Regulatory Misconceptions in Pricing Thrift Conversions: A Closer Look at the Appraisal Process

A series of news articles in the summer and fall of 1993 reported excessive managerial compensation and stock option packages at some large state-approved thrift mutual-to-stock conversions. Congress reacted to these reports and the House Banking Committee introduced legislation late in 1993 requiring state-chartered thrifts to comply with federal regulations in conversions. At the heart of the public policy debate in 1994 was whether windfall profits existed in conversions, and at the time of conversion from mutual to stock organizational form, who would be the rightful beneficiary of the accumulated build-up in proceeds. Under current OTS regulations, conversion from a mutual-to-stock organizational form is done under the sale-of stock approach, by selling stock to managers and depositors. Stock not purchased by these groups are offered for public sale. Issue proceeds are retained within the thrift as capital which is added to the accumulated equity of the mutual thrift to create a new capital base for the converted entity. Regulations require that the stock be priced based on an independent appraisal of the pro forma value of the converting thrift. Regulatory guidelines for the appraisals include specific valuation equations which appraisers must use to identify the offering price of the conversion. The appraisal industry estimates that during the 1970s approximately 1600 institutions were appraised in excess of $16 billion. Hence, these appraisal equations have had a significant effect in pricing these conversions. The validity of the appraisal equations has never been discussed either in the academic literature or in Congressional hearings. This paper evaluates the assumptions imbedded in these equations and demonstrates how regulators overlooked the inapplicability of these assumptions in thousands of conversions. The author raises serious questions about the integrity of the appraisal process in these conversions. The paper starts with a brief description of the historical background for mutual-to-stock conversions, continuing with the regulatory view on conversions, the fallacies in the regulatory design of conversions, and concluding with case examples that show how appraisers cope with conversion regulations that defy logic. Historically, four approaches were proposed in regulating the conversion of mutual savings and loans to stock charters: 1) the free-distribution-of-stock approach; 2) the sale-of-stock approach; 3) the public-trust-fund method; and 4) the transferable stock rights approach. While each of these approaches has strengths and weaknesses, the issue of greatest concern for regulators is that the stock not be underpriced. In its "Guidelines for Appraisal Reports for the Valuation of Saving and Loan Association and Savings Banks Converting from Mutual to Stock Form of Organization" (1983), the Federal Home Loan Bank Board explains the basis for its concern regarding appropriate stock pricing. There are two reasons for this. First, since a conversion is akin to a sale of a thrift from mutual owners to its new stockholders, the Board does not want a windfall to accrue to the new owners and this would happen if the stock were underpriced. On the other hand, the Board also has a concern that the stock not be overpriced because the conversion stock is often marketed to mutual depositor-members, many of whom may be unsophisticated concerning equity investments. Thus, the Guidelines explicitly define how pricing decisions should be done by appraisers. To evaluate the logical shortcomings of the guidelines, the author derives the appraisal equations and explains the economic meaning of the assumptions behind the equations. The conclusions are quite remarkable. The author concludes that to obtain a positive issue price using the equations, regulators are assuming that the issue proceeds are invested such that the thrift loses money and this loss exactly offsets the positive equity value that was inherited from the mutual thrift. This simple point is missed by regulators; the resulting pricing equations give positive results only under one unreasonable assumption. For other reasonable cases, the equations break down and are not usable. The author then explores how appraisers report the "proforma market value" of the converting thrifts using these guidelines. The author demonstrates that appraisers must use fictitious numbers if the equations are to yield a positive number for the issue proceeds and resulting new capital. To obtain these numbers the appraiser must falsely assume that the pre-conversion mutual equity value is negative, or falsely assume that the thrift would be making a negative NPV investment such that this loss would eliminate the positive pre-conversion equity value. Since it is common to all appraisal reports to report positive estimates of pre-conversion mutual equity value, the only possible explanation that fits the guideline equation requirements is that managers, depositors, and other purchasers are making negative NPV investment decisions. The author demonstrates how the equations and assumptions work in five representative cases of actual conversions. The author suggests three policy implications from this analysis. First, a moratorium should be placed on conversions until the validity of the regulatory requirements relating conversion pricing are examined. Second, the appraisal process should be brought under close scrutiny by the regulatory authorities, or the Congress. Third, the sale-of-stock approach must be redesigned such that the current appraisal process is eliminated.