Thrift Institution Operations: Savings Banks and Credit Unions

Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2

Chapter 21 takes us into the world of thrift institutions. These are the savings banks, savings and loan associations (S&Ls), and credit unions that most of us interact with without thinking twice. They are different from commercial banks in important ways, and this chapter explains exactly how.

What Is a Thrift Institution?

A thrift institution is a depository institution that specializes in mortgage lending. They were created to accept deposits and funnel most of those funds into mortgage loans, home equity loans, and mortgage-backed securities. Some thrifts are independent. Others are subsidiaries of larger financial conglomerates.

Savings institutions include savings banks and savings and loan associations. S&Ls are the dominant type. Most are small, with assets under $1 billion. They can be chartered at the state or federal level.

Ownership: Stock vs. Mutual

Thrifts come in two flavors of ownership. Stock-owned institutions are owned by shareholders, just like regular corporations. Mutual institutions are owned by their depositors.

Many savings institutions have converted from mutual to stock ownership through what is called a mutual-to-stock conversion. This lets them raise additional capital by issuing stock. Stock-owned institutions give shareholders direct benefits when the institution performs well. Dividends can grow, stock prices can rise. With mutual institutions, depositors have a claim to net worth, but that claim disappears once they close their account.

Stock-owned thrifts are also more susceptible to hostile takeovers. With mutual institutions, management typically holds all voting rights, making a takeover nearly impossible.

Sources of Funds

Savings institutions get most of their money from deposits. Think passbook savings accounts, retail certificates of deposit, and money market deposit accounts.

When deposits are not enough, they can borrow from three places. First, the federal funds market, where they borrow from other depository institutions with excess reserves. Second, repurchase agreements, which are basically short-term secured loans. Third, the Federal Reserve, though this is less common.

Capital comes from retained earnings and stock issuance. It serves as a cushion against losses, which became very relevant during the credit crisis.

Uses of Funds

The main asset for any savings institution is mortgages. About 90 percent of mortgages they originate are for homes or multifamily dwellings. The rest are commercial properties.

They also invest in mortgage-backed securities, Treasury bonds, corporate bonds, and consumer and commercial loans. Many thrifts have increased their consumer and commercial lending to reduce their heavy dependence on mortgages. This makes sense because consumer loan maturities more closely match their deposit maturities, which helps reduce interest rate risk.

The Interest Rate Risk Problem

This is where things get interesting. Savings institutions take in short-term deposits and lend out long-term fixed-rate mortgages. When interest rates rise, the cost of their deposits goes up quickly, but the income from their fixed-rate mortgages stays the same. The spread between what they earn and what they pay shrinks. Profitability drops.

Madura walks through a detailed example using a fictional institution called Tucson Savings. Its asset duration is 2.76 years, but its liability duration is only 0.45 years. That is a massive mismatch. If interest rates jump, the market value of assets drops much more than liabilities, and the institution takes a big hit.

Managing Interest Rate Risk

Thrifts have three main tools to manage this risk:

Adjustable-rate mortgages (ARMs): These tie the mortgage rate to market rates, so when rates rise, income rises too. The downside is that when rates fall, the benefit of cheaper deposits gets offset by lower mortgage income.

Interest rate futures: By selling Treasury bond futures, a savings institution can profit when interest rates rise, offsetting the squeeze on their spread.

Interest rate swaps: A thrift can swap fixed-rate payments for variable-rate payments. In a rising rate environment, the variable inflows increase while fixed outflows stay the same. This helps offset the damage.

None of these strategies are perfect. Mortgage prepayments make it nearly impossible to match asset and liability durations exactly.

Two Crises, Same Lessons

The chapter covers two major disasters for the thrift industry.

The S&L Crisis of the Late 1980s. Rising interest rates crushed thrifts that had locked in long-term fixed-rate mortgages. Many had jumped into commercial lending without knowing what they were doing, and loan defaults piled up, especially in the oil-dependent Southwest. Fraud was rampant. Managers used depositor funds to buy yachts and artwork. The Resolution Trust Corporation ended up closing or finding buyers for 747 insolvent institutions and recovering $394 billion from liquidated assets.

The Credit Crisis of 2008-2009. Many savings institutions went right back to risky behavior. Some used extremely liberal standards for subprime mortgages, charging premiums of 3+ percentage points over conventional rates. When the economy weakened and home prices collapsed, defaults surged. Washington Mutual became the largest depository institution ever to fail, with $307 billion in assets. IndyMac saw depositors withdraw $100 million per day before the FDIC took over. Countrywide was rescued through acquisition by Bank of America.

The pattern is clear. In good times, thrifts chase high returns through risky loans. In bad times, they pay the price.

Credit Unions

The second half of the chapter covers credit unions. These are nonprofit organizations with members who share a common bond, like working for the same employer or living in the same area.

There are about 7,800 credit unions in the US. Their total assets are less than one-tenth of commercial banks. Deposits are called “shares,” interest is called “dividends,” and because they are nonprofit, their income is not taxed.

This tax advantage lets credit unions offer higher deposit rates and lower loan rates than competitors. Their overhead is low because office space and furniture are often donated through their affiliated organizations.

The downsides are real though. The common bond requirement limits growth. If all members work for the same employer and that employer does layoffs, the credit union faces a wave of withdrawals and defaults at the same time. Geographic concentration means a local economic downturn hits every member. And since they cannot issue stock, raising capital quickly is difficult.

Credit unions use most of their funds for personal loans to members. These are typically short-term secured loans. Because both their assets and liabilities are rate-sensitive, credit unions have less exposure to interest rate risk than savings institutions. Their spreads tend to stay stable regardless of what interest rates do.

Regulation

The regulatory landscape changed significantly after the financial crisis. The Dodd-Frank Act assigned the Office of the Comptroller of the Currency to supervise mutual and federal savings institutions. The Federal Reserve regulates holding companies of thrifts. The Bureau of Consumer Protection oversees larger institutions.

Federal savings institutions must pass the Qualified Thrift Lender Test, requiring at least 65 percent of assets to be in qualified thrift investments like housing loans and mortgage-backed securities.

Credit unions are regulated by the National Credit Union Administration (NCUA), which also administers deposit insurance through the NCUSIF up to $250,000 per depositor.

My Take

The thrift chapter is a cautionary tale told twice. Both in the 1980s and in 2008, savings institutions forgot that higher returns come with higher risk. The institutional memory lasted about 15 years before the same mistakes were repeated.

What stands out is how the fundamental business model of a savings institution, taking short-term deposits to fund long-term mortgages, creates a structural vulnerability to interest rate risk. It is baked into the DNA of these institutions. The tools to manage it exist, but they require discipline and foresight that many managers apparently lack.

Credit unions come across as the more conservative cousins. Their nonprofit structure, common bond requirement, and focus on short-term personal loans naturally limit both their growth potential and their risk exposure. Sometimes boring is good.

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