GAO Iteport, to Congressional Rcqueskrs -..- ~--. .--- March 1!))I!) HIGH YIELD BONDS Issues Concerning Thrift Investments in High Yield Bonds i ,I unitedstates General Accounting Office GAO Wahington, D.C. 20548 General Government Division B-231276.8 March 2, I989 The Honorable Donald W. Riegle Chairman, Committee on Banking, Housing and Urban Affairs United States Senate The Honorable Henry B. Gonzalez Chairman, Committee on Banking, Finance and Urban Affairs House of Representatives This report completes our responseto the requirements of Section 1201 of the Competitive Equality Banking Act of 1987 (P.L. lOO-86),which directed us to study several aspects of the high yield bond market As required by the act, we did our work in consultation with the Securities and Exchange Commission, the Federal Home Loan Bank Board, the Comptroller of the Currency, the Board of Governors of the Federal ReserveSystem, the Federal Savings and Loan Insurance Corporation, the Federal Deposit Insurance Corporation, the Secretary of the Treasury, and the Secretary of Labor. Copies of this report are being provided to those agenciesand are available to others on request. This report was prepared under the direction of Craig A. Simmons, Director, Financial Institutions and Markets Issues, Other major contributors are listed in the appendix. Richard L. Fogel Assistant Comptroller General Ekecutive Summ~ The growth of the high yield (“junk”) bond market in the 1980s has Purpose been fraught with controversy. Numerous congressionalhearings have focused on the role of these bonds as a tool to finance takeovers-of com- panies. Major figures in the high yield bond market have been the target of investigations by congressionalcommittees, the Securities and Exchange Commission, and the Justice Department. The Competitive Equality Banking Act of 1987 (Public Law 100-86) directed GAO to study several aspectsof the high yield bond market. The act reflected congressionalconcerns about the extent to which high yield bonds might foster corporate takeovers and the risks to federal deposit insurance funds represented by insured institutions that invest in high yield bonds. GAO has issued two reports in responseto certain of the act’s require- ments. The first, issued in February 1988, discussesthe issuers and pur- chasers of high yield bonds and the extent to which the bonds had been used to finance corporate takeovers. The second,issued in May 1988, provides the record of a March 1,1988, public hearing on the nature of the high yield bond market, This final report responds to the act’s remaining requirements. It focuses on investment in high yield bonds by federally insured thrift institutions and also discussesstate and federal laws regulating those investments and the relationship of high yield bonds to federal monetary policy. In 1977, the high yield bond market consisted primarily of bonds of B$ckground companiesthat had fallen on hard times, called “fallen angels.” The market has evolved considerably since then. It now consists primarily of bonds issued by small- or medium-sized companiesthat are not able to obtain an investment grade rating or bonds issued in connection with h leveraged buyouts, mergers and acquisitions, or corporate restructur- ings. The amount of high yield bonds issued each year has increased from less than $2 billion in 1978 to about $31 billion in 1987, and the amount of high yield bonds outstanding rose from about $9 billion in mid-1977 to about $169 billion in mid-1988. Within certain limits, federally insured thrifts can invest in high yield bonds under the provisions of the Garn-St Germain Act of 1982. About 6 percent of the 3,026 federally insured thrifts held high yield bonds, and almost 76 percent of the bonds held by these thrifts are held by just 10 institutions. However, several thrifts have recently becomeinvestors in high yield bonds, and the amount held by thrifts has more than doubled Page 2 GAO/GGLM9-48 Thrift Industry , Executive Summary since the end of 1986 to over $13 billion in September 1988. As dis- cussedin GAO'S February 1988 report, bank regulators discourage banks from investing in high yield bonds. , So far, high yield bonds have been attractive investments for thrifts Re$ults in Brief compared to many alternative investments, and high yield bond invest- ments have not contributed to the thrift industry’s current problems. However, the higher yields on these bonds carry higher risks compared to traditional thrift assetssuch as residential mortgage loans. In addi- tion, the high yield bond market, in its present size and form, has not been tested by a recession.A severe economic downturn might increase bond defaults, especially for those companiesissuing bonds as part of leveraged buyouts. For these reasons,thrifts need to have the expertise to invest in high yield bonds and should exercise caution in selecting and managing their portfolios. In January 1989, the Federal Home Loan Bank Board (FHLBB), the agency that regulates thrifts, took prudent steps to establish manage- ment and review standards for thrifts investing in high yield bonds. If properly understood and enforced, these standards should help assure thrifts invest in high yield bonds without incurring unnecessaryor unreasonable risk. c Pribcipal Findings R&m on High Yield Compared to other fixed income investments, such as Treasury and Raids Exceed Risks to investment grade bonds, high yield bonds have a higher risk of default. A n-A. However, studies by academicsand investment bankers show that from Yitqe 1977 to 1987 high yield bonds have provided investors higher net returns than these other investments becausetheir relatively high yields have outweighed the additional lossesfrom default. (Seepp. 21-26.) GAO found that not much data were available from the FHLBB or from thrifts regarding how the risks and returns on high yield bonds compare to other thrift assets.GAO did, however, obtain and analyze a study by Wharton Econometric Forecasting Associateswhich showed that, from 1986 to 1987, returns on high yield bonds were secondonly to credit cards and ahead of residential mortgage lending, commercial and con- sumer loans, and Treasury and investment grade bonds. The study also Page 3 GAO/GGD89-48 Thrift Industry , ExecutiveSummary showed that credit losseson high yield bonds were greater than on other assetsexcept for credit cards, but the higher losseswere outweighed by higher yields. The study had certain data limitations and cannot be used to predict future trends of asset risk and returns during a recessionor sluggish economic growth. However, its conclusions were supported by testimony at a GAO March 1, 1988, public hearing and by information GAO obtained during visits to the major thrift investors in high yield bonds. (Seepp. 34-37.) High Yield Bonds Have Not A review of FHLBB data and discussionswith its officials showed only Cabsed the Current Thrift one casein 1985 where high yield bond investments appeared to have been a factor in a thrift failure. However, in that case,mismanagement In ustry Problems of the institution’s high yield bond portfolio was only one part of a broader pattern of unsafe lending and investment practices leading to : the institution’s collapse. (Seepp. 46-48.) High yield bond portfolios for the 11 thrifts GAO visited had default rates of about 2 percent on bond holdings totaling over $9 billion as of March 1, 1988. After actual and estimated recoveries, the thrifts expected total lossesof about $73 million, or less than 1 percent of the portfolio. (Seepp. 31-33.) C&rent Bond Market Has Proponents of high yield bonds have pointed to the 1981 to 1982 reces- Ncjt Been Tested in sion as proof that the bonds can survive in bad economictimes. How- ever, since then the size of the market expanded significantly from $19 Rdcession billion in bonds outstanding in mid-1982 to $169 billion by mid-1988. In addition, in the mid-1980s high yield bonds began to be used to finance mergers and acquisitions, leveraged buyouts, and financial restructur- I ings. These changesin the market occurred during an unprecedented b peacetime economicexpansion, and many market observers point out that the market in its present size and form has not weathered a reces- sion that could test many issues.(See pp. 25-27.) I Fl$LBB Increasing In January 1989 FHLBB issued final guidelines for federally insured Oversight Over High Yield thrifts to use in purchasing and managing high yield bond investments. n*-+I, These standards were under review and consideration for nearly a year. DWI LUS The guidelines prohibit insolvent thrifts from making any new invest- ment in high yield bonds and provide that institutions that are solvent but undercapitalized may make new investments in high yield bonds only with the approval of FHLBB. The guidelines also state that a thrift’s Page4 GAO/GGD-8948Thrift Industry Executive Summary board of directors is responsible for establishing and maintaining a high yield bond investment policy that is consistent with the safe and sound operation of the institution, provides guidance for diversifying the high yield bond portfolio, outlines the standards thrifts should use in carry- ing out a credit analysis of the bond, and provides guidance for thrifts to follow in establishing adequate loss reserve allowances. FHLBB also is in the processof developing a program to uniformly clas- sify high yield bonds held by thrifts and identify those for which a loss reserve allowance should be established. (Seepp. 43-46.) GAO is not making recommendations in this report, / Officials of the Securities and Exchange Commission, FHLBB, the Comp- Agency Comments troller of the Currency, the Federal ReserveSystem, the Federal Savings and Loan Insurance Corporation, the Federal Deposit Insurance Corpo- ration, the Department of the Treasury, and the Department of Labor received a draft of this report for informal comment. Only the Federal Reserveand FHLBB had comments.