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The Growing Crisis In Our S&L Industry

The federal government will soon be responsible for tens of billions of dollars, and taxpayers will have to pick up the tab

The Fed, Savings-and-loans

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Washington, D.C. – Neither George Bush Nor Michael Dukakis is likely to talk about it, but one of the major time bombs awaiting the next president is the brain-dead savings-and-loan industry. Disposing of the carcass is going to be very expensive for the federal government – and ultimately the taxpayers. It will add tens of billions to a federal budget that’s already deep in red ink.

Right now about 1,000 savings-and-loan associations – one-third of the thrift industry – are either bankrupt or nearly insolvent. When regulators close them down, the Federal Savings and Loan Insurance Corporation (FSLIC) is obligated to pay off the depositors. The American Bankers Association (ABA) calculates that eliminating all of the busted S&Ls will cost about $43 billion. Trouble is, FSLIC is broke, too.

The federal insurance fund that guarantees deposits at commercial banks, the Federal Deposit Insurance Corporation (FDIC), is in better shape, but it too faces substantial losses. FDIC bank examiners report that there are 1,500 “problem” banks around the country, an unprecedented number in modern times, and nearly 200 banks will close their doors this year. The cost of liquidating all the failed banks, according to the ABA, will be anywhere from $3 billion to $9 billion.

Altogether, this is a major hemorrhage in the federal budget that no politician wishes to face – especially a new president who will want to spend money in such areas as education, housing and health care. Citizens who expect the next administration to pursue a more humane agenda of domestic aid programs are likely to be deeply disappointed. The next president, whoever he is, will be pinned down by all the bills coming due from the Reagan years.

But here is the fiendish angle to this problem: if President Dukakis or President Bush tries to put off dealing with the mess of the financial system (as President Reagan has done year after year), the eventual cost will simply get larger and larger. The managers of ruined S&Ls and troubled banks have nothing to lose – they are already broke, so they keep on borrowing money at high interest rates in order to make more risky loans. The effect is to pile up greater losses and larger obligations, which the federal insurance funds will have to pay off. The only real solution is to put the thrift institutions out of their misery as quickly as possible – close them down and pay off the depositors.

“This problem is growing at the rate of $35 million a day, seven days a week,” one bank analyst told me. That’s $12 billion more that is being added to the federal burden in 1988 because neither the White House nor Congress has had the guts to face the music in this election year. The public is not likely to be amused when it realizes that it has been stuck with the tab.

Not to worry. The inside players of Washington – bank lobbyists and their lawyers and like-minded associates – claim that they have already solved this problem for the next president. They are confident, even a little cocky, that they can sell their scheme to him (and to Congress) once he is in office and face to face with the full dimensions of this crisis. In my years as a Washington reporter, I have seen a lot of outrageous hustles worm their way through the political system, but I must say this one is slick and malodorous on a worldclass scale.

The proposal that bank lobbyists are now discreetly peddling around town is legislative sleight of hand of the grandest proportions – a gimmicky way to lift $40 billion or $50 billion from the public treasury without the average taxpayer’s even noticing. “We’re hiding the money under the rug,” one bank lobbyist cheerfully explained to me. “Most of us see the money problem as already dealt with. There is a very high probability that this idea is going to go.” If it does, it will also deliver a huge bonanza for the banks themselves.

Now here is how the deal would go down: Rather than appropriating the needed billions, a painfully obvious procedure that would be sure to aggravate a lot of voters, Congress would instead simply authorize the Board of Governors of the Federal Reserve System to pay for the cleanup from its own independent account. The central bank, though cloaked in secrecy and mystique, is actually a great power center within the government, steering the economy by regulating interest rates and the banking system. The Fed is ostensibly independent of politics but is actually a political institution that operates beyond the reach of voters. Most citizens hardly know that it exists, much less how its power affects their lives.

The Fed enjoys privileged status outside the regular processes of public debate. Its budget is private – not even subject to review by the president or Congress. Thus, as one congressional aide told me, a transaction on the Fed’s balance sheet would seem obscure and insignificant. “It’s a little paper shuffle in the realms of heaven known as the Federal Reserve,” he said. “Who cares about that?”

If taxpayers understood how the Fed works, they would care – because the money is coming out of their pockets. In its management of money and banking, the Fed holds the reserves for the country’s commercial banks – earnest money, in a sense, that ensures prudent behavior by the bankers. The Fed’s holdings are mostly invested in government bonds, and there is a sort of daisy chain of money between the Treasury Department and the central bank. Treasury pays the Fed interest on the U.S. notes and bonds in the central bank’s portfolio. The Fed uses the money to pay its own operating expenses, and then it sends the surplus back to the Treasury as a year-end dividend that amounts to as much as $15 billion a year.

Therefore, if the Fed’s funds are diverted to deal with the S&L crisis, the money is really coming out of the Treasury. Every dollar spent by the Fed would add directly to the federal budget deficits – which are ultimately the obligation of all taxpayers.

Because the Fed’s balance sheet is beyond public scrutiny, once Congress authorizes this arrangement, billions could flow out year after year without the awkward necessity of annual congressional action. Thus, it’s an enticing deal for the politicians who could resolve this mess without having to vote every year on billions in bailouts for banks and S&Ls.

But there’s another wrinkle to this scheme that makes some bankers salivate. The Federal Reserve would be authorized to do something that Congress has always forbidden – pay interest to the commercial banks on the idle bank reserves that the Fed holds for them. The banks would graciously agree that their interest money could first be used to clean up the financial mess – with the proviso that eventually it would be theirs to keep. At the end of the rainbow, ten years or so hence, when all of the failed financial institutions will have been liquidated, the banks themselves would collect a huge windfall from the federal government – an annual bonus they would receive in perpetuity.

This is not small change. According to a plan advocated by William M. Isaac, the former director of the FDIC, the Fed would owe $2.8 billion a year in interest to the banks on the $43 billion it holds now in bank reserves. It would take twelve years to cover the cleanup costs, but by then the annual interest payment would have grown to $4.4 billion – and the banks would get it all. Actually the largest banks would get most of it, because sixty-five percent of the reserves at the Fed belong to the 120 biggest banks.

This idea of connecting interest on reserves to the S&L crisis has actually been gestating privately in banking circles for several years, but Isaac recently took it public as a trial balloon. He heads a bank-consulting firm, Secura Group, a subsidiary of Arnold and Potter, the high-powered Washington law firm. Secura’s clients include Chase Manhattan and other big mules in banking. Isaac’s S&L study was commissioned by two major trade groups. To sell Congress, the lobbyists must first shape a consensus among the competing sectors of the financial industry. Other banking lobbyists quarrel with some aspects of Isaac’s plan, but I found unanimous enthusiasm for the backdoor approach.

“This plan puts an enormous carrot out there for the banks and the S&Ls that are still profitable,” Isaac says. “… I would think banks would love to get their hands on that money.”

The bankers have lusted after interest on their idle reserves for many years. The last time they tried to slip this goody through Congress, in 1984, they prevailed in committee. But Senator William Proxmire of Wisconsin, at the time the ranking Democrat on the Senate Banking Committee, denounced it on the Senate floor as a “big-bank bonanza” that would mostly benefit “a mere handful of giant money-center banks” while Congress was cutting aid to the poor and elderly and others. Squeamish senators backed away, and the proposal was deleted from the bill in which it was included. Unfortunately, Proxmire is retiring this year – and the bank lobbyists figure that makes one less obstacle to final victory.

Besides, the new packaging may make the idea a lot more attractive to senators and representatives (and perhaps to the next president), because it gets them off the hook, too. They can shuffle the S&L crisis off their balance sheet – the federal budget – and hand it to the Fed. The bonanza for bankers would be rationalized as a far-distant problem that some future Congress could correct if it wished.

It is such a slick piece of work that common sense argues that public protest surely will stop it – and perhaps it will. Still, during many years in Washington, I have learned never to underestimate the ability of the financial industry to intimidate and manipulate politicians. Or to underestimate the capacity of politicians to evade political responsibility – and embarrassment – if someone shows them how to do it.

The destruction of the savings-and-loan industry – created originally to ensure reasonably priced mortgages for home ownership – is one of the great scandals of the Reagan administration, yet it’s gotten insufficient scrutiny from the press. It is a story of wholesale fraud by some financiers but also of a willful attitude of “anything goes” among Reagan-administration regulators. There were wrongheaded economic policies that guaranteed widespread failures and also a persistent unwillingness to confront problems before they got much worse (see “Debt Trap,” RS 509). The ultimate cost of this mess, in fact, may be much larger than the estimates I have cited. Some experts think it will be $60 billion to $75 billion.

So why aren’t the Democrats bashing the Republicans and having a field day with this scandal? Because the Democrats have dirty hands, too. I am not just talking about the cozy relationships that some Democrats in Congress have had with the sleazy S&Ls that have generously provided campaign money. This bipartisan scandal runs much deeper than that.

A pivotal moment was the 1980 deregulation of interest rates – executed by a Democratic president and Congress in order to free the banks and the savings-and-loan industry from the supposedly odious ceilings on interest rates. Albert M. Wojnilower, one of Wall Street’s most astute minds, observed at the time that freeing the thifts to compete head to head with commercial banks was “like freeing the family pets by abandoning them in the jungle.”

The complete elimination of the legal limits on interest rates, legislated under the pressures of double-digit inflation, was a fundamental mistake, which Senator Proxmire, one of its principal advocates, now regrets. Both banks and S&Ls were in effect allowed to shop anywhere for deposits by paying higher and higher interest rates – and then lend the money out again to their customers. The federal insurance on deposits made it look risk free to investors, and indeed the federal government was assuming the risk for all of these high-flying operations.

“The combination of interest-rate deregulation with 100-percent deposit insurance is like the invention of gunpowder – sooner or later it was bound to explode,” says Kenneth A. Guenther, executive vice-president of the Independent Bankers Association of America, a trade group for thousands of small banks.

Then the Reagan administration came to town and made things worse – a lot worse. When hundreds of S&Ls were underwater and couldn’t meet the minimum regulatory standards for solvency, Reagan’s laissez-faire regulators simply lowered the standards. When that wasn’t enough, they changed the accounting rules. The dangers were obvious, but the Reagan administration actually shrank the number of federal bank examiners – even as bank failures soared.

Both Democrats and Republicans next collaborated on a series of patch-up measures that only exacerbated the problems. To help the drowning S&Ls, the thrift managers were allowed to go into business-lending ventures, in which they had little expertise – real-estate developments, for instance. Not surprisingly, that set the stage for even grosser fiascoes. Some clever developers figured out that they could open an S&L, borrow money for deposits and then lend the money to their own ventures – and the feds would pick up the wreckage when the S&L failed.

Finally, neither congressional leaders nor the president had the guts to act in a timely fashion. Only last summer, Congress authorized the S&L insurance fund to borrow $10.8 billion to deal with the failed thrifts. Everyone knew at the time that $10 billion wouldn’t be enough; the measure was intended to postpone a real reckoning until after the 1988 election. When the government does finally get around to facing the truth, the problem will be at least twice as bad.

The worst aspect of the bank lobbyists’ bailout scheme is not the money. The taxpayers cannot escape the cost of cleaning up this mess – not unless they want to abandon deposit insurance and threaten the soundness of the banking system. But what the bankers are proposing – and what politicians might buy if the public does not object – is antidemocratic. It would remove the whole problem from public debate and consign it to the inner sanctum of the Federal Reserve – making it even harder for the taxpayers to understand these costly shenanigans.

When democracy goes secret, the broad public interest gets trashed, just as it has been in the S&L scandal. The only real cure is more democracy – open debate and an informed citizenry that gets really angry when it’s presented with the bill.


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