Introduction and summary
The failure rate for thrifts (savings and loan associations and some savings banks) in the second half of the 1980s and early 1990s was substantially higher than in earlier decades. For example, the number of thrift failures averaged about 32 per year between 1980 and 1985, compared with about 136 per year between 1986 and 1992 (CBO, 1993). The Federal Home Loan Bank (FHLBank) System was the primary federal regulator of thrifts and was responsible for the supervision and examination of most of these failing institutions. The FHLBank System also lent funds to thrifts and became a reliable source of nondeposit funds to support the lending activities of safe and sound institutions. According to Bodfish and Theobald (1938) and as discussed in Barth and Regalia (1988), the FHLBank System lending program was not intended to "bail out" failing thrifts. However, many failed thrifts borrowed from the FHLBank System during the 1980s, and some borrowed a substantial amount several years prior to their closure. For example, of the 205 failed thrifts that were resolved (that is, liquidated or merged with regulatory assistance) in 1988, the year before Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), 76 percent borrowed from their FHLBank three years before closure. In some cases, borrowings by these thrifts were as high as 35 percent of total assets. In their last year of operation, some of these thrifts financed about 72 percent of their total assets with FHLBank loans. By contrast, only 40 percent of their solvent NEED MONEY QUICK counterparts borrowed from FHLBanks at the end of 1988, financing, in some cases, only 46 percent of total assets.
At the time of their closure, the estimated present-value cost to the now defunct Federal Savings and Loan Insurance Corporation (FSLIC) to resolve the 205 thrift failures exceeded billion. Because of their poor financial condition, some of these thrifts could not provide adequate collateral (that is, eligible assets) to secure their FHLBank loans.(1) Hence, the FSLIC issued guarantees for some of the more poorly capitalized thrifts to secure the funds lent by FHLBanks (see Garcia and Plautz, 1988).(2) Given these developments, the question of whether FHLBank lending to financially distressed thrifts increased FSLIC losses during the 1980s naturally arises. Because FHLBanks' claim on thrift assets was senior to that of the FSLIC, lending to troubled thrifts increased the risk of loss to the FSLIC and potentially added to the cost of thrift failure resolutions. As a result, taxpayers and policymakers have an interest in understanding the economic role of the FHLBank System in the thrift debacle of the 1980s and how a given government regulatory structure can have unintended consequences.
The FHLBank System was created to provide long-term liquidity to residential real-estate-specialized lending institutions so as to improve the flow of mortgage credit. While this concept made sense after the Great Depression, it may not make sense in a financial market that has become more efficient with the introduction of a secondary market for mortgages and mortgage securitization. These developments raise the question whether there is a need for a government-sponsored liquidity facility for real-estate-specialized lending institutions. The question takes on added importance in view of evidence that smaller thrifts, which are likely to have fewer alternative sources of long-term liquidity, tend to use the FHLBank advance (loan) program less than larger thrifts. Also, it is Need money quick important to note that FHLBank advances do not subject borrowing thrifts to the discipline that would be imposed by other creditors and market analysts. By insulating them from market discipline, FHLBank advance programs provide incentives for borrowing thrifts to take more risk. This is an important issue for policymakers, who are concerned about minimizing the loss exposure of the federal deposit insurance funds.
During the thrift debacle of the 1980s, FHLBank advances to individual thrifts varied considerably in terms of net worth and borrowings relative to the thrifts' total assets. We use data on these variations to test whether FHLBanks made credit available to the most troubled thrifts, defined as those with the largest gap between their regulatory accounting principle (RAP) capital and generally accepted accounting principle (GAAP) capital. RAP allowed thrifts to count, as part of capital, appraised equity capital, qualifying subordinated debentures, and net worth certificates issued by the Federal Home Loan Bank Board (FHLBB) to increase recorded, though not economic, net worth. In addition, thrifts were allowed to defer losses on the sale of assets that carried below-market interest rates.(3) These items capture the extent to which regulators granted thrifts regulatory forbearance by allowing them to "invent" assets that artificially inflated their capital. These modifications in the definition of capital were designed to give troubled thrifts time to initiate strategies that would return them to financial health. Thrifts with most of their reported capital in these forms might not be able to raise noninsured sources of funds in the private sector. FHLBank lending to thrifts with the largest gap between RAP and GAAP capital gave them time to Need money quick attempt to recover, as well as time to "gamble for resurrection" by making large volumes of higher-risk, potentially high-profit investments. If the investments made good, the thrift would reap the profits, but if the investments soured and the thrift went broke, the FSLIC NEED MONEY QUICK and not the thrift's owners would be liable for the losses. This incentive to gamble for resurrection is strongest when there is little equity left. Thus, it is likely that the magnitude and cost to taxpayers of the 1980s thrift debacle were increased by regulatory forbearance policies, including FHLBanks' provision of aid to financially distressed firms.(4)
In addition to examining whether financially distressed thrifts made greater use of FHLBank advances than financially sound thrifts, we consider whether the pattern of borrowings differed by FHLBank district. Because of the Need money quick collapse of the oil industry and its associated effect on real estate prices in the early 1980s, many thrift institutions in the ninth district of the FHLBank System (Arkansas, Louisiana, Mississippi, New Mexico, and Texas) became insolvent.(5) In some states, congressional pressure persuaded thrift regulators to grant forbearance and increased access to the FHLBank advance program to aid poorly capitalized institutions. Finally, because we would expect financially distressed thrifts to benefit most from access to FHLBank funds and this benefit to be reflected in their stock returns, we examine whether changes in FHLBank advances are related to thrift stock returns.
We find that total advances to thrift institutions rose sharply over the 1980s, reached a peak in 1988, and declined in the latter part of the 1980s and early 1990s. The peak borrowing was reached in 1988, one year prior to the enactment of FIRREA, and the decline took place over the period when regulators were closing down failing thrifts. We find that, for each year from 1985 to 1991, thrifts with book-value capital less than or equal to zero borrowed proportionately more from FHLBanks than better capitalized thrifts. That is, there is a negative correlation between FHLBank advances and capital. Our results are consistent with those of Garcia and Plautz (1988), who used data for FSLIC-insured thrifts for the fourth quarter of 1986 to show that the growth of FHLBank advances was greater for troubled thrifts than other institutions.
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