Thrift

1
22

• Thrift
• Operations

2
Chapter Objectives

• Describe the key sources and uses of funds for
  savings institutions
• Evaluate the exposure of savings institutions to
  various types of risk
• Estimate the valuation of a savings institution
• Describe the savings and loan crisis and its
  resolution

3
Background on Savings Institutions

• Savings institutions have federal or state
  charters
• Mutual ownership means the institution is owned
  by its depositors
• Mutual-to-stock conversions are popular
• Characteristics of stock ownership
• Manager/owners have greater potential to benefit
• Opportunity to increase capital
• More susceptible to unfriendly takeovers

4
Background on Savings Institutions

• Savings banks have characteristics similar to
  SLs
• Mutual and stock ownership
• State or federal charter
• Key differences between SLs and savings banks is
  that savings banks
• Are concentrated in the northeastern U.S.
• Have traditionally had more diverse asset
  investments

5
Sources of Funds

• Deposits can include
• Passbook savings
• Certificates of deposit
• Consumer
• Jumbo
• Money market accounts

6
Sources of Funds

• Borrowed funds are an added source of funds
• Sources of borrowed funds include
• Federal funds
• The Federal Reserves discount window
• Repurchase agreements
• Long-term sources
• Mortgage-backed securities
• Subordinated debentures

7
Sources of Funds

• Capital is composed of retained earnings and
  funds from issuing stock
• If earnings are strong, capital increases via
  retained earnings
• Regulators set minimum capital standards
• Capital is a source of funds
• Serves to absorb loan and security losses
• Provides base to leverage deposits
• Serves to maintain confidence in institution

8
Sources of Funds

• Mortgage-backed securities are issued by larger
  institutions to obtain funds
• Other institutions/investors purchase
  mortgage-backed securities
• Thrift earns origination fee and may continue to
  service the mortgages
• Prepayment risks exist if mortgages are repaid or
  prior to their maturity
• Provides liquidity for thrift for reinvestment in
  mortgages

9
Uses of Funds

• Cash and due from accounts
• Satisfies reserve requirements for checking
  services--enforced by the Federal Reserve
• Meets liquidity needs if customers decide to
  withdraw funds
• Correspondent accounts are cash balances at other
  institutions maintained in return for various
  services
• Due from accounts assist in the check clearing
  process

10
Uses of Funds

• Mortgages are the primary asset of savings
  institutions
• Characteristics of mortgages at savings
  institutions
• Long-term maturities15 and 30 year maturities
• Can be prepaid by borrowers
• Most are for homes or multifamily dwellings
• Standardized contracts that can be sold in the
  secondary market
• Credit risk and interest rate risk assumed with
  mortgages

11
Uses of Funds

• Mortgaged-backed securities may be purchased
• Receives interest and principal from pool of
  mortgages
• Risks include
• Credit risk
• Price risk
• Prepayment risk especially when interest rates
  fall
• Provides diversified income source from borrowers
  outside market area

12
Uses of Funds

• Other securities include U.S. Treasury, agency,
  and corporate bonds
• Savings banks hold a greater proportion of
  securities as compared to savings and loans
• Past investments in junk bonds or high-risk bonds
  created problems that led to a regulatory
  response
• States imposed limits
• Additional investment in junk bonds prohibited in
  1989 legislation

13
Uses of Funds

• Consumer and commercial loans are of increasing
  importance on the asset side of the balance sheet
• Legislation in 1980 and 1982 expanded guidelines
  for federally charted SLs
• Many state-chartered SLs gained added asset
  powers

14
Uses of Funds

• Making corporate and consumer loans and reducing
  the concentration of mortgage loans affects
  overall risk
• Interest rate risk is reduced
• Credit risk increases
• Other uses of funds
• Reverse Repurchase agreementssecurities
  purchased under agreement to resell
• Federal funds sold

15
Regulation of Savings Institutions

• Regulators assess savings institutions using
  criteria similar to those used to evaluate
  commercial banks
• Capital adequacy
• Asset composition
• Management
• Earnings
• Liquidity
• Regulators conduct on-site examinations

16
Regulation of Savings Institutions

• Deregulation of services allowed institutions
  more flexibility to diversify their investments
  and services
• Flexibility can offer customers the advantage of
  one-stop shopping
• Sudden deregulation caused sudden investments
  that later contributed to losses

17
Exposure to Risk

• Liquidity risk exists because institutions use
  short-term liabilities to fund longer-term assets
• If deposits are not sufficient, institutions
  obtain funds from financial market sources for
  short-term
• Repurchase agreements
• Federal funds
• Sell marketable assets in exchange for cash
• U.S. Treasury securities
• Mortgages

18
Exposure to Risk

• Credit or default risk
• Conventional mortgages are not insured like
  Federal Housing Authority and Veterans
  Administration loans
• To manage the risk savings institutions
• Private mortgage insurance
• Perform credit analysis
• Geographically diversify their loans

19
Exposure to Risk

• Interest rate risk
• Commonly measured by the gap or difference
  between rate-sensitive assets and liabilities
• Gap measurement depends on the criteria used to
  classify assets and liabilities
• Institutions may calculate duration and use this
  as an alternative measure of risk
• Regulators monitor interest rate risk assumed by
  savings institutions

20
Exhibit 22.5 Average Duration of Assets Versus
Liabilities
2.5
2.0
1.5
1.0
0.0
Dec
March
June
Sept
Dec
March
June
Sept
Dec
March
2000
1999
1998
2001
T
ime
a
a
21
Management of Interest Rate Risk

• Adjustable-rate mortgages (ARM) have rates tied
  to market-determined rates and are adjusted on a
  periodic basis using the formula stated in the
  ARM contract
• Reduces the risk from rising rates but also
  reduces the favorable impact from declining rates
• Borrowers are exposed to interest rate risk
  because their payment can change with varying
  rates

22
Management of Interest Rate Risk

• Interest rate futures contracts
• A standardized contract allowing the institution
  to buy or sell a specified amount of a specified
  instrument for a specified price at a specified
  future point in time
• Negatively GAPed thrift might sell T-bond futures
  to hedge against rising rates
• Interest rate swaps
• A swap is an agreement between two parties to
  exchange one set of interest rate payments for
  another
• Thrifts often swap fixed interest income for
  variable-rate income to offset negative GAPed
  position

23
Valuation of Savings Institutions

• Value of a savings institution depends on its
  expected cash flows and required rate of return

?V f ?E(CF), ?k

Where
? V Change in value of the institution
? E(CF) Change in expected cash flows
? k Change in required rate or return
24
Exhibit 22.6 Framework for Valuing a Savings
Institution
25
Valuation of Savings Institutions

• Factors that affect cash flows

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


?
Where
E(CF) Expected cash flow
ECON Economic growth
Rf Risk free interest rate
INDUS Prevailing industry conditions
MANAB The ability of the institutions
management
26
Valuation of a Savings Institution

• Investors required rate of return

?k f(?Rf , ?RP)


Where
Rf Risk free interest rate
RP Risk premium
27
Valuation of a Savings Institution

• Change in the risk-free rate

?Rf f (?INF, ?ECON, ?MS, ?DEF)



Where
Rf Risk free interest rate
INF Inflationary expectations
ECON Economic growth
MS Money supply
DEF Budget deficit
28
Valuation of a Savings Institution

• Change in the risk premium

?RP f (?ECON, ?INDUS, ?MANAB)
?
Where
RP Risk premium
ECON Economic growth
INDUS Prevailing industry conditions for
the institution
MANAB The ability of the institutions
management
29
Performance of Savings Institutions

• Performance Trends
• Lower net interest marginsearning asset yields
  declined faster than interest expense
• Noninterest income improvement
• Declining loan loss provisions
• Lower non interest expense
• Net earnings (ROA) improving

30
Exhibit 22.9 Income Statement Per Total Assets
for Savings Institutions
1
9
9
6
1
9
9
8
2
0
0
0
Interest Income
7
.
0
2

6
.
5
3

6
.
6
7

Total interest expense
4
.
1
0
3
.
8
5
4
.
1
4

Net interest income
2
.
9
2
2
.
6
8
2
.
5
3

Loan loss provision
.
2
4
.
1
6
.
1
6

Noninterest income
.
7
3
.
8
4
.
9
0

Noninterest expense
2
.
5
0
2
.
1
6
2
.
0
3

Earnings before tax
.
9
1
1
.
2
0
1
.
2
4

31
Savings and Loan Crisis

• During the 1980s many SLs failed
• Reasons for failure
• Losses on loans and securities
• Loan losses related to commercial real estate
• Junk bond losses
• Fraud as illustrated by a wide variety of
  examples
• Lack of liquidity

32
Savings and Loan Crisis

• Provisions of the FIRREA
• New regulations designed to solve the crisis
• Bailout bill contained numerous provisions
• Resolution Trust Corporation formed to deal with
  insolvent SLs until it was dissolved in 1995
• Several methods for dealing with failures

33
Savings and Loan Crisis

• Bailout of savings institutions was financed from
  several sources including
• Sale of failed SL assets
• Taxpayers
• Surviving SLs
• Impact of the bailout
• Stronger capital positions
• Higher asset quality
• More consolidation

34
Savings and Loan Crisis

• Institutions have performed well since FIRREA
  based on a number of criteria
• Future outlook for the industry
• Increase efficiencies by
• Reducing noninterest expenses
• Divest inefficient assets
• Continue to diversify asset mix
• Conflict between diversification and
  specialization

35
Savings Institutions in Other Countries

• Institutions in other countries have not had
  problems similar to those in the United States
• Institutions in other countries have
  characteristics that let them reduce
  susceptibility to economic conditions
• Reduced interest rate risk
• Less regulated more asset diversification
• Different regulations apply to institutions in
  different countries