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Chapter 21 Thrift Operations Financial Markets and Institutions, 7e, Jeff Madura Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved. 1 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  2 Chapter Outline (cont’d) 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  3 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 4 Background on Savings Institutions (cont’d) 2% 20% 78% More than $1 billion Between $100 million and $1 billion Less than $100 million 5 Background on Savings Institutions (cont’d)  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 6 Background on Savings Institutions (cont’d)  Ownership (cont’d)  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 7 Background on Savings Institutions (cont’d)  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 Deregulation of services  Recently, SIs have been granted more flexibility to diversify products 8 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 9 Sources of Funds (cont’d)  Borrowed funds     SIs can borrow from other depository institutions in the federal funds market SIs can borrow at the Fed’s discount window SIs can borrow through repos Capital   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 10 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 11 Uses of Funds (cont’d)  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 12 Uses of Funds (cont’d)  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 Other uses of funds   Repos Lending in the federal funds market 13 Uses of Funds (cont’d) Single-Family Mortgages Multifamily Morgages Other Mortgages 11% 12% Commercial Loans 50% 8% Mortgage-Backed Securities Other Securities 6% 4% 4% Consumer Loans 5% Other Assets 14 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 Credit risk    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 2001–2002 15 Exposure to Risk (cont’d)  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 2001–2002 period when interest rates declined 16 Exposure to Risk (cont’d)  Interest rate risk (cont’d)  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 17 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 18 Management of Interest Rate Risk (cont’d)  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 19 Management of Interest Rate Risk (cont’d)  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 20 Management of Interest Rate Risk (cont’d)  Conclusions about interest rate risk  Although strategies are useful, it is virtually impossible to completely eliminate interest rate risk  Mortgages may be prepaid 21 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   - 22 Valuation of a Savings Institution (cont’d)  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 23 Valuation of a Savings Institution (cont’d)  Factors that affect cash flows (cont’d)  Change  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 the risk-free interest rate in industry conditions SIs are exposed to regulatory constraints, technology, and competition 24 Valuation of a Savings Institution (cont’d)  Factors that affect cash flows (cont’d)  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 SI’s assets and liabilities to capitalize on existing economic or regulatory conditions  25 Valuation of a Savings Institution (cont’d)  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 )   -  26 Valuation of a Savings Institution (cont’d)  Factors that affect the required rate of return by investors (cont’d)  Change  in the risk premium When the risk premium increases, so does the return required by investors: RP f ( ECON , INDUS, MANAB ) ? - 27 Interaction with Other Financial Institutions Type of Financial Institution Interaction with Savings Institutions Commercial banks Compete with banks in attracting deposits and providing consumer and commercial loans Have merged with banks in recent years Sell mortgages to commercial banks Finance companies Compete Money market mutual funds Compete with finance companies in providing consumer and commercial loans with money market mutual funds in attracting short-term deposits Investment companies and brokerage firms Contact investment companies to engage in interest rate swaps Insurance companies Insurance and caps Have made arrangements with brokerage firms companies sometimes purchase mortgages sold by SIs 28 Participation in Financial Markets Type of Financial Market Participation by Savings Institution Money markets Compete with other institutions for short-term deposits Bond markets Purchase Mortgage markets Sell Futures markets Hedge against interest rate risk by taking positions in interest rate futures Options markets Hedge against interest rate risk by purchasing put options on interest rate bonds for their investment portfolios Issue bonds to obtain long-term funds mortgages in the secondary market and issue mortgage-backed securities futures Swap markets Hedge against interest rate risk by engaging in interest rate swaps 29 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  30 Performance of Savings Institutions (cont’d)  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 31 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 32 Savings Institution Crisis (cont’d)  Reasons for failure (cont’d)  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 33 Savings Institution Crisis (cont’d)  Reasons for failure (cont’d)  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  34 Savings Institution Crisis (cont’d)  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 35 Savings Institution Crisis (cont’d)  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 36 Savings Institution Crisis (cont’d)  Impact of the bailout  Stronger  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  capital positions consolidation FIRREA allows commercial banks and other institutions to purchase failing or healthy SIs 37 Savings Institution Crisis (cont’d)  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 38 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 39 Background on Credit Unions (cont’d)  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 40 Background on Credit Unions (cont’d)  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 CU’s growth   Many CUs are unable to diversify geographically CUs have increasingly been merging 41 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 Fed’s 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 42 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 43 Credit Union Exposure to Risk (cont’d)  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 44 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 45 Regulation of Credit Unions (cont’d)  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 46