Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies

SOLUTIONS MANUAL
Chapter Fourteen
Answers to Chapter 14
Questions:
1. A comparison o !a"#e 11-1 $ith !a"#e 14-% revea#s that un#i&e "an&s, savings institutions
ho#d the vast ma'orit( o their assets in the orm o mortgages and mortgage "ac&ed securities.
Li&e "an&s, the #ia"i#ities o savings institutions consist primari#( o demand and time deposits.
!he assets o commercia# "an&s are more diversiied than those o savings institutions.
A#though there is a $ide dispersion o si)es or commercia# "an&s, $e can see rom
Figure 11-* that in %+1+ there $ere *,*,* "an&s $ith assets o -11,.*..+ "i##ion, giving us an
average si)e o -1,,.%./ mi##ion. From !a"#e 14-%, $e see there $ere 1,104 savings institutions
$ith assets tota#ing -1,%01.0 "i##ion giving us an average o -1,+/4.0 mi##ion.
%. !he origina# mandate o the thrit industr( $as to poo# sma## deposits rom individua#s and
househo#ds in order to inance mortgage #ending. 1esidentia# home o$nership $as deemed to "e
socia##( desira"#e and thereore this sector o the inancia# services industr( received a ranchise
to encourage mortgage inancing. !his ranchise "ecame #ess va#ua"#e $ith the gro$th o the
securiti)ed mortgage mar&et. !hus, the va#ue o the intermediation unction perormed "( thrits
2unne#ing sma## savings into home mortgage #ending3 $as eroded "( competition.
At the same time, the Federa# 1eserve changed its conduct o monetar( po#ic(, a##o$ing
interest rates to rise signiicant#( and "ecome much more vo#ati#e. !his change in po#ic( had the
$orst possi"#e impact on thrits $ith their porto#ios o #ong-term, i4ed- rate mortgages. !he
interest rate increases caused the mar&et va#ue o the thrits5 mortgage porto#ios to dec#ine,
there"( rendering man( o the thrits inso#vent. Since the va#ue o the thrit ranchise a#read( had
"een eroded, thrits had ver( #itt#e to #ose $hen the( received e4panded #ending po$ers in 1./+
and 1./%. !he( too& $i#d gam"#es on ris&( underta&ings $ith the rea#i)ation that the( $ere
"etting $ith ta4pa(ers5 mone(. !he on#( thing that the thrit o$ners rea##( had to #ose $as the
thrit charter. 6an( savings institutions ai#ed as a resu#t o these ris&( investments.
7. !he 8epositor( Institutions 8eregu#ation and 6onetar( Contro# Act 28I86CA3 o 1./+
sought to a##o$ thrits to compete $ith nondepositor( FIs "( oering mar&et rates o interest on
deposits. !his $as accomp#ished via a #iting o the 1egu#ation 9 cei#ings on deposit interest
rates over the period rom 1./+ unti# 1./*. Furthermore, to ma&e thrit and "an& deposits more
attractive to the pu"#ic, the cei#ing on deposit insurance coverage $as #ited rom -4+,+++ to
-1++,+++.
!he :arn-St. :ermain 8epositor( Institutions Act o 1./% 28IA3 urther e4panded the
#ending po$ers o edera##( chartered thrits and a##o$ed interest-"earing ;O< accounts to "e
opened. !he impact o these initiatives, ho$ever, $as to increase interest e4penses or thrits and
other depositor( institutions. !hereore, thrits $ere given added po$ers to invest in higher
(ie#ding consumer and commercia# #oans so as to provide them $ith the opportunit( to earn a
positive net interest margin 2the spread "et$een interest income and interest e4pense3. =o$ever,
this #ed to e4cessive ris& ta&ing and eventua##( #ed to the ai#ure o thrits.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
4. !he ma'or shortcoming shared "( the 8I86CA and the :S:8IA #egis#ation $as their ai#ure
to reso#ve mora# ha)ard pro"#ems so as to induce incentive compati"#e "ehavior. !he changes in
the savings institution 2SI3 industr( had eroded the va#ue o o$ning a traditiona##( managed
thrit. !hereore, $hen conronted $ith ne$ "an&ing po$ers, traditiona# SI o$ners had ver(
#itt#e to #ose i the( undertoo& ver( ris&( endeavors. Indeed, it $as a game o Aheads I $in, tai#s
(ou #ose@ $ith American ta4pa(ers. I the ris&( endeavor succeeded, the potentia# proit $as
high and $ent entire#( to the thrit o$ners. 6ore #i&e#(, ho$ever, the ris&( endeavor $ou#d ai#,
in $hich case, the deposit insurance und $ou#d pa( out insured 2and sometimes uninsured3
depositors, $ith the u#timate cost "orne "( American ta4pa(ers.
0. !he FI11>A o 1./. rescinded some o the e4panded SI #ending po$ers o the 8I86CA o
1./+ and the :arn St. :ermain Act o 1./% "( instituting the ?ua#iied thrit #ender test 2$hich
re?uires a## thrits to ho#d porto#ios predominate#( comprised o mortgages3. It a#so re?uired
thrits to divest their 'un& "onds "( 1..4 and rep#aced the FSLIC $ith a ne$ thrit deposit
insurance und, F8IC-SAIF.
!he F8ICIA o 1..1 amended the 8I86CA o 1./+ "( introducing ris&-"ased deposit
insurance premiums in 1..7 to prevent e4cess ris&-ta&ing. It a#so introduced prompt corrective
actions 2@CA3 so that regu#ators cou#d c#ose "an&s aster $hen the( ai#ed. @revious#(, a po#ic(
o or"earance a##o$ing them to continue as #ong as possi"#e and #ed to the high cost o "ai#outs
o the thrits in the #ate 1./+s. F8ICIA a#so amended the Internationa# Aan&ing Act o 1.,/ "(
e4panding the regu#ator( oversight po$ers over oreign "an&s.
*. !a"#e 14-% sho$s the "a#ance sheet o savings institutions in %+1+. On this "a#ance sheet,
mortgages and mortgage-"ac&ed securities 2securiti)ed poo#s o mortgages3 represent */.70
percent o tota# assets. Figure 14-% sho$s the distri"ution o mortgage re#ated assets or savings
institutions as o %+1+. As noted ear#ier, the F8ICIA uses the 9!L test to esta"#ish a minimum
ho#ding o *0 percent in mortgage-re#ated assets or savings institutions. 1e#ecting the enhanced
#ending po$ers esta"#ished under the 1./+ 8I86CA and 1./% 8IA, commercia# #oans and
consumer #oans amounted to 0.+4 and *.*/ percent o assets, respective#(. Fina##(, savings
associations are re?uired to ho#d cash and investment securities or #i?uidit( purposes and to
meet regu#ator-imposed reserve re?uirements. In %+1+, cash, U.S. !reasur(, and other non-
mortgage securities ho#dings amounted to 1%.0+ percent o tota# assets.
Sma## time and savings deposits are sti## the predominant source o unds, $ith tota#
deposits accounting or ,1.,/ percent o tota# #ia"i#ities and net $orth. !he second most
important source o unds is "orro$ing rom the 1% Federa# =ome Loan Aan&s 2F=LAs3, $hich
the savings associations themse#ves o$n. Aecause o their si)e and government-sponsored status,
F=LAs have access to $ho#esa#e mone( mar&ets or notes and "onds and can re#end the unds
"orro$ed on these mar&ets to savings associations at a sma## mar&up over $ho#esa#e cost. Other
"orro$ed unds inc#ude repurchase agreements and direct edera# und "orro$ings. Fina##(, net
$orth is the "oo& va#ue o the e?uit( ho#dersB capita# contri"utionC it amounted to 11.7, percent
in %+1+.
,. Savings institutions are regu#ated "( the Oice o !hrit Supervision, the F8IC-8IF deposit
insurance und, and state agencies 2or state chartered savings institutions3.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
/. !he va#ue o the savings institutions charter has gone do$n dramatica##( in the period o time
since Octo"er 1.,.. !his charter gave the FI a mandate to poo# short term deposit #ia"i#ities into
#ong-term mortgage #oans. !his Ashort "oo&@ strateg( "ecame ver( ris&( 2and unproita"#e3 in
an environment o increasing and high#( vo#ati#e interest rates. !he (ie#ds on short-term
#ia"i#ities rose a"ove the i4ed rates on #ong-term mortgages. I the savings institution paid the
mar&et rates on deposits, then interest e4penses $ou#d e4ceed interest income, resu#ting in a
negative spread I the savings institution did not pa( mar&et rates, then depositors $ithdre$
their mone( and accessed the non"an&ing FIs that provided mone( management services
2Adisintermediation@3.
Savings institutions a#so $ere "eing pressured on the earnings side since the( $ere
e4periencing greater competition in their niche mar&et: the residentia# mortgage mar&et. !he
pro#ieration o mortgage "ro&ers and ?uasi-governmenta# agencies that specia#i)ed in mortgage
inancing 2:;6A, F;6A, F=L6C3 created a threat to the savings institutions5 dominance in
the residentia# mortgage mar&et. !he resu#t o "oth o these circumstances $as a mar&ed dec#ine
in proita"i#it( during this period.
.. 6utua# organi)ations are savings institutions in $hich the depositors are a#so #ega##( the
o$ners o the institution.
1+. !he high interest rates in the #ate 1.,+s and ear#( 1./+s #ed to sti competition in the deposit
mar&ets or savings institutions, $hich had to oer higher rates to stem the #o$ o unds to other
inancia# institutions. A#though the 8I86CA and :S:8IA acts in the ear#( 1./+s a##o$ed or
more #e4i"i#it( in investments, the( induced managers to invest in more ris&( pro'ects, such as
'un& "onds. !his #ed to a rea# dec#ine in their net $orth and, since regu#ator( or"earance resu#ted
in a num"er o these "an&s "eing &ept open even though the( $ere technica##( inso#vent, the(
u#timate#( had to "e "ai#ed out "( regu#ators. !he net resu#t has "een a s#o$ and stead( dec#ine in
the assets o the savings institution industr(.
11. Li&e the commercia# "an&ing industr(, savings institutions e4perienced record proits in the
mid- to #ate 1..+s as interest rates 2and thus the cost o unds to savings institutions3 remained
#o$ and the U.S. econom( 2and thus the demand or #oans3 prospered. !he resu#t $as an increase
in the spread "et$een interest income and interest e4pense or savings institutions and
conse?uent#( an increase in net income. In 1..., savings institutions reported -1+., "i##ion in net
income and an annua#i)ed 1OA o 1.++ percent. On#( the -1+./ "i##ion o net income reported in
1../ e4ceeded these resu#ts. Asset ?ua#it( improvements $ere $idespread during 1...,
providing the most avora"#e net operating income that the industr( had ever reported. =o$ever,
the do$nturn in the U.S. econom( resu#ted in a dec#ine in savings institutionsB proita"i#it( in
%+++. Speciica##(, their 1OA and 1O> ratios e## s#ight#( in %+++ to +..% percent and 11.14
percent, respective#(, rom their 1... #eve#s. 8espite an economic recession, this do$nturn $as
short-#ived. Aoth 1OA and 1O> increased to record #eve#s each (ear rom %++1 through %++7.
One reason or this trend $as that in the ear#( %+++s, the industr(Bs net interest margins roseC the
cost o unding earning assets dec#ined "( %.,+ percent, $hi#e the (ie#d on earning assets
dec#ined "( on#( %.70 percent. A #at 2and at times even do$n$ard s#oping3 (ie#d curve increased
unding costs and contri"uted to decreased margins in the mid-%+++s.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
In the #ate %+++s, as the U.S. econom( e4perienced its strongest recession since the :reat
8epression, savings institutionsB perormance deteriorated. For a## o %++,, net income $as -*.+
"i##ion, do$n -11.1 "i##ion rom %++*. !he average 1OA or the (ear $as +.17 percent, the
#o$est (ear#( average since 1./.. In %++/, net income $as --/.* "i##ion. !his $as the irst
negative earnings (ear since 1..1. !he 1OA or the (ear $as -+.,% percent. =o$ever, on#( 0
savings institutions ai#ed or $ere assisted during the (ear. In this group $as <ashington 6utua#
the #argest savings institution, $ith over -7++ "i##ion in assets. At (ear-end, 1/ savings
institutions $ere on the F8ICBs D@ro"#em List,E up rom * institutions at the end o %++,. Li&e
commercia# "an&s, as the econom( improved in the second ha# o %++. and %+1+, so did savings
institution perormance. Savings institutions earned -1.4 "i##ion in net income in the third ?uarter
o %++., up rom --1/.7 mi##ion in the second ?uarter. !his trend continued into %+1+ as savings
institutions earned -4.+ "i##ion in the irst si4 months o %+1+. !hrough Fune %+1+, 1OA or the
industr( $as +.*0 percent and 1O> 0./0 percent up rom -+.%. percent and -%..+ percent
respective#( through Fune %++..
1%. =istorica##(, savings institutions have concentrated primari#( on residentia# mortgages. Credit
unions have historica##( ocused on consumer #oans unded $ith mem"er deposits.
17. Credit unions did not suer the same ate as the savings institutions "ecause their porto#ios
$ere much more conservative than those o savings associations and savings "an&sC the(
specia#i)e in ma&ing short-term consumer #oans and tend to ho#d more government securities and
#ess #ong-term residentia# mortgages. !heir mem"ers usua##( "e#ong to the credit union "ecause
o their association $ith $or& or geograph(, $hich resu#ts in more #o(a#t( and a #o$er
inc#ination to move to other institutions. !hus, the actors that #ed to the thrit crisis, higher
interest rates and ris&ier investments, $ere not e4perienced "( credit unions.
14. Over %0 percent o CU assets are in the orm o sma## consumer #oans. !ota# #oans, ho$ever,
comprised *+./ percent o tota# assets in %+1+. Figure 14-0 i##ustrates the composition o the #oan
porto#io or a## CUs. As mentioned in the ChaptersB introduction, CUs concentrate main#( on
servicing the inancia# needs o its mem"ers -main#( individua# consumers. According#(, */.7
percent o the #oan porto#io consists o irst mortgages and 2ne$ and used3 vehic#e #oans.
Credit unions invest heavi#( in investment securities 2%,.+ percent o tota# assets in
%+1+3. Figure 14-* sho$s that 00.. percent o the investment porto#io o CUs is in U.S.
government !reasur( securities or edera# agenc( securities, $hi#e investments in other FIs
2"an&s, savings institutions, and corporate credit unions3 tota#ed 7*.* percent o the investment
porto#io. !he investment porto#io composition, a#ong $ith cash ho#dings and reserves at the Fed
2,.4 percent o tota# assets3, a##o$ credit unions amp#e #i?uidit( to meet their dai#( cash needs.
CUs a#so have increased their o-"a#ance-sheet activit(. Unused #oan commitments, inc#uding
credit card #imits and home e?uit( #ines o credit $ere greater than -14+ "i##ion in %+1+.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
Credit union unding comes main#( rom mem"er deposits 2//.1 percent o tota# unding
in %+1+3. Figure 14-, presents the distri"ution o these deposits in %+1+. Certiicates o deposits
accounted or 7+.+ percent o a## CU deposits, o##o$ed "( regu#ar share transaction accounts
2simi#ar to ;O< accounts at other depositor( institutions3 2%/.0 percent o deposits3, mone(
mar&et deposit accounts 2%0.1 percent o deposits3, and share drat accounts 211.7 percent o
deposits3. In %+1+, CUs capita# to assets ratio $as ,., percent compared to 11.4 percent or
savings institutions and 11.4 percent or commercia# "an&s.
10. Li&e savings institutions, credit unions can "e edera##( or state chartered. Appro4imate#(
t$o-thirds o credit unions are edera##( chartered and su"'ect to ;ationa# Credit Union
Administration 2;CUA3 regu#ation. In addition, through its insurance und 2;CUIF3, the ;CUA
provides deposit insurance guarantees o up to -%0+,+++ or insured credit unions. Current#(, the
;CUIF covers ./ percent o a## credit union deposits.
1*. As CUs have e4panded in num"er, si)e, and services, "an&ers c#aim that CUs unair#(
compete $ith sma## "an&s that have historica##( "een the ma'or #ender in sma## to$ns. For
e4amp#e, the American Aan&ers Association has made c#aims that the ta4 e4emption or CUs
gives them the e?uiva#ent o a -1 "i##ion a (ear su"sid(. !he response o the Credit Union
;ationa# Association 2CU;A3 is that an( cost to ta4pa(ers rom CUsB ta4 e4empt status is more
than oset "( "eneits to mem"ers and, thereore, the socia# good the( create. !he CU;A
estimates that the "eneits o CU mem"ership can range rom -%++ to -0++ a (ear per mem"er
or, $ith over .+ mi##ion mem"ers, a "eneit o -14 "i##ion to -70 "i##ion per (ear.
In 1..,, the "an&ing industr( i#ed t$o #a$suits in its push to narro$ the $idening
mem"ership ru#es governing credit unions. !he irst #a$suit cha##enged an occupation-"ased
credit union-s a"i#it( to accept mem"ers rom companies unre#ated to the irm that origina##(
sponsored the credit union. In the second #a$suit, the American Aan&ers Association as&ed the
courts to "ar the edera# government rom a##o$ing occupation-"ased credit unions to convert to
communit(-"ased charters. Aan&ers argued in "oth #a$suits that such actions, "roadening the
mem"ership o credit unions a#ong other than occupation-"ased guide#ines, $ou#d urther e4p#oit
an unair advantage a##o$ed through the credit union ta4-e4empt status. In Fe"ruar( 1../, the
Supreme Court sided $ith "an&s in its decision that credit unions cou#d no #onger accept
mem"ers that $ere not a part o the common "ond o mem"ership. In Apri# 1../, ho$ever, the
U.S. =ouse o 1epresentatives over$he#ming#( passed a "i## that a##o$ed a## e4isting mem"ers
to &eep their credit union accounts. !he "i## $as passed "( the Senate in Fu#( 1../ and signed
into #a$ in August 1../. !he ina# #egis#ation not on#( a##o$ed CUs to &eep their e4isting
mem"ers "ut it a##o$ed CUs to accept ne$ groups o mem"ers--inc#uding sma## "usinesses and
#o$ income communities that had "een #oc&ed out "( the Supreme Court ru#ing.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
1,. Li&e other depositor( institutions, the credit union industr( has gro$n in asset si)e in the
1..+s and %+++s. Asset gro$th rom 1... to %+1+ $as more than ,.0 percent. In addition, CU
mem"ership increased rom *7.* mi##ion to .1., mi##ion over the 1...-%+1+ period. Asset
gro$th $as especia##( pronounced among the #argest CUs 2$ith assets o over -1++ mi##ion3 as
their assets increased "( a#most %+ percent annua##( rom 1... through %+1+. Figure 14-/ sho$s
the trend in 1OA or CUs rom 1..7 through %+1+. !he decrease in 1OA over the period is
most#( attri"uted to earnings decreases at the sma##er CUs. For e4amp#e, the #argest credit unions
e4perienced an 1OA o +.70 percent in %++., $hi#e 1OA or the sma##est CUs $as -+.*1 percent.
1OA or the overa## industr( $as +%+ percent. Sma##er CUs genera##( have a sma##er and #ess
diversiied customer "ase and have higher overhead e4penses per do##ar o assets. !hus, their
1OAs have "een hurt.
:iven the mutua#-o$nership status o this industr(, ho$ever, gro$th in 1OA 2or proits3
is not necessari#( the primar( goa# o CUs. 1ather, as #ong as capita# or e?uit( #eve#s are
suicient to protect a CU against une4pected #osses on its credit porto#io as $e## as other
inancia# and operationa# ris&s, this not-or-proit industr( has a primar( goa# o serving the
deposit and #ending needs o its mem"ers. !his contrasts $ith the emphasis p#aced on
proita"i#it( "( stoc&ho#der-o$ned commercia# "an&s and savings institutions.
1/. !he three t(pes o inance companies are 213 sa#es inance institutions, 2%3 persona# credit
institutions, and 273 "usiness credit institutions. Finance companies dier rom commercia#
"an&s in that the( re#( on short-and #ong-term "orro$ings, such as commercia# paper and "onds,
instead o deposits. !heir assets consist main#( o "usiness and consumer #oans, usua##( short
term. !he( are #ess regu#ated and as a resu#t a#so tend to ho#d more e?uit( to assets to signa# their
so#venc( "ecause the( are heav( "orro$ers in the credit mar&ets.
1.. A comparison o !a"#e 14-0 $ith !a"#e 11-1 sho$s that inance companies ho#d re#ative#(
more e?uit(, 1%., percent or inance companies and 11.4 percent or commercia# "an&s. !he
dierence is most #i&e#( attri"uta"#e to the de"t o commercia# "an&s "eing insured, usua##( "(
the F8IC. !his insurance ma&es the de"t saer rom the depositors5 and stoc&ho#ders5 perspective.
!his a##o$s the commercia# "an& to ta&e on more de"t than the uninsured inance compan(.
%+. Ausiness and consumer #oans 2ca##ed accounts receivable3 are ma'or assets he#d "( inance
companiesC in %+1+ the( represented 0*., percent o tota# assets. 1ea# estate #oans are %+.1
percent o tota# assets o inance companies in %+1+. In %+1+, consumer #oans constituted 47.71
percent o a## inance compan( #oans, mortgages represented %*.+% percent, and "usiness #oans
comprised 7+.*, percent.
In %+1+, "an& #oans amounted to -1%+.1 "i##ion 2*.0 percent o tota# assets3, commercia#
paper $as -*7.+ "i##ion 27.4 percent o tota# assets3, and other de"t 2due to parents and not
e#se$here c#assiied3 tota#ed -1,1+..4 "i##ion 2*+.7 percent o tota# assets3. !ota# capita#
comprised -%77.0 "i##ion 21%., percent o tota# assets3.
%1. According to !a"#e 14-,, consumer inance areas, especia##( motor vehic#e #oans, as $e## as
rea# estate #oans have "een the astest gro$ing areas o "usiness or inance companies.
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Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
%%. @resuma"#( "ecause inance companies genera##( attract a ris&ier c#ass o customers than do
"an&s. In the #ate 1..+s, ho$ever, economic pro"#ems in emerging mar&et countries resu#ted in
unusua##( #o$ car sa#es in the U.S. As an incentive to c#ear the e4panding stoc& o ne$ cars, auto
inance companies o$ned "( the ma'or auto manuacturers s#ashed interest rates on ne$ car
#oans.
%7. First, inance companies are not su"'ect to regu#ations that restrict the t(pes o products and
services the( can oer. Second, the( have no regu#ators monitoring them since the( do not
accept deposits. !hird, since the( are usua##( su"sidiaries o industria# companies, the( are #i&e#(
to have more product e4pertise. Fourth, the( are more $i##ing to ta&e on ris&( customers. Fina##(,
inance companies have #o$er overhead than "an&s.
%4. Finance companies are #ess regu#ated than commercia# "an&s "ecause the( do not accept
deposits the $a( commercia# "an&s do.
%0. Since the !a4 1eorm Act o 1./*, on#( home e?uit( #oans oer ta4 deducti"#e interest or
the "orro$er. =ence these t(pes o #oans are much more popu#ar than those $ithout a ta4
deduction. !he increased demand or these t(pes o #oans has attracted the inance companies
into this product #ine.
%*. A $ho#esa#e #oan is a #oan to a compan( used to inance "usiness $ith its supp#iers as
opposed to a retai# #oan that inances a transaction "et$een a compan( and a consumer.
%,. A #o$ de"t-to-assets ratio or a inance compan( $ou#d #i&e#( "e interpreted as a signa# o
saet( and a"i#it( to "orro$ more mone( i needed. As such it is a positive signa#.
14-,