It is estimated that the cost of the savings and loan debacle will cost taxpayers $183 million plus interest. Actions taken by Congress and regulators, as well as regulatory accounting principles (RAP), have been widely cited as major contributing factors for having "misled" and "masked" the speed and extent of the financial deterioration of the thrift industry. A greater understanding of the magnitude and manner in which the actions of Congress and regulators and the use of RAP contributed to the severity of losses suffered by the thrift industry might help those trying to sort out what went wrong.

Although innumerable variables affected the severity of losses suffered by the thrift industry, there were four major legislative and regulatory policy objectives:

1. Enhance both the short-term and long-term economic survival of the thrift industry by reducing the industry's exposure to interest rate risk through asset diversification;

2. "Bide" time for legislative and regulatory efforts to affect an economic recovery by facilitating the avoidance of violations of capital requirements by troubled thrifts which would result in regulatory supervision and/or dissolution ("forbearance");

3. Encourage "leveraged" asset growth through debt financing; and

4. Halt and prevent the massive withdraws of funds by depositors (dis- intermediation).

The Traditional Role of the Savings and Loan Institution

Traditionally, the thrift industry included savings and loan associations and mutual saving banks (sometimes credit unions). The principal activity of the thrift industry was to promote home ownership by providing low-cost mortgage financing. Thrifts commonly distinguished from commercial banks as they were regulated by different agencies and were insured by different insurance corporations. In addition, the balance sheet of thrifts contained different assets and liabilities. The thrift industry was regulated by the Federal Home Loan Bank Board (FHLBB) and deposits were insured by the Federal Savings and Loan Insurance Corporation (FSLIC).

Thrifts sought funds from depositors in the form of savings accounts and other short-term liabilities. These funds were then loaned to finance the purchase of residential housing through fixed-rate mortgages (long- term assets). The economic survival of the thrift industry depended upon the return on assets (ROA) being greater than the cost of funds (COF). ROA largely reflected the level of long-term interest rates on fixed rate mortgages which were established years earlier. The COF was the rate of interest paid to depositors on savings and short-term time deposits, which reflected current short-term interest rates.

Enhancing Economic Viability

One of the most far-reaching policy decisions of regulators was the decision to enhance the economic viability of the thrift industry by reducing interest rate risk through asset diversification.

Interest rate risk is the risk that changes in interest rates result in operating losses and/or decreases in the market value of assets. The exposure to interest rate risk for thrifts was twofold. If the short- term COF increased above the ROA, thrifts could do little in the short run to reduce losses, since ROA was tied almost solely to long-term fixed-rate mortgages. Secondly, if interest rates were to increase, the market value of the mortgage portfolio would decrease, since the fixed cash flows represented by mortgages are discounted by the market using a higher discount (interest) rate. In such a scenario, losses would be realized if a thrift were forced to sell a portion of the mortgage portfolio by the need to increase its cash holdings. Compared to banks, thrifts were particularly vulnerable to interest rate risk due to a lack of diversification in both the type and maturity of their assets.

Due principally to inflationary pressures, interest rates started to rise. The increase in the COF from 7% in 1978 to 11% in 1982 resulted in catastrophic loses in 1981 and 1982 when the COF exceeded ROA. Legislative and regulatory actions were later initiated to enable thrifts to diversify their assets beyond a portfolio of long-term fixed- rate mortgages. Congress responded with the Depository Institutions Deregulation and Monetary Control Act (effective March 31, 1980) which allowed thrifts to invest up to 20% of their assets in a combination of corporate debt securities, consumer loans, and commercial paper. Another 3% of the assets could be invested in service corporations. The Garn-St Germain Depository Institutions Act (October 15, 1982) permitted even greater diversification. This Act allowed investment in the following assets: commercial, corporate, business, or agricultural loans (10%), consumer loans (30%), loans secured by non-residential real estate (40%), and personal property (10%). Given the investment alternatives described above, diversification of assets for the thrift industry meant diversification into assets of greater inherent risk. Lastly, as thrifts moved into unknown lending areas, the risk of investment in unsound assets also increased.

A Policy of Forbearance

To provide the thrift industry with enough time for deregulatory efforts to achieve a recovery, regulators adopted a policy of "forbearance." Through a number of methods, regulators facilitated the avoidance by troubled thrifts of violations of capital requirements that trigger regulatory supervision and/or liquidation.

Reduction of the Capital Requirement.

Historically, the FHLBB required net worth be at least 5% of assets. (The terms "net worth," "capital," and "equity" are used interchangeably and refer to regulatory capital unless otherwise noted.) Capital requirements act to moderate the growth rate of assets as well as provide a cushion of safety for depositors and other creditors. RAP were used to calculate regulatory net worth, the difference in RAP net worth versus net worth calculated using GAAP ranged from significant to extreme.

The FHLBB reduced the minimum capital requirements from 5% to 4% in November 1980, and then to 3% in January 1982. The immediate result of reduced capital requirements was that many troubled thrifts could avoid, or at least delay, becoming technically insolvent, thus avoiding related consequences. However, in the long run, thrifts that ultimately became bankrupt were in greater financial ruin for having been allowed to operate longer and suffer even greater losses.

In December 1972, the FHLBB adopted a special provision which allowed the minimum capital requirement to be calculated as an average of liabilities and deposits over the five-year period comprising the year of calculation and the preceding four years, rather than on current liabilities and deposits. This provision drastically lowered capital requirements for those thrifts that had expanded most aggressively.

Another provision adopted provided for a reduced net-worth requirement for thrifts that had been chartered for less than 20 years. Under this provision, the capital requirement for relatively new thrifts was calculated by multiplying the existing capital requirement (which was 3% to 5% depending on the time period) by the fraction of the 20-year period the thrift had been covered by deposit insurance. In the most extreme scenario, a thrift in its first year of deposit insurance could reach a debt-to-equity ratio of 666 to 1 (3% capital requirement x 1/20). The FHLBB began phasing out both the five-year averaging and the 20-year phase-in provisions in March 1985.

Inclusion of Certain Promissory "Certificates" in the Calculation of RAP Net Worth. In 1981, the FHLBB allowed thrifts to include income and capital certificates and mutual capital certificates in the calculation of RAP net worth. These certificates were issued by the FSLIC in exchange for promissory notes from weakened thrifts. In 1982, similar net worth certificates were introduced. These regulatory actions further cheapened the capital requirement and reduced once again the number of RAP-insolvent thrifts or thrifts subject to supervisory control. By permitting nearly insolvent thrifts to remain open, the FHLBB encouraged excessive risk-taking by thrifts trying desperately to save themselves.

Lax Enforcement of Net-Worth Requirements. Another factor which enabled troubled thrifts to avoid regulatory supervision or dissolution was inadequate staffing of regulatory enforcement bodies during the early 1980's, the period in which the thrift industry experienced intensive growth. As an example, during the period form 1980 to 1985, the number of FSLIC field examiners declined. In 1980, there were 700 examiners to handle 297 troubled thrifts. By 1985, the number of examiners declined to 679 while the number of troubled thrifts more than doubled to 791.

These regulatory efforts to reduce net worth requirements, (some of which were overt, some relatively covert) effectively postponed the closing of failing thrifts, allowing them to further deteriorate. However, these actions had an even more profound impact on the ultimate severity of losses suffered by the thrift industry; namely, the ability of industry to experience unprecedented growth.

Leveraged Asset Growth Through Debt Financing

A number of actions taken by legislators and the FHLBB not only enabled thrifts to experience unprecedented growth of assets but also provided incentives. Traditionally, regulators used percentage capital requirements to restrict the extent to which assets could be acquired through debt financing and to provide incentives for prudent investment management.

Ability to Grow Through Debt Financing. For thrifts to grow through debt financing, they had to be able to both attract and accept additional customer deposits. The previously described regulatory actions, which effectively reduced the capital requirement, directly enabled thrifts to increase their level of debt; this enabled thrifts to accept additional deposits from customers. However, these regulatory actions did not enable thrifts to attract new deposits. In 1980, legislation was passed that enabled thrifts to attract additional deposits by allowing them to pay more competitive rates of interest to depositors via the elimination of Regulation Q and by increasing FSLIC insurance coverage from $40,000 to $100,000 per account. These additional deposits, coupled with a higher leverage ratio, fueled the unprecedented growth of thrift assets.

Incentives. Several important incentives contributed to the tremendous growth of assets. First, the possibility of achieving greater profitability through leveraged growth provided financially troubled thrifts with a potential remedy. Secondly, the possibility of generating large profits with the use of government guaranteed deposits is even more appealing when only a small amount of equity is at risk. Lastly, FSLIC did not adjust insurance premiums to reflect the additional risk attributable to the use of leverage, i.e., the insurance rate structure permitted highly leveraged thrifts to do business "at no additional cost."

Halt and Prevent Disintermediation

The Banking Act of 1933 established Regulation Q which prohibited the payment of interest on demand accounts and limited the rate paid on saving deposits. Thrifts were not subject to Regulation Q until 1966. The rate ceilings placed on thrifts were higher than those imposed on commercial banks.

The Problem. In the 1970's, regulatory constraints (such as deposit rate ceilings, portfolio and liability restrictions, capital requirements, reserve requirements, and loan restrictions) stimulated growth in innovative products offered by non-regulated financial intermediaries such as money market mutual funds. Not subject to rate ceilings and reserve requirements, these funds were able to offer a higher rate of return to the investor, which ultimately proved to be a huge drain of deposits from thrifts which were prevented by Regulation Q from raising rates to depositors.

The Remedy. To provide relief from such disintermediation, the FHLBB in 1978 permitted thrifts to offer six-month money market certificates in $100,000 denominations at rates slightly above U.S. Treasury bills of the same duration. In 1980, the Depository Institutions Deregulation and Monetary Control Act provided for the phasing-out of deposit interest rate ceilings. The Garn-St. Germain Depository Institutions Act of 1982 further enabled thrifts to compete for funds by authorizing depository institutions to offer money market deposit accounts with no rate ceiling. Although these legislative efforts eventually alleviated the problem of disintermediation, they caused some undesirable side effects.

Side Effects. The ability to increase rates paid to depositors, coupled with competition from non-regulated intermediaries, increased the cost of funds to thrifts. In turn, a higher return on assets was required to cover the increased cost of funds; this provided an incentive for thrifts to seek and diversify into higher-risk assets. Also, as previously discussed, the ability to pay competitive rates of interest enabled thrifts to attract new deposits and this, coupled with the increased leverage driven by reduced capital requirements, led to the unprecedented growth of thrifts' assets financed by debt.

An Inside Look at RAP

Regulatory accounting principles and interpretations authorized by the FHLBB during the late 1970's and the 1980's have been harshly criticized by a wide spectrum of observers as there were extreme differences regarding the solvency of the thrift industry as depicted by GAAP versus RAP. The more controversial accounting techniques authorized by the FHLBB to support one or more of their regulatory policy objectives are discussed below.

Construction Loan Fees. Before 1979, recognition of income from construction loan fees was the same under RAP and GAAP; i.e., immediate recognition for the loan fee only to the extent of costs incurred in originating the loan. The balance of the fee was taken into income ratably over the life of the loan if it remained current, or upon sale.

In 1979, the FHLBB authorized thrifts to immediately recognize at date of closing income from loan fees equal to 2.5% of the loan, plus $400. For example, on the closing date of a $10 million construction loan, the thrift would recognize $250,400 in loan fee income |$10 million x .025 + $400 which would increase capital by the same amount and could then support additional leveraged assets.

Deferral of Losses on Sale of Loans. Traditionally, thrifts have held large asset portfolios of long-term mortgages which are carried on balance sheet at cost. The high interest rates prevalent in the early 1980's forced the market value of these assets to drop significantly below book value. Under GAAP, the sale of such loans at a "discount" would require the immediate recognition of a loss.

To encourage thrifts to diversify their portfolios, the FHLBB passed a resolution in October 1981 which allowed thrifts to sell such low- interest, long-term mortgages and record the entire amount of the related losses as assets. These deferred losses could then be amortized over the remaining contractual life of the mortgages whose sale generated the related deferred losses. In addition, the sale of old loans generated significant tax benefits, since the related realized losses were tax-deductible.

As of December 31, 1985, such deferred losses exceeded $6.3 billion, or 13% of reported regulatory net worth. This deferral of $6.3 billion of losses permitted by RAP could be leveraged to support $210 billion in assets at a capital requirement of 3%.

Appraised Equity Capital Under GAAP, capital assets such as property and equipment are valued at cost less accumulated depreciation; any increase in market value above book value is recognized only when sold. In 1982, the FHLBB authorized thrifts to include in the calculation of regulatory net worth any appreciation in the market value of property and equipment above book value. Not only was the inclusion of such unrealized gains a clear departure from GAAP, it also was particularly inconsistent with RAP treatment of unrealized losses related to the investment portfolio, which were not recognized for any purpose until realized. Again, this change in RAP helped troubled thrifts avoid technical insolvency and/or provided for additional growth, as each dollar of appraisal capital could be leveraged to support as much as $33 of additional assets financed through debt. Before this rule was rescinded on December 31, 1986, appraised equity capital constituted regulatory net worth of approximately $2.2 billion, about 4% of regulatory net worth at that date, which could be leveraged to support over $65 billion of additional growth in assets.

Liberal Interpretations of GAAP

Creative uses of Goodwill. Faced with a record number of failing thrifts and a dwindling fund balance with which to close these thrifts, the FHLBB encouraged the acquisition of insolvent thrifts by thrifts that were solvent, at least from a regulatory standpoint. Consider the following scenario: A troubled thrift has the following book and fair market values (FMV) (in millions) before it is acquired:

CostFMV

TotalAssets$882$650

TotalDebt900900

TotalEquity(18)(250)

Assuming no other consideration for the purchase, under GAAP, the entry to record the acquisition by the purchaser is:

Goodwill(plug)$250

Assets(FMV)650

Liabilities(FMV)$900

This scenario raises two questions: 1) Why would a buyer execute an arms-length transaction which appears to result in an immediate $250 decrease in the tangible value of the buyer's firm and 2) What does goodwill represent in this situation?

Regarding the first question, this seemingly irrational behavior is understandable given the "non-monetary" incentives provided by the FHLBB in terms of forbearance. First, the FHLBB allowed the acquiring thrift to include the purchased goodwill in its calculation of regulatory net worth. Ironically, the greater the negative fair market value of the acquired thrift, the greater would be the amount of so-called "goodwill" and the related increase in regulatory capital. These opportunities to increase capital were particularly appealing to many potential buyers who were insolvent themselves on a market-value basis. In some cases, acquiring thrifts obtained explicit forbearance agreements from the FHLBB. Buyers of insolvent thrifts also understood it would be embarrassing for the FSLIC to arrange a merger, applaud it publicly, and put the new entity into receivership soon afterward.

The fact that deposits were guaranteed by the FSLIC provided another incentive for the acquisition of insolvent thrifts by other troubled thrifts, since there was no risk of further loss for the buyer's owners. Such thrifts had every incentive to take extreme risks (including the acquisition of insolvent thrifts) which promise the possibility high yields. If the gamble paid off, the owners of the thrift captured all the profit; if the gamble failed, the FSLIC or the FDIC paid for the loss. Finally, the quick growth of assets achieved by mergers provided executives of the acquiring thrift an opportunity for personal financial gain; running a larger thrift justified higher salaries and bonuses.

The regulatory incentives described above provide some rationale concerning the willingness of buyers to acquire thrifts that had a negative market value. It also provides some insight into the nature of the "goodwill" itself. These incentives were, in substance, regulatory "breaks" delivered under the banner of additional forbearance. The nature of such "purchased forbearance" raises some troubling questions concerning the legitimacy of the asset (goodwill) when it reflects the "cost" of additional forbearance.

Amortization of Goodwill and the "Discount." To facilitate the purchase of troubled thrifts, another regulatory incentive was created through a liberal interpretation of GAAP. Assets acquired by the purchaser are mortgages which represent fixed cash flows. The difference between the fair market value (present value) and book value (principal amount), represents income to be recognized over the life of the mortgage by the purchaser. GAAP allowed such income (the "discount") to be amortized and recognized over the life of the asset using the interest rate method. The average life of such purchased assets was 10 years.

Prior to 1981 under RAP, goodwill could be amortized over a period of not greater than 10 years. In August 1981, the FHLBB eliminated the 10- year limit. Consequently, some thrifts indiscriminately used the 40-year maximum period allowed by GAAP. The amortization of the discount over a 10-year period using the interest rate method (which amplifies income recognition in the early years), matched with the amortization of goodwill on a straight-line basis over 40 years created earnings which have been described as "purely imaginary."

Equally important, treating the negative net worth of the acquired thrift as "goodwill" had the effect of increasing the overall capital of the thrift industry by eliminating the capital shortage of the insolvent acquired thrift. In 1982 alone, over $15 billion in goodwill was created in purchase transactions, thereby enabling thrifts to maintain approximately $500 billion in deposits and to make an equivalent volume of loans without a single dollar of tangible capital investment. In that year, goodwill as a percentage of total industry GAAP capital rose from 6% to approximately 82%.

The Phoenix Rises. Specific types of transactions were structured to take advantage of these accounting practices. Thrift regulators had difficulty finding financially sound buyers for insolvent thrifts as the number of insolvent thrifts rapidly expanded. In what was referred to as a "phoenix" transaction, regulators selected several thrifts, all of which usually were insolvent, and designated one of the insolvent thrifts as the purchaser of the others. By applying the RAP purchase accounting and the treatment of goodwill described above, the new thrift formed by the combination (although economically insolvent) immediately generated reported profits.

No Shortage of "Moral Hazards"

Critics of the thrift regulatory apparatus often highlight what economists refer to as "moral hazards." In this context, moral hazards are policies or situations which provide incentives for regulators or thrift managers to act in an imprudent, unethical, or reckless manner.

It is widely recognized that from their inception in the 1930's to their demise in 1989, the FHLBB and the FSLIC were heavily influenced by the thrift industry and its congressional representation. The influence of the thrift industry upon its regulators has been cited as a prime example of a regulatory agency being "captured" by the industry it purports to regulate.

The FSLIC has also been criticized. Unlike the FDIC, which is under the control of an independent board of directors, the FSLIC was controlled by Congress, which must approve funds for examinations and other enforcement activities. The political clout wielded by both the thrift and real estate industries may partly explain Congress's reluctance to authorize funds for the FSLIC's enforcement activities and its lack of enthusiasm for regulatory reform.

At the regulatory level, critics have observed a blatant conflict of interest between the FHLBB and the FSLIC (which was a part of the FHLBB). A high priority of the FHLBB was the survival of the thrift industry. A high priority of the FSLIC was the survival of the FSLIC, which often required the speedy closing of ailing thrifts to reduce damages. The fact that board members of the FHLBB also are required to be directors of the FSLIC created a fundamental conflict of interest. FHLBB members, in effect, wore two hats--guardian of the thrift industry as well as guardian of the public trust.

Other moral hazards existed regarding the structure of insurance premiums and related government guarantees. The incentive for managers to engage in speculative investments was bolstered by the FSLIC's policy of charging one flat insurance rate regardless of the riskiness of the insured assets. Insured depositors have no incentive to monitor the thrifts' activities, because their deposits are insured. Another moral hazard exists when state chartered thrifts are insured by federal deposit insurance; states determine allowable investment activities and the related risk taking even though the states do not stand to bear the cost of their actions. Lastly, the reduction of reserve requirements, coupled with ability to invest in higher-risk investments, created a synergy of several moral hazards. This ability to pursue leveraged growth with less "at risk" capital made speculative investments even more attractive, especially to ailing thrifts.

End of the Charade--FIRREA

As a legislative mea culpa, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act of 2989 which eliminated both the FHLBB and the FSLIC. The regulatory function was transferred to the Office of Thrift Supervision, a new bureau within the Department of the Treasury. The insurance function was transferred to the FDIC. FIRREA also created the Resolution Trust Corporation to handle the disposition of failed thrifts. In most situations, FIRREA reinstated the capital requirement to 6% and requires the use of GAAP for thrift financial reporting and the calculation of capital requirements. It also banned the type of agreements used in purchase transactions of insolvent thrifts. As a result, the government has now seized many thrifts that were considered solvent only because of their RAP goodwill. Some of these thrifts are litigating the matter including suing for damages. The story continues.

James J. Tucker, III, PhD, CPA and Abroad W. Salam, PhD, are professors at the School of Management, Widener University.