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Copyright © 2004 by Thomson Southwestern All rights reserved.

19-1

Managing Diversified Financial Services Firms

Corporate Governance and Merger and International

ConsiderationsChapter 19


19-2

Finance Companies

Various types• General purpose versus special function• Diversified versus specialized purpose

Different from banks• Do make loans• Do not accept deposits

Sources of funding• Parent company• Issuance of debt• Borrowing from financial institutions• Equity


19-3Consumer and Captive

(Sales) Finance Companies

Captive (sales) finance companies• Increase sales by financing products of a

specific company• Support durable goods sales

Consumer finance companies• Finance all types of transactions

Both make personal loans which are• Secured• Unsecured


19-4

Industrial Loan Companies

Created by non-financial corporations• To allow them to engage in banking activities• To accept deposits via Certificates of

Investment• To provide consumer loans

Activities restricted• Can’t provide credit cards, sales financing,

etc.• Now prohibited by law in most states


19-5

Commercial Finance Companies

Activities• Business loans• Equipment leasing• Asset-based loans• Factoring

Can be• Independent• Captive• Subsidiary of a larger financial services firm


19-6

Diversified Finance Companies

Activities• Consumer loans• Business loans

Can be• Independent• Captive• Subsidiary of a larger financial services firm

Largest include GE Capital Corporation, Ford Motor Credit Company, Household International, MBNA Corporation, SLM Corporation


19-7

Credit Card Companies

Issue standard credit cards• Businesses• Individuals

Issue specialty or “affinity” credit cardsPurchase and sell consumer loans


19-8Government- Sponsored

Enterprises and Mortgage Banks

Activities• Originate loans• Sell or securitize loans• Service loans

Include• Federal Home Loan Mortgage Association (Freddie Mac)• Federal national Mortgage Corporation (Fannie Mae)• Government National Mortgage Association (Ginnie Mae)• Student Loan Marketing Association (Sallie Mae)• Universal Lending• Countrywide Credit


19-9

Finance Company Industry

Heavily concentratedSecuritization provides liquidityGlobalizationRisks are

• Concentrated• Highly liquid• Transmitted rapidly• Transmitted more broadly


19-10

Sources of Funding

(Ranked in descending order of importance)

BondsOther sourcesCommercial paperDebt due to parent corporation (if a captive)EquityBank loans


19-11

Other Characteristics

Consolidation is continuingInnovations

• New products and services• New business lines of activity (via acquisition)

Profitability is volatileProblems with Subprime Predatory Lending


19-12

Financial Analysis for Finance Companies

Financial statements similar to banksMost assets are loans (receivables)Many assets are interest-sensitiveMost funding is debt (~89%)Income comes from

• Spread or Net Interest Margin (NIM)• Fees

Special liquidity ratios used


19-13

Finance Company Regulations

Primarily regulated at the state level

Must conform to all federal regulations• Truth in Lending Act• Equal Credit Opportunity Act• Uniform Commercial Credit code


19-14

Diversified Financial Firms

Financial Holding Companies (FHCs)Financial services

• Deposit• Credit• Investment• Insurance• Risk management

Largest firms are• Diversified across all areas• Global in scope of operations


19-15Citigroup – An Example of a Diversified Financial Holding

Company

Scope• $1.3 trillion in assets• 275,000 employees in 100 countries

Operating groups1) Global consumer group2) Global corporate & investment banking group3) Global investment management group4) Private client services group (Smith Barney)


19-16

Why FHCs Developed

1. Gain diversified income by type and source

2. Gain greater debt capacity & lower cost of funds

3. Gain economies of scale and scope

4. Diversify away from maturing industries into new and emerging profitable areas

5. Reduce unemployment risk of managers

6. Achieve improved efficiencies


19-17

Practical Reasons for the Development of FHCs

Easy to enterFinancial services are homogeneousNew financial services appear profitable

while others become less soTechnology costs can be spread over diverse

ProductsSynergy – economies of scope


19-18

Trends in Financial Service conglomerates

Conglomerate Waves• Nonfinancial firms• Financial firms• Some successful, some not

Experiences• Sears• General Electric Financial Services, inc.• Merrill Lynch & Company• Prudential Insurance Company of America


19-19

Managerial Implication of Diversified Financial Services

FirmsSynergies easier to promise than to achieveIntegration is

• Essential• Difficult, time-consuming, and expensive

Diseconomies of scale may come with economies of scope

Expected consumer behavior uncertain


19-20

Rationale for Financial Megaplayers in the 21st

Centurya) Technology

• Allows global management• Supports large, low-cost delivery systems

b) Improved efficiency with scale and scopec) Opening new markets and geographic

regionsd) New fee-income productse) Better cost-benefit balance f) Reduced costs with consolidationsg) Sharing of knowledge across institution


19-21

Evaluating Business Lines Using RAROC: Citigroup’s

ApproachMakes business entry & exit decisions based

on a risk-adjusted return on capital (RAROC) approach

Uses VAR to calculate capital required to cover unexpected economic losses • In both

◦ New income◦ Value of equity

• Due to unusual events over a given time period


19-22

Citigroup Approach (continued)

Risk capital to cover losses include• Credit Risk• Market Risk• Operational Risk• Insurance Risk• Cross-sector Diversification

Estimated RAROC compared to cost of capital to make business line decisions


19-23

Some Merger Considerations for Financial Services Firms

Regulatory considerations

Market concentration via acquisition

• Herfindahl-Hirschman Index (HHI)

• Applicability to regional or national firms

• Applicability to firms with competition from other types of financial and nonfinancial firms


19-24Pricing and earnings dilution with financial institution mergers

Pricing benchmarks include:• market-to-book ratio• P/E ratio.

The premium percentage paid over book value is given by

[Market price/Book value] - 1


19-25

In a stock swap, the exchange ratio is given by

EPS dilution is given by

Market Price per Share of the Target

Market Price per Share of the Acquirer

EPS of Acquirer - EPS with Consolidation

EPS of Acquirer


19-26

Assume a target has earnings of $500,000, the typical P/E ratio for similar targets is 3, the target’s book value of equity is $750,000 and the typical market-to-book ratio is 2.

The starting valuation for the target using the P/E ratio would be

3 × $500,000 = $1,500,000 The starting valuation for the target using the

Market-to-Book would be

2 × $750,000 = $1,500,000


19-27

The premium paid would be:

($1,500,000 ÷ $750,000) - 1 = 1 or 100%

The higher the premium paid, the more difficult it will be for the acquirer to earn a return on the investment to justify the purchase price and the risk involved with the acquisition.

If the target has 100,000 shares outstanding, its market price per share would be $15. Assuming the acquirer has a market price per share of $15, the exchange ratio in a stock swap would be 1.


19-28

If the acquirer has an expected EPS of $10 and the expected EPS with the consolidation is $8, the earnings dilution would be

($10 -$8) ÷ $10 = .20 or 20%

EPS dilution should not be greater than 5% to get a reasonable return on the acquisition.


19-29

Other Considerations

Purchase accounting required for mergersQualitative considerations

• Reputation• Service efficiency• Convenience• Personal relationships• Credit-worthiness• Specialized expertise• Distribution & trading activity• Marketing ability


19-30

International Business Issues

Factors to consider• Cultural differences• Country risk• Translation risk• Transaction risk• Sovereign risk• Economic risks• Operational and tax risks• Currency exchange & transfer restrictions


19-31

Special Bank International Lending Considerations

Indirect• Loan participations

Direct• International Banking Facilities (IBFs)• Edge Act subsidiaries• Shell branches• Bank Export Services Act of 1982

To control future risk• International Lending Supervision Act ( ILSA)


19-32

Risk Management Considerations for International Loans

Sovereign Risk• Country risk must be estimated◦ Moody’s◦ Standard & Poor◦ Internal assessment group

• Debt priced to cover expected losses due to risk

For loans to a foreign country• Debt Service RatioInterest + Debt Amortization

Exports


19-33

Regulation of Foreign Banks in the United States

International Banking Act (IBA) of 1978

International Banking Facilities (IBFs)

Foreign Bank Supervision Enhancement Act

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