Savings and loan associations ; Mortgages ; Interest rates

Stuart A. Gabriel

English

Research Papers in Economics

FRBSF WEEKLY LETTER
Number 94-39, November 11, 1994
Crises in the Thrift Industry
and the Cost of Mortgage Credit
*Source: U.S. Department of Housing and Urban Development
and Office of Thrift Supervision
Figure 1
Thrifts' Shares on the Decline
1990 1985 1980 1975
60
50
40 .
:~ I '" rl\t\t.:\~
'0 ::!:::: ::!i::::::: .i.i.·.i::.: ~,t~~ Net AcquisKtl"nS'j'." o +:::&:::'~----B'::ffl::::::;'-::-------:\~·ffl:·:·:~~··-----~~ij;'- ..::----."
I:; ::!:!r:: i!::: ~t~:1:~:
- -2' 00 :!.:: :'::.: •.... ::::::.::.::... iII: : .. :~ .. :: .. :~ .. :~ ..: ::.:!: •.•. :::::::.:: :!:::i:::::: ·.:.:·.i·.!:
: .:I:~:::!::i:!::i:1::i:: :~:~:~:~':. .::~:: ~:'::: ~:':::
-30 -f""";-:':-r,...-;-"'9-...-r-r...-f"-r-':,+,~,,:,";-:,' -r...-r-r...-r---r''i'-r-,-,-
1970
Percent
70
~~Ij
In recent decades, the relative advantage thrifts
enjoyed in housing finance has diminished. As
shown in Figure 1, thrifts' shares of mortgage
acquisitions and mortgage originations have de-
clined since the late 1970s. The downward trend
can be traced to a number of developments. One
is intermittent industry crises. During the early
1980s, the run-up in interest rates, along with the
mismatch in the maturities ofthrift assets and
liabilities, contributed to a high level of disin-
termediation and a large number of thrift failures.
As a result, the thrift share of mortgage credit fell
back sharply. Furthermore, regulatory and tech-
nological changes-including the removal of
Regulation Q-have eroded the relative ad-
vantages of thrifts in mortgage lending. Those
changes also have permitted the separation of
mortgage origination, servicing, and holding
functions, facilitating the flow of capital into
mortgage markets from general capital markets
and other sources. Hendershott (1989) and others
have argued that the distinguishing characteristic
Adve.rse developments in the thrift industry
Historically, thrifts have been specialized mort-
gage lenders with considerable expertise in
evaluating potential borrowers, establishing long-
term relationships with customers, and designing
loan agreements that reduce adverse selection.
Such expertise, along with tax incentives, gave
thrifts a prominent role in providing housing fi-
nance. During the mid-1970s, thrifts accounted
for as much as one-half of all home mortgage
originations in the United States.
This Weekly Letter explores an issue that may not
be well-appreciated, namely, that the immediate
closure of all insolvent thrifts during the early
1980s would have imposed a different set of
costs on the economy, in the form of higher mort-
gage interest rates and concomitantly reduced
levels of housing activity. The results show that
those adverse effects would have all but disap"
peared by the late 1980s, owing in large measure
to the proliferation of nonportfolio mortgage
lenders and the expanded coverage of secondary
mortgage markets. Looking back, those larger
economic costs associated with immediate reso-
lution of troubled thrifts may have provided some
justification for a policy of regulatory forbearance
during the early 1980s. By late in the decade,
however, there remained little detectable mort-
gage rate effect associated with thrift industry
operation, providing further credence to a policy
of immediate resolution of troubled institutions,
rather than forbearance.
During the thrift industry crises of the 1980s, the
preferred policy in dealing with undercapitalized
or insolvent thrift institutions was one of capital
forbearance. For example, legislation enacted in
the early 1980s substantially reduced the capital
requirements imposed on thrifts. Furthermore,
regulatory accounting principles introduced dur-
ing that period masked the insolvency of many
institutions. Broad consensus among industry
analysts suggests that delays in the closure of in-
solvent institutions led to substantial increases
in both the direct and indirect costs of thrift
resolution.FABSF
Percent
Figure 2
Mortgage Rate-Treasury Spread
The econometric analysis usesintertemporal
fluctuations in net new deposits to proxy the ef-
fects of disruptions in the thrift industry on the
ability or willingness of those institutions to
provide mortgage credit. We use the deposit
measure because it reflects the view prevalent
in the early 1980s that thrift supply of mortgage
credit moved in step with thrift deposit flows.
1986 1991 1976 1981
2
o I I
1971
than 20 percent, off substantially from levels re-
corded during the mid-1980s. The mClst recent
disruption in the thrift industry, a tightening of
thrift regulation under FIRREA, and increased
competition from non-thrift lenders all have
served to reduce thrift presence in the market.
The more recent decline in thrift market share,
however, appears to have had Iittle effect on the
pricing of mortgages in the primary market.
5
4
3
Our recent research (Bradley, Gabriel, and
Wohar forthcoming) takes a more systematic ap-
proach to evaluating the influence of periodic
disruptions in the thrift industry on mortgage
credit intermediation and housing activity. The
research is based on an econometric model that
analyzes the links between shocks to the thrift in-
dustry during the 1980s and the loss of thrift
intermediation services. From these results, we
evaluate the effects of contraction in thrift mort-
gage market intermediation on the price of
mortgage credit.
It is not surprising then that over the course of the
past decade, the development of secondary mort-
gage markets has supported the proliferation of a
large number of competitors. Nor is itsurprising
that lenders in primary markets now often base
their credit decisions on underwriting guidelines
set forth by secondary market institutions such as
Fannie Mae and Freddie Mac.
While many individual thrifts remain econom-
ically viable, these developments have raised
questions about the future of specialized fed-
erally insured institutions to promote housing
finance. Analysts and policymakers alike also
have expressed concems about the larger eco-
nomic effects of crises in the thrift industry. These
issues take on greater significance in the wake of
the Financial Institutions Reform, Recovery, and
Enforcement Act of 1989 (FIRREA), which im-
posed much of the ultimate burden of resolving
troubled institutions on the taxpayer.
ofthrifts-that of holding mortgages in portfolio
-may no longer be economically viable. They
point to a decline in the spread between rates
earned on mortgage assets (adjusted for the
values of the default and prepayment options
imbedded in the mortgage contract) and the all-
in thrift cost of funds.
Thrift lending activity
and mortgage interest rates
One way to gauge the effects of thrift crises on
the larger economy is to examine the movement
in fixed rates on mortgages relative to other inter-
est rates. In the early 1980s, the reduction in
thrift provision of mortgage credit coincided with
a sharp increase in the interest rate spread be-
tween fixed-rate mortgages and comparable
maturity Treasury securities. For example, rates
on fixed-rate mortgages averaged 16.36 percent
in 1981-82, reflecting a 291 basis point markup
over comparable maturity Treasury securities.
This spread was about twice that recorded for
the 1975-1980 period. On balance, then, the
disruption to the thrift industry during that period
may have reduced the aggregate supply of mort-
gage credit and resulted in relatively higher
mortgage interest rates. Given the sizable and
well-documented interest elasticity of housing
demand, the disruption to the thrift industry dur-
ing the early 1980s may have exacerbated the
cyclical downturn in housing activity.
In recent years, the thrift share of mortgage orig-
inations has continued to trend down. By early
1994, thrift market share had declined to lessFurthermore, it also allows us to simulate and
empirically distinguish between the interme-
diation effects of sizable declines in net new
deposits during the early and late 1980s. The
model first analyzes the influence of fluctuations
in net new deposits on the thrift share of resi-
dential1-4 family net mortgage acquisitions.
Subsequent statistical analysis evaluates the ef-
fects of thrift market share on the interest rate
spread between conventional- fixed-rate mort-
gages and comparable maturity Treasury securi-
ties. In undertaking that analysis, we control for
the values ofthe borrower prepayment and de-
fault options embedded in the mortgage asset.
Risk borne by the mortgage holder for potential
borrower default or loan prepayment serves to
explain much of the upward adjustment in mort-
gage rates over comparable maturity Treasury
securities.
Our research results indicate that during the late
1970s and the early 1980s, a sharp curtailment in
thrift intermediation activities would have sig-
nificantly reduced the supply of loanable funds
and boosted mortgage interest rates. Our simula-
tions suggest that if all institutions that became
market-value insolvent in early 1982 had been
immediately resolved by the thrift regulatory
agency, interest rate spreads between mortgages
and Treasuries would have moved up in that year
by about 30 basis points. Such an effect is not in-
consequential, given that the mean value ofthat
interest rate spread was 150 basis points during
the 1975-1980 period. However, our analysis
also indicates that both the magnitude and the
statistical significance of the thrift affect on mort-
gage-Treasury rate spreads declined rapidly
during the latter part ofthe 1980s. More specifi-
cally, little home mortgage or housing market
consequence is ascribed to immediate resolution
of troubled thrifts during the more recent period.
Conclusions
Results of our research suggest that the thriftcri-
sis of the early 1980s imposed real costs on the
economy by reducing the amount of mortgage
credit intermediation. In particular, the interest
rate spread between mortgages and comparable
maturity Treasury securities during that period
was considerably higher than it would have been
if those disruptions had not occurred. Those
higher mortgage interest rates served to damp
the demand for housing and in so doing exacer-
bated the decline in economic activity recorded
during early years of that decade. In hindsight,
then, the policy of regulatory forbearance fol-
lowed by the thrift regulatory agency may have
enabled other providers of mortgage credit to
substitute for the credit provided by thrifts, thus
reducing the disruption to mortgage markets. Re-
search findings further suggest that the disruption
to the mortgage market would have. been signifi-
cantly WOise, if all thrifts had been immediately
resolved in the early 1980s. Of course, such
benefits of a policy of forbearance must be
weighed against the substantial costs associated
with the delays in closing troubled institutions.
Having said that, our research also clearly in-
dicates a severing of the link between thrift
provision of mortgage credit and mortgage in-
terest rates during the post-recession years of
the 1980s. This is attributable, in part, to devel-
opments in primary and secondary mortgage
markets which permitted the mortgage product
to be unbundled. Many thrifts remain viable pro-
viders of mortgage intermediation servicesin the
evolved housing finance and regulatory environ-
ment. However, concerning the large number of
troubled institutions that have been closed in re-
cent years, our research suggests little effect of
industry contraction on the price or availability
of mortgage credit or more generally on the de-
mand for housing.
Stuart A. Gabriel
Visiting Scholar
Professor of Finance and Business Economics
Graduate School of Business Administration
University of Southern California
References
Bradley, Michael, Stuart Gabriel, and Mark Wohar.
1995. "The Thrift Crisis, Mortgage Credit Inter-
mediation, and Housing Activity." journal of
Money, Credit, and Banking.
Hendershott, Patrie H. 1989. "The Future ofThrifts as
Home Mortgage Portfolio Lenders." In The Future
of the Thrift Industry: Proceedings ofthe Four-
teenth Annual Conference, pp. 153-63. Federal
Home Loan Bank of San Francisco.
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94-38
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California Recession and Recovery Cromwell
Just-in-Time Inventory Management: Has It Made a Difference? Huh
GATS and Banking in the Pacific Basin Moreno
The Persistence ofthe Prime Rate Booth
A Market-Based Approach to CRA Neuberger/Schmidt
Manufacturing Bias in Regional Policy Schmidt
An "Intermountain Miracle"? Sherwood-Call/Schmidt
Trade and Growth: Some Recent Evidence Trehan
Should the Central Bank Be Responsible for Regional Stabilization? Cogley/Schaan
Interstate Banking and Risk Levonian
A Primer on Monetary Policy Part I: Goals and Instruments Walsh
A Primer on Monetary Policy Part II: Targets and Indicators Walsh
Linkages of National Interest Rates Throop
Regional Income Divergence in the 1980s Sherwood-Call
Exchange Rate Arrangements in thePacific Basin Glick
How Bad is the "Bad Loan Problem" in Japan? Huh/Kim
Measuring the Cost of "Financial Repression" Huh/Kim
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Explaining Asia's Low Inflation Moreno
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974-2246, Fax (415) 974-3341.Aeseorch Department Federal Reserve Bank of

The Future ofThrifts as Home Mortgage Portfolio Lenders.&quot; In The Future of the Thrift Industry:

The Thrift Crisis, Mortgage Credit Intermediation, and Housing Activity.&quot;

Crises in the thrift industry and the cost of mortgage credit

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Crises in the thrift industry and the cost of mortgage credit

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