17. Depository Institutions 17.1 What are other depository institutions? Savings and Loans Savings

1. 17. Depository Institutions • 17.1 What are other depository institutions? • Savings and Loans • Savings • Credit Unions • Trusts (Canadian)

2. 17.2 Savings & Loans • Initially savings and loans were set up for home construction when it was difficult to attain from banks and insurance companies • Established 1831 • Individuals formed mutuals where each member would contribute to the savings & loan institute and receive part ownership and voting rights proportional to deposits • Many of these mutuals have been converted to stock • From 1932 to 1989, FHLBS (Federal Home Loan Bank System) regulated S&Ls. After the crisis, OTC (Office of Thrift Supervision) regulated S&Ls and savings institutions. • Prior to the 1989, FSLIC (Federal Savings and Loan Insurance Corp) insured the S&Ls upto $40,000 prior to 1980 and upto $100,000 afterwards. In 1989, deposit insurance was shifted to SAIF (Savings Assoc. Insurance Fund) as part of FDIC.

3. 17.2 Savings • Established in 1816 for low income people. Encouraged savings. • Focus on savings rather than mortgages as found with S&Ls. Fewer loans by comparison to S&Ls. S&Ls has almost 86% of their assets allocated to mortgages. Still the main use of funds for Savings banks is mortgage loans. • Heavily invested in government securities. • Regulated and chartered by the OTS. Many of the same capital requirements of commercial banks also apply to savings banks and S&Ls. • Insured by SAIF upto $100,000 • Mutuals Savings Banks were mutuals and had no capital. Reserves/surplus were the counterpart to capital.

4. 17.3 Thrift Crisis • Thrifts is the generic term for both S&Ls and savings banks together. • During the 1980s, there was a massive meltdown of the thrift industry. The estimated cost of the thrift crisis is US$500 billion. Sequence of Events of the Crisis • Interest rates rose dramatically during the 1970s owing to inflation. • Regulation Q protected thrifts from interest rate movements by capping the level of deposit rates charged by thrifts. • These interest rate ceilings were lifted in 1980s because of disintermediation. Other institutions were successful in attracting depositors away from thrifts because they offered more competitive rates. • Once Reg Q was lifted, the increased interest rates created huge difficulties for thrifts because of duration mismatching.

5. 17.3 Thrift Crisis Sequence of Events of the Crisis (cont.) • Book value accounting allowed thrifts to hide losses. • Regulators turned a blind eye to the weakening balance sheet. • To compete for liabilities, thrifts offered NOW accounts and MMDAs with competitive interest rates. This tightened the profit margin and the interest spread of borrowing and lending since lending was locked in at the lower rates. • Because of regulatory forbearance, thrifts started to take wild bets to make up for the low return on assets. • Regulators permitted this by increasing insurance coverage from $40,000 to $100,000 in 1980. They also allowed “phantom capital” to replace actual capital. • The betting behaviour made the financial situation of the thrifts more dire.

6. 17.4 Thrift Crisis: Prevention • Close institutions with negative market value of assets instead of allowing them to remain open. • Regulation Q provided protection for banks that could not be sustained. • Enforce strong and binding capital standards • If losses had been realized sooner, the cost to the US would have been marginal by comparison to the actual cost.

7. 17.5 Credit Unions • Serve low income families • Usually a sponsoring organization of which you have to be affiliated or a member, ie. church, union, employer • Not-for-profit organization with volunteers working as directors and officers. • Liabilities include interest bearing time depostis. • Assets include consumer loans, short-term loans, unsecured loans, and now mortgages. • Insure deposits for $100,000 by the NCUSIF (National Credit Union Shares Insurance Fund)

8. 17.6 Summary • Many of the depository institutions were established for different reasons. Some helped low income families set up a savings while others helped finance low income family mortgages. • Over time, the depository institutions become more difficult to distinguish. • In the US, thrifts, credit unions, and banks are regulated and insured by different bodies. • In Canada, OSFI regulates all federal depository institutions and provincial regulators control the provincial depository institutions. Regulation is determined by the place of business rather than the type of business. • The thrift crisis was a major disaster in US banking. It could have been avoided with proper regulation. Regulatory forbearance exacerbated the crisis.

9. 18. Non-Depository Institutions 18.1 Insurance Companies Three types of Insurance • Life/health Insurance • Property/casualty • Reinsurance Insurance companies can be either mutual or stock companies. Many mutual insurance companies are changing to stock companies. In the US, there are 1700 stock companies and 100 mutuals. In Canada, there are only 2 stock companies. Property insurance companies can sometimes have a reciprocal exchange where each subscriber is liable for a portion of each policy.

10. 18.1.1 Life Insurance Companies Four lines of insurance. Each line of insurance differs by the way in which it is sold or marketed. • Ordinary--marketed to individuals in units of $1000. Policymakers make periodic payments. • Group--covers a large number of insured persons with one single policy. • Industrial--similar to group coverage except payments are collected weekly by company representatives. • Credit--insures a lender against a borrower’s death prior to debt repayment

11. 18.1.2 Types of Ordinary Life Insurance Five types of ordinary life insurance • Term life--Beneficiary receives a specified payout if the insured dies within the coverage time. Coverage times range from 1-40 years although the coverage time tends to be relatively short. Often term life comes with renewable or convertible options. A renewable insurance guarantees the insured the right to renew up to the age of 60 yrs without proof of insurability. Premiums tend to be higher than because of the embedded option to renew. A convertible insurance provides the insured with a right to convert term insurance into whole or universal life insurance. Premiums increase once the policy is converted.

12. 18.1.2 Types of Ordinary Life Insurance Five types of ordinary life insurance • Whole Life--Protects the individual over their entire lifetime. The beneficiary of the individual will receive the face value of the insurance once the insured dies. Reserves need to be set aside by the insurance company to cover the face value. A policy loan is available if the insured wants to access cash values before death. Any amount owing on the loan would be reduced from the face value of the insurance policy. Nonparticipating contracts (usually issued by stock companies) guarantee premiums and annual cash surrender values. Participating contracts (usually issued by mutual companies) provide policy dividends at the end of each year. Dividends are the investment performance less mortality experience and overhead expenses.

13. 18.1.2 Types of Ordinary Life Insurance Five types of ordinary life insurance • Endowment Life--Combines a term life policy with a savings element. If the insured lives to the end of the coverage period, the insured receives the face value of the policy. • Variable Life--Invest fixed premium payments in mutual fund stocks, bonds, and money market instruments. The face value of the policy is not fixed and varies depending on the performance of the investments. • Universal Life--The insured can change both the premium amount and the maturity of the contract. Bounds are specified for the premium. The premium less mortality expenses and administrative fees is placed in an interest bearing fund. Interest earned is tax deferred and is tied to an index, ie. Tbill +100bp. Withdrawal option allows the insured to access cash values without a policy loan.

14. 18.1.3 Additional Life Insurance Businesses Three additional businesses of a life insurance company: Annuities--Contract that liquidates a fund rather than builds up a fund. Pay the insurance company an upfront amount which then pays out fixed or variable payments over a period of time. The variable annuity agrees to purchase a fixed number of units as payment and the value of the units vary. Two purchase methods: single premium or periodic premiums over an accumulation period. Interest is tax deferred during the accumulation period. Single Premium Deferred Annuity--one premium paid which accrues at a variable interest rate. At the end of the accumulation period, the SPDA can be surrendered as a lump sum payment or as an annuity. Surrendering the annuity usually results in back-end load fees.

15. 18.1.3 Additional Life Insurance Businesses Three additional businesses of a life insurance company: Pension Funds--Guaranteed Investment Contracts (GICs). Guaranty a rate of return over a specified period (5 yrs). The annuity rates may also be guaranteed to beneficiaries. Retirement plans purchase GICs to stabilize their portfolios. Separate Account plans are separated from other assets on the balance sheet. They can invest in stock or bonds without regulatory restrictions applied to balance sheet. The payoff of the policy depends on the performance of the assets. Disability Insurance: Covers income lost from an accident or illness. You can purchase for periods from 1-40 years. Universal disability insurance provides access to cash values at the termination of the contract if no disability has occurred.

16. 18.1.4 Balance Sheet of a Life Insurance Company Assets Liabilities Policy Reserves 52.9% Policy Claims 1.1% Policy Dividend Accumulation .9% Dividend Reserve .6% Premium and Deposit Funds 8.7% Commissions, taxes, expenses .7% Securities Valuation Reserve 1.4% Other 3.0% Separate Account Business 24.7% Total Capital/Surplus 6% Bonds 52% Preferred Stock .5% Common Stock 2.4% Mortgage loans 8.9% Real estate 1.6% Policy Loans 4.3% Cash 0.1% Other Invt 2.7% Life, annuity, accident premiums due .8% Separate Account Assets 24.8% Other 1.9%

17. 18.1.5 Risk-Weights and Capital Adequacy of Life Insurers Like banks, capital of insurance companies is regulated. There are four types of risks that are risk-weighted: assets (C1), insurance (C2) , interest rate (C3) , and business risk (C4). The risk-weights for interest rates range from .5% to 2%. Business risks-weights range from 0.5-2%. The risk-weights for ASSETS of life insurance companies are given below. US government bonds 0 AAA-A .3 BBB 1 BB 4 B 9 CCC 20 Default 30 Residential Mortgage .5 Commercial Mortgage 3 Common Stock 30 Preferred Stock 2

18. 18.1.5 Risk-Weights and Capital Adequacy of Life Insurers Once the assets and other risks have been risk-weighted the risk-based capital is determined by where C1 is the risk-adjusted assets C2 is the risk-adjusted insurance risk C3 is the risk-adjusted interest rate risk C4 is the risk-adjusted business risk

19. 18.2 Property and Casualty (Liability) Insurance Two major product groups: Personal Lines: Automobile, home, renter’s insurance Commercial Lines: Cover fixed costs in the event of a strike, Crime such as steeling by employees, Liability from a legal suit Errors and omissions Worker’s Compensation Property insurance is considered short-tailed risk. Liability insurance is considered long-tailed risk.

20. 18.2.1 Balance Sheet of Property-Casualty Insurance Assets Liabilities Losses 37.6% Loss expenses 7.9% Reinsurance payable on losses .3% Unearned premiums 13.5% Reinsurance Funds 1.1% Commissions, taxes, expenses 1.5% Securities Valuation Reserve 1.4% Other 4.8% Policy Holder Surplus 31.9% Bonds 60.7% Preferred Stock 1.4% Common Stock 13% Mortgage loans .3% Real estate 1.1% Cash 4.8% Other Invt 6% Premium Balance 7.2% Reinsurance Funds 0.5% Reinsurance recoverable 1.3% Other 3.7%

21. 18.2.2 Risk-Weights and Capital Adequacy of Property Insurers There are six types of risks that are risk-weighted: assets which are investments in property-casualty (R0), assets in fixed income (R1), assets in common and preferred not in affiliates (R2), credit from reinsurance recoverables (R3), underwriting of loss reserves (R4), underwriting of written premiums (R5). The risk-weights for ASSETS of life insurance companies are given below. US government bonds 0 AAA-A .3 BBB 1 BB 2 B 4.5 CCC 10 Default 30 Residential Mortgage 5 Commercial Mortgage 5 Common Stock 15 Preferred Stock 2

22. 18.2.2 Risk-Weights and Capital Adequacy of Property Insurers Once the assets and other risks have been risk-weighted the risk-based capital is determined by where R0 is the risk-weighted assets of property-casualty affiliates R1 is the risk-weighted assets of fixed income R2 is the risk-weighted equity (other than property affiliates) R3 is the risk-weighted credit of reinsurance receivables R4 is the risk-weighted underwriting of loss reserves R5 is the risk-weighted underwriting of premiums

23. 18.3 Pension Funds Two major product groups: Defined Benefit Plan: Retirement benefit is fixed (usually as a % of average salary) but the contributions vary. Defined Contribution Plan: Contribution fixed but the retirement benefit is variable. • Long-term investors in stocks and bonds • Observe a decrease in the number of funds offering Defined Benefit Plans compared to Defined Contribution Plans. • Often tax benefits associated with investing in pension

24. 18.4 Mutual Funds Two types of mutual funds: • Closed-End Funds • Open-End Funds 18.4.1 Closed-End funds • Sold at an exchange or Over-the-counter • Price can sell at a premium or discount to the mark-to-market value of the underlying securities. • Closed-End fund puzzle is that the shares usually sell at a discount to the mark-to-market price (10-20%). Research is unable to explain why. Three theories have failed to explain this puzzle: agency costs, tax liabilities, and illiquidity of assets.

25. 18.4.2 Open End Funds • Number of shares vary depending on purchases and redemptions • Shareholders redeem at the current Net Asset Value (NAV) • Two types of funds: Retail and institutional • Large selection of funds: Balanced, Money Market, Growth, Industrial, Index. • Research shows open-end funds underperform other similar investment vehicles. Much of this is explained by the fees charged but not all. • Enormous growth. By 1996, 21.2% of market is owned by stock mutual funds compared to 7% in 1987. • In the US, the SEC regulates mutual funds. The Investment Act of 1940 documents regulation.

26. 18.4.2 Fees Charged by Open End Funds • Load fees (Front and back-end loads) • Management fees • Administrative • 12b1 fees • Fee Waivers • Soft-dollars • Capital gains taxes and the affect on investment What are the net returns reported on your mutual fund statement? What are the expense ratios reported in a prospectus?

27. 18.4.3 Money Market Funds • Restricted to holding assets with maturities less than 270 days • Very liquid • Grew enormously during the 1970s and 1980s by attracting depositors away from banks • Accounting rules allow money market funds to report book values rather than market values because the durations are short. These are the only funds allowed to do this. • Net Asset Value is always $1 share What does it mean to break-the-buck?

28. 18.4.5 Manager’s Incentives: Investor Attrition Rates: An Example of Dreyfus Worldwide How could a company like Steadman charge expenses of 20%?

29. 18.4.4 Manager’s Incentives: Performance and Asset Growth in Money Market Funds

30. 18.4.4 Manager’s Incentives: Performance and Fee Waiving in Money Market Funds

31. 18.4.6 Issues raised from the growth of Mutual Funds • Does the transfer from institutional investors to individual investors through mutual funds create market instability? • Are management fees too high? • Are mutual funds getting too big to invest in the market? • Why are investors slow to leave poor performing funds? • Should management fees be visible on statements?

32. 18.5 Summary • Two main types of non-depository institutes were discussed: insurance companies and mutual funds. • Other non-depository institutes include hedge funds, financing companies, and pension funds. • Insurance companies bear risk because of the policies they offer. • Mutual funds bear little to no risk. Instead the investor bears the risk of market fluctuations. The only mutual fund which is exposed to some risk from asset price fluctuations are money market funds.