THE IMPACT OF REAL ESTATE LENDING ON THRIFTS' FRANCHISE VALUES DURING THE 2007–2009 CRISIS: A COMPARISON WITH COMMERCIAL BANKS

• DOI: http://doi.org/10.1111/jfir.12089
• Author: Valentina Salotti,Natalya A. Schenck,John H. Thornton
• Published date: 01 March 2016
• Date: 01 March 2016

THE IMPACT OF REAL ESTATE LENDING ON THRIFTS’FRANCHISE

VALUES DURING THE 2007–2009 CRISIS: A COMPARISON WITH

COMMERCIAL BANKS

Valentina Salotti

Iowa State University

Natalya A. Schenck

The Office of the Comptroller of the Currency

John H. Thornton Jr.

Kent State University

Abstract

The real estate bubble and 2007–2009 financial crisis revived the debate about the

viability of the thrift charter and its imposed limits on lending diversification. We

compare the impact of real estate exposure on franchise values of publicly traded thrifts

and size-matched banks during and after the crisis. Whereas thrifts are mostly exposed to

residential real estate, banks have a higher concentration in commercial real estate

(CRE), which is significantly associated with the decline in their franchise values. We

conclude that the constraints on loan portfolio diversification, such as the one on CRE,

are not detrimental to the thrift charter.

JEL Classification: G21, G28

I. Introduction

The 2007–2009 financial crisis was arguably the most volatile period for the U.S.

banking industry in many decades. Although the crisis affected both thrifts and banks,

some of the earliest and costliest failures of 2008 involved a few large thrifts supervised

by the Office of Thrift Supervision (OTS).

1

In the debate that arose during the crisis and

continued in its aftermath, some advocated for the repeal of the charter, considering the

required concentration in real estate and constraints on asset diversification unnecessary

and obsolete (Chatman 2013). Others favored its continuation, citing the importance of

thrifts for mortgage lending and the danger of leaving this segment exposed to the

The views herein are those of the authors and do not necessarily represent the views of the Office of the

Comptroller of the Currency or the Department of the Treasury. We thank the associate editor (Scott Frame) and the

anonymous referree for all their helpful comments and suggestions.

1

For example, Countrywide failed and was absorbed by the Bank of America in January 2008, IndyMac was

closed by regulators in July 2008, and Washington Mutual was closed in September 2008 and its banking

operations and loan portfolio were acquired by JPMorgan Chase. AIG housed its problematic credit default swap

business in a unit that was legally a thrift institution.

The Journal of Financial Research Vol. XXXIX, No. 1 Pages 35–62 Spring 2016

35

© 2016 The Southern Finance Association and the Southwestern Finance Association

RAWLS COLLEGE OF BUSINESS, TEXAS TECH UNIVERSITY

PUBLISHED FOR THE SOUTHERN AND SOUTHWESTERN

FINANCE ASSOCIATIONS BY WILEY-BLACKWELL PUBLISHING

competition of nonbank lenders.

2

Although the Obama Administration initially

supported the repeal of the thrift charter,

3

the Dodd–Frank Wall Street Reform and

Consumer Protection Act of 2010 (Dodd–Frank) kept it alive without altering its real

estate focus and statutory limits to commercial lending.

4

More recently, the discussion

has shifted toward allowing more flexibility for thrifts to operate in a bank-like regulatory

environment without undergoing a charter conversion.

5

As the current debate circles

around the necessity of maintaining or loosening the charter’s lending limits, the question

that we pose is whether such limits were especially detrimental to franchise values during

and after the crisis period.

6

Although the benefits of diversification are not unexplored

(e.g., Diamond 1984; Boyd and Prescott 1986), the literature has not yet considered how

imposing limits to lending diversification on certain intermediaries (thrifts) while

allowing others (commercial banks) to choose their optimal level of diversification,

might ultimately affect their market valuation, that is, their franchise values.

Comparing the franchise values of small and medium-sized publicly traded

thrifts with a matched sample of banks during the 2000–2011 period, we demonstrate that

the thrift charter continued to hold its value relative to that of banks, even during the

2007–2009 crisis. Although franchise values decline for both types of charters during the

crisis, banks suffer a steeper decline. And although thrifts have significantly lower

franchise values during the precrisis period, by the end of the acute phase of the financial

crisis (2009), the franchise values of the two charter types are essentially equal. The

total levels of real estate lending negatively affect banks’franchise values during the

2007–2009 financial crisis, but surprisingly there is no significant effect on thrifts.

7

To

2

See ABA Memo, July 14, 2009 (http://www.aba.com/Tools/BankType/Mutual/Documents/ThriftCharter

Memo.pdf).

3

In 2009, the Obama Administration proposed the complete repeal of the charter. See the “Financial

Regulatory Reform: A New Foundation”proposal by the U.S. Department of the Treasury in June 2009 (www.

treasury.gov/initiatives/Documents/FinalReport_web.pdf).

4

Dodd–Frank eliminated the OTS and moved the regulation of federally chartered thrift institutions to the

Office of the Comptroller of the Currency (OCC), state-chartered thrifts to the Federal Deposit Insurance

Corporation (FDIC), and savings and loan holding companies to the Federal Reserve Board (FRB). Although

the process of regulatory convergence between thrifts and commercial banks preceded the 2008 crisis, pursuant to

Dodd–Frank, most of the remaining advantages of the thrift charter were eliminated. See Appendix B for an

overview of the changes made to the thrift charter.

5

For example, see the testimony of Toney Bland, Senior Deputy Comptroller for Midsize and Community

Bank Supervision, OCC, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, February 10,

2015, in which he mentions a drafted legislation “that would give a federal savings association a choice: continue to

operate as a traditional thrift or file a notice to be treated as a ‘covered savings association.’. . . This option would

provide a federal savings association with the flexibility to retain its current corporate form and governance

structure without unnecessarily limiting the evolution of its business plan”(http://www.occ.gov/news-issuances/

congressional-testimony/2015/pub-test-2015-19-written.pdf).

6

Before proceeding, a note on terminology is needed. In the banking literature, a more common term for what

we denote as “franchise value”is “charter value”(e.g., Keeley 1990; De Nicolo 2001; Saunders and Wilson 2001;

Osborne and Lee 2001; Stolz2007; Frame andWhite 2007). Using the typical parlance of thebanking literature, we

study the effect of a depository institution’scharter (i.e., the right to operate that i s granted tothe institution by a regulatory

authority) on its charter value (i.e., the present value of future abnormal profits). To avoid confusion between the

institution’s charter and the institution’s charter value, henceforth we use the term “franchise value”exclusively.

7

We recognize that our analysis relies on publicly traded thrifts and is therefore representative of larger

institutions within the thrifts’industry. For this reason, our results do not necessarily extend to the thrifts’

population overall and in particular to smaller privately held thrifts.

36 The Journal of Financial Research