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January 1, 1993

Federal Reserve Bank of Cleveland

The Cost of Buying Time:
Lessons from the Thrift Debacle
by James B. Thomson

M. he collapse of the Federal Savings and
Loan Insurance Corporation's (FSLIC)
deposit insurance fund, coupled with the
subsequent appropriation of taxpayers'
money to underwrite the cleanup of the
thrift industry, ranks as one of the greatest
financial disasters of our time. When all is
said and done, around $200 billion (in
1990 dollars) will have been spent to
honor the claims of depositors in closed
thrifts and to dispose of failed-thrift assets.
To put this number into perspective, the
combined loan guarantees for Lockheed,
New York City, and Chrysler Corporation
in the 1970s were only about $9 billion in
equivalent dollars.
As researchers continue to sift through
the rubble of the FSLIC meltdown,
they have unearthed the following
facts: First, the economic insolvency of
the FSLIC occurred early in the 1980s.2
Economist Edward Kane of Boston
College estimates that the cost of cleaning up the giant red-ink spill on the
FSLIC's balance sheet reached $100
billion as early as 1982, a figure that
was validated by former Federal Home
Loan Bank Board (FHLBB) Chairman
Richard Pratt in his 1990 testimony
before Congress.3
Second, official recognition of the
FSLIC's financial problems did not begin until 1987, when Congress authorized $10.8 billion in new funding
through the Competitive Equality
Banking Act. Official recognition of
the FSLIC's irremediable insolvency
did not occur, however, until August
ISSN 0428-1276

1989, when Congress passed the Financial Institutions Reform, Recovery, and
Enforcement Act (FIRREA).4
Between the onset of the FSLIC's insolvency and the signing of FIRREA, the
chosen regulatory option for dealing with
undercapitalized and insolvent thrifts was
capital forbearance. Rather than confronting the emerging problems of the industry early and vigorously by enforcing existing capital standards, regulators and
policymakers instead poured their energy
into papering over losses to cover up
both the insolvency of a large number of
thrifts and the deteriorating condition of
the FSLIC. In buying time, they hoped
that lower interest rates would restore the
industry's health and reduce the ultimate cost of resolving the deficit in the
FSLIC's insurance fund. This interestrate bet was not symmetric, however,
since the prepayment option held by
mortgagors would make interest-rate
declines less profitable for thrifts than
increases would be costly.5
Forbearance may have seemed like a
reasonable strategy to policymakers at
the time, because the underlying source
of the thrift industry's problems was the
historically high interest rates of the
early 1980s. Indeed, interest rates did
decline after 1982, and a number of insolvent institutions used the extra time
afforded them to regain their health. But
the majority of troubled thrifts did not
recover and were closed by the end of
1992, or are due to be closed this year.
What's more, forbearance increased the

Forbearance is urged by those who think
we can avoid paying a billfor what we
have already spent. It is urged by those
who believe that we can operationaUze
an industrial policy for banks that will
somehow save money by propping up the
sick and poorly managed. It is urged by
those who wish to further postpone the
costs so that they will be incurred on
someone else's watch. Regardless of why
forbearance is urged, its outcome will be
the same: more costs for the taxpayer
and more inefficiency for the economy.
Thomas Woodward
Chief Economist, Republican Staff
House Budget Committee

ultimate cost of closing these institutions, as well as the total cost of resolving the thrift debacle.
Despite the unprecedented size of the
taxpayer bailout of the thrift deposit
insurance fund and the attendant political fallout, some current and former
regulators, as well as a number of academics and industry analysts, still advocate capital forbearance programs.
Former Federal Deposit Insurance Corporation Chairman William Taylor's
"hospital plan" for troubled banks is
but one example of this.6 The most recent case is OTS Chairman Timothy Ryan
Jr.'s call for more lenient treatment of distressed real estate assets on the books of
the nation's depository institutions.
This Economic Commentary takes a critical look at capital forbearance as a policy
for dealing with troubled financial institutions. A review of the mounting evidence
on the cost of thrift forbearance leads to
the inexorable conclusion that it was indeed a losing proposition for taxpayers.
• Capital Forbearance
and Moral Hazard
The problems of the thrift industry in the
1980s can be traced to a combination of
record-high interest rates in the early
years of the decade and the structure of
thrift institution asset and liability portfolios. Traditional thrift portfolios, which
consist of long-term fixed-rate loans
(principally mortgages) financed with
short-term liabilities (principally deposits), are extremely vulnerable to sudden,
unexpected increases in interest rates.
The three-month Treasury bill rate, which
stood at 6.49 percent in January 1980,
rose to a peak of 16.30 percent in May
1981 before returning to single digits in
August 1982. By 1982, unrealized capital
losses on thrift balance sheets exceeded
not only book-value tangible equity at a
large number of institutions, but also surpassed the explicit resources of the
FSLIC's deposit insurance fund.

Capital forbearance in the 1980s had two components. First, regulators systematically
lowered the actual requirement from 5 percent to 3 percent of assets:

November 1980: The FHLBB reduced thrifts' explicit capital requirement from
approximately 5 percent to about 4 percent and provided for a "qualifying balance
deduction" that effectively lowered the requirement even more.

• January 1982: The capital requirement was further reduced to 3 percent.

After 1987: Regulators largely ignored capital standards.

Second, policymakers adopted regulatory accounting practices that represented a
departure from generally accepted accounting principles (GAAP):

November 1981: The FHLBB accepted net-worth certificates from thrifts with
less than 3 percent net worth as capital in exchange for FSLIC promissory notes,
with face value guaranteed by the FSLIC.

• July 1982: Thrift regulators permitted goodwill to be amortized over a 40-year
period while allowing income from unbooked gains to be realized in as little as
five years.

November 1982: The FHLBB began to include "appraised equity capital" in its
calculations of regulatory net worth.

The initial policy response to the S&L
insolvency was capital forbearance.
Both the Depository Institutions Deregulation and Monetary Control Act of 1980
(DIDMCA) and the Gam-St Germain
Act of 1982 aimed at providing relief for
the industry. DIDMCA, the first in a
series of actions taken by legislators and
regulators to grant thrifts new investment
powers, authorized federally chartered institutions to invest up to 20 percent of their
assets in corporate bonds and consumer
loans and extended their authority to make
construction or acquisition loans. The portfolio investment limits for commercial
and consumer loans were raised further by
the Gam-St Germain Act. More significantly, DIDMCA increased the deposit insurance ceiling from $40,000 to $ 100,000,
an unprecedented 250 percent rise.
These two pieces of legislation, combined with regulatory efforts, resulted
in both a dramatic reduction in thrift
capital requirements and the introduction of regulatory accounting principles

aimed at masking the industry's insolvency. The box above briefly outlines
the evolution of capital forbearance in
the 1980s.10
Armed with these new asset powers, little or no capital, essentially 100 percent
government guarantees of their deposits, and with the encouragement of thrift
regulators, FSLIC-insured institutions
saw their assets expand 18.6 percent
and 19.9 percent in 1983 and 1984,
respectively. Thrifts in the Sunbelt
states grew at rates nearly twice the
national average. And as a group, those
institutions that failed later in the decade more than doubled their assets between 1982 and 1985." The dramatic
expansion in credit extension surely contributed to the sharp increase in the supply
of real estate, which has depressed prices
over the past several years.

Unfortunately, the combination of little
or no private capital and the underwriting of thrift losses through FSLIC insurance provided thrift managers and
owners with a perverse set of incentives
to dramatically increase the risk of their
portfolios. This is the classic moral
hazard problem. Thrift operators, in a
desperate gamble to regain solvency,
booked increasingly speculative investments that often had little chance of
paying off. 13
Consequently, while historically high
interest rates were responsible for the
industry's problems in the early 1980s,
losses in the latter half of the decade
stemmed primarily from the poor asset
quality of troubled institutions' portfolios. By 1987, the deteriorating quality of thrift assets, particularly real estate investments in the Southwest,
accounted for virtually all of the industry's remaining problems. Ironically,
fraudulent activity in closed thrifts has
received the bulk of the media's attention, but its contribution to the overall
cost of resolving insolvent thrifts was
only about 10 percent of the total
resolution costs. 15

• Thrift Capital Forbearance:
A Losing Proposition
Although the price tag for resolving the
insolvency of the FSLIC insurance fund
is staggering, it does not necessarily mean
that forbearance was a losing proposition.
A recent study by economists George
Benston and Mike Carhill suggests that
forbearance was not particularly costly.
Most other analyses, however, support the
conclusion that forbearance was at best a
misguided policy that increased the ultimate cost of resolving the thrift mess.

Economist Philip Bartholomew looks
at all thrifts closed between 1980 and
the end of 1990, as well as at those that
were slated for closure in 1991. For
the 1,130 institutions in his sample, he
finds that the present-value cost of delayed closure was $66 billion (in 1990
dollars). This conclusion is consistent
with the results of an earlier paper,
which showed that the most significant
determinant of the cost of closing troubled thrifts was the number of months
they were insolvent. 19
Another study examined the 996 thrifts
that did not meet book capital standards
at the end of 1979.20 The final sample
of "forbearance thrifts" consisted of the
952 institutions that were neither
merged nor closed in 1980. Tracing
these thrifts into the future, the authors
collected the estimated resolution costs
for the 362 firms closed between January 1981 and July 1992.21 The
present-value cost of the delayed closing of these thrifts beyond 1980 was
more than twice the projected cost of
resolving all 952 forbearance thrifts in
that year.
All of the above studies examine only the
direct costs of forbearance. That is, they
look at differences in the cost of closing
thrifts at one point in time versus a future
point in time. But the indirect costs of forbearance, which unfortunately are difficult to quantify, are also potentially large
and economically significant.
• Indirect Costs
of Capital Forbearance
Capital forbearance as practiced in the
1980s had important unintended, or
secondary, effects. These resulted from
the changes in economic incentives that
forbearance entailed (specifically, from
the increase in risk-taking incentives for
insured depositories). Moreover, as Kane
notes, the profitability of the healthy segment of the depository industry was reduced as insolvent thrifts, in a last-ditch
attempt to regain their solvency, bid
down lending rates and bid up deposit
rates to unsustainable levels.22

The most notable example was the Texas
deposit premium in 1987. Because the
state was home to a disproportionate
number of troubled depositories, solvent
thrifts had to pay 50 basis points more for
deposits than did thrifts in other parts of
the country. Thus, capital forbearance
impacted negatively on industry stability
as the erosion of profit margins pushed a
number of marginally capitalized institutions over the edge into insolvency. 24
Although the degree to which forbearance contributed to the record-high
post-World War II level of bank and
thrift failures in the 1980s has yet to be
quantified, three studies have identified
significant economic costs. The first argues that thrift forbearance was a major
factor in the 1980s' real estate construction boom and subsequent collapse,
with the authors estimating that deadweight losses in this market ranged
from $124 billion to $150 billion. 25
The second study, conducted by the
Congressional Budget Office, calculates that between 1981 and 1990, the
misallocation of resources associated
with the thrift insurance collapse produced a deadweight loss of $200 billion
(in 1990 dollars) in forgone gross national product (GNP), and that the total
loss in potential GNP by the year 2000
will reach nearly $500 billion.26
The final study links the record-high
real interest rates to "zombie" thrift behavior in deposit markets.27 Federally
insured certificates of deposit and
Treasury bills are close substitutes
(made even closer by forbearance). As
zombie thrifts bid up the rates offered
on quasi-government debt, they also
drove up the required rate of return on
official U.S. Treasury debt. The authors
project that this increased the Treasury's borrowing costs by as much as
$100 billion (in 1990 dollars) per year
by the end of the 1980s.

• Conclusion and
Policy Implications
Capital forbearance for thrifts in the
1980s was at best a misguided policy
whose costs will have long-term consequences for the health of both the
nation's depositories and the overall
economy. A review of the thrift insurance debacle shows that despite the
dramatic decline in interest rates over
the 1980s, few troubled institutions
recovered, and the losses on those that
have been forced to close their doors
significantly eclipsed the cost of
prompt closure in the early years of the
decade. Furthermore, there is growing
evidence of massive secondary costs associated with thrift forbearance that
may exceed the increase in direct resolution costs. These include overinvestment in real estate at the expense of
capital formation and public infrastructure, and increased borrowing costs for
the U.S. Treasury for the foreseeable future — all at a time when interest on
the national debt has become one of the
largest nondiscretionary expenditure
items in the federal budget.

Unfortunately, it appears that policymakers have turned a jaundiced eye
toward the lessons of the thrift insurance disaster applicable to the dangers
of forbearance. Even as Congress grapples with the need to appropriate more
funds to complete the cleanup of the industry, forbearance remains an attractive option for regulators. The
prompt corrective action provisions of
the Financial Institutions Reform, Recovery, and Enforcement Act of 1989,
which became effective last December
19, are an important first step in changing regulators' incentives to forbear,
making them directly accountable for
their actions and limiting their discretion when dealing with undercapital29

ized depositories.

• Footnotes
1. See Woodward (1992).
2. Insolvency occurs when the market value
of a firm's assets is less than the market
value of its liabilities. In the case of the
FSLIC, the unrealized losses of insolvent
savings and loans (S&Ls) exceeded the
market value of the assets held by the insurance fund.
3. See Kane (1985), chapter 4, and Pratt
4. FIRREA provided $50 billion in new
money to close insolvent thrifts and created
an entirely new federal regulatory structure
for the industry. The FSLIC was replaced by
the Savings Association Insurance Fund, a
subsidiary of the Federal Deposit Insurance
Corporation, and the FHLBB was replaced
by the Office of Thrift Supervision (OTS),
which operates under the U.S. Treasury. Furthermore, FIRREA created the Resolution
Trust Corporation (RTC) to oversee thrift
resolutions from January 1, 1989 through the
end of fiscal year 1993 (September 30,
1993). For a discussion of FIRREA and the
RTC, see Pike and Thomson (1991).
5. Mortgagors have the option of paying off
their loans before the contract date. As interest
rates decline, they can take out a new mortgage
at the current lower rates and use the proceeds
to retire the old loan. On a typical mortgage, it
becomes profitable to refinance or to exercise
the prepayment option whenever prevailing
mortgage rates are 200 basis points below the
rate on the old contract.
6. For an accounting of recent proposed forbearance schemes, see Woodward (1992).
7. See Ryan (1992).
8. See. U.S. General Accounting Office

9. Kane (1989) argues that bank and thrift
regulatory agencies are self-maximizing
bureaucracies whose primary task may be
seen as acting as the taxpayers' agent (the
government's principal) in order to ensure a
safe and sound banking system and to minimize taxpayers' exposure to loss. Regulators
also must cater to a political clientele who are
intermediate or competing principals and
who are likewise motivated by their own selfinterest, which may not coincide with the
interests of taxpayers. These political pressures and self-interest considerations create
socially perverse incentives that make forbearance an appealing alternative to dealing
with emerging problems in the industry early
and forcefully. In sum, Kane's analysis suggests that forbearance might be an attractive
bet for bureaucratic-minded managers of financial service regulatory agencies and their
political constituencies, even if it is not a fair
bet for taxpayers.
A second reason forbearance appealed to
policymakers is that the FSLIC did not have
the explicit resources to deal with losses.
Given the unwillingness of the President to
request and the Congress to allocate funds to
recapitalize the FSLIC in the early 1980s,
thrift regulators could not have moved decisively against a large number of insolvent
S&Ls, even if it had been in their best interest to do so.
10. For a more complete accounting of forbearances, see Barth and Bradley (1989),
Kane (1989), and White (1991).
11. See White (1991), chapters 5 and 6.
12. See Hendershott and Kane (1991).
13. Evidence of moral hazard behavior can
be found in Barth, Bartholomew, and Labich
(1989), Barth, Bartholomew, and Whidbee
(1989), Brewer and Mondschean (1992), and
Cole, McKenzie, and White (1991).
14. See Kane (1989), chapters 2 and 3,
White (1991), chapter 8, and DeGennaro,
Lang, and Thomson (1991).
15. See Barth, Bartholomew, and Labich
16. See Benston and Carhill (1992).

17. For example, studies of thrifts that were
either GAAP insolvent or undercapitalized in
the early 1980s reveal that despite the
dramatic decrease in interest rates after 1982,
the majority of institutions receiving capital
forbearance failed to recover later in the
decade. See U.S. General Accounting Office
(1987), Rudolph (1989), DeGennaro, Lang,
and Thomson (1991), and DeGennaro and
Thomson (1992).
18. See Bartholomew (1991).
19. See Barth, Bartholomew, and Bradley
20. See DeGennaro and Thomson (1992).
21. Resolution costs are the estimated costs of
resolution by the FSLIC (before August 1989)
and the RTC (after August 1989) at the time of
closing. Blalcck, Curry, and Elmer (1991) suggest that the FSLIC estimates understated
actual resolution costs by an average of 26 percent between 1984 and 1987. For thrifts resolved through liquidation, FSLIC estimates
were even worse, undershooting actual costs
by 35.3 percent on average.
22. See Kane (1989), pp. 4-5.
23. See White (1991), chapter 8.
24. Kane (1989), pp. 4-5, draws a clever
parallel between these insolvent but open
thrifts and horror-movie zombies. In essence,
insolvent thrifts are the living dead, kept
alive by government guarantees and forbearances. As they gamble to recover, they
suck the profitability out of healthy institutions, thereby creating new zombies.
25. Deadweight losses are the difference between the cost of building excess commercial
and industrial structures and the current
value of those structures. These losses are not
recoverable. See Hendershott and Kane
26. See Congressional Budget Office
27. See Shoven, Smart, and Waldfogel
28. See Cobos (1989), Ryan (1992), and
Woodward (1992).
29. See Carnell (1992), Jones and King
(1992), and Pike and Thomson (1992).

• References
Barth, James R., Philip F. Bartholomew,
and Michael G. Bradley. "Determinants of
Thrift Institution Resolution Costs," Journal
of Finance, vol. 45 (July 1990), pp. 731-54.
, and Carol J. Labich.
"Moral Hazard and the Thrift Crisis: An
Analysis of 1988 Resolutions," Proceedings
of a Conference on Bank Structure and Competition, Federal Reserve Bank of Chicago,
1989, pp. 344-84.
, _ _ _ _ _ , and David A. Whidbee. "How Damaging Was Moral Hazard?"
Federal Home Loan Bank Board Journal,
vol. 19 (August 1989), pp. 11-13.
, and Michael G. Bradley.
"Thrift Deregulation and Federal Deposit Insurance," Journal of Financial Services Research, vol. 2 (August 1989), pp. 231-59.
Bartholomew, Philip F. "The Cost of Forbearance during the Thrift Crisis," Congressional Budget Office Staff Memorandum,
June 1991.
Benston, George J., and Mike Carhill.
"FSLIC Forbearance and the Thrift Debacle," Proceedings of a Conference on
Bank Structure and Competition, Federal
Reserve Bank of Chicago, 1992, pp. 121-44.
Blalock, Joseph B., Timothy J. Curry,
and Peter J. Elmer. "Resolution Costs of
Thrift Failures," FDIC Banking Review,
vol. 4 (Spring/Summer 1991), pp. 15-26.

Brewer, E., and Thomas H. Mondschean.
"Ex Ante Risk and Ex Post Collapse of
S&Ls in the 1980s," Federal Reserve Bank
of Chicago, Economic Perspectives, vol.
16, no. 4 (July/August 1992), pp. 2-12.
Carnell, Richard S. "A Partial Antidote to
Perverse Incentives: The FDIC Improvement Act of 1991," unpublished manuscript,
June 1992.
Cobos, Dean F. "Forbearance: Practices
and Proposed Standards," FDIC Banking
Review, vol. 2, no. 1 (Spring/Summer
1989), pp. 20-28.
Cole, Rebel A., John A. McKenzie, and
Lawrence J. White. "Deregulation Gone
Awry: Moral Hazard in the Savings and
Loan Industry," New York University, Working Paper, 1991.
Congressional Budget Office. The Economic Effects of the Savings and Loan
Crisis. Washington, D.C.: CBO, January
DeGennaro, Ramon P., Larry H. Lang,
and James B. Thomson. "Troubled Savings
and Loan Institutions: Voluntary Restructuring under Insolvency," Federal Reserve
Bank of Cleveland, Working Paper 9112,
September 1991.
, and James B. Thomson. "Capital Forbearance and Thrifts: An Ex Post
Examination of Regulatory Gambling," Federal Reserve Bank of Cleveland, Working
Paper 9209, September 1992.

Hendershott, Patric H., and Edward J.
Kane. "Causes and Consequences of the
1980s Commercial Construction Boom,"
Ohio State University and National Bureau
of Economic Research, Working Paper,
January 1991.
Jones, David S., and Kathleen Kuester
King. "The Implementation of Prompt Corrective Action," Proceedings of a Conference on Bank Structure and Competition,
Federal Reserve Bank of Chicago, 1992,
pp. 68-100.

Shoven, John B., Scott B. Smart, and Joel
Waldfogel. "Real Interest Rates and the Savings and Loan Crisis: The Moral Hazard Premium," Journal of Economic Perspectives,
vol. 6, no. 1 (Winter 1992), pp. 155-67.
U.S. General Accounting Office. "Thrift
Industry: Forbearance for Troubled Institutions, 1982-1986," Briefing Report to the
Chairman, Committee on Banking, Housing, and Urban Affairs, United States
Senate, May 1987.

Kane, Edward J. The Gathering Crisis in
Federal Deposit Insurance. Cambridge,
Mass.: MIT Press, 1985.

White, Lawrence J. The S&L Debacle:
Public Policy Lessons for Bank and Thrift
Regulation. New York: Oxford University
Press, 1991.

. The S&L Insurance Mess: How
Did It Happen? Washington, D.C.: The
Urban Institute Press, 1989.

James B. Thomson is an assistant vice president and economist at the Federal Reserve
Bank of Cleveland. The author thanks William P. Osterberg, Christopher J. Pike, and
Walker F. Toddfor helpful comments and
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve

Woodward, Thomas J. "The Return of Forbearance," Budget and Economic Analysis,
vol. 2, no. 11 (October 9, 1992).

Pike, Christopher J., and James B. Thomson. "The RTC and the Escalating Costs of
the Thrift Insurance Mess," Federal Reserve
Bank of Cleveland, Economic Commentary,
May 15, 1991.
. . "FDICIA's
Prompt Corrective Action Provisions," Federal Reserve Bank of Cleveland, Economic
Commentary, September 1, 1992.
Pratt, Richard T. Statement before the
U.S. House of Representatives, Committee
on Banking, Finance, and Urban Affairs, October 20, 1990.
Rudolph, Pamela. "The Insolvent Thrifts
of 1982: Where Are They Now?" AREUEA
Journal, vol. 17 (Winter 1989), pp. 450-62.
Ryan, Timothy. "To Help Banks, Shore Up
Real Estate," Wall Street Journal, December 8, 1992.

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