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FABSF

WEEKLY LETTEA

October 24, 1986

"Recapitalizing" the FSLIC
For 50 years, the direct expenses of the federal
deposit insurance agencies were more than adequately covered by the premiums levied on
insured banks and thrifts. In the past few years,
however, the premium income of the Federal
Savings and Loan Insurance Corporation (FSLlC)
has not been sufficient to absorb the expenses
sustained by the agency in dealing with failing
thrifts. As a result, the reserves of the FSLlC have
shrunk considerably and are now viewed by the
Federal Home Loan Bank Board (FHLBB), which
oversees the insurance agency, as inadequate for
dealing with the large number of problem thrift
cases still outstanding.
To help relieve the FSLlC of its current funding
squeeze, the Treasury, in conjunction with the
FHLBB, has developed a plan for "recapitalizing" the thrift insurance fund. This plan, which
is incorporated into House and Senate bills
HR4907 and S2752, respectively, may be the
most practical alternative, considering current
conditions, for giving the FSLlC the needed
boost to its current reserves.
The recapitalization plan, however, provides
only short-term relief because of its inability,
over the long run, to increase the overall
resources available to the FSLlC. The proposal
mainly reshuffles future resources to meet current outlays. Without a true recapitalization, a
lasting solution to the problem of financial stress
on the FSLlC would require a significant reduction in the insurance corporation's future
exposure to losses.
The problem and the plan

With its current reserves, the FSLlC reportedly
does not have enough resources to recognize
the loss it would sustain if all problem thrifts
were liquidated or merged with financial assistance from the insurance corporation. In addition, the FSLlC is quite restricted in its ability to
raise additional funds to bolster its reserves. For
example, the insurance agency cannot issue its
own debt or raise its maximum insurance premium, which is set by the Congress.

To give the thrift insurance fund the needed
addition to current reserves, the Treasury and
the FHLBB have proposed a new funding option
that does not involve direct Treasury assistance
or a hike in the insurance premium rate. As
shown in the chart, the heart of the plan is a
newly created federally sponsored agency,
referred to as the Financing Corporation, that
would be authorized to borrow funds in the capital market and to pass the proceeds on to the
FSLlC. While it is not certain, borrowing by the
Financing Corporation could amount to about
$12 to $15 billion over the next few years.
Under the plan, the 12 regional Federal Home
Loan Banks (FHLBs) would advance the Financing Corporation up to $3 billion, for which they
would receive nonvoting capital stock in the
Financing Corporation. Most of the FHLBs'
investment (up to $2.2 billion) would be used by
the Financing Corporation to purchase zero coupon bonds whose maturities would match those
of the Financing Corporation's own debt. In that
way, the principal amount due on the Financing
Corporation's bonds could be paid off with the
proceeds from the zero coupon bonds.
The interest payments on the Financing Corporation's debt, however, would come primarily
from what otherwise would have been the
FSLlC's premium income.
Under the plan, the Financing Corporation
would be authorized to receive payments
directly from FSLlC-insured thrift institutions.
Insurance premiums paid by thrifts to the FSLlC
then would be reduced by the amount the thrifts
had to pay to the Financing Corporation. (If
necessary, some of the FHLBs' investment also
could be used to make interest payments on the
Financing Corporation's debt.)
In exchange for forwarding the borrowed funds
to the FSLlC, the Financing Corporation would
be given equity in the insurance agency. If $15
billion were borrowed and passed on to the
FSLlC, the insurance agency would issue $3 bil-

FRBSF
lion in redeemable stock and $12 billion in nonredeemable certificates to the Financing
Corporation.
While the $3 billion in stock, which essentially
represents the FHLBs' original investment,
would be redeemable, the amount eventually
repaid would remain uncertain. To provide for
repayment to the Federal Home Loan Banks, the
FSLlC would make contributions to an "equity
return account" beginning in 1997. These contributions would vary with the reserve-to-deposit
ratio ofthe FSLlC.Whenall ofthe Financing
Corporation'sdebt matures, which would be no
later than 2026, the FHLBs would receive the
funds in the equity return account. The repayment realized might be zero or perhaps the original investment plus some return.

Budget issue
A major debate over this recapitalization plan
centered on the implications for the federal budget deficit. At issue was whetherthe funds from
the Financing Corporation really would represent equity in the FSLlCor debt obligations of
the insurance agency.
Equity contributions received by the FSLlC can
be used to offset the insurance agency's expenditures (which are treated as spending in the
federal budget), in part, because the insurance
agency would have discretion over the distribution of dividends. The Congressional Budget
Office (CBO), however, maintained that, under
the plan as first proposed, the Financing Corporation's borrowings represented debt obligations
of the FSLlC since the FSLlC was directly responsible for the interest costs. As a practical matter,
this meant thatthe FSLlC would have no option
but to make those payments, which would not
be the case if it were in fact dealing with dividend payments on stock it had issued.
This initial controversy was resolved by giving
the Financing Corporation direct access to the
insurance premiums paid by thrifts, as discussed
earlier. As important as this might be in satisfying the technical aspects of the law, the change
is not substantive.

Beyond the budget
In particular, the change in the plan does not
alter the fact that only a small portion of the
increase in the FSLlC's current reserves would
consist of an injection of new resources (the
investment of the FHLBs). Most of the boost to
reserves would come from borrowings, and a
large portion of what would have been the
FSLlC's future income stream (that is, payments
from thrifts to the Financing Corporation) would
be committed to paying the interest on that debt.
Such a commitment would greatly reduce the
resources available to absorb future FSLlC
expenses.
At current market rates, the annual interest cost
on federally sponsored agency debt of $12 to
$15 billion would be on the order of $1 billion.
In 1985, regular premium income to the FSLlC
totaled only $700 million (l/'i2th of one percent
of thrift deposits). A special assessment raised
another $1 billion (Vsth of one percent of thrift
deposits) in premiums last year. The special
assessment, however, has raised some questions
concerning competitive imbalance since thrifts
have had to pay more than commercial banks
for deposit insurance. Indeed, the thrift industry
has been pushing hard to get the special assessment phased out by 1991 as part of the
recapitalization plan.
The thrift industry has argued that the special
assessment could be eliminated because regular
premium income would increase as the thrift
deposit base expands. A broader deposit base by
itself is not the answer, however. Deposit growth
would mean not only higher gross income but
also greater risk exposure for the FSLlC, everything else the same. Therefore, even if the higher
income generated from the growth in deposits
were enough to meet the interest on the Financing Corporation's debt, the FSLlC could need
additional resources to cover its other expenses
in the future.

Reducing risk
The only way the FSLlC can meet its expenses
over time, without access to more resources, is
to reduce its exposure to losses. The Federal

FSLlC's ability to remain "self-sufficient" than
are innovations such as risk-related insurance
premiums.

The FSLlC Recapitalization Plan
A. Funding
$3 b

Even with strictly enforced new capital requirements, capital regulation that is based on book
value rather than market value measures of capital could continue to present problems for the
FSLlC This is particularly true if there should be
an unexpectedly sharp rise in interest rates.
Despite deregulation, exposure to interest rate
risk will continue to be a source of potential
losses to the thrift industry. As in the past, unexpected increases in interest rates will mean
immediate declines in the market value of thrift
net worth, with book value net worth adjusting
only with a long lag.

B. Repayments
FSLIC·insured S&Ls
Fe interest and operating costs
Amount in equity
..
return account

FHLBs •

.

I
+.

Amount in equity
return account

Financing •
Corporation
Interest and
~~n~i~~i on

)
j

l(FC

FSLIC

Proceeds from zero
coupon bonds

Capital
Market

Continued reliance on book value could perpetuate the tendency to close institutions too
late - that is, when market net worth is already
below zero. The degree to which the reliance on
book value accounting will result in misleading
signals regarding the financial health of thrifts
wi II depend in part on the stabi Iity of market
interest rates.

Conclusion
Home Loan Bank Board already has adopted
higher capital requirements for insured thrifts to
help protect the FSLlC Currently, the minimum
capital requirement for FSLlC-insured institutions
is 3 percent of deposits, or about half the
required ratio for banks. The FHLBB has
announced a new minimum requirement for
thrifts of 6 percent of deposits. (The requirement
for an individual institution could be higher
depending on the composition of its assets and
liabilities.) The new standard, which takes effect
in 1987, will be phased in over a period of 6 to
12 years. In addition, the FHLBB has proposed
doing away with the use of regulatory capital
(such as net worth certificates issued to thrifts by
the FSLlC) to meet the new capital requirements.
These types of policy changes are important to
the long-run financial integrity of the FSLlC But
the new capital standards have to be enforced if
they are to make a difference. To limit the
FSLlC's losses, poorly performing thrifts with
"low" capital ratios have to be closed promptly.
Such a closure policy is more important to the

It is important for the FSLlC to have the
resources needed to deal with the backlog of
problem thrift cases. In this regard/the
"recapitalization" plan proposed by the Treasury and the Federal Home Loan Bank Board
would significantly boost the insurance corporation's current reserves. However, the net addition to the resources available to the FSLlCover
time would be limited. Under the plan, the bulk
of the funds would come from the Financing
Corporation's borrowings, the interest on which
must be paid out of the FSLlC's future income
stream.
With much of the future income of the FSLlC
earmarked to meet the costof borrowing funds.
to payoff its current obligations, the insurance
fund would be able to meet its future liabilities
without still more resources only if those liabilities were quite small. Fai.lure to realize less
than minimal exposure to risk would mean that
in the future the FSLlC would have to be truly
recapitalized, most likely with resources from
outside the thrift industry.

Frederick T. Furlong
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank .of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author ••.• Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )jDeficiency (-)
Borrowings
Net free reserves (+ )jNet borrowed( -)
1
2

3
4

S
6
7

Change from 10/2/85
Dollar
Percent!

Amount
Outstanding

Change
from

10/1/86
203,175
182,380
49,801
66,649
39,662
5,619
12,576
8,218
209,172
56,038
36,861
17,483
135,652

9/24/86
1,394
331
124
924
39
41
1,009
53
6,432
5,763
1,518
565
105

46,762

436

33,533
27,961

-

396
2,693

-

-

Penod ended

3.6

5,053
4,240

Penod ended

9/22/86

2.4
1.8
- 3.4
2.1
4.6
3.6
4.5
12.6
3.1
11.3
- 20.3
23.0
1.8

1,639

-

4,848
3,372
1,805
1,391
1,778
200
550
924
6,439
5,726
9,398
3,275
2,560

9/8/86

20
27
7

38
51
12

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

~

13.0
17.8