Industry Overview—Finance Companies1
3.01 Finance companies provide lending and financing services to consumers (consumer financing) and to business entities (commercial financing). Many finance companies engage solely in consumer or commercial financing activities; others provide both types.
3.02 Manufacturers, retailers, wholesalers, and various other business entities may provide financing to encourage customers to buy their products and services. Such financing, generally known as captive finance activity, may be provided directly by those companies or through affiliated companies. Although most such companies originally financed only their own products and services, many have expanded their financing activities to include a wide variety of products and services sold by unaffiliated businesses.
3.03 Consumer finance activities comprise direct and indirect consumer loans, including auto, credit card, and mortgage loans and retail sales financing. Direct loan companies provide loans directly to the customers. Indirect lenders either purchase loans from retail establishments and other companies, or provide financing, typically secured by loans to the retailer’s customers, to retail establishments. Many companies that provide consumer financing also offer a variety of insurance services or other ancillary products to their borrowers.
3.04 Insurance and other ancillary products and services. Many companies engaged in consumer finance activities also offer insurance coverage to their customers. Such coverage may include life insurance to repay remaining loan balances if borrowers die; accident and health insurance to continue loan payments if borrowers become sick or disabled for an extended period of time; debt cancellation products to cover the remaining obligation on certain events covered in the contract; and property insurance to protect the values of loan collateral against damage, theft, or destruction. Some lenders may also sell extended service contracts, auto clubs, or other ancillary products or receive commissions for those products. Some lenders may provide insurance through subsidiaries. Others act as brokers and, if licensed, often receive commissions from independent insurers or third-party service providers. Lenders also may receive retrospective rate credits on group policies issued by independent insurers. In still other instances, policies may be written by independent insurance companies and then reinsured by the insurance subsidiaries of finance companies.
3.05 Commercial finance companies often provide a wide range of services, including factoring arrangements, revolving loans, installment and term loans, floor plan loans, portfolio purchase agreements, and lease financing to a variety of clients, including manufacturers, wholesalers, retailers, and service organizations. Many activities of commercial finance companies are called asset based financial services because of the lenders' reliance on collateral.
3.06 Commercial loans may be secured by various types of assets, including notes and accounts receivable; inventories; and property, plant, and equipment; or they may be unsecured.
3.07 Increased competition has come from both within the industry and from nontraditional players such as investment companies, brokers and dealers in securities, insurers, and financial subsidiaries of commercial entities. These entities now do business directly with potential customers of finance companies in transactions traditionally executed through finance companies. This disintermediation has increased the need for innovative approaches to attracting customers. It has also led to an increased need for more complex financing structures such as use of tax oriented vehicles, the ability to offer longer term financing than traditional banks, and a higher level of asset knowledge to take more aggressive residual positions and collateral risk.
3.08 The basic activity of finance companies is borrowing money at wholesale interest rates and lending at a markup. Strong credit ratings of the finance company foster the ability to attract wholesale funds at a competitive cost. Accordingly, in order to qualify for high credit ratings, it is common for finance companies to structure financing transactions according to predetermined rating agency credit criteria. A credit rating represents a measure of the general creditworthiness of an obligor with respect to a particular debt security or financial obligation, based on relevant risk factors. Historically, the credit ratings from rating agencies such as Standard & Poor's Rating Services, Moody's Investor Service, and Fitch Ratings have been used to differentiate an obligor’s credit quality.
3.09 Unlike most depository institutions, finance companies typically do not utilize low-cost customer deposits as a significant source of funding. Accordingly, access to a variety of funding sources is vital to market access, liquidity, and funding cost effectiveness. Typical short-term funding sources include commercial paper and bank credit facilities. Senior debt, senior subordinated debt, and junior subordinated debt are typical medium term to long term funding sources. It is common for these types of funding sources to contain restrictive covenants.
3.10 Securitization is often utilized by finance companies to expand and diversify their funding sources. In some markets, securitization has reduced entry barriers and increased competition. Securitization involves the sale, generally to a trust, of a portfolio of loan receivables. Asset-backed certificates are then sold by the trust to investors through a private placement or public offering. Typically, the finance company will retain the servicing rights for the loans sold to the trust. A subordinated interest in the trust is also typically retained by the finance company, serving as a credit enhancement to the asset-backed certificates. Such structures provide the opportunity for less credit worthy companies to obtain funding at competitive levels through the asset-backed and other structural characteristics of securitization vehicles.
3.11 The Risk Management Association, an organization of bank lending officers, has developed financial information questionnaires for lenders engaged in retail sales financing, direct cash lending, commercial financing, captive financing activities, and mortgage banking. Finance companies generally complete and submit the questionnaires to credit grantors as an integral part of the process of obtaining credit lines with commercial banks and other lenders. The information is used to analyze the quality of the operations and creditworthiness of finance companies. More information can be found at www.rmahq.org.
3.12 Publicly held finance companies are generally subject to requirements of federal securities laws, including the Securities Act of 1933, the Securities Exchange Act of 1934 (the 1934 Act), and the Sarbanes-Oxley Act of 2002. Companies whose securities are registered under the 1934 Act must comply with its reporting requirements through periodic filings with the SEC.
3.13 Numerous state and federal statutes affect finance companies' operations. Some statutes apply only to specific types of activities. Regulations affecting finance companies generally are limited to matters such as loan amounts, repayment terms, interest rates, collateral, compliance with state laws, and consumer loan product disclosure requirements; they generally do not address financial accounting and reporting. Certain of the more significant state and federal laws related to consumer lending are discussed in chapter 8, “Loans,” of this guide.
3.14 Lending and other activities of finance companies are also generally subject to oversight by the Consumer Financial Protection Bureau (CFPB). The CFPB was created by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act).
3.15 Securitizations. The Dodd-Frank Act requires changes to rules and regulations for securitization transactions. The Dodd-Frank Act also requires entities that sponsor products such as mortgage-backed securities to retain at least 5 percent of the credit risk, unless the underlying loans meet standards that reduce the risk. It also requires these sponsors to disclose more information about the underlying assets, including analysis of the quality of the underlying assets.
3.16 In January 2011, the SEC adopted new rules related to representations and warranties in asset-backed securities offerings, as outlined in Release No. 33-9175, Disclosure for Asset-Backed Securities Required by Section 943 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules require securitizers of asset-backed securities to disclose fulfilled and unfulfilled repurchase requests. The rules also require nationally recognized statistical rating organizations to include information regarding the representations, warranties and enforcement mechanisms available to investors in an asset-backed securities offering in any report accompanying a credit rating issued in connection with such offering, including a preliminary credit rating.2
3.17 Pursuant to Section 945 of the Dodd-Frank Act, the SEC issued Release No. 33-9176, Issuer Review of Assets in Offerings of Asset-Backed Securities, which requires any issuer registering the offer and sale of an asset-backed security to perform a review of the assets underlying the asset-backed security. In addition, the rule amended Regulation AB by requiring an asset-backed security issuer to disclose the nature, findings, and conclusion of its review of the assets.
3.18 Section 942(a) of the Dodd-Frank Act eliminated the automatic suspension of the duty to file under Section 15(d) of the 1934 Act for asset-backed securities issuers and granted the SEC the authority to issue rules providing for the suspension or termination of such duty. To implement Section 942(a), the SEC issued Release No. 34-65148, Suspension of the Duty to File Reports for Classes of Asset-Backed Securities Under Section 15(d) of the Securities Exchange Act of 1934, which establishes rules to provide certain thresholds for suspension of the reporting obligations for asset-backed securities issuers.
3.19 In October 2014, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the FDIC, the SEC, the Federal Housing Finance Agency, and the U.S. Department of Housing and Urban Development issued the joint final rule Credit Risk Retention to implement the credit risk retention requirements of Section 15G of the 1934 Act, as added by Section 941 of the Dodd-Frank Act. Section 15G generally requires the securitizer of asset-backed securities to retain not less than 5 percent of the credit risk of the assets collateralizing the asset-backed securities. Section 15G includes a variety of exemptions for these requirements, including an exemption for asset-backed securities that are collateralized exclusively by residential mortgages that qualify as qualified residential mortgages. The final rule became effective February 23, 2015.
3.20 In connection with making amendments to its "safe harbor" rule that were necessary due to the implementation of FASB Statement No. 166, Accounting for Transfers of Financial Assets, an amendment of FASB Statement No. 140 (codified in FASB Accounting Standards Codification [ASC] 860, Transfers and Servicing), and FASB Statement No. 167, Amendments to FASB Interpretation No. 46(R) (codified in FASB ASC 810, Consolidation), the FDIC included a condition to qualify for the safe harbor that, among other conditions, sponsors must retain an economic interest of no less than 5 percent of the credit risk of the financial assets underlying a securitization until the joint interagency regulations that are required to be adopted under the Dodd-Frank Act become effective. The sponsor is not permitted to hedge the credit risk of the retained interest but may hedge certain other risks (such as interest rate and currency). Other conditions are also necessary to qualify for the safe harbor. The rule grandfathers the previous safe harbor rule for transfers of financial assets on or prior to December 31, 2010. For further information on the FDIC's safe harbor rule, readers are encouraged to access the September 27, 2010, board minutes from the “FDIC Board Meetings” page on the FDIC website.