The Savings and Loan Industry: Current Problems and Possible Solutions

By Walter J. Woerheide | Go to book overview

set his asset and liability portfolios to achieve the highest possible yield spread. Then the manager would adjust the portfolios for differences in durations based on his own forecast of interest rates. The adjustment process would continue only so long as the reduction in expected profits is sufficiently offset by the reduction in interest rate risk exposure.

In the case of SLAs, managers have had little control over their assets and liabilities. Tax laws and regulations have forced the associations to hold the vast majority of their assets in long-term, fixed-rate mortgages. Similarly, regulations have restricted the associations to offering short-term liabilities. So the SLA manager has been forced, under the threat of stringent penalties, to hold a portfolio with a high interest rate risk exposure. In fact, based on their duration mismatch, SLAs have been one of the institutions with the largest interest rate risk exposure in our economy today. It is little wonder that they have been one of the industries which has been hurt the most by the rapid rise in interest rates in recent years.


NOTES
1.
Implicit in equation (2) is the assumption that the holding period T is less than or equal to the maturity of the bond.
2.
For simplicity, I have assumed that all coupon payments are reinvested at the same rate of y.
3.
A more proper, but not necessarily more insightful, formulation of the holding period yield would be:
4.
Also for simplicity of exposition, I have omitted the possibility of default.
5.
This is not always true, and the exceptions will be discussed later in the chapter.
6.
The numbers in this example, as in all the examples to follow, unless otherwise noted, are derived with the assumptions that coupon payments are paid and compounded annually, that the bonds are noncallable and nonconvertible, and that the bonds have a par value of $1,000.
7.
See, for example, Richard W. McEnally, "Duration as a Practical Tool for Bond Management," Journal of Portfolio Management, Summer 1977, pp. 53-57.
8.
Ibid., p. 55.
9.
A second characteristic of note in Table 3.2 is that even if bonds have a maturity of infinity, they still have a finite duration. Furthermore, the coupon rate is immaterial in computing this value. The formula to compute the duration of a perpetual bond is

d = (r + p)/rp

where d = the duration of a bond with a maturity of infinity, r = the annual yield-to-maturity expressed as a decimal fraction, and p = the number of interest payments per year.

For example, a bond which has a maturity of infinity, a 6 percent yield-to-maturity,

-67-

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The Savings and Loan Industry: Current Problems and Possible Solutions
Table of contents

Table of contents

  • 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
  • About the Author 217
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