This all changed in 1989 with the passing of the Financial Institutes, Reform, Recovery and  Enforcement Act  (FIRREA) by Congress.  The Resolution Trust Corporation (RTC) was created, and all  S&L's we re-regulated.  This meant that they couldn't be as "risky" with our money (deposits.)   Hence, they couldn't charge enormous interest rates to their borrowers anymore (except for credit cards.)   Immediately all S&L's had to lower their "cost" or expense by lowering what they could pay to you and me on our deposits, i.e. checking, savings, money market, C/D's.

After the FIRREA legislative was passed in 1989, till today, all S&L's are still offering low  interest rates on *checking accounts, savings accounts and C/D's.  This was still true after Y2K and the Stock Market's highs and lows, not to mention all the many Federal Reserve increases in the PRIME Rate.

* The 11th District COFI is based mainly on these savings rates, hence the Cost Of Funds Index had to drop, and it won't go back to those higher rates of the 1970's and 80's.

For more information about the past and future effects of the FIRREA legislation, please read the article written in 1992 by First Boston, and the article by Salomon Brothers written in 1993. 

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Fixed Income Research
First Boston
TO: TFI Salesforce August 25, 1992
FROM: Andrew Carron -x4860
RE: The Downward Bias in the 11^th District Cost of Funds Index

The 11^th District Cost of Funds Index (COFI), upon which $33 billion in ARM securities and another $6 billion in CMO tranches are based, will decline sharply in coming months, irrespective of movements in market interest rates, and will remain consistently much lower relative to market rates than it has in the past. Declines average 10-15 basis points per month can be expected for the next six months, and further decreases will follow. Structural changes affecting thrift institutions and deposit markets in the 11^th District are the cause, and the result will be a level of COFI some 75 basis points lower than it otherwise would have been. The long-run equilibrium level of COFI, assuming a continuation of today’s market interest rates, is approximately 3.85%, about 140 basis points lower than the 5.26% reported for June.

These findings, as incorporated in a revised First Boston model of COFI, suggest that COFI TBA ARMs should trade 1 to 2 points lower than they have recently been quoted, even adjusting for their tight technical situation. CMO COFI floaters also are generally rich. On the other hand, COFI inverse floaters probably represent extraordinary value based on recent prices.

First Boston commissioned an independent analysis of the 11^th District market by outside consultants to help identify trends relevant to the future path of the index. That study, supplemented by our own research, together with FBC’s econometric analysis of COFI, form the basis for our conclusions.

Structural Changes

Numerous structural and market changes in the 11^th District have set the stage for dramatic declines in COFI.

Many of these developments have been underway for a year or more, and their effects are now being seen in the recently reported levels of COFI; others will manifest themselves only in the months to come. There are, and will be, fewer institutions paying high rates, fewer high–rate funds in the remaining institutions, and less rate competition among the survivors.

A.  Fewer cost thrifts. Over the last two years, thrifts closed by the RTC had a cost of funds 53 basis points higher than the district average. The elimination of thrifts such as Lincoln, Imperial, and the old American Savings-which to grow rapidly by bidding up deposit rates- has already lowered COFI by about 14 basis points. New West, a liquidating thrift set up to dispose of old American’s problem loans, is gradually paying down the $6 billion balance on a note originally indexed at COFI+275; as this is managed thrifts continue to be included in COFI. The RTC and OTS are currently managing 11^th District thrifts with more than $15 billion in liabilities, paying an average existing interest rates and force depositors to accept lower rates. Alternatively, high cost deposits in RTC thrifts may be sold to commercial banks, in which case the deposits disappear from the index. The resolution of failed and failing thrifts over the next year will result in further declines in COFI.

B.  Fewer high-cost funds. Since the passage of FIRREA in 1989 and the imposition of higher capital requirements, thrift institutions have had to reduce the size of their balance sheets. In less than three years, liabilities of 11^th District thrifts included in COFI have declined by 32 percent. Since the interest credited to deposit accounts automatically tends to make liabilities grow (at an annual rate approximately equal to COFI), the actual cash outflows are even greater than this number suggests. As thrifts "other borrowed funds" (repos, subordinated debt, and other borrowings) declined by 13 percentage points from June 30, 1989, to March 31, 1992. (And of this remaining amount, one-third is attributable to the note payable by New West.) Meanwhile, the share accounted for passbook, checking, and money market deposit accounts grew by 13 percent. Brokered CDs have declined substantially. Clearly these are important trends that are likely to continue.

C.  Reduced rate competition. One by-product of the RTC’s liquidation activities is a substantial increase in market concentration. In mid-1989, nine thrifts accounted for just over half of 11^th District liabilities. Currently, six institutions hold more than half of the liabilities. Furthermore, two of the six (Glendale Federal and California Federal) are weak institutions with inadequate capital. Should they come under RTC control, the most likely disposition scenarios would have their deposits going to some combination of the remaining four large thrifts or to commercial banks. Either way, there would be more concentration and less competition for funds. Historically when market concentration increases, the market leaders are less likely to bid up deposit rates. Deposit costs would decline.

D.  Acquisition of low-cost out-of-state funds. A thrift institution’s liabilities are included in COFI if it has its headquarters in the 11^th District. (Branches held by a non-11^th District holding company are not included. There are currently about 123 institutions in the 11^th District states of California, Arizona, and Nevada with total liabilities of $275 billion. Many of these institutions, however have branches in other states, acquired through mergers and purchases. Currently, about 18 percent of the $230 billion in total COFI deposits are located outside the 11^th District, mostly in Florida. Thrifts have acquired these branches from the RTC largely as a source of lower cost funds than are available in their traditional markets. This activity has already had a negative impact on COFI, and the process is likely to continue.

E.   Removing the floor on deposit accounts.   Interest rates offered by 11^th District thrifts on many shorter-maturity accounts have declined to record lows. In the past, passbook and NOW accounts rates were largely insensitive to market interest rates. Hence as rates fell, these constants served to retard the decline in COFI. Now the apparent floor (at about 4%) has been removed and rates on such accounts have fallen below 2% in some instances. A new level has been established and accepted. In the less competitive environment that is evolving, these rates are unlikely to adjust fully upward to any subsequent rise in market rates.

Future developments affecting COFI. 

The FIRREA legislation opened up Federal Home Loan Bank membership to other lenders involved in housing. In recent years, banks and credit unions have begun to join the 11^th District FHLB of San Francisco.  Banks’ average cost of funds is traditionally lower than that of thrifts: they have significant demand deposits which do not bear interest, they pay about 25 basis points less on money market accounts and 50 basis less on CDs, and they have less of a need for longer-term higher-rate funds. But so far only thrift liabilities are counted in calculating COFI-the result of contracts made between the FHLB of San Francisco and 11^th District thrifts in 1989. The legality of this deal- which requires thrifts to provide the COFI data to the FHLB and which prevents the FHLB from including commercial banks in the index-has not been tested in the courts. Meanwhile, many large thrifts would give up their memberships if they could, because their FHLB dividends have been cut sharply due to mandated contributions to the thrift bailout; legislation is pending in Congress that would make FHLB membership voluntary for thrifts. To the extent that banks added to COFI have low costs of funds and thrifts exiting COFI have high costs of funds, these developments could add a further downward bias to the index.

The Future Direction of COFI

Large thrifts in the 11^th District tend to price their deposits based on the commercial banks who are the dominant forces in the market. Smaller thrifts then follow the lead of the larger thrifts. Although commercial bank rates will tend to move when market rates move, the linkage between the components of COFI and market levels is indirect at best.

Historically, COFI has tracked market rates incompletely and with a lag. Hence deposit rate spreads over comparable market rates have moved inversely with the level of rates: wider spreads when rates are low, tighter (or negative) spreads when rates are low, tighter (or negative) spreads when rates are high. This relationship now appears to have been broken, due to the structural developments previously described. COFI models must be adjusted to take account of the structural changes which have occurred. Some of these have already been reflected in the index, while the remainder will become apparent over time as older sources of high costs funds reach maturity, roll off, and are not replaced. "The bucket effect" or "Bath Tub effect." And some judgment must be made about the likely impact of impending structural changes, appropriately balanced against the probability of their occurrence.

First Boston’s COFI model has been revised. While the original structure remains intact (see Forecasting the 11^th District Cost-of-Funds Index, November 11, 1988), several parameters have been re-estimated. In particular, we have adjusted the functions specifying the shares of deposits versus borrowings and the pricing of non-certificate deposit accounts. The new model is highly accurate in tracking the level of COFI, even over the last three years as market conditions have changed (Exhibit 1); the R-squared is 0.99 without auto correlation adjustment. The accuracy in predicting month-to-month percentage changes in the index is also very good, with an R-squared of 0.80.

 Exhibit 1. Actual and Projected Levels, 11^th District Cost of Funds Index

Based on current short-and intermediate-term interest rates, our model predicts that COFI will decline from 5.26% in June to 4.47% by December, eventually dropping to about 3.85%, as of 5/1/94 already 3.629! This is a drop of 140 basis points, which we predict will occur even without any further decreases in market interest rates. It would take an increase of about 175 basis points in short term rates for COFI top stabilize at the June level of 5.26%; even so, COFI would continue to decline for the remainder of this year before eventually reversing course.

Although the model predicts fairly continued monthly declines in the index, COFI is subject to substantial short-term volatility. The quarter-end data are reported in a different format from the other two months of the quarter, leading to some inconsistencies. Thrifts often restate expense or liability items for a given month after later month. Occasionally, a thrift may not report in time to be included in COFI, particularly when control is passing from private to RTC ownership or from RTC to acquirers. All of these factors require the staff of the San Francisco FHLB to make numerous adjustments to the data in order to arrive at what they perceive as a valid estimate of COFI. While it appears that FHLB staff have exercised competent judgement in editing the COFI data, the process inevitably introduces unintended short-term variability ("noise") to the computation. Such month-to-month perturbations, however, should not obscure the significant long-term downward trend.

The magnitude of the drop that we are predicting may initially appear somewhat unlikely in the context of COFI’s historical stability. To validate the long-term trend, First Boston conducted a survey of deposit rates at major 11^th District thrifts as of July 22. If market rates were to remain unchanged, presumably all deposit rates will largely determine the future level of COFI. This is even more true in the likely even that borrowed funds continue to decline as a share of liabilities.

We contacted the nine largest thrifts, which together account for two-thirds of 11^th District liabilities, and obtained rates on six different categories of deposits. We asked for rate differentials, if any, among the different geographic regions in which they appreciably higher than our long-run COFI estimate, which on the date was 3.87%. Applying the March 1992 liability mix to our survey results (Exhibit 2) gives an estimated current marginal cost of funds of about 4.04%, which is very close to the economic results from our model. Further downward rate resets in reaction to lower market yields, the expected run-off of high cost borrowings, and the narrowing of thrift-bank rate differentials accounts for the difference.

Exhibit 2. Current Rates on Incremental Funds 11^th District Thrifts, July 22, 1992

Relative Value

Our findings have negative relative value implications for intermediate-and longer-term securities indexed to COFI. (Short-term COFI floaters that pay off before COFI has declined substantially will be less affected.) Conversely, inverse floaters linked to COFI appear to have excellent value, even in a rising rate scenario.

TBA COFI ARMS (125 b.p. margin) have traded recently around 103-16. Using the FBC COFI model, a price of 103-16, and a prepayment assumption of 20% CPR, the yield is 4.23% and the average life is 4.18 years. This yield is only 40 b.p. over the interpolated 1.5-year Treasure (the effective duration of COFI). CMT floaters, by comparison, trade at about 100 b.p. over the 1-year Treasury.

COFI ARMs also fare poorly on an OAS Basis. Again using the revised COFI model, the OAS at 10% volatility is only 48 b.p. With our old COFI model, which approximates the market consensus, the OAS would be 75-90 b.p. This comparison suggests a fair price of about 1-1-24 to 102-12. COFI floaters in the CMO market would be similarly affected.

Inverse floaters linked to COFI will benefit substantially from the downward bias of the index. Two examples are presented in Exhibit 3.

FHR1296-H is stripped from the last tranche of a deal backed by 7-year balloon Gold PC 7’s. It has ‘leverage of 2.80 x COFI and its coupon is currently 10.618%. At 200% PSA, its average life is 6.5 years. Because of the collateral, however, there is no extension risk. As shown in Exhibit 3, this bond yields 9.15% assuming that COFI remains unchanged at the June level of 5.258%. Using the FBC model, and assuming market interest rates (LIBOR, Treasury) remain constant, the yield is 12.60%. Even under the assumption that market interest rates rise as implied by forward rates, the yield remains a respectable 9.00%

FHR 1341-SB is a 5-year Type-II PAC backed by 15 –year Gold PC 7s. It has leverage of 2.33333 and its initial coupon is 9.387%. At 150% PSA, its average life is 5.7 years. There is moderate average life variability outside the PAC range of 120-180% PSA. With a constant level of COFI, the yield is 9.45% while using the COFI model indicates a yield of 12.30%. Based on forward rates, the yield is 9.30%.

The performance of these COFI inverse floaters should be measured against comparable duration indexes such as CMT inverses. They represent value given the market misperception over the long-run level of COFI.

Exhibit 3. COFI Inverse Floaters

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Salomon Brothers

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