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  • 1. 21 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 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
  • 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 Reserve’s 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 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
  • 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 S&Ls
    • Many state-chartered S&Ls 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 agreements—securities 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
      • C apital adequacy
      • A sset composition
      • M anagement
      • E arnings
      • L iquidity
    • 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 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
  • 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]  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
    • 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
    • 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
    • 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
    • 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
    • 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
  • 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 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
  • 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 S&Ls 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 S&L assets
      • Taxpayers
      • Surviving S&Ls
    • 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