The Savings and Loan Industry: Current Problems and Possible Solutions

By Walter J. Woerheide | Go to book overview

3
Measuring the Interest Rate Risk Exposure of Savings and Loans

Casual observers of the savings and loan industry identify the basic cause of current industry problems as the fact that interest rates have risen substantially in the last few years. This statement is true but somewhat of an over simplification. There are benefits which accrue to savings and loans when interest rates rise. Unfortunately, the disadvantages from the rise far outweigh the advantages.

For these reasons, an examination of the consequences of interest rate changes for savings and loans is in order. One of the best tools for this examination is a statistic referred to as duration. The next few pages will mathematically define duration and provide a discussion of the intuitive interpretation of the formulas. The emphasis of the discussion is on the intuitive concept, so any reader unfamiliar with the mathematics of the various formulas should nonetheless be able to grasp their significance. Once the meaning, significance, and limitations of duration have been clarified, we proceed to the concept of "immunization," which refers to the process of reducing or eliminating the effects of interest rate changes on the net worth of SLAs.

DURATION: AN INTRODUCTION

Duration is most easily described with examples drawn from its historical derivation as a tool for describing the interest rate risk of bonds. A bond is a fixed- return investment which usually has two features: a promise to repay principal at maturity and a promise to provide regular interest payments. There are several types of yields associated with bonds, but the one of most relevance is the yield- to-maturity. The yield-to-maturity has a very precise mathematical definition: the value of i which makes true the following equation for the price of a bond:

(1)

where Po = price of the bond today,

Ct = interest (coupon) paid at the end of the time period t,

-49-

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The Savings and Loan Industry: Current Problems and Possible Solutions

• Title Page iii
• Contents vii
• Tables ix
• Acknowledgments xi
• Introduction xiii
• Note xv
• Abbreviations xvii
• 1 - History of the Federal Home Loan Bank System 3
• Notes 23
• 2 - The Determinants of Profitability for Savings and Loans 28
• 3 - Measuring the Interest Rate Risk Exposure of Savings and Loans 49
• Notes 67
• 4 - Alternative Mortgage Instruments 70
• Notes 97
• 5 - Financial Futures and Forward Commitments 104
• Notes 121
• 6 - Consumer Lending 124
• Notes 135
• 7 - The Elimination of Interest Rate Ceilings 138
• Notes 148
• 8 - The Introduction of Now Accounts 152
• Notes 160
• 9 - Mergers and Conversions 163
• SUMMARY AND CONCLUSIONS 184
• 10 - The Future 189
• Notes 195
• Bibliography 197
• Index 211
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