Question

Describe and explain the behavior of thrifts, both insolvent and solvent, in the early 1980’s. Use the model of firm equity as a call option in your analysis.

Answer 1

The Behavior of Thrifts classified by Market Value Solvency:

It is likely that financial institutions take actions with consequences that occur over a period longer than a year. Consequently, we first examine the investments and changes in net worth of thrifts classified according to their economic (market-value) net worth at the end of 1984 over the years through 1988. The observations are divided into two groups: thrifts that operated throughout the period and those that ceased operations as a result of failure. Those that ceased being independent institutions because of voluntary mergers are not included in this group and are not analyzed at this point. This separation was made so that the changes over time would not be subjected to sample-composition bias, at least for those thrifts that continued operating.

The Behavior of Thrifts that Were Market-Value Insolvent:

The delinquency rate on non mortgages is significantly higher and escalates quickly for the very insolvent thrifts after 1985, particularly as compared to the strongest thrifts. These data are consistent with the hypothesis and perhaps with the "asset-deregulation" hypothesis, although with commercial mortgages included in the mortgage delinquency rate, the hypothesis cannot really be tested with these data. Furthermore, as noted above, nonmortgage (commercial and consumer) loans are relatively small percentages of total assets at most thrifts, although relatively high delinquencies on small amounts of loans could be sufficient to drive weakly capitalized thrifts into insolvency.