Moral Hazard: Asset Substitution and Transfer of Value Between Securityholders after FIRREA

Abstract

I show that thrifts engaged in sizable substitution from relatively uncorrelated asset returns to relatively highly correlated assets after the passage of the Financial institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”). I also show that the book value of liabilities (principally deposits) exceeded the economic value of assets - that is, thrifts were “under water.” On average, thrifts had 95 cents worth of assets for each dollar of deposits and other liabilities. Because of their precarious financial position (that is, being so far out-of-the-money), thrifts did not redirect a substantial amount of wealth from the government insurer to equity holders after the enactment of FIRREA in spite of the asset substitution that occurred.

One can see a strong indication in the data for morally hazardous conduct by thrifts - that is, asset substitution into higher variance investments. But either the economic circumstances (being sufficiently out-of-the-money) or regulatory scrutiny (preventing even more asset substitution) resulted in minimal losses (in expectation) to the government insurer.

Keywords: Moral Hazard, Asset Substitution, FIRREA, Intangible Capital, Supervisory Goodwill, Asset Volatility

JEL Classification: d21, d61, d62, e44, e53, e59, g14, g21, g28, g38, k20, k23, l50, l51, m49