Journal of Financial Economics 16 (1986) 345-371.

North-Holland

ACCESS TO DEPOSIT INSURANCE, INSOLVENCY RULES

AND THE STOCK RETURNS OF FINANCIAL INSTITUTIONS*

James A. BRICKLEY
Unic~rsi!yof Utah, Salt hke City. UT 84112. USA

Christopher M. JAMES
Universi[v of Oregon, Eugene, OR 97403-1208. USA

Received June 1984, final version received September 1985

This paper analyzes how access to deposit insurance affects the common stock returns of financial
institutions during periods of financial distress. During periods of distress the definition of
insolvency used by insuring agencies may be modified to avoid a substantial number of bank
failures. These modifications can increase the value of future deposit guarantees and affect the
behavior of stock returns of banks and S&Ls. This hypothesis is examined using S&L data for the
1976 through 1983 period. Modification of insolvency rules applied to S&Ls appears to have
reduced significantly the co-movement of S&L stock returns with S&L portfolio holdings.

1. Introduction

Under the current system of deposit insurance, insurance agencies and bank
regulators are given broad discretion in defining insolvency. This discretion,
afforded both the Federal Deposit Insurance Corporation (FDIC) for banks
and the Federal Savings and Loan Insurance Corporation (FSLIC) for savings
and loans (S&Ls), is particularly important during crisis periods, when
enforcing restrictive covenants or applying existing insolvency rules would
result in a substantial number of failures. During such periods, to avoid

*Financial support for this study was provided by a grant from the Federal Home Loan Bank
Board and McGraw Hill Corporation which provided us access to the Data Resources Incorno-
rateds Securities Pnce File. The authors thank S. Bhagat. A. Hess, M. Hopewell, S. Manaster, R.
Masulis, J. McConnell, W. Mikkelson, J. Schallheim. C. Smith and an anonymous referee for
comments.
1Insolvency for an insured financial institution occurs when the insurer will no longer provide
deposit guarantees and the banks charter is revoked. Prior to failure, however, the activities of the
financially distressed institution may be restricted by regulators [see Smith (1982, pp. 326-327)].
For non-financial firms, insolvency is traditionally defined as a situation in which the firm is unable
to meet its currently due debt obligations [see for example Haugen and Senbet (1978)]. For a
depository institution with debt immediately putable at par value, a sufficient condition for
insolvency wrrhout deposit insurance is when the market value of the banks assets falls below the
present value of its contractural obligations, i.e., net worth is zero. With deposit insurance,
insolvency may not occur when net worth (as defined above) is zero, but rather is determined by
the insuring agency.

0304405X/86/$3.50~1986, Elsevier Science Publishers B.V. (North-Holland)

346 J.A. Brickley and C.M. James, Deposrt insurance and S&L stock returns

failures, the FDIC or FSLIC may modify its definition of insolvency. Changes
in FSLIC capital requirements and the capital certificate program begun in
1980 are examples of modifications in the solvency criteria for S&Ls.
Modification of the rules governing insolvency can affect the value of access
to federal deposit insurance. Recent studies by Merton (1977) and Buser, Chen
and Kane (1981) show that providing deposit guarantees at less than their
market value provides banks with a subsidy. The value of this subsidy equals
the difference between the cost of risky and riskless (guaranteed) deposit claims
less the premium charged for insurance. Access to future deposit guarantees,
under these circumstances, is an asset of the bank. The value of this asset is
equal to the present value of the stream of subsidies the bank or S&L expects
to receive. The rules used to determine insolvency affect the value of access to
insurance by defining the states in which insurance will be provided. Relaxing
insolvency rules under these circumstances will increase the value of access to
deposit insurance.2
In this paper we examine how modification of insolvency rules, together with
access to fixed premium deposit insurance, affect the common stock returns of
financial institutions. Because a decrease in the value of the banks portfolio
holdings increases the risk of deposits, the value of access to fixed premium
deposit insurance will be negatively correlated with the value of the banks
portfolio holdings. Relaxing insolvency rules, by increasing the value of access
to deposit insurance, may result in a decrease in the co-movement of bank
stock returns with the return on the banks portfolio holdings. Therefore,
during crisis periods, the co-movement of bank stock returns with the underly-
ing assets of the bank (i.e., assets exclusive of deposit guarantees) may
decrease.3 We refer to this prediction as the subsidy hypothesis.
In the absence of the modification of insolvency rules, contingent claims
analysis predicts that the elasticity or co-movement of stock prices with respect
to the value of the underlying assets will increase as insolvency is approached.4
This prediction is based, however, on the assumption that insolvency rules are
adhered to, i.e., me first rules providing debt strict priority over equity are
enforced. Therefore, examining the co-movement of bank stock returns with
the returns on the banks portfolio holdings provides a means of testing the
subsidy hypothesis.5

zSimilarly relaxing insolvency rules may increase the value of access to other government
subsidies, e.g., government loans at below market rates and tax subsidies. These additional gains
due to forebearance are discussed in detail in section 6.5.
3The decrease in the co-movement of bank stock returns with the return on the banks portfolio
holdings may also result in a decrease in the estimated beta and the variance of bank stock returns.
4See Black and Cox (1976) and Galai and Masulis (1976).
sOnly under the subsidy hypothesis will the elasticity decrease during financial distress. The lack
of a significant increase in the elasticity is also consistent with our subsidy hypothesis. Formulating
the subsidy hypothesis in terms of a decrease in the elasticity provides therefore a strong test of the
subsidy hypothesis.
 J.A. Bricklqv and C.M. James, Deposit msurance and S&L stock returns 341

To test the subsidy hypothesis, we examine the stock returns of S&Ls during
the period 1976 through 1982. We focus our analysis on S&Ls for four
reasons. First, as a result of the unexpected increase in the level of interest
rates in the late 1970s S&Ls entered into a period of financial distress.
Second, in response to this crisis, there is evidence of vast recontracting
between the FSLIC and S&Ls involving modifications of insolvency rules.
Third, the portfolios of S&Ls consist primarily of mortgages. This permits us
to develop a measure of changes in the market value of S&L portfolio
holdings. Using this measure we can examine the relation between common
stock returns and the returns on the underlying assets of the S&L. Finally, the
uniformity in financial reporting required by the Federal Home Loan Bank
Board (FHLBB) facilitates our analysis.
Our empirical analysis reveals a significant decrease in the co-movement of
S&L stock returns with the returns on their underlying assets (as proxied by
the return on an index of mortgages) after 1979. Moreover, estimates of betas
for S&L stocks drop significantly after 1979. These changes coincide with a
substantial decrease in the value of S&L assets and as a result an increase in
S & L leverage.
While the evidence from the S&L industry is consistent with the subsidy
hypothesis, we cannot rule out the possibility that some other factors, not
related to forebearance and government subsidies, explain the behavior of
S&L stock returns. For example, during the period in which insolvency rules
were changed, S&Ls were provided broader asset powers and broader author-
ity to use interest rate futures for hedging. A careful examination of the
changes in S&L assets and futures market suggests that these factors are not
the major source of the change in the behavior of S&L stock returns. In
addition, an examination of the stock returns of other financial institutions
during this period suggests that the change in the behavior of S&L stock
returns is not the result of some other factors affecting all financial institutions.
The paper is organized as follows: Section 2 discusses the nature of federal
recontracting during the 1976 through 1982 period and formally states the
hypotheses to be tested. Section 3 describes our methodology. Section 4
describes our sample design. Section 5 presents results concerning the behavior
of S&L risk measures. In section 6 we examine the effect of other factors that
may explain the results. Section 7 provides our conclusions.

2. The crisis in the thrift industry and FSLIC forebearance

2.1. FSLIC policies concerning insolvency

The financial distress of the thrift industry, which began in the late 1970s is
well documented.6 As a result of the increase in the level of interest rates

See Kane (1981, 1983) and Balderston (1981)

348 J.A. Brickley and CM. James. Deposit insurunce and S& L stock returns

during this period, the market value of S&L portfolio holdings (primarily
mortgages) decreased substantially. The resulting deterioration of the financial
condition of S&Ls is reflected in the decrease in S&L earnings during the
1980-1982 period and in the negative spread between mortgage interest
income and S&L cost of funds. The return on book value of equity and the
relation between mortgage interest income and S&L cost of funds during the
period 1976 through 1983 are presented in table 1. Another indicator of
the financial problems of thrift institutions is the relation between the market
value of S&L portfolio holdings and the value of S&r L deposit liabilities.
Estimates by Kane (1983) indicate that the face value of S&L deposit
liabilities exceeded the market value of S&L booked assets by $150 billion (or
25 percent of S&L assets) by year end 1981.
As a result of the crisis in the thrift industry, the FSLIC implemented a
series of policies, beginning in 1980, that changed the rules used in determining
insolvency. In particular, prior to 1980 S&Ls were required to maintain a ratio
of book ualue of net worth to deposits of at least 5 percent as a condition for
obtaining deposit insurance. However, these requirements were reduced by
the FSLIC in June of 1980 to 3 percent.8
In addition to the changes in net worth requirements, the FSLIC imple-
mented several other regulatory changes designed to forestall S&L failures.
First, in September 1981, the deferred accounting for losses on the sale of
mortgages and securities was authorized, which permitted S&Ls to sell assets
and realize capital losses for tax purposes without reducing their capital
account for regulatory purposes. Second, beginning in 1981, certain S&Ls
were permitted to issue to the FHLBB capital certificates which were counted
as net worth. Third, in many instances the FHLBB did not enforce the net
worth requirements [see Kane (1983)]. Evidence from the S&Ls in our sample
(described below) is consistent with this contention. Of the 48 individual S&Ls
in our sample, four had a negative book value of equity during the 1980

Bank regulators have traditionally defined insolvency for insured S&Ls and commercial banks
in terms of book value of net worth [see Campbell and Glenn (1984)]. Since federal regulatory
agencies do not require S&Ls to carry their mortgage portfolios at market value on their balance
sheets, S&Ls may continue to operate even though they would be insolvent in the absence of
insurance (i.e., the market value of their underlying or booked assets is less than the value of their
contracted liabilities).
See Sut~;~rgs und Loan Fact Book, 1982. Horton (1979) provides evidence that net worth
requirements were strictly enforced for all S&Ls prior to 1980. For S&Ls less than 20 years old,
statutory net worth is calculated in a more complex manner. For these S&Ls net worth
requirements are determined by dividing the age of the S&L by twenty and multiplying this
number by the statutory net worth requirement. Four of the S&Ls in our sample were less than 20
years old. Of these four, the most recently chartered was in 1973.
Capita1 certificates represent the clearest form of modifying S&L insolvency rules. For S&Ls
that failed to meet net worth requirements and were in danger of being declared insolvent by state
regulators, the FHLBB purchased capital certificates in exchange for promissory notes. A capital
certificate is similar to cumulative preferred stock, with a dividend requirement equal to the
interest paid on the FHLBBs promissory note. Dividends are payable on!v if the net income of
the S&L is positive. Thus, insurance was provided to S&Ls with negative book net worth.
 J.A. Brickley and CM. James, Deposit insurance and S&L stock relurns 349

Table 1
Average return on book equity and the average spread between S&L cost of funds and the return
on mortgages 1976 through 1983 for all federally insured S&Lsa

Spread between mortgage returns and cost of funds

(percent)
Average return on Interest income Average cost
Year equity (percent)b on mortgages of funds Spread

1976 11.11 8.00 6.38 1.62

1977 13.99 8.26 6.44 1.82
1978 14.21 8.50 6.79 1.81
1979 12.11 8.86 7.47 1.39
1980 2.45 9.34 8.94 0.40
1981 - 15.39 9.91 10.92 - 1.01
1982 - 16.20 10.68 11.38 - 1.70
1983 7.05 11.04 9.81 1.23

Source: I/. S. Savings and Loan Fact Book, U.S. League of Savings and Loans, 1984.
bRepresents net income as a percent of the book value of equity.
Spread equals the difference between interest income on mortgages and the average cost of
funds.

through 1982 period. Moreover, in our sample the average ratio of book equity
to deposits was 2 percent (the median value was 2.3 percent) less than the
regulatory requirement of 3 percent.

2.2. Statement of hypotheses

The primary hypothesis examined in this paper is that changes in insolvency

rules during the 1980-1982 period significantly affected the behavior of S&L
stock returns by increasing the value of access to deposit insurance and other
government subsidies. The subsidy hypothesis predicts that these changes
reduced the elasticity of S&L stock prices with respect to the underlying assets
of the S&L.
The subsidy hypothesis can be tested empirically by examining the relation
between the stock returns of S&Ls and the return on their underlying assets.
Using option pricing theory Galai and Masulis (1976) show that the following
relation exists between the return on equity and the return on the assets of the
firm:

where

r, = return on equity,
17, = the elasticity of equity (S) with respect to the value of the assets of the
firm (V), and
r(, = return of the firms assets.
350 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns

Under absolute me first priority rules, as the value of the underlying assets
of the S&L (V) approaches the value of deposits (D),the elasticity ql, will
increase without limit. Therefore, as insolvency approaches, the sensitivity of r,
to changes in r, will increase. Moreover, the elasticity of equity relates the
systematic risk of the stock to the systematic risk of the firms assets and
the standard deviation of the return on equity to the standard deviation of the
return on the firms assets. In particular,

where & and & denote the beta of equity and the beta of the firms assets,
respectively, and us and a, denote the standard deviation of the return on
equity and the return on the firms assets. lo Given the asset composition of
S&Ls and the enforcement of me first priority rules, the elasticity of S&L
stock prices (17,) and therefore the beta and standard deviation of S&L stocks
should increase during the 1980 through 1982 period.
The subsidy hypothesis predicts, however, that failure to enforce me first
rules and the continued provision of fixed premium deposit insurance results in
a decrease in the S&L stock price elasticities. With access to fixed premium
deposit insurance an S&L consists of two types of assets, its portfolio holdings
and access to deposit insurance. Relaxation of insolvency rules increase the
value of access to deposit insurance (I) relative to the S&Ls portfolio
holdings (V). Because the common stock returns of S&Ls reflect the return on
both types of assets and because the return on access to insurance is negatively
correlated with the return on S&L portfolio holdings, relaxing insolvency rules
reduces the co-movement of the S&Ls stock returns with the return on its
portfolio holdings.
The effect of changing insolvency rules when deposit insurance is provided
at fixed premiums can be illustrated within the option pricing framework.
Merton (1977) has shown that the value of a deposit guarantee is equal to the
value of a European put option on the assets of the bank with a striking price
equal to the face value of debt and an expiration date equal to the date when
the banks debt matures (time t). Assuming access to insurance is guaranteed,
the value of future deposit guarantees is equal to the value of a put option
written at some future date (t) with an expiration date of t + r. The value of
this option is simply equal to the value of a European put expiring in t + r
periods. The elasticity of the put (access to insurance) with respect to the
underlying assets of the bank (denoted as nl) is strictly less than zero [see
Jarrow and Rudd (1983)]. Therefore, with access to insurance the elasticity of

See Black and Scholes (1973) and Smith (1976). Similar results can be obtained without the
use of options pricing theory. See Hamada (1969).
 J.A. Bricklqv and C.M. James. Deposit insurance and S&L stock returns 351

equity (denoted as 9,) with respect to the assets of the S&L is

V V
qs=-17,+----
T/+ V
v+ vfql,
where n, is the elasticity of equity in the absence of insurance (and n,, 2 1).
Increasing the value of V relative to V results therefore in a decrease in the
elasticity of the S&Ls stock. In general as long as the value of this access to
insurance and other subsidies is less than perfectly correlated with the market
value of the S&Ls portfolio holdings, relaxing insolvency conditions will
reduce the S&Ls stock elasticity with respect to its underlying (booked) assets.
In addition to affecting the value of access to deposit insurance modifying
insolvency rules may affect the value of other subsidies provided thrifts. In
particular, relaxing insolvency rules provided thrifts with continued access to
Federal Home Loan Bank (FHLB) advances. Since the interest rate on FHLB
advances is determined by the FHLBs own borrowing costs, advances repre-
sent a source of government subsidized borrowing.12
Changes in insolvency rules also affected the ability of S&Ls to utilize tax
loss carry backs. By permitting certain S&Ls to continue to operate and
through permitting S&Ls to realize losses on the sale of mortgages for tax
purposes (but not for purposes of determining net worth requirements), access
to tax refunds was preserved. l3 The effects of these other subsidies together
with access to deposit insurance are examined as part of the subsidy hypothe-
sis.

3. Methodology

Testing the subsidy hypothesis requires a measure of the return on the

S&Ls underlying assets. Since S&Ls invest primarily in mortgages we assume
that the primary factor affecting the value of S&L portfolio holdings is

Note that the subsidy hypothesis involves testing the joint hypothesis of changes in insolvency
rules and S&L asset rerums and equity returns follow a log normal diffusion process, so that the
relation in eq. (1) holds. The options pricing framework is used only to illustrate the effect of
deposit insurance on S&L equity returns. A formal model of the effect of access to insurance
would need to incorporate how insurance effects nT through changes in the boundary conditions
*In this way the effect of access to advances on S&L stock returns is similar to access to
deposit insurance. A decrease in the value of S&L assets increases the difference between the
S&Ls own uninsured borrowing rate and the advance rate. However, given the importance of
insured deposits as a funding source, access to deposit insurance is likely to be a more important
government subsidy. For a description of the advance program. see FHLBB Journal, December
1983.
Prior to 1981 S&Ls could not realize losses from the sale of mortgages without reducing their
regulatory net worth. As a result S&Ls paid federal taxes in 1978 through 1980 though they would
have had no federal tax liability if losses on their mortgage portfolio had been realized. See Kane
(1981).
352 J.A. Bricklqv and CM. James, Deposit insurance and S& L stock returns

changes in the market value of mortgages. (The average proportion of mort-

gage loans to total assets for S&Ls during the 1976 through 1982 period was
0.89.)14 Weekly holding period returns associated with Government National
Mortgage Association (GNMA) eight percent certificates are used to measure
changes in the market value of mortgages. The GNMA index was obtained
from Data Resources Incorporated (DRI). The index consists of price quotes
for the most recently issued eight percent certificates at the close of trading on
Friday of each week. Weekly holding period returns were calculated from
changes in the price quotes.
Our methodology involves first estimating the relation between stock returns
and the return on GNMA certificates. This provides an estimate of the S&Ls
stock price elasticity with respect to the value of its underlying assets. Next, we
examine the effect of FSLIC policy changes on the S&Ls stock price elasticity.
To obtain an estimate of an S&Ls stock elasticity we estimated the
following model:

(2)
where
R,, = the holding period return on the jth S&L stock over the period ending
at the time t,
R,, = the holding period return on an index of mortgage bonds ending at time
t, and
E = error term.
/I

The coefficient on the mortgage index plj measures the co-movement

between an S&Ls stock returns (Rj,) and the underlying assets of the S&L.16

%avings and Loan Fact Book, 1982.

t5DRI obtains price quotes from Telstat which supplies price information to The WaN Street
Journal and other sources. GNMA eight percent certificates were used because price data was
available from January 1976. A potential problem with using GNMA certificates is interest and
principle payments are insured, whereas S&L mortgages have positive default probabilities. For
this reason the GNMA index only measures changes in the value of S&L portfolio resulting from
interest rate changes. Moreover, since the last GNMA eight percent certificate was issued in April
1982 after this date price quotes are for a security with a decreasing term to maturity. After April
1982, the GNMA quotes represent prices in the secondary market for seasoned GNMA eight
percent pools. A third problem with the GNMA index is that because of prepayments its maturity
or duration may change with the level of interest rates, As discussed in section 6.4, to avoid these
last two problems a Treasury Bill index was also used.
t6Note that by definition
B,, = dR,/dR,.
Since R, serves as a proxy for rt,, the above relation may be rewritten as
&, = (dR,/dr,,)(dr,/dR,) =n,(dr,/dR,).
Clearly B,, will differ from the elasticity of the stock to the extent that there is not a one-to-one
correspondence between rL and R,.
 J.A. Brick& and C. M. James, Deposit insurance and S&L stock returm 353

In conducting our empirical analysis, we chose January 1980 as the date that
insolvency rules were relaxed. l7 Our hypothesis is that the average value of the
/3,, will be lower in the 1980-1982 period than in the 1976-1979 period.

4. Sample design
Eq. (2) was estimated using weekly common stock returns data over the
period January 1,1976 to January 7,1983. Weekly common stock returns were
obtained for a sample of 30 S&L holding companies owning a total of 48
individual S&Ls. Common stock returns were calculated using price and
dividend data obtained from DRIs Security Price File. S&L holding com-
panies were included in the sample if they met the following criteria: (1) had
SIC codes between 6120 and 6129 (operation of a S&L is the firms primary
line of business) and had common stock price and trading information
contained in the DRI Securities File; (2) traded continuously (every week) for
at least four consecutive years (208 weeks) during the 1976 to 1983 period; and
(3) the S&Ls within the holding company comprised at least 80 percent of the
S&L holding company assets.*
The sample of S&Ls used in this study consists principally of large S&Ls.
The median asset size for S&Ls in our sample was $1.7 billion in 1981. S& Ls
ranged in size from $248 million to $13 billion. In contrast the median size of
all federally insured S&Ls was $50 million in 1981.
Since our sample consists of large S&Ls, our results may not be applicable
to all S&Ls. In particular, the S&Ls in our sample may be more likely to
receive government subsidies through modification of insolvency rules than
smaller S&Ls. In particular, federal regulators may be less willing to close
relatively large financial institutions in financial distress than smaller institu-
tions.Appendix 1 contains a list of the S&Ls in our sample and information
concerning their size and trading activity.

Choice of this date is arbitrary. Greater specificity in terms of dates for these regulatory
changes is difficult to obtain since regulatory proceedings concerning the crisis in the thrift
industry occurred over an extended period of time.
The median ratio of S&L assets to holding company assets is 0.97. No signiticant change in
this ratio occurred during our sample period. For example, the median ratio was 0.96 during the
1976 through 1979 period and was 0.97 during the 1980 through 1982 period. For multiple S&L
holding companies the assets of the individual S&L subsidiaries were summed in constructing this
ratio. In the case of mergers assets of the acquired S&L were included in the holding companys
assets following the merger. Assets for the holding companies were obtained from Moodys
Banking and Finance Manual.
See Kane (1983). For example, in a recent report to Congress the Comptroller of the Currency
indicated that he would not permit the ten largest commercial banks to fail. This statement, made
after the financial distress of Continental Illinois, implies a willingness to modify insolvency rules
if necessary to avoid large bank failures (The Wall Street Journal, Sept. 20, 1984, p. 2). The
extension of federal guarantees to all depositors at American Savings and Loan, following the
financial distress of the parent, Financial Corporation of America, provides another example (see
The Wall Street Journal, Aug. 30, 1984, p. 3).
354 J.A. Brickley and C.M. James, Deposit insurance and S& L stock returns

5. Behavior of S&L risk measures

5.1. Elasticity estimates

I!$. (2) was estimated for each of the 30 S&Ls in our sample. As a way of
summarizing those results, estimates for an equally weighted portfolio of these
S& Ls are reported below (standard errors are in parentheses): 2o

Rp,= 0.004 + 0.835 R,, R2 = 0.151, D. W. = 1.76,

(0.002) (0.110)

where D. W. stands for Durbin-Watson statistic.

The positive and highly significant coefficient on the mortgage index indicates,
as expected, S&L stock prices move contemporaneously with mortgage bond
prices (the value of /?, describes this co-movement).
Our hypothesis is that recontracting resulted in a decrease in the co-move-
ment of S&L stock prices with the return on their asset portfolios (R,) during
the 1980 through 1982 period. We test this hypothesis by estimating the
following model:

RPI = (YPO+ PP/Rl, + PPs

RIf * D + WPI 3 (3)

where

R,, = weekly holding period return on an equally weighted portfolio of S&L

stocks in week t,
RI, = weekly holding period return on the GNMA index in week t, and
D = a binary variable taking on the value of zero during the period January
through December 1979, one otherwise.

The coefficient on the interactive dummy variable (FPs) is intended to

measure any change in the co-movement of S&L stocks prices with the return
on their assets over the two periods. The subsidy hypothesis predicts a
reduction in the stock price elasticity so that the expected sign of & is
negative. To avoid shifts in the parameter estimates of (3) due to changes in
portfolio composition, eq. (3) was estimated using a portfolio of 20 S&L stocks
which traded over the entire seven-year period. The estimate of eq. (3) is
provided below:

zip, = 0.004 + 1.41 R,, - 0.874 R,, * D,

(0.02) (0.287) (0.281)

R2 = 0.142, D. W. = 1.67.

OThe number of S&L stocks in the portfolio varied, depending on the availability of price data,
from 30 to 20 stocks. Appendix 1 contains elasticity estimates for each of the S&Ls in our sample.
 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns 35s

Consistent with the subsidy hypothesis, the coefficient associated with the
interaction variable is negative and statistically significant at the 0.01 leveL21
This decrease in the elasticity estimate occurred during a period in which the
market value of S&L booked assets decreased significantly. This decline in
asset values resulted in a substantial increase in S&L leverage. For the S&Ls
in our sample (as discussed below), the mean ratio of debt to the market value
of common stock increased from 24.19 in the 1976 to 1980 period to 40.53 in
the 1980 through 1982 period (the difference in means is statistically signifi-
cant; the t-statistic is 4.34). 22 The increase in leverage in the absence of FSLIC
policy changes would be expected to increase the elasticity of S&L stocks. We
observe, however, a significant decrease in the co-movement of S&L stocks
with interest rate changes.

5.2. Changes in other risk measures

To examine changes in the beta of S&Ls we estimated the following market

model:

R,, = al+ P,R, + P,,R,, * D + e,, (4)

where
R,, = weekly holding period return on an equally weighted portfolio of S&L
stocks trading from 1976 through 1982,
R,,,, = weekly holding period return on the NYSE composite index, and
D = binary variable which is one for the period January 1980 to January
1983, zero otherwise.
An estimate of eq. (4) is provided below (standard errors are in parentheses):

R,, =(0.002) + 1.51 R,, - 0.25 R,, * D,

(0.001) (0.125) (0.110)

R2 = 0.48, D.W. = 1.67.

Consistent with the subsidy hypothesis the coefficient associated with the
market portfolio ( j?,) declined significantly in the post-1979 period.23

All 20 S&Ls that traded continuously over the 1976 through 1982 period had lower estimated
values for /I, in the 1980 through 1982 period. See appendix 1. Similar results were obtained when
eq. (3) was estimated over the two subperiods and the equality of coefficients associated with R,
examined using an F-test. The F-statistic is 6.32.
Kane (1983) estimates that the unrealized losses on mortgages during the 1979 through 1982
period for all S&Ls was $21 billion dollars or about 15 percent of total S&L assets. For all
federally insured S&Ls the ratio of debt to book value of equity increased from 17.02 in the 1976
to 1980 period to 28.25 in the 1980 through 1982 period.
Similar results are obtained if the market model is estimated separately in both periods and an
F-test is used. The F-statistic is 3.87.
356 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns

Table 2
An analysis of changes in the ratio of standard deviations of returns for an equally weighted
portfolio of 20 S&L stocks and the Government National Mortgage Association (GNMA) index
over the 1976 through 1982 period.

1976 1977 1978 1979 1980 1981 1982

o/al 4.63 5.18 5.34 3.48 1.66 1.28 1.86

1976 to 1980 1980 to 1983

0, /a, 4.14 1.58

u, and (r, are estimates of the standard deviation of weekly stock returns for a portfolio of 20
S&L stocks and the standard deviation of the weekly return on the GNMA index, respectively.
S&L holding companies included in the sample are those with common stock price and trading
information contained in the DRI Securities File and which traded over the entire study period.
The return on the GNMA index represents the holding period return on an index of GNh4A eight
percent certificates.

The decrease in the beta for S&L stocks may result from a change in the
systematic risk of the mortgage index [see eq. (l)]. We therefore estimated eq.
(4) using the return on the GNMA index as the dependent variable. The results
of this estimation are provided below (standard errors are in parentheses):

R,,= 0.000 + 0.19 R,,+ 0.11 R,, * D,

(0.001) (0.065) (0.086)

R* = 0.11, D. W. = 2.08.
These results indicate the absence of any significant decrease in the beta for the
GNMA index.
We also calculated the ratio of the standard deviation of S&L stock returns
to the standard deviation of the return on the GNMA index. A decrease in the
elasticity of the stock returns should result in a decrease in this ratio after 1979.
These ratios are reported in table 2. Consistent with our hypothesis the ratio
declines after 1979. In addition, the ratio of the standard deviation of each
S&Ls returns to the standard deviation of R, was calculated for the two
subperiods, 1976-1979 and 1980-1982. 24 Using a paired t-test the mean ratio
of standard deviations was found to be significantly lower during the 1980
through 1982 period (for the 20 S&Ls that traded over both periods). The
calculated r-statistic is - 4.86.

14We analyze the ratio of the standard deviations because our concern is with the variability of
S&L stock returns relative to the return on S&L underlying assets. The decrease in the ratio of
standard deviations results primarily from the increased volatility of interest rates (R,). The
standard deviation of the returns on the S&L portfolios during the 1976 to 1982 period are:
1976 1977 1978 1979 1980 1981 1982

0s 0.036 0.024 0.040 0.042 0.041 0.040 0.051

 J.A. Brickley and C. M. James, Deposit insurance and S&TL stock returns 351

6. Contemporaneous factors affecting the S&L industry

In this section we explore alternative explanations for the change in the

behavior of S&L stock prices. In particular, we examine the effect of (1)
changes in the composition of the S&L assets and liabilities, (2) S&L activity
in financial future markets, and (3) changes in the level of interest rates.25 Our
analysis suggests these factors are not the source of the decrease in S&L stock
price elasticities. We also examine the effect of FHLB advances and tax
subsidies on S&L stock returns. These factors may have contributed to the
change in S&L stock price behavior as discussed below.

6.1. Changes in the asset and liability composition of S& Ls

During the early 1980s S&Ls were given broader powers to issue variable
rate mortgages and to expand their nonmortgage lending activities. If S&Ls
significantly altered the maturity composition of their assets (moving, for
example, from fixed rate mortgages to variable rate mortgages), this may
change the relation between S&L stock returns and R,. In particular, since
changes in the value of mortgages occur primarily because of changes in the
level of interest rates, the shorter the maturity of S&L assets, the less S&L
stock prices will respond to interest rate changes like a long-term mortgage
certificate and the lower the PI,. We examined this issue by analyzing the
relation between the maturity mismatch (the difference between the average
maturity of assets and liabilities of S&Ls) and cross-sectional, as well as
intertemporal, differences in the /3[,s.
A measure of maturity mismatch was constructed by subtracting the dollar
value of S&L liabilities maturing or subject to repricing within one year from
the dollar value of assets subject to repricing within the same period. This
measure is denoted as Short. By construction, assets and liabilities excluded
from this measure are assumed to mature or be repriced in more than one year,
and will be referred to as Long. A negative value of Short implies that the
value of short-term assets is less than the value of short-term liabilities. This, in
turn, implies the value of long-term assets exceeds the value of long-term
liabilities. Appendix 2 describes how we constructed Short.
The Short measure was computed for each S&L in our sample using the
FHLBB Report of Condition for December of each year. (Consistent balance
sheet information could be obtained from the FHLBB for December 1977
through December 1982.) In the case of multiple S&L holding companies
Short was computed by summing the Short measure for each of the S&Ls
within the holding company. Finally, we deflated Short by the year-end market
value of the S&L holding companys outstanding common stock so that the

2SSee Eisenbeis (1983) for a discussion of these changes

358 J.A. Brickley and C.M. James, Deposit insurance and S&L stock returns

dollar measure of maturity mismatch is in the same units of measure as PI,.

Our Short measure is denoted as Short/MV, where MT/ is the market value of
the S&Ls common stock.
If the PI, decline because of an increase in the net short assets of S&Ls (so
that S&L stocks move less with long-term bonds), then one would expect a
significant increase in Short/MV during the period 1980 to 1983. Table 3
summarizes the behavior of the average value of Short/MV for the S&Ls in
our sample during the period 1977 through 1982. The data in table 3 indicate
an increase in the maturity of S&L assets relative to the maturity of liabilities.26
Therefore, the behavior of Short/MV does not appear to explain the decrease
in PI after 1979.
An alternative explanation for the decrease in the elasticity of S&L stock
returns is a decrease in S&L leverage. To examine this issue we computed the
market value of the common stock outstanding for each S&L at the end of
each year. We also calculated the book value of S&L debt obligations (all
deposits plus other debt obligations for December of each year). We then
calculated the debt to equity ratio of each S&L (denoted as Debt/Ml). To
the extent that S&Ls have risky debt obligations Debt/MV will represent an
upward biased estimate of S&L leverage.
Table 4 provides the mean leverage ratio for the S&Ls in our sample over
the period 1977 through 1982. As shown in table 4 the leverage ratio increased
during the 1980-1982 period. In the absence of changes in FSLIC policies the
increase in leverage would be expected to increase the elasticity measures,
however the elasticity measures decrease during the 1980-1982 period.27
To analyze further the relation among /3,, the maturity composition of
S&Ls and leverage we estimated the following pooled cross-section time series
model:

p,,, = (Ye + a,(Short/MV),, + +,(Short/MV)j, *D

+ty3( Debt/MV),, + E,~, (5)

26The mean value of Short/MV during the period 1980 to 1982 is significantly smaller than the
mean value of Short/MV for the 1976 to 1979 period. The z-statistic for the difference in means
test is - 5.95. The decrease in Short is not attributable primarily to a decrease in MV during the
1980 to 1982 period. Scaling Short by the book value of total assets yields a similar pattern.
*The median elasticity coefficients for S&L in our sample over the 1977 through 1983 period
are:

1977 1978 1979 1980 1981 1982

81 2.18 3.54 1.28 0.78 0.45 0.94

 J.A. Brickley and C. M. James, Deposit insurance und S&L stock returns 359

Table 3
The average ratio of net short-term assets to the market value of S&L equity from 1977 through
1982.a

1977 1978 1979 1980 1981 1982

Short/MVb - 4.85 - 6.65 - 10.04 - 12.16 ~ 22.39 - 17.61

Sample size ranged from 20 S&Ls to 30 S&Ls. Holding companies in the sample are those
with common stock and trading information contained in the DRI Securities File and which
traded for at least four consecutive years during the study period. To be included in the sample the
S&Ls within the holding company must have comprised at least 80 percent of the holding
companys assets.
Shorf/MV equals the ratio of short-term assets minus short-term liabilities to the market value
of the common stock of the S&L. Short-term assets and liabilities are defined as claims maturing
or being repriced within one year.

Table 4
Average debt to market value ratios for S&Ls 1977 through 1982.

1977 1978 1979 1980 1981 1982

Debt/M Vh 24.27 24.02 24.37 28.64 30.90 42.80

Sample size ranged from 20 S&Ls to 30 S&Ls. Holding companies included in the sample are
those with common stock and trading information contained in the DRI Securities File and which
traded for at least four consecutive years during the study period. To be included in the sample the
S&Ls within the holding company must have comprised at least 80 percent of the holding
companys assets.
bDeht/MV equals the ratio of the book value of S&L debt to the market value of equity. The
book value of the S&Ls debt was obtained from Moodys Banking and Finunce Manual. The
market value of equity (MV) was computed based on shares outstanding and price data for
December, 31 of each year. All information pertains to S&L holding companies where applicable.

where

P IJl = the estimated coefficient associated with R, for the jth S&L
over the period t,
Debt/My, = debt to equity ratio for the jth S&L over the period t, where the
dollar value of debt includes all deposit and other debt obliga-
tions and equity represents the market value of equity,
D = binary variable taking on the value of zero for the 1976 through
1979, one otherwise, and
EJl = error term.

In eq. (5) Short/MI/ is intended to measure the effect of differences in the

maturity composition of S&L assets and liabilities on the relation between R,
and S&L stock returns. The expected sign of CQ is negative. If our measure of
Short captures maturity mismatch, an increase in net short-term assets (imply-
ing a corresponding decrease in long-term assets and/or an increase in
long-term liabilities) should result in a decrease in PI.
360 J.A. Brickley and C.M. James, Deposit insurance and S&L stock returns

An interactive binary variable, Short/MV * D, is included in the model to

measure any change in the relation between PI and maturity composition of
Short/MI/. After insolvency rules were changed Short/MT/ is expected to be
less important in the determination of PI,. Therefore, the expected sign of (Y*is
positive.
If investors expect the FSLIC to enforce me first priority rules, the
expected sign on the leverage variable is positive. Under the subsidy hypothe-
sis, however, leverage increases do not necessarily imply an increase in the
elasticity of the stock. In particular, since increases in leverage increase the risk
borne by the FSLIC, an increase in leverage may increase the value of access to
insurance and therefore lower p,,. Thus, including Debt/MV provides an
additional test of the subsidy hypothesis.
In estimating eq. (5) we used estimates of plj obtained over two subperiods:
1976 through 1979 and 1980 to 1983. Average values for Short/MV and
Debt/MV were obtained for each S&L for each of the two subperiods (1977
through 1979 and 1980 through 1982). These values were calculated using data
for December, 31 of each year.
Eq. (5) was estimated using OLS techniques for our sample of 30 S&L
holding companies over the two time periods. The results are presented below
(standard errors are in parentheses):

j,,, = 1.36 - (l/$hort/MV)j~ + O.l7(Short/MV),, *D

(0.053)

- 0.62( Debt/MV),,, R2 = 0.35.

(0.257)

The negative and statistically significant coefficient on Short/MV is con-

sistent with the hypothesis that cross-sectional differences in the effect of
changes in mortgage interest rates on the stock returns of S&Ls result, in part,
from differences in the maturity composition of S&L assets and liabilities. An
increase in Short (or decrease in net long-term assets) results in a decrease in
the co-movement of S&L stock returns with the return on long-term mort-
gages. In addition, the coefficient on the interaction variable ((Ye) is positive
and statistically significant. This indicates that Short/MV is significantly less
important during the 1980 and 1983 period than before the changes in
insolvency rules. Changes in the maturity composition of S&Ls do not appear
to explain the significant decrease in sensitivity of S&L stock prices to
mortgage rate changes after 1979. Indeed, changes in the maturity composition
of SdzLs would indicate that the co-movement should have increased after
1979.
Finally, consistent with the subsidy hypothesis, the coefficient on the
Debt/MV variable is negative and statistically significant at the 0.01 level
 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns 361

(one-tailed test). Increases in leverage, given fixed insurance premium, increase

the value of access to insurance and thereby result in a reduction of /3I.28
While the changes in S&L asset and liability composition do not appear to
explain the behavior of the elasticity of S&L stocks during the 1976 to 1983
period, changes in the elasticity of S&L stocks may reflect changes in S&L
activities that are not reflected on S&L balance sheets. One such activity is the
origination and sale of mortgages. The origination and sale of mortgages may
generate fee income while reducing S&L exposure to unexpected interest rate
changes. To investigate this issue, information on mortgage loans and par-
ticipations purchased and sold by insured S&Ls was obtained for the period
1976 through 1982.
Net mortgages sold increased during the 1976 through 1979 period and in
1982. If increased mortgage sales are the source of th! decline in the elasticity
of S&Ls one would expeft to observe a decrease in PI, in 1976 through 1977
and in 1982. However, PI increased in both of these periods (see footnote
27).29
A final piece of evidence as to whether changes in S&L stock price behavior
is the result of changes in asset composition is obtained from estimating
elasticity coefficients for the 25 S&Ls in our sample with stock price data
available for 1983 (balance sheet data was not available from the FHLBB for
1983). If the decrease in S&L elasticities is the result of changes in asset
composition (resulting from regulatory changes), then our elasticity measure
would not be expected to increase in 1983. However, if changes in insolvency
rules and the resulting increase in the value of insurance is the source of the
decrease in p,,, then as the earnings of thrifts improved in 1983 (see table 1)
the estimates of /?,, should increase.
We estimated eq. (2) was estimated using data for 1983. The median value of
fi,, increased in 1983 to 1.90 (from 0.94 in 1982). Moreover, the average value
of b,, increased to 1.63 (from 0.92 in 1982). This change in the average value

s Because the dependent variable in eq. (5) is measured with error and given the shift in j?,, over
the two periods, the errors in eq. (5) may be cross-sectionally heteroskedastic. To correct for
possible heteroskedasticity, we re-estimated eq. (5) using a generalized least squares model which
utilizes estimates of the cross-sectional variances from the OLS regression [see Kmenta (1971. pp.
510-512)]. The results using this procedure are similar to those obtained using OLS estimates.
Net mortgages sold (mortgages sold less mortgages purchased) during the 1976 to 1982 for all
S&Ls are given below (in millions) (source: FHLBB Journal, table 54.5):
1916 1977 1978 1979 1980 1981 1982

$ - 4,352 $ - 651 $4,501 $6,299 $2,901 $2,094 $30,118

The decrease in fi, may result from commitments to sell mortgages (particularly during 1980 and
1981). We were unable to obtain information on commitments to sell mortgages. However. since
most commitments are for delivery within one year, commitments to sell mortgages does not
appear to be the primary reason for the decrease in S&L stock elasticities.
362 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns

of 8, is significantly different from zero using a paired c-test at the 0.01 level
(the t-statistic is 5.56). The increase in the elasticity in 1983 appears therefore
consistent with the subsidy hypothesis.

6.2. Futures market activity

A potential alternative explanation for the decrease in our elasticity measure

is the expanded use of financial futures by S&Ls as a means of hedging
interest rate risk. During July 1981, the FHLBB implemented regulations
permitting S&Ls to transact in futures markets.30 While increased use of
interest futures may reduce S&L interest rate risk, S&L use of interest rate
futures during the period appears limited even among large S&Ls. A recent
survey of futures activity reveals only 47 percent of S&Ls with assets over $1
billion transacted in financial futures. [See Booth, Smith and Stolz (1984).] The
net short position for all S&Ls as of March 1984 was only $1.702 billion
(based on par value of securities).31
To examine whether hedging in the futures market might explain the
decrease in the elasticity estimate for the S&Ls in our sample, we estimated the
relation between /3, and Short/MV during the period 1976 through 1979 (a
period during which futures activity was almost non-existent). We next used
these coefficient estimates, together with the estimated value of PI for the 1980
through 1982 period, to determine the average Short/MI implied by the lower
elasticity estimates in the 1980 through 1982 period. Given the market value of
S&L equity, the lower estimates for PI imply an increase in average short-term
assets of $1.2 billion (i.e., the estimates of BIj imply short-term assets of $1.2
billion greater than the actual level observed; the average asset size of S&Ls in
our sample during this period was $2.6 billion and average short-term assets
were $881 million). Based on a sample of 30 S&Ls this implies an aggregate
increase in short assets of $36 billion in the 1980 through 1982 period. This
required increase in short-term assets exceeds the net short position of all
S&Ls in GNMA futures contracts held as of March 1984 by $34 billion.
These, admittedly crude estimates, suggest that S&L activity in the futures
market is not the source of the decline in elasticity estimates.

6.3. Changes in the level of interest rates

While the change in the relation between S&L stock returns and RI appears
consistent with the subsidy hypothesis, the decrease in the elasticity estimates
might result from some contemporaneous economy-wide event-unrelated to
FSLIC policies. For example, the level of interest rates rose dramatically after

Sauings and Loan Fact Book, 1982.

Federal Home Loan Board, Report of Condition, March 1984
 J.A. Brickley and C.M. James, Deposit insurance and S& L stock returns 363

Table 5
An analysis of shifts in market model parameters and elasticity estimates for
portfolios of commercial bank and life insurance stocks over the period 1976
through 1982.a

Panel A: Bank ana!wis

Relation between bank stock returns and the return on GNMA index
R,,= 0.002 + 0.245R, - O.l45R, * D, R2 = 0.03, D. W. = 1.67
(0.001) (0.106) (0.133)
Market model estimates for banks
RB, = 0.112 + 0.370R, - O.O30R, * D, R2 = 0.37, D. IV. = 1.85
(0.000) (0.038) (0.049)

Panel B: Life insurance unalysis

Relation between life insurance stock returns and the return on GNMA index
R,,= 0.003 + 0.204R, - O.OOOR, * D, R2 = 0.04, D. IV. = 1.23
(0.001) (0.076) (0.165)
Market model estimates for life insurance stocks
R,,= 0.004 + 0.431R, + O.OOlR,,* D, R = 0.28. D. W. = 2.03
(0.001) (0.062) (0.043)

aR, = weekly return on an equally weighted portfolio of bank stocks ob-

tained from Data Resources Incorporated (DRI).
R I -- weekly holding period return on an index of Government National
Mortgage Association (GNMA) eight percent certificates,
D = binary variable taking on the value of zero for the period 1976 to
1980, one otherwise,
R ml = weekly return for the NYSE composite index, and
R I --weekly return on an equally weighted portfolio of life insurance
stocks obtained from DRI.

1979. The effect of a change in the level of interest rates on the elasticity of a
stock in the absence of deposit insurance is an empirical issue.32 Christie
(1982) finds for common stocks in general a positive relation between q, and
interest rates. Christies results suggest therefore that in the absence of access
to insurance, the elasticity of S&L stocks should increase as interest rates
increase.
To examine whether the change in the relation between S&L stock returns
and the return on mortgages is due to some event-unrelated to changes in
insolvency rules (such as the level of interest rates), we analyze the relation
between the stock returns of other types of financial institutions and R,. We
chose as control groups commercial banks and life insurance companies. Since

Galai and Masulis (1976) demonstrate that there exists ceteris paribur an inverse relation
between the level of interest rates and nf. However, changes in the level of interest rates also affect
the value of the firms assets. Fama and Schwert (1977) find on average a negative relation between
stock returns and interest rate changes. An increase in interest rates may therefore reduce the value
of the firms assets leading to an increase in elasticity.
364 J.A. Brickley and C. M. James, Deposii insurance and S&L stock returns

Flannery and James (1984b), using a model similar to eq. (2) find a significant
relation between bank stock returns and R, and given the similarity between
the portfolio composition of banks and S&Ls (i.e., both consist primarily of
financial contracts), commercial banks provide an appropriate control group.
Life insurance companies were selected because of their specialization in
mortgage lending and their portfolio of other relatively long-term assets.33
Finding a significant reduction in /I, for commercial banks and insurance
companies in the period 1980 through 1982 would suggest that the decline in
p, for S&Ls is not the result of changes in insurance administration.34
Table 5 presents estimates of eq. (3) for a portfolio of commercial bank
stocks and life insurance companies. 35 Unlike the results for S&Ls, the
interactive dummy for both banks and insurance companies is not significantly
different from zero at the 0.10 level. Moreover, an analysis of the behavior of
the market model parameters for these firms indicates no significant change in
&, during the period 1980 to 1983.

6.4. Other factors

Another factor that may affect our elasticity estimates is a change in the
behavior of our mortgage index. Since our index is constructed from newly
issued GNMA eight percent certificates, changes in the level of interest rates
may affect the price volatility of the GNMA series. In particular, because
prepayments on mortgages in GNMA pools may decrease as interest rates rise
the duration of the GNMA index may increase as interest rates rise. If similar
changes in prepayments for mortgages held by the S&Ls in our sample did not
occur, this may reduce the estimate of PI. To insure that our findings are not
the result of a change in the behavior of the returns on GNMA certificates, we
reestimated eq. (3) using a series constructed from six-month Treasury bill
returns. Treasury bill returns were used because Treasury bills have a known
and constant duration. To insure that the Treasury bill return series reflected
unanticipated interest rate changes, the series was whitened using an AR(3)
process. Eq. (3) was estimated using as an interest rate series the residuals of
the AR(3) model. The interactive dummy variable is again negative and
significantly different from zero at the 0.01 level (the t-statistic is - 2.79).

331n 1983 life insurance companies held an average of 50 percent of their assets in corporate
bonds and 30 percent of their assets in mortgages, Source: Board of Governors of the Federal
Reserve System, Flow of Fun& Account, 1983.
No changes in capital requirements for insured commercial banks occurred during the
1976-1982 period. Commercial banks and S&Ls benefited from the introduction of All Saver
Certificates in 1981 and personal interest tax exemptions in 1980. If these events are significant
factors in the decrease in S&L stock elasticity, a similar change should be observed for commercial
banks.
35Equally weighted portfolios of bank and life insurance stocks were obtained from DRI.
 J.A. Brickley and C.M. James, Deposit rnsurance und S&L stock returns 365

6.5. Other subsidies

While our focus has been on the effect of changes in insolvency rules on the
value of access to deposit insurance, these changes may also affect the value of
other subsidies provided thrifts during crisis periods. Two potentially im-
portant sources of subsidies during the 1980 through 1982 period were FHLB
advances and tax refunds associated with tax loss carry-back provisions of the
corporate tax code. By modifying insolvency rules, the FSLIC provided S&Ls
continued access to these subsidies.36
The FHLB advance program permits S&Ls with qualifying collateral to
borrow up to 25 percent of their assets at rates determined by each FHLBs
cost of funds. Since FHLB borrowing carries an implied guarantee of the
federal government, advances represent a source of federally subsidized bor-
rowing for S&LS.~
The S&Ls in our sample increased their borrowing under advances from 8
percent of their liabilities during the 1976-1979 period to 14.2 percent of their
liabilities during the 1980-1982 period. The increased use of advances is
therefore a potential explanation for the decline in PI. Because the effect of
access to advances should be similar to the effect of access to deposit
guarantees on the elasticity of S&L stocks, the subsidy hypothesis predicts a
negative cross-sectional relation between changes in PI and advances during
the 1976 through 1982 period.
To test this implication of the subsidy hypothesis, we obtained data of
advances for the 20 S&Ls in our sample that traded over the entire seven-year
period. We then examined the relation between filj and the ratio of advances
to market value of common stock outstanding. The results of this analysis are
presented below (standard errors are in parentheses):

&,,= 1.30 - 0.18 (ADV/MV),,, R2 = 0.12.

(0.08)

shChanges in insolvency rules not only permitted S&Ls to continue to utilize these subsidies,
but also permitted expanded access. In particular, by permitting S&Ls to realize losses from the
sale of mortgages for tax purposes while deferring the loss for purposes of determining regulatory
net worth, S&Ls were provided greater access to tax loss carry-backs. Kane (1981) argues that net
worth requirements limited the use of carry backs during 1979 and 1980.
Advance policy is outlined in the Federal Home Loan Bank Boards Office of District Banks
Advance Guidelines. Advances are collateralized primarily by residential mortgages at market value.
District Banks require S&Ls to specify the use for which the advance will be used and to
demonstrate sound management. In the event of failure, the District Bank has first claim on the
collateralized assets. During the 1976 through 1981 period S&Ls increased their use of advances
primarily to obtain liquidity due to disintermediation caused by deposit rate ceilings on longer-term
deposits [see Kent (1981)].
366 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns

where
a [Jr
= the estimated coefficient associated with R, for the jth S&L
in period t, and
(ADV/MV)J,
= ratio of FHLB advances to total market value of equity for
the jth S&L in period t.
Consistent with the subsidy hypothesis we find a negative and significant
relation between p, and advance activity.38
In estimating S&L stock price elasticities, we use the changes in the market
value of GNMA certificates as a proxy for changes in the market value of S&L
portfolios. Increased use of tax loss carry-backs in the 1980-1982 period may
alter the relation between before-tax earnings (proxied by R,)and S&L stock
returns. In this way use of tax loss carry-backs may contribute to the decrease
in p, during the 1980-1982 period.
Evaluating the importance of tax refunds in explaining the decrease in PI is
complicated by the fact that S&L tax payments are related to earnings.
Earnings, in turn, are negatively correlated with the value of access to deposit
guarantees. Disentangling the influence of tax subsidies from access to deposit
insurance is therefore extremely difficult. Finding a positive relation between
p, and tax payments is consistent with changes in the value of access to
deposit insurance as well as increased access to tax refunds.39
For the S&Ls in our sample tax payments as a percent of total assets
decreased from 0.5 percent during the 1976 through 1979 period to -0.16
percent during the 1980 through 1982 peeod. This change in tax payments is a
potential explanation for the decline in p1.4o

7. Summary

Consistent with the subsidy hypothesis we find a significant decrease in the

co-movement of S&L stock returns with the returns of S&L portfolio holdings
following the reduction of net worth requirements in 1980. Moreover, we find

sSeveral caveats concerning the interpretation of these results are required. First, to the extent
that advances are used simply to substitute for deposits, an increase in advances should cereris
par&s not affect /3,,. New financing with advances does imply an increase in subsidies, Second,
because the FHLBs claim to S&L assets is senior to that of the FSLIC, increases in advances
increase the risk of the FSLICs position and thereby increases insurance subsidies. Discussions
with the Seattle FHLB indicate that advances were used by financially distressed thrifts to replace
outflows of large certificates of deposit (see also The Wall Street Journal, Aug. 30, 1982, p. 3).
However, in these circumstances, the District Bank required the FSLIC to guarantee the advances.
39Failure to find a significant relation between tax payments and /3,, would suggest that
reported net income for tax purposes serves as a poor proxy for changes in the market value of
S&L portfolio holdings. We find a positive and statistically significant relation between p, and tax
payments (refunds).
The ability to utilize tax loss carry-back was in part the result of changes in insolvency rules
[see Kane (1981)]. Tax refunds were not, however, sufficient to offset operating losses for S&Ls
(see table 1). If the entire drop in j3, were the result 9f expanded access to tax refunds, one would
not expect to observe the negative relation between /?,, and leverage.
 J.A. Brickley and C.M. James. Deposit insurance and S& L stock returns 367

cross-sectionally, a negative relation between leverage and the sensitivity of

S&L stock returns to changes in the value of the firms assets. This finding is
inconsistent with the enforcement of me first priority rules.
An important implication of our analysis is that inferences regarding the risk
of insured financial institutions, based on the behavior of their stock returns,
should be made with caution. 41 In particular, since their stock returns reflect
investor expectations concerning the reaction of the insuring agent to changes
in risk (in terms of insurance availability), changes in the value of their
portfolio holdings need not be reflected fully in changes in the equity value of
the institution.
Finally, our analysis provides further evidence concerning the behavior of
the stocks of firms in financial distress. Consistent with the findings of
Aharony, Jones and Swary (1980) and Baldwin and Mason (1983) we find a
decrease in the beta estimates of financially distressed firms. However, because
of the relative simplicity of S&L balance sheets we are able to trace this
decrease in beta to a decrease in the elasticity of S&L stock prices with respect
to the value of underlying assets. In this way our analysis contributes to the
understanding of the stock price behavior of firms in financial distress.

Appendix 1

Table A.1 contains a listing of the 30 S&Ls in our sample. For each
observation: (1) the years included in the sample, (2) the asset size (from
Moodys, 1982), (3) the stock exchange, and (4) the state where the lead S&L
is located are listed. The table also includes the elasticities of the stock prices
with respect to the underlying assets estimated over the periods: 1976-1979
and 1980-1982. The technique for estimating elasticities is described in sec-
tion 3.
The table indicates that the sample includes large S&Ls, based pre-
dominately in California. The median asset size for the sample is approxi-
mately $1.7 billion, ranging from a low of $248 million to a high of $13 billion.
The median asset size of all insured S&Ls in 1982 was $50 million. Seventeen
of the S&Ls operated in California. Twenty were listed on national exchanges
(fifteen NYSE and five ASE). The remaining ten S&Ls traded over-the-coun-
ter.
The elasticity estimates contained in the last two columns document the shift
in elasticities between the 1976-1979 and 1980-1982 periods. In all cases
where sufficient data existed to provide estimates in both subperiods, the
elasticities were lower in the later period.

4For example Marcus and Shaked (1984) utilize estimates of the variance of equity returns in
the Black-Schol& put option pricing formula to obtain an estimate of the market value of FDIC
insurance. However, our analysis suggests the variance of equity returns may provide a downward
biased estimate of the variance of asset returns, resulting in an underestimate of the value of
insurance.
 Table A.1
Sample of 30 savings and loans used in the study:Years included in sample, asset size, stock exchange, state of lead S&L, and
elasticity estimates for 1976-1979 and 1980-1982 periods.

Elasticitv
1976 1980
Years in Asset size Stock to to
sample (ooos) exchange Stat@ 1979 1982

Ahmanson, H.F. (AHM) 1976-83 13JO9.603 NYSE CA 2.00 1.02

Alamo Savings Association (ALMO) 1979-83 313,781 NASDAQ TX - 0.58
American Savings and Loan (AAA) 1976-83 2.225.894 NYSE FL 1.79 0.71
Beverly Hills Savings and Loan (BHSL) 1980-83 490,560 NASDAQ CA - 062
Biscayne Federal Savings and Loao (BIS) 1976-83 1,784,267 NYSE FL 1.20 0.68
Downey Savings and Loan (DSL) 1976-83 1.388,128 ASE CA 1.81 1.08
Equitable Savings and Loan (EQIB) 1976-82 1,519,018 NASDAQ OR 2.23 0.38
Far West Financial Corporation (FWF) 1976-83 908,381 NYSE CA 1.12 0.50
Fidelity Financial Corporation (FDY) 1976-82 2.852,623 NYSE CA 2.75 0.31
Financial Corporation of America (FIN) 1976-83 3,757.352 NYSE CA 1.18 0.74
Financial Corporation of Santa Barbara (FSB) 1980-83 1.898.018 NYSE CA - 0.84
Financial Federation (FFI) 1976-83 2,455.617 NYSE CA 1.51 064
First Charter Financial Corporation (FCF) 1976-83 9,750,034 NYSE CA 1 94 0.95
First Federal Savings and Loan Raleigh (FFSR) 1980-83 248.137 NASDAQ NC 0.20
First Savings and Loan Shares (FSX) 1976-82 1.310.636 ASE co 1.35 0 28
First Western Financial Corporation (FWES) 1978-83 703,401 NASDAQ NV 1.27 0.53
Frontier Savings and Loan Association (FRNT) 1979-83 N.L. NASDAQ NV 0.67
Gibralter Financial Corporation (GFC) 1976-83 4.771.371 NYSE CA 2.23 1.02
Golden West Financial Corporation (GDW) 1976-83 5.541.347 NYSE CA 2.10 0.90
Guarantee Financial Corporation (GFCC) 1978-83 1,693,073 NASDAQ CA 1.13 0.94
Homestead Financial Corporation (HOMF) 1978-83 513,161 N ASDAQ CA 0 76 0.34
Imperial Corporation of America (ICA) 1976-83 5,169,203 NYSE CA 2.17 0.98
Land of Lincoln Savings and Loan 1980-83 586,889 NASDAQ IL - 0.24
Mercury Savings and Loan (MSL) 1976-83 1,122,741 ASE CA 1.2x 0.86
Nevada Savings and Loan Association (NEV) 1976-83 654,014 NYSE NV 1.93 0.69
North Carolina Federal Savings and Loan (NCES) 1980-83 367.580 NASDAQ NC _ 0.26
Northern California Savings and Loan (NCX) 1976-82 1.912,394 NYSE CA 1.81 0.93
Transohio Financial Corporation (TFC) 1976-83 5.169,203 NYSE OH 0.83 0.68
Wesco Financial Corporation (WSC) 1976-83 361,525 ASE CA 1 .Ol 0.16
Western Financial Corporation (WFN) 1976-82 1.904.272 ASE AZ 1.04 0.84

As shown in Moo& s, 1982.

%tate where the lead S&L is located
Estimated by regressing weekly S&L stock returns on an index of GNMA securities.
 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns 369

Table A.2
Definition of variables.

I. Assets

(4 Cash and short-term investments: Cash includes vault cash, demand deposits at commercial
banks, deposits at a Federal Home Loan bank or at Federal Reserve banks which are
unpledged. Short-term investments represent the book value of unpledged investments
which are defined as liquid assets for regulatory purposes (Regulation 523.108). Included
are certificates of deposit, repurchase agreements, US government obligations, and other
debt obligations with a maturity of less than one year.

(W Vuriahle rute mortguges: Any mortgage on a one-to-four-family dwelling with non-graduated

payments with a contracted interest which may be adjusted over the life of the mortgage.
All variable rate mortgages regardless of restriction on interest or payment adjustments are
included in this category.

CC) Open-end consumer loans: Credit extended in connection with credit cards, overdrafts on
NOW and demand deposit accounts, other open end credit extended.

(D) Unsecured construction loans: All unsecured loans made for the purpose of constructing new
residential property.

03 Accrued interest recetuable: Accrued interest receivable on all loans where interest is
maintained in separate accounts plus interest receivable on investments.

F) Loans on .suvings uccounts: Loans fully secured by the pledge or assignment of the
borrowers savings accounts.

(G) Advances on customer borrowing: Payments due for taxes and insurance payments made on
loan security properties.

II. Liubihties

(4 FHLBB advances due in less than one yew: All advances maturing within one year.

(B) Commercial paper: Commercial paper issued by the S&L.

(0 Other borrowmg due in less than one year: Borrowing from all sources other than the FHL
bank due in less than one year.

0% Overdrafts on demand deposit accounts: Negattve demand deposit balances and cashiers
checks outstanding.
03 Other uccounts payable: Amounts owed and accrued for services supplies and other
expenses including advance payments for borrowers taxes and insurance.
03 CDs greuter than $100,000: Certificates of deposits earning excess of the passbook rate
issued in denominations of 100,000 or more.

(G) Repurchase agreements and accounts pa.ving more than passbook rate maturing in less than one
year: Repurchase agreements plus accounts with maturities less than one year with
minimum deposits of less than $100,000 and earning in excess of the passbook rate.
370 J.A. Brickley and C. M. James, Deposit insurance and S&L stock returns

Appendix 2

Methodology used to construct a measure of net current claims (Short)

The definition of Short used is: (cash and short-term investments + variable
rate mortgages + open end consumer loans + accrued interest receivable +
advances for customer borrowing + unsecured construction loans + loans on
savings accounts) - (FHLBB advances due in less than one year + commercial
paper + overdrafts on demand deposit accounts + CDs greater than $100,000
+ bank loans due in less than one year + other borrowing due in less than one
year + other accounts payable + repurchase agreements and accounts paying
more than the passbook rate maturing in less than one year). A detailed
description of each of these items is provided in table A.2.
Excluded from Short are deposits under $100,000 paying the passbook rate
or less. While these deposits can be withdrawn on short notices and might
therefore be considered short-term, there exists considerable evidence that
these deposit stocks adjust slowly to interest rate changes, giving them longer
effective maturities [see Flannery and James (1984b) and Hester and Pierce
(1975)]. Including these items in the Short measure does not significantly affect
the results reported in this paper.
Included in Short are all variable rate mortgages. Most variable rate
mortgages issued by S&Ls contain no limits on interest rate adjustment or
monthly payment adjustment [see FHLBB Journal, December 1982). Exclud-
ing mortgages with caps from our Short measure does not affect our basic
results.

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