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 probl ems that led to massive numbers of insolvencies which bankrupted the g ovemment fund established to insure the industry's deposits.1 Public c oncem about the enormous cost of the cleanup, though certainly justifi ed, obscures an important fact: Unlike industries that require insolve nt institutions to renegotiate with creditors immediately or under Cha pter 11 protection (see Gilson, John, and Lang [17]), thrifts often op erate in an insolvent condition for extended periods. Although most un dercapitalized thrifts remain weak or eventually fail, some do success fully rebuild their capital ratios to levels exceeding the regulatory minimum. Differently from previous studies, this paper investigates th e restructuring strategies adopted by these recovered institutions and compares them to the operating strategies of thrifts that failed.2 Al though many factors contributed to the thrift industry's problems, two are generally considered most important: interest rate risk and credi t risk. The industry's policy of funding long-term loans (principally mortgages) with short-term financing (principally deposits) makes it v ulnerable to unexpected increases in interest rates. Short-term rates reached 20% in 1979. Three years later, according to a 1987 U.S. Gener al Accounting Office (GAO) report, unexpected rate increases had infli cted large capital losses on thrifts having positive duration gaps. Fo r many of these firms, however, the losses were largely offset by the unexpected decrease in rates (and the lower volatilities of those rate s) 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 deteriorati ng quality of assets in thrift portfolios, particularly real estate in vestments in the Southwest, accounted for virtually all of the industr y's remaining problems. From the late 1970s through mid-1989, regulato rs, gambling that unexpectedly lower interest rates would restore thri ft institutions to health, progressed through several stages in their attempts to resolve the crisis. The required capital ratio was dramati cally reduced, and regulators even permitted a number of thrifts deeme d insolvent under regulatory accounting principles (RAP) to continue t o operate. Despite the potential problems inherent in such a policy, t his action gave the industry two important advantages: First, beginnin g in the early 1980s, the policy granted thrifts expanded investment a nd lending powers with which to restructure their business strategies. Second, although many of these new powers were restricted by early 19 85, thrifts were given an extended period in which to rebuild their ca pital ratios. Granting new powers and the time to implement them did n ot change the incentive structure that the industry faced, however. Th e FSLIC continued to provide deposit insurance at rates independent of risk. In addition, 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 ta ke larger risks, even if the expected retum is not commensurate with t hose risks.3 Therefore, it was not clear a priori that the industry wo uld utilize its newfound advantages to retrench and restructure in an attempt to regain solvency. Thrifts could have chosen to engage in ris ky operations that would have eroded their portfolio quality and endan gered their recovery. Our study shows that almost all of the largest 3 00 thrifts posting capital deficiencies at the end of 1979 utilized th e flexibility granted by the lower required capital ratio; yet, only 2 4% had recovered by the end of 1989. In contrast, more than half (55%) of the institutions had failed or merged. The remaining thrifts conti nued to operate, but with less capital than required by Congress in th e Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA ) of 1989. Even with continued regulatory forbearance, we find no evid ence that their condition improved. Unlike previous studies, which exa mine differences between insolvent and well-capitalized firms, we stud y differences between insolvent firms that recover and those that do n ot. Three conclusions emerge: First, our evidence suggests that identi fying which firms will eventually recover would, at best, be difficult . Combining our results with those of the earlier studies, we find tha t although it is relatively easy to distinguish undercapitalized thrif ts from safe ones, pinpointing which of the insolvent but still operat ing institutions will ultimately recover may not be possible using onl y financial data. Second, while we find some differential use of the n ew investment opportunities, this does not greatly distinguish recover ed firms from failed institutions. However, over time, unsuccessful fi rms show a movement towards poorer asset quality and non-deposit fundi ng 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, w e find little evidence that nonrecovered thrifts consuine more perks t han their more successful counterparts. This implies that managers of failed firms are no more susceptible to owner-manager principal-agent problems than managers of successful ones; rather, they simply may be less fortunate or less adept at operating thrift institutions.