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FINA 3315

Chapter 21

thrift institution aka savings institution.. a depository institution that specializes in mortgage lending.
Why thrift institutions were created? To accept deposits and channel the funds for mortgage loans
What do savings institutions include and which is the most dominant type? Savings banks and savings and loan associations. S&Ls are the most dominant.
How are savings institutions classified? As either stock owned or mutual (owned by depositors).
mutual-to-stock conversion allows SIs to obtain additional capital by issuing stock
What do stock-owned institutions provide to their owners? Provide them with greater potential to benefit from their performance. Divdidends and/or stock price of a high-performance instituion can grow, therby providing direct benefits to the shareholders.
What are stock-owned institutions susceptible to? Because of the difference in owner control, they are more susceptible to unfriendly takeovers. management doesn't hold all voting rights.
Process of merger-conversion A mutual SI is converted to a stock owned SI in an acquisition. The acquiring firm then arranges to purchase the existing stock to be acquired. The acquiring institution purchases the stock.
Can the SI stil maintain its operations when it has been acquired by a commercial bank? Yes it can. It can maintain its operation but under the ownership of the commerical bank.
What has happened to the number of SIs since consolidations and acquisitions? It has caused the number of mutual and stock SIs to decline consistently over the years. There are less than half as many SIs today as in 1994.
What has happened to the total amount of SI assets? The total assets of stock SIs have more than doubled since 1994, while the total assets of mutual SIs has remained steady.
How are savings institutions regulated? Regulated at both the state and federal levels.
Who regulates federally chartered SIs? Regulated by the Office of Thrift Supervision (OTS).
Who regulates state chartered SIs? Are subject to some oversight by the state that has chartered them, but the states have no authority over federally chartered institutions.
Deposit Insurance Fund (DIF) The insuring agency for both S&Ls and savings banks. It is administered by the Federal Deposit Insurance Corportation (FDIC) and insured deposits up to $250,000 until 2013. Formed on March 31, 2006 as a result of the merger of the SAIF.
Savings Association Insurance Fund (SAIF) formerly insured SIs and the Bank Insurance Fund (BIF), which had insured savings banks. The FDIC charges the SIs annual insurance premiums, which are placed in the DIF. If an SI fails, the FDIC uses funds from the DIF to reimburse depositors.
How are SIs monitored? Monitored using the CAMELS rating. Assessed according to their capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to mk conditions. If an SI gets a CAMELS rating of 4 or up, it is named a "problem" and recieves attention.
How have SIs been deregulated? In recent years, SIs have been granted more flexibility to diverisfy the products and services they provide. Have merged with other businesses specializing in real estate, insurance, and brokerage.
What are SIs' main sources of funds? Deposits, borrowed funds, and capital
Types of deposits SIs obtain most of their funds from a variety of savings and time deposits, including passbook savings, retail CDs, MMDAs.
What happened in 1981? SIs allowed offer NOW (negotiable order of withdrawl) b/c of the Depository Institution Deregulation and Monetary Control Act (DIDMCA). Major change b/c before unable to offer checking svcs. differences between banks and SIs weren't obvious to savers.
What did the creation of MMDAs in 1982 allow SIs to do? this creation allowed SIs to offer limited checking combined with a mkt-determined interest rate and therefore to compete against money mkt funds. increased the sensitivity of SIs' liabilities to int rate movements.
What three sources can SIs borrow from when they are unable to attract sufficient deposits? 1- borrow from other depository institutions have excess funds. int rate = federal funds rate. 2- borrow through Repo agreements, commits to repurchase their govt securities at a later date. 3rd- can borrow at the Federal Reserve. not as common as others
What is SIs' capital generally composed of? Primarily composed of retained earnings and funds obtained from issuing stock. During pds when SIs are performing well, capital is boosted by additional retained earnings. Used to support ongoing/expanding operations
What are SIs main uses of funds? cash, mortgages, mortgage-backed securities, other securities, consumer and commercial loans, and other uses.
What do SIs maintain cash for? Used to satisfy reserve requirements enforced by the Federal Reserve System and to accommodate withdrawal requests of depositors.
What is the primary asset of SIs? Mortgages. typically are long term and can usually be prepaid by borrowers. 90%= family homes 10%= commerical properties. Can be sold in secondary mkt. mkt value changes in response to int rate mvmts, subject to int and credit rate risk
What do all SIs invest in? all SIs invest in T-bonds and corporate bonds because they provide a high liquidity, as they can be quickly sold in the secondary mkt if funds are needed.
How did the DIDMCA and Garn-St. Germain Act help with the lending capacity of SIs? lending guidelines for both federally and state chartered SIs were loosened. Federally chartered SIs are allowed to invest up to 30% of their assets in consumer (nonmortgage loans and securities as well as 10% in non-real estate commercial loans.
How does investing in commerical and consumer loans reduce SIs exposure to int rate risk? b/c SIs can reduce their fixed-rate mortgage loans in favor of consumer loans. results in some noninteresst costs though. Can affect SIs overall degree of credit risk. loss rate on mortgages is lower than the loss rate on consumer loans.
Where on the balance sheet are the sources and uses of SIs' funds? sources of funds= liabilities or equity of an SI. Uses of funds= assets.
What types of risks are SIs exposed to? liquidity risk, credit risk, and interest rate risk. Their exposure to risk varies from those of banks.
Liquidity Risk of SIs Since SIs commonly use short-term liabilities to finance long-term assets, they depend on additional deposits to withdrawal requests. If new deposits dont cover w/drawal requests liquidity results. fixed through repos/borrow funds in federal funds mkt.
How can a longer-term liquidity problem be resolved? An alternative way to remedy a probblem of insufficient liquidity is to sell assets in exchange for cash. SIs can sell Treasury securities/mortgages in 2nd mkt. This will reduce the SIs' size and possibly its earnings. typically resolved w/ inc liabilitie
What is the main reason SIs have credit risk? B/c their primary asset is mortgages. Federal Housing Authority and Veterans Administration mortgages are insured, conventional mortgages aren't insured against this risk. Private insurance can be obtained, but most SIs incur the risk than buy insurance.
When did the exposure of SIs to interest rate risk increase? During the 1980s when int rate increased alot. SIs had a heavy concentration of fixed-rate mortgages, while their liabilities were mostly rate sensitive.Difference b/t int rev and int exp narrowed when int rates increased. Loan defaults higher as a result
How is interest rate risk measured? Commonly measured the gap between their rate sensitive assets and their rate sensitive liabilities in order to determine their exposure to interest rate risk. However, the gap measurement is dependent on the criteria used to classify an asset/liability.
What are the three methods for SIs to manage their interest rate risk? Can be managed through adjustable-rate mortgages, interest rate futures contracts, and interest rate swaps.
Adjustable-Rate Mortgages (ARM) int rates on ARMs are tied to mkt-determined rates such as 1 yr T-bill rate and are periodically adjusted in accordance w/ the formula stated in the ARM contract. enable SIs to maintain a more stable spread btw int rev and int exp.
What do ARM's reduce and expose? Reduce the adverse impact of rising int rates as well as the favorable impact of declining int rates. Expose consumers to int rate risk while reducing the risks of SIs. The impact of int rates on housing mortgages payments is significant.
Interest Rate Futures Contracts Allows for the purchase of a specific amt of a particular debt security for a specified price at a future point int time. Sellers of future contracts are obligated to sell the securities for the contract price at the stated future pt in time.
What type of security do SIs use in interest rate futures contracts? Use T-bonds b/c the cf qualities of T-bonds resemble those of fixed-rate mortgages. Like mortgages, T-bonds offer fixed periodic payments, so their mkt value moves inversely to int rate mvmts. SIs that sell these can hedge their fixed-rate mortgages.
What happens to the mkt value of securities represented by the futures contract when interest rates rise? the mkt value of the securities will decrease. The SIs will benefit from the difference btwn mkt value at which they purchase these securiites in the future and the futures price at which they sell the securities. can reduce diff btwn int rev and int exp
Interest Rate Swaps Allows an SI to swap fixed-rate pmts (outflow) for variable rate pmts (an inflow). the outflows can be matched against the fixed rate mortgages held so that a certain spread can be got. the inflows due to swap can be matched against the variable costs.
What happens to the outflows and inflows in interest rate swaps in a rising rate environment? SIs' fixed rt outflow pmts from the swap agreement remained fixed, while variable rt inflow pmts due to the swap increase. offset the normally unfavorable impact of rising int rates on an SIs spread. also reduces favorable impact of declining int rates.
Conclusion about SIs interest rate risk It is virtually impossible to completely eliminate risk. Homeowners often pay off mortgage bef maturity w/o much advance notice to SI. don't know the actual maturity of mortgages they hold and can't perfectly match the int rt sensitivity of their a & L.
Who do SIs compete with? SIs compete w/ banks and money market mutual funds to obtain funds as well as w/ commercial banks and finance companies in lending funds. Hedging of int rate risk is helped by investment Co. ability to sell mortgages is enhanced by ins co that buy them.
How are SIs valued? The value of an SI can be modeled as the Present value of its future cfs. the value of an SI should change in response to changes in its expected cfs in the future and to changes in the required rate by investors.
What are the factors that affect cash flows of SIs? Economic growth, change in the risk-free int rate, change in industry conditions and change in managment abilities.
What does economic growth do to SIs' cash flows? positive correlation Economic growth can enhance cfs by increasing household demand for consumer/mortgage loans, thereby allowing SI to provide more loans. Loan defaults are reduced. Demand for other goods tend to be higher (households have high levels of disposable income).
How do changes in the risk-free int rate affect SIs' cash flows? neg correlation If the rf int rate decreases, other mkt rate may decline, and may result in a stronger demand for the SIs loans. W/ fixed rate loans, when int rates fall, an SIs cost of obtaining funds decline more than the decline in the int earned.
How do changes in industry conditions affect SIs' cash flows? unknown correlation Industry conditions= regulatory constraints, technology, and competition. If regulatory constraints are reduced, the expected cf of SIs could increase and could cause some of the less efficient SIs to lose mkt share and experience a reduction in cfs.
How do changes in managment abilities affect SIs' cash flows? (positive correlation) SI has control over the composition of its managers and its org. structure. managers attempt to make internal decisions that will capitalize on the external forces that the SI cant control.
What affects SIs required rate of return? risk premiums and the risk free rate.
How does the risk free rate affect the rate of return for SIs? an increase in the risk free rate results in a higher return required by investors. A substantial increase in inflation/budget deficit results in lower valuations of SIs.
How does a change in the risk premium affect SIs required rate of return? If the risk premium on an SI rises, so will the the required rate of return by investors who invest in the SI. High economic growth and increase in management abilities can reduce risk premium.
In general, what causes the value of an SI to increase? SIs' value is favorably affected by strong economic growth, a reduction in interest rates, and high-quality management.
What are some of the reasons for the credit crisis of the late 1980s? 1- inc in int rts SIs that provided longterm mortgages were badly affected. net income declined. 2- SIs had made commercial loans w/o much expertise in assessing the credibility of firms. 3- had a cf deficiency b/c of loan losses. ppl withdrawed from SIs.
Provisions of the FIRREA (Financial Institutions Reform, Recovery, and Enforcement Act) of 1989? increased penalties for officers of SIs convicted of fraud, revised the SIs regulations, & raised the capital requirements for SIs. Allowed commercial banks to acquire SIs. SIs were required to sell any junk bond holdings & can't invest in them in future
Resolution Trust Corporation (RTC) formed to deal w/ insovlent SIs. It liquidated the assets of the insolvent SIs and reimbursed depositors or sold the SIs to other financial institutions.
Reasons for Credit Crisis of 2008-2009 SIs offered subprime mortgage loans, which were granted to borrowers who didnt qualify for conventional mortgages. Many were aggressive and originated loans w/o assessing creditworthiness. When house prices dropped, mortgages worth more than house.
Credit Unions nonprofit organizations composed of members with a common bond, such as affiliation w/ a particular labor union, church, university, or even residential area. Serve as intermediaries for their members. 10,200 CUs in U.S. Total assets less 1/10 of banks.
How do credit unions serve as intermediaries w/ their members? They accept deposits from their members w/ excess funds and channel most of the money to those members who want to finance the purchase of a car or other assets.
Who has ownership of credit unions? B/c CUs don't issue stock, owned by depositors. The deposits=shares, and int paid on deposits is called a dividend. Income is not taxed. Generally very small. Objective is to satisfy its members.
Advantages of Credit Unions CUs are not taxed. Can offer higher deposit rates and lower loan rates than their competitors and achieve a satifactory level of of performance, b/c profits are not taxed. noninterest exp are low.
Disadvantages of Credit Unions employees may not have the incentive to manage operations right. Common bond req for membership restricts CU from growing beyond the potential size and limits the CU from diversifying. Can't diversify geographically b/c all members live in same area.
To overcome some of CU disadvantages, what have they been doing? They have been merging. Some CUs now draw their members from a number of employers, organizations, and other affliations. Also trying to diversify their products by offering traveler's checks, money orders, and life insurance to their members.
What are credit unions sources of funds? Most of their funds come from share deposits by members. Also offers share certificates (provide higher rates than share deposits but require a min amt & specified maturity). Offer checkable accts (share drafts). capital=RE
Who is the lender for Credit Unions who need funds temporarily? Central Liquidity Facility (CLF) acts as lender for CUs to accomodate seasonal funding and specialized needs or to boost the liquidity of troubled CUs.
What are credit unions' uses of funds? Use the majority of their funds for loans to members. Loans finance cars, home improvements, and other personal expenses. Some CUs offer long-term mortgages loans, but many prefer to avoid these. CUs purchase govt & agency securities to keep liquidity.
Who supervises and regulates Credit Unions? Federal CUs are regulated by the National Credit Union Administration (NCUA). State chartered CUs are regulated by their respective states.
How is risk assessed for CUs? The NCUA implemented a Corporate Risk Information System (CRIS), which provides a detailed analysis of each CUs risk.
How are CUs insured? About 90% of CUs are insured by the National Credit Union Share Insurance Fund (NCUSIF), which is administered by the NCUA. The NCUSIF sets aside a portion of its funds as reserves to cover exp resulting from CU failures each yr.
What types of risks are CUs exposed to? liquidity, credit, and interest rate risks.
How does liquidity risk differ for CUs than other depository institutions? B/c the mkt for CUs is restricted to those consumers who qualify as members, CUs have less ability to quickly generate additional deposits.
Created by: shiflettlk