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  1. 1. 21 Thrift Operations
  2. 2. Chapter Objectives <ul><li>Describe the key sources and uses of funds for savings institutions </li></ul><ul><li>Evaluate the exposure of savings institutions to various types of risk </li></ul><ul><li>Estimate the valuation of a savings institution </li></ul><ul><li>Describe the savings and loan crisis and its resolution </li></ul>
  3. 3. Background on Savings Institutions <ul><li>Savings institutions have federal or state charters </li></ul><ul><li>Mutual ownership means the institution is owned by its depositors </li></ul><ul><li>Mutual-to-stock conversions are popular </li></ul><ul><li>Characteristics of stock ownership </li></ul><ul><ul><li>Manager/owners have greater potential to benefit </li></ul></ul><ul><ul><li>Opportunity to increase capital </li></ul></ul><ul><ul><li>More susceptible to unfriendly takeovers </li></ul></ul>
  4. 4. Background on Savings Institutions <ul><li>Savings banks have characteristics similar to S&Ls </li></ul><ul><ul><li>Mutual and stock ownership </li></ul></ul><ul><ul><li>State or federal charter </li></ul></ul><ul><li>Key differences between S&Ls and savings banks is that savings banks </li></ul><ul><ul><li>Are concentrated in the northeastern U.S. </li></ul></ul><ul><ul><li>Have traditionally had more diverse asset investments </li></ul></ul>
  5. 5. Sources of Funds <ul><li>Deposits can include: </li></ul><ul><ul><li>Passbook savings </li></ul></ul><ul><ul><li>Certificates of deposit </li></ul></ul><ul><ul><ul><li>Consumer </li></ul></ul></ul><ul><ul><ul><li>Jumbo </li></ul></ul></ul><ul><ul><li>Money market accounts </li></ul></ul>
  6. 6. Sources of Funds <ul><li>Borrowed funds are an added source of funds </li></ul><ul><li>Sources of borrowed funds include </li></ul><ul><ul><li>Federal funds </li></ul></ul><ul><ul><li>The Federal Reserve’s discount window </li></ul></ul><ul><ul><li>Repurchase agreements </li></ul></ul><ul><li>Long-term sources </li></ul><ul><ul><li>Mortgage-backed securities </li></ul></ul><ul><ul><li>Subordinated debentures </li></ul></ul>
  7. 7. Sources of Funds <ul><li>Capital is composed of retained earnings and funds from issuing stock </li></ul><ul><li>If earnings are strong, capital increases via retained earnings </li></ul><ul><li>Regulators set minimum capital standards </li></ul><ul><ul><li>Capital is a source of funds </li></ul></ul><ul><ul><li>Serves to absorb loan and security losses </li></ul></ul><ul><ul><li>Provides base to leverage deposits </li></ul></ul><ul><ul><li>Serves to maintain confidence in institution </li></ul></ul>
  8. 8. Sources of Funds <ul><li>Mortgage-backed securities are issued by larger institutions to obtain funds </li></ul><ul><ul><li>Other institutions/investors purchase mortgage-backed securities </li></ul></ul><ul><ul><li>Thrift earns origination fee and may continue to service the mortgages </li></ul></ul><ul><ul><li>Prepayment risks exist if mortgages are repaid or prior to their maturity </li></ul></ul><ul><ul><li>Provides liquidity for thrift for reinvestment in mortgages </li></ul></ul>
  9. 9. Uses of Funds <ul><li>Cash and due from accounts </li></ul><ul><ul><li>Satisfies reserve requirements for checking services--enforced by the Federal Reserve </li></ul></ul><ul><ul><li>Meets liquidity needs if customers decide to withdraw funds </li></ul></ul><ul><ul><li>Correspondent accounts are cash balances at other institutions maintained in return for various services </li></ul></ul><ul><ul><li>Due from accounts assist in the check clearing process </li></ul></ul>
  10. 10. Uses of Funds <ul><li>Mortgages are the primary asset of savings institutions </li></ul><ul><li>Characteristics of mortgages at savings institutions </li></ul><ul><ul><li>Long-term maturities—15 and 30 year maturities </li></ul></ul><ul><ul><li>Can be prepaid by borrowers </li></ul></ul><ul><ul><li>Most are for homes or multifamily dwellings </li></ul></ul><ul><ul><li>Standardized contracts that can be sold in the secondary market </li></ul></ul><ul><ul><li>Credit risk and interest rate risk assumed with mortgages </li></ul></ul>
  11. 11. Uses of Funds <ul><li>Mortgaged-backed securities may be purchased </li></ul><ul><ul><li>Receives interest and principal from pool of mortgages </li></ul></ul><ul><ul><li>Risks include: </li></ul></ul><ul><ul><ul><li>Credit risk </li></ul></ul></ul><ul><ul><ul><li>Price risk </li></ul></ul></ul><ul><ul><ul><li>Prepayment risk– especially when interest rates fall </li></ul></ul></ul><ul><ul><li>Provides diversified income source from borrowers outside market area </li></ul></ul>
  12. 12. Uses of Funds <ul><li>Other securities include U.S. Treasury, agency, and corporate bonds </li></ul><ul><ul><li>Savings banks hold a greater proportion of securities as compared to savings and loans </li></ul></ul><ul><ul><li>Past investments in junk bonds or high-risk bonds created problems that led to a regulatory response </li></ul></ul><ul><ul><ul><li>States imposed limits </li></ul></ul></ul><ul><ul><ul><li>Additional investment in junk bonds prohibited in 1989 legislation </li></ul></ul></ul>
  13. 13. Uses of Funds <ul><li>Consumer and commercial loans are of increasing importance on the asset side of the balance sheet </li></ul><ul><li>Legislation in 1980 and 1982 expanded guidelines for federally charted S&Ls </li></ul><ul><li>Many state-chartered S&Ls gained added asset powers </li></ul>
  14. 14. Uses of Funds <ul><li>Making corporate and consumer loans and reducing the concentration of mortgage loans affects overall risk </li></ul><ul><ul><li>Interest rate risk is reduced </li></ul></ul><ul><ul><li>Credit risk increases </li></ul></ul><ul><li>Other uses of funds </li></ul><ul><ul><li>Reverse Repurchase agreements—securities purchased under agreement to resell </li></ul></ul><ul><ul><li>Federal funds sold </li></ul></ul>
  15. 15. Regulation of Savings Institutions <ul><li>Regulators assess savings institutions using criteria similar to those used to evaluate commercial banks </li></ul><ul><ul><li>C apital adequacy </li></ul></ul><ul><ul><li>A sset composition </li></ul></ul><ul><ul><li>M anagement </li></ul></ul><ul><ul><li>E arnings </li></ul></ul><ul><ul><li>L iquidity </li></ul></ul><ul><li>Regulators conduct on-site examinations </li></ul>
  16. 16. Regulation of Savings Institutions <ul><li>Deregulation of services allowed institutions more flexibility to diversify their investments and services </li></ul><ul><li>Flexibility can offer customers the advantage of one-stop shopping </li></ul><ul><li>Sudden deregulation caused sudden investments that later contributed to losses </li></ul>
  17. 17. Exposure to Risk <ul><li>Liquidity risk exists because institutions use short-term liabilities to fund longer-term assets </li></ul><ul><li>If deposits are not sufficient, institutions obtain funds from financial market sources for short-term </li></ul><ul><ul><li>Repurchase agreements </li></ul></ul><ul><ul><li>Federal funds </li></ul></ul><ul><li>Sell marketable assets in exchange for cash </li></ul><ul><ul><li>U.S. Treasury securities </li></ul></ul><ul><ul><li>Mortgages </li></ul></ul>
  18. 18. Exposure to Risk <ul><li>Credit or default risk </li></ul><ul><li>Conventional mortgages are not insured like Federal Housing Authority and Veterans Administration loans </li></ul><ul><li>To manage the risk savings institutions </li></ul><ul><ul><li>Private mortgage insurance </li></ul></ul><ul><ul><li>Perform credit analysis </li></ul></ul><ul><ul><li>Geographically diversify their loans </li></ul></ul>
  19. 19. Exposure to Risk <ul><li>Interest rate risk </li></ul><ul><ul><li>Commonly measured by the gap or difference between rate-sensitive assets and liabilities </li></ul></ul><ul><ul><li>Gap measurement depends on the criteria used to classify assets and liabilities </li></ul></ul><ul><ul><li>Institutions may calculate duration and use this as an alternative measure of risk </li></ul></ul><ul><ul><li>Regulators monitor interest rate risk assumed by savings institutions </li></ul></ul>
  20. 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. 21. Management of Interest Rate Risk <ul><li>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 </li></ul><ul><li>Reduces the risk from rising rates but also reduces the favorable impact from declining rates </li></ul><ul><li>Borrowers are exposed to interest rate risk because their payment can change with varying rates </li></ul>
  22. 22. Management of Interest Rate Risk <ul><li>Interest rate futures contracts </li></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>Negatively GAPed thrift might sell T-bond futures to hedge against rising rates </li></ul></ul><ul><li>Interest rate swaps </li></ul><ul><ul><li>A swap is an agreement between two parties to exchange one set of interest rate payments for another </li></ul></ul><ul><ul><li>Thrifts often swap fixed interest income for variable-rate income to offset negative GAPed position </li></ul></ul>
  23. 23. Valuation of Savings Institutions <ul><li>Value of a savings institution depends on its expected cash flows and required rate of return </li></ul> 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. 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. 25. Valuation of Savings Institutions <ul><li>Factors that affect cash flows </li></ul>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. 26. Valuation of a Savings Institution <ul><li>Investors required rate of return </li></ul> k = f (  R f ,  RP) + + R f = Risk free interest rate Where: RP = Risk premium
  27. 27. Valuation of a Savings Institution <ul><li>Change in the risk-free rate </li></ul> 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. 28. Valuation of a Savings Institution <ul><li>Change in the risk premium </li></ul>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. 29. Performance of Savings Institutions <ul><li>Performance Trends </li></ul><ul><ul><li>Lower net interest margins—earning asset yields declined faster than interest expense </li></ul></ul><ul><ul><li>Noninterest income improvement </li></ul></ul><ul><ul><li>Declining loan loss provisions </li></ul></ul><ul><ul><li>Lower non interest expense </li></ul></ul><ul><ul><li>Net earnings (ROA) improving </li></ul></ul>
  30. 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. 31. Savings and Loan Crisis <ul><li>During the 1980s many S&Ls failed </li></ul><ul><li>Reasons for failure </li></ul><ul><ul><li>Losses on loans and securities </li></ul></ul><ul><ul><ul><li>Loan losses related to commercial real estate </li></ul></ul></ul><ul><ul><ul><li>Junk bond losses </li></ul></ul></ul><ul><ul><li>Fraud as illustrated by a wide variety of examples </li></ul></ul><ul><ul><li>Lack of liquidity </li></ul></ul>
  32. 32. Savings and Loan Crisis <ul><li>Provisions of the FIRREA </li></ul><ul><ul><li>New regulations designed to solve the crisis </li></ul></ul><ul><ul><li>Bailout bill contained numerous provisions </li></ul></ul><ul><li>Resolution Trust Corporation formed to deal with insolvent S&Ls until it was dissolved in 1995 </li></ul><ul><li>Several methods for dealing with failures </li></ul>
  33. 33. Savings and Loan Crisis <ul><li>Bailout of savings institutions was financed from several sources including </li></ul><ul><ul><li>Sale of failed S&L assets </li></ul></ul><ul><ul><li>Taxpayers </li></ul></ul><ul><ul><li>Surviving S&Ls </li></ul></ul><ul><li>Impact of the bailout </li></ul><ul><ul><li>Stronger capital positions </li></ul></ul><ul><ul><li>Higher asset quality </li></ul></ul><ul><ul><li>More consolidation </li></ul></ul>
  34. 34. Savings and Loan Crisis <ul><li>Institutions have performed well since FIRREA based on a number of criteria </li></ul><ul><li>Future outlook for the industry </li></ul><ul><ul><li>Increase efficiencies by </li></ul></ul><ul><ul><ul><li>Reducing noninterest expenses </li></ul></ul></ul><ul><ul><ul><li>Divest inefficient assets </li></ul></ul></ul><ul><ul><li>Continue to diversify asset mix </li></ul></ul><ul><ul><li>Conflict between diversification and specialization </li></ul></ul>
  35. 35. Savings Institutions in Other Countries <ul><li>Institutions in other countries have not had problems similar to those in the United States </li></ul><ul><li>Institutions in other countries have characteristics that let them reduce susceptibility to economic conditions </li></ul><ul><ul><li>Reduced interest rate risk </li></ul></ul><ul><ul><li>Less regulated; more asset diversification </li></ul></ul><ul><li>Different regulations apply to institutions in different countries </li></ul>