Ch22
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    Ch22 Ch22 Presentation Transcript

    • 21 Thrift Operations
    • 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
    • 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
    • Background 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 Funds
      • Deposits can include:
        • Passbook savings
        • Certificates of deposit
          • Consumer
          • Jumbo
        • Money market accounts
    • Sources 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 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 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 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 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 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 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 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 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 Institutions
      • Regulators assess savings institutions using criteria similar to those used to evaluate commercial banks
        • C apital adequacy
        • A sset composition
        • M anagement
        • E arnings
        • L iquidity
      • Regulators conduct on-site examinations
    • 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
    • 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
    • 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
    • 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
    • Exhibit 22.5 Average Duration of Assets Versus Liabilities a a T ime 0.0 Dec March June Sept Dec March June Sept Dec March 1.0 1.5 2.0 2.5 2000 1999 1998 2001 Assets Liabilities
    • 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
    • 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
    • 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]  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 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)
    • Valuation of Savings Institutions
      • 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 + + ?
    • Valuation of a Savings Institution
      • Investors required rate of return
       k = f (  R f ,  RP) + + R f = Risk free interest rate Where: RP = Risk premium
    • Valuation of a Savings Institution
      • 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 + + +
    • Valuation 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 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 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
    • Savings 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 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 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 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 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