S&Ls, Big Banks and Other Triumphs of Capitalism
PLENTY OF WARNING SIGNS
Ed Gray is probably not exaggerating in the slightest when he says of the S&L lobby, "The fact is ... when it came to thrift matters in the Congress, the U.S. League and many of its affiliates were the de facto government. What the League wanted, it got. What it did not want from Congress, it had killed.... Every single day that I served as chairman of the Federal Home Loan Bank Board, the U.S. League was in control of the Congress as an institution." And that, he says again accurately, is why Congress, "compromised by campaign contributions ... did nothing year after year" to resolve the problem.
Nevertheless, Edward Kane is equally justified in tying the can to Gray's tail by pointing out that as boss of the bank board he could have tried to overcome Congressional resistance by using his official position "as a 'bully pulpit.' A top official could develop persuasive data with which to alert the press and therefore the taxpayer as to the extent and dangers" of industry conduct "and plan to resign pointedly if Congress refuses to come around. If evidence developed that Congress chose to believe old friends and supporters within the thrift industry over his top regulatory officials, a conscientious regulator should find this to be an intolerable situation."
Obviously, Gray did not find it an intolerable situation. He stayed to the end of his term in 1987. And although by sticking around he did manage to put in place a few reform rules, he could probably have done much more for the cause of industry reform if he had, as Kane recommends, raised holy hell on his way toward resignation, and continued to raise hell thereafter.
Indeed, some think Gray would have been wise to arouse Congress by pulling the roof down. "If there's one point to fault Ed on," says Eric Hemel, who was Gray's director of economic policy, "it was that he was not willing to risk a financial crisis in order to really spill the beans on this one. In late 1985, if he had said, 'This is a house of cards and it's going to fall,' he felt that would have spurred financial panic. Did he make a mistake not taking that chance? In retrospect, sure. But at the time it was very hard to knowingly create a national financial crisis on your own."
But Congress shouldn't have needed bleats of outraged panic from Gray, either on or off the job, or a contrived financial crisis. A very real financial crisis was at hand and signs of it were surfacing everywhere. There was plenty of frightening evidence (had Congress been alive enough to feel fright) that both commercial banks and S&Ls were sliding down a very slippery deregulated slope on the way to disaster. Supervision by federal examiners was at an absurdly low level; incredibly, the number of federal examiners was slashed in 1982, 1983 and 1984, "precisely when the economics of FSLIC's exposure to zombie risk taking was expanding and becoming harder to assess," writes Kane. Hundreds of F.S.L.l.C.-insured thrifts went several years without having their books glanced at even once, while most state corps of examiners resembled Keystone Kops.
Financial institutions were succumbing to the crazed anarchy. Congress didn't have to learn that through the bureaucratic grapevine. It only had to look at the statistics: Whereas before Ronald Reagan came to Washington the largest number of federally insured thrifts to fail in a single year (1941) was thirteen, in the first three years of his Administration 435 thrifts were buried and the first full year of Gray's F.H.L.B.B. watch saw the death of another forty-one. It was a massacre. As for the commercial banking world, in September 1984 the chair of the House Banking Committee, Fernand St. Germain, noted that "56 commercial banks have slipped quietly down the tubes this year--a failure rate rivaled only in the dark days of the Depression." And if statistics bored Congress, then it could simply read the headlines. Three mid-1980s catastrophes were warning enough of the mindlessness that was gripping the financial world.
In Banks We Trust?
In 1984 Continental Illinois--with $40 billion in assets the biggest bank in Chicago, the biggest bank in America excluding the two coasts, a bank that Dun's Review called one of the five best-managed companies in the country because of what many outsiders perceived as its careful controls and high-quality loans--went kaput. It failed because the outside observers were wrong; Continental was rotten with bad management and bad loans.
More than $1 billion of the bad loans had been passed along to it in the oil-boom days by little Penn Square Bank in Oklahoma City. Growing by 1,500 percent (largely through brokered funds) in seven years, Penn Square had a reputation as a go-go bank. William Patterson, the senior executive vice president who ran Penn Square's oil and gas division, had been called "monkey brains" when he was in college. Sometimes he came to work wearing a hat with Mickey Mouse ears. Sometimes he wore a German helmet. He was known around town for drinking beer from his cowboy boots.
Shopping-center banks like Penn Square don't have the money to make huge loans all by themselves. They have to have help. They go "upstream" to enlist big banks as partners in the loans, just as small bookies pass off big bets to the Mafia. Penn Square's partner was Continental Illinois, which had such oil fever that its top managers (who, by the way, were the highest-paid bank managers in the nation) issued orders to "buy more, more, more, more Penn Square loans." Congressional investigators would later learn that Continental did not have loan documents for one-fourth of its oil and gas loans, and had no collateral for half of all its loans. Federal regulators didn't mind. Every six months their auditors certified the bank to be safe and sound.
Then the oil boom died. Penn Square died. And within two years Continental Illinois was dead too--the biggest bank failure in U.S. history. Ironically, its death was caused by Penn Square only in the sense that those highly publicized Penn Square dealings had caused the public, particularly foreign investors (who accounted for half of Continental's deposits), to lose confidence in the bank, and moneylenders can't survive without the public's confidence. When a rumor spread around the world that Continental faced bankruptcy (which it didn't at the moment), the big foreign banks turned rumor into reality by withdrawing many billions of dollars. Rumor killed Continental. Ah, what a disaster was there! If you added together all the deposits of all 10,000 banks that failed during the Great Depression, you would have a bank only one-quarter the size of Continental Illinois in 1984.
But federal officials and other major U.S. banks, fearful that if the corpse grew cold it might bring down the entire national banking structure, brought the brain-dead monster back to quasi-life by pumping $9.5 billion into it. The Federal Deposit Insurance Corporation--for the first time ever--guaranteed all deposits at Continental, not just those under $100,000. In fact, to reassure the banking public, it guaranteed all deposits at the twelve largest banks in the country--a commitment of about, gulp, $1 trillion. (Since that traumatic experience, it has been the government's standard though unofficial policy in virtually all bailouts to cover all deposits, however large, disregarding the $100,000 ceiling. This is in violation of the spirit of the deposit insurance law.)
Unable to find a buyer for Continental, the F.D.I.C. became its owner. As Judy Woodruff put it, "The nation's eighth-largest bank had, in effect, been nationalized by the most conservative Administration in fifty years. Nothing like this had ever happened before." Once again the formula had been capitalism for profits, socialism for losses.
Hardly had the financial world got over the embarrassment of Continental Illinois than it was confronted with two other great embarrassments, this time with S&L networks in 1985. Home State, the largest S&L in Ohio, had invested 43 percent of its assets in a shady Florida firm that went belly up. Ohio S&Ls were then covered only by a state deposit guarantee fund, but Home State's losses alone depleted almost the whole fund. When depositors heard of Home State's predicament, they began such a run on all Ohio S&Ls that the Governor temporarily closed them and called on the Federal Reserve for help.
So we come back to the question, Did Congress know that the same kind of bankruptcies from stupid, often illegal, loans could endanger the federal S&L insurance system? You bet it did. Representative Charles Schumer, who had no corner on the information, said at the time, "Here's a scary fact. Just one scary fact. The F.S.L.I.C., the federal system which is much safer because it has the federal government behind it...right now has less, a smaller percentage of assets for each deposited guarantee than the Ohio system had."
And then, only two months later, came Maryland. Public reports of "management problems"--which the public was savvy enough to interpret as hanky-panky--triggered a run on Old Court Savings and Loan and began to spread so swiftly through the whole system that the Governor had to call a partial bank holiday (all withdrawals limited to $1,000 a month). Maryland's S&L system, like Ohio's, was state-supervised and privately insured. In fact, there was virtually no supervision and a totally inadequate insurance system. How did the debacle come about? Maryland's Attorney General, Stephen Sachs, said it was because "highrollers were shooting crap with other people's money." It was the direct result of a "mom-and-pop regulatory apparatus ... which has not been able to survive a go-go investment" and deregulatory atmosphere.
Schumer, in reference to the Maryland rubble, said, "Old Court had over $150 million invested in loans in which the bank was a partner. In other words, the lender and the person getting the loan were the same person. That's outrageous. No bank is going to check and see if it's a sound loan if it itself is the owner of the property to which it is lending.... These state insurance systems allow banks and thrifts to do anything under the sun." But in fact, as he was quick to add, federal regulations were allowing anything under the sun, too: "You have some federally insured thrifts that have huge percentages of their investments in real estate they own.... You have lots of them owning junk bonds."
Indeed they did. And the federally insured S&Ls were already collapsing. Some of the biggest and most scandalous bankruptcies had already occurred or were on the brink of happening at the very moment Ohio and Maryland sprang their headline-grabbing leaks. But only a few members of Congress, like Henry Gonzalez of Texas and Jim Leach of Iowa, paid much attention. When Ed Gray asked for more regulators in 1984, Congress ignored him, just as it did when he warned (as early as March) that unless Congress got ahold of the problem it was "very possible that at some point in the future, massive infusions from the U.S. Treasury and, hence, the American taxpayers, may well be necessary to shore up the system."
Congress was much more willing to believe--because the S&L lobby paid it to believe--industry finks like Alan Greenspan, who on a Nightline program devoted to the Ohio shutdown was tossed this marshmallow question by Sander Vanocur: "Is there a process of adjustment that every industry has to go through when deregulation takes effect?" Greenspan's cheerful appraisal: "I would think so, Sandy. The advantages of deregulation will be quite considerable when they're finally matured. And I think consumers, depositors, people involved with these institutions, will have a far greater range of services when it's all in place. It is true, we are having a lot of minor difficulties in this process. I think it's worth it, there's no question about that." Then he added one final shill: "I think that the banking and savings and loan community in this country is probably as solid as one could get in any type of institution."
At that moment, hundreds of banks and S&Ls were failing in the largest depository wipeout since the Great Depression. And the S&Ls, with their shabby little billion-dollar Ponzi schemes, couldn't touch the Ponzi scheme then (and now) in operation among the international bankers, who had made, by investment banker Felix Rohatyn's calculations, a trillion dollars' worth of shaky loans to gamblers like Nigeria, Mexico, Brazil and Argentina. Rohatyn's description of the situation in 1985 was the purest Ponzi: "A thousand billion dollars. It's a great deal of money. And we are on this kind of treadmill where we have to keep lending more and more money to these countries [with the loans on the banks' books as "assets"] or to these borrowers in order to maintain a facsimile of solvency, in order to maintain the capital of the banking system."
Let us pause for a moment to savor Rohatyn's analysis. Behind it is a morality tale (never mentioned by financial writers these days) that dates back to the late 1970s and early 1980s, when Middle East oil producers, savaging the world's economies with their high prices, deposited much of their new riches in big U.S. banks. Having so much money on hand made the bankers very nervous (they needed to lend it to someone in order to make a profit), until they decided they could "recycle" it through the Third World at very high interest rates. Never mind that the borrowers really couldn't afford such rates. Never mind that the developing nations were so desperate for money that this was like offering unlimited credit to a drunk gambler.
But the loan sharks weren't as smart as they thought. The world market couldn't support the high oil prices, which thereupon collapsed. So did the economies of many Third World debtors, who told the big banks they might as well forget about the loans. When Rohatyn was talking, in 1985, the banks were still lending money to them to maintain the fiction of solvency. Some still do. But most of the mighty moneylenders, grudgingly conceding that the relationship is hopeless, have in recent years been writing off many billions of dollars of bad debts. Occasionally, in the banking/thrift story, crime does not pay. But beware of happy endings. Today the big banks and their buddies in Washington are arguing, with little opposition, that they need more deregulation to get out of a mess caused, in part, by those bum loans to the Third World. But we're getting ahead of our story.