The Case of a Phoenix Jack M. Guttentag his article d attempt to clarify the issue of whether it is appropi.de for a T Phoenix to hedge in futures markets. A Phoenix is a s a v i n g and loan association that is insolvent but maintained as a going concern by the Federal Savings and Loan Insurance Corporation (FSLIC) because doing so is less costly to the agency than liquidation or merger with another fkm.1 Phoenix associations, l i e most other thrift institutions today, maintain an extremely unbalanced portfolio that makes them highly vulnerable to a rise in interest rates. The analysis will clarify the relationship between hedging and solvency, and therefore has applicability to a wider range of firms whose solvency is in doubt.
I. THE FROZEN PORTFOLIO CASE
Assume an association that came into existence four years ago, when it borrowed $100 million for three months at 8% to invest in consols yielding lo%, to generate net income of $2 million per year. (Consols are interest-only mortgages-they never mature and never amortize or prepay.) Today the association is paying 12% on its three-month liabilities for a net loss of $2 million per year. Assume further that by hedging it can freeze the cost of its liabilities at the prevailing level? Finally, assume the association has no business opportunities at the margin but merely administers its existing $100 million portfolio.
Question: Should the association hedge its liability costs? Hedging eliminates any possibility that solvency can be attained through a decline in rates, while also avoiding the possibility that losses will become larger if interest rates rise. In fact, the question posed cannot be answered without first specifying the association's objectives. If the association's sole objective is to attain a state of solvency, clearly 'At year end 1982 there were five Phoenix associations with assets aggregating about $18 billion. 2Thi is. of course, a great oremimp-n that &&a& from basis and other risks, aa well as from market expctatiom. A more accurate atatemnt would be that in principle hedging can freeze liabiliy wata at the rates now prevailing a d q c c t c d by the market, expectations being reflected in prcvding futures prim. Jack M. Guttentag is the Robert M o r h Professor of Banking at the Wharfon School of the University of Pennsylvania.