If you've ever bought a car, especially a new one, you're familiar with captive finance -- financing available from the company you're buying from.

On this week's Industry Focus: Financials, Gaby Lapera and special guest Tyler Crowe lay down the basics of how and why companies have captive finance. Also, what a SIFI designation means and why it's not the most sought-after title, and one thing to check out before going in to buy a new car.

A full transcript follows the video.

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This podcast was recorded on Feb. 8, 2016. 

Gaby Lapera: Captive finance, the second most interesting topic after the Super Bowl.

Hello, everyone! Welcome to Industry Focus, Financials. I'm Gaby Lapera here in the studio with Tyler Crowe! I'm so excited to have...

Tyler Crowe: Little bit of a change-up for this week.

Lapera: I know. Not that I don't miss you, Maxfield, don't get me wrong, but I'm so excited to actually have a person with me in the studio. Tyler Crowe, if you don't know, just in case you don't listen to our energy podcast, is one of The Motley Fool's best energy and industrials analysts.

Crowe: She's overstating things very, very much. But I'll take it anyways.

Lapera: (laughs) Well, thank you for joining us. And I wasn't kidding, we're actually going to talk a little about the Super Bowl today. There's this guy Robert Stovall. He's an analyst on Wall Street, and he came up with this thing called the Super Bowl Predictor. I'm going to let Tyler talk about it, because I made six mistakes when I was attempting to describe this to him. He was like, "Those teams don't exist anymore. I don't know what you're talking about." So, I'll hand it off to you.

Crowe: So, there is a weird predictor of the Super Bowl that basically says if a team from the NFC wins, we're going to have an up Wall Street year -- the market's going to end up. And when an AFC team wins, we're going to have a down market. Last year, as we know, Patriots won, and the market was down 2.2%. The crazy thing about it is, over the last 49 Super Bowls, 40 of them have been right. That's better than most Wall Street analysts, which is, you know, pretty impressive. So, now that the Denver Broncos have won, there is, some are saying, predicting, that we're going to have a down market again. And so far, this year, we haven't exactly gotten off to a great start.

Lapera: Gosh darn it, one of the Manning brothers.

Crowe: So, we'll see how it goes.

Lapera: Peyton?

Crowe: She's trying really hard to talk about football right now, and it's not going great for her. But we're going to make it work anyways.

Lapera: Anyways! Now that the super-interesting, accessible part of our show is over, now we're going to talk about captive finance, something that you never thought you wanted to know about, but now you are going to, if you listen to the rest of this podcast.

Captive finance, you've probably encountered this before and haven't realized it. It's basically when you get financing to buy something from the company that you're buying the product from. You mostly see this with car dealerships. So, if you've ever bought a car, say, from Ford, you have the option of going to your bank and getting a loan or Ford will provide you financing to buy their vehicle. Most of the time, companies do this to remove a friction point.

So, you've got a car, you're in the dealership, and you're like, "Oh wait, I have to go call my bank to see if I can get a loan." And the sales agents are like, "No, no, but we can provide financing for you instead!" That works out great, for them anyways. You're much more likely to buy then. So, the other things you can do instead of captive finance and going to a loan is you can go to a random finance company. So, that's a finance company that is not a bank, a non-banking finance company is the official designation for these things, and it's literally anything from a pawn shop to Lending Club or...

Crowe: What, you've never bought a car from the pawn shop?

Lapera: You could buy a car from a pawn shop.

Crowe: You haven't lived until you've bought a car from a pawn shop.

Lapera: It's basically anything that can't take deposits, but can give loans. That's what a finance company is. And then, your other option, of course, is "Buy here, pay here." Tyler, do you want to do your impression of these commercials?

Crowe: So, basically, you've probably heard them on the radio. It's "When you come on down to Randy's Auto Emporium, bad credit, no credit, no problem!" If you've ever heard that statement, that is a "Buy here, pay here" kind of establishment.

Lapera: Right, that is the dealer giving you financing directly through that dealership, not through corporate or anything. Captive finance is through corporate, and the captive finance company is the company that is wholly owned by a parent company. And it can be for anything, but we're obviously going to be talking about captive finance companies, because this is the financials edition. Shocking!

I think the best-known industrial examples, like I said, are probably auto makers. The biggest captive financiers are Ford and Toyota. They, I think, originated the most loans for new cars out of anything. This is including banks like Wells Fargo and stuff. They originate the most loans for new cars, which is crazy.

Crowe: Yeah, and one of the interesting things about it, and if we look back a couple years ago, thinking like, pre-recession times, these things were massive, massive financing arms. If you look at somebody like General Motors, when they had GMAC, just before they spun it off into Ally (ALLY -2.03%). Is it Ally Bank or Ally Financial? I'm not as good with financial names on things like that. But I digress. Either way, if you actually look at the pre-recession numbers for General Motors' financial arm, the revenue from it was greater than the actual cars themselves, because it had become such a large component of the business. When you're talking about these financial arms, they can be a considerable, considerable component of these businesses.

Lapera: Definitely. And, of course, you're probably asking yourself, "What about the used-car market? That probably doesn't go through dealerships in the same way." And you're right, but these captive arms for these dealers, they're making mostly loans for new cars. So, the amounts that they're lending out are higher. And, they also tend to be lending to people -- people who are buying new cars tend to have higher credit scores than the people who are buying used cars. I think the average in 2015 for someone buying a new car, their credit score was 710, which is technically prime.

Crowe: Technically.

Lapera: (laughs) Technically prime. And the average for someone who is buying a used car is only 650.

Crowe: And if we look at the trends, you can actually see that that's starting to trend back down again, which isn't exactly the most encouraging sign, if you look at the numbers from 2010 on the way down. If anyone is at all interested in the captive finance market of industrial companies, especially in the automotive sector, great market research is the Experian Automotive Finance Market. They give all the credit statistics when it comes to stuff like this. And the average credit score in 2010 for a new car financing was 733. By 2015, it's dropped down to 710. So, not exactly the most encouraging sign, as we come out of a recession. But hey, sometimes you get a little more ambitious as the times get good.

Lapera: Right. And obviously the problem with this, for our less experienced listeners, is that people with lower credit scores are more likely to default. That's what the credit score is telling people. So, when those credit scores go down, it's concerning for people who are actually holding the loans, which, in this case, would be the actual corporations.

Crowe: Yeah, when you're looking at the financial arm, if you're looking at a business in this sort of realm, the captive finance aspect of a business, obviously the risk of default is probably the first thing you think about. If we look at what happened with GE Capital, with the issues they had at GM with Ally Bank, the first thing that everybody points to is the risk of default, what are the chances of it actually defaulting on their loans and causing issues?

But, if you're looking at it from a business, there's other things that certainly, if you're looking to invest in one of these companies, like a GM, Toyota, or even some of the industrial ones, like, say, a John Deere (DE -3.77%), GE (GE -1.76%), you have to look at some of the other components. And I think one of those things you actually have to think about is artificial inventory build. It sounds really weird. We're talking about some fascinating stuff here today.

Lapera: (laughs) 

Crowe: But...

Lapera: I'm sorry that we're not as exciting as commodities markets, Tyler (laughs).

Crowe: It can be! Because, you know, we're tying in commodities on this one. So, let's use a great example, John Deere, right now. Since 2012, sales at Deere have been slumping. Actual sales, straight-up sales of something where they take the cash, wipe their hands, and say, "Go have fun with your new equipment."

Lapera: Can I ask you something really quick?

Crowe: Sure.

Lapera: Do they make anything other than tractors?

Crowe: Oh, yeah.

Lapera: Is tractors their thing?

Crowe: Any agricultural equipment aside from tractors, you're also getting into some of the heavy construction equipment, excavators, things like that. So, there's a pretty large component of John Deere that is agriculture, but they do have some construction stuff. And that's actually why things have been getting kind of funky. Agricultural sales have been slumping for the last few years, and then you throw on the commodities bust we've had over the past while for iron ore and a lot of other commodities, it's been five years; and you throw in energy over the past 18 months, and nobody is liking what's going on.

So, with somebody like Deere, while their sales have gone down, their operational leases, where they actually lease out their equipment through their financing arm to farmers or whoever, that has grown a very large amount. But what that leads to is, once the lease expired, John Deere is left with a whole bunch of used equipment. Then, they have to sell it, because there's no point in having an inventory of used equipment. Once you get that inventory build, you have to drop prices, and then your margins start to go down. So, it's that interesting play on, how does the financing arm of the business really play into how that actually works for them?

Lapera: Yeah, and that's really interesting, because I also remember seeing that the number of car leases as well has been going up over the last few years as well. Which is actually a question we get in personal finance all the time, which is, "Should I buy or lease my car?" We're not going to get into that, but that question you ask yourselves is also something that the corporation is asking itself.

Crowe: Yeah, at least with somebody on a lease end, they want to sell you the car, because when it's done, they want to wipe their hands of it. They don't want to have a used car in inventory, because it's a drag on margins. But so when times like this happen, you do have to have that financing arm to, like you were saying earlier, grease the skids, remove that friction point from the sale.

I do remember, because you were talking about the financing arm of it, I was in a dealership three or four years ago, when I bought my car. That was the first thing that came to mind, how before you go, it's always the "Check in with banks, check what you can get," and then you get there and they're like, "Oh, we have the financing right here and ready and waiting for you, in 30 seconds we're going to check your credit and tell you what you can get." And it keeps you in the door and it makes the signing on the bottom line a heck of a lot faster. And when you're trying to make a large purchase like that, it helps a lot when it comes to making the sale at the end of the day.

Lapera: Yeah. It incentivizes them. It's all staying in-house, which they like. I bought a new car a couple years ago, too. I did the same thing, I did in-house financing. I love my car. It snowed a lot here, and my car has four-wheel drive, and I've never had a car with four-wheel drive before, and I still drive really carefully because I'm terrified of the snow because technically I grew up in the South ... (laughs) Tyler's laughing, because he grew up in New England, and he's, like, "Ugh, snow, what's that?"

Crowe: What's that? We can figure that out pretty quickly. So, I do want to ask you, thinking of the risk of default, I'm more on the industrial side, so I don't understand that as much. If you could maybe give some details, at least for me, say, only industrials person and I don't know anything about the risk of default, what are maybe some of the things that I should be watching for in a captive finance business that has that? If I'm looking through an income statement or balance sheet?

Lapera: So, what you're going to want to look for is net charge-offs. Those are basically saying how much the company has had to charge off on loans that are delinquent, that just aren't going to be fulfilled. If you see a trend of those rising bad news bears. (laughs) And typically, if companies really know what they're doing, it's not going to get much above 1%. Most have it below that. During the financial crisis, it went nuts. It got up to 4%. I mean, you remember the financial crisis. It was bad times. (laughs) 

Crowe: It was not a good time.

Lapera: So, really, you're looking at that, and once it starts getting past that 1% mark, you're, like, "I don't know... " The other thing that you want to look for is the loan reserves. Companies budget a certain amount of their profits, saying, like, "We know that some people are going to default on their loans. That's just a fact of life." And some companies have more or less of a buffer in order to pay off those loans. Ideally, you'd want a company with a conservative buffer. This is actually something we've seen with banks with a lot of oil exposure, a lot of them are raising their reserves in response to this, because a lot of the people they've given loans to are going to default, especially if you're a small...

Crowe: And, trust me, there are a lot of people that are going on default right about now.

Lapera: Yeah. (laughs)

Crowe: You can see why it's happening.

Lapera: Yeah. So, those are really the two things you're going to want to look for in terms of worrying about defaults. And companies are required to give you this data. It's going to be in their 10-Q. One of the things that was actually really interesting in that Experian auto loan finance market thing we looked at was, it showed us a map of the U.S. and how likely a state was to default on its auto loans. And it was, like, the entire South was red, and the Northwest Pacific was green, which meant it was good, really low, below 0.5% or something.

Crowe: It certainly has changed over time. I think we went back and looked at the past five years, and 2010, 2009, it wasn't looking is great. But things are looking a little bit better as of late. Almost across the world.

Lapera: The entire country, I think, in 2010 was like...

Crowe: Defaulting at a pretty high rate.

Lapera: Yeah, it was various shades of red. It wasn't good (laughs). So, yeah. The other thing that we want to talk about is, lots of companies have captive finance arms. It's not just cars. One of the most well-known ones would be GE, which is General Electric, in case you don't know (laughs). Obviously, they sell a lot of stuff, in terms of consumer goods, like washing machines and stuff like that. Although, they have recently sold off their appliances.

Crowe: Yeah, so, aside from light bulbs, I think, might be their last real consumer-facing product that they've been doing as of late. But you can almost name anything on the industrial side of things, and GE probably has their fingers in it somewhere.

Lapera: Yeah. Airplanes, healthcare...

Crowe: Oil and gas.

Lapera: All sorts of things.

Crowe: All across the board.

Lapera: Anyways, back in 2013, GE got designated as a SIFI, which is a systematically important financial institution, which I think Tyler says as sci-fi, which I like.

Crowe: Well, I'm not a finance person, so I just assumed it was sci-fi.

Lapera: I actually don't know which one is right. I've never heard anyone else say it besides me and Maxfield.

Crowe: OK.

Lapera: So maybe you're right and I've just been saying it wrong.

Crowe: We'll find out.

Lapera: I'm sure someone will write in and tell us which one of us is right (laughs).

So, GE was labelled as a SIFI in 2013. And that's a huge hassle. If you're not a bank... and it's already a huge hassle for banks... it's a huge hassle, because it comes with a lot of expensive regulatory requirements. You're required to have all of these capital bases, and you have to do all these stress tests, which aren't cheap to do. And it means that a lot of your capital is tied up in just-in-case financing. Just in case you go belly up, you can't, because you have all this capital saved up so you can't. Which means, for a company that's trying to innovate or do other things, that isn't a bank, it's a problem, because banks have to have that money. They have deposits and stuff anyway. It's not a big deal for them. It's part of their business model. But for GE, it doesn't really make a ton of sense.

Crowe: Well, if you look at the history of GE, GE Capital, more specifically, you can almost see why this happened. Let's start pre-financial crisis. GE Capital had just become a massive, massive component of the entire business. If you look at 2007, their total net income, their financial or capital markets aspect of the business was anywhere between 40% to 50% of their entire business. And this is somebody who makes almost everything.

So, when you had that, and even CEO Jeff Immelt has said this over time is, they got caught up in the numbers of profit on the capital end and didn't really focus on who they were as an industrial manufacturer. And I mean, if you look at some of the things that were on the GE Capital balance sheet at the time, they were doing private-label credit cards for Amazon.comWalmartGap, companies like that.

And just, taking on a lot more of a role of a bank or financing company, just for the simple fact that the returns where there, rather than maybe using their captive finance aspect of their business purely for their industrial operations or whatever they're selling for. So, when the collapse happened, they had to get a $3 billion preferred share TARP-esque buyout from Warren Buffett, who gave them a little bit of approval there, it made them look in the mirror and say, "Oh, wow, we really should get out of this capital business and focus on what we do well as an industrial manufacturer." So, we've seen the results of that, where they've spun off Synchrony Financial (SYF -2.13%), they've sold, what is it, $30 billion worth of assets to Wells Fargo? You're a little better with the numbers.

Lapera: Yes, $30 billion worth of commercial lending leasing to Wells Fargo.

Crowe: So, on top of that, and I believe it somewhere in the $150-160 billion range, in terms of assets they've been selling or deleveraging from GE Capital.

Lapera: Right. So, about $115 billion asset management business. They're in talks with State Street (STT 2.53%), which is already a SIFI, to sell it to them. And that is relevant as of, I believe, Friday or Thursday of last week, which would have been Feb. 4, just in case you're listening to this in July of 2017. (laughs) So, it's a great deal for State Street. But it does make a lot of sense for GE. They're getting rid of a very expensive part of their business for them. If you look at a little chart that says what made GE the most money in 2001, it was hands-down GE Capital. Now, it's somewhere like 5th on the list, it's not making them nearly as much money as it used to.

Crowe: And for good reason. On top of the SIFI, however we want to call it, designation, what it also does for somebody like an industrial manufacturer like GE, it limits some of the shareholder things you can do, or shareholder return things like buybacks, dividend raises, things like that, that, as you're an investor in the industrial space, those are the things you're probably going to be looking for a little bit more aggressively than, say, in the financial realm. So, with that designation, they're being held back from a lot of things.

Lapera: The reason for that is because, like I said, there's capital requirements for these companies. They have to pass these tests, and the federal government will basically tell them whether or not they're allowed to give out dividends. And the federal government had said no to them in the past.

Crowe: So far, federal government has said no to GE in that realm for the most part. The interesting thing now is, since it's sold of such a large component of its GE Capital, it's to the point where it maybe shouldn't necessarily be considered a systematically important financial institution anymore.

Lapera: And they did this on purpose. They straight up said first quarter.

Crowe: "We want to get rid of this."

Lapera: "First quarter of 2016, we are going to apply to lose our SIFI designation. We don't want it, we're going to do as best we can to sell off everything we have."

Crowe: Yeah, and as a part of that, they basically told shareholders what they get out of it. They're going to get $35 billion in stock buybacks, another $35 billion, potentially, in dividends. So, they're really trying to throw some large numbers out there to the shareholders, and give them to the incentive, "Hey, we need to get rid of this, this is why." And hopefully the federal government will drop that systematically important designation soon enough, because for GE to really unleash their capital, all that reserves built up, not just in terms of returning to shareholders but even toward reinvestment in the actual business itself, it really needs to happen. So, hopefully, this will be a lesson to GE and many others that, you know, it's nice to have a financing arm, but it shouldn't be the biggest component of your business if you're a manufacturer.

Lapera: Right. Soon, we won't be able to talk about them on Industry Focus: Financials at all.

Crowe: Well, let's hope not. That's at least my opinion. I know everybody has their own investing opinions and things like that, but I like to think of a captive financing arm of an industrial manufacturer or any big thing like that, it should never be talked about, at least in my opinion. If I'm listening to a quarterly earnings call or looking at some of the financial statements, it should almost feel like an after-statement. It's something there to smooth the skids when we're trying to make some sales happen, maybe it'll generate a modest return on it...

Lapera: You definitely don't want to see a loss on it.

Crowe: Well, granted. But, I don't want to see that the dominant component of the business in any way, because it really, as we've seen over these past six, seven, eight years of that transformation of GM, GE, people like that, that when it becomes such a large component of the business, it distracts from what a company does well. GE, by most rights, probably didn't need to be into the private credit card business, they just got enamored with it. And now that it's not there, hopefully they can focus on what they do best.

Lapera: Right. And that, just in case you're curious, that private-label credit card business got spun off with Synchrony back in October of 2015...

Crowe: 2014.

Lapera: Oh, 2014. So, it's been gone for a while.

Crowe: All for the better.

Lapera: All for the better. Just in case you're wondering, by the way, why Tyler Crowe is on the show with me today (laughs), this week, we've come up with a number...

Crowe: Industry Mashup.

Lapera: Industry Mashup. The Venn diagram week. I don't know. One of us is going to appear on someone else's show all week. So, tomorrow, I'll be on Consumer Goods. Get excited. I have no idea what we're talking about yet (laughs).

Crowe: Actually, Taylor Muckerman was supposed to be in here. He's the other Industrials analyst with us. Unfortunately, he's a very large Carolina Panthers fan.

Lapera: (laughs) No!

Crowe: And he is nowhere to be seen. So, hopefully, we can find him someday.

Lapera: Aw. If you're out there, Taylor, feel better! (laughs) So, yeah, thank you guys so much for joining us on Industry Focus. As always, people on this program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear. Thanks for joining us, hope you have a great week, and don't forget to email us about your opinions on how SIFI is pronounced. Email is [email protected]. Thanks very much!