Journal of Financial Economics 18 (1987) 29-59. North-Holland CHANGES IN OWNERSHIF’ STRUCTURE Conversions of Mutual Savings and Loans to Stock Charter Ronald W. MASULIS* Southern Methodist University, Dallas, TX 75275. USA Received December 1984. final version received June 1986 This study analyzes both the causes and effects of mutual S&L conversions to corporate charter. Changes in technology and government policies have substantially increased S&L competition, riskbearing, and potential scale and scope economies. Evidence indicates that these changes have decreased the relative operating advantages of mutual S&Ls, encouraging conversions to stock charter. The S&L’s financial and operating characteristics, which affect the success of the conversion etTort, are also explored. 1. Introduction Rapid organizational change in an industry is rarely observed. Thus, the decision by a large number of mutual savings and loan associations (MS&Ls) to convert to stock charter offers a unique opportunity to further our under- standing of the economics of organizational choice. In this paper the economic causes and consequences of this major organizational change are explored. By studying the contractual relationships associated with both savings and loan association (S&L) organizational forms and the financial implications of the conversion decision for the S&L and its various claimants, a number of testable propositions are developed concerning the wealth gains and losses to contractual parties and sources of organizational efficiencies that are likely to result from the conversion decision. *I would like to thank Henry Cassidy, Harry DeAngelo, Espen Eckbo, Kenneth French, David Hirshleifer, Brett Trueman, Lee Wakeman, David Mayers (the referee), and the editor, &fichaeI C. Jensen, for valuable comments and discussions. I would like to also thank the FHLBB staff for their invaluable assistance. Earlier versions of the paper were presented at the Western Finance Association Meetings in Vancouver, Boston University, Federal Reserve Bank of Philadelphia, Harvard University, Southern Methodist University, University of California at Los Angeles. University of Connecticut, University of Indiana, University of Pennsylvania, University of Pittsburgh and University of Washington and I would like to acknowledge the useful comments made by participants. This research was done while at UCLA and was partially supported by the Research Center for Managerial Economics and Public Policy. Responsibility for any remaining errors is mine. 0304~405X/87/$3SOQ 1987, Elsevier Science Publishers B.V. (North-Holland) J.F.E.- B
Transcript
Journal of Financial Economics 18 (1987) 29-59. North-Holland
CHANGES IN OWNERSHIF’ STRUCTURE Conversions of Mutual Savings and Loans to Stock Charter
Ronald W. MASULIS*
Southern Methodist University, Dallas, TX 75275. USA
Received December 1984. final version received June 1986
This study analyzes both the causes and effects of mutual S&L conversions to corporate charter. Changes in technology and government policies have substantially increased S&L competition, riskbearing, and potential scale and scope economies. Evidence indicates that these changes have decreased the relative operating advantages of mutual S&Ls, encouraging conversions to stock charter. The S&L’s financial and operating characteristics, which affect the success of the conversion etTort, are also explored.
1. Introduction
Rapid organizational change in an industry is rarely observed. Thus, the decision by a large number of mutual savings and loan associations (MS&Ls) to convert to stock charter offers a unique opportunity to further our under- standing of the economics of organizational choice. In this paper the economic causes and consequences of this major organizational change are explored. By studying the contractual relationships associated with both savings and loan association (S&L) organizational forms and the financial implications of the conversion decision for the S&L and its various claimants, a number of testable propositions are developed concerning the wealth gains and losses to contractual parties and sources of organizational efficiencies that are likely to result from the conversion decision.
*I would like to thank Henry Cassidy, Harry DeAngelo, Espen Eckbo, Kenneth French, David Hirshleifer, Brett Trueman, Lee Wakeman, David Mayers (the referee), and the editor, &fichaeI C. Jensen, for valuable comments and discussions. I would like to also thank the FHLBB staff for their invaluable assistance. Earlier versions of the paper were presented at the Western Finance Association Meetings in Vancouver, Boston University, Federal Reserve Bank of Philadelphia, Harvard University, Southern Methodist University, University of California at Los Angeles. University of Connecticut, University of Indiana, University of Pennsylvania, University of Pittsburgh and University of Washington and I would like to acknowledge the useful comments made by participants. This research was done while at UCLA and was partially supported by the Research Center for Managerial Economics and Public Policy. Responsibility for any remaining errors is mine.
The major finding of this study is that, on average, all the major claimants in the MS&Ls choosing to convert to stock charter gain from this action.
Mayers and Smith (1986) draw the same conclusion in their analysis of the causes and effects of the opposite form of organizational change: the mutuali- zation of stock insurance companies. The evidence in both studies supports the agency theory prediction of Alchian (1950) and Jensen and Meckling (1976); namely, that organizational change occurs when economic efficiencies are to be gained.
The paper begins by describing the S&L industry and the mutual form of organization. The conversion process is outlined and the resulting major changes in financial contracts and their market values are summarized. Predic- tions are developed concerning the operating and financial characteristics of
MS&Ls most likely to attempt and complete the conversion process. The remaining sections of the paper discuss sample properties, present empirical
evidence and draw conclusions.
2. The savings and loan industry
S&Ls with assets over $750 billion at year-end 1983 have specialized in providing origination and servicing of long-term residential mortgages and short-term time deposits. In the last ten years, major changes have occurred in the competitive and regulatory environment within which S&Ls operate. The advent of electronic funds transfer (EFT) technology has opened up new services and offered greater economies of scale and scope than were previously available,’ thereby significantly increasing the competition for deposits among S & Ls, commercial banks and other non-bank companies by rendering ineffec- tive state and federal laws and regulations which previously restricted deposit competition. Recent regulatory changes such as the Depository Institution Deregulation and Monetary Control Act of 1980 and the Depository Institu- tions Act of 1982 allow S&Ls to offer services previously reserved for commercial banks, and have lifted interest rate ceilings on S&L liabilities. This has created significant growth opportunities for individual S&Z Ls while requiring substantial amounts of new investment.
Historically, MS& Ls have had a competitive advantage over stock-chartered commercial banks in terms of a lower federal tax burden. S&Ls were exempt from federal taxation until 1951, and thereafter enjoyed a substantial tax shield in the form of bad debt reserves. However, with the passage of the Tax Acts of 1969 and 1976, S&Ls have gradually lost their tax advantage and in recent years have been treated almost identically to commercial banks. Thus, S& Ls have lost an important competitive advantage over their stock-organized
‘See McNulty (1981) for some recent evidence on economies of scale in the S&L industry. For earlier estimates, see Benston (1970. 1972).
R. W. Madis, Muoul IO stock conversions 31
commercial bank competition. Not surprisingly, the after-tax profitability of the S&L industry declined noticeably with this added tax burden.
Interest rate changes have also had an effect on the S&L industry. Both the rise in interest rate volatility since the mid-1970s and the unexpectedly high level of interest rates in the late 1970s and early 1980s adversely affected the S&L industry, which invests in large amounts of fixed interest rate mortgages. The rise in volatility increased S&L earnings variability and the risk of insolvency, creating a demand for sophisticated hedging expertise. The unex- pected increases in interest rates caused large losses for a large majority of S&Ls, lowering their net worth and raising leverage ratios at a time when increased earnings variability was likely to be lowering S&L? preferred debt-equity ratios.2
3. Mutual savings and loan associations
Depositors are technically the legal owners of mutual S&Ls, but their actual ownership rights are severely limited. For example, depositors’ liquidation rights decrease proportionately with declines in deposit balances. Depositors’ claims to the association’s current earnings are non-transferable, and these earnings are generally retained indefinitely as net worth to finance expansion and to offer a cushion in economic downturns rather than being paid out to depositors as dividends or other distributions. Over the 1966-1982 period, cash and asset distributions to depositors were legally prohibited under FHLBB interest ceiling regulations.
MS&L depositors also lack significant voting rights. Generally, the board of directors control a MS&L through perpetual proxies signed by a majority of depositors. These proxies are revocable, but limited disclosure requirements, per capita voting rules limiting the maximum number of votes a depositor can control, restrictions on outside nominations to the board, and the board’s ability to redeem a member’s savings account (thereby eliminating his voting rights) any time sufficient funds are on hand, together virtually assure manage- ment of perpetual operating control.3 Thus, depositors hold virtually valueless ownership claims in a MS&L.
Unlike founding shareholders of stock S&Ls, mutual S&L organizers receive no legally recognized rights in their association. Federal Savings and Loan Insurance Corporation (FSLIC) regulations actually prohibit the S&L from reimbursing founders for bearing organizing expenses and requires these organizers to contribute significant amounts of risk capital to an association (a
‘For a more formal analysis of optimal capital structure decisions by S&Ls in the face of bankruptcy costs see DeAngelo and Masulis (1980), Orgler and Taggart (1983) and on the effects of earnings variability see Castanias (1983).
‘See Brigham and Pettit (1969), Kreider (1972) and especially Yancey (1975, pp. 642-644) for additional details. Also see Hetherington (1969) on mutual insurance companies.
MS&L’s initial equity capital) in the form of deposits receiving the passbook interest rate.4 However, organizers do determine the composition of the S&L’s initial board of directors, the permanence of which is virtually assured given the depositors’ weak voting rights. With no threat of takeover, the board is free to capture a portion of the S&L’s accumulated profits directly through high management salaries and fringe benefits and indirectly through (1) loans extended to friends, family and at?lliated businesses on a preferential basis and (2) S&L purchases at non-competitive prices of mortgage-related services such as appraisals and credit analysis from companies owned by friends or rela- tives. However, the portion of S&L profits captured by the board is limited currently by FSLIC regulation and prior to deposit insurance by state banking authoriti.es and closer depositor monitoring. Overall, this analysis indicates that the board of directors has economically significant, though legally unrec- ognized and illiquid ownership claims in a MS&L.
4. Decreasing organizational advantages of the mutual savings and loan
In earlier periods, MS&Ls experienced two potential agency cost ad- vantages over stock S&Ls, one with respect to the depositor-owner relation- ship and another with respect to the owner-manager relationship. Since MS&L owners (boards of directors) are only able to extract a portion of a S&L’s current and accumulated earnings, they have less incentive to take risks than the owners of stock companies who can capture the entire stream of
scumulated and expected future profits by selling their stock. Prior to deposit insurance, this meant a lower conflict of interest between risk-averse deposi- tors and owners of MS&Ls, and therefore, lower agency costs for the mutual relative to the stock MS&L. This argument is supported by significantly lower rates of insolvency for MS&Ls and mutual savings banks than stock-chartered commercial banks over the pre-deposit insurance era.5 However, with the institution of deposit insurance, this agency cost advantage was lost.
Most MS&Ls were founded as small community-based organizations de- signed to offer mortgages to community members. Given the relative simplic- ity of early MS & Ls’ operations, the coincidence of management and ownership (i.e., the board of directors) would appear from an agency cost standpoint to
4With respect to the risk capital that founders are required to invest, the GAO Report (1981) states: ‘Mutual applicants (requesting FSLIC deposit insurance) must pledge 20 percent of withdrawable savings or %250,000, whichever is less, with the appropriate Federal Home Loan Bank Board (District Bank) as a guarantee against operating deficits in excess of reserves.’ If the S&L fails within this five-year period, these pledged deposits can be used by FSLIC to coyer losses on insured deposits.
5 For some evidence on this issue, see Historical Statistics of the United Stmes: Colonial Times to f970, U.S. Bureau of the Census, 1975. For further development of the argument. see Mayers and Smith (1981, 1985) and more formally Rasmusen (1985).
R. W. Ma&is, Mutual to stock coa~erxmw 33
yield organizational efficiencies unrealizable by a stock association because of the conflicts of interest between the independent managers and owners. This also assumes that the MS&L does not suffer offsetting costs resulting from a loss of specialization in managerial skills and riskbearing which occur with independent managers and owners. However, in recent years the risk of S&L ownership has increased significantly, raising the costs of managers being owners, and MS&L operations have become more complex with increased size and investment in risky specialized assets, increasing the demands for managerial expertise and discretion as noted by Mayers and Smith (1981) and Fama and Jensen (1983). In fact, boards of directors of larger MS&Ls have increasingly chosen managers on the basis of expertise rather than their relationships to S&L owners, especially in growth markets where large invest- ment decisions must be made. Thus, this second agency cost advantage of mutual associations has diminished relative to the advantage of specialization of both management and riskbearing realized by widely held stock associa- tions.
The mutual form of organization exhibits a financial weakness which has worsened in recent years, the inability to sell common stock. This constraint implies that a MS&L’s current earnings or losses are the sole determinant of changes in its net worth. Thus, when operating losses are sustained, a S&L’s leverage is forced to rise unless it sells assets having market value to book value ratios greater than a* (defined as face value of deposits and secured debt to book value of total assets) with the proceeds applied to debt retire- ment. For a typical S&L, whose major assets are mortgages booked at face value but often earning below current market interest rates, this can be a serious constraint. For S&Ls in serious financial distress, the proportion of its mortgage portfolio where the ratio of book value to market value is above cx* can be quite small. 6 This above constraint has serious implications for a MS&L’s growth and viability, since the FSLIC attempts to limit its loss exposure by requiring S&Ls to have one dollar of net worth for every 33 dollars of deposits on its balance sheet. Thus, when a S&L’s leverage rises sufficiently high, a supervisory action by FSLIC can be triggered. In earlier periods when the S&L industry had stable earnings and limited capital requirements, this structural weakness of mutuals appeared to have little or no impact on their market values. More recently, with less stable industry earnings prospects, managements of MS& Ls nearing their minimum net
6There are some exceptions to the severity of this constraint: MS&Ls are allowed to sell off mortgages that are far below face value and amortize the losses over a long period of time. In some cases MS&Ls can obtain FSLIC income certificates which artificially increase net worth and total assets. Also, MS&Ls can in principle increase net worth by issuing uninsured subordinated debt or participating certificates (which are much like preferred stock). However, no mutual S&L’s has sold significant amounts of these instruments, presumably because of their high agency costs.
34 R. W. Mawh. Mutual IO stock conoers,otu
Table 1
Proportion of the S&L industry represented by stock associations in the 1950-1983 period.”
Year
All FSLIC-insured stock S&Ls
Percent of all Percent of FSLIC-insured total industry
‘Source: Federal Home Loan Bank Board, Savings and Home Financrng Source Book, 1980, Washington, DC, August 1981, tables 6 and 7, and Combined Financial Statements, FSLIC-Insured Savings and Loan Associations, 1983.
bData are for all S&L associations and MSBs insured by the Federal Savings and Loan Insurance Corporation (FSLIC).
worth requirements are motivated to convert to stock charter or to merge with a stronger association to avoid termination of their employment and residual claims due to a supervisory action. Conversion is beneficial because stock S&Ls can lower leverage by issuing additional stock or by making exchange offers of new equity for outstanding debt.
Given the changing S&L operating environment, how has the MS&L fared? In 1955, 90% of the S&L industry was comprised of mutual associa- tions. Since then, the S&L industry has undergone a significant structural transformation as seen in table 1: stock-chartered S& Ls have become an increasingly important factor. This trend accelerated with the lifting of the moratorium on mutual-to-stock conversions in 1976. New stock charters and the high growth rate of existing stock-chartered S&Ls are two additional reasons for this industry change. Between 1955 and year-end 1984, federally insured stock S&Ls grew from 10% to 30% of all S&Ls and increased their holdings of industry assets from 11% to 52%. This trend is likely to continue given the large number of conversion applications recently filed with the Federal Home Loan Bank Board (FHLBB).
A similar change in organizational form is also currently occurring in the mutual savings bank (MSB) industry. At the end of 1983, 122 MSBs were under FHLBB jurisdiction, 17 of which had applied to convert to stock charter and 8 of these having successfully completed the process. In 1984, there were 18 additional MSB applicants and another 12 successful MSB conversions.
R. W. .Masuks. Murd IO stock conc’rr~~ons 35
MSBs converting to stock charter under FHLBB regulations are included in the following empirical analysis.
5. The conversion process
Prior to 1950, most state and federal regulations prohibited both the chartering of stock S&Ls and the conversion of mutual associations to stock charter. However, over the subsequent 35 years most states have altered their statutes to permit newly chartered stock S&Ls. Following a twelve-year moratorium. the FHLBB began in 1976 to allow federally chartered mutual associations to convert in states which allow stock-chartered S&Ls; the Depository Institutions Act of 1982 extended this option to S& Ls in all states.
Under FHLBB regulations a conversion must involve a public sale of stock in a manner similar to a standby rights offering to depositors and management with an underwriting agreement signed only at the expiration of the subscrip- tion rights. Conversion leads to major changes in S&L voting rights, property rights and capital structure, yet no direct tax consequences for a S&L, its management or its securityholders occur. An outline of the conversion process f0110ws:’
Board (FHLBB) regulations required that the (conversion) plan be approved by two-thirds of the association’s board of directors. After informing its members, the association files a conversion application, including the plan, with the Board. If the Board approves.. . a special meeting is called to obtain the approval of association members to convert. If approved (by a two-thirds vote of depositors), a preliminary stock offering, approved by the Board, is offered to eligible subscribers. If not fully subscribed, all remaining stock must be sold to the public. [GAO Report (1977, pp. l-2)]
The regulations stipulate that a converting institution must sell all of its capital stock at market value, based on an independent valuation. The sale must be made by subscription through stock rights issued to eligible accountholders, with any unsubscribed stock sold through a public offer- ing that is either underwritten or is part of an FSLIC approved market program. [Lucarelli and Teague (1979, p. 6)]
The rights offering (termed a subscription offering) has two unusual features. First, non-transferable rights to purchase S&L stock are distributed to deposi- tors and management under a complicated priority system. Second, the offering price is unknown over the subscription period: only a price range of
‘These regulations were significantly modified in March 1983.
36 R. W. Man&. Mutual to stock con~emonr
15% around an independent appraiser’s estimate of the S&L’s net worth is specified.
The priority system required in the distribution of subscription rights is as follows:
- Eligible accountholders (anyone having a savings account at the eligibility record date, at least 90 days before the conversion plan is adopted by the converting association’s board of directors). The amount of stock offered to each account holder is based on his/her deposit at the eligible record date, but limited to five percent of the available stock.
- Supplemental eligible account holder (anyone who has qualifying deposits at a predetermined supplemental eligibility record date preceding Board approval of a conversion application).
- Other association members (any voting association member not included in the previous categories is entitled to purchase 200 shares to the extent that shares are available).
- Community offering (all remaining shares are offered to the community, but an individual may purchase no more than two percent of the stock offering). [GAO Report (1977, pp. 13-14)]
The FHLBB permits between 15 and 25 percent of total issue to be set aside in an optional category for sale to officers and directors after the rights of the first three categories are exercised. The percentage of the issue set aside is 25 percent for S&Ls under $50 million in assets, 15 percent for S&Ls over $500 million in assets, with a sliding scale in between [Goldberg and Marcotta (1982, p. 859)]. For further details on the conversion process, see Lucarelli and Teague (1979), Amott (1982), Goldberg and Marcotta (1982) and Dunham (1985). In sum? the conversion process results in changes in both the wealth and riskbearing of a S&L’s major claimants, who are its management, depositors and deposit insurer.
6. Conversion effects and associated predictions
The conversion process alters the market value of a S&L by (1) causing an equity capital inflow, (2) increasing the present value of the S&L’s cash flows from existing assets and current and future operations, (3) decreasing the market value of deposit insurance coverage, and (4) creating current and future conversion related expenses. The changes in a S&L’s existing assets and liabilities (AV + AP) as well as expenses (E) which typically result from a conversion will differ across S& Ls, yielding predictions as to which MS&Ls are more likely to convert.
R. W. Masulis, Murul to stock comersions 37
The most significant valuation effect of conversion is the increase in an association’s net worth due to the sale of equity. This equity capital inflow alleviates the problems associated with equity capital shortages and enhances a S&L’s potential growth by (i) raising the maximum level of liabilities allowed under FSLIC net worth requirements and (ii) increasing the capital available for investment in new services and new branches which typically involve short-term losses, thereby enabling a S&L to realize future economies of scale and scope. This cash inflow also lowers a S&L’s leverage which decreases its probability of insolvency. These benefits are likely to be most significant in very competitive markets where profitability is more uncertain and where the pressures for investment in new services and products are mtiie incense. in stable or shrinking markets, additional scale economies may be better ob- tained by mergers of MS&Ls.
With the separation of ownership and management which has occurred in many larger MS&Ls, the choice of managerial incentives contracts becomes important. Because managerial wage contracts are risky fixed liabilities, their market values fall as S&L assets become riskier. Thus, incentives are created for independent MS&L managers to choose less profitable but lower-risk investment projects over more profitable but riskier investments. By convert- ing to stock charter, the adverse effects of this risk aversion can be mitigated by management ownership of stock and stock options whose market values increase with the firm’s riskiness [an advantage of stock organizations noted by Jensen and Meckling (1976) and Smith and Watts (1986) and formally demonstrated by Green (1984)].
On the negative side, conversion results in a wealth gain to FSLIC by causing an immediate short-run decline in a S&L’s leverage (defined as market value of debt divided by market value of S&L assets).’ This decline lessens the deposit insurance risk of FSLIC but leaves unchanged the insurance premiums paid by a S&L, which are a fixed percent of total deposits per year. Since deposit insurance coverage is effectively a S&L asset, the value of a S&L’s residual claims decreases with the decline in leverage. The extent of this adverse effect is determined by the length of time that the leverage ratio remains at this lower level, which in turn is negatively related to the growth rate of S&L assets.
MS&Ls bear substantial expenses in effecting a conversion to stock charter. The mean ratio of expenses to gross proceeds from sales of S&L stock for a sample of large conversions was found to be twice as great as a sample of similar size stock rights offerings with standby underwriting agreements re-
8The valuation effects of this leverage change on the values of the deposit insurance and the uninsured debt can be estimated by applying Option Pricing Theory as shown in Merton (1977, 1978). This analysis can also be used to demonstrate a conflict of interest between FSLIC and S&L stockholders under fixed price ipsurance. For application of Option Pricing Theory to the valuation of a S&L’s major assets, its mortgages, see Smith (1980) and Masulis (1982).
38 R. W. Mm&. Mutual to srock conoersionr
ported in Smith (1977). Smith observed a significant fixed component to these costs. Conversion can also increase an association’s future operating costs since FHLBB regulations require a public sale of stock. This involves signifi- cant ongoing costs associated with meeting SEC disclosure and proxy regu- lations, exchange listing requirements and other shareholder servicing costs. Since these costs involve a significant fixed component, small associations can find these costs to be considerable, as suggested by the DeAngelo, DeAngelo and Rice (1982) study of firms going private. It follows that merger with a financially stronger MS&L is likely to be a preferred alternative for the small MS&L.
In summary, while the negative effects of conversion appear to be greatest for smaller MS&Ls with low leverage operating in low-growth markets, positive effects appear greatest for larger MS&Ls with high leverage operating in highly competitive growth markets. Converting S&Ls are also predicted to exhibit greater investment in specialized (e.g., non-financial) assets and higher growth rates in comparison to other MS&Ls in the same market.’
7. Financial conditions necessary for a successful sale of stock
While a MS&L’s pre-conversion net worth appears to be assigned to existing depositors at the time of conversion, in reality these claims are distributed on a pro rata basis to the S&L’s initial stockholders (i.e., mainly the S&L’s depositors and management). ‘Board (FHLBB) regulations require each converting association to establish a liquidation account equal to the converting association’s net worth as of the last practicable date prior to conversion. Upon any future liquidation of the association, the money remain- ing in this account would be distributed to the eligible account holders before any equity was distributed to the stockholders.’ [GAO Report (1979, p. 13)] Interestingly, these liquidation rights have little value since (1) no payments of dividends are made to depositors prior to liquidation, (2) they have a fixed nominal value which is realized only under a voluntary liquidation, which is likely only in the distant future, and (3) these rights are progressively lost whenever deposit balances are decreased below those outstanding at the record date, without redistribution of these rights to remaining depositors. This effectively transfers these liquidation rights to outstanding stockholders. More formally, properties one and two can be approximated by a single coupon bond with an infinite life, which was shown by Merton (1974) to have zero value under reasonable conditions.
The market value of a S&L’s pre-conversion net worth, W,, which is being distributed to initial stockholders, is equal to the present value of its future
‘Consistent with an increase in the benefits of stock over mutual structure, most recently chartered S&Ls have been stocks, though some new MS&Ls have been chartered in states allowing stock S&Ls over the 19761983 period.
R. W. Ma&is, Mutual to rrock cowersions 39
cash flows from assets and operations, V,, plus the market value of the deposit insurance subsidy (or tax), PO, minus the face value of deposits, D, (assuming all deposits are effectively insured and market interest rates are paid), W, = V, + PO - D,, 2 0. The S&L’s initial stockholders also obtain pro rata claims to the proceeds of the sale of stock since no founding shareholders exist to claim a portion of the net proceeds or the initial net worth as in a typical sale of unseasoned stock. Thus, the market value of a converting association’s stock, IV,, is equal to its pre-conversion net worth, W,, plus the gross proceeds of the stock offering, S, the conversion-related change in the market value of the S&L’s existing assets, AV, and the change in the market value of deposit insurance due to a conversion induced change in FSLIC risk bearing, A P, minus conversion related expenses, E; that is,
w, = W,+S+AV+AP-E. (1)
It follows that the initial secondary market stock price should differ from the offering price, S, by the pre-conversion net worth, W,, plus the conversion induced net change in the S&L’s total assets [i.e., the remaining three terms of the right side of(l)].
In order for rational investors and underwriters to buy a S&L’s stock at the conversion date, its purchase price (the gross proceeds, S) cannot exceed the stock’s post-conversion expected value or net worth defined in eq. (1) W, 2 S. Thus, for a successful offering investor rationality requires that the pre-conver- sion net worth adjusted for the conversion induced changes in S&L value (excluding proceeds of the equity sale) be non-negative:
W,+AV+AP-EzO. (2)
So unlike a conventional stock offering, in a conversion the stock’s offering price is relevant for an offering’s success only to the extent that it affects the last three terms of condition (2). Another implication of condition (2) is that no competitively determined offering price exists because an immediate gain is expected in terms of a higher secondary market price. However, this inde- terminancy problem is overcome by FHLBB appraisal guidelines which re- quire that the offering price be set in a prescribed manner.
For a S&L in serious financial distress, a dollar change in its tangible assets will be offset by a nearly equal and opposite change in the value to the S&L of FSLIC deposit insurance (given fixed insurance rates), so that a sale of stock which increases tangible assets causes little change in the market value of S&L equity or net worth. Under these circumstances a purchase of stock by investors is unprofitable. In general, violation of the investor rationality condition renders such an investment in stock unprofitable regardless of the
40 R. W. Madis, .Murual to stock comersions
stock’s offering price, causing a subsequent failure in the attempted conver- sion.”
Since S&Ls primarily hold long-term fixed interest debt instruments (i.e., conventional residential mortgages), the market value of the S&L’s assets, V,, falls when market interest rates rise. At the same time, the market value of insured liabilities, D,,, changes very little because they are short-term variable rate debt claims for the most part. It follows that unexpected interest rate changes are negatively related to the market value of S&L net worth. Thus, an unexpected rise in interest rates can cause conversion failures, while an unexpected fall in rates can encourage conversion applications by MS&Ls which until then had violated condition (2). In addition, S&Ls which experi- ence increases in their debt to net worth ratios due to losses are less likely to complete the conversion process because of poor cash flow prospects, causing a violation of condition (2). But S&Ls experiencing leverage increases due to deposit growth (and therefore asset growth) with the potential for additional scale economies, should have higher probability of successful conversion. Therefore, while persistent negative operating earnings should be closely associated with failure, persistent growth in liabilities should not.
8. Effects on board of directors/management wealth and riskbearing
The MS&L’s board of directors must initiate and approve any conversion proposal before it can be voted upon by depositors. Hence, this decision should improve board members’ expected utility by some combination of (1) increasing the expectation of their future income, (2) decreasing the riskiness of their future income, and (3) increasing their perquisite consumption. Nevertheless, the conversion process involves both positive and negative effects for board members and management.
On the positive side, conversion offers board members and management rights to purchase at a fixed price a transferable claim to a portion of the association’s pre-conversion net worth as well as the net gains derived from converting. As the market value of this pre-conversion net worth increases relative to the market value of the new equity being raised, the incentives to obtain a transferable equity claim by converting grow. Management frequently receives stock options and additional compensation in the form of stock-based bonus plans. One effect of these holdings of market-sensitive financial claims is improved managerial incentives. In contrast, FSLIC regulations effectively limit the level of direct compensation received by the board of directors and
“This problem can occur in any corporation with risky debt where the market value of debt outstanding assuming fuIl default insurance exceeds the market value of assets.
R. W. ,Musuhs. Murual to stock concers,om 41
management of a MS&L to a percentage of average yearly earnings.” To the extent that conversion increases the financial strength and profitability of the association, management benefits from more valuable stock and options and through lower risk of both insolvency and FSLIC directed supervisory mergers.
On the negative side, the conversion process induces the board and manage- ment to make additional equity investment in an association, and subjects their actions to closer scrutiny by government regulatory authorities and outside investors. Increased restrictions are likely to be placed on board member and management perquisite consumption and discretion over the credit allocation process and the selection of agents and services purchased from outside the S&L. Conversion also increases a director’s and manager’s threat of termination resulting from a hostile takeover bid or a proxy tighti* While the board and management may view these changes unfavorably, they are likely to increase the market val.ue of the S&L by subjecting its manage- ment to the discipline of the market for corporate control.
9. Sample and data sources
Conversion activity is studied over the ten years commencing with the FHLBB’s acceptance of conversion applications in 1973. Table 2 presents the number of conversion applications by year of filing. classified as completed conversions, conversions in process and inactive applications. The table indi- cates that at year-end 1983 there were 76 active applications and 118 inactive applications composed of 67 applications subsequently withdrawn, 31 ap- plicants acquired by other S&Ls prior to completing the conversion process, and 20 conversion attempts where the S&L failed to sell all of its stock. This sample also includes 22 mutual savings banks (MSBs) under FHLBB jurisdic- tion, of which 9 converted to stock charter and 13 applied to convert in 1983. Given the close similarity of MSBs to S&Ls, they are not distinguished from S&Ls in the remainder of this study. Table 3 gives a more detailed description of the 205 completed conversions. Conversions were most frequent in the 1981-1983 period with 1983 dominating in both number of conversions and dollar value of equity raised. Three of these 1983 stock issues exceeded 250 million dollars in value.
“FHLBB has various powers to use in influencing MS&L policies. Discussions with staff members of the Office of District Banks of the FHLBB indicate that management/board member salaries that exceeded industry norms and which were a significant portion of S&L earnings would be actively discouraged. This regulatory action is sanctioned under FHLBB Regulation 563.39.
“See DeAngelo and Rice (1983) and DeAngelo, DeAngelo and Rice (1984) for evidence of managerial aversion to takeover threats. However, this risk is mitigated by board and management stock and stock option holdings.
Table 2
I&%&L applications to convert to stock charter’ and their disposition by year in the 1974-1983 periodh
Applications No. of Successful withdrawn
applications conversions to Applications Inactive due to Conversion Year filed stock charter in process applications mergers failures
“Classification is based on tiling status as of the beginning of 1984. These figures exclude supervisory conversions and one conversion completed in 1976 that aas applied for in 1973 and one conversion completed in 1979 by a Puerto Rican S&L. One 1983 application from a Puerto Rican S&L was also excluded. Conversion failures occur when not all of the S&L’s stock is sold in its initial public offering. In 1984, there were 76 new conversion applicants and 89 successful conversions.
bSource: Federal Home Loan Bank Board
The major sources for public information on S&L conversions were the semi-weekly Saoings and Loan Inoestor and the FHLBB Statement and Re- ports to Congress on Mutual to Stock Conversions of 1976-1979. The primary sources of data for individual conversions were the S&L associations’ con- version proxy statements, and subscription and offering circulars. Individual S&L income and balance sheet statements were obtained from FHLBB Semi-Annual Reports on Statement of Condition. The annual number of S&Ls and total deposit levels by state are taken from the FHLBB’s Combined
Financial Statements of FSLIC Insured Institutions. Annual S&L branch and deposit data were obtained from the FHLBB Branch Ofice Docket Directory
and Branch Directory and Summary of Deposits with Market Indicators by
Decision Research Sciences. The dollar value of S&L mortgage originations by state was obtained from the FHLBB Savings and Home Financing Source Books, 1977-1983. Daily stock price data were obtained primarily from Standard and Poors NYSE, ASE and OTC Stock Price Records, Data Re- sources Inc.‘s DRISEC database, and the National Daily Quotation Service’s Stock Section. Most of these are OTC stocks and consequently most of their daily rates of return are based on bid-ask averages. Changes in the number of S&Ls outstanding by state is derived from FHLBB Annual Reports and the various issues of the FHLBB’s annual Asset and Liabiliy Trends.
R. W. ~Mawlis. Murual to stock conversions 43
Table 3
Number of MS&Ls converting to stock charter by year, with total equity capital raised and total assets of converting S&Ls in the 1976-1983 period.’
YSource: Federal Home Loan Bank Board. Due to a FHLBB imposed moratorium on conver- sion approvals, only one conversion from mutual to stock company was approved and completed in the 1963-1975 period. In early 1971. Citizens Federal S&LA of San Francisco converted through a free distribution of stock to members.
bTbese figures are based on the year the conversion is completed. It excludes supervisory conversions of failing mutual S&Ls arranged by FSLIC and one conversion in 1979 by a Puerto Rican S&L.
10. Methodology
The analysis of the conversion process is multi-faceted. In order to show how market conditions influence the conversion application decision, a linear regression model is used to estimate differences across states in the percentage of MS&L associations converting and proposing to convert. Multivariate probit analysis is used (1) to assess whether or not individual S&L applicants are significantly different in operating and financial characteristics from MS&Ls operating in the same markets which did not apply to convert and (2) to test whether successfully convertin, 0 associations differ in financial char- acteristics from associations voluntarily suspending their conversion applica- tions.t3 Annual S&L debt to net worth ratios around the effective date of conversion are also studied to help assess the effects of conversion on the value of a S&L’s deposit insurance. Event study methodology is used to test whether
“There have been a number of earlier empirical studies of the differences between mutual and stock-chartered S&Ls by Hester (1968), Hadaway (1982). Brigham and Pettit (1969), FLHBB Report to Congress (1979). Nicols (1972), Verbrugge and Goldstein (1981), and O’Hara (1982). The only empirical analysis of converting mutuals has been by Hadaway (1982). Multiple discriminant analysis was employed to compare characteristics of each of the 29 converting associations in the period January 1976-June 1979 with those of a stock and a mutual association of similar size in the same FHLBB district.
the initial returns realized by the buyers of the converting S&L’s stock offering are significantly different from zero. This allows an assessment of the efficiency gains to a S&L from conversion and a measure of the S&L’s pre-conversion net worth being distributed to the initial stockholders. To evaluate management’s incentives for supporting the conversion proposal, their stock purchases and changes in compensation and wealth immediately after conversion are also reviewed.
The conversion decision is inherently a discrete choice. Thus. employing ordinary least squares to measure relationships with such a binary dependent variable is an inappropriate estimation technique since it assumes that the deviations of the dependent variable from its estimated values are normally distributed. Statistical estimation of the functional relationship between the conversion decision and its potential determinants requires a qualitative response model, such as a probit probability model, if desirable properties for the model’s parameter estimates are to be obtained.14 In these models, the dependent variable is defined as the conditional probability of a conversion decision P( D, = 1) = P( yr = /3,X,( -JJ* > 0), where the explanatory variables are assumed to enter the probability function linearly and the conversion decision is determined by whether or not the net gains from converting /3,X,! exceed some threshold y*. In the probit model, the condition probability function is represented by F, the cumulative distribution function of a unit normal as shown below:
After adding a term E, to reflect the fact that P( y, < 0) is observed with error, this equation is transformed by F-‘, the inverse of the normal cumulative distribution function, to yield a linear equation in the explanatory variables,
F-v,+%) =B,X,,+vwt),
where P, represents P( yI -C 0) and Z( P,) is the value of the unit normal density evaluated at P,. To estimate the model’s parameters, the observations are arranged by whether the categorical variable takes on its first possible value (e.g., conversion) represented by n1 observations or its second possible value (e.g., non-conversion) represented by the remaining n2 observations. The
14An estimation technique very similar to probit regression is logistic regression which was also used as an alternative estimation procedure in the results that follow. Probit regression is generally preferred over logistic regression because the probit regression assumes normally distributed errors while the logistic regression assumes Weibull-distributed errors which have no clear justification.
R. W. Ma&is. Mutual IO stock comersions
logarithmic likelihood function can then be written as
z log P( y, < 0) + ‘l5’ log[l - P(Y, < 0)17 r-1 t=n,+l
where P( y, < 0) is defined above for each observation. Calculating the parame- ters of this maximum likelihood estimator involves an iterative Newton- Raphson method. For further discussion of these issues, see Judge, Griffiths, Hill and Lee (1980) or Maddala (1983).
11. Frequency of conversions across states
While the FHLBB prohibits inter-state branching of financially healthy associations, S&Ls are generally exempt from state laws restricting branch banking. Thus, individual S&L markets are clearly defined by state boundaries. Because states differ in their S&L and commercial bank chartering and branching regulations, competition among depository institutions differs across states. Further, growth rates of deposits and mortgage originations also differ across states. Consequently, the conversion analysis will be segmented into state-wide markets. The first evidence considered is the extent to which conversion activity is influenced by differences in market characteristics across states measured by potential growth and intensity of competition for deposit services and mortgage originations. The theoretical analysis predicts that conversions are positive functions of both potential growth and intensity of competition.
A cross-sectional linear regression model is employed to explain the per- centage of mutual S&Ls converting and proposing to convert by state in the 1976-1983 period. Since FHLBB approval of conversion applications can take more than a year, the analysis is restricted to the 40 states allowing conver- sions as of January 1982. Proposed or actual conversions were made in all but three of these statesI Growth opportunities for new deposits are measured by the percentage change in deposits of both depository institutions ADEP (defined as S&Ls, commercial and mutual savings banks), and S&Ls alone, ASLDEP. The opportunity for growth in mortgage originations is measured by the percentage change in the dollar value of new S&L mortgage otigina- tions, AMGT. (Data on commercial bank mortgage originations were unavail- able.) Intensity of competition is measured by (1) the percentage change in the number of depository institution offices, AOFF, and (2) average number of branch offices per depository institution, OFFZNST, the latter variable prox-
“with the passage of the Depository Institutions Act in November 1982. conversion to federal stock charter was allowed in all states.
46 R. W. Madis, Murual to stock converriom
Table 4
OLS parameter estimates of the cross-sectional relation between MS&L conversion application frequencies across states, permitting stock charters and market conditions, in the 1976-1983
‘DEPENDENT = the proportion of MS&Ls applying to convert in a state based on the mean VARIABLE number of MS&Ls outstanding over the 1976-1983 period,
AMTG = percentage change in dollar value of S&L mortgage originations in the state, OFFINST = ratio of depository institution offices to depository institutions in the state
(depository institutions are defined as commercial banks, mutual savings banks, and S&Ls).
AOFF = percentage change in state-wide depository institution offices, ADEP = percentage change in state-wide deposits of depository institutions, ASLDEP = percentage change in state-wide S&L deposits.
bFigures in parentheses are r-statistics. Explanatory variables are measured over the 1977-1983 period (since 1976 data were generally unavailable). Data are for the 40 states which allowed conversions from mutual to stock charter as of the beginning of 1982; of these 3 states had no conversion applications by the end of 1983.
ying for the scale economies being realized by competing branch networks.16 These state-wide ratios are all measured over the 1977-1983 period. It could be argued that the percentage change in bank and S&L offices jointly measure the supply response to growth in demand for depository institution services and the differential impacts of anti-competitive state regulations (e.g., unit banking laws, chartering restrictions). However, given that the model includes growth rates in demand for S&L deposit and mortgage services as additional explanatory variables, the coefficient estimate for the change in branch offices should measure the partial correlation between conversion frequency and state regulatory constraints on depository institution competition.
Table 4 presents estimates of an ordinary least squares model of conversion frequency across states. The dependent variable is the ratio of MS&Ls converting to the average number of MS&Ls outstanding over the period, including those converting. Several regressions are estimated to help assess the stability of the parameter estimates when one or more explanatory variables
r6Data on the number of banks are overstated, since they do not combine multi-bank holding companies. Thus, the size of the ratio of branch offices to banks is understated in states with significant multi-bank holding companies.
R. W. Masulis. Mutual to stock conversions 47
are excluded. The signs of all the significant parameter estimates are consistent with the predictions of positive relationships between the likelihood of conver- sion and growth in demand and intensity of competition. Parameter estimates for the percentage change in the dollar value of mortgage originations, the ratio of depository institution branches to institutions, and the percentage change in S&L offices are large enough to reject the null hypothesis of zero parameter values at a 5% significance level in all but one of the regressions. However, the parameter estimates of the percentage changes in both deposits of S&Ls and of all depository institutions were close to zero. In terms of importance, both the percentage changes in depository institution offices and the dollar value of S&L mortgage originations appear to have the most influence on the conversion decision. These regression models, which use only market-wide characteristics, explain approximately half the variation in con- version activity across states.”
12. Characteristics of MS &Ls applying to convert
Estimates from a binomial multivariate probit model are used to test whether mutual associations applying and not applying to convert had signifi- cant differences in their financial and operating characteristics in the direc- tions predicted by the earlier analysis. The explanatory variables used to predict MS&L conversion applicants are (1) magnitude of investment in specialized assets (i.e., excluding relatively easily managed assets such as securities and other financial claims) which, following along the lines of Fama and Jensen (1983) are measured by the ratio of (a) business income to total income, NFI, and (b) non-financial assets (excluding foreclosed real estate holdings) to total assets, NFA, (2) size of total assets, which reflects the potential for various scale and scope economies and the need for managerial specialization, ASSET, (3) stringency of the S&L’s equity capital constraint as measured by the ratio of net worth to total assets, NET, and (4) expected growth rate of the S&L as measured by the current growth rates of total assets, GA, savings deposits, GD, and loan origination fees, GL. All explana- tory variables for the converting S&Ls are based on data from the three years prior to conversion application, Conversion applicants are predicted to have: larger ratios of business receipts to total receipts and non-financial assets to total assets, larger total assets, lower net worth to total assets, and higher growth rates of assets, deposits and loan fees.
To formally test these predictions, each set of conversion applicants from a given year was matched with the remaining mutual associations operating in
“TWO other explanatory variables were investigated. These were changes in S&L offices as a substitute for the changes in depository institution offices and S&Ls’ average cost of funds. Neither variable had a significant parameter estimate and the latter variable showed limited variability.
48 R. W. ~Uasuhs. Mutual to stock conversions
Table 5
Mtimum likelihood parameter estimates of a S&L’s probability of tiling a conversion application over the 1976-1983 period, using a binomial probit regressionbb
“The binary dependent variable represents a MS&L’s conversion application status (non-appli- cant = 0, applicant = 1)
Mean values of explanatory variables for MS& Ls separated
Explanatory variables by conversion application status
Non-applicant Conversion MS&Ls applicants
(N = 2333) (N=267) NN = Non-financial business income/
total income of S&L 0.036 0.062 ASSET= Natural log of S&L’s total assets 17.744 18.394 NET = Net worth/total assets of S&L 0.059 0.048 NFA = Non-financial assets/total assets of S&L 0.018 0.019 GA = Growth rate of S&L’s total assets 0.223 0.499 GD = Growth rate of S&L’s deposits - 0.036 0.097 GL = Growth rate of S&L’s loan origination fee 0.561 0.894
These data are for the 40 states allowing conversions from mutual to stock charter as of the beginning of 1982. For conversion applicants, growth rate variables are measured over the three years prior to conversion, all other explanatory variables are averages over this period. For non-applicants, the prior three-year period is chosen by randomly selecting a base year according to the relative frequency of conversions across the years in that state.
bFigures in parentheses are r-statistics. Similar parameter estimates were obtained using logit estimation.
the same state for that year. From the population of non-converting MS&Ls in a given state, a random sample was selected by year in proportion to the frequency of conversion in that state over the 1976-1983 period, and financial data were collected for the prior three years. Any association lacking a complete set of FHLBB financial data for the previous three years was excluded from this analysis. Then all conversion applicants and all non-appli- cant mutual associations from ail states with conversions were grouped to- gether.
Estimates based on a binomial probit model are presented in table 5. The results indicate that the conversion decision is positively and significantly related to the size of association assets and the ratio of non-financial business
R. W. Masulis. Mutual to stock comersions 49
income to total income, as predicted by Fama and Jensen. Non-financial assets, however, fail to exhibit a significant relation to the conversion decision. The analysis also indicates that the conversion decision is significantly posi- tively related to the growth rates of deposits and mortgage loans or altema- tively the growth rate of assets. It is also negatively related to the ratio of net worth to total assets. These results support the hypothesis that conversion is not solely motivated by a desire to lower leverage but is also influenced by opportunities to realize further scale and scope economies and the demand for increased managerial expertise and discretion.
13. Conversion completion
The earlier analysis of the conditions necessary for a successful conversion suggests that failure to complete the conversion process is a distinct possibil- ity. Indeed, over the sample period 20 attempted conversions were unsuccess- ful. By the end of 1983, an additional 31 conversion applications were cancelled due to subsequent mergers and 67 other applications were voluntar- ily suspended by the initiating S&Ls prior to their public offerings. The previous analysis predicted that a conversion would fail if the market value of an association’s net worth is close to zero after accounting for the valuation gains of conversion. This is most likely to occur when conversion efficiency gains are relatively low and pre-conversion net worth is of the same magnitude as conversion expenses. Thus, conversion applicants not completing the pro- cess are predicted to have smaller operating and total profits relative to asset size (OPINC and ZNC, respectively), lower net worth, NET, smaller asset size, ASSET, lower fractions of income from specialized assets, NFI, and slower growth rates of deposits, GD, and loans, GL, than converting associa- tions.
To formally test these predictions for both inactive or terminating appli- cants and S&Ls successfully converting, a maximum likelihood probit model is estimated where these variables are measured over the three years prior to the application date. Table 6 presents these parameter estimates for several alternative measures of the explanatory variables. With the exception of deposit growth, the signs of the parameter estimates are all consistent with the earlier predictions. Summarizing the statistically significant results, the conver- sion process is most likely to be completed when an S&L exhibits high net worth to total assets, is more profitable as measured by higher ratios of total income or operating income to total assets, and has a higher growth rate in loan origination fees, with the profitability measures having the largest in- fluence. These results indicate that completion of the conversion is influenced both by the size of the S&L’s net worth and the conversion gains to be realized but, contrary to the earlier analysis, is not affected by asset size.
50 R. W. Mawiis. Mumal to stock conversions
Table 6
Maximum likelihood parameter estimates of a conversion applicant’s probability of successful conversion over the 1976-1983 period using a binomial probit regression.‘b
The binary dependent variable represents the individual conversion application’s completion status (failure to convert = 0, successful conversion = 1).
Mean values of explanatory variables for MS&L applicants separated
NET = Net worth/total assets 0.043 0.046 NFI = Non-financial business income/total income 0.056 0.066 GD = Growth rate of deposits - 0.035 0.332 GL = Growth rate of loan origination fees 0.435 1.087 ASSET= Natural log of total assets 18.554 18.656 INC = Total income to total assets 0.045 0.048 OPINC- Operating income to total assets 0.045 0.047
bFigttres in parentheses are f-statistics. Similar parameter estimates were obtained using logit estimation.
14. Changes in S&Ls’ debt to net worth ratios
One disadvantage of conversion is that leverage drops substantially, decreas- ing the value of the S&L’s deposit insurance. Table 7 indicates that converting S&Ls typically experience leverage increases over the three years prior to conversion, which is consistent with the earlier theoretical analysis. On conver- sion, the S&Ls’ leverage ratios fall substantially as expected. But in most cases, only small increases in leverage are observed over the following three years. This is indicative of a marked and sustained drop in the market value of FSLIC deposit insurance coverage and of a significant decrease in risk bearing by FSLIC.
15. Market prices of converting stock
Conversions benefit management and subscribing depositors if initial net worth is positive and is distributed to stockholders in the conversion process,
R W. Mawlis. Mutual to stock conversions 51
Table 1
Quartiles of the frequency distributions of semi-annual debt to net worth ratios for S&Ls converting to stock charter over the 1973-1983 perioda (for six semi-annual periods preceding
aSource: FHLBB semi-annual reports on statement of condition of insured S&Ls, 1973-1983. In the post-conversion three-year period, data were not available for much of the sample since many of the conversions occurred in the last two years of the 1973-1983 study period. This is indicated by the dropoff in the number of observations in the later periods. However. similar leverage ratio trends were observed when the subsample with a full set of semi-annual observa- tions was analyzed.
bThe semi-annual period in which the conversion takes place is defined as period zero. Adjacent earlier semi-annual periods are denoted with minus signs, while subsequent periods have positive signs.
or if the conversion increases a S&L’s market value net of conversion expenses (even when the S&L’s initial net worth is zero). A sample of 78 conversions was found where an active secondary market in the stock devel- oped within five trading days of the public offering date. Of this sample, which represents most of the largest conversions in terms of equity value, all but two were underwritten and these two avoided an underwritten public offering simply because stock was fully sold in the subscription offering.
The percentage gain from purchasing stock in the subscription or public offering is measured by the percentage change in the closing market price on the first trading day relative to its offering price and is termed the stock’s initial daily rate of return (which is unadjusted for contemporaneous market effects). In an informationally efficient capital market, these initial returns should capture the valuation effects of conversion related increases in firm value net of conversion expenses, and the distribution of pre-conversion net worth, given the absence of any founding shareholders.
52 R. W. Mawlis. Murual to stock ~oncemons
Table 8
Average and cumulative average S&L stock returns over the 20 trading days following conversion in the 1976-1983 period” (sample of 78 conversions).
aThe distribution of the 78 conversions over the years 1976-1983 is: 3, 2, 0, 7, 8, 6, 4 and 48, respectively.
bAll but three of the conversions studied had secondary market trading beginning within a day of the public offering’s completion. The remaining three conversions had active secondary market trading begin within five trading days of the public offering date.
Turning to the evidence presented in table 8, the stock prices of converting S&Ls on the first day of secondary market trading exhibit a large positive mean return of 5.61 percent, reflecting positive stock returns for 90 percent of the sample. This is followed on day two by a 1.88 percent return. Further gains are realized on average as implied by the sample’s total return over the first 20 trading days of 11.42 percent. The positive stock returns beyond day two are due to the large fraction of the conversion sample drawn from 1983; they disappear when the 1983 events are eliminated, indicating that they result from market-wide effects. However, the average day one and day two returns are similar when the 1983 conversions are excluded from the sample. The positive day one return of the converting S&L stocks is consistent with a conversion induced increase in the S&L’s market value and with the distribu- tion to stockholders of positive initial net worth, but no reliable method is available to separate the magnitudes of these two effects.
R. W. Madis, Mutual to stock convemons 53
Analysis of the cross-sectional distribution of the 75 converting S&Ls’ initial daily stock returns presented in table 9 shows that over the 1976-1983 period, 7 S&Ls exhibit negative initial daily stock returns, with returns of zero for 6 others. Since the association’s net worth is risky, it can fall significantly, even over the short time period required for a public offering of stock. This implies that the post-conversion market price of a converting S&L’s stock will not always be above its offering price, even though its expectation is positive.
It is tempting to compare the S&L stocks’ 11.42% average 20-day return with the 11.4% initial monthly residual return of a portfolio of unseasoned new stocks issued over the period 1960-1969 reported by Ibbotson (1975). However, Ibbotson’s results are seriously upward biased since investors do not have an opportunity to purchase much, if any, of underpriced offerings because underwriters allocate sales in these over-subscribed offerings. Thus, the large initial security returns reported in studies of initial public offerings (IPOs), such as Ibbotson’s, are not really obtainable by the average investor. This upward bias in the initial stock returns of IPOs does not generally apply to the subscription rights of converting MS&Ls since over-subscription of these rights is rare and discretionary allocation of rights is prohibited.
16. Changes in management wealth and riskbearing following conversion
The previous analysis argues that board of director approval of a conversion is prompted by the prospect of increased wealth and greater likelihood of association survival. In part, management wealth and incentives are altered in a significant way by holdings of stock and stock options and the increased discipline associated with the market for corporate control. Evidence on the speed of these actions and the size of management wealth changes is presented below.
It was argued previously that management must hold a significant equity position if their incentives to maximize firm value are to be improved and if they are to minimize the risk of takeover following conversion.” Further, management must subscribe to the stock issue in order to obtain part of the distribution of the S&L’s pre-conversion net worth. Table 9 describes senior management’s initial dollar gain from subscribing to the stock at the offer price relative to the stock’s market price at the end of the first day of secondary market trading. It also shows management’s percentage stockhold- ings and dollar investment at conversion as well as the stock’s percentage price
i6Tbis risk of takeover is initially not great since conversion regulations preclude takeover for three years, e.g., only conversions completed prior to 1981 could legally be taken over in the period through early 1984. However, since 1976 at least five converting associations have been taken over and there has been at least two serious but unsuccessful takeover attempts. This is a tangible threat to a S&L’s management, and especially for a larger S&L where management can only afford to purchase a small fraction of the association’s stock.
54 R. W. Mawlis, Muruai to stock con~vrs~om
Table 9
Management’s initial gains and losses from stock purchases in S&Ls converting to stock charter (ranked by dollar gains), management’s initial stock purchases and the S&L stocks’ initial daily returns over the 1976-1983 period’ (sample of 75 conversions having an active secondary market
within five trading days of the public offering date).
Management’s initial gains and losses from S&L stock
purchasesb ($ millions)
Management’s initial purchases of converting S&L stock
‘Source: Individual public offering circulars of converting S&Ls for conversions having an active secondary market within a day of the public offering.
bOnly management stock purchases derived from subscriptions to the S&L’s initial stock offering are included. Initial stock gains and losses are defined as the first closing price on the first day of secondary market trading minus the offering price, all multiplied by the shares subscribed by senior management and the board of directors.
‘The stock’s percentage change in price on the first day of secondary market trading relative to the offering price.
56 R. W. Masulis, Mumal IO stock con~emons
change at the end of the first day of secondary market trading relative to the offer price. The evidence indicates that management generally realizes large wealth gains: losses are small and infrequent. Senior management and board of directors investment in a typical S&L’s stock is also significant; in this sample it ranges from $100,000 to $7.4 million and has a median value of $825,000. The distribution of the stocks’ percentage price changes on the first day of secondary market trading relative to the offering price ranged from 37.23% to -3.00%. Significantly, stock option plans are proposed in all but 3 of these 75 conversions. These stock options give management the right to purchase new shares equal to 10% of the outstanding stock at exercise prices near the stock’s offering price. As a result, management incentives are altered so as to increase their interest in the association’s long-term profitability and to decrease their aversion to undertaking risky investment opportunities.
17. Summary
It is rare to observe an industry undergoing rapid organizational change. Thus, the phenomenon of a large number of MS&Ls converting to stock charter offers an important opportunity to further our understanding of the economics of organizational choice. In this study, various conversion induced changes in the S&Ls’ contractual relationships and the welfare of their major claimants are documented. The statistical evidence indicates that all major claimants benefit from the conversion decision. This is not surprising given that the board of directors/management must initiate the conversion pro- posal, a majority of depositors must vote to approve it, and the FSLIC/FHLBB has crafted the conversion regulations that are in force. The statistical evidence also suggests that conversion yields organizational efficiency gains which are associated with the injection of new equity capital into the association, distribution of managerial stock and stock option holdings, and a decreased risk of insolvency.
The evidence shows that mutuals are more likely to convert to stock associations in state markets that exhibit greater competition and growth. Within state-wide markets, large MS&Ls and S&Ls having a higher per- centage of income from specialized assets exhibit a much greater probability of conversion. Successful conversion applicants exhibit greater net worth to total assets and higher returns to capital and higher growth rates of total assets and loan fees. S& Ls exhibit significant declines in leverage in the conversion year which persist for a number of years thereafter, lowering the risk of insolvency. Across the sample, management generally makes substantial investments in the stock of converting S&Ls. At the time of conversion, management stock option plans are adopted or proposed by most large S&Ls so that the coincidence of management interests with outside stockholders is quickly enhanced. Evidence also indicates that at the time of conversion a S&L’s
R. W. Masulis. Mutual to stock comersions 57
initial net worth is distributed to subscribing stockholders, including manage- ment, and that the conversion increases the market value of the S&L over and above the level of capital raised in the sale of stock. Evidence is also found suggesting that conversions are motivated by potential scale economies and the need for equity capital to lower the risk of insolvency and aid in the growth of S&L assets.
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