1) The Savings and Loan (S&L) industry had an extremely difficult time during the 1980s, as interest rate levels reached new highs. The following problem illustrates the nature of these difficulties.
(NOTE: This problem assumes you are familiar with the relationship between the market values of long-term, fixed-income securities and changes in the market rate of interest. See Problem and Issue 1, found at the end of chap. 6 [assigned in Module 2] if you need a refresher.)
i) Assume an S&L's balance sheet is as follows. While this balance sheet is obviously over-simplified, it represents an approximation of the financial condition of many S&Ls. All values represent market values.
Assets: Liabilities and Equity:
Mortgage Loans $1,000,000 Deposits $1,300,000
Other Assets 600,000 Equity 300,000
Total Assets $1,600,000 Total L&E $1,600,000
ii) Assume the mortgage loan portfolio consists of 30-year, fixed-rate mortgages with an average interest rate of 5% per year. The present value of these mortgages (their principal) is currently $1,000,000.
iii) Find the monthly payment for this mortgage loan portfolio, using Excel's PMT function. (HINT: Set PV = outstanding principal, NPER = the life of the mortgages (in months), and RATE = the average interest rate (per month) for the mortgage loan portfolio.)
iv) Use your answer to part (iii) to determine the new market value of the mortgage loan portfolio, assuming that the market rate of interest rises to 9% per year. (HINT: Use Excel to find the PV of this portfolio, defining NPER as above, RATE = 9% per year divided by 12, and PMT = the value you obtained in part iii) In the 1980s, actual market rates of interest rose by much more than this, with mortgage rates in the range of 12% or more uncommon.
v) find out the decline in market value of the mortgage loan portfolio that occurred by comparing your answer in part (iv) to the value of the portfolio as revealed in the balance sheet above.
vi) Compare this decline in market value to the amount of equity on the S&L's balance sheet. Is the institution now insolvent? describe.