McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Fourteen Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies

14-2 Savings Institutions (SIs) Historically referred to as Savings and Loans (S&Ls) Savings banks (SBs) appeared in the 1980s Specialize in long-term residential mortgages, which are usually financed with short-term deposits of small savers Faced a major crisis during the period resulting in the failure of half of SIs Historically referred to as Savings and Loans (S&Ls) Savings banks (SBs) appeared in the 1980s Specialize in long-term residential mortgages, which are usually financed with short-term deposits of small savers Faced a major crisis during the period resulting in the failure of half of SIs

14-3 The S&L Crisis of Some 4,000 SIs existed at the end of the 1970s By 2010, only 1,138 SIs exist with total industry assets of $1.253 trillion The Federal Reserve radically changed its monetary policy during October 1979 to October 1982 targeted reserves rather than interest rates led to sudden surge in interest rates many SIs faced negative net interest margins SIs lost depositors because of Regulation Q Some 4,000 SIs existed at the end of the 1970s By 2010, only 1,138 SIs exist with total industry assets of $1.253 trillion The Federal Reserve radically changed its monetary policy during October 1979 to October 1982 targeted reserves rather than interest rates led to sudden surge in interest rates many SIs faced negative net interest margins SIs lost depositors because of Regulation Q

14-4 The S&L Crisis of Depository Institutions Deregulations and Monetary Control Act (DIDMCA) of 1980 and Garn-St. Germain Depository Institutions Act (GSGDIA) of 1982 addressed the crisis allowed interest-bearing transaction accounts allowed SIs to offer floating- or adjustable-rate mortgages allowed expansion into real estate development and commercial lending some SIs chose to invest in the junk bond market and suffered large losses when the junk bond market collapsed in the mid- 1980s Depository Institutions Deregulations and Monetary Control Act (DIDMCA) of 1980 and Garn-St. Germain Depository Institutions Act (GSGDIA) of 1982 addressed the crisis allowed interest-bearing transaction accounts allowed SIs to offer floating- or adjustable-rate mortgages allowed expansion into real estate development and commercial lending some SIs chose to invest in the junk bond market and suffered large losses when the junk bond market collapsed in the mid- 1980s

14-5 The S&L Crisis of Real estate and land prices collapsed in many areas of the U.S. in the mid-1980s many mortgages defaulted as a result The Federal Savings and Loan Insurance Corporation (FSLIC) had a policy of regulatory forbearance i.e., its policy was to not close economically insolvent FIs, allowing them to continue to operate 1,248 SIs failed in the 1982 to 1992 period the FSLIC became massively insolvent as a result Real estate and land prices collapsed in many areas of the U.S. in the mid-1980s many mortgages defaulted as a result The Federal Savings and Loan Insurance Corporation (FSLIC) had a policy of regulatory forbearance i.e., its policy was to not close economically insolvent FIs, allowing them to continue to operate 1,248 SIs failed in the 1982 to 1992 period the FSLIC became massively insolvent as a result

14-6 The S&L Crisis of The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 abolished the FSLIC created a new Savings Association Insurance Fund (SAIF) that was put under the management of the Federal Deposit Insurance Corporation (FDIC) replaced the Federal Home Loan Bank Board with the Office of Thrift Supervision (OTS) created the Resolution Trust Corporation (RTC) to close and liquidate insolvent SIs the Qualified Thrift Lender Test (QTL) sets a floor on the mortgage-related assets that thrifts must hold (currently at 65%) introduced Prompt Corrective Action (PCA), which mandates that regulators must close problem banks and thrifts faster The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 abolished the FSLIC created a new Savings Association Insurance Fund (SAIF) that was put under the management of the Federal Deposit Insurance Corporation (FDIC) replaced the Federal Home Loan Bank Board with the Office of Thrift Supervision (OTS) created the Resolution Trust Corporation (RTC) to close and liquidate insolvent SIs the Qualified Thrift Lender Test (QTL) sets a floor on the mortgage-related assets that thrifts must hold (currently at 65%) introduced Prompt Corrective Action (PCA), which mandates that regulators must close problem banks and thrifts faster

14-7 SI Balance Sheets Mortgages and mortgage-backed securities (MBSs) represent 68.35% of total assets compares to 31.02% for commercial banks Commercial loans represent 5.04% of total assets compares to 9.29% for commercial banks Consumer loans represent 6.68% of total assets compares to 10.66% for commercial banks Cash and investment securities represent 8.12% of total assets compares to 36.1% for commercial banks Mortgages and mortgage-backed securities (MBSs) represent 68.35% of total assets compares to 31.02% for commercial banks Commercial loans represent 5.04% of total assets compares to 9.29% for commercial banks Consumer loans represent 6.68% of total assets compares to 10.66% for commercial banks Cash and investment securities represent 8.12% of total assets compares to 36.1% for commercial banks

14-8 SI Balance Sheets Transaction accounts and small time deposits are the predominant source of funds for SIs total deposits account for 71.8% of total liabilities and net worth The second most important source of funds is borrowings from the 12 Federal Home Loan Banks (FHLBs) Net worth is the book value of the equity holders’ capital contribution 11.37% compares to 11.40% for commercial banks most SIs were historically mutual organizations many have switched to stock charters in order to more easily attract capital investment Transaction accounts and small time deposits are the predominant source of funds for SIs total deposits account for 71.8% of total liabilities and net worth The second most important source of funds is borrowings from the 12 Federal Home Loan Banks (FHLBs) Net worth is the book value of the equity holders’ capital contribution 11.37% compares to 11.40% for commercial banks most SIs were historically mutual organizations many have switched to stock charters in order to more easily attract capital investment

14-9 Regulation of SIs The primary regulator of nationally chartered SIs is the Office of Thrift Supervision (OTS) established in 1989 under the FIRREA State agencies regulate state chartered SIs The FDIC oversees the deposit insurance fund of SIs the Savings Association Insurance Fund (SAIF) from 1989 to 2007 the Deposit Insurance Fund (DIF) since January 2007 The primary regulator of nationally chartered SIs is the Office of Thrift Supervision (OTS) established in 1989 under the FIRREA State agencies regulate state chartered SIs The FDIC oversees the deposit insurance fund of SIs the Savings Association Insurance Fund (SAIF) from 1989 to 2007 the Deposit Insurance Fund (DIF) since January 2007

14-10 Recent Trends for SIs Experienced record profits in the mid- to late-1990s as interest rates were low and the U.S. economy prospered Like commercial banks, SIs experienced substantial consolidation in the 1990s The downturn in the U.S. economy eroded SIs’ profitability in the early 2000s The subprime mortgage crisis of the mid-2000s substantially hurt SIs Experienced record profits in the mid- to late-1990s as interest rates were low and the U.S. economy prospered Like commercial banks, SIs experienced substantial consolidation in the 1990s The downturn in the U.S. economy eroded SIs’ profitability in the early 2000s The subprime mortgage crisis of the mid-2000s substantially hurt SIs

14-11 Recent Trends for SIs Performance in the late 2000s dropped due to the recession In 2008 net income was -$8.6 billion, the first negative annual earnings since ROA was -0.72% SI performance improved in 2009 along with the economy, by the first quarter of 2010 ROA was back to 0.65% and ROE was 5.85% Performance in the late 2000s dropped due to the recession In 2008 net income was -$8.6 billion, the first negative annual earnings since ROA was -0.72% SI performance improved in 2009 along with the economy, by the first quarter of 2010 ROA was back to 0.65% and ROE was 5.85%

14-12 Credit Unions (CUs) Not-for-profit depository institutions mutually organized and owned by their members (depositors) First established in the early 1900s as self-help organizations members deposit savings and the funds are lent to other members CUs are prohibited from serving the general public—i.e., members are required to have a common bond of occupation, association, etc. Because CUs are not-for-profit, their earnings are not taxed may offer higher interest rates than commercial banks on deposits may charge lower interest rates than commercial banks on loans Not-for-profit depository institutions mutually organized and owned by their members (depositors) First established in the early 1900s as self-help organizations members deposit savings and the funds are lent to other members CUs are prohibited from serving the general public—i.e., members are required to have a common bond of occupation, association, etc. Because CUs are not-for-profit, their earnings are not taxed may offer higher interest rates than commercial banks on deposits may charge lower interest rates than commercial banks on loans

14-13 Credit Unions (CUs) Most numerous of all depository institutions: 7,598 CUs in 2010 with 91.7 million members In 2010 the average size credit union was $120.6 million compared to the $1,792.8 million for banks The largest credit union is the Navy Credit Union at $40.7 billion in assets Most numerous of all depository institutions: 7,598 CUs in 2010 with 91.7 million members In 2010 the average size credit union was $120.6 million compared to the $1,792.8 million for banks The largest credit union is the Navy Credit Union at $40.7 billion in assets

14-14 Credit Unions (CUs) Less affected by the crisis of the 1980s that hit SIs and CBs hard traditionally make small consumer loans loans are funded with deposits tend to hold large amounts of government securities as assets hold increasing amounts of residential mortgages Less affected by the crisis of the 1980s that hit SIs and CBs hard traditionally make small consumer loans loans are funded with deposits tend to hold large amounts of government securities as assets hold increasing amounts of residential mortgages

14-15 Credit Unions (CUs) National credit union system consists of three tiers U.S. Central Credit Union is the top tier provides investment and liquidity services to Corporate CUs 34 Corporate Credit Unions comprise the middle tier at the state or regional level cooperatively owned by their member CUs serve members by investing and lending excess funds that member CUs place with them provide settlement services, securities safekeeping, etc. individual credit unions make up the bottom tier National credit union system consists of three tiers U.S. Central Credit Union is the top tier provides investment and liquidity services to Corporate CUs 34 Corporate Credit Unions comprise the middle tier at the state or regional level cooperatively owned by their member CUs serve members by investing and lending excess funds that member CUs place with them provide settlement services, securities safekeeping, etc. individual credit unions make up the bottom tier

14-16 Credit Unions (CUs) Recently CUs have expanded their services to compete with CBs and SIs many have converted to a common charter to expand their customer base now offer mortgages, credit lines, and ATMs some offer business and commercial loans to their employer groups Banking industry challenged CU expansion in 1997 Supreme Court sided with the banking industry Congress quickly passed a bill that sided with CUs Recently CUs have expanded their services to compete with CBs and SIs many have converted to a common charter to expand their customer base now offer mortgages, credit lines, and ATMs some offer business and commercial loans to their employer groups Banking industry challenged CU expansion in 1997 Supreme Court sided with the banking industry Congress quickly passed a bill that sided with CUs

14-17 CU Balance Sheets Total assets of all CUs is less than the total assets of the single largest commercial bank total assets of all CUs is $916.1 billion total assets of the entire industry are less than some of our largest banks Consumer loans represent 25.3% of total assets compares to 10.66% at CBs and 6.68% at SIs Home mortgages represent 35.5% of total assets compares to 31.02% at CBs and 68.35% at SIs Investment securities represent 23.0% of total assets compares to 36.1% at CBs and 8.12% at SIs The majority of the CU investment portfolio is in U.S. government or federal agency securities Total assets of all CUs is less than the total assets of the single largest commercial bank total assets of all CUs is $916.1 billion total assets of the entire industry are less than some of our largest banks Consumer loans represent 25.3% of total assets compares to 10.66% at CBs and 6.68% at SIs Home mortgages represent 35.5% of total assets compares to 31.02% at CBs and 68.35% at SIs Investment securities represent 23.0% of total assets compares to 36.1% at CBs and 8.12% at SIs The majority of the CU investment portfolio is in U.S. government or federal agency securities

14-18 CU Balance Sheets 88.1% of total funding comes from member deposits compares to 68.9% for CBs and 71.8% for SIs share draft transaction accounts account for % of all CU deposits share certificates (CDs) account for 30.0% of all CU deposits money market deposit accounts (MMDAs) account for 21.1% of CU deposits share accounts account for 11.3% of CU deposits CU equity is the accumulation of past earnings that is “owned” collectively by member depositors 88.1% of total funding comes from member deposits compares to 68.9% for CBs and 71.8% for SIs share draft transaction accounts account for % of all CU deposits share certificates (CDs) account for 30.0% of all CU deposits money market deposit accounts (MMDAs) account for 21.1% of CU deposits share accounts account for 11.3% of CU deposits CU equity is the accumulation of past earnings that is “owned” collectively by member depositors

14-19 CU Regulators and Performance 62.4% of CUs are federally chartered regulated by the National Credit Union Administration (NCUA) deposit insurance is provided by the National Credit Union Share Insurance Fund (NCUSIF) Remaining CUs are regulated at the state level Assets grew by more than 7.5% annually from 1999 to 2010 Membership increased from 63.6 million to 91.7 million from 1999 to 2010 ROA decreased from 1999 to 2010, mostly due to profit declines at smaller CUs 62.4% of CUs are federally chartered regulated by the National Credit Union Administration (NCUA) deposit insurance is provided by the National Credit Union Share Insurance Fund (NCUSIF) Remaining CUs are regulated at the state level Assets grew by more than 7.5% annually from 1999 to 2010 Membership increased from 63.6 million to 91.7 million from 1999 to 2010 ROA decreased from 1999 to 2010, mostly due to profit declines at smaller CUs

14-20 Finance Companies (FCs) There are three major types of finance companies (FCs) sales finance institutions specialize in loans to customers of a particular retailer or manufacturer personal credit institutions specialize in installment and other loans to consumers business credit institutions specialize in business loans, especially through factoring factoring is the process of purchasing accounts receivables from corporations, usually with no recourse to the seller should the receivables go bad There are three major types of finance companies (FCs) sales finance institutions specialize in loans to customers of a particular retailer or manufacturer personal credit institutions specialize in installment and other loans to consumers business credit institutions specialize in business loans, especially through factoring factoring is the process of purchasing accounts receivables from corporations, usually with no recourse to the seller should the receivables go bad

14-21 Finance Companies (FCs) Industry assets were $1,840.8 billion in 2010 FC industry is highly concentrated the 20 largest FCs account for more than 65% of industry assets many of the largest FCs are captive subsidiaries (i.e., wholly owned subsidiaries of parent corporations) Ford Motor Credit is a FC subsidiary of Ford Motor Industry assets were $1,840.8 billion in 2010 FC industry is highly concentrated the 20 largest FCs account for more than 65% of industry assets many of the largest FCs are captive subsidiaries (i.e., wholly owned subsidiaries of parent corporations) Ford Motor Credit is a FC subsidiary of Ford Motor

14-22 Balance Sheets of FCs Business and consumer loans (called accounts receivables) represent 76.8% of total assets Consumer loans include motor vehicle loans and leases and other loans Ford Motor Credit finances a Ford dealer’s inventory via a procedure called ‘floor planning.’ In floor planning the retailer has possession of the collateral, but the lender has a specific lien against it. The retailer pays interest on the amount of the loan but the loan is not due until the car is sold. Business and consumer loans (called accounts receivables) represent 76.8% of total assets Consumer loans include motor vehicle loans and leases and other loans Ford Motor Credit finances a Ford dealer’s inventory via a procedure called ‘floor planning.’ In floor planning the retailer has possession of the collateral, but the lender has a specific lien against it. The retailer pays interest on the amount of the loan but the loan is not due until the car is sold.

14-23 Balance Sheets of FCs Some finance companies make loans to riskier customers at higher interest rates than CBs subprime lenders are FCs that lend to high risk customers loan sharks are subprime lenders that charge unfairly exorbitant rates to desperate subprime borrowers payday lenders provide short-term cash advances that are often due when borrowers receive their next paycheck Some finance companies make loans to riskier customers at higher interest rates than CBs subprime lenders are FCs that lend to high risk customers loan sharks are subprime lenders that charge unfairly exorbitant rates to desperate subprime borrowers payday lenders provide short-term cash advances that are often due when borrowers receive their next paycheck

14-24 Balance Sheets of FCs FCs often have advantages over CBs with respect to business loans because FCs: are not subject to regulations that restrict the type of products and services they can offer do not accept deposits—accordingly, bank-type regulators do not monitor their behavior often have substantial industry and product expertise are more willing to accept risky customers generally have lower overhead than CBs FCs often have advantages over CBs with respect to business loans because FCs: are not subject to regulations that restrict the type of products and services they can offer do not accept deposits—accordingly, bank-type regulators do not monitor their behavior often have substantial industry and product expertise are more willing to accept risky customers generally have lower overhead than CBs

14-25 Balance Sheets of FCs Real estate loans represent 20.1% of total assets second mortgages are in the form of home equity loans, i.e., loans that let customers borrow on a line of credit secured with a second mortgage on their home securitized mortgage assets are mortgages purchased and used as assets backing secondary market securities mortgage servicing is a fee-related activity whereby the flow of mortgage repayments is collected and passed on to investors in whole mortgage loan packages or securitization vehicles Real estate loans represent 20.1% of total assets second mortgages are in the form of home equity loans, i.e., loans that let customers borrow on a line of credit secured with a second mortgage on their home securitized mortgage assets are mortgages purchased and used as assets backing secondary market securities mortgage servicing is a fee-related activity whereby the flow of mortgage repayments is collected and passed on to investors in whole mortgage loan packages or securitization vehicles

14-26 FC Performance and Regulators Problems arose in the FC industry in the mid-2000s with the crash of the market for subprime mortgage loans many FCs saw sharply lower equity values FCs are subject to state-imposed usury ceilings and additional restrictions have been imposed on payday loans in many states Because FCs do not accept deposits, they are not subject to the extensive oversight that CBs, SIs, and CUs are FCs signal their safety and soundness to investors with higher capital-to-assets ratios (12.7%). Problems arose in the FC industry in the mid-2000s with the crash of the market for subprime mortgage loans many FCs saw sharply lower equity values FCs are subject to state-imposed usury ceilings and additional restrictions have been imposed on payday loans in many states Because FCs do not accept deposits, they are not subject to the extensive oversight that CBs, SIs, and CUs are FCs signal their safety and soundness to investors with higher capital-to-assets ratios (12.7%).

14-27 FC Performance and the Financial Crisis of Several major subprime lenders have either gone bankrupt or were near bankruptcy as the economy slumped Mortgage loan delinquencies peaked at an all-time high of 6.89% in December 2009 Small business loan failure rates hit 11.9% (up from 2.4% in 2004) and the national default rate for commercial real estate rose from 1.62% in the fourth quarter of 2008 to 2.25% Several major subprime lenders have either gone bankrupt or were near bankruptcy as the economy slumped Mortgage loan delinquencies peaked at an all-time high of 6.89% in December 2009 Small business loan failure rates hit 11.9% (up from 2.4% in 2004) and the national default rate for commercial real estate rose from 1.62% in the fourth quarter of 2008 to 2.25%

14-28 FC Performance and the Financial Crisis of GMAC lost $8 billion in the 2007 to 2008 period. GMAC was subsequently approved as a bank holding company making it eligible for up to $6 billion in government assistance. This was a controversial move, made by the Fed on practical grounds rather than because GMAC resembled a bank. GMAC was required to diversify its loan portfolio to look more like a bank. GMAC is now Ally Financial. GMAC lost $8 billion in the 2007 to 2008 period. GMAC was subsequently approved as a bank holding company making it eligible for up to $6 billion in government assistance. This was a controversial move, made by the Fed on practical grounds rather than because GMAC resembled a bank. GMAC was required to diversify its loan portfolio to look more like a bank. GMAC is now Ally Financial.

14-29 Global Issues Unlike the U.S., SIs in Europe traditionally catered to the commercial industry The majority of SIs in Europe are mutually owned SIs worldwide are quite small compared to CBs Nonbank FI lending has increased in both Latin America and in Europe in the last decade Postal SIs exist in about 30 countries throughout the world, mostly in Europe operate virtually as full-service banks many post offices have savings products linked to stock markets Unlike the U.S., SIs in Europe traditionally catered to the commercial industry The majority of SIs in Europe are mutually owned SIs worldwide are quite small compared to CBs Nonbank FI lending has increased in both Latin America and in Europe in the last decade Postal SIs exist in about 30 countries throughout the world, mostly in Europe operate virtually as full-service banks many post offices have savings products linked to stock markets