Short Term Notes and Deposits

One of the least known investment banker investments as far as the general public is concerned is the deposit in a finance company or a short-term note of a finance company. In light of the lack of general knowledge of finance company notes and deposits it is surprising that there is the large volume of such obligations outstanding.

Two major types of finance companies are (1) consumer finance companies and (2) sales finance companies. The former for the most part make small loans and the latter finance retail sales made on the installment plan, such as automo­bile and refrigerator time sales.

In the early part of 1961 one investment banker finance company was advertising regularly in the Wall Street Journal. It called its offering to the public "Thrift Notes." The prospective investor could write in to the head office of the company and secure a financial statement on the company together with an application blank to fill in and return to the company together with his check to purchase thrift notes. Any sum of $100 or more could be invested.

The company, upon receipt of the check, made out a thrift note, which resem­bles a bond or share of stock. This note is returned to the investor as evidence of the $100 invested. It stated that the thrift note was for a term of six months and the interest rate was 6% per annum. At the end of six months the company repaid the $100 with interest for one-half year—$3.00.

If the depositor chose to leave his money in, the company would keep both principal and interest. At the end of the next six months, his 3% interest was based on $103—his original investment plus the $3 earned for the first six months.

If the investor wanted to get his money out after one month and did not want to leave it in for the entire six months he could do this, and he would receive one month's worth of interest—one-half of 1%—$.50. In this respect as far as the investment banker is concerned, the deposit or thrift note is very much the same as the deposit in a building and loan association, which has the option of holding funds for a period of time if it is not convenient to permit withdrawals. But, whereas the thrift notes of this finance company were issued for a period of six months and withdrawals on demand might be permitted, the building and loan association deposits are demand investments with the option on the part of the association to hold up repayment for a period of time.

Another difference is that the thrift notes are a fixed obligation of the finance company to pay both interest and principal, and that if either one is defaulted on, bankruptcy can follow. Deposits in building and loan associations are really the purchase of shares in the association. The association has no obligation to pay a fixed rate of interest. In fact it is not interest at all but a dividend, and it can be changed any time by the board of directors of the association. This change is made from time to time by the board, either up or down.

Although it would seem obvious, the point should be mentioned here that the federal building and loan associations are government insured up to $10,000 per account, while the finance companies are not.

The building and loan associations return 4% to 4.6% per year while the particu­lar thrift note offered paid 6%. Obviously 6% is better than 4½% provided the safety factor is high. On $10,000 the building and loan association returns yearly $450 and the finance company $600. The difference ($140) is about one-third of the building and loan annual rate.

Before any deposits are placed with an investment banker finance company it is necessary to ex­amine the company. In your letter of inquiry on the thrift notes, it is necessary to ask for two things: (1) a financial statement showing the current position of the company and indicating the company's earnings for the past three or five years, and (2) the banks from which the finance company borrows.

As soon as the reply containing this information is received, the banks must be written to, or preferably visited, in order to find out the soundness and the reputability of the finance company. In addition, your local bank should be re­quested to secure a Dun and Bradstreet report on the finance company. The bank may charge you $3.00 or some similar amount to get this report for you to re­view, but it will be $3.00 well spent.

You will then have to review the financial statements sent to you by the com­pany. For an example we can take the actual financial statement of the company offering the thrift notes through the Wall Street Journal.

The total assets of this company as of March 31,1961 were close to $6,000,000, so that the company is by no means small or unsubstantial. A finance company is in the business of financing, not of investing in elaborate offices or owning land or any other relatively fixed assets. Out of the total assets of $5,738,000, the amount in current assets—cash and the receivables in which the company deals-was $5,514,000. This current total represented very nearly all the assets of the company. The rest of the assets were only $224,000. In this total was $93,353 representing "goodwill and other intangible assets." This sum would have to be subtracted from the total to arrive at true tangible assets, but in relation to total assets it is very small.

Since a finance company exists through its ability to borrow funds at a par­ticular rate and lend them at a higher rate, it is necessary to see the borrowings against the $5,514,000 of current assets. These current assets consist primarily of the company's receivables.

The total borrowings were $3,377,000. These borrowings are known as current liabilities. In the normal or average business a 2 to 1 ratio of current assets to current liabilities is considered adequate. The current ratio of this finance com­pany is less than 2 to 1. It is explained by the fact that the company has only $300,000 of long-term debts and relies almost 100% on current borrowings.

A composite balance sheet of American finance companies does show a current ratio of 2 to 1, but when long-term debt is added to these current liabilities the ratio of current assets to total debt becomes 1.17 to 1. What this particular com­pany owns in relation to what it owes is thus satisfactory.

The protection that the purchaser of the thrift notes has is the net worth of the company—the capital stock and surplus. This is the cushion that protects him against losses, and if the company gets into financial trouble all of the net worth must be lost before the thrift notes and other debt obligations are impaired.

In this particular company, net worth is $1,253,934. This net worth represents 32% of all of the liabilities of the company, both long term and short term. For the composite of the major sales finance companies net worth represents 17½% of all liabilities of the companies. This particular company is thus in an extremely favorable position in comparison with other companies in its field.

The direction in which the company is moving profit-wise is of great impor­tance, and for this reason it is advisable to ask any company offering notes for sale to submit profit figures for three or five years. The company offering the thrift notes for sale submitted profit and other financial figures for four years and a final figure for March 31, 1961, so the prospective investor is brought up to date. The profit picture of any company might change in six months.

The figures show that the company had a steady growth in profits from 1957 to 1961. In addition surplus grew steadily. This means that not all of the earnings for the period were paid out to the stockholders in dividends or went to the management in the form of high salaries and big expense accounts. The trend is thus favorable.

Conceivably a company can have so much success in selling these thrift notes or other short term obligations that it might be reluctant to stop selling at the right time. If the particular company with $1,254,000 net worth sold $10,000,000 of these notes, the net worth of the company would be less than 10% of the total obligations of the company. If losses amounted to 10% of the total portfolio of loans held by the company the entire capital of the company would be lost and the notes would be impaired. The investor should consequently from time to time get financial statements from the company to bring him up to date on exactly where the company stands.

In total, there was outstanding probably between $150,000,000 and $200,000,000 of these short term notes of finance companies in 1961.

From the composite balance sheets of sales and consumer finance companies it seems fair to conclude that there are hundreds of companies offering these notes to the public.

There is little real difference between these notes and what is known as com­mercial paper offered for sale by the largest finance companies. These largest companies offering short-term obligations known as commercial paper are:

General Motors Acceptance Corporation CIT Financial Corporation

• Commercial Credit Company
• Associates Investment Company
• General Electric Credit Corporation

In late years other large finance companies have turned to direct placement to the public of commercial paper:

International Harvester Credit Corporation Sears Roebuck Acceptance Corporation Pacific Finance Corporation General Finance Corporation
It is expected that at the present time (1962 - the astute investment banker will see this in perspective) this directly placed paper by these companies totals over $3,000,000,000.

Several distinctions are made between this commercial paper and the thrift notes previously described:

1. Commercial paper is offered by the very largest, soundest companies in American industry. These finance companies are at least as sound as the largest manufacturers in the country, and in poor times they tend to fare better than manufacturers.



2. The offerings are generally in large amounts and are placed with pension funds, trust funds and manufacturing and commercial corporations who want some interest on their working capital while they are waiting to invest it else­ where. The offerings are sometimes taken up by estates and wealthy individuals.



3. The commercial paper rate is very low, often under 3% per annum.  It is low because it reflects the high quality of the paper and the low degree of risk, but this rate is not of much interest to the small investor.



4. There is a very active market in commercial paper. The market for thrift notes of the smaller companies is thin or nonexistent, but the market does not mean much where maturities are under a year. If you want your money you don't have to wait long before it is due and payable by the company.

A few years ago a tabulation was made of where the five largest sales finance companies obtained funds. Over 50% came from commercial paper and just a little over 40% came from bank loans.

The five largest consumer investment banker finance companies got 10% of their funds from commercial paper, the five medium sized sales finance companies got 9% of their funds from this source, and the comparable percentage for the 20 smaller sales finance companies was 6%. The 15 smaller consumer finance companies secured 4.5% from commercial paper.

The market in this paper is well developed by the largest companies and the rates are low. The smaller investor must look to the smaller companies in which to invest his funds. Conversely the smaller companies should begin turning to this source of funds, because for the past five years the smaller companies have experienced the greatest amount of trouble in securing bank loans, even the soundest of the smaller companies. The banks have been loaned up; they have been starting their own small loan and sales finance departments, and they will often not even look at the financial statements of finance companies, which apply for loans.

It is expected that short-term finance company loans will be offered to the public more in the future and because such loans and deposits haven't been much employed by finance companies to secure funds, these companies are not in general overextended in this type obligation.

Almost every finance company borrows from banks. If a finance company cannot borrow it cannot earn a satisfactory rate of return; there is something wrong with a finance company that does not borrow. It is thus unlike other industries, in which a lack of borrowing might be construed as conservatism.

The best kind of thrift note or short-term loan is one that is coordinate with bank lines. That is, the short term note or loan is of rank equal to bank lines. If it is subordinate to bank loans and the finance company runs into difficulties the banks are paid off first, after which the holders of the subordinated notes are paid, provided there is something left with which to pay. If you, the note holder, feel that the company in which you have invested is in trouble you can get out by not reinvesting when your note comes due in six months or whatever period it is written for. If you have a demand note you can demand payment right away. You might get ahead of the banks. At least the banks cannot be preferred over you.

If the investment banker finance company is very sound and has a large net worth in relation to debts a subordinated note may not be a bad risk, since all of the capital has to be lost before you lose your money. It must be remembered, however, that the banks have the right to be paid off before you are paid off.

The question comes to mind as to why short-term notes of finance companies are stressed in this chapter rather than short-term notes of manufacturers and mercantile establishments. The answer lies, to a great extent, in the liquidity of a finance company. Every month the finance company receives not only interest on its money but a substantial return of its capital. The person who buys a car and finances it over three years makes monthly payments which include not only interest on the money but a portion of the principal as well, so that over the three year period the entire sum of money lent by the finance company to the purchaser of the car is repaid in full.

The fact that the principal is repaid in installments along with interest means that if hard times came to the country or to a particular section of the American economy a finance company could stop lending and simply collect its outstanding loans. Every finance company is proud to point to its "liquidation figure." It states, for instance, that its average loan is for 35 months or 28 months, or what­ever it is, meaning that if it made no more new loans it would be able to turn its average investment into cash through repayment by its borrowers in 35 or 28 months.

The previously mentioned company offering the thrift notes has a liquidation period of about 35 months. In that period of time the company could collect in cash probably 90% of its assets. Its fixed assets in total amount to only $30,000 out of $5,738,000, and these assets consist of furniture and fixtures and auto­mobiles used in the business.

Now in contrast, a manufacturing plant has a very major portion of its assets in buildings, machinery and other equipment. The more specialized the build­ings and machinery the less liquid are these assets. Then too, if a manufacturing company falls on hard times it will sell its fixed assets only as a last resort, because without them it is out of business. A finance company can liquidate to a great extent, or even wholly, in poor times and go back in business when good times return. A finance company can always go into the market and buy receivables on which to get started in business again.

Although finance companies have certainly had bad experiences and some have failed, failure is not the rule in this business. Diversification of the loans of any finance company is, however, a "must." "One-paper" companies, where all the paper is appliance paper, auto paper, or mobile home paper create a question mark as to their soundness from the point of view of the investor. A company in Yonkers, N.Y. that held a great deal of receivables covering the retail sale of foreign sewing machines ran into trouble as did a finance company in the southeast and one in Oklahoma which specialized in mobile home receivables. Another finance company which specialized in the finance of jukeboxes ran into similar trouble and lost literally millions of dollars.

As a categorical statement there are few investments better than in a well-run diversified finance company.

To a great extent finance company notes and deposits are offered only to the residents of a particular state. If a finance company is located in New York it usually allows only residents of the state of New York to buy its notes. If the offering is to be made in states other than the finance company's home state, a full SEC registration is usually required, and this is a costly and long drawn out process. If the offering is within the company's home state the SEC usually does not interfere, and it is up to the state Finance Commission or other regulatory body to see that the offering is truthful, in good faith and not unsound from the point of view of the investor. The Finance Commission may do its job well, or it may do little or no job at all. Not all states permit such notes to be sold. Some prohibit their issuance entirely.

The rates obtainable vary. The giant companies offer rates of under 3%. The smaller companies offer rates of up to 6% and sometimes higher. Some of the companies offering such obligations to the public are:*

* The National Consumer Finance Association, 1000 Sixteenth Street, N. W., Washing­ton, D. C, can supply you with the name of the head of the finance association in your state. This official can tell you what finance companies in your state, if any, offer notes for sale to the public.

Ithaca Loan and Finance Co., 127 West State, Ithaca, N.Y.—6%two to ten-year subordinated notes, but the company states they will be redeemed on demand with interest four times per year, and upon withdrawal interest is paid to day of withdrawal.

Thorp Finance Corporation, Thorp, Wis.—5% 20-year subordinated notes, but the company states it is a practice to repurchase the notes on demand with interest twice a year.

Welfare Finance Corporation, 616 Walnut Street, Cincinnati, Ohio, offers the following notes equal in status to bank loans:

6 months payable on 90 days' notice	4¼%
12 months payable on 90 days' notice	4½%
18 months payable on 90 days' notice	5½%

This company also offers long term-subordinated notes:

10 years	5½%
15 years	6%

Capital Finance Corporation, 42 East Gay Street, Columbus, Ohio, offers a one-year subordinated note carrying an interest rate of 4% and a ten-year note at 5%. Interest is paid annually on the 4% note and semiannually on the 5% note.

Economy Savings and Loan Co., Capital's subsidiary, issues deposit certificates on which 4% interest is paid. If deposits are left in for a year 4½% is paid.

Community Credit Company, 3023 Farnam Street, Omaha, Nebraska, pays 4% on 120-day notes equal in status to bank loans and higher rates on five to ten-year junior subordinated notes.

The Central Pacific Bank, 50 North King Street, Honolulu, Hawaii, reports the following finance company debenture rates in effect in Hawaii:

Installment payments	4½% per year
1 year debentures	5%
5 year debentures	6%

Certified Credit Corporation, 30 East Town Street, Columbus, Ohio, issues a ten-year, 5% subordinated thrift plan certificate with interest compounded semi­annually. These certificates are sold to buyers only in Ohio and in the past the company has repurchased some certificates before the ten-year maturity.

People's Finance Service, Inc., 910 Bank of Lansing Building, Lansing, Mich­igan, sells 5%, 90-day, six months or a year notes, not subordinated to bank loans and available to buyers in any state.

The smaller investment banker finance companies are often financed by larger finance companies, and it is often the policy of these larger "refinance" companies to ask the smaller company to assign to the refinance companies their receivables. Thus, if the smaller company lends a prospective auto purchaser $3,000 to buy his car, it secures from the purchaser a signed conditional sales contract for $3,000. The buyer agrees to pay the finance company $3,000 plus interest over, say, three years. The finance company then sends to the refinance company this sales con­tract and is lent by that company perhaps $2,700, a part of the money the smaller company advanced for the purchase.

The refinance company makes a substantial charge to the smaller finance company for this money and keeps the conditional sales contract as security or collateral. If the smaller company falls down on its interest payments to the larger company, the latter company can collect directly from the car purchaser. It thus protects itself by making this type loan, which is known as a collateral loan, the conditional sales contract on the car being the collateral.

Even if a finance company in your city does not offer for sale thrift notes or short term notes it is possible for you as an individual to lend on a short-term basis to such a company by approaching it directly. The other day I was talking on the phone to a firm in Richmond, Va., LeWood Homes, manufacturers of pre-cut or factory built homes. These homes the company erects on land owned by the purchaser. Generally LeWood erects only the shell and the purchaser puts in electricity and plumbing and the interior walls.

This construction company has its own finance company and the latter sells its conditional sales contracts to larger finance companies. I asked whether the finance company would be interested in selling these contracts direct to private investors, and the reply was that it would. The investor would thus hold the conditional sales contract on the home and have the guarantee of the finance company plus the guarantee of the construction company. This is a form of lending to a finance company with guarantees and collateral.

Any finance company in which you invest should be checked out carefully to make sure it is sound. It should certainly have been in business for three and better still, five years, and its portfolio should be at least $250,000 and its net worth over $100,000, although these are certainly arbitrary figures. The per­sonnel of the company should be checked out thoroughly at the banks from which the company borrows, and a Dun and Bradstreet report should be secured.

Major cities are filled with little, unethical finance companies, and in a city like New York a finance company would have to be triple checked before in­vesting one dollar.

It is possible to make a loan to a finance company at quite substantial rates— 8%, 10% or even 12%. For years I have had funds invested in the demand note of a finance company at 12% per annum, interest paid monthly. So has my aunt, my wife's aunt and two of my closest friends. I would not permit such investments, much less make them myself, if there were not a reasonable degree of safety.

Possibly I should require that the company give me collateral. If you are not intimately familiar with the company, collateral might be required. This col­lateral should be checked out by your lawyer, or your banker or both, and by lawyers and bankers familiar with time sales and consumer finance. You must make sure that the collateral really exists and is worth what it is supposed to be worth; and you must keep track of payments on the collateral as time goes on. Otherwise at the end of three years you may find that you have $10,000 worth of automobile conditional sales contracts all of which have been paid off to the finance company, so that all you have left are pieces of paper.

This all sounds like a lot of work, but $100,000 invested in the building and loan association returns $4,000 per year, and this finance company loan of a similar amount returns $12,000. My family cannot live on $4,000 per year but they can on $12,000. The extra $8,000 is thus worth considerable trouble and pains on my part to make a sound loan in the first place and to keep on checking the company periodically—at least once every two months.

During the decade of the 1950's there was an enormous expansion of retail finance companies and retail finance departments of banks. In 1955 the consumer installment credit outstanding was $29,000,000,000. In 1960 the total was $43,300,000,000.

Out of this total commercial banks had $10,600,000,000 in 1955 and $16,-400,000,000 in 1960.

Out of the same total sales finance companies had $8,400,000,000 outstanding in 1955 and $11,100,000,000 in 1960.

It is obviously much sounder for a person or institution to lend to a finance company than to buy paper direct from the ultimate customer because in order to lose, both the customer and the finance company have to default. The finance company, however, has to have a return, so it must offer people lending to it less than these people can get if they lent directly to the customer and by-passed the finance company.

Thus I get a lower rate of return by lending to an investment banker finance company than I got on the conditional sales contracts, which I have owned. But to me as an in­dividual investor, the lower rate of return is offset by fewer collection headaches and no losses, whereas when I bought conditional sales contracts direct, par­ticularly those of customers located at a distance from me, I had headaches, collection expenses and sometimes losses. The individual investor must decide for himself whether he wants to invest in a finance company or direct to the customer—or whether he wants to forego both of these risks and put his money into government insured savings accounts!