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Barth's analysis of the savings and loan debacle: an empirical test.

I. Introduction

The failure rate of F.S.L.I.C. insured savings and loan associations (S&Ls) in the United States during recent years has assumed unprecedented proportions. For the period from 1934 through 1941, a total of 33 F.S.L.I.C. insured S&Ls failed. Over the period from 1942 through 1962, a total of 15 F.S.L.I.C. insured S&Ls failed. The number of failed so-insured S&Ls rose to 82 for the period from 1963 through 1979. However, since 1980, the annual number of failed F.S.L.I.C. insured S&Ls has reached unprecedented levels. Indeed, according to Barth |1, 29~, over the period 1980 through 1989, a total of 525 F.S.L.I.C. insured insolvent S&Ls failed (were liquidated or sold at an enormous cost). A similar conclusion is observed when considering the percentage of the total number of F.S.L.I.C. insured S&Ls that failed: the percentage that failed during the 1980-1989 period far exceeded any prior experience. These alarming facts are discussed in detail in a recent book by James Barth |1~.(1) Based on his experience and knowledge, Barth |1~ describes and interprets the underlying causes of the S&L debacle in great detail.

In this brief paper, we seek to empirically evaluate whether Barth's contentions are valid.(2) Section II of this paper essentially summarizes Barth's basic arguments and conclusions. Section III provides the empirical test. It is shown that through the use of a reduced-form, distributed lag model, Barth's contentions are remarkably accurate. Concluding remarks are presented in the final section of the paper.

II. The Analytical Framework

Following Barth |1~ and others |6; 10~, the basis premise of the present analysis is that the diminishing profit margin resulting from the changes in economic conditions prior to deregulation and the increased competition brought about by deregulation are primary causes of the S&L failures in the last decade.(3) Specifically, the increase in the variability in the S&L profitability and thus the increased incidence of failure are the results of: (1) long periods of regulation which not only protected but also adversely constrained the S&Ls since the 1930s; (2) the changes in economic conditions over the last two or three decades and the lack of regulatory response to these changes, and (3) the subsequent deregulation of the financial services industry in the 1980s: a period of time with volatile economic conditions.(4)

Whereas at one time regulation and supervision of S&Ls on the federal and state levels contributed to a stable housing and housing-financed industry and may have protected the managers from the consequences of their mistakes, regulations have also adversely affected the revenue and cost conditions of the thrift institutions, thereby limiting their profit potentials. As discussed by Barth |1~, a perhaps more serious problem is that for years regulation has inhibited and discouraged S&Ls from adapting to changes in the market forces.(5) As a result, they were relatively less prepared for the adverse economic conditions in the 1980s and the newly deregulated competitive environment; thus, they were hard hit.

On the cost side, while regulation Q provided a stable and low-cost supply of mortgage funds to S&Ls, the maximum interest rates on savings deposits also limited their ability to compete for funds with other depository institutions. The exodus of funds (disintermediation) has been evidenced by the periods of credit crunch in 1966, 1969, 1974-1975, and 1979-1980.(6) The problem has become particularly serious in the late 1970s and early 1980s, when the nominal interest rates rose sharply because of the inflationary expectations, and the tight monetary actions taken by the Fed to dampen these expectations, as well as other factors, such as large federal budget deficits |4; 5; 8~.

Deregulation in the 1980s has restrained the process of disintermediation. In particular, the Depository Institutions Deregulation and Monetary Control Act (DIDMCA) of 1980, which mandates the gradual phaseout of the interest rate ceilings, and the Garn-St. Germain Depository Institution Act (GSGDIA) of 1982 which authorizes a new ceiling-free account, the money market deposit account, have increased the competitiveness of S&Ls in the financial system. However, there were two adverse effects involved: (1) The cost of funds increased; and hence, the price-cost margins were narrowed and strained to a level S&Ls were not accustomed to operating with, and (2) Deregulation came at a time when the fluctuations of interest rates were particularly volatile, another environment S&Ls were not accustomed to or well prepared for. With diminishing profit margins, some unprepared and mismanaged institutions thus failed in this new competitive environment.

The adverse effects of the Acts on the profit margins can also be seen from the revenue side of S&Ls. Under regulation, S&Ls were severely restricted in their uses of funds. Diversifications of asset portfolios were prohibited and thus most deposits which were short-term liabilities had been used to fund long-term, fixed-rate mortgages |1, 37-38~. With interest rates fluctuating following the changes in economic conditions, for many years S&Ls were able to operate profitably by setting the mortgage rates above the average level of the cyclical variations of interest rates. But as market interest rates fluctuated and rose sharply in the late 1970s with inflation, the profit margin based on the fixed rate became thin as usury ceilings prevented S&Ls from charging profitable mortgage rates. Of course, there also is the issue of adjustable rate mortgages (ARMs). The adoption of ARMs in the 1980s has undoubtedly eased the constraint on the S&Ls in making more profitable price-cost adjustments. But, by the end of 1981, only about two percent of the mortgage loans were in variable rates. Further, the new competitive environment under deregulation made it difficult for the S&Ls to have a quick recovery from the erosion of the profit margins. Additionally, to be competitive, S&Ls often had to offer interest rate discounts to buyers of new homes. The caps on rate increases also limited the pricing ability of S&Ls. Moreover, even if new loans were provided at an adjustable rate in the 1980s, there was still a massive backlog of previous fixed-rate mortgages in S&L portfolios. Thus, whereas it appears that S&Ls were considerably less exposed to interest rate risk after deregulation, their ability to have a quick fix on the erosion of the price-cost spread was clearly limited by a new set of market conditions under deregulation and the remnants of fixed-rate assets created under regulation. Clearly, these various considerations will tend to be reflected at least to some degree in the S&L mortgage portfolio yield. Naturally, the smaller this yield, ceteris paribus, the greater the S&L failure rate.

In addition to the diminishing price-cost spread during deregulation years, there has been a deterioration in the asset values in the thrift institutions resulting from the tight-money recession of 1981-1982. The most serious recession since WWII, combined with high nominal interest rates, had a devastating effect on the real estate industry in general and the asset values and the profitability of S&Ls in particular. Moreover, falling oil prices further aggravated diminishing real estate values and thereby reduced the profitability of S&Ls in some parts of the country, especially the Southwest |1, 40~.

Whereas the DIDMCA of 1980 and GSGDIA of 1982 have increased the ability of S&Ls to secure funds competitively, as mentioned above, the changes in the capital requirement under these Acts may have contributed to the S&L failures in the 1980s.(7) Following the DIDMCA of 1980, the FHLBB was allowed to reduce the statutory requirement from five percent to four percent and then to three percent. With the GSGDIA of 1982, the statutory requirement was further reduced to simply an "adequate" level of capital. These changes in the capital requirement increased the S&Ls leverage to compete with other financial firms. But a thin capital "cushion" also exposed the S&L's to a higher failure risk |1; 10, Chapter 2~.

Finally, there is the issue of deposit insurance. It is argued that the federal deposit insurance system (F.S.L.I.C.) encouraged S&Ls to take additional risk |1, 100-101~. For example, Barth |1, 100~ argues that "... the very availability of such insurance (federal deposit insurance) enabled many inadequately capitalized savings and loans to engage in high-risk activities and to gamble for resurrection." Barth |1, 101~ in fact alleges that "... the federal deposit insurance system was the unifying cause of the savings and loan disaster." Clearly, a higher ceiling on deposit insurance is likely to lead to a higher degree of risk taking by S&Ls.

III. The Empirical Analysis

The preceding discussions, based largely on Barth |1~, suggest that a variety of economic factors and public policies have influenced the S&L failure rate (SLF). These influences are largely reflected in the following: the 1981-1982 recession (REC), oil prices (OILP), the cost of funds (COST) to S&Ls, the S&L mortgage portfolio yield (MORT), the S&L capital-to-asset ratio (CAP), and the ceiling on federal deposit insurance (INS).

The basic model thus takes the following form:


where, according to Barth |1~, it is expected that, ceteris paribus, SLF is an increasing function of REC, COST, and INS, whereas SLF is a decreasing function of OILP, CAP, and MORT.

Naturally, the impact of these explanatory variables on the S&L failure rate is not instantaneous, suggesting that a distributed-lag structure would provide the best insights into the problem. Accordingly, based on this Barth |1~ inspired framework, we estimate the following reduced-form equation:

SLFt=a + b RECt + c OILPt - 2 + d COSTt - 2 + e MORTt + fCAPt - 2 + g INSt - 2 + u (2)


SLFt = the percentage of federally insured S&Ls that failed in year t;

a = constant term;

RECt = a binary (dummy) variable indicating the 1981-82 recession; RECt = 1 for the years 1981 and 1982 and RECt = 0 otherwise;

OILPt - 2 = the average price (in constant U.S. dollars) per barrel of imported crude oil in year t - 2 (1982 = 100.0);

COSTt - 2 = the average cost of funds to S&Ls in year t - 2, expressed as a percent per annum;

MORTt = the average S&L mortgage portfolio yield in year t, expressed as a percent per annum;

CAPt - 2 = the average S&L capital-to-asset ratio in year t - 2; this ratio of regulatory capital to assets is expressed as a percent;

INSt - 2 = the F.S.L.I.C. insurance ceiling per account on deposits at S&Ls in year t - 2, expressed in thousands of constant (1982) dollars (1982 = 100.0);

u = stochastic error term.

The data are all annual, the principal form in which the data are available. The time period examined runs from 1965 through 1989; this period is the only one for which all the data were available. The basic data sources were Barth |1~, Barth and Bradley |3~, various issues of the Statistical Abstract of the United States, and the Office of Thrift Supervision's Savings & Home Financing Source Book, 1989. Estimating equation (2) by OLS, using the Cochrane-Orcutt technique to adjust for first-order autocorrelation, yields:

SLFt= 17.76 + 2.68RECt - 0.19701LPt - 2 + 0.74COSTt - 2

(+5.12) (-3.48) (+2.24) - 1.31MORTt - 1.83CAPt - 2 + 0.0331NSt - 2,

(-5.07) (-6.51) (+2.70)

DW = 2.09, Rho = -0.10, RSQ = 0.79 (3)

where terms in parentheses are t-values.

As shown in equation (3), all six of the explanatory variables exhibit the expected signs (as per Barth |1~) and are statistically significant at the four percent level or better. Indeed, five of the estimated coefficients are significant at the one percent level or better. The coefficient of determination is nearly 0.80, so that the model explains nearly 80 percent of the S&L failure rate.(8) It appears that Barth's |1~ analysis is extraordinarily useful: the factors of the 1981-1982 recession, oil prices, the cost of borrowing to S&Ls, the S&L mortgage portfolio yield, the S&L capital-to-asset ratio, and deposit insurance ceilings all acted, in concert, to profoundly influence the S&L failure rate.

IV. Concluding Remarks

The present analysis finds that the S&L failure rate has been significantly affected by the 1981-1982 recession, oil prices, the cost of funds to S&Ls, the S&L mortgage portfolio yield, the S&L capital-to-asset ratio, and the federal deposit insurance ceiling. Thus, while fraudulent activities such as defalcations, embezzlements, and self-serving manipulations by S&L officials may have contributed somewhat to the S&L debacle |1, 44~, the present analysis clearly supports Barth's basic contentions that recent S&L failures are principally the consequence of factors such as those described in the present analysis.

1. See also the discussions in Barth |2~ and Barth and Bradley |3~.

2. While there were extensive discussions on how the regulatory changes may have impacted on the financial system in recent decades, much empirical research dealing with the causes of the S&L failures has been limited to the impact of deregulation on the market value of S&Ls |7; 9~.

3. The recent S&L failures have been characterized by many as "crisis failures" because they occurred mainly as a result of adverse economic conditions rather than just mismanagement, fraudulent practices, or simple misfortune |1; 6, 164-68~.

4. For a detailed discussion of the regulatory changes in the 1980s, see Barth |1, 123-32~ and Kaufman and Kormendi |10~.

5. See Barth |1, 37-38~ for a detailed discussion.

6. Disintermediation was inevitable. As estimated by Pyle |11~, the opportunity interest income lost at the S&Ls that resulted from the interest rate regulation was $1.59 billion during the 1968 through 1970 period alone.

7. See Barth |1, 48-62~ and Kaufman and Kormendi |10, Chapter 2~. Note also that as pointed out by Cornett and Tehranian |7~, the Acts impacted adversely more on smaller, less efficient S&Ls than on larger, more efficient S&Ls.

8. Alternative variations of the basic model (2) yield similar results. For instance, modest variations of the lag structure of the model leave our conclusions unchanged. These results will be supplied by the authors upon written request.


1. Barth, James R. The Great Savings and Loan Debate. Washington, D.C.: The AEI Press, 1991.

2. -----. Bank Structure and Competition. Chicago: Federal Reserve Bank of Chicago, 1985.

3. ----- and Michael G. Bradley, "Thrift Deregulation and Federal Deposit Insurance." Journal of Financial Services Research, September 1989, 231-59.

4. Barth, James R., George Iden, and Frank S. Russek, "Do Federal Deficits Really Matter?" Contemporary Policy Issues, Fall 1984-1985, 79-95.

5. -----, -----, and -----, "Federal Borrowing and Short-term Interest Rates: Comment." Southern Economic Journal, October 1985, 554-59.

6. Cooper, Kerry S. and Donald R. Fraser. Banking Deregulation and the New Competition in Financial Services. Cambridge, Mass.: Ballinger Publishing Co., 1984.

7. Cornett, Marcia M. and Hassan Tehranian, "An Examination of the Impact of the Garn-St. Germain Depository Institutions Act of 1982 on Commercial Banks and Savings and Loans." Journal of Finance, March 1990, 95-111.

8. Hoelscher, Gregory, "New Evidence on Deficits and Interest Rates." Journal of Money, Credit, and Banking, February 1986, 1-17.

9. James, Christopher, "An Analysis of Intra-industry Differences in the Effect of Regulation: The Case of Deposit Rate Ceilings." Journal of Monetary Economics, May 1983, 417-32.

10. Kaufman, George G. and Roger C. Kormendi, eds., Deregulating Financial Services: Public Policy in Flux. Cambridge, Mass.: Ballinger Publishing Co., 1986.

11. Pyle, David, "The Losses on Savings Deposits From Interest Rate Regulations." Bell Journal of Economics, Autumn 1974, 614-22.
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Title Annotation:Communications; James Barth
Author:Chao-shun Hung
Publication:Southern Economic Journal
Date:Oct 1, 1992
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