An Analysis of the Cost of Paying for Thrift Deposits Insured by the Government

The cost to the federal regulators of resolving the problems in the savings institution industry has been the focus of much debate for many years, both in the academic literature (Kane, 1987) and in the popular press (Ely, 1986). The most recent evidence indicates that the total cost will be several hundred billion dollars (e.g., Barth, 1991, and Congressional Budget Office, 1992). Many past estimates (both private and government) were frequently too low, although a few Wall Street firms were close when they estimated a $100 billion problem as early as 198B (Day, 1988). The cause of the typical underestimation of the problem was that too great a reliance was placed on asset book values and too little attention was paid to the underlying earning power of thrift institutions. This note provides a potential solution to that problem by valuing thrift assets based on the reported income from those assets.The thrift problem stems from the guarantees that government agencies have issued on all savings institution deposits under $100,000 in amount. For solvent thrifts, the risk to the government insurer is small, but there often exist numerous thrifts that are suffering a steady stream of losses. The latter institution may not be able to pay off the insured deposits without government assistance and can be classified as economically insolvent.Many of these economically insolvent institutions are already insolvent by various accounting measures, including Generally Accepted Accounting Principles (GAAP) and GAAP adjusted for Intangibles (Tangible GAAP). GAAP is the accounting procedure generally used for financial reporting, and GAAP adjusted for Intangibles is GAAP accounting with the value of Intangibles written down to zero. Each of these accounting procedures yields a figure for the net worth of savings institutions, which would be negative for insolvent institutions. A negative book value would represent an estimate of the cost to the government to clean up insolvent institutions if the assets could be liquidated at book value to pay off the liabilities at book value.I. A PROCEDURE FOR ESTIMATING THE COST OF INSURING DEPOSITSAn assumption that the assets in the insolvent institutions could be liquidated at accounting book value is questionable. A superior measure of asset values and of insolvency would take into consideration the cash flow value of the assets. In particular, future cash flows from thrifts' assets can be estimated by:A. using the most recent quarter's reported net operating income as the basis for future projections;B. adjusting net operating income for non-recurring, non-cash revenue and expenses such as amortization of intangibles and future gains or losses;C. assuming that all assets reprice at 1% above the forward Treasury rates upon principal payment and that all liabilities reprice at the forward Treasury rates;(1)D. assuming that all gains or losses on service corporation investments (defined as investments that are not part of the thrifts' normal mortgage lending operations, as separately listed in thrift financial statements) that exceed the absolute value of 1% over the long-term Treasury rate are non-recurring (see footnote 1);E. assuming that payments on home fixed-rate mortgage principal are a function of the time to maturity and the spread between market fixed-rate mortgage rates and the coupon rates on the mortgages (Murphy, 1991);F. assuming that loan losses will equal 5% of loan delinquencies (Murphy, 1992);G. assuming a 30% tax rate (which equals the approximate 34% corporate tax rate, less special industry tax breaks);H. assuming liquidation of the assets in 25 years at a value equal to the capitalized cash flow projected in year 25;I. assuming that unrealized appreciation on direct real estate investments occurs at a 4o annual rate;J. adding in the cost of the liabilities, which are assumed to yield a return equal to the long-term Treasury rate. …