How Well Does the Modigiliani-Miller Invariance Proposition Apply to Savings and Loans and Thrifts? An Empirical Examination

An empirical analysis of a sample of publicly-traded thrifts demonstrates that there is little evidence that the supervisory goodwill “asset” conferred on thrifts by regulators in the late-1970s and 19080s possessed meaningful economic value in 1989 when, pursuant to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (“FIRREA”), Congress unilaterally curtailed (then eliminated) this “asset” from thrifts' balance sheets and compelled thrifts to meet higher capital requirements. Specifically, FIRREA mandated broad changes in the regulatory environment for thrifts, one of which related to the regulatory treatment of intangible capital: While thrifts were previously allowed to count intangible capital toward their capital requirements, the passage of FIRREA required thrifts to exclude certain intangible capital immediately and phase out the remainder on an accelerated basis. Because this regulatory change constrained the quantity of deposits a thrift could accept (holding tangible capital constant), it provides a natural mechanism to examine whether and to what extent the Modigliani-Miller invariance proposition (“MM”) applies to the thrift industry. This research is motivated by (1) the more than 120 suits filed by thrifts against the U.S. government claiming that the change in debt-to-equity ratios caused by FIRREAS's treatment of intangible capital reduced their profitability; (2) conflicts among plaintiffs and defendants over the value of leverage and the markedly different results emerging from the courts; and (3) disputes about whether, and under what conditions, MM applies to the regulated savings and loan industry. I find that the change in treatment of intangible capital, although it lowered thrifts' leverage, did not impose large costs on the thrifts in question. However, one cannot reject the hypothesis that the costs imposed by the regulatory change exceed the cost of replacing the intangible capital with fresh money from external capital markets under certain conditions - which is of course the upper bound implied by MM - but if there is a cost in excess of the replacement cost it is not particularly large