COMSATS Virtual Campus
Islamabad
Handouts No 17
Savings and loan association
A savings and loan association (or S&L), also known as a thrift, is a financial institution that
specializes in accepting savings deposits and making mortgage and other loans. The terms
"S&L" or "thrift" are mainly used in the United States; similar institutions in the United
Kingdom, Ireland and
some Commonwealth countries
include building
societiesand trustee
savings banks. They are often mutually held (often called mutual savings banks[citation
needed]
),
meaning that the depositors and borrowers are members with voting rights, and have the ability
to direct the financial and managerial goals of the organization like the members of a credit
union or the policyholders of a mutual insurance company. While it is possible for an S&L to be
a joint-stock company, and even publicly traded, in such instances it is no longer truly a mutual
association, and depositors and borrowers no longer have membership rights and managerial
control. By law, thrifts can have no more than 20 percent of their lending in commercial loans —
their focus on mortgage and consumer loans makes them particularly vulnerable to housing
downturns such as the deep one the U.S. has experienced since 2007.
Early history of the savings and loan association
At the beginning of the 19th century, banking was still something only done by those who
had assets or wealth that needed safekeeping. The first savings bank in the United States,
the Philadelphia Saving Fund Society, was established on December 20, 1816, and by the 1830s
such institutions had become widespread.
In the United Kingdom, the first savings bank was founded in 1810 by the Reverend Henry
Duncan, Doctor of Divinity, the minister of RuthwellChurch in the Dumfriesshire, Scotland. It is
home to the Savings Bank Museum, in which there are records relating to the history of
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the savings bank movement in the United Kingdom, as well as family memorabilia relating
to Henry Duncan and other prominent people of the surrounding area. However the main type of
institution similar to U.S. savings and loan associations in the United Kingdom is not the savings
bank, but thebuilding society and had existed since the 1770s.
U.S. savings and loan in the 20th century
The savings and loan association became a strong force in the early 20th century through
assisting people with home ownership, throughmortgage lending, and further assisting their
members with basic saving and investing outlets, typically through passbook savings accounts
and term certificates of deposit.
The savings and loan associations of this era were famously portrayed in the 1946 film It's a
Wonderful Life.
Mortgage lending
The earliest mortgages were not offered by banks, but by insurance companies, and they differed
greatly from the mortgage or home loan that is familiar today. Most early mortgages were short
term with some kind of balloon payment at the end of the term, or they were interest-only
loans which did not pay anything toward the principal of the loan with each payment. As such,
many people were either perpetually in debt in a continuous cycle of refinancing their home
purchase, or they lost their home through foreclosurewhen they were unable to make the balloon
payment at the end of the term of that loan.
The US Congress passed the Federal Home Loan Bank Act in 1932, during the Great
Depression. It established the Federal Home Loan Bank and associated Federal Home Loan
Bank Board to assist other banks in providing funding to offer long term, amortized loans for
home purchases. The idea was to get banks involved in lending, not insurance companies, and to
provide realistic loans which people could repay and gain full ownership of their homes.
Savings and loan associations sprang up all across the United States because there was low-cost
funding available through the Federal Home Loan Bank for the purposes of mortgage lending.
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Further advantages
Savings and loans were given a certain amount of preferential treatment by the Federal
Reserve inasmuch as they were given the ability to pay higher interest rates on savings deposits
compared to a regular commercial bank. This was known as Regulation Q (The Interest Rate
Adjustment Act of 1966) and gave the S&Ls 50 basis points above what banks could offer. The
idea was that with marginally higher savings rates, savings and loans would attract more deposits
that would allow them to continue to write more mortgage loans, which would keep the
mortgage market liquid, and funds would always be available to potential borrowers.
However, savings and loans were not allowed to offer checking accounts until the late 1970s.
This reduced the attractiveness of savings and loans to consumers, since it required consumers to
hold accounts across multiple institutions in order to have access to both checking privileges and
competitive savings rates.
In the 1980s the situation changed. The United States Congress granted all thrifts in 1980,
including savings and loan associations, the power to make consumer and commercial loans and
to issue transaction accounts. The Depository Institutions Deregulation and Monetary Control
Act (DIDMCA) of 1980 was designed to help the banking industry to combat disintermediation
of funds to higher-yielding non-deposit products such as money market mutual funds. It also
allowed thrifts to make consumer loans up to 20 percent of their assets, issue credit cards, and
provide negotiable order of withdrawal (NOW) accounts to consumers and nonprofit
organizations. Over the next several years, this was followed by provisions that allowed banks
and thrifts to offer a wide variety of new market-rate deposit products. For S&Ls, this
deregulation of one side of the balance sheet essentially led to more inherent interest rate risk
inasmuch as they were funding long-term, fixed rate mortgage loans with volatile shorter-term
deposits.
In 1982, the Garn-St. Germain Depository Institutions Act was passed and increased the
proportion of assets that thrifts could hold in consumer and commercial real estate loans and
allowed thrifts to invest 5 percent of their assets in commercial, corporate, business, or
agricultural loans until January 1, 1984, when this percentage increased to 10 percent.
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Decline of S&Ls
During the Savings and Loan Crisis, from 1986 to 1995, the number of federally insured savings
and loans in the United States declined from 3,234 to 1,645. This was primarily, but not
exclusively, due to unsound real estate lending. The market share of S&Ls for single family
mortgage loans went from 53% in 1975 to 30% in 1990.
The following is a detailed summary of the major causes for losses that hurt the S&L business in
the 1980s according to the United States League of Savings Associations:
1. Lack of net worth for many institutions as they entered the 1980s, and a wholly
inadequate net worth regulation.
2. Decline in the effectiveness of Regulation Q in preserving the spread between the cost of
money and the rate of return on assets, basically stemming from inflation and the
accompanying increase in market interest rates.
3. Absence of an ability to vary the return on assets with increases in the rate of interest
required to be paid for deposits.
4. Increased competition on the deposit gathering and mortgage origination sides of the
business, with a sudden burst of new technology making possible a whole new way of
conducting financial institutions generally and the mortgage business specifically.
5. A rapid increase in investment powers of associations with passage of the Depository
Institutions Deregulation and Monetary Control Act (the Garn-St Germain Act), and,
more important, through state legislative enactments in a number of important and
rapidly growing states. These introduced new risks and speculative opportunities which
were difficult to administer. In many instances management lacked the ability or
experience to evaluate them, or to administer large volumes of nonresidential
construction loans.
6. Elimination of regulations initially designed to prevent lending excesses and minimize
failures. Regulatory relaxation permitted lending, directly and through participations, in
distant loan markets on the promise of high returns. Lenders, however, were not familiar
with these distant markets. It also permitted associations to participate extensively in
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speculative construction activities with builders and developers who had little or no
financial stake in the projects.
7. Fraud and insider transaction abuses, especially in the case of state-chartered and
regulated thrifts, where regulatory supervision at the state level was lax, thinly-spread,
and/or insufficient (e.g.: Texas, Arizona).
8. A new type and generation of opportunistic savings and loan executives and owners —
some of whom operated in a fraudulent manner — whose takeover of many institutions
was facilitated by a change in FSLIC rules reducing the minimum number of
stockholders of an insured association from 400 to one.
9. Dereliction of duty on the part of the board of directors of some savings associations.
This permitted management to make uncontrolled use of some new operating authority,
while directors failed to control expenses and prohibit obvious conflict of interest
situations.
10. A virtual end of inflation in the American economy, together with overbuilding in
multifamily, condominium type residences and in commercial real estate in many cities.
In
addition,
real
estate
values
collapsed
in
the
energy
states
—
Texas, Louisiana, Oklahoma particularly due to falling oil prices — and weakness
occurred in the mining and agricultural sectors of the economy.
11. Pressures felt by the management of many associations to restore net worth ratios.
Anxious to improve earnings, they departed from their traditional lending practices into
credits and markets involving higher risks, but with which they had little experience.
12. The lack of appropriate, accurate, and effective evaluations of the savings and loan
business by public accounting firms, security analysts, and the financial community.
13. Organizational structure and supervisory laws, adequate for policing and controlling the
business in the protected environment of the 1960s and 1970s, resulted in fatal delays
and indecision in the examination/supervision process in the 1980s.
14. Federal and state examination and supervisory staffs insufficient in number, experience,
or ability to deal with the new world of savings and loan operations.
15. The inability or unwillingness of the Federal Home Loan Bank Board and its legal and
supervisory staff to deal with problem institutions in a timely manner. Many institutions,
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which ultimately closed with big losses, were known problem cases for a year or more.
Often, it appeared, political considerations delayed necessary supervisory action.[5]
While not specifically identified above, a related specific factor was that S&Ls and their lending
management were often inexperienced with the complexities and risks associated with
commercial and more complex loans as distinguished from their roots with "simple" home
mortgage loans.
The consequences of U.S. government acts and reforms
As a result, the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA)
dramatically changed the savings and loan industry and its federal regulation. Here are the
highlights of this legislation, signed into law August 9, 1989:
1. The Federal Home Loan Bank Board (FHLBB) and the Federal Savings and Loan
Insurance Corporation (FSLIC) were abolished.
2. The Office of Thrift Supervision (OTS), a bureau of the United States Treasury
Department, was created to charter, regulate, examine, and supervise savings institutions.
3. The Federal Housing Finance Board (FHFB) was created as an independent agency to
oversee the 12 Federal Home Loan Banks (also called district banks), formerly overseen
by the FHLBB.
4. The Savings Association Insurance Fund (SAIF) replaced the FSLIC as an ongoing
insurance
fund
for
thrift
institutions.
(Like
the Federal
Deposit
Insurance
Corporation(FDIC), FSLIC was a permanent corporation that insured savings and loan
accounts up to $100,000.) SAIF was administered by the FDIC alongside its sister fund
for banks, Bank Insurance Fund (BIF) until 2006 when the Federal Deposit Insurance
Reform Act of 2005 (effective February 2006) provided, among other provisions, that
the two funds merge to constitute the Depositor Insurance Fund (DIF), which would
continue to be administered by the FDIC.
5. The Resolution Trust Corporation (RTC) was established to dispose of failed thrift
institutions taken over by regulators after January 1, 1989.
6. FIRREA gave both Freddie Mac and Fannie Mae additional responsibility to support
mortgages for low- and moderate-income families.
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The Tax Reform Act of 1986 had also eliminated the ability for investors to reduce regular wage
income by so-called "passive" losses incurred from real estate investments, e.g., depreciation and
interest deductions. This caused real estate value to decline as investors pulled out of this sector.
The characteristics of savings and loan associations
The most important purpose of these institutions is to make mortgage loans on residential
property. These organizations, which also are known as savings associations, building and loan
associations, cooperative banks (in New England), and homestead associations (in Louisiana),
are the primary source of financial assistance to a large segment of American homeowners. As
home-financing institutions, they give primary attention to single-family residences and are
equipped to make loans in this area.
Some of the most important characteristics of a savings and loan association are:
1. It is generally a locally owned and privately managed home financing institution.
2. It receives individuals' savings and uses these funds to make long-term amortized loans to
home purchasers.
3. It makes loans for the construction, purchase, repair, or refinancing of houses.
4. It is state or federally chartered.
How savings banks are different from savings and loans
Accounts at savings banks were insured by the FDIC. When the Western Savings Bank of
Philadelphia failed in 1982, it was the FDIC that arranged its absorption into the Philadelphia
Savings Fund Society (PSFS).[citation
needed]
Savings banks were limited by law to only offer
savings accounts and to make their income from mortgages and student loans. Savings banks
could pay one-third of 1% higher interest on savings than could a commercial bank. PSFS
circumvented this by offering "payment order" accounts which functioned as checking accounts
and were processed through the Fidelity Bank of Pennsylvania.[citation
needed]
The rules were
loosened so that savings banks could offer automobile loans, credit cards, and actual checking
accounts.[citation needed] In time PSFS became a full commercial bank.
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Accounts at savings and loans were insured by the FSLIC. Some savings and loans did become
savings banks, such as First Federal Savings Bank of Pontiac in Michigan. What gave away their
heritage was their accounts continued to be insured by the FSLIC.
Savings and loans accepted deposits and used those deposits, along with other capital that was in
their possession, to make loans. What was revolutionary was that the management of the savings
and loan was determined by those that held deposits and in some instances had loans. The
amount of influence in the management of the organization was determined based on the amount
on deposit with the institution.
The overriding goal of the savings and loan association was to encourage savings and investment
by common people and to give them access to a financial intermediary that otherwise had not
been open to them in the past. The savings and loan was also there to provide loans for the
purchase of large ticket items, usually homes, for worthy and responsible borrowers. The early
savings and loans were in the business of "neighbors helping neighbors"
Credit risk
Credit risk refers to the risk that a borrower will default on any type of debt by failing to make
required
payments.[1] The
risk
is
primarily
that
of
the
lender
and
includes
lost principal and interest, disruption to cash flows, and increased collection costs. The loss may
be complete or partial and can arise in a number of circumstances.[2] For example:

A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit,
or other loan

A company is unable to repay asset-secured fixed or floating charge debt

A business or consumer does not pay a trade invoice when due

A business does not pay an employee's earned wages when due

A business or government bond issuer does not make a payment on a coupon or principal
payment when due

An insolvent insurance company does not pay a policy obligation

An insolvent bank won't return funds to a depositor

A government grants bankruptcy protection to an insolvent consumer or business
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To reduce the lender's credit risk, the lender may perform a credit check on the prospective
borrower, may require the borrower to take out appropriate insurance, such as mortgage
insurance or seek security or guarantees of third parties. In general, the higher the risk, the higher
will be the interest rate that the debtor will be asked to pay on the debt.
Types of credit risk
Credit risk can be classified as follows:

Credit default risk — The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit
obligation; default risk may impact all credit-sensitive transactions, including loans,
securities and derivatives.

Concentration risk — The risk associated with any single exposure or group of exposures
with the potential to produce large enough losses to threaten a bank's core operations. It may
arise in the form of single name concentration or industry concentration.

Country risk — The risk of loss arising from a sovereign state freezing foreign currency
payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk);
this type of risk is prominently associated with the country's macroeconomic performance
and its political stability.
Assessing credit risk
Significant resources and sophisticated programs are used to analyze and manage risk. [4] Some
companies run a credit risk department whose job is to assess the financial health of their
customers, and extend credit (or not) accordingly. They may use in house programs to advise on
avoiding, reducing and transferring risk. They also use third party provided intelligence.
Companies like Standard & Poor's, Moody's, Fitch Ratings, Dun and Bradstreet, and Rapid
Ratings provide such information for a fee.
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Most lenders employ their own models (credit scorecards) to rank potential and existing
customers according to risk, and then apply appropriate strategies.[5] With products such as
unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers
and vice versa.[6][7] With revolving products such as credit cards and overdrafts, risk is controlled
through the setting of credit limits. Some products also require collateral, most commonly in the
form of property.
Credit scoring models also form part of the framework used by banks or lending institutions to
grant credit to clients. For corporate and commercial borrowers, these models generally have
qualitative and quantitative sections outlining various aspects of the risk including, but not
limited to, operating experience, management expertise, asset quality, and leverage and liquidity
ratios, respectively. Once this information has been fully reviewed by credit officers and credit
committees, the lender provides the funds subject to the terms and conditions presented within
the contract (as outlined above).
Sovereign risk
Sovereign risk is the risk of a government being unwilling or unable to meet its loan obligations,
or reneging on loans it guarantees. Many countries have faced sovereign risk in thelate-2000s
global recession. The existence of such risk means that creditors should take a two-stage decision
process when deciding to lend to a firm based in a foreign country. Firstly one should consider
the sovereign risk quality of the country and then consider the firm's credit quality.[8]
Five macroeconomic variables that affect the probability of sovereign debt rescheduling are:[9]

Debt service ratio

Import ratio

Investment ratio

Variance of export revenue

Domestic money supply growth
The probability of rescheduling is an increasing function of debt service ratio, import ratio,
variance of export revenue and domestic money supply growth. The likelihood of rescheduling is
a decreasing function of investment ratio due to future economic productivity gains. Debt
rescheduling likelihood can increase if the investment ratio rises as the foreign country could
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become less dependent on its external creditors and so be less concerned about receiving credit
from these countries/investors.
Counterparty risk
A counterparty risk, also known as a default risk, is a risk that a counterparty will not pay as
obligated
on
a bond, credit
derivative, trade
credit
insurance or payment
protection
insurance contract, or other trade or transaction. Financial institutions may hedge or take out
credit insurance. Offsetting counterparty risk is not always possible, e.g. because of
temporary liquidity issues or longer term systemic reasons.
Counterparty risk increases due to positively correlated risk factors. Accounting for correlation
between portfolio risk factors and counterparty default in risk management methodology is not
trivial.[13]
Mitigating credit risk
Lenders mitigate credit risk using several methods:

Risk-based pricing: Lenders generally charge a higher interest rate to borrowers who are
more likely to default, a practice called risk-based pricing. Lenders consider factors relating
to the loan such as loan purpose, credit rating, and loan-to-value ratio and estimates the
effect on yield (credit spread).

Covenants: Lenders may write stipulations on the borrower, called covenants, into loan
agreements:

Periodically report its financial condition

Refrain from paying dividends, repurchasing shares, borrowing further, or other specific,
voluntary actions that negatively affect the company's financial position

Repay the loan in full, at the lender's request, in certain events such as changes in the
borrower's debt-to-equity ratio or interest coverage ratio

Credit insurance and credit derivatives: Lenders and bond holders may hedge their credit
risk by purchasing credit insurance or credit derivatives. These contracts transfer the risk
from the lender to the seller (insurer) in exchange for payment. The most common credit
derivative is the credit default swap.
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
Tightening: Lenders can reduce credit risk by reducing the amount of credit extended, either
in total or to certain borrowers. For example, a distributor selling its products to a
troubled retailer may attempt to lessen credit risk by reducing payment terms from net
30 to net 15.

Diversification: Lenders to a small number of borrowers (or kinds of borrower) face a high
degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk
by diversifying the borrower pool.

Deposit insurance: Many governments establish deposit insurance to guarantee bank
deposits in the event of insolvency and encourage consumers to hold their savings in the
banking system instead of in cash.
Interest Rate Risk
It's common today to discount the importance of that old dependable asset liability standby, the
gap report. Yet, the gap report still provides an important window on interest rate risk. Let's
review basic gap analysis, and then look at two banks and their gap results.
Gap is the difference between the amount of assets and liabilities on which interest rates are reset
during any particular bucket of time. If a bank has both $5 million in assets and $5 million in
liabilities that reprice in any given time window, changes in interest rates should not change the
bank's net interest margin. This is known as a balanced gap position.
If instead, $10 million in assets reprice with only $5 million in liabilities repricing, the bank is in
an asset sensitive position. An asset sensitive bank will enjoy a net interest margin increase if
interest rates increase. Of course, as we've seen over the past few years, the asset sensitive bank
will have net interest margin compression if rates fall.
The converse situation, with $5 million in assets repricing during the same period that $10
million in liabilities reprice is known as a liability sensitive position. Here, if interest rates
increase net interest margin will decline. Similarly, if interest rates fall the liability sensitive
bank will anticipate a wider net interest margin.
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One of the key criticisms of gap analysis is that it fails to account for optionality in assets and
liabilities. That is, if rates fall and your assets prepay faster, or if rates rise and the average life
of your assets extend, this information is typically not given by a simple static gap report.
Another criticism concerns repricing assumptions on non-maturity deposits. This is a critical
assumption and a recent blog post shows our perspective.
In order to deal with these criticisms, when we create a gap analysis we don't stop with the static
information from the ledger. Instead, we examine each line item and every time bucket of assets
and liabilities for potential prepayment activity. Some line items such as U.S. Treasury
securities, are typically non-prepayable bullets and no adjustment is needed. Loans however,
typically amortize, as well as prepay at different speeds for different interest rate environments.
By adjusting our base case gap analysis for these, and other, likely behavior traits, we begin the
process of converting static accounting data into a dynamic asset liability format. We further
extend the analysis by examining the change in the bucketed cash flows for each of the rate
shock environments.
So now that we have literally pages of detailed cash flow information, how do we evaluate it?
It's here that a picture truly is worth 1000 words. Let's take a look at two examples. The chart
shows cumulative gap for each of the time buckets and how it changes in each interest rate shock
scenario.
The first bank shows a cumulative
gap that is a negative at the one year
point, indicating a slight liability
sensitive position. Note however
that all of the lines representing the
various interest rate scenarios are tightly bound. This indicates that regardless of the movement
in interest rates the bank's gap position is not expected to change significantly.
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Now let's look at the second bank. Here, the cumulative gap position is positive, indicating asset
sensitivity, in the one year bucket. Note however the significantly wider variability in gap given
changes in interest rates. The message is
clear. As rates change this bank's gap
position, especially in the one to three year
bucket, will vary substantially. If you were
to look at the underlying cash flow detail, he
would find this bank holds significant volumes of fixed rate securities and loans that reprice in
the one to three year window. By examining the area of widest variability in gap, you have a
head start on identifying the time periods with the most inherent interest rate risk.
In fact, if we were to look at the other measurements of interest rate risk for the same banks we
would find that earnings at risk, and economic value of equity show behavior consistent with
gap. That is, the first bank shows a very flat to neutral earnings at risk, and economic value of
equity, with a slight bias toward long term liability sensitivity. The second bank, with wider
variability in gap results, also shows substantially higher variability in both earnings at risk and
EVE.
For most community banks, without a concentration of complex instruments on the balance
sheet, the three basic measurements of interest rate risk should generally show consistent results.
Don't shy away from using gap to identify where your interest rate risk lies simply because it's an
older, time-tested tool. As long as you understand the limitations of gap, it remains a highly
effective measure of interest rate risk.
Duration gap
Definition
The difference between the duration of assets and liabilities held by a financial entity.
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Overview
The duration gap is a financial and accounting term and is typically used by banks, pension
funds, or other financial institutions to measure their risk due to changes in the interest rate. This
is one of the mismatches that can occur and are known as asset liability mismatches.
Another way to define Duration Gap is: it is the difference in the price sensitivity of interestyielding assets and the price sensitivity of liabilities (of the organization ) to a change in market
interest rates (yields).[2]
The duration gap measures how well matched are the timings of cash inflows (from assets) and
cash outflows (from liabilities).
When the duration of assets is larger than the duration of liabilities, the duration gap is positive.
In this situation, if interest rates rise, assets will lose more value than liabilities, thus reducing the
value of the firm's equity. If interest rates fall, assets will gain value while liabilities lose value,
thus increasing the value of the firm's equity.
Conversely, when the duration of assets is less than the duration of liabilities, the duration gap is
negative. If interest rates rise, liabilities will lose more value than assets, thus increasing the
value of the firm's equity. If interest rates decline, liabilities will gain more value than assets,
thus decreasing the value of the firm's equity.
By
duration
matching,
that
is
creating
a
zero
duration
gap,
the
firm
becomes immunized against interest rate risk. Duration has a double-facet view. It can be
beneficial or harmful depending on where interest rates are headed.
Some of the limitations of duration gap management include the following:

the difficulty in finding assets and liabilities of the same duration

some assets and liabilities may have patterns of cash flows that are not well defined

customer prepayments may distort the expected cash flows in duration

customer defaults may distort the expected cash flows in duration

convexity can cause problems.
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When the duration gap is zero, the firm is immunized only if the size of the liabilities equals the
size of the assets. In this example with a two-year loan of one million and a one-year asset of two
millions, the firm is still exposed to rollover risk after one year when the remaining year of the
two-year loan has to be financed.
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