1. Explain in general terms how savings institutions differ from commercial banks with respect to their sources of funds and uses of funds. Discuss each source of funds for savings institutions. Identify and discuss the main uses of funds for savings institutions.

Savings institutions obtain a large portion of their funds from savings deposits, more than large commercial banks. While savings institutions can offer NOW accounts, they cannot offer the traditional demand deposits. Savings institutions concentrate on mortgages as their main use of funds. Commercial banks concentrate on commercial loans and some consumer loans.

The major sources of funds for savings institutions
1. Deposits, which include passbook savings, retail CDs, and money market deposit accounts;
2. Borrowed funds, which come from either their district Federal Home Loan Bank for an extended length of time, the Federal Reserve discount window for very short-term loans, through repurchase agreements, and in the federal funds market;
3. Capital obtained by issuing stock and retaining earnings.

The main uses of funds for savings institutions are:
1. Cash to satisfy reserve requirements enforced by the Federal Reserve System and to accommodate withdrawal requests of depositors;
2. Mortgages where the real estate represented serves as collateral to guard against default risk;
3. Mortgage-backed securities issued by other savings institutions that were in need of funds;
4. Investment securities like Treasury securities and corporate bonds that provide savings institutions with liquidity;
5. Consumer and commercial loans where consumer loans are typically for home improvements and education
6. Other uses include providing temporary financing to other institutions through repurchase agreements, and the federal funds market.

2. What are the alternative forms of ownership of a savings institution?

Stock savings institutions are owned by shareholders, and mutual savings institutions are owned by depositors.

3. What criteria are used by regulators to examine a thrift institution?

Capital, asset quality, management ability, earnings potential, liquidity, and sensitivity to risk factors.

4. Discuss the entrance of savings institutions into consumer and commercial lending. What are the potential risks and rewards of this strategy? Discuss the conflict between diversification and specialization of savings institutions.

Savings institutions that diversify their business may become less reliant on mortgage lending and therefore may be able to stabilize their earnings. However, by diversifying, they forgo their specialization in their area of expertise. There is a cost to learning other businesses, such as commercial lending. The costs may be worthwhile in the long run, as diversification of services may be a necessary goal for survival.
Regulatory restrictions have been loosened, allowing savings institutions to offer commercial loans and consumer loans. The potential risk to savings institutions that now provide such loans is that they improperly assess creditworthiness due to inexperience.

5. Describe the liquidity and credit risk of savings institutions, and discuss how each is managed.

Savings institutions experience liquidity risk since they commonly use short-term liabilities to finance long-term assets. They commonly increase their liabilities rather than reduce their assets in order to increase liquidity. Mortgages are the main reason for default risk. Insurance is available for the many types of mortgages issued.

6. Explain why many savings institutions experience financial problems at the same time.

Savings institutions are exposed to credit risk as a result of their heavy concentration in mortgages, mortgage-backed securities, and other securities. They attempt to diversify their investments to reduce credit risk. Savings institutions are highly susceptible to interest rate risk because their asset portfolios are typically less rate sensitive than their liability portfolios to interest rate movements

7. What were some of the more obvious reasons for the SI crisis?

1. Rising interest rates in the late 1980s, which reduced the spread between interest earned on loans and interest paid on deposits; 2. Fraud by managers or executives of some S&Ls; 3. Illiquidity, resulting from withdrawals by depositors.

8. Explain how the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) reduced the perceived risk of savings institutions.

FIRREA prohibited investment by savings institutions into junk bonds. It mandated an increase in capital requirements of savings institutions. It helped to eliminate many of the troubled savings institutions.

9. Background on Credit Unions. Who are the owners of credit unions? Explain the tax status of credit unions and the reason for that status. Why are CUs typically smaller than commercial banks or savings institutions?

Credit Unions are technically owned by the depositors. CUs are not taxed because they are nonprofit institutions. Each CU is designed to accommodate a particular group or affiliation.

10. Explain how credit union exposure to liquidity risk differs from that of other financial institutions. Explain why credit unions are more insulated from interest rate risk than some other financial institutions.

Credit unions must rely on members for future deposits. They cannot accept deposits from nonmembers and are therefore more limited than other depository institutions. This can limit their ability to resolve any illiquidity problems. Their interest rate risk of CUs is limited because they do not provide long-term loans with fixed rates.
BONUS QUESTION: 1-10 POINTS
Explain how the credit crisis in the 2008-2009 period affected some savings institutions. Compare the causes of the credit crisis to the causes of the savings institution crisis in the late 1980s. One big reason was that the subprime market crashed. Some subprime lenders did not anticipate that market interest rates would rise, or that the higher mortgage payments resulting from the higher market interest rates would cause so many loan defaults. Even the subprime lenders that sold all the mortgages they created were adversely affected by the credit crisis, because once the economy weakened, the level of mortgage originations declined substantially. Both crises were caused by lenders that attempted to generate very high returns without recognizing the risk involved.