An empirical analysis of federal budget deficits and interest rates directly affecting savings and loans.

• Author: Cebula, Richard J.

1. Introductory Remarks

   The crisis in the Savings and Loan (S&L) industry in recent years has reached dimensions unmatched since the Depression years prior to 1934. In the period from 1934 through 1989, there were some 14 years when not a single federally insured S&L failed; furthermore, over the same period, there were some eight years when only one federally insured S&L failed. By contrast, during the 1980s alone, some 525 federally insured S&Ls failed.

   Studies such as Carron [5] and Barth [1] argue that the rise in the S&L failure rate can to some significant degree be traced to interest rates (especially the cost of funds to S&Ls), which, particularly in the late 1970s and early 1980s, rose to unexpectedly high levels. The basic purpose of this study is to ascertain whether the federal budget deficit played a role in this escalation of interest rates for the S&Ls and thereby may have affected the health of the S&L industry. Although there is a rich literature on the interest-rate impact of federal budget deficits [3; 4; 6; 7; 10; I 1; 13; 15; 16; 17; 18], none of the published research has investigated the impact of the budget deficit on interest rate measures directly faced by S&Ls, such as the cost of funds to the S&Ls, the yield on new home mortgages at S&Ls, or the S&L mortgage portfolio yield. Accordingly, this study investigates empirically the impact of federal budget deficits upon these interest rate measures that directly affect S&Ls.

2. Model

   The model adopted in this paper parallels the loanable funds model found in the well-known study by Hoelscher [11, which contains a number of components found in many other loanable funds analyses [3; 4; 7: 10; 17]. The basic Hoelscher model is given by:

   R = R (EP, ERSR, RDEF, Y) (1) where:

   R = the nominal rate of interest;

   EP = expected future inflation;

   ERSR = the ex ante real interest rate yield on U.S. Treasury bills;

   RDEF= the real federal budget deficit (N.I.P.A.);

   Y = the change in per capita real GNP.

   Based upon Hoeischer [10; 11], as well as the standard loanable funds model, it is argued that R is an increasing function of both expected inflation and the real budget deficit. Based upon various arguments in Hoelscher [11], it is also expected that R is an increasing function of ERSR, whereas the impact of Y on R is a priori unknown.

   The analysis in this paper focuses upon the cost of funds to S&Ls on the one hand (COST) and the yield on new home mortgages at S&Ls (NEW) or the S&L mortgage portfolio yield (MORT) on the other hand. Predicated upon equation (1) above, the quasi-reduced-form equations to be estimated are given by:

   [COST.sub.t] = [a.sub.0] + [a.sub.1.EP.t] + [a.sub.2.ERSR.sub.t] + [a.sub.3.RDEF.sub.t] + [a.sub.4.Y.sub.t] + [a.sub.5.sub.TR] + [u.sub.1] (2)

   [NEW.sub.t] = [b.sub.0] + [b.sub.1.EP.sub.t] + [b.sub.2.ERSR.sub.t] + [b.sub.3.RDEF.sub.t] + [b.sub.4.Y.sub.t] + [b.sub.5.TR] + [u.sub.2] (3)

   [MORT.sub.t] = [c.sub.0] + [c.sub.1.EP.sub.t] + [c.sub.2.ERSR.sub.t] + [c.sub.3.RDEF.sub.t] + [c.sub.4.Y.sub.t] + [c.sub.5.TR ]+ [u.sub.3] (4)

   where:

   [COST.sub.t] = the average nominal cost of funds to S&Ls in year t, expressed as a percent per annum;

   [NEW.sub.t] = the average nominal yield on new home mortgages at S&Ls in year t, expressed as a percent per annum;

   [MORT.sub.t]= the average nominal S&L mortgage portfolio yield in year t, expressed as a percent per annum;

   [a.sub.0, b.sub.0, c.sub.0] = constants

   [EP.sub.t] = the expected rate of inflation of the CPI in year t, expressed as a percent per annum;

   [ERSR.sub.t] = the ex ante real interest rate yield in year t on three-month U.S. Treasury bills, expressed as a percent per annum;

   [RDEF.sub.t] = the U.S. federal budget deficit N.I.P.A.) in year t, expressed in billions of 1982 dollars;

   [Y.sub.t] = the change in year t in the level of per capita real GNP, expressed in 1982 dollars;

   [TR] = a simple trend variable;

   [u.sub.1, u.sub.2, u.sub.3] = stochastic error terms.

   The variables [COST.sub.t] and [MORT.sub.t], were obtained from the Office of Thrift Supervision's publication the 1989 Savings & Home Financing Source Book [14], whereas the variable [NEWT.sub.t] was obtained from The Economic Report of the President, 1991 [8]. The inflationary expectations variable is the Livingston survey data and was obtained from the Federal Reserve Bank of Philadelphia. The variable ERSR, was computed by subtracting the expected inflation rate in year t from the average nominal yield on three-month U.S. Treasury bills in year t. The three-month Treasury bill rate was obtained from The Economic Report of the President, 1991, as were the budget deficit data and the GNP deflator used to convert the budget deficit data into 1982 dollars. Finally, the data used to compute the variable [Y.sub.t] were also obtained from The Ecollomic Report of the President, 1991. The model to be estimated is annual since some of the data are available only in...