Chapter 21

Thrift Operations

Financial Markets and Institutions, 7e, Jeff Madura Copyright 2006 by South-Western, a division of Thomson Learning. All rights reserved.

Chapter Outline
Background on savings institutions Sources and uses of funds Exposure to risk Management of interest rate risk Valuation of a savings institution Interaction with other financial institutions

Chapter Outline (contd)

Participation in financial markets Performance of savings institutions Savings institution crisis Background on credit unions Sources and uses of credit union funds Credit union exposure to risk Regulation of credit unions

Background on Savings Institutions

Savings institutions include savings banks and S&Ls

S&Ls

are the most dominant type Savings institutions are mainly concentrated in the Northeast The insuring agency for S&Ls is the Savings Association Insurance Fund (SAIF) The insuring agency for savings banks is the Bank Insurance Fund (BIF)

Both agencies are administered by the FDIC

Savings

banks and S&Ls are very similar in their sources and uses of funds
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Background on Savings Institutions (contd)

2% More than $1 billion Between $100 million and $1 billion Less than $100 million 20%

78%

Background on Savings Institutions (contd)

Ownership
Most

SIs are mutual (owned by depositors) Many SIs have shifted their ownership structure from depositors to shareholders through mutual-to-stockconversions

Allow SIs to obtain additional capital by issuing stock Provide owners with greater potential to benefit from performance Make SIs more susceptible to hostile takeovers

Background on Savings Institutions (contd)

Ownership (contd)
In

an acquisition, both SIs have to be stock-owned

Merger-conversion

The

number of SIs today is about one-half of the number in 1994 The total assets of stock SIs has increased by more than 60 percent since 1994 The total assets of mutual SIs has remained steady since 1994
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Background on Savings Institutions (contd)

Regulation of savings institutions

Regulated at both the state and federal level Federally chartered SIs are regulated by the Office of Thrift Supervision (OTS) State-chartered SIs are regulated by the state that has chartered them Regulatory assessment of SIs

Regulators conduct periodic onsite examinations of capital and risk Monitoring is conducted using the CAMELS rating Recently, SIs have been granted more flexibility to diversify products
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Deregulation of services

Sources of Funds

Deposits
Most

funds come from savings and time deposits such as passbook savings, CDs, and MMDAs Since 1981, SIs are allowed to offer NOW accounts as a result of DIDMCA Since 1982, SIs are allowed to offer MMDAs as a result of the Garn-St Germain Act Since 1978, SIs are allowed to offer retail CDs with rates tied to Treasury bills

Sources of Funds (contd)

Borrowed funds

SIs can borrow from other depository institutions in the federal funds market SIs can borrow at the Feds discount window SIs can borrow through repos The capital (net worth) of SIs is composed of retained earnings and funds obtained from issuing stock SIs are required to maintain a minimum level of capital

Capital

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Uses of Funds

Cash
SIs

maintain cash to satisfy reserve requirements and accommodate withdrawal requests

Mortgages:
Are

the primary asset of SIs Typically have long-term maturities and can be prepaid by borrowers Are mostly for homes or multifamily dwellings Are subject to interest rate risk and default risk
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Uses of Funds (contd)

Mortgage-backed securities
SIs

issue securities backed by mortgages Cash flows to holders of these securities may not be steady because of prepayment

Other securities
All

SIs invest insecurities such as Treasury bonds and corporate bonds

Provide liquidity

Some

thrifts invested in junk bonds prior to 1989

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Uses of Funds (contd)

Consumer and commercial loans

Federally chartered SIs are allowed to invest up to 30 percent of their assets in nonmortgage loans and securities

10 percent can be used to provide non-real estate commercial loans

Maturities typically range from one to four years Substituting loans for mortgages reduces interest rate risk but increases credit risk Repos Lending in the federal funds market

Other uses of funds

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Uses of Funds (contd)

11% 12% 50%
Single-Family Mortgages Multifamily Morgages Other Mortgages Commercial Loans

8% 6% 4% 4% 5%

Consumer Loans Mortgage-Backed Securities Other Securities Other Assets

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Exposure to Risk

Liquidity risk

SIs commonly use short-term liabilities to finance long-term assets If new deposits are not sufficient to cover withdrawal requests, SIs can experience liquidity problems SIs can obtain temporary funds through repurchase agreements or in the federal funds market Conventional mortgages are the primary source of credit risk SIs often carry the risk rather than paying for insurance Many SIs were adversely affected by the weak economy in 20012002

Credit risk

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Exposure to Risk (contd)

Interest rate risk

Many

SIs were hurt by rising interest rates in the 1980s because of their heavy concentration on fixedrate mortgages Many SIs benefited from their exposure to interest rate risk in the 20012002 period when interest rates declined

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Exposure to Risk (contd)

Interest rate risk (contd)

Measurement

of interest rate risk

SIs commonly measure the gap between rate-sensitive assets and liabilities to determine interest rate risk exposure Gap measurement is dependent on the criteria used to classify an asset or liability as rate sensitive Some SIs measure the duration of assets and liabilities to determine the imbalance in sensitivity of interest revenue versus expenses

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Management of Interest Rate Risk

Adjustable-rate mortgages (ARMs)

The

interest rate on ARMs is tied to marketdetermined rates and are periodically adjusted ARMs enable an SI to maintain a more stable spread between interest revenue and interest expenses ARMs reduce the adverse impact of rising interest rates and the favorable impact of declining interest rates

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Management of Interest Rate Risk (contd)

Interest rate futures contracts

Allows for the purchase of a specific amount of a particular financial security for a specified price at a future point in time Some SIs use T-bond futures because they resemble fixed-rate mortgages

Selling T-bond futures effective hedges fixed-rate mortgages If interest rates rise, the market value of the securities represented by the futures contract will decrease SIs benefit from the difference between the market value at which they purchase the securities in the future and the futures price

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Management of Interest Rate Risk (contd)

Interest rate swaps

Allows

an SI to swap fixed-rate payments (outflow) for variable-rate payments (inflow) Fixed-rate outflows can be matched against fixedrate mortgages held Variable-rate inflows can be matched against the variable cost of funds

Beneficial in a rising rate environment

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Management of Interest Rate Risk (contd)

Conclusions about interest rate risk

Although

strategies are useful, it is virtually impossible to completely eliminate interest rate risk
Mortgages may be prepaid

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Valuation of a Savings Institution

The value should change in response to changes in its expected cash flows and to changes in the required rate of return:
V f E(CF ), k -

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Valuation of a Savings Institution (contd)

Factors that affect cash flows

E(CF ) f ( ECON , Rf , INDUS, MANAB )
Change

in economic growth

During periods of strong economic growth:

Consumer loan and mortgage loan demand is higher Loan defaults are reduced

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Valuation of a Savings Institution (contd)

Factors that affect cash flows (contd)

Change

in the risk-free interest rate

SIs cash flows are inversely related to interest rate movements

SIs rely heavily on short-term deposits SIs assets commonly have fixed rates

Change

in industry conditions

SIs are exposed to regulatory constraints, technology, and competition

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Valuation of a Savings Institution (contd)

Factors that affect cash flows (contd)

Change

in management abilities

Managers can attempt to make internal decisions that will capitalize on the external forces that the bank cannot control Skillful managers will recognize how to revise the composition of the SIs assets and liabilities to capitalize on existing economic or regulatory conditions
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Valuation of a Savings Institution (contd)

Factors that affect the required rate of return by investors

k f ( Rf , RP ) Change in the risk-free rate

When the risk-free rate increases, so does the return required by investors:

Rf f ( INF, ECON , MS , DEF )

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Valuation of a Savings Institution (contd)

Factors that affect the required rate of return by investors (contd)

Change

in the risk premium

When the risk premium increases, so does the return required by investors:
RP f ( ECON , INDUS, MANAB ) ? -

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Interaction with Other Financial Institutions

Type of Financial Institution
Commercial banks

Interaction with Savings Institutions

Compete with banks in attracting deposits and providing consumer and commercial loans Have merged with banks in recent years Sell mortgages to commercial banks Compete with finance companies in providing consumer and commercial loans Compete with money market mutual funds in attracting short-term deposits

Finance companies Money market mutual funds

Investment companies and brokerage firms

Insurance companies

Contact investment companies to engage in interest rate swaps and caps Have made arrangements with brokerage firms
Insurance companies sometimes purchase mortgages sold by SIs

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Participation in Financial Markets

Type of Financial Market
Money markets Bond markets Mortgage markets Futures markets Options markets Swap markets

Participation by Savings Institution

Compete with other institutions for short-term deposits Purchase bonds for their investment portfolios Issue bonds to obtain long-term funds Sell mortgages in the secondary market and issue mortgage-backed securities Hedge against interest rate risk by taking positions in interest rate futures Hedge against interest rate risk by purchasing put options on interest rate futures Hedge against interest rate risk by engaging in interest rate swaps

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Performance of Savings Institutions

The difference between interest income and interest expenses has fluctuated in recent years The loan loss provision has declined since 2001 Noninterest income has increased Noninterest expenses have increased

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Performance of Savings Institutions (contd)

Comparison of factors that affect the performance of SIs and commercial banks
Loan

loss provisions are typically much lower for SIs than for commercial banks SIs earn substantially less noninterest income than commercial banks Noninterest expenses are lower for SIs than for commercial banks
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Savings Institution Crisis

Numerous SIs became insolvent during the late 1980s

Congress

enacted the FIRREA in 1989

Reasons for failure

Increase

in interest expenses

Interest rates increased in the late 1980s, affecting SIs with long-term mortgages negatively

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Savings Institution Crisis (contd)

Reasons for failure (contd)

Losses

on loans and securities

Crisis was precipitated by unpaid loans Major loan losses were in commercial real estate SIs were forced to assume real estate holdings that were sometimes worth less than half the loan amount originally provided
Fraud

Most commonly, managers used depositors funds for purchases of personal assets
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Savings Institution Crisis (contd)

Reasons for failure (contd)

Illiquidity

SIs experienced a cash flow deficiency as a result of loan losses SIs were forced to offer higher interest rates on deposits to attract more funds The FSLIC was experiencing its own liquidity problems, exacerbating the liquidity problem

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Savings Institution Crisis (contd)

Provisions of the FIRREA

The

FSLIC was terminated SIs were required to have $1.50 in tangible capital per $100 of deposits The FHLBB was replaced by the OTS The RTC was created to deal with insolvent SIs The penalties for officers of SIs and other institutions were increased for fraud SIs were required to use 70 percent of their assets for housing loans
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Savings Institution Crisis (contd)

Creation of the RTC

The

RTC was formed to deal with insolvent SIs Liquidated assets and reimbursed depositors or sold the SI to another institution SIs were processed based on their size, health, and sales potential The most popular method for handling failures was the deposit transfer

Deposits of failed SIs were transferred to an acquiring firm for a fee

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Savings Institution Crisis (contd)

Impact of the bailout

Stronger

capital positions

Many SIs are now required to maintain a higher minimum level of capital

Higher

asset quality

SIs have been forced to maintain more conservative asset portfolios

More

consolidation

FIRREA allows commercial banks and other institutions to purchase failing or healthy SIs
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Savings Institution Crisis (contd)

Performance since the FIRREA

ROA

became positive in 1991 and has increased since then Capital ratio has increased substantially since 1989 The number of SI failures has declined to less than 12 in each of the last several years

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Background on Credit Unions

Credit unions are nonprofit organizations composed of members with a common bond
e.g.,

labor union, church, university

CUs accept deposits from members and channel funds to those members who want to finance the purchase of assets
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Background on Credit Unions (contd)

Ownership of credit unions

CUs

are technically owned by depositors Deposits are called shares, which pay dividends CUs income is not taxed CUs can be federally or state chartered

Federal CUs are growing at a faster rate

Most

CUs are very small

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Background on Credit Unions (contd)

Advantages and disadvantages of credit unions

Can

offer attractive rates to their members Noninterest expenses are relatively low because much of their assets is donated Volunteer labor may not have the incentive to manage operations efficiently Common bond requirements restrict a given CUs growth

Many CUs are unable to diversify geographically CUs have increasingly been merging
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Sources and Uses of Credit Union Funds

Sources of funds
Mostly from share deposits by members Either share deposits, share certificates, or share drafts For temporary funds, CUs can borrow from other CUs

or from the Central Liquidity Facility (CLF)

Acts as a lender similar to the Feds discount window

CUs

maintain capital, primarily in the form of retained earnings

Uses of funds
The majority of funds is used for loans to members Some CUs offer long-term mortgage loans CUs purchase government and agency securities
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Credit Union Exposure to Risk

Liquidity risk
CUs

can experience liquidity problems when an unanticipated wave of withdrawal occurs without an offsetting amount of new deposits

Credit risk
CUs

concentrate on personal loans to members Most loans are secured CUs with very lenient loan policies could experience losses
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Credit Union Exposure to Risk (contd)

Interest rate risk

Maturities

on consumer loans are short term, causing assets to be rate sensitive Movements in interest revenues and interest expenses are highly correlated The spread between interest revenues and interest expenses remains stable over time

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Regulation of Credit Unions

Supervised and regulated y the National Credit Union Administration (NCUA)

Employs

a staff of examiners to monitor CUs CUs complete a semiannual call report that provides financial information NCUA examiners derive financial ratios that measure the financial condition of the CU Criteria used to assess risk are CAMELS
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Regulation of Credit Unions (contd)

Regulation of state-chartered credit unions

Regulated

by their respective states Products offered are influenced by the type of charter and their location

Insurance for credit unions

90

percent of CUs are insured by the National Credit Union Share Insurance Fund (NCUSIF) Some states require their CUs to be federally insured
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