S&L Regulators Should Look in the Mirror

Everyone now knows that the S&L crisis will cost hundreds of billions of taxpayer dollars to clean up, but not everyone knows why. Government officials would like us to believe that this huge federal debt came about solely because of fraud and self-dealing within the S&L industry.

If pressed, they may admit that the willingness of federal regulators "to look the other way" may have contributed to the problem. But they will flatly dispute that, in large part, the S&L crisis is a direct result of governmental negligence, mismanagement, and blundering on a massive scale. And the same kinds of regulatory mistakes are being repeated today, threatening to prolong the S&L crisis instead of resolving it.

Investors' Aid Sought

An example is the government's treatment of investors who struck bargains with government regulatory agencies in the last decade. In the early 1980s, after prevailing interest rates skyrocketed, all S&Ls took a severe drubbing on their portfolios of fixed-rate mortgages. The weaker ones suffered liquidity problems and began to fail, thus taxing the government's deposit insurance fund to a historically unprecedented degree.

Rather than allow all the weaker S&Ls to fail, and pay billions of dollars to depositors, regulators chose to persuade private investors and the stronger S&Ls to take over the failing ones.

Regulators' Goodwill Offer

The regulators had one problem: They could not induce an investor or healthy S&L to take on the same liability the government was seeking to avoid -- the difference between the amount the failing S&L owed to depositors and the much-reduced market value of its fixed-rate loans -- unless the government gave something of equal and offsetting value.

The regulators found a solution. They promised investors and acquiring S&Ls that they could offset the amount of the failing S&L's "capital hole" with an equal amount of goodwill -- a book entry often used in other industries that use purchase-method accounting in acquisitions.

In most cases, the government negotiated and signed written contracts promising the acquirer that it could book, and amortize over many years, the goodwill created by the merger as a capital asset.

Thus, if an insolvent S&L owed $500 million more to its depositors than its loans and other assets were worth on the day of the acquisition, the acquirer booked goodwill of $500 million.

Not coincidentally, the $500 million replaced -- dollar for dollar -- the amount the deposit insurance fund would have had to pay to depositors upon liquidation of the failed thrift if no merger partner had been found.

This accounting technique allowed the government to avoid billions of dollars of its insurance liabilities throughout the 1980s. But it only postponed, rather than solved, the problem.

In 1989, when the comprehensive S&L reform legislation known as FIRREA was enacted, legislators revisited the goodwill issue and decided to phase out the use of goodwill for regulatory capital purposes, despite their knowledge of the many agreements the government had entered into with investors.

Property Interests Affected

This was a mistake of monumental proportions. Because FIRREA failed to provide a mechanism for dealing with claims arising from the government's reneging on its contract commitments, the literal terms of the 1989 statute have led to a large, uncompensated confiscation of private property.

Those property interests, however, will be protected by the judiciary because of our constitutional guarantees, and an avalanche of litigation has ready begun.

Remarkably, the regulators have chosen to defend these claims on a scorched-earth basis, arguing that contract commitments were never made, or, if made, that they do not bind the government.

They have refused to acknowledge that the contracts were entered into for the mutual financial benefit of the investors and the government agencies responsible for federal deposit insurance.

If this conduct had occurred in Iran or Chile, the State Department would be characterizing it as one of the century's most massive expropriations of U.S. investors' interests. Because our government effected the taking, however, the issues arising from it will have to be litigated for years before the regulators are forced to acknowledge their legal obligations.

Perhaps this administration, like the last one, is hoping that by then it will be someone else's problem. But that's precisely the kind of thinking that allowed the magnitude of the crisis to grow, unnoticed, throughout the 1980s.

Mr. Gaston is a partner with the Washington law firm of Spriggs & Hollingsworth.

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