Chapter 21
Thrift Operations
Financial Markets and Institutions, 7e, Jeff Madura
Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.
1
Chapter Outline
Background on savings institutions
 Sources and uses of funds
 Exposure to risk
 Management of interest rate risk
 Valuation of a savings institution
 Interaction with other financial institutions

2
Chapter Outline (cont’d)
Participation in financial markets
 Performance of savings institutions
 Savings institution crisis
 Background on credit unions
 Sources and uses of credit union funds
 Credit union exposure to risk
 Regulation of credit unions

3
Background on Savings Institutions

Savings institutions include savings banks and
S&Ls
 S&Ls
are the most dominant type
 Savings institutions are mainly concentrated in the
Northeast
 The insuring agency for S&Ls is the Savings
Association Insurance Fund (SAIF)
 The insuring agency for savings banks is the Bank
Insurance Fund (BIF)

Both agencies are administered by the FDIC
 Savings
banks and S&Ls are very similar in their
sources and uses of funds
4
Background on Savings Institutions
(cont’d)
2%
20%
78%
More than $1
billion
Between $100
million and $1
billion
Less than $100
million
5
Background on Savings Institutions
(cont’d)

Ownership
 Most
SIs are mutual (owned by depositors)
 Many SIs have shifted their ownership structure from
depositors to shareholders through mutual-to-stockconversions



Allow SIs to obtain additional capital by issuing stock
Provide owners with greater potential to benefit from
performance
Make SIs more susceptible to hostile takeovers
6
Background on Savings Institutions
(cont’d)

Ownership (cont’d)
 In

an acquisition, both SIs have to be stock-owned
Merger-conversion
 The
number of SIs today is about one-half of the
number in 1994
 The total assets of stock SIs has increased by more
than 60 percent since 1994
 The total assets of mutual SIs has remained steady
since 1994
7
Background on Savings Institutions
(cont’d)

Regulation of savings institutions




Regulated at both the state and federal level
Federally chartered SIs are regulated by the Office of Thrift
Supervision (OTS)
State-chartered SIs are regulated by the state that has
chartered them
Regulatory assessment of SIs



Regulators conduct periodic onsite examinations of capital and risk
Monitoring is conducted using the CAMELS rating
Deregulation of services

Recently, SIs have been granted more flexibility to diversify
products
8
Sources of Funds (cont’d)

Borrowed funds




SIs can borrow from other depository institutions in the federal
funds market
SIs can borrow at the Fed’s discount window
SIs can borrow through repos
Capital


The capital (net worth) of SIs is composed of retained earnings
and funds obtained from issuing stock
SIs are required to maintain a minimum level of capital
9
Uses of Funds

Cash
 SIs
maintain cash to satisfy reserve requirements
and accommodate withdrawal requests

Mortgages:
 Are
the primary asset of SIs
 Typically have long-term maturities and can be
prepaid by borrowers
 Are mostly for homes or multifamily dwellings
 Are subject to interest rate risk and default risk
10
Uses of Funds (cont’d)

Mortgage-backed securities
 SIs
issue securities backed by mortgages
 Cash flows to holders of these securities may not be
steady because of prepayment

Other securities
 All
SIs invest insecurities such as Treasury bonds
and corporate bonds

Provide liquidity
 Some
thrifts invested in junk bonds prior to 1989
11
Uses of Funds (cont’d)
Single-Family
Mortgages
Multifamily
Morgages
Other Mortgages
11%
12%
Commercial Loans
50%
8%
Mortgage-Backed
Securities
Other Securities
6%
4%
4%
Consumer Loans
5%
Other Assets
12
Exposure to Risk

Liquidity risk




SIs commonly use short-term liabilities to finance long-term
assets
If new deposits are not sufficient to cover withdrawal requests,
SIs can experience liquidity problems
SIs can obtain temporary funds through repurchase agreements
or in the federal funds market
Credit risk



Conventional mortgages are the primary source of credit risk
SIs often carry the risk rather than paying for insurance
Many SIs were adversely affected by the weak economy in
2001–2002
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Exposure to Risk (cont’d)

Interest rate risk
 Many
SIs were hurt by rising interest rates in the
1980s because of their heavy concentration on fixedrate mortgages
 Many SIs benefited from their exposure to interest
rate risk in the 2001–2002 period when interest rates
declined
14
Management of Interest Rate Risk
(cont’d)

Conclusions about interest rate risk
 Although
strategies are useful, it is virtually
impossible to completely eliminate interest rate risk

Mortgages may be prepaid
15
Valuation of a Savings Institution

The value should change in response to
changes in its expected cash flows and to
changes in the required rate of return:
V  f E (CF ), k 

-
16
Valuation of a Savings Institution
(cont’d)

Factors that affect cash flows
E (CF )  f ( ECON, Rf , INDUS, MANAB)

 Change

-
?

in economic growth
During periods of strong economic growth:


Consumer loan and mortgage loan demand is higher
Loan defaults are reduced
17
Valuation of a Savings Institution
(cont’d)

Factors that affect cash flows (cont’d)
 Change

SIs’ cash flows are inversely related to interest rate
movements


SIs rely heavily on short-term deposits
SIs’ assets commonly have fixed rates
 Change

in the risk-free interest rate
in industry conditions
SIs are exposed to regulatory constraints, technology, and
competition
18
Valuation of a Savings Institution
(cont’d)

Factors that affect cash flows (cont’d)
 Change
in management abilities
Managers can attempt to make internal decisions
that will capitalize on the external forces that the
bank cannot control
 Skillful managers will recognize how to revise the
composition of the SI’s assets and liabilities to
capitalize on existing economic or regulatory
conditions

19
Valuation of a Savings Institution
(cont’d)

Factors that affect the required rate of
return by investors
k  f ( Rf , RP )


 Change in the risk-free rate

When the risk-free rate increases, so does the return
required by investors:
Rf  f ( INF, ECON, MS, DEF )


-

20
Valuation of a Savings Institution
(cont’d)

Factors that affect the required rate of
return by investors (cont’d)
 Change

in the risk premium
When the risk premium increases, so does the return
required by investors:
RP  f ( ECON, INDUS, MANAB)
?
-
21
Savings Institution Crisis (cont’d)

Reasons for failure (cont’d)
 Losses
on loans and securities
Crisis was precipitated by unpaid loans
 Major loan losses were in commercial real estate
 SIs were forced to assume real estate holdings
that were sometimes worth less than half the loan
amount originally provided

 Fraud

Most commonly, managers used depositors’ funds
for purchases of personal assets
22
Savings Institution Crisis (cont’d)

Reasons for failure (cont’d)
 Illiquidity
SIs experienced a cash flow deficiency as a result
of loan losses
 SIs were forced to offer higher interest rates on
deposits to attract more funds
 The FSLIC was experiencing its own liquidity
problems, exacerbating the liquidity problem

23
Savings Institution Crisis (cont’d)

Impact of the bailout
 Stronger

Many SIs are now required to maintain a higher
minimum level of capital
 Higher

asset quality
SIs have been forced to maintain more
conservative asset portfolios
 More

capital positions
consolidation
FIRREA allows commercial banks and other
institutions to purchase failing or healthy SIs
24
Background on Credit Unions

Credit unions are nonprofit organizations
composed of members with a common
bond
 e.g.,

labor union, church, university
CUs accept deposits from members and
channel funds to those members who
want to finance the purchase of assets
25
Background on Credit Unions
(cont’d)

Ownership of credit unions
 CUs
are technically owned by depositors
 Deposits are called shares, which pay
dividends
 CUs’ income is not taxed
 CUs can be federally or state chartered

Federal CUs are growing at a faster rate
 Most
CUs are very small
26
Background on Credit Unions
(cont’d)

Advantages and disadvantages of credit unions
 Can
offer attractive rates to their members
 Noninterest expenses are relatively low because
much of their assets is donated
 Volunteer labor may not have the incentive to manage
operations efficiently
 Common bond requirements restrict a given CU’s
growth


Many CUs are unable to diversify geographically
CUs have increasingly been merging
27
Sources and Uses of Credit Union
Funds

Sources of funds
 Mostly from share deposits by members
 Either share deposits, share certificates, or share drafts
 For temporary funds, CUs can borrow from other CUs
or from the Central Liquidity Facility (CLF)

Acts as a lender similar to the Fed’s discount window
 CUs
maintain capital, primarily in the form of retained
earnings

Uses of funds
 The majority of funds is used for loans to members
 Some CUs offer long-term mortgage loans
 CUs purchase government and agency securities
28
Credit Union Exposure to Risk

Liquidity risk
 CUs
can experience liquidity problems when an
unanticipated wave of withdrawal occurs without an
offsetting amount of new deposits

Credit risk
 CUs
concentrate on personal loans to members
 Most loans are secured
 CUs with very lenient loan policies could experience
losses
29
Credit Union Exposure to Risk
(cont’d)

Interest rate risk
 Maturities
on consumer loans are short term,
causing assets to be rate sensitive
 Movements in interest revenues and interest
expenses are highly correlated
 The spread between interest revenues and
interest expenses remains stable over time
30