Listen Well to Greenspan’s Warning Words
Are conditions ripe for a new financial disaster on the order of the savings and loan debacle of the 1980s?
That question is suddenly pertinent because Charles H. Keating Jr. is leaving prison, his conviction for looting a savings and loan and defrauding investors thrown out because of juror irregularities.
And it’s pertinent because worries are mounting about speculation in the stock markets. “Irrational exuberance” is infecting the stock market and the Federal Reserve must be wary, Fed Chairman Alan Greenspan said Thursday.
Stock prices fell in Tokyo immediately after Greenspan made his remarks, and prices plunged Friday morning on U.S. markets--although they recovered somewhat later in the day.
The exuberance Greenspan refers to is the search by ordinary investors as well as professional traders for higher returns, or yield, on retirement savings.
That’s ominous because it was a search for yield that led originally to difficulties for the S&L; industry in the late 1970s. Those difficulties were then compounded in the 1980s by mistaken policies and dishonesty in government, along with the depredations of Keating and other scoundrels.
But today is different in one major respect. We do not have the lax government environment that opened the barnyard gates to wolves in the early ‘80s. Greenspan’s vigilance reflects a sterner regulatory attitude toward finance and markets.
However, the markets themselves are incredibly larger, more technologically complex and global than they were then. More than $2 trillion is now invested in mutual funds, and more than $1 trillion a day is traded globally in currencies and government bonds.
“Regulation is more difficult because technology has blurred distinctions between bank accounts, insurance and securities” and global trading is at a furious pace, notes Bert Ely, an Alexandria, Va., financial consultant who was one of the first to call attention to the S&L; crisis.
Accidents happen, says Ely, recalling that last year’s collapse of Britain’s Barings investment bank because of rogue trading activities in Singapore threatened to destabilize world markets.
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Closer to home, Orange County Treasurer Robert Citron’s reach for higher returns, fed by Merrill Lynch’s loading up his portfolio with ill-advised securities, forced the county into seeking bankruptcy protection.
So in this anxious world, we should review briefly the savings and loan crisis as a cautionary tale. And then assess where we’re headed today.
The S&L; crisis began in the 1970s when interest rates were deregulated so savers could offset inflation by earning higher returns on certificates of deposit, in accounts protected by federal deposit insurance.
But when deposit interest rates soared higher than rates on the mortgages that S&Ls; held as assets, the institutions were threatened with insolvency. Common sense might have dictated direct aid from government for the old mortgages and a switch to adjustable rates for new loans.
But Congress and the Reagan administration, attempting to avoid federal expenditure, passed a law that said S&Ls; should overcome their difficulties by going beyond home loans to more adventurous commercial lending--by reaching for higher yield. California went further and removed virtually all restrictions on S&L; lending of insured deposits.
It was a disastrous ducking of responsibility. The result was a real estate boom and thieves’ carnival. Shopping centers, hotels, apartments and office buildings went up with abandon as developers suddenly had a new source of construction loans.
Keating, an Arizona developer at the time, borrowed money from Michael Milken’s Drexel Burnham Lambert firm and bought Lincoln Savings in Irvine in 1984. He then used its insured deposits to invest in junk bonds and to build the lavish Phoenician hotel complex in Phoenix.
After going bust in 1989, at an eventual cost to taxpayers of $3.5 billion, Keating was convicted in 1990 of looting Lincoln and of defrauding 23,000 mostly elderly investors by selling them bonds under false pretenses.
That federal conviction was set aside last week, and Keating now awaits a new trial, although there is sentiment that he not be retried because of cost and the fact that Keating is 73 and has served 38% of his 12-year, seven-month sentence.
But the sentiment is wrong. Keating should be retried to establish firmly that financial wrongdoing is treated as seriously as any other kind of crime. And the fact that he’s elderly cuts no ice at all--many other elderly people are poorer and Keating is to blame.
“We should not forget the scale and scope of fraud in the S&L; debacle,” says Kitty Calavita, a criminologist at UC Irvine and co-author, with Henry Pontell of UCI and Robert Tillman of St. John’s University in New York, of a new book, “Big-Money Crime, Fraud and Politics in the Savings and Loan Crisis.”
The S&L; debacle is expected to ultimately cost taxpayers as much as $500 billion, including interest on the bailout bonds. That contrasts with the roughly $25 billion it might have cost the government to pay off insured deposits of troubled S&Ls; in 1983.
The lessons of that debacle are apropos now because the stock market could well decline further over the next year. And if it does, there will be pressure on mutual fund managers to take greater risks to maintain performance.
Ordinary investors will be tempted to try to preserve their gains by reaching for returns that the market won’t deliver without unacceptable risk.
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That’s where Greenspan comes in. With his remarks last week, he was trying to cool speculation and throttle back the market a bit so as to avoid a crash that could damage the economy. He chooses his words carefully, sometimes to great effect. In 1989 in a speech to bankers, Greenspan warned that their credit positions were dangerously weak. But unlike the government in its earlier policy with S&Ls;, Greenspan didn’t encourage banks to make riskier loans.
On the contrary, he bluntly told them to cut back loans and repair their balance sheets. The strategy worked, and U.S. banks today are among the healthiest in the world.
If his cautious words on the stock market are as successful, we’ll all be better off.
