The two latest major pieces of banking legislation -- the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 and the Federal Deposit Insurance Corp. Improvement Act of 1991 -- were products of congressional demagoguery. Their results will be exactly the opposite of what their titles advertise.
Together, these acts prevent troubled financial institutions from earning their way back to financial health and thereby minimizing losses to taxpayers.
One underlying presumption of both the laws is simpleminded: that government can do a better job of managing the business of our problem institutions than existing private-sector managers.
When government-controlled liquidations impose average losses of 40% on sales of hundreds of billions in assets, it is time to reconsider this premise.
Forbearance's Bad Name
In regulatory parlance, refraining from closing a capital-deficient institution is referred to as forbearance. The ill repute of forbearance stems from the conventional wisdom that taxpayer losses would have been dramatically reduced if regulators had acted earlier to close brain-dead institutions.
The idea is that executives at insolvent institutions no longer had the incentive to safeguard against imprudent lending and investing policies since the thrift's own capital was no longer at risk.
By almost all accounts, the entire thrift industry was economically insolvent in the early 1980s. Fixed-rate home mortgages were being offered at 15% and short-term deposits at rates even higher.
For savings and loans that knew only one line of business -- 30-years mortgages funded by short-term deposits -- those high interest rates were deadly. Most S&Ls paid out more in deposit costs than they got back in loan interest income.
Meanwhile, the now defunct Federal Savings and Loan Insurance Corp. had insured $600 billion in thrift deposits while maintaining reserves equal to perhaps 1% of that amount. In the face of mountainous losses, the FSLIC's solution was forbearance.
The thrifts' primary regulator, the Federal Home Loan Bank Board, as administrator of the FSLIC, developed its own accounting gimmickry, referred to as regulatory accounting principles, to paper over the problems.
In consideration of an IOU known as supervisory goodwill, institutions in advanced stages of rigor mortis were grafted onto the slightly healthier ones in assisted mergers.
Where accounting norms would have required the FSLIC to recognize the budget for big losses, the regulators allowed savings and loans to write up the value of the acquired assets and to report this fanciful number as regulatory capital.
The ultimate cost of this regulatory sleight-of-hand was quantified in a recent Congressional Budget Office study undertaken at the request of the House Banking Committee.
The research concluded that of the estimated $127 billion cost of the S&L fiasco, $66 billion is attributable to the forbearance granted to insolvent institutions.
Effect of Forbearance
The CBO analysis was straightforward. It examined all thrifts at the point where they first reported insolvency. Then, it noted the period of forbearance.
Finally, it computed the difference between the thrifts' reported initial claims of insolvency and the eventual cost to the taxpayer of resolving these thrifts.
This last calculation led the CBO to its $66 billion estimate. Its report states: "The average failed thrift deteriorated in value at an annual rate of 37% between the time it first became book-value insolvent and when it was closed and resolved by the federal regulator."
House and Senate conferees relied heavily on this research in drafting the 1991 law's provisions on "Prompt Corrective Action" for critically and significantly undercapitalized institutions.
From Private Hands to Public
Once an institution is so classified, an almost inexorable process is set into motion to move the depository out of private and into public hands for disposal.
The CBO's research was flawed on a fundamental count. In measuring the thrift's value at the point of insolvency, the study assumes that the book value was an accurate indicator of the thrift's value in liquidation.
Yet, any bank or savings and loan analyst knows that similarities between book value of equity and market value of the institution can be little more than coincidental.
Accounting in a Vacuum
Institutions that the study described as barely insolvent were typically massively insolvent by the time they reported negative equity.
This is true because thrift accounting in the 1980s generally reflected the impact of neither changes in interest rates nor changes in credit quality on the value of the thrift's assets.
New evidence suggests that in many cases keeping problem institutions in the hands of private management may be the "least costly [resolution] to the deposit insurance fund" mandated by the 1991 law.
In other words, when applied with good judgment and appropriate controls on existing management, forbearance works.
Recent work by Professor George Benston of Emory University and others indicates that regulatory delay in closing institutions in the early 1980s was, after the fact, the least costly solution for many thrifts.
Mr. Benston's work also implies that adjusting for changes in interest rates and credit quality, the value of problem institutions from closure to liquidation undergoes a strange reductive metamorphosis while in government hands.
According to Jim Barth, who was formerly chief economist of the Federal Home Loan Bank Board is now at Auburn University, if the 1991 law's early closure rules had been in effect at yearend 1984, well over half of the thrift industry's assets would have come under government control, presumably at even more horrendous cost to the taxpayers.
Other studies, including the recent work of Christopher James of the University of Florida, suggest similar conlusions, based on the FDIC's experience as a caretaker of problem banks.
Mr. James' research which focuses on bank resolution costs and recoveries, concludes that the FDIC recovered an average of less than 70% of asset book values. The General Accounting Office's measurements of recent thrift liquidation activity report lower recovery rates of 60%.
Given the higher quality of thrift assets liquidated thus far, even this figure may be overly optimistic.
Are government conservators better equipped to maximize the performance of undercapitalized institutions than present management?
A Telling Example
The case of Sterling Savings is particularly illuminating in this regard. Sterling is a $700 million Spokane, Wash-based thrift that committed the unpardonable sin of doing its regulator a favor. During the course of the mid-1980s, regulators frequently approached Sterling to acquire troubled thrifts.
After initially rebuffing the regulators' requests, Sterling ultimately acquired three problem thrifts, creating substantial amounts of supervisory goodwill - the counterfeit currency of the FSLIC - along with an agreement that this goodwill would continue to count as capital.
When the bailout law was enacted in 1989, capital definitions were rewritten to exclude this goodwill. Along with hundreds of other thrifts, Sterling thus fell out of capital compliace.
Sterling, which has always been profitable, was taken over by regulators for a brief period in 1989, only months before private investors committed to purchase $10 million of the institution's common stock.
Sterling Wins Lawsuit
The regulators forced Sterling to cancel the offering. By spring 1990, the thrift successfully brought suit against its regulators to return to private hands.
The happy conclusion is that Sterling recently completed the sale of $21 million in stock, which puts it in full capital compliance and out of the regulators' cluthes.
Every taxpayer should feel at least slightly enriched by the outcome to this cautionary tale. If historical loss experience is a good indicator, government ownership of Sterling would have cost taxpayers a quarter of a billion dollars.
There is no question that there have been and will continue to be managers of financial institutions who are crooked, incompetent, or both. Sometimes, the state of our problem thrifts and banks is directly traceable to the poor or corrupted decisions of these managers.
Since managers of these institutions have the ability to write a check on the U.S. government, they should be constrained, removed, or even jailed.
But institutions are often undercapitalized because of factors over which the executives, employees, and directors of the bank or thrift had no control.
Hard evidence shows that when the honesty and competence of management are not in doubt, private management will do better than government employees.