bad debt risk.

Leasing is smart financing. The finance company buys equipment and leases it to a business. The business avoids putting more debt on its balance sheet, which matters a lot when you are close to your debt capacity and worried about credit ratings.

Real estate loans include commercial real estate mortgages and second mortgages on residential properties. During the 2003-2006 period, some finance companies got into subprime mortgage lending. That ended badly during the credit crisis. Many significantly reduced real estate loans from 2009 to 2013.

Risk Exposure

Finance companies face three types of risk, but their exposure profile is different from other financial institutions.

Liquidity risk is actually lower for finance companies than for banks. Their assets are not very liquid, but their balance sheet does not require much liquidity either. They fund themselves through borrowing, not deposits. No deposits means no risk of bank runs.

Interest rate risk exists but is moderate. Both their assets and liabilities tend to be short or intermediate term. The maturity mismatch is much smaller than what savings institutions face. They can further reduce this risk by shortening asset maturities or using adjustable rates.

Credit risk is the big one. Most of their money goes to consumer and business loans, and their borrowers tend to be riskier than average. The loan delinquency rate at finance companies is typically higher than at other lending institutions. But the higher default rate is supposed to be offset by the higher interest rates they charge. The keyword is “supposed to.” When the economy turns, that math can fall apart quickly.

Valuation

Like every financial institution covered in this book, finance company valuation comes down to expected future cash flows and the required rate of return.

Economic growth is especially important for finance companies. Strong economies mean more loan demand, fewer defaults, and better cash flows. Weak economies are dangerous because finance companies serve riskier borrowers who are more likely to default when times get tough.

Interest rates matter too. When rates fall, the cost of funds declines faster than the interest earned on existing loans, widening spreads. When rates rise, the opposite happens.

Management quality shows up in the ability to properly assess borrower creditworthiness and adapt to changing economic conditions.

Competition and Interaction

Finance companies compete directly with commercial banks, savings institutions, and credit unions in consumer lending. The competition for business loans overlaps mainly with commercial banks.

Some finance companies have insurance subsidiaries that compete with insurance companies and pension plans. Securities firms underwrite bonds issued by finance companies.

The largest finance companies are multinational. GE Money, for example, provides consumer finance services in 55 countries and serves more than 130 million customers worldwide.

My Take

Finance companies are the shadow lenders of the financial system. They fill the gap between what banks are willing to do and what borrowers need. When banks tighten lending standards during a credit crunch, finance companies tend to pick up business because they have always been comfortable with riskier borrowers.

The captive finance subsidiary concept is clever. Car manufacturers realized that if they controlled the financing, they could control the entire sales process. Offering below-market rates on loans is essentially a hidden discount on the product itself. It is one of those financial innovations that seems obvious in hindsight but required someone to think outside the traditional banking model.

The weakness of finance companies is the same as their strength. They lend to riskier borrowers, which means their fortunes are tightly tied to the economy. When growth is strong, they look like geniuses. When recession hits, their loan portfolios take outsized damage.

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