By William K. Black
After I wrote part one of this column three weeks ago I did a two-part series on the Council of Economic Advisers’ (CEA) reports for 2005-2007. I focused on the 2006 report because it had a significant discussion of the theory of financial intermediation and a paragraph on financial regulation. As one would it expect, the CEA wrote to sing the praises of deregulation and to oppose efforts to reregulate banks. In preparing for a book forum I am hosting in two weeks on Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance my research led me to read a scholarly article (“Manufacturing Tail Risk”) by two of the co-authors of the book. That article discusses regulation, including savings & loan (S&L) regulation during the debacle. Reading the article convinced me of the need to describe the non-statutory reregulation and re-supervision of the S&L industry that prevented the debacle from becoming a systemic economic crisis and led to the most effective prosecution of elite white-collar criminals in history.
A brief timeline is necessary. The first phase of the S&L debacle became a crisis when Federal Reserve Chairman Volcker decided to break inflationary expectations by substantially increasing interest rates. S&Ls were overwhelmingly portfolio lenders making long-term, fixed rate mortgages funded by extremely short-term deposits. S&Ls were exposed to severe interest rate risk. On a market value basis, the industry was insolvent by roughly $150 billion by mid-1982. Federal Home Loan Bank Board (Bank Board) Chairman Richard Pratt (an academic expert in “modern finance” who had served as the S&L trade association’s top economist) drafted a bill (informally known then as “the Pratt bill”) modeled on Texas’ deregulation. Deregulating at a time of mass insolvency was significantly insane, but Pratt was an anti-regulator of great fervor. Using econometric techniques to choose Texas as the model – without recognizing that Texas S&Ls’ superior reported income was as fictional as the reported income and capital arising from merging two insolvent, unprofitable S&Ls – was insane and caused severe losses.
Pratt also cut the number of examiners and, at the behest of the Reagan administration, ceased virtually all closures of failed S&Ls. Instead, he merged insolvent S&Ls and used abusive accounting schemes that hid real losses and created massive amounts of fake income and “capital.” He then, ever so modestly, claimed credit for “resolving” hundreds of S&L failures at virtually no cost to the insurance fund. The “resolutions,” of course, were typically accounting shams that led to increased losses. (Yes, Pratt was Secretary Geithner’s role model as a carnival barker.)
Pratt’s 1982 deregulation bill became the Garn-St Germain Act of 1982. It immediately prompted a competition in regulatory laxity. California and Texas “won” the race to the bottom – and those two states caused roughly 60% of total losses in the debacle.
Pratt declared victory and resigned in early 1983. He went to Merrill Lynch to sell MBS to S&Ls. Edwin Gray had been a Bank Board Member with Pratt. Gray was a personal friend of the President and Mrs. Reagan. He has said that the S&L trade association chose him to be its top regulator because he was a strong supporter of financial deregulation and because they believed he would be friendly to the S&L industry (in which he had worked).
Gray became Chairman of the agency in April 1983. Initially, he largely continued Pratt’s deregulatory approach. Within months, however, he became convinced that the industry was headed towards catastrophe even though the industry reported that it was experiencing a robust recovery.
Gray deserves particular credit for his accurate analysis because it is easy to “fight the last war” (interest rate risk) and miss the development of the new war (accounting control fraud). For a conservative, free market, ultra-loyal Reagan supporter, officer from the S&L industry to be willing to believe that hundreds of S&L CEOs could be felons also showed remarkable openness to unpleasant facts.
My prior column explained that Pratt, Texas, and California had (unintentionally) optimized the S&L industry as a criminogenic environment for accounting control fraud by deregulating, desupervising, leaving insolvent S&Ls open, ignoring extreme conflicts of interest among S&L acquirers and founders, approving federal deposit insurance for newly created (de novo) S&Ls in Texas, California, and Florida despite the total inability and unwillingness of these states to regulate, and debasing the accounting, concentration, and capital rules. Criminal referrals (and prosecutions) were virtually non-existent under Pratt. The Bank Board had no system for ensuring that criminal referrals were made, for monitoring the progress of the FBI in pursuing the referrals, or for training agency, FBI, and Department of Justice staff in how to detect, investigate, and prosecute elite frauds.
The Bank Board did not have remotely adequate numbers of examiners and too many of its senior supervisors were unwilling to take vigorous action against major S&Ls. Texas and Louisiana were totally out of control. By 1983, there were hundreds of frauds growing at an average annual rate of 50 percent. Had Pratt’s anti-regulatory policies continued even a few more years that level of obscene growth would have soon led the frauds to dominate the entire industry and to hyper-inflate multiple regional real estate bubbles.
Gray went to an emergency footing. He refused to grant federal deposit insurance to any California, Texas, or Florida de novos unless those states provided adequate examiners and supervisors. He doubled the number of examiners and supervisors within 18 months. He reassigned hundreds of examiners from outside Texas on temporary duty to examine Texas S&Ls. He fired the President of the Federal Home Loan Bank of Dallas. He ordered supervisory agents to certify that any violations of law or unsafe conditions or practices found by the examiners had either been fixed or that the supervisor had referred the matter to enforcement to force the S&L to fix the problem.
Gray personally recruited senior banking regulators with reputations for competence, integrity, and vigor and put them in charge of every region with severe problems. He picked the two regulators he found most impressive, Joe Selby and Mike Patriarca, to be the top regulators for the regions responsible for regulating Texas and California S&Ls.
Gray, over the opposition of his fellow Bank Board members, adopted a series of rules and orders in 1983-1986 that targeted the accounting control frauds. The rule restricting growth doomed the accounting control frauds. Gray also prioritized for closure the worst frauds identified by the examiners and the agency began to place S&Ls in conservatorship even when they were reporting profitability and adequate capital.
Gray also requested Congress to provide additional funds and statutory powers to the agency to fight the frauds. Congress refused to meet any of Gray’s requests while he was in office. Instead, a majority of the members of the House, at the behest of Charles Keating’s Lincoln S&L (the most notorious S&L fraud) co-sponsored a resolution calling on the agency to cease reregulation. Congress passed the Competitive Equality in Banking Act (CEBA) in 1987. They passed CEBA after Gray’s term ended.
The White House reached a secret deal with Speaker Wright not to reappoint Gray in the Spring of 1987. Speaker Wright was a Texan and his closest business associates (who employed the Speaker’s spouse) owed substantial sums to failed S&Ls. The receivers we appointed for failed S&Ls would typically sue to recover these debts. Speaker Wright put held the bill that eventually became CEBA hostage in order to extort the Bank Board to give special regulatory favors to Texas S&Ls controlled by contributors to the Democratic Party. Gray spent virtually all the cash in the FSLIC insurance fund to close failed S&Ls. We spent the fund down to $500 million – which was insuring a deeply insolvent industry with over a trillion dollars in liabilities. CEBA was a Rube Goldberg financing scheme to allow the agency to borrow additional funds so that it could continue to close the frauds. The financing scheme was necessary because the administration refused to admit that the industry and the insurance fund were massively insolvent. Getting the additional funds was our ultimate agency priority, and Speaker Wright knew that by holding the bill hostage he could exert maximum leverage to try to kill Gray’s reregulation. Speaker Wright became so brazen in his extortion that he asked Gray to force Selby out as the top regulator in Texas on the purported grounds that Selby was a homosexual who Wright claimed was sending all the legal business of the regional agency to “homosexual law firms.” M. Danny Wall, then the top aide to Senate Banking Chairman Jake Garn, urged Gray to accede to Wrights’s reprehensible demands to get rid of Selby.
The CEBA bill had two components, which generated two Faustian bargains. As proposed, the bill would have allowed the agency to raise an additional $15 billion through the convoluted financing mechanism and it would have given the Bank Board additional supervision and enforcement powers. The S&L trade association’s top priority was minimizing the funding to the insurance fund because it indirectly came from the industry. Political scientists had called the S&L trade association the third most powerful lobby in America. Americans liked S&Ls and the trade association had a large group of S&L CEOs – each of them an important contributor to members of Congress with whom they were on a first name basis – pledged to be in DC walking the Hill offices within 48 hours of receiving the trade association’s call to arms. Their trade association was a force of nature, but they S&L control frauds had even closer ties with a subset of Congressional leaders. They induced Speaker Wright to hold the bill hostage in the House and Senator Cranston to place a secret “hold” on the bill in the Senate. The fraudulent S&Ls wanted to delay and reduce the funding provided to the agency to close the frauds, but they had a more audacious approach to the portion of the draft bill that would grant the agency additional supervisory and enforcement powers. They decided to pervert that portion of the bill to accomplish the opposite – to use it to gut the agency’s power to supervise and enforce. The first Faustian bargain was the agreement of the trade association and the frauds to combine their lobbying efforts against the bill in order to reduce the funding dramatically and mandate regulatory “forbearance.”
The second, inconsistent, Faustian bargain was between the administration and Speaker Wright. (They despised each other because of their conflicts over U.S. support for the Contras’ war against the Nicaraguan government.) Wright and the frauds were happy to the full $15 billion in funding passed as long as it was used to bail out rather than close the insolvent S&Ls. The administration had always opposed Gray’s reregulation. It only cared about the dollar amount of the funding. Speaker Wright agreed to stop holding CEBA hostage and to support the $15 billion in financing in return for the administration’s agreement not to oppose mandatory regulatory forbearance and not to reappoint Gray for another term. The administration’s sole S&L priority at all times during the debacle was covering up the scale of the crisis and it welcomed the opportunity to halt and reverse Gray’s reregulation. The administration had no intention of reappointing Gray to another term as Chairman of the Bank Board and Speaker Wright had no intention of really supporting $15 billion in funding for the agency to close down hundreds of Texas S&Ls. The Speaker spoke in favor of the bill while his Whip told the Democrats to ignore his words and crush the funding amount, which they (and many Republicans) proceeded to do with gusto.
CEBA provided the agency with some additional funds, but it sought to mandate “regulatory forbearance” provisions drafted by counsel for the leading frauds for the purpose of eviscerating Gray’s re-regulatory efforts. (“Reregulation” was the label the Reagan administration ascribed to us. It was their vilest curse and they bestowed on Gray the special disdain and rage reserved for true believers who become apostate.) We were able to work with Representatives Henry B. Gonzalez, Jim Leach, Tom Carper (now a U.S. Senator), and Buddy Roemer helped us insert subtle changes in the CEBA drafts that removed most of the harm that the “regulatory forbearance” were intended to cause. Senator Gramm was also helpful to us in this effort. Senator Gramm’s actions are instructive of an important fact of human life, people are not always consistent. Senator Gramm also asked the President to appoint an attorney to the Bank Board who created the de facto trade association of the worst Texas control frauds. The worst two S&L frauds in the nation Vernon Savings (referred to by its regulators as “Vermin” – 96% of its loans defaulted) and Charles Keating’s Lincoln Savings exerted the most successful lobbying power. Speaker Wright intervened on behalf of Lincoln Savings and Vernon Savings. Senator Cranston put the secret freeze on the CEBA bill in Senate as a favor to Charles Keating.
Gray’s reregulation saved the nation a trillion dollars and prevented an economic crisis. He acted despite the combined opposition of a majority of the House, the Reagan administration, the OMB (which threatened to file a criminal referral against Chairman Gray on the specious grounds that he violated the anti-Deficiency Act by closing too many insolvent S&Ls, the “Keating Five,” the industry’s trade association, the great bulk of the business media, most of the state S&L regulatory heads, his fellow Bank Board members, and important segments of the Bank Board’s professional staff. The Reagan administration appointed Danny Wall as Gray’s replacement and Wall publicly took “credit” for forcing Selby to resign. This followed the administration’s 2006 effort to appoint two members of the Bank Board chosen by Charles Keating, the worst S&L fraud. The Bank Board had three members, so this would have given Keating control of the agency and added massively to the losses. Keating succeeded in getting the administration to appoint one of his choices to the agency and he proceeded to serve as Keating’s “mole” at the agency until I blew the whistle on him. He resigned as part of a deal with a Justice Department to end its investigation.
Several of us were sued by Lincoln Savings in our personal capacities for $400 million. Keating hired investigators twice that we learned of to investigate me. Keating was able to induce William Weld, one of the most senior Justice Department officials to order a criminal investigation of the agency at the same time that the DOJ initially declined to investigate our criminal referrals (which eventually led to convictions).
Wall removed our (the Federal Home Loan Bank of San Francisco’s) jurisdiction over Lincoln Savings because we persisted in recommending that the agency take it over. This had never happened before in regulatory history and it sent shock waves through the financial regulatory community. Wall tried to engineer a sham examination of Lincoln Savings, but there was a revolt by many field regulators and the California Department of Savings and Loan. Wall’s removal of our jurisdiction, the sweetheart deal he cut with Keating, and the $3.4 billion in fraud losses at Lincoln Savings led to his resignation in disgrace after our (the field regulators’) Congressional testimony.
The story of why the S&L debacle did not lead to a general financial crisis is a story of an agency head and staff identifying the coming crisis through an “autopsy” process of reviewing every failure and looking for patterns. The agency head then rose above his long-held anti-regulatory perspective and abandoned business as usual in favor of an emergency response along over a dozen dimensions. The agency’s analytics proved superb and its remedies proved effective. The head of the agency recruited strong, competent leaders with great integrity. Many of those regulatory leaders paid a high personal price for their successful work in preventing the debacle from becoming a systemic economic crisis. Gray’s regulators were sometimes crushed during Wall’s tenure but their blood was always on the front of their shirts as they interposed themselves between the frauds and their political patrons and the American people.
None of this history comes through in the recent article that (correctly) observes that the S&L debacle has important lessons for understanding the causes and appropriate responses to the ongoing crisis. The full citation to the published article (available free on line through the author’s web page) is: Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009. By Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter Foundations and Trends in Finance Vol. 4, No. 4 (2009) 247–325
The authors incorrectly state that deregulation began at the federal level instead of the reality that the federal deregulation was modeled on Texas’ earlier deregulation. The authors do not distinguish between the Bank Board Chairmen. The article talks about the large number of newly chartered S&Ls but misses the fact that Gray denied hundreds of them deposit insurance and they never opened. They do note correctly that the industry fought bitterly to prevent the recapitalization of the FSLIC insurance fund and they seem to understand that the agency’s goal was to use the proceeds to close hundreds of failed S&Ls. The authors’ imply that S&Ls took steps that caused most of their losses primarily late in process after they became “zombies” (the walking dead) and their managers developed perverse incentives to make honest gambles for resurrection. This is contrary to the facts. First, the agency developed and used techniques to place insolvent S&Ls in receivership that required relatively litter upfront cash. Second, the agency restricted growth, so the ability of zombies to increase their risk exposure was limited by regulation. Third, the agency adopted a far more stringent examination and supervision regime beginning in 1983, so over time (during Gray’s tenure) even most fraudulent S&L were increasingly constrained rather than becoming “banks gone wild.” Fourth, the agency often prioritized the fastest growing insolvent S&Ls for enforcement and receiverships. Fifth, the incentive for S&Ls to engage in fraud generally had nothing to do with the S&Ls being zombies. The opposite was true – it was the healthiest S&Ls, the de novos, that were far more likely to engage in accounting control fraud than traditional S&Ls that had been insolvent on a market value basis for several years. Traditional S&Ls were all insolvent in early 1982, but only a small percentage of them became “high flier” frauds. The percentage of frauds among Texas and California chartered de novos was far higher because the new S&Ls were typically created and operated by real estate developers with intense conflicts of interest.
The reregulation of the industry by the regulators began in 1983. The statutory reregulation of the S&L industry began only six years late in 1989. Absent the regulatory actions there would have been a systemic crisis, but the authors of the article draw the opposite conclusion. They do so contrary to the facts and without citation.
There are several lessons from the S&L mess. [R]egulators can easily be captured by the industry they regulate. This was clearly the case with the FHLBB.
It would be difficult to find an regulatory agency that was more clearly not captured by the industry than the S&L regulators under Gray and Ryan. The reason Keating and the other S&L control frauds had to go to such extraordinary lengths to try to crush the agency was that the agency was the industry’s most bitter and successful opponent. Superficially, one might think that the agency was captured by the industry under Chairman Pratt or Wall’s terms of office, but that too would be incorrect. One trait that all four of the heads of the federal S&L regulatory agency and the head of the S&L industry’s trade association during the S&L debacle shared was a mutual loathing. Yes, the industry supported financial deregulation, as did Pratt, but his worship of deregulation was due to his ideological and policy views. Pratt refused to grant the industry its dearest dream – the ability to create massive fictional accounting income and capital without merging with another S&L. When an administration appoints anti-regulatory leaders as its top financial regulators there is normally no need for the industry to “capture” the regulator. Gray is the exception that proves the rule.
The third portion of this column will describes the essential role that Office of Thrift Supervision (OTS) Director Tim Ryan, and his chief counsel, Harris Weinstein, played in the successful enforcement, civil action, and prosecution of the elite criminals that drove the second phase of the S&L debacle.