The financial outlook for the savings and loan industry - speech delivered before U.S. League of Savings Institutions, San Francisco, Nov. 14, 1983 - transcript

The Financial Outlook for the Savings and Loan Industry

Forecasting is a difficult task and, as the last several years have indicated, is an increasingly treacherous one. But the assessment that I have to make today--regarding the outlook for the savings and loan industry--is triply difficult. The outlook for S&Ls depends not only on interest rates and housing activity, but also on the very difficult strategic and portfolio restructuring decisions that the thrift industry will need to make in the months and years ahead. So many dramatic changes have confronted this industry over the last several years: interest rate upswings and downswings, the dramatic transformation of the secondary mortgage market, and an array of new asset and liability powers. And because these changes are so sudden, and so pivotal, we just don't know how the thrift industry as a whole will respond over the long haul, and whether individual institutions can respond quickly and wisely enough to determine the difference between success and failure.

With that rather sweeping confession up front, that my crystal ball is not very clear and does not see very far into the future, I'd like to strike a more positive note. I do think that the statistical and economic data that we already have can provide us some important insights into the state of the thrift industry. And perhaps more important, by looking closely at the economics of the industry we can avoid a variety of misconceptions that are already quite prevalent.

Thrift Earnings and the Interest Rate Yield Curve

Any careful financial analysis will tell us that the single most important factor that can distort the true economic outlook for the thrift industry in the nar future is the enormous steepness of the interest rate yield curve that exists today and has existed since the fall of 1982. The slope of the yield curve, as measured by both the difference between 20-year Treasury rates and six-month Treasury rates and between five-year rates and six-month rates, has been near or at historic post-World War II highs at least briefly over the last several weeks. There have been points in the last ten days when the difference between 20-year Treasury rates and six-month Treasury rates was as high as 250 basis points, whereas the average spread since 1960 has only been about 35 basis points.

Now what does all this mean for the thrift industry? What it means is that the accounting figures received over the next several years may bear virtually no relationship to the underlying long-term economic realities. Financial accounting is tricky in every industry, the thrift industry particularly. But when you have a steeply sloped yield curve, and you are an industry that makes its money lending long and borrowing short, the earnings statements are particularly irrelevant for assessing underlying economic health.

Now, if the position and slope of the yield curve do not change precipitously, the strict accounting picture of industry earnings over the next 18 to 24 months is likely to appear extremely rosy. Some quarters with industry net earnings of a billion dollars are quite likely, and even a quarter or two with higher earnings are not out of the question. While the industry is unlikely to reach a return-on-asset level as high as the record numbers of the late 1970s, we may come close for a brief period of time. And, undoubtedly, individual institutions that are willing to trade off a hype in short-term accounting profits against a decline in long-term safety can beef their earnings statements up further by using all their resources to lend long and borrow short.

So that no one falls into the dangerous trip of thinking this gives us cause for great rejoicing, let me test your patience by taking a ride along the yield curve a little further than next year to three, four, five years down the line. As tough and precarious as it is to forecast more than two years out, I think we all can be reasonably confident that by that point the spread between long rates and short rates will have narrowed considerably.

As I stated earlier, the average spread between 20-year and six-month Treasury bills since 1960 has been only about 35 basis points. I can't say with any precision whether a 35 basis-point spread is what we're likely to see, on average, in the future. But I do think it's a good bet that, over the next several years, the gap between long rates and short rates is likely to narrow considerably. Economic theory tells us this will occur since, over the long haul, short rates and long rates will tend to remain fairly close to each other, allowing for some differential due to the risk premium. History certainly tells us that the windfall we will reap from a highly sloped yield curve will dissipate, since we have had spreads between long and short rates of today's magnitude three times in the last twelve years, with it dissipating each time within several years and, in a few cases, even months. Finally, the futures market for Treasury instruments indicates that the spread between 20-year and six-month Treasuries will decline about 50 percent over the two years for which futures market contracts are outstanding, with short rates going up by more than 150 basis points.

So, if we run the same scenario that gives us rosy earnings numbers in 1984 and early 1985 on through the end of the decade, what we see is short rates moving closer to long rates, and a gradual decline in earnings levels as the years go on. And so, what this interest rate ricture indicates is that those institutions that fall into the dangerous trap of lending long and borrowing short, in order to hype short-term profit, will find themselves in an increasingly uncomfortable squeeze.

The point in my taking you through this somewhat long-winded financial scenario is not to make a forecast. I simply mean to point out that the high quarterly earnings that we may see over the next year or longer, while readily welcome, may also tend to give us a sense of comfort and security that is both false and short-lived. It is only when we look behind the yield curve--to what history, basic economic analysis, and the futures market can tell us about the relationship between long-term and short-term rates--that we can interpret current accounting numbers.

The Breathing Room Provided by Passbook Deposits

Another source of breating room for the thrift industry, and one which can also distort the relationship between the short-term accounting picture and the long-term economic picture, is the remarkable extent to which passbook deposits paying 5 1/2 percent have stayed on thrifts' books--and will probably stay on the books in the near future, at least over the next several years. One of the great mysteries in this era of banking deregulation is why passbook deposits still account for $70 billion in thrift deposits, almost twelve percent of the total.

According to most estimates, close to 80 percent of passbook deposits are in accounts with more than $2,500, so the current $2,500 minimum denomination on MMDAs does not provide a sufficient explanation. We don't know who these passbook depositors are or why they have decided to sacrifice the greater yields available from MMDA and other deregulated deposits. In fact, I am almost reluctant to bring up this subject in a public forum for fear that at least some passbook depositors may suddenly wake up and transfer their funds from low-yield to high-yield accounts.

The DIDC has voted to reduce the minimum denomination on MMDAs to $1,000 in 1985 and to zero in 1986, which will result in at least some small accountholders making the shift from passbook to other accounts. But given our experience in the last several years, we would not expect further deregulation, by itself, to affect all or even a majority of passbook deposits. Only about 20 percent of passbook depositors will face new opportunities--which they don't have right now--as a consequence of the DIDC's most recent actions. And that leaves us with the mystery as to how the other four-fifths will react over time to the opportunities that they have already had available since the advent of the MMDA.

While we don't know exactly why so large a level of deposits remains in passbooks, we do know one thing--those passbook deposit holders are making a major contribution to thrift industry earnings. A shift of all passbook accounts into deregulated accounts would reduce thrift industry earnings by an estimated $2 billion a year. If a significant percentage of passbook depositors continues to overlook the better earning opportunities they have elsewhere, they could continue to make an important contribution to the thrift industry's bottom line even after all interest rate egulations have expired in 1986.

Thrift Earnings and Interest Rates

The prospective earnings picture for the thrift industry that I drew earlier was on the basis of today's interest rate structure and, more or less, the interest rate structure that has prevailed since rates declined so precipitously in the fall of last year. And there are obvious dangers in even venturing a short-term thrift earnings forecast that relies on today's interest rate scenario. By now, I think we are all aware of the various factors that could cause a shift in both long-and short-term interest rates, including the unknown effect of $200 billion deficits, the uncertain lengh and magnitude of the recovery, the course of future monetary policy, whether Brazil or Argentina or Venezuela will default and, even if they do default, what the effect on interest rates will be. Obviously, neither I nor anyone else has the answers to all those questions, so none of us can be exactly sure as to how stable the current rate situation is. At the same time, I do think the situation appears to be at least more stable now than it has been since the fall of 1979. By a variety of statistical measures, interest rates in 1983 have proven far more stable month-to-month than in the previous four years. And there is some consensus among most observers that, at least for the short haul, price inflation should remain bubdued and economic growth should prove vigorous. While there are still a number of threats on the horizon--and they are all very genuine and very disturbing--we are at least enjoying the first period since the fall of 1979 where we can be reasonably confident that we have some breathing room regarding prices, real economic activity and, hopefully, interest rates for another 12 or 18 months.

Forecasting and Thrift Restructuring Decisions

I don't want to downplay the potential usefulness of a "breathing period' for the thrift industry. At the Bank Board, we need some time to handle the large inventory of outstanding FSLIC and supervisory cases that have accumulated during the crisis period of the last several years. More important, the thrift industry as a whole needs some breathing time, even if temporary, to bolster its sagging net worth. Even if the economic scenario that I've described turns out to be deadly accurate--with profits going up and then down again--the industry will be far better prepared to face declining earnings figures several years down the line if it has had some time to bolster its net worth and capital cushions.

So, the forecast that I would most like to make, but cannot make, concerns the most important issue facing both the Bank Board and the industry: to what extent thrift institutions will use this breathing period of one, two, three, or however many years to change the composition of their portfolios, so as to alter both their risk profile and their earnings performance toward the end of this decade and beyond.

The restructuring issue that was hottest at the time of last year's US League convention was to the extent to which thrifts would expand their use of Garn-St Germain asset powers in the years ahead. While we have seen some very small expansion in consumer and commercial lending for the first six months of 1983, these changes amount to a sliver of a fraction of a percentage point of total thrift assets. We are not surprised by this, since changing the pattern of lending activities should be approached cautiously and carefully. But the preliminary data that we now have do not even provide a hint as to whether it will take 5 years, 10 years, 20 years, or 100 years before the Garn-St Germain Act substantially affects thrift asset activities and, consequently, their bottom lines.

Nor do we have clues as to the ultimate effect on thrift earnings of the extensive transformation that is now occurring in the Nation's secondary mortgage markets. We have, over the last decade, moved from a world in which all mortgages were held as whole loans to a world in which approximately 20 percent of all outstanding mortgages are packaged into mortgage-backed securities, with that percentage increasing dramatically year by year. Mortgage debt, which accounts for almost one-third of total personal, corporate, and governmental debt in the United States, is now being packaged and securitized in increasingly sophisticated ways. But how the increasing liquification of mortgages will affect your bottom lines is impossible to predict. In making mortgages more liquid, transformation of the secondary market will tend to reduce the spread between mortgage rates and the rates on other instruments at least somewhat while, at the same time, increasing the market value of existing mortgage portfolios at least slightly. Whether the massive shuffling and reshuffling of mortgage paper that is occurring will change the risk profile of the industry, or whether it will simply increase the liquidity and administrative convenience of holding mortgages, will depend on the decisions made by you and your counterparts.

The aspect of asset restructuring that has received the most attention currently within the industry, at the Bank Board especially, is the origination and purchase of adjustable rate mortgages. I think both Chairman Gray and other people have already made extremely persuasive cases as to the advantages of ARMs, and there is very little information that I can add. While we have no evidence as to what the composition of mortgage lending will be years down the road, the monthly statistics we have received since last summer on ARM and fixed-rate mortgage lending are extraordinarily encouraging, and certainly give us a basis for hope. According to our own figures, ARMs as a percentage of mortgage loans originated by thrifts more than doubled over the last four months, with ARMs constituting more than half of thrift mortgage originations in September and close to three-fifths in October. Obviously, we cannot be sure to what extent this development reflects a delayed consumer response to the wide spreads between long-term interest rates and short-term interest rates, and to what extent it indicates that thrifts have achieved new levels of sophistication in packaging and marketing ARMs. Nor does it tell us to what extent thrifts will change the ratio of fixed-rate and adjustable rate mortgages that they hold for portfolio. But the ARM origination numbers that we've seen for September and October are encouraging and provide a considerable basis for optimism, if not for a forecast. We can only hope that our optimism proves justified after long rates and short rates are closer in tandem, and ARMs, at least superficially, appear less immediately attractive to homebuyers.

There are also major uncertainties on the liability side of thrift portfolios as they evolve over the next several years. As a consequence of the regulatory changes that the DIDC has instituted over the last several months, thrifts have dramatically increased flexibility and discretion egarding the maturity profile of their deposits. By adopting new pricing strategies, individual institutions can significantly affect where they want to concentrate their deposits on the maturity spectrum. Increased access to national capital markets through the use of brokered inermediaries, while raising a host of other concerns, can allow thrifts to secure at least a small percentage of long-term deposits outside of their immediate local retail markets. And, also important, as a result of recent Federal Home Loan Bank System changes, thrifts now have easy access to Bank System advances of up to ten years, with a new 20-year advance under consideration by the Bank Board.

The Length of Time Needed for Portfolio Restructuring

In talking about thrift restructuring over the next several years and the effect it can have on the bottom line, I would like to attempt to dispel what I think makes the position of he industry look far worse than it really is. All too often the inference is made that because thrift borrowings are of short maturity, and because the bulk of their assets is in 25- to 30-year fixed-rate mortgages, somehow it will take decades before thrifts can effectively change their exposure to interest rate fluctuations. This general impression seriously exaggerates the bind that the industry is in, and reflects very little understanding of the underlying economics.

First of all, 25- and 30-year mortgages are rarely held by borrowers to maturity. On average, mortgages are repaid within 7 to 14 years of their origination, depending on the region of the country. Evan a stereotypical savings and loan, which plans no secondary mortgage sales and holds 80 percent of its assets in fixed-rate mortgages, has a portfolio with an economic duration --or economic half life--of less than five years. What this means is that a savings and loan that isn't even growing can reduce 50 percent of its interest rate exposure over five years jsut by changes on the asset side. If the S&L is growing, it could cut interest rate exposure in half by actions on the asset side in less than five years. And, if the institution is willing to do anything creative on the liability side, it could cut total interest rate exposure in half in even less time. What this means is that, in even just three or four years, a savings and loan can reduce by half its exposure to rate fluctuations. If we do have several years of breathing time, as I think we might, the game just isn't over for thrifts who want to reduce their interest rate exposure before the next major run-up in interest rates occurs.

Don't misunderstand me. A large percentage of existing mortgage portfolios are under water, and the implicit losses presented by those mortgages create a situation that neither you nor anyone else can control. Interest rate fluctuations that began in the fall of 1979 were beyond anybody's ability to foresee, and there is simply no point in blaming the victim of that precipitous change. But the further behind us that time period gets, the less of an excuse any institution has for imprudent interest rate exposure. What economic analysis--or what the technicians call duration analysis--points out, is that even three, four, or five years provide thrift institutions with the leverage needed to dramatically decrease their interest rate risk, even without resorting to secondary mortgage sales.

One of the great difficulties that we face at the Bank Board, and one that you undoubtedly face at your respective institutions, is precisely measuring interest rate risk. At least at this point in time, interest rate risk measurement is quite primitive, especially in regard to fixed-rate mortgages. It is my personal hope that, over the next several years, better methods and tools will evolve by which we can measure the risk position a thrift institution is taking and what the trade-off might be between risk and return. It is almost impossible for any thrift or depository institution to make sufficient profits while maintaining a portfolio that is completely riskless. But, hopefully, methods are evolving that will, at least, allow a thrift to decide explicitly how it wants to trade off risk and profit, rather than simply doing so blindly and unconsciously.

As most of you know, the Bank Board has instituted a new reporting system that will begin next year, which should provide us with the information needed to at least make a stab at assessing the interest rate risk exposure for both the thrift industry generally and individual thrifts specifically. Hopefully, by this time next year, I will have fairly extensive information for you on just what the risk exposure position of the industry is, and what that exposure portends for the future.

Conclusion

In summary, I would like to leave several key thoughts with you. First, the current slope of the interest rate yield curve and the remarkable durability of passbook deposits could result in accounting profit figures for the thrift industry over the next several years that bear little relation to long-term economic reality. And, second, over the long run, effective portfolio restructuring takes years, but not decades, to reduce interest rate risk exposure.

We have learned in the last several years that thrifts must come to view themselves as risk managers, just as commercial banks and insurance companies always have. How we come to grips with the challenges of risk management poses the most interesting issues facing the thrift industry today.

COPYRIGHT 1984 U.S. Government Printing Office
COPYRIGHT 2004 Gale Group