An Empirical Test of the Incentive Effects of Deposit Insurance: The Case of Junk Bonds at Savings and Loan Associations

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The Case of Junk Bonds at Savings and Loan Associations

Much of the debate concerning the savings and loan (S&L) crisis has focused on questions regarding the various investments undertaken by S&Ls. The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989, requires, among other things, that S&Ls' existing holdings of corporate debt securities not of investment grade ("junk" bonds) be divested by July 1, 1994.(1) Proponents of this restriction believe that S&Ls should return to their original purpose and concentrate on providing credit to potential and existing homeowners. They argue that junk bonds are inappropriate investments for institutions with federal deposit insurance. However, others contend that investing in junk bonds may improve the diversification of an S&L's assets and therefore lead to less risky, healthier institutions. Has allowing investment in junk bonds contributed to the severity of the S&L crisis by permitting increased risk-taking by some institutions? Or did holdings of junk bonds actually reduce S&L portfolio risk through the benefits of diversification? This is an important empirical question because the FIRREA restrictions have adversely affected the low-grade-bond market by eliminating a potential source of demand for these securities. It is also important because

many of the large losses of the S&L industry in the 1980s were borne by the taxpayer.

It may be argued, however, that debates about which assets thrifts should be allowed to hold are focusing on the wrong questions. There are many types of risky assets that thrifts are still permitted to hold in their portfolios even after the passage of FIRREA, for example, fixed-rate, thirty-year mortgage loans. If an institution wishes to increase its risk exposure, prohibiting junk bond investment will not prevent it from doing so. Thus, a more relevant policy question is what factors induce thrifts to take on additional risk. We believe that by studying the effects of junk bond investment on S&Ls, we can better understand the motivation for greater S&L risk-taking in general. In the case of junk bonds, we find empirical support for the view that the existence of deposit insurance created a moral hazard situation that gave poorly capitalized institutions a greater incentive to increase their risk exposure.

Several recent studies suggest that poorly capitalized institutions have actively sought to take additional risk. Benston and Koehn (1989) reported that increased emphasis on riskier nontraditional activities resulted in greater stock return volatility for poorly capitalized S&Ls and lower volatility for healthier institutions. Brewer (1991) found that shifts in asset composition toward nontraditional activities resulted in increases in the return on equity for distressed institutions but had no effect on healthy institutions. This suggests that the shareholders rewarded risk-shifting actions that raised the value of the insurance subsidy.

This paper differs from the previous studies in that we analyze the impact of S&L junk bond exposure on market risk. Using a sample of seventy-four S&Ls from September 1985 to the end of 1989, we report that institutions with larger shares of junk bonds (as a proportion of their market value of net worth) had greater stock return volatility. This suggests that these institutions did use junk bonds to increase rather than reduce their risk exposure.

Next, we examine whether S&Ls with larger shares of junk bonds in their portfolios paid higher interest rates to depositors. One explanation for the growth in junk bonds at some S&Ls is that it is a manifestation of a moral hazard problem that is endemic to a system of fixed rate deposit insurance pricing. Merton (1977) and Buser, Chen, and Kane (1981) have shown that providing deposit guarantees at less than their market value subsidizes S&Ls. …