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Investing in Savings and Loan

Written By Briton Ryle

Posted January 6, 2015

Mention the banking category of “Savings and Loans” and you will get markedly different reactions from different people.

Generally, if you’re speaking with someone young, they will likely point to Savings and Loans companies and say, “They’re ok. A little flat, but great dividends.”

But if you’re speaking with someone a few years older, perhaps over 50 years of age, they will stop you with a stern warning, “Stay away from Savings and Loans. They’ll ruin you.”

Why does that segment of the banking sector get such stark reactions? Are Savings and Loans good investments or not?

To answer the first question we’ll need to take a brief look at the recent past. To answer the second question we’ll need to take a look at projections for the near future.

The Savings & Loans’ Tarnished Past

The reason many older folk will still speak ill of this segment of the banking system is because of the “Savings & Loan Crisis” of the 1980s and 90s which resulted in the failure of 1,043 out of 3,234 S&Ls in America – some 32% of them. It was something of a prequel to the larger financial crisis of 2008-09 which struck the entire banking sector.

First, let’s consider what Savings & Loans are and how they differ from other banks.

“Commercial Banks and Savings & Loans both provide banking and loan products to consumers. However, there are differences,” explains The Nest.

“Commercial banks, also called national banks, tend to place a greater emphasis on business customers than S&Ls, underwriting billions of dollars in loans for construction projects, expansion plans, acquisitions and other events. Many of their clients are large corporations and governments. A number of commercial banks also offer investment banking services.”

Whereas “a savings & loan focuses mainly on mortgages and other kinds of consumer loans. By law, savings and loans are mandated to have at least 70 percent of their assets in residential mortgages or mortgage-backed securities, which are assets backed by residential mortgages. You can still deposit your money in an S&L, but you would not be able to apply for a business loan such as a commercial line of credit.”

Thus, while Commercial Banks can engage in other income generating activities – offering commercial loans, even their own investment brokerage services and other investment services – Savings & Loans are pretty much stuck with residential mortgages, with some car loan and personal loan activities on the side. Think of them as mini-banks, like a mini-McDonald’s which does not offer the full McDonald’s menu.

Being so heavily dependent on mortgages and small consumer loans makes Savings & Loans highly vulnerable to interest rate changes. Essentially, S&Ls take deposits from customers’ savings and lend them to borrowers, collecting more interest from loans than they pay on deposits, and keeping the spread in between.

The system works well when interest rates are stable. But things can quickly get out of hand when rates rise abruptly – as they did at four different stages from the late 1970’s to the mid 1990s, as graphed below in green.

snl crisis 2 image 1


Why do rising interest rates hurt Savings and Loans? As Wikipedia explains, “S&Ls issued long-term loans at fixed interest rates using short-term money. When the interest rate increased, the S&Ls could not attract adequate capital and became insolvent.”

When issuing mortgages which generally extend as far as 30 years into the future, interest rates are locked for extended periods of time. However, interest paid on customers’ deposits adjust much more quickly. Hence, any sharp move up in interest rates incurs rising costs for S&Ls as they need to pay more on their deposits, while the income they collect from their locked mortgage rates stays the same – ultimately resulting in diminishing profits.

Four such periods of rising rates hit S&Ls extremely hard beginning in 1975. Imagine the losses to S&Ls that had locked mortgages at 5 or 6% while having to pay as much as 20% on deposits by 1980. More losses were sustained from 1983-85, 1987-89, and 1993-95.

What was the total damage? “FSLIC closed or otherwise resolved 296 institutions from 1986 to 1989 and the RTC closed or otherwise resolved 747 institutions from 1989 to 1995… with an estimated cost to American taxpayers of $160 billion,” reports Wikipedia.

Are Savings & Loans on the Mend?

Naturally, the Savings & Loans Crisis triggered a slew of regulatory changes, which apparently didn’t go far enough, given the subsequent larger banking crisis that struck the nation in 2008 – this time affecting the much larger commercial banking system as a whole.

Interestingly enough, however, during the larger mortgage crisis of 2007-09, the S&L industry did not suffer nearly as much as the rest of the financial sector, as graphed below.

Where the broader market S&P 500 index [black] fell 56% and the SPDR Financial Sector ETF (NYSE: XLF) [blue] fell 83%, the three largest Savings & Loans fell much less:

• New York-based New York Community Bancorp (NYSE: NYCB) [beige] fell 53%,

• New Jersey-based Hudson City Bancorp (NASDAQ: HCBK) [purple] fell 30%, and

• Connecticut-based People’s United Financial (NASDAQ: PBCT) [orange] fell just 3%.

snl crisis 2 image 2


But there is a price to pay for outperforming the market during a correction, and that is underperforming the market during an advancement, as graphed below.

Since the economic recovery began in March of 2009, where the S&P has gained 197% and XLF has gained 286%, NYCB has gained 90%, HCBK has gained 17%, while PBCT has lost 14%.

snl crisis 2 image 3


The saving grace for some Savings and Loans companies is their rather high dividend yield. Factoring in NYCB’s hefty 6.4% annual yield over the past 6 years would raise its performance to around 128%, while adding PBCT’s 4.5% annual yield would raise its performance out of the hole to a plus 13% total return. Yet these still pale in comparison to what the rest of the market has been doing, especially the financial sector XLF.

How does the future look for the Savings & Loans segment?

Not great, to be honest. Remember how rising interest rates are an S&L’s worst nightmare? Well, that nightmare is about to strike once again, as interest rates in the U.S. are set to begin rising possibly in H2 of this year or H1 of 2016. And once they begin, they will likely continue to rise (gradually) for some 3 to 5 years until they reach their normal level in the 5 to 6% range.

As per the data table below, earnings growth for the three largest S&Ls are expected to grossly underperform the S&P’s average earnings growth rates for several years to come, highlighted in yellow.

snl crisis 2 image 4

Wise to Stay Clear

Despite rather attractive dividend yields, investors would do well to avoid the Savings & Loans segment. Although they will likely not suffer a collapse of one third of their population over the upcoming interest rate rises as they did in the past, they are still expected to underperform the broader market notably.

Investors looking to stay with financials would likely fair much better with the sector overall, which includes national bank and investment banking firms that can enter other financial arenas outside of the constrictive mortgage space. Rising rates will benefit many financial institutions, but only those with ample cash flows to allow them to continue lending at higher rates.

If you have a hard time selecting the right candidates, you could just as easily opt for the entire financial sector as a whole, such as the XLF graphed above.

Joseph Cafariello