Despite Cleanup, Healthy S&Ls Struggle

Two years into the savings and loan cleanup, one thing has become crystal clear: The recovery of the thrift industry has run into unexpected roadblocks.

The landmark thrift-bailout law was aimed primarily at weeding out hundreds of terminally ill institutions, thereby giving the healthy half of the industry a better chance to survive.

And, indeed, regulators have closed some 458 S&Ls since President Bush signed the thrift bill into law two years ago next Friday.

But three factors have conspired to prevent the thrift industry from a return to robust health: Slack loan demand, heightened competition from banks, and the slow pace at which seized assets are being sold.

On top of that, the bailout law is having an unintended side effect. By confining thrifts largely to mortgage lending, the measure is laying the groundwork for another crisis should inflation reignite.

Why? Lower interest rates have pushed up demand for fixed-rate loans, and thrifts once again are loading up on them. If rates soar, many institutions will have lots of underwater loans on their books - the predicament that touched off the thrift crisis in the early 1980s.

All of this raises the question of whether even healthy thrifts will be able to survive the 1990s. Increasingly, it looks like the industry's worst fears could be realized: Weak thrifts will perish while strong ones flee to more flexible bank charters.

"We've still got one heck of a challenge before us," said Richard D. Jackson, vice chairman and chief executive of Georgia Federal Bank, an $4.7 billion-asset thrift based in Atlanta.

Atmosphere Was Charged

Enacted in an atmosphere of crisis and retribution, the bailout law was the government's cure for what ails the thrift industry.

The legislation - formally called the Financial Institutions Reform, Recovery, and Enforcement Act - appropriated tax dollars to bail out the insolvent thrift deposit insurance fund, created a huge federal agency to liquidate or sell failed thrifts, tightened the industry's financial standards, and established a tough regulatory framework.

The underlying goal was to return the thrift industry to its roots in home mortgage lending.

The economy and national real estate markets, however, have not cooperated.

Roughly a year after the law's enactment, the creeping tentacles of the nation's first recession since 1982 began squeezing loan demand, occupancy rates, and property values.

That dashed the hopes for recovery of many marginal institutions and undermined the profitability of healthy ones.

Originations Plummet

The $15.5 billion of residential mortgage originations booked by healthy thrifts in the first quarter is down a whopping 27%, or $5.6 billion, from the second quarter last year, according to data compiled by W.C. Ferguson & Co.

"Fewer people can afford to buy houses," said Kenneth Abt, president of First Federal Savings and Loan Association, Middletown, N.Y.

And banks are snapping up a growing portion of what mortgage lending remains.

Banks Invade Turf

Even before passage of the law, bankers had tapped out the main lending avenues of their industry and were eyeing home mortgages as one of the few sources of loan growth.

"We saw mortgages as a natural extension of our franchise, and many troubled thrifts were withdrawing from that market," said Allen Lastinger Jr., president of Barnett Banks Inc., Jacksonville, Fla.

Commercial banks have charged into the mortgage market with a vengeance, now dominating the only arena in which thrifts are allowed to compete.

Between December 1988 and March of this year, U.S. banks racked up a 47%, or $129.7 billion, increase in one- to four-family realty credits. By contrast, healthy thrifts recorded an increase of just 12.8%, or $37.5 billion.

Cleanup Plods Along

A further worry is the seemingly paralytic pace of the thrift industry cleanup.

While the RTC has seized 631 of the roughly 850 thrifts expected to require rescues, it has digested less than one-third of their assets. Some $350 billion of loans, other investments, and foreclosed property still have to be liquidated or sold.

The results: Higher deposit interest rates paid by ailing thrifts awaiting rescue, lower loan yields because of overcapacity, and a glut of nationalized properties that restrains asset sales and fresh lending by healthy thrifts.

"FIRREA hasn't been a success in cleaning up the mess," said Martin Regalia, chief economist with the National Council of Savings Institutions.

Meanwhile, lending restrictions imposed by the law apparently are steering thrifts right back into the interest rate exposure that originally got them into trouble.

The law specifies that thrifts must have high concentrations of mortgage loans. It also restricts other types of lending. So thrifts have few ways to counterbalance mortgage lending risks.

It seems like a prescription for trouble.

Interest Rate Gamble

When institutions use short-term deposits to make long-term mortgage loans at fixed rates, they are taking a gamble on future interest rates. If rates rise by the time deposits mature, the profit margin between fixed mortgage yields and the cost of funds narrows.

With high inflation, this phenomenon can accelerate to the point that lenders pay more in deposit interest than they earn on fixed-rate mortgages.

The problem is not new: Vast losses stemming from soaring rates are what first got the thrift industry in trouble a decade ago.

But the healthy portion of the industry has made little progress in reducing interest rate risk since the law was passed.

Profitable thrifts with tangible capital exceeding 3% of assets at March 31 had $155.5 billion, or 41.65% of their total mortgages, tied up in fixed-rate instruments, according to Ferguson.

That percentage was virtually the same as 15 months earlier. Meanwhile, the total amount of fixed-rate mortgages increased by $11.5 billion during the period - thanks in part to the demands of the thrift-reform law.

"Forcing savings and loans back into heavy residential mortgage lending doesn't necessarily guarantee their survival, because that's what sank the industry in the first place," said James Barth, the former chief economist at the Office of Thrift Supervision who is a professor at Auburn University. "The potential for thrifts to be severely hurt by high interest rates still exists."

Equity Capital Scarce

Amid all the uncertainty, Wall Street has virtually halted the flow of equity capital to the thrift industry.

U.S. thrifts have issued only $24.5 million of common equity so far this year, according to Securities Data Co. By contrast, U.S. banks sold $2 billion of common equity - 85 times more.

The red light is lackluster thrift profitability.

The anemic 0.52% return on average assets posted by healthy thrifts in 1990 represents a minuscule increase over the prior year. And though ROA jumped to 0.73% during the first quarter of this year, it is not at all clear that ratio is sustainable.

"The fundamental issue is that those with capital are not very interested" in thrifts, said T. Timothy Ryan Jr., director of the OTS.

Exacerbating the capital shortage are provisions of the law that reversed previous government commitments. With the government revising or repudiating the terms of previous thrift sales, investors are in no mood to take further risks on the industry.

Goodwill Denied

After buying hosts of ailing thrifts at the encouragement of regulators, for example, acquirers have been denied the use of goodwill accounting entries that kept their thrifts in compliance with capital standards.

And currently, the Resolution Trust Corp. is busy acting on the reform law's directive to rework federally assisted thrift sale transactions completed in 1988.

"The government has got to start playing fair if fresh capital is to be brought into the industry," said Joseph Matlock, president and chief executive of Franklin Federal Bancorp, Austin, Tex. The executive fears for the health of his institution following a federal revision of his 1988 purchase contract.

Rogues Driven Out

Despite all the troubles, clear progress is being made in ridding the industry of its rogue executives and notorious institutions. With 458 institutions sold or closed already, bankers and thrift executives express relief that the worst of the worst has been dealt with.

"The law finally gave regulators the tools to get rid of the mavericks and highfliers," said Ray Martin, chairman and chief executive of Coast Savings Financial Inc., Los Angeles.

Over the long run, however, the thrift reform law could end up sweeping away not only the thrift industry's losers but the industry itself.

Because banks have lower supervisory costs and much greater flexibility, healthy thrifts have a strong inducement to exit their industry and convert to banks, said consultant William Ferguson.

And in that light, Mr. Ferguson said, the thrift-reform law has only worked to hasten the convergence of the banking and thrift industries. What with banks already a dominant force in mortgage lending, he said, "the walls between the two industries are steadily being chipped away."

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