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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
6th Edition
1. Finance Companies
Finance companies provide specialized lending services to various market subsets as
described below. Their primary sources of funding are short and long term debt.
a. Size, Structure, and Composition of the Industry
Finance companies were originally created to make unsecured installment loans to
consumers. Recall that historically banks made few unsecured loans to individuals.
Because finance companies are not tightly regulated, they can offer loans to customers
that bank regulators might not consider prudent risks. Some finance companies can even
create the financing needed right in the store where the item is purchased in a matter of
minutes because of their affiliation to manufacturers. Of course loan rates reflect the
perceived riskiness of the customer and finance company loan rates are often above
comparable rates offered by banks. Nevertheless, over the last 32 years industry assets
have grown at an annualized rate of about 8.4% per year and many finance companies
now have highly diversified loan portfolios.1 For instance General Electric Capital Corp
(GECC, $285.4 billion) was originally a captive consumer finance lender. It now has a
very large diversified loan portfolio that includes commercial loans of all kinds. Total
industry assets as of 2013 were $1,759.4 billion, a decline from 2010 of about $81
billion.
The three major types of finance companies include:
Sales finance institutions (Ford Motor Credit, Sears Roebuck Acceptance Corp.) that
specialize in making loans to customers of a specific retailer or manufacturer. These
are often wholly owned subsidiaries of the manufacturer or retailer. They are captive
finance companies. Their advantage over banks is speed of granting credit.
Personal credit institutions (Household Finance and AIG American General
Financial Services) that specialize in installment loans to consumers including credit
card operations and loans for manufactured and mobile homes. One of their
advantages over banks is their willingness and ability to lend to high risk
borrowers with low collateral.
Business credit institutions (CIT Group2, U.S. Bancorp Equipment Finance) that
provide factoring and leasing services. Factoring is purchasing a firm’s receivables
at a discount. The finance company then has the collections responsibility.
Advantages of this group include industry knowledge and expertise with
collections.
Many large finance companies now engage in all three activities. The twenty largest
firms account for about 65% of assets. The industry is concentrated at the top. Many of
the larger finance companies are now subsidiaries of financial service firms. Their size
and lack of regulation allow finance companies to be better diversified than many banks
and to engage in riskier activities.
1 The industry had $81.6 billion in assets in 1975.
2 CIT Group filed for Chapter 11 bankruptcy protection in November 2009 even after
being allowed to switch to a bank charter to receive Federal aid.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
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b. Balance Sheets and Recent Trends
i) Assets 2013
Major assets include:
Accounts receivables (business, real estate and consumer loans) 79.5%
Business loans 22.5%
Consumer loans 47.3%
Real Estate 9.7%
Loss Reserves and Reserves for Unearned Income (3.0%)
Other assets 23.5%
Note: Securitized business and consumer loans contain motor vehicle loans; securitized
real estate contains single family real estate loans.
Real estate loans are fairly new additions to the finance company’s loan portfolio,
business lending and leasing are currently the fastest growing areas.
The largest single component of consumer loans is loans for motor vehicles. Some
finance companies have offered lower loan rates on new cars than banks. This
reflects attempts by captive finance companies to stimulate auto sales in the wake of
the weak economy.
Consumer loans offered by finance companies typically require higher interest rates
than similar bank loans because finance companies attract subprime (high risk)
borrowers. Some loan shark style companies charge exorbitant interest rates on
consumer loans, sometimes as high as 35% and these loans are often accompanied by
high fees. Nevertheless, text Table 17-7 indicates that since about 1997 auto finance
company rates have been lower than commercial bank rates on new car loans. This
result should be interpreted with caution because the auto sales people can adjust the
price to make the deal appear to be low cost financing when it is really not.
Teaching Tip: Many poorer, less educated inner city residents never use banks or other
mainline financial intermediaries. They may cash their paychecks at pawn shops or at
payday lenders or other check cashing stores that charge high interest rates and/or fees.
Instruct your students to always inquire about the APR on a loan. Alternatives to finance
company loans such as credit counseling and bill reduction services are available
throughout the country. Many churches can also provide credit counseling services free
of charge, or they may assist persons in paying for such services.
Another type of subprime lender is the payday lender. Cash America International is
one of the nation’s largest payday lenders. Payday lenders provide short term loans
typically due when the borrower receives their next paycheck. Payday loan revenues
were about $10 billion in 2013. There are an estimated 19,700 payday lenders
nationwide. A typical borrower pays about $15 per $100 borrowed for a two week
loan (many workers are paid twice a month). This is a 390% APR or a 3,686% EAR.
Borrowers are typically wage earners that make between $25,000 and $50,000 per
year. The growing demand for these loans in spite of the extremely high rates are
probably indicative of both the need for short term lending programs and a lack of
consumer education. Payday lending is coming under increasing state level scrutiny.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
6th Edition
As of 2013 eighteen states had banned payday loans. Others place certain limits on
the practice. Some states also limit the periodic interest rate, but large APRs are still
commonplace.
Finance companies made few or no real estate loans prior to 1979, but many finance
companies are now willing to grant mortgage loans (9.7% of loans), even to
individuals with prior bankruptcies. Home equity loans are an increasing portion of
their business. Finance companies are also originating and selling mortgages,
keeping the mortgage servicing contract to generate fee income. Mortgage
securitization facilities this practice. A weaker economy that brings higher default
rates on mortgages may make mortgage lending less attractive in the future.
The second largest single component of finance company loans are business loans
(22% of assets). Finance companies make many wholesale motor vehicle loans, as
well as the aforementioned consumer loans. For instance, Ford Motor Credit finances
a car dealer’s inventory via a procedure called ‘floor planning.’ In floor planning the
retailer has possession of the collateral, but the lender has a specific lien against it.
The retailer pays interest on the amount of the loan but the loan is not due until the
car is sold. Equipment loans are another large category of business receivables.
These include the rapidly growing area of business leasing, particularly to small
firms. In leasing the finance company retains title to the asset. This reduces the costs
and efforts involved in collections if the lessee fails to make the scheduled payments.
Many small companies do not have enough taxable income to fully utilize the tax
writeoffs associated with depreciation. The finance company can purchase the
equipment, use the tax writeoff and then lease the equipment to the business user.
Other areas of lending include financing for dealers of recreational vehicles,
manufactured and mobile homes and other small business needs.
ii) Liabilities and Equity
Major liabilities and equity include: (2013)
Bank Loans 6.9%
Nonrecourse debt 23.5%
Commercial Paper 6.8%
Debt Due to Parent 9.2%
Notes and Bonds 30.5%
Other Liabilities 9.8%
Equity 13.3%
The primary source of funding for finance companies is medium to long term notes and
bonds and nonrecourse debt. Nonrecourse debt is debt secured only by specific finance
company loans. Nonrecourse debt holders have no claim on other finance company
assets in the event of non-repayment of the debt. In the 1990s finance companies began to
rely less on bank sources of funds, bank loans are 6.9% of total financing and are
primarily used to meet seasonal funding needs. Debt due to the parent is a significant
component of financing, and if the finance company has a bad year and can’t repay the
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
6th Edition
parent, the parent company could suffer serious losses, as was the case for GMAC (now
Ally Financial) and its parent GM during the financial crisis. Both eventually were bailed
out. Industry equity capital is at 13.3%, higher than for banks and SIs.
Teaching Tip: Without federally insured deposits finance companies must maintain higher
margins of safety than banks.
A significant portion of financing is raised from commercial paper (6.8% of assets).
This percent is now increasing but fell during the financial crisis and the resulting
problems in the commercial paper market. Recall from Chapter 5 that commercial paper
is unsecured promissory notes issued by borrowers. Finance companies are the largest
issuers of commercial paper. Many larger finance companies maintain sales staffs to
market their paper and are more or less continuously in the market. This implies that
finance companies are defacto using the commercial paper market as a long term source
of funding, albeit at short term rates. This strategy works well when the term structure is
upward sloping and short term rates remain low. If rates rise, the industry could face
significantly higher funding costs that would quickly erode profit margins. The safety of
the finance company is very important for funding. Poorly rated issuers either cannot
issue at cost effective rates or must obtain a bank letter of credit backing the issue (adding
to the cost). Long term notes and bonds are another major source of funds for finance
companies.
c. Industry Performance
The overall health and future prospects of finance companies are quite good. Finance
companies have several advantages over banks. For instance:
Banks have extensive product regulations and finance companies (FCs) do not
Banks have powerful federal regulators with oversight powers and FCs do not
In many cases FCs have valuable information about products and industry
because of their ties to manufacturers
FCs can take riskier customers than banks and if they are good at credit analysis
can earn a higher rate of return on these customers
FCs have lower overhead than banks because they do not seek retail sources of
funds that require substantial investments in brick and mortar (i.e., branches).
Banks also have some advantages over finance companies. For instance,
Many banks are larger and have more expertise in providing a wider range of
financial services. These two factors imply that banks can exploit economies of
scale and scope and may have higher profitability than finance companies (FCs).
Banks obtain a major portion of their funds (deposits) at a subsidized cost because
of federal deposit insurance. This lowers their funds cost and allows them to
carry less equity on the balance sheet, potentially improving the shareholders
return on equity.
Consumer finance companies have the reputation for providing high risk loans
and tend to attract those types of customers. Subprime and consumer FCs are
sensitive to the economy because their customer’s finances are often
compromised by economic downturns.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
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2006 and 2007 were not good years for finance companies involved in the mortgage
markets and in subprime lending in general. Loan defaults increased in 2005 through
2007 with weaker home prices and higher interest rates. On mortgage loans, some
homeowners had borrowed at interest only loans that had to be refinanced and some had
ARMs that had payments adjusting upward. With the weaker economy and softer home
prices payment problems began to emerge. At the end of 2006 14% of subprime
mortgages had payments that were 60 days past due, up from only 6% in 2005. Some
estimated that 1 in 5 subprime originations in 2006 would end in foreclosure. In 2007
originations fell 30% from their $600 billion dollar 2006 level. This reduced profits at
many finance companies. New Century Financial, which was the second largest
subprime originator had a share price drop at one point of 79%. Countrywide Financial,
the largest mortgage lender in the country, saw its share prices cut in half as it announced
subprime losses. Countrywide would have failed but for a $2 billion equity injection by
Bank of America, which eventually acquired the finance company. With about 2/3s of
mortgages being securitized, the problems in the subprime industry quickly spilled over
into the broader mortgage and credit markets.
Although the long term prospects of the overall finance company industry remain strong,
several industry sectors could be at risk from future economic changes. Over the last few
years several major subprime lenders have either gone bankrupt or were near bankruptcy.
If economic growth remains slows and interest rates increase, resulting in large numbers
of consumers having difficulty paying off their high rate loans, these types of finance
companies could face severe solvency problems.3 For instance, mortgage loan
delinquencies peaked at an all time high of 6.89% in December 2009. There were over
7.2 million mortgage holders behind on their payments. Overall industry ROE increased
slightly to 9.33% in 2012, but fell for personal finance companies to 13.73%. Overall
industry assets continue to fall.
GE Capital’s problems led to about a 50% decline in the value of the parent company
during the financial crisis. GECC was able to issue debt backed by the government
through the FDIC’s Temporary Liquidity Guarantee Program (TLGP). This was
technically possible because GECC owned a federal savings bank and an industrial loan
company. GMAC lost $8 billion in the 2007 to 2008 period. GMAC was subsequently
approved as a bank holding company making it eligible for up to $6 billion in
government assistance. This was a controversial move, made by the Fed on practical
grounds rather than because GMAC resembled a bank. GMAC was required to diversify
its loan portfolio to look more like a bank. GMAC is now Ally Financial.
Allegations that many subprime lenders have used misleading and so called ‘predatory’
lending practices to effectively charge usurious rates have also hurt this industry.
Citigroup recently agreed to pay $200 million to settle charges that its acquisition,
3The largest danger now continues to be the home mortgage market. A long term or
sharp decline in housing values would impair household balance sheets considerably and
constrain lending and spending as people would be forced to focus on limiting or
reducing their debts
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
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Associates First Capital Corp engaged in practices such as encouraging customers to
consolidate their debts into home loans with high interest rates (and fees), and having
customers unknowingly buy additional optional insurance on the loans (for more fees) as
well as abusive collections practices. First Plus Financial Group (now bankrupt) just
settled similar charges on second mortgages and home equity loans where they failed to
reveal the true APR on such loans and engaged in false marketing practices.
Firms focused primarily on retail E-lending continue to have difficulties. Apparently,
very few people are willing to apply for a loan on-line, and FCs have not sufficiently
simplified the process. In addition, the FC’s target market is probably not inclined or
equipped to use on-line services.
d. Regulation
There is relatively little direct regulation of finance companies although recently efforts
have been made to standardize rules concerning subprime lending practices. Higher loan
loss reserves may be imposed on subprime lenders to offset the higher risk of these loan
types. Finance companies are subject to the major lending laws such as the Fair Credit
Trade Act and the Truth in Lending requirements, antidiscrimination legislation and
state usury laws where they exist. Finance companies are subject to market discipline
because their funding costs reflect the riskiness of the institutions. Thus, finance
companies have higher equity to asset ratios than many other regulated financial service
providers and many use letters of credit or other external guarantees to back their debts.
The captive finance companies also have implicit or explicit guarantees from their parent
firm.
The Dodd-Frank bill gives the Fed a greater ability to assist non-bank financial
institutions in the event of another crisis. The Financial Services Oversight Council is
charged with identifying systemic risks arising from any type of financial institution.
Teaching Tip: The American Financial Services Association is a trade organization of
consumer and small business lenders (primarily finance companies). Their website
contains some useful personal financial information that may interest students. The
information includes what to do if they become overextended and what bankruptcy
actually entails.
Teaching Tip: According to the American Financial Services Association’ (see website at
end), there were 1.6 million personal bankruptcy filings in 2004. Consumer lenders
complained for years that certain individuals were systematically abusing the bankruptcy
laws, overborrowing intentionally and then declaring bankruptcy. In April 2005,
President Bush signed the Bankruptcy Abuse Prevention and Consumer Protection
Act. For details see www.senate.gov, Bill S.256. The law had many subparts, but the
gist was a strengthening of the creditor’s ability to recover from the debtor in the event of
bankruptcy. The law made it more difficult to receive a Chapter 7 bankruptcy (complete
relief of all debts). The law changed the presumption of the need for relief to the
presumption of abuse of the bankruptcy provisions for individuals who have a monthly
income above a given calculated amount. In certain situations the burden of proof is on
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
6th Edition
the debtor to show that abuse has not occurred. The courts now have more discretion to
convert the Chapter 7 filing to a Chapter 11 (reorganizing the debts without complete
relief) or Chapter 13 (adjustments of debts of an individual with regular income). The law
also requires education for consumers filing bankruptcy. A second part of the law
amends the Truth in Lending Act to include increased consumer protections from
predatory lending practices, greater disclosure on minimum payments, introductory rates
and APRs, late payments and fees, and rules on Internet solicitations. Interestingly, the
law calls for a study of the effect of offering credit to dependent college students.
2. Global Issues
Savings institutions in other countries are usually more focused on channeling small
savers’ funds into local commercial projects rather than real estate. Most in Europe
remain mutually owned and may have public service and local economic development as
a goal (sometimes thrust upon them) rather than profitability. Finance companies (FCs)
abroad are generally subsidiaries of banks. These FCs usually obtain a large proportion
of their financing from the parent bank, and FC performance is strongly related to the
performance of the parent bank. The very large U.S. finance companies are making
inroads in international operations. Several finance companies often issue commercial
paper in overseas markets.
Nonbank financial institutions have grown in importance overseas. From 1994 to 2010
the percent of aggregate credit issued by nonblank FIs increased from 22% to 35% in
Latin America and from 4% to 15% in central Europe. Many foreign countries use their
postal system as a savings institution. There are about 30 postal savings systems around
the world with most of them in Europe. Japan has a very active postal savings system. A
postal savings system has a ready made target audience, particularly for small savers.
The financial crisis did affect overseas thrifts. There were failures, restructurings and
consolidations in places as far off as Russia and New Zealand.
1.1.1.1 VI. Web Links
http://www.federalreserve.gov/ Website of the Board of Governors of the Federal
Reserve
http://www.americanbanker.com The publication of the banker’s trade association.
http://www.fdic.gov/ The Federal Deposit Insurance Corporation’s
website. New regulations and current and historical
banking statistics are available on this site.
http://www.ncua.gov/ The National Credit Union Administration
http://www.wsj.com/ Website of the Wall Street Journal Interactive
edition. The web version of the well known
financial newspaper can be personalized to meet
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
6th Edition
your own needs. Instructors can also receive via
e-mail current events cases keyed to financial
market news complete with discussion questions.
http://www.afsaonline.org/ American Financial Services Association’ website:
The AFSA is the trade association for finance
companies, mortgage lenders and credit card
issuers. One of their goals is to promote consumer
awareness about the use of debt.
https://www.gecapitalbank.com/en.html General Electric website with links to GE
Capital
http://www.allyfinancial.com/ Ally Financial’s website
http://www.fordcredit.com/ Ford Motor Credit’s website
http://www.us.hsbc.com/ HSBC Finance website
http://www.cit.com/ CIT website
1.1.1.1.1.1 VII. Student Learning Activities
1. Find the number of savings associations, the largest savings institution, its
size, and the total assets of all savings institutions in your state. How do these
numbers compare to the banking industry in your state?
2. Investigate the banks’ claims that credit unions have an unfair advantage since
they are tax exempt. Are credit unions a serious threat to banks? Defend your
explanation.
3. Go to a local credit union and learn what types of loans and deposit services
are offered. Is the credit union actually offering favorable loan and deposit rates? If
not, why do you think they are not? Is a checking account at a credit union different
from a bank? How?
4. Why are more people declaring bankruptcy now than in the past? Does this
have an effect on those who do not declare bankruptcy? How does declaring
bankruptcy affect your ability to obtain credit in the future? You may wish to obtain
the pamphlet: Bankruptcy: Facts and Consequences from the American Financial
Services Association website.
5. Check rates around your locale and ascertain whether finance company auto
loan rates are below bank auto loan rates for new cars. Can you explain why or why
not?
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
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6. What is the online “Center for Debt Management?” What major services do
they provide? How much does a typical family spend on food and clothing per
month?
7. Go to www.jumpstart.org and take their jumpstart reality test. What kind of
job do you need to fit your projected lifestyle? How much money will you have to
make?
8. Go to GE Capital Corp’s website and search for job opportunities available for
those who are pursuing a bachelor’s degree with a major in finance. How many jobs
are currently available? In what areas?
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