Solutions of Questions - Financial Markets and Institutions | FINA 4400, Study notes of Financial Market

Download Solutions of Questions - Financial Markets and Institutions | FINA 4400 and more Study notes Financial Market in PDF only on Docsity! Chapter 14 - Other Lending Institutions: Savings Institutions,Credit Unions, and Finance Companies Answers to Chapter 14 Questions 1. A comparison of Table 11-1 with Table 14-2 reveals that unlike banks, savings institutions hold the vast majority of their assets in the form of mortgages and mortgage backed securities. Like banks, the liabilities of savings institutions consist primarily of demand and time deposits. The assets of commercial banks are more diversified than those of savings institutions. Although there is a wide dispersion of sizes for commercial banks, we can see from Figure 11-6 that in 2004 there were 7,350 banks with assets of $10,411.0 billion, giving us an average size of $1,416 million. From Table 14-2, we see there were 1,257 savings institutions with assets totaling $1,914.4 billion giving us an average of $1,523 million. Surprisingly, the average bank size is smaller than the average savings institution. This speaks to the large number of relatively small banks reported in Figure 11-6. 2. The original mandate of the thrift industry was to pool small deposits from individuals and households in order to finance mortgage lending. Residential home ownership was deemed to be socially desirable and therefore this sector of the financial services industry received a franchise to encourage mortgage financing. This franchise became less valuable with the growth of the securitized mortgage market. Thus, the value of the intermediation function performed by thrifts (funneling small savings into home mortgage lending) was eroded by competition. At the same time, the Federal Reserve changed its conduct of monetary policy, allowing interest rates to rise significantly and become much more volatile. This change in policy had the worst possible impact on thrifts with their portfolios of long-term, fixed- rate mortgages. The interest rate increases caused the market value of the thrifts' mortgage portfolios to decline, thereby rendering many of the thrifts insolvent. Since the value of the thrift franchise already had been eroded, thrifts had very little to lose when they received expanded lending powers in 1980 and 1982. They took wild gambles on risky undertakings with the realization that they were betting with taxpayers' money. The only thing that the thrift owners really had to lose was the thrift charter. Many savings institutions failed as a result of these risky investments. 3. The Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980 sought to allow thrifts to compete with nondepository FIs by offering market rates of interest on deposits. This was accomplished via a lifting of the Regulation Q ceilings on deposit interest rates over the period from 1980 until 1986. Furthermore, to make thrift and bank deposits more attractive to the public, the ceiling on deposit insurance coverage was lifted from $40,000 to $100,000. The Garn-St. Germain Depository Institutions Act of 1982 (DIA) further expanded the lending powers of federally chartered thrifts and allowed interest-bearing NOW accounts to be opened. The impact of these initiatives, however, was to increase interest expenses for thrifts and other depository institutions. Therefore, thrifts were given added powers to invest in higher yielding consumer and commercial loans so as to provide them with the opportunity to earn a positive net interest margin (the spread between interest income and interest expense). However, this led to excessive risk taking and eventually led to the failure of thrifts. 4. The major shortcoming shared by the DIDMCA and the DIA legislation was their failure to resolve moral hazard problems so as to induce incentive compatible behavior. The changes in the savings institution (SI) industry had eroded the value of owning a traditionally managed thrift. 14-1 Chapter 14 - Other Lending Institutions: Savings Institutions,Credit Unions, and Finance Companies Therefore, when confronted with new banking powers, traditional SI owners had very little to lose if they undertook very risky endeavors. Indeed, it was a game of Aheads I win, tails you lose@ with American taxpayers. If the risky endeavor succeeded, the potential profit was high and went entirely to the thrift owners. More likely, however, the risky endeavor would fail, in which case, the deposit insurance fund would pay out insured (and sometimes uninsured) depositors, with the ultimate cost borne by American taxpayers. 5. The FIRREA of 1989 rescinded some of the expanded SI lending powers of the DIDMCA of 1980 and the Garn St. Germain Act of 1982 by instituting the qualified thrift lender test (which requires all thrifts to hold portfolios predominately comprised of mortgages). It also required thrifts to divest their junk bonds by 1994 and replaced the FSLIC with a new thrift deposit insurance fund, FDIC-SAIF. The FDICIA of 1991 amended the DIDMCA of 1980 by introducing risk-based deposit insurance premiums in 1993 to prevent excess risk-taking. It also introduced prompt corrective actions (PCA) so that regulators could close banks faster when they failed. Previously, a policy of forbearance allowing them to continue as long as possible and led to the high cost of bailouts of the thrifts in the late 1980s. FDICIA also amended the International Banking Act of 1978 by expanding the regulatory oversight powers over foreign banks. 6. Table 14B2 shows the balance sheet of savings institutions in 2007. On this balance sheet, mortgages and mortgage-backed securities (securitized pools of mortgages) represent 73.20 percent of total assets. Figure 14-2 shows the distribution of mortgage related assets for savings institutions as of 2007. As noted earlier, the FDICIA uses the QTL test to establish a minimum holding of 65 percent in mortgage-related assets for savings institutions. Reflecting the enhanced lending powers established under the 1980 DIDMCA and 1982 DIA, commercial loans and consumer loans amounted to 3.93 and 5.00 percent of assets, respectively. Finally, savings associations are required to hold cash and investment securities for liquidity purposes and to meet regulator-imposed reserve requirements. In 2007, cash, U.S. Treasury, and other non- mortgage securities holdings amounted to 10.10 percent of total assets. Small time and savings deposits are still the predominant source of funds, with total deposits accounting for 61.12 percent of total liabilities and net worth. The second most important source of funds is borrowing from the 12 Federal Home Loan Banks (FHLBs), which the savings associations themselves own. Because of their size and government-sponsored status, FHLBs have access to wholesale money markets for notes and bonds and can relend the funds borrowed on these markets to savings associations at a small markup over wholesale cost. Other borrowed funds include repurchase agreements and direct federal fund borrowings. Finally, net worth is the book value of the equity holders= capital contribution; it amounted to 11.84 percent in 2007. 14-2 In 1997, the banking industry filed two lawsuits in its push to narrow the widening membership rules governing credit unions. The first lawsuit challenged an occupation-based credit union=s ability to accept members from companies unrelated to the firm that originally sponsored the credit union. In the second lawsuit, the American Bankers Association asked the courts to bar the federal government from allowing occupation-based credit unions to convert to community-based charters. Bankers argued in both lawsuits that such actions, broadening the membership of credit unions along other than occupation-based guidelines, would further exploit an unfair advantage allowed through the credit union tax-exempt status. In February 1998, the Supreme Court sided with banks in its decision that credit unions could no longer accept members that were not a part of the common bond of membership. In April 1998, however, the U.S. House of Representatives overwhelmingly passed a bill that allowed all existing members to keep their credit union accounts. The bill was passed by the Senate in July 1998 and signed into law in August 1998. The final legislation not only allowed CUs to keep their existing members but it allowed CUs to accept new groups of membersCincluding small businesses and low income communities that had been locked out by the Supreme Court ruling. 18. The three types of finance companies are (1) sales finance institutions, (2) personal credit institutions, and (3) business credit institutions. Finance companies differ from commercial banks in that they rely on short-and long-term borrowings, such as commercial paper and bonds, instead of deposits. Their assets consist mainly of business and consumer loans, usually short term. They are less regulated and as a result also tend to hold more equity to assets to signal their solvency because they are heavy borrowers in the credit markets. 19. Consumer lending, business lending, and mortgage financing. 20. A comparison of Table 14-4 with Table 11-1 shows that finance companies hold relatively more equity, 11.0% for finance companies and 10.1% for commercial banks. The difference is most likely attributable to the debt of commercial banks being insured, usually by the FDIC. This insurance make the debt safer from the depositors' and stockholders' perspective. This allows the commercial bank to take on more debt than the uninsured finance company. 21. Business and consumer loans (called accounts receivable) are major assets held by finance companies; in 2007 they represented 54.0 percent of total assets. Real estate loans are 26.1 percent of total assets of finance companies in 2007. In 2007, consumer loans constituted 42.8 percent of all finance company loans, mortgages represented 28.3 percent, and business loans comprised 28.8 percent. In 2007 commercial paper amounted to $154.0 billion (7.1 percent of total assets); other debt (due to parents and not elsewhere classified) totaled $1,175.5 billion (54.4 percent of total assets). Total capital comprised $237.3 billion (11.1 percent of total assets), and bank loans totaled $153.5 billion (7.1 percent of total assets). 14-5 22. According to Table 14-7, consumer finance areas, especially motor vehicle loans, as well as real estate loans have been the fastest growing areas of business for finance companies. 23. Presumably because finance companies generally attract a riskier class of customers than do banks. In the late 1990s, however, economic problems in emerging market countries resulted in unusually low car sales in the U.S. As an incentive to clear the expanding stock of new cars, auto finance companies owned by the major auto manufacturers slashed interest rates on new car loans. 24. First, finance companies are not subject to regulations that restrict the types of products and services they can offer. Second, they have no regulators monitoring them since they do not accept deposits. Third, since they are usually subsidiaries of industrial companies, they are likely to have more product expertise. Fourth, they are more willing to take on risky customers. Finally, finance companies have lower overhead than banks. 25. Because they do not accept deposits the way commercial banks do. 26. Since the Tax Reform Act of 1986, only home equity loans offer tax deductible interest for the borrower. Hence these types of loans are much more popular than those without a tax deduction. The increased demand for these types of loans has attracted the finance companies into this product line. 27. A wholesale loan is a loan to a company used to finance business with its suppliers as opposed to a retail loan that finances a transaction between a company and a consumer. 28. This would likely be interpreted as a signal of safety and ability to borrow more money if needed. As such it is a positive signal. 14-6