1. CHAPTER 22 Thrift Operations

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

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

4. Background on Savings Institutions n Savings banks have characteristics similar to S&Ls l Mutual and stock ownership l State or federal charter n Key differences between S&Ls and savings banks is that savings banks l Are concentrated in the northeastern U.S. l Have traditionally had more diverse asset investments

5. Sources of Funds n Deposits can include: l Passbook savings l Certificates of deposit u Consumer u Jumbo l Money market accounts

6. Sources of Funds n Borrowed funds are an added source of funds n Sources of borrowed funds include l Federal funds l The Federal Reserve’s discount window l Repurchase agreements n Long-term sources l Mortgage-backed securities l Subordinated debentures

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

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

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

10. Uses of Funds n Mortgages are the primary asset of savings institutions n Characteristics of mortgages at savings institutions l Long-term maturities—15 and 30 year maturities l Can be prepaid by borrowers l Most are for homes or multifamily dwellings l Standardized contracts that can be sold in the secondary market l Credit risk and interest rate risk assumed with mortgages

11. Uses of Funds n Mortgaged-backed securities may be purchased l Receives interest and principal from pool of mortgages l Risks include: u Credit risk u Price risk u Prepayment risk– especially when interest rates fall l Provides diversified income source from borrowers outside market area

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

13. Uses of Funds n Consumer and commercial loans are of increasing importance on the asset side of the balance sheet n Legislation in 1980 and 1982 expanded guidelines for federally charted S&Ls n Many state-chartered S&Ls gained added asset powers

14. Uses of Funds n Making corporate and consumer loans and reducing the concentration of mortgage loans affects overall risk l Interest rate risk is reduced l Credit risk increases n Other uses of funds l Reverse Repurchase agreements—securities purchased under agreement to resell l Federal funds sold

15. Regulation of Savings Institutions n Regulators assess savings institutions using criteria similar to those used to evaluate commercial banks l Capital adequacy l Asset composition l Management l Earnings l Liquidity n Regulators conduct on-site examinations

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

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

18. Exposure to Risk n Credit or default risk n Conventional mortgages are not insured like Federal Housing Authority and Veterans Administration loans n To manage the risk savings institutions l Private mortgage insurance l Perform credit analysis l Geographically diversify their loans

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

20. Exhibit 22.5 Average Duration of Assets Versus Liabilities aa Time 0.0 DecMarchJuneSeptDecMarchJuneSeptDecMarch 1.0 1.5 2.0 2.5 2000199919982001 Assets Liabilities

21. Management of Interest Rate Risk n 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 n Reduces the risk from rising rates but also reduces the favorable impact from declining rates n Borrowers are exposed to interest rate risk because their payment can change with varying rates

22. Management of Interest Rate Risk n Interest rate futures contracts l 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 l Negatively GAPed thrift might sell T-bond futures to hedge against rising rates n Interest rate swaps l A swap is an agreement between two parties to exchange one set of interest rate payments for another l Thrifts often swap fixed interest income for variable-rate income to offset negative GAPed position

23. Valuation of Savings Institutions n Value of a savings institution depends on its expected cash flows and required rate of return  V = f [  E(CF),  k]  V = Change in value of the institution  k = Change in required rate or return Where:  E(CF) = Change in expected cash flows +

24. Exhibit 22.6 Framework for Valuing a Savings Institution Economic Growth Expected Cash Flows to Be Generated by the Commercial Bank Required Return by Investors Who Invest in the Commercial Bank Inflation Money Supply Budget Deficit Risk-Free Interest Rate Risk Premium on the Commercial Bank Value of the Commercial Bank Abilities of the Savings Institution’s Managers Industry Conditions (such as Regulations, Technology, and Competition)

25. Valuation of Savings Institutions n Factors that affect cash flows E(CF) = Expected cash flow R f = Risk free interest rate INDUS = Prevailing industry conditions Where:  E(CF)= f (  ECON,  R f,  INDUS,  MANAB) ECON = Economic growth MANAB = The ability of the institution’s management ++?

26. Valuation of a Savings Institution n Investors required rate of return  k = f(  R f,  RP) ++ R f = Risk free interest rate Where: RP = Risk premium

27. Valuation of a Savings Institution n Change in the risk-free rate  R f = f (  INF,  ECON,  MS,  DEF) INF = Inflationary expectations R f = Risk free interest rate MS = Money supply ECON = Economic growth Where: DEF = Budget deficit +++

28. Valuation of a Savings Institution n Change in the risk premium INDUS = Prevailing industry conditions for the institution Where: ECON = Economic growth MANAB = The ability of the institution’s management RP = Risk premium  RP = f (  ECON,  INDUS,  MANAB) ?

29. Performance of Savings Institutions n Performance Trends l Lower net interest margins—earning asset yields declined faster than interest expense l Noninterest income improvement l Declining loan loss provisions l Lower non interest expense l Net earnings (ROA) improving

30. Exhibit 22.9 Income Statement Per Total Assets for Savings Institutions 199619982000 Interest Income7.02%6.53%6.67% – Total interest expense4.103.854.14 = Net interest income2.922.682.53 – Loan loss provision.24.16.16 + Noninterest income.73.84.90 – Noninterest expense2.502.162.03 = Earnings before tax.911.201.24

31. Savings and Loan Crisis n During the 1980s many S&Ls failed n Reasons for failure l Losses on loans and securities u Loan losses related to commercial real estate u Junk bond losses l Fraud as illustrated by a wide variety of examples l Lack of liquidity

32. Savings and Loan Crisis n Provisions of the FIRREA l New regulations designed to solve the crisis l Bailout bill contained numerous provisions n Resolution Trust Corporation formed to deal with insolvent S&Ls until it was dissolved in 1995 n Several methods for dealing with failures

33. Savings and Loan Crisis n Bailout of savings institutions was financed from several sources including l Sale of failed S&L assets l Taxpayers l Surviving S&Ls n Impact of the bailout l Stronger capital positions l Higher asset quality l More consolidation

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

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