Troubled Savings and Loan Institutions: Turnaround Strategies under Insolvency

Abstract

Unexpected increases in interest rates during the early 1980s and decreases in asset quality in the late 1980s caused massive losses throughout the savings and loan industry. Insolvency was common. But because of bureaucratic forbearance, funding constraints, and federal deposit insurance, hundreds of insolvent thrifts continued to operate. This is because regulatory agencies were unwilling or unable to close thrift institutions immediately upon insolvency. Instead, they progressively reduced the thrift capital requirement and later refrained from enforcing that requirement in the hope that the industry would recover. Coupled with deposit insurance and the expanded investment and lending powers granted to the industry in the early 1980s, this regulatory forbearance gave thrift managers the opportunity to pursue strategies to turn around their firms, to regain profitability and to restore adequate capital levels. Did the thrift industry seize this opportunity? Did managers of successful thrifts adopt different strategies to turn around their firms than managers of their unsuccessful counterparts? Or did they select the same strategy and simply enjoy good fortune? Our results show that when the crisis surfaced in the early 1980s, recovering thrifts operated in a fashion similar to failing thrifts. However, in the mid-1980s, recovering firms pursued risk-minimizing strategies while non-recovering firms pursued riskier, and on average, higher-growth strategies. The asset growth of unsuccessful thrifts is consistent with a speculative growth strategy, while that of recovered thrifts is more consistent with the natural market growth associated with successful firms. Perhaps surprisingly, given media attention to fraud and managerial misconduct, we find no evidence of excessive perquisite consumption in unsuccessful thrifts. We find that only 24 percent of the 300 thrifts in our sample eventually did recover between the end of 1979 and the end of 1989, while 55 percent fail or merge. The others survive as independent institutions, but with less than the three percent capital requirement of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989; that is, they not only failed to rebuild their capital to the previous five percent requirement, they did not even meet the much less stringent hurdle in place by the end of the decade. Even with continued regulatory forbearance, we find no evidence that their condition improved. These results have important implications for both thrift managers and supervisory agencies. Our results suggest that successfully turning around poorly capitalized thrifts during the 1980s was neither easy nor likely. Those managers that were successful tended to concentrate on more traditional thrift activities involving lower-risk assets and liabilities. Regulatory agencies and thrift supervisors charged with monitoring the industry cannot ignore the recovery rate for our sample thrifts of a mere 24 percent, and further, our evidence suggests that identifying firms which would eventually recover would at best have been very difficult. Although other studies have shown that it is relatively easy to distinguish risky thrifts from safe ones, pinpointing which of the insolvent institutions will ultimately recover may not be possible using only financial data.

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