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Troubled savings and loan institutions: turnaround strategies under insolvency.

Throughout the 1980s and into the 1990s, the thrift industry (savings and loans (S&Ls) and mutual savings banks) was plagued by severe problems that led to massive numbers of insolvencies which bankrupted the government fund established to insure the industry's deposits.(1) Public concern about the enormous cost of the cleanup, though certainly justified, obscures an important fact: Unlike industries that require insolvent institutions to renegotiate with creditors immediately or under Chapter 11 protection (see Gilson, John, and Lang |17~), thrifts often operate in an insolvent condition for extended periods. Although most undercapitalized thrifts remain weak or eventually fail, some do successfully rebuild their capital ratios to levels exceeding the regulatory minimum. Differently from previous studies, this paper investigates the restructuring strategies adopted by these recovered institutions and compares them to the operating strategies of thrifts that failed.(2)

Although many factors contributed to the thrill thrift industry's problems, two are generally considered most important: interest rate risk and credit risk. The industry's polk 'y policy of funding long-term loans (principally mortgages) with short-term financing (principally deposits) makes it vulnerable to unexpected increases in interest rates. Short-term rates reached 20% in 1979. Three years later, according to a 1987 U.S. General Accounting Office (GAO) report, unexpected rate increases had inflicted large capital losses on thrifts having positive duration gaps. For many of these firms, however, the losses were largely offset by the unexpected decrease in rates (and the lower volatilities of those rates) later in the year.

Although interest rate risk was the major source of thrifts' losses in the first half of the 1980s, credit risk became the dominant factor behind the industry's woes during the second half of the decade (see White |34, Ch. 5 and 6~). By 1987, the deteriorating quality of assets in thrift portfolios, particularly real estate investments in the Southwest, accounted for virtually all of the industry's remaining problems.

From the late 1970s through mid-1989, regulators, gambling that unexpectedly lower interest rates would restore thrift institutions to health, progressed through several stages in their attempts to resolve the crisis. The required capital ratio was dramatically reduced, and regulators even permitted a number of thrifts deemed insolvent under regulatory accounting principles (RAP) to continue to operate. Despite the potential problems inherent in such a policy, this action gave the industry two important advantages: First, beginning in the early 1980s, the policy granted thrifts expanded investment and lending powers with which to restructure their business strategies. Second, although many of these new powers were restricted by early 1985, thrifts were given an extended period in which 10 to rebuild their capital ratios.

Granting new powers and the time to implement them did not change the incentive structure that the industry faced, however. The FSLIC continued to provide deposit insurance at rates independent of risk. In addition, starting staffing reductions at the Federal Home Loan Bank Board (FHLBB) meant fewer examiners and thus less-stringent monitoring. Under these conditions, theory suggests that thrift managers will take larger risks, even if the expected return is not commensurate with those risks.(3) Therefore, it was not clear a priori that the industry would utilize its newfound advantages to retrench and restructure in an attempt to regain solvency. Thrifts could have chosen to engage in risky operations that would have eroded their portfolio quality and endangered their recovery.

Our study shows that almost all of the largest 300 thrifts posting capital deficiencies at the end of 1979 utilized the flexibility granted by the lower required capital ratio; yet, only 24% had recovered by the end of 1989. In contrast, more than half (55%) of the institutions had failed or merged. The remaining thrifts continued to operate, but with less capital than required by Congress in the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989. Even with continued regulatory forbearance, we find no evidence that their condition improved.

Unlike previous studies, which examine differences between insolvent and well-capitalized firms, we study differences between insolvent firms that recover and those that do not. Three conclusions emerge: First, our evidence suggests that identifying which firms will eventually recover would, at best, be difficult. Combining our results with those of the earlier studies, we find that although it is relatively easy to distinguish undercapitalized thrifts from safe ones, pinpointing which of the insolvent but still operating institutions will ultimately recover may not be possible using only financial data. Second, while we find some differential use of the new investment opportunities, this does not greatly distinguish recovered firms from failed institutions. However, over time, unsuccessful firms show a movement towards poorer asset quality and nondeposit funding strategies. This is consistent with the hypothesis that regulators were gambling that troubled firms could "grow out of their weakness" by fueling rapid asset growth from nontraditional sources. Finally, we find little evidence that nonrecovered thrifts consume more perks than their more successful counterparts. This implies that managers of failed firms are no more susceptible to ownermanager principal-agent problems than managers of successful ones; rather, they simply may be less fortunate or less adept at operating thrift institutions.

I. Institutional Background and Hypotheses Testing

A. The Rise and Fall of the S&L Industry

The National Housing Act of 1934 established the FSLIC and limited deposit insurance coverage to $5,000 per account. This limit was progressively increased to $40,000 over the next 40 years and was then raised to its current level of $100,000 by the Depository Institutions Deregulation and Monetary Control Act of 1980 (DIDMCA). Because customers can establish multiple accounts while easily availing themselves of technology to spread funds across several insured institutions, essentially all thrift deposits are federally insured. Kormendi, Bernard, Pirrong, and Snyder |25~ report that as of September 1988, the FSLIC explicitly insured about $1.3 trillion in S&L deposits.

The thrift industry's traditional policy of funding longterm, fixed-rate mortgages with short-term deposits was generally profitable during the relatively tranquil period that preceded the mid-1960s. Although this strategy made thrifts vulnerable to unexpected increases in interest rates, such upticks were, until then, historically unlikely. The solvency crisis of the 1960s was followed by more severe losses in the late 1970s, when rapid inflation led to unexpectedly higher interest rates. By 1982, short-funded institutions were experiencing huge capital losses that drove many into insolvency, since thrifts had traditionally operated with relatively low capital levels.

The incentive effects of flat-rate deposit insurance magnify both the potential and the realized problems connected with the factors listed above.(4) Merton |28~ models insurance as a put option, and it is well known that the value of options increases with volatility. Thus, although insurance is worth more to riskier thrifts, flat-rate pricing means that they pay no more for it than safer institutions. Kane |20~ and Kormendi, Bernard, Pirrong, and Snyder |25~ argue that this incentive is particularly powerful for insolvent or nearly insolvent firms, and empirical evidence supports their claim. For example, Brewer and Mondschean |7~ find that poorly capitalized thrifts which adopted riskier strategies obtained higher stock returns than well-capitalized thrifts that pursued similar strategies. This result is consistent with the notion that owners of thinly capitalized firms place the insurer's capital at risk rather than their own. By 1987, interest-rate-related capital losses had been mostly eliminated or restored, but the credit quality of thrift assets had deteriorated dramatically, accounting for virtually all of the industry's remaining problems.

In principle, an insurer can protect itself by charging sufficiently high premiums and by taking steps to reduce its loss exposure (for instance, by assigning staff members to supervise those thrifts most likely to take risks that are unacceptable to the insurer). However, as Kane |20~ and Kormendi, Bernard, Pirrong, and Snyder |25~ note, deposit insurance contracts do not include any of the standard methods to accomplish this, as there are no provisions for deductibles, coinsurance, or enforced limits on coverage.

The incentive problems associated with deposit insurance are also magnified by scarce regulatory resources. Benston and Kaufman |4~, among others, claim that the relatively small number of FSLIC examiners could not have prevented the plethora of financially distressed thrifts from engaging in risky operations, especially during the period examined here. Fraud and managerial incompetence further exacerbated these problems.(5)

B. The Regulatory Response to the Crisis

In the early 1980s, most thrifts in financial straits suffered losses due to unanticipated increases in interest rates. Policymakers, reasoning that unexpectedly lower rates or more diversified assets would restore these institutions to health, chose to forbear and took actions to cover up emerging problems in the industry. Regulatory forbearance often took the form of capital augmentation, reductions in mandatory capital requirements, and failure to enforce existing requirements.(6) The government also allowed thrifts to invest in nontraditional assets such as nonmortgage loans and equity. We include a partial listing of regulatory forbearances below.(7)

In November 1980, the FHLBB both reduced thrifts' explicit capital requirement from approximately five percent to about four percent and provided for a "qualifying balance deduction" that, in effect, lowered the requirement still further. Beginning in November 1981, the FSLIC accepted net-worth certificates from thrifts with less than three percent net worth in exchange for FSLIC promissory notes, with face value guaranteed by the insurer. These "net-worth certificates" were an expedient device for relabeling a particular class of debt as capital for calculating regulatory net worth.(8) Permitting thrifts to count these certificates as part of capital represented a movement away from the use of generally accepted accounting principles (GAAP) by thrift regulators and towards the use of accounting gimmicks to improve the appearance of the industry's balance sheet. In January 1982, the capital requirement was further reduced to three percent. The following July, thrift regulators permitted good will (an intangible component of capital) to be amortized over a 40-year period, while allowing income from unbooked gains to be realized in as little as five years. Furthermore, the FHLBB began to include "appraised equity capital" in its calculations of regulatory net worth in November 1982.(9)

Beginning with the DIDMCA in March 1980, legislative and regulatory authorities began granting thrifts new investment powers. The DIDMCA, for example, authorized federally chartered S&Ls to invest up to 20% of their assets in corporate bonds and consumer loans and extended their authority to make construction or acquisition loans. The Garn-St. Germain Depository Institutions Act of December 1982 expanded the limits on commercial and consumer loans still further.

Even though interest rates had fallen substantially by 1985, the S&L industry remained troubled.(10) In March 1985, the FHLBB issued new regulations that limited the amount of direct investment thrifts could undertake and reinstituted higher capital standards (Kane |21, Tables 2-4~). Later that year, FHLBB Chairman Edwin Gray testified before Congress that both regulations were needed to protect the FSLIC fund from ever-increasing credit risks. However, these actions were motivated in a large part by the FHLBB's desire to maintain the S&L industry's image, thus protecting its own regulatory turf and buying time to allow the industry to recover. During the second half of the decade, the FHLBB continued its policy of forbearance; but rather than augmenting capital through accounting adjustments or reduced capital requirements, regulators simply ignored the requirements after 1987.(11)

In brief, regulatory and legal action taken during the 1980s produced both lower capital requirements and increased investment powers, providing thrifts with additional time to improve their business strategies and to regain solvency. For example, regulators gave troubled thrifts the opportunity to restructure their assets towards shorter-term commercial or consumer loans, which in turn allowed these firms to reduce their risk and to raise their asset quality. But the FHLBB also scaled back regulatory supervision and left intact the risk-taking incentive structure for insured thrifts. Given these perverse incentives, there could be no guarantee that regulatory forbearance and new investment powers would be profitably utilized rather than abused.

C. Testable Hypotheses

Our interest centers on whether the S&L industry did, in fact, seize this opportunity to restructure itself. During the additional operating time provided by regulatory forbearance, did thrift managers effectively utilize their new powers? If so, we hypothesize that recovered institutions may have diversified their asset portfolios and restructured their liabilities in order to achieve a more effective funding mix. However, less frequent monitoring, coupled with the perverse incentives inherent in flat-rate deposit insurance, may have resulted in thrifts taking on more asset and liability risk. Our empirical evidence suggests that successful institutions took on less risk than those that failed, a finding that is consistent with Cole, McKenzie, and White |9~, Benston |3~, Barth and Bradley |2~, Barth, Bartholomew, and Bradley |1~, and Kane |21~. Given this, we hypothesize that firms in financial distress at the beginning of a sample period might also have taken steps to reduce or to manage risk by switching to a less risky portfolio, changing their funding mix, or increasing their capital to provide a cushion against losses. Clearly, these options are not mutually exclusive.

Another strategy distressed thrifts could have employed is based on the theoretical work of Marcus |27~ and Ritchken, Thomson, DeGennaro, and Li |30~. By modeling the equity of an insured banking firm as a call option, these studies show that the firm's equity value is a decreasing function of capital and an increasing function of portfolio risk. Although risk-seeking in order to maximize the value of the call option is the opposite of the observed risk-minimizing or risk-managing strategies noted above, it may be an optimal strategy for undercapitalized firms. In fact, the deteriorating credit quality of thrift portfolios during the second half of the 1980s is likely a consequence of this restructuring strategy.

Our null and alternative hypotheses are as follows:

H0: Recovered thrifts pursued a different restructuring strategy than nonrecovered thrifts.

H1: Recovered thrifts pursued the same restructuring strategy as nonrecovered thrifts, but were luckier.

We also ask whether managers of failing firms consumed more perks. If not, then perhaps self-dealing by management was not a material factor in the industry's problems.

II. Data and Sample Selection

We obtained data from the FHLBB Thrift Financial Reports (call reports). These reports, which the FHLBB uses in off-site examinations, contain financial information on balance sheet and income statement items, as well as on items such as regulatory capital and rates paid on accounts. The data pertain to FSLIC-insured S&Ls and mutual savings banks.

Our sample period begins December 31, 1979 and extends through December 31, 1989. Because the FHLBB required thrifts to file these reports semiannually through December 31, 1983, and quarterly thereafter, our sample covers 33 call reports. To permit meaningful comparisons through time, we semiannualize the data beginning in 1984, resulting in 21 semiannual observations.

We chose December 31, 1979, as our starting date for several reasons. First, 998 thrifts were unable to meet capital requirements at that time. Second, the date precedes the 1980 and 1982 legislative changes and the explicit adoption of forbearance policies by thrift regulators. Third, it provides a full ten-year period to track the progress of thrifts in financial difficulty. Finally, December 31, 1979, marks the transition date from one call report format to another. As one might expect, specific data items included in these reports evolve through time, with substantial changes introduced periodically. By beginning our sample immediately after such a change, we minimize the number of variables lost. In a few cases, we are able to reconstruct variables by combining others according to information contained in the Microdata Reference Manual (see Board of Governors of the Federal Reserve System |5~). Because we wanted to focus on the most important thrifts, we selected the 300 largest firms having GAAP net worth/total asset ratios of less than five percent at the end of 1979.(12) Exhibit 1 gives the time profile of the sample. Firms may disappear from the sample for any of several reasons. First, they may have failed and been closed by regulatory authorities. Second, regulators may have forced them to merge with other institutions. Finally, they may have been acquired by other firms without federal intervention. Barth, Bartholomew, and Bradley |1~ claim that most thrift failures prior to 1983 resulted from unexpected interest rate increases. They further argue that 1983 and 1984 were characterized by relatively few failures and that most thrifts failing after 1985 did so because of credit problems in their asset portfolios. The relative paucity of failed thrifts in the mid-1980s is somewhat misleading, because the number of surviving firms in our sample declines in each period. This drop-off makes the large number of failures from January 1988 through 1989 still more substantial, as it reflects more than 23% of the total number of firms in the sample at the beginning of 1988.
Exhibit 1. The Summary Statistics of the Sample

 Number of Remaining
 Failures/Mergers Firms

Beginning sample:
(7/1/79 to 12/31/79) -- 300
1/1/80 to 12/31/80 10 290

1/1/81 to 12/31/81 18 272
1/1/82 to 12/31/82 48 224
1/1/83 to 12/31/83 16 208
1/1/84 to 12/31/84 6 202
1/1/85 to 12/31/85 5 197
1/1/86 to 12/31/86 11 186
1/1/87 to 12/31/87 12 176
1/1/88 to 12/31/88 17 159
1/1/89 to 12/31/89 24 135

Total 165 135

Notes: Failures and mergers of the 300 largest FSLIC-insured
thrifts with GAAP net-worth-to-total-asset ratios less than
five percent in 1979. The data are taken from the Federal Home
Loan Bank Board Thrift Financial Reports (call reports). Firms
that failed between July 1, 1979 and December 31, 1979 do not
appear on the December 31, 1979 call reports and are not in the

III. Empirical Evidence and Discussion

The appropriate measure of thrift net worth depends on the intended use of the information. When available, market-based measures are preferred, but because relatively few thrifts in our sample have publicly traded equity, we are limited to using financial data. Three measures using historical cost are most commonly employed. First, net worth may be computed according to GAAP net worth. This measure is useful for standard auditing purposes. Second, tangible net worth can be derived by subtracting goodwill from GAAP. This measure is often used as an estimate of liquidation value, since goodwill is lost in liquidation. Third, RAP net worth, which is useful for judging whether thrifts are in conformity with regulatory standards, can be derived by adding GAAP net worth to various items designed to augment thrifts' apparent capital positions. Examples include net-worth certificates, appraised equity capital, income-capital certificates, accrued net-worth certificates, qualifying subordinated debentures, and qualifying mutual-capital certificates. From these three net-worth measures, we have selected GAAP net worth for this analysis because it best represents a firm's going-concern value. The exact construction of GAAP net worth from call report data is discussed in the Appendix.

To ensure that thrifts were correctly classified in the sample, we matched all firms not filing a complete series of call reports over the sample period against the merger history file and the list of thrift failures published by the Office of Thrift Supervision. Using these two files, we were able to classify all but ten institutions as failed or merged over the sample period. We then hand-checked these ten against various issues of the U.S. Savings Institution Directory (published by Rand McNally) and were able to classify seven as either mergers or failures. The remaining three thrifts (two of which recovered) were found to be in existence, but were reporting call data under a different docket number than in 1979.

Of the 300 thrifts in our sample, failing firms that were closed by regulators account for 25%, institutions merged (with or without federal assistance) account for 30%, and surviving thrifts that did not recover to meet capital standards account for 21%. Thus, recovered thrifts represent only 24% of the total sample. These firms were not only in existence in December 1989, but had rebuilt their average capital-to-asset ratios to the FIRREA-mandated 1.5% tangible-net-worth-to-total-assets and 3% GAAP net-worth-to-total-asset minimum capital standard.(13) Because the patterns of most variables for failing, merged, and surviving thrifts are similar, we combine these three groups to form the nonrecovered sample.

By including merged thrifts in the nonrecovered sample, we implicitly assume that they would not have survived had they remained independent. Ideally, the merged thrifts should be separated into two types: private mergers (which may include firms that would have survived) and supervisory mergers (which should be treated as failures).(14) Unfortunately, with the exception of assisted mergers (classified here as failures), we cannot distinguish private mergers from unassisted supervisory mergers. Thus, including merged firms in the nonrecovered sample may bias us against finding differences between the recovered and nonrecovered samples.

To check the sensitivity of our merged-sample results, we also conducted the tests after excluding thrifts that disappeared because of a merger. Overall, we found that the results are not sensitive to inclusion of the merged thrifts in the nonrecovered sample. This suggests that the majority of thrifts in the merged sample entered into merger agreements (either voluntarily or under supervisory pressure) because their prospects for recovery, and even survival, would have been dim had they remained independent.

We also checked the sensitivity of our results to the use of the three percent FIRREA-mandated capital guideline as the rule for classifying the sample of surviving firms as recovered and nonrecovered. Note that the FIRREA capital standards are less stringent than the original five percent capital test we used for inclusion into our sample. Therefore, we also conducted the tests using five percent GAAP net worth to total assets in December 1989 as the criteria for determining whether or not a firm is in the recovered sample. While this resulted in a smaller sample of recovered firms (39 firms as opposed to 73) the results of the tests are very similar to those reported here.(15)

Before presenting our empirical results, a discussion of our sample sizes is in order. Although 227 firms failed to recover, we include only 221 in the first portion of our sample (December 1979 to June 1985) when reporting comparisons through time. This is because six firms failed between December 1979 and June 1980; no change through time can be observed. We treat the second subperiod (June 1985 through December 1989) in a similar manner. Although 126 nonrecovered firms were in existence in June 1985, we include only 124 because two failed before December 1985. For comparisons between groups (recovered versus nonrecovered), the sample sizes depend on the particular semiannual period examined, because some thrifts failed in each.

We split the sample period in June 1985 because in March of that year the FHLBB implemented new regulations restricting S&L growth and investment powers -- a policy change that certainly affected thrift behavior in the second half of the decade (see White |34, Ch. 7~). In addition, the critical restructuring decisions that ultimately determined whether a thrift recovered, survived, or failed were likely to have been made in the early 1980s (see White |34, Ch. 3~). Therefore, simply comparing thrifts included in the sample at the beginning with those in existence at the end could be misleading.

Exhibit 2 reports average total assets and GAAP net-worth ratios for both subperiods. Both groups of firms grew at about the same rate in the first sample. During the first subperiod, which is characterized by increased investment powers, the arithmetic average of the annual growth rates of total assets for successful thrifts was 18.3% compared to 18.0% for unsuccessful thrifts. Unsuccessful thrifts still in the sample as of June 1985 grew at a rate of 28.8%. During the second subperiod, both groups exhibited slower growth with recovered thrifts growing at a rate of 13.1% annually, while nonrecovered thrifts grew 5.2%.

Kaufman |23~ reports that the S&L industry expanded faster than the commercial banking industry between 1980 and 1987, a finding that is consistent with the high growth rate we observe for our total sample. But this pattern runs counter to that of most industries, which typically shrink during times of financial stress. Levy, Sandler, and Shackelford |26~ cite excessive growth as an important factor in thrift failure, suggesting that the 28.8% growth rate of nonrecovered firms that survive until the end of our first subperiod may have played a significant role in these institutions' subsequent demise.

The differences in the average GAAP net-worth-to-total-asset ratios are impossible to ignore. Initially, both recovered and nonrecovered firms had similar capital levels, as well as similar retained earnings and paid-in surplus (though small standard errors permit establishing statistical significance). However, in both subperiods, nonrecovered thrifts experienced continuous earnings problems that eroded their retained earnings and net worth. In contrast, successful thrifts had higher earnings in both periods (especially the second), and their net-worth ratios were boosted by substantially larger capital infusions, reflected in paid-in surplus.

As shown in Exhibit 3, we find very little evidence that the asset structures of recovered and nonrecovered thrifts differed significantly in December 1979. This is not surprising given the role of the industry at that time. Traditionally, thrifts made mortgage loans that matured in 30 years. But in the early 1980s, legislation was adopted that allowed these institutions to make commercial and consumer loans as well as traditional mortgage loans. Both commercial and consumer loans typically mature much quicker than traditional mortgages and afford thrifts the opportunity to spread their assets among a wider range of TABULAR DATA OMITTED TABULAR DATA OMITTED investments. Given these new powers, one would expect to find a shift in asset structure from traditional mortgage loans to nonmortgage investments.

Exhibit 3 shows that this expected shift was underway by the mid-1980s. Importantly, the asset structure of nonrecovered firms diverged from that of recovered thrifts over time, with nonrecovered thrifts holding more risky assets. For thrifts in existence in June of 1985 (column 3 of the exhibit) holdings of nonresidential loans, land loans, and real estate investments by nonrecovered thrifts were significantly higher than for their successful counterparts, while their holdings of traditional single-family mortgages were lower by a statistically significant amount.(16) By June 1985, the single-family mortgage investments of both types of thrifts had been significantly reduced, whereas investment in land loans, mortgage-backed securities, commercial loans and consumer loans had risen.

In the second subperiod, the proportion of total assets in single-family mortgages continued to decline, as both groups of thrifts invested more heavily in mortgage-backed securities; however, no other economically important investment changes were evident over time. This does not mean that thrifts collectively opted to hold safer portfolios. In fact, the drift toward riskier investments continued: nonrecovered institutions held more junk bonds and invested more in service corporations in December 1989 than in June 1985. However, the difference was not significant. Importantly, the unsuccessful firms' riskier portfolios yielded significantly less total income than the safer portfolios of the recovered firms.

Exhibit 4 shows that the liability structures of both recovered and nonrecovered thrifts were largely the same in December 1979. Retail deposits were statistically smaller and foreclosed assets were statistically larger for nonrecovered thrifts than for recovered thrifts. However, neither difference is important economically.

Increases in FHLBB advances in the mid-1980s are significant both statistically and economically for nonrecovered thrifts, signaling the deteriorating financial condition of these firms. However, this finding also indicates that nonrecovered thrifts were utilizing an important government subsidy. Firms that are members of the Federal Home Loan Bank (FHLB) system are afforded the privilege of borrowing from their district FHLB. These borrowings provide liquidity and a subsidized source of funds.


During the first subperiod, both recovered and nonrecovered thrifts decreased their reliance on retail deposits from the beginning to the end of the time period, and the difference is statistically significant. Conversely, both groups significantly increased their reliance on wholesale deposits from December 1979 to June 1985.

A potentially speculative funding strategy employed by unsuccessful firms is exhibited in a growing reliance on brokered deposits across time. Although the flow of brokered deposits to successful firms continued to grow during the sample, it increased much more substantially for nonrecovered thrifts.(17) Though starting from the same level, nonrecovered thrifts held more than three times the brokered deposits of recovered firms by December 1989. However, the growing reliance of the nonrecovered thrifts on brokered deposits is more likely due to their poor condition than to a speculative growth strategy during the second sample period.

Clearly, recovered firms used the funding flexibility afforded depository institutions by the DIDMCA (1980) and the Garn-St Germain Act (1982) more successfully than nonrecovered thrifts. The difference in the two groups' funding strategies reflected on their 1985 balance sheets suggests that while both types of institutions grew during the first half of the decade, the recovered thrifts pursued more conservative growth strategies than their unsuccessful counterparts. Recovered thrifts pursued a core-deposit growth strategy by expanding their assets at a rate they could primarily fund with inexpensive retail deposits. Therefore, the asset growth of recovered thrifts is consistent with the natural market growth associated with successful firms.

Nonrecovered firms' continued reliance on large, interest-sensitive wholesale deposits and nondeposit liabilities during this period might indicate a more speculative pattern of growth. These institutions used the new funding flexibility to decrease their retail deposits while rapidly expanding their asset portfolios. This suggests that nonrecovered thrifts pursued a speculative growth strategy, since it is likely that the retail-deposit growth rate is closely linked to the growth rate of income, which in turn is linked to the growth rate of the economy.

The liability structures of the recovered and nonrecovered thrifts diverged during the second subperiod, and the differences in asset quality in Exhibit 4 are difficult to miss. In December 1979, recovered and nonrecovered thrifts showed no difference in their levels of nonperforming loans (slow loans), and while statistically significant, the difference in their levels of foreclosed assets was economically trivial. By the end of the first sample period, though, both types of thrifts showed significant increases in both slow loans and foreclosed assets, with nonrecovered thrifts holding a significantly higher level of bad assets than the recovered sample. Consistent with the shift in the thrift debacle from an interest rate problem to an asset quality problem in the mid-1980s, the second subperiod showed the continued deterioration of the asset quality of both types of thrifts. However, the increase in problem assets for the nonrecovered sample was more than twice as large as that for the recovered sample. Recovered thrifts saw their slow loans and foreclosed assets rise from 1.4 and 0.4% of total assets to 2.7 and 0.9% of total assets, respectively, from June 1985 through December 1989. Slow loans and foreclosed assets for nonrecovered thrifts rose from 2.6 and 0.9% of total assets at the beginning of the second period to 9.4 and 4.5% of assets, respectively, at the end of the subperiod.

Interestingly, while nonrecovered thrifts spent more for advertising than recovered firms during the first sample period, the opposite was true during the second period, and the difference is statistically significant.

Benston |3~, among others, reports that fraud is often an important determinant of thrift failure. Although we cannot measure fraud directly with our data, we are able to study a related factor: perquisite consumption. Exhibit 5 includes three proxies for perk consumption -- directors' fees, office expenses, and travel expenses -- and reports no important differences across recovered and nonrecovered firms. Although fraud may well have contributed to individual thrift failures, our evidence lends little support to the hypothesis that overconsumption of perks was an important factor in the industry's problems. Instead, failed thrifts' poor performance may have been due to bad business judgment, bad luck, or both.

IV. Sensitivity Tests

To investigate the robustness of the univariate analysis presented in Exhibits 2 through 5, we perform discriminant analysis to select variables that distinguish recovered from nonrecovered thrifts in December 1979, June 1985, and December 1989. Similar results are obtained.


As is typically the case in economics and finance studies, the hypothesis tests presented here represent tests of joint hypotheses. That is, our univariate tests are really a test of (i) the null hypothesis that capital-deficient thrifts which recovered pursued a different operating strategy during the 1980s than those which did not, and (ii) the maintained hypothesis that both groups of thrifts were essentially the same in December 1979. To test this ancillary hypothesis, we performed a number of logit regression experiments to determine whether we could statistically discriminate between the two samples in December 1979. Variables for these regressions were chosen in three different ways. First, we constructed variables shown to be significant predictors of thrift failure. Second, we used stepwise discriminant analysis to select regressors for logit estimation from the variables used in this study and in Cole, McKenzie, and White |9~.(18) Finally, we used factor analysis to construct factor loadings from the combined set of variables used here and in Cole, McKenzie, and White |9~ for use as regressors in the logit analysis. Regardless of the model specification, logit analysis was unable to discriminate between successful and unsuccessful thrifts, indicating significant similarities between the two samples. Thus, we cannot reject the maintained hypothesis that the capital-deficient thrift samples were relatively homogeneous in 1979.

V. Conclusion

Unexpected increases in interest rates during the early 1980s and decreases in asset quality in the late 1980s caused massive losses throughout the S&L industry. Insolvency was common, if not the rule. But because of bureaucratic forbearance, funding constraints, and federal deposit insurance, hundreds of insolvent thrifts continued to operate. These factors, coupled with the expanded investment and lending powers granted to the industry in the early 1980s, gave thrift managers the opportunity to restructure their firms and to regain profitability and solvency. The model in Buser, Chen, and Kane |8~ suggests that the combination of expanded powers, flat-rate deposit insurance, and lower capital requirements implied the need for more effective monitoring. However, rather than subjecting economically insolvent thrifts to more careful monitoring, regulators and policymakers instead developed accounting devices to improve the apparent capital positions of troubled thrifts and thereby reduce the regulatory caseload. In addition, the number of examiners was reduced. Unfortunately, the net result of these actions was a reduction in monitoring at a time when the potential for abuse was increasing, because the incentives for these zombie institutions to take on risk was left virtually intact. As a result, it is not surprising that the condition of the industry does not appear to improve during our sample period.

Most thrifts in our sample shifted away from traditional mortgage assets between December 1979 and December 1989. Only 24% of the 300 thrifts studied both survived and rebuilt their capital ratios to the 3% GAAP net-worth and 1.5% tangible-net-worth standard mandated by FIRREA. We found that these thrifts held less risky portfolios than their unsuccessful counterparts. Overall, our empirical tests support the null hypothesis that the successful thrifts pursued a different turnaround strategy than those that failed.

Finally, because there was little difference between the initial asset and liability structures of thrifts that were ultimately successful and those that were not, it is unlikely that regulators would have been able to predict in December 1979 which of the firms in our sample would eventually recover.

1 Ely |12~ reports that as of June 30, 1989, 538 thrifts were insolvent, while taxpayer losses stemming from the failure of the Federal Savings and Loan Insurance Corporation (FSLIC) are projected to be in the hundreds of billions of dollars. Pauley |29~ estimates the cost of disposing of approximately 500 insolvent institutions as $124 billion at midyear 1989. Other estimates range from $50 billion (Barth, Bartholomew, and Bradley |1~) to as much as $150 billion (Kane |21~ and White |34~). More recently, the Congressional Budget Office |10~ projected that the final cost of resolving the thrift insurance mess would exceed the $115 billion provided by the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 by $105 billion. Finally, Benston and Kaufman |4~ point out that the $115 billion provided by FIRREA is 50 times larger than the cost of the celebrated bailout of New York City in 1975 and 80 times larger than the cost of the Chrysler rescue in 1979.

2 Previous studies such as Barth, Bartholomew, and Bradley |1~, Benston |3~, Cole, McKenzie, and White |9~, Kane |21~, and Rudolph and Hamden |33~ examine either differences between insolvent and well-capitalized firms, or failed firms. Rudolph |32~ studies the progression of insolvent thrifts through time but does not examine restructuring strategies.

3 For example, see Buser, Chen, and Kane |8~, Marcus |27~, Ronn and Verma |31~, Flannery |15~, and Keeley |24~. John, John, and Senbet |19~ and Ritchken, Thomson, DeGennaro, and Li |30~ illustrate the importance of frequent monitoring.

4 Emerson |13~ identified certain of these problems within a year after the Glass-Stegall Act of 1933 instituted deposit insurance.

5 Perhaps the most amazing example of both fraud and incompetence is Vernon Savings and Loan of Vernon, Texas. By the time regulators closed Vernon in 1987.96% of its loans were in default. Most of the remaining loans contained some form of deferred interest provision; they could not possibly have been in default because the first interest payments had not yet come due. Scott Taylor, a former FSLIC deputy director of liquidations who saw more than 50 institutions placed into receivership, stated that, "Those companies did not fail because of broader asset and investment powers, or because of direct investments in real estate. They failed because of fraud. incompetence and criminality ...." See Benston |3~.

6 The wisdom of permitting insolvent institutions to continue to operate has been challenged by Kane |20~, |22~, Kormendi, Bernard, Pirrong, and Snyder |25~, and Benston and Kaufman |4~, among others. They argue that incentives to adopt risky business and investment strategies are greatest for insolvent firms. DeGennaro and Thomson |11~ estimate the cost of regulatory forbearance from 1980 through July 1992. Their evidence suggests that forbearance increased the cost of resolving the insolvent thrifts by a factor of two or three times.

7 For a more detailed examination, see Barth and Bradley |2~, Kane |21~, and White |34~.

8 Born and Moser |6~ investigate the effect of Federal Home Loan Bank policy on thrift equities.

9 Appraised equity capital is the difference between the appraised market value and the book value of certain assets.

10 Kane |22~ reports that the interest-rate decline was less helpful than it might have appeared because many mortgage borrowers exercised their option to refinance at the lower rates.

11 According to the GAO |16, pp. 3 and 8~, the FHLBB announced on February 25, 1987, that "... the Bank Board is unlikely to take administrative action to enforce the minimum capital requirements for ... basically sound, well-managed thrifts with regulatory capital above 0.5 percent, and with problems in the energy, agricultural, natural resources or other distressed sectors |of~ the economy." In large part, the change in the forbearance rationale was born of necessity. Barth and Bradley |2~ report that the FSLIC lacked the reserves to close and resolve all of the insolvent thrift institutions.

12 The five percent selection criterion closely approximates the statutory capital requirement in force in December 1979.

13 Note that the actual capital requirement in FIRREA turned out to be more stringent than the three percent GAAP net-worth-to-total-assets and 1.5% tangible-net-worth-to-total-assets ratios cited in this paper. In addition to these two minimum capital rules. FIRREA mandates that thrift capital requirements be no less stringent than those for national banks. Except for banks which garner the top rating on their last bank examination, the minimum capital requirement for national banks is typically greater than the three percent of GAAP net-worth-to-total-assets ratio specified lot thrifts by FIRREA. Thrift capital standards are discussed in Section 301 of FIRREA 1989 (P.L. 101-73). For a discussion of bank capital standards, see Huber |18, Ch. 15~.

14 Note that 39% of the thrifts that disappeared from the sample due to mergers merged into a thrift that was either closed or placed into conservatorship by the Resolution Trust Corporation between December 31, 1989 (the end of our sample period) and December 31, 1991.

15 These results are available from the authors upon request.

16 For evidence that these activities are riskier than traditional mortgage lending, see Brewer and Mondschean |7~.

17 Brokered deposits are similar to wholesale deposits in that they are raised in regional and national money markets and thus tend to be a volatile and interest-sensitive source of funds. Unlike wholesale deposits, which thrifts raise directly, brokered deposits are placed in thrifts by a money broker, who divides the deposits into pieces small enough to be fully insured.

18 We performed stepwise discriminant analysis using stepwise, forward, and backward elimination. Stepwise and forward selection indicated one logit regression specification, while backward elimination suggested another. However, neither specification proved capable of discriminating between successful and unsuccessful thrifts in December 1979.


1. J.R. Barth, P.F. Bartholomew, and M.G. Bradley, "Determinants of Thrift Institution Resolution Costs," Journal of Finance (July 1990), pp. 731-754.

2. J.R. Barth and M.G. Bradley, "Thrift Deregulation and Federal Deposit Insurance," Journal of Financial Services Research (August 1989). pp. 231-259.

3. G.J. Benston, An Analysis of the Causes of Savings and Loan Association Failures, New York. Salomon Brothers, 1985.

4. G.J. Benston and G.G. Kaufman, "The Savings and Loan Debacle: Causes and Cures," The Public Interest 99 (Spring 1990), pp. 79-95.

5. Board of Governors of the Federal Reserve System, Microdata Reference Manual, Washington, D.C., Board of Governors. June 1989.

6. J.A. Born and J.T. Moser, "Countercyclical FHLBB Policy: Implications for S&L Equity," Review of Business and Economic Research (Spring 1988), pp. 38-50.

7. E. Brewer, III, and T.H. Mondschean, "An Empirical Test of the Incentive Effects of Deposit Insurance: The Case of Junk Bonds at Savings and Loan Associations," Journal of Money, Credit and Banking, forthcoming.

8. S.A. Buser, A.H. Chen, and E.J. Kane, "Federal Deposit Insurance, Regulatory Policy, and Optimal Bank Capital," Journal of Finance, (March 1981), pp. 51-60.

9. R. Cole, J.A. McKenzie and L. White. "Deregulation Gone Awry: Moral Hazard in the Savings and Loan Industry," Working Paper, New York University, 1991.

10. Congressional Budget Office. The Economic and Budget Outlook: An Update, Washington D.C., CBO, August 1991.

11. R.P. DeGennaro and J.B. Thomson, "Capital Forbearance and Thrifts: An Ex Post Examination of Regulatory Gambling," Working Paper, Federal Reserve Bank of Cleveland, 1992.

12. B. Ely, Testimony, Resolution Trust Corporation Task Force of the Subcommittee on Financial Institutions, Regulation, and Insurance, Committee on Banking, Finance, and Urban Affairs, U.S. Congress. House of Representatives, October 19, 1989.

13. G. Emerson, "Guaranty of Deposits under the Banking Act of 1934," Quarterly Journal of Economics (Fall 1934), pp. 229-244.

14. Federal Home Loan Bank Board, Purchasing an Insolvent Savings Institution through the Federal Savings and Loan Insurance Corporation, Washington, D.C., FHLBB, 1988.

15. M.J. Flannery, "Pricing Deposit Insurance When the Insurer Measures with Error," Journal of Banking and Finance (September 1991), pp. 975-998.

16. General Accounting Office, Thrift Industry Forbearance for Troubled Institutions, 1982-1986. Washington. D.C., GAO, May 1987.

17. S. Gilson, K. John, and L.H.P. Lang, "Troubled Debt Restructurings: An Empirical Study of Private Reorganization of Firms in Default," Journal of Financial Economics (October 1990), pp. 315-354.

18. S.K. Huber, Bank Officer's Handbook of Government Regulation, 2nd edition (1991 Cumulative Supplement No. 1), Boston, MA, Warren, Gorham & Lamont, 1991.

19. K. John, T. John, and L. Senbet, "Risk-Shifting Incentives of Depository Institutions: A New Perspective on FDIC Reform," Journal of Banking and Finance (September 1991), pp. 894-915.

20. E.J. Kane, The Gathering Crisis in Federal Deposit Insurance, Cambridge, MA, MIT Press, 1985.

21. E.J. Kane, The S&L Insurance Mess: How Did It Happen?, Washington, D.C., The Urban Institute, 1989.

22. E.J. Kane, "Principal-Agent Problems in S&L Salvage," Journal of Finance (July 1990), pp. 755-764.

23. G.G. Kaufman, "Comments on 'Thrift Deregulation and Federal Deposit Insurance' by J.R. Barth and M.G. Bradley," Journal of Financial Services Research (September 1989), pp. 261-264.

24. M. Keeley, "Deposit Insurance, Risk, and Market Power in Banking," American Economic Review (December 1990). pp. 1183-1200.

25. R.C. Kormendi, V.L. Bernard, S.C. Pirrong, and E.A. Snyder, Crisis Resolution in the Thrift Industry. A Mid America Institute Report, Boston, MA, Kluwer Academic Publishers, 1989.

26. G.J. Levy, H.M. Sandler, and D.B. Shackelford, "Statement before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate." August 2. 1988.

27. A.J. Marcus, "Deregulation and Bank Financial Policy," Journal of Banking and Finance (December 1984), pp. 557-565.

28. R.C. Merton, "An Analytic Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of Modern Option Pricing Theory," Journal of Banking and Finance (June 1977), pp. 3-11.

29. B. Pauley, The Thrift Reform Program: Summary and Implications, New York, Salomon Brothers, April 1989.

30. P.H. Ritchken, J.B. Thomson, R.P. DeGennaro, and A. Li, "On Flexibility, Capital Structure, and Investment Decisions for the Insured Bank," Journal of Banking and Finance, forthcoming 1993.

31. E.I. Ronn and A.K. Verma, "Pricing Risk-Adjusted Deposit Insurance: An Option-Based Model," Journal of Finance (September 1986), pp. 871-895.

32. P.M. Rudolph, "The Insolvent Thrifts of 1982: Where are They Now?," AREUEA Journal (Winter 1989), pp. 450-462.

33. P.M. Rudolph and B. Hamden, "An Analysis of Post-Deregulation Savings and Loan Failures," AREUEA Journal (Spring 1988), pp. 17-33.

34. L.J. White, The S&L Debacle: Public Lessons for Bank and Thrift Regulation, New York, NY, Oxford Press, 1991.

Appendix A. The Construction of GAAP Net Worth

Perhaps surprisingly, GAAP net worth is generally not reported in the call reports. Because the data are collected for regulatory purposes, RAP values are used instead. We are able to compute GAAP net worth for the years in which data are unavailable, however, by using the following procedures:

* Prior to June 30, 1981: "Total net worth" minus deferred losses on securities sold and accounts receivable secured by pledged savings.

* For December 31, 1981: "Total net worth" minus qualifying mutual-capital certificates minus deferred losses on securities sold and accounts receivable secured by pledged savings.

* For June 30, 1982: Same as for December 31, 1981, although the call report variable number for qualifying mutual-capital certificates is different.

* For 1983: RAP net worth minus the sum of qualifying mutual-capital, income-capital, and net-worth certificates, qualifying subordinated debentures, appraised equity capital, deferred losses on loans sold, and accounts receivable secured by pledged savings.

* For March 31, 1984 to December 31, 1986: The sum of preferred stock, permanent reserve or common stock, capital contributions, and undivided profits, less the sum of deferred net losses (gains) on loans sold, deferred net losses (gains) on other assets sold, and accounts receivable secured by pledged savings, plus the sum of reserves for contingencies and other capital reserves, plus net retained earnings.

* For March 31, 1987 through December 31, 1988: Perpetual preferred stock plus the sum of permanent reserve or common stock, capital contributions, and undivided profits, less the sum of deferred net losses (gains) on loans sold, deferred net losses (gains) on other assets sold, and accounts receivable secured by pledged savings.

* For 1989: GAAP net worth is reported directly on the call reports.

Ramon P. DeGennaro is Associate Professor of Finance at the University of Tennessee, Knoxville, Tennessee, Larry H.P. Lang is Associate Professor of Finance at New York University, New York, and James B. Thomson is Assistant Vice-President at the Federal Reserve Bank of Cleveland, Cleveland, Ohio.
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Title Annotation:Financial Distress Special Issue; includes appnedix
Author:DeGennaro, Ramon P.; Lang, Larry H.P.; Thomson, James B.
Publication:Financial Management
Date:Sep 22, 1993
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