Why was the S&L Crisis not a Systemic Economic Crisis?

By William K. Black
Sub title: S&L Crisis – Lessons Learned and Forgotten

Some of the most important examples of criminogenic behavior and control fraud in our history were encountered and eventually resolved during the S&L crisis era.  And yet we went on to repeat the same behavior patterns in the immediately following twenty years.  Before trying to answer the title question, a historical timeline is necessary for reference.  The major events and dates are outlined in the first section which follows.

S&L Crisis Timeline – Major Events

1979           – Paul Volcker appointed Federal Reserve Chairman by Pres. Carter.

1979-1981 – Volcker’s Fed raises federal funds rate to a high of 20% in June, 1981.

1981           – Richard T. Pratt appointed chairman of the Federal Home Loan Bank Board (Bank Board), the national regulator for S&Ls by Pres. Reagan.

1982           – Pres. Reagan signs the Garn-St. Germain Act deregulating S&Ls.  Bill was proposed by Pratt.

1983           – Pratt resigns and is replaced as chairman fellow board member by Edwin Gray.

1987           – Pres. Reagan appoints M. Danny Wall as chairman, declining to reappoint Gray.

1989           – Pres. George H. W. Bush signs taxpayer-financed bailout measure known as the FIRREA authorizing $50 billion to close failed banks.

1990           – M. Danny Wall resigns as Bank Board chairman, under pressure (re-Lincoln S&L).

1990           – Pres. George H.W. Bush appoints Timothy Ryan as chairman.

1986-1995 – Over 1,000 banks with total assets of over $500 billion failed.

1999           – Crisis cost was determined to be $153 billion, with taxpayers footing the bill for $124 billion, and the S&L industry paying the rest.

Beat Inflation, Break the Bank

Fed Chairman Paul Volcker’s inflation control efforts in the late 1970s and early 1980s did great damage to S&Ls, which were overwhelmingly portfolio lenders making long-term, fixed rate mortgages funded by extremely short-term deposits.

S&Ls were exposed to severe interest rate risk.  On a market value basis, the industry was insolvent by roughly $150 billion by mid-1982.  Bank Board Chairman Pratt (an academic expert in “modern finance” who had served as the S&L trade association’s top economist) drafted a bill (informally known then as “the Pratt bill”) modeled on state of Texas deregulation.  Deregulating at a time of mass insolvency was significantly insane, but Pratt was an anti-regulator of great fervor.  Using econometric techniques to choose Texas as the model – without recognizing that Texas S&Ls’ superior reported income was as fictional (reported income and capital arising from merging two insolvent, unprofitable S&Ls) – was insane and caused severe losses.

Pratt (pictured) also cut the number of examiners and, at the behest of the Reagan administration, ceased virtually all closures of failed S&Ls.  Instead, he merged insolvent S&Ls and used abusive accounting schemes that hid real losses and created massive amounts of fake income and “capital.”  He then, ever so modestly, claimed credit for “resolving” hundreds of S&L failures at virtually no cost to the insurance fund.  The “resolutions,” of course, were typically accounting shams that led to increased losses.  (Yes, Pratt was Secretary Geithner’s role model as a carnival barker.)

Pratt’s 1982 deregulation bill became the Garn-St Germain Act of 1982.  It immediately prompted a competition in regulatory laxity.  California and Texas “won” the race to the bottom – and those two states caused roughly 60% of total losses by the end of the debacle.

Pratt declared victory and resigned in early 1983.  He went to Merrill Lynch to sell MBS to S&Ls.

Edwin Gray, who replaced Pratt as Bank Board chairman, had been a Bank Board Member with Pratt.  Gray was a personal friend of the President and Mrs. Reagan.  He has said that the S&L trade association chose him to be its top regulator because he was a strong supporter of financial deregulation and because they believed he would be friendly to the S&L industry (in which he had worked).

Gray became Chairman of the agency in April 1983.  Initially, he largely continued Pratt’s deregulatory approach.  Within months, however, he became convinced that the industry was headed towards catastrophe even though the industry reported that it was experiencing a robust recovery.

Gray deserves particular credit for his accurate analysis because it is easy to “fight the last war” (interest rate risk) and miss the development of the new war (accounting control fraud).  For a conservative, free market, ultra-loyal Reagan supporter, as well as an officer from the S&L industry to be willing to believe that hundreds of S&L CEOs could be felons also showed remarkable openness to unpleasant facts.

The Biscayne Federal Savings Story

In 1983, I was a senior associate who was part of a team of outside counsel defending a challenge to the Bank Board’s appointment of a receiver for Biscayne Federal Savings.  Pratt had been Chair when the agency put Biscayne into receivership.  His successor, Ed Gray, was Chair by the time the case came to trial.  I was researching Pratt’s statements and actions to prepare the defense to the receivership challenge.  I found that the Reagan administration had been so bizarre about receiverships that the Pratt Bank Board had become crazed on the issue.  I also found that the Pratt Bank Board had a soft spot for accounting scams.  The Reagan administration’s paramount priority at all times during the savings and loan debacle was covering up the scale of the losses.  Pratt adopted a series of accounting abuses designed to delay loss recognition for years and create fictional income and net worth.  The Reagan administration knew, however, that receivership would require the recognition of massive losses.  The Pratt Bank Board, therefore, refused to place failed S&Ls in receivership.

During this period the Bank Board “resolved” hundreds of failed S&Ls by merging them and using accounting scams to transmute the merged entity into an S&L that reported it was profitable and solvent.  Typically, these deals were done with no federal financial assistance.  By 1983, hundreds of these scam mergers had been done and the fictional accounting income and net worth were so large that they made a deeply insolvent and unprofitable industry appear profitable and solvent.

Biscayne’s dominant owner was Kaufman & Broad (the huge real estate developer).  Biscayne was losing money in 1981 and 1982 due to interest rate risk and headed towards GAAP insolvency (on a market basis it had long been insolvent).  The Pratt Bank Board and Biscayne decided that an accounting scam might greatly delay Biscayne’s insolvency.  The idea was for Biscayne and the Federal Savings and Loan Insurance Corporation (FSLIC) to exchange notes.  The notes would have the same present value, but they would be structured to create a major difference in their face values.  The FSLIC note would have a high face value but pay a very low interest rate while the Biscayne note would have a low face value but pay a very high interest rate.  The goal was for Biscayne to book the difference in the face values of the notes as a “gain.”  That would have created fictional income and net worth for Biscayne, but the Bank Board feared that the auditors would not agree to treat the fictional income as real.

Pratt inherited one legal challenge to the appointment of a receivership (Telegraph Savings) from his predecessor.  The Reagan administration was so obsessed with covering up the S&L losses that its Treasury spokesman testified to Congress that it would be “irrational” to appoint a receiver based on the insolvency of an S&L because a federally insured bank could always meet its liquidity needs by raising the rate it paid on deposits to ensure that it grew rapidly enough to meet any withdrawals.  Yes, you understood his testimony correctly – the Reagan administration’s official position was that we should run the industry as a Ponzi scheme.

The same senior Treasury official then testified in support of Telegraph Savings’ legal challenge to the agency appointment of receiver on the basis of the S&L’s self-reported insolvency.  In addition to all the obvious insanity of all of this it is worth emphasizing that had Telegraph Savings won its case the Treasury would likely have had to pay damages to its shareholders.  The court ruled that the statute expressly authorized the agency to place an insolvent S&L in receivership.

The Reagan Ponzi Scheme

By early 1983, Pratt concluded that his “resolutions” of hundreds of insolvent S&Ls had stabilized the industry and it was appropriate to begin to place GAAP insolvent S&Ls in receivership.  Biscayne was the first major receivership.  Thomas Vartanian, the Bank Board’s general counsel, however, was not a litigator.  Despite the favorable Telegraph Savings ruling, the clear statutory authority to appoint a receiver for an insolvent S&L, and Biscayne’s admitted insolvency, Vartanian worried that the court might rule against the agency.  Vartanian was not a litigator and his concerns were not sensible.  The irony was that it was his suggestion as to how the agency could improve its litigation position that created the problem that he feared.  Vartanian, in front of a number of Bank Board lawyers, including one who kept detailed notes, suggested that the agency could appoint a conservator on Monday “hope for a run” on Wednesday and use the run as the basis for appointing a receiver on Friday.  Vartanian’s suggestion was immediately rejected by his colleagues, but the damage was done.  The trial judge decided (1) that the notes of Vartanian’s suggestions were not privileged and had to be turned over to Biscayne’s lawyers and (2) that Vartanian was a snake.  He ruled that the Bank Board had acted in bad faith and declared the appointment of the receiver was improper.  We were able to overturn the ruling on appeal.

All of the discussion to this point has been background to my review of Pratt’s exit interview when I was preparing to help defend the Biscayne case.  Pratt was almost uniformly viewed as a genius.  He was an academic expert in finance.  The Bank Board staff was amazed at how quick he was.  The Reagan administration loved him.  He was the architect of the Garn-St Germain deregulation law of 1982.  (He based it on Texas’ deregulation law – the worst possible template.)  He had come into an impossible situation – the mass insolvency of the S&L industry – and instilled a “can do” attitude among the dispirited staff.  He had “resolved” hundreds of failed S&Ls at virtually no cost to the FSLIC Federal Savings & Loan Insurance Corp.).  Only the S&L industry hated Pratt (because he made no effort to hide his disdain for the industry’s leaders).

My review of the Biscayne files gave me a tremendous advantage over those who were amazed at Pratt’s accomplishments, for I knew of the cynical proposed exchange of notes between Biscayne and FSLIC and Pratt’s willingness to create fictional accounting income to “resolve” problems. I knew that Pratt’s claims of success had to be false.  How could one merge two insolvent, unprofitable S&Ls and produce an S&L that was instantly solvent and profitable? Pratt’s claims were too good to be true and given what I had learned about his willingness to assist Biscayne in using accounting scams it was likely that accounting fictions explained Pratt’s claims that he had “resolved” hundreds of insolvent S&Ls through mergers.  This insight into the madness in Pratt’s method was helpful in 1984 when I accepted the Bank Board’s request to become their litigation director.

Criminogenic Environment

The Biscayne story and summary of “resolutions” (above) describe how Pratt, Texas, and California had (unintentionally) optimized the S&L industry as a criminogenic environment for accounting control fraud by deregulating, desupervising, leaving insolvent S&Ls open, ignoring extreme conflicts of interest among S&L acquirers and founders, approving federal deposit insurance for newly created (de novo) S&Ls in Texas, California, and Florida despite the total inability and unwillingness of these states to regulate, and debasing the accounting, concentration, and capital rules.  Criminal referrals (and prosecutions) were virtually non-existent under Pratt.  The Bank Board had no system for ensuring that criminal referrals were made, for monitoring the progress of the FBI in pursuing the referrals, or for training agency, FBI, and Department of Justice staff in how to detect, investigate, and prosecute elite frauds.

Starving the Regulatory Beast

“In this present crisis, government is not the solution to our problem; government is the problem.” Ronald Reagan Inauguration Speech, January 20, 1981.

The “government is the problem” philosophy supported the perpetration of a problem.  The Bank Board did not have remotely adequate numbers of examiners and too many of its senior supervisors were unwilling to take vigorous action against major S&Ls.  Texas and Louisiana were totally out of control.  By 1983, there were hundreds of frauds growing at an average annual rate of 50 percent.  Had Pratt’s anti-regulatory policies continued even a few more years that level of obscene growth would have soon led the frauds to dominate the entire industry and to hyper-inflate multiple regional real estate bubbles.

Edwin Gray, Knight in Shining Armor

When Gray arrived as chairman, he went to an emergency footing.  He refused to grant federal deposit insurance to any California, Texas, or Florida de novos unless those states provided adequate examiners and supervisors.  He doubled the number of examiners and supervisors within 18 months.  He reassigned hundreds of examiners from outside Texas on temporary duty to examine Texas S&Ls.  He fired the President of the Federal Home Loan Bank of Dallas.  He ordered supervisory agents to certify that any violations of law or unsafe conditions or practices found by the examiners had either been fixed or that the supervisor had referred the matter to enforcement to force the S&L to fix the problem.

Gray personally recruited senior banking regulators with reputations for competence, integrity, and vigor and put them in charge of every region with severe problems.  He picked the two regulators he found most impressive, Joe Selby and Mike Patriarca (pictured), to be the top regulators for the regions responsible for regulating Texas and California S&Ls.

Gray, over the opposition of his fellow Bank Board members, adopted a series of rules and orders in 1983-1986 that targeted the accounting control frauds.  The rule restricting growth doomed the accounting control frauds.  Gray also prioritized for closure the worst frauds identified by the examiners and the agency began to place S&Ls in conservatorship even when they were reporting profitability and adequate capital.

Gray also requested Congress to provide additional funds and statutory powers to the agency to fight the frauds.  Congress refused to meet any of Gray’s requests while he was in office.  Instead, a majority of the members of the House, at the behest of Charles Keating’s (pictured) Lincoln S&L (the most notorious S&L fraud) co-sponsored a resolution calling on the agency to cease reregulation.  Congress passed the Competitive Equality in Banking Act (CEBA) in 1987.  They passed CEBA after Gray’s term ended.

Defeat of the Knight in Shining Armor

The White House reached a secret deal with Speaker Wright not to reappoint Gray in the spring of 1987.  Speaker Wright was a Texan Democrat and his closest business associates (who employed the Speaker’s spouse) owed substantial sums to failed S&Ls.  The receivers we appointed for failed S&Ls would typically sue to recover these debts.  Speaker Wright put held the bill that eventually became CEBA (Competitive Equality Banking Act of 1987) hostage in order to extort the Bank Board to give special regulatory favors to Texas S&Ls controlled by contributors to the Democratic Party.   Gray spent virtually all the cash in the FSLIC insurance fund to close failed S&Ls.  We spent the fund down to $500 million – which was insuring a deeply insolvent industry with over a trillion dollars in liabilities.  CEBA was a Rube Goldberg financing scheme to allow the agency to borrow additional funds so that it could continue to close the frauds.  The financing scheme was necessary because the administration refused to admit that the industry and the insurance fund were massively insolvent.   Getting the additional funds was our ultimate agency priority, and Speaker Wright knew that by holding the bill hostage he could exert maximum leverage to try to kill Gray’s reregulation.  Speaker Wright (picture) became so brazen in his extortion that he asked Gray to force Selby out as the top regulator in Texas on the purported grounds that Selby was a homosexual who Wright claimed was sending all the legal business of the regional agency to “homosexual law firms.”  M. Danny Wall, then the top aide to Senate Banking Chairman Jake Garn, urged Gray to accede to Wright’s reprehensible demands to get rid of Selby.

Lobby Control and Faustian Bargains

The CEBA bill had two components, which generated two Faustian bargains.  As proposed, the bill would have allowed the agency to raise an additional $15 billion through the convoluted financing mechanism and it would have given the Bank Board additional supervision and enforcement powers.  The S&L trade association’s top priority was minimizing the funding to the insurance fund because it indirectly came from the industry.  Political scientists had called the S&L trade association the third most powerful lobby in America.  Americans liked S&Ls and the trade association had a large group of S&L CEOs – each of them an important contributor to members of Congress with whom they were on a first name basis – pledged to be in DC walking the Hill offices within 48 hours of receiving the trade association’s call to arms.  Their trade association was a force of nature, but the S&L control frauds had even closer ties with a subset of Congressional leaders.  They induced Speaker Wright to hold the bill hostage in the House and Senator Cranston to place a secret “hold” on the bill in the Senate.   The fraudulent S&Ls wanted to delay and reduce the funding provided to the agency to close the frauds, but they had a more audacious approach to the portion of the draft bill that would grant the agency additional supervisory and enforcement powers.  They decided to pervert that portion of the bill to accomplish the opposite – to use it to gut the agency’s power to supervise and enforce.  The first Faustian bargain was the agreement of the trade association and the frauds to combine their lobbying efforts against the bill in order to reduce the funding dramatically and mandate regulatory “forbearance.”

The second, inconsistent, Faustian bargain was between the administration and Speaker Wright.  (They despised each other because of their conflicts over U.S. support for the Contras’ war against the Nicaraguan government.)  Wright and the frauds were happy to support passage of the full $15 billion in funding as long as it was used to bail out rather than close the insolvent S&Ls.  The administration had always opposed Gray’s reregulation.  It only cared about the dollar amount of the funding.  Speaker Wright agreed to stop holding CEBA hostage and to support the $15 billion in financing in return for the administration’s agreement not to oppose mandatory regulatory forbearance and not to reappoint Gray for another term.  The administration’s sole S&L priority at all times during the debacle was covering up the scale of the crisis and it welcomed the opportunity to halt and reverse Gray’s reregulation.  The administration had no intention of reappointing Gray to another term as Chairman of the Bank Board and Speaker Wright had no intention of really supporting $15 billion in funding for the agency to close down hundreds of Texas S&Ls.  The Speaker spoke in favor of the bill while his Whip told the Democrats to ignore his words and crush the funding amount, which they (and many Republicans) proceeded to do with gusto.

Fighting Regulatory Forebearance

CEBA provided the agency with some additional funds, but it sought to mandate “regulatory forbearance” provisions drafted by counsel for the leading frauds for the purpose of eviscerating Gray’s reregulatory efforts.  (“Reregulation” was the label the Reagan administration ascribed to us.  It was their vilest curse and they bestowed on Gray the special disdain and rage reserved for true believers who become apostate.)  We were able to work with Representatives Henry B. Gonzalez (picture left), Jim Leach, Tom Carper (now a U.S. Senator), and Buddy Roemer to insert subtle changes in the CEBA drafts that removed most of the harm that the “regulatory forbearance” provisions were intended to cause.  Senator Gramm was also helpful to us in this effort.  Senator Gramm’s actions are instructive of an important fact of human life, people are not always consistent.  Senator Gramm (picture right) also asked the President to appoint an attorney to be one of the three Bank Board Members.  The attorney created the de facto trade association of the worst Texas control frauds that took the lead in drafting the CEBA provisions designed to destroy effective regulation.  The worst two S&L frauds in the nation, Vernon Savings (referred to by its regulators as “Vermin” – 96% of its loans defaulted) and Charles Keating’s Lincoln Savings, exerted the most successful lobbying power.  Speaker Wright intervened on behalf of Lincoln Savings and Vernon Savings.  Senator Cranston put the secret freeze on the CEBA bill in Senate as a favor to Charles Keating.

A Trillion Dollars Saved for Taxpayers

Gray’s reregulation saved the nation a trillion dollars and prevented an economic crisis.  He acted despite the combined opposition of a majority of the House, the Reagan administration, the OMB (which threatened to file a criminal referral against Chairman Gray on the specious grounds that he violated the anti-Deficiency Act by closing too many insolvent S&Ls), the “Keating Five,” the industry’s trade association, the great bulk of the business media, most of the state S&L regulatory heads, his fellow Bank Board members, and important segments of the Bank Board’s professional staff.  The Reagan administration appointed Danny Wall as Gray’s replacement and Wall publicly took “credit” for forcing Selby to resign.  This followed the administration’s 1986 effort to appoint two members of the Bank Board chosen by Charles Keating, the worst S&L fraud.  The Bank Board had three members, so this would have given Keating control of the agency and added massively to the losses.  Keating succeeded in getting the administration to appoint one of his choices to the agency and he proceeded to serve as Keating’s “mole” at the agency until I blew the whistle on him.  He resigned as part of a deal with a Justice Department to end its investigation.

Sued by Criminals and Supervised by Frauds

Several of us were sued by Lincoln Savings in our personal capacities for $400 million.  Keating hired investigators twice that we learned of to investigate me.  Keating was able to induce William Weld, one of the most senior Justice Department officials to order a criminal investigation of the agency at the same time that the DOJ initially declined to investigate our criminal referrals (which eventually led to convictions).

Wall removed our (the Federal Home Loan Bank of San Francisco’s) jurisdiction over Lincoln Savings because we persisted in recommending that the agency take it over.  This had never happened before in regulatory history and it sent shock waves through the financial regulatory community.  Wall tried to engineer a sham examination of Lincoln Savings, but there was a revolt by many field regulators and the California Department of Savings and Loan.  Wall’s removal of our jurisdiction, the sweetheart deal he cut with Keating, and the $3.4 billion in fraud losses at Lincoln Savings led to his resignation in disgrace after our (the field regulators’) Congressional testimony.  (See next section.)

Transition from Disaster

When the first President Bush took office he faced a dilemma in determining the regulatory response to the S&L debacle.  As Reagan’s Vice President, Bush chaired the administration’s financial deregulation task force.  He was, therefore, as culpable as anyone in the nation for the deregulation and desupervision that made the S&L industry a criminogenic environment.  We now know from documents obtained through discovery from Lincoln Savings that Keating’s lobbyists viewed VP Bush’s offices as containing strong supporters of Keating and Gray’s fiercest critics.  Bush also owed Wall a large political debt.  Wall’s nickname on the Hill was “M. Danny Isuzu.”  (Isuzu was running commercials then featuring a car salesman who was an obvious, inveterate liar.)  The central lie that Wall was spreading in 1988 in the run-up to the election was that there was no S&L crisis and no need for federal funds.  This lie was of significant benefit to Bush’s candidacy.

Bush also knew, however, that Wall was a disaster.  Bush’s response to the dilemma was politically astute.  He immediately ordered that the Bank Board would no longer run any receiverships but would instead appoint the FDIC as its receiver for any new failed S&Ls.  He framed the FIRREA bill (Financial Institutions Reform, Recovery and Enforcement Act of 1989) that terminated FSLIC and transferred the S&L insurance function to the FDIC.  Both of these actions enraged Wall.  The FIRREA bill, however, did something extraordinary for Wall.  It appointed him as head of the successor agency, the Office of Thrift Supervision (OTS), without the advice and consent of the Senate.  Bush was warned in advance that this act could be held to be unconstitutional.  The Senate Banking Committee was delighted not to hold hearings.  Its chairman and ranking Democrat were members of the Keating Five and the ranking Republican, Garn, was co-sponsor of the Garn-St Germain Act of 1982 (the key deregulation bill) and Wall’s great patron.  Senate confirmation hearings would have been intensely embarrassing to the new Bush administration, Wall, and the Senate Banking committee’s most powerful members.

FIRREA became law, Wall was appointed head of OTS by statute without the Senate’s advice and consent, and a federal court declared Wall’s appointment unconstitutional.  The key development, however, was that Henry B. Gonzalez became Chairman of the House Financial Services Committee and began holding hearings on Wall’s regulatory failures at Lincoln Savings.  Gonzalez’ actions were brave.  Four of the five members of the Keating Five were Democrats.  Many of Gonzalez’ Democratic senior colleagues were enraged that Gonzalez would hold hearings that were certain to embarrass the Keating Five.

Gonzalez’ series of hearings led to our powerful testimony explaining in detail Wall’s refusal to take action against Keating.  Wall used the enforcement director as his attack dog to respond by attacking the FHLBSF and Gray – and to claim that Keating was the victim.  Bush eventually responded by indicating that he no longer had confidence in Wall and Wall was forced to resign.  His resignation was reported on December 5, 1989.  Bush nominated Timothy Ryan to head the OTS and gave him a simple mandate – find the most prominent S&L frauds and take them down in the most public fashion to show that there was a new sheriff in town.

Our testimony also led to the resignation of the agency’s top supervisor, Mr. Dochow, who returned to a relatively low level supervisory position in our most obscure office – Seattle.  Dochow was notorious because of his support for Wall’s cowardly caving in to Keating’s political pressure.

Timothy Ryan, Second Knight in Shining Armor

Ryan came into office shortly after we had provided a graphic example of how effective regulation could be.  Pinnacle West, MeraBank’s holding company, had signed a net worth maintenance agreement as a condition of acquiring MeraBank.  MeraBank was deeply insolvent, which meant that Pinnacle West was on the hook for many hundreds of millions of dollars.  Pinnacle West’s lawyers came up with a clever means of evading the net worth maintenance agreement.  They would dividend to their shareholders Pinnacle West’s ownership of MeraBank.  The net worth maintenance agreement only obligated entities that “controlled” MeraBank to maintain MeraBank’s net worth, and because Pinnacle West’s shareholders were diverse there would be no one remaining (after the dividend) who owned a controlling interest in MeraBank.

There were only three problems to the clever scheme.  First, there was a mechanical problem.  As part of the deal in which Pinnacle West acquired 100% of MeraBank, the parties agreed that MeraBank would issue a single share certificate representing that 100% ownership to Pinnacle West.  Pinnacle West’s lawyers thought they had a straight forward answer to the mechanical problem – MeraBank would issue hundreds of thousands of individual share certificates to Pinnacle West and Pinnacle West would dividend them to its shareholders.

That lawyerly solution to the mechanical problem, however, ran into the second and third problems.  The second problem was the FHLBSF.  After he removed the FHLBSF’s jurisdiction over Lincoln Savings, Wall’s effort to cover up its insolvency and frauds were blown up by courageous examiners from the California Department of Savings and Loan and several other Federal Home Loan Banks (special kudos to the FHLB Chicago staff).  Wall realized that he was faced with a disaster on multiple dimensions and that he had to stop his jihad against the FHLBSF.  That meant that he could no longer block us from taking vigorous regulatory actions, e.g., against Pinnacle West.

The third problem was that it would be a naked violation of their fiduciary duties for MeraBank’s board of directors to vote to issue additional shares.  Pinnacle West’s primary asset was the net worth maintenance agreement.  Voting to effectively remove that agreement would violate the duty of care.  If the MeraBank directors who were also Pinnacle West officers voted to effectively destroy the net worth maintenance agreement that would violate the duty of loyalty (because of their crippling conflict of interest) and the duty of care.  The FHLBSF’s senior staff flew to Arizona to address the MeraBank board of directors meeting to make this explicit to each director.  In the trade in the U.S., this is known as a “come to Jesus” meeting.  The MeraBank directors promptly decided that there was no way to issue the additional share certificates.

The FHLBSF then took the lead in negotiating an agreement that released Pinnacle West from its net worth maintenance agreement – in return for a $450 million payment.  The OTS approved the settlement on December 7, 1989.

Harris Weinstein

The Pinnacle West deal confirmed Ryan’s view that OTS could accomplish great things if it were vigorous.  He recruited Harris Weinstein, an accomplished, senior litigation partner at one of the nation’s most prestigious firms as his Chief Counsel.  Among their first acts were to make clear that they supported fully the FHLBSF’s vigorous approach to regulation.  (Most FHLB’s shared that same approach, but openly embracing us signaled that Wall’s jihad against the FHLBSF was over.  Weinstein proved adept as a manger.  He did not fire or criticize the enforcement director.  He simply removed her monopoly over enforcement.  OTS established three regional enforcement bodies headed by its most vigorous personnel and parallel enforcement bodies in Washington.  The supervisors were permitted to use whichever enforcers they found most effective.  The former litigation director left the agency for private practice.

The OTS took actions against the most elite control frauds on four fronts:  regulation, civil actions, administrative enforcement actions, and support for criminal prosecutions.  It closed the remaining frauds, virtually all of which had collapsed due to Gray’s rule restricting growth.  (For a Ponzi scheme, growth is life.)  More impressively, the West Region of OTS (staffed by supervisory personnel from the FHLBSF), killed through normal supervision the growing practice in Orange County, California of making “liar’s” loans and imprudent subprime loans.   Michael Patriarca, personally recruited by Gray to crack down on the Western frauds, led the West Region’s crackdown.  The effort was so successful that the leading nonprime S&L lender, Roland Arnall, gave up his federal charter (and federal deposit insurance) in order to escape our jurisdiction.  Arnall created Ameriquest, a mortgage banker, to take advantage of a regulatory “black hole.”  Arnall’s leading competitors also came from the S&L industry, e.g., the Jedinaks, who we “removed and prohibited” from the federally-insured financial industry through an enforcement action.

Ryan and Weinstein were exceptionally effective in prompting effective enforcement actions.  In interpreting the magnitude of the increase in enforcement actions in 1990 over 1989 one must recall that the administration did not select Ryan until March 1990.  Ryan then had to go through a bitterly contested Senate investigation and vote to secure appointment.  Ryan’s selection of Weinstein became public on May 9, 1990.  It, of course, took Weinstein months to create the parallel enforcement structure that I described and staff it.

Ryan and Weinstein Hit the Ground Running

In 1989, the agency issued 34 cease and desist (C&D) orders.  In 1990, agency issued 63 C&Ds.  In 1989, the agency issued 47 removal and prohibition (R&P) orders, in 1990 it issued 78.  In 1990, the agency used its new grant of enforcement powers (via FIRREA) to issue 26 civil money penalties (CMPs).  In 1989, the agency entered into 260 formal agreements, in 1990 that number rose to 347.  The cliché “hit the ground running” applies to Ryan and Weinstein.  In 1991, the agency completed 868 enforcement actions and in 1992 it completed 667 actions.  Ryan announced his intent to resign on November 9, 1992.

How to Kill a Career in Government

In addition to the dramatic increase in the number of enforcement actions one must take into account that the actions brought under Ryan and Weinstein were far more major than the actions brought under Wall.  Ryan and Weinstein went after the most elite, politically connected frauds to demonstrate that no one was above the law.  The classic proof was the agency’s enforcement action against President Bush’s son, Neil (picture left).  The enforcement action antagonized the Bush family.  William Seidman’s (then, FDIC chair), book about his governmental service recounts how a senior White House staffer got the bright idea of convincing the FDIC to take over the case from the OTS so that the FDIC could kill the action.  He called the FDIC’s general counsel to propose the idea.  The general counsel, being a bear of very little brain, went to Seidman with the proposal.  Seidman (picture right) told him the idea was insane and not to get involved with it.  The general counsel, being a bear with very little brain and soul, called the OTS to pitch the idea.  Ryan made sure that the OTS filed an ethics complaint.  The OTS went ahead and issued the enforcement order.  (In truth, the order was a slap on the wrist – but royalty doesn’t think it should be slapped by peons.)  From that day on, Ryan’s chances for advancement under President Bush were dead.

Ryan was quoted in a New York Times article following his resignation:

“Because of Neil Bush, I was persona non grata,” Mr. Ryan said. “At first I think it was because they did not want to influence me, and afterward I don’t know why they did not talk to me.”

The amazing aspect of the Bush administration’s response to the OTS enforcement action against Neil Bush is that it never became a scandal.  In the current era, it would lead to an immediate demand for impeachment.

New Priorities

In 1993, the new Clinton administration moved DOJ resources to refocus on health care fraud.  That may have been a correct prioritization of DOJ resources given our success against the worst S&L frauds, but it does mean that our 1000 convictions represents only a portion of fraud identified in our criminal referrals.

By the time Ryan and Weinstein left governmental service the S&L industry was cleansed of major frauds.  The “liar’s” loans lenders had been driven out of the industry.  The OTS criminal referral process was superb.

Banking Fraud Redux

In the current crisis, President Bush (the Second) appointed “Chainsaw” Gilleran as OTS director – providing the crisis’ iconic image.  Gilleran is holding a chain saw and standing next to the nation’s three leading bank lobbyists and the FDIC’s Vice-Chair, who are holding pruning shears.

They are poised and posed over a pile of regulations.  To make the imagery clear, the regulations are tied up in elaborate red tape.  The image makes clear Gilleran’s and the FDIC’s intention to slash through all regulation.  (Mission Accomplished!)  Naturally, the anti-regulators were so proud of this image that they featured it the FDIC’s 2003 annual report.

The OTS leaders decided that the key to destroying regulation was to bring back to power the nation’s most notorious professional regulator – Dochow (of Keating infamy).  Dochow rode Washington Mutual (WaMu) (based in Seattle) back to power.  WaMu was a great “success” because it engaged in a variant of the accounting control fraud that made Keating infamous, but Dochow was not one to learn from his mistakes.  The OTS leadership then used Dochow to convince Countrywide to convert its charter and become an S&L in order to avoid a potential enforcement by the somnolent Office of the Comptroller of the Currency (OCC).  Dochow finally had to be asked to leave when he was caught agreeing to allow IndyMac (which, like WaMu, specialized in making “liar’s” loans) to backdate documents to inflate its financial “strength.”

Learn from History or Repeat It

Jumping to the present, how many criminal referrals did OTS make in current crisis?  Zero – during what the FBI aptly described in September 2004 as an “epidemic” of mortgage fraud that would cause a financial “crisis” if it were not contained.  Gray, Patriarca, Ryan, and Weinstein were all available to the second President Bush (and Obama) to use their expertise, integrity, and vigor to clean up the Stygian stables of the fraudulent and systemically dangerous institutions (SDIs) that drove this crisis.  They are all available now, as are many of the people that helped these leaders clean up the industry.  Patriarca and Ryan are young enough to serve as full time regulatory leaders.  To my knowledge, the Bush II and Obama administrations have not drawn on the expertise of any of these leaders or their principal lieutenants, who led the successful struggle against prior epidemics of accounting control fraud, to implement an effective response to this crisis.

What would it take for the Geithners and Holders of the world to admit that allowing control fraud to occur with impunity is insane and that they should learn from people with a track record of success, integrity, and courage?  Geithner, like “M.Danny Isuzu Wall,” is still pretending that he “resolved” the crisis at virtually no cost and kvetching that the world doesn’t applaud his genius.  Like the Wizard of Oz, he demands that we: “ignore the man behind the curtain,” i.e., the man holding the liar’s loans at Fannie and Freddie, that will cause hundreds of billions of dollars of losses, the man at the Fed with hundreds of billions of dollars of losses on fraudulent mortgage paper pledged to Fed (which the Fed will eventually dump on Fannie and Freddie – which is to say, the Treasury), and the men holding the hundreds of billions of dollars of unrecognized losses among the SDIs.  Geithner’s con has only fooled one person.  Unfortunately, the man that fell for the Geithner con is President Obama, he of the infamous “man crush” for the admitted tax evader he appointed to be in charge of our nation’s tax collection.

Eventually Truth Will Out

The story of why the S&L debacle did not lead to a general financial crisis is a story of an agency head and staff identifying the coming crisis through an “autopsy” process of reviewing every failure and looking for patterns.  The agency head then rose above his long-held anti-regulatory perspective and abandoned business as usual in favor of simultaneous emergency responses in multiple dimensions.  The agency’s analytics proved superb and its remedies proved effective.  The head of the agency recruited strong, competent leaders with great integrity.  Many of those regulatory leaders paid a high personal price for their successful work in preventing the debacle from becoming a systemic economic crisis.  Gray’s regulators were sometimes crushed during Wall’s tenure but their blood was always on the front of their shirts as they interposed themselves between the frauds and their political patrons on one side and the American people on the other.

There are several lessons from the S&L mess, but, first and foremost, regulators can easily be captured by the industry they regulate. This was clearly the case with the Bank Board.

It would be difficult to find a regulatory agency that was more clearly not captured by the industry than the S&L regulators under Gray and Ryan.  The reason Keating and the other S&L control frauds had to go to such extraordinary lengths to try to crush the agency was that the agency was the industry’s most bitter and successful opponent.  Superficially, one might think that the agency was captured by the industry under Chairman Pratt or Wall’s terms of office, but that too would be incorrect. Mutual loathing was consistent between the four successive heads of the federal S&L regulatory agency and the S&L trade association during the years of  regulatory battles.  Yes, the industry supported financial deregulation, as did Pratt, but his worship of deregulation was due to his ideological and policy views.  Pratt refused to grant the industry its dearest dream – the ability to create massive fictional accounting income and capital without S&L mergers.  When an administration appoints anti-regulatory leaders as its top financial regulators there is normally no need for the industry to “capture” the regulator.  Gray is one exception that proves the rule.

The same is true of the essential role that Office of Thrift Supervision (OTS) Director Tim Ryan, and his chief counsel, Harris Weinstein, played in the successful enforcement, civil action, and prosecution of the elite criminals that drove the second phase of the S&L debacle.

Parallel Processes:  Pratt and Geithner

The alert reader will find familiar the regulator’s use of accounting scams and hidden tax and Fed subsidies to claim victory – which turns inevitably to disaster.  Timothy Geithner (left) is now infamous for emulating Pratt’s one-two punch – use accounting scams to hide the losses and claim that your policies have “resolved” the crisis at virtually no cost.

Our earlier discussion showed how wrong Pratt proved to be, and why we study and emulate Gray’s successful policies.  Gray, in his day, was even more successful than Bair in our current FDIC regulatory era, and he succeeded in an impossible environment.  The second installment will also demonstrate why Geithner’s claims that he resolved the ongoing crisis for far less than the costs of resolving the S&L debacle are absurd.  Gray’s and Timothy Ryan’s policies actually resolved the S&L crisis instead of emulating Pratt’s use of accounting scams to claim that he resolved a crisis at trivial cost.  Geithner has not resolved the ongoing crisis, but he has sown the seeds for the next crisis.  His claims that he has resolved the current crisis for far less costs than was the case for the S&L debacle is simply absurd!

When You Care Enough to AVOID Sending the Very Best

Through the last three administrations we have seen the consequences of not sending the very best into the ranks of regulatory leadership.  There were times during the Civil War in which thousands of men’s lives were thrown away because their senior officers were incompetent political hacks.  Why do we routinely send incompetent political hacks and the equivalent of “flat earth” anti-regulatory ideologues to be our regulatory leaders and then blame “regulation” for the disaster?  Even the Soviets figured out that one of the secrets of success was to “never reinforce failure.”  We promote our failures and give them presidential medals.  The high priests of theoclassical economics and their legal and economics acolytes will always fail as regulators.  They are trained to create and worship intensely criminogenic environments, and not to correct them.

It is vital to keep in mind that these are after the fact remedies.  It is vastly more important for financial regulators to understand accounting control fraud mechanisms and patterns so that they can identify and take regulatory action that will prevent the next crisis.  Patriarca’s actions to end liar’s loans in by Orange County S&Ls (taken while Ryan was Director) are a classic example of how successful a regulator can be when it understands the need to function as a “cop on the beat” and prevent the Gresham’s dynamics that drive fraud epidemics.  The same actions show one of the important lessons of regulation.  No one builds a bank vault and then puts an unguarded and unlocked hole in it, but our anti-regulators constantly seek to achieve the equivalent by creating financial regulatory systems that are designed to fail.  The Fed had unique authority under HOEPA to close all of these regulatory black holes.  Alan Greenspan and Ben Bernanke refused to do so.  If Gray, Ryan, Patriarca, or Weinstein had been in charge there would have been no epidemic of mortgage fraud, no crisis at Fannie and Freddie, no overall financial crisis, and no Great Recession.  (I’m not suggesting they had the power to end recessions and business cycles, but competent, responsible regulators can certainly reduce risks that explode into disasters.)

Heroes and Villains Don’t Have Only One Political Label

I do not know whether you, the reader, has focused on the politics of the leaders I have been praising.  Gray and Ryan are Republicans.  I worked for years with Patriarca and Weinstein and do not know their political affiliation.  It never mattered to us.  We despised the elite frauds and their professional and political toadies regardless of their party.


This article is dedicated to Sheila Bair.  The background for the article here came from three columns posted at New Economic Perspectives and Benzinga:

If you like Sheila Bair you’d love Ed Gray and Tim Ryan – Part 1

If you liked Sheila Bair, You Would Have Loved Ed Gray and Tim Ryan:  Part 2

If you liked Sheila Bair you would have loved Ed Gray and Tim Ryan – Part 3

From one of those articles:

Sheila Bair, FDIC Chair, has justly reserved praise for her service.  Here willingness to support meaningful regulation distressed the Obama administration (and would have enraged the Bush administration).  Without in any way diminishing her accomplishments it is important to understand that regulation has become so pathetic that Bair’s actions seem to be the zenith of regulatory vigor.  We live in a time when even progressives have given up on regulation.  Effective financial regulation is not only possible but essential if we are to avoid suffering recurrent, intensifying financial crises.  We need to insist that regardless of the party in power the financial regulatory professionals are supported in accomplishing their prime mission – serving as the regulatory “cops on the beat.”  Only regulatory cops on the beat can break the “Gresham’s dynamic” that accounting control fraud causes that can produce fraud epidemics, hyper-inflate bubbles, and cause financial crises.


None of this history comes through in the recent article that (correctly) observes that the S&L debacle has important lessons for understanding the causes and appropriate responses to the ongoing crisis.  The full citation to the published article (available free on line through the author’s web page) is:  Manufacturing Tail Risk: A Perspective on the Financial Crisis of 2007–2009.

By Viral V. Acharya, Thomas Cooley, Matthew Richardson and Ingo Walter

Foundations and Trends in Finance Vol. 4, No. 4 (2009) 247–325


The authors incorrectly state that deregulation began at the federal level instead of the reality that the federal deregulation was modeled on Texas’ earlier deregulation.  The authors do not distinguish between the Bank Board Chairmen.  The article talks about the large number of newly chartered S&Ls but misses the fact that Gray denied hundreds of them deposit insurance and they never opened.  They do note correctly that the industry fought bitterly to prevent the recapitalization of the FSLIC insurance fund and they seem to understand that the agency’s goal was to use the proceeds to close hundreds of failed S&Ls.  The authors’ imply that S&Ls took steps that caused most of their losses primarily late in the process after they became “zombies” (the walking dead) and their managers developed perverse incentives to make honest gambles for resurrection.  This is contrary to the facts.  First, the agency developed and used techniques to place insolvent S&Ls in receivership that required relatively little upfront cash.  Second, the agency restricted growth, so the ability of zombies to increase their risk exposure was limited by regulation.  Third, the agency adopted a far more stringent examination and supervision regime beginning in 1983, so over time (during Gray’s tenure) even most fraudulent S&L were increasingly constrained rather than becoming “banks gone wild.”  Fourth, the agency often prioritized the fastest growing insolvent S&Ls for enforcement and receiverships.  Fifth, the incentive for S&Ls to engage in fraud generally had nothing to do with the S&Ls being zombies.  The opposite was true – it was the healthiest S&Ls, the de novos, that were far more likely to engage in accounting control fraud than traditional S&Ls that had been insolvent on a market value basis for several years.  Traditional S&Ls were all insolvent in early 1982, but only a small percentage of them became “high flier” frauds.  The percentage of frauds among Texas and California chartered de novos was far higher because the new S&Ls were typically created and operated by real estate developers with intense conflicts of interest.

The reregulation of the industry by the regulators began in 1983.  The statutory reregulation of the S&L industry began only six years later in 1989.  Absent the regulatory actions there would have been a systemic crisis, but the authors of the article draw the opposite conclusion.  They do so contrary to the facts and without citation.

Related Articles

Analysis Blog articles by William K. Black

Opinion Blog articles by William K. Black:

About the Author

William K. Black is Associate Professor of Economics at University of Missouri, Kansas City.  From 1990-1994 Prof. Black was Senior Deputy Chief Counsel, Office of Thrift Supervision, which was formed in 1989 to supervise the thrift industry following the Saving & Loan crisis.  He is the author of the widely acclaimed book “The Best Way to Rob a Bank is to Own One.”  Full bio here.

2 replies on “Why was the S&L Crisis not a Systemic Economic Crisis?”

  1. The power of Bill’s writing flows from the fact he has “been there”. He knows all the names and remembers clearly who did what, and when. Bill is a slayer of kleptocrats (though he humbly neglects to identify himself as one of the “white knights” of sane regulation), and for that we owe him our gratitude and encouragement. Because of men (and women) like Bill the S&L perpetrators did not “get away with it”. Is it too much to hope that the perpetrators of the current crisis will see similar justice?

Comments are closed.