Barbara Bennett

English

Research Papers in Economics

FRBSF WEEKLY LETTER
January 11, 1985
Restructuring the S&L Industry
The recent decline in the level of interest rates has
provided the savings and loan (S&L) industry with
some much-needed relief. As aresult, earnings for
1984 shouId show some improvementover those
fon983, ahdS&Ls ma.y be a.ble to postslightgains
in theiroverall net worth positions. Nonetheless,
the industrywill remain weakwithouta further
sizeable drop in interest rates. Overthe last five
years, S&Ls' recorded networth has declined
morethan 30 percent from 6.1 to 4.1 percent of
liabilities. Moreover, the market value ofnet
worth is substantially lowerstill, given the mag-
nitude ofthe industry's unbooked losses from de-
preciation in the value of its low-yielding, long-
term assets.
As problems nearly overwhelmed the industry in
1981 and 1982, legislators and regulators worked
quickly to implementassistance programs de-
signed to patch upthe industry's condition. This
Letter examines the various forms ofassistance
granted and evaluates the progress the industry
has made in addressing its basic problems. While
the industry has enjoyed certain tax subsidies, the
actual fiscal impactofthe direct assistance has
been small in comparison to the magnitude ofthe
problem. In contrast, the implicit (and, therefore,
unfunded) guarantees have been enormous and
mayactually have caused the industryto postpone
real solutions to its problems.
Expanded powers
Many have argued that the S&L industry's current
problems are due to its lack ofdiversification in
the types and maturities of its assets. An extremely
large proportion ofthe industry's portfolio has
been (and still is) invested in long-term, fixed-rate
mortgages that make the industry especially vul-
nerable to housing and interest rate cycles. Con-
sequently, when pressed to provide relief for the
industry's worsening condition, regulators and
legislators expanded S&Ls' investment powers.
The Federal Home Loan Bank Board (FHLBB)
loosened various restrictions on the industry's as-
set powers, including removing some restrictions
on the mortgage instrument itself. S&Ls were
given great latitudeto design adjustable rate mort-
gage instruments that, in theory, would insulate
them from fluctuations in interest rates.
For its part, Congress enacted two majorpieces of
legislation-the Depository Institution Deregula-
tion and Monetary Control Actof 1980 and the
Garn-St GermainDepository Institutions Actof
1982--bothofwhich expanded the menu of as-
sets S&Ls couldchoose to invest in. For example,
the 1980 Act authorized S&Ls to invest in com-
mercial paper debtsecurities, tooffercreditcards,
and to make consumer, education and commer-
cial real estate loans. The 1982 Actfurther ex-
panded S&Ls' investment powers to include obli-
gations ofstate and local governments, time and
savings deposits ofother S&Ls, and tangible per-
sonal property. In addition, S&Ls were given
authority to make commercial loans and Small
Business Investment Corporation loans. While
these Acts, as well as certain tax considerations,
impose limitations on S&Ls' investments in each
ofthe new areas, the restrictions are not likely to
become binding for a long time to come, ifever.
With these two pieces of legislation, then, S& Ls
presumably need no longer confine themselves to
housingfinance, or limittheirinvestmentsto long-
term assets.
Capital assistance
Byearly 1982, however, the industry's losses were
large enough to threaten what remained ofmany
S&L's recorded net worth. Consequently, legisla-
tors and regulators decided to buytime for the
industry to restructure itself. Assistance came
largely in the form ofvarious implicitand explicit
off-budgetguarantees ofthe industry's net worth.
In the Garn-St Germain Actof 1982, for example,
Congress authorized explicit capital assistance for
the industry by directingthe Federal Savings and
Loan InsuranceCorporation (FSLlC) toset up anet
worth certificate program. By allowing qualifying
institutions to issue networth certificates in ex-
change for the FSLlC's promissory notes, this pro-
gram created additional net worth for the industry
without requiring federal cash outlays unless the
institutions receiving aid failed.
The FHLBB, moreover, has given the industrysub-
stantial implicitcapital assistance that also has not
entailed any directfederal outlays. Through vari-
ous changes in its regulatory accounting princi-
ples (RAP), the FHLBB allowed S&Ls to include inFRBSF
net worth such questionable items as "appraised
equity capital." Moreover, the industry now has
considerable "intangible assets" arising from de-
ferral and purchasing accounting. These changes
augmented the industry's recorded net worth by
an estimated $21 billion at year-end 1983. (For
discussion ofnetworth certificates and RAP tech-
niques, see the Weekly Letterof December 21,
1984.)
In addition to these accounting changes, the
FHLBB has provided implicitcapital assistance to
the industryby lowering regulatory net worth re-
quirements in two steps from an average of5
percentof liabilities in early 1980 to 3 percent in
January 1982. Such a reduction was clearly in-
tended to assist the industry since the condition of
mostS&Lsatthetimeposed risks forthe insurance
system that could have warranted higher net
worth standards.
Moreover, the FHLB!3's decisions to reduce net
worth requirements and allowwhatamounted to
a redefinition ofregulatory net worth indirectly
generated tax benefits for the industry. Changes in
RAP enabled S&Lsto sell offlow-yieldingassets to
generate cash for reinvestment without havingto
record immediatelosses onthesale ofthose assets.
At the same time, S&Ls could record immediate
losses for tax accounting purposes, thereby sub-
stantially reducing theirtax liabilities.
Insolvency vs. illiquidity
The capital assistance provided by Congress and
the FHLBB indeed has bought the S&L industry
time. Despite substantial consolidation (more
than 700 institutions have been liquidated or
merged outofexistence), the industry itself is sti II
intactand, in some respects, thriving. In 1983 and
1984,forexample, the industry's assets grewatan
annual average rate of9.5 percent. This growth is
especially noteworthygiven the magnitudeofthe
priordeterioration in the market valueofthe in-
dustry's long-term assets.
The use ofbook valuation masks the large decline
in the industry's true net worth position. Ifthe
industry were required to recognize its heretofore
unbooked losses, its net worth position would fall
from 4.1 percentto an estimated - 3.7 percentof
liabilities, based on an approach developed by
Kane. These losses arose because the contract
interest rate on many ofthe industry's long-term
mortgages is less than the prevailing market rate.
The resulting depreciation in value eventually ap-
pears on S&Ls' books as a low (relative to pre-
vailingrates) recorded yield on assets. However, it
may take many years forthis reduced income
stream to showthe fu II effect ofthe decline in the
portfolios' marketvalue.
In effect, then, S&Ls have been able to use book
value accountingtodeferthe recognition ofcapital
losses as long as the assets in question remain in
portfoIio. ShouId investors become wary ofthe
condition ofan S&L with substantial unbooked
losses and begin towithdrawfunds, however, that
S&L may be forced to sell its "underwater" assets
and recognize its losses; the effect would be to
wipe out its net worth. Withoutsome assistance
from its regulator, such an S&L presumably\vould
be forced into bankruptcy.
Although manyfirms in the industryare technically
insolvent (i.e., the market value oftheir networth
is zeroornegative), theywill notfail as longasthe
FHLBB is willing to allowthese institutionsto stay
in operation. Because the Federal Savings and
Loan Insurance Corporation (FSLlC) explicitly in-
sures at least 72 percentofS&Ls' liabilitiesand the
Federal Home Loan Banks hold another 7 percent
in the form ofadvances, the failure to close in-
solvent institutions means that these government
institutions are underwritingthe industry's losses.
One could even argue that "uninsured" investors
are protected as long as the FHLBB gives them
sufficienttime to withdraw theirfunds priorto
closing afailing institution.
The FHLBB's seeming willingness to underwrite
staggering losses is perhaps hard to understand
since promptaction to close failing institutions as
they become insolvent would have substantially
reduced the FSLlCs presentexposure. Such action,
however, would have required a redefinition of
insolvency using a market valuation ofnet worth.
Moreover, because ofthe S&L industry's lack of
diversification, the deterioration in its condition as
rates began to rise was notlimitedto afewassocia-
tions but was nearly universal. Thus, by the time
the problem was recognized, itwould have been
difficultforthe FHLBB to take action withoutex-
haustingthe deposit insurance fund.
As a result, the FHLBB chose to allow insolvent
institutionsto continue in operation, in effect, pre-
tending thattheir losses did notexist. As a result,
the industry'snegativenetworth, which maybe asIndex
50 L-_-L..__L-_-L..__'--_-'-_---'__ .....J
1978 1979 1980 1981 1982 1983 1984
Large S&Ls~
" " " I I
I , • J
I \/'!\ r 'WI I i I
I ,
I I.,,.
,.~Jf I ,
: \ l
I ,
Stock Price Indexes for Large S&Ls*and the
Standard and Poor's 500 Stocks
• Equally weighted weekly price movements of a sample of 21 S&Ls with
deposits over $1 billion.
Barbara Bennett
This seeming lackofsignificant restructuring by
theS&L industrywill continuetobeaproblemfor
the regulators as long as implicitand explicit net
worth guarantees are given technically insolvent
institutions to help them continue in operation. In
effect, the FHLBB and other government institu-
tions are underwritingthe industry's losses and
discouraging S&Ls from taking steps to reduce
theirexposure to risk. As a means of reducing the
value ofthe unfunded guarantees the industry
nowenjoys, the FHLBB oughttoconsiderphasing
in tougher networth requirements, including ad-
opting a market-value definition ofinsolvency,
and closing the weakest institutions.
the proportion ofARMs in the industry's overall
mortgage portfolio remains atonly 14 percent at
the end of 1983. Moreover, since many associa-
tions apparently reduced their underwriting stan-
dards to make ARMs more marketable, increased
exposure to defauIt risk may have supplanted ex-
posure to rate risk.
.r, .. ~ i·,. ,..I,
A.J ••1 I I ,
''I rl...., '/ I I
J \,1 V " /
,,~ "
100 /...,.,,~-
150
200
250
300
350
Risk-takingand restructuring
The existenceofthese unfunded guarantees,
moreover, encourages S&Ls toundertake exces-
sive risks. As Kane (Housing Finance Review, July
1982) has argued, the FHLBB's actionswith regard
to regulatory networth requirements havehad the
effectofreducingthe cost ofdeposit insurance
and ofincreasing both the value ofthese guaran-
tees and thevalueofan S&Lcharter. The behavior
ofS&L stockprices (see chart) supportsthis lineof
reasoning. While large S&Ls' stock prices deter-
iorated significantlyduringthe darkestdays of
1981-82, theirappreciation since then seems out
oflinewiththe meager improvementin the indus-
try's condition. Governmentassistance programs
probably accountfor a substantial portion ofthis
appreciation and, as aresult, maybe discouraging
the industryfrom reducing its exposure to risk.
lowas negative $30billion,exceedsthe resources
ofthe $6.3 billion insurance fund. This disparity
represents an unfunded guarantee ofS&Ls' sol-
vency, which the Treasury and taxpayers would
haveto underwrite ifdepositors and investors
wereto lose confidence in the insurance system.
A study by Kaplan-Smith & Associates (an S&L
consulting firm) shows thatthe S&L industry has
not reduced its exposure to interest rate risk since
1981. Thanks to the considerable expansion of its
asset powers, the industry has reduced its propor-
tionate investment in mortgage loansfrom 80per-
centoftotal assets in 1981 to 63 percent in June
1984, and increased its investment in cash and
marketable securities by 26 percentto 18 percent
oftotal assets. However, the industry used an in-
flux ofshort-term funds primarilyto paydown
longerterm liabilities. This leftthe industry's sensi-
tivityto interest rate risk about unchanged.
Likewise, since 1982, the use ofadjustable rate
mortgages (ARMs) has grown steadily, with ARMs
now accounting for 67 percentofall newmort-
gages issued by S&Ls. This increase undoubtedly
reduces the industry's exposure to rate risk by
transferring thatrisk to borrowers. Nonetheless,
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthe managementofthe Federal Reserve Bank ofSan
Francisco, orofthe Board of Governorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor...•FreecopiesofFederal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bankof San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollaramounts in millionsl
"J!le::> 'mspueJ::I ues
lSL "ON llWlEld
OIVd~9VlSOd "sOn
llVW SSVD ISMI::I
OHMOS~Md
Selected Assets and Liabilities
Large Commercial Banks
Amount
Outstanding
12/26/84
Change
from
12/19/84
uo~6U!450m 40~n U060JO 0POJ\0U
040PI !!omoH O!UJoJ!l0) ouozPl::J 0>150Il::J
O)SI)UOJ:J UOS
JO ~U08
aAJaSa~ IOJapa:J
~uew~Jodea lpJOeSe~
Change from 12/28/83
Dollar Percent!
Loans, Leases and Investments1 2 189,718 1,361 13,693 7.7
Loans and Leases1 6 171,366 1,412 16,011 10.3
Commercial and Industrial 53,383 435 7,420 16.1
Real estate 62,018 73 3,119 5.2
Loans to Individuals 32,000 314 5,349 20.0
Leases 5,079 °
16 0.3
U.S. Treasury and Agency Securities2 11,265 - 82 - 1,242 - 9.9
Other Securities2 7,087 32 - 1,076 - 13.1
Total Deposits 195,464 1,096 4,467 2.3
Demand Deposits 46,891 602 - 2,346 - 4.7
Demand Deposits Adjusted3 32,188 2,049 857 2.7
OtherTransaction Balances4 12,634 - 1 - 141 - 1.1
Total Non-Transaction Balances6 135,939 495 6,954 5.3
MoneyMarketDeposit
Accounts-Total 41,429 338 1,832 4.6
Time Deposits in Amounts of
$100,000 or more 41,236 242 3,071 8.0
Other Liabilities for Borrowed Monevs 20,745 -1,713 - 2,262 - 9.8
Two Week Averages
of Daily Fi2ures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-l
Borrowings
Netfree reserves (+l/Netborrowed(- l
Period ended
12/17/84
40
44
3
Period ended
12/03/84
65
51
13
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes u.s. governmentand depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers
S Includes borrowingvia FRB, TI&L notes, Fed Funds, RPs and othersources
6 Includes items notshown separately
7 Annualized percentchange

Restructuring the S&L industry

http://www.frbsf.org/publications/economics/letter/1985/el85-02.pdf

Restructuring the S&L industry

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Research Papers in Economics