S. Craig Pirrong

Resolution of Insolvent Thrifts: Fundamental Issues

Once insolvent thrifts are under its control, FSLIC must provide financial assistance to induce others to assume deposit liabilities. But how should FSLIC use its primary resolution alternatives -- assisted acquisition and liquidation -- to minimize the cost of meeting its obligations to depositors? Should FSLIC liquidate all insolvent thrifts? If only some, which ones? In this section we discuss principles that should guide the resolution process and thereby establish a basis for our substantive analysis in Chapters 4 through 6 that follow.

The Economic Function of Futures Trading

To evaluate properly the function of the delivery process, and therefore how changes in delivery specification influence the larger economy, it is necessary to understand the economic role of futures markets. We discuss that role in this chapter, paying special attention to the factors that differentiate futures markets from other forward markets.

The Economic Effect of Potential Grain Futures Contract Redesign

The preceding chapter noted that an expansion of the deliverable set can reduce the profitability—and hence the likelihood—of a long manipulation. An increase in the number of deliverable locations would also increase available delivery capacity, which would reduce the likelihood of pricing anomalies due to the exhaustion of regular space or quality problems. Those are beneficial objectives, but such an expansion will have other effects as well. An increase in the number of deliverable grades or delivery locations will, for example, change the basis risks faced by the hedgers of various grades in various locations. As noted in Chapter 2, the costs and benefits of any such change depend upon the geographic distribution of hedgers.

The Role of the Futures Delivery Process

The delivery terms of futures contracts specify the types and grades of deliverable goods, and denote the places and times of delivery that must be met to avoid default on an outstanding contract. It is exceedingly difficult to ascertain proper specifications for a futures contract. But if the contractual terms are improperly specified, too few buyers or too few sellers of the contract will appear in the market at any given price, and the contract will fail.

Maintaining the Integrity of Grain Futures Contracts: The Economics of Manipulation and Its Prevention

Since the birth of grain futures markets, considerable attention has been paid to the danger of manipulation of futures prices. During the early years of futures trading, attempts to exploit the delivery process in order to cause an artificial price change were alleged to be common.1 Even more recently there have been several allegations of attempted manipulation, but the allegations have become infrequent with the refinement of self-regulatory and governmental regulatory techniques.2

Futures Contracts as a Merchandising Tool: The Role of Delivery as a Means of Ownership Transfer

As noted above, many futures industry participants believe that grain futures contracts are not, and should not be, an important merchandising tool. There are three reasons for examining the evidence for that belief. First, the data upon which the belief is based are misleading. Second, an intention to take delivery is sometimes cited as a rationale by traders who are long, and who have carried unusually large positions into the delivery month. Consequently, the enforcement of rules against manipulation requires an understanding of the rationality of using the futures market for merchandising purposes.1 Third, theoretical work by Jeffrey Williams at Stanford’s Food Research Institute implies that futures markets are a means of borrowing and lending the commodities underlying the futures contracts. Williams argues that hedgers do not use futures contracts to avoid risk, but instead to obtain or dispose of supplies of the spot commodity. The delivery process plays a crucial role in his models. It is the means by which commodity loans implicitly created by combinations of futures and spot positions are repaid. In other words, according to Williams the delivery process is an important means of allocating the physical commodity among its high value users just as bank loans are an important means of allocating supplies of capital. Thus, his models imply that a substantial fraction of futures contracts should be offset by delivery.2 But that does not appear to happen in practice.

Empirical Evidence on FSLIC’s Cost of Solution

There has been considerable public controversy and speculation surrounding several aspects of FSLIC’s 1988 assisted acquisitions. In particular, people have questioned whether the “December deals” and “Texas deals” were as cost-effective as other deals, and whether deals involving large tax considerations added to the total cost of resolving cases through acquisition. Precisely because of all the controversy, it is important to begin the process of confronting the speculation with empirical evidence.

The Timeliness of Regulatory Action

In this Chapter we examine the sources of liability growth and analyze FSLIC’s efforts to control this growth. Much of this Chapter provides institutional detail about the process by which an insolvent institution is identified and brought under FSLIC control. It is important to point out that inasmuch as FSLIC’s exposure to deposit insurance claims reflects poor investment decisions made by thrifts in the past, the net worth deficit represents a problem that cannot be undone by FSLIC or the FHLBB. Hence, attention should be focused on the time required for FSLIC to assume control of insolvent thrifts and the rate of growth of FSLIC liabilities once an insolvent thrift is under FSLIC control.

FSLIC’s Acquisition Process

In the remainder of this report we describe and analyze FSLIC’s resolution methodology and the application of this methodology during the 1988 calendar year. In this Chapter we analyze the competitive bidding and negotiation process used by FSLIC. The methods used to evaluate the bids and to compare them with the option to liquidate are evaluated in Chapter 5. Empirical analysis of the results of the 1988 resolution process are then presented in Chapter 6.

Analysis of FSLIC’s Methodology for Evaluating Bids

As indicated in Chapter 3, the ideal approach for making the liquidation versus acquisition decision would be for FSLIC to measure directly thrift franchise value. If a positive franchise value exists, FSLIC would attempt to capture that value in sales to acquirers. If no franchise value exists, the thrift would be liquidated provided that the problem assets can be managed by a receivership without too great a loss in efficiency.