The Politics of Denying an S&L; Crisis : Thrifts: The Bush Administration’s refusal to acknowledge the size of the S&L; problem only increases the damages.

Even before M. Danny Wall was forced to resign as director of the Office of Thrift Supervision last week, he had come to symbolize the failure of a massive regulatory apparatus. His political approach to savings-and-loan regulation not only survives his departure, it is reflected in the Administration’s costly response to the crisis--a massive infusion of funds unlikely to solve the problems that plague the thrift industry.

What Wall did in person, the Bush Administration’s Financial Institutions Reform, Recovery and Enforcement Act of 1989--FIRREA--does on paper. It denies the severity of the crisis, does nothing to ensure that insolvent S&Ls; will be closed in a timely fashion and perpetuates flaws in the pricing policies of federal deposit insurance that led to the crisis in the first place.

Wall can be seen as a case study of a bureaucrat. He flourished by being a loyal soldier, doing the politically correct thing despite disastrous economic consequences. When a disagreement arose between the local examiners at the San Francisco Federal Home Loan Bank and Lincoln Savings and Loan owner Charles H. Keating Jr.--over auditors’ recommendations about Lincoln’s investment portfolio--Wall sided against his colleagues and with the politically influential Keating. Wall’s unprecedented removal of the San Francisco regulators delayed Lincoln’s closing by almost two years and cost taxpayers literally billions of dollars.

In addition, Wall helped George Bush become President in 1988 by issuing outrageously low estimates of the costs of handling the S&L; insurance crisis. While private sources estimated a bailout would cost more than $100 billion, Wall claimed the problems were modest and no taxpayer funds would be needed.

But after the election, the Bush Administraton calculated S&L; losses at $90 billion. With FIRREA, the Administration determined it would cost the taxpayers $50 billion to meet its insurance obligations and administer the current stock of insolvent S&Ls.;

For two reasons these sums are not likely to satisfy the Federal Deposit Insurance Corp.’s obligations to depositors in insolvent thrifts. First, FIRREA did not alter the political environment that caused the thrift crisis. The crisis became acute because regulators responded to political pressure to keep thrifts open long after they were insolvent. Thrift shareholders could use the extra time to make extremely risky investments. In the rare event that investments paid off, the institution would be restored to viability and the shareholders’ stock worth something again. In general however, like all long shots, the gambles did not pay and losses to the Federal Savings and Loan Insurance Corp. soared. As the value of an insolvent thrift’s liabilities came to dwarf the value of its assets, the FSLIC was called on to make up the difference.

Second, mirroring Wall’s actions during the presidential election, the Bush bailout is optimistic in its cost estimates. It fails to recognize that hundreds of thrifts are “solvent” only in a technical or accounting sense, that they are actually insolvent because the market value of their assets will not cover their contractual obligations to depositors. These “zombie thrifts,”--an estimated 25% of the industry--continue to offer the lure of high-interest payments on insured deposits in order to grow in size and stave off failure. When they are ultimately closed, costs to the taxpayer will be far higher than if Congress had the political courage to face up to the full dimensions of the problem. But as noted bank economist Edward J. Kane has observed, the careers of industry regulators and politicians depend on short-term success.

If a thrift can be closed at the moment it becomes insolvent, then depositors can be paid in full on liquidation without costing taxpayers a dime. The political problem with this simple approach is that the prompt closing of a thrift wipes out all the shareholders’ equity. Unfortunately, FIRREA does nothing to alter a basic fact: The decision about when to close an insolvent S&L; is subjective. The cost of keeping these institutions open is carried by taxpayers. The benefits come in the form of political support to senators and congressmen who exert pressure on regulators like Wall.

An important step in the right direction would require banks and thrifts whose shares are not publicly traded to use market-based accounting systems to value assets and liabilities. If a thrift’s shares are publicly traded, it is easy to determine when it is insolvent--but when the shares are closely held, market-based accounting would allow interested parties to determine which institutions are insolvent and which not. The next step would be to require that federally insured financial institutions be closed the moment they become insolvent. Shareholders who think the accountants--using market-based methods--are wrong can avoid insolvency by putting up additional equity. In this way the shareholders, not the FDIC, would be taking the big risks.

But market-based accounting is unpopular. It would impose costs on politically powerful S&L; shareholders; it would exacerbate the S&L; problem in the short term. The Administration valued many assets on the books of the nation’s thrifts at their historical worth to arrive at the $90-billion bailout figure. If these assets had been valued at market, the cost to the Treasury might have increased by as much as $50 billion.

The Administration defends itself against the charge that FIRREA did not make the politically difficult choices, pointing out that the act imposes higher capital requirements on thrift institutions and that, by 1990, capital levels must not be materially different from those required for national banks. But it is not clear how these new requirements will be enforced. Long delays between the date a bank’s capital is depleted and the date it is closed will give bank owners the opportunity to gamble with taxpayers’ money.

In addition to increased capital requirements, FIRREA raises the premiums that thrifts must pay for deposit insurance. But, as before, all thrifts will continue to pay the same insurance premiums. This means that thrifts will not pay higher premiums even if they engage in risky practices. The only explanation for such misguided policy is that the thrifts remain a powerful political force.

The combination of fixed-rate deposit insurance and higher capital requirements is bad news for taxpayers. It means S&Ls; will have to generate higher earnings to obtain the same returns for shareholders. This will induce thrifts to find even riskier investments. Far from solving the crisis, FIRREA may have made it worse.

The real disease that crippled the nation’s S&Ls; was not the regulatory ineptitude of such people as Wall. The blame begins with the legion of politicians seduced into trading political favors for regulatory forbearance, creating a legal environment where only politically inept thrift institutions were subject to meaningful regulation.

As long as the legislators lack the political will to forge lasting solutions to real social problems, loyal political functionaries like Wall and half-baked political compromises like FIRREA will continue to be an important part of the U.S. political scene.