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CHAPTER
2222Thrift
Operations
© 2003 South-Western/Thomson Learning
Chapter ObjectivesChapter 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
Background on Savings InstitutionsBackground 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
Background on Savings InstitutionsBackground on Savings Institutions
Savings banks have characteristics similar to S&Ls Mutual and stock ownership State or federal charter
Key differences between S&Ls and savings banks is that savings banks Are concentrated in the northeastern U.S. Have traditionally had more diverse asset
investments
Sources of FundsSources of Funds
Deposits can include: Passbook savings Certificates of deposit
Consumer Jumbo
Money market accounts
Sources of FundsSources of Funds
Borrowed funds are an added source of funds Sources of borrowed funds include
Federal funds The Federal Reserve’s discount window Repurchase agreements
Long-term sources Mortgage-backed securities Subordinated debentures
Sources of FundsSources 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
Sources of FundsSources 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
Uses of FundsUses 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
Uses of FundsUses of Funds
Mortgages are the primary asset of savings institutions
Characteristics of mortgages at savings institutions Long-term maturities—15 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
Uses of FundsUses 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
Uses of FundsUses 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
Uses of FundsUses 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 S&Ls
Many state-chartered S&Ls gained added asset powers
Uses of FundsUses 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 agreements—securities
purchased under agreement to resell Federal funds sold
Regulation of Savings InstitutionsRegulation 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
Regulation of Savings InstitutionsRegulation 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
Exposure to RiskExposure 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
Exposure to RiskExposure 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
Exposure to RiskExposure 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
Exhibit 22.5 Average Duration of Assets Exhibit 22.5 Average Duration of Assets Versus LiabilitiesVersus Liabilities
Time
0.0
Dec March June Sept Dec March June Sept Dec March
1.0
1.5
2.0
2.5
200019991998 2001
Assets
Liabilities
Management of Interest Rate RiskManagement 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
Management of Interest Rate RiskManagement 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
Valuation of Savings InstitutionsValuation of Savings Institutions
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
+
Exhibit 22.6 Framework for Valuing a Exhibit 22.6 Framework for Valuing a Savings InstitutionSavings Institution
EconomicGrowth
ExpectedCash Flows
to Be Generatedby the
Commercial Bank
Required Returnby InvestorsWho Invest in
the CommercialBank
Inflation MoneySupply
BudgetDeficit
Risk-FreeInterest
Rate Risk Premiumon the
Commercial Bank
Value of theCommercial Bank
Abilitiesof the
SavingsInstitution’sManagers
IndustryConditions(such as
Regulations,Technology, and
Competition)
Valuation of Savings InstitutionsValuation of Savings Institutions
Factors that affect cash flows
E(CF) = Expected cash flow
Rf = Risk free interest rate
INDUS = Prevailing industry conditions
Where:
E(CF)= f (ECON, Rf , INDUS, MANAB)
ECON = Economic growth
MANAB = The ability of the institution’s management
+ +?
Valuation of a Savings InstitutionValuation of a Savings Institution
Investors required rate of return
k = f(Rf , RP)++
Rf = Risk free interest rate
Where:
RP = Risk premium
Valuation of a Savings InstitutionValuation of a Savings Institution
Change in the risk-free rate
Rf = f (INF, ECON, MS, DEF)
INF = Inflationary expectations
Rf = Risk free interest rate
MS = Money supply
ECON = Economic growth
Where:
DEF = Budget deficit
++ +
Valuation of a Savings InstitutionValuation of a Savings Institution
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)?
Performance of Savings InstitutionsPerformance of Savings Institutions
Performance Trends Lower net interest margins—earning asset yields
declined faster than interest expense Noninterest income improvement Declining loan loss provisions Lower non interest expense Net earnings (ROA) improving
Exhibit 22.9 Income Statement Per Total Exhibit 22.9 Income Statement Per Total Assets for Savings InstitutionsAssets for Savings Institutions
1 9 96 1 9 98 2 0 0 0
Interest Income 7.02% 6.53% 6.67%
– Total interest expense 4.10 3.85 4.14
= Net interest income 2.92 2.68 2.53
– Loan loss provision .24 .16 .16
+ Noninterest income .73 .84 .90
– Noninterest expense 2.50 2.16 2.03
= Earnings before tax .91 1.20 1.24
Savings and Loan CrisisSavings and Loan Crisis
During the 1980s many S&Ls 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
Savings and Loan CrisisSavings 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 S&Ls until it was dissolved in 1995
Several methods for dealing with failures
Savings and Loan CrisisSavings and Loan Crisis
Bailout of savings institutions was financed from several sources including Sale of failed S&L assets Taxpayers Surviving S&Ls
Impact of the bailout Stronger capital positions Higher asset quality More consolidation
Savings and Loan CrisisSavings 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
Savings Institutions in Other CountriesSavings 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