Strategic Practice Exercise

It is 1982. Zombie Savings and Loan is in trouble. This is a time when many savings and loans (S&Ls) are in financial difficulty. Zombie holds many 30-year mortgages at low fixedinterest rates in its loan portfolio. Interest rates have risen significantly, and the Deregulation Act of 1980 has given Zombie and other S&Ls the right to make business loans and hold up to 20% of its assets as such. Because interest rates in general have risen, but the rate that Zombie receives on its old mortgages has not, Zombie must now pay out higher interest rates to its deposit customers or see them leave, and it has negative cash flow until rates fall below the rates in its mortgage portfolio or Zombie itself fails. In present value terms, Zombie is insolvent, but the accounting rules of the time do not require marking assets to market, so Zombie is allowed to continue to operate and is faced with two choices: It can wait and hope interest rates fall before it is declared insolvent and is closed down, or it can raise fresh (insured) deposits and make risky loans that have high interest rates. Risky loans promise high payoffs (if they are repaid), but the probability of loss to Zombie and being closed later with greater loss to the Federal Savings & Loan Insurance C