Understanding Thrift Institutions: Evolution and Challenges in the Financial Sector

1. Overview: Thrifts • Savings Associations • (aka – S&L’s, 1,074 in 2004) • concentrated primarily on residential mortgages • Savings Banks • (339 in 2004) • large concentration of residential mortgages • commercial loans • corporate bonds • corporate stock • Credit Unions • (9,210 in 2004) • consumer loans funded with member deposits McGraw-Hill/Irwin

2. Thrift Institutions • Thrift Institutions originated out of the needs that the retail (consumer) sector had for financial services that commercial banks did not address. • Historically, the primary service has been residential mortgage lending McGraw-Hill/Irwin

3. Thrift Institutions Residential Mortgages Savings Associations Individuals Deposits Residential Mortgages Individuals Deposits Savings Banks Commercial Loans Corporations Deposits Consumer Loans Credit Unions Individuals Deposits McGraw-Hill/Irwin

4. Savings Banks • Established as mutual organizations and largely confined to the East Coast and New England states • Deposits are insured by the FDIC under the Bank Insurance Fund (BIF) • Have been allowed greater freedom to diversify into corporate bonds and stocks • Rely more on deposits than savings associations and have fewer borrowed funds McGraw-Hill/Irwin

5. Real Estate Assets of Savings Associations and Savings Banks McGraw-Hill/Irwin

6. Definitions • Net interest margin - interest income minus interest expense divided by earning assets • Disintermediation - withdrawal of deposits from depository institutions to be reinvested elsewhere, e.g., money market mutual funds • Regulation Q ceiling - an interest ceiling imposed on small savings and time deposits at banks and thrifts until 1986 (continued) McGraw-Hill/Irwin

7. Regulator forbearance - a policy of the FSLIC not to close economically insolvent FIs, allowing them to continue in operation • Savings institutions - savings association and savings banks combined • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 - abolished the FSLIC and created a new savings association insurance fund (SAIF) under the management of the FDIC • QTL test- qualified thrift lender test that sets a floor on the mortgage-related assets that thrifts can hold • Mutual organization - an institution in which the liability holders are also the owners McGraw-Hill/Irwin

8. Regulators of Savings Institutions • Office of Thrift Supervision - established in 1989 under the FIRREA, charters and examines all federal savings institutions and supervises the holding companies of savings institutions • The FDIC - oversees, manages SAIF and BIF • SAIF - provides insurance coverage for savings associations • BIF - provides insurance coverage for savings banks • Other regulators - state-chartered savings institutions are regulated by state agencies McGraw-Hill/Irwin

9. Savings Institutions • Primary asset • Long-term residential mortgage loans • Primary liability • Short-term deposits of small savers • How do they make money? • Lend long (residential mortgages) 6% • Borrow short (Savings account deposits) 1.50% McGraw-Hill/Irwin

10. Borrow short, lend long • In general this strategy worked well from mid 1940’s to the late 1970’s • Characteristically, during this period: • Typically the yield curve was normally sloped • Globalization was much less developed • Interest rates were not very volatile • The economic problems of one country had less impact on the economies of other countries • Borrow short, lend long - broke down in the mid to late 1970’s • Initially, the oil shock (73-74) ignites inflationary concerns • Fed responds by constricting the money supply • Targeted reserves rather than interest rates (Oct 79 – Oct 82) • Result: • Historically high inflation rates • Historically high interest rates • An inverted yield curve McGraw-Hill/Irwin

11. Borrow short, lend long McGraw-Hill/Irwin

12. Borrow short, lend long continued • Now savings associations are faced with: • Negative interest margins • Paying 15% on short-term deposits • Receiving 12% on long-term lending • Threat of disintermediation by money market mutual funds • Driven by Regulation Q • Savings associations were regulated in what interest rate they could pay on deposits • Capped at 5.25 to 5.50% McGraw-Hill/Irwin

13. S & L Crises • Legislation expanded deposit taking and investment powers • Liability side • NOW accounts (interest bearing checking) • MMDA’s (money market deposit accounts) • Asset side • ARM’s (adjustable rate mortgages) • Expanded commercial lending • Expanded consumer real estate development • New powers enticed some to assume undue risk • Mid 1980’s real estate in Texas and Southwest collapses • Later economic downturns in Northeast and Western U.S. • Result - Many savings associations with exposure to these areas defaulted McGraw-Hill/Irwin

14. S & L Crises • FSLIC practiced “regulator forbearance” which encouraged the assumption of risk • Insurance premiums were not tied to risk profile of the institution • Result: • From 1982 - 1992, 1248 savings associations failed • FSLIC was forced into insolvency • Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) • FSLIC abolished • Office of Thrift Supervision created • Resolution Trust Corp (RTC) created • Charged with closing and liquidating insolvent institutions McGraw-Hill/Irwin

15. Current status of Savings Associations • Viability of savings associations is challenged • Mortgage lending is a very competitive • GSE’s • Securitization • Commercial banks • Other financial institutions • Long-term mortgage lending has risks • Credit • Interest rate • Liquidity • Transition from mutual to stock organizations • Mutual - Less risky - Less access to capital • Stock - Higher required returns - Greater access to capital McGraw-Hill/Irwin

16. Credit Unions • Are not-for-profit depository institutions mutually organized and owned by their members (depositors) • CU member deposits (shares) used to provide loans to other members with earnings from these loans used to pay interest on member deposits • Tend to hold higher levels of equity than other depository institutions • Can be federally chartered and regulated by NCUA or state chartered and regulated by the state • Growth is not the primary goal McGraw-Hill/Irwin

17. Credit Unions • Not for profit depository institutions. Originated as mutual organizations throughout the U.S. (initially the NorthEast) as “self-help” organizations. • Objective – use common resources to alleviate poverty • Tax exempt status • Defined “common bond” of members • Members pay an entrance fee, make their deposits and those monies are lent to other members • Three tiers • U.S. Central Credit Union • Corporate Credit Unions • Credit Unions • Federally chartered credit unions subject to regulation by NCUA McGraw-Hill/Irwin

18. Composition of Credit Union Loan Portfolio, 2004 McGraw-Hill/Irwin

19. Composition of Credit Union Investment Portfolio, 2004 McGraw-Hill/Irwin

20. Composition of Credit Union Deposits, 2004 McGraw-Hill/Irwin