Chapter 21

Thrift Operations

Financial Markets and Institutions, 7e, Jeff Madura

Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

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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

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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

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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
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Background on Savings Institutions
(cont’d)
2%

More than $1
20%
billion

Between $100
million and $1
billion
Less than $100
million
78%

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Background on Savings Institutions
(cont’d)
 Ownership
 MostSIs are mutual (owned by depositors)
 Many SIs have shifted their ownership structure from
depositors to shareholders through mutual-to-stock-
conversions
 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

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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

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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

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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

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Uses of Funds
 Cash
 SIsmaintain 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

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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

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Uses of Funds (cont’d)
Single-Family
Mortgages
11% Multifamily
Morgages
Other Mortgages
12%
Commercial Loans
50%
8% Consumer Loans

6% Mortgage-Backed
Securities
4% Other Securities
5%
4% Other Assets

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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 fixed-
rate mortgages
 Many SIs benefited from their exposure to interest
rate risk in the 2001–2002 period when interest rates
declined

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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

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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 
 -

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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

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Valuation of a Savings Institution
(cont’d)
 Factors that affect cash flows (cont’d)
 Change in the risk-free interest rate
 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 industry conditions
 SIs are exposed to regulatory constraints, technology, and
competition

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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

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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 )

  - 
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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 )

- ? -

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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

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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

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Savings Institution Crisis (cont’d)
 Impact of the bailout
 Stronger capital positions
 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 consolidation
 FIRREA allows commercial banks and other
institutions to purchase failing or healthy SIs
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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

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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
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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

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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
 Themajority of funds is used for loans to members
 Some CUs offer long-term mortgage loans
 CUs purchase government and agency securities

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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

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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

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