Answers – Project 3 – GBG 333 – Fall 2004

(1a) From 1990 to 1996, the total value of receivables owned or securitized by finance companies increased more than 50 percent, to $771 billion. Business receivables are about 44% of this total, or $341 billion. Business share of finance company activity increased from 19 percent in 1985 to about 25 percent by 1990.

(1b) The slowdown in the 1990s in the use of business receivables financing by small business was due to a number of factors. First, the finance companies saw better opportunities in consumer products such as credit cards and “subprime” (higher risk lending). Second, the favorable economic conditions during the early 1990s boosted the demand for financial services by small businesses at commercial banks for credit lines, loans, and leases. About 41 percent of small business obtained these services from commercial banks and thrift institutions, but only 19 percent turned to finance companies and other non-depository lenders. Strengthening balance sheets of small business may have encouraged banks to ease credit standards for their business customers during this time. Third, many small business owners turned to credit cards for business financing. Fourth, disclosure rules for commercial banks covered by the 1995 revisions to the Community Reinvestment Act of 1977 encouraged the banks to seek out opportunities for lending to small business.

(1c) The wholesale category of the motor vehicle finance sector consists of inventory or “floor plan” financing for automobile and truck dealers, provided chiefly by the finance subsidiaries of the car and truck manufacturers. A major change from 1990 to 1996 was the practice of securitizing wholesale receivables by the finance companies. The finance companies issue asset-backed securities with the wholesale receivables as collateral to the public to raise funds to finance the loan advances to the dealers. Such asset-backed securities carry a high credit rating, which allows the issuing firm to acquire funds at a lower cost than a bank loan or bond offering. Finance companies also took advantage of continuing strong investor demand for asset-backed securities to securitize this loan growth, thereby restraining the growth of assets carried on their balance sheets and thus minimizing the need for direct financing.

(1d) In 1985, the revisions to the federal tax code phased out the deductibility of interest payments on consumer loans and thus boosted the relative appeal to consumers of leases for financing the acquisition of cars and light trucks. Promotion of leases expanded the leases outstanding at finance companies from $22 billion to $94 billion during the early 1990s. The commercial banks had previously been the largest supplier of motor vehicle financing, but in essence the finance companies for the auto industry “captured’ the growth of the lease business as an in house operation that previously would have been handled by the banks. Finance companies accommodated this growth by securitizing loan growth, which had a ready market due to strong investor demand.

(2a) Medium term notes (MTNs) noncallable, unsecured, senior debt securities with fixed coupon rates and investment-grade credit ratings, of terms to maturity between nine months and 10 years. A corporation files a shelf registration with the Securities and Exchange Commission (SEC), after which a prospectus is filed which describes the MTN program. The amount of debt ranges between $100 million and $1 billion. The corporation's agents sell the issue, and post offering rates over a range of maturities. MTNs look and feel like a corporate bond. However, MTNs differ from bonds in their primary distribution process. MTNs are sold on a "best effort" basis and sales agents have no obligation to the issuer to guarantee funds. This can be a disadvantage of MTNs. However, relative growth of the MTN market is a tribute to the advantages MTNs have over bonds. Bonds do have economies of scale, and lower issuing costs, in terms of very large issues. For smaller scale issues, MTNs offer a number of advantages. First, financing costs can be lower for MTNs as the issuer can price discriminate, and is able to sell the notes at varying interest rates whereas the bond issuer has only one price. Second, MTNs are more flexible since shelf registration allows the issuer to issue the amount of bonds it actually needs for periodic finance requirements. Third, this also allows the issuer to average out the cost of the notes over time. Bonds are issued in only one block. Fourth, the MTN market is also discreet, since the issuer, investor, and agent are the only market participants that need to know about the transaction. Fifth, the MTN market can also respond to the requests by the investment community for securities of a specific maturity, called a “reverse inquiry”. An MTN issuer can design a security for an investor if it meets the objectives of both parties, as interest rates can be tied to floating rates, based on equity or commodity prices. MTNs arose in the 1980s as the General Motors Acceptance Corporation (GMAC) desired a security as an extension of the commercial paper market, which is restricted to a term limit of 270 days. The MTN provided the opportunity for GMAC to match funding terms and maturities of their loan portfolio to sources of financing. The high underwriting costs of bonds, and rigidity of fixed terms and maturities, made MTNs look extremely attractive. Two institutional changes set the stage for rapid MTN growth, which allowed the auto finance companies to find a ready market for MTNs. First, investment banks were committed to providing secondary market liquidity for the medium term market. Since these banks were prepared to add MTNs to their portfolios, this improved the receptiveness of MTNs to the investment community at large. Second, the adoption by the SEC of Rule 415 in 1982 allowed for the “shelf registration” of corporate securities. Issuers after this date could take up to two years to sell registered securities, without having to return to the SEC if not all securities were sold immediately.

(2b) Maturities on MTNs reflect the financing needs of the borrowers. Financial firms tend to issue MTNs with maturities matched to the maturity of loans made to their customers. Thus, for the financial sector, maturities are concentrated in the range of one to five years. Nonfinancial firms often use MTNs to finance long-lived assets such as plant and equipment. As a result, maturities on MTNs issued by nonfinancial firms cover a wider range, and some 25% to 30% were even longer than 10 years.

(2c) MTNs have caused a reduction in the use of commercial paper and bank loans by finance companies. MTNs have enabled finance companies to match funding requirements and terms of their loan portfolio to the issuance of MTNs of similar amounts and terms. It is a flexible approach that avoids the need for direct financing that would appear on the company’s balance sheet. In effect, the use of MTNs is a form of off-balance sheet financing that is customized to the needs of its lending portfolio. Finance companies doubled their use of MTNs during the early 1990s.

(3a) Factoring is the sale of accounts receivable by a company at a discounted amount to another firm (a factor) who collects the full amount from the credit customer. The advantages of factoring over alternative forms of short-term financing include improved cash flow, reduced credit risk, opportunity cost savings, and an improved balance sheet. Improved cash flow results from an immediate influx of cash, rather than the carrying of an account receivable, which also involves the commitment of working capital. With factoring, the company transfers credit risk to the factor. Third, the company no longer needs to devote resources to a credit and collections department that can be re-deployed to other functions the company does best (opportunity cost argument). Fourth, a large factoring company may be more efficient at credit and collections than a small company that cannot afford such specialized expertise. There is an immediate effect on the balance sheet of the company as liquidity is improved, and the company can qualify for better credit terms. The disadvantages of factoring outlined in the article refer to the cost of factoring to the company. Greater sales volume and invoice size enjoy better terms from a factor. Longevity of the relationship with the factor will reduce costs. The faster that accounts receivable are turned over will also result in a lower cost. The dilution rate (uncollectible accounts) and concentration rate of uncollectible accounts among a few large customers will also drive up factor costs. The article also discusses another potential drawback of factoring. There is the perception (incorrect) that companies in financial trouble only utilize factoring. Other disadvantages not mentioned in the article might include the following. First, if the company has a low margin business, there may not be room to use factoring. Second, if the company is new, and in a new business line, there may be no record of success in collections, and factoring costs may be too high, considering unknown collection risk. Third, the collection practices of the factor could alienate the firm's credit customers if too heavy-handed.

(3b) The balance sheet advantages of factoring the Weisel cites are as follows. In comparison to a loan to finance accounts receivable, which creates a liability, factoring converts accounts receivable directly into cash. The current and quick ratios are relatively unaffected, but the cash position and flow of the firm is enhanced. It will be easier for the firm with better cash flow to maintain minimum cash balances as required by loan covenants. Asset-based and cash-flow based loans have the disadvantage that they add dollars to both current assets and current liabilities, actually worsening current and quick ratios over 1.

(3c) Small business bankers are often in a bind to help healthy small businesses when they face a cash crunch. Bank loans and lines of credit are often issued on the basis of cash flow. Small businesses may have healthy sales, but a few large customers may be slow to pay. So the small business may not have the cash flow to qualify for bridge type financing from the bank. The Faber article states that many of the banks are referring their small business customers to factors who are able to convert accounts receivable into cash flow. This maintains the viability of the small company as a customer of the bank for other services, such as a depository relationship.

(4a) LIBOR is the London Interbank Offered Rate, the interest rate set on US dollar denominated deposits in the “Eurodollar” market. The Eurodollar market started in London in the 1970s as a place where excess dollars could be lent outside of the United States. At that time, there were interest rate ceilings on most deposit accounts in the US, and large quantities of US dollars circulating outside of the US, in large part due to the increase in oil prices during the 1970s.

(4b) Some of the shift toward LIBOR reflects the globalization of finance and the fact that American and foreign banks compete for the same clientele of multinational clients. Lenders thus have decided to adopt LIBOR as a mortgage loan index (Adjustable Rate Mortgages (ARMs)), since it is a more responsive measure of their funding costs. This recognizes that funding costs are now dictated by world credit conditions, rather than just credit conditions in the US. Also, the US Treasury no longer issues some short term securities, such as one-year T bills, that have been used as short term benchmarks in the past.