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ESSAYS ON ISSUES DECEMBER 1990 NUMBER 40 THE FEDERAL RESERVE BANK OF CHICAGO Chicago Fed Letter T he incredible shrinking S&L industry The savings and loan debacle has important repercussions for many parties. Among these is the savings and loan association (S&L) industry itself, which is shrinking rapidly as a major financial player. For most of the post-World War II period, savings and loans were the great success story among financial institutions in the U.S. The assets of the industry grew rapidly, not only in absolute dollar terms, but also relative to most other major types of financial institutions. The market share of S&L assets in creased steadily from 6% of the assets of 11 major types of financial institu tions in 1950, to 12% in 1960, to 14% in 1970, and to 15% in 1980 (see Table 1). In contrast, the market share of commercial bank assets de clined from 52% in 1950 to 37% in 1980, of life insurance companies from 22% to 12%, and of mutual savings banks from 8% to 4%. Only pension funds among the larger types of institutions had increased their market share more rapidly in this period. S&Ls grew from the fourth largest type of institution in 1950 to the second largest in 1980, behind only commercial banks. S&Ls lost money in 1982, and when measuring their assets and liabilities on a market-value basis, some twothirds of the associations were insol vent. Although interest rates de clined sharply in the mid-1980s, many S&Ls continued to lose money be cause of bad loans, excessive operat ing costs, including very high rates on deposits, and fraud. Furthermore, S&Ls incurred a sharp increase in deposit insurance premiums—from .08% to .21%—which also increased operating costs significantly. Never theless, through 1988 they increased their market share relative to com mercial banks and to life insurance companies, which were the third largest type of financial institution. MS ' . ■ ■ ■ ' ' ' • This scenario changed abruptly after 1988. First, regulators adopted a tougher attitude, particularly with respect to permitting insolvent asso ciations to remain in operation and to expand rapidly. Second, in 1989 Congress enacted the Financial Insti tutions Reform, Recovery and En forcement Act (FIRREA). The act accelerated the resolution of insol vent associations by providing greatly increased funds to the FDIC, so that it could make up the shortfall be tween the value of the institutions’ assets and the guaranteed par value of their deposits. The resolution of these insolvent associations resulted in lower deposit growth, as the exces sive interest paid by many of the asso■ ' ' ■■ : ■ ■ ■ 1. M arket share changes for financial interm ediaries Interm ediary Assets 1990a (billions of dollars) Commercial banks Life insurance companies ■ lillliil % of total interm ediary assets3 1950 1960 1970 1980 1990 3,279 52 38 38 37 32 1,378 22 20 15 12 13 Private pension funds 1,194 2 6 9 12 12 S&Ls 1,159 6 12 14 15 11 State & local pension funds 753 2 3 5 5 7 M utual funds 588 1 3 4 2 6 Finance companies 539 3 5 5 5 5 Shrinking shares and numbers for S&Ls . . . Casualty insurance com panies 507 4 5 4 4 5 Money market funds 453 - - - 2 4 S&Ls maintained their market shares through most of the 1980s despite a precarious financial situation. Pri marily as a result of losses from lend ing long and borrowing short when interest rates soared in the late 1970s and early 1980s, about 85% of all M utual savings banks 284 8 7 6 4 3 Credit unions Total 213 - 1 1 2 2 10,347 100 100 100 100 100 SOURCE: Board of Governors of the Federal Reserve System, Flow o f Funds Accounts, various years. aSecond quarter for 1990. Fourth quarter for all other years. ciations to attract funds quickly was reduced. In addition, the act re quired higher capital-to-asset ratios at the remaining institutions.1 This also slowed deposit growth because most associations chose to increase their capital ratios by reducing deposits rather than by increasing capital. More recently, a significant percent age of the deposits at insolvent asso ciations closed by the Resolution Trust Corporation (RTC) was pur chased by commercial banks and left the S&L industry. 1 ---------------------------------------------------- 1950 1960 Along with declines in market share, the industry has also seen the num ber of associations decline. At yearend 1989, there were near 2,900 S&Ls in operation, and by year-end 1990, the num ber of associations may be below 2,500.2 This num ber would be nearly one-half the num ber of associations in 1980 and only about one-third the num ber in 1960, when nearly 6,500 S&Ls were in operation. Of course, during most of the period of decreases in the number of associa tions, total S&L assets were increasing rapidly, so that through 1988 the remaining associations were larger, on average. But since 1988 total assets have declined faster than the total num ber of associations, as propor tionately more larger associations have become insolvent and resolved. As a result, the average asset size of the remaining associations has begun to decline. . . . But not shrinking services for customers The shrinking of the S&L industry does not necessarily imply an equal 1980 1990c Total residential m ortgages (billions o f dollars) 45 142 S&Lsa 29 39 Commercial banks 21 M utual savings banks As a result, S&L market share of fi nancial institutions slid from a peak of 16% in 1984 to 15% by year-end 1988 and then more rapidly to only 11% by midyear 1990. This wiped out the gains of 30 years of growth. It is not unreasonable to project that by year-end 1990, the market share of S&Ls will not be greatly different from what it was 35 years earlier in the mid-1950s, when the associations began their rapid growth. 1970 10 298 978 2,4 93 41 45 27 14 14 17 16 15 14 7 5 % D istribution Life insurance com panies 19 18 9 2 1 Households 17 7 8 6 6 G overnm ent 3 5 7 8 6 M ortgage poolsb - - 1 9 31 Other Total 1 2 6 6 8 100 100 100 100 100 SOURCE: Board of Governors of the Federal Reserve System, Flow o f Funds Accounts, various years. inclu des mortgage pools. bExcludes savings and loan associations. cMidyear. shrinking of the services it tradition ally provided, namely, residential mortgage lending and savings deposit gathering. In fact, S&Ls have been reducing their share of the residential mort gage market for some time with little discernible negative effect on mort gage borrowers. In mid-year 1990, S&Ls held 27% of all mortgages.3 As can be seen from Table 2, this repre sents a decline of 40% from the 45% market share in 1980 and is the low est percentage penetration since the 1940s. This decrease in mortgage activity reflects three developments in the industry. First, S&Ls shifted into other kinds of lending, such as con sumer loans and commercial mort gages, in response to the new powers granted them by deregulation in the early 1980s. Second, as noted earlier, the growth in their overall asset base slowed and then turned negative. Third, residential mortgage lending became more attractive to commer cial banks and life insurance compa nies with the advent of mortgagebacked securities, which, unlike whole mortgages, are marketable. It is difficult to identify precisely the institutions that took up the slack in mortgage investment from the avail able data, because the ownership of mortgages that are pooled and securi tized cannot be broken out for inves tors other than S&Ls. Such mort gage-backed securities have grown rapidly in recent years and now ac count for more than one-third of all residential mortgages outstanding. At the same time that S&Ls have de creased their residential mortgage activity, they have been facing new competition for savings deposits, largely from money market funds. Thus, the diminished role of S&Ls is likely to result primarily in a reshuf fling of their activities to other types of institutions. This is not to say that there may not be some disruptions and additional search required by traditional S&L customers during the transition period, but other sources of these services will be out there. What will S&Ls do in the future? In the longer run, the financial serv ices industry may very well resemble the grocery industry: firms of every conceivable size and shape would cater to every conceivable taste on a voluntary basis, with no product or geographic regulation other than that of the market place. Survival and success will belong to the best managed institutions in each niche. Thus, the surviving S&Ls must be come sufficiently expert in some activities to fend off competition from a wide variety of other types of institutions. It is likely, however, that many of the S&L survivors will re main primarily residential mortgage lenders, an area in which they have long experience. At the same time that the S&L indus try is undergoing this transition, the entire depository institutions subsec tor of the financial services industry may be expected to grow more slowly or even to contract in the near fu ture as a result of three forces:1 1. Steeply higher premiums for fed eral deposit insurance. These premi ums are equivalent to a tax on these institutions that is not levied on their competitors.4 In part, this may be viewed as reducing or even reversing any implicit subsidies from underpricing deposit insurance in the past, particularly for poorly capitalized or insolvent institutions, which had en couraged rapid growth. Higher pre miums are particularly important in light of a perceived implicit expan sion of the federal safety net to some important quasi-government com petitors, such as the Federal Home Loan Mortgage Corporation (Fred die Mac) and the Federal National Mortgage Corporation (Fannie Mae), without charging insurance premiums.5 This lowers the cost of funds to these institutions and per mits them to bid higher for invest ments and accept a lower interest rate, putting depository institutions at a competitive disadvantage. 2. Higher equity capital require ments. These requirements are costly to meet because, unlike interest pay ments on deposits, dividend payments on equity are not deductible from taxable income. 3. Technological innovations in com puterization and telecommunications. These reduce the comparative advan tage of depository institutions in gath ering and analyzing credit informa tion as well as transferring funds from investors to borrowers. For example, technology makes it possible to track and monitor the hundreds of individ ual loans that make up a securitized pool. In addition, technology makes it easier for prime corporate borrow ers to issue commercial paper directly to investors instead of obtaining bank loans, particularly if the bank has suffered during the industry’s recent financial difficulties and so has a lower credit rating than the ultimate borrower. Thus, the cost structure of financial intermediation by traditional depository institutions may be too high to make them economically vi able without a reduction in the result ing overcapacity. y ear-end 1989, 281 associations w ith assets o f $128 billio n w ere u n d e r th e supervi sion o f th e RTC. Six m o n th s later, on J u n e 30, 1990, th e n u m b e r was 247 asso ciatio n s w ith $141 billion o f assets. T his re p re s e n te d a b o u t 9% o f all associations a n d 11 % o f all assets. D u rin g these six m o n th s, 170 associations w ere sold, m e rg e d , o r liq u id a te d a n d 136 o th e r in so lv en t associations w ere tra n sfe rre d to th e RTC. 3S&Ls o rig in a te d a la rg e r p e rc e n ta g e o f new m o rtg ag es b u t sold th em to o th e r investors. 4O n Ja n u a ry 1, 1990 p re m iu m s w ere in c re a se d fro m .21% to .23% fo r S&Ls a n d fro m .08% to .12% fo r co m m ercial banks. P rem iu m s are sc h e d u le d to in crease again fo r c o m m ercial b anks on Ja n u a ry 1, 1991 to a t least .195% a n d possibly h ig h e r fo r all in stitutions. 5 d e sc rip tio n o f th ese ag encies a n d th e ir A g o v e rn m e n t su p p o rt a p p e a rs in U n ite d States G en e ra l A c c o u n tin g O ffice, Govern ment-Sponsored Enterprises: The Govern m ent’ Exposure to Risks, W ashington, D.C., s A ugust 1990. In sum, S&Ls are being hit from two sides. Shrinkage from financial diffi culties is occurring simultaneously with shrinkage of all depository insti tutions from technological and regu latory change. It is unlikely the S&Ls will again achieve the relative impor tance they had in recent decades. -George G. Kaufman, J o h n S m ith P ro fesso r o f F in an ce a n d E co n o m ics a t Loyola U niversity o f C h icago a n d C o n su lta n t to th e F ed eral R eserve B ank o f C hicago l 2 lA m o re d e ta ile d d e sc rip tio n o f th e provi sions o f FIRREA a p p e a rs in Elijah B rew er, “ Full-blown crisis, half-m easu re c u re ,’’ Economic Perspectives, N o v e m b e r/D e c e m b e r 1989, p p . 2-17. 2T h e p recise n u m b e r o f S&Ls c u rre n tly in o p e ra tio n is d ifficult to identify, as a large n u m b e r o f in so lv en t associations a re o p e r a te d in c o n serv ato rsh ip o r receiv ersh ip by th e RTC aw aiting final d isp o sitio n by sale, m e rg e r, o r liq u id a tio n . F o r ex am p le, at Karl A. S cheld, S e n io r V ice P re sid e n t a n d D ire c to r o f R esearch; David R. A llard ice, Vice P re sid e n t a n d A ssistant D ire c to r o f R esearch ; J u d ith Goff, E d ito r. Chicago Fed Letter is p u b lish e d m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views e x p re sse d are th e a u th o r s ’ a n d are n o t necessarily th o se o f th e F ed eral Reserve B ank o f C h icag o o r th e F ed eral R eserve System . A rticles m ay b e r e p rin te d if th e so u rce is c re d ite d a n d th e R e search D e p a rtm e n t is p ro v id e d with co p ies o f th e re p rin ts . Chicago Fed Letter is available w ith o u t ch arg e fro m th e P ublic In fo rm a tio n C e n te r, F ed eral Reserve B ank o f C hicago, P.O . Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 In August, manufacturing activity in the Midwest declined 0.6%, marking the second monthly decline after the peak for the current expansion in June. While over half of the 17 industries in the MMI recorded declines in August, two key industries showed improvement—machinery and metalworking. Over the last three months, strength in Midwest manufacturing activity has centered on the metalworking and transportation industries. Nationally, the Federal Reserve Board’s Index of Industrial Production has been buoyed by a relatively strong durable goods manufacturing sector, also led by the metal working- and transportation-related industries. However, planned auto pro duction for the fourth quarter indicates softening in the transportation indus try in the months ahead. Chicago Fed Letter F E D E R A L R E S E R V E B A N K O F C H IC A G O P u b lic In fo rm a tio n C en ter P .O . B ox 834 C h ica g o , Illin o is 60690 (312) 322-5111 N O T E : T h e MMI a n d th e USM I are co m p o site in d ex es o f 17 m a n u fa c tu rin g in d u strie s a n d a re d eriv ed fro m e c o n o m e tric m o d e ls th a t estim ate o u tp u t fro m m o n th ly h o u rs w o rk ed a n d kilow att h o u rs data. F o r a discu ssio n o f th e m e th o d o lo g y , see “R e c o n sid e rin g th e R egional M a n u fa c tu rin g In d e x e s ,” Economic Perspectives, F e d e ra l R eserve B ank o f C h icag o , Vol. X III, N o. 4, J u ly /A u g u s t 1989.