Troubled savings and loan institutions: turnaround strategies under insolvency - includes appnedix - Financial Distress Special Issue

Financial Management (Financial Management Association), Autumn, 1993 by Ramon P. DeGennaro, Larry H.P. Lang, James B. Thomson

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.