Chapter 21
Thrift Operations
Outline
Background on Savings Institutions
Ownership
Regulation of Savings Institutions
Sources and Uses of Funds
Valuation of a Savings Institution
Exposure to Risk
Liquidity Risk
Management of Interest Rate Risk
Adjustable-Rate Mortgages (ARMs)
Exposure of Savings Institutions to Crises
Savings Institution Crisis in the Late 1980s
Credit Crisis of 2008-2009
Reform in Response to the Credit Crisis
Credit Unions
Ownership of Credit Unions
Advantages and Disadvantages of Credit Unions
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Key Concepts
2. Compare the sources and uses of funds between savings institutions and banks to explain why the
savings institution’s exposure to risk differs from that of banks (especially interest rate risk).
4. Explain the sources and uses of funds for credit unions.
POINT/COUNTER-POINT:
Can All Savings Institutions Avoid Failure?
POINT: Yes. If savings institutions use conservative management by focusing on adjustable-rate
mortgages with limited default risk, they can limit their risk and avoid failure.
WHO IS CORRECT? Use InfoTrac or some other source search engine to learn more about this issue
and then formulate your own opinion.
ANSWER: When economic conditions are weak, mortgage loan defaults will occur. When interest rates
Questions
1. SI Sources and Uses of Funds. Explain in general terms how savings institutions differ from
commercial banks with respect to their sources of funds and uses of funds. Discuss each source of
funds for savings institutions. Identify and discuss the main uses of funds for savings institutions.
ANSWER: Savings institutions obtain a large portion of their funds from savings deposits, more so
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The major sources of funds for savings institutions are as follows:
1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts;
The main uses of funds for savings institutions are:
1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to
accommodate withdrawal requests of depositors;
2. Ownership of SIs. What are the alternative forms of ownership of a savings institution?
3. Regulation of SIs. What criteria do regulators use when examining a savings institution?
ANSWER: Capital, asset quality, management ability, earnings potential, liquidity, and sensitivity to
risk factors.
4. MMDAs. How did the creation of money market deposit accounts influence the savings institution’s
overall cost of funds?
ANSWER: Money market deposit accounts (MMDAs) increased a savings institution’s cost of funds,
5. Offering More Diversified Services. Discuss the entrance of savings institutions into consumer and
commercial lending. What are the potential risks and rewards of this strategy? Discuss the conflict
between diversification and specialization of savings institutions.
ANSWER: Savings institutions that diversify their business may become less reliant on mortgage
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6. Liquidity and Credit Risk. Describe the liquidity and credit risk of savings institutions and discuss
how each is managed.
ANSWER: Savings institutions experience liquidity risk since they commonly use short-term
7. ARMs. What is an adjustable-rate mortgage (ARM)? Discuss the potential advantages that such
mortgages offer a savings institution.
ANSWER: An adjustable rate mortgage has an interest rate that is tied to some market-determined
8. Use of Financial Futures. Explain how savings institutions could use interest rate futures to reduce
interest rate risk.
ANSWER: Savings institutions can sell financial futures in order to hedge against interest rate risk. If
9. Use of Interest Rate Swaps. Explain how savings institutions could use interest rate swaps to reduce
interest rate risk. Will savings institutions that use swaps perform better or worse than those that were
unhedged during a period of declining interest rates? Explain.
10. Risk. Explain why many savings institutions experience financial problems at the same
time.
ANSWER: Many savings institutions have a similar composition of assets, such as long-term fixed
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11. Hedging Interest Rate Movements. If market interest rates were expected to decline over time, will
a savings institution with rate-sensitive liabilities and a large number of fixed-rate mortgages perform
best by (a) using an interest rate swap, (b) selling financial futures, or (c) remaining unhedged?
Explain.
ANSWER: A savings institution would perform best by not hedging since it could benefit from lower
12. Exposure to Interest Rate Risk. The following table discloses the interest-rate sensitivity of two SIs
(dollar amounts are in millions).
Interest Sensitivity Period
From From
Within 1–5 5–10 Over 10
1 Year Years Years Years
Lawrence S&L
Interest-earning assets $ 8,000 $3,000 $7,000 $3,000
Interest-bearing liabilities 11,000 6,000 2,000 1,000
Manhattan S&L
Interest-earning assets 1,000 1,000 4,000 3,000
Interest-bearing liabilities 2,000 2,000 1,000 1,000
Based on this information only, which institution’s stock price would likely be affected more by a
given change in interest rates? Justify your opinion.
ANSWER: Manhattan S&L would likely be affected more by a given change in interest rates because
its interest-rate sensitive liability level differs from its interest-rate sensitive asset level to a greater
13. SI Crisis. What were some of the more obvious reasons for the SI crisis?
ANSWER: Some obvious reasons are: (1) rising interest rates in the late 1980s, which reduced the
14. FIRREA. Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)
reduced the perceived risk of savings institutions.
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15. Background on Credit Unions. Who are the owners of credit unions? Explain the tax status of credit
unions and the reason for that status. Why are CUs typically smaller than commercial banks or
savings institutions?
16. Sources of Credit Union Funds. Describe the main source of funds for credit unions. Why might the
average cost of funds to credit unions be relatively stable even when market interest rates are volatile?
ANSWER: The main sources of funds are (1) share deposits, with no specified maturity, and (2) share
17. Regulation of Credit Unions. Who regulates CUs? What are the regulators’ powers? Where do
credit unions obtain deposit insurance?
18. Risk of Credit Unions. Explain how credit union exposure to liquidity risk differs from that of other
financial institutions. Explain why credit unions are more insulated from interest rate risk than some
other financial institutions.
ANSWER: Credit unions must rely on members for future deposits. They cannot accept deposits from
19. Advantages and Disadvantages of Credit Unions. Identify some advantages of credit unions.
Identify disadvantages of credit unions that relate to their common bond requirement.
ANSWER: Possible answers are:
1. They offer attractive rates to members, as they are non-profit and not taxed.
20. Impact of Credit Crisis. Explain how the credit crisis in the 2008-2009 period affected some savings
institutions. Compare the causes of the credit crisis to the causes of the savings institution crisis in the
late 1980s.
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ANSWER: Some subprime lenders did not anticipate that market interest rates would rise, or that the
21. Impact of Interest Rates on an SI. Explain why savings institutions may benefit when interest rates
fall.
ANSWER: The assets (such as consumer loans and fixed-rate mortgage loans) of savings institutions
22. Impact of Economic Growth on an SI. How does high economic growth affect an SI?
ANSWER: High economic growth results in less risk for an SI because its consumer loans, mortgage
CRITICAL THINKING QUESTION
The Future of Thrift Operations Write a short essay on the future of thrift operations? Should they be
merged into the banking industry, or should they remain distinctly different from commercial banks?
ANSWER
Thrift institutions are distinguished from commercial banks in that they specialize in providing mortgage
Interpreting Financial News
Interpret the following statements made by Wall Street analysts and portfolio managers.
a. “Deposit insurance can fuel a crisis because it allows weak SIs to grow.”
Deposit insurance protected depositors, so that the protected depositors place deposits in risky
b. “Thrifts are no longer so sensitive to interest rate movements, even if their assets and liability
compositions have not changed.”
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c. “Many SIs did not understand that higher returns from subprime mortgages must be weighed
against risk.”
SIs that provided subprime mortgages were betting that the economy would remain strong
Managing in Financial Markets
Hedging Interest Rate Risk
As a consultant to Boca Savings & Loan Association, you notice that a large portion of 15-year, fixed-rate
mortgages are financed with funds from short-term deposits. You believe the yield curve is useful in
indicating the market’s anticipation of future interest rates and that the yield curve is primarily determined
by interest rate expectations. At the present time, Boca has not hedged its interest rate risk. Assume that a
steep upward-sloping yield curve currently exists.
a. Boca asks you to assess its exposure to interest rate risk. Describe how Boca will be affected by
rising interest rates and by a decline in interest rates.
b. Given the information about the yield curve, would you advise Boca to hedge its exposure to
interest rate risk? Explain.
Boca should hedge its exposure to interest rate risk, because interest rates are expected to
c. Explain why your advice to Boca may possibly backfire.
Flow of Funds Exercise
Market Participation by Savings Institutions
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Rimsa Savings is a savings institution that provided Carson Company with a mortgage for its office
building. Rimsa recently offered to refinance the mortgage if Carson Company would prefer a fixed-rate
loan rather than an adjustable-rate loan.
a. Explain the interaction between Carson Company and Rimsa Savings.
Carson Company benefits from Rimsa because it has access to funds that it needs to pay for its
b. Why is Rimsa willing to allow Carson Company to transfer its interest rate risk to Rimsa? [Recall
that there is an upward-sloping yield curve.]
Rimsa offers to provide a fixed-rate loan because the initial spread on the loan is increased.
c. If Rimsa maintains the mortgage on the office building purchased by Carson Company, what is
the ultimate source of the money that was provided for the office building? If Rimsa sells the
mortgage in the secondary market to a pension fund, what is the source that is essentially
financing the office building? Why would a pension fund be willing to purchase this mortgage in
the secondary markets?
If Rimsa maintains the mortgage, its depositors provide the money. If Rimsa sells the mortgage to